Over the past several weeks I've started several posts with titles like "Time for the Fed to Raise Rates", "Where are the adults?", "Time to cut the Deficit" and "Time to Stand up to the Chinese". Each time, however, I've thought about the facts and stopped. As I've stated many times before, the Dynamist tries to be a neutral observer of how the world actually is, not a prescriber of how the world should be. In a perfect world, I would like to see a more stable set of economic policies that promote balance and equilibrium. In the real world we have something very different: a volatile set of economic policies that try to promote long term equilibrium by shifts in short term disequilibrium. The US government adopts aggressive new policy imbalances to deal with old economic imbalances. The first step in developing an economic outlook is to assess the imbalances in the economy and to prioritize how and when they will get dealt with. As I have done so, I have come to the conclusion that our government is actually doing pretty well under the circumstances.
How we got here
The last 40 years or so have been a period of transition between the "old economy" and the "new economy". The new economy is the R&D-centric, globalized economy driven by technology, biotech and health care, financed by equity, based in the Northeast, parts of the Upper Midwest and the Pacific Coast. The old economy is the consumption-centric economy driven by automobiles, residential investment, petroleum, mass agriculture, mass media and retail, financed by debt, based everywhere but prominent in the Sunbelt and Rust Belt.
Government policy in the time of transition has been a hodge-podge that has favored both economies, allowing the new economy to thrive and supporting globalization, while continuing to heavily subsidize housing, petroleum, mass agriculture and cheap imports (with an overvalued dollar) and encouraging the over-production of automobiles. The US military subsidizes both economies, investing in new technologies and protecting the flow of oil from the Middle East.
So while some of the new economy innovations like derivatives and hedge funds helped us get into the mess we're in, the real problem has come in the collapse of the old economy. Securitized housing and consumer loans are what blew up the balance sheets of US banks. The other, lesser culprits for banking problems are the LBO loans made to buy old economy companies.
The way forward
The way forward is for the Obama administration to complete the transition. Policies meant to prop up the old economy, like "cash for clunkers", the homebuyer tax credit the use of now-nationalized Fannie Mae to effectively dominate the market for housing loans, will only offer short-term salves and cannot lead to sustainable recovery. There is no going back to the old housing, consumer credit and retail bubble.
Other Obama policies have encouraged the transition. The reduction of auto capacity makes sense, as does encouraging the move to hybrid and electric cars. The proposed consumer protection agency, the proposed reining in of financial system leverage and other financial market reforms should discourage consumer borrowing. Long term I would expect to see Fannie Mae dismantled and perhaps an end to the favorable treatment received by corporate borrowing over equity financing. The proposed cap-and-trade scheme, for all its flaws, would also encourage the move away from imported petroleum, the biggest source of our structural trade deficit. Even health reform, if it is structured in a way that doesn't stifle innovation, will be a benefit if it levels the health care playing field between small businesses and large corporations.
One of the core tenets of Dynamism is that the American people tend to elect the right government for the times. They will shift around control of the presidency and congress to adjust for imbalances that build up. The US system also leaves the opposition in a powerful enough position that they can help prevent excessive imbalances from building up. The American people were right to favor conservative economic policies over the past 30 years. They were also right to support Obama last year. At some point, when deficits become the most important problem, they will elect a Republican congress. That time is not likely 2010, however.
Thanks to the TARP, the Fed's "unconventional measures" and some deft maneuvering by Treasury, the financial system has been stabilized, although many of its underlying problems remain. Now that the financial system is stabilized, GDP can grow. GDP always wants to grow. GDP growth is driven by business competition, which leads to innovation, which leads to investment and hiring, and so on. Business competition gets interrupted when there are financial sector problems. In business competition, there are always businesses on the rise and businesses in decline. In good times, the declining businesses are shielded a bit from their core problems. In bad times those problems are magnified. Recessions accelerate the trends that are already in place. Thus the continued shift of employment from manufacturing to health care. After a bubble, however, a recession can also mark a major turning point. I would argue that we are witnessing a major turning point in housing, energy and retail.
Residential investment has been declining as a percent of GDP since 2005, while personal consumption expenditures as a percent of GDP have been flat. Because personal consumption is less volatile than business investment, it usually rises as a percent of GDP in a recession. As an aside, also notice that the big surge in consumption as a percent of GDP came during periods of supposedly "supply-side" tax cuts in the early 1980s and early 2000s (and late 1990s, with the cuts in capital gains taxes on equities and housing).
Clearly a key pillar of demand during the recession has been the government.
While residential investment as a percent of GDP has fallen by 2 percentage points since 2005, government spending has risen by the same amount. Government spending is now back up to the levels of the 1980s and still below the levels of the 1950s and 1960s. Going forward, increased infrastructure and health care spending will likely be offset by decreases in spending on the wars in Iraq and Afghanistan and by state and local governments, meaning that government spending will likely remain in the 21% of GDP range for the intermediate term.
Where I'd like to see the next wave of demand come from would be exports.
The drag of net imports has been reduced by more than 3 percentage points of GDP since 2005, but this has been driven more by the collapse of imports than by an increase in exports.
The key will be to see if exports start increasing as a percent of GDP while imports are stable or declining. As I've said many times before, a sustained reduction in our trade deficit or the creation of a trade surplus driven by export gains would be the most effective and least painful way to reduce US public and private indebtedness.
Once the recovery has clear traction, business investment should recover.
Business investment as a percentage of GDP is at the lowest level since recessions in the 1950s, a period when business investment was effectively suppressed by government policies. The recovery in investment is likely to be "U" shaped, like in the early 1990s. I expect stabilization by the fourth quarter of 2009, but no real sustained increases until late 2010 at the earliest.
In summary, when examining GDP during the upcoming expansion, look for the following:
- An increase in the share of GDP by exports and government near term and exports and business investment long term.
- A decrease in the share of personal consumption and imports short term.
- If the short term pillars of economic growth are going to be exports and government spending, then expect to continue to see budget deficits, low interest rates and a weak dollar.
- Interest rates won't really need to rise until business investment gains traction. When it does, inflation and interest rates will rise, and the American people force the government to focus on cutting the budget deficit.
- The likely policy mix to both fight the budget deficit and discourage trade deficits while encouraging domestic business investment will be to raise taxes on the rich, but increasing the amount that can be saved tax-free, effectively creating a progressive consumption tax.
We should also expect to see a reformation of the corporate tax code, lowering rates across the board while eliminating some of the subsidies for old economy industries.