Levy Economics Institute of Bard College

Strategic Analysis
December 2011
IS THE RECOVERY SUSTAINABLE?
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Fiscal austerity is now a worldwide phenomenon. The United States and many other countries
are essentially importing fiscal austerity from troubled economies in Europe and elsewhere. This
is one way of looking at the predicament posed by the current world growth slowdown, which
has developed during Americas weak recovery from the 200709 recession. Following the finan-
cial collapse of perhaps four countries in Western Europe, US companies will not find much
demand for their products abroad, since few of the affected countries will be able to implement
appropriate stimulus measures within a year. Rather, countries such as Greece, Portugal, and
Ireland are being forced to implement austerity measures as a condition for receiving interna-
tional loans and bailouts, and some staggering giants such as the United Kingdom, Spain, and
Italy are making deep budget cuts of their own.
Unfortunately, even before the collapse of the Greek and Italian governments, and the deba-
cle in the relatively large Italian bond market, forecasters were predicting weak economic growth
in most of the world in the coming months and years. Figure 1 corresponds to International
Monetary Fund (IMF) growth-rate forecasts for this year and next for some of the largest nations,
certain economic blocs, and the world. The 2011 forecast for the eurozone is less than 2 percent
among the worst of the forecasts depicted in the figureand the IMF expects the region to expe-
rience even slower growth of 1.1 percent next year (the European Unions own forecast for its
member countries is a grimmer 0.6 percent [Dalton 2011]). Overall, the advanced economies will
grow at a 1.9 percent annual rate next year, according to the IMF numbers.
Although the IMF expects a modest uptick in growth rates for many countries in 2012, the
important point is that many of the largest countries are already in an abysmal slump, even as the
euro debt crisis intensifies and spreads. Moreover, as seen in the figure, even the economies of the
developing world, which grew the most quickly last year, are expected to slow down at least mod-
estly in 2012. Finally, some more recent forecasts are even less optimistic. In new figures released
The Levy Institutes Macro-Modeling Team consists of President nixi1vi n. v.v.nixi1viou and Research Scholars cvvc u.xxscvx
and cvxx.vo zvzz.. All questions and correspondence should be directed to Professor Papadimitriou at 845-758-7700 or dbp@levy.org.
of Bard College
Levy Economics
Institute
late last month, the Organisation for Economic Co-operation
and Development projected economic growth in the euro-
zone at 1.6 percent in 2011 and 0.2 percent in 2012 (OECD
2011). All official forecasters seem to recognize, if belatedly,
the implications of the deepening European fiscal crisis and
related economic problems around the world.
Growth abroad is helpful to faltering economies, so the
international slowdown documented by these forecasts is very
unfavorable for the outlook of policymakers at the national
level. In these conditions, it will be hard for the United States
to turn a huge trade deficit into even a moderate one without
transforming US industry into an export leader, as Japan,
Korea, and other Asian nations did in the last half of the 20th
century. This kind of industrialization has been a rare feat in
world economic history, and it is unlikely that more than a
handful of countries will follow in the footsteps of Japan and
other export-oriented, late-developing economies. To the
extent that more countries adopt an export-led growth strat-
egy, they may accomplish little more than drawing a small num-
ber of scarce customers away from other exporting nations,
which will also be counting on exports to lead domestic growth.
IMF figures support this point of view.
2 Strategic Analysis, December 2011
Figure 2 shows the current account balances for all trading
nations and economic blocs over the period 200016. The
bars below the horizontal line correspond to deficits; the bars
above the line represent surplus countries and blocs. Since the
deficits and surpluses of all countries add up to zero, the stack
of bars above the line is equal in length to the stack beneath it.
The gray bars, which depict US deficits for all the years shown
in the figure, shrank markedly during the recession of
200709; last year, the deficit once again began increasing. The
IMF predicts a further reduction in the US current account
deficit through 2013, followed by a renewed expansion of this
drain on demand for US products beginning the following
year. Through 2014, the US deficit is expected to fall from
$468 billion to $273 billion. This would amount to a reduc-
tion in the current account deficit of $194 billion, or about 1.3
percent of the approximate US GDP of $15 trillion. The cur-
rent shortfall in aggregate demand from the private, public,
and foreign sectors combined is far larger than this. The US
Bureau of Economic Analysis estimates that GDP was 6.8 per-
cent below its potential level in the third quarter of this year
(St. Louis Fed 2011).
While the IMF expects a lesser role for export-led growth
in China and Germany, it also expects other countries in
Figure 1 IMF Annual Real GDP Growth Forecasts
Source: International Monetary Fund (IMF) World Economic Outlook database
2011
2012
3 2 1 -1 0 4
Russia
Brazil
China
UK
Eurozone
United States
Advanced
World
India
Developing
Japan
9 8 7 5 6 10
Percent
Figure 2 Current Account Balances
Source: IMF World Economic Outlook database
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Rest of the World
Oil Exporters
Emerging Asia
Germany and Japan
Other Developed Countries
United States
2014 2012 2004 2000 2002 2016 2010 2006 2008
emerging Asia to rely on exports for growth, so that the over-
all level of global imbalances stabilizes. (Recent figures suggest
that the IMF may have actually underestimated the pace of
export growth in Germany, as that country is expected by
some observers to set all-time records for export volumes in
2011; see Parkin 2011). As implied in the chart, this would
require nations in the rest of the world to be willing to
absorb Asian imports by running a current account deficit.
Since it is hard to believe that other developing countries would
be able to sustain domestic growth with an external deficit on
this scale, the IMF projections may prove to be inconsistent
