Many today wonder how long it will take for the sub-prime debacle to end so the economy can get back on its feet. Such questions, however, reflect on Americans’ misconception about the current economic weakness. A better understanding begins with a recognition of the role recessions play in a free-market capitalist economy. This will provide some insight on how long the current malaise is likely to last.

All recessions have a purpose. They are the free-market economy’s way to purge itself of a destructive economic disease and a healing mechanism to get the nation back on track. In order to assess the likely duration of any recession and the extent of its pain, one first must understand its purpose and the causes which led to its necessity. Most recognize the need for a “stock market correction” when stock prices far exceed their intrinsic values which should reflect the earnings firms are delivering or could possibility hope to deliver in the future. So it is with recessions. We must ascertain what the real problem is and what must happen to constitute a “correction”.

The Past and the Present
Virtually all recessions emanate from some type of excess. During the ‘70s, the primary problem was misplaced monetary policy, leading to excessive money growth and entrenched inflation. What was required was correcting monetary policy and moving the U.S. economy towards much lower inflationary expectations. The former, under FED chairman Paul Volker, came quickly; the latter required pain and patience. The initial correction produced the worst recession since the Great Depression and the process of full recovery really lasted through the mid-‘90s when Americans finally began to accept 2 to 3 percent inflation as the norm. Of course, the best policy to avoid or minimize recessions is to never allow excesses to build up to the point of requiring a painful reality check.

As we examine the excesses which have led to today’s gloomy economic picture, we must not simplistically put all of the blame on an out-of-control mortgage market. The causes of our current economic dilemma should be more broadly defined in terms of a decade of spending beyond our means. In that light one recognizes the sub-prime phenomena as merely one of many means used to continue spending progressively more.

Easy mortgage money allowed us to tap booming home equities to pay for this continued consumption spree. Easy mortgage money enabled us to push up the paper value of home equities even though the rental value of residential real estate was increasing only modestly. Easy money induced many households in the lower 35 percentile of national incomes into owner-occupied housing. These households were certain to be unable to afford the full cost of ownership when adjustable interest rates rose and when the inevitable repair costs hit.

Rebalancing the National Economy
To clear the slate and prepare the economy for a recovery, we need to bring spending under control, not stimulate it. But, wouldn’t that guarantee a recession? Not necessarily. What we need to do is alter the proportion of aggregate national demand away from consumption and into investment and net exports. Even government investment in social infrastructure and technology is permissible as long as government balances its budget. Aggregate demand need not fall. Only the mix needs to change.

We are nowhere near the point of needing the over-used Keynesian solution of deficit spending to stimulate the economy. That has relevance only when consumers and businesses are “saving too much”. So, what in the world are we doing passing a fiscal stimulus package to save the economy?

The importance of increased savings in building a viable foundation from which to start the next recovery has many dimensions. First of all, this decade’s level of consumer spending is simply not sustainable. Laden with both bad mortgage debt and bad credit card debt, uncurtailed spending will only exacerbate the underlying problem that plagues us. Yet, policy makers and even many economists keep worrying that the consumer won’t spend enough.

The Interconnection Between the Savings and Trade Deficits
Because consumers, businesses, and government are collectively net borrowers, further deficit spending by government, which enlarges the nation’s overall savings deficit, only means that America must borrow or sell assets abroad. Such negative savings have both serious short and long term downside consequences. For example, every dollar that foreigners use to buy U.S. debt (or assets) is one less dollar they don’t use to buy American goods. Thus, a comparison over time of the U.S. savings and trade deficits shows a remarkable correlation. In the late ‘90s when the federal government was running a surplus and the national savings rate was positive (though still rather pathetic), the trade deficit was a meager $100 billion. As all sectors of the U.S. economy fell more deeply into deficit spending, the trade deficit soared. It had too. We had no other choice but to borrow abroad. What’s remarkable is that we seem to be totally blind to the consequences of foreign borrowing. For years we’ve talked of the “twin deficits” without understanding that they are intrinsically connected.

