What's Gone Wrong with Our Economy, and What To Do about It

WHAT'S GONE WRONG WITH OUR ECONOMY,

AND WHAT NEEDS TO BE DONE ABOUT IT?

(Notes for a talk to a Community Forum in Jackson, MI, 1/15/09)

A. What's Gone Wrong with Our Economy

Some History

1. The U.S. economy has gone through cycles of expansion (boom) and recession (bust) for two centuries; it's in the nature of capitalism. Fortunately, expansions typically last a lot longer than recessions; and the economy grows over the long-term, raising standards of living.

2. By far the most serious recession in our history – in both length and depth – was the Great Depression of the 1930s, set off by the stock market crash of 1929. The unemployment rate reached 25%, and the U.S. economy did not fully recover until the early 1940s (though there was some improvement in the mid-1930s). The crisis of the U.S. economy soon became a global economic crisis, because of the important role of the U.S. in world trade and investment.

3. The next most serious recessions in our history occurred in the 1870s and the 1890s, following the bank panics of 1873 and 1893; unemployment rates are estimated (roughly) to have reached between 10 and 15% soon after each panic. These recessions were also international in scope, though less so than in the 1930s because the U.S. was not yet such a large player in the global economic arena.

4. Since World War II the U.S. economy has experienced relatively mild recessions; the deepest was in the early 1980s, but that one was not as bad as in the 1870s – the unemployment rate peaked around 10%, and the bad times lasted only about a year and a half; so it did not earn the label "depression."

5. Economists have a good explanation for the relative mildness of recessions since World War II: we have learned how to cope much better with economic downturns, thanks largely to the work of macroeconomist John Maynard Keynes (in the 1930s) and his disciples in academia and in government (after WW II). Keynesian economics provides ways for national governments to conduct fiscal policy – i.e., government spending and taxation – and monetary policy – i.e., interest rates and credit management – to keep the economy on a relatively even keel.

The Current Situation

6. We are now one year into the latest recession of the U.S. economy: roughly 2.5 million jobs were lost in 2008 (roughly 2 million during the last 4 months); since a gain of 1.5 million jobs a year is now necessary to keep employment & unemployment rates stable, we were 4 million jobs short of doing this last year!

7. Further losses on the scale of the past 4 months are expected for the next several months, no matter what kind of stimulus plan is introduced by the Obama Administration; so the official unemployment rate is bound to rise and may well reach double-digit level. We don't yet know how deep or how long this recession will be, but all signs indicate that it will be the worst recession since WW II – and it is quite possible that it will come to be known as the third Great Depression.

8. The current economic crisis began in the U.S. housing market, quickly spread to the U.S. financial sector, and then overtook the whole U.S. economy. Because of the rapid globalization of finance over the last few decades, the U.S. financial crisis immediately became a global financial crisis; and the ensuing general economic crisis encompassed the whole world economy, more integrated than ever since the collapse of the former Soviet bloc and the economic integration of most of the remaining communist-led nations – notably China – into the world capitalist system.

9. The U.S. housing and financial crises were set off by the spread, over the last decade, of sub-prime mortgages – i.e., loans made to home-buyers or home-owners who simply did not have the means to meet their payment obligations. Why would any financial institution lend to such borrowers? Several key developments over the past few decades – a period of worldwide economic expansion – combined to make this happen:

-- Economic actors became increasingly confident that economic good times would last forever, and that serious recessions were a thing of the past;

-- There was a huge world-wide build-up of pools of savings, increasingly in search of new kinds of profitable investment outlets;

-- Financial institutions developed all manner of new financial instruments that they thought would protect them against risky ventures, and that enabled them in any case to pass the burden of risk onto other institutions or investors;

-- Governments adopted an increasingly laissez-faire attitude toward business in general and financial institutions in particular, weakening regulatory policies that had been put in place in the 1930s (to deal with the Great Depression) and allowing the new financial instruments to operate without regulation.

10. As a result of the above, mortgage brokers were encouraged to lend to borrowers with no serious questions asked about their ability to pay; many of these loans required no down payment and had attractively low initial interest rates, which would be raised sharply a few years later; borrowers were often not made aware of the true nature of their payment obligations; the initial lenders would quickly sell the mortgage contracts to financial institutions, thus escaping any exposure to risk of default; the financial institutions would in turn "securitize" the acquired mortgage contracts – i.e., package them into complex financial securities that they would then market to other investors, thus also escaping any exposure to risk of default; and credit-rating agencies, afraid of losing business by refusing to go along with the whole scam, would accord undeservedly high credit ratings – i.e., assurances of low risk – to the complex financial securities.

