2012 Economic Outlook


After harsh treatment by the Great Recession, the Puget Sound economy is back in its customary position, growing faster than the rest of the nation. Boeing, which recently added several thousand workers to its payroll, is providing much of the drive. But the economic future of the region—and indeed the nation—will be significantly shaped by events and decisions taking place in the “other” Washington.

When Joseph Stiglitz, winner of the Nobel Prize for economics, was asked recently about the Occupy Wall Street demonstrations, he gave an answer that was as much about politics as it was about economics: He said he was surprised the protests hadn’t started earlier.

Four years after the housing bubble burst, triggering a financial crisis, we remain mired in slow growth and high unemployment. Yet we as a nation are divided as to how to get the economy back on the road. The Keynesian approach advocates stimulating aggregate demand in the economy through additional infrastructure and other spending. Supply-siders prefer low taxes, a balanced federal budget and deregulation, with the goal of encouraging new savings and investment leading to greater employment opportunities.

Liberals and conservatives tend to view Keynesian and supply-side economics as being at odds with each other. Both approaches have a role in achieving stable growth, low unemployment and minimal inflation. There are times in the life of an economy, however, when one set of policies works better than the other.


Forgotten lessons

History suggests that Keynesian tactics are more effective than supply-side measures in pulling the economy out of deep recessions. The economic recoveries from the Great Depression and the double-dip recession that began in 1980 illustrate this point. Real Gross Domestic Product (GDP) fell 30 percent in the three years following the 1929 stock crash that triggered the Great Depression, while the unemployment rate climbed to 25 percent. Initially, little was done to staunch the bleeding. At the time, monetary policy was hamstrung by the gold standard. Any expansion of the money supply would have resulted in an outflow of gold. Moreover, most economists assumed that falling wages would eventually increase demand for labor and put the economy back on a growth path.

That didn’t happen. In 1933, newly elected President Franklin D. Roosevelt initiated sweeping changes to economic policy in what he called the New Deal. Among other things, he took the United States off the gold standard; he created the Reconstruction Finance Corporation to increase the liquidity of the economy and resurrect the financial system; and he provided jobs for workers through the Civilian Conservation Corps (CCC), the Public Works Administration (PWA) and the Works Progress Administration (WPA).

In Washington state, the federal government financed construction of three Columbia River dams—Rock Island, Bonneville and Grand Coulee. The Grand Coulee, the greatest construction project undertaken in the world up to that time, at one point employed 8,800 workers. Hundreds of other jobs sprang up in the small settlements around the construction site, where the dam builders lived and spent their wages.

In addition to providing badly needed jobs, the Columbia River dams also helped to control flooding, enable navigation on the river, supply water to the rich soils of the Columbia basin, and generate electricity for homes and factories. The abundance of cheap hydroelectric power enticed the federal government and private companies to establish seven aluminum smelters in Washington. In 1980, the Pacific Northwest aluminum industry produced 40 percent of the nation’s primary aluminum and employed 11,000 people in the state.

Scholars continue to debate the relative importance of fiscal and monetary policies in pulling the economy out of the Great Depression. But it is clear that federal intervention worked. Between 1933 and 1937, real GDP advanced at a 9 percent annual rate, well above the 5 percent rate achieved during the Roaring Twenties (1921–29). National output expanded 43 percent, creating 7 million payroll jobs, and lowered the unemployment rate by 11 percentage points to 14 percent.

The Depression and the New Deal programs were not without cost. From 1929 to 1937, the federal debt more than doubled, rising to nearly half of GDP. In an attempt to balance the federal budget, policymakers shifted direction and cut government spending by 4 percent in 1937, throwing the nation back into recession. In 1938, real GDP declined 3 percent and the unemployment rate climbed again, rising to 19 percent.

Faced with the choice of either balancing the budget or lowering unemployment, the Roosevelt administration took the latter course. After boosting federal spending by one-sixth over a two-year period, the economy resumed its recovery, expanding at an 8 percent rate between 1937 and 1940, and lowering the unemployment rate to 15 percent. The Great Depression did not end altogether until the United States entered World War II, when federal spending soared tenfold.

One oddity of the Great Depression is that income tax rates rose during the period. The highest income tax rate jumped from 25 percent in 1929 to 63 percent in 1932 and 79 percent in 1936. While the increase in tax rates helped to pay the mounting federal bills, thereby slowing the escalating debt, they also reduced the effectiveness of the efforts to stimulate the economy. If policymakers had held the tax rates constant and let the federal deficit ride, the economy would have emerged from the Depression sooner.

Supply-side economics was put to the test during President Ronald Reagan’s reign. When Reagan took office in 1981, he inherited a recession caused by the Federal Reserve’s efforts to stamp out rampant inflation as well as an income tax structure with a top rate of 70 percent. In 1946, at the end of World War II, the highest tax rate had been elevated to 94 percent in order to retire the nation’s massive federal debt, which at the time amounted to 122 percent of GDP.

To end the recession, Reagan’s economic advisers advocated supply-side policies based on classical economic arguments. Supply-siders agreed with Keynesians that economic growth depended on higher investment rates. But rather than inducing investment by stimulating demand, supply-siders felt that it was more effective to do so by lowering tax rates to encourage savings.

The Reagan administration proceeded to drop the top tax rate in three steps, from 70 percent to 28 percent, while the capital gains tax was lowered from 28 percent to 20 percent. Almost immediately, the national economy took off, growing 5 percent in 1983 and 7 percent in 1984.

