Obama's economic challenge

We Americans are progress junkies. We think that today should be better than yesterday and that tomorrow should be better than today. Compared with most peoples, we place more faith in "opportunity" and "getting ahead". We may now be on the edge of a new era that frustrates these expectations. It is not just the financial crisis. The crisis coincides with other changes - an aging society, runaway health spending, global warming - that imperil economic growth. Barack Obama will take office facing the most daunting economy in decades: certainly since Ronald Reagan and double-digit inflation; and perhaps since Franklin Roosevelt and 25 per cent unemployment.

To be sure, the US economy has often defied pessimistic predictions. Our national culture, with its pervasive ambition and its proven capacity for innovation, favours expansion. These are powerful forces. But it's equally true that economic progress has periodically stalled. The Great Depression lasted a decade; unemployment in the 1930s averaged 18 per cent. The inflation of the 1970s arrested living standards and the stock market (it was no higher in 1982 than in 1965). By 1979, inflation hit 13 per cent. Americans do not have a divine right to rapid growth.

Could the economy now be at a historic inflection point when it changes fundamentally? That's the central question confronting Obama. Only the most hardened among us cannot have been rattled by recent events. Government has taken over mortgage giants Fannie Mae and Freddie Mac. The Federal Reserve is pumping out $1 trillion (Dh3.67 trillion) to stabilise credit markets. Government figures released Friday showed that the US unemployment rate in October rose to 6.5 percent, its highest level since 1994. According to forecasts, the jobless rate could hit 7.5 per cent next year.

Obama's challenge is to improve the economy's stability without subverting its vitality.

The good news is that even if the present slump deepens (an 8 per cent peak jobless rate would make it the third-worst recession since World War II), the odds are that it won't approach the Great Depression in severity or suffering. Too much attention is being paid. The Fed and the Treasury have frantically supported the financial system - exactly the opposite of the 1930s when two-fifths of the nation's banks were allowed too fail. And Congress is contemplating a second "stimulus" package of $300 billion or more.

The bad news is that recovery may disappoint. Our new economic era may lapse into "affluent deprivation". That's an unfamiliar term. It doesn't mean poverty. The United States will remain a wealthy society. Rather, "affluent deprivation" signifies a mindset. People feel poorer, because sluggish income gains get siphoned off into higher taxes, energy costs and health spending. Whatever benefits these confer, they don't pay everyday bills. There's an approaching collision between private and public wants - from retirement benefits to defence.

To some observers, we are so materialistic that sacrifices should be easy. Do we really need fancier grills? Of course, there's waste. But what this argument ignores is psychology. "Luxuries" quickly become "necessities" - cell phones being a recent example. "Getting ahead" feeds people's optimism, and an upbeat society shows more "tolerance of diversity, social mobility (and a greater) commitment to fairness," as Harvard economist Benjamin Friedman argues. Economic growth has anchored our national self-esteem; slower growth suggests a grumpier and more contentious America. Unfortunately, slower growth seems probable. What Obama should understand is that the present crisis marks the end of an economic era. For a quarter-century, the US economy benefited from the expansionary side effects of falling inflation - lower interest rates, greater debt, higher personal wealth. But we overdosed on its pleasures. The deeper causes of the crisis lie in this prolonged prosperity and the permissive practices it inspired.

Largely unrecognised, the dominant economic event of the past half-century was the rise and fall of double-digit inflation. From 1 per cent in 1960, rising inflation destabilised the economy. There were four recessions between 1969 and 1981. Unemployment peaked at 10.8 per cent in 1982. That last devastating recession, imposed by then-Fed Chairman Paul Volcker with Reagan's backing, purged the worst inflationary psychology. By 1984, inflation was less than 4 per cent. Then, declining inflation - disinflation - bolstered the economy.

Consider. The stock market recovered spectacularly: lower inflation led to lower interest rates, causing investors to switch from bonds to stocks. For much of 1982, the Dow Jones industrial average was less than 1,000; by 1989, it averaged about 2,500; by 1999, almost 10,500. There was a consumption boom. Feeling wealthier, Americans borrowed and spent. The personal savings rate dropped from 11 per cent in 1982 to almost zero by 2005. There were only two mild recessions (1990-91 and 2001). But prosperity also bred bad habits.

By now, these are clear. As stocks and real estate rose in value, many Americans concluded that prices could only go up. As that view spread, lax investment standards (for high-tech companies) and lending practices (for homes) mushroomed. "Bubbles" followed. People overinvested in tech stocks and overborrowed to buy homes at inflated prices or to raise cash from bloated real estate values. But the borrowing surge could not last indefinitely, because debt outpaced income. By 2006, household debt was 134 per cent of personal income.

An ageing society

The recession will end, but recovery won't ensure faster economic growth. A larger threat looms: an ageing society.

Arithmetically, economic growth reflects the increases in the labour force and its productivity. From 1960 to 2005, annual US economic growth averaged 3.4 per cent, split almost evenly between labour force growth (1.5 per cent) and productivity gains (1.9 per cent). As baby boomers retire, labour force growth will slow. By the mid-2020s, the Social Security Administration expects the economy to grow only about 2.1 per cent annually, with scant labour force increases (0.4 per cent) and higher productivity gains (1.7 per cent). If productivity falters, as in the 1970s, the US economy would virtually stagnate.