11. All of this left many high-risk investments – later relabeled "toxic assets" – in the hands of major financial institutions around the world who had bought the complex securities as part of a profit-raising strategy that included a very high level of financial leverage, i.e., maintenance of a very high level of investments (hopefully yielding high future returns) to liquid assets on hand (to deal with a immediate cash needs to pay employees, clients withdrawing money, etc.). Financial institutions were increasingly moved to pursue this kind of high-risk strategy because of the same key developments I noted above (under point #9) that stimulated mortgage brokers to push sub-prime mortgages.

12. It was only a matter of time before this whole mortgage and finance structure – in effect, a global Ponzi scheme – would come to a crashing end. One can never predict precisely when this will happen, because so much depends on the confidence (however ungrounded) of the participants. One can only observe that the longer the reckoning is delayed, the worse it is likely to be. And so, in the year 2008, the cards began to fall – first a few mortgage banks like Indy Mac, then later in the year a surge including the huge government-sponsored mortgage purchasers Fannie Mae and Freddie Mac, Wall St. investment houses like Bear-Sterns and Lehman Brothers, and insurance companies like AIG. By September the collapse was fully underway, the stock market fell 40% below its previous peak (reminiscent of 1929), and credit markets virtually froze; so the U.S. Treasury Department, the Fed and the Congress rushed to try to deal with the crisis.

13. The efforts undertaken by the U.S. Government since September 2008, led by Treasury Secretary Hank Paulson and Federal Reserve Board (Fed) Chairman Ben Bernanke, reflected their view that the crisis was largely financial in nature; they believed (or at least hoped) that swift and massive action to stabilize the financial sector would avert a major recession in the rest of the U.S. economy. This was the rationale for the huge financial bail-out bill (officially known as the "Troubled Assets Recovery Program," or TARP) that Congress was pressured to pass in October. Alongside TARP, handled by the U.S. Treasury, the Fed pitched with a dramatic lowering of the interest rate it controls to the unprecedented level of almost 0%, as well as an unprecedented expansion of credit in the form of direct loans to private sector corporations.

14. The above measures (implemented in ever-changing ways as overall economic circumstances worsened and notions of how best to deal with it evolved), and similar measures carried out by other major players in the world economy, did succeed in loosening up credit markets, but it soon became clear that they had not succeeded in averting a major recession. Huge job losses, rising unemployment and falling production levels in late 2008 have dashed any hope that the U.S. economy – and the world economy – will be able to escape from a crisis worse than any other since the Great Depression of the 1930s.

Underlying Reasons for The Current Economic Crisis

15. As my observations in points #9-11 above suggest, a major enabling reason for the crisis is the de-regulation and non-regulation of significant parts of the U.S. financial sector. The U.S. Government's laissez-faire attitude toward business in general goes back 30 years. Since the late 1970s U.S. economic policy has been increasingly informed by a pro-free-market economic ideology – advanced by ever more mainstream economists as well government policy-makers – that views government as a source of problems rather than solutions. This view is most obviously characteristic of the Reagan and Bush II Administrations, but it also had much influence among economic policy-makers in the Bush I and Clinton Administrations and in the U.S. Congress under Republican control from 1994 to 2006.

16. A second long-term trend, over the same past three decades, is growing economic inequality. It is well documented that the distributions of both income and wealth in the United States have become much more unequal over the past 30 years; they have now reached peaks not seen since the late 1920s, just before the Great Depression. There are many reasons for this growing inequality, including heightened low-wage competition from abroad and patterns of technological change reducing the demand for semi-skilled labor. But a major contributor has been deliberate government policy – from the Reagan Administration's assault on labor unions to the Bush II Administration's huge tax cuts favoring the very rich.

17. Related to the growing economic inequality is the third long-term trend: a huge long-term rise in household debt. It is well documented that there has been an explosion of debt in the United States over the past few decades. The savings rate of the American household sector as a whole has dropped to virtually zero, and a substantial fraction of the American population has incurred debts well in excess of the value of their assets. This is due in considerable part to the fact that middle- and lower-income-class people have found it impossible to maintain their standard of living with stagnating or declining real incomes, so that borrowing and going into debt is their only recourse.

18. Greater household borrowing was also promoted by increasingly energetic solicitation of consumers by credit card companies and of homeowners by banks pushing home equity loans. And it was facilitated by a Federal Reserve Board policy (under Alan Greenspan for most of the relevant time period) that leaned heavily in the direction of low interest rates and that encouraged lenders to find more ways to enable consumers and homeowners to borrow.

