Tuesday, January 15, 2008

What Went Wrong With the US Economy?

The US economy remains the biggest and most influential economy in the world. Yet, despite its status the US economy is experiencing unprecedented problems and the threat of a recession is only one of many problems affecting the US economy. Many of the economic problems faced by the US were largely avoidable and are the result of economic mismanagement at various levels.

Fundamental Problems of US Economy

  • National Debt of $10,000 bn (68% GDP
  • Current Account Deficit $857 billion equivalent of 6.5% of GDP [1]
  • Housing Market - House prices have fallen by 30% in some areas.
  • Rising Inequality
  • Devaluing Dollar - Loss of Confidence In America and America's economy. (US Dollar Collapse?)
  • Record Debt Levels - Past growth has been financed by consumer borrowing and
  • Credit Crunch - Loss of confidence in banking system due to bad loans

Housing Boom and Bust

House Prices - Boom and Bust

The US Housing Market is a classic example of an avoidable asset price boom and bust. Various factors allowed house prices to rise much faster than incomes creating an asset which was fundamentally overvalued. As house prices fall to correct the imbalance, there will be a marked slowdown in consumer spending and could tip the economy into recession.

Why did the Housing Bubble Occur?

  1. No regulation of Subprime mortgages. Simply put, the mortgage industry was able to sell mortgages with casual disregard for whether they could be paid back. This is a simple recipe for future mortgage defaults, home repossessions and declining house prices. In Europe, this mortgage mess would not have occurred because the mortgage industry is closely regulated to prevent this kind of mis selling. The US mortgage industry was irresponsible, but, the government are also to blame for allowing irresponsible practices to occur.
  2. Low Interest Rates. In 2001 interest rates were cut to stimulate growth, with interest rates so low, people felt mortgages were affordable; wrongly assuming they would not increase. Alan Greenspan never saw the housing market as an overvalued asset bubble and thus did not nothing to prevent it.
  3. Adjustable Mortgages. To avoid volatility in the housing market, European economies (except the UK) generally promote more fixed rate, long term mortgages. This insulates against interest rate induced volatility and helps create greater stability (although it is fair to say many European economies have experienced a booming housing market)

Trickle Down Effect and Rising Inequality

Graph showing rising inequality in the US

Since 1980 inequality in the US economy has increased. Even Alan Greenspan has admitted that rising inequality in the US "is a very disturbing trend"The fastest income growth has been focused in the highest earners Yet, income tax cuts have also been repeatedly been targeted at high income earners. In real terms the minimum wage has failed to keep up with growth in real incomes. At the same time more people have moved into part time / unskilled / low income jobs. The effect has been to create a two tier labour market. One highly paid with job security; the other low paid with little security. Although, unemployment figures are low, this hides a large amount of temporary, low paid and insecure jobs. The fundamental problem is that the government have shown little regard for effectively reducing relative poverty. It has been low on the agenda and the national debate in US has tended to ignore this problem

Further reading: inequality in the US Economy

Budget Deficit and National Debt

US National Debt - $9,007.7 2007 Bureau of the Public Debt (65% of GDP)

It doesn't take a genius to work out that if you cut taxes for the rich and increase spending, you will get an increase in the government deficit. But, with the exception of the Clinton administration, recent American Presidents have casually disregarded any aspiration for fiscal responsibility. Despite a looming demographic problem, the Bush's and Reagan have allowed the size of the budget deficit to increase. This budge deficit puts upward pressure on interest rates, increases consumption at the expense of private sector investment and means future generations will be forced to pay back a higher interest payments. The National debt is even worse when the governments liabilities for public sector pensions are included. Furthermore, the ageing population will aggravate the national debt in the future. An ageing population places higher demand on health care and pensions, and pays less tax.

