Microsoft Word Baily-Bosworth 11-09-2013 (revised)

Sources of the Weak Recovery 
Absent cyclical fluctuations, the composition of GDP changes only slowly over time; so, 
we can use the distribution of aggregate demand in the years before the recession relative to 
potential GDP as a benchmark to explore the composition of the current shortfall of GDP relative 
to potential. That comparison is shown in Table 1. During the pre-crisis years of 2006-07, actual 
GDP was essentially equal to potential (column 1). Columns 2-4 show the distribution of the 
GDP shortfall in the trough of the recession (2009:2) and two more recent quarters. At the level 
of total GDP, it shows the same shortfall discussed above with respect to Figure 2, but the table 
shows its distribution among the major components of aggregate demand. Because 
consumption accounts for a dominant share of GDP (67%), it is the largest single contributor to 
the deficit. However, it is also highly endogenous and sensitive to income changes. While the 
saving rate did rise in the early stages of the crisis (discussed later) the changes in consumer 
spending have largely matched those of household income.
On the other hand, residential construction stands out for contributing a disproportionate 
share of the shortfall compared to its relatively small role in the total economy. Similarly, the 
falloff in state and local government spending has been substantial; and, while federal spending 
was initially an important source of countercyclical stimulus, it has turned slightly negative in 
recent quarters. It is interesting to note that the shortfall in state and local (S&L) government 
spending seems to be growing as the recession continues, presumably due to the termination of 
the financial support that the federal government provided in the first few years of the downturn. 
Nonresidential investment was initially a large negative factor in the recession, but it has 
recovered significantly in recent years. The external trade balance has been the most important 
offset to the general fall in demand, but more than half of its change can be traced to a lower 
level of imports, which is in turn a reflection of the weakness of domestic demand.
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Historically, countries subject to large financial crises (Sweden, Japan, and Korea in the 1990s, for example) 
recovered through devaluation and a strong expansion of their trade balance. However, it is a limited option for the 
United States within the context of a weak global economy in which many other countries seek the same solution to 
their problems.

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An alternative approach, shown in Figure 3, is to index each component of real GDP to it 
level at the peak of the business cycle in 2007:4, and compare the cumulative change to their 
average behavior over past business cycles. The first two panels for GDP and consumption 
highlight the weakness of the general recovery. But again, residential investment stands out for 
the huge magnitude of its shortfall; and state and local expenditures and nonresidential 
investment, which are larger components of GDP, also remain below their pre-recession peaks.
The slow rebound of business investment is concentrated in nonresidential structures (not shown 
separately), which was about half the size of residential construction in the years before the 
recession and has followed a very similar pattern of collapse and feeble recovery. The depressed 
level of S&L spending is a particular surprise because they have not played a significant role in 
past business cycles. Federal expenditures were initially highly stimulative compared to past 
recessions, but have turned down in recent quarters. Exports and imports were both hit hard by 
the disruption of global trade in late 2008;since then, exports have matched their past rates of 
cyclical recovery, while imports have remained depressed. 
In summary, Table 1 and Figure 3 point to three main areas of difference between the 
economy of early 2013 and the full-employment economy of 2007. Residential and non-
residential construction, state and local spending and consumption all remain below their 
expected levels. Understanding the overall lack of recovery, therefore, requires explanations of 
why these components of demand have not rebounded. 
There is then a second question: why have other components of GDP not expanded to 
replace the missing demand? Many economists, ourselves included, complained before the 
recession that US growth was unbalanced, with too much residential construction and 
consumption, too little investment and too large a trade deficit. But we have learned to be 
careful what we wish for. Construction and consumption took a big hit in the Great Recession, 
but unfortunately investment and exports have not expanded to fill the demand gap.