The New Economy - Part II

[Note: A post on this same subject was posted on a second blog inadvertently. The second blog was set up in error at approximately the same time as this one. I've deleted the second blog just to clear up the clutter.]

There is an old "New Yorker Magazine" cartoon of two guys in a dungeon. They are both suspended in mid-air, side by side in their cell, by chains from each of their arms to the roof and from each of their legs to the floor. One guy turns to the other and says: "Now here's my plan."

Another favorite, also from the New Yorker, pictures two guys in suits walking down a busy and crowded street in New York. One guy's pants have fallen down to his knees. The other guy leans over and whispers in his ear: "Just bluff it through."

Both of these cartoons remind me today of Federal Reserve Chairman Ben Bernanke and U.S. Treasury Secretary Paulson.

Welcome to The New Economy - Part II. Part I was the dotcom bubble; Part II is the present housing crisis, which I'll get to in a couple of posts, after re-reviewing Part I.

The term New Economy refers to the shift, beginning in the late eighties, in the U.S. economy from one based on manufacturing to one based on service. The motivation for this shift was, supposedly, due to technological advancements ranging from massive reductions in shipping costs to personal computing. Our future, we were told, lay in a high-tech, post industrial society, which would create less pollution and make everyone rich. All the old nasty stuff would go to the developing Third World, who would feed manufactured products to us, the inhabitants of the "Shinning City on the Hill."

If you thought about it much, it was all sort of Orwellian "1984" stuff (or perhaps more accurately Huxley's "Brave New World") and it virtually mandated one global economy, with a global division of labor. The idea, I suppose, was that the United States would become the World's "bank" and global regulator, providing a safe harbor for the world's wealth, overseeing its investment and distribution (in part through international institutions such as the World Bank, the International Monetary Fund and the World Trade Organization). Key's to maintaining this position were a strong dollar, a strong military, strong financial institutions and strong graduate education at our universities, the latter of which allowed us to maintain our high-tech lead and educate the World's elite to the "American Way."

The driving force behind all of this was relatively simple: Technology had opened the door to an inevitable "globalization" of the world's economy and it was far better for us to be leading this process rather than following it. Additionally, the end of communism offered an enormous opportunity in expanding western free markets globally. The trick was to bring literally billions of people (the former Soviet Union, China, India, SE Asia, etc.) into the free market system before their failed communist systems drove them into anarchy and chaos, thus endangering all of us via the rise of new dictatorships and war.

Overall, this was not a bad plan; there were, however, a few problems that were overlooked.
The first was the underestimation of how easily the new technology (our advantage) transferred across borders. It's one thing to build a factory; it's another to transfer software over a global internet. The second was an underestimation of one of the few benefits of communism, universal education and, as a result of that education, how quickly the ex-communist countries would be capable of assuming our former role. Third, we transferred our manufacturing base (the Old Economy) before securing our high-tech position (the New Economy) with effective global intellectual property rights agreements - lower labor costs trumped common sense. Fourth, we underestimated the importance of our dependency on middle eastern oil and its linkage to fragile dictatorships, facing a fantical religious awakening. Fifth, we overestimated the ease of transition of American Labor from the Old to the New Economy. And, sixth, we allowed our "real power," military force, to deteriorate within the context of the "peace dividend" provided by the fall of the Soviet Union and China's move toward a fledgling market economy.

In sum, the "plan" required far, far more control over the global economy than we actually had. This rise in a "Masters of the Universe," American mentality came, I think, from several sources, but most significantly from the belief that we "beat the Russians." In turn, this interpretation strengthened the Goldwater/Reagan/Bush brand of economic conservatism, which in turn distorted our perception of the global reality (partially genuinely believed, partially for political gain).

By the time Ronald Reagan won the Presidency, the Cold War had practically ended. Reagan largely, in his mind, "fought" the Soviet Union of the fifties and sixties, not its reality in the eighties. It was sort of like applying the coup d grace after the firing squad had finished their work. With or without RR, it is difficult to see how the Soviet Union could have carried on much longer without the same type of economic changes as those being embraced by China. Fundamentally, the people of the Soviet Union brought down the Soviet Union themselves. I suspect, with a little more distance from the actual events, historians will find that economic pressures, not from the West, but from the successes of Communist China and an unwanted war in Afghanistan, contributed more than RR to the dissolution of the "Evil Empire."

