About this time of the year 8 years ago I prophesised that George W Bush would live to regret having been elected president because of the impending downturn arriving hot on the heels of the Dot-com bubble. Of course it went differently, with W setting out for higher goals and leaving the economy to a Treasury Secretaries almost anonymous enough that they are already forgotten (O'Neill and Snow, just in case). In the Federal Reserve they were matched by a self-declared ideological crusader, who saw it as one of his life's missions to keep state intervention in the economy to a minimum in the belief that human greed would engender the necessary caution and stability in the markets.
In the aftermath of the Dot-Com bubble, Greenspan did what he had done in earlier cases of economic turmoil: he lowered the interest rates. However, in 2001 profound liberalisations had been introduced by the Clinton administration. And everybody went on a lending or borrowing spree. In the US, the accumulation of debt relative to GDP rose to an all time high. And then last summer, this bubble also burst. George W had in the meantime replaced John Snow in the Treasury by Henry (Hank) Paulson. A former star athlete, White House insider, and Government Sachs CEO, Paulson demonstrated great energy in his attempts to avert the crisis.
As Barack Obama was sworn in as the 44th President of the United States, the economic crisis was as deep as ever, and worsening. Judged by early data, the US economy could have shrunk by as much as 5 per cent annualised in the last quarter of 2008. Lay-offs continue faster than any time since World War II. World trade is nosediving, hitting a nascent American export boom. The economy needs between $850bn and $1000bn as a stimulus package, and counting for every day. Paulson's ill-formulated TARP programme to salvage the US banking system is gradually proving as ineffectual as critics believed it would be, while largely leaving untouched the very individuals who were responsible for reckless lending and underwriting activities. Abroad – in the export markets - things have not been much better with demand falling off a cliff.
Obviously, the markets are looking to Obama and his team to take decisive action. I am just afraid that they may be too optimistic. Obama and his team are probably fully aware that they need to take painful action now in order for it to be forgotten when re-election is up in 2012. There is just a snag here. This crisis is no normal bump-in-the-well-paved road economic crisis. The root lies with what one could call the American Way of Lending. And it will take a while to fix.
Let me be precise about the use of words here. By American Way of Lending I refer to a culture of easy credit, lax regulatory standards, banks underwriting securities instead of lending, generous rules for personal bankruptcies, and so on. Roughly since the Reagan era, the US economy has been gradually liberalised. There is no doubt that the positive side of this that the US economy has been as vibrant and innovating as it is the case. But the negative side has been a household sector which has gradually – and over the time span of a whole generation – learnt the consume first and pay later. This culture, paired with a low-interest rate policy and financial innovation has created not only the biggest housing bubble in history. It has also created the biggest current account deficit in history.
I have on earlier occasions written that it takes time to get out of a situation like this. First, the households have to increase their savings rate. To pay off debts. Given that a lot of private debt is mortgage debt, and given that the employment situation will not improve until maybe sometime in 2010, many consumers will experience negative equity and perceive of their economic situation to be more insecure than just 6 months ago. This leads to an even sharper economic downturn. It is therefore unlikely that the US consumer will begin to consume at a rapid clip again until debts have been worked off and the negative equity have been removed. Other countries have made experiments with the same combination, and invariably it has taken a period of 4-5 years until the decks have been cleared. Typically, the economy shrinks sharply in the beginning of the period as the savings rate is pushed up, and the economy grows slower than potential for a while, because of a slow growth in private consumption.
Barack Obama was elected on a promise of change. Probably it was not supposed to be a change for the worse, economically speaking, and for a longer period of subpar economic growth. Bill Clinton famously beat George HW Bush on a simplistic "It's the economy, Stupid" message. For all his compelling rhetoric, I am afraid that Barack Obama in 2011 may find himself open to exactly the same criticism, as the economy may still be subdued. Even if he and his economics team arrive at just the right actions. Life is tough, but unfair...
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