Post Depression Economics

Post-Depression Economics
Neal Solomon
The essay presents the argument that the U.S. experienced a shallow economic depression in 2007-9 reminiscent of pre-war economic contractions. The economic data are analyzed to show that the downturn was more severe than any previous post-war downturn. Though technically over, the severity of the depression has led to extremely slow growth and a protracted period of high unemployment. The policies of the 2000s and the concentrated industrial structure they spawned are shown to have contributed to the severity of the downturn and to the slow recovery. The Keynesian and libertarian schools of economic thought are discussed in the context of their roles in offering prescriptions for improving economic growth. The essay critiques the academic economics profession for not predicting the downturn or providing useful prescriptions for solving economic problems. It is shown that Chinas policies created a monetary and trade environment in the 2000s for the depression and that they are constraining economic growth as the U.S. exits the depression. A number of policy prescriptions are provided to improve economic growth. These best practices include constraining federal government spending, adjusting and balancing tax, competition, trade and intellectual property policies, promoting investment, education and innovation policies, and modulating Fed monetary policy. Index Introduction: What Happened to America? Economic Analysis of the Downturn Was the Downturn a Recession or a Depression? This Time IS Different Causes and Consequences of the Depression The Rise of China Policy Factors in the Economic Bubble and Aftermath Redefining Conservatism Failed Economics Policy Prescriptions List of Figures List of Charts Bibliography ____________ 2 5 13 25 36 45 49 57 62 66 78 78 79
B.A., Reed College, 1981; A.M., University of Chicago, 1982; CEO, Advanced System Technologies, Inc.
2010 by Neal Solomon. All rights reserved.
Introduction: What Happened to America?

