2008 January 24 Thursday
Was Recent Prosperity Illusory?

An article in BusinessWeek captures the mood among business writers and an increasing portion of the general public in an article entitled How Real Was the Prosperity?

Sometimes consumers would get ahead of the economy for a few years, and sometimes fall behind, but never for very long.

That pattern changed in the 1990s. As of the third quarter of 2007, the 10-year growth rate for consumption was 3.6%, vs. GDP growth for the same period of 2.9%. This difference represents an enormous gap.

That adds up to $3 trillion dollars worth of living beyond our means. I've been writing about this problem for years and now I take no joy out of finding more agree with me. The seriousness of the problem outweighs being right about it. It is ultimately dissatisfying to watch people wake up to the economic fears that a smaller group of us have been voicing for years. The horse has left the barn as suddenly the business press is writing about our economy in ways reminiscent of Warren Buffett's term for America: Squanderville. Suddenly Buffett isn't just rich. His views have become conventional wisdom.

Some optimists pointed to higher corporate earnings as an argument for why we could afford to run up our debts. But turns out the improvement in profit margins were concentrated in the financial industry. Well, how many of those profits were due to temporary luck of investing in a financial bubble?

Corporate Earnings. Yes, there's been a profit boom in recent years. Corporate earnings, as measured by government statisticians, have averaged 8% of GDP over the past decade, up from a low of 6.5% in the early '90s. That has helped propel stocks upward.

But here's an unfortunate truth—the profit surge has been mainly in one area, financial services. Financial institutions have benefited from the consumer credit boom, the proliferation of new financial instruments, and relatively low rates. By contrast, the earnings of nonfinancial companies over the past decade have averaged about 5.3% of GDP, about the same since the mid-1980s. There are few signs of any acceleration, even after years of restructuring.

Will financial companies regain their position as high profit earners? Or will they end up losing as much as they earned in recent years?

David Leonhardt of the New York Times examines how much of the last 10 years of economic growth came from improvements in fundamentals in an article entitled Worries That the Good Times Were Mostly a Mirage.

The recent financial turmoil has many causes, but they are tied to a basic fear that some of the economic successes of the last generation may yet turn out to be a mirage. That helps explain why problems in the American subprime mortgage market could have spread so quickly through the world’s financial system. On Tuesday, Mr. Bernanke, who is now the Fed chairman, presided over the steepest one-day interest rate cut in the central bank’s history.

The great moderation now seems to have depended — in part — on a huge speculative bubble, first in stocks and then real estate, that hid the economy’s rough edges. Everyone from first-time home buyers to Wall Street chief executives made bets they did not fully understand, and then spent money as if those bets couldn’t go bad. For the past 16 years, American consumers have increased their overall spending every single quarter, which is almost twice as long as any previous streak.

Now, some worry, comes the payback. Martin Feldstein, the éminence grise of Republican economists, says he is concerned that the economy “could slip into a recession and that the recession could be a long, deep, severe one.”

Leonhardt says three factors argue for a deeper and longer lasting recession: Wall Street financial institutions still haven't revealed the full depth of their losses; stock and home prices are still above their historical norms; and consumer debt has accumulated to levels that will require a substantial period of lower spending to pay down what's owed.

If the correction comes slowly it will last longer like Japan's downturn that started in the early 1990s and lasted well into this decade (and some argue is still in effect). Attempts by political leaders to cushion the downturn could make the downturn last longer. Then again, intervention by the US Federal Reserve might prevent a depression too. Hard to say.

Certain rickety but key components of financial markets have attracted a lot of regulatory attention as governments seek to prevent vicious cycles of failures of financial institutions. Notably, regulators are looking to prevent failures of bond insurance companies.

Regulators fear a possible chain of events in which the troubled bond insurers, MBIA and Ambac, might be unable to keep their promise to pay investors if borrowers default on their debt.

That could leave the buyers of the bonds — including many banks and pension funds — on the hook for untold billions of dollars in losses, shaking confidence in the financial system.

To avoid a possible crisis, insurance regulators met with representatives of about a dozen banks on Wednesday to discuss ways to shore up the insurers by injecting fresh capital, much as Wall Street firms have turned to outside investors recently after suffering steep losses related to subprime mortgages.

