US economy: Three steps to havoc

Larry Elliott analyses the three stages that have led to the economic challenge facing Barack Obama
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Larry Elliott, economics editor
guardian.co.uk, Friday November 21 2008 18.40 GMT
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Not since Roosevelt in 1933 has an incoming US president had a tougher economic challenge to face than Barack Obama.

He is still piecing together his Treasury team but he doesn't need a pointy-headed academic to tell him the economy has hit the wall. The housing market is still crashing, unemployment is rising sharply, Wall Street is traumatised and it appears the life expectancy of another big bank, Citigroup, can be measured in days rather than weeks.

This is a crisis long in the making. And three big structural changes help explain the mess the US now finds itself in.

The first is that a profound shift in the balance of power between labour and capital over the past three decades has resulted in nugatory increases in real earnings for most people but massive rewards for those at the top.

The second is that the US is living beyond its means at every level. In recent years, it has spent $106 (£71) for every $100 it has earned.

The third is that Wall Street has grown in size and importance as more of America's manufacturing capacity has been exported overseas.

America, as the world's can-do society, found a way of making this work for a time. More women worked, which disguised the fact that male incomes were under pressure. Couples worked longer to maintain their spending. When both those avenues were exhausted, they took on more debt.
Borrowing was a readily available option because the shifting of production from North America to east Asia created big trade surpluses, particularly for China. Beijing had to do something with its export earnings and it parked a large chunk of them on Wall Street.

This influx of capital helped push down borrowing costs, while the cheap goods from Asia kept the lid on inflation and allowed the Federal Reserve to keep interest rates low.

Cheap money drove up house prices, so consumers used their homes as cash machines. House prices only continue rising if there is a flow of first-time buyers, and these were found by offering mortgages to those who would normally have been disqualified. These were risky loans which Wall Street disguised by putting them into a blender with good-quality mortgages and selling them on to anybody who would buy them. Many investors, including UK banks, did.

Inevitably, the housing bubble burst. The banks found they were sitting on huge, unquantifiable losses and by refusing to lend to each other set off a prolonged domino effect that has now reached deep into the heart of the American economy.

Policymakers have throw the kitchen sink at the issue. The Fed has cut rates to 1% and there was a $150bn (£100bn) tax cut in the summer. Banks have been nationalised and recapitalised. So far none of it has worked. The scarring economic memory of the US remains the Great Depression; as things stand the sub-prime crisis will run it a close second.