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The essay presents the argument that the U.S. experienced a shallow economic depression in2007-9 reminiscent of pre-war economic contractions. The economic data are analyzed to showthat the downturn was more severe than any previous post-war downturn. Though technicallyover, the severity of the depression has led to extremely slow growth and a protracted period of high unemployment.
The policies of the 2000s and the concentrated industrial structure they spawned are shown tohave contributed to the severity of the downturn and to the slow recovery. The Keynesian andlibertarian schools of economic thought are discussed in the context of their roles in offeringprescriptions for improving economic growth. The essay critiques the academic economicsprofession for not predicting the downturn or providing useful prescriptions for solving
economic problems.
It is shown that China’s policies created a monetary and trade environment in the 2000s for thedepression and that they are constraining economic growth as the U.S. exits the depression.
A number of policy prescriptions are provided to improve economic growth. These bestpractices include constraining federal government spending, adjusting and balancing tax,competition, trade and intellectual property policies, promoting investment, education andinnovation policies, and modulating Fed monetary policy.
Index
Introduction: What Happened to America? 2Economic Analysis of the Downturn 5Was the Downturn a Recession or a Depression? 13This Time IS Different 25Causes and Consequences of the Depression 36The Rise of China 45Policy Factors in the Economic Bubble and Aftermath 49Redefining Conservatism 57Failed Economics 62Policy Prescriptions 66
List of Figures 78List of Charts 78Bibliography 79____________
† B.A., Reed College, 1981; A.M., University of Chicago, 1982; CEO, Advanced System Technologies, Inc.
“After the most severe recession since the 1930s, the U.S. economy appears to berecovering. Real (inflation-adjusted) gross domestic product (GDP) grew during thethird quarter of 2009, after having fallen 3.7 percent since the recession began in thefourth quarter of 2007. However, the economy’s output is still about 7 percent belowthe Congressional Budget Office’s (CBO’s) estimate of potential GDP—the outputthe economy would produce if its resources were fully employed. From December2007 to December 2009, the unemployment rate jumped from 4.9 percent to 10.0percent, and payrolls fell by about 7.2 million jobs. Moreover, if employment hadgrowth during this period at the same rate at which it had growth from 1990 to 2007,millions of additional jobs would have been added to the economy during that period;all told, the recession has lowered employment by about 11 million relative to what itwould otherwise be. Nearly all professional forecasters believe that the economy haspassed the trough of the recession, but many also predict that the pace of the recoverywill be slow.” [CBO, Policies for Increased Economic Growth and Employment
in 2010 and 2011, p. 1, 2010]
In 2000, the U.S. government experienced record federal budget surpluses and the federal
debt was being paid down. Middle class wages were growing and economic growth was strong.
Industrial corporations experienced a productivity revolution with robust profits and high
competition. Unemployment and poverty rates were at historic lows.
In 2010, the U.S. government experienced record federal budget deficits while adding to
an extraordinary federal debt. The unemployment rate peaked at 10.6% and industrial capacity
was at a record post-war low. With a poverty rate of 14.3%, 44.3 million people were in
poverty. Industry concentration was at a peak and income structures were more stratified than at
any time since 1928. High commodity prices from a commodity bubble in 2008 squeezed an
already strained middle class. Remarkably, real median income of $49,777 in 2009 was lower
than in 2000. The U.S. education system did not make the top 10 list among industrial countries.
And, two significant wars were being wound down.
What happened in such a short time? America obviously witnessed the consequences of
the application of a “conservative” economic and social experiment. To identify the solutions to
the economic problems, it is essential to understand the anatomy and sources of the problems.
While there is little controversy about the economic depression in the housing sector, the
long-term effects of the housing bubble are detrimental to consumers and economic growth.
Furthermore, while the housing bubble and economic contraction are indisputable, perhaps more
problematic are the facts about the erosion of the middle class during the 2000’s. Economic
pressures have resulted in a fundamental restructuring of the composition of the middle class.
The effect of these changes is to increase the stratification of American society, with the top 1%
responsible for 23%, and the top tenth of 1% responsible for 11%, of income in 2007. However,
it is argued that stratification is the effect, not the cause, of economic challenges and that a
consequence of increased stratification is increased economic instability.
The parallels between the economic policies of the 1920’s and the 2000’s are very
similar.1 It should be no surprise, then, that the consequences of these policies lead to financial
crises and economic instability.
While the U.S. experienced a housing bubble, a middle class decline and an economic
depression, China experienced an economic Renaissance in the 2000s. It is argued that China’s
rise had adverse effects on the U.S. economy during this period.
Though the economics profession largely failed to predict the downturn, whether because
of increased specialization, an overemphasis on math, a lack of policy or historical experience, or
1 Income inequality is similar when comparing the 1920s and 2000s. “Income disparities before [the1929] crisis and before the recent one were the greatest in approximately the last 100 years. In 1928, thetop 10 percent of earners received 49.29 percent of total income. In 2007, the top 10 percent earned a
strikingly similar percentage: 49.74%. In 1928, the top 1 percent received 23.94 percent of income. In2007, those earners received 23.5 percent.” Story, L., “Income Inequality and Financial Crises,” NYT,2010 [drawing parallels between economic conditions of the Depression and the recent downturn]. Realmedian household income was $21.7K in 1947, $28K in 1977 and $50.2K in 2007, according to U.S.Census Bureau data. In 1977, the top 1 percent of the top 1 percent earned $2M and by 2009, the top.01% earned $11.5M, showing far faster growth at the top. See Atkinson, T. and T. Piketty, Top Incomes
Over the Twentieth Century: A Contrast Between Continental European and English-speaking Countries,2007 [showing 20th century income patterns between several countries] and; Saez, E. and T. Piketty,“Income Inequality in the United States, 1913-1998,” Quarterly J. of Economics, 2003 [showing 20th
Source: Federal Reserve Flow of Funds Report [F.6 “Distribution of Gross Domestic Product: 9/18/08,9/17/09 and 9/17/10] * Projected
The economy grew very slowly from the fourth quarter of 2007 to the third quarter of
2008. The financial crisis that was triggered by the failure of Lehman Brothers in September of
2008 shows a decline of 4.2%2 in the fourth quarter of 2008, a decline of 8% in the first quarter
of 2009 and a decline of .7% in the second quarter of 2009. The economy then grew 1.6% in the
third quarter of 2009 and 5% in the fourth quarter of 2009. 2007 had a growth rate of about
2.5%, 2008 experienced a decline of 2.7% and 2009 had a growth rate of .2%. From the third
quarter of 2008 to the second quarter of 2009, however, the economy declined at a 4.1%
annualized rate, the largest and most protracted post-war economic decline.3
2 The economic growth and decline data are annualized.3 If the U.S. economy had grown at 5% a year from 2007 to 2011, GDP would be $17T at the end of 2010, rather than its actual $15T. Therefore, the U.S. economy lost about thirteen percent of its potentialgrowth in the downturn in a three year period.
failure of Lehman Brothers. This was followed by a 7.7% decline in the first quarter of 2009.
While the GDP data reflect public and private spending and show federal government spending
comprising a disproportionately larger share, the net worth data show a very severe downturn
that affected the private sector.4 The contraction in net worth from the fourth quarter of 2007 to
the third quarter of 2009 more clearly maps the extent of the downturn. According to this data, it
will take three and a half more years (early 2014) at a five percent annual growth rate to return to
the peak level of net worth shown in the first quarter of 2008.
Figure 2
Total Household Net Worth
Figure 2 graphically shows the relative decline in net worth since 1952. This illustrates
several post-war recessions, but the extraordinary decline of 2008-9 is illustrated at the right side.
The 2000s are shown as the “V” immediately prior to the precipitous decline.
4 The decline in net worth in the fourth quarter of 2008 and first quarter of 2009 reflected the drop invalue in the prices of both real estate and equities.
The U.S. equity markets declined significantly in the downturn, with the Dow dropping
from about $14,000 in 2007 to about $6,500 in March, 2009, for a total decline of 53%,
comparable to the peak post-war decline in 1973-4.
Figure 3
S&P 500 [September 2007 to September 2010]
Source: S&P 500
Figure 3 shows S&P 500 data from September, 2007 to September, 2010. The equity
markets have been in a relatively narrow trading range during much of late 2009 and 2010,
reflecting the realities of slow expected economic growth. Note that it took the Dow Jones
Industrials twenty three years to return to its October, 1929, levels.5
The unemployment rate, however, rose rapidly beginning in the third quarter of 2008.
According to the U.S. Bureau of Labor Statistics, the unemployment rate moved from 4.6% in
2007, to 5.8% in 2008, 9.3% in 2009 and 9.9% in 2010. The unemployment rate peaked at
10.6% in March of 2010. This shows that while the economy grew nominally in the third quarter
5 The NASDAQ peaked at 5050 in March, 2000 and was about half of this level in 2010, suggesting thepotential for several more years to return to its peak level. The NASDAQ may be tracking the Dow’s1930s and 1940s performance.
of 2009, unemployment was increasing to a peak level before declining in April of 2010.6 The
aftereffects of the downturn show a long tail in which unemployment continues to be unusually
high after the technical end of the downturn.7
Figure 4
Job Losses in Recent Recessions, as a Share of Employment
6 To show the relative severity of the depression, the total number of unemployed in 2008-10 was greaterthan in the downturns of 1981-2, 1990-1 and 2001 combined. While these data show the generalunemployment rate, the actual rate may be higher since those who are underemployed or who stoppedlooking are not counted. The Bureau of Labor Statistics indicated that the real unemployment rate peakedin 2010 at 16.6% (26M people) including underemployed and discouraged workers. An average of five
individuals applied for each job opening in 2010, the worst percentage since the 1930s.7 Poverty in the U.S. increased to its highest level – over 14% – since records were kept in the 1960s.An estimated twenty percent of children were in poverty. An eighth of Americans were on food stamps.The reason that our cities do not have Hoover town encampments of homeless and soup lines is that NewDeal and Great Society federal programs of unemployment insurance, food stamps, Welfare and socialsecurity provide a crucial social safety net. The idea of unraveling the safety net as a way to increaseeconomic efficiency and to save money is to shift risk onto individuals’ at their most vulnerable time,leading to nasty, brutish and short lives in a disintegrated post-industrial modern society. In the absenceof economic growth, the U.S. government maintains the burden of responsibility for surplus labor, whichpresents an economic conundrum in the long-run.
