The Economic Crisis Explained

Pam at Notesalongthepath asked me when I would post something explaining the current economic crisis.  I’ve done so many posts about the economy I assume I had one that explained my view of what is happening, but there really is no one clear post laying it out.  So I’ll attempt here to explain just what’s going on, why, and why it’s not likely to get better anytime soon.

In 1980 the US economy entered its worst post-war recession, one that would last until 1983.  The pain was real — high unemployment, high interest rates to fight inflation, and major manufacturing sectors going out of business, most notably the steel industry.   Nonetheless, the economic fundamentals were not all that bad.  The US government had gone from total debt of 120% of GDP at the end of World War II to only 30% of GDP, budget deficits were small, and the US ran a current accounts surplus, meaning that we were a net investor in the world.   The US could have responded to that recession by saving the manufacturing sector and investing in national infrastructure.   Instead, the Reagan Administration made a series of bad decisions, starting a process that would yield increasingly unsustainable economic imbalances for the next thirty years.

First, the recession was ending in 1983 due to a dramatic drop in oil prices, which stimulated the economy.  The oil price drop also eased inflationary pressures, allowing interest rates to go back down.   All other things being equal, we were going into a clear recovery.  Yet the Reagan administration increased budget deficits radically.   Total debt went from 30% of GDP in 1980 to 60% of GDP by 1990.   This hyper-stimulated the economy, creating an illusion of economic prosperity — you can think of the country as the equivalent of a family whose costs are declining but yet spending beyond their income through increased credit card debt.

Second, believing in the free market, the Reagan Administration allowed industries like the steel industry and manufacturing jobs to die out, to be replaced by jobs supposedly fitting our comparative advantage.   It was thought these would be high tech jobs that would benefit our advanced economy, but it turned out to be mostly service sector jobs, often in the financial industry, which did not produce any goods.   We started consuming more than we produced, as our current account went into deficit.

A current account deficit (not to be confused with a budget deficit or debt) means that we take in more from the rest of the world than we put back.  For us, this was mostly a trade deficit.  You can’t do that unless this is financed by foreigners buying US assets — property, bonds, stocks, currency, etc.    In this case China, Japan, and the Arab world were willing to buy US bonds and currency.  They trusted the dollar and thought these were good investments.   More importantly we were purchasing goods from them, and they knew the money would cycle right back to their economy, bolstering their industrial sector.  For China especially this was a win-win situation — they get a stake in the US economy, and we use that money to buy their goods, further stimulating their economy.   At this point China has over $1 trillion of US assets, and the US relies on China to help finance the deficit.  If China wanted to, it could launch a crippling blow to the US economy.   That would hurt China too, but if you ever wonder why the US doesn’t ever really pressure China, this is the reason.   In vulgar terms, they have us by the economic balls.

The current account deficit becomes a problem at 3% of GDP.  The US hit that by 1990 and it kept growing.   We kept consuming more than we produced.   Moreover, the country as a whole went into debtor mode.   Saving rates dropped, personal debt (credit card and otherwise) increased, to the point that now the country is about $60 trillion in debt if you take all sectors into account.  Credit card debt alone is $1 trillion.  Savings rates hit zero in 2006.   Some economists sounded alarms over this, but the wealth illusion made it seem like savings were unnecessary.  Instead of having money in savings, we had it in stock portfolios (in the 90s) and real estate (in the 00’s).   That theoretically meant that we could dip into our wealth if we needed funds, and thus low interest savings accounts were irrational.

Yet the wealth illusion was built on bubbles.   First was the stock bubble, where people literally believed all they had to do to get rich was buy some stock and watch it grow.   We got addicted to the notion of something for nothing.   People were borrowing to buy stocks, knowing they’d earn enough to pay back the loan and make money.  It was quite literally too easy.   And in 2000 (over a year before 9-11-01) the inevitable occurred:  it crashed.   The tech-heavy Nasdaq collapsed, and stocks started reeling.   The current account deficit was up to 5% of GDP, and the only good news is that we briefly had small budget surpluses rather than deficits.   But those surplusses were built on the bubble economy, and represented a kind of illusionary sense of economic health.

At this point in time a painful recession like that of 1980-83 might have been enough to correct the imbalances and force us to increase production to bring it in line with consumption (and balance our current account).   Yet after 9-11, the US decided that we could not let terrorism bring down the economy.  President Bush said the patriotic thing to do was to go shopping, interest rates were kept very low, and thus a new bubble formed, the housing bubble.