I find it equally remarkable that many economists and most government agencies continue to buy into other old worn-out economic concepts. For example, just two months ago, it was argued that were the FED to lower interest rates, the dollar would fall much further. The FED did much more than expected, yet the dollar held steady, until the fiscal stimulus package passed Congress and further evidence suggested that the U.S. was continuing to weaken. The dollar is weak, not so much because of real interest rate differentials, but because foreigners have simply had their fill of dollar-denominated assets of a country whose economy is sick. Yet, here we go trying to peddle another 150 billion dollars in debt abroad to finance the fiscal stimulus package. That will prove much more damaging to the dollar than the FED’s reduction in interest rates.

Others think that the weak dollar is due to our trade deficit, but the trade deficit is the symptom not the problem. Our trade deficit is not because our trading partners are not playing fair. As long as we are running a national savings deficit of nearly $1 trillion per year, we’re going to be stuck with a near $1 trillion trade deficit, regardless of what “get tough” trade policies we pursue. Before we start a return to restrictive isolationist trade policies, we’d better first get our act together.

The Savings Deficit and the Real Social Security Crisis
The savings deficit has another serious consequence. Domestic savings is the source of new investment and the returns provide us with a stream of added production extending into the future. But, the returns to foreign investment on U.S. soil go abroad. Amazingly, some have tried to put a positive spin on the enormous amount of foreign investment in the U.S. as though this were good. It means, they say, that the world must think that the U.S. is the best place in the world to invest. The problem is that while foreign investment in the U.S. increases the stock of capital in this country, enhancing productivity, we have no claim to those gains. Unfortunately, failing to increase our own ownership of productivity-producing capital couldn’t be coming at a worse time, just as the baby boomers are about to abandon the labor market.

At the beginning of the decade, those over 65 consumed about 17% of national output. By 2020 that will have risen to about 25%, leaving the working generation in a decade or so less fruits from their labor. This could lead to a new type of class warfare, not between the races or sexes, but between the generations. The only solution to this dilemma is to reduce the burden imposed by the “retired” generation by making national output larger. Giving up another 8% of their production may be tolerable to the next generation if their 75% is taken out of a much larger GDP pie. Yet, the pie can get only bigger if we save and invest more, thereby greatly increasing U.S. productivity which we ourselves own.

Some historical statistics can put the challenge in perspective. During the past 60 years, the U.S. economy produced, on average, growth in real dollar per capita income of about 2% per year. This occurred despite productivity gains in the labor market of only around 1% per year. The extra 1% came primarily from a steady increase in female participation in the labor force after World War II. During the 1990s, gains in real per capita income were also around 2%, aided by stellar productivity gains of 1.6% per year, but dampened by a slowdown in the growth in female labor force participation. With the coming surge in retired population which will reduce the worker-to-population ratio, U.S. productivity gains will have to be around 3.6% per year in order to generate the same historical gains in per capita income. That’s more than twice what was achieved during the high tech ‘90s. If we just replicate the ‘90s productivity gains, real per capita income will rise only .75% per year, and with productivity growing at our 60 year average, income growth will increase only .6% per year. In either case, the next generation of workers will be significantly disappointed.

For decades the U.S. economy has produced net national savings (all sectors) averaging around 7.5% per year. Today, it is less than 1.5%. In order to get back on a sustainable path, the U.S. needs to join the rest of the developed world with savings rates closer to 10%. That’s certainly feasible, but the transition from consumption mania to prudent living will not be easy. This is really what the current recessionary environment is about. Consumption must be brought into check and investment, an improved trade balance, and disciplined government spending must be in place before we’ll see a sure foundation for renewed economic prosperity.

This transition won’t happen overnight. Whether the U.S. economy falls into a technical recession or not, the bad news is that it’s going to be some time before we can expect to see a return to healthy, sustainable economic growth. However, what is more worrisome is that policy makers are taking us in the wrong direction, trying their hardest to keep us spending, instead of helping us live within our means.