Executive summary
- The U.S. has become a nation preoccupied with consumption over investment; outsourcing its jobs, hollowing out its middle class and accumulating increasing debt burdens to do so.
- U.S. wages and salaries have plunged to the lowest share of GDP in history, while the civilian labor force participation rate has dropped to levels not seen since the 1970s. Yet consumption as a share of GDP is near a record high. This gap between income and expenses has been financed by debt accumulation, encouraged by the Federal Reserve’s policy of zero interest rates and enabled by fiscal policies that prioritize income replacement rather than targeted spending and investment.
- Since December 1999, total civilian employment among individuals 55 years of age and older has increased by 15.3 million jobs. Yet total civilian employment – including those over 55 – has grown by only 13.8 million jobs. This means exactly what you think: outside of workers 55 years of age and older, Americans of working age have 1.5 million fewer jobs today than 15 years ago.
- There are now more than 46 million Americans on food stamps, with SNAP (Supplemental Nutrition Assistance Program) expenditures increasing fivefold since 2000.
- While transfer payments and entitlements have increased, government consumption and investment as a share of GDP have declined to near the lowest levels in history. In effect, fiscal policy has been heavily biased toward income replacement, but has otherwise been a deer in the headlights in the face of repeated economic crisis. While the contribution of private investment has slowed to a crawl, fiscal policy – except for transfer payments – has actually been in retreat.
- In the investment sector, real gross private domestic investment has grown at a rate of just 1.5% annually since 1999 (versus a 4.7% real annual rate in prior decades), with growth of just 1% annually over the past decade. Yet while real capital accumulation in the U.S. has weakened, corporate profit margins have never been higher.
- In an economy where wages and salaries are depressed, but government transfer payments and increasing household debt allow households to bridge the gap and consume beyond their incomes, companies can sell their output without being constrained by the fact that households can’t actually afford it out of the labor income they earn. Meanwhile, our trading partners are more than happy to pursue mercantilist-like policies; exporting cheap foreign goods to U.S. consumers, and recycling the income by lending it back to the U.S. in order to finance that consumption.
- Debt-financed consumption, while it proceeds unhindered, is a central driver of elevated corporate profits. Unusually elevated corporate profits (a surplus) are largely a mirror image of unusually large deficits in the household and government sectors.
- The most reliable stock market valuation measures (i.e. the measures that have a nearly 90% correlation with actual subsequent stock market returns) are those that explicitly take account of the level of profit margins and mute the impact of that variability. These measures suggest that the S&P 500 Index is likely to be lower a decade from now than it is today (though dividend income should bring the total return to about 1.5% annually).
- Even if the Federal Reserve was to immediately reduce the monetary base by one-third (from nearly 24 cents of monetary base per dollar of GDP to a smaller 16 cents of monetary base per dollar of GDP), short term interest rates would still be zero.
- Once we account for movements in the Federal funds rate that can be captured by a fairly simple linear policy rule such as the Taylor Rule, additional activist monetary policy (deviations from that rule) have effectively no ability to explain subsequent changes in GDP or employment. There is a strong economic justification for proposals that would require the Fed to outline Taylor-type policy guidelines, and to explain deviations from those guidelines. These proposals should be advocated by Republicans and Democrats alike.
- Yield-seeking speculation promoted by the Federal Reserve caused the housing bubble and the resulting global financial crisis. A change in accounting rules by the Financial Accounting Standards Board in March 2009, not extraordinary monetary policy, is what ended that crisis.
- The true Phillips Curve is a relationship between unemployment and real wage inflation, it cannot be usefully exploited by monetary policy, and it is the only version of the Phillips Curve that actually exists in empirical data. Pursuing general price inflation does not somehow “buy” more jobs. It also does not raise real wages. It lowers them.
What raises both real wages and employment simultaneously is economic policy that focuses on productive investment – both public and private; on education; on incentivizing local investment and employment and discouraging outsourcing that hollows out middle class jobs in preference for cheap foreign labor; on international economic accords that harmonize corporate taxes, discourage corporate tax dodging and beggar-thy-neighbor monetary policies, and provide for offsetting penalties, import tariffs and export subsidies when those accords are violated. What our nation needs most is to adopt fiscal policies that direct our seed corn to productive soil, and to reject increasingly arbitrary monetary policies that encourage the nation to focus on what is paper instead of what is real.
Introduction
One of the central policy errors since the global financial crisis –Â and indeed since the collapse of the technology bubble after the 2000 market peak –Â has been the notion that economic problems caused by financial crisis must be fixed by financial means, monetary policy in particular. Unfortunately, this line of thinking has progressively weakened the U.S. economy, making it increasingly dependent on debt, encouraging the diversion of scarce savings to speculative purposes, promoting beggar-thy-neighbor monetary policies abroad that encourage the substitution of domestic jobs for cheaper foreign labor and creating what is now the third U.S. equity valuation bubble in 15 years.
