[Economic Report of the President (2012)]
[Administration of Barack H. Obama]
[Online through the Government Printing Office, www.gpo.gov]


The Year in Review and the Years Ahead

The U.S. economy continued to recover in 2011 from the deep recession
that began at the end of 2007. The real value of goods and services
produced in the economy, as measured by gross domestic product adjusted
for changes in prices (real GDP), has now grown in each of the past 10
quarters. In the third quarter of 2011, real output surpassed the level
last reached at the business--cycle peak in the fourth quarter of 2007.
Employment continued to expand in 2011, and the private sector created
more than 3 million new jobs in 2010 and 2011, about in line with the
recovery from the 1991 recession and faster than the recovery from the
2001 recession.
However, the level of unemployment remains too high, and the pace of
the recovery in output and employment would in all likelihood be faster
if it were not for the lingering effects of the financial crisis. The
destruction of household wealth during the financial crisis and the
deep recession that followed appears to have restrained the growth of
consumption during the recovery, particularly in services. Investment
in new residential construction also remains much weaker than in
typical recoveries, a reflection of soft demand since the recession as
well as the vast amount of overbuilding of houses during the years
leading up to the crisis. Growth in other components of demand, such
as business investment and exports, has followed trajectories more
typical of business--cycle recoveries, and in some cases has been even
stronger than average.
To put the current U.S. recovery in historical and international
context, this chapter presents an overview of the influential work by
Charles Kindleberger (1978) and Carmen Reinhart and Kenneth Rogoff
(2009), who argue that recessions associated with financial crises are
typically deeper than normal downturns and that the recoveries that
follow tend to take longer. As severe as the recession was, the drop in
U.S. real GDP after the financial crisis of 2008 was smaller than the
average decline in recessions associated with other severe, systemic
financial crises in various countries over the past 40 years.
Similarly, the rise in U.S. unemployment was less extreme than the
average experience following these financial crises, and it peaked
earlier. As of January 2012, the unemployment rate has fallen by 1.7
percentage points since peaking in October 2009.
This chapter also reviews the developments of 2011 for individual
sectors of the U.S. economy. In the household sector, credit conditions
continued to improve, and purchases of durable goods--such as motor
vehicles--rose at a robust pace. Households continued to work down debt
in 2011. As noted, growth in consumption remained somewhat restrained,
however, as households continued to pay down debt and growth in nominal
income slowed. In the business sector, investment in equipment and
software posted solid gains in 2011, and global demand for U.S. goods
and services was strong. The growth in U.S. exports supported job
creation in 2011 as well as the continued expansion of manufacturing
output. Conditions in residential real estate markets continued to
stabilize in 2011, with a modest uptick toward the end of the year, but
demand for new housing remained weak. Spending by State and local
governments was also severely restrained in 2011 by tight budgets. Much
of the weakness in these areas can be tied directly to the financial
crisis and the problems that precipitated the crisis.


Real GDP rose 1.6 percent over the four quarters of 2011 after having
risen 3.1 percent in 2010. Output expanded at an annual rate of only
0.8 percent in the first half of the year, when a series of shocks--
among them a sharp rise in the price of oil due to turmoil in the
Middle East--appeared to reduce consumer and business sentiment and
dampen economic activity. As the effects of the transitory shocks waned
in the second half of the year, real GDP growth picked up to an average
annual rate of 2.3 percent (Figure 2-1).
Nonfarm private payroll employment expanded by 2.1 million jobs
during the twelve months of 2011, having added 1.3 million jobs in the
last 10 months of 2010. The recovery in payroll employment, like that
in real output, was uneven over the months of 2011. Payrolls expanded
moderately near the beginning of the year, but job creation slowed in
the spring and summer before picking up again in the fall. The
unemployment rate fell over the course of the year, from 9.4 percent in
December 2010 to 8.5 percent in December 2011, and then to 8.3 percent
in January 2012.
A Series of Global Shocks and Revised GDP Data. A succession of
global shocks turned 2011 into a turbulent year for the U.S. economy.
The collapse of Libyan crude oil production during that nation's
revolution caused world oil markets to tighten near the beginning of
the year. The price

refiners paid for crude oil rose from an average of $78 a barrel in the
second half of 2010 to $101 a barrel in the first half of 2011. The $23
per-barrel increase led to higher gasoline prices, eroded the real
purchasing power of disposable personal income by more than $50 billion
at an annual rate, and dampened consumer confidence. Consumers appear
to have reacted with a combination of reduced spending on other goods
and services and a lower saving rate than might otherwise have been the
case. The 2 percentage point cut in the payroll tax for workers that
President Obama proposed and the Congress passed near the end of 2010
helped offset the impact of higher oil prices.
Another supply shock hit the world economy in March 2011, when an
earthquake struck northeastern Japan and set off a tsunami, a disaster
that resulted in a devastating human toll and required a massive
rebuilding effort. Economic activity across the globe slowed because
damage to Japan's electrical grid disrupted industrial output
throughout the country. As a result, global supply chains in some
industries faced shortages of key parts. In the United States, vehicle
assembly plants were forced to cut production when supplies of critical
parts produced in Japan became scarce. U.S. motor vehicle production
fell 21.2 percent at an annual rate in the second quarter before
rebounding in the third and fourth quarters.
In the summer, concerns mounted over sovereign debts and financial
institutions in Europe and the likelihood of a global slowdown in
economic growth. In addition, the contentious debate in Congress over
raising the statutory debt ceiling kept financial markets on edge and
appeared to weigh on equity markets over the summer and fall.
In addition, revised estimates of U.S. real GDP released by the
Bureau of Economic Analysis (BEA) in July 2011 revealed that the
2007-09 recession was more severe than had been originally reported.
Real GDP fell at an average annual rate of 7.8 percent in the fourth
quarter of 2008 and the first quarter of 2009, the sharpest two-quarter
contraction since quarterly GDP data began being collected in 1947. The
change to the estimate for the fourth quarter of 2008 was particularly
stark. The BEA originally estimated that output contracted at an annual
rate of 3.8 percent that quarter, but its July 2011 revised estimate
showed an 8.9 percent rate of contraction. The downward change of 5.1
percentage points was the largest downward adjustment to the quarterly
data ever reported. The BEA also revised down the average annual rate
of growth during the recovery (from the second quarter of 2009 through
the first quarter of 2011) by 0.2 percentage point, to 2.6 percent.
Policy Developments in late 2010 and 2011. Supportive policies
enacted near the end of 2010--the Tax Relief, Unemployment Insurance
Reauthorization, and Job Creation Act (TRUIRJCA)--cushioned the adverse
shocks experienced in 2011. Provisions in the legislation included a 2
percentage point reduction in workers' payroll taxes and a continuation
of the extended and emergency unemployment benefit programs through the
end of 2011. In the absence of this legislation, real GDP growth over
the four quarters of 2011 would have been lower by 0.9 to 2.8
percentage points, according to the Congressional Budget Office (CBO
2011b). Because the legislative package was constructed to be
temporary (including mostly one- and two-year provisions), it had
little effect on the long-term deficit.
The American Recovery and Reinvestment Act (Recovery Act), enacted in
early 2009 when real GDP was contracting at an annual rate of more than
6 percent and employment was falling by more than 700,000 jobs a month,
also continued to support the level of real GDP in 2011, although its
effect, which had been designed to be strongest during 2009 and 2010,
was gradually declining. In 2011, Recovery Act-related outlays,
obligations, and tax cuts totaled $117 billion, down from $350 billion
a year earlier, as measured in the National Income and Product
Accounts. The Council of Economic Advisers (CEA 2011) estimates that
the Recovery Act increased GDP as of the second quarter of 2011,
relative to what it otherwise would have been, by 2.0 to 2.9 percent
and raised employment by between 2.2 million and 4.2 million jobs. The
CBO and outside analysts have also presented estimates in this range.
In 2011, the Administration proposed additional steps to strengthen
and sustain the economic recovery in the wake of world events that
posed increasing risks to growth. Before a joint session of Congress on
September 8, 2011, the President proposed the American Jobs Act to
strengthen the current recovery and spur the creation of new jobs. The
American Jobs Act incorporated a number of proposals that some
independent economists estimated could have boosted payrolls by 1.3
million to 1.9 million jobs by the end of 2012 (for example,
Macroeconomic Advisers 2011). Equally important, the American Jobs Act
would not have added to the long-term Federal Budget deficit. The CBO
(2011a) estimated that revenue raisers recommended by the President in
September would have more than offset the cost of the proposed tax cuts
and investments. Specifically, the bill proposed limiting deductions
and exclusions for upper-income taxpayers, taxing carried interest
earned on private equity and hedge fund investments at the same rate as
ordinary income, and eliminating certain tax provisions for oil and gas
production companies.
The full American Jobs Act did not pass Congress in the form that the
President proposed. Nevertheless, the President kept pressing for
measures to support economic growth and job creation and will keep
doing so until every American looking for work can get a job. In
November, the President won enactment of one element of the American
Jobs Act: a new tax credit for America's veterans that provides up to
$5,600 to businesses that hire veterans who have been unemployed for
more than 26 weeks and $9,600 for businesses that hire a veteran with a
service-related disability.
And, in the waning days of 2011, the President signed into law a
2-month extension of the 2 percentage point reduction in workers'
payroll taxes and of the emergency and extended unemployment insurance
programs. Those initiatives were mostly paid for by an increase in
guarantee fees charged to lenders by Fannie Mae and Freddie Mac. The
President has called on Congress to extend these policies for the
entire calendar year. The extension of the payroll tax cut for the rest
of 2012 would help approximately 160 million full-time and part-time
workers and provide a typical worker with an additional $40 in each
bi-weekly paycheck. The full-year extension of unemployment insurance
programs would prevent 5 million unemployed workers from exhausting
benefits this year and help support the equivalent of about 500,000
cumulative job-years of employment by the end of 2014 as these benefits
are spent.
Policy actions by the Federal Reserve also supported the recovery in
2011. Monetary policy remained accommodative throughout the year, with
the Federal Open Market Committee (FOMC) maintaining a target range for
the federal funds rate of 0 to 0.25 percent. During the first half of
the year, the FOMC continued to advise that economic conditions were
"likely to warrant exceptionally low levels for the federal funds rate
for an extended period." In June, the Federal Reserve completed the
program first announced in November 2010 under which it purchased $600
billion of longer-term Treasury securities, and the FOMC maintained its
policy of reinvesting principal payments from its holdings of debt and
mortgage-backed securities issued by Fannie Mae and Freddie Mac.
The FOMC took steps in the second half of 2011 and in the early part
of 2012 to further ease conditions in financial markets and to provide
additional support to the recovery. In the statement released following
its August 2011 meeting, the FOMC said that it expected economic
conditions to warrant exceptionally low levels for the federal funds
rate at least through mid-2013. In January 2012, the committee extended
this period until at least late-2014. The committee voted at its
September 2011 meeting to extend the average maturity of the Federal
Reserve's holdings of Treasury securities in order to lower longer-term
interest rates. In response to the escalation of the sovereign debt
crisis in Europe, the FOMC approved an extension of the temporary U.S.
dollar liquidity swap arrangements with a number of foreign central
banks in June and again in November.\1\