The deficit was created with little long term benefit. The deficit has not been used to stimulate demand in a recession, it has not been used to invest in public services. When Bush, cut taxes for high income earners in 2001, it was a badly targeted expansionary fiscal policy - it did nothing to increase the long term productive capacity of the economy. The increased spending on military hardware benefits the economy little save a small group of defence companies.

The problem is that now the US economy faces a real recession, there is little scope for expansionary fiscal policy. The next President will face real difficulties in reducing the national debt because demographics will work against fiscal stability and the deficit will worsen because of the stage of the economic cycle. One of the most damaging economic legacy of the Bush era is a burgeoning national debt with little hope of fixing it. This will be a constraint to future growth. The national debt will require either higher taxes and lower spending, or it will put upward pressure on interest rates crowding out private sector spending.

Current Account Deficit

The US Current Account deficit stands at over 5% of GDP (down from 6.5% in 2006). It is true in an era of capital mobility a current account deficit is easier to finance. But, if you maintain a deficit of over 5% for a prolonged period of time, it is unsurprising if, eventually, you face difficulties in attracting the necessary capital flows. Because Asian investors are becoming more cautious over the prospects in the US deficit, capital flows are slowing down contributing to the devaluing dollar. The current account deficit shows that there is a fundamental imbalance between consumption and domestic production and could act as a contstraint on future growth.

Devaluation of Dollar.

The Long term decline in the dollar

The recent devaluations of the dollar partly reflects changes in the trade cycle; i.e worsening prospects of growth and falling interest rates make it less attractive to buy dollar assets. But,in addition to short term factors, the falling dollar is also symptomatic of the structural weaknesses in the US economy. It is becoming less competitive compared to its trading partners.

Confidence in America and the Dollar

Because the US economy is weakening, the dollar no longer seems so attractive. The financial losses resulting from the subprime crisis even raise the riskiness of any US assets. Because the US is the strongest economy it seems inconceivable that the US could default on its loans. But, some believe it is now at risk of defaulting.

Further Reading

[1] Current Account deficit 2006 Economist (Since 2006, the current account deficit has decreased to 5.5%

Image Sources:


Anonymous said...

You talked of Inequality.... that is because Middle-class is being killed by outsourcing their jobs. Soon, you will see US divided among Corporate crowns and low-income earners. Income per capita will be good, but distribution was GDP among population will be insane.

Anonymous said...

The old saying that the rich get richer and the poor get poorer is true and a big part of this problem. I am having financial difficulty and the last resort was for my husband to clean out his 401K to avoid foreclosure. We are still having trouble. The measley 39K we took out pushed us a few thousand over the point where we don't get homestead rebates, stimulus rebate, screwed up the kids college financial aid, etc.

I know people who are independently wealthy but because they have "no income" due to the fact that they are not employed--have no mortgages but own in excess of 1.5 million in real estate, brand new cars (paid cash) but they qulify for all and kids get free tuition, free lunch, etc. Just another display of what's wrong.

Anonymous said...

The US is basically a bankrupt economy. Remember Ross Perot and his utterances. Perot blamed the nation’s economic problems on the government’s inability to contain deficit spending ($350 billion in 1992) and pay off the ever-increasing national debt (a little over $4.1 Trillion in ’92, less than half of what it is now).

I am sure the Chinese have trillion USD investments in the US which is salvaging the US economy from total ruin. I am sure Iraq and Afghan war costs (which is deliberately overlooked by the CBO and the biased and unfair US media) are also adding up to the swelling crisis. The capitalist US economy has resorted to socialist principles of nationalization and interventions in the markets to retard the downslide far worse than the Great Depression. You even see the Bush administration trying to deviate the focus away from this financial fiasco by labeling Russia as isolationist and irrelevant which is an irresponsible and dangerous statement from a person who has hardly two months left in her dull fruitless career.

At this moment of crisis, Bush should spend the billion sent to the corrupt regime in Georgia on honest, hardworking, straightforward mainstream middle class Americans.

Anonymous said...