that is, overall import demand may be insufficient to enable the
worlds economies to achieve the growth rates projected.
To estimate the impact of an export-led growth policy
intended to reduce the US current account deficit, we ran a
simulation in which we assumed a 10 percent devaluation of
the dollar relative to a basket of currencies. Figure 3 shows the
three US financial balances (which, by accounting identity,
must sum to zero) and how each balance would change rela-
tive to a baseline in which the value of the dollar was held con-
stant through the end of the simulation period in the fourth
quarter of 2016. The uppermost line in the figure corresponds
to a simulated path for the current account balance. Following
Levy Economics Institute of Bard College 3
a one-time depreciation beginning next quarter, the line rises
throughout the simulation period but never surpasses +1.5
percent of GDP at any point. As we will see in a later section,
our baseline analysis shows that a far larger impetus to growth
is required to restore the economy to health.
Turning to the domestic private sector, signs of hope do
not abound even in markets for products such as paper tow-
els, wheat, and automobiles, although consumption is now
growing again in real terms. Figure 4 depicts the percent change
in consumption, personal disposable income, and wages, all
measured at constant prices and at an annual growth rate. It
is interesting to note that the effects of fiscal stimulus, in both
the 200102 recession and the recent Great Recession, are vis-
ible in the figure when disposable incomesustained by net
transfers from the public sectorgrows faster than wages.
The figure also marks the end of each of these two episodes,
with accelerating wage and disposable-income growth begin-
ning in 2003 and 2010. It is also evident that the effects of the
recent stimulus are now over, and with both real wages and
real disposable income stagnant in real terms, the increase in
consumption will either be temporarily sustained by an
increase in borrowing or possibly revised downwards with the
next, final release of GDP data from the BEA.
Figure 3 US Main Sector Balances: Effects of a Devaluation*
Source: Authors calculations
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External Balance
Private Sector Investment minus Saving
Government Deficit
2016 2014 2013 2012 2015
* Difference against baseline solution
Figure 4 Real Disposable Income, Wages, and Consumption
Source: Bureau of Economic Analysis (BEA)
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Consumption
Real Personal Disposable Income
Real Wages
2010 2005 2000 1990 1995
4 Strategic Analysis, December 2011
Some domestic demand growth may come from nonres-
idential investment. As shown in Figure 5, an increase in prof-
its in the nonfinancial business sector is usually followed by
an increase in investment, with a high correlation after a lag of
about six quarters. We therefore expect that the recent strong
surge in profits in this sector will sooner or later show up in
investment, which has started to pick up already. On the other
hand, profits in the financial industry have recovered from the
Great Recession and the financial crisis, but the correlation
between profits in this sector and gross investment is very
small. We therefore expect no net contribution to aggregate
demand growth from the financial sector, even if the major
US banks manage to emerge from the eurozone sovereign-
debt crisis in relatively good shape.
The lack of strong growth in demand has kept unem-
ployment at high levels since early 2009. The ratio of employed
people to the total population remains well below the levels that
were first reached as women entered the labor force in large
numbers in the 1970s and 1980s (Figure 6). Results from the
governments most recent (September) Job Openings and Labor
Turnover Survey show that there are about 3.4 million available
jobs (BLS 2011b), while 12.6 million Americans (5.6 million
women and 6.9 million men) reported to the Census Bureau
that they were completely unemployed and looking for work in
November (BLS 2011a). In that month, more than 5.6 million
people had been looking for work for 27 weeks or more.
Another 8.3 million were working part-time rather than full-
time for economic reasons.
Meanwhile, the sudden intensification of the euro debt
crisis in November led to an abrupt deterioration in con-
sumer sentiment and ripple effects in the domestic financial
sector. All of these developments have helped elicit more pes-
simistic US economic forecasts from all quarters.
Given this bleak situation in industries that must sell
their products to paying customers either at home or abroad,
further fiscal stimulus is in order. But as in Europe, a particu-
larly ill-timed round of fiscal austerity seems to be in prospect.
In fact, as a result, Washington may be in a situation as per-
ilous as the one that President Roosevelt faced in 193738
(Bartlett 2011; Krugman 2010). To wit, the lead-up to the
recession in those years began with a political defeat not
unlike the one suffered by congressional Democrats in 2010s
off-year election.
In 1936, having waged a bruising and largely unsuccess-
ful campaign on behalf of the Democratic Congress, Roosevelt
returned to the capital to find a more conservative mood. His
treasury secretary was advising sharp cuts in the deficit. It
appeared that strong growth had gained momentum, and the
financial and business establishment was anxious to put an
end to what it regarded as dangerous overspending. What fol-
lowed was a cut in government stimulus that could not have
been more decisive. The deficit, which had sharply increased
Figure 5 Profits and Investment in Nonfinancial Business
Source: BEA
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Gross Saving (lagged 6 quarters)
Gross Fixed Capital Formation in Equipment and Software
2010 2005 2000 1995
Figure 6 Employment as a Share of Working-age Population
Source: Bureau of Labor Statistics (BLS)
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1990 1980 1970 1950 1960
Note: Shaded areas indicate recession.
2000 2010
Employment
during Roosevelts first four-year term, plunged because of
deliberate and untimely policy actions. Specifically, federal
spending was cut by about 7 percent in 1937 and 11 percent
in 1938, while the introduction of payroll taxes for the new
Social Security program resulted in a tax revenue increase of
38 percent in 1937 and 24 percent the following year. The
ensuing rise in the government balance led, predictably, to a
