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The “Super Subprime” Problem

May 28th, 2008 . by economistmom

Steven Pearlstein gets it exactly right in his column in today’s Washington Post when he relates the current headlines on our economic woes to our broader, longer-term economic challenges, including our government deficits problem.  He leads off with:

Suddenly, it seems, we’re getting hit from all directions.

Energy and food prices are soaring. The housing market continues to collapse. Government revenue is falling, and taxes are rising. Airlines are jacking up fares and fees while reducing service. Banks are pulling credit lines. Auto companies are cutting production once again. Even investment bankers are losing their jobs.

The tendency is to see these as separate developments, each with its own causes and dynamic. Fundamentally, however, they are all part of the same story — the story of the global economy purging itself of large and unsustainable imbalances that for a time allowed many Americans to think they were richer than they really were.

And he concludes with:

Across the country, state and local governments are already hip-deep into budget crises in response to declining revenue from property assessments and real estate transfers. Here in Washington, a dramatic drop off in revenue from business profits and capital gains has wiped out any hope of reducing federal operating deficits that, under the likeliest political and economic scenarios, will exceed $500 billion a year for as far as the eye can see.

This is another example of an unsustainable equilibrium that has roots in the trade deficit and the credit bubble. Despite the happy talk you might be hearing from the presidential candidates, it presents Americans with a stark and unpleasant choice.

One option is to raise taxes and leave less money for private spending, which is what many state and local governments have begun to do. The other is to accept lower levels of government service and subsidies, which inevitably will lower the incomes of some households while forcing others to go without services or pay for them privately. Either way, it amounts to a lower standard of living than we thought we had achieved.

Is all this the end of the world? For the richest country on the planet, certainly not. But it does represent the end of a decade or more during which Americans were permitted and even encouraged by the rest of the world — and by their own leaders — to live way beyond their means. As a result, the United States has gone from being the largest creditor nation to the world’s largest debtor. For the first time since the early 1980s, Americans will have to endure several years of uncomfortably slow growth and uncomfortably high inflation as the U.S. economy regains its balance and creates a foundation for more solid and sustainable growth.

Steven’s conclusion is exactly right–this is not the end of the world.  It’s simply that for awhile now, both individually and collectively, we Americans have been saving far too little.  Part of it was because of our American nature, wanting more things, and sooner.  But part of it was because our institutions, both public and private, encouraged or at least enabled us to do that “living beyond our means.”  It has led to this “super subprime” crisis.  But now natural market forces, and hopefully new political will, we lead us back to a new “equilibrium,” where our economy will not go down in flames but will walk through the flames (save more) and emerge stronger in the longer run for it.

7 Responses to “The “Super Subprime” Problem”

  1. comment number 1 by: Jeffrey

    I think I’ve heard this before. It came from Jimmy Carter, Mr. Malaise. Luckily, Ronald Reagan didn’t buy it and ushered in one of the great growth spurts in recent memory.

    So, who exactly is not saving enough. On a personal level I believe I save quite a bit and don’t live beyond my means. Unfortunately, taxes make sure I don’t save too much. Well, I’m sure the gov’t isn’t squandering my hard earned money. Oh wait, much of it is being transferred to those who don’t save or to Social Security which provides a below market return those receiving it. Maybe if the gov’t didn’t punish saving and subsidize waste things might improve.

    What happens if a household is living beyond it’s means? The first thing to do is reduce expenditures. What’s the first thing a gov’t does under the Democrat mantra? Raise taxes! That’s like telling a crack addict the first step to sobriety is to smoke more crack.

    The Wall Street Journal pointed out the effects of following this “raise taxes” first method in Michigan under Granholm. Revenues come in less than expected and businesses are fleeing the state.

  2. comment number 2 by: johnchx

    While I’m generally in sympathy with the policy conclusion — raise taxes and/or cut spending to align government’s revenues with its expenditures — I want to take issue with the “living beyond our means” claim. This has been so frequently repeated as to take on the air of unquestionable conventional wisdom, but I don’t think it actually fits the facts.

    The key question is this: is the U.S. borrowing from abroad to finance current consumption? Or, to put it another way, do net imports exceed net domestic investment? This is a question that can be answered with a quick trip to the BEA website, and the answer is, “no.”

    Not that all’s right with the world. We *have* seen a sharp increase in the share of net domestic investment financed with foreign savings (now in the neighborhood of 80%). So domestic savings is doing little more than replacing the existing capital stock. But at the same time, foreign savers have agreed to finance our net investment at very favorable rates, and in the form of obligations denominated in dollars — so it’s not clear that this isn’t simply a good business decision: you finance your investment with the cheapest source of funding available.

    Now, I think that there’s a good argument that government savings should be centered around zero (rather than persistently and permanently negative). But that argument doesn’t rest on the (incorrect) premise that we’re relying on foreign savers to finance our current consumption.

