Some 9 percent Problems

By Bill Woolsey, Special Economic Correspondent of The Free Enterprise Foundation

America’s key economic problem today is that nominal expenditures are too low. In third quarter 2009, total final sales of domestic product were $14.4 trillion (GDP). GDP measures total purchases of goods and service produced in the U.S. It includes consumption expenditures by households, investment expenditures by businesses, and spending by all levels of government. It includes purchases of U.S. goods by foreigners, but doesn’t include spending by U.S. households and firms on foreign goods and services.

The trend growth rate for total spending on final goods and services during the “Great Moderation” between 1984 and fall 2008 was 5.2 percent. During the “Great Recession” of the last two years, spending first grew more slowly, and then sharply dropped in third quarter 2008 and again in first quarter 2009. Spending increased slightly in second quarter and a bit more in third quarter 2009. Still, the current level of nominal expenditure remains far below trend. If nominal expenditures had continued to grow 5 percent, its value would be $15.9 trillion. Nominal expenditure is 9.3 percent below trend.

The depressed level of nominal expenditure is important because firms will not produce what they cannot sell. In third quarter 2009, real GDP, the volume of goods and services produced by the U.S. economy was $13 trillion in 2005 dollars. Real GDP measures production in the U.S., including consumer goods and services, capital goods, and government goods and services. During the Great Moderation, real GDP grew 3 percent per year. It began decreasing in third quarter 2008, and then dropped sharply in both fourth quarter 2008 and first quarter 2009. After a modest further decrease in second quarter 2009, it increased a bit in the third quarter. However, if the production of goods and services had continued to grow at a 3 percent rate, then its currently level would be $14.2 trillion. Real GDP is 9.4 percent below trend.

The production of goods and services requires labor and most people obtain the income needed to purchase goods by working. In December 2009, total employment was 138 million. During the Great Moderation, employment increased at a trend rate of 1.4 percent. Employment began decreasing at the end of 2007 and has fallen nearly every month since. If employment had continued to grow at a 1.4 percent rate, there would be 152 million jobs. Employment is 9.4% below trend.

It is hardly an accident that the Great Recession has left nominal expenditure, real production, and employment all a bit more than 9 percent below the trend consistent with the Great Moderation. However, it would be possible for nominal expenditure to fall below trend, while the real volume of purchases, real production, and employment all remain on trend. All that would be necessary is for the prices of goods and services to be sufficiently low that the lower volume of spending can purchase an unchanged level of output.

In third quarter 2009, the price level, as measured by the GDP implicit price deflator, was 110. That means that prices on average were approximately 110 percent of their level in 2005. During the Great Moderation, the trend growth rate of the price level—the average inflation rate--was 2.4 percent. The only decrease in the price level during the Great Recession, was a very modest decrease of .07 percent during second quarter 2009. However, the inflation rate has been less than 2.4 percent. The trend value for the GDP deflator for third quarter 2009 is approximately 111. The price level is currently about 1.12 percent below trend. Prices of goods and services would need to be approximately 8 percent lower for the current level of nominal expenditure to be consistent with the trend values of real GDP and employment. Prices are too high relative to the volume of nominal expenditure.

Unfortunately, all prices need to fall, not only the prices of consumer goods and services. That includes the prices of resources—particularly labor. In third quarter 2009, the average hourly wage was $18.64. During the years of the Great Moderation, the trend growth rate of wages was 3.2 percent. During the Great Recession, wages have risen continuously. When employment began decreasing at the beginning of 2008, wages were $17.66, so the total increase has been more than 5 percent. Of course, prices continued to rise as well.

Dividing the average hourly wage by the measure of the price level, provides a measure of the real wage, the wage rate in terms of its purchasing power over goods and services. During the period of the Great Moderation, the trend growth rate of real wages was .8 percent rate. During the Great Recession, real wages have continued to rise. During the period employment has been falling, the total increase in real wages has been approximately 1.4 percent.

Why did real wages increase? Pay hikes actually slowed during the Great Recession, but inflation slowed more, so real wages grew. Average hourly wages are currently above their long run trend. If they had continued growing at 3.2 percent, their current level would be $18.51. Average hourly wages are a little less than 1 percent above trend. For prices to fall an additional 8 percent, and wages would need to drop approximately 10 percent.

Rather than convince everyone to promptly take a 10% pay cut, so that businesses will be able to make an additional 8 percent price cut, a more reasonable approach is to get nominal expenditure back up to trend. That requires that the Federal Reserve increase the quantity of money enough so that it matches the amount of money people demand—want to hold—when their nominal expenditures are at trend. Looking to next year, a target for total final sales of domestic products of $16 trillion for the fourth quarter of 2010 is the best alternative._._

Copyright © 2010 by William Woolsey and The Free Enterprise Foundation. All rights reserved

About the author: Professor William Woolsey is a member of The Free Enterprise Foundation's editorial staff and senior writer on national economy reporting. Dr. Woolsey is a distinguished Professor of Economics in the Citadel’s School of Business Administration and a former Libertarian candidate for Congress.

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