4 More Years Of What? The Past As Prologue

by: Martin Lowy

Like many SA followers, I have been reading pundits' post-election stock market predictions, both at SA and elsewhere. I am finding that there is almost unanimity of opinion: Republicans forecast a dark and dire four years; Democrats forecast a gradually improving economy, with the stock market continuing to provide good long-term returns. All of us seem to be caught repeating our pre-election rhetoric.

I am no exception. I voted for President Obama, and I am optimistic about the next four years economically. If you are a reader who is convinced that four more years of Obama will be a tragedy for America and you are not willing to listen to anyone who will not parrot that perspective, you may stop reading this article, leave a sassy comment, remain in your silo, and surf somewhere else. But if you think that maybe you might not be 100% correct and that if the next four years are going to be okay, you would rather know about it now rather than have it surprise you, then please continue.

The Last Four Years

Republicans have claimed that the last four years were among the darkest in our history. A repeat of the Obama Administration, they have alleged, will be a horrible thing for the country. Moreover, they allege, additional regulations that are still coming on-stream will hamstring business and reduce economic growth to a crawl, if not outright recession.

First things first: Presidents -- indeed, entire governments -- take too much credit or blame for the economy. The economy is a long-term process that is relatively little affected by the policies of four years. Eight years could have a greater impact, but even that should not be exaggerated. Except for the impact that increases or decreases in government spending automatically have on GDP computations, demographics, global trends and serendipity all play roles as important as the government.

President Obama took office at a time that was both lucky and unlucky for his economic legacy. The economy was very bad at the beginning of 2009, so it was relatively easy to help it to perform better -- but only a little bit better. The economy was saddled with consumer debt problems and a deficiency of final demand that were -- and are -- not remediable in the short term. See the acclaimed book This Time Is Different by Carmen Rienhart and Kenneth Rogoff for a detailed discussion of why it is so difficult to recover from the type of recession we had. There was, in my opinion, nothing better that a president could do than provide some stimulus in the beginning, then muddle through and let the economy heal. At the beginning of 2009, the stock market was close to what was bound to be an historic buying opportunity. In fact, the market rebounded strongly for three and a half years (with a hiccup in 2011), making Obama, as of Election Day 2012, the best first-term best president for the stock market since FDR took over in the depths of the Depression. Eisenhower, Clinton and Bush 41 all also had excellent first-term results. Eisenhower and Clinton had good second-term results as well; Bush 41, of course, had no second term. Taking over when the market is down in the dumps is the best policy for creating strong returns, it seems.

It is ironic that the presidency that is claimed to have been the worst for business -- maybe ever, according to rightwing pundits -- actually resulted in the greatest shift from the share of corporate revenue going from labor to corporate profits. I believe it is that shift that has propelled the stock market. I give President Obama no credit for the shift -- I think it resulted from global forces -- but not to recognize that this shift happened on his watch is, frankly, pig-headed partisanship.

The U.S. economy has been improving gradually for the last three years. The biggest missing ingredient has been one of the traditional drivers of economic growth: housing.

Household Formation As A Driver Of The Economy

Housing is now starting to come along. In theory, there should be significant pent-up demand for new houses, if only household formation would pick up. I discussed this issue here. Nobody talks about household formation on the campaign trail, but it is one of the big drivers of the economy as a whole. And over the last four years, it has lagged behind population growth significantly, probably due to the scarcity of jobs and to substantial numbers of young people going back to complete college. (According to the Pew Research Center, the percentages of young people earning a college degree, after stagnating for a decade or more, increased to a record number over the period 2009 to 2011, with a third of Americans between the ages of 25 and 29 now having completed college.) As the economy improves, however gradually, the young people living at home, whether they have been completing college or not, will tend to form households at a higher rate than usual. That demographic movement will engender a rising demand for housing and other household necessities like appliances and furniture, with all the benefits that normally accompany an increase in home construction.