\1\The Federal Reserve receives collateral in the form of foreign
currency during the life of the transaction. The exchange rate used for
the transaction is based on the market exchange rate at the time of the
transaction. The swap is unwound at the same exchange rate, so the Fed
is not exposed to any currency risk resulting from the transaction.


The 2007-08 financial crisis and the drop in economic activity during
the recession were unprecedented. In the two and a half years that have
elapsed since the official end of the recession, real U.S. GDP has
risen 6.2 percent, enough to recoup the 5.1 percent loss of real output
recorded during the recession. The pace of GDP growth during the
recovery has been almost the same as the rates of growth observed
during the recoveries that followed the 1991 and 2001 recessions
(Figure 2-2), although private employment has grown at a faster pace
than in the 2001 recession.
A major reason that the rate of real GDP growth has not been faster
during the current recovery involves the lingering effects of the
financial crisis. As argued by Kindleberger (1978) and Reinhart and
Rogoff (2009), recessions linked with financial crises tend to be
deeper than other recessions, and the subsequent recoveries take
longer. Hall (2010) and Woodford (2010) argue that recessions around
financial crises are worse, in part,

because the critical intermediation role played by the financial sector
is disrupted. Financial crises also tend to spread across countries,
temporarily reducing the volume of world trade and restraining growth
of output during the recovery, as noted by Reinhart and Rogoff (2009)
and IMF (2009). Housing slumps are also typically associated with
slower growth during recoveries (Howard, Martin, and Wilson 2011).
Some sectors of the U.S. economy are recovering at a moderate pace,
while growth in other sectors continues to be restrained by the
lingering effects of the financial crisis. In the current recovery,
real U.S. exports have risen at a robust pace and have exceeded their
average rate of growth in the preceding eight recoveries. Business
fixed investment has been about as strong in the current recovery as in
the average U.S. recovery. Real residential investment, in contrast,
had barely returned to its level at the business-cycle trough by the
very end of 2011, whereas this type of investment in a typical U.S.
recovery would have increased roughly 34 percent over a comparable
period. In addition, real expenditures by State and local governments
have continued to decline, on balance, during the current recovery,
instead of rising, as they had in every other postwar recovery.
Personal consumption expenditures have risen more slowly in the
current recovery than in the average U.S. recovery. The slower recovery
in consumer spending may partly reflect the sharp losses in household
net worth caused by the financial crisis and the high levels of
consumer debt--including mortgage debt--taken on during the period
leading up to the financial crisis. After the collapse in house prices
destroyed large amounts of household net worth, households have reduced
their consumption as they work down debt taken on before the crisis.
To put the 2007-09 U.S. recession in international and historical
contexts, Figure 2-3 compares the depth and duration of the 2007-09
recession in the United States with 14 recessions including the 1929
downturn in the United States, a group of recessions categorized by
Reinhart and Rogoff (2009) as occurring near major systemic banking
crises.\2\ The horizontal bars on the left of the figure refer to the
decline in real output measured in each of the recessions, and the bars
on the right report the length of each recession, measured as the
number of quarters between the peak and trough of real output.

\2\ The crises shown in Figure 2-3 are the major, systemic banking
crises included in Reinhart and Rogoff (2009) Table 14-3. The analysis
here differs from Reinhart and Rogoff (2009) in that we use seasonally
adjusted quarterly real GDP rather than annual real GDP per capita.

While the drop in real U.S. GDP reached as high as 8.9 percent at an
annual rate in the last quarter of 2008, the figure shows that the
cumulative decline in GDP was 5.1 percent during the recession. This
was the biggest drop in U.S. output during any business-cycle
contraction since the Great Depression, although it was less drastic
than the declines in output experienced in most other financial
crises, and well below the average decline of 10.2 percent. The
duration of the recent U.S. downturn, which measured six quarters, was
about 10 percent shorter than the average. The breadth and speed of the
emergency economic recovery measures that were put in place to address
the financial and economic crisis, including the Recovery Act and
Financial Stability Plan, as well as extraordinary actions by the
Federal Reserve Board, are the main reasons why the economy avoided a
steeper and more prolonged decline, with growth returning by the middle
of 2009.
Figure 2-4 compares the rise in the unemployment rate in the United
States between the fourth quarter of 2007 and January 2012 with the
average rise in unemployment following the business-cycle peaks for the
14 financial crises shown in Figure 2-3. Between the fourth quarter of
2007 and the fourth quarter of 2009, the U.S. unemployment rate rose
more sharply than the average cumulative rise over the first 8 quarters
after these business-cycle peaks, but then it peaked and declined over
the next two years--an outcome less severe than the average rise in
unemployment around other financial crises. If the United States had
followed the path of the average country during a financial crisis
recession, the unemployment rate would have been 10.4 percent in
January 2012 instead of 8.3 percent.

According to analysis by the Congressional Budget Office and private-
sector forecasters, the Recovery Act, the Financial Stability Plan, and
the extraordinary and exigent actions taken by the Federal Reserve had
sizable, positive effects on U.S. GDP and employment in 2009. Rather
than plunging into what many think could have been a second Great
Depression, the U.S. economy began to grow again in the second half of
2009. As a result, the 2007-09 recession was shallower and shorter in
duration than the average recession experienced by a country after a
major financial crisis, and unemployment started to come down sooner
and swifter.


Consumption and Saving

Consumer spending--a category that makes up about 70 percent of GDP--
rose moderately in 2011, as credit conditions continued to ease,
household liabilities fell relative to income, and the labor market
continued to recover. Gains over the year were uneven, however, in the
face of upheavals at the beginning of the year. Partly reflecting
these shocks, real consumer spending rose at an annual rate of only 1.4
percent in the first half of 2011, having increased more than 3 percent
at an annual rate in the second half of 2010. The slowdown in spending
growth would have been more severe in the absence of the workers'
payroll tax cut, which offset oil price shocks early in the year and
supported household consumption.
The disturbances that slowed consumption growth in the early part of
the year proved transitory, and their effects dissipated in the second
half of the year; oil prices stabilized over the summer, and by the
fourth quarter, production (and availability) of motor vehicles had
returned to levels that prevailed before the earthquake in Japan
disrupted supply chains. The second half of 2011 brought new
challenges, however. Concerns about the weakening pace of growth in
several industrialized economies--most notably in Europe--escalated
during the summer, and the contentious debates held in Congress over
raising the statutory debt ceiling unsettled equity markets. The stock
market and consumer confidence both fell in the third quarter before
rebounding in the fourth quarter and early 2012. Despite these
headwinds, the growth rate of real consumer spending picked up in the
third and fourth quarters to an average annual rate of 1.9 percent.
Several key developments in 2011 shaped the contours of consumer
Household Income in 2011. Nominal personal income grew 3.9 percent
during the four quarters of 2011, a somewhat slower pace of growth
than in 2010. Growth in nominal personal income was held down in 2011
by a slowdown in job growth near the middle of the year. Real
disposable personal income, which is personal income less personal
taxes and adjusted for price changes, edged down 0.1 percent over the
four quarters of 2011 after having risen 3.5 percent in the year-
earlier period. The purchasing power of wages and salaries was
curtailed somewhat in 2011 by a run-up in food and energy prices in the
first half of the year, which appeared to have passed through to the
prices of some other goods and services as well. As noted, tax policies
passed near the end of 2010 helped cushion some of the effects of these
price increases on consumers while providing an additional boost to
income. The Administration seeks to extend the workers' payroll tax cut
in 2012 and to provide additional immediate support for aggregate demand
through the continuation of extended unemployment insurance benefits and
other measures initially proposed in the American Jobs Act.
Household Wealth and Saving in 2011. The wealth-to-income ratio,
depicted in Figure 2-5, declined in the third quarter of 2011 after
rising, on balance, since the beginning of 2009. The consumption rate
(shown in the figure as the share of disposable income consumed) tends
to fluctuate with the wealth-to-income ratio. As a rule of thumb, a one
dollar drop in wealth tends to reduce annual consumer spending by about
two to five cents, although the source of the wealth change (housing or
equities, for example)

