The “Fundamentals” of the US Economy


WASHINGTON – Senator John McCain has been repeatedly mocked by his opponent, Senator Barack Obama, for having stated very recently that the “fundamentals of the US economy are strong” –or words to this effect. Of course, in light of the significant slowdown, with rising unemployment and now the unfolding, disastrous Wall Street and Main Street meltdown, McCain’s sunny optimism sounds dumb. But, whatever it was that McCain really meant, there is an obvious distinction between “the fundamentals” of the US economy and the present contingency faced by America. The present contingency is as bad as it can be. The dominance of finance over economic activity –intended as production of new wealth– with financial wizardry having turned into recklessness, has dragged the whole edifice down. So, the current situation is bad, if not awful; and the severe damage may be felt for years.

The real fundamentals

But what about “the fundamentals”? And what can we say about them? If we really focus on the fundamentals, is McCain’s optimism as silly as Obama describes it? Well, here the evaluation is not as clear cut. A reply to this –indeed—”fundamental” question needs to be nuanced, as the fundamentals have changed –and not for the better. 

They used to be good

Until not too long ago, it could be argued that the basic elements of the US economy were, if not excellent, quite good. America routinely ranked in the very top tier in most international comparisons on competitiveness and easiness to do business. The positives included a truly free society; a reasonably educated, mobile and flexible workforce, depth of capital markets. America had and still has a system in which the rule of law is usually dependable, in which contracts are enforced. But, most importantly –and this is truly the envy of the world– America had a system that favored healthy synergies between outstanding academic institutions producing basic research, significant public and corporate R&D spending, entrepreneurship and venture capital.

Rewarding innovators

This future oriented mix made it possible, indeed always desirable, to push the envelop, to think and do outside the box, with the expectation of being financially rewarded for developing new products and bringing them to market. So, the system would brew innovators who could find the money to commercialize their inventions; while the market place rewarded success, creating thus more incentives for others to do the same.

Good results

And we see the results. It is not due to random accident that the most significant innovations of the unfolding knowledge economy have been hatched here, in the USA. A competitive environment, in turn, encouraged established economic sectors to adopt the cost saving, efficiency enhancing, new technologies, with the objective of making their businesses leaner and more productive. Because of these investments, the overall economy has become more efficient and more productive. More could be said, but these are some of the critical “fundamentals” that other nations wished they had. This was the picture until not too long ago.

Can public policy make a difference?

Sure enough, public policy does matter in this context, as it affects the basic environment in which economic actors operate. But if we would want to take literally Senator Obama’s scathing critique of McCain’s apparently uninformed optimism, concluding –as Senator Obama asserts– that the fundamentals of the US economy are bad, then public policy, whatever its goals, would face tremendous obstacles, assuming bad fundamentals.

…It can fine tune; but it cannot make things happen

Indeed, if the fundamentals were really bad, well, public policy alone, however thoughtful and inspired, would make small inroads, as it would fall on an unreceptive terrain. To name just one variable, should there be all of a sudden a dearth of entrepreneurship in America, with no new companies launched, how could we have growth and how could we bring innovation into the market place?

Or, on a different level, should morality all of a sudden take a fall, with most people becoming corrupt, public policy could not turn this around. Forgive the extreme example: you can have the best public policy in the Congo DRC, but results would be small, as the country, unfortunately, still lacks most of the fundamentals. Public policy can strive to create an environment more favorable to enterprise, but it cannot make it happen on a significant scale, just by fine tuning the rules and creating fiscal incentives. If we do not have the fundamentals, or if the fundamentals are skewed by other factors, (take social ties that constrain economic behavior in Japan), governmental action will have at best a limited impact.

Good public policy can help unleash enterprise but it cannot create it

Good policies, and let us assume that Obama’s ideas are excellent, can have a truly positive impact if the “fundamentals” are good. If the society is educated and healthy, if there is respect for the rule of law, if sophisticated skills exist and are constantly upgraded, if people on balance are law abiding, if the courts are impartial, then we have the basic ingredients. In short, “good fundamentals” are the preconditions for a performing economy. Good public can help optimize performance; but it cannot create the system. This is why, lacking the fundamentals, good policies will have a modest impact.