After the most severe recession since the 1930s, the U.S. economy appears to be recovering. Real (inflation-adjusted) gross domestic product (GDP) grew during the third quarter of 2009, after having fallen 3.7 percent since the recession began in the fourth quarter of 2007. However, the economys output is still about 7 percent below the Congressional Budget Offices (CBOs) estimate of potential GDPthe output the economy would produce if its resources were fully employed. From December 2007 to December 2009, the unemployment rate jumped from 4.9 percent to 10.0 percent, and payrolls fell by about 7.2 million jobs. Moreover, if employment had growth during this period at the same rate at which it had growth from 1990 to 2007, millions of additional jobs would have been added to the economy during that period; all told, the recession has lowered employment by about 11 million relative to what it would otherwise be. Nearly all professional forecasters believe that the economy has passed the trough of the recession, but many also predict that the pace of the recovery will be slow. [CBO, Policies for Increased Economic Growth and Employment in 2010 and 2011, p. 1, 2010]
In 2000, the U.S. government experienced record federal budget surpluses and the federal debt was being paid down. Middle class wages were growing and economic growth was strong. Industrial corporations experienced a productivity revolution with robust profits and high competition. Unemployment and poverty rates were at historic lows. In 2010, the U.S. government experienced record federal budget deficits while adding to an extraordinary federal debt. The unemployment rate peaked at 10.6% and industrial capacity was at a record post-war low. With a poverty rate of 14.3%, 44.3 million people were in poverty. Industry concentration was at a peak and income structures were more stratified than at any time since 1928. High commodity prices from a commodity bubble in 2008 squeezed an already strained middle class. Remarkably, real median income of $49,777 in 2009 was lower than in 2000. The U.S. education system did not make the top 10 list among industrial countries. And, two significant wars were being wound down. What happened in such a short time? America obviously witnessed the consequences of the application of a conservative economic and social experiment. To identify the solutions to the economic problems, it is essential to understand the anatomy and sources of the problems.
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There is no debate about the fact that the United States experienced a significant economic downturn. There is considerable controversy, however, about the technical
classification of the downturn. Was it a recession or a depression? Are we still in the downturn? What policy programs got us into the problems and what policy programs are most likely to improve economic conditions? answer. A thesis of this essay is that the U.S. was in, and is recovering from, a shallow economic depression. While there are numerous technical factors that require analysis to understand the scale and scope of the economic contraction and aftermath, the present analysis seeks to clarify the economic events of 2007-9 and its recovery. The evidence reveals that the U.S. is in a major historical economic structural transformation. In addition to the empirical evidence about the U.S. economy in the last few years, evidence about the international economy shows several factors that influence the U.S. economic picture. The main argument is that the U.S. adopted policies in the 2000s that led to a sharp economic contraction with a long tail that is caused by the process of continued deleveraging of debt from a substantial financial bubble. This process of GDP decline and deleveraging was complicated, and aggravated, by a financial industry crisis, which was apt to prolong economic growth prospects. During this long recovery period, unemployment and debt levels are likely to remain high while housing prices and industrial capacity are likely to have downward pressure from a protracted period of constrained demand. Further, the evidence suggests that the U.S. is in a pre-war type of shallow economic depression that, even after heroic policy actions, now constrains government policy makers to engineer near-term economic solutions and thereby protracts the downturn. In the environment of the long tail, federal government political These questions require historical and analytical insight to
paralysis and Federal Reserve policy constraints will likely limit significant economic growth.
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While there is little controversy about the economic depression in the housing sector, the long-term effects of the housing bubble are detrimental to consumers and economic growth. Furthermore, while the housing bubble and economic contraction are indisputable, perhaps more problematic are the facts about the erosion of the middle class during the 2000s. Economic pressures have resulted in a fundamental restructuring of the composition of the middle class. The effect of these changes is to increase the stratification of American society, with the top 1% responsible for 23%, and the top tenth of 1% responsible for 11%, of income in 2007. However, it is argued that stratification is the effect, not the cause, of economic challenges and that a consequence of increased stratification is increased economic instability. The parallels between the economic policies of the 1920s and the 2000s are very similar.1 It should be no surprise, then, that the consequences of these policies lead to financial crises and economic instability. While the U.S. experienced a housing bubble, a middle class decline and an economic depression, China experienced an economic Renaissance in the 2000s. It is argued that Chinas rise had adverse effects on the U.S. economy during this period. Though the economics profession largely failed to predict the downturn, whether because of increased specialization, an overemphasis on math, a lack of policy or historical experience, or
Income inequality is similar when comparing the 1920s and 2000s. Income disparities before [the 1929] crisis and before the recent one were the greatest in approximately the last 100 years. In 1928, the top 10 percent of earners received 49.29 percent of total income. In 2007, the top 10 percent earned a strikingly similar percentage: 49.74%. In 1928, the top 1 percent received 23.94 percent of income. In 2007, those earners received 23.5 percent. Story, L., Income Inequality and Financial Crises, NYT, 2010 [drawing parallels between economic conditions of the Depression and the recent downturn]. Real median household income was $21.7K in 1947, $28K in 1977 and $50.2K in 2007, according to U.S. Census Bureau data. In 1977, the top 1 percent of the top 1 percent earned $2M and by 2009, the top .01% earned $11.5M, showing far faster growth at the top. See Atkinson, T. and T. Piketty, Top Incomes Over the Twentieth Century: A Contrast Between Continental European and English-speaking Countries, 2007 [showing 20th century income patterns between several countries] and; Saez, E. and T. Piketty, Income Inequality in the United States, 1913-1998, Quarterly J. of Economics, 2003 [showing 20th century U.S. income inequality patterns].
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ideological biases, it is crucial to analyze empirical economic data and economic policy in order to develop cogent, pragmatic and bipartisan policy prescriptions.
Economic Analysis of the Downturn Chart 1 shows GDP changes from the third quarter of 2007 to the third quarter of 2010. Chart 1 U.S. Gross Domestic Product (Trillions of dollars) 2007 2007 2008 2008 2008 2008 2009 2009 2009 2009 2010 2010 2010 III IV I II III III IV I II III IV I II 13.95 14.03 14.37 14.49 14.54 14.34 14.05 14.03 14.11 14.28 14.45 14.57 14.68*
Source: Federal Reserve Flow of Funds Report [F.6 Distribution of Gross Domestic Product: 9/18/08, 9/17/09 and 9/17/10] * Projected
The economy grew very slowly from the fourth quarter of 2007 to the third quarter of 2008. The financial crisis that was triggered by the failure of Lehman Brothers in September of 2008 shows a decline of 4.2%2 in the fourth quarter of 2008, a decline of 8% in the first quarter of 2009 and a decline of .7% in the second quarter of 2009. The economy then grew 1.6% in the third quarter of 2009 and 5% in the fourth quarter of 2009. 2007 had a growth rate of about 2.5%, 2008 experienced a decline of 2.7% and 2009 had a growth rate of .2%. From the third quarter of 2008 to the second quarter of 2009, however, the economy declined at a 4.1% annualized rate, the largest and most protracted post-war economic decline.3
2 3
The economic growth and decline data are annualized. If the U.S. economy had grown at 5% a year from 2007 to 2011, GDP would be $17T at the end of 2010, rather than its actual $15T. Therefore, the U.S. economy lost about thirteen percent of its potential growth in the downturn in a three year period.
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Figure 1 Relative GDP Decline of 2007-9 Downturn
Figure 1 shows the 2007-9 downturn GDP decline relative to post-war recessions. The chart illustrates the relative severity of the downturn in technical terms. Both the length (18 months) and depth (negative 4.1% GDP) show a severe contraction. Chart 2 Total Net Worth 2007-2010 2007 2007 2007 2007 2008 2008 2008 2008 2009 2009 2009 2009 2010 2010 I II III II III IV I IV I II III IV I II 56.8 58 58.7 58.1 61.4 60.6 57.8 52.9 48.8 50.5 53 53.6 55 53.5
Source: Federal Reserve Flow of Funds Report [B.100 Balance Sheet of Households and Nonprofit Organizations 9/18/08, 9/17/09 and 9/17/10]
Chart 2 shows the total net worth data. These data reveal a much more substantial 19% decline in the one year period from the second quarter of 2008 to the first quarter of 2009. The 8.4% decline from the third quarter of 2008 to the fourth quarter was the largest quarterly drop since record keeping in 1951, reflecting the financial crisis in the immediate aftermath of the
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failure of Lehman Brothers. This was followed by a 7.7% decline in the first quarter of 2009. While the GDP data reflect public and private spending and show federal government spending comprising a disproportionately larger share, the net worth data show a very severe downturn that affected the private sector.4 The contraction in net worth from the fourth quarter of 2007 to the third quarter of 2009 more clearly maps the extent of the downturn. According to this data, it will take three and a half more years (early 2014) at a five percent annual growth rate to return to the peak level of net worth shown in the first quarter of 2008. Figure 2 Total Household Net Worth
Figure 2 graphically shows the relative decline in net worth since 1952. This illustrates several post-war recessions, but the extraordinary decline of 2008-9 is illustrated at the right side. The 2000s are shown as the V immediately prior to the precipitous decline.
The decline in net worth in the fourth quarter of 2008 and first quarter of 2009 reflected the drop in value in the prices of both real estate and equities.
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The U.S. equity markets declined significantly in the downturn, with the Dow dropping from about $14,000 in 2007 to about $6,500 in March, 2009, for a total decline of 53%, comparable to the peak post-war decline in 1973-4. Figure 3 S&P 500 [September 2007 to September 2010]
Source: S&P 500
Figure 3 shows S&P 500 data from September, 2007 to September, 2010. The equity markets have been in a relatively narrow trading range during much of late 2009 and 2010, reflecting the realities of slow expected economic growth. Note that it took the Dow Jones Industrials twenty three years to return to its October, 1929, levels.5 The unemployment rate, however, rose rapidly beginning in the third quarter of 2008. According to the U.S. Bureau of Labor Statistics, the unemployment rate moved from 4.6% in 2007, to 5.8% in 2008, 9.3% in 2009 and 9.9% in 2010. The unemployment rate peaked at 10.6% in March of 2010. This shows that while the economy grew nominally in the third quarter
The NASDAQ peaked at 5050 in March, 2000 and was about half of this level in 2010, suggesting the potential for several more years to return to its peak level. The NASDAQ may be tracking the Dows 1930s and 1940s performance.
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of 2009, unemployment was increasing to a peak level before declining in April of 2010.6 The aftereffects of the downturn show a long tail in which unemployment continues to be unusually high after the technical end of the downturn.7 Figure 4 Job Losses in Recent Recessions, as a Share of Employment
To show the relative severity of the depression, the total number of unemployed in 2008-10 was greater than in the downturns of 1981-2, 1990-1 and 2001 combined. While these data show the general unemployment rate, the actual rate may be higher since those who are underemployed or who stopped looking are not counted. The Bureau of Labor Statistics indicated that the real unemployment rate peaked in 2010 at 16.6% (26M people) including underemployed and discouraged workers. An average of five individuals applied for each job opening in 2010, the worst percentage since the 1930s. 7 Poverty in the U.S. increased to its highest level over 14% since records were kept in the 1960s. An estimated twenty percent of children were in poverty. An eighth of Americans were on food stamps. The reason that our cities do not have Hoover town encampments of homeless and soup lines is that New Deal and Great Society federal programs of unemployment insurance, food stamps, Welfare and social security provide a crucial social safety net. The idea of unraveling the safety net as a way to increase economic efficiency and to save money is to shift risk onto individuals at their most vulnerable time, leading to nasty, brutish and short lives in a disintegrated post-industrial modern society. In the absence of economic growth, the U.S. government maintains the burden of responsibility for surplus labor, which presents an economic conundrum in the long-run.
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Source: U.S. Department of Labor
Figure 4 shows the extraordinary unemployment decline in the 2007-9 downturn compared to several prior recessions. The aggregate unemployment decline show the worst downturn since the Great Depression. Figure 5 Case Shiller Index
Source: S&P/Case Shiller Home Price Index Housing price data show a substantial market decline as well. In the U.S., California, Arizona, Florida, Nevada, Michigan and Ohio were particularly affected by the housing contraction. In the aggregate, the U.S. experienced a dramatic housing price decline of over 30%, shown in figure 5, mainly driven by the oversupply of homes from record foreclosures. The depression was not isolated to the U.S. World trade data with declines of 12.2% from 2008 to 2009 also reflect a severe contraction akin to an economic depression. These data are mirrored in commodity price declines from 2008 to 2010 and in industrial capacity data.
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Figure 6 Volume of World Merchandise Exports, 1965-2009
Source: WTO Secretariat
Figure 6 shows a 12.2% contraction in the volume of global trade from 2008 to 2010, the worst post-war trade contraction. Figure 7 Real GDP and Trade Growth of OECD Countries, 2008-9
Source: OECD Quarterly National Accounts
Figure 7 shows an even larger trade decline among Organisation of Economic Cooperation and Development (OECD) countries, with corresponding GDP declines. Note that, though global trade declined 12.2%, trade in the OECD countries in both imports and exports declined at a sharper 15% from Q3 2008 to Q2 2009.
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Figure 8 Growth in World Merchandise Exports Trade by Region
Source: IMF
The merchandise trade data from 2007 to 2009, shown in Figure 8, reflects the commodity bubble in 2007 to 2008 that burst in 2008 to 2009. This suggests that the commodity bubble may be a cause of or a factor in the economic destabilization period from 2007 to 2009. Figure 9 Prices of Selected Primary Products, Jan. 2000 Jan. 2010
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Source: IMF Primary Commodity Prices
The commodity price data, shown in Figure 9, also show a dramatic decline from mid2008 to mid-2009. Oil prices, for example, dropped from about $140 a barrel in August of 2008 to about $35 a barrel in July of 2009, reflecting both cartel market manipulation and a precipitous drop in demand. By all metrics, then, the global trade data indicate a greater correction than a typical recession. Finally, Ireland, Spain, Portugal, Greece, Hungary and the Czech Republic experienced dramatic economic contractions that, in some cases, precipitated sovereign debt crises. Spains Q2 2010 unemployment rate was over 20%. England experienced its worst GDP decline at 5.9% since 1921. Japans severe export-driven downturn precipitated significant political instability. These economic events were not immediately responsive to coordinated heroic international stimulus actions, indicating the intensity of the economic downturn. Collectively, these cases illustrate the severity of the decline beyond a typical recession as well as the global character of the economic downturn. Multiple data sets, then, show that this was the worst downturn since the 1930s.
Was the Downturn a Recession or a Depression? An economic recession is defined as a GDP downturn of two or more consecutive quarters, while an economic depression is defined as a GDP downturn of three or more consecutive quarters. In addition, a depression is characterized as a GDP decline of at least ten percent from peak to trough; a great depression is characterized as a decline of at least twentyfive percent. Since the 2007-9 downturn occurred over several quarters but GDP declined only
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4.1%, it is generally seen as a severe recession, the so-called Great Recession.8 I have suggested using the word repression to show an intermediary position between a recession and a depression. However, the net worth, housing, trade, and industrial capacity declines of 12-30% and the extraordinary unemployment data suggest that the contraction was more severe than a recession. For example, the present downturn experienced an aggregate unemployment (viz., over 15M people) of greater than those in all of the last three recessions combined, including the severe recessions of 1981-2 and 1990-1. The extraordinary unemployment data simply point to the extreme depth and intensity of the fall-off of industrial production.9 There is some controversy about precisely when the contraction occurred. According to Federal Reserve data, the contraction in GDP occurred from Q3 of 2008 (Lehman Brothers collapse) to Q2 of 2009. This would provide a term of ten months. On the other hand, the National Bureau of Economic Research (NBER) places the contraction period beginning in December of 2007 and running to June of 2009 for a total of 18 months. If, however, the U.S. economy did not come out of the contraction, based on NBER data, until Q1 of 2010 when unemployment peaked at 10.6% in March, 2010.10 The period from December, 2007, to March, 2010, would constitute a 28 month contraction period if one includes the phase of the downturn that accommodates the peak of unemployment. However, whether using the NBER 18 month
8
In 1931, Herbert Hoover used the term Great Depression to distinguish the severity of the economic contraction to other events in recent historical memory. In 1981, the Reagan administration used the term Great Recession to describe the relative severity of the economic downturn at that time. The economic contraction from 2007 to 2009 could be characterized as neither a recession nor as a Great Depression, thus suggesting that the terms depression or shallow depression are more accurate descriptions. 9 See Barro, R. and J. Ursua, Stock-Market Crashes and Depressions, NBER Working Paper W14760, 2009 [showing links between financial crises and economic contractions] and; Barro, R. and J. Ursua, Macroeconomic Crises since 1870, NBER Working Paper W13940, 2008 [analyzing post-Civil War economic cycles]. 10 If the economy contracts from Q2 of 2010 to Q2 of 2011, following a trend of weak housing data and high unemployment, then the contraction period may be interpreted as qualifying as a double dip recession or as a continuous depression of up to 42 months. The evidence shows a net worth decline in the third quarter of 2010 providing the prospect of a continuation of the contraction.
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mark or the 28 month mark that factors in a period to the peak phase of unemployment, the downturn was empirically the worst continuous period of economic contraction since 1929-32. In retrospect, there appears to have been three phases of the contraction. First, the initial phase from Q4 2007 to Q3 2008 shows a period of disinflation and GDP atrophy. The second phase, comprising the financial crisis and its immediate aftermath, consisted of a period of GDP contraction from Q3 2008 to Q2 2009. The final phase, comprised of a period from Q2 2009 to Q2 2010, witnessed an unemployment spike as industrial capacity dropped to a new equilibrium. Though unemployment is a lagging indicator, and is expected to remain stubbornly high with a gradual decline over several years, this later phase is a key characteristic of a severe economic contraction. The multi-phasal view of the anatomy of the downturn suggests that the 2007-9 downturn was a protracted shallow depression much more reminiscent of pre-war downturns than post-war downturns. However, even the minimalist view of the three-quarter technical GDP contraction (i.e., phase II alone) qualifies as a shallow depression by historical standards.11 It is instructive to compare the 2007-9 downturn to the U.S. downturns since the Civil War in order to assess its relative impact. Chart 3 shows the history of U.S. post-Civil-war downturns.