also may matter. The decline in the wealth-to-income ratio from the
second quarter of 2007 to its low point in the first quarter of 2009
amounted to 1.8 years of income. (In other words, household wealth
declined by the amount of income earned in 1.8 years). The drop in the
wealth-to-income ratio over this period was the deepest sustained
decline since 1952, when these data began to be compiled. Of the total
decline, 1.1 years were lost from the decline in stock market wealth,
and about 0.6 year from net housing wealth. All told, a drop in wealth
of this magnitude could be expected to reduce personal consumption
expenditures by about 6.7 percent.
Equity prices fell during the summer of 2011 before regaining most of
the losses toward the end of the year. Driven in part by the rise in
uncertainty during the debt ceiling debate as well as external events
in Japan and Europe, consumer sentiment also dropped to low levels in
the summer before partially rebounding toward year's end.
Households continued to work down their debt through the third
quarter of 2011 (the latest data available as this report goes to
press). The personal saving rate--expressed in the National Income and
Product Accounts as a share of disposable personal income--fluctuated
around 5 percent for the first half of 2011, about the same rate as in
2010 but below the average rate of about 6 percent observed in the
first half of 2009. The personal saving rate fell in the second half of
2011 to 3.8 percent, a decline from the first half of 2011 that may
have partially reflected the pick up in purchases of consumer
durables, especially new vehicles. Purchases of new motor vehicles, are
counted as a consumption outlay in the National Income and Product
Accounts even though households view these purchases as investment, and
so a rise in vehicle purchases reduces the personal saving rate.
Looking ahead, the personal saving rate appears roughly consistent at
current levels with household wealth. As a consequence, while some
further drops in the saving rate are possible, the growth rate of real
consumer spending in the years ahead would be expected to largely
mirror the growth rate of income, barring a dramatic change in asset
prices. Even so, further increases in household purchases of durable
goods, perhaps reflecting pent-up demand for motor vehicle purchases
that were deferred during the recession, may reduce the saving rate
Some of the recent patterns in aggregate spending and saving
behavior--including the sluggish growth in consumer spending--may
reflect the sharp rise over the past 30 years in the inequality in the
income distribution in the United States. As the Congressional Budget
Office recently noted, the top 1 percent of families had a 278 percent
increase in their real after-tax income from 1979 to 2007, while the
middle 60 percent had an increase of less than 40 percent. As a result
of these trends, the very top income earners have pulled much further
ahead of everyone else. (See Chapter 6 for a discussion of shifts in
the income distribution.)
The effects of this dramatic shift in the income distribution on
aggregate demand are hard to document, although some of the spending
patterns in the Consumer Expenditure Survey reveal evidence of the
increasing inequality of income. For example, the share of income spent
on luxury goods and services, such as entertainment, relative to
necessities, such as food, is higher for high-income households than
for low-income households, and this gap has widened over time (Aguiar
and Bils 2011).
Several authors have argued that increases in inequality have likely
adversely affected the economy.\3\ For example, the rise in income
inequality may have reduced aggregate demand, because the highest
income earners typically spend a lower share of their income-at least
over intermediate horizons-than do other income groups. The following
calculation illustrates the potential magnitude of this effect. As
shown in recent research by Piketty and Saez (2003, 2010), the share of
all income going to the top 1 percent has risen sharply over the past
three decades, rising by 13.5 percentage points, from 10 percent to
23.5 percent, between 1979 and 2007. This is the equivalent of about
$1.2 trillion of annual income in 2007. Research on the saving rate (or
marginal propensity to consume) of families at the very top of the
income distribution is scarce, but one study (Dynan, Skinner, and
Zeldes 2004) implies that the top 1 percent of households save about
half of their total current income, while the population at large has a
saving rate of about 10 percent of their total income.\4\ This finding
implies that if another $1.2 trillion had been earned by the bottom 99
percent instead of the top 1 percent of income earners, annual
consumption could have been about $480 billion--or about 5 percent--

\3\ See Rajan (2010) and Reich (2010). Kaldor (1956) provides some
early research in this area.
\4\ The saving rate cited here refers to the change in real net worth
as a share of real pre-tax income, a measure that differs from the
personal saving rate reported in the National Income and Product

There are many caveats to this calculation, because the marginal
propensity to consume is not well established for the extreme upper end
of the income distribution. In addition, aggregate consumption may not
have been reduced by a full 5 percent because the dramatic shift in the
income distribution likely led many households to accrue more debt. In
his book Fault Lines, Raghuram Rajan (Rajan 2010) argues that slow
income growth for the middle class led, in part, to the rising levels of
debt and the overleveraging that played a central role in the 2007-08
financial crisis.\5\

\5\ Note that the increase in leverage by the middle class may explain
why the aggregate saving rate did not rise despite the shift in income
to high savers.

Increases in the inequality of income have been developing for some
time, but their effects on aggregate demand may have become more
pronounced in the wake of the financial crisis. Increasing levels of
debt during 1979-2007 may have masked the influence of the rising
inequality of incomes on aggregate consumer spending, because increased
access to credit card debt, other consumer loans, and mortgage loans
allowed the growth of purchases to outpace the growth of income for
most income groups. With the onset of the recession and financial
crisis, however, the scope for this level of borrowing came to an
abrupt end. Access to credit, particularly for mortgages, was severely
restricted, and the average consumer was left with elevated levels of
debt taken on before the crisis. Since the crisis, the process of
deleveraging appears to have reduced consumption below what it would
have been otherwise. By targeting support to a broad group of American
workers--including those with a higher propensity to spend additional
income--the measures the President put forward in the American Jobs
Act, like the payroll tax cut and extension of unemployment benefits,
are likely to have a greater impact on consumption and aggregate demand
than alternative measures.
Other Influences on Consumption in 2011. For the second consecutive
year, lending standards eased, as reported in the Federal Reserve's
senior loan officer survey, and consumer credit expanded modestly over
the first three quarters of 2011. The level of overall household debt
fell in 2011, reflecting a decline in mortgage debt. The decline in
real household debt outstanding in the current recovery has been
unprecedented, which suggests that the process of deleveraging has
played a sizable role in household consumption decisions in recent
Reflecting, in part, the improvement in credit availability since
2009, household consumption of durable goods, including items such as
new and used automobiles as well as household electronics, furniture,
and other appliances has risen at a solid pace in the current recovery
and somewhat more strongly than the rates of growth observed during the
recoveries that followed the 1991 and 2001 recessions. Household
consumption of nondurable goods and services, in contrast, has risen
at a slower pace in the current recovery than in most previous U.S.
recoveries. Real consumer spending on services has increased only 2.9
percent so far in the current recovery, whereas this type of spending
grew by an average of 10.7 percent over the first ten quarters of the
previous eight recoveries. Consumer spending on services has been
particularly weak in categories such as housing services, financial
services, and insurance, likely reflecting the continuing effects of
the financial crisis, and on categories that are more discretionary,
such as recreation and gambling.\6\

\6\ Consumption of services is more difficult to measure than is
consumption of goods, and estimates for 2011 may be revised
considerably when the Services Annual Survey is incorporated into the
National Income and Product Accounts. Nonetheless, the pattern of
weaker-than-normal growth in services consumption in the current
recovery has been quite pronounced through 2010, a period for which
estimates reflect the latest annual survey.

Restrained demand for services may have implications for the labor
market, because the production of services accounts for about two-
thirds of U.S. GDP and a larger share of U.S. employment. (For a
discussion of the measurement of services see Data Watch 2-1.) Although
it is difficult to tie final consumption of a particular type of good
or service to employment in that industry (the purchase of a new motor
vehicle creates jobs in a number of service industries, for example),
jobs in service-producing sectors accounted for about 68 percent of
total nonfarm payroll employment in 2007.\7\

\7\ Industries counted in this figure include professional and business
services, education and health services, leisure and hospitality, other
services, and government services.

Developments in Housing Markets

After posting steep declines during the 2007-09 recession, activity
in the housing sector remained at subdued levels in the first half of
2011 before edging up in the second half of the year. New housing
starts were about 607,000 units in 2011, an increase of 3.7 percent
from the level in 2010. New housing starts remain well below the long-
run trend in U.S. housing demand. According to researchers at the Joint
Center for Housing Studies at Harvard University, projected rates of
household formation and immigration for the period 2010 through 2020
are consistent with housing starts in the range of 1.6 million to 1.9
million units a year (Masnick, McCue, and Belsky 2010). Activity in the
housing sector is likely to remain below these levels for some time,
however, as new construction continues to be restrained by a sizable
overhang of vacant properties for sale.

House prices, discussed in more detail in Chapter 4, fell 4.7
percent, on net, during the twelve months of 2011, according to the
CoreLogic home price index. Distressed sales--which include short sales
and sales of properties owned by lenders (real-estate owned, or
REO)--remained a headwind in 2011: CoreLogic estimates that 1.6 million
properties were seriously delinquent, in foreclosure, or owned by
lenders in October 2011, equal to about five months of supply at the
current pace of sales. The modest rates of growth in personal income
and the tighter mortgage underwriting standards observed in recent
years also kept sales and starts below their long-run trend levels.

