Monday, August 1, 2011

The collapse of America's middle class, forget the compromise....

The collapse of America's middle class, forget the compromise....
By Spengler

People seem to act irrationally when they have nothing to lose. Often we observe in wars that the losing side expends more blood and treasure after its position becomes hopeless.

The American South sustained most of its casualties in the Civil War after July 1863, when the dual defeats at Gettysburg and Vicksburg made its position untenable. Athens suffered its worst casualties in the Sicilian gamble at the end of the Peloponnesian War.

The Spanish ruined their empire and depopulated their core provinces during the second half of the Thirty Years War of 1618-1648 rather than cede dominance to France. Germany took most of its casualties after Stalingrad. Japan was prepared to absorb an arbitrarily large number of casualties after Okinawa, and its resistance was terminated only by nuclear attack.

Some aspects of the apparently suicidal behavior observed in great wars may be at work in the present budget stalemate in Washington, where the Republican right and the Democratic left yet may undo a compromise. I do not think this will happen - yet. But the extremes of polarization in the American body politic are different from anything I have seen in my lifetime.

If the Tea Party wanted most of all to govern, it would declare that a split government cannot accomplish the agenda on which its members were sent to congress, and that the 2012 presidential election would become a national referendum on America's future. It would then agree to an interim compromise on the debt ceiling.

The trouble is that both the Tea Party and President Barack Obama have existential reasons to force a crisis. Obama, as I wrote two weeks ago, faces probable defeat with a becalmed economy, and may benefit from a crisis in which he casts himself as savior-in-chief (see
Obama could stir a Tea Party crisis, July 19). The Tea Partiers may conclude that no compromise will benefit them, and decide to take the system down in revenge.

There is an underlying economic motive for this confrontation: the cure for the American economy is not necessarily a cure for the majority of the American middle class. The only recovery thus far (and the only recovery possible under the circumstances) has occurred in corporate profits and equity prices.

But this benefits only the small minority of wealthy American families who hold financial assets. The majority of Americans hold most of their wealth in real property (mainly their own homes). They have had no recovery and have no prospect of one. And the quickest path to recovery is one that offers few benefits to them.

The home price bubble drew on a flood of foreign investment in American mortgage-backed securities and other assets; Americans saved very little, because foreigners shipped their savings to America.

After the crisis, savings rose sharply, and the current account deficit shrank by half. That is just what was supposed to happen; from a macroeconomic viewpoint, that was the reason a crisis was necessary in the first place.

Savings stagnated as current account deficit widened
– and reversed after the crisis

Source: Bureau of Economic Affairs

The savings of the rest of the world, in short, invested in an already overbuilt American housing market that has few prospects for recovery. The toothpaste can't be squeezed back into the tube. America needs to compensate for its years of under-saving, and the normal way to do that is to export more to other countries and save the proceeds (or, correspondingly, to import less). The reduction in the current account deficit is the correct outcome, particularly as it is driven by a jump in exports.

US exports of goods and services

Source: Bureau of Economic Affairs

Only a tiny proportion of the American labor force, though, contributes to the rise in exports. Manufacturing in the US is so capital-intensive that a substantial increase in output has a negligible impact on employment.

America is exporting and saving. An increase in savings is the same thing as an increase in demand for assets. But the asset of choice of the late 1990s and 2000s, namely housing, continued to suffer from declining demand.

Home prices (30 major metropolitan markets)

Source: S&P Case-Schiller Index

Housing faces a demographic headwind that may last indefinitely, as I showed in a May 2009 study for First Things entitled "Demographics and Depression." As I wrote:
America's population has risen from 200 million to 300 million since 1970, while the total number of two-parent families with children is the same today as it was when Richard Nixon took office, at 25 million. In 1973, the United States had 36 million housing units with three or more bedrooms, not many more than the number of two-parent families with children - which means that the supply of family homes was roughly in line with the number of families. By 2005, the number of housing units with three or more bedrooms had doubled to 72 million, though America had the same number of two-parent families with children.
This will get worse, not better: The Virginia Tech economist Arthur C Nelson predicts that American households with children will comprise just a quarter of the total by 2025 compared to half in 2010 as the Baby Boomers retire, and that demand for large-lot single family homes will fall by 40%.