new recession within the Great Depression, with growth turn-
ing negative in 1938.
Within a similarly hostile political setting, President Obama
was forced in July to agree to a set of automatic cuts to discre-
tionary spending amounting to a total of $1.2 trillion over a 10-
year period. These cuts were to go into effect if the congressional
supercommittee failed to come up with deficit reductions of a
similar size and secure their approval by Congress and the pres-
ident. With the supercommittee deadlocked over the appropri-
ate choice of spending cuts and tax increases, the automatic cuts
will begin to go into effect in January 2013, probably resulting in
massive layoffs of federal government workers.
Obamas most recent stimulus proposalwhich amounted
to $447 billion in deficit-neutral changes to taxes and spend-
ing programsfoundered on the congressional rocks. The
plan contained provisions for cutting corporate subsidies and
reforming the tax code that lent credibility to the administra-
tions description of the bill as deficit-neutral. In other words,
if passed without amendment, the bill would have paid for
itself. Keynesian theory suggests that the multiplier for new
spending that is exactly matched with new taxes is equal to one.
This means that $1 in new spending coupled with $1 in new
taxes raises overall GDP by $1. This plan has unfortunately
failed in Congress, where Republicans continue to insist on cuts
for larger businesses and wealthy taxpayers, as well as a virtual
ban on new spending. Only a few, relatively minor provisions in
the bill have made it through Congress so far.
Similarly, the main economic proposals offered by the
Republican presidential candidates purport to be revenue
neutral, leaving the deficit unaffected once both tax cuts and
increases are taken into account. The candidates plans for flat
taxes, sales taxes, and other tax reforms would further tilt
the burden of taxation toward the middle and lower classes.
Their positions tend toward cutting spending above all else,
regardless of the state of the economy and the labor market,
and their speeches hold out little hope that this anti-Keynesian
Levy Economics Institute of Bard College 5
approach would usher in prosperity or help the country grow
stronger in any other way. Rather, they rail against govern-
ment interference and the governments purportedly illegiti-
mate use of money for what the candidates inevitably regard
as frivolous expenditures. This emphasis contrasts with the
substance of the new American Jobs Act, which includes prac-
tical and simple approaches such as providing funds to help
localities avoid cutting police, firefighters, and teachers from
their payrolls (White House 2011).
But many groundbreaking and major projects also
remain undone, and they need to be done as soon as possible.
One only has to think of the nations potholed roads and mea-
ger disaster preparations to see that stimulus spending need
not be spending for spendings sake, or for the enrichment of
an elite. The American Society of Civil Engineers (ASCE)
tracks the nations efforts to keep ahead of the decay of its
bridges, roads, pipelines, drinking water systems, et cetera. In its
latest report, the ASCE (2009) gave US infrastructure low rat-
ings once again. Only one categoryenergyhas improved its
mark since 2005, and even this rating is a subpar D+. As one
example of the ASCEs concerns, the report estimated the
nations five-year shortfall in public infrastructure spending
at nearly $550 billion in the roads and bridges category alone.
Figure 7 shows that the United States has lagged behind
most industrialized countries in this regard. In other words,
we are high on the list of countries that have directed the most
resources toward boosting individual consumption and pri-
vate investment rather than constructing and maintaining
long-lasting public goods. The need for improved and better-
maintained infrastructure is seemingly evident to almost
everyone but the various political candidates vying to establish
their conservative bona fides in the struggle for the Republican
presidential nomination.
As a final example, how about investments in care work?
This term refers to labor-intensive services such as home
health care, preschool, and day care for children. Simply scal-
ing up a number of existing federal, state, and local govern-
ment programs could create new jobs in this area. These
include Head Start, which has never been fully funded; and
home-based care provided by Medicaid, which unfortunately
has lost its funding in some states. (See Antonopoulos et al.
2010 and Kim and Antonopoulos 2011.)
6 Strategic Analysis, December 2011
Thus, Keynesian stimulus need not involve make-work,
though simply putting people to work is relevant any time
there is a large supply of available and even desperate workers.
Rather, infrastructure work answers an important long-term
need. Also, researchers and ordinary Americans dont have to
look hard to find families in their own localities who badly need
help with child care, health care, and other labor-intensive
care work.
Right-wing economists claim to be able to show that the
government spending multiplier is less than oneeven when
selling bonds pays for the spending involved. Figures cited in
some of their opinion pieces in the press purport to show that
a $100 increase in government spending would decrease GDP,
or at best increase it by a few dollars (Barro 2011). Figures of
this type tend to be repeated in the media, but they lack a solid
basis in fact and logic.
It can be put no more plainly than by Princeton econo-
mist Alan Blinder in a recent newspaper article: In sum, you
may view any particular public-spending program as waste-
ful, inefficient, leading to big government or objectionable
on some other grounds. But if its not financed with higher
taxes, and if it doesnt drive up interest rates, its hard to see
how it can destroy jobs (2011). By definition, when the gov-
ernment hires people to work in the public sector or buys
goods from the private sector, it is undertaking economic
activity that counts as part of officially measured GDP. As
long as these activities do not cause the business sector to
reduce its total output of goods and services, they will imme-
diately increase GDP at least dollar-for-dollar as government
spending increases.
Moreover, it is hard to escape the conclusion that govern-
ment spending has an additional multiplier effect. Namely,
people who are hired by the government or by government
