CAMBRIDGE: America’s economy is entering a risky phase. The conditions that underpinned its long boom are weakening. It is a fool’s game to try to predict changes in public sentiments. Nonetheless, good economic reasoning can help us to anticipate the economic turbulence ahead.
The US boom has been a mix of reality and wishful thinking. The reality is that technological advancement, combined with flexible and dynamic labor and capital markets, led to a rapid rise in productivity growth and the spread of new technologies. Lives in the US changed remarkably for the better recently, with improvements in the service economy, new medical technologies, access to information, and the like.
Wishful thinking transformed economic gains into visions of easy wealth. The New Economy – which is real – became the “invincible” economy where risks are discounted, stocks always rise, world economic conditions are always beneficial, and budget surpluses continue forever. Optimism manifested itself in two ways. First, American stock markets rose giddily – adding $8 trillion in paper wealth to owners of US equities in a five-year period. Second, American consumers increased spending as a result of their paper wealth, reducing or eliminating their savings from income because their stock market wealth would protect them in the future.
The combination of large business investments in new technologies, combined with high levels of consumer spending, fueled a spending boom. For every dollar of income produced in America, spending by consumers, businesses, and the government now equals one dollar and four cents. The extra four cents per dollar is paid for, in essence, by borrowing from abroad. Foreigners have been keen on buying US stocks and bonds, while American businesses and households used that capital to support their investment and spending.