William Galston

Shock Therapy

By

Although the current economic downturn is not a depression, neither is it a normal recession. Instead, it signals an abrupt transition from the previous state of the world to a very different one. Our economic future depends on how well we understand, and respond to, this momentous shift.

Consider how the operating assumptions of recent decades have been shattered:

  • Since 2007, declines in equities and housing have shaved $14 trillion off U.S. household wealth.
  • In response, the household savings rate, which was below zero as recently as 2006, has soared to nearly 7 percent of disposable income, reducing projected annual personal consumption by about $700 billion.
  • Over the past year, U.S. imports have fallen by about one-third, while exports have fallen more slowly, reducing the monthly trade deficit from more than $60 billion to less than $26 billion.
  • The reduced U.S. demand for imports has triggered massive declines in exports, especially for countries such as Japan, China, and Germany. The IMF estimates that global trade could decline by as much as 12 percent this year.

These and other trends have converged to produce what is, by many measures, the weakest domestic job market since the Great Depression. The long-term unemployment rate has reached 5.1 percent-almost eight million workers-a post-Depression high. On average, the unemployed have been out of work for nearly 25 weeks, and the percentage of workers who have been unemployed for more than six months has reached its highest level since at least 1948. The average hours of work per employed person has fallen to a record low, and average wage income is on the decline.

In recent weeks, I've talked about these trends with economists of varying political persuasions. At some point in the conversations, most of them utter some variant of, "I just don't see where the growth is going to come from." We may well be facing an extended period of below-trend line growth and above-average unemployment. But one thing is clear: When growth does return, it must be based on a new model-less consumption as a share of GDP, more savings and investment, and a diminished appetite for imports coupled with more production for exports.

There are two critical preconditions for reaching this new equilibrium. The federal government must get its fiscal house in order, otherwise the budget deficit, now projected to average nearly $1 trillion per year over the next decade, will soak up every penny (and then some) of household savings and squeeze private sector investment. And the world's major exporting nations will have to adjust by focusing more on domestic investment and consumption and less on exporting to the United States. The only alternative to a new trade balance is a lower long-term level of global trade, which would leave everyone worse off.

This suggests two urgent tasks in the months ahead. After acting on the 2009 legislative agenda, Congress and the Obama administration must pivot toward long-term fiscal restraint. Unless the president takes the lead early next year by highlighting this challenge in his State of the Union address and submitting a budget that begins to tackle it, it's hard to imagine much progress. And second, returning to global trade negotiations and forging the compromises between developed and developing nations needed to complete the Doha Round, which began nearly eight years ago, must be more than talking points for policy wonks.

These steps are necessities if we are to avoid an outbreak of national beggar-thy-neighbor fiscal and trade policies. We saw that movie in the 1930s, and it ended badly.

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