The 1980s turned out to be one of the most successful decades in our economic history. Between 1982 and 1989, the economy added 18 million jobs, reducing the unemployment rate from 10 percent to 5 percent. Supply-side economists still point to the Reagan years as evidence that lower taxes boost savings, investments, and jobs.

But a closer look shows that savings as a percentage of disposable income actually declined, from 11 percent in 1982 to 7 percent in 1989, while nonresidential investments rose at an unimpressive 4 percent annual rate during that time. Meanwhile, contrary to Reagan’s expectations, the federal debt tripled to $2.7 trillion (52 percent of GDP) during his presidential term.

Tax cuts produced growth during Reagan’s tenure not by boosting investment but by increasing consumption, which doubled in growth during the period. Combined with a 55 percent increase in real defense spending to fight the Cold War with the Soviet Union and a 30 percent hike in real domestic output, the tax cuts gave the economy its biggest fiscal shot in the arm since the Great Depression. A boom in international trade triggered by a weakening dollar also helped.


Down a beaten path

Our current Great Recession is remarkably similar to the Great Depression, although not as severe. The bursting of a speculative housing bubble was followed by a freeze in the credit markets, tight credit, falling home values, a 50 percent plunge in the stock market and rising unemployment. Consumer spending slowed, housing construction came to a virtual halt, and state and local governments began to experience shortfalls in tax revenue. In early 2009, when President Barack Obama was inaugurated, the mood of Americans could be summed up in one word: fear.

President Obama (with the assistance of President Bush late in his term) and the Federal Reserve acted quickly to right the economy. They had two objectives: stabilize the housing and credit markets as well as stimulate the economy. The fiscal stimulus package, much of which went for infrastructure projects and transfers to state and local government, amounted to $750 billion.

In the first quarter of 2009, real GDP was plunging at a 7 percent annual rate, while jobs were disappearing at a rate of 9 million per year. But real GDP began to grow again in the third quarter of 2009 and employment turned up not long after that. During the course of 2010, real GDP advanced 2.4 percent (a bit below trend rate), leading to the creation of more than a million jobs.

Critics argue that Obama’s recovery plan was ineffective, pointing to the lack of significant progress in creating jobs and lowering the unemployment rate. Voters turned control of the House of Representatives over to the Republican Party in the 2010 national elections.

Reminiscent of the 1938 recession, the new Congress turned its attention to balancing the budget. The abrupt reversal in fiscal policy put the brakes on the economy in the latter half of 2010. In 2011, matters only got worse when bad winter weather, a big cut in defense spending, spiraling gasoline prices and the Japan earthquake combined with less government spending to slow the economy down to a crawl, a 0.8 percent annual growth rate in the first half of the year.

Then, a deadlock in Congress over raising the debt ceiling took the United States to the brink of default and led Standard & Poor’s to downgrade the nation’s long-term credit rating—the first downgrade in history. Stock prices plunged, while consumer confidence plummeted back to its recession low.

It is not entirely clear where we go from here. In light of the recent developments, Blue Chip economists have lowered their consensus forecast of real GDP growth to 2.1 percent in 2012 and 2.8 percent in 2013, one-half the normal speed of the economy at this stage of the recovery. The Economic Cycle Research Institute argues that, based on its index of leading economic indicators, we may already be in a recession. But that call is likely premature.

One hopeful sign is the report by the U.S. Bureau of Economic Analysis, which indicates that real GDP advanced at a better-than-expected 2.4 percent rate in the third quarter of 2011, boosted in part by stronger consumer spending.

Another positive development is that home prices have finally begun to rise again, according to the Case-Shiller home price index. Along with record low mortgage rates, stable or rising home prices should greatly reduce the risk of home buying as well as home lending.

The Washington state economy is in the same boat as the rest of the nation. More than two years after the National Bureau of Economic Research officially announced the end of the Great Recession, we are all still dealing with a severely damaged economy. How quickly the region emerges from this disastrous downturn largely depends on how fast the nation recovers.

The Puget Sound region, however, is doing better than the rest of the country, growing 1.6 percent over the year compared to 1 percent for the nation. That’s largely thanks to Boeing, which hired 7,000 more workers during the period and probably created, through the multiplier process, a like number of indirect jobs. Without those 14,000 jobs, regional employment would have increased at about the same rate as the nation.

Despite the lift from Boeing, our regional economy remains in a fragile state. Foreclosures are still holding down the housing market, while weak tax collections are forcing state and local governments to cut programs and eliminate jobs. Our Puget Sound Index of Leading Economic Indicators, which is constructed to anticipate upturns and downturns in employment, reversed eight straight quarters of sharp increases to a decline in the third quarter of 2011.

Barring a major shift in policy by the federal government toward greater fiscal stimulus, our latest regional outlook calls for an extended period of slow growth. After rising 1.5 percent in 2011, employment is predicted to increase 1.6 percent in 2012 and 1.6 percent in 2013. Our 10-year projections now indicate that Puget Sound jobs will not return to their prerecession level until the fourth quarter of 2014. Unemployment in the region, as in the nation, will decline slowly from about 9 percent to about 7 percent during that period.

That’s still a marked improvement in the economy, but it’s far short of the optimistic forecast that we should be presenting at this point in an economic recovery. The Great Recession has been frustrating on two accounts: It never should have occurred in the first place and the recovery has been unnecessarily prolonged by the failure of the federal government to continue stimulating the economy.

DICK CONWAY is a Seattle economist and a member of the Washington State Governor’s Council of Economic Advisors. Since 1993, he has copublished The Puget Sound Economic Forecaster (economicforecaster.com).

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