Along with that increase in activity will come increases in house prices (now that the overhang of foreclosed houses has been reduced -- see the Calculated Risk blog for a sampling of the measures showing this trend) that will have a number of beneficial impacts: (1) people will feel richer, (2) some people, particularly those in their 60s, who have been waiting to sell their homes will be able to do so, benefiting the housing markets and economies in retirement destinations such as Florida, and (3) some people who have not been able to refinance their homes at current low rates because of low appraised values will be able to do so. All that is good for employment, accelerating the virtuous upward cycle.

The Causes Of The Great Recession

These positive developments are best understood against the backdrop of what really happened in 2007-2008 that made the economy fall off the cliff. There are countless explanations floating around, many of them highly technical and complex, many of them seeking to put the blame, alternatively, on (A) the big bad bankers, or (B) the repeal of Glass-Steagall, or (C) Barney Frank and others who advocated lending to lower income households, or (D) the Federal Reserve Board. Although the bankers, housing policy that advocated loans to people who probably were not creditworthy, and the Fed played roles, the answer to what happened is simpler and more direct.

The incomes of middle class Americans began to stagnate in the 1990s. The following table is in 2010 dollars:




TOP 5%


















Data in 2010 dollars from census.gov. Table prepared by the author.

As you can see, only the top earners continued to have rising incomes. If we looked only at 2000 and beyond, the table would show declining incomes for the lower three quintiles.

At the same time that incomes were stagnating, the financial world saw an increase in demand for safe investments that would yield more than U.S. Treasuries. Where this demand came from has not quite been pinned down, but I believe it came principally from Europe, through the transmission mechanism of U.S. money market funds that bought the paper of European banks on the strength of their apparent government guarantees. I have explained that process at greater length here. But wherever the demand came from, it clearly was there, was not "responsible" demand in that it did not do its job of policing the market, and the demand was satisfied by the U.S. securities markets that created AAA securities backed by mortgages that, increasingly, were poorly underwritten. The process of creating those mortgages fueled the demand for houses, causing house prices to rise, appraised values to rise, and thereby enabled millions of Americans to make up for their stagnant incomes by borrowing large amounts of the apparent equity in their houses that resulted from the increases in prices. The spending of this equity extraction was what made the U.S. economy appear healthy in 2004-2006, when in fact, it was not if one had to base final demand on incomes rather than on money borrowed against supposed house appreciation.

The following table quantifies the impact of spending with equity extraction dollars on real GDP over the period 2002 through 2006. Equity extraction includes home equity loans, cashout refinancings, and sale proceeds not reinvested in another home. Some of that equity extraction was invested rather than spent. I have estimated the spent part based on work by James Kennedy and Alan Greenspan at the Federal Reserve Board. The graph that appears after the table updated estimated equity extraction through 2010.

Impact of Equity Extraction from Homes on U.S. GDP 2002 to 2006 (Dollars in Billions)






Reported Real GDP






% Reported Real GDP Growth

1.6 %

2.5 %

3.6 %



% Real GDP Growth Net of Impact of Equity Extraction Spent






Without the consumer spending from equity extraction, the economy would have been in or near recession for the entire period from G.W. Bush's election to 2007.


What happened in 2007-2008 was that, when the mortgage backed securities market dried up and house values declined, consumers were no longer able to borrow against their homes. That lack of borrowing power was not immediately apparent in 2007, as home equity lines of credit, for example, that had been extended in the 2004-2006 period were not immediately withdrawn in 2007, but were only withdrawn as 2008 progressed. (The above graph suggests that equity extraction was still positive through 2007, and turned negative only late in 2008.) The public horror at the sight of the Secretary of the Treasury and the Chairman of the Federal Reserve Board going hat-in-hand to Congress at the end of September 2008, saying, in effect, that the financial world would come to an end if Congress did not act finally made even the most optimistic consumers aware that they could borrow no more and would have to live within their incomes. Not surprisingly, consumer demand dried up precipitously, the stock market tanked, and a deep recession ensued. As Warren Buffett put it at the time, "The economy fell off a cliff."

