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

• Boom and Bust in US Housing Market
• Reasons for Fall in US Dollar
• Debt in US
• Essays on Recession
  

Sources

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

• US External Debt as a % of GDP
• Federal Debt at Treasury Direct

Image Sources:

• US House Prices
• Long Term Dollar
  
• Current account deficit
• Inequality - Federal Reserve Bank of San Francisco