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Structural Economic Problems More Worrying than Cyclical Ones

Irwin M. Stelzer

President Obama blames the recent turmoil in financial markets on floods in Japan and Republicans who won’t raise taxes. Republicans blame roiling markets on the president and Democrats who won’t cut spending. The Europeans blame short-sellers. Stock traders blame the problem variously on Standard & Poor’s decision to downgrade America’s credit rating, the unsafe condition of French banks, the Federal Reserve Bank’s failure to give the economy a boost, the Fed’s insistence on giving the economy a boost by announcing that near-zero interest rates will be maintained past the presidential elections in November of 2012, and the fact that this week contains a Friday, a day on which traders shun risk lest their weekends be fraught. And if it rains on Monday….

You get the idea. The economic news mucks around in an attempt to explain short-term share price movements, ignoring the longer-term phenomena that will dictate the future course of the American and, because of linkage, European and world economies. 

I don’t mean to imply that these matters are trivial: When a plunge in share prices wipes out some $3 trillion in assets in a few days, businesses and households get hurt. But there is little that policymakers can durably do about these shifts in investor sentiment, short of passing the baton to others, and much they can do to affect the underlying trends that are there for the discerning eye to find.

The first relates to the labor market. All eyes are focused on the 9.1 percent unemployment rate. That focus leads to calls for monetary easing, infrastructure construction, and other Keynesian solutions, few of which can have any affect so long as consumers and businesses are retrenching in the face of news that economic growth is likely to be somewhere between zero and negative in the near future. The longer-term problem is revealed not in the figure for the unemployment rate, or even in the far higher figure that includes workers too discouraged to continue pounding the pavements in search of work, and those involuntarily working short hours. It is revealed in the fact that over 6.5 million workers, 44 percent of those counted as unemployed, have been out of work for more than 27 weeks. At the end of the last recession in November 2001 that figure was 13.9 percent.

Even if the economy starts to grow at an acceptable rate, many of those long-term unemployed will not find work or, if they do, only at jobs paying far less than the ones that disappeared. Skills atrophy, or become obsolete in the face of technological change; traditional American jobs migrate overseas; increased efficiencies discovered in the recession-induced hiring clampdown enable manufacturers to produce more with smaller staffs; a large pool of unemployed available workers permits subtle discrimination against older workers, reducing their chance of being rehired.  

Edmund Phelps, a Columbia University professor and Nobel laureate, says that the so-called natural rate of unemployment—the rate prevailing when the economy is growing at a rate unaffected by a cyclical downturn—has jumped to about 7% from 5.5% in the mid-1990s. That means that two million more workers will be out of work when times are good than would have been the case a decade or so ago, barring any change in a host of economic variables. Unfortunately, the hunt for quick fixes by the Fed and the administration is ignoring this structural change in the work force, perhaps best revealed by the pleas of many employers to ease restrictions on the granting of visas to skilled immigrant workers, despite the millions of American workers looking for jobs.

A second long-term problem left unattended is the massive debt burden that will sooner or later have to be addressed. No, not the mere $14 trillion-and-rising debt recorded on the books of the U.S. Treasury. The trillions more that are not reflected on the nation’s ledgers. Economists Carmen Reinhart and Kenneth Rogoff, who have studied what they call “eight centuries of financial folly,” note: “public obligations are often ‘hidden’ and significantly larger than official figures suggest. In addition, off-balance-sheet guarantees and other creative accounting devices make it even harder to assess the true nature of a country’s debt until a crisis forces everything out into the open.” Think of the massive debt burden that came with recognizing that the federal government is the guarantor of the debt of mortgage lenders Freddie Mac and Fannie Mae, and of the viability of banks that are too big to fail.

For many companies, this debt mountain is no abstraction, and the conversion of Uncle Sugar into Uncle Scrooge is a harsh reality. The government is a key customer of defense firms such as Lockheed Martin, health care firms such as Humana, equipment suppliers such as Dell—to mention a few on the list compiled by the Wall Street Journal. They and their shareholders will have to look elsewhere for growth. And those shareholders—the “rich”—also have to worry that the president is intent on raising their taxes. They just might make the second half of the year less happy than the first for Ralph Lauren, Tiffany, and other high-end employers of swarms of retail clerks. This will have a profound effect on the retail sector, which has been heavily dependent for much of its recent growth on sales at the luxury end. Indeed, we are witnessing the end of credit-fuelled consumerism. Fed chairman Ben Bernanke’s decision to keep interest rates low is putting pressure on bank profits, pressure they can do without as they confront the new risk of dealing with European banks whose books are loaded with IOUs from Greece, Spain, Italy, Portugal, and other not-so-solid borrowers, and whose reluctance to lend to each other is causing scary talk of a 2008-style freeze-up in interbank lending. Even if that fear proves unfounded, shrinking profits and new regulations will reduce the banks’ ability to lend—the words “credit crunch” are again heard in the land, especially from small businesses.

Meanwhile, consumers no longer can be counted on to borrow and spend as they did in past decades. Yesterday’s report that the Thomson Reuters/University of Michigan survey of consumer sentiment is at its lowest level since May 1980 is a warning shot across the bow of retailers who are counting on a big back to school season, and wondering how much to spend on inventory in advance of the Christmas shopping season. Combine that pessimism with consumers’ need to restore their balance sheets to something approaching pre-binge levels, and it is not unreasonable to assume that when the recovery comes it will not be consumer led. 

These are only a few of the underlying trends that will in the end matter more than share price gyrations: A mismatch of the unemployed and available jobs, the withdrawal of government purchasing power as a source of growth, and banks less able to lend and consumers less willing and able to borrow. These will be with us long after calm replaces panic on the world’s stock markets.

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