The Aftermath Of The Great Recession

When we understand that simple story, we can see why it has taken so long for the economy to recover. The economy actually had been suffering since 2000, if the home equity extraction spending is excluded. There simply was no source of increased demand that quickly could bring the economy into vibrant growth. No governmental magic could make that happen. We had to live through it. See Reinhart and Rogoff for detailed reasons why it takes a long time to recover from an event like the Great Recession. Probably it would have been worse without stimulus and without the Fed's heroic efforts to provide liquidity -- although I think there may be penalties to pay for those policies down the road. But we did have to get through the crisis and back to some sense of normalcy. Which is where I think we are now.


There are some countervailing headwinds that I think will continue to hold the economy back, but I think they are not so great that the virtuous cycle cannot begin. Those headwinds fall into two categories: (1) Global competition and soft European demand, and (2) the costs of regulation, particularly the costs of the Healthcare Reform Act.

Global Competition And European Economic Weakness

Global competition is the biggest hurdle the economy has to overcome. The best jobs are going to the people best suited for those jobs, regardless of where they reside, and "best suited" includes price. A PhD scientist from India is just as good as a PhD scientist from California, so if the Indian scientist will work for less than the California scientist, the Indian one will get the job. The same holds true on down the line of educational attainment. This is good for the world long-term, but it is hard for Americans to compete in this environment, and it depresses American incomes. This is not a short-term problem. It has been with us for most of the last two decades, and it is likely to persist for the next 20 to 30 years, as incomes in developing economies catch up with American incomes. Nor is there anything that the U.S. government can do abut this situation, except try to assist Americans to become better educated and therefore, better able to compete in the global economy.

The European economy is not growing, and it is not likely to grow for some time. That has an impact on the U.S. economy, but less of an impact than one might think. The U.S. economy is still basically a domestic economy in terms of demand, not an economy that depends primarily on export growth. It is likely that no major economy will be able to depend on export growth for its economic growth over the next few years, since all are pursuing weak currency policies at the same time.

Although these global factors will tend to keep the American economy from achieving a more or less traditional robust recovery, they are not sufficient to prevent the pent-up housing and household formation demand and gradual improvement in the jobs picture from maintaining fairly steady, though perhaps not spectacular, growth.

Regulatory Drag

The regulatory drag, although real, also will not prevent increasing growth. The two major pieces of legislation of President Obama's first term, the Healthcare Reform Act and Dodd-Frank, both have aspects that were needed and both got taken over by the legislative process and turned into Christmas trees with goodies for somebody dangling all over them. As a consequence, both pieces of legislation will tend to retard economic growth more than their principal goals would have required. I see these two pieces of legislation as major missed opportunities. The flaws in the Healthcare Act appear greater than the flaws in Dodd-Frank, but both suffer from excessive complexity and an inability to see, much less apply, Occam's Razor.

Dodd-Frank is basically a good set of legislative ideas gone wild. The Consumer Protection Bureau will not only protect consumers; it will protect bankers and other financial services firms from the kinds of over-reaching that caused them to make so many bad consumer loans in the past. The Bureau will be the best part of the legislation, despite banks' and rightwing commentary to the contrary. The Bureau's regulations will reduce the level of consumer debt to more manageable amounts. That will reduce consumer demand in the short run, but because the loans not extended would have been high-interest-rate loans, the lower level of debt will put money in consumers' pockets in the long run.

The Volcker Rule also will be a positive for the economy in the long run because it will force banks to concentrate on serving customers, which is what the economy needs. Pay no attention to the bankers' pleas or those who decry regulatory interference. The banks exist by reason of governmental subsidies. It is entirely reasonable and proper to tell them they cannot engage in a business that has no economic benefit. Whatever benefits there might be to proprietary trading will come from hedge funds and others who will continue to do the business. Higher capital requirements and stress tests come under the same heading -- they are a net positive. It is all the new pork and red tape that is unnecessary and wasteful.

Even if banks have to shrink to meet capital requirements, which no major U.S. bank has to do, that is not a problem for the economy. There is no lack of funding available. Banks, large corporations and individual investors are awash in liquidity. The problem is a dearth of creditworthy would-be borrowers. Without equity in real estate to back a loan, most individuals and small businesses are not creditworthy beyond small amounts.

