Policy makers in the US failed to recognize four significant events that led to our current circumstances. In prevalent analysis of the current financial situation, its roots go back at the end of World War II,” according to Byron Wien, Vice Chairman, Blackstone Advisory Group.
The first two events occurred in 1980, when Europe and Japan were competing once again after 35 years of rebuilding post WWII making it more difficult for the US to compete globally.
An industrial policy emphasizing energy independence or infrastructure would have been an ideal response. By tapping into our abundant natural gas supplies to generate electricity and to power municipal transportation, we could have diminished environmental damage and reduced dependence on Middle Eastern oil. We also should have upgraded manufacturing worker skill.
With the 80s becoming the “Me Decade”, the US saw the widespread accumulation of personal debt.
The third event took place in 1990, when China and the former Soviet Union moved away from command economies. At that time India entered the world economy while producing goods for its own consumption. We viewed this positively, failing to recognize competitiveness.
The fourth event took place in the late 1990s, early 2000s, as the government and the private sector enabled the idealistic concept, whereby more Americans own their homes, resulting in many acquiring expensive homes beyond their means, because house prices were appreciating 10% a year. Paying over several years, they could sell for profit to buy a comfortably affordable unit.
This worked until 2007 housing prices started to decline. Many found themselves with high monthly payments and a declining value, if it could be sold at all. We all know what happened to the economy then.
The debt added at all levels of the US financial system in relation to GDP growth, means that capital has become less productive over the last three years.
The pride of our enviable post-war position formed the foundation of our present circumstances and we also adopted a series of broad social programmes.
Little competitive pressure made this period productive. From 1950-1970, the economy as a whole had to add less than two dollars of debt to produce one dollar of growth in GDP. By 1980, with competition from Europe and Japan, it took three dollars to produce a dollar of GDP growth, an over 50% increase in a decade. Furthermore, the number of people working in manufacturing continued to decline.
“We were becoming a service economy, and services do not export well so our balance of payments deficit began to expand. The sector employment increased from 40% in the ‘40s to 65% in ‘10. The high price of oil in ‘73-‘74 also contributed. It is worth noting that in January 2012 increases in manufacturing employment exceeded increases in service sector employment for the first time since ’77, hopefully a new trend.
“Policy action against the decline in the productivity of capital and the decline in the manufacturing work force didn’t take place. An industrial plan should have been designed for alternative energy, mimicking the contribution that putting a man on the moon had on the birth of Silicon Valley, the IT cradle. We would be much less dependent on foreign oil today, with enormous economic and political ramifications.
“Our universities, the world’s greatest, didn’t take advantage of innovative capabilities over the last forty years. As technology began to play a more important part in both service and manufacturing, policy makers should also have implemented programmes to upgrade the capabilities of the American workforce.
“The 1990s were favorable for capital productivity. In spite of the competitive challenges represented by low labor cost countries in Latin America and Asia, the debt required to increase GDP by a dollar remained at about 3:1 due to America’s IT dominance.
“This changed in the new millennium. Debt requires an increase GDP by a dollar increased to over five dollars. Money was borrowed to buy overpriced houses and we were engaged in two wars with uncertain outcomes. The ’08 financial crisis required enormous increases in the federal debt to avoid a banking meltdown. In 2000, when George W. Bush was elected, the national debt, accumulated over 200 years, was less than $6 trillion. Today it is $15 trillion – more than doubling in only 12 years. Nominal GDP increased from $10 trillion to $15 trillion.
“To buy homes, lending standards were relaxed and bank and shadow bank leverage increased. The Federal Reserve could have been tougher on lending but it was believed that the free market would provide the necessary discipline without recognizing the consequences to the excesses.
“If it takes five dollars of debt to produce one dollar of GDP growth, the return on that one dollar may not be enough to service the five dollars and provide a return to the equity investor as well. That may be one reason for high-cash corporate balance sheets. Increasing competitiveness makes it difficult to get a satisfactory return.
“The question is: ‘what to do now?’ Clearly, government expenditures need to be reduced as accumulating debt is unsustainable. However, we need to be careful not to cut spending too quickly because it represents 25% of GDP – a huge subsidy for the economy. The Congressional Super Committee’s objective was to cut government expenditures by $1.2 trillion over ten years, or $120 billion annually this could be accommodated without throwing us back into recession. A cut in spending of as much as $500 billion in a single year would reduce the growth of the deficit, but would put GDP in negative territory.
“It is not likely that our budget gap can be closed significantly without some increase in taxes which currently represent 15% of GDP. The base should be broadened and tax preferences and subsidies will be under pressure to be modified, but there are groups and political forces that will resist significant change.
Amidst these longer-term problems the economy has regained lost momentum. Observers thought real GDP growth of 2% seemed likely, but now 3% would appear attainable for 2012, keeping payrolls increasing and the budget deficit growing. We must bring it down or face a crisis.
By 2020 the cost of debt annually could rise to over 20% of revenues, crowding out spending on defense, social security and healthcare and causing social problems that Congress should face.
The ‘wake-up’ call for Congress is the rising interest rates on government debt. Paying 2% to borrow for ten year reflects legislator complacency. If the cost of borrowing exceeded nominal GDP growth, they might have a greater feeling of urgency.