4.1%, it is generally seen as a severe recession, the so-called “Great Recession.”8 I have
suggested using the word “repression” to show an intermediary position between a recession and
a depression. However, the net worth, housing, trade, and industrial capacity declines of 12-30%
and the extraordinary unemployment data suggest that the contraction was more severe than a
recession. For example, the present downturn experienced an aggregate unemployment (viz.,
over 15M people) of greater than those in all of the last three recessions combined, including the
severe recessions of 1981-2 and 1990-1. The extraordinary unemployment data simply point to
the extreme depth and intensity of the fall-off of industrial production.9
There is some controversy about precisely when the contraction occurred. According to
Federal Reserve data, the contraction in GDP occurred from Q3 of 2008 (Lehman Brothers
collapse) to Q2 of 2009. This would provide a term of ten months. On the other hand, the
National Bureau of Economic Research (NBER) places the contraction period beginning in
December of 2007 and running to June of 2009 for a total of 18 months. If, however, the U.S.
economy did not come out of the contraction, based on NBER data, until Q1 of 2010 when
unemployment peaked at 10.6% in March, 2010.10 The period from December, 2007, to March,
2010, would constitute a 28 month contraction period if one includes the phase of the downturn
that accommodates the peak of unemployment. However, whether using the NBER 18 month
8 In 1931, Herbert Hoover used the term “Great Depression” to distinguish the severity of the economiccontraction to other events in recent historical memory. In 1981, the Reagan administration used the term“Great Recession” to describe the relative severity of the economic downturn at that time. The economiccontraction from 2007 to 2009 could be characterized as neither a “recession” nor as a “Great
Depression,” thus suggesting that the terms “depression” or “shallow depression” are more accuratedescriptions.9 See Barro, R. and J. Ursua, “Stock-Market Crashes and Depressions,” NBER Working Paper W14760,2009 [showing links between financial crises and economic contractions] and; Barro, R. and J. Ursua,“Macroeconomic Crises since 1870,” NBER Working Paper W13940, 2008 [analyzing post-Civil Wareconomic cycles].10 If the economy contracts from Q2 of 2010 to Q2 of 2011, following a trend of weak housing data andhigh unemployment, then the contraction period may be interpreted as qualifying as a “double diprecession” or as a continuous depression of up to 42 months. The evidence shows a net worth decline inthe third quarter of 2010 providing the prospect of a continuation of the contraction.
mark or the 28 month mark that factors in a period to the peak phase of unemployment, the
downturn was empirically the worst continuous period of economic contraction since 1929-32.
In retrospect, there appears to have been three phases of the contraction. First, the initial
phase from Q4 2007 to Q3 2008 shows a period of disinflation and GDP atrophy. The second
phase, comprising the financial crisis and its immediate aftermath, consisted of a period of GDP
contraction from Q3 2008 to Q2 2009. The final phase, comprised of a period from Q2 2009 to
Q2 2010, witnessed an unemployment spike as industrial capacity dropped to a new equilibrium.
Though unemployment is a lagging indicator, and is expected to remain stubbornly high with a
gradual decline over several years, this later phase is a key characteristic of a severe economic
contraction. The multi-phasal view of the anatomy of the downturn suggests that the 2007-9
downturn was a protracted shallow depression much more reminiscent of pre-war downturns
than post-war downturns. However, even the minimalist view of the three-quarter technical
GDP contraction (i.e., phase II alone) qualifies as a shallow depression by historical standards.11
It is instructive to compare the 2007-9 downturn to the U.S. downturns since the Civil
War in order to assess its relative impact.
Chart 3 shows the history of U.S. post-Civil-war downturns.
11 A case can be made that a fourth, atrophy, phase may occur in 2010-12 from a further housing pricecontraction; this period has begun to experience disinflation as measured by price data and by net worthdeclines in the third quarter of 2010 from the second quarter of 2010.
War recessions were generally far more moderate at only 10.8 months each. The only anomaly
was the “double dip” recessions from 1980 to 1982 that could be described as a continuous
recession promulgated by activist Fed policy to correct exogenous inflationary pressures. The
depth of the downturn, in terms of industrial production, international trade, housing price
deflation and unemployment data is consistent with a prolonged and substantial pre-war slump.
As Chart 3 shows, excluding the Great Depression, in the 42 years between 1887 and
1929, there were thirteen downturns, for an average of one downturn roughly every three years.
The average downturn duration was 16.2 months and the average recovery period was 22.8
months. This Progressive era appears to have been an extremely volatile period of
entrepreneurship, financial crisis and urbanization. The intensely stratified configuration of the
economy was likely a key reason for explaining the unusually destabilized macroeconomic
system in this period of rapid industrial growth. With an average recession and expansion period
of about 39 months over this forty year period, this era is not a good harbinger for the near-term
future of the U.S. economy as it trends to an extremely stratified configuration. One key
implication of this observation is that before the Great Depression endogenous instability
generated from a stratified economic configuration. For instance, in contrast to the extreme
stratification from 1890 to 1930, the U.S. middle class thrived after WWII and the U.S.
witnessed a remarkable growth period to about the mid-70s. But projecting the model forward, it
is suggested that the U.S. may experience either a difficult period of slow growth or a worse
period of instability and a succession of crises.12
12 Using the analogy of the Progressive era, a period in which there was a recession after the trough of aprevious downturn every 22.8 months, there may be another recession in the U.S. shortly after mid-2011assuming the 2007-9 contraction ended at the end of the second quarter of 2009. Further, in the long-run,if the macroeconomic system is tracking this volatile period – with the absence of government policyinfluences – the U.S. may be in a generational period of extreme volatility in which significant recessionsoccur every three or four years, rather than every ten years like in the past generation. If we recall theperiod in the 1970s – the instability of which was largely caused by exogenous factors – we obtain a
The financial crisis of 1907 created an unstable period, with recessions in 1907, 1910 and
1913, to which the central bank was a response. The Federal Reserve Bank was created by
President Wilson in 1913 as a monetarist mechanism to moderate the extremes of market
speculation. But even with the genesis of the modern Fed, the frequency of recessions were not
moderated until after WWII.
One major theory used to describe the reduction in severity of post-War recessions to pre-
Great Depression contractions was the Fed’s active use of monetary policy to modulate
economic activity.13 It is interesting to note the protracted periods of growth between each
recession before 2007, at 92, 120 and 73 months, respectively, signifying the effectiveness of
Fed policy in a period of general growth.14 This evidence would support the view that
monetarist policy has been generally stimulative and effective to modulate growth and constrain
unemployment. However, even with supererogatory action, the Fed’s power is severely
closer picture of the potential for macroeconomic disequilibrium created from endogenous factors causedby extreme stratification. The massive build-up of debt (public, consumer and business), the difficulty of deleveraging, the limits of Fed and international central bank policy, the political paralysis, a massivewave of retiring baby boomers, sovereign debt crises and enormous trade imbalances all point to thepotential of a destabilizing period of continuous recessions and shallow recoveries for at least a
generation. It is possible, then, that the U.S. may witness a new equilibrium period of slowgrowth, increasingly frequent recessions and a new range of unemployment between 8% and12%. On the other hand, it is possible that the rate of growth will pick up in 2011 and 2012,much as the economy experienced a rapid growth phase in late 1993 after the 1990-1 recessionand long tail from a deleveraging process.13 See Bernanke, B., Essays on the Great Depression, 1994 [discussing Depression era monetary policy];
Bernanke, B., “The Macroeconomics of the Great Depression,” NBER Working Paper No. 4814, 1994[identifying economic policy conditions and prescriptions in the Depression]; Bernanke, B.,“Nonmonetary Effects of the Financial Crisis in the Propagation of the Great Depression,” The American
Economic Review, Vol. 73 (June), pp. 257-276, 1983 [showing the role of the banking crisis in theDepression] and; Bernanke, B. and H. James, “The Gold Standard, Deflation, and Financial Crisis in theGreat Depression: An International Comparison,” NBER Working Paper No. W3488, 1990 [showing therole of the gold standard on monetary conditions in the Depression].14 In the twelve post-war recessions, though the average contraction duration was 10.8 months, theaverage recovery period was 60 months, for an average cycle period of 71 months or about double theduration of business cycles before the Great Depression.
constrained at the present time, suggesting that we are in a new equilibrium period. In fact,
monetarism may be worthless in a disinflationary economy in which interest rates are near zero.
