One simple way of looking at the economy is in examining the big categories of spending.   Economists call these the national income accounts, or Y = C + I + G + Ex - Im (sorry, I couldn’t resist an equation). 

The total value of all production of goods and services in the U.S. (Y) has four big parts: consumption by consumers, investment in new equipment and buildings by businesses, government spending and net exports (the difference between imports and exports).   Consumption by households is the biggest part of the pie, followed by government spending, investment and net exports.

Net exports are a very small, currently just under 5 percent of the economy, but have improved enough since the recession ended that they are not worry.  Likewise, consumer spending— consumption—returned to pre-recession levels in late 2010.  If our economy relied wholly on consumption and net exports, the unemployment rate would back to normal.  It is not.

Government spending is a mixed bag.  At the federal level, government spending has grown substantially over the recession, while most states have cut back on spending.  Total federal spending increases over the recession were intended to ‘plug’ this decline in spending or ‘stimulate’ the economy.  It was accomplished through a TARP spending of more than $750 billion, a stimulus bill of more than $850 billion and annual budget increases that topped 10 percent of the federal budget.  This is several times what would have been necessary to bridge the gap in the economy that emerged from late 2007 to mid-2009, if stimulus spending worked as advertised in political speeches.  It clearly did not.  Why it did not is worth some explanation.

Throughout the 1990s economic research focused new on the cause of recessions.  The result was a better understanding of the small frictions that occur in business and households as they adjust spending, prices, locations, production levels, etc. to overall changes in the economy. My own doctoral dissertation measured these types of frictions, and was (a very small) part of a research stream known as New Keynesian theory. 

The failure of the stimulus and large federal budgets to lead to significant employment gains is very consistent with this new research.  Numerous small frictions by business and households unwittingly defeat government efforts to stimulate the economy.

Still, this does not seem to fully explain the languishing investment spending by businesses and households.  Another economist, who deserves a nod by the Nobel Prize committee this week, explained in the ’70s and ’80s that large government deficits were viewed by businesses and households as equivalent to large, but as yet uncollected tax increases. This meant that a stimulus plan would go largely unspent as businesses prepare for inevitable tax increases.  This is known technically as Barro-Ricardian Equivalence for you Wikipedia fans.

At some future date, these two explanations (favored by politicians from the left and right respectively) will be synthesized. Today, they both suggest that the large stimulus and enormous government spending deficits are in part to blame for the continued ill performance of the U.S. economy.