How Sound Is the Economy?

When Bank of America, the largest commercial bank in the United States, agreed on Monday morning to buy the beleaguered brokerage firm Merrill Lynch & Co. for less than a fifth of the price the firm traded for at the beginning of last year, BofA investors were so disturbed that they launched a sell off of the bank’s stock, eliminating $32 billion or 21 percent of the bank’s market capital in one day. That was on the heels of the demise of the 158-year-old Wall Street investment house Lehman Brothers Holdings Inc. and more than four months after Treasury Secretary Henry Paulson pronounced that the worst of the financial crisis was behind us.

So, what is going on? How did we get into this mess, and how will we get out?

It is clear to any detached observer that the travails on Wall Street are not simply a superficial kink in the circulation of the nation’s money supply. There are deep-seated problems here that will impede growth, and accelerate business failures and job losses if not objectively identified and forcefully addressed. While we have recklessly disregarded the need for prudent supervision of our banking and financial systems, the real problem is even deeper.

For eight years we have papered over the fact that American consumers do not have the purchasing power to sustain economic expansion. As a report I authored a little more than a month ago details, the wage and salary increases that have occurred since 2000 have not been sufficient to even maintain the level of income that most families enjoyed at the beginning of this decade. Employment has not kept pace with population growth. And even though worker productivity has increased by nearly 20 percent over this period, weekly wages are barely higher than they were on the day the current president took office.

Under normal circumstances, we would have seen the effects of slow wage and job growth much sooner in the economic cycle. But the Bush administration and their enablers at the Federal Reserve Board found a way to inoculate the economy temporarily from the fact that the paychecks which Americans were taking home were insufficient to buy the goods and services the economy was capable of producing. The prescription was easy credit—car loans, credit cards, and most importantly, mortgages.

Families from the bottom of the income ladder to the very top were showered with offers of cheap credit driven by the fact that our central bank was willing to loan money at or even below the rate of inflation. Americans were given the opportunity to use their homes as ATM machines; between 2002 and 2007 borrowing against homes exceeded the amount spent on homes and home improvements by $1.7 trillion. While incomes were not rising at a rate to support a growing economy, credit made up the difference.

Today we have an economy that has not only suffered from stagnant wages and falling incomes for nearly eight years, but one which is far more burdened by debt—debt which in a growing number of instances is beyond the ability of families to repay. Our failure to recognize the fundamental underlying causes of the current malaise not only delay the prospects for recovery but will make recovery more difficult and costly.

Stephanie Pomboy, the founder of the economic consulting firm MacroMavens, has been right repeatedly in forecasting the severity and duration of the housing and credit crises. She was quoted in this week’s Barron’s:

Once again, we can’t resist pointing out had Paulson and his bailout crew used their powers for ‘good’ from the get-go, they could have saved a lot of time, energy and, most importantly, money. Had they simply established a fund to buy up the surplus housing inventory, presently valued at just over $1 trillion, they could have stitched up this wound for less than they’ve spent layering Band-Aid after Band-Aid on top of it.

The erratic shifts by this administration between radical free market laissez fairism and heavy-handed government intervention in financial markets is making it increasingly apparent that its officials refuse to exercise detachment in examining the underlying problems that face the U.S. economy and are incapable of addressing those problems in a deliberate and effective manner. That perception is adding further to the traumas now plaguing U.S. and global markets.

Scott Lilly is a Senior Fellow at the Center for American Progress.