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How Can the Economy Recover?

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Doug Mills/The New York Times/Redux
President Barack Obama speaking with local residents in Albuquerque, New Mexico, about the need for education to ensure long-term economic prosperity, September 28, 2010

Many recent books and articles by economists and policy analysts ask how the US can recover rapidly from the worst economic crisis since the 1930s. They usually merely assume that the ideal objective is to return to the stable economic growth that preceded the crisis of 2007 and 2008. The underlying assumption is that once adjustments are made, the economy will continue again much along the path it had for a quarter-century.

This optimism isn’t at all warranted. The recession that began in late 2007 was declared over in mid-2009 by the National Bureau of Economic Research, which keeps track of business cycles. But nearly fifteen months later, the unemployment rate remains at 9.6 percent, leaving nearly 15 million Americans out of work. Another 11.5 million, some 7.5 percent of the population who are ready and willing to work, have given up looking for a job or are working part-time because they can’t find a full-time job. The nation’s Gross Domestic Product is growing so slowly that it has not yet reached its prerecession level. By this point in the recovery from all of the nine previous recessions since the end of World War II, GDP had attained its former peak.

What makes this recovery different is clear. Consumers have record levels of debt compared to income and some $12 trillion in losses on their houses and financial investments. They are not going to spend money as they usually do—perhaps not for a long time. A damaged financial system is also not lending significantly, partly because business clients aren’t seeking loans unless they directly generate more sales, and consumer demand is low. Business investment, propelled by piles of cash on the balance sheets, is nevertheless slowing after rising strongly from low levels for the past year.

The economy could slide back into an outright recession again. A fragile financial system could also again be pushed to the brink by a new round of mortgage and other defaults. Fortunately, the number of jobs in October rose by 159,000, breaking a trend of even more modest job creation. More jobs will mean more income and perhaps rising consumer confidence. A “double dip” recession may well have been avoided, but as the Economic Policy Institute points out, the economy will have to produce 300,000 jobs a month, twice a many as this October, for several years to return to the unemployment rate of 5 percent in December 2007. Economists at Goldman Sachs calculate that if historical precedents apply, it would require four years of GDP growth of 4 percent a year, after inflation, to return us to full employment. Many economists believe the nation cannot attain that rate.

The US economy is growing so slowly that the case is strong for another multibillion-dollar investment in government spending to stimulate it. The nonpartisan and usually cautious Congressional Budget Office estimates that the US GDP could easily be 6 percent higher without threatening inflation—that is, it is 6 percentage points below what the CBO estimates as its optimal level. But both the President and Congress are avoiding any substantial stimulus now because of the current surge in the deficit. The Republican leaders of the House in the newly elected Congress say they will demand $100 billion in immediate spending cuts to reduce the budget deficit even as they seek the permanent extension of the tax cuts passed under George W. Bush that are set to expire this year.

Those tax cuts, if extended permanently, will add considerably to the future deficit. But this contradiction does not deter the politicians who are apparently more interested in reducing the size of government than of the deficit itself. In addition, pressure is growing from nations like Germany, China, and Brazil to reduce the US deficit as a way, they say, for the US to cut its reliance on foreign capital and thereby reduce its trade deficit. They fear that current Federal Reserve policies to reduce interest rates will lower the value of the dollar abruptly and make their exports to the US more expensive.

Right now, the best hope is that heavy cuts in government expenditures will be postponed for two to three years. But such a delay will probably not be long enough. Erskine Bowles and Alan Simpson, the cochairmen of the fiscal commission President Obama appointed to propose ways of reducing the deficit, are calling for sharp cuts in spending but say they want to delay the first reductions until 2012, when the economy will have sufficiently emerged from the recession. This would be a severe miscalculation. Barring a surge in growth, the unemployment rate in 2012 will probably be at least 8 percent, roughly the highest level reached since the end of the recession of the early 1990s.

If this poorly considered advice is the best that this commission can give the President, the nation is in trouble. An obsession with taming the deficit, provoked by the rapid rise in the current deficit to $1.5 trillion for 2010, will make a large stimulus impossible. But the sharp surge in the deficit was mostly caused by the recession itself, which reduced tax revenues and raised the level of spending—such as unemployment payments—in response to the recession. President Obama’s stimulus package of $800 billion passed in early 2009 also added to the deficit, but that spending was only temporary and kept the economy from sinking further.1 According to a convincing economic model by the economists Alan Blinder and Mark Zandi, without the stimulus the deficit would have been substantially bigger in coming years.