That leaves most American households deeply in the hole: according to the Federal Reserve's most recent survey of personal wealth, American households' real estate is worth about a third less than it was in 2006, that is, $16.1 trillion compared to $22.7 trillion. The problem is that most Americans approaching retirement age in 2007 had most of their net worth in non-financial assets.

Apart from real estate, the next-largest component of middle class wealth was in the form of equity in small businesses. Small business has had no share in the recovery. A rough gauge of small business income is non-farm proprietors' income as reported in the gross domestic product (GDP) tables.

As the table below indicates, corporate profits have soared to a record, but proprietors' income remains below the pre-recession peak. Judging from the surveys published by the National Federation of Independent Business and other organizations, small business remains in a slump. That is not surprising, for reasons spelled out in a recent study by New York Federal Reserve economists. Most small business growth during the past decade followed the housing bubble.

Corporate profits surge while
proprietors' income stagnates

Source: Bureau of Economic Affairs

As corporate profits rose, so did stock prices. The trouble is that the top 10% of American households by net worth own roughly 80% of all the stocks owned by households. That does not take into account corporate pension funds, to be sure, the vehicle through which the less affluent usually participate in the stock market.

Nonetheless the vast majority of American households concentrated their wealth in housing during the decade before the crash, and for apparently good reasons. With home prices rising at 10% a year and banks demanding a 10% down payment or less for most mortgages, the rate of return on equity for a homeowner on such terms was often 100% per year. No other asset class offered a fraction of the returns available to the general public.

America's path to recovery lies through exports. There is no way around this. The growth rate of emerging nations with young populations struggling to enter the modern world far exceeds that of mature economies, including the United States. Americans need to save, and exports generate income to be saved. But the kind of exports at which America excels, including farm products, employ a tiny fraction of the workforce. And the financial benefits to the turnaround - in the form of higher equity prices - accrue mainly to the top 10% of American households.

The Tea Party reflects the frustrations of the middle class, especially the middle-aged middle class in places where you can’t sell a home, maintain a business, and fund a retirement. It believes that cutting the deficit is the problem, and a balanced budget is the solution. They are half right. The federal deficit is the monster that gobbled up the credit markets. The growth in federal borrowing corresponds almost exactly to the decline in mortgage borrowing.

Mortgage borrowing collapses while federal
government borrowing surges

Source: SIFMA

Eliminating federal borrowing (which at present would mean reducing government payments equivalent to 10% of GDP) would not, however, lead to a recovery in mortgage borrowing, but an economic crash on the scale of 1933. The notion that a balanced budget would solve America's problems has the stench of a millennial cult. America is spending far too much, and needs to restore its finances.

But that requires economic growth and rising tax revenues, and a massive cut in spending would bring about neither. For that, America needs deregulation and tax cuts - and that means living with a deficit for a while longer. It was Ronald Reagan who shocked conventional wisdom in the early 1980s by telling the country not to worry about the deficit while his tax cuts restarted the economy.

The Tea Party has the chance to become a catalyst for fundamental economic change. But it remains at risk of becoming the Ghost Dance of the American housing bubble, a millennial movement inspired by sinking circumstances, like the pathetic resistance of the defeated Plains Indians after 1890, or the New Guinea Cargo Cults of the 1940s. The economic cure America requires will benefit the beleaguered middle class slowly, and too late to prevent misery for many of them.

If economic fundamentals leave the middle class in the cold, they have put the core constituency of the hard left into the deep freeze. The welfare state is collapsing because the money isn't there to support it. State and local governments have eliminated 400,000 jobs since August 2008, and are cutting spending at a 2.4% annual rate. That eviscerates the so-called public service unions, the core of the Democratic Party's activist constituency.

The poorest and least-educated Americans, moreover, have seen no recovery at all. High-school dropouts have a reported unemployment rate of 13%, while Americans with a bachelor's degree have an unemployment rate of 4.5%. The discrepancy is much worse, because the labor force participation rate of high-school dropouts is only 46%, against 77% for college-educated workers.