11
A case can be made that a fourth, atrophy, phase may occur in 2010-12 from a further housing price contraction; this period has begun to experience disinflation as measured by price data and by net worth declines in the third quarter of 2010 from the second quarter of 2010.
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Chart 3 Business Contractions: Business Cycle Dates Peak (Quarter) June 1869 (II) October 1873 (III) * March 1882 (I) March 1887 (II) July 1890 (III) January 1893 (I) * December 1895 (IV) June 1899 (III) September 1902 (IV) May 1907 (II) * January 1910 (I) (dd) January 1913 (I) (dd) August 1918 (III) ** (dd) January 1920 (I) (dd) May 1923 (II) October 1926 (III) August 1929 (III) * May 1937 (II) February 1945 (I) ** November 1948 (IV) July 1953 (II) ** August 1957 (III) April 1960 (II) December 1969 (IV) ** November 1973 (IV) January 1980 (I) (dd) July 1981 (III) (dd) July 1990 (III) March 2001 (I) December 2007 (IV)* * Financial crisis Trough (Quarter) December 1870 (IV) March 1879 (I) May 1885 (II) April 1888 (I) May 1891 (II) June 1894 (II) June 1897 (II) December 1900 (IV) August 1904 (III) June 1908 (II) January 1912 (IV) December 1914 (IV) March 1919 (I) July 1921 (III) July 1924 (III) November 1927 (IV) March 1933 (I) June 1938 (II) October 1945 (IV) October 1949 (IV) May 1954 (II) April 1958 (II) February 1961 (I) November 1970 (IV) March 1975 (I) July 1980 (III) November 1982 (IV) March 1991 (I) November 2001 (IV) [June 2009 (III)] ** War Contraction (months) 18 65 38 13 10 17 18 18 23 13 24 23 7 18 14 13 43 13 8 11 10 8 10 11 16 6 16 8 8 18 dd: Double dip Prior Expansion (months) 18 18 36 22 27 20 18 24 21 33 19 12 44 10 22 27 21 50 80 37 45 39 24 106 36 58 12 92 120 73
Source: National Bureau of Economic Research
It is significant to note and it is a key thesis of this essay to show that the average economic contraction from the Civil War to the Great Depression was 20.5 months, or about exactly the average period 18 months of the 2007-9 downturn. On the other hand, the post-
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War recessions were generally far more moderate at only 10.8 months each. The only anomaly was the double dip recessions from 1980 to 1982 that could be described as a continuous recession promulgated by activist Fed policy to correct exogenous inflationary pressures. The depth of the downturn, in terms of industrial production, international trade, housing price deflation and unemployment data is consistent with a prolonged and substantial pre-war slump. As Chart 3 shows, excluding the Great Depression, in the 42 years between 1887 and 1929, there were thirteen downturns, for an average of one downturn roughly every three years. The average downturn duration was 16.2 months and the average recovery period was 22.8 months. This Progressive era appears to have been an extremely volatile period of
entrepreneurship, financial crisis and urbanization. The intensely stratified configuration of the economy was likely a key reason for explaining the unusually destabilized macroeconomic system in this period of rapid industrial growth. With an average recession and expansion period of about 39 months over this forty year period, this era is not a good harbinger for the near-term future of the U.S. economy as it trends to an extremely stratified configuration. One key implication of this observation is that before the Great Depression endogenous instability generated from a stratified economic configuration. For instance, in contrast to the extreme stratification from 1890 to 1930, the U.S. middle class thrived after WWII and the U.S. witnessed a remarkable growth period to about the mid-70s. But projecting the model forward, it is suggested that the U.S. may experience either a difficult period of slow growth or a worse period of instability and a succession of crises.12
12
Using the analogy of the Progressive era, a period in which there was a recession after the trough of a previous downturn every 22.8 months, there may be another recession in the U.S. shortly after mid-2011 assuming the 2007-9 contraction ended at the end of the second quarter of 2009. Further, in the long-run, if the macroeconomic system is tracking this volatile period with the absence of government policy influences the U.S. may be in a generational period of extreme volatility in which significant recessions occur every three or four years, rather than every ten years like in the past generation. If we recall the period in the 1970s the instability of which was largely caused by exogenous factors we obtain a
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The financial crisis of 1907 created an unstable period, with recessions in 1907, 1910 and 1913, to which the central bank was a response. The Federal Reserve Bank was created by President Wilson in 1913 as a monetarist mechanism to moderate the extremes of market speculation. But even with the genesis of the modern Fed, the frequency of recessions were not moderated until after WWII. One major theory used to describe the reduction in severity of post-War recessions to preGreat Depression contractions was the Feds active use of monetary policy to modulate economic activity.13 It is interesting to note the protracted periods of growth between each recession before 2007, at 92, 120 and 73 months, respectively, signifying the effectiveness of Fed policy in a period of general growth.14 This evidence would support the view that
monetarist policy has been generally stimulative and effective to modulate growth and constrain unemployment. However, even with supererogatory action, the Feds power is severely
closer picture of the potential for macroeconomic disequilibrium created from endogenous factors caused by extreme stratification. The massive build-up of debt (public, consumer and business), the difficulty of deleveraging, the limits of Fed and international central bank policy, the political paralysis, a massive wave of retiring baby boomers, sovereign debt crises and enormous trade imbalances all point to the potential of a destabilizing period of continuous recessions and shallow recoveries for at least a generation. It is possible, then, that the U.S. may witness a new equilibrium period of slow
growth, increasingly frequent recessions and a new range of unemployment between 8% and 12%. On the other hand, it is possible that the rate of growth will pick up in 2011 and 2012, much as the economy experienced a rapid growth phase in late 1993 after the 1990-1 recession and long tail from a deleveraging process.
See Bernanke, B., Essays on the Great Depression, 1994 [discussing Depression era monetary policy]; Bernanke, B., The Macroeconomics of the Great Depression, NBER Working Paper No. 4814, 1994 [identifying economic policy conditions and prescriptions in the Depression]; Bernanke, B., Nonmonetary Effects of the Financial Crisis in the Propagation of the Great Depression, The American Economic Review, Vol. 73 (June), pp. 257-276, 1983 [showing the role of the banking crisis in the Depression] and; Bernanke, B. and H. James, The Gold Standard, Deflation, and Financial Crisis in the Great Depression: An International Comparison, NBER Working Paper No. W3488, 1990 [showing the role of the gold standard on monetary conditions in the Depression]. 14 In the twelve post-war recessions, though the average contraction duration was 10.8 months, the average recovery period was 60 months, for an average cycle period of 71 months or about double the duration of business cycles before the Great Depression.
13
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constrained at the present time, suggesting that we are in a new equilibrium period. In fact, monetarism may be worthless in a disinflationary economy in which interest rates are near zero. The duration of the recent downturn has been unusually protracted. While the decline in GDP stopped in mid-2009,15 according to technical factors, the recovery period has been particularly slow, with annual growth below 2%. With growth at a steady state level, total employment will not change beyond the population growth rate, thereby maintaining a high unemployment rate. Clearly, this relatively slow growth period is consistent with a downturn that is accompanied by a financial crisis.16 When identifying those periods of economic
downturns accompanied by financial crises, such as 1873, 1907 and 1929, the present period qualifies as a longer downturn than a typical recession. The financial industry crisis had as the root cause the housing bubble.17 The housing industry has clearly been in a protracted economic depression that began in 2006 and persisted through 2010.18 Since most people use their house as a source of economic value, the housing price declines have affected the debt and credit components of a large portion of the economy. Until excessive debt is liquidated, the housing sector will continue to languish. In addition, when
15
In some ways, the 2008 financial crisis was a perfect storm of events, particularly with the political uncertainty of a major presidential election and transition. While the early stimulus legislation likely averted a more severe downturn, the Obama administration clearly inherited the legacy of previous policy efforts to limit damage from the financial crisis. The severity of the crisis left few good options. 16 See Reinhart, C. and K. Rogoff, The Aftermath of the Financial Crises, NBER Working Paper, No. W14656, 2009 [showing the macroeconomic effects of financial crises, indicating a pattern of protracted downturns after crises]. 17 The sub-prime lending sector was not the only problem of the financial industry in the 2000s. In retrospect, offering creative, adjustable, loans with no credit or down payment, securitizing the loans, mis-rating the securities (often with conflicts of interest), offering credit default swap insurance on the securities by the London-based AIG Financial Products group and paying absurdly high transaction-fees and bonuses to bankers to perform these financial services was probably not a good idea. One U.S. securities industry regulator responsible for policing the industry never heard of the credit default swaps used to insure mortgage backed securities, which seems a little puzzling. 18 Fannie and Freddie offer home loans on median sized mortgages at 3% to 4% in 2009-2010, far below the 6% to 8% private market interest rates. Despite these subsidized loan prices the market still remains soft in 2010.
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unemployment is high, further pressure is put on housing prices, deepening the cycle of debt deleveraging. Since the bursting of the housing bubble was at the core of the recession, it is critical to get control of this debt deleveraging process. Continuing housing price declines, which are expected with a high backlog of foreclosures in the pipeline, will likely be a drag on economic growth for the next few years.19 International trade, a measure of industrial production, experienced a 12.2% decline in 2008-2009, consistent with a significant economic depression. The trade data reflect the sharp manufacturing contractions in the U.S., Japan, Europe and China as consumer demand dropped precipitously. Furthermore, commodity prices dropped dramatically from 2008 to 2009,
reflecting a global economic depression caused by a sharp drop in demand. The global character of the downturn is particularly indicative of an economic depression. All economic data sets point to the greatest declines in GDP, employment, industrial capacity, trade and housing prices since the Great Depression of the 1930s, suggesting that there was a more severe economic downturn than a recession. In fact, the similarity of the downturn to the early 1930s is instructive since there are parallels with the housing crises and the financial crises between the periods.20 Going further, one can argue that the world economy experienced a depression in 2007-10 that originated in the U.S. If the U.S. experienced a shallow depression from 2007-9, an analysis of history shows that the period from 2010 to 2015 is likely to witness protracted unemployment and a long tail of
There appears to be about five million homes in the foreclosure pipeline in 2010. At a rate of 95K a month, this excess housing inventory is likely to have deflationary consequences. See the argument below on the causes and consequences of the economic downturn. Finding ways to control the continuing soft demand in the housing sector is critical to arresting the slow economic growth rate. On the other hand, some argue that letting the housing market bottom is the best way to realize eventual healthy economic growth. 20 See Stiglitz., J., Freefall: America, Free Markets, and the Sinking of the World Economy, 2010 [arguing that the U.S. is in a structural economic decline] and; Day, V., The Return of the Great Depression, 2009 [arguing that the economic conditions in 2008-9 are similar to the conditions in the early 1930s].
19
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slow economic growth from reduced demand and continued debt deleveraging.21 This period of relative stagnation may be reminiscent of the Japanese lost decade of the 1990s. The two periods are likely to share similar economic and policy causes of a slow deleveraging process as banks are unwilling to write off bad loans and as protracted high unemployment diminish consumer demand. This period of relative stagnation may be part of a longer process associated with a shallow economic depression, but is also a period highly susceptible to exogenous economic shocks, such as commodity bubbles that lead to corresponding inflation. One way to transmit this inflation is with a weakening dollar that is likely to occur, based on historical experience, because of the large federal debt, projected federal deficits, U.S. trade imbalances and expansionary Fed monetary policy. The effects of the stagnation and bubbles will lead to further pressures on, and perhaps a recomposition of, the middle class. The possibility exists, then, that the U.S. is only in the early phases of a protracted economic depression with a period of tepid recovery, but then a period of declining demand, possibly a deflationary period and then rapid inflation akin to the experience of the 1970s. These economic conditions will make the Feds policy decisions particularly challenging. For much of the 19th century there was no central bank to moderate economic downturns by supplying and regulating money to banks, companies and consumers. The markets were at the mercy of the industrial and financial institutions and their entrepreneurial leaders which tended to experience booms and busts. The post-Civil War depression of 1873 lasted five years, with nearly half of the population unemployed at some point during the period. The depression of 1893 was also substantial and protracted. These depressions were protracted because of the
21
See Reinhart, C. and K. Rogoff, This Time is Different: Eight Centuries of Financial Folly, Princeton, 2009 [arguing that economic bubbles share a common pattern] and; Reinhart, C. and V. Reinhart, After the Fall, op. cit. [arguing that economic crises that stem from financial crises require several years of debt deleveraging from which to recover].
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limited ability of the federal government to provide an antidote, particularly in the absence of a central bank. The private economy was forced to repair itself without any assistance and these self-organizing mechanisms were relatively slow to act. Similarly, the downturns of 190722 and 1929 witnessed a limited ability of the federal government to respond. In the 1930s, the Fed made substantial policy mistakes that had the adverse effects of protracting the Depression in 1931 and 1937. It should be obvious in hindsight that the present situation is reminiscent of these periods that limits the extent to which government or the Fed can intervene.23 For example, with interest rates at record lows, there is little more ammunition the Fed possesses to stimulate the economy with monetary policy. Similarly, the federal governments ideological polarization has led to severe political constraints that limit the ability to stimulate the economy by adding to deficits. In terms of economic policy, the period of the 2000s was very similar to the 1920s.24 The 1920s industrial and financial deregulation policy resulted in a housing bubble and industrial concentration that led to a financial crisis that stimulated the protracted economic downturn of the 1930s. In the 2000s, similar industrial and financial deregulation policy resulted in a similar housing bubble and industrial concentration that led to a financial crisis that stimulated a protracted downturn in its aftermath. These similarities suggest that there are clear policy considerations that led to both economic downturns. While the 1931 bank crisis contributed to making the 1929 recession a protracted 43 month depression, which resulted in a 96%
See Bruner and Carr, The Panic of 1907: Lessons Learned from the Markets Perfect Storm, 2007 [describing multiple conditions for the 1907 financial crisis]. 23 In September of 2008, the Fed held $480B of treasuries. By Q2 of 2010, the Fed held $2T of securities, including $1.2T in mortgage securities. In the first three quarters of 2010, Americans bought $200B of all debt securities and foreign holders bought $375B in treasuries. These actions have driven interest rates to near zero. 24 See Leuchtenburg, The Perils of Prosperity, 1914-32, 1993 [arguing that the conditions for the Great Depression were sewn by adhering to laissez faire policies].
22
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decline in the value of the Dow from 1929 to 1932, the 2008 banking crisis25 may be shown to have made the 2007 recession a depression that led to a 53% decline in the value of the Dow from 2007 to 2009, rivaling the worst post-war equity price decline in 1973-4.26 Although the composition of industry in 1930s America is not completely analogical to the present situation, mainly because the country now enjoys a much larger27 and more diversified economy, comparing the 2007-9 downturn to the recession of 1991 to 1992 is more instructive. The real estate bubble of the 1980s led to a financial industry crisis that required several years to deleverage debt and was accompanied by slow growth and a period of high protracted unemployment. The economy did not substantially rebound until the fourth quarter of 1993, while real estate prices declined an average of five percent a year from 1990 to 1998 in many cities. However, the financial and real estate bubbles of the 2000s were larger and more pervasive than those in the 1980s fed by both deregulation and Fed easing suggesting a far more substantial downturn from 2007-9 than in 1990-1. While viewing GDP data alone provides an ambiguous interpretation, viewing strategic industries such as real estate, automobile and manufacturing as well as trade data, which collectively experienced thirty percent declines from 2007 to 2009, shows that the recent economic contraction was particularly onerous. Similarly, when viewing the net worth data declines, it appears that the downturn was much more severe than the GDP data show, indicating
25
See Murphy, An Analysis of the Financial Crisis of 2008: Causes and Solutions, SSRN, 2008 [revealing the anatomy of the financial crisis]; Reinhart, C. and K. Rogoff, Banking Crises: An Equal Opportunity Menace, NBER Working Paper W14656, 2009 [arguing that banking crises typically show similar patterns] and; Reinhart, C. and K. Rogoff, Is the 2007 U.S. Sub-Prime Financial Crisis so Different? An International Historical Comparison, NBER Working Paper W13761, 2008 [using historical and international evidence to show common patterns of banking crises]. 26 Without aggressive Fed policy and U.S. government stimulus and TARP policy actions, the decline would likely have been more severe. 27 The U.S. income tax receipts in 1929 were $1.1B and in 1935 were about $500M. Even after factoring in inflation, when considering that the sources of federal government income were personal income taxes, corporate taxes and excise taxes, the size of the federal government in the 1930s was significantly smaller than the present time.
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that the private sector was particularly hard hit and that public spending from government stimuli was crucial to mitigate even further declines. The implications of a more severe contraction than traditional measurements of GDP data alone show are that these past metrics may be inadequate to capture the depth of the downturn. If the data were much more straightforward to interpret, the NBER would not have waited fifteen months after the technical indicators showed an end to the downturn to define its parameters. Although the aggregate data regarding the typology of the economic downturn is controversial, the effects of the downturn on specific classes of individuals are less controversial. The manufacturing sector experienced a structural decline responsible for a reduction from 30% of GDP in 1970 to only 12% of GDP in 2009.28 Similarly, the middle class experienced an afterinflation net decline of wages from 2001 to 2010 even while energy, education and health costs increased at rates higher than the core rate of inflation. For the middle class, the average worker and the poor, then, this downturn was, and is, structural and persistent. Given these economic data points, it is appropriate to consider that the U.S. experienced a significant, but relatively shallow, economic depression from late 2007 to at least mid-2009. The depth, intensity, speed, prolonged duration and global character of the downturn suggest that the U.S. experienced significantly more than a recession. For these reasons, the case can be made that the U.S. was in, and is gradually recovering from, a shallow economic depression.