  3. comment number 3 by: economistmom

    By “living beyond our means” I simply mean that I believe our current level of saving (or the difference between our current income and our current consumption) is too low. It’s true that it’s not negative, and it’s true that foreign capital makes it possible to keep up a decent amount of American investment even with the drop in savings (and at currently low cost). But the trouble is that we’re probably moving to a new equilibrium where the cost of borrowing from abroad will not stay so cheap. It’s also the fact that a lot of what we’ve been borrowing from abroad has gone toward government spending and tax cuts (not just private U.S. investment), and such government spending has supported current consumption much more than future consumption (or current investment). So that’s the sense in which foreign savers are helping support our current consumption, and the sense in which it’s accurate to say we are “relying” on that foreign capital to finance at least our current level of consumption.

  4. comment number 4 by: B Davis

    Jeffrey wrote:

    I think I’ve heard this before. It came from Jimmy Carter, Mr. Malaise. Luckily, Ronald Reagan didn’t buy it and ushered in one of the great growth spurts in recent memory.

    If you look at the red line in either graph at http://home.att.net/~rdavis2/gdpchg07.html , you’ll see that there was nothing special about GDP growth under Reagan. The red line shows the GDP growth over every 10-year span and happens to come close to matching the length of the business cycle since about 1965. We had recessions in 69-70, 80-82, 90-91, and 2001 (with an additional one in 74-75). You can’t measure Reagan strictly by the up-cycle from 1983 to 1989 any more than you can judge Clinton strictly be the up-cycle from 1992 to 2000.

    Speaking of business cycles, that is the main problem with the paper by Laffer that you linked to here. Most of the cherry-picking of data that I mentioned in my reply appeared to be designed to give Reagan full credit for the up portion of a business cycle and give Carter full blame for the down portion of the prior business cycle. By the way, much of the inflation under Carter may have been due to the huge unfunded costs of the Vietnam War. In any event, you need to look at data over the full business-cycle, not some cherry-picked portion of it.

  5. comment number 5 by: johnchx

    (1) Is current savings too low? Maybe. What “should” the national savings rate be, and how do we know?

    (2) Is foreign savings financing government consumption? In the narrow transactional sense, yes — foreigners do in fact buy and hold U.S. Treasury securities. But dollars are fungible: foreigners lend to the Treasury so Americans don’t have to. Put another way, every dollar of foreign savings you “count” towards government consumption is a dollar of domestic savings you have to “count” towards net domestic investment. The totals have to add up. Personally — given that dollars are fungible — I don’t think the transactional “this dollar paid for that” approach tells us anything worth knowing.

    (3) Will the cost of borrowing abroad rise? Yes. And that should more-or-less automatically increase incentives for domestic savings. And — because adjustments are rarely one-sided — it will probably lead to a reduction in domestic investment (though I’m guessing that much of this will materialize in the form of a slower pace of residential construction).

    I think, at the core, my quibble with the “beyond our means” formulation is that it amounts to an expression of opinion about where the supply curve for domestic savings happens to lie. We’re saying, “the supply curve for domestic savings is too far to the left; it *ought* to be further to the right of its apparent position.” But on what grounds to we get to express such an opinion? What’s the standard for where this or that supply curve ought to be?

  6. comment number 6 by: Sarah

    On the question of whether our lack of savings is due to “our American nature, wanting more things, and sooner” please see Elizabeth Warren’s lecture at Berkeley (available here: http://www.youtube.com/watch?v=akVL7QY0S8A ). She demonstrates that the classic two-parent, two-child family is now spending considerably less than it did a generation ago on things like clothes and electronics. What it’s spending more– much more — on are the fixed-cost items like housing, medical care and education.

    The picture painted in the media of the ‘average’ family gives us about as accurate a picture of reality as the image of the ‘average’ woman in fashion magazines.

    By the way, I don’t know whether I commented before or just thought about it– but as the daughter of an earlier generation of economistmom I’m very glad to see you in the blogosphere!

  7. comment number 7 by: Unsympathetic

    It’s time we confront the fantasy that was Ronald Reagan.

    His message was CNBC before there was CNBC - “We’re doing great - I promise!” He picked a fight with communism, the only horse with more wounds than Barbaro. He threw trillions of tax dollars at the military, most of it to line the pockets of insiders like Cheney’s Halliburton.

    Reagan’s “turnaround” was a sham. The only thing he turned around was the previous administration’s responsibility and willingness to diagnose and confront true problems. He also ended multiple decades in which the US had a growing middle class. So what if he could jawbone Saudi Arabia to open the spigot once more? The problem facing America wasn’t gasoline prices.. it was then (and is now) our need for energy independence on a national scale. Who described this problem? Yep, Carter.

    Jeffrey, you are wrong. Reagan was not a hero, Reagan was not a genius, Reagan was not even a good president. Reagan and the elitist Republican party are quite simply SOLELY to blame for the economic devastation that faces the US. Their plan, as always, is to talk about how good they’re doing while systematically gutting the economy.

    Faith-based economics are not about a faith in God - or a faith in America. They’re simply about a faith in the appropriateness of the top 0.5% to take more money from the middle class.

    Want to vote Republican? You’re voting against America.