The U.S. Economy


Associate Professor of Economics, Indiana University, Bloomington

The U.S. economy during 2003 has been an exercise in cognitive dissonance. By most measures, the economy has performed quite well (and quite close to the outlook we presented a year ago). Yet the “man on the street” by most reports believes that things are not going well. In this national overview, I will first look at the good news from last year and dissect the fly in the ointment. Then I will outline our relatively optimistic view of what we can expect in 2004, along with some things that could cause problems during the next year.

Overall, output growth for 2003 will probably come in at about 3 percent, with growth accelerating in the second half of the year. Figure 1 shows the past six years of real output growth. At the same time, inflation has remained low (about 2 percent for consumer prices), and interest rates dropped at mid-year to levels not seen in over four decades. Household income, driven by rising labor productivity with a boost from the federal tax cut, has registered solid growth. Households have used this income (and funds from mortgage refinancing) to purchase nearly seventeen million new cars and trucks and push housing construction to an all-time high. Since the spring, clear signs of a sustained recovery in business investment exist, especially in the high-tech area. Even the stock market has had an up year.

Figure 1
Real Output: Annual Rate of Change

Figure 1

During the past summer, the National Bureau of Economic Research—a Boston-based group of economists who arbitrate the beginnings and ends of recessions—declared that the “official” end of the recession occurred in November 2001. This means we are now two full years into the recovery period. Indeed, in terms of output, we are beyond recovery and into a new period of expansion.

Yet there is a continuing string of anecdotal evidence that Americans are apprehensive about the economic outlook. Central to this concern is the labor market. Figure 2 shows why. During the late 1990s, the economy was adding almost three million jobs each year. For the past two and a half years, job losses have averaged over a million each year. As of September 2003, total employment was nearly 2.6 million below its peak in early 2001. As a result, unemployment has risen steadily to above 6 percent. This is not high by historical standards, but it is far removed from the below 4 percent levels reached prior to the recession.

Figure 2
Changes to the Labor Market

Figure 2

The situation in the manufacturing sector, an especially important part of the Indiana economy, is even grimmer. Nationally, the sector accounts for all of the job losses and then some. Since July of 2000, employment in manufacturing has declined month after month without a break. Over that period the decline has totaled almost 16 percent. Moreover, much of this contraction represents permanent structural change and not a cyclical phenomenon. In some cases, jobs are being lost to lower cost areas abroad; in others, they are being eliminated by the tide of advancing productivity that permits firms to produce more goods with fewer workers.

Although the labor market situation is troubling, we think that most of the bad news is behind us and are optimistic about the outlook for 2004. While we don’t expect to see numbers matching the 8.2 percent growth registered in the third quarter of 2003, we do expect output growth next year to approach 4 percent. This growth should also be more broadly based than during the past two years when household spending on consumption and housing was keeping the economy afloat. Next year, economic growth should have significant help from business investment in new plant and equipment, and probably also from some inventory rebuilding.

Another sector that should experience definite improvement is international trade. Since the beginning of 1997, the U.S. net export deficit (in inflation-adjusted dollars) has quintupled to over $500 billion (more than 5 percent of GDP). This has been partly a reflection of

But now two of these factors seem to be changing. The dollar has been falling in the foreign exchange market since 2002, by over 15 percent against other major currencies. More importantly, economies in the rest of the world are looking better than in quite a while.

The continuing expansion we foresee should finally begin to produce improvement in the labor market. We think the economy could generate close to two million new jobs in 2004. This would be sufficient to pull the unemployment rate down to the mid 5 percent range by the end the year.

Our scenario should also make life interesting for the Federal Reserve. The Fed is committed to holding short-term interest rates at their very low current levels for “a considerable period.” If our outlook is correct, this considerable period will end sometime after mid-year. By the end of the year, two or three upward movements in short-term rates cannot be ruled out.

One area where things are not likely to show any marked improvement is the federal budget. During the last two years, the deficit has risen at a very rapid pace, as spending (on defense and other things) has increased and tax cuts have held down revenues. A growing economy should yield some expansion of revenue, but only enough for the deficit to stabilize.

Any economic forecast can be upset by unforeseen occurrences. The shift of monetary policy away from its very accommodative stance of the past three years could present difficulties for the expansion. There is a lot of leverage in the U.S. economy, which makes increasing interest rates certain to cause at least a little anguish.

However, the greatest risk during the next year probably lies in the international arena. The situation in Iraq is currently unsettling. If it were to worsen, the impact on the economy would be hard to predict. But it is unlikely that it would be good, especially if the fallout entailed higher oil prices.

But the period since September 11 has shown the enormous resilience of the U.S. economy in the face of external threats. And it is well to remember that since 1982 the U.S. economy has had less than two years of contraction and nearly twenty years of expansion. All signs point to 2004 being added to the expansion side of the ledger.