November 2010, Week 5


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Tue, 30 Nov 2010 21:58:11 -0500
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The Broken Economy

By Mark Levinson

Dissent Magazine Fall 2010 issue


Two and a half years after the recession started, Wall Street
executives are once again collecting billions in bonuses,
businesses are flush with cash, but most of America is still
hurting. After a growth spurt at the end of last year, the
U.S. economy is slowing, as the fiscal stimulus dissipates
and spending contractions at the state and local level
undermine injections from the federal government. The growth
that has occurred is largely the result of replenishing
inventories, and this has run its course. Most distressing,
unemployment is at 9.5 percent, a rate historically
associated with a severe recession, and it now appears likely
that it will rise into next year.

The unemployment rate understates the scope of the problem
for U.S. workers: 25.8 million workers are either unemployed
or underemployed (this includes those who want to work but
have given up looking and thus are not counted in official
unemployment figures and the underemployed, those who are
working part time but want full-time jobs). The Economic
Policy Institute estimates that roughly a third of the work
force and more than 40 percent of minority workers will be
unemployed or underemployed at some point during the year.
Almost half of all unemployed workers (6.6 million) have been
unemployed for over six months.

The economy has 7.7 million fewer jobs than it did when the
recession started. In fact, we needed to add around 3.2
million jobs simply to keep pace with population growth. The
job shortage is now a staggering 10.9 million.

Unemployment at this level, for this length of time, will
substantially harm many individuals and families. There is a
growing body of evidence on the deleterious effects of long-
term unemployment - what John Irons has called "economic
scarring." A few examples:

* The average mature worker who loses a stable job will see
his or her earnings fall by 20 percent over fifteen to twenty
years. Job displacement also leads to a 15 percent to 20
percent increase in death rates over the ensuing years.

* Recent surveys confirm that unemployment is hard on
families. More than half of the long-term unemployed reported
that they had borrowed money from family or friends, 45
percent have increased credit card debt, and 70 percent have
used money saved for retirement.

* Four in ten people surveyed said that they went without
medical care for themselves or family members.

* Are we entering a new era of unprecedented high
joblessness? John Schmitt and Tessa Conroy of the Center for
Economic Policy Research have pointed out that even if the
economy creates jobs at a pace equal to the fastest four
years of the early 2000s, we will not return to the December
2007 level of employment until April 2021. And even if we
make the more optimistic assumption that jobs grow at the
rate of the fastest four years of the 1990s recovery, we
would not return to pre-recession levels until September

The only thing more disturbing than the size of the economic
hole we are in is the shocking, and inexcusable, lack of
response from the federal government. How did we get to a
point where a 9.5 percent unemployment rate doesn't evoke
urgent legislative and executive action from a Democratic
president and Congress? Why has the Obama administration's
economic recovery plan fallen so short? What is it about this
recession that makes economic recovery more difficult?

Origins of the Bubble Economy

Our story begins in the Reagan years, when finance was
accorded a special place in the American economy. Policies
promoting the free movement of capital across borders, the
deregulation of finance, and the repeal of regulations
separating commercial and investment banking were the order
of the day. By the late 1990s, Treasury Secretary Lawrence
Summers was simply repeating conventional wisdom when he
said, "Financial markets don't just oil the wheels of
economic growth; they are the wheels." For a quarter-century
almost all the benefits of economic growth went to the very
wealthy. In the typical family, parents were working longer
hours, yet their real wages were either stagnant or
declining. Fewer Americans had health insurance, and only one
in five workers enjoyed guaranteed pension benefits. Poverty
was increasing and inequality was growing.

Meanwhile, Wall Street saw its opportunities and took them.
From 1973 to 1985, the financial sector never earned more
than 16 percent of domestic corporate profits. In 1986, that
figure reached 19 percent. Under George W. Bush, it reached
41 percent. Bankers' pay rose just as dramatically. From 1948
to 1982, average compensation in the financial sector ranged
from 99 percent to 108 percent of the average for all
domestic private industries. After 1983 it shot upward
reaching 181 percent in 2007. With growing wealth came
political power. The unprecedented gap between pay and
productivity growth was the result of a dramatic shift of
bargaining power away from workers toward employers. A
multitude of factors contributed to stagnant wages and
growing inequality: the steep drop in unionization rates, the
failure to raise the real value of the minimum wage,
macroeconomic policy that has keep the unemployment rate too
high for most of the last thirty years, unfettered
globalization, the off-shoring that increasingly puts U.S.
workers in competition with workers around the world, and
economic deregulation and the privatization of government

For thirty years both major U.S. political parties pursued
policies that led to a low-wage, high-spending economy. The
result was an economy driven by asset bubbles fueled by cheap
debt. The stock market boom and bust of the late eighties was
followed by the dot-com boom and bust of the late nineties,
which created a "wealth effect" that buoyed consumption and
investment. This is what came to be known as "asset-price
Keynesian." Paul Volcker summed up the situation: "The fate
of the world economy is now totally dependent on the growth
of the U.S. economy, which is dependent on the stock market,
whose growth is dependent upon about 50 stocks, half of which
have never reported any earnings."

