Home > Update > Spring 2009

Shifting Gears

Getting the economy moving forward again

By Dean Michael Knetter

It is a difficult time to analyze the economy. After nearly 25 years of robust growth (in absolute terms and relative to other developed economies), the U.S. economy has experienced extraordinary capital-market disruptions and rapidly declining employment levels in recent months. Market participants and analysts alike are very focused on the moment, seeking clues on the next shoe about to drop. On top of the uncertainty caused by the downturn itself, there is tremendous uncertainty about monetary, fiscal, and regulatory policy responses to the current situation.

While it is very natural to focus on the present at times like this, we can gain valuable perspective by taking stock of longer-term trends in the global economy that have shaped U.S. economic challenges and opportunities in recent decades. While we face serious short-term problems, there is still reason to be optimistic about the future.

“While some households are certainly overextended, the savings debate has been sensationalized in contemporary media accounts.”

Changing Fortunes

While still in progress, the current downturn appears comparable in certain respects to the recession of 1982-83. That recession proved to be the culmination of a bleak period for the U.S. economy. From the early 1970s until about 1984, the U.S. economy experienced very sluggish growth with rising inflation. U.S. firms were losing ground to foreign competitors in automobiles, steel, and other heavy-manufacturing industries and it seemed a foregone conclusion that Japan and Germany would soon supplant the United States as the world’s economic superpowers.

1980		2008
Company	Market Cap ($B)	Company	Market Cap ($B)
1. International Business Machs Cor	$74.51	1. Exxon Mobil Corp	$511.89
2. American Telephone & Teleg Co	$59.39	2. General Electric Co	$374.64
3. Exxon Corp	$31.62	3. Microsoft Corp	$333.05
4. General Electric Co	$26.65	4. AT&T Inc	$252.05
5. General Motors Corp	$23.42	5. Procter & Gamble Co	$228.02
6. Standard Oil Co Ind	$14.83	6. Chevron Corp New	$197.06
7. Schlumberger Ltd	$14.48	7. Johnson & Johnson	$190.88
8. Sears Roebuck & Co	$13.16	8. Wal-Mart Stores Inc	$190.35
9. Eastman Kodak Co	$12.61	9. Bank of America Corp	$183.13
10. Du Pont E I De Nemours & Co	$12.42	10. Apple Inc	$173.43
11. Shell Oil Co	$12.37	11. Cisco Systems Inc	$164.23
12. Standard Oil Co California	$11.85	12. Google Inc	$162.84
13. Mobil Corp	$11.70	13. Altria Group Inc	$159.20
14. Hewlett-Packard Co	$10.80	14. Intel Corp	$155.88
15. Atlantic Richfield Co	$10.80	15. Pfizer Inc	$155.24
16. Minnesota Mining & Mfg Co	$9.67	16. Berkshire Hathaway Inc Del	$153.78
17. Procter & Gamble Co	$9.47	17. International Business Machs Cor	$148.96
18. Texaco Inc	$9.29	18. American International Group Inc	$147.86
19. Philip Morris Inc	$8.97	19. Citigroup Inc	$146.64
20. GTE Corp	$8.34	20. JPMorgan Chase & Co	$146.62

Of course, that’s not how the movie ended. It took an unexpected turn.

Up until the past few months, U.S. macroeconomic performance since 1984 has been quite impressive on many dimensions. Real GDP growth was higher than in previous decades, unemployment rates got progressively lower with each business cycle, and productivity made a strong recovery from what had been lackluster performance in the 1970s and early ‘80s. The market capitalization of U.S. firms as revealed by the S&P 500 or other major indices rose substantially.

While it was very unclear in the mid-1980s what could possibly emerge to replace the jobs and income lost in various manufacturing industries, in hindsight we can see what happened. Some of the greatest success stories of this period were firms that either developed or applied information technology, telecommunications, and the infrastructure that enables Internet connectivity to create value in the economy. Many successful firms relied on global partnerships, often with partners in newly developing economies.

“To mitigate the paradox of thrift, we need to persuade households to rebuild their balance sheets over ten years, not one year.”

Along with these technological breakthroughs, the “marketization” of China, India, and the nations of Central and Eastern Europe brought the potential for disruptive change and new value creation to many industries. Many U.S.-based firms seized these opportunities. Indeed, there has been a complete makeover of the largest firms in America measured by market capitalization. Many of these firms were virtually unknown in the early 1980s. (Table 1)

This period of innovation and strong performance led many observers to cite the virtues of the American brand of capitalism in contrast to the more regulated and protected varieties in Europe and Japan—a complete reversal of the thinking of the mid-’80s. Relatively strong incentives for innovation, broad and deep capital markets, labor market flexibility (including openness to immigration), and reduced trade barriers contributed to newfound U.S. dynamism.

Of course, these accomplishments of American capitalism are not the end of the story either. In recent years, other economic indicators were flashing serious warning signs. In particular, consumption rose markedly as a share of GDP, savings rates fell as a share of disposable income, governments were prone toward deficit spending, and the U.S. current-account deficit swelled to well over 5 percent of GDP. These developments led to an alternative theory of the strong U.S. performance: Unsustainable consumer spending was propping up an economic house of cards that would eventually crumble.

Reduced lending standards indeed fueled a mortgage origination and housing boom that has now gone bust. A highly leveraged financial system, in which an explosion in exotic securities spread hidden or well-disguised risks around the globe—combined with the collapse in value of mortgage-backed securities—has produced a credit crunch of epic proportions. Many once-venerable financial firms have disappeared or been acquired for next to nothing only thanks to federal backing of poor assets. The values of real and financial assets have plummeted, weakening the balance sheets of banks, firms, and households. The resulting collapse in consumer confidence and spending has sent the economy into its sharpest decline since at least 1982. The proportionate decline in employment from September 2008 to January 2009 is more than half of what occurred in the entire 1982-83 recession.