28
Much of U.S. manufacturing is concentrated in a few industries dominated by incumbents such as Boeing, Caterpillar, Intel, Ford and GM.
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This Time IS Different29 How was this time different? The magnitude and duration of the downturn, the international aspect of the downturn and the inclusion of the financial (bank and sovereign debt) crises suggest that 2007-9 was substantially worse than any economic downturn since 1929-32. The case for an economic depression from 2007-9 is reinforced by looking at both empirical and policy data from 2001 to 2010 and by comparing the data to historical economic downturns. The depth of the decline is registered in unemployment data, industrial utilization data, trade data and real estate price data from 2007 to 2010. According to these data, the economic decline was unequivocally greater than any post-war recession. The argument for viewing the economic contraction as a shallow depression suggests that we are in a new destabilizing period with a long tail of recovery.30 In the aftermath of the contraction phase, the long tail that characterizes the slow recovery is notable because of a new post-contraction equilibrium phase characterized by
See Reinhart, C. and K. Rogoff, This Time is Different: Eight Centuries of Financial Folly, 2009 [arguing that similar patterns of boom and bust are seen at different times and places]. 30 The argument for a continuous shallow depression sees the increase in factory production of the last half of 2009 and the first half of 2010 as a period of inventory restoration that, once complete, will then lead to a period of protracted demand decline that mirrors the experience of the early 1930s. Further, the GDP gains in the last half of 2009 are likely caused by the federal government stimulus and by a relatively weak dollar that artificially stimulated exports. However, this modest temporary increase is more typically part of a period of protracted decline characteristic of a continuous deflationary (or disinflationary) period. The notion that the U.S. may witness a double dip recession of a second phase of GDP contraction is consistent with the view of one single continuous event. The U.S. experienced one postwar double dip recession in 1980 and in 1981-1982. However, this period could also be characterized as a single continuous event, with two stimulative components. The first cause was the Iranian oil embargo that raised oil prices by two to three times, thereby causing both contraction and inflation. Because of the high inflation, the Fed, in keeping with its inflation targeting strategy, raised interest rates in 1981-2 so high as to stimulate the second phase of the recession. It is argued that these phases of a process were causal and continuous and thus a single event, not a double dip. Nevertheless, parts of Europe appear to be experiencing either a double dip recession in 2010 or one continuous depression. See Bernanke, B. and M. Woodford, eds., The Inflation-Targeting Debate, 2006 [discussing the Feds inflation targeting strategies] and; Bernanke, B., T. Laubach, F. Mishkin and A. Posen, Inflation Targeting: Lessons from the International Experience, 2001 [articulating the use of inflation targeting by central banks in the international context].
29
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consistently slow growth. The industrial utilization and employment data are at post-war lows in the aftermath of the initial downturn period largely because of persistent constrained demand. It is this long tail that one can argue characterizes a repression or a protracted stagnation phase of a prolonged period of severe recession. While the near-zero growth stagnation period is not a depression, it is not characteristic of post-war growth either. Using a medical analogy, it appears as though, after the original sickness, the patient has lost a considerable amount of weight and cannot gain the weight back to return to a normal healthy state. We appear to be in a completely new equilibrium going forward. However, most post-war recessions have ended with a period of 5-6% annual growth. With anticipated 1.5-2.5% annual growth in 2010-2011 and with unemployment at or near double digits for the foreseeable future, the present long tail is not characteristic of past termination periods of recessions. With only 80K jobs created monthly in 2010, this tepid employment growth, experienced with 2.5% or less annual GDP growth, will not keep up with population growth. It will take four years of 5% GDP growth to reduce the unemployment rate from about 10% to a pre-downturn unemployment rate of about 4.6%. At an economic growth rate substantially less than 5%, the U.S. may experience a structural employment slump over five years. Most U.S. recessions in the twentieth century had common profiles. For instance, 1907 and 1931 had financial crises. 191831 and 1945 were characterized by the end of WWI and WWII. Each of the recessions from 1973 to 2001 was characterized by economic bubbles. In 1973 and 1979, the recessions resulted from commodity (i.e., exogenous oil) bubbles, 1990-1 from the 1980s real estate bubble and 2001 by the Internet and telecommunications bubble.
31
The influenza epidemic probably did not help the economic conditions in 1918.
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Each recession experienced a prolonged period of asset price deflation. In effect, each recession was a solution to a period of abnormal price inflation.32 The 2000s real estate bubble was caused in part by an unusually protracted period of low interest rates promulgated by the Fed to control the 2001 recession and by deregulation of financial institutions in the aftermath of Glass-Steagall. However, the middle class from 20002007 experienced slow employment growth (about two million, generally low quality service, net jobs created mainly from 2003 to 2007) and a net after-inflation decline in real wages while manufacturing was substantially off-shored. The considerable stress on the middle class in the 2000s set up a high-debt period that would lead to the intensity of the depth of the downturn, much like the 1920s set up the conditions for the 1930s protracted contraction. It is the extraordinary debt picture, and its deleveraging process, that set up the downturn and slow recovery. The following figures show the debt data. Figure 10 U.S. Debt by Sector
32
See Jagannathan, R., M. Kapoor and E. Schaumburg, Why are We in a Recession? The Financial Crisis is the Symptom Not the Disease, NBER Working Paper No. W15404, 2009 [arguing that the core problems of the banking crisis are excess leverage that requires the deleveraging process manifest in a recession].
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Source: Fed Flow of Funds 2010 Fig. 10 shows the dramatic buildup of debt since 1990 in business, household, finance and government sectors. Figure 11 U.S. Gross Federal Debt as a Percentage of GDP
Figure 11 shows federal debt since WWII. The growth in federal debt is clear from 1981 to the present. The build-up of debt in the 1980s led to the deleveraging process in the 1990s. The federal debt accumulated in the last few years is also non-trivial.
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Figure 12 U.S. Debt and GDP 1990-2010
Source: Fed Flow of Funds 2010 Figures 12 shows private and public debt from 1990 to the present relative to GDP. While the public debt is significant, the relative size of the private debt is alarming. Figure 13 U.S. Private Debt to GDP
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Source: Fed Flow of Funds 2010 Figure 13 shows the level of private debt relative to the change in debt. The drop in the rate of change of debt ratio in the downturn is dramatic. Figure 14 Correlation of Change in Debt and Unemployment
Source: Fed The change of debt ratio, shown in figure 14, is correlated to the unemployment rate change, showing the drop in demand that led to the dramatic increase of unemployment in the downturn. It can be inferred from this correlation that the demand for goods was driven by debt. This imbalance is also manifest in the U.S. trade deficits.33
33
Does the correlation of debt and employment imply that debt supports overconsumption and high employment?
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Figure 15 U.S. Trade Deficits
Source: U.S. Census Bureau The U.S. trade data, shown in figure 15, reveal a persistent trade imbalance as U.S. consumers spend more on products and services than they produce, thereby fueling more debt.34 The late 2000s real estate bubble deflationary process caused an equity price adjustment and then an investment-bank run that affected overleveraged financial institutions.35 Somewhat
How long can the U.S. maintain $500B+ trade deficits? The majority of the deficits represent the acquisition of cars (Japan), oil (Middle East) and goods (China). 35 The Lehman Brothers collapse was a trigger of market fear of risk taking after the U.S. government arbitrary decision not to cover all private hazard. Without public subsidization of all private risks, the market naturally corrected. See Diamond, D. and R. Rajan, The Credit Crisis: Conjectures About Causes and Remedies, NBER Working Paper No. W14739, 2009 [ascertaining the origins of the financial crisis]; Krugman, P., The Return of Depression Economics and the Crisis of 2008, 2009 [reassessing the conditions for economic crises]; Brunnermeier, M., Deciphering the Liquidity and
34
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reminiscent of the 1930s, the restructuring of the financial industry that began to occur in 2008 was a key factor in setting up the slow deleveraging process of the depression. For example, if the banks were allowed to write off more of their real estate debts, the system would have likely deleveraged debt far more quickly than it has. However, with a substantial amount of debt on the books of businesses and consumers, and with a persistent deflationary real estate environment in which millions of houses and commercial buildings were foreclosed, the deleveraging process is more protracted than it would have been if the bank debts were substantially written off in 2008.36 The Troubled Asset Relief Program (TARP) represented a political compromise in which it was intolerable to rapidly write off public debt. The choice to slowly write off mortgage related debt produced the present protracted deleveraging process. This political decision has had, and will continue to have, significant ramifications akin to the Japanese lost decade in
Credit Crunch 2007-08, NBER Working Paper No. W14612, 2008 [describing the credit crisis as a liquidity crisis]; Calomiris, C., Banking Crises and the Rules of the Game, NBER Working Paper No. W15403, 2009 [showing how banking policies change during banking crises]; Cassidy, J., How Markets Fail: The Logic of Economic Calamities, 2009 [describing patterns of economic crises]; Rothbard, M., Americas Great Depression, 2005 [describing the economic policies responding to the conditions of the Depression]; Krugman, P., The Great Unraveling: Losing Our Way in the New Century, 2004 [arguing that libertarian economic policies promote too much debt that eventually is deleveraged in an economic downturn]; Cole, H. and L. Ohanian, The U.S. and U.K. Great Depressions Through the Lens of Neoclassical Growth Theory, American Economic Rev., 2002 [study of two nations remedies to the Depression]; Chancellor, E., Devil Take the Hindmost: A History of Financial Speculation, 2000 [history of economic bubbles and recessions showing common patterns of financial speculation]; Garber, P., Famous First Bubbles: The Fundamentals of Early Manias, 2000 [history of economic crises from the South Sea bubble to the 21st century]; Romer, C., The Great Crash and the Onset of the Depression, The Quarterly J. of Economics, 1990 [showing the 1929 stock market crash as a destabilizing event that precipitated the Depression] and; McElvaine, R., The Great Depression: America, 1929-1941, 1983 [economic history of the Depression]. 36 See Krugman, P., Financing Vs. Forgiving a Debt Overhang, NBER Working paper No. W2486, 1989 [presenting different arguments for policies to accelerate debt losses to promote rapid economic recovery] and; Kessler, A., TARP and the Continuing Problem of Toxic Assets, WSJ, 2010 [describing the monetary causes of the financial crisis and showing that the deleveraging process originated in TARP policy decisions].
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which banks refused to write down real estate debt and suffered average annual real estate price declines of 5% from 1990 to 2005.37 If we are in a protracted economic depression, we may not have definitive information for another several years about persistent price declines. In other words, we may not have enough data to determine whether we are in a more substantial depression or stagnation period at the present time, akin to only seeing the first two to three years of the Great Depression. But if we are in a protracted depression, the federal government and Fed stimulus policy are limited to modulate the economy going forward, thereby complicating economic development.38 The argument that a steep downturn leads to a strong recovery which has been the general rule in post-war recessions has not been actualized in the present period. For the most part, the rate of debt liquidation appears to determine the rate of recovery. In effect, a sharp contraction is the cure for the mania of the 2000s, wherein a deleveraging period is required to re-equilibrate the economy.39 But the 2007-9 contraction period, like the periods of 1929-32 and the early 1990s, also witnessed financial industry crises. In the current period, the financial industry is constraining credit and thereby perpetuating the duration of the deleveraging process.40 This financial
37
See Schularick, M. and A. Taylor, Credit Booms Gone Bust: Monetary Policy, Leverage Cycles, and Financial Crises, 1870-2008, NBER Working Paper No. 15512, 2010 [describing the history of postCivil War economic cycles from a perspective of monetary policy]; Taylor, J., The Financial Crisis and the Policy Responses: An Empirical Analysis of What Went Wrong, NBER Working Paper No. W14631, 2009 [an anatomy of policy options to solve the financial crisis]; Taylor, J. and J. Williams, A Black Swan In the Money Market, NBER Working Paper No. W13943, 2008 [arguing that the small probability of catastrophe was not adequately measured in monetary risk analyses] and; Whalen, R., The Subprime Crisis: Cause, Effect and Consequences, Networks Financial Institute Policy Brief No. 2008PB-04, 2008 [analysis of the sub-prime mortgage market as a key cause of the financial crisis]. 38 See Mishkin, F., Is Monetary Policy Effective During Financial Crises?, NBER Working Paper No. W14678, 2009 [arguing the limits of monetarism particularly when it is needed most]. 39 See Minsky, H., Stabilizing an Unstable Economy, 1986 [showing the policy choices in economic crises with a particular focus on monetary institutions]. 40 See Ivanshina, V. and D. Scharfstein, Bank Lending During the Financial Crisis of 2008, EFA 2009 Bergen Meetings Paper, 2009 [showing the transformation of bank lending as the crisis evolved].
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industry crisis was exacerbated by the extreme and rapid concentration of the industry in 2008. In other words, while housing is a drag on the economy, the financial industry has limited credit at the precise time that consumers need credit to sustain economic growth. Substantial evidence shows that limited consumer and business lending created by the banking sector is stifling the recovery. Furthermore, the correlation between high unemployment data and a very soft housing market suggests a negative feedback loop that will be particularly slow to change in the next few years. The unemployment rate needs to come down substantially before consumers buy homes, consumers need to buy homes before prices stabilize and prices need to stabilize before economic growth will continue so as to bring the U.S. out of a protracted downturn. While the technical factors show a severe contraction from 2007-9 from which the U.S. is slowly recovering, some positive data reflect the successful performance of industrial corporations. After a decline of corporate profits in 2008-9 of about thirteen percent, the profits of large corporations have been robust in 2009-10. Unique factors that pertain to the increased industrial globalization and concentration of American corporations in the 2000s have allowed them to maintain robust profits in the aftermath of the downturn. Many industries, including energy, finance, technology, communications and pharmaceutical, are oligopolously configured, and consequently enjoy substantial monopoly profits. Therefore, while much of the U.S. is experiencing a substantial downturn, including record post-war aggregate unemployment, corporate profits in several industries have been excellent. Rarely in history have these
industries seen more highly valued corporations combined with record profits. Although the extreme concentration of industrial organization is a result of decades of lax antitrust regulation, the success of large corporations is contrasted to the performance of small and mid-sized
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businesses. This extreme industrial stratification41 in the 2000s has similarities to the period of the 1890s to 1920s of U.S. industrial development.42 It is this lack of government regulation that provides a similarity of the 2000s to the 1920s and suggests there is little the government can do to mitigate the depth of the downturn at the present time. The theory that we are in a shallow depression similar to those in the 19th century follows the view that the U.S. government did little to prevent 19th century recessions because of industry structure constraints and limited potential government stimuli.43 The prevailing logic is that Keynesian44 economic stimulus would add to the already absorbitant deficits and restrict further stimulus actions. In other words, there is a perception that, politically, there is little that the government can do to deal with the depth of the economic downturn. Both the federal government and the Fed simply have no ammunition left in their economic arsenal to stimulate the economy. This is particularly problematic if an exogenous event occurs that plunges the economy into a new stage of decline, such as another MiddleEastern crisis. According to the prevailing economic theory, then, the contraction occurred from 2007 to 2009 and could be mapped by catastrophe mathematical theory, while the technical recovery began in mid-2009 and continues at a relatively slow pace. However, the data also seem to show that a more substantial depression may be occurring in which the shallow depression of 2007-9
See Williamson, O., The Economic Institutions of Capitalism, 1998 [showing the market hierarchy of industrial organizations] and; Williamson, O., Markets and Hierarchies: Analysis and Antitrust Implications, 1983 [showing how markets organize and evolve]. 42 See Porter, G., The Rise of Big Business, 1860-1920, 2006 [mapping the growth of corporations from the Civil War to the Progressive period] and; Prechel, H., Big Business and the State: Historical Transitions and Corporate Transformation, 1880s to 1990s, 2000 [showing the complex relations of government and big business over the 20th century]. 43 This extreme industrial stratification is related to the increased, even symbiotic, relations of big business and the federal government in the 2000s. 44 See Keynes, J., The General Theory of Employment, Interest and Money, 1936 [the classic economic work arguing for activist government policy during economic crisis periods].
41
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was merely the first component of a longer process, particularly when factoring in the period of unusually high unemployment rates or the duration of a return to the point of peak net worth or potential economic growth. While post-war recessions have shown similar patterns, the recent depression and aftermath are substantially different in depth and duration. This time it was different.
Causes and Consequences of the Depression There are several causes of the depression. In general, the core of the problem is diminished demand from consumers. The source of diminished consumer demand is the housing contraction caused by the bursting of the housing bubble in 2007. The economic downturn was complicated by the financial crisis in 2008, which was promulgated by over-leverage, poor risk management, short-term incentives and limited oversight. The financial crisis was a debt crisis that moved from a U.S. consumer housing crisis to a European sovereign debt crisis. With substantially diminished consumer demand, industrial capacity dropped and, with it, employment. In general, consumers stopped buying goods financed by borrowing from the inflating value of their homes.45 There are several causes of the prolonged downturn after the initial debt crisis. These include (a) a liquidity crisis, (b) a deleveraging process and (c) a savings paradox. Many businesses require capital flows that were interrupted by the financial crisis in 2008. With diminished access to capital, many businesses were adversely affected by the downturn, which was protracted as banks moved from an overt liberal strategy to an overt conservative strategy during the downturn. Since capital flows were constrained, high debt worked through the
45
See Phelps, E., Structural Slumps: The Modern Equilibrium Theory of Unemployment, Interest, and Assets, 1998 [dialectically discussing advantages and limits of various macroeconomic schools].