contractors tend to contribute most of their paychecks toward
household purchases, broadly defined. Hence, one would tend
to assume that the effects on GDP of a $100 increase in gov-
ernment spending would be a multiple of the original spend-
ing increase. For example, suppose that such a spending increase
leads to a $60 increase in the aftertax income of workers house-
holds. The household savings rate in the United States is cur-
rently about 6 percent, and has not been above 10 percent in
the last 20 years. Hence, it seems reasonable to propose that
government workers households would save roughly 6 per-
cent of a $60 increase in their paychecks, or $3.60. This would
leave $56.40 for new household purchases. Hence, including
first- and second-round effects, our hypothetical $100 stimulus
would increase GDP by a total of $156.40.
As suggested above, orthodox economic theory some-
times suggests that multiplier effects may be much smaller
than in this example (Barro 2011). Many economists believe
that households tend to save a much higher percentage of
increases in their incomes than 6 or even 10 percent. They argue
that unless people know their income will remain at an ele-
vated level for a fairly long time, they will increase their
household expenditures by much less than one dollar for each
dollar of new disposable income. They often use models that
rely upon the existence of a measurable human preference
to spread purchases out over ones lifetime. In behavioral
studies, such economic theories often prove inadequate as an
Source: OECD
Percent of GDP
3 2 1 0 4
Figure 7 Government Investment* in OECD Countries,
19952009
* Government expenditure on gross fixed capital formation
Australia
Belgium
Canada
Chile
Czech Republic
Denmark
France
Germany
Greece
Italy
Japan
Korea
Mexico
Netherlands
Norway
Poland
Portugal
Spain
Sweden
Switzerland
Turkey
UK
United States
Austria
5 6
OECD average (2.83 percent)
Levy Economics Institute of Bard College 7
explanation of observed consumer spending habits. For exam-
ple, many consumers will wait months for a much-anticipated
check to come in the mail before committing the funds repre-
sented by the check toward new purchases.
Many stimulus skeptics have gotten used to the idea that
the Federal Reserve is far better suited than Congress and the
president to deal with a lack of aggregate demand. In other
words, we should just lower short- and long-term interest
rates further and wait for the business sector to respond with
increased investment. Indeed, proposals for new types of
monetary policy stimulus continue to emanate from the acad-
emy, including nominal GDP targeting (Romer 2011). This
would be quite a departure from the Feds de facto practice
of informally targeting an acceptable range of inflation rates
and treating growth as a secondary objective. In general, the
academic literature is skeptical of claims that interest rate
changes substantially affect corporate investment. Hence, it
seems likely that the Feds actions are aimed at stocks and at
the housing market, where prices are still falling. Real price
indices for these markets are shown in Figure 8. It is clear
from the figure that the economic progress since the official
end of the last recession relied to a significant extent on a ris-
ing stock market.
Even the business-oriented Fed itself has been pointing out
that in this era of contraction and stagnation, restoring growth
will require more than readily accessible loansprobably
much more. Daniel Tarullo, a Fed governor and member of the
Feds policy-setting committee has pointed out that neither
monetary nor fiscal policy will be able to fill the whole aggre-
gate demand shortfall quickly. But appropriate policies could
surely boost output and employment (2011, 6). He goes on
to attack the red herring that unemployment is high mostly
because of structural problems in the labor market, such as
a workforce that is largely ill qualified for work in the key
industries that are still hiring. Such comments are a measure
of the extraordinary seriousness of the current crisis. In fact,
the Feds recent pleas for additional stimulus legislation rep-
resent a significant departure from that institutions usually
cautious fiscal approach. During the past 30 years, the Fed has
done nothing more frequently in congressional hearings than
urge legislators to cut fiscal deficits.
There are several reasons that tend to justify Tarullos
views on the power of monetary stimulus to awaken the stag-
nant economy. First, nonfinancial corporations are already
sitting on at least $2 trillion in cash. Specifically, the most recent
flow-of-funds data report from the Fed Board of Governors
noted the following assets on the books of non-financial, non-
farm corporate businesses: $84.2 billion in deposits in foreign
countries, $501.8 billion in checking accounts in the United
States, $574.5 billion in time deposits and savings accounts,
$479.7 billion in money market funds, $77.0 billion in
commercial paper, $46.1 billion in Treasury securities, $15.4
billion in certain other types of federal securities, and $235.5
billion in mutual fund shares (Federal Reserve 2011b).
Second, banks had about $1.5 trillion in excess reserves
on their balance sheets as of early November (Federal Reserve
2011a) and are offering extremely low rates for many kinds of
loans, including mortgages. Third, loan officers are apparently
still pessimistic about the chances that business borrowers
will repay their loans on time and with interest, given finan-
cial and economic conditions. In October, fewer loan officers
reported easing their lending standards than in previous months
(Federal Reserve 2011c). Even major Fed policy actions will not
easily change lenders minds about the riskiness of lending
during this financial and economic crisis. The data depicted in
Figure 9 suggest that low interest rates and reduced mortgage
lending have lowered the burden of servicing existing house-
hold debt, but an aura of financial caution seems likely to
Sources: S&P; National Association of Realtors; BEA
40
60
80
100
120
140
160
Existing Home Price Index
S&P 500 Index
2008 2006 2004 2000 2002 2010
Figure 8 Indexes of the Real Prices for Equities and Existing
Homes (January 2000 = 100)
8 Strategic Analysis, December 2011
prevail following the trauma of the subprime crisis. The
deleveraging process has reversed a long rise in household
borrowing, but as seen in the figure, the cost of servicing
household loans is no lower than it was in the aftermath of the
