From the February 2011 issue of Research Magazine • Subscribe!

February 1, 2011

Less Pain, Less Gain

The U.S. government has opted to soften the recession’s blow at the expense of healthy growth over the long term.

The economic downturn that started in 2008 and is stretching into 2011 has been the deepest and the most protracted in U.S. economic history since the Great Depression. But since its severity didn’t match that of the early 1930s, it has been called merely the Great Recession.

It has been a severe slump by almost any measure, in terms of human misery and financial losses. Some 8 million jobs have been lost since the start of 2008, and members of three graduating classes of high school and college students have had major trouble finding jobs. The unemployment rate reached 9.2 percent in December, and the rate of underemployed Americans, those who work part time but would like to increase their hours and earnings, rose to 9.3 percent. Together, nearly one-fifth of the workforce are unable to find satisfactory work. The prices of homes, which represent the largest asset of most American families, dropped by a quarter nationwide, based on the Case-Shiller index, and declines in the worst impacted regions of the country have been far worse.

Too Little Pain

However, I would argue that the current problem with the U.S. economy has been not too much pain, but, on the contrary, far too little of it. The reason why we have not been able to shake off the doldrums and to resume growth is that politicians and the nominally independent (but actually finely attuned to political reality) U.S. Federal Reserve have prevented a more severe downturn. One ramped up deficit spending and the other printed massive amounts of dollars and keeps buying Treasury bonds directly from banks to make sure that the government is able to fund its spending.

The Republicans in Congress are complaining about sky-high federal debt after a string of $1 trillion-plus deficits. Ron Paul, a Texas Republican and the new chairman of the House Subcommittee on Domestic Monetary Policy, has been an outspoken Fed critic. But the truth is that spending to counteract the spreading recession began as early as in fiscal 2007-2008, under George W. Bush. As to the Fed’s profligacy with money, it dates back even earlier, and the main culprit, Alan Greenspan, was appointed Fed chairman by Ronald Reagan and reappointed by two Republican and one Democratic President.

What we are seeing in the Great Recession is the continuation of a bad old habit: a willingness to use fiscal and monetary policy to play games with the economic cycle in order to lessen near-term pain for voters. Playing games with the cycle, however, can only come at the expense of the longer-term health of the U.S. economy.

Economist Joseph Schumpeter famously wrote about capitalism’s creative destruction, the ability of entrepreneurs to create and then destroy wealth in order to create it anew. According to Schumpeter, it is the driving force of economic progress. Economic downturns are an important prerequisite for creative destruction and rejuvenation of the economy, as well as a hands-off attitude on the part of the government, which has to allow such processes to take place unimpeded. An economic slump puts inefficient producers out of business allowing more efficient ones to thrive.

When the Internet bubble popped back in 2000, the Fed prevented a true correction in the economy, lowering interest rates to an extremely low level and keeping them there through the ensuing recovery. Easy credit, in turn, inflated a massive bubble in the U.S. real estate market. At least the government back then didn’t step in to save thousands of fly-by-night Internet companies which emerged from the information technology revolution, so that the few more efficient survivors, such as Amazon and eBay, were able to thrive in a suddenly open marketplace.

In the 2008 downturn, on the other hand, Washington chose to rescue troubled U.S. automakers General Motors and Chrysler. GM has since returned to profit, and the Obama Administration is taking credit for what it reckons was more than a million jobs it saved by pumping money into the company.

The government also points out that it will not only get back all the money it spent on rescuing GM, but may even turn a profit on its investment.

But solving one problem, the government has created another for the future. With the artificial resuscitation of GM the automotive industry will continue to be plagued by worldwide overcapacity, estimated by industry experts at around 30-40 percent. A stronger GM means a weaker Toyota, Nissan, Fiat or Renault. No doubt governments in Japan, Italy or France will also step in to support their carmakers once they are faced with bankruptcy, and Uncle Sam, for one, will not be able to object. In the end, there will be a back-and-forth of profits and losses among producers. Moreover, the jobs saved by the government rescue of GM — which in reality were probably far fewer than 1 million, because a competitor would have likely purchased parts of the bankrupt company and gone on producing — might now be lost at more efficient Toyota or Honda plants, some in the United States.

In short, the government shouldn’t be lauding itself for its business acumen. If GM was worth saving, some other automotive company would have invested in it long ago. But potential investors with deep pockets probably realized that by saving GM they would have cannibalized their own sales. Allowing GM to self-destruct, on the other hand, would have greatly rewarded more efficient producers, such as Ford. This way, Washington may be back in the automotive business soon, this time to bail out Ford.

New Bubbles

The real problem of the Great Recession is that the U.S. economy has run out of sources of growth. The old ones stopped working; they actually did so about a decade ago, and the economy was kept growing by a combination of unfunded tax cuts (and the resultant deficit spending) and the real estate bubble. It was a giant Ponzi scheme and it is only natural that it eventually collapsed.

Instead of allowing the bubble to burst fully, the White House and the Fed have been busy inflating it even more. On the one hand, fiscal spending and U.S. government debt continue to grow, creating an unsustainable bubble in the Treasuries market. That investors will sooner or later dump Uncle Sam’s bonds has been demonstrated in Europe, where highly indebted Greece, Ireland and Portugal have been brought to the brink of default and are paying as much as 12 percent on two-year notes.

At the same time, the Fed is allowing banks to neglect their core function — channeling savers’ assets to investors — and to engage in speculation, which got us into the financial crisis in the first place.

The new Ponzi scheme works as follows. Banks are refusing to lend to businesses and consumers, and the Fed is keeping interest rates low and is engaging in quantitative easing to pump liquidity into the banking system in order to induce banks to resume lending. But banks still have no desire to lend because it is a low-margin, capital-intensive business. Since mortgages can no longer be turned into mortgage-backed securities and sold off to investors, a bank now has to hold them on its books for 30 years, bear the risk and get a 5 percent interest for its troubles.

Instead, banks could take the free money from the Fed and invest it into the same Greek government bonds, which pay 12 percent a year. It is speculation, of course, but returns are high and, by rescuing big banks in 2008 and 2009, Uncle Sam has put the markets on notice that those banks are too big to fail even if they suffer massive speculative losses.

This is an excellent example of how, by pursuing the path of least political resistance, the government and the Fed are creating a wrong set of incentives for companies and financial institutions.

In other words, the U.S. government has opted for less pain in the short run at the expense of healthy growth over the long term. Growth can only come from the private sector, from ideas that individuals and companies develop under the conditions of free market competition.

But even preserving the status quo doesn’t work over the long run. Consumers are still overstretched and indebted, and the government will sooner or later have to cut its spending sharply. The most likely medium-term prospect for the U.S. economy is sluggish, jerky growth with a considerable risk of another slump.

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