Neither the middle-class Republicans who support the Tea Party, nor the core Democratic constituencies who elected Barack Obama, have much of a stake in the outcome of the budget debate. That explains why the debt ceiling has turned into a cliffhanger, to the consternation of financial markets.

I do not think America will go over the brink this time. The Tea Partiers ultimately will accept the argument that they have to keep some dry powder for the 2012 presidential election. But the polarization of American politics will get worse, not better, and the crisis of American governance will be delayed but not defused if congress and the president reach a budget agreement this week....
The United States debt ceiling crisis can be averted by enforcing the Fourteenth Amendment, which mandates the government to pay its debts already incurred, including pensions. That means social security, which is an "entitlement", in the original sense of the word. We're entitled to it because we've paid for it with taxes.

The game of Russian roulette being played with the US federal debt has been called a "grotesque political carnival" and political blackmail. The uproar stems from a statute that is unique to the United States and never did make much sense.

First passed in 1917 and revised multiple times since, it imposes a dollar limit on the federal debt. What doesn't make sense is that the same congress that voted on the statute votes on the budget, which periodically exceeds the limit, requiring the statute to be revised. The debt ceiling has been raised 74 times since 1962, 10 of them since 2001. The most recent increase, to $14.294 trillion by H J Res 45, was signed into law on February 12, 2010.

Taxes aren't collected until after the annual budget is passed, so congress can't know in advance whether or how much additional borrowing will be required. Inevitably, there will be some years that the budget pushes the debt over the limit, requiring new legislation. And inevitably, now that this tactic has been discovered, there will be a costly battle over the increase, wasting congressional time, destabilizing markets, and rattling faith in the American financial and political systems. There will be continual blackmail, arm-twisting and concessions. The situation is untenable and cries out for a definitive resolution.

Fortunately, there is one. A bevy of legal scholars are recommending that the issue be eliminated altogether by playing the constitutional trump card. The Fourteenth Amendment provides at Section 4:
The validity of the public debt of the United States, authorized by law, including debts incurred for payment of pensions and bounties for services in suppressing insurrection or rebellion, shall not be questioned.
Where statute and the constitution collide, the constitution prevails. Whether the government should pay the bills it has already incurred is not a matter of negotiation. It is a constitutional mandate. And those are the bills we are talking about here, as President Barrack Obama stressed in his remarks on the issue last Friday. He said:
Raising the debt ceiling simply gives our country the ability to pay the bills that congress has already racked up. I want to emphasize that. The debt ceiling does not determine how much more money we can spend, it simply authorizes us to pay the bills we already have racked up. It gives the United States of America the ability to keep its word.
Ignoring the debt ceiling on constitutional grounds would not, as Michelle Bachmann declares, make President Obama a "dictator". It would simply mean he is complying with his constitutional mandate to pay the government's bills on time and in full.

Social security is not welfare
The president could have a clean resolution of the issue, but he is not jumping at the opportunity. Rather, he appears to be ready to throw granny under the bus by slashing social security, Medicare and Medicaid, all in the name of "compromise".

The Fourteenth Amendment says debts already incurred shall not be questioned, "including debts incurred for payment of pensions". That includes social security, which is an "entitlement" in the true sense of the word: we're entitled to it because we've already paid for it.

In fact, the Social Security Act was originally sold to congress and the nation in 1935 not as a government benefit but as a retirement savings program. Earlier this year, the Urban Institute published a study evaluating the program in this way, concluding that the average worker who retires today will withdraw from social security just about the same amount he put in over the years, with a modest 2% real interest rate (after inflation).

A deal is a deal. We paid for it, we are owed it, and the US government is good for it. To change the terms of the deal ex post facto is both a breach of contract and a violation of the constitution.

Where to get the money
A sovereign nation can always find the money to pay debts owed in its own currency. The US could, if it wished, pay its bills using debt-free US notes or greenbacks, just as president Abraham Lincoln did to avoid a crippling debt during the Civil War. Alternatively, it could eliminate the deficit with Congressman Ron Paul's plan, which amounts to the same thing. As Stephen Gandel explains Paul's solution in Time Magazine:
In the last year or two the Fed has been buying up US Treasury bonds in an effort to lower interest rates and boost the economy. The most recent round of that buying has been dubbed QE2, and has come under a good deal of criticism, though most economists agree that it was a generally helpful policy. The result is that the Fed now holds nearly $1.7 trillion in US debt.