Again, a something for nothing mentality took over.   Making money on real estate became easy, people could borrow from the equity on their home to buy more property, knowing it would go up in value.   Or at times people would borrow against their home just to have a better lifestyle, invest in a company, or pay for college.   With housing values rising, it seemed to be easy money.   The claim was that though housing values might finally stop rising, real estate values never actually decline, so the investments appeared safe.   Again, a wealth illusion spurred greater consumption, and by 2006 the current account deficit reached a whooping 7% of GDP.   Budget deficits started to rise again as well, as a mix of tax cuts and war (I still cannot comprehend cutting taxes in a time of war) led to rising debt and deficits.

With the financial markets deregulated, bizarre financial products were put on the market.   Mortgages were bundled and sold, and then those bundles were rebundled and resold.   These ‘derivatives’ were wholly unregulated, and produced huge gains as people saw them as both safe, and rising in value by 10% or more a year.  The perfect investment!   On top of that, other financial products were sold that were really insurance policies on those mortgages.  They appeared to be safe investments, and many buyers didn’t realize they were obligated to pay if that insurance was needed — meaning they could lose whole principle on those “safe” investments overnight.

When the housing bubble burst, this started a chain reaction.   Note: the bad mortgages or subprime sector could not alone bring down the economy.   If it wasn’t for how these got bundled up and turned into complex financial products, the housing bubble could have burst with containable damage, easy mortgages alone were not the problem.   Rather, these complex and little understood financial products came crashing down, bringing the entire financial industry with them.  Bear Stearns felt it first in March 2008, then the biggie came when Lehman brothers had to declare bankruptcy in September 2008.

By September 18, 2008 credit markets had seized completely, the financial system stood at an abyss.  Without a dramatic injection of capital the financial sector was about to collapse, and with it the US and likely the world economy.  If that had happened, a spiral into depression was all but guaranteed.  That’s why free marketeers like Treasury Secretary Hank Paulson were forced to go for a massive government bailout, and why Alan Greenspan admitted he was wrong in trusting the market to “get it right.”

However, that is only the tip of the iceberg.   The imbalances in the US economy not only are unsustainable, but it’s clear that China and the rest of the world are no longer willing to continue to finance a completely out of balance US economy.   We need to start producing more, or we will be forced to consume much less.    Even as we try to stimulate the economy, we do so by increasing debt, now at about 90% of GDP, and likely to rise to over 120% of GDP by 2015.

This has been a long post, but the upshot is this:  there is no way  we can right our economy without a massive decrease in our standard of living, and some kind of restructuring of our budget, especially as the baby boomers retire.  The imbalances are real, and with the US no longer seen as a safe investment, countries will refuse to finance our debt and deficits.   That means unemployment will be with us for quite awhile, and the US is in the midst of a severe economic decline/restructuring which will weaken us on the world stage, force a more isolationist foreign policy, and end the days of US global economic and military dominance.    I suspect it will be at least a decade before things start to turn around, and even then it will not be like the heady days of 2006.

Or, as I tell my students, “my generation has enjoyed a thirty year party of wild excess, a kind of consumerist orgy.   Now we’re leaving you with the bill.   Sorry.”

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  1. #1 by notesalongthepath on November 12, 2009 - 05:44

    I’m not sure I followed everything, Scott, but thanks so much for writing this. It has helped me to understand, if I got it right, that we must make and sell products to have a real economy. And, wow, did we get suckered with the real estate bundling- derivatives.
    I have two questions, which may be related. How has what we have spent on the two wars affected our economy? And, we were at 7% of the US Gross Domestic Product in 2006 and now, nearing the end of 2009, we’re at 90%? Are there any numbers you could use to explain how that happened?
    Thank you so much,
    Pam

    • #2 by Scott Erb on November 12, 2009 - 11:18

      Hi Pam, thanks for the response! The 7% of GDP was the current account deficit, made up of mostly a trade deficit. That means we’re spending more on buying stuff from outside the US than outsiders are spending on buying stuff we make. It’s a sign of how we consume more than we produce. Anything above 3% is dangerous. The 90% of GDP is a budget deficit, meaning how much government has to borrow to finance its spending. That was at about 60-70% in 2006. I’m sorry for the confusion, those are two different numbers, each signifying an aspect of our economy which developed an unsustainable imbalance.

      The war’s impact on the economy was profound on many levels, and it hurt the US in ways not directly related to the economy. I’ll have to write a whole post on that soon, but the wars definitely increased debt and have made the US more vulnerable.

  2. #3 by notesalongthepath on November 12, 2009 - 20:21

    Don’t be sorry because I’m confused–I’m confused every day to one degree or another. 🙂 Thanks for clearing that up for me and for being so kind as you did it. I’ll look forward to reading about the effect of the wars on the economy and otherwise.
    Have you written what could be an ‘advice’ posting on parenting? I think you and your wife are among the best parents I’ve met online and would love to add something at my blog in the Parenting series. Altogether, they’ll make up some pretty great reading.

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