CHAPTER 5

NATIONS IN NEUTRAL

The Output Gap and the Vanishing of Wealth

The first place one can see the sun rise in the United States is from the summit of Cadillac Mountain in Acadia National Park in Maine. Yet within fifteen minutes of this first glimpse, the entire eastern seaboard is bathed in morning sunlight. And on any given weekday, tens of millions of people are getting up to start work, as the world’s fourth-largest labor force begins a new day.

Yet for millions of Americans (and millions of Europeans), a typical weekday is one of not working. And not producing. And not paying taxes. And, in many cases, if part-time work is all that can be found, it means not earning and consuming at levels they would be if they were working full-time.

The worst of the economic crisis may be over, but the large economies of the advanced world—the most powerful wealth creation engines in history—are still grossly underperforming, with huge human and economic costs. Never mind the huge gains in the stock market in recent years. And never mind the near-record corporate profits we’ve been seeing. The hard truth is that the United States and the rest of the developed world remain mired in one of the worst economic slumps in modern history—a slump that shows little real sign of ending, whatever the tidbits of good news from Wall Street or corporate headquarters.

“Output gap” may sound like a technical term, but it’s pretty simple: an output gap is the difference between the potential output of an economy at the so-called natural rate of unemployment that results in neither inflation nor deflation and the actual level of output at any point in time.

If the gap is a positive one, an economy is producing at a rate higher than its long-term potential, and wages, prices, and assets tend to inflate. If the opposite is true, as is the case today, actual output lags potential output and the condition is deflationary—or at least highly disinflationary. And that is where we are five years after the financial crisis. America is stuck in neutral, if not reverse, along with the rest of the developed world.

WASTED HUMAN CAPITAL

There are 245 million Americans of working age (and not in jail or in the military), according to the U.S. Department of Labor. In April 2013, as I write this, 155 million of these people are officially part of the labor force—63.3 percent. Of that number, 143 million have jobs.1

This leaves about 100 million Americans who, on any given day, are not working. Millions of these people aren’t working by choice—they are students, stay-at-home parents, or retired but still able. Millions more would like to be working, but can’t find a job. By the Department of Labor’s count, just under 12 million of the 100 million nonworking Americans are “unemployed.” Another 8 million of those who are officially counted as employed are working part-time because they can’t find full-time work and 3.6 million are counted as “marginally attached to the labor force” or “discouraged workers,” for a grand total of about 23 million people who should be working full-time, but aren’t.

The Bureau of Labor Statistics tallies up another number to capture this picture, a number that most people have never heard about and the media rarely mentions: the U-6 unemployment rate. In a dry table on “Alternative measures of labor underutilization,” the BLS offers up a more accurate unemployment rate. While the standard unemployment rate in March 2013 was 7.6 percent; the U-6 rate of underemployment was 13.8 percent.2 The often disregarded U-6 underemployment rate incorporates workers who are not included in the “civilian labor force” because they have given up looking for work even though they desire and are available to work and does not count as employed people who work part-time because they can’t find a full time job. The standard unemployment rate, by contrast, counts as employed anyone who worked at least one hour in the employment survey week, even if they were part-time for reasons of not being able to find a full-time job. In fact, even the U-6 rate counts that one-hour-a-week worker as “employed” if they are working that one hour by choice rather than because of a lack of alternatives.

Of course, even this number may be way too low since it is impossible to truly calculate how many of the remaining 87 million nonworking Americans, who are considered not in the labor forces but who are of working age, would rather have a job but gave up looking long ago, and the survey instruments used by the Department of Labor are incapable of divining this number. If you’ve been sitting home in your pajamas (so to speak) for a decade, the government probably doesn’t know it.

John Williams, who writes the Shadow Government Statistics blog, compiles an alternate unemployment rate that estimates the number of long-term discouraged workers and adds that number to the BLS estimate of U-6 unemployment, which includes short-term discouraged workers. In March 2013, Williams’s SGS unemployment rate stood at around 23 percent—nearly twice what it was in 2000 and ten points higher than in 2007, before the crash.3 While Williams’s economic data is sometimes criticized, and for some good reasons, his numbers here seem pretty on point to me.

European countries also tend to undercount the number of unemployed, counting as unemployed only those who have looked for a job in the past four weeks. But we don’t need to quibble with those details because the official levels of unemployment there are plenty alarming. Across the Atlantic, even more human capital is sidelined and idle than here.