But, the American public perception was it was a Reagan victory and therefore the rest of the stuff must really work as well...such as supply side economics, etc.

I was in Europe during this period working with the European automobile industry. A few days after the wall in Berlin came down, I was having lunch in the Executive dining room of Mercedes-Benz. I was the only American at the table; the others were customers and friends from Mercedes, with whom I'd worked closely for two-three years. We were discussing the impact of the end of the Cold War and Communism and, of course, the problems in integrating East Germany into West Germany. I noted that this would be an enormous task requiring vast resources from the entire western world (referring to the larger problem, not just East Germany). One of my friends at the table spoke up: "East Germany is a German problem, not an American one." And, everyone else at the table agreed. I went back to my office thinking, "the end of the Cold War and Communism probably also means the end of U.S. hegemony in the West." I don't think this thought computed well with Goldwater/Reagan/Bush Republican economic planning. Rather, it was "to the victor go the spoils."

William Jefferson Clinton inheirted the "plan" and the problems. The first two years of his Administration were pretty much lost on universal health care. For the remaining six years of his Presidency he was faced with a Republican Congress, so it really didn't matter too much whether he spent his time conjuring up programs he knew he couldn't get past Congress or defending himself against ill-considered personal behavior.

Following the failure of the health care plan, he basically pursued economic policies not too different from the Republicans, with the occasional rheotical crump thrown to the Democratic base. In fact, off-hand, I can recall only three "accomplishments." He balanced the budget, supported NAFTA and took us militarily, via NATO, into the Balkans. The other side of the coin to each of these was balancing the budget through a reduction in government spending, largely at the expense of the military, and raising taxes; the formation of NAFTA as a counter to the European Union; and the commitment of U.S. forces abroad, without Congressional approval. However, as long as casualties in the Balkans were kept low through a predominately fought air war and everyone was getting rich, the Republican Congress was content with its efforts to impeach him over lying to a grand jury regarding his personal sexual behavior. Republicans were actually so happy with an impotent (perhaps the wrong adjective in this case) Democratic Presidency, they were kind enough to run Bob Dole against him in the second term election.

During the Clinton Administration, however, the modus operanti for the "phony economy" was established. With the help of Alan Greenspan and Robert Rubin (and the zeitgeist of The New Economy, which all three pushed heavily) Clinton was effectively able to practice a Democratic version of supply side economics without the down side; an economic approach his predecessor, George Bush Senior, had labelled as "voodo economics."

Embracing the "Plan," through support for NAFTA and free trade, and masking the impact of American jobs being shipped overseas through new ways of accounting for unemployment and cheap money, the Administration provided the "fuel" for the dotcom bubble. It was during the Clinton years that I first noticed it seemed that as the national economy became stronger and stronger, the middle class became weaker and weaker. Ultimately, under Bush II, Clinton would look like a piker, but turning the American economy into a giant Ponzi scheme, sustainable only through devalued currency and overvalued assets, to mask the impact of globalization, begin with the Clinton years.

As the manufacturing based economy transitioned to "The New Economy" - essentially a service economy, $20/hr jobs were lost overseas to be replaced, basically with $10/hr jobs. The impact of this on the bulk of the American workers was lessened through the flow of cheap goods from abroad and a generous monetary policy at the Fed.

National growth in gross domestic product is generally a leading indicator of a nation's economic health. If the economy grows at 4% a year, in 18 years (or about a generation), the economy will approximately double in size and if you look at the statistics you'll find this overall trend in American economic history, with slower or even negative growth occasionally, and faster growth occasionally. All economics is comparative, so the final judgement on our economy is how fast or slow we're growing compared to other nations. Given the "plan" of bringing heretofore absent nations into the global economy (China, India, the Soviet Union, etc.), successfully developing nations grow at roughly 6-9%, while most of the developed world, grows slower, in the 3-5% range.

This, however, says nothing about the nature of the growth or how the added wealth is distributed. Through the Clinton and Bush years growth floated around the 4% figure. If that wealth had been distributed equally throughout the population, household incomes would have approximately doubled. Instead they remained essentially flat for the middle class, slightly improved for the poor and skyrocked for the top 10%. The stratification or dispersion of wealth in the United States is now approximately what it was during the Age of the Robber Barons (the late 1800's and early 20th century). This growing stratification was certainly intentionally promoted via supply side economics and the urgency in expanding the global economy; it also conveniently fit the replacement of those $20/hr jobs with $10/hr jobs. National poverty improved abit under Clinton and got a bit worse under Bush; middle class income rose with the dotcom bubble, flattened and lost ground under Bush, recovering slightly in 2006-07. However, middle class households today are still approximately $1500/yr behind where they were in 2001.

