The Limits of False Prosperity

When economists and economic historians come to write about the crash of 2008, I hope that they take a longer view. This wasn't just a "housing bubble," or a "dot.com bubble," or a "credit crunch." At some point, probably back in the Reagan administration, the government, corporations, and individuals all decided to "put it on the never-never." (That's an old British expression for installment payment plans, under which one could have a desirable something now, and cost of it would be stretched into the "never-never.") I could even trace it to a single tacit agreement between a national leader and the people of this country.

In 1980 Ronald Reagan promised to increase military spending, cut taxes, and balance the budget. Let me digress for a moment into the world of project management. A popular theory of project management holds that there are three conditioning factors for a project: time, money, and quality. A project manager can increase quality by spending more time or more money, or can cut the budget by decreasing quality, but you can't improve quality, use less time, and spend less money. Similarly, I think that everyone knew that it was impossible, barring some sort of miracle, to increase spending, decrease revenue, and decrease the budget deficit. But a majority of Americans, myself included, voted for Mr. Reagan, by that action tacitly agreeing to base government programs on make-believe, rather than reality.

Parenthetically, I might say that there was an escape clause here, and it lay in the ambiguity between "cutting taxes" and "lowering revenue." According to economic theories attributed to Joel Laffer, a decrease in the tax rate could lead to an increase in tax collections, because of the removal of incentives to evade taxes, and because of the stimulus to economic activity provided by the tax rate cut. My personal problem with Laffer curves is that they were based upon the experience of the early 1960s, when maximum tax rates were decreased from 91 per cent to 70 per cent. The incentive to evade, and the disincentive to invest, at 91 per cent may have been enough to increase revenue in an otherwise favorable economic climate. But there was little or no evidence about what would happen when maximum tax rates were already in the 40 per cent range.

It has become a commonplace that incomes (in real terms, i.e., adjusted for inflation) have been pretty much flat since the early 1970s, and that such income growth as has occurred has been at the upper levels. On the other hand, productivity has been rising, which would have supported substantial wage increases. If workers, who were also consumers, could not purchase goods in some proportion to their increase production, an oversupply, with the inevitable deflation, would have occurred. Moreover, because the profits of corporations were not being distributed to the workers, money was accumulating in their accounts. What to do, what to do?

I want to make clear that I do not believe that there was some master plan at work here. I think the set of rules and incentives established in the early 1980s, along with an aversion to deferring gratification, led to the following results, which reinforced one another in various ways.

First, money was shipped overseas, for investment in foreign plants. That removed the threat of inflation due to excessive money circulating in the system.

Second, cheap products were imported from overseas. That removed the threat of cost-push inflation, by ensuring that there was always a cheap alternative.

Third, because more production was happening overseas, manufacturing jobs declined in number in the United States. And that took care of wage-driven inflation.

Fourth, a lot of jobs appeared in services. Some of these were very low-wage food service jobs, but some were commissioned sales jobs in the financial sector.

Fifth, noting that demand might not be keeping up with supply, which would lead to deflation (mustn't have deflation!), the authorities loosened all of the rules on borrowing.

In other words, because people's wages didn't go up with their productivity, they couldn't buy a lot of stuff that other people needed to sell, because so many people - mortgage brokers, stockbrokers, real estate salespeople - were commissioned. Therefore, it was in everyone's (apparent) interest to make it easy for people to borrow the money, so that they could buy houses, and cars, and appliances, and stuff. So, individuals stopped saving, and increased their borrowing. When savings occurred in spite of them, as when the values of their houses rose, they borrowed against that increased equity.

But corporations were also borrowing. I might note that one reason for this is that equity financing, which corporations pay for with dividends, lacks tax advantages over debt financing, which corporations pay for with (tax-deductible) interest. Corporations borrowed huge sums to buy other corporations, assuming their debt.

And, after a brief period in the 1990s, caused more by the inability of the branches of the government to agree on tax and spending policy, than by their agreement on a sensible approach to these things, the government has been borrowing. Not only are their constituents averse to taxes, they actually seem to believe that higher taxes are unnecessary! So President Bush cut taxes for the wealthy, and many not-so-wealthy, and then didn't rescind those cuts when he became involved in expensive overseas combat operations.

So, that's the real core of the crisis. No one, and I mean no one, has been willing to accept the spending discipline required to, in a phrase that falls quaintly on the ear, "live within their means."

I read an article in the Washington Post (National Weekly Edition) issue of October 6, which gave me a perfect example. A woman bought a townhouse in Dale City, Virginia, for $75,000 in 1993. After a number of actions, including refinancing the house for $208,000 with a reverse-amortization loan, she defaulted on the mortgage. The house reverted to Fannie Mae. They couldn't sell it at $149,000. They are now trying to sell it for $69,900. In other words, that house is worth today just about the same amount it was worth in 1993. It's always been worth $70-75,000. It has never been worth more. It, and a lot of other things, were made to appear worth more than they were, because unlimited credit led to massive inflation, which wasn't counted as such. Nobody wanted to say that the prosperity was false, or that the emperor had no clothes.