U.S. economy may stay sluggish long after recession

Signs advertising sales are seen outside a hardware store in Islip, New York January 29, 2009.

WASHINGTON (Reuters) - When the U.S. recession eventually ends, consumers who have been awaiting a new boom in the economy may find that happy days are not going to be there again -- at least not at the level they hoped for.

The damage inflicted on the economy from the credit crisis now gripping the country may be so great that it takes many years to return to the level of growth that was the norm before the crisis erupted.

A massive budget deficit and high unemployment that is likely to linger long after the current crisis fades will exact a heavy toll. If borrowing costs spike that will make it even more difficult for companies to generate the rich profits that helped drive stock markets to record highs just 16 months ago.

The result may be a lower standard of living than what Americans have grown accustomed to over the past decade, when huge investment gains left households feeling flush and easy credit made spending even more attractive.

"Even assuming that the United States achieves a sustained recovery by 2010, post-crisis growth is a lot more likely to mirror the 1970s than the decade prior to the subprime crisis," said Kenneth Rogoff, a Harvard University professor and former chief economist at the International Monetary Fund.

How long the economy trudges along at sub-optimal speed depends largely on whether problems such as high unemployment and weak corporate profits are merely symptoms of recession or signs of deeper structural issues.

If they are cyclical, the economy should be able to regain its footing after perhaps three to five lean years while banks rebuild balance sheets with intensive government help.

If they are structural, it will take far longer and be much more difficult for policy measures to counteract.

At issue is potential growth, the rate at which the economy can safely expand without triggering overly high inflation. The number is subject to much economic debate, but is generally thought to be somewhere around 2.5 percent or 2.75 percent.

After the recession ends, potential growth may be no better than 2 percent, largely because it will cost companies more to invest and grow, said Torsten Slok, an economist with Deutsche Bank in New York.

Rogoff takes an even gloomier view. He said the massive run-up in government debt needed to clean up the banks and fight recession will eventually push up inflation and interest rates, and it was "hard to imagine that U.S. growth won't be at least 1 percent per annum lower than it might have been."

NO UPSIDE

Slower growth means fewer jobs and weaker consumer spending, which is bad news for the domestic economy and U.S. trading partners. It could also make the United States less attractive to foreign investors, whose purchases of U.S. debt have kept borrowing costs low.

Economists widely agree that the budget deficit is structural, and have warned for years that the cost of paying for Social Security and health-care benefits for millions of soon-to-retire baby boomers would one day constrain growth.

But there is less agreement on whether rising unemployment is solely a function of the business cycle turning sour or also a sign that the labor force cannot keep up with changes in the economy.

"Whenever there's a cyclical turn you can say it's part of a healing process," said JPMorgan economist Michael Feroli. "With a structural shift there's just no upside to it."

The longer these problems persist, the more entrenched they become. That means what begins as a cyclical rise in unemployment can turn into a structural problem.

Feroli thinks that could be happening now. He studied the relationship between unemployment and job vacancies and found that the natural rate of unemployment may be rising toward 6 percent from the current level below 5 percent.

"This implies that even after the economy returns to growth, the unemployment rate may be unlikely to return to levels sustained throughout most of the past two decades," he said.

In essence, there is a mismatch between the skills of the growing ranks of the unemployed and the jobs available. Retraining workers is never an easy task, but the housing bust is making it even harder for people to move where jobs are.

FED HEADACHE

Stubbornly high unemployment combined with a massive decline in household wealth suggests that consumer spending won't return to its pre-crisis level any time soon either.

John Silvia, chief economist with Wachovia in Charlotte, North Carolina, said the credit crisis has left consumers deeply concerned about job security and their financial futures, which is why spending has crumbled.

The less consumers buy, the less money Corporate America makes, and the same goes for companies that sell goods to the United States.

Silvia said older workers who may have planned to retire will have to stay in the workforce longer, which adds to the difficulty in finding jobs for the younger unemployed.

Persistently sluggish growth creates a quandary for the Federal Reserve, which aims to promote maximum employment while keeping inflation in check. If the economy's safe speed limit is lower than before, the central bank's normal reaction would be to raise borrowing costs sooner to prevent inflation.

But when the federal deficit is uncomfortably large, households are carrying heavy debts, and the housing market is still getting back on its feet, the best response may be to allow price pressures to build, Harvard's Rogoff said.

"The Fed is likely going to end up allowing far more inflation than it ever might have dreamed," he said.

(Editing by Leslie Adler)