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The following OECD assessment and recommendations summarise chapter 1 of the Economic survey of the United States published on 9 December 2008.
The US economy is going through very difficult times
After a long period of robust growth, the US economy has been struck by a confluence of adverse developments in reaction to past excesses during the upswing, as well as to exogenous shocks. The sharp housing downturn and the associated turmoil in financial markets have led to higher risk premiums, lower equity wealth and tighter credit standards, thereby hurting real activity. This has happened at a time when policymakers already had to grapple with persistent external imbalances and unsustainable fiscal trends. While financial intermediaries have suffered from heavy write downs, the household sector has also paid a heavy tribute of eroding real incomes, job losses, home foreclosures and declining wealth. The authorities have chosen to provide macroeconomic policy support to avert a prolonged decline of output, while keeping inflation expectations in check, but activity is nonetheless likely to get weaker before it gets better. Over time, these shocks will be absorbed and the economy will return toward its robust path of potential growth. Nevertheless, a variety of fiscal, social and environmental problems needs to be overcome. In this light, the present Survey discusses three important policy issues:
Macroeconomic policy to steer through conflicting forces. The adverse shocks that have pulled down growth are still exerting negative effects, and the negative feed back loop between the financial sector and the real economy may intensify. Steering a path through the various negative forces affecting the economy poses a severe test for monetary and fiscal policy.
Safeguarding and regulating the financial system. The collapse of the privately-securitised mortgage market has triggered a broad dislocation of the financial system, including outside the United States. The authorities responded by introducing a range of initiatives intended to support liquidity in a number of markets. In addition, they acted forcefully to address the risks posed by the imminent failure of systemically important financial intermediaries. But these actions run the risk of encouraging further imprudent behaviour in the future. The challenge will be to remain ready for further interventions if necessary, while improving prudential oversight.
Moving toward universal access to health care. US health spending per capita is the highest in the OECD, but health status does not compare especially favourably with other OECD countries and nearly 50 million Americans do not have adequate access to non-urgent medical care Because rapidly rising health costs contribute to increasing government spending, the challenge is to extend insurance coverage to all without causing a sharp rise in budgetary imbalances.
Strong headwinds are blowing from various directions.
The series of negative developments has been exerting a substantial drag on activity since mid-2007. The housing market is going through its most severe correction of the past 50 years, the financial crisis has intensified and commodity prices soared, before easing. The financial sector has been hard hit, with severe write downs and depressed equity prices. Households have also been hit with job losses, real income cuts, home foreclosures, tighter credit conditions and declining wealth. Acting against recessionary forces, the fiscal authorities have taken aggressive stimulus measures to support consumption, successfully attenuating the slowdown, though only temporarily. In addition, the monetary authority has eased its policy stance considerably. Welcome support has also come from buoyant exports, reflecting a weak dollar. While the economy stood up better than expected given the circumstances in the first half of 2008, labour markets and household incomes have deteriorated. House prices appear to have further to fall, and foreclosures are widely expected to continue to rise. The financial sector faces further difficulties in absorbing losses and recapitalising. Crafting appropriate monetary and fiscal policies will be vital in the context of what is likely to be a severely weakening real economy.
The financial crisis is affecting household spending
The US economy was facing substantial difficulties even before the recent deepening of the financial crisis. Enabled by loosening credit standards, households have borrowed at an unprecedented rate during the past 15 years. Households’ saving flows fell close to zero as they increasingly relied on rising stock and housing wealth to achieve their consumption objectives. Consumption expenditure rose above 70% of GDP, an historic record, as households borrowed against wealth to finance consumption, and US household indebtedness at present exceeds that in most other OECD countries. Now that household wealth is declining and credit conditions have become much stricter, consumers will probably have to boost their rate of saving appreciably over time and reduce their reliance on borrowing.
Activity is likely to contract over the near term, and there are downside risks
As the economy confronts these difficulties, real activity is likely to contract over the near term. Once financial conditions normalise, recessionary forces should attenuate and the economy should gradually revive. The collapse of residential investment, following past excesses in the mortgage market, has exerted a strong drag on growth, but this negative contribution will eventually wane. As well, the negative effect of elevated commodity prices, which entailed real income cuts, has reversed, which should attenuate the downturn. Nonetheless, sharp downside risks to growth may aggravate the situation further. Solvency issues at some financial institutions are still a concern, raising the threat of further financial market disruption. The credit squeeze has been spreading from the mortgage market to other forms of lending and could impair the credit market further. The dynamism of exports, which have supported growth as domestic demand slumped, could disappear if sharply weaker growth becomes a global problem. Overall, macroeconomic policy should stand ready to provide renewed stimulus.
Headline inflation was high
Headline inflation was high for most of 2008. Although commodity prices fell in the second half of the year, their past ascent pushed up headline inflation and core inflation to higher levels than the Federal Reserve would have preferred. Second round effects, however, have been limited, thanks to reduced margins, wage moderation and dynamic productivity. While some indicators suggested that near term inflation expectations had moved up temporarily, long term inflation expectations always appeared relatively well anchored.
Strong monetary policy stimulus is appropriate, but will need to be withdrawn promptly as conditions normalise
Facing strong headwinds and severe financial turbulence, monetary policy has been aggressively eased. In addition, the Federal Reserve has implemented innovative steps to address strains in financial markets and to circumvent liquidity trap risks, by sharply changing the size and composition of its balance sheet as well as by extending credit to nonfinancial corporations. These aggressive steps have helped to boost liquidity, but the full effects of the forceful easing of monetary policy should be felt only after financial market conditions normalise. Monetary policy is now more accommodative than what would be suggested by standard policy rules. However, it appears to be roughly appropriate in light of the adverse effects on real activity of factors such as the financial crisis, including high credit spreads and sharply tightened lending standards. Monetary policy should remain highly accommodative for quite some time to support the economy and the financial system. However, interest rates will have to be normalised promptly as the economy starts to recover and concerns about a worsening of financial market instability recede.