Data Watch 2-1: The Data Implications of the Transition to a Services-
Based Economy

In 1947, services represented less than 40 percent of U.S. gross
domestic product (GDP). Today, service industries account for almost 70
percent of total U.S. domestic output. For many years, however, the
measurement of service activity lagged the sector's growing importance.
A fundamental challenge in measuring the value of services is the
disparate range of activities encompassed within the service sector.
The Bureau of Economic Analysis (BEA) defines services as "products
that cannot be stored and are consumed at the place and time of their
movie theaters, Internet subscriptions, haircuts, and apartment rents,
but also some less apparent things such as meals at restaurants, check
clearing by banks, and the "rental value" of homeownership. (Although
the purchase of a newly constructed home is categorized under
residential investment, the BEA estimates the amount homeowners would
have had to pay to rent similar houses and classifies this imputed rent
under housing services.)
A major breakthrough in the measurement of service output came with
the introduction of the North American Industry Classification System
(NAICS) beginning in 1997 to replace the Standard Industrial
Classification (SIC) system. Originally developed during the 1930s and
reflecting the economy of its time, the SIC provided far more detail
for goods-producing industries such as manufacturing and mining than
for service-producing industries. The 1997 NAICS added more than 149
new services industries. Just as important, a process was put in place
to add new industries to NAICS as they develop. A parallel effort
carried out over the past decade, the development of the North American
Product Classification System, similarly will provide a consistent
basis for categorizing the rich array of outputs produced in the
growing service sector.
The quality of the source data on the volume of service transactions
also has improved over time. Since the 1980s, the BEA has collected
data on international trade in services. In 2004, the Census Bureau
introduced the Quarterly Services Survey (QSS) to provide more timely
data on domestic consumption of services. The QSS, normally published
about 2% months after the end of each quarter, allows the BEA to
incorporate actual survey data on many services into its quarterly
estimates of GDP, rather than relying on "judgmental trends."
Furthermore, the Census Bureau has expanded the scope of its annual
surveys of the service sector. In fact, the Services Annual Survey and
the Quarterly Services Survey both now capture 55 percent of U.S. GDP-
equaling the coverage of services in the Economic Census and marking
substantial improvement relative to even just a few years ago.
Measurement of real activity in the service sector requires
appropriate price deflators for service outputs. In 1990, the Producer
Price Index (PPI) covered less than 5 percent of U.S. service output.
Today, thanks to a concerted effort by the Bureau of Labor Statistics,
PPI deflators are available for more than three-quarters of
domestically provided services. This has translated directly into more
accurate estimates of real GDP.
Nevertheless, as the U.S. economy continues to evolve, the work of
accurately measuring service activity grows accordingly. Despite recent
innovations in the collection of primary source data, there are still
conceptual issues pertaining to the appraisal and definition of
services that remain unresolved. As an example, improvements in health
care have contributed to longer life spans and better quality of life,
but there is not a consensus about how to value and incorporate these
benefits in a national income accounting framework. Similarly,
industries such as finance largely produce intangible outputs that are
difficult even to identify, much less quantify. Furthermore, although
estimates of international trade in services are now more detailed than
was the case before the 1980s, the statistics still could and should be
improved. Data on the prices of traded services are extremely limited,
and even the most disaggregated data collected by the BEA on services
extend to only 36 categories, in contrast to thousands of categories
for manufactured goods. Continued research and investment in the
development of data on services are needed to ensure timely and
accurate measurement of the U.S. economy.
Although home prices in some parts of the country have stabilized,
CoreLogic estimates that more than 20 percent of homeowners with
mortgages remained underwater at the end of the third quarter of 2011
(that is, the value of the mortgage exceeds the house price). The share
of mortgages in the foreclosure process remained elevated by historical
standards in 2011 and changed little from the level in 2010, as
reported by the Mortgage Bankers Association.
For a description of the Administration's housing policy proposals,
see Chapter 4.

Business Fixed Investment

Business fixed investment grew at a solid 7.3 percent annual rate
during the four quarters of 2011, after rising 11.1 percent at an
annual rate in the four quarters of 2010. Among the two main components
of business fixed investment, spending on equipment and software
investment grew 9.0 percent over the four quarters of 2011, and
investment in nonresidential structures increased 2.7 percent.
Within equipment and software, purchases of transportation equipment
rose at a brisk 22.7 percent annual rate over the four quarters of
2011, after having surged at a 68.1 percent annual rate in 2010.
Business outlays on information technology rose at a 4.1 percent annual
rate over the four quarters of 2011, a third consecutive year of solid
growth. Investment in industrial equipment also grew notably, posting a
four-quarter increase of 15.2 percent. (For more information on how
investment is defined, see Data Watch 2-2.)
Investment growth among the categories of nonresidential structures
was mixed in 2011. On one hand, investment in mining and drilling
structures was strong, reflecting elevated oil prices as well as some
advances in technology that have enabled drilling at new sites. (See
Chapter 8.) Investment in commercial and health care structures, on the
other hand, edged down over the four quarters of 2011.
The strength of business fixed investment since mid-2009 reflects
several developments. Investment fell sharply during the recession,
and, as the prospects for sales have begun to improve, businesses have
invested in recent years to replace aging equipment. In addition, the
Administration's 100 percent business expensing policy boosted business
investment by allowing firms to take an immediate deduction on
investments made in new equipment in 2011. The President has proposed
extending this provision into 2012.
Business investment may be positioned to grow rapidly if demand
accelerates because corporations have plenty of internal funds (Figure
2-6). Corporate profits continued to rise in 2011 and were above their
pre-reces-sion level, while corporate dividends have returned roughly
to pre-recession levels. Largely as a result, corporate cash flow, a
measure that includes undistributed profits and depreciation and
represents the internal funds available for investment, has also risen
substantially during the recovery. A large share of these investable
funds has been channeled to financial investments rather than to new
physical capital, as can be seen by the rising level of liquid assets
held by nonfinancial corporations.

Manufacturing Output

The real output of U.S. factories rose 3.7 percent over the twelve
months of 2011 after having risen 6.4 percent in 2010, according to the
manufacturing component of the industrial production index published

by the Federal Reserve Board. The manufacturing sector has been growing
faster than the rest of the economy during the recovery, with real
output rising at an average annual rate of 5.7 percent since its low
in June of 2009--its fastest pace of growth in a decade.
The rise in manufacturing output during the recovery has provided a
considerable boost to the U.S. economy. Following two decades of
shrinking employment--a trend that reflected both increases in
automation and the lower labor costs in emerging-market
economies--manufacturers in the United States have added more than
400,000 jobs since employment in the sector reached its low in January
2010. These numbers reflect an emerging trend of some companies
bringing jobs back to the United States, as discussed in the special
report, Investing in America: Building an Economy that Lasts (White
House 2012). This nascent trend likely reflects, in part, the
improvement in unit labor costs in the United States relative to many
of our trading partners in recent years. (See Chapter 5 for more
discussion of the rising competitiveness of U.S. industry.)
The robust gains in manufacturing output during the recovery appear
to reflect rising investment demand for domestically-produced capital
goods from both domestic and foreign customers. The rebound of the U.S.
motor vehicle industry has played a particularly large role, with the
production of motor vehicles and parts directly accounting for about 23
percent of the increase in manufacturing output since mid-2009. As U.S.
demand for new

Data Watch 2-2: Investment in Intangibles

Investment can be defined as devoting resources to produce a durable
asset that will yield a future flow of services. Until recently,
measures of investment in the National Income and Product Accounts
(NIPAs) were restricted to investments in physical capital such as
buildings, machinery, and equipment; new residential construction; and
net additions to inventories. In today's knowledge economy, however,
intangible assets such as computer software and scientific innovations
make increasingly important contributions to economic growth.
The Bureau of Economic Analysis (BEA) has begun to incorporate
investments in intangible capital into the NIPAs. The first step in
this direction, taken in 1999, was to treat spending on computer
software as an investment outlay, which enters GDP directly, rather
than as a business expense, which is considered an intermediate input
rather than a part of final demand; the treatment of government
spending on computer software was changed at the same time. Because
business and government spending on computer software had been growing
rapidly compared to other types of spending, these changes raised the
measured growth rate of GDP slightly. In 2013, BEA plans to begin
treating spending on scientific research and development as an
investment rather than an expense; had this treatment been in effect
historically, it too would have raised the average measured rate of
growth of GDP in recent decades.
Some researchers have argued that investment in intangibles should be
defined even more broadly (Corrado, Hulten, and Sichel 2009; Corrado
and Hulten 2010). In addition to research and development that builds
on a scientific base of knowledge, for example, there is an argument
for treating as investment the money firms spend on other sorts of new
product development, such as the development of new motion pictures or
new financial services products. Businesses also spend money on
strategic planning, the implementation of new business processes, and
employee training, all of which may add significantly to future
productivity and thus arguably should be treated as investment as well.
Taking an even broader perspective, time and money devoted to formal
education add to the human capital of the American workforce and thus
to its future productivity. While accounting accurately for the value
of these investments poses some difficult measurement challenges
(Abraham 2010), their importance to future economic growth should not
be overlooked. According to some research (Krueger 1999), returns on
human capital generate the lion's share of national income.


vehicles has recovered, the Detroit auto companies along with the
foreign-domiciled auto companies have been expanding U.S. production to
serve both U.S. and foreign markets. Over the past two years, the
entire U.S. auto industry--including dealerships and suppliers of auto
parts--has added nearly 160,000 jobs. General Motors was the world's
top-selling automaker in 2011, Ford is investing in new American
plants, and sales at Chrysler grew faster in 2011 than in recent years.