The European Union has the third-largest labor force, behind China and India—about 225 million workers. Officially, 26 million of these people are out of work—a record high. Looking just at the Eurozone, which has a population of 332 million (slightly higher than the United States), we find that 18.8 million people are officially unemployed, with overall unemployment at a record high of 11.8 percent in January 2013.4

Of course, these aggregate numbers don’t capture the total meltdown of labor markets in southern Europe, where unemployment rates are at levels comparable to those at the height of the United States’ Great Depression. As of this writing, Spain’s unemployment rate stands at 26.6 percent; Greece’s is 26 percent; and Portugal’s is 16.3 percent. Beyond that, four other Eurozone countries have an unemployment rate of more than 14 percent.5

Youth unemployment in Europe has now hit previously unthinkable levels: It’s at nearly 25 percent in the Eurozone and over 50 percent in both Spain and Greece.

What’s particularly insidious about the unemployment crisis in the developed world is how many people have been unemployed for a year or more. In a normal economic downturn, people lose their jobs and then, when things get better, get rehired pretty quickly. That experience is like falling and being caught by a safety line just before you hit the ground. If people are rehired after a few months, they are less likely to completely exhaust their life savings, use all their allowable unemployment benefits, and come to the end of the goodwill of friends (and charity).

This downturn has been different, particularly in the United States, where the ranks of the long-term unemployed are larger than they have been since the Great Depression. According to a 2012 Pew study based on BLS data, about 29.5 percent of the nearly 13.3 million Americans who were unemployed in early 2012 had been jobless for a year or more. Many of these people lost their jobs when the financial crisis hit in late 2008 and early 2009, and never found new work.6

And perhaps never will.

There is much research to suggest that once you’re unemployed for a year or more, employers will presume that your skills have eroded. Make that two or three years and you’re really in trouble. In fact, the long-term unemployed are so looked down upon by employers that many employers would rather hire no one, leaving jobs vacant, than hire people who last worked in, say, 2009. That was the finding of a paper from the Boston Fed in late 2012.7 A depressing 60 Minutes segment earlier that year showed, in wrenching terms, exactly how the long-term unemployed typically can’t even get a foot in the door—and that discriminating against such workers, or rather, ex-workers, is entirely legal.8

A survey of recruiting and hiring managers published in September 2012 found that these gatekeepers considered the long-term unemployed harder to place in jobs than those who were employed but had a criminal record.9 Other research has documented how employers think less of job candidates who are unemployed, no matter how short a time they have been out of work.10

Worse, the long-term unemployed tend to turn against themselves. “There is no comparison to being unemployed for six months and being unemployed for ninety-nine weeks. Your needs change in a drastic way,” said a state unemployment official quoted in the 60 Minutes segment. “The change is the mind. That two years of unemployment erodes your self-confidence, your self-esteem. It separates you from your profession, your education, whatever you might have done previously. There’s all sorts of things. It causes divorces. It causes problems with children.”

Unlike in previous recessions, more of the unemployed today keep falling once they have started to fall—until they hit bottom.

Some end up like Janis Adkins, who once had a prosperous plant nursery in Moab, Utah. She lost the business when the real estate market crashed, and people were no longer buying drought-resistant shrubs for their new homes—or second homes—in southern Utah. Adkins spent a year sending out résumés and cover letters, looking for work. Nothing. Eventually she burned through her savings and lost her home.

In 2012, a reporter from Rolling Stone profiled Janis Adkins and described her life at the bottom—living out of her car in Santa Barbara, California. And, of course, it’s even harder to climb up from the very bottom: “It’s weird,” Adkins told the reporter. “When people find out I’m homeless, it changes how they feel about me. I get declined for jobs. As soon as they learn I live in a van, I’m a thief.”11

VANISHING WEALTH

So what does all this mean? What does it mean that nearly a quarter of all workers in the United States who want to have full-time jobs can’t find such jobs? Or that 26 million Europeans are unemployed? In total, we’re talking about between 40 and 60 million people in Europe and the United States who should be working full-time, but aren’t.