Fundamentals stem from societal values

The fundamentals come into existence as part of the culture, of the value system of a given society. Sure enough what governments do does matter; but public policy alone, divorced from broader efforts aimed at creating or sustaining values will do little. Creating those fundamentals is immensely difficult. And there is no clear road map. It is a matter of complex cultural transformations grounded on belief systems tested over time through experience and results. There is no clear recipe, no one size fits all.

Repeated failures of attempts to “import” fundamentals

And the evidence of how difficult it is to create the culture underpinning and sustaining the fundamentals is in the repeated and in some cases catastrophic failures of development economics aimed at introducing, via new policies, the good underpinning and the values that would sustain them –all these constituting the good fundamentals– in parts of the world that never had them.

The bad record of development economics

Hundreds and hundreds of billions and hundreds of country strategies later, the results in international development efforts are modest. And this is not for lack of persistence. Disappointing results simply underscore how difficult it is to create and sustain what  development experts fondly call “the enabling environemnt”. A good “enabling environment” assumes many if not most fundamentals to be already in place and vibrant. All this does not mean that, with good fundamentals in place, there will be no crises, even though the present one gripping America is exceptional because of its depth and reach. But a society in which the fundamentals are still basically sound can overcome massive crises like this one.

Lacking values, good policies rarely create fast transformations

Thus, it should be clear to all that, aside from exceptional contingencies like the present one, in most cases, an overall bad economic environment, characterized by lack of development or disappointingly modest rates of growth, is due to the lack of fundamentals. These fundamentals unfortunately cannot be quickly wished in place by wise and well meaning policy experts. While bad policies can contribute to bad economic outcomes, the reverse is not necessarily true. Good policies alone cannot rapidly create a healthy situation, if the “fundamentals” are not in place.

If new policies were enough, Africa would be booming

Indeed, if good intentions and well meaning effort alone (see above) would suffice to will the fundamentals in place, then Africa should be booming, as it has been the focus of relentless attention by development planners and strategists for decades. But growth in Africa has been disappointing precisely because many of the fundamentals are not yet there, or at least not there in the measure that is required to create the virtuous cycle of healthy growth begetting more growth. Of course, change is possible, and there are some encouraging examples. But change is usually slow and uneven.

In Europe: loss of an old pro-growth culture

And if we look at Europe, we see countries that are developed –in fact countries that historically invented development– but whose growth, overall, is disappointing. Well, the causes could be debated. But many would argue that low growth is due to a change in the culture, that is a change in the societal disposition with all the attendant repositioning of values and economic and social priorities.

Conserving what exists, rather than create new things

In Europe today, on balance, there is a stronger emphasis on equality and the creation of guaranteed good conditions for all. And so we have a concern for keeping people in their existing jobs, even if these economic activities are less competitive, rather than stimulating risk taking with the possibility, albeit not the certainty, that more competitive jobs will be created. Overall, a dependable status quo seems preferable to a risky, free for all system in which some will win but many may be losers. So, the delivery of social services comes before enterprise creation. While the goals of social policies are laudable, as they are aimed at minimizing disruptions, they detract resources from investments and growth.

Demographic trends: more older people and retirees

Furthermore, given the demographic shift in Europe to older and older populations, the focus on social programs will mean that a larger and larger percentage of whatever wealth is produced will be spent on the needs of the older people who are growing as a percentage of the total population. With more resources absorbed by the no longer productive elderly, there will be less for anything else. Unless a new economic engine is created that will produce spectacular new wealth, this will mean even slower growth.

European fundamentals: not optimal for growth

This does not mean that the “fundamentals” are bad in Europe. It means that they are not optimal for growth. There is more social equality, while fewer people fall through the cracks, but less wealth overall. While public policy could change some elements of this picture, the underlying issue is a political culture more focused on justice, stability and distribution than on wealth creation. These values have consequences. They affect, indeed they shape priorities and thus the fundamentals.

What about America?

So, after saying all this, can we just conclude that, current financial crisis notwithstanding, we should congratulate ourselves, because the fundamentals of the US economy are basically sound and good? Well, not so fast. As I said at the beginning, there used to be almost total unanimity as to the soundness of America’s economic fundamentals. But some key elements in the picture have changed –and definitely for the worse.