In addition to rescuing the American auto industry, the
Administration has more broadly supported American manufacturing
through its efforts to reduce barriers for American businesses to sell
products all over the world. To build on the progress already made, the
President laid out in his 2012 State of the Union address a Blueprint
for an America Built to Last, which included proposals to encourage
companies to create manufacturing jobs in the United States while
removing tax deductions for shipping jobs overseas.

Business Inventories

Businesses continued to build inventories during 2011, and
inventories in the manufacturing and trade sectors remained lean
relative to sales. Inventory investment--measured as the change in
inventories from one quarter to the next--is typically an important
contributor to the changes in real GDP during recessions and the early
stages of recoveries.
Over the course of 2011, real inventory investment stepped up in the
first quarter and then slowed in the second and third quarters, but
closed out the year on a high note. The slower pace of inventory
investment in the second quarter reflected, in part, the reduced rate
of motor vehicle production caused by disruptions to the flow of auto
parts following the earthquake and tsunami in Japan. Altogether, real
inventory investment added roughly 0.2 percentage point to real GDP
growth between the fourth quarter of 2010 and the fourth quarter of

Government Outlays, Consumption, and Investment

The Federal budget deficit during Fiscal Year 2011--which ended on
September 30--was $1.3 trillion, roughly unchanged from the year before.
As a share of GDP, the deficit fell to 8.7 percent in FY 2011 from 9.0
percent in FY 2010. Federal receipts rose 6.5 percent during FY 2011,
largely driven by a 21.5 percent increase in individual income tax
receipts. Corporate tax receipts fell 5.4 percent in FY 2011, partly
reflecting the introduction of 100 percent depreciation for business
equipment investment in calendar year 2011 (up from 50 percent in
calendar year 2010), which pulls forward deductions that businesses
would otherwise receive over several years. Corporate tax receipts in
FY 2011 were only about half what they were in FY 2007, even as
domestic corporate profits (excluding Federal Reserve Banks) were
roughly unchanged.\8\ In contrast, individual income tax receipts in FY
2011 were more than 90 percent of their FY 2007 level.

\8\ The divergence of corporate profits and corporate tax receipts
between 2007 and 2011 reflects changes in tax policy and differences in
how profits in the National Income and Product Accounts (NIPA) and
corporate taxable income are calculated. Business credits for
corporations have increased between 2007 and 2011. The components of
NIPA profits that are not counted in taxable income include capital
gains, bad debt, and Federal Reserve profits.

Federal outlays rose 4.2 percent in FY 2011 from FY 2010 but remained
steady as a share of GDP at 24.1 percent. According to the CBO,
approximately half of the year-over-year increase in Federal outlays
reflects re-evaluations of the cumulative cost of the Troubled Asset
Relief Program (TARP).\9\ The President's FY 2013 Budget estimates that
the cumulative cost of TARP will be $67.8 billion, well below the
Administration's 2009 estimate of $341 billion.

\9\ The CBO (2011c) estimates the net present value of the cumulative
cost of TARP each year and--if costs are revised down--records the
changes in these valuations in the Budget as a negative outlay. The CBO
adjusted down the total cost of the program in FY 2010 and FY 2011, but
the downward adjustment in FY 2011 was smaller than in FY 2010.

Nominal spending on defense grew more slowly in FY 2011 than in
recent years. Combined total spending on Social Security, Medicare, and
Medicaid rose in FY 2011, though at a slower pace than the average over
the past three years. According to the Department of Labor, extended
unemployment benefits and emergency unemployment benefits are on track
to be about $60 billion in 2011, following total benefits of $80
billion in 2010. The past three years of unemployment benefits
stabilized consumer spending at a level higher than would have occurred
absent this income support. In addition, the 2 percentage point
reduction in payroll taxes through the end of 2011 lowered tax
liabilities by about $114 billion.
During the four quarters of calendar year 2011, real Federal
expenditures on consumption and gross investment, as measured in the
National Income and Product Accounts, declined 3.3 percent; federal
defense spending fell 3.7 percent over the four quarters of 2011, and
federal nondefense spending declined 2.6 percent.
As projected in the Administration's FY 2013 Budget, which includes
demand-supporting initiatives for FY 2012 that have not yet been
approved by the Congress, the deficit as a share of GDP will fall from
8.7 percent in FY 2011 to 5.5 percent in FY 2013, and to 3.4 percent in
FY 2015. The full-employment deficit as a share of GDP (the budget
deficit that would exist if the economy were at full employment) would
be roughly unchanged in FY 2012 and fall by about 3 percentage points
in FY 2013 and by another 1.5 percentage points in FY 2014. This fiscal
consolidation will restrain the growth of demand in those years, but an
increase in private-sector demand in those years is projected to fill
in the gap.
Looking further ahead, the deficit reduction from the cuts mandated
by the Budget Control Act of 2011 and the expiration of the tax cuts on
upper-income Americans enacted between 2001 and 2003, combined with the
winding down of operations in Afghanistan and Iraq, will bring deficits
down to approximately 2.8 percent of GDP near the end of the 10-year
budget window. Policy changes recommended in the FY 2013 Budget put the
debt on a stable or declining path as a share of the economy and
would--if enacted--place the budget in a fiscally sustainable position
in the ten-year budget window.

State and Local Governments

State and local governments remained under severe fiscal pressure in
2011, and, as noted, declines in this sector's revenues have forced
sharper declines in real State and local consumption and gross
investment than in earlier U.S. recoveries. Although nominal State and
local government tax receipts continued to increase in 2011, Federal
funds from the Recovery Act--which helped support State and local
governments during 2009 and 2010--declined, and employment continued to
State and local tax revenues rose about 4 percent, or $50 billion,
during the four quarters through the third quarter of 2011, roughly
the same pace as during the year-earlier period. About half of the rise
came from personal income taxes. State and local taxes on production
and imports--a category that includes sales and property taxes--
increased about $32 billion over this period, while corporate taxes
were down $8 billion. Federal grants-in-aid to the states plunged $87.8
billion during the four quarters of 2011 after rising notably during
2009 and 2010; both the earlier increase and the 2011 decline were
attributable to the Recovery Act, which was designed to offer temporary
support to State and local governments.
Current State and local government expenditures--which include
transfers to individuals as well as government consumption--fell 0.2
percent over the four quarters of 2011, following a 4.4 percent
increase in the year-earlier period. Reflecting, in part, the decline
in Federal grants-in-aid between the third quarters of 2010 and 2011,
the operating position of State and local governments deteriorated to
an aggregate deficit of $83 billion by the third quarter of 2011, the
fourth consecutive year of operating deficits for the State and local
Employment in State and local government declined by 235,000 in 2011,
and employment in the sector fell 660,000 from its peak in August 2008
to December 2011. About 36 percent of the jobs lost over this period
were in education.
Real investment by State and local governments in structures, such as
schools, roads, and bridges, fell 9.9 percent during the four quarters
of 2011, a decline notably steeper than those of the preceding three
years. Some of the decline is attributable to the expiration of the
Build America Bonds program at the end of 2010. Part of the Recovery
Act, the program subsidized municipal bonds issued for infrastructure
development and helped finance $181 billion worth of capital projects,
including schools, bridges, and hospitals (Department of Treasury
State and local governments have made tough budget decisions during
the past four years. They will likely continue doing so in 2012 as
Federal transfers diminish, and past declines in house prices erode the
property tax base. The Administration took important steps in 2010 and
2011 to help State and local governments maintain critical services in
public safety and education. In addition to the grants-in-aid
components of the Recovery Act, the Administration eased the burden on
State and local governments in August 2010 by establishing a new
teacher job fund and by extending the enhanced Federal matching formula
for certain social services and medical insurance expenditures covered
by the States. In 2011, the President proposed additional funds as
part of the American Jobs Act to prevent layoffs of teachers, police,
and firefighters. To support infrastructure investment, the
Administration also included funds in the American Jobs Act to
modernize more than 35,000 schools.

Real Exports and Imports

Real exports grew 5.2 percent during the four quarters of 2011 after
jumping 8.8 percent in 2010. As noted, the rebound in exports since the
trough of the recession has been strong and reflects rising demand for
U.S. goods and services abroad. Total exports rose at an average rate
of almost 16 percent per year between 2009 and the twelve-month period
that ended in November 2011, an increase that creates jobs for U.S.
workers and puts U.S. exports on track to meet the President's goal of
doubling nominal exports between 2009 and the end of 2014. Meeting this
goal depends, in part, on healthy growth of the world economy; world
growth, however, may falter in the near term for reasons related to the
sovereign debt crisis in Europe. Maintaining robust exports is a key to
building an American economy that can prosper in the global economy in
the years to come (see Chapter 5).
Real imports also grew in 2011, expanding 3.8 percent over the four
quarters of the year. The rise in real imports over the past year
likely reflects the increase in consumer spending on goods, the rise in
real business fixed investment, and the continued recovery in
industrial production in 2011.
All told, real net exports--exports less imports--made a small positive
contribution to the rise in real GDP over the four quarters of 2011,
after subtracting from real GDP growth in the year-earlier period.

