Can the US "Fully Recover"?

In early 2020, when COVID hit, the unemployment rate in the United States was 3.5%, wages for low-income earners were rising faster than wages for high-income earners, living standards were rising...the economy was on a roll.

Then, because scientists said lockdowns would stop COVID, they turned the light switch off. Real GDP fell at a 5.1% annual rate in the first quarter of 2020 and then an annualized 31.2% in the second quarter.

Since then, because of re-opening, Federal Reserve money printing, and massive Treasury debt issuance to fund pandemic loans and benefits, the economy has rebounded. Real GDP hit at an all-time high in Q2 this year, 0.8% higher than it was at the pre-COVID peak at the end of 2019.

But this is not very comforting. Not only would the economy have grown roughly 3% in the absence of COVID, the economy has been boosted by over $800 billion in direct payments to individuals. That $800 billion is roughly 4% of annual GDP. Without this borrowing from the future, the economy would be smaller today, not larger.

We estimate that the lockdowns have cost the US economy 6% (4% from stimulus growth 3% growth absent COVID – 0.8% all time high from pre-COVID peak) in lost output. Of course, it doesn't appear this way because borrowing from the future allowed more spending today. It's like giving morphine to an automobile crash victim. No pain, but underlying injuries.

So, how long will it take to fully recover? Factors that will boost growth include the general waning trend in COVID (yes, in spite of Delta, the death rate is running well below levels last winter), the natural process of economic recovery, faster productivity growth, entrepreneurs – who have packed many years of innovation into the past eighteen months – and the loose stance of monetary policy.

It's important to pause for a moment and recognize that monetary policy, with short-term interest rates set near zero, has effectively become looser as inflation has moved upward. In the past year, the consumer price index is up 5.3%, which means that a short-term interest rate target of 0.1% generates a "real" (inflation-adjusted) interest rate of -5.2%. By contrast, the lowest real short-term interest rate in 2020 was -1.4% in March 2020. To put this in perspective, the lowest real rate in the aftermath of the Financial Crisis was -3.8%.

However, at least a few factors will also weigh on economic growth in the year ahead. First, the removal of fiscal stimulus compared to what was done in 2020 and early 2021. Take away the pain medication and the economic pain will become even more evident.