The duration of the recent downturn has been unusually protracted. While the decline in
GDP stopped in mid-2009,15 according to technical factors, the recovery period has been
particularly slow, with annual growth below 2%. With growth at a steady state level, total
employment will not change beyond the population growth rate, thereby maintaining a high
unemployment rate. Clearly, this relatively slow growth period is consistent with a downturn
that is accompanied by a financial crisis.16 When identifying those periods of economic
downturns accompanied by financial crises, such as 1873, 1907 and 1929, the present period
qualifies as a longer downturn than a typical recession.
The financial industry crisis had as the root cause the housing bubble. 17 The housing
industry has clearly been in a protracted economic depression that began in 2006 and persisted
through 2010.18 Since most people use their house as a source of economic value, the housing
price declines have affected the debt and credit components of a large portion of the economy.
Until excessive debt is liquidated, the housing sector will continue to languish. In addition, when
15 In some ways, the 2008 financial crisis was a perfect storm of events, particularly with the politicaluncertainty of a major presidential election and transition. While the early stimulus legislation likelyaverted a more severe downturn, the Obama administration clearly inherited the legacy of previous policyefforts to limit damage from the financial crisis. The severity of the crisis left few good options.16 See Reinhart, C. and K. Rogoff, “The Aftermath of the Financial Crises,” NBER Working Paper, No.W14656, 2009 [showing the macroeconomic effects of financial crises, indicating a pattern of protracteddownturns after crises].17
The sub-prime lending sector was not the only problem of the financial industry in the 2000s. Inretrospect, offering creative, adjustable, loans with no credit or down payment, securitizing the loans,mis-rating the securities (often with conflicts of interest), offering “credit default swap” insurance on thesecurities by the London-based AIG Financial Products group and paying absurdly high transaction-feesand bonuses to bankers to perform these financial services was probably not a good idea. One U.S.securities industry regulator responsible for policing the industry never heard of the credit default swapsused to insure mortgage backed securities, which seems a little puzzling.18 Fannie and Freddie offer home loans on median sized mortgages at 3% to 4% in 2009-2010, far belowthe 6% to 8% private market interest rates. Despite these subsidized loan prices the market still remainssoft in 2010.
unemployment is high, further pressure is put on housing prices, deepening the cycle of debt
deleveraging. Since the bursting of the housing bubble was at the core of the recession, it is
critical to get control of this debt deleveraging process. Continuing housing price declines,
which are expected with a high backlog of foreclosures in the pipeline, will likely be a drag on
economic growth for the next few years.19
International trade, a measure of industrial production, experienced a 12.2% decline in
2008-2009, consistent with a significant economic depression. The trade data reflect the sharp
manufacturing contractions in the U.S., Japan, Europe and China as consumer demand dropped
precipitously. Furthermore, commodity prices dropped dramatically from 2008 to 2009,
reflecting a global economic depression caused by a sharp drop in demand.
The global character of the downturn is particularly indicative of an economic
depression. All economic data sets point to the greatest declines in GDP, employment, industrial
capacity, trade and housing prices since the Great Depression of the 1930s, suggesting that there
was a more severe economic downturn than a recession. In fact, the similarity of the downturn
to the early 1930s is instructive since there are parallels with the housing crises and the financial
crises between the periods.20
Going further, one can argue that the world economy experienced a
depression in 2007-10 that originated in the U.S.
If the U.S. experienced a shallow depression from 2007-9, an analysis of history shows
that the period from 2010 to 2015 is likely to witness protracted unemployment and a long tail of
19
There appears to be about five million homes in the foreclosure pipeline in 2010. At a rate of 95K amonth, this excess housing inventory is likely to have deflationary consequences. See the argumentbelow on the causes and consequences of the economic downturn. Finding ways to control the continuingsoft demand in the housing sector is critical to arresting the slow economic growth rate. On the otherhand, some argue that letting the housing market bottom is the best way to realize eventual healthyeconomic growth.20 See Stiglitz., J., Freefall: America, Free Markets, and the Sinking of the World Economy , 2010[arguing that the U.S. is in a structural economic decline] and; Day, V., The Return of the Great
Depression, 2009 [arguing that the economic conditions in 2008-9 are similar to the conditions in theearly 1930s].
slow economic growth from reduced demand and continued debt deleveraging.21 This period of
relative stagnation may be reminiscent of the Japanese “lost decade” of the 1990s. The two
periods are likely to share similar economic and policy causes of a slow deleveraging process as
banks are unwilling to write off bad loans and as protracted high unemployment diminish
consumer demand. This period of relative stagnation may be part of a longer process associated
with a shallow economic depression, but is also a period highly susceptible to exogenous
economic shocks, such as commodity bubbles that lead to corresponding inflation. One way to
transmit this inflation is with a weakening dollar that is likely to occur, based on historical
experience, because of the large federal debt, projected federal deficits, U.S. trade imbalances
and expansionary Fed monetary policy. The effects of the stagnation and bubbles will lead to
further pressures on, and perhaps a recomposition of, the middle class. The possibility exists,
then, that the U.S. is only in the early phases of a protracted economic depression with a period
of tepid recovery, but then a period of declining demand, possibly a deflationary period and then
rapid inflation akin to the experience of the 1970s. These economic conditions will make the
Fed’s policy decisions particularly challenging.
For much of the 19th
century there was no central bank to moderate economic downturns
by supplying and regulating money to banks, companies and consumers. The markets were at
the mercy of the industrial and financial institutions – and their entrepreneurial leaders – which
tended to experience booms and busts. The post-Civil War depression of 1873 lasted five years,
with nearly half of the population unemployed at some point during the period. The depression
of 1893 was also substantial and protracted. These depressions were protracted because of the
21 See Reinhart, C. and K. Rogoff, This Time is Different: Eight Centuries of Financial Folly, Princeton,2009 [arguing that economic bubbles share a common pattern] and; Reinhart, C. and V. Reinhart, “Afterthe Fall,” op. cit. [arguing that economic crises that stem from financial crises require several years of debt deleveraging from which to recover].
limited ability of the federal government to provide an antidote, particularly in the absence of a
central bank. The private economy was forced to repair itself without any assistance and these
self-organizing mechanisms were relatively slow to act. Similarly, the downturns of 190722 and
1929 witnessed a limited ability of the federal government to respond. In the 1930s, the Fed
made substantial policy mistakes that had the adverse effects of protracting the Depression in
1931 and 1937.
It should be obvious in hindsight that the present situation is reminiscent of these periods
that limits the extent to which government or the Fed can intervene.23 For example, with interest
rates at record lows, there is little more ammunition the Fed possesses to stimulate the economy
with monetary policy. Similarly, the federal government’s ideological polarization has led to
severe political constraints that limit the ability to stimulate the economy by adding to deficits.
In terms of economic policy, the period of the 2000s was very similar to the 1920s.24 The
1920s industrial and financial deregulation policy resulted in a housing bubble and industrial
concentration that led to a financial crisis that stimulated the protracted economic downturn of
the 1930s. In the 2000s, similar industrial and financial deregulation policy resulted in a similar
housing bubble and industrial concentration that led to a financial crisis that stimulated a
protracted downturn in its aftermath. These similarities suggest that there are clear policy
considerations that led to both economic downturns. While the 1931 bank crisis contributed to
making the 1929 recession a protracted – 43 month – depression, which resulted in a 96%
22 See Bruner and Carr, The Panic of 1907: Lessons Learned from the Market’s Perfect Storm , 2007[describing multiple conditions for the 1907 financial crisis].23 In September of 2008, the Fed held $480B of treasuries. By Q2 of 2010, the Fed held $2T of securities, including $1.2T in mortgage securities. In the first three quarters of 2010, Americans bought$200B of all debt securities and foreign holders bought $375B in treasuries. These actions have driveninterest rates to near zero.24 See Leuchtenburg, The Perils of Prosperity, 1914-32, 1993 [arguing that the conditions for the GreatDepression were sewn by adhering to laissez faire policies].
decline in the value of the Dow from 1929 to 1932, the 2008 banking crisis25 may be shown to
have made the 2007 recession a depression that led to a 53% decline in the value of the Dow
from 2007 to 2009, rivaling the worst post-war equity price decline in 1973-4.26
Although the composition of industry in 1930s America is not completely analogical to
the present situation, mainly because the country now enjoys a much larger27 and more
diversified economy, comparing the 2007-9 downturn to the recession of 1991 to 1992 is more
instructive. The real estate bubble of the 1980s led to a financial industry crisis that required
several years to deleverage debt and was accompanied by slow growth and a period of high
protracted unemployment. The economy did not substantially rebound until the fourth quarter of
1993, while real estate prices declined an average of five percent a year from 1990 to 1998 in
many cities. However, the financial and real estate bubbles of the 2000s were larger and more
pervasive than those in the 1980s – fed by both deregulation and Fed easing – suggesting a far
more substantial downturn from 2007-9 than in 1990-1.
While viewing GDP data alone provides an ambiguous interpretation, viewing strategic
industries such as real estate, automobile and manufacturing as well as trade data, which
collectively experienced thirty percent declines from 2007 to 2009, shows that the recent
economic contraction was particularly onerous. Similarly, when viewing the net worth data
declines, it appears that the downturn was much more severe than the GDP data show, indicating
25 See Murphy, “An Analysis of the Financial Crisis of 2008: Causes and Solutions,” SSRN, 2008[revealing the anatomy of the financial crisis]; Reinhart, C. and K. Rogoff, “Banking Crises: An Equal
Opportunity Menace,” NBER Working Paper W14656, 2009 [arguing that banking crises typically showsimilar patterns] and; Reinhart, C. and K. Rogoff, “Is the 2007 U.S. Sub-Prime Financial Crisis soDifferent? An International Historical Comparison,” NBER Working Paper W13761, 2008 [usinghistorical and international evidence to show common patterns of banking crises].26 Without aggressive Fed policy and U.S. government stimulus and TARP policy actions, the declinewould likely have been more severe.27 The U.S. income tax receipts in 1929 were $1.1B and in 1935 were about $500M. Even after factoringin inflation, when considering that the sources of federal government income were personal income taxes,corporate taxes and excise taxes, the size of the federal government in the 1930s was significantly smallerthan the present time.