Human costs aside, all these idle people—and eroding human capital—means far less wealth creation overall than would be the case if those people had jobs. In the United States, it’s generally estimated that putting 1 million people to work adds roughly about 1 percent to the nation’s GDP—or about $150 billion. So if all 12 million Americans officially looking for jobs had had them in 2012, the nation’s GDP would have been $1.2 trillion greater. Kick in millions of other people who, ideally, would be working full-time, and we’re probably talking about over $2 trillion in lost domestic production due to unemployment and underemployment in the United States.

Of course, though, not every single person who wants a job gets one—the United States has never had truly “full” employment—and so it’s not realistic to muse about $2 trillion in lost wealth from unemployment. Anyway, there are more dimensions to the output gap than just those related to idle workers. The gap also reflects efficient use of technology, capital, and other resources.

Overall, for 2011, the IMF calculated the output gap in the United States at 5.1 percent of GDP. Since U.S. GDP is approximately $15 trillion per annum, the output gap would represent an annual loss of $765 billion in potential economic activity. That’s a lot of money; the losses in 2012 will probably be comparable when the final data is available. Looking further back, the IMF estimated that the output gap was also 5.1 percent in 2010 and 6.9 percent in 2009.12 Based on the GDP levels of this year, the total U.S. output gap in those three years was about $2.5 trillion.

That number is similar to the output gap estimated by the Congressional Budget Office in 2011. Taking stock of the past and future effects of the economic crisis, the CBO estimated the output gap from 2008 through 2015 at $5.1 trillion, with $2.8 trillion incurred between 2008 and mid-2011.13

The output gap of the Eurozone is also substantial, although the IMF estimates it as smaller than that of the United States—at least up through 2010, where IMF data ends. The output gap in the Eurozone was 3.5 percent in 2009 and 2.3 percent in 2010—figures that represent tens of billions of dollars in wealth that never was produced but would have been produced under normal conditions. The output gap has surely risen again as the Continent has sunk back into recession.

And let’s not forget about Japan, with the third-largest economy in the world. Its output gap in 2011 was 4.5 percent, which translated to about $261 billion of wealth that wasn’t produced.14

All told, the brutal fact is that the advanced countries of the world—the United States, the European Union, and Japan—have a combined output gap well north of $1 trillion a year as growth sputters or falls, and tens of millions of workers sit on the sidelines. The picture looks grimmer if we pull the lens back further to include more countries. It is estimated by various sources (The World Bank, the Bank of Canada, and the G20, among others) that the current gap between potential and actual GDP for the G20 nations—which represent almost 90 percent of global GDP—is at this writing running between $3 trillion and $4 trillion. This has been going on for years, and in Europe the situation has been getting worse, not better.

And could get worse still.

In a much-cited paper on “Hysteresis in Unemployment,” the economist Laurence Ball argued that long-term unemployment has a tendency to become permanent.15 It’s not hard to see why this would be so. When able-bodied workers are sidelined from the labor force—many in the prime of their careers—and then find it impossible to again get into the labor force in a meaningful way, a society loses earners who create demand. More broadly, it loses a slice of human capital that is no longer able to generate wealth. In other words, large-scale unemployment reshapes the level of demand in a society—and in a bad way that becomes self-reinforcing.

That’s the big risk today: that millions of the long-term unemployed across the developed world may never reenter the workforce. Meanwhile, older workers who have jobs are retiring later or not at all, leaving less room for younger workers.

Other factors are also at work in influencing output. Economic output doesn’t just rise and fall in cyclical fashion. Productivity advances, infrastructure development, discovery of natural resources, changes in population demographics—all these act to change the potential output of nations. Changes in geopolitical circumstances—wars, for example, or the relatively sudden emergence of new capacity (the core event underpinning this book)—act to hugely change not only potential global output but also the gaps within nations.

While potential economic output has (unsurprisingly) risen consistently over the broad sweep of global history, economists have come to understand that factors at play in individual national economies can permanently reduce potential output as well. Shrinking populations (either naturally or through war or disease) in the absence of offsetting technology-led productivity gains is a good example of how an economy’s potential can decline. We may be seeing such an ongoing reduction in output potential in Japan, as aging there accelerates to the highest level in the developed world. Although if any country can at least partially offset that problem with technological advances, it is Japan.

