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Mired in a Colossal Muddle -- US Economy Remains Stuck in Long-Term Slump

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opednews.com Headlined to H2 7/3/11

"We have involved ourselves in a colossal muddle, having blundered in the control of a delicate machine, the working of which we do not understand."-- John Maynard Keynes

B lack Tuesday. On October 29, 1929, the stock market crashed triggering the worst economic collapse in history, the Great Depression. Thousands of banks and businesses failed, shanty towns sprung up across the country, and 15 million Americans (25% of the workforce) lost their jobs.

President Herbert Hoover, who believed the turmoil would be over in a matter of weeks, opposed providing aid to the needy and unemployed. He supported the same policies as his GOP heirs in Congress today who seek to deepen the present crisis by cutting unemployment benefits, slashing fiscal stimulus and balancing the budget on the backs of workers. The Hoover Doctrine was summed up by Treasury Secretary Andrew Mellon who famously said, "Liquidate labor, liquidate stocks, liquidate real estate...purge the rottenness out of the system." Mellon's views prevailed and by July 8, 1932, the Dow Jones Industrial Average had fallen to 41 points (an 89 percent drop from its peak in 1929) while the economy sunk into a decade-long slump.

Before the crash, stock prices had been propped up by massive amounts of margin debt that melted away in a deflationary inferno when the panic selloff began in late October. The calamity took down 4,000 banks and left the broader economy in ruins. John Kenneth Galbraith summed it up like this in his masterpiece "The Great Crash: 1929":

"Had the economy been fundamentally sound in 1929 the effect of the great stock market crash might have been small. .... But business in 1929 was not sound; on the contrary it was exceedingly fragile. It was vunerable to the kind of blow it received from Wall Street. Those who have emphasized this vulnerability are obviously on strong ground. Yet when a greenhouse succumbs to a hailstorm something more than a purely passive role is normally attributed to the storm. One must accord similar significance to the typhoon which blew out of lower Manhattan in October 1929." (Extracts from "The Great Crash: 1929", John Kenneth Galbraith, First Published 1955, Page 204.)

The years leading up to the 2008 Financial Crisis saw similar trends as those before the Great Depression. It was also a period of extreme inequality and excessive risk taking. Credit-binging had inflated bubbles in housing and stocks clearing the way for a painful downturn and years of retrenching. The economy was also weak before the crisis, but the weakness was largely masked by the frenzy of credit spending that kept activity high. On August 9, 2007, the mask was stripped away when French-owned bank BNP Paribas suspended withdrawals at three of its funds because the value of the toxic mortgage-backed assets it held could not be determined. News of the incident spread quickly through the markets where trillions of dollars of mortgage-backed securities (MBS) were held by all the major banks and financial institutions. That set off a cascade of downgrades which ate away at bank capital and led to the collapse of Lehman Brothers.

When Lehman failed, all Hell broke lose; markets plunged, interbank lending slowed to a crawl, and forced liquidations wiped out trillions in capital. The unwinding continued for a full 6 months despite Congress's $700 billion TARP bailout and the Fed's blanket guarantees on all manner of dodgy financial assets. Finally, in mid-March 2009, the stock market hit rock-bottom and slowly began to recover. In contrast, the real economy remains stuck in a long-term Depression characterized by flagging output, falling housing prices, and high unemployment.

The basic problem facing the economy, is lack of demand. Stagnant wages, high unemployment and gross inequality have made a strong recovery impossible. Working people simply don't have the purchasing power to generate positive growth. If it wasn't for monetary and fiscal stimulus, the economy would be in recession right now. Even so, personal consumption has not slipped as much as one would expect. What has dropped off is investment, and, as author Robert Skidelsky notes, "In a growing economy, the gap between consumption and production must be filled by investment if full employment is to be maintained."

So, why aren't businesses investing?

Because working people are underwater on their mortgages, maxed out on their credit cards, and overdue on their bills. There's no reason to build more capacity when consumers are struggling just to stay afloat. But that creates a big problem for the economy, because new investment is crucial to keeping things running smoothly. Here's how John Bellamy Foster and Fred Magdoff explain it in their book "The Great Financial Crisis":

"For a capitalist economy to work well the surplus (or savings) that it generates must be invested in new productive capacity. Yet, investment in modern capitalism...is at best a risky undertaking since investment decisions that determine the level of output in the present are based on expectations of profits on this investment...in the future....Any lessening of investment tends to generate a vicious circle, pulling down employment, income, and spending generating growing financial problems, and negatively affecting the business climate generally -- resulting in an economic slowdown." ("The Great Financial Crisis", John Bellamy Foster and Fred Magdoff, Monthly Review Press)

The recycling of surplus capital has hit a road-bump, so the economy has started to sputter. This situation should persist until household deleveraging ends and consumers regain their footing.

The Fed has tried to offset the lack of investment by inflating an equities bubble, but, so far, the results have been disappointing. The so called "wealth effect" has not boosted investment or trickled down to the broader economy. Demand remains weak and there are no signs of another credit expansion. Unless there's a surge in borrowing, (which seems unlikely) the financialization process will slow and the economy will languish in a long-term slump. That appears to be what's happening.

Last week, in his second press conference, Fed chairman Ben Bernanke claimed victory in his war against deflation. He said, "I think the point I would make about where we are today versus last August, is that then deflation was a non-trivial risk. I don't think people necessarily appreciate deflation can be very pernicious."

Is Bernanke right; is deflation no longer a threat?

Not likely. While the consumer price Index (CPI) has been on the rise, the fight against deflation is far from over. Consumers and households are still deleveraging, housing prices are falling and unemployment is stuck at 9 percent with 16.5 percent underemployed. Private sector debt is still at historic levels and will have to come down further. If that process is not eased by increasing the government's budget deficits, then economy will shrink even more and lapse back into recession.

We're at a point of extreme vulnerability. Bernanke's bond purchasing program (QE2) may have temporarily lifted stocks and commodities out of the doldrums, but there are no guarantees that the trend will continue.

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Mike is a freelance writer living in Washington state.

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Mike-- I wonder if the gov't could inject 3 trilli... by Elizabeth Hanson on Monday, Jul 4, 2011 at 3:21:27 AM
Excellent analysis Mike. My belief is that we need... by Howard Schneider on Monday, Jul 4, 2011 at 9:55:47 AM
Were it only due to the money issues, then a solut... by David Chester on Monday, Jul 4, 2011 at 11:21:37 AM
I really like your analysis David. A chain of reas... by Elizabeth Hanson on Monday, Jul 4, 2011 at 12:22:54 PM