How was this time different? The magnitude and duration of the downturn, the
international aspect of the downturn and the inclusion of the financial (bank and sovereign debt)
crises suggest that 2007-9 was substantially worse than any economic downturn since 1929-32.
The case for an economic depression from 2007-9 is reinforced by looking at both
empirical and policy data from 2001 to 2010 and by comparing the data to historical economic
downturns. The depth of the decline is registered in unemployment data, industrial utilization
data, trade data and real estate price data from 2007 to 2010. According to these data, the
economic decline was unequivocally greater than any post-war recession. The argument for
viewing the economic contraction as a shallow depression suggests that we are in a new
destabilizing period with a long tail of recovery.30
In the aftermath of the contraction phase, the long tail that characterizes the slow
recovery is notable because of a new post-contraction equilibrium phase characterized by
29
See Reinhart, C. and K. Rogoff, This Time is Different: Eight Centuries of Financial Folly, 2009[arguing that similar patterns of boom and bust are seen at different times and places].30 The argument for a continuous shallow depression sees the increase in factory production of the lasthalf of 2009 and the first half of 2010 as a period of inventory restoration that, once complete, will thenlead to a period of protracted demand decline that mirrors the experience of the early 1930s. Further, theGDP gains in the last half of 2009 are likely caused by the federal government stimulus and by arelatively weak dollar that artificially stimulated exports. However, this modest temporary increase ismore typically part of a period of protracted decline characteristic of a continuous deflationary (ordisinflationary) period.
The notion that the U.S. may witness a “double dip” recession of a second phase of GDPcontraction is consistent with the view of one single continuous event. The U.S. experienced one post-war “double dip” recession in 1980 and in 1981-1982. However, this period could also be characterized
as a single continuous event, with two stimulative components. The first cause was the Iranian oilembargo that raised oil prices by two to three times, thereby causing both contraction and inflation.Because of the high inflation, the Fed, in keeping with its inflation targeting strategy, raised interest ratesin 1981-2 so high as to stimulate the second phase of the recession. It is argued that these phases of aprocess were causal and continuous and thus a single event, not a double dip. Nevertheless, parts of Europe appear to be experiencing either a double dip recession in 2010 or one continuous depression. SeeBernanke, B. and M. Woodford, eds., The Inflation-Targeting Debate, 2006 [discussing the Fed’sinflation targeting strategies] and; Bernanke, B., T. Laubach, F. Mishkin and A. Posen, Inflation
Targeting: Lessons from the International Experience, 2001 [articulating the use of inflation targeting bycentral banks in the international context].
Each recession experienced a prolonged period of asset price deflation. In effect, each recession
was a solution to a period of abnormal price inflation.32
The 2000s real estate bubble was caused in part by an unusually protracted period of low
interest rates promulgated by the Fed to control the 2001 recession and by deregulation of
financial institutions in the aftermath of Glass-Steagall. However, the middle class from 2000-
2007 experienced slow employment growth (about two million, generally low quality service,
net jobs created mainly from 2003 to 2007) and a net after-inflation decline in real wages while
manufacturing was substantially off-shored. The considerable stress on the middle class in the
2000s set up a high-debt period that would lead to the intensity of the depth of the downturn,
much like the 1920s set up the conditions for the 1930s protracted contraction.
It is the extraordinary debt picture, and its deleveraging process, that set up the downturn
and slow recovery. The following figures show the debt data.
Figure 10
U.S. Debt by Sector
32 See Jagannathan, R., M. Kapoor and E. Schaumburg, “Why are We in a Recession? The FinancialCrisis is the Symptom Not the Disease,” NBER Working Paper No. W15404, 2009 [arguing that the coreproblems of the banking crisis are excess leverage that requires the deleveraging process manifest in arecession].
The U.S. trade data, shown in figure 15, reveal a persistent trade imbalance as U.S.
consumers spend more on products and services than they produce, thereby fueling more debt.34
The late 2000s real estate bubble deflationary process caused an equity price adjustment
and then an investment-bank run that affected overleveraged financial institutions.35 Somewhat
34 How long can the U.S. maintain $500B+ trade deficits? The majority of the deficits represent theacquisition of cars (Japan), oil (Middle East) and goods (China).35 The Lehman Brothers collapse was a trigger of market fear of risk taking after the U.S. governmentarbitrary decision not to cover all private hazard. Without public subsidization of all private risks, themarket naturally corrected. See Diamond, D. and R. Rajan, “The Credit Crisis: Conjectures AboutCauses and Remedies,” NBER Working Paper No. W14739, 2009 [ascertaining the origins of thefinancial crisis]; Krugman, P., The Return of Depression Economics and the Crisis of 2008, 2009[reassessing the conditions for economic crises]; Brunnermeier, M., “Deciphering the Liquidity and
reminiscent of the 1930s, the restructuring of the financial industry that began to occur in 2008
was a key factor in setting up the slow deleveraging process of the depression. For example, if
the banks were allowed to write off more of their real estate debts, the system would have likely
deleveraged debt far more quickly than it has. However, with a substantial amount of debt on
the books of businesses and consumers, and with a persistent deflationary real estate
environment in which millions of houses and commercial buildings were foreclosed, the
deleveraging process is more protracted than it would have been if the bank debts were
substantially written off in 2008.36
The Troubled Asset Relief Program (TARP) represented a political compromise in which
it was intolerable to rapidly write off public debt. The choice to slowly write off mortgage
related debt produced the present protracted deleveraging process. This political decision has
had, and will continue to have, significant ramifications akin to the Japanese lost decade in
Credit Crunch 2007-08,” NBER Working Paper No. W14612, 2008 [describing the credit crisis as aliquidity crisis]; Calomiris, C., “Banking Crises and the Rules of the Game,” NBER Working Paper No.W15403, 2009 [showing how banking policies change during banking crises]; Cassidy, J., How Markets
Fail: The Logic of Economic Calamities, 2009 [describing patterns of economic crises]; Rothbard, M., America’s Great Depression, 2005 [describing the economic policies responding to the conditions of theDepression]; Krugman, P., The Great Unraveling: Losing Our Way in the New Century, 2004 [arguingthat libertarian economic policies promote too much debt that eventually is deleveraged in an economicdownturn]; Cole, H. and L. Ohanian, “The U.S. and U.K. Great Depressions Through the Lens of Neoclassical Growth Theory,” American Economic Rev., 2002 [study of two nations’ remedies to theDepression]; Chancellor, E., Devil Take the Hindmost: A History of Financial Speculation, 2000 [historyof economic bubbles and recessions showing common patterns of financial speculation]; Garber, P.,
Famous First Bubbles: The Fundamentals of Early Manias, 2000 [history of economic crises from theSouth Sea bubble to the 21st century]; Romer, C., “The Great Crash and the Onset of the Depression,” The
Quarterly J. of Economics, 1990 [showing the 1929 stock market crash as a destabilizing event thatprecipitated the Depression] and; McElvaine, R., The Great Depression: America, 1929-1941, 1983[economic history of the Depression].36 See Krugman, P., “Financing Vs. Forgiving a Debt Overhang,” NBER Working paper No. W2486,1989 [presenting different arguments for policies to accelerate debt losses to promote rapid economicrecovery] and; Kessler, A., “TARP and the Continuing Problem of Toxic Assets,” WSJ, 2010 [describingthe monetary causes of the financial crisis and showing that the deleveraging process originated in TARPpolicy decisions].
which banks refused to write down real estate debt and suffered average annual real estate price
declines of 5% from 1990 to 2005.37
If we are in a protracted economic depression, we may not have definitive information
for another several years about persistent price declines. In other words, we may not have
enough data to determine whether we are in a more substantial depression or stagnation period at
the present time, akin to only seeing the first two to three years of the Great Depression. But if
we are in a protracted depression, the federal government and Fed stimulus policy are limited to
modulate the economy going forward, thereby complicating economic development.38
The argument that a steep downturn leads to a strong recovery – which has been the
general rule in post-war recessions – has not been actualized in the present period. For the most
part, the rate of debt liquidation appears to determine the rate of recovery. In effect, a sharp
contraction is the cure for the mania of the 2000s, wherein a deleveraging period is required to
re-equilibrate the economy.39
But the 2007-9 contraction period, like the periods of 1929-32 and the early 1990s, also
witnessed financial industry crises. In the current period, the financial industry is constraining
credit and thereby perpetuating the duration of the deleveraging process.40
This financial
37 See Schularick, M. and A. Taylor, “Credit Booms Gone Bust: Monetary Policy, Leverage Cycles, andFinancial Crises, 1870-2008,” NBER Working Paper No. 15512, 2010 [describing the history of post-Civil War economic cycles from a perspective of monetary policy]; Taylor, J., “The Financial Crisis andthe Policy Responses: An Empirical Analysis of What Went Wrong,” NBER Working Paper No.W14631, 2009 [an anatomy of policy options to solve the financial crisis]; Taylor, J. and J. Williams, “A
Black Swan In the Money Market,” NBER Working Paper No. W13943, 2008 [arguing that the smallprobability of catastrophe was not adequately measured in monetary risk analyses] and; Whalen, R., “TheSubprime Crisis: Cause, Effect and Consequences,” Networks Financial Institute Policy Brief No. 2008-PB-04, 2008 [analysis of the sub-prime mortgage market as a key cause of the financial crisis].38 See Mishkin, F., “Is Monetary Policy Effective During Financial Crises?,” NBER Working Paper No.W14678, 2009 [arguing the limits of monetarism particularly when it is needed most].39 See Minsky, H., Stabilizing an Unstable Economy, 1986 [showing the policy choices in economiccrises with a particular focus on monetary institutions].40 See Ivanshina, V. and D. Scharfstein, “Bank Lending During the Financial Crisis of 2008,” EFA 2009Bergen Meetings Paper, 2009 [showing the transformation of bank lending as the crisis evolved].