The bubbles of the late eighties and nineties were replicated
in the 2000s in the housing and commercial real estate
markets. The rush of foreign dollars into the United States
(a result of the trade deficit) helped the Federal Reserve
keep interest rates near zero. With the rates plummeting,
home sales rose. And as sales rose, the price of homes rose.
Homeowners used their newfound home equity to purchase cars
and second homes. Construction boomed, even while
manufacturing floundered. When home prices threatened to
discourage new purchases, banks and brokers, encouraged by
the Fed, offered new subprime mortgage deals. When the banks
and brokers became worried about risk from these mortgages,
they invented elaborate financial instruments to cushion and
spread the risk. And when housing prices finally stalled, the
whole Ponzi scheme collapsed and the recession, the most
severe since the 1930s, began.

Obama's Response to the Economic Collapse

When Barack Obama took office the economy was losing 750,000
jobs a month, and the unemployment rate was 7.6 percent and
heading toward double digits. GDP was declining at an annual
rate of 6.4 percent. Mortgage foreclosures were surging at
the rate of 250,000 a month. State and local governments were
falling short of revenues because of the recession at just
the moment when demand for public services were rising. Wall
Street was in shambles.

During the campaign, Obama promised to create the largest
public works program since the inception of the interstate
highway system. His plan was to repair roads and bridges,
schools, sewer systems, mass transit, electrical grids and
dams. He also wanted to create public jobs in areas such as
expanding broadband access; making government buildings more
energy efficient; and creating alternative fuels, windmills,
and solar panels; building energy efficient appliances; or
installing fuel-efficient heating or cooling systems. It
seemed that an economic reversal comparable to the Roosevelt
revolution of the 1930s was at hand.

It didn't happen. The head of Obama's Council of Economic
Advisers, Christina Romer, initially wanted a stimulus of
$1.2 trillion, convinced that anything less would be
inadequate in the light of escalating unemployment. The
president's political aides and Summers believed that was too
big to be enacted and feared its impact on the deficit. Obama
and his advisers did push through a $787 billion stimulus
program. It cut taxes, provided extra funds for unemployment
insurance, gave significant aid to state governments, and
funded public infrastructure projects. Although the stimulus
clearly saved jobs (2.7 million according to economists Mark
Zandi and Alan Blinder) and succeeded in averting a
catastrophic second Great Depression, it was not enough to
generate a recovery.

Why hasn't the administration been able to do more?

Deficit Thinking

The administration's embrace of austerity was first expressed
in the president's State of the Union address, where he
announced a freeze on domestic spending after this fiscal
year, as well as in his decision to set up a fiscal
commission headed by two well-known deficit hawks, Erskine
Bowles and Alan Simpson. And while the administration talks
about the need for jobs, and rightly complains that Congress
would not pass even the limited proposals it has put forward,
these actions strengthened the hand of Senate Republicans and
conservative Democrats, who refuse to appropriate another
dime for jobs measures that are not "paid for" by tax
increases or other spending cuts (which of course undercuts
any stimulus effect).

From the beginning, the administration seemed to accept the
argument that the fiscal stimulus that passed Congress was
the limit, on the grounds of fiscal sustainability and the
need to retain the confidence of the markets. As private
credit conditions improved, they believed the private sector
would pick up the responsibility for growth. If this was
insufficient, they hoped the Federal Reserve would flood the
banks with liquidity and that this would encourage bankers to
lend more.

But these policy commitments rest on a misunderstanding of
the limits of deficits and how to reduce them. The
administration also misunderstands the nature of this
recession, which is different than most post-Second World War
recessions, and it gets the banks' reluctance to lend money
wrong, too.

There is simply no evidence that markets lack confidence in
U.S. government-issued debt. The United States has carried a
considerably larger debt burden in the past and had no
difficulty finding willing lenders at the time. Other
countries that currently carry much higher debt burdens are
still able to borrow at relatively low cost in financial
markets. The market for U.S. Treasury debt continues to be
robust, in fact, yields are low and declining! In short,
there is no reason to believe that the United States faces
any loss of confidence based on its debt levels.

We have been in this situation before. After the Second World
War our debt-to-GDP-ratio was about 120 percent, a greater
burden than now. But Congress paved the way for sustained
economic growth - it passed the GI Bill, the federal highway
program, low cost mortgages - and in doing so it reduced the
deficit. During the postwar boom, we ran annual deficits
around 2 percent of GDP but the economy grew at a much faster
rate, so that by the 1970s the debt-to-GDP ratio was below 30
percent. That is a far more attractive path to recovery than
an austerity policy. The lesson of the post World War II
period is that we can't reduce the debt or the deficit if our
economy isn't growing.