The wealth lost so far to economic stagnation and decline may be nothing compared to what is to come. Without the resumption of growth, the lost wealth from unrealized output could range from $6 trillion to $9 trillion by 2017. For the G20 nations, according to the Bank of Canada, that would be a shortfall of 12 percent to 15 percent of potential GDP by 2017. And one should note that the shortfall is decidedly skewed to the developed-nation members of the G20, because the large emerging nations, such as China, are operating close to their current capacities.

THE FISCAL SQUEEZE

An underperforming global economy is bad news, and for many reasons. But economic stagnation and a persistent or rising output gap has especially ominous implications for financing the public sector—and, among other things, affording the social-insurance programs that aging populations will depend on.

If you listen too closely to the politicians in Washington talk about budget deficits, you’re apt to get an entirely wrong view of why government faces a fiscal squeeze. Republicans repeatedly say that the federal government has a “spending problem” while Democrats often blame budget shortfalls on today’s historically low tax rates for most Americans (more about all that later). Some version of the same debate is heard in many European countries.

There is truth in both charges, of course—particularly in the observation that rising health-care costs are a central driver of deficits in the United States. But the biggest factor behind today’s fiscal squeeze is slow growth—or, in some countries, negative growth.

Take the United States, where taxes at all levels of government have hovered between 25 percent to 29 percent of GDP over the past few decades. Most tax revenue in the United States is raised from income and payroll taxes, with such revenue rising or falling with the economy. But wealth is also taxed through taxes on estates and on the value of real property. Overall, more revenue rolls into the coffers of government when the economy is growing and asset values are rising, and less when it is not.

So let’s go back to that IMF estimate that the United States lost $765 billion in potential economic activity during 2011. During that same year, taxes amounted to 25 percent as a share of GDP. Which means that the U.S. output gap for 2011 translated to nearly $200 billion in lost government revenue for 2011—not enough to close the budget deficit, but enough to make a serious dent. Or consider the bigger figure of $2.5 trillion in unrealized U.S. wealth for 2009 through 2011. Government missed out on some $625 billion in revenues as a result of those three years of reduced output.

The fiscal costs of the output gap are all the more sobering when projected into the future—a future in which thousands of baby boomers will be retiring every day (and if not retiring, at least requiring health care); and the United States will need every dime of tax revenue it can find. Yet a modest but persistent output gap over the next decade could easily diminish tax revenues by $1 trillion, which is big money.

In short, growth matters—a lot. Just as slow growth and a persistent output gap could have extremely negative fiscal implications, the opposite is also true: much faster growth could erase several trillion dollars in projected debt over the next decade.

All the same is true for Europe—a continent that also faces huge pressures on its entitlement programs and public treasuries as its populations age. In fact, because taxes make up a much bigger share of the GDP in most European nations, the fiscal effects of the output gap are greater across the Atlantic.

The fiscal squeeze on the United States and other advanced countries doesn’t just affect their ability to pay for entitlement programs for the aged, the costs of which increase literally every day. The squeeze also undermines the ability to invest in the foundations of prosperity—particularly education and infrastructure. In a self-reinforcing dynamic, that underinvestment could ensure that the current output gap becomes permanent—or gets worse. At some point, in other words, the investment gap will begin to exacerbate the output gap.

With respect to infrastructure alone, the American Society of Civil Engineers in its January 2013 “Failure to Act” report calculated that “overall, if the investment gap is not addressed throughout the nation’s infrastructure sectors, by 2020 the economy is expected to lose almost $1 trillion in [annual] business sales, resulting in a loss of 3.5 million jobs. Moreover, if current trends are not reversed, the cumulative cost to the U.S. economy from 2012–2020 will be more than $3.1 trillion in GDP and 1.1 trillion in total trade.”16

This isn’t a pretty picture. What we have today is no ordinary cyclical downturn. Not by a long shot. Instead, present economic conditions are far more akin, as Paul Krugman has argued, to the Great Depression.17 That economic crisis also began with a financial crisis. And many experts believed that it was a merely cyclical phenomenon—that pent-up demand would eventually get the economy humming again. But that didn’t happen, and the hard times ground on for year after year—eventually for a decade.

Things aren’t nearly as bad today as they were in the 1930s (unless you live in Greece or Spain). But one obvious parallel is the widespread assumption that things will naturally turn around, given enough time.

They won’t. And those who imagine a “natural” solution—or, more bizarrely, a return to growth brought on by cutting government—don’t recognize that we are in a new era in which many of the rules have changed.