businesses. This extreme industrial stratification41 in the 2000s has similarities to the period of
the 1890s to 1920s of U.S. industrial development.42
It is this lack of government regulation that provides a similarity of the 2000s to the
1920s and suggests there is little the government can do to mitigate the depth of the downturn at
the present time. The theory that we are in a shallow depression similar to those in the 19th
century follows the view that the U.S. government did little to prevent 19 th century recessions
because of industry structure constraints and limited potential government stimuli.43
The prevailing logic is that Keynesian44 economic stimulus would add to the already
absorbitant deficits and restrict further stimulus actions. In other words, there is a perception
that, politically, there is little that the government can do to deal with the depth of the economic
downturn. Both the federal government and the Fed simply have no ammunition left in their
economic arsenal to stimulate the economy. This is particularly problematic if an exogenous
event occurs that plunges the economy into a new stage of decline, such as another Middle-
Eastern crisis.
According to the prevailing economic theory, then, the contraction occurred from 2007 to
2009 and could be mapped by “catastrophe” mathematical theory, while the technical “recovery”
began in mid-2009 and continues at a relatively slow pace. However, the data also seem to show
that a more substantial depression may be occurring in which the shallow depression of 2007-9
41 See Williamson, O., The Economic Institutions of Capitalism, 1998 [showing the market hierarchy of
industrial organizations] and; Williamson, O., Markets and Hierarchies: Analysis and Antitrust Implications, 1983 [showing how markets organize and evolve].42 See Porter, G., The Rise of Big Business, 1860-1920, 2006 [mapping the growth of corporations fromthe Civil War to the Progressive period] and; Prechel, H., Big Business and the State: Historical
Transitions and Corporate Transformation, 1880s to 1990s, 2000 [showing the complex relations of government and big business over the 20th century].43 This extreme industrial stratification is related to the increased, even symbiotic, relations of bigbusiness and the federal government in the 2000s.44 See Keynes, J., The General Theory of Employment, Interest and Money, 1936 [the classic economicwork arguing for activist government policy during economic crisis periods].
system. Because about 75% of jobs are created by small business, the challenges of business
entrants are especially prominent in a downturn. Particularly with constrained access to capital
and relatively higher energy and health care costs, small businesses are disincentivized to grow
and hire workers. High relative debt requires a period of time to deleverage, which is
detrimental to stable business and consumer activity. While consumers had too much debt prior
to the downturn – in fact, a record negative savings rate – they are now saving relatively too
much. With too much savings, consumers are not spending as much on goods, which further
prolongs the recovery.46 The sum of these factors suggests that the downturn’s contraction
period was complicated by debt deleveraging aspects more typical in economic depressions.
47
While some have argued that increased class stratification has caused the crisis,48 I argue
that class stratification is a consequence of a set of economic events rather than its cause. One
can argue that when 1% of the population has 23% of income (and .1% with 11%) the economy
is very stratified, but this is only a symptom of an economic system that configured industries
into cartels and that removed constraints on economic incentives for the top.49 This elite group
benefited from relaxation of taxes on the wealthy but also from the increasingly stratified
structure of organizations that is made possible in a global economy by increasing efficiency and
productivity from using technology and from offshoring cheap labor. It is argued that the
stratification of the elite classes is merely an indicator of the larger issue of the restructuring of
organizations within industries.
Figure 16
46 It is logical for Congress to consider instituting policies to promote savings so as to encourageinvestment in a primarily consumer-driven nation.47 See Shiller, R., Irrational Exuberance , 2001 [showing how investor over-confidence leads to bubbles].48 See Reich, R., Aftershock: The Next Economy and America’s Future, 2010 [arguing that stratificationcaused the 2000s economic bubble].49 See Saez, E. and T. Piketty, op. cit. and; Atkinson, T. and T. Piketty, op. cit. See footnote 1.
Median Family Net Worth by Percentile of Net Worth
Source: Federal Reserve
The distribution of net worth is shown in Figure 16. The top ten percent of families have about
ten times the net worth of the top 75-89.9% and about thirty times the net worth of the bottom
half of the population. This sort of stratification is reminiscent of the economic structure of a
Third World country.50
The lack of competition policy enforcement yielded a set of strategic industries – in
technology, communications, energy, pharmaceuticals and finance – that are extremely
concentrated. In most cases, there are only several mega-capitalized corporations in each
industry with large market shares, often with $100B or greater market capitalizations, and a few
relatively small or mid-sized competitors.51
This situation of extreme industrial concentration
lies at the end of a three decade period of merger activity that created a set of giant U.S.-based
50 The reader may be reminded of Swift’s Gulliver’s Travels (1726) in which those within the top 75-89.9% are able to live in “average” suburbia, those in the bottom half are the Lilliputians (one tenth thesize of the “average”) and those in the top 10% are the giants (ten times the size of the “average”).Pushing the analogy further, those in the top 1% are ten times larger than the giants and those in the topone percent of the top one percent are ten times larger still.51 See Porter, G., op. cit. and; Prechel, H., op. cit.
compensated earners of many organizations, there is a tendency to increase the instability of
organizations; it would appear that there is a natural tendency to find a balance between the
highest- and average-compensated workers.55
The economic polarization mirrored in such extreme industrial concentration is more
characteristic of a Third-World country, which typically has a financial institution, an energy
institution and a telecommunications institution, whether state-owned or a monopoly. The U.S.
has not seen this sort of industrial concentration or economic stratification in about 100 years.
Not coincidentally, this extreme gap between the wealthiest 1% and the median 50% has not
been seen since at least 1928, or, possibly, since the 1890s.
Though the economic stratification followed the industrial concentration, it was
exacerbated by the biased 2001 and 2003 tax cuts that accelerated the gap between the top 1%
and median income earners.
In particular, the financial industry is far too concentrated. Only a handful of companies
have combined 80% market share in some markets: Goldman Sachs, J.P. Morgan Chase, Bank of
America Merrill Lynch, Citigroup, Wells Fargo and Morgan Stanley. With Wachovia,
Washington Mutual, Merrill Lynch, Bear Stearns, AIG and Lehman Brothers acquired or
eliminated, the current configuration of financial institutions presents a dangerous obstacle to
future industrial growth. Furthermore, 40% of U.S. corporate profits in 2008 were attributed to
the financial industry, compared to about 15% in 1970.56 This suggests that the financial
55 See Rajan, R., Fault Lines: How Hidden Fractures Still Threaten the World Economy , 2010[suggesting the conditions for economic crises still lurk in the international system]. This view isreinforced by Rajan’s arguments about the skewed incentives of investment banking compensation rates.England and the EU elected to tax banker bonuses to realign private incentives with public duties.56 It is interesting that Wall Street compensation numbers for 2007, 2008 and 2009 do not show adownturn. For example, many Goldman Sachs Group “partners” get paid more than Fortune 500 CEOs,even in bad years. This promotes moral hazard, which ultimately requires public institutions to bail outthe risky bets of the financial institutions. It is surprising that shareholders allow such high executivecompensation. Private incentives need to be realigned with public duties. If the companies themselves
industry evolved to become a critical strategic industry. In effect, finance replaced
manufacturing in the U.S. economy. A thesis of this essay is that there are adverse effects of this
economic repositioning.
FDIC data show that American banks had $620 billion less in assets in mid-2010 than at
the end of 2008. Further, business loans in the period dropped twenty percent, from $1.49T to
$1.175T. A $600B drop in total loans from $7.996T to $7.395T is also shown. One of the
reasons attributed for the loan declines is that in 2009-10 U.S. government regulators (in
accordance with financial reform and the Basel II and III regimes) began to require greater bank
capitalization. With higher capitalization requirements, banks have less to lend. Therefore,
while the money center U.S. banks have substantial cash on their balance sheets ($185B for
Citibank, $172B for Bank of America Merrill Lynch and $72B for JP Morgan Chase in 2010),
they have smaller lending programs and higher lending standards at the precise time when
businesses need loans.57
Similarly, the consumer savings rate went from a historic low of below 1% before the
depression to 6% in 2010, suggesting that the pendulum for consumers had swung too far too
fast. The paradox of savings suggests that consumers should be spending cash in order to
increase demand for goods. Instead, they are saving and liquidating debt, thereby constraining
demand and protracting the recovery.