A helpful short-term fiscal stimulus…
The 2008 fiscal stimulus package, with rebate cheques worth nearly 1% of GDP sent to eligible households in record time, has provided strong and timely support to aggregate demand. The tax rebate payments boosted household disposable income sharply during the second quarter and a share of this additional income was used to increase consumer spending. The budgetary stimulus should have continued to exercise positive effects on private consumption during the third quarter, but it is expected to wane towards the end of the year. This prospect of a fall back in consumption has prompted discussions about a second fiscal stimulus package to steer the economy towards recovery. If financial conditions and the economic outlook do not quickly improve, additional fiscal stimulus would be desirable to firm up prospects for a more rapid recovery. However, given the underlying fiscal situation, the package should aim to be strictly temporary, timely and targeted -- like the first stimulus package.
… but the financial crisis entails large fiscal risks …
Resolving the financial sector’s difficulties is requiring substantial government spending, as did past banking crises. The public sector is assuming very large fiscal and quasi fiscal contingent liabilities. The Federal Reserve, the US Treasury and the Federal Deposit Insurance Corporation (FDIC) have taken indispensable decisions when financial institutions faced sudden liquidity squeezes, but the long-term effects of these actions pose challenges. In the course of facilitating the Bear Stearns transaction and opening a secured lending facility for AIG, the Federal Reserve exposed its balance sheet to the risk of losses from mortgage related assets; if realised such losses would flow through to the federal government. The recently enacted Emergency Economic Stabilization Act of 2008 has authorised outlays of up to $700 billion to inject capital into financial institutions as well as to purchase or guarantee a broad array of assets. Large contingent fiscal liabilities stem from the government takeover of Fannie Mae and Freddie Mac. Past banking crises have been expensive in terms of deposit insurance, as shown by the experience of the Resolution Trust Corporation created in the early 1990s to deal with the savings and loans crisis, which came with large fiscal costs. Future bailouts, if needed, should similarly be tailored to be highly effective in combating financial market stress, while protecting taxpayers as much as possible.
… and long-term fiscal trends are unsustainable
Fiscal policy has to deal with other difficult issues in the next few years. In particular, there is strong pressure for reforming the Alternative Minimum Tax (AMT), which will reach a sharply higher number of households starting in 2009 if left unchanged, due to expiring provisions. Similarly, the tax reliefs of 2001 and 2003, which temporarily reduced personal income taxation, are set to expire at the end of 2010. Extending these tax cuts without offsetting budgetary measures would, however, cause additional fiscal gaps. Over the longer term, the ageing of the population and other trends put the federal budget on an unsustainable course. According to the Congressional Budget Office, under current legislation Social security spending on retirement income will increase from 4.3% to 5.6% of GDP in 2055. Even more worryingly, health related public expenditure (Medicare and Medicaid) will rise from 4.1% to 12% of GDP in 2050, reflecting the combination of population ageing and technology related rises in health expenditure. In view of this, the budget should be put back on a course of consolidation as soon as possible, with both expenditure and revenue measures.
Pricing carbon emissions to reflect their environmental costs could minimise the economic costs of achieving climate change objectives
US policymakers also face the challenge of reducing growth in greenhouse gas (GHG) emissions in the context of global efforts to combat climate change. The US contribution to these efforts will have an important bearing on their success owing to the scale of US emissions, which are approximately one sixth of the global total. Such emissions have grown somewhat more quickly in the United States than in most other OECD countries since 1990, mainly reflecting higher economic growth, and are much higher in relation to either economic activity or population than in many other countries. Factors that contribute to high US emissions include reliance on traditional coal fired power stations and high annual distances travelled per capita in vehicles that, on average, have relatively high fuel consumption. Low road fuel taxes may contribute to relatively high annual vehicle miles travelled and household preferences for lower fuel economy vehicles. The US authorities have adopted the targets of reducing the GHG emission intensity of the economy by 18% over 2002 2012 and of stabilising GHG emissions by 2025. The government also signed a G8 declaration to cut GHG emissions by 50% by 2050. To support the achievement of these goals, the government is focusing on improving vehicle fuel economy standards, increasing the domestic production of bio fuels, and supporting energy R&D for cleaner energy supply technologies, renewable sources, methane capture and use, and nuclear energy. Currently, U.S. bio fuels are mainly produced from maize based ethanol. Studies suggest that support for such first generation bio fuels programmes is an inefficient means of reducing GHG emissions and has put upward pressure on some commodity prices. The government is also supporting the development of second generation bio fuels, which promise to be more efficient but for which significant technical barriers remain to be overcome before commercialisation. In addition to revising current R&D support to be more technology-neutral, the authorities could price carbon emissions to reflect their environmental costs, either through a cap-and-trade system or a carbon tax. In this way, emission reductions could be achieved at the lowest economic costs. For substantial global emission cuts to be achieved at a manageable cost, it will also be necessary for other large emitters, countries and sectors to adopt similar policies.
How to obtain this publication
The Policy Brief (pdf format) can be downloaded in English. It contains the OECD assessment and recommendations.The complete edition of the Economic survey of the United States 2008 is available from:
For further information please contact the United States Desk at the OECD Economics Department at email@example.com. The OECD Secretariat's report was prepared by David Carey and Andrea de Michelis under the supervision of Patrick Lenain. Research assistance was provided by Laure Meuro and Roselyn Jamin.