What we demonstrate below is this. The U.S. has become a nation preoccupied with consumption over investment: outsourcing its jobs, hollowing out its middle class and accumulating increasing debt burdens to do so. Making our country stronger will require us to turn our backs on paper monetary fixes that discourage saving while promoting speculation and debt-financed consumption. It will also require us to turn toward policies that encourage productive investment – public (e.g., infrastructure), private (e.g., capital investment and R&D), and personal (e.g., education). The good news is that these policy options are within reach if we are enlightened enough to choose them.
How we got here
The 1990s embodied two major economic shifts. An increasing trend toward globalization began to substitute domestic labor and output for outsourced labor and cheaper foreign goods. From a position of balanced trade in 1990, the U.S. current account deficit gradually expanded, reaching 4% of GDP annually by 2000 (and 6% by 2004). Meanwhile, the growth of the internet provoked an expansion of technology investment and eventually a bubble, which the Federal Reserve did little to counter, other than Alan Greenspan’s purely rhetorical question asking “how do we know?” when a bubble has reached the point of irrational exuberance.
Following the collapse of that bubble during 2000-2002, the role of the Federal Reserve changed from a benign observer to an active facilitator of bubbles. By pushing short-term interest rates toward 1% in 2003, the Fed provoked a reach for yield by investors, who found refuge in mortgage securities (which until that point had historically had low rates of default despite offering a “pickup” in yield over Treasury securities). Wall Street responded to that demand by creating a massive volume of new supply, eventually lending to anyone with a pulse in order to create new “product” that could be repackaged and sold to yield-hungry investors. The financial collapse that followed would push the U.S. economy to the brink of depression, yet the role of the Federal Reserve in producing the crisis has been forgotten.
Part of that memory failure is the result of misattributing the subsequent recovery to Federal Reserve heroics. In that context, it’s essential to understand that it was not extraordinary monetary policy that ended the financial crisis. The crisis ended – and in hindsight, ended precisely – on March 16, 2009, when the Financial Accounting Standards Board abandoned mark-to-market rules, in response to congressional pressure by the House Committee on Financial Services on March 12, 2009. The decision by the FASB gave banks “significant judgment” in the values that they assigned to assets. While the Fed did have a legitimate role as a lender of the last resort, it vastly overstepped that role by violating Sections 13 and 14 of the Federal Reserve Act (which Congress later amended in order to lay out the restrictions like a See Dick Run book).
In the years since, the Federal Reserve has done everything in its power to reignite a financial bubble, in hopes of generating a “wealth effect” sufficient to encourage economic activity via greater consumption and debt finance.
This is like advising someone “if you want to prosper, you should consume more, and go as deeply into debt as possible.” We all know intuitively that this is the wrong message. Prosperity requires productive investment. To fully understand why there seems to be such a growing gap between Main Street and Wall Street; between working Americans and corporations, let’s briefly examine the drivers of the economy one by one.
The U.S. economy: sector by sector
Gross domestic product (GDP) is equal to consumption, plus real investment (factories, housing, capital equipment) plus government spending plus exports minus imports. This isn’t a theory. It is simply an accounting identity, but we can understand a great deal about the state of the economy by examining these components individually.
In the consumer sector, wages and salaries have plunged to the lowest share of GDP in history, while the civilian labor force participation rate has dropped to levels not seen since the 1970s. Yet as the U.S. has become underemployed, it has become a more active consumer nation, with consumption as a share of GDP recently hitting a record high. This gap between income and expenses has been financed by debt accumulation, encouraged by the Federal Reserve’s policy of zero interest rates, and enabled by fiscal policies that prioritize income replacement rather than targeted spending and investment.
In the investment sector, real gross private domestic investment has crawled at a growth rate of just 1.5% annually since 1999 (versus a 4.7% real annual rate in prior decades) with growth of just 1% annually over the past decade. Yet while real capital accumulation in the U.S. has slowed to a crawl, corporate profit margins have never been higher. Coupled with yield-seeking speculation encouraged by the Federal Reserve’s zero interest rate policies, reliable measures of stock market valuation have now been pushed beyond every cyclical peak in history except the 2000 bubble peak. There are, of course, numerous unreliable measures of valuation that appear more “reasonable,” but these also have little relationship with actual subsequent market returns.
In the government sector, the global financial crisis resulted in a sharp boost in transfer payments such as food stamps and unemployment compensation. While unemployment compensation has declined considerably, there are now more than 46 million Americans on food stamps, with SNAP (Supplemental Nutrition Assistance Program) expenditures increasing fivefold since 2000. But while transfer payments and entitlements have increased, government consumption and investment as a share of GDP have declined toward the lowest levels in history. In effect, fiscal policy has been heavily biased toward income replacement, but has otherwise been a deer in the headlights in the face of repeated economic crisis. While the contribution of private investment has slowed to a crawl, fiscal policy – except for transfer payments – has actually been in retreat.
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