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system. Because about 75% of jobs are created by small business, the challenges of business entrants are especially prominent in a downturn. Particularly with constrained access to capital and relatively higher energy and health care costs, small businesses are disincentivized to grow and hire workers. High relative debt requires a period of time to deleverage, which is
detrimental to stable business and consumer activity. While consumers had too much debt prior to the downturn in fact, a record negative savings rate they are now saving relatively too much. With too much savings, consumers are not spending as much on goods, which further prolongs the recovery.46 The sum of these factors suggests that the downturns contraction period was complicated by debt deleveraging aspects more typical in economic depressions.47 While some have argued that increased class stratification has caused the crisis,48 I argue that class stratification is a consequence of a set of economic events rather than its cause. One can argue that when 1% of the population has 23% of income (and .1% with 11%) the economy is very stratified, but this is only a symptom of an economic system that configured industries into cartels and that removed constraints on economic incentives for the top.49 This elite group benefited from relaxation of taxes on the wealthy but also from the increasingly stratified structure of organizations that is made possible in a global economy by increasing efficiency and productivity from using technology and from offshoring cheap labor. It is argued that the stratification of the elite classes is merely an indicator of the larger issue of the restructuring of organizations within industries. Figure 16
It is logical for Congress to consider instituting policies to promote savings so as to encourage investment in a primarily consumer-driven nation. 47 See Shiller, R., Irrational Exuberance, 2001 [showing how investor over-confidence leads to bubbles]. 48 See Reich, R., Aftershock: The Next Economy and Americas Future, 2010 [arguing that stratification caused the 2000s economic bubble]. 49 See Saez, E. and T. Piketty, op. cit. and; Atkinson, T. and T. Piketty, op. cit. See footnote 1.
46
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Median Family Net Worth by Percentile of Net Worth
Source: Federal Reserve
The distribution of net worth is shown in Figure 16. The top ten percent of families have about ten times the net worth of the top 75-89.9% and about thirty times the net worth of the bottom half of the population. This sort of stratification is reminiscent of the economic structure of a Third World country.50 The lack of competition policy enforcement yielded a set of strategic industries in technology, communications, energy, pharmaceuticals and finance that are extremely concentrated. In most cases, there are only several mega-capitalized corporations in each
industry with large market shares, often with $100B or greater market capitalizations, and a few relatively small or mid-sized competitors.51 This situation of extreme industrial concentration lies at the end of a three decade period of merger activity that created a set of giant U.S.-based
50
The reader may be reminded of Swifts Gullivers Travels (1726) in which those within the top 7589.9% are able to live in average suburbia, those in the bottom half are the Lilliputians (one tenth the size of the average) and those in the top 10% are the giants (ten times the size of the average). Pushing the analogy further, those in the top 1% are ten times larger than the giants and those in the top one percent of the top one percent are ten times larger still. 51 See Porter, G., op. cit. and; Prechel, H., op. cit.
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corporations representing about 70% of global profits. This extreme industrial concentration and polarization explains why the largest companies have such robust and record profits. Exxon Mobil,52 Chevron, GE, IBM, Hewlett Packard, Microsoft, Intel, Apple, Cisco, Oracle, AT&T, Verizon, Merck, Pfizer, Johnson and Johnson, Berkshire Hathaway, Wal-Mart Stores, Goldman Sachs and JP Morgan Chase enjoy unusually high market caps and typical 11-digit ($10,000,000,000.00+) annual profits characteristic of monopolies. Surprisingly, these
Brobdingnagian profits were made even during the economic contraction period of 2008 and 2009. These cartels are sitting on hundreds of billions of dollars, in contradistinction to cashstarved smaller competitors, and thereby perpetuate their advantages. This industrial structure polarization is a key source of economic challenge in the U.S. With extreme industry concentration and extreme organizational structures,53 the benefits of economic growth flow to a very small slice of the population. The industry and organizational configuration changes over the last generation has mirrored the stratification of American society. While middle class incomes have not grown in the last decade, the upper classes have experienced high income growth rates, with an increase to $11.5M+ annual incomes for the top 1% of the top 1% in 2007, $1.6M for the top .12% and a mere $410K for the top 1%.54 With this dramatic increase of extremely wealthy along with the atrophied middle class, the gap between the average worker and the most elite executives has produced an extreme polarization. Yet, it should be clear that the extreme income gap is a product, not a cause, of the economic stratification caused by reduced enforcement of unfair competition policy, and limited control of incentives for the highly compensated, that results from extreme industrial concentration. In fact, evidence shows that by not controlling the top compensation of the most highly
52 53 54
Exxon Mobile enjoyed windfall profits of about $40B in 2006 and in 2008. See Williamson, O., op. cit. See footnote 1.
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compensated earners of many organizations, there is a tendency to increase the instability of organizations; it would appear that there is a natural tendency to find a balance between the highest- and average-compensated workers.55 The economic polarization mirrored in such extreme industrial concentration is more characteristic of a Third-World country, which typically has a financial institution, an energy institution and a telecommunications institution, whether state-owned or a monopoly. The U.S. has not seen this sort of industrial concentration or economic stratification in about 100 years. Not coincidentally, this extreme gap between the wealthiest 1% and the median 50% has not been seen since at least 1928, or, possibly, since the 1890s. Though the economic stratification followed the industrial concentration, it was exacerbated by the biased 2001 and 2003 tax cuts that accelerated the gap between the top 1% and median income earners. In particular, the financial industry is far too concentrated. Only a handful of companies have combined 80% market share in some markets: Goldman Sachs, J.P. Morgan Chase, Bank of America Merrill Lynch, Citigroup, Wells Fargo and Morgan Stanley. With Wachovia,
Washington Mutual, Merrill Lynch, Bear Stearns, AIG and Lehman Brothers acquired or eliminated, the current configuration of financial institutions presents a dangerous obstacle to future industrial growth. Furthermore, 40% of U.S. corporate profits in 2008 were attributed to the financial industry, compared to about 15% in 1970.56 This suggests that the financial
55
See Rajan, R., Fault Lines: How Hidden Fractures Still Threaten the World Economy, 2010 [suggesting the conditions for economic crises still lurk in the international system]. This view is reinforced by Rajans arguments about the skewed incentives of investment banking compensation rates. England and the EU elected to tax banker bonuses to realign private incentives with public duties. 56 It is interesting that Wall Street compensation numbers for 2007, 2008 and 2009 do not show a downturn. For example, many Goldman Sachs Group partners get paid more than Fortune 500 CEOs, even in bad years. This promotes moral hazard, which ultimately requires public institutions to bail out the risky bets of the financial institutions. It is surprising that shareholders allow such high executive compensation. Private incentives need to be realigned with public duties. If the companies themselves
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industry evolved to become a critical strategic industry.
In effect, finance replaced
manufacturing in the U.S. economy. A thesis of this essay is that there are adverse effects of this economic repositioning. FDIC data show that American banks had $620 billion less in assets in mid-2010 than at the end of 2008. Further, business loans in the period dropped twenty percent, from $1.49T to $1.175T. A $600B drop in total loans from $7.996T to $7.395T is also shown. One of the reasons attributed for the loan declines is that in 2009-10 U.S. government regulators (in accordance with financial reform and the Basel II and III regimes) began to require greater bank capitalization. With higher capitalization requirements, banks have less to lend. Therefore, while the money center U.S. banks have substantial cash on their balance sheets ($185B for Citibank, $172B for Bank of America Merrill Lynch and $72B for JP Morgan Chase in 2010), they have smaller lending programs and higher lending standards at the precise time when businesses need loans.57 Similarly, the consumer savings rate went from a historic low of below 1% before the depression to 6% in 2010, suggesting that the pendulum for consumers had swung too far too fast. The paradox of savings suggests that consumers should be spending cash in order to increase demand for goods. Instead, they are saving and liquidating debt, thereby constraining demand and protracting the recovery. Evidence shows that the financial industry went from too lax credit policies to far too restrictive policies in 2008. The after-effects of the financial crisis continue to affect the long tail period of the economic recovery from the depression, but the financial industry configuration is a
cannot control this problem, the government should intervene, as the governments of England and the EU have intervened to tax absurdly excessive banker compensation. It is neither logical nor moral for the U.S. to publicly subsidize losses while allowing the benefits of risky bets to be privatized. 57 See Ivashina, V. and D. Scharfstein, op. cit.
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major problematic source of restrictive competition that adds a capital layer between the Fed and businesses.58 While the symptom of a financial industry layer that blocked liquidity also existed in the 1990-1 recession, with adverse effects that prolonged the recovery, the present prolonged tail of the depression is particularly affected by the adverse effects of the extremely concentrated financial industry. Much like the effect of the financial industry on the economy during Japans lost decade in the 1990s, it is argued that the extremely concentrated configuration of the U.S. financial industry is largely responsible for a slow deleveraging of real estate debt from the 2000s. Like with Japan, the refusal to write down these loans has protracted the recovery. So far, in July of 2010, 14% of home loans were in foreclosure or delinquent. The inventory of homes was at an all time high in 2010, at about 100K homes foreclosed per month, with the longest time-to-sale period (i.e., one year or longer) since records were maintained. In effect, the refusal to write off bad loans forces real estate prices down further. With a second round of housing declines in the downturn in 2010, the rest of the economy may experience asset disinflation in 2010 and 2011 and, perhaps, a period of deflation. Historically, employment gains are unlikely to come from large corporations. The
economic advantages of the wealthiest corporations have been reinforced by investment into productivity enhancing technologies that allow for increased automation and a decreased need for human capital. With reduced employment during the downturn, larger corporations are outsourcing employment to lower cost countries and increasing the use of automation to increase productivity of existing employees. Therefore, one would not expect the largest corporations to be the greatest source of employment in the recovery.
58
A manifestation of the adverse effects of the financial industry layer is the refusal of banks to reorganize mortgage debt in accordance with congressional legislation. This problem of the unwillingness of banks to write down debt is a key source of continued housing market instability.
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Rather, the greatest source of employment in the private economy will come from small businesses. Traditionally, small and new businesses hire about 75% of total employees. Yet, the strains to small business are particularly severe in the economic downturn. While the increased industrial concentration and competitive pressures of small companies are causes of the extreme U.S. economic stratification, the effects are limited demand for goods and high unemployment. There are correlations of high unemployment with
constrained demand, on the one hand, and of high unemployment and the housing crisis, on the other. The 2000s witnessed a generally soft demand for employment that barely kept up with population growth. Between 2003 and 2007 about two million net jobs were created,59 compared to the 1990s, during which twenty two million net jobs were created. However, median wages atrophied after inflation from 2000 to 2007; 2007 real median wages were actually marginally lower than in 2000. The depression, however, knocked out over eight million jobs from 2008 to 2010. The data on unemployment are unarguably the worst since the Great Depression.60 In addition to having a relatively extreme unemployment rate, the employment picture is extremely lopsided. Though college educated workers had a 5.6% unemployment rate in the third quarter of 2010, those with less than a college degree, those over fifty years old or those under 25 years old, particularly minorities, had a 15-25% unemployment rate. Children of color had a stunning 25% or greater rate of being on food stamps. Moreover, some regions have a
59
Over eight million jobs were created from 2003 to 2007, but six million jobs were also lost in the period, mainly to offshoring. 60 Including the underemployed and those that stopped looking, the Bureau of Labor Statistics states the unemployment rate of about 16.6% peaked in the first quarter of 2010. About five unemployed applied for each job opening on average, a record. The total unemployed in the 2007-9 depression were greater than the aggregate unemployed in the 1981-2, 1990-1 and 2001 recessions combined.
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higher unemployment rate than others. For instance, Californias 2010 unemployment rate was 12.4%. While the unemployment rate spiked and remains at an unusually high equilibrium rate with a slow economic growth rate, evidence shows that the U.S. is slipping further behind in the one area that has a hope of improving the quality of life for most Americans, viz., education. A positive feedback loop is recognized in the advantages of an investment in education. Yet by 2010, the U.S. had slipped to eleventh place in science, ninth place in math and fifteenth place in reading literacy among industrial countries. If the correlation between education and innovation, productivity and economic growth is a strong one, then the improvement in education would be a strategic goal. However, the investment in education, particularly public education by the states, is jeopardized by extremely tight public budgets and a political choice of spending on health care and prisons over education. Education is a barometer of progress, particularly for the middle class, and in this case, the barometer is measuring dangerous signs of a future of missed opportunities. While opportunities exist for the elite, the middle class is clearly falling very far behind as measured by virtually every metric. Without an intensive investment in education, the future of the U.S. economy is jeopardized. As a 1984 Department of Education report acknowledged, if a foreign power were to threaten to harm our schools the way that we have harmed them through neglect and extreme poor investment, then we would consider the acts hostile and justifying a war. Nevertheless, the deteriorated state of the education system is a symptom of the effects of an elite-biased conservative economic philosophy.
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The Rise of China Given the ordinary economic equilibrium established in the post-war period, perhaps the U.S. economy would not be suffering an economic downturn as significant as the one it encountered in 2007-9. However, a critical destabilizing force in the global economy has been the rise of China. Chinas hybrid capitalist-mercantilist economic system and the present historic period of industrialization and urbanization have had profound effects on industrialized economies. If Japans rise was a miracle of economic growth from 1960 to 1990, Chinas quantum speed of growth from 1980 to the present can be characterized as similarly phenomenal.61 But Chinas communist government has applied aggressive economic and
monetary policies to promote its domestic industries and manage rapid growth at the expense of trading rivals. While the U.S. economic development of the 2000s experienced substantial effects of Chinas economic development, typically in moderately priced goods and lost manufacturing jobs, the effects of Chinas policies during the downturn were egregious. In the 2000s, China used capital from trade surpluses to buy U.S. treasuries, effectively financing our debt. This had the positive effect of keeping down U.S. interest rates. Further, a weak yuan had the consequence of limiting inflation, which allowed the U.S. to maintain a relatively lower inflation rate target regime. In an ordinary economic growth paradigm, low prices for goods and low interest rates are optimal, but during the economic slump, there was downward pressure on prices that produced disinflation and deflation. In the present period, disinflation is protracted by the effects of Chinas currency and trade manipulations.62 In a
61
Along with spectacular economic growth, it is interesting to observe Chinas own extreme economic stratification, which is ironic in light of communist egalitarian political ideology. Nevertheless, despite strong economic growth to parity with Japan, GDP per capita in China is only one tenth of Japans in 2010. 62 For much of the past two decades, the yuan was pegged to the dollar. However, as the yuan floats and the dollar weakens, inflation will likely be transmitted. The main question remains as to the degree of the U.S. trade deficit (25% in 2010) that will result as a consequence of a strong yuan. There is a better than
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period of slow economic growth, employment and wage growth are prominent problems; while the U.S. experienced slow employment and wage growth during the 2000s period, it is particularly problematic in the aftermath of the depression. Similarly, when the effects of Chinas economic manipulation on manufacturing was detrimental in the 2000s, it is devastating in the period after the depression when the U.S. economy is experiencing economic growth so slow that employment growth is not keeping up with population growth, thereby perpetuating an unusually high unemployment rate. Consequently, while the new economic equilibrium that resulted from the rise of China has resulted in benefits of cheap goods and low interest rates during the moderate growth period of the 2000s, it has had disastrous consequences during the slump and afterwards.63 The Chinese economic model has several features that result in unfair trade practices. For example, China uses subsidized land grants, unusually cheap labor costs and low interest loans to accelerate their export industries.64 Using Japans government-coordinated export
industrial policy as a model, the Chinese have turbo-charged economic subsidization with systematic unfair trading practices. In addition to subsidizing land, labor and capital and For
coordinating export industries, the Chinese tax imports so as to create protectionism.
instance, automobile tariffs are 25%. Furthermore, the Chinese systematically pirate intellectual property. In the case of the alternative energy industry, China requires companies that want access to the burgeoning Chinese market to give up their intellectual property the only
even chance, based on the experience of the strong yen in the 1980s that there will be little effect on the American-Chinese trade deficit from a strong yuan. Compare the view of a floating Chinese currency to the view that Americans should save more and the Chinese should consume more. The Feds Bernanke has echoed these sentiments in the past. See Roach, S., Cultivating the Chinese Consumer, NYT, 2010 [arguing that a floating yuan may not matter to American consumers since their appetite for Chinese goods is high]. 63 See Kaletsky, A., Blaming China Wont Help the Economy, NYT, 2010 [arguing that the U.S. should find multi-lateral solutions to Chinese trade imbalances]. 64 See Bradsher, K., China Takes Lead in Clean Energy, With Aggressive State Aid, NYT, 2010 [stating that China subsidizes its clean energy industry in opposition to WTO rules].
