We are flailing economically. No question about that. Sadly, no one has any good answers for what to do about it.

Sometimes, there's just not that much to do. We just have to ride it out.

The immediate economic problem is quite simple. There is a gigantic hole in the economy where real estate investment used to be. The chart below pretty much sums it up.

Source: Economy.com, calculations by tylernewton.com

As a percent of GDP, business investment has snapped back nicely and has returned to a relatively normal level. As I mentioned in my previous post "Momentum is Building", I think we are likely on the front end of a powerful investment cycle for business investment.

Real estate investment, on the other hand, has cratered to by far the lowest level recorded since World War II.

Enter John Maynard Keynes

The Keynesian economic solution would be for the government to step in and fill the hole in demand (1) by supporting consumption with lower taxes and transfer payments and by (2) directly investing in infrastructure and other public works. The government has done plenty of number (1), which is why our deficit is so large, and not enough of number (2).

What people forget about Keynes was that he advocated withdrawing stimulus and running surpluses when the economy is strong. Instead, the "Keynesians" that have been running our economy since World War II (and that includes both political parties) have made stimulus a permanent feature of our economic policy. Overall it worked great…until 2008.

As a result, we have run up huge debts in all sectors of the economy (government, financial, consumer, business).

Source: Economy.com, calculations by tylernewton.com

And have gotten to the point that government transfer payments and health benefits are equal to about 20% of GDP.

Source: Economy.com, calculations by tylernewton.com

Even more disturbing, if we total transfer payments and investment income (dividends, interest and rental income), non-work income equals 35% of GDP, while work-related income (wages, salaries and proprietor's income) equals only 50% of GDP. This is a classic sign of potential national decline, when more and more income flows to the upper "rentier" class and the government mollifies the masses with transfer payments.

This trend can also be seen as fewer people of working age are even participating in the labor force (working or looking for work).

Source: Economy.com, calculations by tylernewton.com

Generational imbalance

It gets worse as time goes on. As the baby boomers retire, transfer payments will take up more and more of GDP, particularly health care payments, but also Social Security and unfunded pension benefits.

Source: "Where's Your Budget Mr. President?" by Paul Ryan, Wall Street Journal, 8/3/11

As can be seen above, if left unchecked government health care spending will continue to gobble up more and more of GDP. The chart above assumes that the rest of the government actually shrinks as a percent of GDP.

So while in the short term today's Keynesians are right, in the long term they are wrong. Our budget deficit is hovering around 10% of GDP, and we still can't stimulate growth. In addition, even though we supposedly have insufficient demand, we are running a trade deficit of 4% of GDP. In other words, even with 9% unemployment and only 76% industrial capacity utilization we consume 4% more than we produce.

We can no longer have a smaller and smaller portion of the population earning a smaller and smaller proportion of income and expect the country to thrive. The welfare state needs to be scaled back to make room for more productive activity.

Seeking American Renewal

While the Republicans are right to focus on scaling back the welfare state, they do not have a good plan for fostering future growth. Scaling back government spending will cut back demand, and the coincidence of super-low interest rates with deficits of 10% of GDP and strong money printing prove there is extremely weak demand for investment capital. It is therefore unlikely that private investment has been crowded out by government deficits.

In the big picture, Obama actually articulates a more credible vision than the Republicans for long term growth…less focus on consumption, imports and residential real estate, more focus on savings, exports and investment, focus on infrastructure investment, technology, education, health care and reducing our reliance on imported oil. His execution, on the other hand, has left a lot to be desired. He was elected to help rebuild the economy and instead dissipated his political capital on his health care bill. Only time will tell if that was the right call or not.

While our political culture is raucous and messy, they are slowly getting it right. Cut back the welfare state, allow private investment to grow and eventually throw the government behind a new growth plan. The focus should neither be on further increasing the returns to investment (the Republican plan) nor on increasing transfer payments (the Democratic plan). We need a plan that gets more people working and making more money. (More on that in a later post.)

In the meantime, all we can do is wait for the real estate downturn to play out before we fire on all economic cylinders again. Until that time, the "Rounded Bottom" scenario holds.