Evidence shows that the financial industry went from too lax credit policies to far too
restrictive policies in 2008. The after-effects of the financial crisis continue to affect the long tail
period of the economic recovery from the depression, but the financial industry configuration is a
cannot control this problem, the government should intervene, as the governments of England and the EUhave intervened to tax absurdly excessive banker compensation. It is neither logical nor moral for theU.S. to publicly subsidize losses while allowing the benefits of risky bets to be privatized.57 See Ivashina, V. and D. Scharfstein, op. cit.
major problematic source of restrictive competition that adds a capital layer between the Fed and
businesses.58
While the symptom of a financial industry layer that blocked liquidity also existed
in the 1990-1 recession, with adverse effects that prolonged the recovery, the present prolonged
tail of the depression is particularly affected by the adverse effects of the extremely concentrated
financial industry.
Much like the effect of the financial industry on the economy during Japan’s lost decade
in the 1990s, it is argued that the extremely concentrated configuration of the U.S. financial
industry is largely responsible for a slow deleveraging of real estate debt from the 2000s. Like
with Japan, the refusal to write down these loans has protracted the recovery. So far, in July of
2010, 14% of home loans were in foreclosure or delinquent. The inventory of homes was at an
all time high in 2010, at about 100K homes foreclosed per month, with the longest time-to-sale
period (i.e., one year or longer) since records were maintained. In effect, the refusal to write off
bad loans forces real estate prices down further. With a second round of housing declines in the
downturn in 2010, the rest of the economy may experience asset disinflation in 2010 and 2011
and, perhaps, a period of deflation.
Historically, employment gains are unlikely to come from large corporations. The
economic advantages of the wealthiest corporations have been reinforced by investment into
productivity enhancing technologies that allow for increased automation and a decreased need
for human capital. With reduced employment during the downturn, larger corporations are
outsourcing employment to lower cost countries and increasing the use of automation to increase
productivity of existing employees. Therefore, one would not expect the largest corporations to
be the greatest source of employment in the recovery.
58 A manifestation of the adverse effects of the financial industry layer is the refusal of banks toreorganize mortgage debt in accordance with congressional legislation. This problem of theunwillingness of banks to write down debt is a key source of continued housing market instability.
Rather, the greatest source of employment in the private economy will come from small
businesses. Traditionally, small and new businesses hire about 75% of total employees. Yet, the
strains to small business are particularly severe in the economic downturn.
While the increased industrial concentration and competitive pressures of small
companies are causes of the extreme U.S. economic stratification, the effects are limited demand
for goods and high unemployment. There are correlations of high unemployment with
constrained demand, on the one hand, and of high unemployment and the housing crisis, on the
other.
The 2000s witnessed a generally soft demand for employment that barely kept up with
population growth. Between 2003 and 2007 about two million net jobs were created,59 compared
to the 1990s, during which twenty two million net jobs were created. However, median wages
atrophied after inflation from 2000 to 2007; 2007 real median wages were actually marginally
lower than in 2000. The depression, however, knocked out over eight million jobs from 2008 to
2010. The data on unemployment are unarguably the worst since the Great Depression.60
In addition to having a relatively extreme unemployment rate, the employment picture is
extremely lopsided. Though college educated workers had a 5.6% unemployment rate in the
third quarter of 2010, those with less than a college degree, those over fifty years old or those
under 25 years old, particularly minorities, had a 15-25% unemployment rate. Children of color
had a stunning 25% or greater rate of being on food stamps. Moreover, some regions have a
59 Over eight million jobs were created from 2003 to 2007, but six million jobs were also lost in theperiod, mainly to offshoring.60 Including the underemployed and those that stopped looking, the Bureau of Labor Statistics states theunemployment rate of about 16.6% peaked in the first quarter of 2010. About five unemployed appliedfor each job opening on average, a record. The total unemployed in the 2007-9 depression were greaterthan the aggregate unemployed in the 1981-2, 1990-1 and 2001 recessions combined.
Given the ordinary economic equilibrium established in the post-war period, perhaps the
U.S. economy would not be suffering an economic downturn as significant as the one it
encountered in 2007-9. However, a critical destabilizing force in the global economy has been
the rise of China. China’s hybrid capitalist-mercantilist economic system and the present historic
period of industrialization and urbanization have had profound effects on industrialized
economies. If Japan’s rise was a “miracle” of economic growth from 1960 to 1990, China’s
quantum speed of growth from 1980 to the present can be characterized as similarly
phenomenal.
61
But China’s communist government has applied aggressive economic and
monetary policies to promote its domestic industries and manage rapid growth at the expense of
trading rivals. While the U.S. economic development of the 2000s experienced substantial
effects of China’s economic development, typically in moderately priced goods and lost
manufacturing jobs, the effects of China’s policies during the downturn were egregious.
In the 2000s, China used capital from trade surpluses to buy U.S. treasuries, effectively
financing our debt. This had the positive effect of keeping down U.S. interest rates. Further, a
weak yuan had the consequence of limiting inflation, which allowed the U.S. to maintain a
relatively lower inflation rate target regime. In an ordinary economic growth paradigm, low
prices for goods and low interest rates are optimal, but during the economic slump, there was
downward pressure on prices that produced disinflation and deflation. In the present period,
disinflation is protracted by the effects of China’s currency and trade manipulations.62 In a
61 Along with spectacular economic growth, it is interesting to observe China’s own extreme economicstratification, which is ironic in light of communist “egalitarian” political ideology. Nevertheless, despitestrong economic growth to parity with Japan, GDP per capita in China is only one tenth of Japan’s in2010.62 For much of the past two decades, the yuan was pegged to the dollar. However, as the yuan floats andthe dollar weakens, inflation will likely be transmitted. The main question remains as to the degree of theU.S. trade deficit (25% in 2010) that will result as a consequence of a strong yuan. There is a better than
period of slow economic growth, employment and wage growth are prominent problems; while
the U.S. experienced slow employment and wage growth during the 2000s period, it is
particularly problematic in the aftermath of the depression. Similarly, when the effects of
China’s economic manipulation on manufacturing was detrimental in the 2000s, it is devastating
in the period after the depression when the U.S. economy is experiencing economic growth so
slow that employment growth is not keeping up with population growth, thereby perpetuating an
unusually high unemployment rate. Consequently, while the new economic equilibrium that
resulted from the rise of China has resulted in benefits of cheap goods and low interest rates
during the moderate growth period of the 2000s, it has had disastrous consequences during the
slump and afterwards.63
The Chinese economic model has several features that result in unfair trade practices.
For example, China uses subsidized land grants, unusually cheap labor costs and low interest
loans to accelerate their export industries.64 Using Japan’s government-coordinated export
industrial policy as a model, the Chinese have turbo-charged economic subsidization with
systematic unfair trading practices. In addition to subsidizing land, labor and capital and
coordinating export industries, the Chinese tax imports so as to create protectionism. For
instance, automobile tariffs are 25%. Furthermore, the Chinese systematically pirate intellectual
property. In the case of the alternative energy industry, China requires companies that want
access to the burgeoning Chinese market to give up their intellectual property – the only
even chance, based on the experience of the strong yen in the 1980s that there will be little effect on theAmerican-Chinese trade deficit from a strong yuan. Compare the view of a floating Chinese currency tothe view that Americans should save more and the Chinese should consume more. The Fed’s Bernankehas echoed these sentiments in the past. See Roach, S., “Cultivating the Chinese Consumer,” NYT, 2010[arguing that a floating yuan may not matter to American consumers since their appetite for Chinesegoods is high].63 See Kaletsky, A., “Blaming China Won’t Help the Economy,” NYT, 2010 [arguing that the U.S.should find multi-lateral solutions to Chinese trade imbalances].64 See Bradsher, K., “China Takes Lead in Clean Energy, With Aggressive State Aid,” NYT, 2010[stating that China subsidizes its clean energy industry in opposition to WTO rules].
The U.S., Europe and Japan need to cooperate with China to adjust China’s present
policy practices so as to prevent a trade war. China must open its markets to foreign goods, it
must let its currency float on the currency exchanges, it must stop stealing intellectual property
and it must stop subsidizing its industries at the expense of foreign industries. A multi-lateral
solution to China’s aggressive economic policies is the preferred approach to this complex
economic problem, but a readjustment of the present equilibrium is necessary if the U.S.
economic recovery is to accelerate to post-war historic standards.
It is a likely scenario that China will gradually devalue the yuan. But this is a mixed
blessing for the U.S. Since China uses its surplus capital to buy U.S. treasuries, which allows the
U.S. to keep interest rates low, China will likely move to a basket of currencies to value the
yuan, away from a close dollar link. As the dollar weakens, and China’s dollar-denominated
investments fall, China will limit their losses by diversifying away from treasuries. Not only will
this transmit inflation to U.S. consumers who buy foreign goods with a weaker dollar, but as the
Chinese buy less U.S. debt, aggregate demand for U.S. debt declines and interest rates will move
higher. So far, the Chinese surpluses reinvested in U.S. debt have allowed the U.S. to enjoy a
subsidized reduction in interest rates in the 2000s. In the absence of these investments in our
burgeoning debt, the U.S. may experience an inflationary depression. U.S. policy with China
must therefore proceed cautiously in order to avoid over-reacting to trade imbalances.65 A
conflict with China will likely hurt American growth prospects at a particularly vulnerable time
in the economic recovery.
65 This view is somewhat between Gary Becker’s claim that the Chinese should let the yuan float andPaul Krugman’s claim that the U.S. should be much tougher with China. See Becker, G., “China’s NextLeap Forward,” WSJ, 2010 [proposing strategies for China in the future] and; Krugman, P., “Taking OnChina,” NYT, 2010 [proposing aggressive U.S. strategies to address the yuan undervaluation issue]. Weshould be careful what we wish for, in part since the Chinese have substantial power to manipulateeconomic factors that are not favorable to the U.S.
depression, the government response inadvertently initiated the financial crisis and limited its
damage.