Labor Market Trends

The job market continued to heal in 2011, adding a total of 1.8
million jobs. The private-sector added 2.1 million jobs during the
twelve months of 2011, while State and local government employment fell
by 235,000. The growth in private-sector jobs was the strongest since
2005. Private sector payroll employment has grown in each month since
February 2010, and layoffs--as measured by the four-week average of
initial claims for unemployment insurance--have come down considerably
over this period (Figure 2-7). The four-week average of initial claims
continued to recede through the end of January 2012.
Private-sector job growth during the current recovery has been
similar to that in the 1991 recovery and faster than that in the 2001
recovery, as illustrated in Figure 2-8. As is typical, the recovery in
jobs since 2009 has lagged the recovery in output. Growth in private
nonfarm jobs in the current recovery began nine months after the
business-cycle trough. By comparison,

payrolls first began expanding consistently twelve months into the
1990-91 recovery, and sustained private-sector job growth in the 2001
recovery did not begin until 21 months after the official end date of
the recession. Thus, although the 2007-09 recession lasted longer and
featured job losses much deeper than those in the recessions of 1990-91
and 2001, recovery in the labor market began somewhat sooner.
Nonetheless, the steep rate of job loss during the recession has left
the rate of unemployment high. During the recovery the unemployment
rate receded from its peak of 10.0 percent in October 2009 to 8.3
percent by January 2012. The unemployment rate dropped by 0.6
percentage point between October 2011 and January 2012 (Figure 2-9).
Other measures of labor market slack--such as the "U-6" unemployment
rate published by the Bureau of Labor Statistics--have also declined
over the past year. The U-6 measure includes in the pool of unemployed
workers those who are underemployed or are marginally attached to the
labor force, that is, would like a job but are not currently searching
for work. The U-6 unemployment rate in January 2012 was a percentage
point below its year-earlier level.
In addition to tracking the number of jobs added in 2011, other
margins of labor market adjustment such as the workweek also contain
important information about the pace of the recovery. At the business-
cycle peak in the fourth quarter of 2007, the workweek for all private-
sector employees

averaged 34.6 hours. By the second quarter of 2009, it had shortened
0.8 hour. By the fourth quarter of 2011, the workweek increased to 34.4
hours, recovering most of the hours lost during the recession. A 0.1
hour lengthening of the workweek is roughly equivalent, in terms of
labor input, to an increase in employment of more than 300,000 jobs.

Wages, Labor Productivity, and Prices

Hourly compensation rose at about the same pace in 2011 as in 2010.
The employment cost index for private-sector workers, including wages
and benefits, rose 2.1 percent over the twelve months of 2011, roughly
the same as the year-earlier increase. Nominal hourly compensation in
the non-farm business sector--a measure based primarily on compensation
in the National Income and Product Accounts--rose 1.7 percent during the
four quarters of 2011, up slightly from the pace during 2010 but well
below the average increase of about 4.0 percent in 2006 and 2007.
Labor productivity in the nonfarm business sector (that is, real
output per hour worked) rose about 0.5 percent during the four quarters
of 2011, a slower pace of growth than during the preceding two years.
Averaged over the nearly four years since the business-cycle peak,
labor productivity grew at a 1.8 percent annual rate.
Consumer prices--as measured by the consumer price index (CPI)--rose
almost 3 percent during the twelve months of 2011, 1.6 percentage
points more than they did in 2010 (Figure 2-10). The cost of food,
crude oil, and many other commodities rose sharply in the first half of
2011, and some of these increases were passed through to consumer
prices for food and energy products. Excluding food and energy
products, the core CPI rose a more moderate 2.2 percent during the 12
months of 2011 after rising at an unusually slow pace of 0.8 percent in
Over the second half of 2011, overall consumer price inflation fell
considerably as the price pressures from the earlier increases in
energy and commodity prices waned. After rising at an annual rate of
3.8 percent in the first six months of the year, consumer price
inflation fell to 2.2 percent between June and December.
Most of the inflation in nonfarm business prices during the past four
years has been due to a rise in the price markup over unit labor costs
rather than to rising unit labor costs. Hourly compensation has risen
at a roughly 2 percent annual rate during the four years since the
business-cycle peak, but this growth has been offset by growth of labor
productivity also by an annual rate of about 2 percent during the same
period, leaving unit labor costs essentially unchanged. Over the long
run, prices of nonfarm business output rise in a roughly parallel
fashion to unit labor costs, so the markup of prices relative to unit
labor costs has been flat, although it has certainly fluctuated in the
short run. As can be seen in Figure 2-11, this long-term property of
the U.S. economy appears to have broken down over the past decade. The
markup has now risen to its highest level in post-World War II history,
with much of that increase taking place over the past four years.
Because the markup of prices over unit labor costs is the inverse of
the labor share of output, saying that an increase in the price markup
is the highest in postwar history is equivalent to saying that the
labor share of output has fallen to its lowest level.
The Administration expects consumer prices to rise slightly below 2
percent a year for the next few years, edging up to a 2.1 percent
annual rate in the long run. The long-run projection is in line with
the levels of inflation deemed by the Federal Reserve as consistent
with stable prices and full employment, and only slightly below survey
measures of long-run inflation expectations and the 5-year forward
inflation rate implied by the yields on inflation-protected Treasury
securities.\10\ Moreover, because slack in the labor market remains, the
economy has considerable room to expand without increasing price

\10\ The Survey of Professional Forecasters projects the CPI will grow
at an average annual rate of 2.5 percent from 2011 through 2020.

Financial Markets

The past year was a volatile one for financial markets. Concerns that
had arisen late in 2009 over sovereign debt in Greece and Portugal
continued into 2011 and spread to several larger countries in the
European Union, with effects that were felt worldwide.
Following a 12.8 percent gain in 2010, U.S. equity prices--as
measured by the Standard and Poor's 500 Composite Index--were
essentially flat in 2011. External factors weighed heavily on investor
sentiment at times over the course of the year. After rising more than
8 percent from the end of 2010 through April, equity values plunged
during the summer, reflecting the uncertainty surrounding the European
sovereign debt problems and the protracted negotiations over raising
the statutory U.S. Federal debt ceiling. Measures of market
volatility--such as the Market Volatility Index (VIX)--rose sharply in
mid-2011 before retreating near the end of the year. The VIX reached
levels in 2011 that were about equal to those in mid-2009 but remained
well below record levels in late 2008. The day-to-day changes in the
S&P index exceeded 1 percentage point on 96 days in 2011, 20 days more
than in 2010. In 2005 and 2006, swings in the S&P index exceeded a
percentage point only 30 times per year on average.
Yields on 10-year Treasury notes were 1.98 percent in December 2011,
down from 3.29 percent in December 2010 (Figure 2-12). Ten-year yields
rose to a monthly high of 3.58 percent in February of 2011, as

elevated their outlook for the U.S. economy. Renewed concerns about
sovereign debt issues in Europe, however, triggered a flight to safety
that pushed down long-term rates, on balance, during the remainder of
2011. The Federal Reserve System's program to lengthen the maturity of
the portfolio of their U.S. government debt also held down long-term
rates. Over the final five months of the year, 10-year Treasury yields
fluctuated around 2 percent, and real long-term interest rates at the
same maturity, as indicated by the market for Treasury Inflation-
Protected Securities, fluctuated around zero.
When the Administration's economic forecast was finalized in mid-
November 2011, interest rates, both short- and long-term, were
recognized as being in the low end of their historical range. Yet, in
light of the Federal Reserve's August 9 announcement that "economic
conditions ... are likely to warrant exceptionally low levels for the
federal funds rate at least through mid-2013," the Administration did
not foresee any material changes in short-term interest rates over the
near term. Thus, the Administration's projected path for 91-day
Treasury bills, calibrated from rates in the market for federal funds
futures, anticipated that these rates would remain extremely low until
the second half of 2013. The FOMC forecasted in January 2012 that these
rates would remain low at least through late 2014.

Small Businesses and the Recovery

Small firms--with fewer than 500 employees--account for about half of
private-sector nonfarm employment. Between 1993 and 2010, more than
half of firms in the private sector had 1 to 4 employees, and nearly 98
percent had fewer than 100 employees. Figure 2-13 illustrates that
small firms experienced proportionately larger job losses than large
firms during the recession and until early 2010. Similarly, the number
of bank loans to small firms fell dramatically during the recession
and--although it has stabilized since--still has not returned to pre-
recession levels (see Figure 2-14). In 13 consecutive quarters between
2007:Q1 and 2010:Q1, respondents to the Federal Reserve's Senior Loan
Officer Opinion Survey reported that credit tightened or remained tight
for small firms (those with less than $50 million in annual sales) and
that, since 2010, credit standards for large firms eased at a faster
rate than for small firms.
Small firms depend more on banks for financing than do larger firms,
in part because larger firms have access to other forms of finance,
including public debt and equity markets, typically unavailable to
small firms. Petersen and Rajan (1994) have documented the critical
relationship between banks and small firms and showed that over half of
financing for small firms came

from bank finance.\11\ Economists have modeled a link between the
supply of credit and macroeconomic activity (Bernanke 1983; Holmstrom
and Tirole 1997; and Peek and Rosengren 2000). Credit conditions have
been shown to affect a variety of specific macroeconomic outcomes,
including investment spending, inventories, and economic growth and
development (Fazzari, Hubbard, and Petersen 1988; King and Levine 1993;
Kashyap, Lamont, and Stein 1994; Levine and Zervos 1998; Rajan and
Zingales 1998; and Guiso, Sapienza, and Zingales 2004). Gertler and
Gilchrist (1994) find that smaller manufacturing firms respond more to
money supply conditions than larger firms, and Kroszner, Laeven, and
Klingebiel (2007) use cross-country evidence to show that banking
crises negatively affect bank-dependent firms more than they affect
firms less dependent on bank finance.