19. The policies stimulating rising household indebtedness did – for a while – help to offset the decline in consumer purchasing power resulting from stagnating or declining wage incomes, thereby sustaining aggregate consumption expenditure. Since consumption is by far the biggest component of aggregate demand for goods and services, and the vitality of the whole economy depends on having sufficient aggregate demand to justify production of goods and services at a high-employment level, the maintenance of consumer purchasing power via increased debt helped to fend off a major economic downturn. But the fact that much of the borrowing was done for consumption, rather than for investment (with the prospect of future earnings in return), meant that borrowers would find it increasingly difficult to meet their payment obligations and to liquidate their debt burden.

20. As soon as the mortgage bubble burst and borrowers started defaulting on payments, the financial sector found itself stuck with a growing accumulation of assets that had lost their value, and the optimism that had sustained credit markets through increasingly risky transactions collapsed, financial institutions started going bankrupt, and the whole debt-based consumption ride came to a crashing end. Suddenly even the free-market ideologists dominating the Bush Administration's economic policy looked to the maligned government for a solution, and frantic efforts were made in the U.S. and abroad to revive the economic system with highly concessionary government loans to financial institutions and (to a lesser extent) directly to manufacturing enterprises. But this effort soon proved to be too little and too late to overcome a crisis whose enabling conditions had been building for three decades.

B. What Needs To Be Done about It?

21. The crisis that has engulfed the U.S. and world economies, and the failure of policy-makers to avert it, is not due to an absence of relevant knowledge about how capitalist economies work (and sometimes fail to work). Much has in fact been learned about the sources of economic downturns and about macroeconomic stabilization policies since the 1930s, thanks to John Maynard Keynes and his followers. But as free-market economic ideology became hegemonic among mainstream economists and policy-makers over the last few decades, Keynesian economics – with its concern about sustaining aggregate demand and its endorsement of active government intervention to make the capitalist economy work well – was brushed aside.

22. It has taken the current economic crisis to rehabilitate Keynesian thinking. Once again, we are all Keynesians; and every serious economist recognizes that we must look to government action, at both the national and international levels, to overcome the economic crisis – action on a huge scale to address a macroeconomic calamity of huge proportions.

23. Most importantly, WE MUST STIMULATE AGGREGATE DEMAND, which will revive production and boost employment. Right now there is significant shortfall of demand for the goods and services that can be produced by the U.S. economy, and that is why production is falling and jobs are disappearing. The single biggest component of aggregate demand – consumer spending – has dropped sharply because so many people are in debt and can no longer borrow to meet their needs, and because so many people are losing their jobs – their main source of income.

24. There are several qualitatively different ways for the federal government to boost aggregate demand:

1. Direct government spending on goods & services; as it happens, there are tremendous needs in:

(a) the long-neglected areas of public "infrastructure" (roads, bridges, water & sewage pipes, communications, etc.);

(b) clean sources of energy, and more efficient use of energy (e.g., weatherization, greater residential density, mass transit, to reduce dependence on fossil fuels);

(d) medicine & public health, as well as other public/social services

(e) environmental clean-up, parks, recreation, bicycle paths, etc.

Much of the above is handled by state governments, which are cutting back because of crisis-driven declining revenues and the obligation to balance their budgets. So what's needed – in addition to direct federal spending, especially on research & development – is a big transfer of federal funds to state governments, which in turn pass some of the funds on to local governments.

2. Provide purchasing power to citizens who desperately need it to maintain a decent standard of living, and thus will spend money transfers – creating demand for goods & services – rather than save the money – doing nothing for aggregate demand. This can most readily be accomplished by federally funding:

(a) better & longer-duration unemployment compensation;

(b) increased tax credits for low-income workers;

3. Tax cuts for the middle class and/or for businesses, providing citizens and businesses with more money that they might spend on domestically-produced goods (raising aggregate demand) but might instead save (e.g., paying off debt) or spend on imported goods.

In terms of "bang for the buck" – the impact of a $ of additional aggregate demand on GDP – the "multiplier" – option #1 is by far the best, option #2 next best, option #3 least best. [N.B.: #3 may, however, be politically necessary to get enough support in Congress for a massive overall stimulus.]

