What is holding back growth?

Earlier this week we saw that the United States is missing 10 million private-sector jobs. We also saw that private job creation is tightly correlated with the performance of the real economy. The jobs were lost because of the worst contraction since the Depression and remain lost because the “recovery,” if one can call it that, has been so achingly slow.

Does the United States have no choice but endure a decade of suffering, or is there a better way?

Most recessions since the end of WWII were caused by the Federal Reserve in order to prevent inflation from running out of control. This was what William McChesney Martin meant when he said that the central bank’s job is “to take away the punch bowl just as the party gets going.”

The past three contractions, however, were not deliberately caused by the Fed. Rather, they were contractions of the old school, when businesses over-invested, households over-borrowed, and banks over-lent. These are sometimes called balance sheet recessions or Austrian business cycles.

In 1984, the private debt of households and nonfinancial businesses was worth 98% of GDP. By 1989, that debt had ballooned to 120%. A year later, Citi was nearly bankrupt and survived only thanks to a timely investment by a Saudi prince. Drexel Burnham Lambert—the investment bank that invented junk bonds—had exploded when it turned out that they had picked an appropriate name for their product. The S&Ls were collapsing every day because their bad bets and criminal behavior were exposed when real estate bubbles in Texas, California, and New England all went bust. Companies that had borrowed by issuing junk bonds could not afford to pay the high yields and went bankrupt. Households survived by slashing their savings rate.

The process of repair took nearly five years. Private employment as a share of the population peaked in early 1990. The subsequent drop was just as painful as the deep recessions of  1974 and 1979-1982, but the recovery was far slower. In fact, the U.S. did not return to full employment, by this measure, until 1995:

The business restructuring was aided by rising government budget deficits and falling household savings. Then came the tech bubble. Businesses borrowed heavily and over-invested in everything from fiber optic cable to foosball tables. The foreign sector funded it all through the current account deficit:

The dollars spent investing in new technologies vastly outnumbered the value of those investments, however. Corporate bankruptcies spiked, businesses retrenched, and millions of people lost their jobs. As you can see in the first chart above, the drawdown in private employment wiped out all the gains since 1996.

Desperate to prevent the economy from falling into the abyss, the Federal Reserve followed the advice of Professor Paul Krugman:

The recession of 2001 wasn’t a typical postwar slump, brought on when an inflation-fighting Fed raises interest rates and easily ended by a snapback in housing and consumer spending when the Fed brings rates back down again. This was a prewar-style recession, a morning after brought on by irrational exuberance. To fight this recession the Fed needs more than a snapback; it needs soaring household spending to offset moribund business investment. And to do that, as Paul McCulley of Pimco put it, Alan Greenspan needs to create a housing bubble to replace the Nasdaq bubble.

That was published on August 2, 2002.

The result was even more unsustainable borrowing. Household debt soared from 81% of disposable personal income in 1998 to 124% by 2007:

More borrowing means that more and more income has to be devoted to debt service. Even if you can refinance at lower interest rates, those rates cannot fall forever. As long as incomes rise in line with the additional debt, this is manageable. But if incomes were rising, the chart above would look like a horizontal line. It is also possible—but far more dangerous—to hope that whatever it is you buy with borrowed money can be sold to someone else for a higher price. Like any pyramid scheme, the plan falls apart when the last possible chump enters the game.

That occurred around 2006 when the housing market peaked. Since then, the Case-Shiller home price index has fallen by over 30%, although it has been far worse in many areas. Most Americans own almost no financial assets and have negligible pension allowances. Their net worth is generally tied up in their homes. How badly have they done?

While household debt has shrunk by about 6% since the peak, it is still at the same level relative to disposable income as it was in mid-2004. This means that most Americans are paying large portions of their paychecks on mortgages for houses worth far less than they paid rather than on new goods, services, and investments that could help the country grow. The debt is a dead weight holding down the economy and preventing new spending on more worthwhile endeavors.

What can be done? David Brooks misread Carmen Reinhart’s and Kenneth Rogoff’s This Time is Different. The long slumps that persist after bubbles burst are not inevitable, although the ways out are often so unpalatable that they are never tried until after years of needless suffering.

The burden of debt has to be lifted, one way or another. There are two basic ways to do this: you can default or you can inflate.

Default is the more elegant solution. It maintains the distinction between responsible borrowers and irresponsible ones, as well as the oft-forgotten distinction between responsible creditors and reckless lenders. However, we currently lack the legal infrastructure for everyone who needs to default to do so without the process lasting for years, if not decades. A debt jubilee is less fair but would be far faster and be equally stimulative. It was discussed in one of my linked articles a few days ago.

The other option is to inflate the debt away, which, after all, is denominated in fixed dollar amounts. This mechanism is often misunderstood. Some people, including quite a few respected economists, believe that the Federal Reserve can create inflation simply by printing money. However, as we saw earlier, the Federal Reserve by itself lacks the ability to directly affect inflation because inflation is caused by spending.  The monetary base has more than tripled in the past three years yet the Consumer Price Index has grown by only a few percent.

This does not mean that the inflation option is off the table. On the contrary, we know exactly how to generate uncontrollable surges in prices and dollar wages. None other than Ben Bernanke, Chairman of the Federal Reserve, described the process in 2002:

A broad-based tax cut, for example, accommodated by a program of open-market purchases to alleviate any tendency for interest rates to increase, would almost certainly be an effective stimulant to consumption and hence to prices…In lieu of tax cuts or increases in transfers the government could increase spending on current goods and services.

For perspective, consider that the U.S. federal government ran deficits equivalent to about 30% of GDP every year during WWII. The Fed lent to the Treasury at the very favorable rate of 2.5% for ten year debt. The result was that the CPI increased by 75% between 1941 and 1948. Similarly, nominal GDP, which is a rough proxy for wages, more than doubled over the same period.

We know how to solve the problem. It persists because we are failing to act.

Have a good weekend.