A New York Times article by Floyd Norris also captures the mood of the day: Familiarity Breeds Gloom Among Financial Experts

But the pessimism is much greater among those closest to the financial system. While some take a functioning financial system for granted, in the same way they view highways or indoor plumbing, others see a system in crisis.

“We’re entering a perfect storm, a period of financial turbulence and very limited capital,” said one executive, whose company needs to borrow money to grow.

“What’s driving everyone crazy,” another executive said, “is, you don’t know who you can trust.” Both are well-known executives who did not want to call attention to themselves.

The commercial bankers and investment bankers are going to emerge from current events looking pretty dangerous. They've set up houses of financial cards that now require government intervention to prevent cascades of failures. I'm not going to forget this. Are you?

Share |      By Randall Parker at 2008 January 24 08:53 PM  Economics Business Cycle

iaintbacchus said at January 25, 2008 9:00 AM:

This is what you get when you have more accountants in a culture than engineers. It's time for this country, and probably the world, to wake up to the idea that anyone "making money" but not creating wealth is stealing.
More importantly it illustrates the principle that any capital enterprise not sufficiently regulated for the public good will inevitibly operate entirely on the greed motive.

Philadelphia Steve said at January 25, 2008 9:17 AM:

But Dick Cheney said that "Deficits don't matter".
What else were we to believe.

kurt9 said at January 25, 2008 10:44 AM:

There WAS small-business lead real growth during the mid 90's (1993-1997). Everything since has been mostly bubble-fueled excess. The real growth of the mid 90's started into a natural corrective cycle in '98, which would have been mild if it had been allowed to occur, then followed by more real growth. The problem is that Greenspan and Clinton were not happy with this outcome. Clinton's reelection campaign got lots of money from large corporations (and from the Chinese) in 1996. So, a mild recession was not acceptable. Also, Greenspan, being the most vain chairman in FED history, was not about to allow one to occur on his watch. So, he bailed out that hedge fund (LTCM Fund) and lowered the interest rates in '98 when he should have left them the same or raised them a little. This created the entirely unnecessary, artificial bubble of the late '90's, where everyone thought we could defy the law of economic gravity forever more. This bubble created many of the marketplace distortions that still have to be worked out.

Then, when the early oughts recession came, he stoked the housing bubble, mainly so that Bush and his neo-nazicons could finance their little venture into Iraq.

On top of this, Greenspan redefined the CPI index with "hedonic" factors and "substitution" factors so that he could lower the interest rates (and flood the economy with cheap money) without the attendant "officially" reported inflation (we have had around 2-3% unreported inflation since 1996).

So, all of this mess was brought about by artificially cheap money, just like Japan in the 1980's. It was the flood of cheap money, starting around 1995 or so, that led to the huge splurge of lax credit and consumer spending that has gone on for the past 12 years or so.

I lived in SoCal and Arizona from '95 to '91. I moved to Japan in 1991 and returned to the U.S. (at the urging of my wife who did not like tropical developing countries) in 2001. I noticed a big difference in consumer spending patterns between the time I left and the time I returned. I especially noticed the difference in the kinds of cars I saw on the road. When I left in '91, most people drove conservatively priced cars that were not extravagant. In '01, I saw lots and lots of high-end BMWs, Mercedes, and Lexus luxury-style of cars on the road.

So, maybe the correct that has been put off since 1998 will have to come after all. Of course, having it put off all of these years will make it far more painful than if it had been allowed to occur in 1998.

Real growth can come only from entreprenuers and small to medium sized businesses. Large companies as well as government are bureaucracies. Bureaucracy, by its very nature, is not capable of real wealth creation. The problem with politicians is that they are members of the largest bureaucracy of all, the federal government. So, by definition, politicians cannot do anything to solve this problem. They can only do damage. The real damage will come from the politicians and the federal government. In its attempts to make things better, they will only make things worse. The best we can hope for in the upcoming elections is for a deadlocked congress that is unable to do anything at all.

The FED can help solve the problem if the chairman is someone of integrity and is willing to do the hard work, like Paul Vochar. Is Bernanke up to the task in front of him? Most of the FED chairmen have not been good. Arthur Burns and Alan Greenspan were terrible. Burns created the stagflation of the 70's and Greenspan created the cheap money supply excess of the late 90's and oughts. The problem with the FED is the same as with the government. It is a centralized institution with too much influence over the economy. Centralization of power is bad because it puts too much influence into the hands of a few individuals. Then when those individuals screw up (as most people do), everyone else suffers as a result of it.