much milder recessions of the early 1980s and early 1990s.
Once again, we are reminded of the high likelihood that
demand will be weak in the coming months and years in the
absence of increased fiscal stimulus.
Our baseline forecast remains glum.
Following our standard approach for the Strategic Analysis
series, we conducted a baseline simulation based on various
given conditions, which include official forecasts for the
future path of the deficit and growth in the rest of the world.
The baseline forecast assumes no change in the value of
the dollar and deficit levels consistent with the bipartisan
Congressional Budget Offices most recent no change scenario
(CBO 2011). Prices for oil and other commodities are
assumed to grow at an annual rate of 2 percent throughout
the simulation period. We also assume that interest rates will
remain at current levels, and posit gradually rising rates of
business and household borrowing.
As shown in Figure 10, the results of our simulation indi-
cate that growth will remain very weak indeed, with a growth
rate hovering a bit above 2 percent in 2012 before falling to
between 1.5 and 2 percent through 2016. Growth of this mag-
nitude does not generate sufficient demand for labor; meas-
ured against our baseline estimate, unemployment will fall
slightly in 2012 and then rise again, remaining somewhat
above 9 percent up to our forecast horizon (see Figure 13).
Figure 10 shows that in our baseline scenario, the general gov-
ernment budget deficit (that of all levels of government com-
bined) falls significantly, while the debt increases, reaching 94
percent of GDP by the end of 2016. The private sector deficit
is now negative, meaning that saving exceeds investment in
that sector. During the simulation period, the absolute size of
this deficit also falls, an outcome that indicates more borrow-
ing and/or less lending by the private sector. Finally, the cur-
rent account balance gradually rises to zero by the endpoint of
the simulationa rebalancing act that could end with the
economy collapsing anyway.
In other words, if our assumptions hold true, fears of
prolonged stagnation and flat employment are well justified.
Figure 9 Debt Burden
Source: Federal Reserve
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Debt-service Ratio
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Sources: BEA; authors calculations
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Government Deficit (right scale)
External Balance (right scale)
Private Sector Investment minus Saving (right scale)
Real GDP Growth (left scale)
2005 2000 1990 1995 2015
Figure 10 Baseline Scenario: US Main Sector Balances and
Real GDP Growth
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Levy Economics Institute of Bard College 9
Scenario 1 indicates that the austerity ahead will
only make things worse.
Starting in 2013, the federal government will be forced to
implement large budget cuts that will total $1.2 trillion over
10 years. In scenario 1, we modify the assumptions used in
our baseline simulation in order to simulate the effect of new
austerity measures of a similar magnitude. However, we assume
that the spending cuts all occur between the next fiscal year
and the end of our simulation period. Specifically, spending
and net transfers are reduced relative to the baseline, begin-
ning in the fourth quarter of 2012, in amounts that add up to
$1.5 trillion through the end of the simulation period in the
fourth quarter of 2016.
In the case of government spending cuts, the multiplier
effect works in the direction of reducing economic growth
rather than increasing it, relative to the outcome of the base-
line scenario. Hence, growth remains stable at an annual rate
of 2.32.8 percent during calendar year 2012, as depicted in
Figure 11. It then falls as low as approximately 0.06 percent in
the second quarter of 2014, before leveling off at around 1
percent for the balance of the simulation period.
The figure also shows the nations three financial bal-
ancesgovernment, foreign, and private. In this scenario, the
government deficit falls gradually to about 0.2 percent,
reflecting both spending cuts and reductions in revenue that
occur because of lower GDP growth rates. The private sector
deficit also moves fairly steadily toward balance, reaching as
high as 2.6 percent at the end of the simulation period. This
private sector rebalancing is faster than the one in the baseline
scenario, mostly because the government deficit falls more
quickly in this case.
The total balance of the two domestic sectors, which
equals the current account balance, moves above 2.4 percent
by the end of the simulation period. This reversal occurs
largely because slow domestic growth tends to reduce imports
relative to exports. It is likely that such a reduction in import
demand would cause severe consequences for economies that
export to the United Statesconsequences that would rever-
berate among all trading nations, including the US. Not sur-
prisingly, given the sharp expenditure cuts and the lack of a
currency devaluation in this scenario, unemployment gets
worse, rising to 10.7 percent by the fourth quarter of 2016
(again, see Figure 13).
Scenario 2 shows that even a frugal stimulus
package would be of great help.
In scenario 2, we conduct a fiscal stimulus experiment. The
modest stimulus package considered in this exercise is made
up of two components: (1) an extension of the 2 percent
reduction in federal payroll taxes that went into effect earlier
this year, and (2) an increase in outlays large enough to yield
a reduction of unemployment to approximately 7 percent by
2016. We determined the appropriate increase in outlays by
starting with the baseline CBO fiscal policy assumptions and
adjusting total government expenditures and transfers until
we found a path that reached the 7 percent unemployment
rate objective in 2016.
Again, we begin our discussion with projected growth
rates. As shown in Figure 12, the additional stimulus assumed
in scenario 2 increases real GDP growth very quickly. Growth
rises to 2.4 percent in the first quarter of 2012 and peaks at 4
percent in the first quarter of 2013. The effect of the stimulus
gradually subsides, causing the growth rate to fall starting in the
first quarter of 2013. Yet the growth rate remains at a reasonably
strong 3 percent even at the end of the simulation period.
The same figure shows that the government deficit declines
fairly sharply, despite the tax-cut extension and spending
Sources: BEA; authors calculations
A
n
n
u
a
l