We should be clear about the source of the current deficits.
They are certainly not caused by so-called "out of control"
social spending. In fact, the United States ranks twenty-
sixth among thirty wealthy nations in social spending. In
many areas - early childhood education, active labor market
policy, unemployment insurance, and pension systems - we are
well behind other wealthy nations. In these areas, as well as
in basic infrastructure, such as high-speed rail and
telecommunications, we should be talking about increasing
expenditures, not cutting. Our deficits are also not caused
by the economic recovery policies pursued by Obama.

In fact, according to the Center on Budget and Policy
Priorities, the tax cuts enacted under George W. Bush, the
wars in Afghanistan and Iraq, and the economic downturn
together explain virtually the entire deficit over the next
ten years. The longer-term debt problem is entirely a
consequence of health care costs, projected to grow at a much
faster rate than the economy. The point is that there is no
crisis of entitlement spending - though we do need to control
health care costs.

This Recession Was Different

Before the growth of asset bubbles, recessions were caused by
high interest rates imposed by the Fed to control inflation.
In each case, housing tanked, then bounced back when interest
rates were allowed to fall again. But the three recessions
since 1990 haven't been deliberately engineered by the Fed;
they happened when credit or stock market bubbles burst.

If this were a normal recovery, interest rates would fall,
the stock market would rebound, and businesses would start
hiring again. But now there's a disconnect: credit isn't
perfect, but neither is it frozen. Businesses have plenty of
cash but are not hiring. The problem is that households are
saving and thus not contributing to aggregate demand, and
businesses are not spending because of that lack of demand in
the economy.

Richard Koo (the chief economist at Nomura Research Institute
in Tokyo), who popularized the notion of a balance-sheet
recession, has argued that when a debt- financed bubble
bursts, asset prices collapse while liabilities remain,
leaving millions of household and business balance sheets
underwater. In order to regain their financial health,
households and businesses in the private sector are forced to
repair their balance sheets by increasing savings or paying
down debt, thus reducing aggregate demand. In this type of
recession, the economy will not achieve self-sustaining
growth until the balance sheets are repaired. This suggests a
prolonged slump. It could take many years before the economy
starts to grow again.

Conventional monetary policy is less helpful because people
with balance sheets underwater are not interested in
borrowing at any interest rate.* Since the government cannot
tell the private sector not to repair its balance sheets, the
only thing it can do to keep the economy going is to borrow
and spend in the private sector, thus putting money back into
the economy's income stream. In other words, fiscal stimulus
becomes indispensable in a balance-sheet recession. Moreover,
the stimulus must be maintained until private sector
deleveraging is over.

This is precisely where the administration made a fatal
mistake. When the administration was formulating its stimulus
plan, Summers said it must be "timely, targeted, and
temporary." As Michael Lind pointed out, "He was wrong. The
expansion of public domestic demand that America needs must
be prompt, productive, and prolonged."

It's Jobs Or...

President Obama is now in the untenable situation of claiming
that jobs are his number one priority while having no program
to increase jobs. Polls show continuing erosion in the
public's confidence in Obama and the Democrats. And the issue
that is killing the Democrats is high unemployment.

It is no mystery what a jobs program might look like. The
public-investment-led recovery that Obama described before he
became president, combined with aid to states and localities
and an ambitious public program to employ a million workers
in the home-care, child-care, and preschool industries, is a
great place to start. Even mainstream economists like Alan
Blinder and Robert Shiller are calling for a government jobs

If Obama continues to try to reduce the deficit through
austerity, he risks prolonging the unemployment crisis - and
making the debt problems worse. The warning signs are clear
for all to see: the economy is slowing, state and local
governments have already cut 316,000 jobs in the last two
years, and if we don't deliver federal aid to states and
localities, the national economy stands to lose up to 900,000
public and private sector jobs. In the second half of 2010,
federal stimulus spending will decline, the inventory
correction that has boosted manufacturing will have run its
course, the housing market appears to be turning down again,
and problems in Europe are leading to a global economic
slowdown. It is no time to be cutting deficits. Short of a
public-investment-led recovery, nothing else will fuel

A recent portrait of the president in Vanity Fair concludes
that Obama believes that if he looks after the "doing" of the
presidency, the "selling" of the presidency will look after
itself. But if what he is "doing" about the economy leads, at
worst, to a double dip recession and, at best, to slow
growth, prolonged unemployment, greater inequality, and
increasing insecurity, it will be a very hard sell in 2012.

* The Federal Reserve, however, could be doing more to
promote employment. The Fed could purchase more long-term
government debt (to keep long-term interest rates low), it
could purchase state and local debt (to help states and local
governments fund local projects), and it could state its
willingness to purchase bonds of a public authority set up to
fund badly needed infrastructure projects.

[Mark Levinson is chief economist for the Service Employees
International Union and book review editor of Dissent.]


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