This isn't that unusual in times of significant economic shifts. The Robber Barons may have taken a bit more than their fair share, but they also moved the country from essentially a regionally based economy to a national economy, from which we've all benefited. Capitalism does work. Today's "Masters of the Universe" (the new Robber Barons) are taking us from a national economy to an international economy via globalization. While I have no qualms about that in itself, my concern is that we are moving at too fast a pace in this transition and that both the pace and method will not result in an ultimately stronger nation, but descent to Third World status.

Much of this is due to the "phony economy," I noted above. Unlike the period in the late eighteen hundreds and early twentieth century, today's growth consists of very little substance.
Instead of expanding national infrastructure, our existing infrastructure is declining. Our assets are being bought by foreign importers and the only new factories that are being constructed are by these same importers seeking to find some way of evening out trade imbalances and getting rid of their value declining dollars as fast as possible.

Instead of "genuine growth," we have through the dotcom and housing bubbles grown largely through low interest rates, cheap money, overvalued product and loose credit; credit for consumers, credit for the nation. If one takes away the effect of the bubbles, I suspect growth over this period would be either flat or negative. U.S. household savings fell throughout this period and are now negative - i.e. America is not only dependent on foreign oil, but on credit. Once this is obvious, global confidence may fail and the house of cards fall. In this respect, I suggest we are rapidly arriving at the "tipping point."

A fundamental tenent of free markets is that they behave "rationally." This is a cornerstone to generally Republican arguments for small government, deregulation and free markets, as opposed to higher taxes and "government planned economies." Much of our national economic policy from Ronald Reagan on, including the Clinton years, has rested on the fundamental belief that free markets behave rationally. As a result of this "rationality," buyers in the market will search for the best products at the lowest price, thus forcing efficiencies upon competing sellers. Lacking in these motivations, government will perform inefficiently and so the less money the government receives, the more efficient the economy as a whole becomes. In a nutshell, that's pretty much Republican economics (or was until Bush II, who managed to bring the worst of both worlds. I blame much of it on his Harvard Business School training).

But do markets really behave rationally and are they really "free?" In a recent appearance on CNBC (the business channel), Warren Buffet, who was rejected by Havard Business School and who would be the last person on earth to call himself an "economist," when asked for a prediction on where the stock market would be in a year, replied: "Oh, I don't know. I don't pick stocks on market trends; it's hard to know where a market will go, they're so irrational."

Instead, Buffet's method, as he described it, is a bit of an obsolete Mid-West-Main Street approach. Buffet buys companies, not stocks. [Buffet's own company, Berkshire Hathaway's stock has done reasonably well, with Class A stock now trading at approximately $140,000/share.] In other words, Buffet looks for soundly managed companies with a competively priced, quality product and tries to sort out the clutter that has come to dominate our "free market." He dosen't worry about stock appreciation or the influence of pension fund managers or, in a curious way, "stock holder value," yet achieves just that by largely ignoring it in the day-to-day conduct of his business. And, his stock holders, who at $140,000/share must be among the world's most sophisticated investors, leave him pretty much alone to do "his thing."

Another example of the point I will eventually make here was in the recent film, "American Gangster," based on the true story of a black businessman, whose "business" happened to be drugs in Harlem. As he watched the "trade," he decided that the best way to grow his business was to eliminate the "middlemen" (figuratively and literally). In this way, he also eliminated the commissions and fees and controlled his own product. His success was that he sold a better quality product, with less costs and at a lower price. [He was eventually caught by the newly formed DEA, who themselves were, in a different way, shaking up the old trade, with all of its police payoffs, MAFIA connections, etc.].

The message, in both Buffet and "American Gangster," is that free markets are often corrupted over time and fail to serve their original reason for being...bringing a quality product to a buyer at a reasonable price.

In the wake of the end of communism and the rising economies of a post WWII Western Europe, and the Third World, American financial institutions sought to expand their markets globally and to somehow remain "on-top," a position they had been in since WWII. In my next post, I will show how they accomplished this during the eighties, by taking control of Corporate America through "bribery" and the phrase: "stockholder value."