More Evidence on What Is Holding the Economy Back

Milton Friedman’s “plucking model” should be back in fashion now because it reminds us of the historical fact that throughout American history—until now—the deeper the recession, the faster the recovery. I like to bring a guitar to talks and lectures to illustrate this: Like a guitar string, when the economy is “plucked” down or pulled down, the “string” or the economy always springs back up. The more the economy is “plucked” down, the faster it springs back up. This has been true throughout recorded American history, and it holds whether or not there has been a financial crisis. Here is a link where you can find Hoover Institution Working Paper E-88-48 in which Friedman described the model. (He also envisioned a board on top of the guitar string to prevent a reverse action on the upside, which he argued was not in the data).

Of course something is now interfering with the usual economic response, because our current recovery is certainly not springing back to normal. I have argued that economic policy is holding the economy back, and I think recent research by Ellen McGrattan and Ed Prescott (on increased regulations) and by Scott Baker, Nick Bloom, and Steve Davis (on policy uncertainty) supports this view. Their work is part of a forthcoming book (Government Policy and the Delayed Economic Recovery) edited by Lee Ohanian, Ian Wright and me.

Here are two charts which show why both increased regulation and policy uncertainty are very significant. The first chart uses data from research by Susan Dudley and Melinda Warren. It takes their series on the number of “full time equivalent” federal employees in regulatory activities and subtracts out the number of Transportation Safety Administration (TSA) workers. (I interpolated the years 2002 and 2003 when TSA was expanding and moving from DOT to DHS). There has been a 25 percent increase just since 2007. And these data barely reflect the increased regulations from the health care and financial reform legislation.

The second chart shows the number of provisions in the tax code that are expiring each year. This is part of an index used by Baker, Bloom, and Davis. It shows a substantial increase in the past few years in policy uncertainty.