The Root of the Problem

The story of the current economic collapse has its roots with a group of economists in the 1980s who believed they were smarter than the rest of the world.  When Ronald Reagan assumed the Presidency in 1981 he promised a dramatic change in the structure of the American economy.  Reagan’s economic policy had four primary components:

1. Lower the Marginal Tax Rates for both labor and capital
2. Lower the growth of government spending
3. Reduce government regulation to encourage economic activity
4. Eliminate the Keynesian policy of manipulating the money supply

By the mid 1980s it became clear they had succeeded in only half their goals.  They had reduced the tax rates (or more specifically readjusted where the taxable income was coming from) and reduced government regulation.  They were never successful reducing government spending and the end result was skyrocketing budget deficits.  What some economists discovered in the mid 1980s was that the balance of payment deficits were not a problem.  They could achieve solid economic growth rates regardless of the deficits.  The new philosophy that began to percolate through Republican economic strategists was that deficits were becoming meaningless.  Politicians and pundits could make it a major issue but the borrowed money was fueling both investment and spending and boosting economic performance.

The deficit turnaround in the late 1990s was viewed as confirmation of this new strategy.  President Clinton became the beneficiary of the economic model pioneered in the 1980s. The investment infrastructure developed during Reagan/Bush bore its fruit with explosion in computers and telecommunications. When George W. Bush assumed the Presidency the same economic policy from the 1980s was renewed.  In recent years conservatives criticized the Bush economic policies as a betrayal of the Reagan policies.  Rather than a betrayal, the Bush policies  were identical to those of the 1980s.  G.W. Bush policies were simply Reaganomics on steroids.   There was an acknowledgment that the best they could do with government spending was manage the growth.  This; however, was no longer a primary concern because the net result of tax cuts without spending cuts would only produce the deficits they no longer feared.

The key to the steroid strategy was the globalized world economy.  In “old” economic models deficits were funded by domestic financing.  Governments would sell their treasury notes to domestic banks and investors.  In the old world this would cause a drain on the economy as government spending was never as efficient as private sector spending.  With the new model the investment dollars were coming from overseas.  Foreign investors were pumping the money into the U.S. economy.  Deficits and credit were actually bringing more money into the economy.

By 2004 it was clear that the traditional dichotomy  between “conservative” and “liberal” economics had been superseded by this “third way.”  The new economics were rewriting and transcending the rules, or so they thought. Three significant economic trends were being ignored by the new geniuses and they would come back to bite them in the ass. The first was the decline in real earnings (real wages adjusted for inflation).  The trend began in the mid 1970s but became an entrenched component of the American economy in the 1980s.  The economic growth was increasingly top heavy and the American public was simply not seeing income growth.  Defenders of the new model, such as Newt Gingrich, would argue in 2006 that this was not important as what consumers owned was greater now and this was the only thing that was relevant.  In 2006 Gingrich pointed to an overall net worth gain as a demonstration of the validity of the new model.

In a 1999 book titled “Myths of Rich & Poor: Why We’re Better off Than We Think,” authors W. Michael Cox and Richard Alm explained the new model:

“The kernel of truth … is that the hourly wage, adjusted for inflation, has fallen nearly 15 percent since 1973. The answer: So what? The only measure that truly counts is what we can buy for the amount of time we spend working. In those terms, prices on the whole have been and continue to be steeply declining. "The statistics on consumption - the most direct measure of Americans' well-being - point to a nation that's better off now than at any other time in its history,"

The “new model” and its proponents were exposed in 2007 because of the other two trends they tried hard to ignore.  In addition to the decline in real earnings there was also a consistent decline the savings of Americans and an increase in consumer debt. Americans were not earning more, they were just spending more.  If Americans could be labeled as being better off they owed it to their credit cards more than to their employers or the strength the labor market.

Furthermore, 77% of consumer net worth gain that Gingrich touted was related to real estate.  Most of the balance was tied to stock value increases.  In other words, personal assets grew not because earnings increased, but because of speculation.  The collapse of the real estate and stock market erased all the gains and essentially discredited what was left of the “new model.”  In 2009 the Cox-Aim book would be more aptly titled “Why We’re Worse off Than We Think.”  The “new model” was simply a mirage and the proponents who thought they were smarter than everyone else turned out to be just fast-talking snake oil salesmen.

Climbing out of the Abyss

Resuscitating the comatose economy requires understanding the magnitude of the problem and then applying textbook policies to rework the economy and erase the effects of Reaganomics.  The biggest hit to the economy was obviously the real estate market collapse.  Far more than the stock market decline, the loss of real estate value simply erased trillions of dollars from the economy.  At last count it was more than $6 trillion.  This is money that basically disappeared.  Unlike the stock market decline, where there money isn’t lost to the economy but simply moved out of the market.  (Trades have winners as well as losers).  Real estate is a different issue.  When the market declines there are no winners (except those that can reap the benefits of buying low after the collapse).  Since the summer of 2008 the Federal Reserve has pumped approximately $2 trillion into the economy.  This turns out to be only a fraction of what is actually needed.  Even Obama’s “massive” stimulus program doesn’t approach the actual amount needed to stabilize the free fall.  The reason inflation is at extremely low levels and consumer confidence at historic lows is because there is not enough money in the economy.

The path back to stability requires either getting serious about Keynesian economics or reinventing the economy in a more traditional, conservative approach.  With the Keynesian model the amount pumped into the economy through government action has to match (actually surpass) the amount lost.  President Obama’s stimulus is just a drop in the bucket.  The conservative approach means some hard lessons for American consumers and requires getting back to a more stable environment where spending matches income.  Whatever the case, anyone that tries to revisit or promote the Reagan/Bush/Bush “new model” should be quickly routed to Gitmo.  There may be a reason to keep the prison camp open after all.