The Dismal Economist’s Joyless Triumph

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Project SyndicateI have long been forecasting that it was only a matter of time before America’s housing bubble – which began in the early days of this decade, supported by a flood of liquidity and lax regulation – would pop. The longer the bubble expanded, the larger the explosion and the greater (and more global) the resulting downturn would be.

Economists are good at identifying underlying forces, but they are not so good at timing. The dynamics are, however, much as anticipated. America is still on a downward trajectory for 2009 – with grave consequences for the world as a whole.

For example, as their tax revenues plummet, state and local governments are in the process of cutting back their expenditures. American exports are about to decline. Consumer spending is plummeting, as expected. There has been an enormous decrease in (perceived) wealth, in the trillions, with the decline in house and stock prices. Besides, most Americans were living beyond their means, using their houses, with their bloated values, as collateral. That game is up.

America would be facing these problems even if it were not simultaneously facing a financial crisis. America’s economy had been supercharged by excessive leveraging; now comes the painful process of deleveraging. Excessive leveraging, combined with bad lending and risky derivatives, has caused credit markets to freeze. After all, when banks don’t know their own balance sheets, they aren’t about to trust others’.

The Bush administration didn’t see the problems coming, denied that they were problems when they came, then minimized their significance, and, finally, panicked. Guided by one of the architects of the problem, Hank Paulson, who had advocated for deregulation and allowing banks to take on even more leveraging, it was no surprise that the administration veered from one policy to another – each strategy supported with absolute conviction, until minutes before it was abandoned for another. Even if confidence really were all that mattered, the economy would have sunk.

Moreover, what little action has been taken has been aimed at shoring up the financial system. But the financial crisis is only one of several crises facing the country: the underlying macroeconomic problem has been made worse by the sinking fortunes of the bottom half of the population. Those who would spend don’t have the money, and those with the money aren’t spending.

America, and the world, is also facing a major structural problem, not unlike that at the beginning of the last century, when productivity increases in agriculture meant that a rapidly declining share of the population could find work there. Nowadays, increases in manufacturing productivity are even more impressive than they were for agriculture a century ago; but that means the adjustments that must be made are all the greater.

Not long ago, there was discussion of the dangers of a disorderly unwinding of the global economy’s massive imbalances. What we are seeing today is part of that unwinding. But there are equally fundamental changes in the global balances of economic power: the hoards of liquid money to help bail out the world lie in Asia and the Middle East, not in West. But global institutions do not reflect these new realities.

Globalization has meant that we are increasingly interdependent. One cannot have a deep and long downturn in the world’s largest economy without global ramifications. I had long argued that the notion of decoupling was a myth; the evidence now corroborates that view. This is especially so because America has exported not just its recession, but its failed deregulatory philosophy and toxic mortgages, so financial institutions in Europe and elsewhere are also confronting many of the same problems.

Many in the developing world have benefited greatly from the last boom, through financial flows, exports, and high commodity prices. Now, all of that is being reversed. Indeed, it is the ultimate irony that money is now flowing from poor and well-managed economies to the US, the source of the global problems.

The point of reciting these challenges facing the world is to suggest that, even if Obama and other world leaders do everything right, the US and the global economy are in for a difficult period. The question is not only how long the recession will last, but what the economy will look like when it emerges.

Will it return to robust growth, or will we have an anemic recovery, à la Japan in the 1990’s? Right now, I cast my vote for the latter, especially since the huge debt legacy is likely to dampen enthusiasm for the big stimulus that is required. Without a sufficiently large stimulus (in excess of 2% of GDP), we will have a vicious negative spiral: a weak economy will mean more bankruptcies, which will push stock prices down and interest rates up, undermine consumer confidence, and weaken banks. Consumption and investment will be cut back further.

Many Wall Street financiers, having received their gobs of cash, are returning to their fiscal religion of low deficits. It is remarkable how, having proven their incompetence, they are still revered in some quarters. What matters more than deficits is what we do with money; borrowing to finance high-productivity investments in education, technology, or infrastructure strengthens a nation’s balance sheet.

The financiers, however, will argue for caution: let’s see how the economy does, and if it needs more money, we can give it. But a firm that is forced into bankruptcy is not un-bankrupted when a course is reversed. The damage is long-lasting.

If Obama follows his instinct, pays attention to Main Street rather than Wall Street, and acts boldly, then there is a prospect that the economy will start to emerge from the downturn by late 2009. If not, the short-term prospects for America, and the world, are bleak.

Joseph E. Stiglitz, professor of economics at Columbia University, and recipient of the 2001 Nobel Prize in Economics, is co-author, with Linda Bilmes, of 'The Three Trillion Dollar War: The True Costs of the Iraq Conflict'.

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