December 23, 2016
U.S. Economy in a Global Context
Congress faces difficult challenges in formulating policies
2009, fiscal policy turned contractionary in 2011. The
to foster economic growth. In the long run, the continuing
Budget Control Act of 2011 specified deficit reduction that
and growing imbalance between federal spending and
eventually resulted in spending cuts, largely in discretionary
revenues would be a major challenge if current policies are
spending. In the beginning of 2013, policy makers faced a
continued. This imbalance will lead to unsustainable growth
major potential contraction (referred to as the fiscal cliff) as
in the federal debt, which crowds out investment. The
the 2001 and 2003 tax cuts and other provisions were slated
economy appears to have largely recovered from the 2007-
to expire and spending reductions were scheduled to take
2009 recession. Nevertheless, deficit reduction that is too
place. Although most of the 2001 and 2003 tax cuts were
large in the near term could damage what is still an
made permanent and other changes were made, the fiscal
incomplete recovery. Addressing this tension in policy
cliff still had a contractionary effect. Thus, addressing the
prescriptions for the short term and the long term is also
recovery in the past few years has fallen to monetary policy
taking place in an increasingly global environment that
conducted by the Federal Reserve.
interacts with these policies.
The current condition of the economy indicates that a fiscal
Short-Run Challenges
stimulus (i.e., a deficit increase through higher spending or
lower taxes) would likely be ineffective in increasing
Unemployment
output. Yet the slow economic recovery and low inflation
The 2007-2009 recession was severe, and the recovery has
rate suggest caution in moving too aggressively to reduce
been relatively slow. The unemployment rate rose from
deficits to address long-run debt challenges.
nearly 4.7% in November 2007 to 10% in 2009, before
declining to pre-recession levels over the next seven years.
The Long-Term Debt Issue
As of November 2016, the unemployment rate stands at
During the recession and recovery, the debt grew from
4.6% and has remained equal to 5.0% or lower since
about 40% of GDP to more than 70%. This increase was
October 2015. According to the Congressional Budget
partly due to an increase in spending (stimulus and
Office (CBO), the current unemployment rate is near
automatic increase in transfer payments) and the decline in
estimates of the natural rate of unemployment (about 4.8%).
revenues. As the recovery has progressed, revenues and
Wage growth has also begun to accelerate in recent months,
spending have returned to more normal levels stabilizing
suggesting a tightening labor market.
the debt in recent years. (The debt can grow without
increasing the ratio of debt to GDP as long as it rises at a
Although the official measure of unemployment appears to
rate less than or equal to GDP growth.)
be returning to normal levels, the labor force participation
rate fell during the recession and remains depressed.
Despite the near-term debt stabilization, the debt is
Underemployment (those who could only find or keep part-
projected to grow in the future largely due to long-
time employment) also remains elevated. A measure that
recognized issues, such as the aging population and
combines the official unemployment rate, and discouraged
increased health care costs. CBO’s long-term projections
or underemployed workers, is at 9.3% compared with 8.4%
show the debt growing from 77% in 2016 to 86% in 2026
in November 2007. Long-term unemployed workers as a
and to 141% in 2049, with accelerating subsequent growth.
percentage of the labor force were 0.9% in 2007 and 1.2%
The debt, in other words, is on an unsustainable path under
in 2016. Thus, although recovery appears to be largely
current policy.
complete, the economy is still fragile. Inflation has
remained below the Federal Reserve’s target rate of 2%,
Trends in Government Spending
and CBO estimates an output gap (i.e., the difference
Recent reductions in the deficit are mostly due to an
between potential and actual gross domestic product
improving economy. But policy changes to reduce the
[GDP]) of 1.5%.
deficit were also achieved, primarily through caps on
discretionary spending (defense and nondefense).
Fiscal and Monetary Policy
Discretionary spending, however, is not the source of the
The U.S. recovery has been sluggish in comparison to
long-run debt problem. Based on current policies and an
previous recoveries. Since the end of the recession, real
extended baseline for certain types of spending, CBO
GDP growth has averaged 2.1% per year, compared with an
projects Social Security, Medicare, and other health
average growth rate of 4.3% during previous post-WWII
transfers (i.e., Medicaid, the Child Health Insurance
recoveries.
Program, and payments in the exchanges) each will
increase by about 1.6% of GDP, reaching a total of 4.7% of
During a recession or a period of slow economic recovery,
GDP, by 2046. Discretionary spending is already set to
reducing the deficit is contractionary. Although a small
decline (due to the caps) by 1.6% of GDP over the next 10
fiscal stimulus was adopted in 2008 and a larger one in
years, leaving defense and nondefense spending at about
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U.S. Economy in a Global Context
2.6% each of GDP in 2026 compared with 3.3% in 2016.
of the dollar, and reduces net exports, which is
(From 2026 on, this spending is assumed to be fixed
contractionary.
relative to GDP in the baseline.) Other mandatory spending
is also projected to decline by 0.7% of GDP by 2046.
