The Real Economy: A Whiff of Irrational Exuberance
Policy + Politics

The Real Economy: A Whiff of Irrational Exuberance

Declaring victory over the recession is like saying, “Mission Accomplished”

Whew. I’m glad that’s over, aren’t you?  First quarter GDP growth of 3.2 percent, a 3.6 percent jump in consumer spending, consumer confidence posting its strongest gain in years: Now that the Great Recession is behind us, we can get back to being a great nation again. Corporate bonds stand at almost back-to-normal levels compared to Treasuries, the stock market is up 70 percent from its low, and even pathetic GMAC managed to pay off its TARP loan. Newsweek economics writer Daniel Gross captured the mood in a triumphant April cover story that touted the resilience of American enterprise and the creativity of homegrown corporations like Apple and Fisker Automotive, a maker of $87,000 electric cars: “America is Back!”

Like soldiers who’ve shipped home from Iraq, the America that
came back from 2008 and 2009 is not the same one that went in.

Perhaps the headline might have been more accurate had it been, “Mission Accomplished.” The self-congratulation in Washington and in banking boardrooms carries a strong odor of premature declaration of victory. Yes, the recession may well be over, but like soldiers who’ve shipped home from Iraq, the America that came back from 2008 and 2009 is not the same one that went in. Our economic prospects, the depth and energy of our financial system, and our credibility in the world are never going to be the same. Let’s face some unpleasant truths:

We were in a fiscal hole before. We are now in a fiscal mine shaft. The Keynesian bargain in our recovery strategy was this: Government spending would cover the hole in private spending, rebuild confidence, and hold open the door to economic recovery. Private enterprise would then walk through the door and growth in the private economy would allow us to pay off the government debt without too much pain.

The problem is there can only be so much deficit spending before things start to come undone. (See Greece, riots in streets of.) The idea that massive deficits will necessarily lead to hyperinflation is not borne out by history, but that doesn’t mean that Dick Cheney’s alarming conclusion — “Reagan proved that deficits don’t matter” — is true. Economic historians Kenneth Rogoff and Carmen Reinhart have documented thatrunaway government borrowing in developed economies does indeed become a drag on output once it exceeds 90 percent of GDP. (For comparison, the ratio of public debt to GDP in 2009 was 119 percent in Greece, 21 percent in China, and 84 percent in the U.S.) Projections of President Obama’s budget by Alan Auerbach of the University of California, Berkeley and William Gale of the Brookings Institution would put the national debt over the 90 percent tipping point by 2020. Unless the deficit is brought under control, say Auerbach and Gale, the upshot will be reduced national income and a falling standard of living, making America something short of the Comeback Kid.

Loans will be scarcer and more expensive for businesses and
consumers—the opposite of what’s needed to rebuild the economy.

So why all the euphoria, especially when there’s less to the banking recovery than meets the eye?  Spooked by the panic following the failure of Lehman Brothers, our financial leaders avoided making essentially insolvent banks like Citi and Bank of America write off their toxic loans. Instead, banks have been allowed to hold such assets on their books at inflated prices while they slowly rebuild their capital — a head-in-the-sand policy sarcastically dubbed “extend and pretend.” While it grinds on, loans will be scarcer and more expensive for businesses and consumers — the opposite of what’s needed to rebuild the economy. “Extend and pretend means that banks will continue to shrink, lending will continue to decline and real economic activity will continue to suffer,” says Christopher Whalen of Institutional Risk Analysis, a bank rating firm. “The cost of extend and pretend runs into the trillions of dollars of lost economic activity.”

“The zero interest rate policy is a massive transfer
of wealth from savers to banks.” –Christopher Whalen

But what about all those record bank profits? Isn’t that a sign that bank lending is back? Not at all, says Whalen: It’s just an indicator that even our most brain-dead banks can make money when the Federal Reserve holds their cost of goods — short-term interest rates — at essentially zero. “The zero interest rate policy is a massive transfer of wealth from savers to banks,” says Whalen. In a financial rondeau that would make even Lloyd Blankfein blush, banks borrow taxpayers’ deposits at close to zero percent rates and essentially lend it back to them at higher rates, through Treasury purchases. The banks keep the profits. Nice work if you can get it, but not exactly the “God’s work” of allocating capital to ensure economic growth.

Finally, America is no longer unquestionably the world’s most admired country. A key part of America’s global authority was the perception that its free market economic philosophy and associated political freedoms held the key to prosperity. The benefits were clear: Other countries accepted our dictates and agreed to trade policies that raised our standard of living. The world’s most talented entrepreneurs and scientists came to our shores to make their fortune. The world’s people wanted to be like us — and as a result, snapped up our cultural exports from movies to soft drinks to fashion to women’s rights.

Not so much now. Our growing addiction to loans from other countries had already begun to erode the appeal of Brand America. But the spectacle of our leadership in a panic and the exposure of our free market prosperity as a debt-induced illusion dealt it a blow that will take more than the iPad and an as yet unproven electric car to restore.

Maybe America is back. But it’s an America whose economic credibility and prospects are doubted as they haven’t been since the 1930s. As University of California, Berkeley, economists Brad DeLong and Steve Cohen put it in The End of Influence, “America may continue to be a world leader, perhaps even the leader. But it will no longer be the boss.”

Reporter: Temma Ehrenfeld

Eric Schurenberg is editor-in-chief of CBS MoneyWatch.