Next Labor Day Our Economy Will Still Be in Serious Trouble

With Labor Day a few days away, the U.S. Department of Commerce has revised its economic growth figure for the second quarter of 2013 up to 2.5%, as opposed to the previous estimate of 1.7%. This figure has been touted as proof of an economic recovery, along with other figures such as increases in housing construction by 12.9%, in business investment by 16.1%, and a fall in unemployment to 7.4% in July with 162,000 jobs created.

Yet as far as the long term goes, America’s economy is still in grave danger. While it is hard to predict where the U.S. will be Labor Day 2014 a year from now, there remain many disturbing signs. America’s recovery has been weak and has been characterized by feeble job and GDP growth. One telling figure is that it would take about seven years for the U.S. to close the job gap created by the recession, based on the average for the 2000s, according to research by the Hamilton Project at the Brookings Institution.

The job gap is estimated to be 7.4 million, which includes jobs lost during the recession and the number of jobs needed for the workers who have entered the labor force each year since the recession. The figure jumps to nearly 23 million when those who have stopped looking for jobs and those who are underemployed in part time jobs are added. This paints a much bleaker picture than official unemployment rates which do not take into account those who are underemployed.

Aside from jobs, another major concern is inflation. Although the U.S. government has engaged in stimulus deficit spending since FDR’s New Deal, the practice of expanding the monetary supply was greatly expanded under Bush and then Obama. The Federal Reserve has engaged in what it calls quantitative easing (QE) as a stimulus measure, in which it buys short or long-term bonds in order to push and then keep interest rates down to encourage lending by banks to consumers. Since 2008 the Federal Reserve has carried out several sessions of QE which have resulted in interest rates being kept near or at 0% for almost the last five years.

In order to do this the Federal Reserve has bought over $2 trillion in Treasury Bonds and securities. As a result, the monetary supply has drastically increased, both in terms of M0, the coins and notes that are not held in reserve or deposits but are in free circulation, and M2, which includes checkable deposits and savings.

Yet despite this unprecedented and unsustainable policy of artificially keeping interest rates down through the expansion of the monetary supply, inflation has strangely hovered around 2% since 2004 and has not been an issue. As a result, many point to this as proof that QE causes no harm. However, there is serious reason to believe inflation could still become an issue.

As Martin Feldstein, professor of economics at Harvard University, explains, the Federal Reserve changed its rules in 2008 to stop QE from causing inflation. The Fed has long required that banks keep a percent of their deposits in reserve to back up their loans or in case depositors wished to withdraw their savings. In 2008 it started paying interest on any excess reserves that banks kept above the required percent. This caused banks to keep more money in reserve and lend a lot less, which meant all those increased reserves were no longer in circulation and thus not expanding the monetary supply. In other words, the Fed’s purchasing of roughly $2 trillion in bonds and securities was offset by incentivizing banks to hold $1.8 trillion deposited as reserves, an amount drastically larger than the normal $2 billion held in 2008.

As a result of this switch, Professor Feldstein concludes that it is “not surprising that quantitative easing has done so little to increase nominal spending and real economic activity.” Instead of letting the market reach equilibrium, the Federal Reserve has incentivized banks not to lend while trying to artificially stimulate demand and lending through the manipulation of interest rates. Ironically, little additional money was actually put into circulation, as called for by standard Keynesian theory. Once banks start to really lend again and the economy takes off, those reserves will be used and the inflation that the Fed has tried to avoid will rear its ugly head. Whether it’s the job gap or looming inflation as a result of monetary stimulus, next Labor Day America’s economy will still be in trouble.