The Two Biggest Problems With The US Economy

Last night was the third and final Presidential Debate. The number one theme throughout all three was, obviously, the economy. Every other issue pales in comparison to the current economic situation. But the most striking thing to me was how little was said about what I believe are it’s two biggest problems: Housing and Income Inequality.

Short term, the biggest reason for the lackluster recovery is housing. With the exception of the dot-com recession of 2001, every post-WWII recovery was driven by a pick up in Residential Investment.

Since the Housing Bubble burst, the contribution from Residential Investment has been at historic lows – a full 2 percentage points lower than average. Once it gets back to average, GDP growth will be 2 points higher. This would take our current growth rate from the latest 1.3% figure up to 3.3%. Now that the excess inventory of the bubble has been absorbed, we should see a noticeable increase in growth the next few years regardless of who wins the election.

Long term, there is a problem with rising income inequality. In The Great Crash 1929 by John Kenneth Galbraith, he lists high income inequality in the late 1920’s as being the most important cause of the Great Depression.

1. The bad distribution of income. In 1929 the rich were indubitably rich. The figures are not entirely satisfactory, but it seems certain that the 5 percent of the population with the highest incomes in that year received approximately one third of all personal income. The proportion of personal income received in the form of interest, dividends, and rent – the income, broadly speaking, of the well-to-do – was about twice as great as in the years following the Second World War.

Between 1980 and 2007, the top 5% saw their share of income rise from 21% to 37%. In the first year of the Great Recession, income inequality was similar to 1929 levels.

Why does this matter? Because our economy is primarily consumer driven. Consumption levels of the rich don’t vary much with their income. For example, the average income for the top 5% in 2009 was $359,781. A drop of even 20% – to $287,825 probably wouldn’t result in people at that income level cutting back much on spending. But when people in lower income levels get squeezed, they cut back or borrow.

Between 1980 and 2007 they chose to borrow – this gave the illusion of a healthy middle class. Now they are beginning to pay down that debt which has led to a big drop in consumption.

The persistent weakness in consumer spending – which is well below trend – has led to a corresponding weakness in economic growth. Unless something is done to address the long-term rise in income inequality, US economic growth could remain weaker than normal for quite some time.