Deterioration of human capital: a worrisome trend

As I have discussed elsewhere, one of the fundamentals, in fact a key fundamental that is increasingly becoming the foundation for everything else in knowledge economies, the quality of human capital, is deteriorating in America. And this is a systemic crisis surprisingly ignored or played down, even by those who should know better. Unless quality education is fully restored, indeed upgraded in the country as a whole, we have to conclude that the fundamentals, although still better than elsewhere, are deteriorating in America, with long term systemic consequences frankly far worse than the impact of the current financial panic. Bad quality of education will translate into low quality labor force and this will affect the future wealth generating capacity of the country as a whole. Panics come and go. But if a country loses its edge in skilled people, it may take generations to reconstitute this asset.

Not enough care for education

Without getting into too much detail, a future thriving knowledge economy is not founded on the quality of truck drivers and store clerks in shopping malls, but in the inventiveness and sophistication of software programmers, biochemists and molecular biologists, electrical engineers, physicists, corporate managers and venture capitalists. Their quality, their worldliness, thier knowledge and their ability and willingness to push forward into unknown territory and to come up with state of the art solutions that will have a market is “the” fundamental that, in the long run, will determine which country will be on top of its game.

Secondary education in crisis

And here we have a great deal of evidence that America has lost and keeps losing ground. Broadly speaking, the US secondary public education system is mediocre at best, abysmal in many instances. This fact is known. But the outcry is muted. No sense of crisis. Who knows, maybe some think cynically that it is fine to have a significant percentage of America’s youth functionally illiterate, as these low skills or no skills people will perform menial jobs that are after all still needed (even though many of them are performed by immigrants, legal or illegal). 

But, if this is the idea, it is an awful, unjust and stupid idea.

No real outcry

Lack of education for millions of Americans is terrible for them, as it amounts to a virtual sentencing to be and stay at the bottom of the pyramid; there perpetuating a situation in which “birth is destiny”. Furthermore, having millions of uneducated Americans in its midst will deprive society of the necessary skills that would contribute to national growth.

No real accontability at the root of the financial crisis

Of course, a lot more could be said about the need to improve on many other fundamentals. The current financial crisis indicates that, as a minimum, we do require much more transparency and accountability in economic transactions. The fact that top tier financial institutions massively engaged in inherently speculative and risky activities, without proper margins and safety measures, while regulators and enforces did not know or would not act, tells us about the loss of accountability standards, within a system whose health is predicated on their existence. 

Myth of easy money

And there is more. Something odd and dangerous happened to America alongside with our disregard for good education as the critical engine of future growth. Whatever the reasons, we were lured into a dream of perpetual wealth that would be generated magically by our little personal cornucopias in the guise of our homes from which we thought that we could extract equity forever, without any problem or downside.

Money has to be made via activities

In other words, we thought that we could sidestep the pressing issue of retooling ourselves in order to improve our wealth generation potential because we “discovered” that we were already much wealthier than we thought. If you sit on top of your own inexhaustible gold mine, well, you are fine. If the cost of keeping your gold mine, (your mortgage) is low and, in any event, it can always be renegotiated at a low or lower level, while the gold production of your mine keeps growing, well, you got it made! The amount of gold (the equity in your home) that you can extract will always outstrip the cost of keeping the whole enterprise going. This way you will always be ahead. You can have the extra cash to do much more than the income derived from your labor would warrant –and all this is risk free, and it will go on forever!

Collective folly in the real estate bubble

OK…It was not exactly as crass and as stupid as described here. But close, very close. Which is to say that the real estate bubble, coming along just at the time in which the US labor force, as a whole, was feeling the pressure generated by the new Asian low cost competition, provided a comfortable, if temporary, hallucination. “Hey, we do not produce as much wealth as we used to. But, not to worry. Our home values make up the difference, and then some!”

Spending forever

So, we had the temporary delusion that we could spend at will, even though our labor derived incomes for the most part were stagnant. We could spend with abandon all those home equity lines of credit, as “the market” would guarantee forever rising real estate value, and so we could extract more equity and spend more of it in the following years. Well, we know what happened……

Go back to the notion that innovation not rent produces real value

What does all this have to do with the fundamentals? A lot. One of the key fundamentals of a healthy, modern capitalistic society is that wealth needs to be produced, it cannot be willed into place by blowing up beyond reason the idea that one can live off one’s equity. Sure enough asset values do matter. If oil is found on my land, that changes my economic circumstances. If the city planners decide to have a subway stop next to my property, well its value will go up.