Ideally the FED should be broken up. It represents a kind of monopoly. We know monopoly does not work in any other industry. Why should we believe it is necessary for banking?

At a minimum, the FED should not be setting the interest rates. The marketplace should be allowed to do this. in addition, the FED should not be the ones to calculate and publish the CPI index. The ratings agencies such as Moody's and S&P can do this job as effectively as the FED. Having several competing indices would be better anyways.

I went through the Asian currency crises in the late 90's (I was in Malaysia at the time). I am well aware of the damage central banks can do. Every financial crises since the great depression has been caused by moral hazard. Even the great depression was cause by the moral hazard at the artificial bubble economy of the 1920's. Moral hazard is inherent to the financial industry. Centralization of financial power (in the form of central banks) amplifies that moral hazard.

The solution can only come from radical decentralization, which means a decentralized economy based on small to medium sized businesses and self-employed individuals. This is the reason why our politicians can not only not solve the problem, but can only create additional damage. Government since FDR has created more and more regulation. This favors big business. The way to create real, lasting economic growth would be a moratorium on government regulation and a radical rollback of existing regulation. This is not about to happen.

Stephen said at January 25, 2008 3:31 PM:

iaintbacchus said: This is what you get when you have more accountants in a culture than engineers.

By way of contrast, since the 1980s all of the members of China's Central Committee have been engineers or scientists. I can't remember the last time a western leader had an engineering or science background.

RKU said at January 25, 2008 8:35 PM:

I think that Paul Krugman put it best a couple of years ago. He was explaining to some of his overseas friends that Americans mostly used to earn their livings by producing goods and services and selling them to other people. But nowadays, they mostly earn their livings by selling each other their houses using money borrowed from the Chinese. He couldn't see how this made a lot of sense in the long run.

averros said at January 26, 2008 2:57 AM:

> I can't remember the last time a western leader had an engineering or science background.

Well, Ron Paul is an MD. But, most likely, the stupid sheep will elect Hillary.

Wolf-Dog said at January 26, 2008 2:58 AM:

Apparently, the French president Giscard d'Estaing studied at the Ecole Polytechnique (the equivalent of MIT) before going to a politics:


It is in the French tradition to go to top science schools before politics, and it is not an accident that 80 % of the French electricity is nuclear (since the 1970s!!!) and many innovative systems like high speed electric trains are developed there. Accidentally, the French nuclear reactors are being sold to China, even though these pressurized water reactors were invented in America first.

In the United States, if you have not heard of Shakespeare, you would be considered uncultured, but if you know nothing about science or technology, it is somehow considered "OK."

Rob said at January 26, 2008 6:57 AM:


Angela Merkel, the Chancellor of Germany, has a background in quantum chemistry. But I'm pretty sure she was an academic scientist, not an industrial one, so maybe that doesn't count. I've read that most European CEOs come out of engineering, that may be part of why they manage to have decent economies even with socialism.

Randall Parker said at January 26, 2008 8:33 AM:


The northern Euro countries have very smart populations. That's the biggest reason they do as well as they do.

They pay too much attention to titles such as Ph.D.s.


The hard choice: Hillary or McCain? McCain has the same policy positions that caused Bush to wreck the Reagan Coalition: Strong support for the war in Iraq and a determination to enact a big immigration amnesty. How is Hillary worse? McCain seems worse. I think Hillary will be more reluctant than McCain on Iraq and immigration amnesty.

Rob said at January 26, 2008 9:16 PM:

Randall, that is most of the reason. But IQ only explains what, about 1/2 the variation in per capita GDP? So a few other things have to count for a bit.

I think McCain is worse than Hillary: first, conservatives will be more on their toes with a Democrat, and her mistakes won't be blamed on conservatives.

averros said at January 27, 2008 4:20 AM:

McCain vs Hillary is the choice only if you decide to participate in the spectacle of giving your vote to the "lesser" evil. I never voted for anyone I did not support, so I do not have to feel ashamed afterwards.

If it comes down to choosing between "100 hundred years of war in Iraq in OK with me" McCain and the demagogue socialist bitch, I'll start preparing to leave the sinking USS Amerika for some saner place; fortunately I have a profession which is in demand in any country, dual citizenship (with option to quickly acquire more), and no loyalty whatsoever to any nation.

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