Distress signal

By R.A. | WASHINGTON

IN 2007, the great ship of the American economy began encountering darkening skies. In 2008, it was suddenly faced with a violent storm which blew it miles off course, well south of where it ought to have been. The country's leaders didn't know how far from their charted path they'd been swept, but they recognised a need to make a course correction. Now, three years later, a look at the maps tells us that the storm was more powerful than previously believed, and it left the vessel much farther south than anyone had expected. The course corrections made earlier? Far too small to bring the ship back to its previous path. Yet none of America's leaders are trying to steer the ship back northward. Indeed, many seem anxious to yank on the tiller and drag the economy farther south still.

It has long been clear that America's recovery sagged worrisomely in the first half of 2011. This morning's second-quarter GDP report reveals, however, that despite concern, most observers were too optimistic in their assessment of the economy's strength. Even more distressing, a series of revisions to past figures reveals a recession that was substantially worse than previously understood, which has left America in a bigger hole than imagined.

America's economy expanded at a 1.3% annual pace in the period from April to June of 2011. That was less than economists expected. Personal consumption growth slowed dramatically behind a drop in purchases of durable consumer goods, largely attributable to higher automobile prices associated with supply disruptions in the wake of the Japanese earthquake. Investment growth continued at a moderate pace. Businesses kept spending on new equipment, and residential investment was a small but positive contributor to output—a rare occurence in recent years. Net exports added slightly to growth, thanks mostly to a big drop in imports. But adding to the weight of the decline in consumer spending was the drag from cuts to government spending and investment.

As disappointing as the second quarter figures are, they're substantially better than the numbers for the first quarter. The Bureau of Economic Analysis initially pegged first-quarter growth at 1.9%, only to revise that figure down to 0.4% growth in the new release. Government represented a significant drag in the first quarter, chopping 1.23 percentage points off of growth, 0.41 precentage points of which were due to state and local cuts, and 0.74 percentage points of which can be chalked up to declining defence spending. Indeed, the new report reveals the extent to which government has been an obstacle to recovery. In five of the last seven quarters, government has contributed negatively to growth, again thanks mostly to large state- and local-government cuts that offset the federal government's modest attempts at stimulus.

The picture grows bleaker the farther back one looks. BEA revised its national accounts numbers back to 2007 for this release, and the picture revealed is far darker than anyone previously believed. From 2007 to 2010, real output declined by 0.3% per year on average. Previously, BEA had estimated annual growth of 0.1% over that period. The decline in output during the intense period of financial crisis was significantly more severe than economists had thought. In 2008, the economy shrank 0.3%, rather than holding flat, as earlier estimated. In 2009, the economy shrank 3.5%, worse than the earlier 2.6% projection. During the ugliest months of the crisis, in the fourth quarter of 2008 and the first quarter of 2009, output declined at a shocking 8.9% and 6.7% annual pace, respectively. It is now clear that the American economy has yet to reattain its previous peak in real output, achieved three full years ago.

If nothing else, this awful report helps to solve a number of lingering mysteries concerning the crisis. Arguments that unemployment must be structural, given the failure of projected growth rates to generate new hiring, now look silly. Projected growth rates were simply overstated, and current unemployment is exactly what we'd expect given such a feeble recovery. Those overly optimistic assessments of the likely impact of interventions, from fiscal stimulus to QE, also make much more sense now. Policymakers were fighting a fire far more intense than they recognised.

Of course, the previous underuse of countercyclical policy suggests that it's more important than ever to get policy right now. Unfortunately, Washington is failing miserably on this score. Policy stances that were inadequate before now look dangerously tight. The Federal Reserve should have all the excuse it needs to reconsider its decision to halt purchases of government assets. Despite all the warnings about inflation, the core Personal Consumption Expenditures price index, which the Fed follows closely, rose just 1.3% in the year to the second quarter. That's far too low.

Meanwhile, Congress' behaviour looks incredibly reckless in light of new figures. This publication has argued consistently that while America needs to address its medium- and long-run fiscal challenges, immediate austerity would be a mistake. The dire economic situation undergirds this point: Washington should delay immediate fiscal cuts. Indeed, it ought to be spending more now and revisiting the possibility of a payroll tax cut.

Instead, it seems as though the best possible outcome of the current debt-ceiling impasse is a deal which hacks away at current spending, increasing the government drag on growth. The risk remains, however, that Congress will fail to reach a deal in time, piling immediate, chaotic spending cuts of about 44% on top of the current malaise. Given consumer anxiety, the risk of a catastrophic government failure, however small, isn't helping.

And of course, there is no shortage of trouble elsewhere. All signs indicate that now is the time for policymakers to rush to the tiller and pilot the ship quickly and decisively back on course. Instead, leaders have left the economy adrift, even as rocks loom ahead.