05.07.10

Coming Soon: The Real Stock Disaster

Thursday’s harrowing Dow roller-coaster ride wasn’t just a trader typo. Reihan Salam on the holes in America’s economy—and why goosing consumption won’t fix the problem.

While Thursday’s mini-crash of the Dow Jones Industrial Average put fear into the hearts of almost all investors, one can easily dismiss it as a moment of temporary insanity greatly exacerbated by a technical glitch that drove down the share price of Procter & Gamble for a few crucial seconds. So one certainly can’t conclude that the economy is going to hell simply because the stock market is having a bad day. Rather, we’ve been reminded that equity prices are a deeply unpredictable and complex system, not unlike the weather. And indeed, we have good reason to believe that the stock market is likely to prove more volatile in the months and years to come than in the past. It’s certainly not true that jitters about Greece’s bailout package made P&G’s stock price plummet. But it does serve as a useful reminder that some of the guarantees on which investors large and small depend aren’t exactly rock-solid. That is a very big deal.

“Normal,” or rather what’s passed for normal for at least the last 15 years, is precisely the problem.

Many have seen the recent stock market rally as further evidence that the U.S. economic recovery is real and sustainable, and the labor market really is in somewhat better shape. The despair that prevailed as recently as a year ago seems to be lifting, and that’s very good news for the millions of families that have been ravaged by the recession. But my fear is that returning to normal is exactly what we don’t want to be doing. “Normal,“ or rather what’s passed for normal for at least the last 15 years, is precisely the problem.

The increase in equity prices, and the broader perking up of the economy, can be traced back to the re-leveraging of the economy. Far from paring back debt levels, the root cause of our balance sheet recession, we’re increasing them at a rapid clip. A year ago, it really did seem as though middle-class households were adapting to a tougher economic environment as the personal savings rate went from zilch to a modest but still encouraging 5 percent. Since then, however, the personal savings rate has tumbled to 2.7 percent, and there’s every reason to believe that it will continue to decline.

Just as President George W. Bush told Americans to shop in the aftermath of the 9/11 terror attacks, we’re finding that goosing consumption we can’t afford is the only way we know how to fuel a recovery. Indeed, goosing consumption in the U.S. often seems like the only way we know how to fuel a global recovery. Germany, Japan, and China are still depending on us to revitalize their all-important exporters. These economies suffer from pathologies that mirror our own: Instead of overconsumption, they suffer from weak and underdeveloped domestic markets that result in underconsumption. It’s like a nightmarishly codependent marriage we can’t escape.

It’s only natural that we’d want to delay the painful deleveraging that must precede a truly sustainable recovery. The aggressive expansion of credit that has defined the U.S. economy for the better part of the last two decades was a way to preserve the American dream for millions of households that saw their wages stagnate or grow at a snail’s pace at best. And from the perspective of the political class, the key advantage of a credit expansion is that it was a form of redistribution that happened off the books. Instead of increasing direct transfers, the federal government offered huge implicit subsidies to the mortgage giants that fueled an enormous wave of home-equity loans. The problem with this brand of redistribution is that it is crude, inefficient, and, in the end, extremely expensive, leaving us with fewer arrows in our quiver for dealing with a real crisis. Far from abandoning aggressive credit expansion as an instrument of policy, we’ve doubled down on it, teeing up a new crisis that might prove worse than the last one.

In addition, we’ve pursued stimulus policies that are poorly designed and, in all likelihood, unsustainably large. In an ideal world, we could spend vast sums of federal dollars to balance out the impact of deleveraging in the private sector. But we also need an approach that could credibly balance the budget over the business cycle. This means that we need to balance the need for stimulus in the short term with the very real possibility that we will need stimulus down the road. Using all of the arrows in our quiver now will leave us extremely vulnerable when the next crisis hits, which it will.

If the deeply depressing financial-reform debate has taught us anything, it’s that our leaders, Democrats and Republicans, are extremely reluctant to bite the bullet and pursue a serious, sweeping overhaul of our broken financial system. Instead, they’ve chosen to pursue a patchwork fix that leaves the biggest banks bigger than ever, and that fails to address a housing sector that remains a ticking time bomb.

As we enter this uncertain phase, the crucial question is whether we’ll be Ireland or Greece. The Irish economy, like our own, went on a debt-fueled consumption binge that lasted for over a decade, and that left the economy utterly ruined in the wake of the financial crisis. But in the months since, the Irish have taken tough steps to pare back public debt levels, including salary cuts of 15 percent for teachers and police and punishing tax hikes. Not surprisingly, these austerity measures haven’t proven wildly popular, and Irish Premier Brian Cowen is backed by just over a fifth of voters. It is impossible to imagine an American president proposing the same steps, no matter how urgently necessary. It’s hard to say exactly why the Irish have managed to get their act together. One possibility is that the country remains small and tight-knit enough to make the idea of shared sacrifice compelling.

What we do know is that Greece has had a far more difficult time adjusting to the new economic circumstances. Faced with a staggeringly large primary deficit of 8 percent, a level the United States could easily approach in the next decade, Greek public-sector workers are ferociously resisting Irish-style austerity plans. Some have even taken to the streets in a series of violent protests. Though I find it hard to imagine Americans tossing Molotov cocktails to protest a balanced budget, the deep distrust that defines our politics means that achieving some kind of workable compromise will be extremely difficult if not impossible, particularly if one group of voters senses that it’s getting the short end of the stick. My worry is that the United States is far more like Greece or Portugal or Spain than it is like Ireland, and that our political leadership would sooner tell us what we want to hear than what we need to hear.

No one likes being the bearer of bad news. Well, it’s possible that some people take a perverse pleasure in it. I certainly don’t. Like anyone, I have friends and family members struggling to find work, and drawing down their savings. I spend a lot of time thinking about people my age and younger with small children, living paycheck to paycheck and wondering if the skills they’ve painstakingly acquired will be worth anything in 10 years’ time, or for that matter in a few months. A wobbly Dow isn’t the real issue. Rather, it’s whether we can build a sustainable economy that works for everyone. Wishing away deep structural problems only makes that process more difficult.