It's been a long row to hoe since the economy entered the Great Recession. Even though the recovery seems to be under way, there's still a way to go until the economy returns to normal. Take a peek at the latest economic activity: On the plus side, February's retail sales rose by a better-than-expected 0.3%, despite the major snowstorms that blanketed parts of the nation and kept people off the roads. Aeropostale (NYSE: ARO), J.Crew (NYSE: JCG), and Nordstrom (NYSE: JWN) all posted good-looking quarters recently. Companies are also starting to put their cash to work in the economy, through acquisitions such as BP's (NYSE: BP) recent $7 billion purchase of Devon Energy's (NYSE: DVN) Brazilian assets.

Yet some economic drags still remain. Americans are struggling to stay in their houses, as evidenced by Bank of America's (NYSE: BAC) addition of 8,000 borrowers to its mortgage modification program. Unemployment is stuck at 9.7%, with companies slow to hire.

To get a sense of the current economic climate, I spoke with John Taylor, Stanford economics professor and George P. Shultz Senior Fellow in Economics at the Hoover Institution. He is well known in economic-policy circles for coining the Taylor Rule, a monetary-policy principle that offers guidance on how to tinker with interest rates to control inflation and maintain economic growth. During our discussion, we spoke about the state of the U.S. recovery and discussed the impact of the government's monetary and fiscal policies on the economy.

Taylor served as Undersecretary of the Treasury for International Affairs during the George W. Bush administration, and he was also a part of the President's Council of Economic Advisers, first as a senior economist during the Ford administration and then as a member during the George H.W. Bush years. He is also the author or editor of numerous books, including, most recently, Ending Government Bailouts As We Know Them.

Here is an edited transcript of our conversation.

Jennifer Schonberger: What's your sense of the strength of the recovery in the U.S.? Does the recovery have momentum?

John Taylor: Yes. I think it has momentum. We had a little offset because of the snowstorms in the first quarter. So when numbers come in, they won't be as strong as you might have expected. But I still think around 3% [GDP growth] is reasonable when the first-quarter number comes out. We still have a little inventory boosting things. Consumption looks like it's solidifying. However, we still have a drag from business construction on residential construction … but equipment spending looks like it's solidifying. It's more of a U-shaped recovery rather than V-shaped at this point. But it looks like it is solidifying as I see it.

Schonberger: What concerns you most about the economy now?

Taylor: The policy is the most concerning. We have had a large government stimulus, and we have the debt problem, which is huge and growing. We had a debt-to-GDP ratio of 40% at the end of the Reagan administration, [and] 40% at the end of Bush 43 -- at least at the end of the fiscal year. CBO projections are now taking our debt-to-GDP ratio to 90% and growing in the next decade. So it's a real concern, and we need to address it.

I think the experience we've seen in Greece shows you the difficulties you can get into. You can say that's a somewhat longer-term concern because these things have a way of building up, but it's a concern nonetheless.

Schonberger: Building on that, there was an editorial in The Wall Street Journal by Andy Kessler, in which he argues that capital misallocation is usually a fallout of bad government policy. He says the Fed's life support right now is misallocating capital and that when that ends, real wealth creation begins. Is the government getting in the way of wealth creation in your view?

Taylor: Yes. I think it is. These interventions have created uncertainty, and they've allocated capital in directions which the government wanted. I think in particular the Fed's purchases of mortgage-backed securities, more than other things, was an allocation of funds to particular sectors. I do believe when the Fed stops the mortgage-backed purchases you'll see the private sector coming in, and the allocation will be as it should be -- based on profit considerations and long-term efficiency.

Schonberger: How did this crisis change your thinking? Did it ever cause you to rethink what you thought you knew?

Taylor: I think the thing that is most striking to me is the rapid transmission globally of shock coming largely from the U.S. in the fall of 2008. Of course you saw the S&P 500 dropped nearly 30% in that period, but all the other major stock indices around the world moved [in] the same pattern. Plus you saw exports and imports plummet, which affected the whole world very rapidly. So it's an indication of how connected things are at this point, and that means that we need to be concerned about the transmission of such shocks.

It's also gratifying -- not so much surprising -- that the bounce back from this shock was so strong, and I think that reflected better policies in many emerging-market countries.

Schonberger: The IMF's chief economist, Olivier Blanchard, recently offered the idea for central banks to target a higher inflation rate [4% vs. 2%] to allow for greater room to lower rates in economic downturns to soften the blow. What do you make of that, especially in light of your rule? Would it lessen the chances of repeating a severe recession, as Blanchard argues?

Taylor: I think it's a mistake to do that. I think we have shown through a longer period of time that the focus on price stability by central banks usually measured by inflation rates -- 2% or so -- has been very successful. So to go back on that, and to argue for higher inflation again, seems to me to lead you to the bad old days of the 1970s, where inflation crept up and we had booms and busts.

I think the argument that he is giving is not a good rationale for doing that. His argument is that, as you mentioned, if you had a higher inflation rate on average, then you'd have higher nominal interest rates on average, and therefore you could cut them more in a recession. But even in this Great Recession, as I see it, the interest rate that the Fed should have been following as we went into the downturn is not much different than it did [set]. I don't see negative interest rates. I still think this formula, the Taylor Rule, is useful, and that really did not call for interest rates certainly at much below zero. So even in this very significant shock, I don't think Blanchard's point is correct.

Do you think the economy is on the mend? Have the government's actions been helpful or hurtful for the economy? Weigh in below!

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