G
r
o
w
t
h

R
a
t
e

i
n

P
e
r
c
e
n
t
-6
-4
-2
0
2
4
6
Government Deficit (right scale)
External Balance (right scale)
Private Sector Investment minus Saving (right scale)
Real GDP Growth (left scale)
2005 2000 1990 1995 2015
Figure 11 Scenario 1: US Main Sector Balances and Real
GDP Growth
P
e
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c
e
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t

o
f

G
D
P
-10
-5
0
5
10
15
2010
10 Strategic Analysis, December 2011
increase. The projected fourth-quarter 2016 deficit of 6.5 per-
cent of GDP exceeds our baseline but may sound remarkably
low, given the hysteria about deficits found in much of the
news media. As mentioned earlier, the private sector deficit is
currently negative, reflecting the tendency of households and
businesses to keep spending low as they deleverage from the
excess borrowing of the prerecession boom years. Returning
to Figure 12, we see that our scenario 2 stimulus plan causes
the private sector to begin spending more and the sector
deficit to rise, although it remains below 4.6 percent
throughout the simulation period.
Finally, the current account balance continues its upward
trend accordingly, beginning with a deficit of 2.9 percent in
the fourth quarter of 2011 and reaching approximately 1.9
percent by the end of 2016. These figures show welcome
progress from the much larger current account deficit of
around 6.5 percent of GDP run by the United States in the
fourth quarter of 2005, despite the administration of a serious
dose of fiscal stimulus in the interim.
According to our simulation, the stimulus package does
raise the ratio of government debt to GDP, as seen in Figure
14. The increased deficits in this last scenario cause total gov-
ernment debt to rise somewhat relative to our baseline num-
bers, but not by much: 97.4 percent of GDP in scenario 2 ver-
sus 94.4 percent of GDP in the baseline and 91.1 percent in
scenario 1. This difference in the path of the debt-to-GDP
ratio is relatively small, since the assumed fiscal stimulus
package has the effect of increasing the denominator of the
ratio as well as its numerator.
Figure 14 Public Debt under Alternative Assumptions
Sources: BEA; authors calculations
P
e
r
c
e
n
t

o
f

G
D
P
40
50
60
70
80
90
100
Baseline (CBO Projections)
Scenario 1 (Deficit Reduction)
Scenario 2 (Fiscal Stimulus)
2015 2010 2000 2005
Sources: BEA; authors calculations
A
n
n
u
a
l

G
r
o
w
t
h

R
a
t
e

i
n

P
e
r
c
e
n
t
-6
-4
-2
0
2
4
6
Government Deficit (right scale)
External Balance (right scale)
Private Sector Investment minus Saving (right scale)
Real GDP Growth (left scale)
2005 2000 1990 1995 2015
Figure 12 Scenario 2: US Main Sector Balances and Real
GDP Growth
P
e
r
c
e
n
t

