What Went Wrong?

Much as I try it is becoming more difficult for me to avoid the thought that we are headed back into recession. Or at least into such low growth that it feels like a recession. If we get much above 1.5% GDP growth for the rest of the year I think we should congratulate ourselves. It didn’t have to be this way, but we have failed. A renewed recession, or ‘near’ recession, is the punishment for our failure.

There is plenty of blame to go around:

There is a conspicuous lack of leadership from the White House. The Democratic caucus in Congress is not to blame: they have attempted to shovel stimulus at the economy, but the White House provided little or no political cover for the necessary actions. The public is now so spooked about debt – and you all know I think that is a foolish concern – that we are very unlikely able to get any concerted policy action to stem the decline. Worrying about debt during a moment of crisis such as this is a bit like fretting over the paintwork of a sinking ship. Who cares what it looks like tomorrow if it’s at the bottom of the ocean and not floating? The lack of urgency in our policy response to the drop in demand two years ago is staggering when we compare it with the drama that surrounded the bank bail outs. It’s as if policy makers thought that by saving the banks from their lunacy was sufficient to re-float the economy that the banks had trashed. Nobody seems to have calculated the correct depth of the abyss into which the banks threw us. This complacency was particularly evident at the White House after Obama came into office. His advisors miscalculated the political backlash against stimulus and didn’t even make the effort to sell the right policy. Instead they caved in before the fight and opted for a ‘get by’ package in the false hope that it would blunt the decline and that GDP would reflate by itself.

That was feckless and stupid. We are all suffering the consequence.

The Republicans are also to blame. They have advocated Hoover style economics from the start. I cannot think of a single policy position they have proposed that helps rather than hinders growth. At times they have been downright nasty: Senator Kyl’s statements in the past few days about unemployment assistance typifies the GOP position. Somehow the unemployed are evil hangers on and freeloaders who need to be punished rather than helped. To give Kyl his due he acknowledged that some assistance was in order, but that it should only come at the price of cuts elsewhere. As economic policy this makes no sense: unemployment assistance pays us back in the extra demand that it creates. That it is also socially beneficial from a moral standpoint is secondary to the main point. It is sound economics. That the GOP fails to recognize this is testimony to their deep commitment to the pre-1930’s social structure. Pre-middle class, pre-entitlement, pre-modern, they cling to disproven economic theory as if it is an enduring truth.

Also feckless and stupid.

The economic profession is also to blame. One would have thought that the last 70 years would have been ample time to sort out an economic theory to deal with Depression like slumps. Instead we have regressed to pre-Keynsian free market dogma and enshrined it within a web of abstruse and incomprehensible mathematics, as if a ton of neat formulae make it right. Wrong. Unfortunately the entire academic effort of the last 30 to 40 years has been a total waste of time. Yet the theories that emerged from that period are the ones that infest the minds of our business and political elites. So much so we have a collective block against the policies that saved the day in the Depression and would do so again now. Government spending and radical action by the Fed are still needed, but until we shed the wrongheaded theories of the likes of Milton Friedman and Robert Lucas we are doomed to repeat Hoover’s errors. We know where they lead.

Also stupid and feckless.

Then there’s all those damn foreigners.

One of the big problems we face is that we are too connected with the global economy for our own policies to be sufficient. We need other countries to move correctly also. They are not. One of the original causes of the crisis was the massive imbalance in the global economy between nations that consumed and those that saved. The US was obviously a consuming economy. This meant that it spend more than it earned. This imbalance showed up in the horrid Federal budget deficits of the Reagan and Bush eras; and in the ever present trade deficit. That trade deficit implied an equal surplus on the capital account – there are two side to trade: the goods and services balance, which is the ‘trade’ account; and the cash balance needed to pay for those goods, which is the ‘capital’ account. If the trade account is in deficit, which ours has ben for decades, then we need to have an equal surplus on the capital account to pay for it. That capital surplus shows up in all sorts of ways: foreign purchases of US government debt, companies, and property are all ways in which we acquire the cash we need to pay for the goods we import. Think of it this way: we sell Rockefeller Center to the Japanese and use the cash to buy Sony TV’s.

This flood of capital into the US was recycled through our real estate market and provided much of the cash used to inflate the property bubble. Without our trade deficit there would have been much less cash to pump that bubble up.

But: the problem is not all ours.

The German, Japanese, and Chinese economies are doing the opposite. They are deliberately under-consuming. Their domestic policies are designed to encourage exports. That means their economies are generating excess savings – German workers save rather than borrow and rely on exports to create jobs. Those savings flow into the global economy as part of the capital flow towards the consumer countries. In effect German, Chinese, and Japanese workers are lending to American [and UK etc] consumers so that the latter will continue to import and thus create jobs for those workers.

Now we reach the crux of the problem: if Americans turn to savings, as they have done during the crisis – the resultant huge drop in demand is a definition of recession – then we need that drop in consumption here to be offset by a surge in consumption in the former ‘savings’ economies. Have we had that? Not at all. Those economies have re-trenched too. So not only were they under-consuming in the good times, they are even worse now. So they are adding to the problem and not helping. When nation’s pursue economic policies built around exports they are implicitly seeking to undermine those of the consumer economies. They are deliberately exporting unemployment, debt, and the disruption that are associated with those factors. Typically such policies have been normal for emerging economies: the US followed the same path in the late 1800’s. But once an economy reaches maturity the export based economy becomes a problem because of the implications for global imbalance. Japan and Germany both are particularly culpable since they have a vast capacity to consume domestically, but steadfastly refuse to enact policies to encourage such activity.

The best example is Germany. Europe’s largest economy is being thrown through a bout of austerity to ensure its budget is balanced. That protects Germans but essentially exports unemployment to its weaker neighbors like Greece and Spain. So those two are forced to over-react to their internal problems because they are dealing not only with domestic crises, but also part of the German refusal to consume. Yet it was German capital flooding into Spain that inflated the Spanish real estate bubble and blew up the Spanish banks! Prior to the crisis unemployment was much lower in Spain than in Germany, and the government accounts were in better balance. It was German economic policies that threw Spain into the fire, yet the Germans see fit to lecture the Spanish on the need for austerity.

This is truly stupid and doubly feckless.

So there you have it. Inept policy making, weak leadership, and rotten theorizing. That’s quite a mountain for the economy to climb. I don’t expect it to succeed.

It’s all gone wrong.

The second half will reveal just how wrong.