Federal government intervention in the economy was crucial to limit damage once the
economic and financial crises were initiated. The TARP and stimulus legislation were
instrumental in preventing further catastrophe resulting from the financial crisis and economic
contraction. The central bank’s aggressive monetary actions were also critical to prevent further
declines during the crisis. These actions collectively constitute the paradigmatic Keynesian
policy responses to economic crisis.
However, the recovery in 2010 should be far more robust than the anemic sub-2% annual
growth based on a comparison to post-war recoveries. The stimulative effects of the federal
government and Fed actions should have had a greater effect so as to propel the economy into a
faster growth period. What went wrong? Viewed retrospectively, the size of the stimuli was
evidently insufficient.66 The deleveraging of debt in the financial industry in the aftermath of
TARP was inadequate to promote healthy growth. The Fed’s present policy of near-zero interest
rates are reminiscent of the Japanese67 lost decade, which experienced very slow growth amid a
protracted period of low interest rates because of a very slow debt deleveraging process. If the
government and Fed stimuli were sufficient, the economy would be on track for a robust
recovery reminiscent of all previous post-war recoveries. The depth of the downturn may have
limited the degree of the recovery as debt was slowly deleveraged through the system. In
retrospect, allowing a substantially greater amount of debt to have been written off from bank
66 See Tyson, L., “Why We Need a Second Stimulus,” NYT, 2010 [arguing for a need for furthereconomic stimulus].67 In retrospect, the cartel structure of the Japanese banking system was a key cause of the slowdeleveraging process. The oligopolous configuration of the U.S. banking industry appears to follow theJapanese.
balance sheets in 2008 would have allowed a more robust recovery, akin to all previous post-war
recoveries.68
The political and monetary policy options are now constrained.
The policies that got the U.S. into the deep hole of the financial crisis in 2008 were
clearly preventable. The anti-government conservative crusade in the 2000s had at least two
main components. The tax cuts were intended to stimulate the economy and the deregulation
was intended to promote competition. But the opposite occurred. The economy did not grow
rapidly in the 2000s relative to other periods. The period from 2003 to 2007 experienced a
dramatic restructuring of industrial configuration that was clearly anti-competitive, while the tax
cuts stimulated neither a significant increase in aggregate employment nor economic growth to
increase real median wages. Further, the depth of the downturn was largely caused by an
application of supply-side libertarian government policies and was thus preventable.69 Only
Keynesian government policies in 2008 and 2009 prevented a far worse economic decline.
While the 2000s policies contributed to the downturn, once the federal government and
Fed stimuli have worked through the system, the effects of further marginal stimulus on the
protracted economic recovery are limited. Much like the Japanese lost decade, the Fed is
constrained in its ability to control the economy, because of the limited number of arrows in its
quiver after the severe economic contraction period, and is thus unable to halt the long debt
deleveraging process.70 Like Japan in the 1990s, at near-zero interest rates, the Fed now has
limited ammunition with which to use if a future economic or financial shock is initiated. If the
68 See Kessler, A., op. cit. and; Krugman, P., “Financing Vs. Forgiving a Debt Overhang,” op. cit.69 One argument to illustrate the preventability of the extent of the downturn shows a counterfactual of the banking system. Both Canada and Australia maintained sound banking industry policies and did notexperience severe downturns as a result. The question remains as to whether U.S. financial industryreform is sufficient to prevent future crises.70 One constructive idea, however, is to allow the accelerated depreciation of losses, particularly in themortgage market.
Fed needs to be reactivated as economic growth rates become moderately higher in the coming
years, higher rates are improbable in the short-run.71
The only tools left in the Fed toolkit are to increase money supply and to buy debt, but
using these tools lead to a high risk of over-stimulating inflation and weakening the dollar. This
problem suggests that the Fed risks creating booms and yet may be constrained to limit busts.72
While there is considerable debate about the effects of government stimulus on economic
growth, one main economic theory that involves government stimulus policy originated with
Keynes in the Great Depression.73 In order to stimulate the economy, the Keynesian theory
recommends increased national government spending and extended tax cuts during an economic
downturn, adding to the federal deficit, while cutting federal spending and increasing taxes to
limit deficits during periods of economic growth.74 The main thesis is that in a severe downturn,
no one has the ability to spend except the national government because only the national
government has the ability to add public debt in the absence of a healthy private credit market.
While there is criticism of the idea of government spending during periods of economic growth
since it merely adds to the federal debt without providing a significant multiplier, the main
Keynesian idea is that during economic downturns the federal government has the ability to
spend to promote jobs and thereby diminish the extent of the private sector employment losses.
71 The elephant in the room is China. The effects of China’s trade and currency policies on the U.S. hadconstrained the Fed’s actions in the 2000s and may have contributed to an artificially low inflation period,while China’s policies going forward may aggravate the Fed’s stimulative actions. See the discussion on
China.72 See Rajan, R., op. cit.73 See Keynes, J., op. cit.74 There are two generations of Keynesian thinking, with New Keynesians integrating tax policy intomacroeconomics. See Romer, C. and D. Romer, “The Macroeconomic Effects of Tax Changes:Estimates Based on a New Measure of Fiscal Shocks,” Am. Economic Rev., 100, pp. 763-801, June, 2010[arguing for using tax policy for effective fiscal action]. However, even the 1937 U.S. tax increases thatstimulated the 1937-8 recession were well known as a problem. See Cogan, J., T. Cwik, J. Taylor and V.Wieland, “New Keynesian versus Old Keynesian Government Spending Multipliers,” ECB WorkingPaper No. 1090, 2009 [discussing different stimulus strategies for fiscal policy].
On the other hand, conservative economists have a preference of promoting tax cuts to
stimulate the economy.75
In the 1980s and 2000s, the hope was that the tax cuts would trigger an
economic expansion, but, much like giving sugar to a child, this stimulus was short lived as the
economy readjusted to the new equilibrium.76 There are limits of the effect of tax cuts. First, tax
cuts are optimized only when there is a federal surplus. In other words, cutting taxes makes
sense only in a period of sound fiscal policy so as to provide capital to the private sector to
stimulate growth. In an optimum scenario, tax cuts yield higher growth and marginally more
aggregate revenues to tax. Second, the tax cuts need to be equitable. Tax cuts for the middle
class are generally spent so as to increase demand, which increases economic growth, while tax
cuts for the wealthy are generally not spent since the wealthy do not need the extra small
percentage of income; rather, the wealthy tend to save the extra tax bonus, which is inefficient
since tax revenues are useful to balance the federal budget. This view of focusing on middle
class tax cuts is consistent with the neoclassical view of marginal utility in which one spends
capital only after a marginal equilibrium point. The view of the conservatives, however, in
pushing tax cuts for the wealthy, is to promote investment capital.77 To be effective, though, this
position requires a focus on specific types of investment, such as risky long-term research, or the
investment incentive promotes moral hazard that fuels bubbles.
75 See Alesina , A., “Tax Cuts vs. ‘Stimulus’: The Evidence is In,” WSJ, 2010 [arguing that tax cuts aresuperior to fiscal stimulus in affecting economic growth]; Boskin, M., “Summer of Economic
Discontent,” WSJ, 2010 [discussing different options for fiscal policy with an aim to optimize economicgrowth]; Feldstein, M., “Rethinking the Role of Fiscal Policy,” NBER Working Paper No. W14684, 2009and; Hubbard, R. and P. Navarro, Seeds of Destruction: Why the Path to Economic Ruin Runs Through
Washington, and How to Reclaim American Prosperity, 2010 [arguing that fiscal policy, particularlyKeynesian stimulus, is an inferior strategy for activating economic growth].76 Note that median real estate prices rose more than 10% a year over ordinary growth rates for threeyears in the 1980s corresponding to the tax cuts, stimulating inflation and creating a new priceequilibrium.77 This is why tax cuts biased to the wealthy, capital gains tax cuts and estate tax cuts are a three-fer forinvestors.
When used as a stimulus, then, tax cuts fit the Keynesian doctrine, because they are used
at a time of economic distress – and may be justified – in a long-term deficit in order to stimulate
the short-term economy. Contrarily, during times of economic growth, taxes should be tailored
to pay down the long-term deficit in conjunction with spending limits.
Nevertheless, the conservative economists focus on tax cuts in part to constrain the size
of government. With less capital from lower taxes, the government has fewer resources with
which to use; the idea is that government spending is a lower multiplier than the private
allocation of capital. In general, then, the argument is that smaller government promotes faster
economic growth.
78
While this may be true during an optimal period of economic growth, the
Keynesian response is that since only the federal government has the capacity to borrow during
periods of economic crisis, only government spending during a crisis will limit the downturn and
stimulate growth in the recovery period even when it enhances deficits.79 A patient takes
medicine when sick and exercises when healthy.