o
f

G
D
P
-10
-5
0
5
10
15
2010
Sources: BLS; authors calculations
P
e
r
c
e
n
t

o
f

L
a
b
o
r

F
o
r
c
e
4
5
6
7
8
9
10
11
Baseline (CBO Projections)
Scenario 1 (Deficit Reduction)
Scenario 2 (Fiscal Stimulus)
2010 2005 2000 1990 1995 2015
Figure 13 Unemployment Rate in Three Scenarios
3
Levy Economics Institute of Bard College 11
The impact of a eurozone crisis on US financial
assets could be significant.
Our simulations have been based on the latest IMF projec-
tions for world growth, which do not take into account recent
events in the eurozone. It is thus interesting to evaluate how a
further slowdown, or possibly a financial crisis, in the euro-
zone might affect our simulation results.
The importance of the euro area as a market for US
exports has declined steadily: while it accounted for more
than 24 percent of total US exports in the 1970s, it now
accounts for only about 16 percent, while the relative impor-
tance of other (mostly Asian) countries has increased in terms
of US trade. Slower growth in Europe will thus have an impact
on US exports, and therefore on US growth and employment,
but one of limited size.
On the other hand, a financial crisis that affects the value
of US assets held in the eurozone may have a much more sig-
nificant impact on net US financial wealth, which in turn is an
important determinant of private expenditure.
Figure 15 breaks down the total value of US debt securi-
ties (bonds, notes, bills, et cetera) by country of origin, accord-
ing to the latest IMF figures. As seen in the figure, Greece,
Ireland, and Portugal made up a fairly modest slice of US
debt-security portfolios as of 2009. Yet all European economies
are at risk. For example, Italy has been running a budget sur-
plus (not including interest payments of course), but bond
markets have been spurning new securities offerings, leading
to escalating yields on the sovereign debt of that country. And
the UK, which still enjoys the benefits of low interest rates, has
nonetheless been rapidly implementing harsh fiscal austerity
measures, and may already be caught in a spiral of low
growth, falling tax revenues, rising debt, and government
spending cuts. As seen in the figure, that country accounts for
more than 20 percent of total debt security holdings in the
United States. So, even though the United States is not directly
holding a large percentage of its financial assets in troubled
eurozone countries, its assets in the UK and other interna-
tional financial centers may be significantly affected by a
financial crisis in the euro area. Many of the worlds central
banks have been intervening to lend to these debt markets, in
an effort to prevent a financial collapse. Such a collapse would
threaten the world economy with a crisis perhaps much more
severe than the one that followed the bankruptcy of Lehman
Brothers in 2008. The US government must take this threat
far more seriously. It could do no better than to prevent a
national recession that would contribute to a chain reaction of
defaults and misery.
Source: IMF
Figure 15 Total Foreign Debt Securities Held By the
United States, 2009
France ($105.9B) 5.4%
Germany ($96.8B) 4.9%
Greece ($1.8B) 0.1%
Ireland ($40.8B) 2.1%
Italy ($19.2B) 1.0%
Luxembourg ($62.8B) 3.2%
Netherlands ($124.1B) 6.3%
Portugal ($0.9B) 0.0%
Spain ($26.0B) 1.3%
Other ($19.0B) 1.0%
* Eurozone
Canada
($245.2B) 12.5%
Cayman Islands
($225.8B) 11.5%
Australia
($148.6B) 7.6%
United Kingdom
($396.6B) 20.3%
Other
($444.1B) 22.7%
Eurozone*
($497.3B) 25.3%
12 Strategic Analysis, December 2011
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Levy Economics Institute of Bard College 13
Recent Levy Institute Publications
STRATEGIC ANALYSIS
Is the Recovery Sustainable?
nixi1vi n. v.v.nixi1viou, cvvc u.xxscvx, and
cvxx.vo zvzz.
December 2011
Jobless Recovery Is No Recovery: Prospects for the
US Economy
nixi1vi n. v.v.nixi1viou, cvvc u.xxscvx, and
cvxx.vo zvzz.
March 2011
Getting Out of the Recession?
cvxx.vo zvzz.
March 2010
Sustaining Recovery: Medium-term Prospects and Policies
for the US Economy
nixi1vi n. v.v.nixi1viou, cvvc u.xxscvx, and
cvxx.vo zvzz.
December 2009
PUBLIC POLICY BRIEFS
Debtors Crisis or Creditors Crisis?
Who Pays for the European Sovereign and Subprime
Mortgage Losses?
).x xvvcvi
No. 121, 2011
Waiting for the Next Crash
The Minskyan Lessons We Failed to Learn
i. v.xn.ii wv.s
No. 120, 2011
The Contradictions of Export-led Growth
1uox.s i. v.iivs
No. 119, 2011
Will the Recovery Continue?
Four Fragile Markets, Four Years Later
cvvc u.xxscvx and nixi1vi n. v.v.nixi1viou
No. 118, 2011
It's Time to Rein In the Fed
sco11 vuiiwiivv and i. v.xn.ii wv.s
No. 117, 2011
POLICY NOTES
Toward a Workable Solution for the Eurozone
x.vsu.ii .uvvn.cx
2011/6
Resolving the Eurozone Crisiswithout Debt Buyouts,
National Guarantees, Mutual Insurance, or Fiscal Transfers
