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TDS Co-Editor William Galston: There Is Only One Way Out of the Recession

This item by TDS Co-Editor William Galston is cross-posted from The New Republic.

Average Americans are noticing what wise economists have been arguing for quite some time: Bubble-driven economic downturns differ qualitatively from standard business-cycle recessions. Not only do they go deeper; GDP takes longer to rebound, and job creation proceeds more slowly.

The mechanism is straightforward. As the value of assets used as collateral collapses, so does borrowing. This depresses consumption, and the real economy dips, making it much harder for businesses and households to service the debts incurred during boom times. Household consumption remains sluggish until debt is reduced to a level that can comfortably be serviced out of current income, a process that cannot proceed without an increase in the household savings rate. The larger the debt overhang, the longer it will take to work off the excess.

As recent as the late 1990s, total household debt stood under $5 trillion, roughly 90 percent of disposable income. After a decade-long borrowing binge, debt peaked in late 2007 at about $12.5 trillion--a stunning 133 percent of disposable income. According to the latest report from the Federal Reserve Bank of New York, the total had declined to $11.7 trillion by the first quarter of 2010, a reduction of $812 billion (6.5 percent) from the peak. During the same period, not surprisingly, the household savings rate rose from 2 percent to more than 6 percent.

While these are sizeable changes, there is good reason to believe that the process of household debt reduction is still in an early stage. Writing for the Center for American Progress, Christian Weller points out that total debt now stands at 121.7 percent of disposable income, still higher than at any point before the second quarter of 2005. In an analysis published in May of 2009, the Federal Reserve Bank of San Francisco suggested that the household debt/disposable income ratio might well have to fall much farther, to around 100 percent, a process that could take much of the decade, even if the household savings rate were to rise to 10 percent.

This extended deleveraging would have a substantial effect on the economy. The FRBSF estimates that it would reduce annual consumption growth by three-fourths of a percentage point from the stable-savings baseline, which would "act as a near-term drag on overall economic activity, slowing the pace of recovery from recession."

This is exactly what we're now seeing. In a superb piece, the Washington Post's Neil Irwin gets outside the Beltway and beyond its stale arguments to probe the real reasons companies aren't hiring. His conclusion is worthy of extended quotation:

Many Democrats say the economy needs more stimulus. Business lobbyists and their Republican allies say it needs less regulation and lower taxes. But here in the heartland of America, senior executives say neither side's assessment fits.

They blame their profound caution on their view that U.S. consumers are destined to disappoint for many years. As a result, they say, the economy is unlikely to see the kind
of unbroken prosperity of the quarter-century that preceded the financial crisis. . . .

They see Americans for years ahead paying down debts incurred during the now-ended credit boom and adjusting spending to match their often-reduced income.

"It's a different era," says Daryl Dulaney, chief executive of Siemens Industry, which has 30,000 U.S. employees who make lighting systems for buildings and a wide rnage of other products. "Our hiring and investment decisions have to be prudent and reflect that."

A different era ... How long will it take our policy makers and political parties to absorb the implications of that stark, undeniable phrase? When they do, they will realize that we have only two strategic options: Either we accept years of sluggish growth and high unemployment, or we shift to a new model that mobilizes the record level of private capital now sitting on the sidelines for public investments that will boost economic activity and employment in the short term, and economic productivity and growth in the long term, while generating rates of return sufficient to interest investors.

This is why we need a national infrastructure bank as the linchpin of a public investment strategy driven by economic analysis rather than congressional politics. Rather than bridges to nowhere, we need a bridge to the future. It's time for hide-bound appropriators to get out of the way.