Somehow Obama must reconcile present and future needs. The immediate imperative is to rev up demand and spending, thereby blunting joblessness and pessimism. But the long-term problem is to mediate between all the competing demands on the nation's income and to expand the economy's capacity to meet those demands. The closer the economy comes to stagnation, the more Americans may succumb to distributional struggles - between the rich and the poor.

People will fight over pieces of a fairly fixed economic pie rather than sharing ever-larger pieces of an expanding pie. The winners may be pleased, but the losers will feel shortchanged - and so conflicts may intensify. Politics, often about rewarding some and punishing others, may become more so. Conflicts are already apparent.

Government is overcommitted: It's made more promises than can be sensibly afforded. The largest involve retirement costs. Three programs for the elderly already represent two-fifths of the $3 trillion federal budget: Social Security, Medicare (health insurance) and Medicaid (nursing home care for the elderly poor). As baby boomers retire, these programs could nearly double - measured as a share of the economy - by 2030. Tough questions are obvious. How much will we permit spending on retirees to raise taxes or crowd out the rest of government?

Healthcare compounds the difficulty. About three-quarters of the increase in federal spending for the elderly involves Medicare and Medicaid. Americans think that people should get all the medical care they need. Spending controls don't work, because we don't want them to work. Health spending has gone from 5 per cent of gross domestic product (GDP) in 1960 to 16 per cent now and may hit 20 per cent by 2015. High health costs depress take-home pay (for those with employer-paid insurance), raise taxes and squeeze other government programmes.

Finally, there's energy. Despite recent drops, oil prices at $65 a barrel remain well above the $29 average of 2003. Combating global warming would also raise prices. Many Americans think greenhouse gases can be cut painlessly - just order companies to do it. That's a fantasy. Most anti-global warming policies would "put a price on carbon" - carbon dioxide is the main greenhouse gas - through a carbon tax or a "cap and trade" program. Under "cap and trade", companies receive permits to emit greenhouse gases; firms needing more permits would buy them from firms willing to sell. Prices of carbon-based fuels would rise, forcing people to use less or making costlier noncarbon energy, say solar, more competitive.

In truth, neither Obama nor John McCain addressed these issues candidly. Their proposals (naturally) aimed at pleasing voters, not clarifying choices. Although both supported "cap and trade", neither forcefully admitted that to succeed these plans would raise energy prices. Each had healthcare proposals that, though claiming to control costs, would expand insurance coverage and seemed likely to increase spending. And each endorsed new tax cuts and spending programmes that would further swell budget deficits. There was a "something for nothing" quality to both campaigns.

Robin Hood effect

For a slumping economy, bigger deficits might be the right medicine - classic "pump priming". For fiscal 2009, the deficit might approach $1 trillion, up from $455 billion (3.2 per cent of GDP) in 2008. But the usefulness of deficits is temporary, whereas they're now semi-permanent - there have been only five budget surpluses since 1961. The deficits mainly reflect the mismatch between what people want from government and what they will support through taxes.

No plausible rate of economic growth could satisfy all of Americans' desires for private and public spending. But some outcomes would be worse than others. If we can't reduce Social Security and Medicare spending, we may face unprecedented tax burdens that further depress economic growth by reducing the rewards to work and risk-taking. By 2030, taxes might have to rise 50 per cent to cover existing benefits. The alternatives are equally undesirable: deep cuts in other programmes, from homeland security to college aid; or unsustainable deficits.

We have not modernised these programmes to reflect changed social conditions. Eligibility ages should be raised gradually. People live longer (life expectancy was 62 in 1935 when Congress passed Social Security; now it's 78) and can work longer. Many retirees have adequate savings that would allow them to rely less on Social Security and Medicare. Benefits could be scaled back for wealthier retirees. Our present system has in part created a reverse Robin Hood effect - it transfers income from the struggling young to the pampered old.

We should also be sensible about global warming. The unpleasant reality is that with today's technologies little can be done. Four-fifths of the world's energy comes from fossil fuels: oil, coal and natural gas. By 2030, global energy consumption may increase 55 per cent from 2005 levels, says the International Energy Agency. China, India and other poor countries would represent three-quarters of the increase. These countries won't sacrifice the chance to reduce their poverty by curbing energy use and economic growth. Expensive policies to reduce US emissions could be self-defeating: costly to our prosperity but barely affecting global warming.

Our main emphasis should be on research and development. Combating global warming requires new technologies that would eliminate greenhouse emissions and produce, at acceptable costs, adequate energy for economic growth. Carbon "capture and storage" would be one; battery powered autos would be another. We could also adopt policies, desirable on other grounds - such as reducing oil imports - that might slightly cut greenhouse gases. Higher fuel taxes, for example, would prod consumers to buy the more fuel-efficient cars.

Whatever happens, the future of American affluence will be a state of mind as much as a state of production. Our national identity is so wrapped up in economic progress that the failure to achieve it would sap Americans' self-confidence. Obama arrives at a crucial juncture. The financial crisis has stimulated massive government intervention - and there will be more. But the wrong kind of intervention will suppress investment and risk-taking. For Obama, advancing American affluence will require the right balance between the past and future.