\11\ Small firms in their paper are the smallest 10 percent of the
sample measured by the book value of assets. Their sample, which is
drawn from the Federal Reserve's National Survey of Small Business
Finances conducted in 1988 and 1989, contains 3,404 firms with fewer
than 500 employees.

The credit-contraction hypothesis has been used to explain the
steeper loss of employment in small firms. Until recently, however, the
literature from the recent financial crisis has largely been unable to
disentangle the contributions of credit-supply and aggregate-demand
conditions. Duygan-Bump, Levkov, and Montoriol-Garriga (2011) use data
from the Current Population Survey, Compustat, and the National Survey
of Small Business

Finances to separate the contributions of these two factors. They find
that, as in previous recessions involving banking crises, following the
crisis of 2007-09, the likelihood of becoming unemployed was greater in
sectors that were more dependent on external finance. Further, among
firms highly dependent on banks for financing, the likelihood that an
employee will become unemployed is greater in small firms (defined as
those with 99 or fewer employees).\12\ The authors do not observe such a
divergence in unemployment incidence in firms with low dependence on
external finance.

\12\ This evidence does not address whether the credit-supply
conditions are due to factors related to lower credit quality.

Prior to the financial crisis, the share of lending to small
businesses by the largest banks--those with assets of over $50 billion--
had risen substantially (Corner and Bhaskar 2010). Since 2009, however,
financing has been constrained and it remains so for small firms
seeking funding. Simultaneously, the data show that other financial
institutions--smaller banks, credit unions, and other alternative
lenders--and government-sponsored programs have filled part of this
gap. Between January and December 2011, Biz2Credit, a private firm that
matches over 1.5 million small businesses seeking loans to nearly 500
lenders and loan intermediaries, reports that loan-approval rates by
large banks fell 3.1 percentage points, while increasing 3.6 percentage
points at small banks, 8.5 percentage points

Box 2-1: SBA's Role in Financing Small Firms During the Recovery

The Small Business Administration (SBA) was created by Congress in
1953 to aid and provide technical support for small businesses.\1\ Many
SBA programs seek to minimize the riskiness of small-business loans for
lenders by guaranteeing a portion of these loans against default. SBA
collaborates with federal agencies and the White House to ensure that
at least 23 percent of Federal Government contract opportunities, worth
nearly $100 billion, are available to small businesses.

\1\ The Small Business Administration's definition of a small business
uses guidelines that reflect, among other things, sales, employment
levels, and sector of economic activity. These guidelines are available
online at http://www.sba.gov/sites/default/files/Size_Standards_

Traditional SBA programs, the 7(a) and 504 loans, target small firms.
These programs have been found to have a positive impact on local
economic performance (Craig, Jackson, and Thomson 2005). In response to
ongoing tight credit conditions facing small firms during the recovery,
the Small Business Jobs Act of 2010 increased the loan limits for SBA
loan guarantees. The limits for equipment and real estate loans were
increased permanently and the limits for working capital loans through
the SBA Express program were increased temporarily. Between FY2010 and
FY2011, the number of SBA loans approved increased 12.5 percent, while
the value of SBA loans approved increased 45.4 percent (see box
figure). SBA increased overall lending supported to $30.5 billion in FY
2011, the highest ever lending year in its 60-year history.\2\

\2\ Lending supported includes gross loan approvals for SBA's 7(a) and
504 programs as well as third-party loans that are made by commercial
lenders as part of the 504 funding package. The box figure depicts the
value of loans 7(a) and 504 loans approved, which will be smaller than
the value of loans supported.

Recent economic research shows that new and young firms contribute
disproportionately to job growth in the U.S. (see Chapter 6). The Obama
Administration has created the Startup America initiative to support
the role that startups play in economic growth and job creation. The
initiative aims to accelerate high-growth entrepreneurship through
policies that unlock access to capital for high-growth companies,
create mentoring programs, accelerate lab-to-market innovation, and
make government work better for entrepreneurs.

As a part of the Startup America initiative, SBA is improving access
to capital for high-growth small businesses. The SBA has launched two
new Small Business Investment Company (SBIC) programs, each seeking to
guarantee an additional $1 billion in private investment within five
years: the Early-Stage Innovation Fund for seed- and early-stage
companies and the Impact Investment Fund for companies in areas of
national priority, including underserved markets and emerging sectors,
such as energy and education. SBA licensed the first SBIC Impact
Investment Fund in Michigan in July 2011. The InvestMichigan! Mezzanine
Fund, with resources of $130 million, is a public-private partnership
between SBA, Dow Chemical Company, and Michigan Growth Capital Partners
that will be managed privately and will focus on funding new and small
firms with plans to expand their operations and create jobs. SBA also
deepened its commitment to underserved markets in 2011 with the
implementation of the Underserved Markets Initiative, which will
disseminate SBA resources to youth, rural, veteran, low-income, and
other communities.

SBA augmented its role as a coordinator of federal agencies in
supporting small businesses in 2011. As is common after financial
crises, small firms are experiencing difficulties managing cash flow
due to adverse credit conditions. To improve access to working capital
for thousands of small firms, in September, President Obama issued an
executive order to institute the QuickPay program, which requires an
agency to pay its contractors within 15 days and, at a maximum, within
30 days. As with the QuickPay program, SBA plays a coordinating role
for the Small Business Innovation Research (SBIR) program, which
focuses on small high-technology firms and includes 11 granting
agencies. Evidence suggests that SBA and SBIR involvement make a
difference to young firms. Between 1983 and 1997 awardees of the SBIR
program subsequently had substantially higher employment and sales
growth compared to a matched sample of similar firms (Lerner 1999). In
December, Congress passed a long-term reauthorization of the SBIR
program that will increase its funding.

at credit unions, and 12.9 percentage points at other alternative
lenders, such as CDFIs, microlenders, and accounts-receivable

\13\ Small firms in the Biz2Credit sample are firms with fewer than 500
employees and under $6 million in annual revenue. Loan-approval rates
are based on a random sample of 1,000 firms in the Biz2Credit database
reported each month between January 2011 and December 2011.

In 2009, the Obama Administration increased the amount of capital
invested in financial institutions and other entities to support
small-business lending. This lending evolved along two lines:
investing capital directly into financial institutions that provide
small business loans and adding funding to new and existing programs
that provide credit support to small business loans. In terms of
direct investment that strengthened small-business lending, the
Administration invested more than $11 billion in over 1,000 financial
institutions, most of which were small banks but also including credit
unions, Community Development Financial Institutions (CDFIs), and
business loan funds. The programs that provide small-business credit
support include the new State Small Business Credit Initiative (SSBCI),
which is expected to channel $15 billion in new small-business lending,
as well as existing programs, such as loan-guarantee programs housed at
the Small Business Administration (SBA), the Department of Agriculture,
and the Export-Import Bank. Other Administration initiatives also
helped small firms gain access to capital at a critical period. For
example, the Financial Stability program was modified in 2009 to
protect auto parts suppliers, 82 percent of which employ less than 100
workers, to ensure that they would be paid for any parts they shipped,
regardless of the fate of the recipient car company. Given the integral
role auto-parts manufacturers play in the manufacturing supply chain,
systemic failure in this sector would have had a substantial effect on
the auto industry, the manufacturing supply chain, output, and

\14\ It is estimated that intervention in the auto industry broadly
averted a loss of approximately 1.1 million jobs and hundreds of small
businesses (White House 2010).

By the end of FY2011, marked increases in these capital-access
programs were partly due to the introduction of two new programs
administered by Treasury--the Small Business Lending Fund (SBLF) and the
SSBCI--and increases in the scope of the aforementioned loan-guarantee
programs. As of the beginning of January, institutions participating in
the SBLF have increased lending to small businesses by roughly $3.5
billion over their baseline, and, in Fiscal Year 2011, SBA supported
over $30 billion in loans. (Box 2-1 further describes the
Administration's efforts to address credit constraints among small
businesses through the SBA's loan-guarantee programs administered
through bank finance and Startup America.)
The most recent data on the expectations of small businesses
concerning financing and future job growth suggest that these efforts,
along with the ongoing economic recovery, are having a positive effect.
Small-business owners who responded to the Wells Fargo-Gallup survey
conducted from January 9 to 13, 2012, for example, report being more
optimistic than at any time since July 2008. This sentiment is largely
attributed to sharp increases in their expectations related to their
firms' financial situation, i.e., revenue and cash flow.\15\ Moreover,
respondents' hiring plans have become more optimistic than at any point
since January 2008, as Figure 2-15 illustrates. In early 2012, more
small businesses expected to add new employees in the next 12 months
(22 percent) than expected to let them go (8 percent). This is the
biggest margin by which small businesses' expectations for increasing
jobs have exceeded those for decreasing jobs since the start of the
financial crisis in 2008.