But that is really phony debt. The Treasury pays the interest on the debt on behalf of the US government to the Fed, which in turn returns 90 percent of the payments it gets back to the Treasury. Nonetheless, that $1.7 trillion in US bonds that the Fed owns, despite the shell game of payments, is still counted in the debt ceiling number, which caps that amount of total federal debt at $14.3 trillion.

Paul's plan: Get the Fed and the Treasury to rip up that debt. It's fake debt anyway. And the Fed is legally allowed to return the debt to the Treasury to be destroyed. A trillion and a half dollars is currently about what spending is expected to exceed tax revenue in 2011.
The biggest drawback to the plan, says Gandel, is just that it "looks bad". It looks as if the government is paying off its debts by printing money. But that is what government-issued money is: a note acknowledging a debt due and owed from the public, good for an equivalent value from the public, traded in the marketplace. A US note or greenback and a Federal Reserve note or dollar bill are both forms of promissory notes. The government can as easily issue a dollar bill as a dollar note or a dollar bond, as Thomas Edison pointed out in the 1920s.

The objection to that solution is that it would be inflationary, but as economist Richard Koo graphically demonstrates, the Fed's quantitative easing has had virtually no inflationary effect on the money supply to date:

Misdirected Fed policy has instead caused $1.6 trillion in "excess reserves" to sit on bank balance sheets, as explained in an earlier article. Conveniently, excess reserves can be used as collateral for futures and derivatives contracts, and that is what some banks appear to be doing with the money: backing trades in the financial markets. This sort of speculation, involving money making money without increasing productivity, can and does drive up prices.

If the money had been delivered directly to the government to be spent on the national budget, it might have gotten into the real economy where it could do some good. The government's budget is spent not on speculation but on goods and services. Increased government "demand" stimulates an increase in "supply", causing supply and demand to increase together, avoiding price inflation while stimulating economic activity.

Time to close the loophole
The debt crisis was created, not by a social safety net bought and paid for by the taxpayers, but by a banking system taken over by Wall Street gamblers. The gamblers lost their bets and were bailed out at the expense of the taxpayers; and if anyone should be held to account, it is these gamblers.

The debt ceiling crisis is a manufactured one, engineered to extort concessions that will lock the middle class in debt peonage for decades to come. Congress is empowered by the constitution to issue the money it needs to pay its debts. Abraham Lincoln did it; Barack Obama could do it. He probably won't, but he does need to follow his constitutional mandate to pay the government's bills as and when due. The statute imposing a ceiling on the national debt is trumped by the Fourteenth Amendment, making it redundant and unnecessary. The statute should be repealed....

Russian Prime Minister Vladimir Putin accused the United States Monday of living beyond its means “like a parasite” on the global economy and said dollar dominance was a threat to the financial markets.

“They are living beyond their means and shifting a part of the weight of their problems to the world economy,” Putin told a Kremlin youth group while touring its summer camp north of Moscow.

“They are living like parasites off the global economy and their monopoly of the dollar.”

President Barack Obama announced a last-ditch deal to cut about $2.4 trillion from the U.S. deficit over a decade, avoid a crushing debt default and stave off the risk that the nation’s AAA credit rating would be downgraded.

The deal initially soothed anxieties and led Russian stocks to jump to three-month highs, but jitters remained over the possibility of a credit downgrade.

“Thank god,” Putin said, “that they had enough common sense and responsibility to make a balanced decision.”

But Putin, who has often criticized the United States’ foreign exchange policy, noted that Russia holds a large amount of U.S. bonds and treasuries.

“If over there (in America) there is a systemic malfunction,

this will affect everyone,” Putin told the young Russians.

“Countries like Russia and China hold a significant part of their reserves in American securities … There should be other reserve currencies.”

U.S.-Russian relations soured during Vladimir Putin’s 2000-2008 presidency but have warmed significantly under President Barack Obama, who took office in 2009 promising a “reset” in bilateral ties.

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