Although the U.S. provided tax cuts in the 2000s – biased to the wealthy with an aim to
stimulate investment – when the federal government had a surplus from the 1990s fiscal
austerity, this was a period to actually raise taxes, particularly on the wealthy, because of a need
to pay higher costs associated with two wars. In other words, the U.S. needed to limit spending,
reduce the deficit and adjust taxation correspondingly, but instead lowered taxes and increased
spending which contributed to an unstable fiscal period. Consequently, the tax cuts had the
adverse effects of higher deficits, increased stratification, diminished demand from constrained
78 See Reinhart, C. and V. Reinhart, op. cit., 2009 [arguing from international evidence that lowergovernment spending after an economic contraction, particularly after a financial crisis, results in a fasterrecovery period]. See also Reinhart, C. and K. Rogoff, “From Financial Crash to Debt Crisis,” NBERWorking Paper, 2010 [discussing the relations between the debt deleveraging process and the initialfinancial crisis].79 See Krugman, P., “Is Fiscal Policy Poised for a Comeback?,” Oxford Rev. of Economic Policy, 2005[arguing for a Keynesian approach to stimulating economic growth].
middle class capital availability and increased economic instability while the U.S. government at
the same time increased spending.
What is now needed are relatively modest tax cuts targeted to the middle class, which is
most likely to spend the bonus and which will then nominally increase economic demand. Once
the economy grows, then taxes need to rise on both the middle class and the higher income
brackets in order to limit the deficit. At the same time, federal spending needs to be constrained
after the economy recovers so as to further limit the deficit.80 In effect, a healthy economy
requires a balanced budget with constrained spending and moderate taxes. Balancing the federal
budget is especially challenging, however, in a period of economic decline, particularly at a time
when the states are strained with increased demands for services that have largely been shifted
from the federal government.
Supply-side tax policy, therefore, fits squarely in neo-Keynesian economic policy. The
application of the extreme approach to tax cuts used in the 2000s illustrates a politicization of tax
policy that allowed the upper class effectively to sack the treasury for personal benefit while
destabilizing the middle class and the general economy in the long-run.
In addition to tax policy, libertarian ideology promoted industrial deregulation that
affected competition policy with perhaps long lasting adverse economic consequences. If the
competitive configuration of industry is a major factor in setting up and protracting a downturn,81
then antitrust and patent laws are crucial for maintaining balanced industry competition. On the
80 See Lazear, E., “How to Grow Out of the Deficit,” WSJ, 2010 [advocating a creative “inflation-rateminus 1%” federal spending stratagem.] A derivative idea is “pay-go” minus 1%.81 It is interesting to note the extreme concentration of Japanese industry and the effects of oligopolousindustry configuration on Japan’s slow economic growth. One can make a similar case in Europe. Weak patents in both regions perpetuate incumbent market power and represent a contradiction to democraticcapitalism. Is the U.S. repeating these mistakes?
libertarian philosophy that have contributed to the economic policies of the 2000s and that these
led to the economic depression in 2007-9, much as a similar conservative economic philosophy
in the 1920s led to the Great Depression. Though there are two distinct waves of libertarianism
from Reagan-Bush in the 1980s that led to the 1990-1 recession and Bush II in the 2000s that led
to the 2007-9 depression, the present discussion is focused on the 2000s.
In general, the libertarian philosophy promotes laissez faire economics espoused by the
Chicago School.82 This view has several components. First, it promotes limitations on
government regulation with a goal to promote private competition. Second, it restricts
progressive taxation. Third, it removes the obligation for social programs from the federal
government and transfers them to the states and localities as much as possible. Fourth, it
advocates diminished government. Taken together, these principles represent a sort of social
Darwinism to promote a private economy. The main aim is to decentralize government to the
private sector with an aim to promote competition through incentives.83 Unfortunately, the
results have been reduced competition, enhanced stratification and increased economic stability.
One main supply-side economic idea is that by providing economic benefits to investors,
mainly through regressive taxation policies, a “trickle-down” from the wealthy to the middle
class will occur. That is, this view maintains that by providing policies that benefit investment
capital, businesses will hire more workers and the economy will flourish. However, classical
economics has shown that industrial development is contingent on demand, not supply alone, in
82 The “Chicago School” is the University of Chicago economics department, which, under theleadership of Milton Friedman, was honored by no less than 23 Nobel prizes in economics or over a thirdof these awards so far. Though there are several components of the Chicago School, the main thrustfocuses on monetarism and laissez faire economics. The Chicago School is often contrasted to theeconomic philosophies of Harvard University and the University of Cambridge (UK). Ironically, thoughReagan and Bush II embodied the Chicago philosophy, Obama actually taught, and maintains a home at,the University of Chicago.83 See Barro, R., “Obamanomics Meets Incentives,” WSJ, 2010 [arguing that private incentives aresuperior than Keynesian stimulus in activating economic growth].
The effects of the application of these extreme libertarian economic policies have been
far more negative than a single economic business cycle. The structural changes to the economy
from the implementation of libertarian policies are bound to have long-term adverse economic
consequences.
The conservative libertarian agenda represented a revolution of political ideology in the
1980s and 2000s. Yet, the libertarian economic philosophy turned out to be reckless and un-
strategic. Now, what is most needed is real “conservatism” – a new moderation – to solve a
broad range of problems. We need responsible economics more than ever. Finding these
solutions is our present challenge.
Failed Economics
Economics is not a science. Academic economists are technical specialists operating
within a quantitative paradigm since WWII. Economics did not predict the onset of the real
estate bubble, the burst of the bubble, the consequences on the financial industry, the
concentration of strategic industries, the effects of monopolization, the timing of events or their
collective consequences on the economy or society. One must question the connection, then,
between what economists do and the real economy.
On December 5, 2008, after the Lehman Brothers bank failure precipitated the global
financial crisis, the Queen of England, in a routine visit to the London School of Economics,
asked economists: “If these things were so large, how come everybody missed them?” After
months of analysis, in a letter to the Queen dated July 22, 2009, the economists replied in a
public mea culpa:
“Many people did foresee the crisis. However, the exact form that it would take and thetiming of its onset and ferocity were foreseen by nobody. . . . There were many warnings aboutimbalances in financial markets in the global economy. . . . But the difficulty was seeing the risk
to the system as a whole rather than to any specific financial instrument or loan. Risk calculations were most often confined to slices of financial activity, using some of the bestmathematical minds in our country and abroad. . . [T]hey frequently lost sight of the biggerpicture. . . . But against those who warned, most were convinced that banks knew what theywere doing. They believed that the financial wizards had found new and clever ways of
managing risks. . . . These views were abetted by financial and economic models that were goodat predicting the short-term and small risks, but few were equipped to say what would happenwhen things went wrong as they have. . . . There was a broad consensus that it was better to dealwith the aftermath of bubbles in stock markets and housing markets than to try to head them off in advance.
“. . . The failure was to see how collectively this added up to a series of interconnectedimbalances over which no single authority had jurisdiction. This, combined with the psychologyof herding and the mantra of financial and policy gurus, lead to a dangerous recipe. Individualrisks may rightly have been viewed as small, but the risk to the system as a whole was vast.
“So in summary, Your Majesty, the failure to foresee the timing, extent and severity of the crisis and to head it off, while it had many causes, was principally a failure of the collective
imagination of many bright people, both in this country and internationally, to understand therisks to the system as a whole.” (“Letter to the Queen: The Global Financial Crisis – WhyDidn’t Anybody Notice?,” July 22, 2009)84
Perhaps there was no experience for the current members of the economics profession to
such a substantial economic decline. Yet the 1980s and subsequent 1990-1 recession illustrated
an adequate dress rehearsal for the present downturn. Also, the experience of the 1920s and its
aftermath are clearly etched in the historical experience, with a clear repetition of economic
policies in the 2000s.
A plausible explanation for the lapse of the economics profession in anticipating the
economic downturn and financial crisis comes from understanding the ideological polarization of
the profession. The conservative movement, with its roots at the University of Chicago, has been
persuasive in convincing policy makers of the righteousness of the libertarian laissez faire
economics approach to political economics. There are times when this group focuses on its
ideological bias at the expense of sound economic principles. This may have been one of those
times.
84 As a program note, the British voters responded to the adverse economic conditions by electing aconservative biased coalition government, which instituted near-Draconian austerity measures to addressthe aftermath of the economic downturn.
as in the 1990s, consumers and businesses will have enough advance warning to plan and adjust
their expectations. But, after the recovery improves, a relatively smaller government86
and a
larger private sector are healthy for long-term economic growth.
The U.S. needs to control costs. The right wants to limit entitlements and the left wants
to limit defense. Both categories need to be reviewed. Foreign wars need to be reigned in since
we cannot afford them and they are at best strategically debatable. A ten to fifteen percent
decline in government spending is possible, and even necessary, over five to ten years. DOD can
be cut twenty to thirty percent (from a stunning $895B in FY 2011 – including veterans costs but
excluding supplemental war costs – equal to all other national defense budgets combined) and
improve readiness with increased automation and competition.
The U.S. needs to improve its infrastructure. The transportation and telecommunications
systems need to be updated. Infrastructure improvement is a long-term multiplier; one dollar
spent now gives several dollars of benefits over several decades.
Another area of needed infrastructure improvement is intellectual. The education system
requires a systematic rethinking. One controversial idea, which is somewhat realistic but
constrains the vision of American middle class opportunities, is to adopt the “tracking” system
used in Europe. At the middle school period, students are tracked for either vocational education
or college preparation. This would increase efficiency in the education system to allow us to
devote public resources to advanced kids that will propel the economy with a significant
multiplier. Another idea is to provide economic incentives akin to a GI plan for high school and
college students to excel. Perhaps we should stop teaching to the test and even reduce the
86 Most of FY 2011 federal government expenses are defense ($895B), social security ($774B), Medicare($829B) and welfare ($557B). While the goal is to increase efficiency with program cuts, the timing of this process is critical so as not to exacerbate the economy as it slowly recovers.
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