s1u.v1 uoii.xn
2011/5
Was Keyness Monetary Policy, Outrance in the Treatise, a
Forerunner of ZIRP and QE? Did He Change His Mind in
the General Theory?
).x xvvcvi
2011/4
A Modest Proposal for Overcoming the Euro Crisis
s.xis v.vouv.xis and s1u.v1 uoii.xn
2011/3
Is the Federal Debt Unsustainable?
).xvs x. c.inv.i1u
2011/2
What Happens if Germany Exits the Euro?
x.vsu.ii .uvvn.cx
2011/1
A New Teachable Moment?
x.vsu.ii .uvvn.cx
2010/4
Why the IMF Meetings Failed, and the Coming Capital
Controls
xicu.vi uunsox
2010/3
14 Strategic Analysis, December 2011
LEVY INSTITUTE MEASURE OF ECONOMIC WELL-BEING
Has Progress Been Made in Alleviating Racial Economic
Inequality?
1uox.s x.s1vvsox, .)i1 z.cu.vi.s, and
vnw.vn x. woivv
November 2009
New Estimates of Economic Inequality in America,
19592004
.)i1 z.cu.vi.s, vnw.vn x. woivv, and
1uox.s x.s1vvsox
April 2009
What Are the Long-Term Trends in Intergroup Economic
Disparities?
1uox.s x.s1vvsox, vnw.vn x. woivv, and
.)i1 z.cu.vi.s
February 2009
Postwar Trends in Economic Well-Being in the United
States, 19592004
vnw.vn x. woivv, .)i1 z.cu.vi.s, and
1uox.s x.s1vvsox
February 2009
ONE-PAGERS
$29,000,000,000,000: A Detailed Look at the Feds Bailout
of the Financial System
i. v.xn.ii wv.s
No. 23, 2011
A Crisis of Advanced Capitalism?
c. ). voiscuvoxiou
No. 22, 2011
Biopolitics and Neoliberalism: The Future of the Eurozone
c. ). voiscuvoxiou
No. 21, 2011
Confusion in Euroland
nixi1vi n. v.v.nixi1viou and i. v.xn.ii wv.s
No. 20, 2011
The Future of the Eurozone Does Not Lie with Enlargement
c. ). voiscuvoxiou
No. 19, 2011
WORKING PAPERS
$29,000,000,000,000: A Detailed Look at the Feds Bailout
by Funding Facility and Recipient
).xvs vvixvvsox
No. 698, December 2011
Distribution and Growth: A Dynamic Kaleckian Approach
v. v.1vi.vc. and c. s.vnoxi
No. 697, November 2011
Time Use of Mothers and Fathers in Hard Times and Better
Times: The US Business Cycle of 200310
cuxsvii nvvix and vnvu xoxc.v
No. 696, November 2011
Orthodox versus Heterodox (Minskyan) Perspectives of
Financial Crises: Explosion in the 1990s versus Implosion
in the 2000s
)vss xuxoz
No. 695, November 2011
Reducing Economic Imbalances in the Eurozone: Some
Remarks on the Current Stability Programs, 201114
cvvcov svxivxiux, 1iii v.x 1vvvcx, and
.cuix 1vucvv
No. 694, October 2011
Euroland in Crisis as the Global Meltdown Picks Up Speed
nixi1vi n. v.v.nixi1viou and i. v.xn.ii wv.s
No. 693, October 2011
Quality of Match for Statistical Matches Used in the
Development of the Levy Institute Measure of Time and
Income Poverty (LIMTIP) for Argentina, Chile, and Mexico
1uox.s x.s1vvsox
No. 692, October 2011
Levy Economics Institute of Bard College 15
Unpaid and Paid Care: The Effects of Child Care and Elder
Care on the Standard of Living
xi)oxc xix and v.xi. .x1oxovouios
No. 691, October 2011
The Measurement of Time and Income Poverty
.)i1 z.cu.vi.s
No. 690, October 2011
Effects of Legal and Unauthorized Immigration on the US
Social Security System
sviux vvvx, uuco nvx1vz-siiv., and
vv. c\vcvivs-vovvn.
No. 689, October 2011
An Unblinking Glance at a National Catastrophe and the
Potential Dissolution of the Eurozone: Greeces Debt Crisis
in Context
c. ). voiscuvoxiou
No. 688, September 2011
Access to Markets and Farm Efficiency: A Study of Rice
Farms in the Bicol Region, Philippines
s.x).s. nvsiiv.
No. 687, September 2011
Estimating the Impact of the Recent Economic Crisis on
Work Time in Turkey
vxvi xvxis and s. .. x.s. n.u.
No. 686, September 2011
Quantitative Easing, Functional Finance, and the
Neutral Interest Rate
.ivoxso v.i.cio-vvv.
No. 685, September 2011
Central Banking in an Era of Quantitative Easing
.xnvvw suvxc
No. 684, September 2011
Permanent and Selective Capital Account Management
Regimes as an Alternative to Self-Insurance Strategies in
Emerging-market Economies
)vc ninow
No. 683, September 2011
Infinite-variance, Alpha-stable Shocks in Monetary SVAR:
Final Working Paper Version
cvvc u.xxscvx
No. 682, August 2011
Lessons We Should Have Learned from the Global
Financial Crisis but Didnt
i. v.xn.ii wv.s
No. 681, August 2011
The Levy Institute Measure of Economic Well-Being:
Estimates for Canada, 1999 and 2005
.xnvvw su.vvv, .ivx.xnvv xuvv.s,
nvx).xix vv.xs, and visvv1u u.zvii
No. 680, July 2011
The Levy Institute Measure of Economic Well-Being,
France, 1989 and 2000
1uox.s x.s1vvsox, .)i1 z.cu.vi.s, sviux vvvx,
and vnw.vn x. woivv
No. 679, July 2011
What Ended the Great Depression? Reevaluating the
Role of Fiscal Policy
x.1u.x vvvvs and x.1.s vvvxvxco
No. 678, July 2011
The Global Crisis and the Remedial Actions:
A Nonmainstream Perspective
sux.xn. svx
No. 677, July 2011
Quality of Match for Statistical Matches Used in the
1989 and 2000 LIMEW Estimates for France
1uox.s x.s1vvsox
No. 676, July 2011
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