The Debt Delusion

A second big American interest-rate cut in a fortnight, alongside an economic stimulus plan that united Republicans and Democrats, demonstrates that US policymakers are keen to head off a recession that looks like the likely 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 one hand, policy must fuel asset bubbles to keep the economy growing. On the other hand, 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 America’s 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.

America’s 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, fuelled 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. Between 1980 and 2000, manufacturing employment continued to grow in expansions, but each time it failed to recover the previous peak. This time, manufacturing employment has actually fallen during the expansion, something unprecedented in American history.

The essential role of asset inflation has been especially visible as a result of the housing bubble, which also highlights the role of monetary policy. Despite the massive tax cuts of 2001 and the increase in military and security spending, the US experienced a prolonged jobless recovery. That compelled the Fed to keep interest rates at historic lows for an extended period, and rates were raised only gradually because of fears about the recovery’s fragility.

Low interest rates eventually jump-started the expansion through a house price bubble that supported a debt-financed consumer-spending binge and triggered a construction boom. Meanwhile, prolonged low interest rates contributed to a “chase for yield” in the financial sector that resulted in disregard of credit risk.

In this way, the Fed contributed to creating the sub-prime crisis. However, in the Fed’s defense, low interest rates were needed to maintain the expansion. In effect, the new cycle locks the Fed into an unstable stance whereby it must prevent asset price declines to avert recession, yet must also promote asset bubbles to sustain expansions.

So, even if the Fed and US Treasury now manage to stave off recession, what will fuel future growth? With debt burdens elevated and housing prices significantly above levels warranted by their historical relation to income, the business cycle of the last two decades appears exhausted.

It is not enough to deal only with the crisis of the day. Policy must also chart a stable long-term course, which implies the need to reconsider the paradigm of the past 25 years. That means ending trade deficits that drain spending and jobs, and restoring the link between wages and productivity. That way, wage income, not debt and asset price inflation, can again provide the engine of demand growth.

Copyright Project Syndicate.

By Thomas I. Palley

7 Responses to “The Debt Delusion”

  1. Reinko Says:

    Good article!
    You could also quantify the debt problem by taking some numbers from the Federal Reserve flow of funds release, not that boring 120 to 130 pages long pdf file but the short cut to what counts, link:

    http://www.federalreserve.gov/releases/z1/current/accessible/d3.htm

    If you add up some of the totals you see that total debt that the US economy has on herself is above 50 trillion or 50,000 billion. The interest needed is a staggering number but when you start estimating how fast the total debt grows you see:

    It is always above GDP growth so in the end the interest beast will win…

    Therefore by the law of exponential growth, this new cycle will reset itself when the interest part becomes a too large part of the GDP (right now interest on total debt is about 18 to 19% of GDP but the so called ‘hidden debt’ is not included in this figure).

  2. MH Burnham Says:

    It is refreshing to read such cogent analyses of the ’sea change’ in economics that occurred about 25 years ago. You suggest, however, that the business cycle of that approximate time period has run its course, to which I must ask, ‘are you sure?’ I base that question on two observations: the first is the nature of the supply-side economic model of the last 25 years that seems to be based on the idea of exploiting segments of the economy ripe for the creation of ‘bubbles’ (inflating assets to stimulate spending). But there also seem to be other tactics afoot that create similar ‘money-churning machines’ that are based on fear mongering. Was not the so-called ‘war on drugs’ once such money-churning machine? And when it was exhausted, was not a new machine ‘invented’? Is not the American incarceration industry another such ‘grand machine’? And is not the so-called war in Iraq the father of all such a money-churning machines? And isn’t that why some politicians talk about being in Iraq for decades (before it too eventually ‘exhausts’)? In short, in this ability to financially mine the American psyche for new markets to exploit, aren’t we a long, long way from ever exhausting this cycle?

  3. Wages. Remember them? « World Business Academy Blog Says:

    [...] Remember them? February 28, 2008 Posted by davidzweig in economics, financial crisis. trackback Economist Thomas Palley has written a clarifying piece about the underlying systemic causes of thecurrent economic troubles. If one reads it without political preconceptions (when do politics even tangentially touch economics?), he makes a point not heard since John Edwards rode into the sunset: that wages have not kept up with productivity gains, as our economy is now based 72% on Consumption. [...]

  4. CA Demand Side Says:

    MH Burnham,

    You asked “aren’t we a long, long way from ever exhausting this cycle?”

    No! The current situation is a simple supply/demand issue. The supply is abundant.

    In the past, wage growth always lead to more demand.

    In the past 30 years, however, wages have not grown. Instead of wages, demand has been keeping up with supply largely due to debt accumulation.

    Now the US consumer is saturated with debt. Their little to no more room. This is NOT a perpetual cycle. It will end soon, and I’m afraid it won’t be pretty when it does.

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