The Threat That Could Scar the Economy for Decades
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By Andrew Fieldhouse,
The Fiscal Times
August 26, 2014

Despite some signs of improvement, the U.S. economy remains far from healed. And the longer the slump persists, the nastier the lingering scar that will mar the economy for decades to come.

By the best measures of economic health, more than five years after the recession ended the U.S. economy is only one-third to half the way to fully recovered. But hidden beyond the immediate tolls of inadequate recovery, notably high unemployment and depressed incomes, lies another grave cost: The economy’s potential health and productivity is atrophying from this prolonged spell of stagnation.

Policymakers must act decisively to mitigate this economic scarring,  which threatens to unnecessarily reduce future living standards and impede our ability to tackle other looming challenges.

Economic output remains depressed more than 4 percent below estimates of its potential—what could be produced if the economy were running at full employment and full utilization of other productive resources, such as factories and capital. And continuing at the average pace of growth over the last year or two, the economy will still be depressed below its estimated potential ­more than a decade from now.

Related: 2009 Stimulus Stopped US from Falling into a Deep Abyss

But the longer productive resources remain idle or underutilized, the more their supply will whither and the economy’s potential will be sapped.

Channels through which a sickly economy has been eroding our long-term economic health include a diminished labor force, decreased investment and reduced rates of business formation.

Most of the recent decline in the unemployment rate has resulted from workers dropping out of the labor force, as opposed to a rising share of the population finding work. Unemployed workers see skills atrophy, and discouraged workers will increasingly exit the labor force permanently the longer jobs remain scarce.

Related: Why Employers Are to Blame for the ‘Skills Gap’

While demand for goods and services remains unusually weak, businesses invest less in research and development than they would in a healthy economy, and fewer new businesses are started. Adjusting for inflation and population growth, private business investment hasn’t caught up with pre-recession levels; thanks to austerity, neither has public investment. The number of new business establishments remains well below pre-recession levels, and their share among all businesses has also shrunk.

As a result of productive resources being underutilized and investments forgone, estimates of the economy’s potential  (such as projections published by the Congressional Budget Office and International Monetary Fund) have been repeatedly lowered since the recession’s onset. So instead of the economy just catching back up with its potential levels of production, economic potential is also shrinking.

For instance, research by Federal Reserve economists suggests that U.S. economic output has fallen roughly 10 percent below its pre-recession trend—and they expect less than one-third of this drop will be recovered.

Unless reversed, economic scarring permanently lowering output by 7 percent would amount to every American giving up on average more than $4,000 each year.

Related: Sluggish Wages Hurt the Unemployed

But as economists Laurence Ball, Brad DeLong and Larry Summers argue, there is good reason to believe that much of the decline in potential can be reversed—if policymakers quickly address the root causes of economic scarring.

The only real insurance policy to minimize the lasting extent of this scarring are government policies to boost employment and growth, such as increasing infrastructure spending or reinstating emergency unemployment benefits.

More jobs would help draw discouraged workers back into the labor force. Public investment in infrastructure or research and development would help compensate for lower private levels of investment. And increasing demand for goods and services would improve prospects for business sales that could only encourage start-ups and entrepreneurship.

Moreover, there’s reason to believe that policies to boost recovery will pay for themselves over the long run by undoing harmful economic scarring.

The degree to which scars from the Great Recession can be reversed is not fully understood. But the status quo of inadequate recovery is unequivocally deepening those scars. And it is all but guaranteed that the longer productive economic resources are allowed to wastefully lie underutilized, the harder it will be to eventually mitigate the related economic effects.

Policymakers owe it to younger Americans and coming generations not to needlessly hobble the economy for decades to come.

Andrew Fieldhouse is a fellow at The Century Foundation, primarily writing about U.S. federal tax and budget policy and the role of fiscal policy on economic recovery.

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