I am a 22 year old single mother trying to get a degree in nursing so i am as close to a guarenteed job as i can get. Now, i am faced with the problem, i wont even be able to afford to go to school because of gas prices.. thus how will i survive? i feel for everyone who is struggling but at the same time what can we do?

Unknown said...

I don't agree with this. Deficit is mostly due to war situation with terrorists and raising cost of energy.
Credit crunch happens due to existence of the big bank and corporations that are too big to fail.
The main differences in income emerges due to very sharp social and cultular differences in US.
The low income people in US are usually low educated people. Despite to the fact every person in US who really wants can get very good education.
High level of legalized previously illegal immigrants contributes to this. We should expect that the next generation of those people supposed to be more competitive.

Jared Clay said...

This economy is getting worse. The gov't needs to lower taxes and the economy will go back up. The people will be ablt to buy more products that way.And this health care....Just plain stupid! We are turning into china! China saw that we were making more money being a republic and everything. The people in the U.S. are just getting way too lazy. They want the gov't to pay for everything but guess where the money is comming from? The people who work for it. The rich are rich because they had to work for their money and mananged it wisly. If you have a million dollars, spend one cent and you arn't a millionair any more. Stand up for what is right for our economy and do something about our gov't.

Senior in high school said...

You know, since im doing indv. speech and my topic is about the economy, I would like some help with it from some people who know what they are talking about. The speech is, Problems with the Economy. If anyone has some advice, I will love to use it. Thanx.

Anonymous said...

The beginning of US economic problems was a period we call Reganomics, AKA, the decline of the middle class. The redistribution of wealth is a function of government, seems the US government since that time hasn't been doing a very good job. I say, start at the bottom. Give consumers buying power and you will create jobs proportionally. However, if you practice trickle-down, the wealth will only end up in a rain barrel!

Tried of Threats said...

It really seems to me that the media and Washington politicians THINK they know how to fix the economy. First off, the Economy is "We the People" No government agency can fix this by pouring money into it. The economy is where American people EARN money, then CIRCULATE IT into what is known as the economy. Now, for years, illegal immigrants have come into this country and obtained a Green Card. They work, many of them getting paid, "Under the table, and NOT paying taxes. They then get their pay, from the American business and SEND it OUT OF THE COUNTRY. Think of it as a wheel with five spokes and taking out 3 of the spokes. It will still turn, but will eventually break. You can NOT earn the American Dollar, and send it out of the country and expect the economy to survive. That is the problem in a nut shell.

Anonymous said...

The notion that rich people are rich because of their own efforts is a peculiarly American fantasy that will apply to a small number of lucky and talented people but in the main, is simply not borne out by the facts. There is a huge amount of inherited wealth in the US, there has been a constant series of tax cuts aimed solely at the rich without any consideration of fairness for other citizens or how this will impact on fiscal deficits (the 2001 Bush tax cut being the most flagrant example), and the statistics on how the top 10-20% have taken an ever-increasing proportion of national income and accumulated capital speak volumes.

As a British outsider who has lived in the USA for three years, I find a great deal to admire in the US system and its cultures, but I find American attitudes to the rich and to health insurance the most difficult to understand. Too many people believe poor people are poor because they deserve it, and the middle classes seem too often to be kept in a state of hopeful acquiescence by the individualist chimera that "everyone can be rich if you try hard enough; therefore if you're not rich, it must be your fault."

The debate over health insurance has at times been frankly deranged; I make no claims that the UK economy and culture is perfect, but at least very very few people would argue that poor people should be left to die or suffer debilitating illnesses just because they can't afford health insurance. The UK's national health service has its problems, and does not seem to work as well as say the French or Canadian systems, but there is a cultural understanding that British people need to cooperate to help others less fortunate than themselves for the common good, and a nationalised system has proved to be one of the least-worse ways of arranging the healthcare side of things, especially when one compares with the US system, which is frankly brutal and primitive and incredibly expensive if you are unfortunate enough to be on low earnings.

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