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remaining competitive asset which creates a no-win solution for foreign companies. One clear consequence of this systematic economic manipulation is to produce artificial trade surpluses at the expense of foreign industries and jobs. The effects of these unfair trade practices on the U.S. are substantial. First, by dumping cheap products in the U.S., the Chinese have an unfair competitive advantage against the indigenous U.S. manufacturing industry. The U.S. manufacturing industry dropped from 30% of GDP in 1970 to 12% of GDP by 2008. With a diminished manufacturing sector, the U.S. is now dependent on foreign manufacturers for goods; if the dollar weakens, inflation will be transmitted since foreign goods become expensive. Second, the middle class is adversely
affected since they lost manufacturing jobs. For example, most of the U.S. jobs created from 2003-7 were low paying service industry jobs. Without indigenous U.S. jobs, consumers lack the capital resources to buy goods, which further constrains economic growth. The consequences of the phenomenon of Chinas rapid industrial growth are not limited to the U.S., but affect trading partners Europe, Japan, Korea and emerging economies as well. The same effects on industrialized nations middle classes from Chinas economic growth engine have had strong implications for our own middle class since the U.S. laissez faire economic system is particularly susceptible to Chinese economic manipulation. One long-term effect of Chinas economic growth has been a structural shift for the U.S. middle class. The only way to maintain a growth of the U.S. middle class is through improving higher education and promoting innovative technology industries, yet the U.S. education system has declined while the Chinese are educating at least ten times the number of engineers as the U.S., suggesting that the U.S. is relatively uncompetitive. With high federal and state debt, it appears that the U.S. is not prepared to dramatically improve the education system that is required to substantially increase economic growth, particularly for the benefit of the middle class.
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The U.S., Europe and Japan need to cooperate with China to adjust Chinas present policy practices so as to prevent a trade war. China must open its markets to foreign goods, it must let its currency float on the currency exchanges, it must stop stealing intellectual property and it must stop subsidizing its industries at the expense of foreign industries. A multi-lateral solution to Chinas aggressive economic policies is the preferred approach to this complex economic problem, but a readjustment of the present equilibrium is necessary if the U.S. economic recovery is to accelerate to post-war historic standards. It is a likely scenario that China will gradually devalue the yuan. But this is a mixed blessing for the U.S. Since China uses its surplus capital to buy U.S. treasuries, which allows the U.S. to keep interest rates low, China will likely move to a basket of currencies to value the yuan, away from a close dollar link. As the dollar weakens, and Chinas dollar-denominated investments fall, China will limit their losses by diversifying away from treasuries. Not only will this transmit inflation to U.S. consumers who buy foreign goods with a weaker dollar, but as the Chinese buy less U.S. debt, aggregate demand for U.S. debt declines and interest rates will move higher. So far, the Chinese surpluses reinvested in U.S. debt have allowed the U.S. to enjoy a subsidized reduction in interest rates in the 2000s. In the absence of these investments in our burgeoning debt, the U.S. may experience an inflationary depression. U.S. policy with China must therefore proceed cautiously in order to avoid over-reacting to trade imbalances.65 A conflict with China will likely hurt American growth prospects at a particularly vulnerable time in the economic recovery.
65
This view is somewhat between Gary Beckers claim that the Chinese should let the yuan float and Paul Krugmans claim that the U.S. should be much tougher with China. See Becker, G., Chinas Next Leap Forward, WSJ, 2010 [proposing strategies for China in the future] and; Krugman, P., Taking On China, NYT, 2010 [proposing aggressive U.S. strategies to address the yuan undervaluation issue]. We should be careful what we wish for, in part since the Chinese have substantial power to manipulate economic factors that are not favorable to the U.S.
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In the long-run, though, the U.S. risks becoming marginalized by the relative economic success of the Asiatic economic philosophies if it does not make dramatic policy changes. The U.S. cannot blame the Asiatic economies alone for its multilateral trade deficits when there are ninety countries with which it has deficits. The U.S. needs to develop less of a consumption economy and more of a productive and savings oriented economy if it is to be successful in the long-run. This is only possible by adjusting incentives. There are larger geo-political implications of the rise of China on American foreign and military policy as well. With the dissolution of the USSR, the rise of China shows that the U.S. has a potential military competitor. The military growth of China is a natural adjunct of its rising regional economic supremacy. Consequently, the U.S. has a complex relationship with China that has complex long-term geopolitical implications. China awakened while America slept.
Policy Factors in the Economic Bubble and Aftermath There are clear causes of the economic bubble of the 2000s. First, the real estate bubble was created by lax credit finance standards. Second, removing Glass-Steagall barriers increased risk-taking with public guarantees. Third, insufficient government regulation of the financial services industry including permitting extraordinary short-term compensation contributed to moral hazard and excessive risk-taking. Fourth, the Feds low interest rate policy from 2001-4 inflated the bubble. Fifth, the high leverage of financial institutions was an exacerbating factor that was a problem as the bubble developed and ruptured. Finally, extreme industrial
concentration caused by weak antitrust and patent law enforcement hurt competition. Collectively, these deregulatory actions represented policy applications of a conservative libertarian philosophy. But while these factors were responsible for creating conditions for the
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depression, the government response inadvertently initiated the financial crisis and limited its damage. Federal government intervention in the economy was crucial to limit damage once the economic and financial crises were initiated. The TARP and stimulus legislation were
instrumental in preventing further catastrophe resulting from the financial crisis and economic contraction. The central banks aggressive monetary actions were also critical to prevent further declines during the crisis. These actions collectively constitute the paradigmatic Keynesian policy responses to economic crisis. However, the recovery in 2010 should be far more robust than the anemic sub-2% annual growth based on a comparison to post-war recoveries. The stimulative effects of the federal government and Fed actions should have had a greater effect so as to propel the economy into a faster growth period. What went wrong? Viewed retrospectively, the size of the stimuli was evidently insufficient.66 The deleveraging of debt in the financial industry in the aftermath of TARP was inadequate to promote healthy growth. The Feds present policy of near-zero interest rates are reminiscent of the Japanese67 lost decade, which experienced very slow growth amid a protracted period of low interest rates because of a very slow debt deleveraging process. If the government and Fed stimuli were sufficient, the economy would be on track for a robust recovery reminiscent of all previous post-war recoveries. The depth of the downturn may have limited the degree of the recovery as debt was slowly deleveraged through the system. In retrospect, allowing a substantially greater amount of debt to have been written off from bank
See Tyson, L., Why We Need a Second Stimulus, NYT, 2010 [arguing for a need for further economic stimulus]. 67 In retrospect, the cartel structure of the Japanese banking system was a key cause of the slow deleveraging process. The oligopolous configuration of the U.S. banking industry appears to follow the Japanese.
66
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balance sheets in 2008 would have allowed a more robust recovery, akin to all previous post-war recoveries.68 The political and monetary policy options are now constrained. The policies that got the U.S. into the deep hole of the financial crisis in 2008 were clearly preventable. The anti-government conservative crusade in the 2000s had at least two main components. The tax cuts were intended to stimulate the economy and the deregulation was intended to promote competition. But the opposite occurred. The economy did not grow rapidly in the 2000s relative to other periods. The period from 2003 to 2007 experienced a dramatic restructuring of industrial configuration that was clearly anti-competitive, while the tax cuts stimulated neither a significant increase in aggregate employment nor economic growth to increase real median wages. Further, the depth of the downturn was largely caused by an application of supply-side libertarian government policies and was thus preventable.69 Only Keynesian government policies in 2008 and 2009 prevented a far worse economic decline. While the 2000s policies contributed to the downturn, once the federal government and Fed stimuli have worked through the system, the effects of further marginal stimulus on the protracted economic recovery are limited. Much like the Japanese lost decade, the Fed is constrained in its ability to control the economy, because of the limited number of arrows in its quiver after the severe economic contraction period, and is thus unable to halt the long debt deleveraging process.70 Like Japan in the 1990s, at near-zero interest rates, the Fed now has limited ammunition with which to use if a future economic or financial shock is initiated. If the
See Kessler, A., op. cit. and; Krugman, P., Financing Vs. Forgiving a Debt Overhang, op. cit. One argument to illustrate the preventability of the extent of the downturn shows a counterfactual of the banking system. Both Canada and Australia maintained sound banking industry policies and did not experience severe downturns as a result. The question remains as to whether U.S. financial industry reform is sufficient to prevent future crises. 70 One constructive idea, however, is to allow the accelerated depreciation of losses, particularly in the mortgage market.
69
68
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Fed increases money supply too much, it risks activating inflationary forces, while if it is inactive it risks prolonging the slow growth. The U.S. is thus very likely in a new equilibrium period of slow growth and high unemployment. If the dollar weakens, this situation of slow growth will be accompanied by relatively high inflation as well, particularly as the U.S. is dependent on foreign goods in the absence of a significant manufacturing sector. If this analysis is correct, then the U.S. economy may eventually enter a new structural paradigm of an inflationary depression. This structural paradigm will have adverse consequences for the middle class because of continued debt deleveraging, restricted capital access, high relative unemployment, diminished industrial capacity, competition constraints, relatively lower consumer demand and diminished quality of life. The Fed has twin mandates. On the one hand, the Fed is entrusted with the goal of limiting inflation. On the other hand, the Fed is entrusted with the goal of maintaining economic growth, including high employment. The two goals are sometimes in conflict, but the aim is to have a balance between moderate inflation and moderate employment, which is possible in a stable period of economic growth. In the period from 2007-9, however, the Fed was required to lower interest rates dramatically to promote growth and constrain unemployment. Now, with a record low interest rate regime, the Fed is constrained in its ability to stimulate growth. The Fed suffers from a liquidity trap and is now immobilized in the event of a future crisis. In fact, as with the low interest rate regime of the early 2000s, the Fed risks creating a bubble as institutions use cheap capital to finance risky endeavors. Notwithstanding the low interest rate regime, the risks of disinflation in the near-term in the face of a continuing housing crisis, slow economic growth and high unemployment are substantial. While the inflation-indexing approach of the
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Fed needs to be reactivated as economic growth rates become moderately higher in the coming years, higher rates are improbable in the short-run.71 The only tools left in the Fed toolkit are to increase money supply and to buy debt, but using these tools lead to a high risk of over-stimulating inflation and weakening the dollar. This problem suggests that the Fed risks creating booms and yet may be constrained to limit busts.72 While there is considerable debate about the effects of government stimulus on economic growth, one main economic theory that involves government stimulus policy originated with Keynes in the Great Depression.73 In order to stimulate the economy, the Keynesian theory recommends increased national government spending and extended tax cuts during an economic downturn, adding to the federal deficit, while cutting federal spending and increasing taxes to limit deficits during periods of economic growth.74 The main thesis is that in a severe downturn, no one has the ability to spend except the national government because only the national government has the ability to add public debt in the absence of a healthy private credit market. While there is criticism of the idea of government spending during periods of economic growth since it merely adds to the federal debt without providing a significant multiplier, the main Keynesian idea is that during economic downturns the federal government has the ability to spend to promote jobs and thereby diminish the extent of the private sector employment losses.
The elephant in the room is China. The effects of Chinas trade and currency policies on the U.S. had constrained the Feds actions in the 2000s and may have contributed to an artificially low inflation period, while Chinas policies going forward may aggravate the Feds stimulative actions. See the discussion on China. 72 See Rajan, R., op. cit. 73 See Keynes, J., op. cit. 74 There are two generations of Keynesian thinking, with New Keynesians integrating tax policy into macroeconomics. See Romer, C. and D. Romer, The Macroeconomic Effects of Tax Changes: Estimates Based on a New Measure of Fiscal Shocks, Am. Economic Rev., 100, pp. 763-801, June, 2010 [arguing for using tax policy for effective fiscal action]. However, even the 1937 U.S. tax increases that stimulated the 1937-8 recession were well known as a problem. See Cogan, J., T. Cwik, J. Taylor and V. Wieland, New Keynesian versus Old Keynesian Government Spending Multipliers, ECB Working Paper No. 1090, 2009 [discussing different stimulus strategies for fiscal policy].
71
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On the other hand, conservative economists have a preference of promoting tax cuts to stimulate the economy.75 In the 1980s and 2000s, the hope was that the tax cuts would trigger an economic expansion, but, much like giving sugar to a child, this stimulus was short lived as the economy readjusted to the new equilibrium.76 There are limits of the effect of tax cuts. First, tax cuts are optimized only when there is a federal surplus. In other words, cutting taxes makes sense only in a period of sound fiscal policy so as to provide capital to the private sector to stimulate growth. In an optimum scenario, tax cuts yield higher growth and marginally more aggregate revenues to tax. Second, the tax cuts need to be equitable. Tax cuts for the middle class are generally spent so as to increase demand, which increases economic growth, while tax cuts for the wealthy are generally not spent since the wealthy do not need the extra small percentage of income; rather, the wealthy tend to save the extra tax bonus, which is inefficient since tax revenues are useful to balance the federal budget. This view of focusing on middle class tax cuts is consistent with the neoclassical view of marginal utility in which one spends capital only after a marginal equilibrium point. The view of the conservatives, however, in pushing tax cuts for the wealthy, is to promote investment capital.77 To be effective, though, this position requires a focus on specific types of investment, such as risky long-term research, or the investment incentive promotes moral hazard that fuels bubbles.
75
See Alesina , A., Tax Cuts vs. Stimulus: The Evidence is In, WSJ, 2010 [arguing that tax cuts are superior to fiscal stimulus in affecting economic growth]; Boskin, M., Summer of Economic Discontent, WSJ, 2010 [discussing different options for fiscal policy with an aim to optimize economic growth]; Feldstein, M., Rethinking the Role of Fiscal Policy, NBER Working Paper No. W14684, 2009 and; Hubbard, R. and P. Navarro, Seeds of Destruction: Why the Path to Economic Ruin Runs Through Washington, and How to Reclaim American Prosperity, 2010 [arguing that fiscal policy, particularly Keynesian stimulus, is an inferior strategy for activating economic growth]. 76 Note that median real estate prices rose more than 10% a year over ordinary growth rates for three years in the 1980s corresponding to the tax cuts, stimulating inflation and creating a new price equilibrium. 77 This is why tax cuts biased to the wealthy, capital gains tax cuts and estate tax cuts are a three-fer for investors.
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When used as a stimulus, then, tax cuts fit the Keynesian doctrine, because they are used at a time of economic distress and may be justified in a long-term deficit in order to stimulate the short-term economy. Contrarily, during times of economic growth, taxes should be tailored to pay down the long-term deficit in conjunction with spending limits. Nevertheless, the conservative economists focus on tax cuts in part to constrain the size of government. With less capital from lower taxes, the government has fewer resources with which to use; the idea is that government spending is a lower multiplier than the private allocation of capital. In general, then, the argument is that smaller government promotes faster economic growth.78 While this may be true during an optimal period of economic growth, the Keynesian response is that since only the federal government has the capacity to borrow during periods of economic crisis, only government spending during a crisis will limit the downturn and stimulate growth in the recovery period even when it enhances deficits.79 A patient takes medicine when sick and exercises when healthy. Although the U.S. provided tax cuts in the 2000s biased to the wealthy with an aim to stimulate investment when the federal government had a surplus from the 1990s fiscal austerity, this was a period to actually raise taxes, particularly on the wealthy, because of a need to pay higher costs associated with two wars. In other words, the U.S. needed to limit spending, reduce the deficit and adjust taxation correspondingly, but instead lowered taxes and increased spending which contributed to an unstable fiscal period. Consequently, the tax cuts had the adverse effects of higher deficits, increased stratification, diminished demand from constrained
78
See Reinhart, C. and V. Reinhart, op. cit., 2009 [arguing from international evidence that lower government spending after an economic contraction, particularly after a financial crisis, results in a faster recovery period]. See also Reinhart, C. and K. Rogoff, From Financial Crash to Debt Crisis, NBER Working Paper, 2010 [discussing the relations between the debt deleveraging process and the initial financial crisis]. 79 See Krugman, P., Is Fiscal Policy Poised for a Comeback?, Oxford Rev. of Economic Policy, 2005 [arguing for a Keynesian approach to stimulating economic growth].
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middle class capital availability and increased economic instability while the U.S. government at the same time increased spending. What is now needed are relatively modest tax cuts targeted to the middle class, which is most likely to spend the bonus and which will then nominally increase economic demand. Once the economy grows, then taxes need to rise on both the middle class and the higher income brackets in order to limit the deficit. At the same time, federal spending needs to be constrained after the economy recovers so as to further limit the deficit.80 In effect, a healthy economy requires a balanced budget with constrained spending and moderate taxes. Balancing the federal budget is especially challenging, however, in a period of economic decline, particularly at a time when the states are strained with increased demands for services that have largely been shifted from the federal government. Supply-side tax policy, therefore, fits squarely in neo-Keynesian economic policy. The application of the extreme approach to tax cuts used in the 2000s illustrates a politicization of tax policy that allowed the upper class effectively to sack the treasury for personal benefit while destabilizing the middle class and the general economy in the long-run. In addition to tax policy, libertarian ideology promoted industrial deregulation that affected competition policy with perhaps long lasting adverse economic consequences. If the competitive configuration of industry is a major factor in setting up and protracting a downturn,81 then antitrust and patent laws are crucial for maintaining balanced industry competition. On the
80