\15\ The Wells Fargo-Gallup telephone survey was based on a nationally
representative sample of 604 firms extracted from the Dun & Bradstreet
database of firms earning $20 million in annual revenue or less. See
Jacobe (2012).


Looking ahead, the Administration projects that the economic recovery
that began in 2009 will continue and gather speed (Table 2-1). In the
economic forecast, which was used to estimate the FY 2013 Budget,
inflation remains moderate, interest rates rise gradually, and the rate
of unemployment recedes. The Administration projects real GDP growth to
rise to 3 percent in 2012 and 2013 after growing 1.6 percent during the
four quarters of 2011.
The Administration also expects the employment situation to continue
to improve in coming years: The Administration's unemployment rate
forecast--also completed in mid-November 2011, when the latest-
available reading on the unemployment rate was 9.0 percent for October,
is shown in the first column of Table 2-2. The Budget forecast does not
reflect the improvement in the job market since the forecast was
finalized. Since that forecast was completed, the unemployment rate has
fallen to 8.3 percent, beginning 2012 well below the 8.9 percent
unemployment rate that had been forecast for the year as a whole. This
should not be interpreted as a projection that the unemployment rate
will rise: instead, it is the result of an out-of date forecast. The
second, third, and fourth columns of Table 2-2 show a range of
forecasts that were completed more recently so as to illustrate a
plausible range through which the unemployment rate is likely to

In early February, the ten forecasters with the lowest unemployment
rate forecasts on the Blue Chip panel of professional forecasters
projected that the unemployment rate would average 8.0 percent in 2012
and 7.4 percent in 2013 while the highest ten projected 8.6 and 8.4
percent for those two years. Similarly, the members of the Federal
Reserve's Open Market Committee projected a central-tendency band of
8.2 percent to 8.5 percent for the fourth quarter of 2012 and 7.4 to
8.1 percent for 2013. And it should be noted that the CBO and FOMC
forecasts are somewhat out of date in view of the encouraging January
labor market report.
The Council of Economic Advisers' forecast for the gain in payroll
employment was finalized in early February, after the labor market
report was released showing growth of 157,000, 203,000, and 243,000 in
November, December, and January, respectively. Looking ahead, the
average monthly change in payroll employment is projected to rise from
146,000 in 2011 to about 167,000 in 2012. At this pace, two million
jobs will be created during 2012, an increase from the 1.8 million
created last year.
Despite shocks that slowed growth in 2011, the Administration expects
an upturn in economic growth. With the economy now operating below its
capacity and many resources still underutilized, we forecast that the
recovery will continue to gain strength.

Growth in GDP over the Long Term

The growth rate of the economy over the long run is determined by the
growth of its supply-side components, although growth rates over
shorter periods can vary considerably. The growth rate that
characterizes the long-run trend in real U.S. GDP--or potential GDP--
plays an important role in guiding the Administration's long-run
forecast, because actual GDP tends to gravitate toward its potential in
the long run. Between 2011:Q3 and 2022:Q4--the projection period for
the FY 2013 Budget--potential real GDP is projected to grow at a 2.5
percent annual rate.
Table 2-3 shows the Administration's forecast for the contribution of
each supply-side factor to the growth in potential real GDP. The
factors include the population, the rate of labor force participation,
the employed share of the labor force, the ratio of nonfarm business
employment to household employment, the workweek, labor productivity,
and the ratio of real GDP to nonfarm output. Each column in Table 2-3
shows the average annual growth rate for each component over a specific
period of time: The first column shows the long-run average growth
rates between the business-cycle peak of 1953 and the business-cycle
peak of 2007, with business-cycle peaks chosen as end points to remove
the substantial fluctuations within cycles and to reveal long-run
trends. The second column shows average growth rates between 2007:Q4
and 2011:Q3, a period that includes the 2007-09 recession and the
recovery so far. The third column shows the Administration's projection
for the 11-year period from 2011:Q3 to 2022:Q4, and the fourth column
shows average projected growth rates between 2007:Q4 and 2022:Q4, a
blended forecast period over which the effects of the recession and
recovery are offsetting.
The working-age population is projected to grow 1.0 percent a year,
on average, over the projection period (line 1, column 3), the same
rate of growth that is projected by the Census Bureau. Over this same
period, the labor force participation rate is projected to decline 0.1
percent a year (line 2, column 3), primarily because of longstanding
demographic trends. The projected moderate decline in the labor force
participation rate reflects the balance of opposing influences. The
entry of the baby-boom generation into its retirement years is expected
to reduce the participation rate in the

coming years, but some of this reduction is projected to be offset as
the labor market improves. The labor force participation rate may also
receive a boost during the forecast period from the recent increase in
the share of young adults enrolled in school. The share of young adults
aged 16 to 24 enrolled in school rose well above its trend between
January 2008 and December 2011, sufficient to account for the entire
decline in the labor force participation rate for this age group over
this period (Figure 2-16). As these young adults complete their
education, they are expected to re-enter the labor force. Taking into
account all of these effects, the labor force participation rate is
projected to recede about 0.1 percent a year between now and 2022.
The employed share of the labor force--which is equal to 1 minus the
unemployment rate--is expected to increase 0.4 percent per year over the
next 11 years (line 3, column 3) but to be nearly unchanged, on
balance, between 2007 and 2022 (line 3, column 4).\16\ Because of the
recession, the employed share of the labor force has contributed
negatively to GDP growth

\16\ To be precise, changes in the employment ratio reduce growth in
real GDP by 0.04 percentage point per year between 2007:Q4 and 2022:Q4,
because the unemployment rate in 2007:Q4 (4.8 percent) was below the
level consistent with stable inflation, which is expected to remain
stable at around 5.4 percent from 2007 through the end of the
projection period.

The workweek is projected to remain roughly unchanged during the
projection period (line 5, column 3) even though it has declined 0.3
percent a year, on average, over the long run (line 5, column 1). The
workweek is expected to hold steady as a natural labor-market
adaptation to the anticipated decline in the labor force participation
Labor productivity is projected to increase 2.3 percent a year over
the forecast horizon (line 6, column 3), a slight increase over the
average growth rate from 1953-2007 (line 6, column 1). The elevated
rate of long-term unemployment poses some risk to the projection
insofar as the human capital of workers may deteriorate with prolonged
unemployment. On the other hand, higher rates of school enrollment
among young adults in recent years, as noted, should contribute to
productivity growth in the coming years.
The ratio of real GDP to nonfarm business output is expected to
subtract from GDP growth over the projection period (line 7, column 3),
consistent with its long-run trend. The nonfarm business sector
generally grows faster than other sectors, such as government,
households, and nonprofit institutions, reflecting an accounting
convention that holds productivity growth to zero for government.

Summing each of these pieces, real GDP is projected to rise at an
average 3.1 percent a year over the projection period (line 8, column
3), notably faster than the 2.5 percent annual growth rate for
potential real GDP (line 9, column 3). Actual GDP is expected to grow
faster than potential GDP primarily because of the projected rise in
the employment rate (line 3, column 3) as millions of workers who are
currently unemployed find jobs. Smoothing through the effects of the
recent business cycle, real GDP is expected to rise 2.4 percent a year,
on average, over the 15-year period from 2007 to 2022, just short of
the growth rate of potential real GDP of 2.5 percent because the
economy in 2007 is estimated to have been above its trend.
Real potential GDP is projected to rise 2.5 percent a year in 2007-
2022 (line 8, column 4), more slowly than the long-term historical
growth rate of 3.2 percent a year (line 8, column 1). The projected
slowdown in real potential GDP growth reflects the lower projected
growth rate of the working-age population and the aging of the baby-
boom cohort into retirement. The effects of the financial crisis and
the 2007-09 recession, in contrast, are expected to have little effect
on the level of potential real GDP by the end of the projection,
because the recession is not expected to permanently reduce any of the
demographically-determined elements of long-term growth.
An important question addressed in the budget outlook, however, is
how quickly real GDP will return to its potential level. In the
Administration's 2013 Budget forecast, the U.S. economy catches up to
potential real GDP in the second half of the forecast period. The
historical record supports this forecast. The full recovery of real GDP
during the decade following the Great Depression suggests that the U.S.
economy can recover from a severe shock to return to this underlying
trend level.


The U.S. economy continued to recover in 2011 from the severe effects
of the financial crisis and the deep recession that followed. The rise
in real GDP since the beginning of the recovery has been roughly
similar to the trend in both following the 1991 and 2001 recessions,
while private payroll growth came sooner and more swiftly than in the
beginning of the recovery from the 2001 recession. The housing market
began to show signs of life in 2011, and is likely to have a positive
effect on the economy, though from a low base.
As 2012 begins, the recovery appears most likely to proceed at a
moderate pace over the coming year, with the gains in output and
employment increasing in subsequent years, as credit conditions
continue to ease and confidence improves. Ensuring this outcome
requires policies that both restore balance to the economy by
increasing aggregate demand and guard against the types of excesses
that led to the crisis in the first place. With millions of Americans
still unemployed, much work remains to restore the U.S. economy to full
health. Only a prolonged and robust expansion can eliminate the large
jobs deficit that opened up during the recession, and the economy as a
whole has considerable room to grow. The fact that private job growth
has closely tracked the pattern of the early 1990s expansion is
encouraging, and highlights the importance of sustaining the recovery.