But by and large, the real health of a knowledge economy cannot rest on the delusion that for most people finite fixed assets will yield an endless stream of income that will be used use to finance consuymption and life style, forever. This is true in many cases featuring property owners collecting rent; but it cannot be a national economic plan. And in reality most spending was not coming from rent but from extracting cash from overvalued equity. So, this was about spending capital that was not recreated. Even assuming a large bank account, one can draw from it. But not forever. Borrowing more and more against an absurdly overpriced home is sheer folly.

Lessons from the Spanish kingdom 

Long ago the Spaniards thought that they had a good economic model founded on the looting of South America’s gold and silver. Well, aside from unleashing inflation in Europe, in the long term, this avalanche of gold did not help Spain a bit, as it was not used for modernization or productive investments in Spain; but to finance expenditures. And, the underlying fundamentals having stayed the same, when the gold finished, Spain was still feudal and backward, minus the gold. Without enterprise and captive of a lingering feudal culture, Spain was left behind; becoming afterwards one of the most stagnant economies in Europe. All the gold ans silver used to finance current expenditures did not do much good.

Back to us, the dimension of the real estate fantasy represented an unhealthy departure from some of the key fundamentals. Rule one should be the notion that real wealth is based on production rather than borrowing against assets. Whatever the value of those properties, (in hindsight we know that it was less than estimated), it was finite. Once it has been used up, there is no more –just like the looted Latin American gold.

Can America rediscover its values?

Assuming that the lesson from the real estate bubble will be learned, (let’s hope), a poorer and humbled America, all else being equal, should go back to the fundamentals and thus tend to the nurturing of human capital. This should be job one, as this –high quality human capital–is the real cornucopia, the source of future innovation and wealth creation. This is the key fundamental that is now in need of serious care and repair. It is often said, and it is indeed an accepted “Truth” that anything is possible in America.

American dream?

Anybody here, assuming determination and will power, can achieve anything they want, no matter their formal education or where they come from. While there is some truth to this, for large segments of the population, lack of eduaction opportunities in fact translates into lack of life opportunities. Hard work alone cannot overcome a huge knowledge divide. So, the restoration of this notion of America as a Land of Opportunity is predicated on spreading the gift of knowledge.

Spreading knowledge

Of course, this requires public policies. But it really requires a societal redifinition of what equality of opportunity should be. Meaningful efforts and the consequent reallocation of resources so that good education becomes truly available is predicated on a transformation of our value system. Hopefully, a new administration in Washington will be able to set the tone for a productive national debate on how best to define our goals and how to accomplish them.

Separating the fundamentals from the current crisis 

So, in the end, Senator Obama’s criticism of McCain’s optimism is justified, albeit not for the reasons that would appear to be self-evident: that is the current gigantic crisis. Leaving aside, if we can, the ongoing financial upheaval and the wasteland that it will leave in its wake, there are other, deeper, reasons for concern over the long term health and viability of the US economy. In a word, the “fundamentals” while still more than passable, have been seriously impaired for reasons not directly connected to the current hurricane. 

Fix education

The systemic flaw represented by the serious, progressive deterioration of the American education system needs to be exposed, addressed and remedied very fast. Assuming action and success, the fundamentals of the economy can be good again; but, until we reverse course, there is no guarantee.

Senator Obama thus is right in criticizing Senator McCain, but only if he truly understands this human capital shortcoming and if he has a better plan that would target education as a top priority and would engineer a societal consensus as to the need to reverse our decline in education standards and quality. Without such a plan and a new national determination and enthusiasm to implement it as soon as possible, the “fundamentals” will stay flawed.

The November winner will have to reverse the downward trend

Whoever will win, and Barack Obama looks the favorite, quite apart from the aftermath of the current financial crisis, he will have to reverse the downward trend that will eventually yield a diminished, sluggish, uncompetitive and ultimately poorer America –an America that will lack its trade mark optimism and consequently the means to be a force for good in world affairs.

, , , ,

Leave a Reply

Your email address will not be published. Required fields are marked *