See Lazear, E., How to Grow Out of the Deficit, WSJ, 2010 [advocating a creative inflation-rate minus 1% federal spending stratagem.] A derivative idea is pay-go minus 1%. 81 It is interesting to note the extreme concentration of Japanese industry and the effects of oligopolous industry configuration on Japans slow economic growth. One can make a similar case in Europe. Weak patents in both regions perpetuate incumbent market power and represent a contradiction to democratic capitalism. Is the U.S. repeating these mistakes?
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one hand, antitrust law constrains dominant firms while, on the other hand, patent law gives market entrants important competitive tools. In the 2000s, antitrust policy was, predictably, very lax. The effect of this was extreme industry concentration and polarization. The effects of cartel industry organization are to retard competition, particularly for job-creating market entrants. At the same time, patent laws were weakened in a succession of judicial decisions in the 2000s, showing the increased market power of dominant beneficiary technology firms protecting incumbent monopoly profits. Strong patent laws promote investment in risky technologies and provide valuable incentives for market entrants. It is therefore essential to a healthy economy to maintain strong patent rights. Without a strong patent system, competition suffers. The projected slow economic growth of the next few years will be caused by a number of factors, but extreme industry concentration is a chief cause. Enforcing strong antitrust and patent laws are an important way to correct the imbalances, with the effect of improved competition and accelerated economic growth. Particularly since small and new companies create the majority of jobs, protecting these endangered species is essential. There are thus clear logical contradictions of libertarian economic principles. These contradictions were applied to policies that had adverse effects on Americas economic performance in the 2000s.
Redefining Conservatism The rise of conservatism in the 1980s and 2000s reveals a philosophy that encompasses social, economic and international issues. While the religious conservatives and international neocons are part of the conservative movement, the focus here is on the libertarian strain of conservatism that affects economic policy. The thesis is that there are contradictions in the
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libertarian philosophy that have contributed to the economic policies of the 2000s and that these led to the economic depression in 2007-9, much as a similar conservative economic philosophy in the 1920s led to the Great Depression. Though there are two distinct waves of libertarianism from Reagan-Bush in the 1980s that led to the 1990-1 recession and Bush II in the 2000s that led to the 2007-9 depression, the present discussion is focused on the 2000s. In general, the libertarian philosophy promotes laissez faire economics espoused by the Chicago School.82 This view has several components. First, it promotes limitations on Second, it restricts
government regulation with a goal to promote private competition.
progressive taxation. Third, it removes the obligation for social programs from the federal government and transfers them to the states and localities as much as possible. Fourth, it advocates diminished government. Taken together, these principles represent a sort of social Darwinism to promote a private economy. The main aim is to decentralize government to the private sector with an aim to promote competition through incentives.83 Unfortunately, the results have been reduced competition, enhanced stratification and increased economic stability. One main supply-side economic idea is that by providing economic benefits to investors, mainly through regressive taxation policies, a trickle-down from the wealthy to the middle class will occur. That is, this view maintains that by providing policies that benefit investment capital, businesses will hire more workers and the economy will flourish. However, classical economics has shown that industrial development is contingent on demand, not supply alone, in
The Chicago School is the University of Chicago economics department, which, under the leadership of Milton Friedman, was honored by no less than 23 Nobel prizes in economics or over a third of these awards so far. Though there are several components of the Chicago School, the main thrust focuses on monetarism and laissez faire economics. The Chicago School is often contrasted to the economic philosophies of Harvard University and the University of Cambridge (UK). Ironically, though Reagan and Bush II embodied the Chicago philosophy, Obama actually taught, and maintains a home at, the University of Chicago. 83 See Barro, R., Obamanomics Meets Incentives, WSJ, 2010 [arguing that private incentives are superior than Keynesian stimulus in activating economic growth].
82
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the long-run. By constraining capital resources for the middle class, demand is suppressed and companies cannot grow and hire employees. Contrarily, when the middle class has resources, they buy goods and companies grow by hiring employees to make the goods. The tax cuts provided by supply-side economics distort the incentives in the short-run by temporarily increasing demand and creating artificial demand. On the other hand, when the tax cuts are provided during periods of economic growth when the government increases spending, deficits increase and jeopardize future growth. In other words, there are only limited conditions for the successful economic effects of tax cuts: focus tax cuts only on the middle class, only during periods of economic decline and only when the cuts are balanced by spending cuts so as not to increase the deficit. substantial success. It is clear that the effect of the libertarian philosophy is to promote benefits for the wealthy at the expense of the middle class. The suppression of resources for the middle class reduces the education system and infrastructure spending as the deficit is increased, with lasting adverse strategic consequences since spending on education and infrastructure are clear multipliers of economic growth as witnessed by investments in the 1950s and 1960s. Seen in the light of responsible economics, balanced budgets and economic growth, it is a contradiction for libertarians to simultaneously want both lower taxes targeted to the wealthy and deficit reduction. Tax cuts targeted to the wealthy is the greatest waste of public resources possible since the wealthy generally save any tax bonus. The rich are the least likely to spend a tax cut and do not need a tax cut and the U.S. cannot afford to give them a tax cut. This simply illustrates a massive abuse of arithmetic. To the degree that tax cuts are stimulative, they should be targeted to the middle class, which tends to spend them to create demand for goods. The best time to use this approach, since Both Presidents Kennedy and Clinton observed these principles with
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it has an adverse effect on the deficit without simultaneously cutting spending, is either during an economic downturn, which then adds to the deficit, or during a period of economic growth while the government also cuts spending. In either approach, since tax cuts are stimulative, they represent macroeconomic policy that fits into Keynesian economic stimulus policy. The libertarian quest to provide tax breaks that are biased to the wealthy are actually economically inefficient since the stimulus is used, not to spend on goods which then stimulates production, but to spend on speculative investments. This unnecessary incentive to speculate allows a small class of investors to take greater risks. This increased risk taking promotes a moral hazard since the government may eventually be required to bail out the riskiest investments. The libertarian view of promoting tax breaks biased to the wealthy also encourage hoarding by the wealthy. After a limited threshold, the wealthy are likely to save their tax breaks. Rather than spend the tax break on goods that they could otherwise buy from other income, their savings are increased. In fact, savings are given to a group that least needs to save since they already have surplus capital beyond their needs. This is why they are rich. One credible libertarian argument is that small business owners, who create jobs by growing their businesses, are often rich and that by providing tax cuts as investment incentives economic growth is promoted. However, it is possible to exempt this small group
(approximately 3% of small business owners earn over $250K a year according to Census data) from tax increases so as to target maximum investment effects. One consequence of the libertarian view is the reinforcement of long-term structural inequality. With more wealth for the wealthy and relatively less for the middle class, society becomes far more stratified. This stratification is more reminiscent of the social structure of Third World countries. Such stratification increases economic instability for the whole society,
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as witnessed by the severe economic downturns of 1929-32 and 2007-9. One adverse effect of the long-term tax cuts of the 2000s, then, was the decline of the middle class relative to all prior historical measures. While conservative economists focus on the success of a small group of elite corporations that inhabit concentrated industries, they ignore the facts that the middle class supports the demand for products and services from these companies. When the middle class is diminished, the profits of the large corporations that cater to them also suffer. The long-term effects of diminished industrial regulation are to decrease competition, which promotes monopoly pricing. A consequence of these elite-focused tax and deregulation policies leaves the middle class between a rock and a hard place. There is a cynical view that the libertarians are focused on limiting political choices, such as through the promotion of high federal debt, in order to tie the hands of future generations to limit spending money on entitlement programs such as social security, Medicare and welfare. The long-term effects of the conservative economic policies have been to harm education, energy, health care, finance, tax and innovation policies. Since it is only through the management of these policy agendas that the U.S. has a promise of prosperity, the conservative economic policies need to be constrained and moderated. It would appear that the middle class was repeatedly deceived by ideological rhetoric to vote for policies that harmed their interests. From a utilitarian viewpoint, there is no moral component in the social Darwinism espoused by the libertarian agenda since it appears to benefit a small group at the expense of the larger society. In fact, if a main duty of democratic government is to promote equity and fairness, the U.S. failed its citizens at a critical turning point in history. Law and policy should be used to protect the weakest in a civil society not to hurt them.
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The effects of the application of these extreme libertarian economic policies have been far more negative than a single economic business cycle. The structural changes to the economy from the implementation of libertarian policies are bound to have long-term adverse economic consequences. The conservative libertarian agenda represented a revolution of political ideology in the 1980s and 2000s. Yet, the libertarian economic philosophy turned out to be reckless and unstrategic. Now, what is most needed is real conservatism a new moderation to solve a broad range of problems. We need responsible economics more than ever. Finding these solutions is our present challenge.
Failed Economics Economics is not a science. Academic economists are technical specialists operating within a quantitative paradigm since WWII. Economics did not predict the onset of the real estate bubble, the burst of the bubble, the consequences on the financial industry, the concentration of strategic industries, the effects of monopolization, the timing of events or their collective consequences on the economy or society. One must question the connection, then, between what economists do and the real economy. On December 5, 2008, after the Lehman Brothers bank failure precipitated the global financial crisis, the Queen of England, in a routine visit to the London School of Economics, asked economists: If these things were so large, how come everybody missed them? After months of analysis, in a letter to the Queen dated July 22, 2009, the economists replied in a public mea culpa: Many people did foresee the crisis. However, the exact form that it would take and the timing of its onset and ferocity were foreseen by nobody. . . . There were many warnings about imbalances in financial markets in the global economy. . . . But the difficulty was seeing the risk
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to the system as a whole rather than to any specific financial instrument or loan. Risk calculations were most often confined to slices of financial activity, using some of the best mathematical minds in our country and abroad. . . [T]hey frequently lost sight of the bigger picture. . . . But against those who warned, most were convinced that banks knew what they were doing. They believed that the financial wizards had found new and clever ways of managing risks. . . . These views were abetted by financial and economic models that were good at predicting the short-term and small risks, but few were equipped to say what would happen when things went wrong as they have. . . . There was a broad consensus that it was better to deal with the aftermath of bubbles in stock markets and housing markets than to try to head them off in advance. . . . The failure was to see how collectively this added up to a series of interconnected imbalances over which no single authority had jurisdiction. This, combined with the psychology of herding and the mantra of financial and policy gurus, lead to a dangerous recipe. Individual risks may rightly have been viewed as small, but the risk to the system as a whole was vast. So in summary, Your Majesty, the failure to foresee the timing, extent and severity of the crisis and to head it off, while it had many causes, was principally a failure of the collective imagination of many bright people, both in this country and internationally, to understand the risks to the system as a whole. (Letter to the Queen: The Global Financial Crisis Why Didnt Anybody Notice?, July 22, 2009)84 Perhaps there was no experience for the current members of the economics profession to such a substantial economic decline. Yet the 1980s and subsequent 1990-1 recession illustrated an adequate dress rehearsal for the present downturn. Also, the experience of the 1920s and its aftermath are clearly etched in the historical experience, with a clear repetition of economic policies in the 2000s. A plausible explanation for the lapse of the economics profession in anticipating the economic downturn and financial crisis comes from understanding the ideological polarization of the profession. The conservative movement, with its roots at the University of Chicago, has been persuasive in convincing policy makers of the righteousness of the libertarian laissez faire economics approach to political economics. There are times when this group focuses on its ideological bias at the expense of sound economic principles. This may have been one of those times.
84
As a program note, the British voters responded to the adverse economic conditions by electing a conservative biased coalition government, which instituted near-Draconian austerity measures to address the aftermath of the economic downturn.
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What we need is evidence-based economics.
It is interesting that the economics
profession cannot agree on the causes and effects of economic phenomena until years after a forensic analysis. For example, why cannot economists come to a common ground on tax policy, on Keynesian policy (especially during economic stress periods) and on social equity? It would appear that only evidence-based economics would make a difference in understanding the causes and effects of economic phenomena. Without an objective analysis of economics, it is impossible to make accurate forecasts or provide policy prescriptions. From such objective economic analysis a collective consensus should evolve. In retrospect, the shallow depression of 2007-9 was predicable. An analysis of history in the 1920s and a comparison with policies in the 2000s showed clear parallels. Libertarianism had the same effects in both periods. The train wreck of the depression was predictable but not actually predicted. Perhaps if the economics profession had scientific credibility these
predictions would have been clear and prescriptions would have been made to correct the problems before they became severe. Instead, ideological policy makers kept drinking the KoolAid and the problems festered until they literally led to a financial breakdown. An example of economic policy that appears to have had clear influence on avoiding economic problems is industrial regulation with competition policy. While antitrust policy affects fair competition, patent law is useful to provide tools for market entrants. Both antitrust regulation and strong patent laws are useful, yet in the 2000s both were weakened. The
cumulative effects of industrial deregulation were clear industrial stratification that had deleterious aggregate economic effects. Another area is the regulation of the financial services industry. The strategic importance of the financial industry shows, in retrospect, that U.S. regulation was instrumental to a healthy functioning economy.
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The libertarian ideologues appear to have only one tool in their policy agenda: tax cuts. But tax policy is not clearly analyzed and has been misused and misunderstood. The adverse consequences of using only tax cuts as an economic tool has become apparent, viz., a stratified society with a large deficit that leads to economic instability. Tax cuts appear to be prominent for libertarians since they fit in with the larger ideological component of smaller government. The lack of objective clarity on economics has blemished the dismal science. Without an evidence-based approach to economics, the economy is a social experiment without sound science behind the policy. There is plenty of room for the economics profession to adapt to get it right in order to predict, and to provide solutions to minimize the impact of, the next economic crisis. A study of economic history would be a good start, but, evidently, most economists do not believe in the value of learning from history and are not apparently well versed in economic history. Along with a review of economic methodology itself and recognition of the overreliance on math, the shortcomings of learning economic history should be rectified by a change in the academic curriculum. The failure of the economics profession to predict or resolve the economic downturn says something fundamental about the failure of the academic bureaucracy. Academia is
marginalized by over-specialization, over-used quantitative thinking and undue politicization. At the end of the day, the social sciences are part science and part art. The origins of economics show that the profession evolved from moral philosophy. Viewed as moral philosophy, it is clear that the ideological polarization of the economics profession has been politicized by rhetoric and biased financial influences. The evidence is that economics has been less an objective science than the exercise of political power.
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Policy Prescriptions There is a rising consensus for policy prescriptions to improve the economy. First, the U.S. needs to stabilize the housing sector. consumer and business demand. Second, the U.S. needs to stimulate domestic
Third, the U.S. needs to bring down unemployment by
increasing domestic production. The main challenge is to figure out how to stimulate the economy within financial constraints, but without over-stimulating inflation. The libertarians want to stimulate the economy by providing tax incentives. The Keynesians want to increase government spending, particularly during downturns, in order to stimulate the economy. There is a need to find some balance between these different
perspectives. What is needed is a philosophical synthesis. If the Keynesians and libertarians both fail, then the U.S. will be shown to be in a structural decline, an end of an epic of American power driven by its laissez-faire capitalist model. The U.S. will have followed England as a great power that declined relative to other economic systems. The U.S. will be seen as uncompetitive relative to East Asian hybrid The U.S. leadership of liberal capitalism and American
communitarian capitalist models.
national security will also wane along with the decline of American economic power, like Rome before it. While, in the aggregate, this is a fatalistic and cynical conclusion, in the aftermath of an economic depression there is an inevitability of a reduced quality of life for many in the middle and lower classes. The depression signifies the structural termination of the
consequences of a failed conservative philosophy. The political paralysis that reflects the divergence of economic philosophies between the Keynesians and the libertarians shows that American democracy itself has a problem. The immobilization of democratic institutions seems to be a reflection of the polarized party system. Moreover, political polarization constrains government action; with much talk about the
