This week's positive reports showing rising consumer confidence and manufacturing activity have raised hopes that a solid economic recovery is now taking hold. But Washington should not expect its tax coffers to overflow anytime soon or for the economy to return to 1990s-level growth rates. In the short term, the economy still faces an uphill struggle to overcome the excesses of the 1990s -- too much consumption, too much debt, and wildly inflated asset prices -- that are now depressing economic growth. Worse, over the longer term, the country must find a way out of its dependency on debt-led consumption growth that has been financed by capital from abroad, and that means saving and investing more and consuming less.
The dilemma for the administration, Congress, and the Federal Reserve is that the policies they have chosen to stimulate the economy in the short term -- tax cuts aimed at boosting consumer spending and low interest rates aimed at propping up the housing market--may only make the long term structural problem of over-consumption more difficult.
In one sense, Washington's reflexive resort to consumption-led growth is understandable. For much of the past 50 years, our consumer-oriented, low savings economy has performed reasonably well. "As the consumer goes, so goes the American economy" has proven to be a relatively accurate adage. But something fundamental began to change in the 1980s. Not only did shopping replace baseball as the national pastime, but an adult gratification culture began to crowd out our traditional concern for future generations. Consequently, we began to borrow from abroad to pay for ever larger doses of consumer spending -- and in less than a decade, we went from being the world's largest creditor to its largest debtor.
By the late 1990s, America's high consumption-low savings economy had gone into overdrive. Personal savings rates plunged, actually falling into the red for several quarters. Consumer debt increased to 110 percent of disposable income. Our current account ballooned to more than 4 percent of GDP in 2001. And our international debt passed the $2 trillion mark, rising to nearly 25 percent of GDP, a sizeable and growing burden that will be borne by the next generation.
There have, of course, been real gains in American productivity in recent years, and American companies have recaptured the competitive lead in a number of areas. But those gains do not hide the fact that for much of the last two decades we have been living beyond our means. Our high consumption, low savings economy has worked only because our European and Asian allies have been willing to save and produce more than they consume, and then lend us money to buy their goods -- a sort of reverse Marshall Plan. In good years, they have sent enough capital to our shores to support both more consumption and investment, and in the late 1990s, so much that it helped fuel a speculative investment bubble in information technology.
In fact, America's consumption and investment boom was made possible by a corresponding production boom in the industrializing economies of Asia as well as in the more mature Japanese and European economies. New productive capacity abroad comfortably outstripped rising consumption in the United States, creating capacity gluts in many basic consumer goods, from electronics to textiles. As a result, many Asian producers soon suffered from falling rates of return on their investment and staggering debt levels even as American consumers enjoyed bargain prices. The resulting Asian financial crisis had the paradoxical effect of pushing even more capital to the United States, inflating both America's consumer boom and the NASDAQ bubble.
By the time the Bush administration took office, the world economy suffered from serious deflationary imbalances -- a production and debt overhang in Asia mirrored by a consumption and debt overhang in the United States that was being made worse by a collapsing tech bubble. Indeed, so serious was America's consumption and debt overhang that it was reasonable to ask whether the U.S. economy might suffer the same fate that befell the Japanese economy a decade earlier. In Japan's case, the economy was brought to its knees by too much productive capacity, particularly in older less productive sectors of the economy; in the case of the U.S. economy, it has become too dependent on consumption that has to be financed by borrowing from abroad.
Personal consumption now accounts for 69 percent of our nation's gross domestic product and 80 percent of American jobs. A prolonged slowdown in consumer spending would therefore have a ripple effect throughout the economy -- rendering unprofitable huge capital investments made in retail stores, shopping malls, housing, and import-serving industries. It would also have a serious effect on America's greatly expanded financial sector that grew with the stock market boom of the 1990s and the recycling of foreign capital. If foreign capital flows dry up, there would be less money to recycle into consumer and business lending. The nation would need more collection agents, and fewer loan officers.
To head off the worst, U.S. economic officials have settled for a two-track strategy of lower interest rates and deficit-creating tax cuts, aimed at bolstering consumer spending in the hope that this will eventually lead to renewed business confidence. Consumer spending has been so central to the administration's economic strategy that in the aftermath of the September 11 terrorist attacks, President Bush elevated it to a patriotic duty. And in the short term, at least, American consumers have delivered, carrying the economy through the bursting of the tech bubble, the war on terrorism, and accounting scandals to a modest recovery.
But consumer spending has held up not because incomes have risen by all that much, but because consumers have taken on more debt, mostly by borrowing against rapidly rising housing prices. With interest rates at record low levels, mortgage refinancing has boomed as households have used their homes as collateral in order to consume more. But borrowing against inflated real estate to fund consumption is as dangerous as betting on the NASDAQ boom. At some point, housing prices will soften, and households will have no choice but to rebalance their balance sheets, sending the economy into a tailspin, unless the administration can find some new way to prop up consumer spending.
In short, U.S. economic officials have opted for an economic strategy that only reinforces the structural weaknesses of the American economy. That strategy can work only as long as foreign investors are willing to finance America's current account deficit. When investors grow tired of holding American assets, a painful adjustment will begin.
A few optimists believe that day can be postponed indefinitely. But a falling dollar (the dollar is now at a 15-month low vis-a-vis the euro) and a weakening stock market suggest the process may have already begun.
Indeed, there is a perceptible shift in investor psychology that does not bode well for America's consumption dependent economy. In the 1990s, investors threw money at our financial markets, not only because of the prospect of higher returns, but because they believed the United States had the deepest and most transparent capital markets that were underpinned by a superior accounting and legal system. In the jargon of the street, the United States was both the growth and restructuring play of the 1990s. But with the NASDAQ crash, Enron and the other accounting scandals, the shine has come off the U.S. market.
By contrast, Europe and Asia are beginning to attract investor attention -- Europe because of the growing confidence in the euro and Asia because countries like South Korea and even Japan have begun to make painful reforms to make their economies both more consumer and investor friendly. South Korea, for example, has stopped shoveling money into loss-making chaebols, and has begun to establish a reliable consumer credit market that is fueling domestic-led growth for the first time in 50 years. As a result, capital is beginning to flow back to Asia, and Europeans have begun to conclude they would be better off investing in the success stories of Central and Eastern Europe than in another American bubble. Increasingly, Europe and Asia look like the growth and restructuring plays of this next decade.
If continued, these changes will be good not only for Asia and Europe but for the world economy as a whole. However, in the near term, they may advance the day of reckoning for the American consumption-dependent economy. The irony is that the more Asian and Europe change and restructure the more vulnerable the United States becomes to its consumption dependence and the more it will need to follow suit with its own reforms and restructuring.
American policymakers therefore need to begin to think about a radically different set of economic and social policies. One logical place to start as an alternative to the administration's effort to prop up an inflated consumer sector would be more public investment in our children -- more money for our schools, for our teachers, for our care-givers, and for the computers and other knowledge-enhancing technology needed to make our young people more productive citizens. It is only by investing in productive future adults that we will be able to both grow our economy and retire the debts we accumulated from our two-decade old shopping spree.