NEW YORK – For many, if not most, Americans, the crisis that befell them in 2008 – leading to slow growth, rising unemployment, and high anxiety among voters – appeared to spring from nowhere. Certainly, the vast majority of economists, investment analysts, financial firms, and regulators failed to see the growing risk. In fact, it had deep roots.
While the precise timing of any crisis is impossible to predict, ample signs of rising risk, distortions, structural problems, and imbalances could be seen by anyone who took the time to interpret a decade’s worth of mounting debt, low savings, surging asset prices, and excess consumption. The United States was on an unsustainable growth path for at least a decade – probably longer – before the crisis.
Restoring balance and eliminating the distortions will require time, investment, and structural change, and should be the central focus of America’s economic policy. The household sector is especially important. If the main problem had been confined to excess leverage and risk-taking within the financial sector, the economic shock would have been large, but the recovery quicker. It was the huge loss of households’ net worth that brought down the real economy (with an assist from the credit squeeze on smaller businesses).
Let’s be clear: elevated savings and reduced consumption relative to pre-crisis levels are likely to be permanent even after households reduce leverage and restore retirement savings – a process that in the US has removed roughly $1 trillion from the demand side of the economy. To make up the difference, Americans need to compete effectively for a portion of global demand.
Does this mean that the US is headed for a “new normal,” rather than a reversion to pre-crisis conditions? It does. Put bluntly, Americans were living beyond their means for too long. With foreign borrowing financing a yawning trade deficit, the US economy as a whole spent more than it earned, which both caused and hid structural problems.
So the main post-crisis challenge is not to return to the old normal, which was not sustainable, nor is it to recover from a deep balance-sheet recession, but rather to make a structural transition from the old abnormal to a new normal that is sustainable.
This does not mean that recovery of households’ balance sheets can be ignored in the post-crisis period. The US Federal Reserve has had to carry out a difficult balancing act: with no sign of inflation on the horizon – and at least some risk of deflation – it has maintained low interest rates even as credit conditions have eased. Contrary to most commentary, this is not a growth strategy, but rather an attempt to limit the considerable risk of another major downturn, induced by further balance-sheet damage in the housing sector.
True, low interest rates, together with a second round of quantitative easing, are causing considerable global distortions, as funds flow into fast-growing emerging markets, fueling inflationary pressure and asset bubbles. But, given the US housing market’s fragility, raising interest rates could cause prices to plummet, sinking the economy again. Despite their complaints, it is not clear that emerging economies would prefer another deep US downturn to the current flood of inbound capital that that they must manage.
As it is, deficient consumption and stubbornly high unemployment are likely to be with Americans for some time. But this is not how the future was sold to the public, and, until recently, financial markets were acting as if recovery was at hand and would be relatively quick. The proverbial dead-cat bounce – when freefall stops and inventories run out, causing output to pick up a bit – was misinterpreted as evidence of a V-shaped recovery: sharply down and sharply back up.
Despite the impression created, particularly in the US, by media commentary and political debate, fiscal stimulus clearly helped in the crisis, though its impact is diminishing rapidly. Recent studies by the International Monetary Fund indicate that in most advanced countries, including the US, the growth in budget deficits was largely automatic, owing far more to declining tax revenues and rising expenditures on unemployment benefits than to stimulus spending.
The appropriate timing of fiscal retrenchment is, in fact, difficult to decide. On one side is concern about another downturn and deflation. On the other side is the risk of excessive debt, currency instability, and – where unemployment is structural – doubts about the benefits of additional stimulus.
Indeed, advanced countries, including the US, have dug themselves into a deep hole. It is not yet a hole of the type one finds in Greece, where restoring fiscal balance and reviving economic growth are probably impossible without a restructuring of public debt. But climbing out will be difficult and painful. At this stage, the best course would be to adopt a credible multi-year plan, based on reasonable but conservative growth assumptions, to reduce deficits to sustainable levels and limit the accumulation of public debt.
With a new, more hostile Congress, and with members of a new economic team coming on board, Obama’s challenge is to build a consensus around a medium- and long-term recovery strategy, with a focus on restoring growth and employment. The limited fiscal resources that are available should be targeted on areas that affect competitiveness in the tradable sector. That means forgoing some government services.
The truth is that all the net employment growth in the US economy over the last 20 years has been in the non-tradable sector, where Americans don’t have to compete. Leading drivers of employment growth have been government, health care, and, until the crisis, construction.
While this is just one part of a much more complex story, it seems unlikely that these and other non-tradable sectors can sustain employment growth in the future. With the tradable sector neutralized and the non-tradable sectors maxed out, the economy lacks sufficiently powerful growth engines.
That must be fixed, which requires that competitiveness become the central focus of longer-term US economic policy – the sooner, the better.