Today, nearly everyone has bought into the “economic house of cards” version of recent history. The economic achievements of the last 25 years seem like a distant memory, if not a mirage. How should we interpret this period? What lessons can we take from it? And how do those lessons shape our policy needs for the future?

Is the Glass Half Empty or Half Full?

My thesis is that just as the economy was not as bad as we feared in the depths of the 1982-83 recession, nor as good as we believed in the early years of the 21st century, our economy today—while staggered by unsound housing investments and financial fallout—will prove resilient. The key is to protect the economic institutions that were responsible for much of the vitality we have seen in recent decades and invest in human capital.

A more balanced view of the U.S. economy must acknowledge that the growth of consumption and decline in savings rates we have witnessed was at least partly a consequence of our “unexpected” economic success since the mid-’80s. That’s right—rising domestic expenditures and current-account deficits can be natural symptoms of an economy that has exceeded prior expectations. This is a counterintuitive idea and merits more explanation.

A classic example of this phenomenon is the case of Norway in the 1970s and ‘80s. During that period, substantial reserves of oil were discovered in the North Sea. As a result of this windfall, domestic expenditures outstripped production and the current account deteriorated. And it was all perfectly rational: Norwegians began to desire more than current production would permit and foreign entities filled the gap.

While less abrupt and less tangible than the case of Norway and the North Sea oil, the knowledge-economy revolution spurred by globalization and technology change in the United States in recent decades likely provided a similarly pleasant surprise for many U.S. households. Coming off the dark period of the 1970s and early 1980s, expectations for asset returns and income growth were likely very modest and, as result, savings rates may have been relatively high.

If actual investment returns exceeded expectations for the period after 1983, then people’s accumulated wealth exceeded expectations as well. When wealth is unexpectedly high, it is natural that consumption may rise as a share of current income. Some of the stock of wealth may be exchanged for foreign goods and services—that’s the definition of a current-account deficit.

In addition to these positive developments in financial investment returns, the United States has an abundance of attractive land relative to other developed economies. As barriers to international ownership of real estate have fallen, it is natural to expect net inflows of real-estate investment to the United States and similarly well-endowed countries (such as Australia and South Africa). Foreign investment in U.S. real estate will both increase the value of U.S. property and provide additional purchasing power for our residents.

The purpose of saving is to store wealth for the future. As shown in Figures 2 and 3, the decline in savings rates coincided with an increase in wealth as a share of disposable income. It seems likely that the decline in savings rates in recent years was at least in part due to many households feeling adequately prepared for the future.

“Rebuilding the faith and confidence individuals have in our future—badly shaken by the collapse in their wealth—is critical to getting through the current downturn.”

Micro estimates of people’s saving are consistent with this view. Work by Wisconsin economists Ananth Seshadri and John Karl Scholz shows that in 2004 almost all Americans born before 1954 had accumulated sufficient wealth to maintain their living standards in retirement. Even now, after the most severe financial and housing market meltdowns since the Great Depression, their framework finds that more than 70 percent of Americans born before 1954 had net worth sufficient to maintain their living standards in retirement. While some households are certainly overextended, the savings debate has been sensationalized in contemporary media accounts.

The Challenge Ahead

There is absolutely no denying that as a nation we invested far too much in housing and that many individuals profited from what proved to be very poor investments. There was a real opportunity cost to the resources we devoted to housing. And the investment losses people have suffered in financing that binge are causing the collapse in confidence and consumption today.

Rebuilding the faith and confidence individuals have in our future—badly shaken by the collapse in their wealth—is critical to getting through the current downturn. Restoring faith and confidence in our financial institutions—damaged by a combination of poor risk management, outdated regulatory institutions, and poor leadership—is essential to long-term economic growth. It is also key in facilitating investment in human and physical capital. These will be big tests for our political
and business leaders.

The Obama administration is now left with the daunting challenge of convincing the public that the short-term remedy for the economy that stands accused of chronic over-spending is (you guessed it): more spending! The effectiveness of fiscal stimulus is far from a sure thing in this environment. We are confronting the “paradox of thrift”: households are increasing their savings rates to rebuild the wealth destroyed in the market, but the reduction in spending is destroying jobs and income in the process. There is no guarantee a tax cut will be spent.

While many factors will determine the effectiveness of stimulus in achieving objectives, three stand out. First, the rate of economic decline is very high right now, so this is the best time to inject demand. Market forces may have us moving forward on their own by next year. Second, new spending should focus on projects that boost productivity or somehow address market failures. Cost-benefit analysis should drive decisions, rather than merely spending for its own sake. It will be a challenge to achieve both of these objectives.

Finally, short-term stimulus must be part of a responsible long-term fiscal plan. This can reduce uncertainty in the market, and it would also model good behavior for households. To mitigate the paradox of thrift, we need to persuade households to rebuild their balance sheets over ten years, not one year.

Our economy has successfully recreated itself in the last 25 years. Coming out of a severe recession a quarter century ago, there was far more uncertainty about our place in the global economy. The revolutions in information technology and globalization that have shaped our evolution appear to be far from finished—strong evidence that we as
a nation will meet today’s challenges.

Michael M. Knetter, the Albert O. Nicholas Dean of the Wisconsin School of Business, has published widely in the areas of international economics and macroeconomics. He served as senior staff economist for the President’s Council of Economic Advisors for former presidents George H.W. Bush and Bill Clinton. Knetter is also a trustee for Neuberger Berman Funds and Northwestern Mutual Series Fund and a director of Wausau Paper.