Foreign Holdings of Debt
Concerns have been raised about the large foreign holdings
Overall, spending outside of interest is projected to increase
of U.S. debt, especially by China, and about the effects of a
by 2.7% of GDP by 2046, with taxes and other receipts
sudden sell-off. However, these concerns may be
rising by 1.2% of GDP (due to real bracket creep in the
overstated. China benefits from holding U.S. debt, and an
individual income tax more than offsetting a slight
abrupt withdrawal and accompanying fall in security prices
reduction in other revenues). Interest payments are
would be costly to China. Moreover, any funds withdrawn
projected to increase by 3.4% of GDP due to rising interest
from the United States would have to be invested
rates and the increased debt. (Interest rates on government
elsewhere. The sellers of those securities would in turn
debt were very low in FY2016.)
invest in U.S. securities (but probably at higher interest
rates). In general, the holding of U.S. debt by foreign
CBO also considers alternative baselines in the long-term
countries probably makes interest rates and capital flows
projections. Under the path where deficits from 2016 are
more stable than privately held debt, which may respond
increased by $2 trillion relative to the current baseline
more powerfully to changes in interest rates.
(excluding net interest and macroeconomic feedback
effects), debt increases to 193% of GDP by 2046. If deficits
Trade Policy in a Global Economy
from 2016 to 2026 instead decline by $2 trillion, debt is
International trade (exports and imports) is equivalent to
projected to increase to 96% of GDP by 2016.
almost 40% of U.S. GDP and will continue to be an
important influence on future domestic economic growth.
CBO projects that a permanent reduction in the deficit of
With the growing impact of the global economy on the
1.7% of GDP would be required to stabilize debt at 75% of
United States, U.S. trade policy comprises a number of
GDP under the standard baseline. A 2.9% cut would be
policy tools to increase market access to countries such as
required to bring debt to the average of the past 40 years
China and to address issues such as the protection of
(39%) by 2046. If the reduction is delayed for 5 years, the
intellectual property rights worldwide. Notably, the United
required decreases will be 2.1% to stabilize debt at 75% and
States is considering two “mega-regional” trade agreements
3.4% to stabilize debt at 39% by 2046. Total discretionary
with 11 Asia-Pacific nations and the European Union to
spending is 5.2% of GDP, which is too small for spending
reduce or eliminate trade barriers. The former has been
cuts limited to this part of the budget to achieve a
agreed to by the United States but not by Congress. There
sustainable debt.
are indications that the incoming Administration may
withdraw from the agreement.
To address the long-term budget pressures, either
significant cuts in mandatory spending (such as Social
Although free trade is generally mutually beneficial for
Security and Medicare) or significant tax increases, or both,
counties overall, it can affect the distribution of income. It
will likely be necessary. Moreover, if Social Security and
can reduce jobs in import-sensitive industries, although it
Medicare Part A (hospital insurance) are to remain self-
creates them in export intensive industries. Concerns have
financed through payroll taxes, increases in these taxes
been raised about the loss of manufacturing jobs, a trend
might be needed through rate increases or, for Social
that has continued for some time. Most economists believe
Security, increases in the earnings ceiling.
the major reason for this effect is not import competition
but automation, as manufacturing output has steadily
The Global Economy
increased while jobs have declined. In the long run, trade
The United States is increasingly interconnected with the
will largely affect the mix of jobs in the United States and
rest of the world through trade and financial flows. As a
not the number.
result, other countries affect the U.S. economy and U.S.
policies affect or are constrained by other countries.
Other Global Issues
The increasingly interconnected global economy has led to
Fiscal Policy in a Global Economy
focusing on a variety of other policy issues. The United
Recessions and economic slowdowns in other countries,
States continues to negotiate with other countries on the
which were worsened in some cases by austerity measures,
adoption and implementation of financial regulatory
contracted demand for U.S. exports. Recession and slower
standards. Global economy concerns, including base
growth in other countries continues to affect the U.S.
erosion and profit shifting, have given rise to a variety of
economy. In addition, fiscal stimulus is less effective the
proposals regarding the corporate income tax, including
more open the economy. Fiscal stimulus pushes up interest
lowering the corporate tax rate and broadening the base.
rates, which attracts capital inflows and drives up the price
The effects of these proposed tax changes would likely be
of the dollar, discouraging net exports, although the
small relative to overall economic growth given the small
magnitude of this offsetting effect is unclear. In addition,
size of the corporate tax, which is about 2% of GDP.
sovereign debt problems in Europe have made European
countries’ investments relatively less attractive and U.S.
Jane G. Gravelle, Senior Specialist in Economic Policy
government securities’ investments more attractive. This
inflow keeps U.S. interest rates lower, drives up the value
IF10569
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U.S. Economy in a Global Context
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