The Healthcare Law is a far worse set of laws than Dodd-Frank. The idea of universal healthcare is unassailably correct. The problem that should have been addressed was how to do it simply and at reasonable cost. Instead of that, Congress created a hodge-podge of overlapping mechanisms and incentives that end up discouraging employers from hiring and imposes large costs on almost all economic actors, including consumers. When you saddle hiring another employee not only with FICA, unemployment tax and workers comp, but also add in mandatory healthcare (or pay another tax), then there must be a disincentive to hiring. But that disincentive is likely to be small relative to the big demographic and educational movements that govern the economy over the long term.

My guess is that these costs and disincentives will not be enough to derail the gradual upswing of the economy, especially since, in the short term, many of the costs will result in companies' needs to hire specialists and thereby to create jobs. The drag on productivity that inevitably accompanies unproductive regulations will be a longer-term problem that will be hard to measure.

My bottom line is that the economic forces that caused the Great Recession were largely outside the control of the U.S. government, the pace of the recovery also has been largely out of the government's control, and the actions the government has taken, some of which are beneficial and some of which are detrimental, will, on balance, encourage rather than discourage economic growth in the near term.

The Federal Debt

My conservative friends -- and conservative readers, if I still have any -- will now be chastising me for not having said enough about government deficits and their impact on future economic progress. Those deficits, my conservative friends argue, and the increased government debt that they imply must hold back the economy because taxes will have to be raised to pay the interest and to eventually pay off the debts. And what about the credit rating of the U.S. and the fact that debt as a percentage of GDP seems to be going into the same territory as bankrupt nations like Spain and Italy? A strong America cannot be an indebted America, I think they contend. As I have pointed out elsewhere, the U.S. borrows in dollars, so it need never default. The issue for the U.S. is inflation. Inflation in the near future is possible, but not likely. Global competition still keeps prices down in high-GDP-per person countries like the U.S. The dollar is not likely to depreciate relative to the yuan or the euro, or even the yen or the Swiss franc, because all of those currency issuers are fighting against their currencies' appreciation. Even oil is unlikely to cause significant inflation in the U.S. in the near future because the supply of oil (and gas) in the U.S. and Canada is growing rather than shrinking. Add to these factors the entire employment picture: There is a large number of unemployed people and the large number of recent college graduates looking for jobs. There also may be an overhang of people who have left the job market, but might return to it if jobs were available. Those are not the kind of conditions that spawn inflation.

The federal debt does have to be addressed, but the problem is not urgent, as demonstrated by the extremely low rates at which the U.S. continues to be able to borrow. The financial world is awash in liquidity with no other safe haven than U.S. Treasuries. No other issuer in the world is likely to come close to the U.S. in terms of security and stability in the near future.

And by the way, if you look at the debt problem dispassionately, Obama inherited most of it. The depths of the Great Recession was not the time to impose new fiscal austerity.

Fiscal Cliff

I have not talked about the fiscal cliff today, but my view is that there will be a compromise. It will not be perfect, but it will not be a significant factor either way. See my article here for some additional detail on my fiscal cliff thinking. Probably the compromise will reduce GDP by about 1%, which will offset some, but not all, of the positive factors driving the private sector forward. A rotation from the public sector to the private sector driving economic growth would be welcome.

Stock Market Valuation

As for the stock market: It is rather fully priced at the moment. The market's progress over any appreciable period of time depends on growth of corporate profits, not on the health of the U.S. economy. It is quite possible to imagine an economy that includes GDP growth and job growth, but not corporate profit growth that exceeds the growth already built into the prices of stocks. For this reason, I am hoping -- because I have a fair percentage of my portfolio sitting on the sidelines awaiting a better opportunity -- that we have a nice little market correction so there will be a buying opportunity. Therefore, I am perfectly content to see the market trading off for a while. A nice Santa Claus rally might well result.

"Steady as she goes" is my investing mantra at the moment.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.