25. What about the size of the stimulus? The Obama Administration is talking about an overall stimulus – over 2 years – of roughly $800 billion, of which a substantial fraction – at least a third – would be devoted to tax cuts. Compare this with the projected shortfall of actual U.S. gross domestic product (GDP), relative to the level of GDP required for reasonably "full" employment: this shortfall is projected to reach at least $1 trillion in 2009 and in 2010. Given that the average "multiplier" for the tri-part stimulus is expected to be between 1 and 1.5, a stimulus of $800 billion will boost aggregate demand enough to fill about half the projected shortfall in GDP. I would therefore suggest that we increase the overall amount of the stimulus by at least 50%; and it would also help to reduce the proportion devoted to tax cuts.

26. What about the danger – as many conservatives are warning – that such a big stimulus will increase the federal government's deficit spending (well above its likely level, even without the stimulus, of a trillion $ a year) and generate even more national debt needing to be paid back in the future? The debt problem is indeed a real one – but it is a long-run problem, which will have to be addressed when the current downturn is over. Moreover, as Keynesian economics teaches us, the debt problem will be even worse if we fail to return the economy to prosperity than if we incur greater short-term debt in a way that revives the economy. The basic point is that, when the economy is in the doldrums, there is such a thing as a free lunch: bigger deficits now mean smaller deficits later, and more GDP out of which to pay off accumulated debt.

27. Note too that, at current low rates of interest, massive borrowing can be done (at home & abroad) at relatively low interest rates, which means smaller interest payments and less of an increase in the national debt. It is true that more than half of our national debt is now held by foreigners – most notably the central banks of China and Japan – and that the U.S. dollar, and indirectly the U.S. economy, would be in deep trouble if foreign holders of our debt decided to sell it for what they might consider a stronger currency – or simply not to continue financing our continued deficit spending. But this is highly unlikely, because foreigners recognize that their own economic fate is bound up with ours in the highly-integrated global economy. China, Japan and other countries are already suffering from the drop in U.S. demand for their products; and they have a huge stake in the revival of the U.S. economy and its humongous aggregate demand. Indeed, there is a tacit global agreement that the rest-of-the-world will continue to lend to the U.S. government as the U.S. government undertakes a major fiscal stimulus that will promote a global recovery from what is a global downturn.

28. There is more that needs to be done, beyond the stimulation of aggregate demand. In the SHORT RUN:

1. Help must be provided to U.S. homeowners threatened or impacted by foreclosure. There should be: (a) a moratorium on new foreclosures; (b) legislation allowing bankruptcy judges to alleviate the loan terms of distressed borrowers; (c) legislation enabling – and in some circumstances requiring – mortgage servicers to restructure mortgage loans in such a way as to allow stressed homeowners to stay on in their homes, in some cases as renters; (d) help those who have already suffered from foreclosure to recover their bearings and find decent, affordable housing. (The last two measures will involve some government financial aid, as noted under point #24-2c.)

2. The U.S. Treasury and the Federal Reserve Board must insure that the flow of credit (that virtually froze last September and is still only partially unfrozen) is revived. Among other things, The new Obama Administration needs to make use of the second half of the $700 billion Paulson-Bernanke financial bail-out funds – the "Troubled Asset Recovery Program" (TARP) – in ways that help financial institutions get rid of their "toxic assets" (poisoned by the subprime mortgage crisis), while holding them to account for reviving their lending and not simply rewarding their own stockholders and executives.

28. In order to avoid a recurrence of the kind of long and deep economic crisis that we are now suffering through, we must in the LONGER RUN:

1. Develop new and effective regulation of financial institutions and financial instruments, to increase the transparency of operations, reduce excessive leverage, eliminate unaccountable risky instruments, and provide greater safeguards for ordinary borrowers and investors.

2. Bring about a significant reduction in the degree of economic inequality in the United States, which has taken on dimensions unparalleled since the late 1920s and is far greater than in any other wealthy capitalist economy. Some of the following measures can help to do so:

-- raising the minimum wage

-- strengthening unions (e.g., by passing the Employee Free Choice Act)

-- restructuring the tax code to make it more progressive (including further broadening of the Earned Income Tax Credit program)

-- implementing universal health insurance coverage (preferably a single-payer system, for maximum efficiency and minimum administrative costs)

3. Extend short-term government investment in promoting clean sources of energy, and greater efficiency of energy use, into a long-term program of government support for the transformation of our energy economy so as to reduce dependence on fossil fuels and to promote environmentally friendly patterns of production and consumption. (Although excessive fossil fuel use was not a major cause of the current economic crisis, it threatens to become a significant source of economic and ecological crisis in the future.)