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problems of deficit spending, there is a fundamental limit to further Keynesian stimulus spending. Yet, it should be clear that without government action, the shallow depression would have been a full scale 19th century style of depression that would have had substantially worse outcomes. Consequently, though the federal government and the Fed have provided some stimulus, there are limits to future stimulus because of the political paralysis. With consumers in a particularly weak position, we can thus expect a slow rebuilding process after a period of debt liquidation and consolidation. Only one president in the last generation has been successful in instituting conservative economic policies. In the 1990s, Clinton was successful at instituting nominal tax increases that ultimately balanced the federal budget and brought down the federal debt. With less public debt, the economy flourished in a golden epoch. In addition to balancing the budget, Clinton applied progressive taxation to limit the inequities of prior periods. Further, Clinton regulated the financial industry, maintained a clear and fair competition policy that limited incumbent monopoly power and promoted strong patent policy that maintained competition. It seems that these policies are worth careful inspection for applying to future economic policy. For now, though, what can be done to accelerate the recovery from the depression? Doing nothing, as anti-government ideologues prefer, is insufficient. To analogize the economy to a patient, not intervening by withholding medicine or surgery would be archaic and inhumane. As a counter-factual, it is uncontroversial to consider that without stimulus in 2008 and 2009 the economy would be substantially worse; despite its limits, stimulus did not fail since it stopped a major decline. We know that balanced economic policy has worked in the past, but what policies should be invoked going forward? In January, 2010, the non-partisan Congressional Budget Office ranked a set of policy options in order to promote economic growth and greater employment. Ranked in order, the
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prescriptions include: (1) Increasing aid to the unemployed; (2) Reducing employers payroll taxes; (3) Reducing employers payroll taxes for firms that increase their payroll; (4) Reducing employees payroll taxes; (5) Providing an additional one-time social security payment; (6) allowing full or partial expensing of investment costs; (7) Investing in infrastructure; (8) Providing aid to states for purposes other than infrastructure; (9) Providing additional refundable tax credits for lower- and middle-income households in 2011; (10) Extending higher exemption amounts for the alternative minimum tax and; (11) Reducing income taxes in 2011.85 These remedies should be carefully inspected; the best of these practices should be implemented. Here is a summary of additional policy recommendations for stimulating economic growth: Finance 1. Accelerate debt liquidation 2. Provide housing stimulus 3. Maintain government debt reduction Infrastructure and education investment Incentives for small business 1. Enforce antitrust laws to promote competition 2. Strengthen patent laws to promote competition 3. U.S. tax incentives should be targeted to R&D 4. Health care costs should be capped 5. Promote energy independence to control costs Targeted tax cuts in short-run
85
See CBO, Policies for Increasing Economic Growth and Employment in 2010 and 2011, January, 2010.
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1. Focus tax cuts on the middle class 2. Exempt small business from tax increases Raise taxes gradually during recovery 1. Increase taxes on financial industry compensation 2. Tax foreign profits of U.S. corporations to repatriate capital The Fed should modulate monetary policy 1. The money supply should be increased in the short-run 2. Interest rates need to be increased in the medium term to control inflation Social security should be balanced 1. Means test for social security 2. Increase the retirement age as a selectable preference Insist that allies pay more for military budgets 1. Reduce the U.S. defense budget Address China trade policy 1. Insist the yuan is in equilibrium with other currencies 2. Enforce WTO issues with Chinas unfair trade practices Change media and campaign finance laws 1. Limit media companies to balanced representation, like before 1986 2. Limit corporate campaign contributions that taint democratic politics When these policies are implemented, the U.S. economy will be far stronger, economic growth will increase, unemployment will drop significantly and stratification will be reduced. It is imperative to find ways to liquidate consumer and business debt. The crisis began in 2007-8 with the decision not to write off a substantial amount of debt from bank balance sheets. Yet, this is reminiscent of Japans lost decade, which the U.S. appears to be repeating. The
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failure to write off debt is particularly evident in the real estate sector. Specifically, we need to work hard to restructure mortgage debt to reduce foreclosures. Congress authorized assistance that banks refuse to implement. The U.S. must accelerate the write off of some types of debt. The 2006 bankruptcy act, largely written by financial services industry lobbyists to prevent debt from being easily written off, needs to be completely revised to accommodate a democratic paradigm of allowing consumers to write off onerous debts to start fresh. Banks need to be allowed by regulators to restructure their balance sheets to have somewhat less capitalization in order to make more business and consumer loans. While the pendulum swung from one extreme to the other, it needs to be moderated. Glass-Steagall legislation, which separated commercial and investment banking institutions, needs to be reinstituted in order to manage financial risks and increase banking industry competition. Dodd-Frank only brought us halfway to the goal. Clearly, the U.S. needs to instigate a housing stimulus. The $8K new owner housing tax credit was very successful, but needs to be extended and applied to all home buyers in order to arrest the oversupply of homes from the dramatic rise in foreclosures that is a root economic problem. A low interest loan program to help home buyers sell their present homes would help both home sales (and prop up property prices) but would also allow the unemployed to find jobs in other areas. The U.S. needs to promote policies that will encourage long-term savings. The U.S. needs to move from a consumption-based economy to a production-based economy. Tax policy may be useful to reward savers. While it may seem to be inconsistent with Keynesian economics, in the long run, the U.S. government needs to limit the federal deficits and the federal debt. One main way to do this is to raise taxes and to cut costs. These processes can be done gradually. If they are done gradually,
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as in the 1990s, consumers and businesses will have enough advance warning to plan and adjust their expectations. But, after the recovery improves, a relatively smaller government86 and a larger private sector are healthy for long-term economic growth. The U.S. needs to control costs. The right wants to limit entitlements and the left wants to limit defense. Both categories need to be reviewed. Foreign wars need to be reigned in since we cannot afford them and they are at best strategically debatable. A ten to fifteen percent decline in government spending is possible, and even necessary, over five to ten years. DOD can be cut twenty to thirty percent (from a stunning $895B in FY 2011 including veterans costs but excluding supplemental war costs equal to all other national defense budgets combined) and improve readiness with increased automation and competition. The U.S. needs to improve its infrastructure. The transportation and telecommunications systems need to be updated. Infrastructure improvement is a long-term multiplier; one dollar spent now gives several dollars of benefits over several decades. Another area of needed infrastructure improvement is intellectual. The education system requires a systematic rethinking. One controversial idea, which is somewhat realistic but
constrains the vision of American middle class opportunities, is to adopt the tracking system used in Europe. At the middle school period, students are tracked for either vocational education or college preparation. This would increase efficiency in the education system to allow us to devote public resources to advanced kids that will propel the economy with a significant multiplier. Another idea is to provide economic incentives akin to a GI plan for high school and college students to excel. Perhaps we should stop teaching to the test and even reduce the
86
Most of FY 2011 federal government expenses are defense ($895B), social security ($774B), Medicare ($829B) and welfare ($557B). While the goal is to increase efficiency with program cuts, the timing of this process is critical so as not to exacerbate the economy as it slowly recovers.
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emphasis on testing since it clearly does not work. Finally, the U.S. should allow corporations to write off education investments so as to encourage retraining. Many ideas and much money have been thrown at the education problem, with a persistent downward trend. But the U.S. education system is in decline by every conceivable metric, except at the most elite levels. States have been forced to increase funding for health care and prisons at the expense of schools, which is problematic in the long-run. The middle class has been short-changed and policies need to be developed to arrest the terrible decline. Like infrastructure, intellectual capital is a multiplier. In the long-run, the U.S. needs to invest in education. Small and new businesses provide about three fourths of new jobs. The U.S. needs to find ways to help small business since bank lending has declined. One way to help small business and market entrants is to enforce the antitrust laws. The large corporations now dominate virtually every industry and use high barriers of entry to support their advantages. The large corporations need to be restrained in their competitive tactics to promote competition for small and mid-sized companies. One way to promote fair competition is to enforce criminal penalties and treble damages for antitrust violations, particularly focused in the financial, energy, technology and communications industries. The courts and Congress need to look carefully at reinstituting the pre-1977 period of effective antitrust enforcement. Moreover, large corporation patent portfolios should be available to market entrants (not peer rivals) by implementation of common carrier policies. One main way to provide tools to small companies to compete is to strengthen patent laws. Patents are critical tools that incentivize innovation and investment and promote
competition. Patents help David against Goliath. Historically, enforcement of strong patent laws has led to periods of sustained growth and weak patent laws have allowed industry incumbents to
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restrain competition and growth to maintain monopoly profits. The U.S. needs to address this critical arena after a period during the 2000s of weakening patent rights with several onerous and narrow judicial decisions that harmed competition, technological progress and economic growth. Pending patent legislation in Congress (written by electronics cartel lobbyists) needs to be completely rewritten and fundamentally rethought in order to promote market entrants rather than the predatory incumbents. Further, the Patent Office needs to accelerate the processing of patents. Since the majority of jobs are created by new and small businesses, promoting strong patents creates jobs. Only the U.S. has a democratic patent system that helps any entrepreneur with a new idea to compete in the marketplace. If history is a guide, strengthening patent laws will create an outsized share of GDP growth, fair competition and robust job creation. Finally, promoting innovation through strengthening patent law should improve productivity in the longrun, which is a tremendous engine of economic growth. Particularly since the U.S. has limited manufacturing, it is necessary to promote innovation through the democratization of strong patent laws. Because innovation is Americas only remaining competitive advantage, it is absurd not to promote strong patents in order to rebuild the economy in the 21st century. Tax incentives should be carefully targeted for specific innovation investments. Rather than applying capital gains tax cuts to all investors, the capital gains tax cuts should be focused on R&D and small business investments that lead to long-term economic growth. The idea is to provide an incentive for investors to take risks. For a decade, investment capital went into inefficient investments (like mortgage securities) and not into innovation. As a consequence, the U.S. has fallen behind in technology development according to any metric compared to a decade ago. The U.S. needs to modify the health care law to control costs. To require health care insurance without controlling costs is a contradiction. Whether through the promotion of
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competition or some sort of insurance exchange, the U.S. needs to address this loose end. Particularly since health care costs are a fundamental part, and, with an aging baby boom generation, represents an increasingly larger share, of the economy, we need to control these costs fairly and humanely. The U.S. also needs to address its energy issues and provide ample alternatives to fossil fuels. Only the government can provide the extensive resources to stimulate the evolution of an alternative energy industry, but the examples of the Brazilian and Chinese energy industry developments are interesting. It is apparent that China is making a push in this area and the U.S. may be able to work symbiotically with the Chinese by promoting innovation and consumer subsidized incentives to increase energy independence with clean energy. In order to promote energy independence, it is clear that the oligopolists in the energy industry need to be provided with carrots and sticks to modify policies to invest in alternatives. Business as usual is not an option. The environment will benefit from these investments. The U.S. needs to promote targeted middle class tax cuts in the short-run in order to provide incentives to increase demand, production and economic growth. In order to encourage small business investment, the tax cuts could be extended to the 3% of small businessmen that earn over $250K a year. Accelerating small business capital expense deductions temporarily is also a way to stimulate demand. A short-term payroll tax holiday is another method of providing incentive for the middle class to spend money to increase demand. Overall, progressive taxation helped the middle class to prosper and benefited the public good. This is why a value added tax, which tends to be regressive, is not a solution. Taxes for the wealthy should to be raised, however, in order to responsibly pay for federal programs and deficits. Tax cuts for the wealthy were based on the presumption of a 2001 federal surplus, which is obviously now no longer relevant. Specifically, the U.S. needs to
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follow Europe to tax financial industry bonuses to realign incentives with the public interest. The U.S. also needs to raise taxes on estates over $3M. Limited tax cuts can be maintained only if they are structured to target specific R&D investments. However, in the long-run, higher marginal taxes need to be paid by the wealthy and the middle class in order to responsibly pay for government programs if spending can be reduced to nullify the deficit. Clinton raised taxes in 1994, and also reduced spending, and the economy experienced a sustained growth for eight years that created 22 million net new jobs. If the tax increases are gradual and responsible and occur during the growth phase after a substantial economic recovery then they will have a positive long-term economic effect. Higher taxes, however, need to be combined with federal spending cuts. U.S. corporate profits from foreign sources need to be taxed as an incentive to repatriate capital. The Fed needs to increase the money supply in the short-run to offset the decline in borrowing and the consumer and business deleveraging process of debt liquidation. It is
straightforward monetarist economics that an increase in the money supply will cause inflation, yet, in the face of disinflation, this is the cure. One can argue that the Fed created the 2003-7 bubble that led to the perfect storm of the financial crisis and depression with its unusually low interest rates in 2001-4. However, no medicine is working now and the Fed is running out of ammunition. If the long tail of the depression continues for another two years, it will be a missed opportunity not to do all that could be done to promote economic growth. The U.S. needs to make the tough decision that it cannot alone cover the military expenses of Europe and Japan. If Japan steps up to share power, the U.S. military budget can be substantially pared. This critical obligation will initially help Japans economic recovery. As
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Chinas economy and military grow, the U.S. must share power with regional allies to maintain strategic equilibrium. Regarding world trade, Chinas aggressive (and occasionally unfair) economic policies have promoted disequilibrium. The U.S. must present cases in the WTO to prevent unfair trading practices that benefit China and hurt American industry and jobs and that open markets. Chinese industrial subsidies, IP theft and protectionism must stop. The U.S. and other nations must work with China to moderate the valuation of the yuan. Failing this, moderate, not punitive, U.S. tariffs for Chinas goods must rise to a level of ordinary trade equilibrium. On the other hand, the Fed needs to be careful to increase interest rates when the economic growth period accelerates and needs to apply interest rate indexing to the core inflation rate. The world runs a risk of another bubble that will require the Fed, and other central banks, to be vigilant. Because of the artificial manipulation of the Chinese yuan and its effects on international exchange rates, the Fed and central banks also need to carefully monitor currency equilibria and international trade. In the long-run, social security, like health care, poses risks to government financial stability. It is clear that social security needs to be means tested, payroll tax rates increased and retirement ages selectively increased in order to balance the budget. importance to a balanced federal budget. It is imperative to address the problem that is at the root of the instability of the democratic system in the U.S., namely the connections between corporate money and politics. The U.S. Congress and courts need to limit corporate campaign contributions if the U.S. democratic system is to be fair and balanced. In addition, the U.S. needs to reinstitute rules, abolished in 1986, to require fair and balanced media enterprises. This is similar in
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When these responsible and common sense proposals are enacted, which take the best practices of several diverse political ideologies into account, the U.S. economy will thrive.
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List of Figures 1 Relative GDP Decline of 2007-9 Downturn 6 7 8 9 10 11 11 12 12 27 28 29 29 30 31 38
2 Total Household Net Worth 3 4 5 6 7 S&P 500 [September 2007 to September 2010] Job Losses in Recent Recessions, as Share of Employment Case Shiller Index Volume of World Merchandise Exports, 1965-2009 Growth in World Merchandise Exports Trade by Region
8 Real GDP and Trade Growth of OECD Countries, 2008-9 9 Prices of Selected Primary Products, Jan. 2000 Jan. 2010
10 U.S. Debt by Sector 11 U.S. Gross Federal Debt as a Percentage of GDP 12 U.S. Debt and GDP 1990-2010 13 U.S. Private Debt to GDP 14 Correlation of Change in Debt and Unemployment 15 U.S. International Trade in Goods and Services 16 Median Family Net Worth by Percentile of Net Worth (thousands of dollars)
List of Charts 1 U.S. Gross Domestic Product (Trillions of Dollars) 2 Total Net Worth, 2007-2010 5 6 16
3 Business Contractions: Business Cycle Dates
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Post Depression Economics

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Introduction: What Happened to America?

Figure 1 Relative GDP Decline of 2007-9 Downturn

Source: S&P 500

Source: U.S. Department of Labor

Figure 6 Volume of World Merchandise Exports, 1965-2009

Source: WTO Secretariat

Source: OECD Quarterly National Accounts

Figure 8 Growth in World Merchandise Exports Trade by Region

Source: IMF Primary Commodity Prices

Source: National Bureau of Economic Research

Figure 12 U.S. Debt and GDP 1990-2010

Figure 15 U.S. Trade Deficits

Median Family Net Worth by Percentile of Net Worth

Source: Federal Reserve

industry evolved to become a critical strategic industry.

In effect, finance replaced

coordinating export industries, the Chinese tax imports so as to create protectionism.

government regulation with a goal to promote private competition.

What we need is evidence-based economics.

It is interesting that the economics

Third, the U.S. needs to bring down unemployment by

communitarian capitalist models.

List of Figures 1 Relative GDP Decline of 2007-9 Downturn 6 7 8 9 10 11 11 12 12 27 28 29 29 30 31 38

3 Business Contractions: Business Cycle Dates

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