If we presume that there will be an economic recovery, almost all of the projected deficit through 2020 will be the result of three factors: the recession, the tax cuts of the early 2000s under George W. Bush, and the hundreds of billions of dollars of war spending. In the 2020s and 2030s, however, projected increases in Medicare and Medicaid spending could raise deficits dramatically—and the amount of government debt and the interest paid on it could grow to alarming levels. Social Security spending will increase only modestly by comparison. But dealing with such long-term problems by abrupt cuts in spending now will likely consign the nation to a decade of slow growth, lost jobs, and low wages—and unnecessary, painful reductions in Social Security and other social programs that Americans value most.

What is rarely recognized is that even if the US can emerge from a weak economy within a few years, the economic foundation that existed before the cataclysm of 2007 and 2008 may not be adequate to restore the widely shared prosperity the US needs. For more than three decades, economic growth had been largely dependent on rapidly rising levels of debt and on two major speculative bubbles, first in high technology and dot-com stocks in the late 1990s, then in housing in the 2000s. What will now replace them?

Income inequality widened sharply in these years and average wages stagnated for the many while record high fortunes were made by the few. The financial security and access to adequate health care and education for children that had defined the middle class since World War II have eroded rapidly. Meanwhile, investments in infrastructure such as transportation, as well as clean energy and education, have been badly neglected. All this raises doubts about America’s future economic vitality whether or not it balances its budget, and it does so at a time when international competition from Asia and the Southern Hemisphere will pose serious challenges during this century. How will Americans live a decade from now?

Few writers are trying to address these future concerns with a new and more hopeful economic agenda. One who has attempted to chart a course for what he considers the next “new economy” is the respected British financial journalist Anatole Kaletsky. In Capitalism 4.0, he makes a thoughtful but moderate set of proposals that are, despite his claims otherwise, largely an extension of pre-crisis thinking, in which he relies heavily on his faith in the ingenuity of capitalism as an adaptive mechanism. “Hoping that ‘something will turn up’ may sound like deluded wishful thinking,” he writes, “but it is really just an extension into politics and macroeconomics of Adam Smith’s arguments about the self-organizing dynamics of the capitalist economy.”

Kaletsky sees the history of capitalism as a struggle between government and markets. He writes that the first capitalist stage—Capitalism 1.0—lasted from the early 1800s to the Great Depression, a laissez-faire period in which “politics and economics are two distinct spheres.” This is one of those widely accepted pieces of conventional wisdom that needs serious correction. Kaletsky points out exceptions to the laissez-faire approach, but his brush is still too broad. The US, for example, was never such a truly laissez-faire society and its government always actively intervened in the economy. The American authorities regulated all kinds of products in the colonial years, and imposed severe regulations on the labor markets. After all, many US workers were legally indentured servants.

Thomas Jefferson himself, who persistently warned against the power of central government, was a leading advocate of federal regulations to make land widely affordable to the American masses. Access to land was also a major reason why he bought the Louisiana Territories, doubling the size of the nation, in likely violation of his constitutional powers. State and local government financed and built the canals that were crucial for commerce in the early 1800s, and a remarkable free and mandatory primary school system emerged by the 1850s. Right up until the present day federal and local governments have financed railroads, technical universities, urban sanitation systems, high schools, highways, college tuition subsidies, and much else.

Underemphasizing this reality, Kaletsky writes that laissez-faire economics did not change significantly until the 1930s with America’s New Deal, Capitalism 2.0. It then reverted to its laissez-faire origins in the 1980s—Capitalism 3.0. The earlier “phase of capitalism, from the 1930s until the 1970s, assumed that governments were always right and markets nearly always wrong,” he writes. “The dominant ideology from the 1980s until the 2007–2009 crisis assumed that markets were always right and governments nearly always wrong.”

Kaletsky believes that all three stages were on balance successful, including the last one. The American economy beginning in the 1980s benefited from “the spectacular success of macroeconomic stabilization…at least until the crisis of 2007.” But this was also the period of rapidly rising income inequality in the US, with millions of people with no health insurance, and an ever lower savings rate as people borrowed to keep their heads above water. Kaletsky pays relatively little attention to inequality.

There was also one financial crisis after another, often leading to a recession or slow growth and often requiring federal bailouts. Kaletsky minimizes or neglects the impact on growth of the Mexican crisis of 1982; the stock market crash of 1987; the savings-and-loan and junk bond failures of late 1989 and 1990; another Mexican catastrophe and hedge fund failures in 1994; the Asian financial crisis of 1997; the collapse of Long-Term Capital Management in 1998; and the bursting stock market bubble of 2000–2001. Capitalism 3.0 was hardly an undiluted success.

  1. 1

    See Kathy A. Ruffing and James R. Horney, “Critics Still Wrong on What’s Driving Deficits in Coming Years,” Center on Budget and Policy Priorities, June 28, 2010. 

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