As the economic slump that began in 2007 persists, the question on everyone's minds is obvious: why? Unless we have a better understanding of the causes of the crisis, we can't implement an effective recovery strategy. And, so far, we have neither.We were told that this was a financial crisis, so governments on both sides of the Atlantic focused on the banks. Stimulus programmers were sold as being a temporary palliative, needed to bridge the gap until the financial sector recovered and private lending resumed. But, while bank profitability and bonuses have returned, lending has not recovered, despite record-low long- and short-term interest rates.
The banks claim that lending remains constrained by a shortage of creditworthy borrowers, owing to the sick economy. And key data indicates that they are at least partly right. After all, large enterprises are sitting on a few trillion dollars in cash, so money is not what is holding them back from investing and hiring. Some, perhaps many, small businesses are, however, in a very different position; strapped for funds, they can't grow, and many are being forced to contract.
Still, overall, business investment - excluding construction - has returned to 10% of GDP (from 10.6% before the crisis). With so much excess capacity in real estate, confidence will not recover to its pre-crisis level anytime soon, regardless of what is done to the banking sector.
The financial sector's inexcusable recklessness, given free rein by mindless deregulation, was the obvious precipitating factor of the crisis. The legacy of excess real-estate capacity and over-leveraged households makes recovery all the more difficult.
But the economy was very sick before the crisis; the housing bubble merely papered over its weaknesses. Without bubble-supported consumption, there would have been a massive shortfall in aggregate demand. Instead, the personal saving rate plunged to 1%, and the bottom 80% of Americans were spending, every year, roughly 110% of their income. Even if the financial sector were fully repaired, and even if these profligate Americans hadn't learn a lesson about the importance of saving, their consumption would be limited to 100% of their income. So, anyone who talks about the consumer 'coming back' - even after deleveraging - is living in a fantasy world.
Fixing the financial sector was necessary for economic recovery, but far from sufficient. To understand what needs to be done, we have to understand the economy's problems before the crisis hit.
First, America and the world were victims of their own success. Rapid productivity increases in manufacturing had outpaced growth in demand, which meant that manufacturing employment decreased. Labor had to shift to services.
The problem is analogous to that which arose at the beginning of the 20th century, when rapid productivity growth in agriculture forced labor to move from rural areas to urban manufacturing centers. With a decline in farm income in excess of 50% from 1929 to 1932, one might have anticipated massive migration. But workers were 'trapped' in the rural sector: they didn't have the resources to move, and their declining incomes so weakened aggregate demand that urban/manufacturing unemployment soared.
Source by: Economictimes.indiatimes.com
