Thursday, February 14, 2008

They Can’t Both Be Right


CNN reported on today’s testimony by Treasury Secretary Henry Paulson and Fed Chairman Ben Bernanke:

The story began:

“Federal Reserve Chairman Ben Bernanke and Treasury Secretary Henry Paulson both acknowledged problems in the U.S. economy Thursday, but both said they believe the nation will avoid falling into recession.

“The two made their comments at a hearing before the Senate Banking Committee about the economy. Their testimony comes in the wake of troubling economic readings that have raised recession fears on Wall Street.

“But while Paulson and Bernanke repeatedly insisted they expect the economy to avoid shifting into reverse - thanks in part to a series of interest rate cuts by the Fed and a $170 billion economic stimulus package signed by President Bush Wednesday - they conceded the economy faces additional headwinds.”

Note the emphasis: Times are rough, but no recession.

For a fascinating counterpoint, take a look at Robert Reich’s op-ed piece in yesterday’s New York Times:

Prof. Reich sums it up in the opening paragraphs:

“WE’RE sliding into recession, or worse, and Washington is turning to the normal remedies for economic downturns. But the normal remedies are not likely to work this time, because this isn’t a normal downturn.

“The problem lies deeper. It is the culmination of three decades during which American consumers have spent beyond their means. That era is now coming to an end. Consumers have run out of ways to keep the spending binge going. “

The point is clear: We’ve had the fat years, get ready for the lean.

It would be easy to dismiss these points of view with a reference to their authors’ orientation. The Treasury Secretary and the Fed Chairman must keep hope alive. They can’t admit recession without being accused of instigating one. The professor is a lefty whose gloomy forecasts have proven wrong before, and left-wing nostrums are sometimes at the heart of his suggested remedies.

But this divergence of views deserves more than a brush-off. Messrs. Paulson and Bernanke are, of course, correct. It’s too early to be absolutely sure we’re in recession. So Prof. Reich’s characterization is premature. Yet the professor builds on a fear that has been expressed before: We’ve borrowed to the hilt and can borrow no more. Spending financed by borrowing must shrink.

Prof. Reich weaves this observation into a historical analysis of recent developments. He reminds us that the typical worker’s income has not grown over several decades. A working spouse and more hours on the job helped, up to a point. So did borrowing ever-larger sums to finance the growing expenditures that enabled a rising level of living. That instigated the asset inflation that perpetuated the boom and postponed the day of reckoning.

Here’s how it worked. Borrowing and spending expanded consumption and also drove up real-estate values. Higher home-values (more collateral) permitted additional borrowing and spending. More borrowing -> More spending -> Soaring real-estate values -> More borrowing -> More spending.

But real-estate values are now collapsing all around us, so the borrowing and spending are grinding to a halt. The average Joe can’t borrow more and can’t earn more. How can he sustain the expenditures required to keep demand growing and the economy going? Prof Reich's answer: He can't, and that's why we're in trouble.

Even if you don’t agree with Prof. Reich’s solution of income redistribution, his basic warning is worth considering. Are we at a historic turning point? Does the bursting of the credit bubble mean the end of borrow and spend? Could it be that the economy’s demand-side engine has finally run out of gas? Many will respond that the supply-side remains in good shape, so not to worry. The New Economy (High-tech) is still with us. We will produce our way out of this.

Yet the stark contrast between the views expressed in these stories is worrisome in itself.

© 2008 Michael B. Lehmann

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