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Two different stories

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Robert Samuelson has an interesting narrative [2] in the Washington Post. He argues that the prosperity of the last 30 years was driven by consumer spending, consumer spending that came from a false sense of wealth as housing prices rose artificially high due to an expansion of credit:

We live in a world of broken models. To understand why world leaders can’t easily fix the sputtering global economy, you have to realize that the economic models on which the United States, Europe and China relied are collapsing. The models differ, but the breakdowns are occurring simultaneously and feed on each other. The result is that the global recovery flags, while pessimism and uncertainty mount.

Take the United States. The U.S. economic model was consumer-led growth. From the early 1980s until the mid-2000s, what propelled the economy was rising wealth — stocks, bonds, real estate — that encouraged households to spend and borrow more. Feeling richer, people traded up for better cars, homes and vacations. Everyone could afford or aspire to “luxury.” Businesses responded by investing in more malls, restaurants, hotels, factories and start-ups.

And whose model is he talking about? What politician or party or wing of a party said the key to prosperity is to get consumers to feel rich so that they’ll spend a lot and that in turn will create more wealth and so on? I don’t remember hearing that model until things fell apart. This is an interesting ex-post narrative consistent with Keynesian view that spending is the source of income via the “circular flow” of money. But I don’t think it was anyone’s model in real time.

And what a strange ex-post narrative it is! How did the idea become mainstream that it is spending rather than productivity that creates economic health and prosperity? Spending is the consequence of productivity, not its cause.

It could be true, of course. If it’s true, then Samuelson is right–the model is broken. It isn’t obvious how to get back to prosperity within the confines of this model:

To grow faster, the U.S. economy can’t rely on large gains in consumer purchases.

What’s to replace it? There are three possibilities: higher exports, more business investment and higher government spending. Weak economies elsewhere hinder exports. Businesses won’t invest unless there’s stronger demand. And more reliance on government means bigger budget deficits, a policy that inspires powerful political resistance.

I have a different model. It’s  an old-fashioned model. In my model, prosperity is driven by productivity. Productivity comes from not spending–from saving, as long as the saving isn’t artificially encouraged to flow into the pet projects of the powerful. We had some real productivity over the last 30 years. The venture capital funded some incredible innovations that made us much more productive. But not everything worked perfectly well. It never does. So there were those who sought to improve what was imperfect. For example, the home ownership rate stagnated during the 1980’s causing alarm that the gains from prosperity weren’t being equally shared. What people forgot was that the divorce rate rose during the 1980’s–a lot of couples who had shared a house were now split into typically a renter and an owner. This lowered the home ownership rate but said nothing about the affordability of houses [3]. But a bootlegger and baptist coalition emerged in the 1990s. The bootleggers were the realtors and the National Association of Home Builders. The politicians sprang into action to “fix” a “problem.” The real problem was demographic not economic and the fix actually ended up destroying the housing market for five years and counting.

There is more to the story of course. There was erratic monetary policy that served intentionally or not, the growth in home ownership and the increase in the price of housing, an increase that began in 1995, when the policies to increase home ownership began to take effect.

And the banks and the investment banks messed things up as well, particularly in housing.

To get back to prosperity, we need to let the housing and financial markets heal. We need to stop trying to manipulate the housing market and the financial sector. We have to let banks fail now and then, especially those who lend to fund reckless investments [4]. As the Hayek character says in The Fight of the Century [5]: Give us a chance so we can discover/The most valuable ways to serve one another.