Laura Tyson: America's Three Deficits

BERKELEY - This year began with a series of reports providing tantalising evidence that economic recovery in the United States is strengthening. The pace of job creation has increased, indicators for manufacturing and services have improved, and consumption spending has been stronger than anticipated. But it is too early to celebrate.

Output growth in the US remains anemic, and the economy continues to face three significant deficits: a jobs deficit, an investment deficit, and a long-run fiscal deficit, none of which is likely to be addressed in an election year.

Although output is now higher than it was in the fourth quarter of 2007, it remains far below what could be produced if labour and capacity were fully utilised. That gap - between actual and potential output - is estimated at more than 7 per cent of GDP (more than US$1 trillion).

The output gap reflects a deficit of more than 12 million jobs - the number of jobs needed to return to the economy's peak 2007 employment level and absorb the 125,000 people who enter the labour force each month. Even if the economy grows at 2.5 per cent in 2012, as most forecasts anticipate, the jobs deficit will remain - and will not be closed until 2024.

America's jobs deficit is primarily the result of inadequate aggregate demand. Consumption, which accounts for about 70 per cent of total spending, is constrained by high unemployment, weak wage gains, and a steep decline in home values and consumer wealth. The uptick in consumption in the last months of 2011 was financed by a decline in the household saving rate and a large increase in consumer credit. Neither of these trends is healthy or sustainable.

With an unemployment rate of 8.5 per cent, a labour-force participation rate of only 64 per cent, and stagnant real wages, labour income has fallen to an historic low of 44 per cent of national income. And labour income is the most important component of household earnings, the major driver of consumption spending.

Even before the Great Recession, American workers and households were in trouble. The rate of job growth between 2000 and 2007 slowed to only half its level in the three preceding decades. Productivity growth was strong, but far outpaced wage growth, and workers' real hourly compensation declined, on average, even for those with a university education.

Indeed, the 2002-2007 period was the only recovery on record during which the median family's real income declined. Moreover, job opportunities continued to polarise, with employment growing in high-wage professional, technical, and managerial occupations, as well as in low-wage food-service, personal-care, and protective-service occupations.

By contrast, employment in middle-skill, white-collar, and blue-collar occupations fell, particularly in manufacturing. Hard-pressed American households slashed their savings rates, borrowed against their home equity, and increased their debt to maintain consumption, contributing to the housing and credit bubbles that burst in 2008, requiring painful deleveraging ever since.

Three forces have driven the US labour market's adverse structural changes:

. Skill-biased technological change, which has automated routine work while boosting demand for highly educated workers with at least a college degree.

. Global competition and the integration of labour markets through trade and outsourcing, which have eliminated jobs and depressed wages.

. America's declining competitiveness as an attractive place to locate production and employment.

Technological change and globalisation have created similar labour-market challenges in other developed countries. But US policy choices are responsible for the erosion of America's competitiveness.

In particular, the US is underinvesting in three major areas that help countries to create and retain high-wage jobs: skills and training, infrastructure, and research and development. Spending in these areas accounts for less than 10 per cent of US government spending, and this share has been declining over time. The federal government can currently borrow at record-low interest rates, and there are many projects in education, infrastructure, and research that would earn a higher return, create jobs now, and bolster US competitiveness in attracting high-wage jobs.

President Barack Obama has offered numerous proposals to invest in the foundations of national competitiveness, but Congressional Republicans have rebuffed them, claiming that the US faces an impending fiscal crisis. In fact, the federal deficit as a share of GDP will shrink significantly over the next several years, even without further deficit-reduction measures, before rising to unsustainable levels by 2030.

The US does indeed face a long-run fiscal deficit, largely the result of rising health-care costs and an aging population. But the current fiscal deficit mainly reflects weak tax revenues, owing to slow growth and high unemployment, and temporary stimulus measures that are fading away at a time when aggregate demand remains weak and additional fiscal stimulus is warranted.

At the very least, to keep the economy on course for 2.5 per cent growth this year, the payroll tax cut and unemployment benefits proposed by Obama should be extended through the end of the year. These measures would provide insurance to the fragile recovery and add nothing to the long-run fiscal gap.

So, how should the US economy's jobs deficit, investment deficit, and long-run fiscal deficit be addressed?

Policymakers should pair fiscal measures to ameliorate the jobs and investment deficits now with a multi-year plan to reduce the long-run fiscal deficit gradually. This long-run plan should increase spending on education, infrastructure, and research, while curbing future growth in health-care spending through the cost-containment mechanisms contained in Obama's health-reform legislation.

Approving a long-run deficit-reduction plan now but deferring its starting date until the economy is near full employment would prevent premature fiscal contraction from tipping the economy back into recession. Indeed, enactment of such a package could bolster output and employment growth by easing investor concerns about future deficits and strengthening consumer and business confidence.

Painful choices about how to close the long-run fiscal gap should be decided now and implemented promptly once the economy has recovered. But, for the next few years, the priorities of fiscal policy should be jobs, investment, and growth.

Laura Tyson, a former chair of the US President's Council of Economic Advisers, is a professor at the Haas School of Business at the University of California, Berkeley.