Tue, Feb 12, 2008 - Page 9 News List

Ending the debt delusion

The US economy must enter a new paradigm of productivity and demand that is tied to wages, not debt

By Thomas Palley

A second big interest-rate cut in a fortnight, along with an economic stimulus plan that united Republicans and Democrats, demonstrates that US policymakers are keen to head off a recession that looks like the consequence of rising mortgage defaults and falling home prices.

But there is a deeper problem that has been overlooked: The US economy relies upon asset price inflation and rising indebtedness to fuel growth.

Therein lies a profound contradiction. On the one hand, policy must fuel asset bubbles to keep the economy growing.

On the other, such bubbles inevitably create financial crises when they eventually implode.

This is a contradiction with global implications. Many countries have relied for growth on US consumer spending and investments in outsourcing to supply those consumers. If the US' bubble economy is now tapped out, global growth will slow sharply. It is not clear that other countries have the will or capacity to develop alternative engines of growth.

The US' economic contradictions are part of a new business cycle that has emerged since 1980. The business cycles of presidents Ronald Reagan, George H.W. Bush, Bill Clinton and George W. Bush share strong similarities and are different from pre-1980 cycles.

The similarities are large trade deficits, manufacturing job loss, asset price inflation, rising debt-to-income ratios and detachment of wages from productivity growth.

The new cycle rests on financial booms and cheap imports. Financial booms provide collateral that supports debt-financed spending. Borrowing is also supported by an easing of credit standards and new financial products that increase leverage and widen the range of assets that can be borrowed against. Cheap imports ameliorate the effects of wage stagnation.

This structure contrasts with the pre-1980 business cycle, which rested on wage growth tied to productivity growth and full employment. Wage growth, rather than borrowing and financial booms, fueled demand growth. That encouraged investment spending, which in turn drove productivity gains and output growth.

The differences between the new and old cycle are starkly revealed in attitudes toward the trade deficit. Previously, trade deficits were viewed as a serious problem, being a leakage of demand that undermined employment and output. Since 1980, trade deficits have been dismissed as the outcome of free-market choices. Moreover, the Federal Reserve has viewed trade deficits as a helpful brake on inflation, while politicians now view them as a way to buy off consumers afflicted by wage stagnation.

The new business cycle also embeds a monetary policy that replaces concern with real wages with a focus on asset prices. Whereas pre-1980 monetary policy tacitly aimed at putting a floor under labor markets to preserve employment and wages, it now tacitly puts a floor under asset prices. This is not a matter of the Fed bailing out investors. Rather, the economy has become so vulnerable to declines in asset prices that the Fed is obliged to intervene to prevent them from inflicting broad damage.

All these features have been present in the current economic expansion. Wages have stagnated despite strong productivity growth, while the trade deficit has set new records. Manufacturing has lost 1.8 million jobs. Prior to 1980, manufacturing employment increased during every expansion and always exceeded the previous peak level.

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