The right prescription for an ailing economy

Published on the Blog of Real-World Economics Review (first on The Nation), by Dean Baker, July 5, 2010.

… In short, the story of economic weakness being the result of a broken banking system is a complete fabrication. This is a good story if your intention is to get more money to the banks. It is not a good story if your goal is getting the economy back to full employment.

The real story is a very simple one of a burst housing bubble. At its peak in 2006, the wealth created by that bubble and the smaller bubble in nonresidential real estate was generating more than $1 trillion in annual demand. This took the form of more than $500 billion in excess construction demand, as builders rushed to complete projects that commanded bubble-inflated prices. It also led to more than $500 billion in additional consumption, as people spent based on $8 trillion worth of bubble-generated home equity. 

As much as economists like to pretend to be sorcerers, they have no easy way to replace $1 trillion in annual demand. The Obama Administration’s 2009 stimulus package went perhaps one-third of the way, but it was nowhere near large enough.

This brings us to the question of why we got the housing bubble in the first place, which goes directly to the issue of inequality. In the three decades after World War II, there were no notable bubbles in the economy. Productivity growth translated into wage growth, which in turn led to more consumption. The increased demand led to more investment, productivity growth and wage growth.

This virtuous circle was broken by Reagan-era policies intended to weaken the power of ordinary workers. Wages no longer kept pace with productivity growth, eliminating the automatic link between productivity growth and demand growth. This led to excess capacity in the economy, which was filled in the 1990s with demand generated by the stock bubble and in the 2000s with demand generated by the housing bubble … //

… Trade and immigration policy have been structured to put non-college-educated workers in direct competition with low-paid workers in the developing world, thereby putting downward pressure on their wages. We can instead restructure trade and immigration policy so as to subject highly paid professionals (doctors, lawyers, dentists, etc.) to the full force of international competition. This will help to bring down the pay of those in the top 2 to 3 percent of wage distribution. It will also raise real wages for the rest of the workforce by lowering the price of the goods and services produced by these professionals.

Finally, unions have long been a major force in reducing inequality. Whatever can be done to protect the right to organize and allow workers the option of joining unions will help to reduce inequality.

It is not difficult to develop policies to reduce the inequality that has given us a crisis-prone economy. The problem is getting the political will. (full text).

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