Washington DC, September 16, 2008 --  

America's economy has drifted into stagnation. A corrective recession is starting to look better every day.

When New York Governor David Paterson warned of up to 30,000 layoffs on Wall Street following the collapse of several brokerages¹, populist Americans were in no mood for sympathy. In an election year where voters have swooned over the Vice Presidential nomination of a folksy governor with a thick accent, the plight of the New York elite is not high on people's agenda.

But while most Americans won't lose their jobs over turmoil in America's financial sector, their lives may well be affected. The sharp drop of stock market following the bankruptcy filing of Lehman Brothers and emergency sale of Merrill Lynch has erased all of the market's tenuous gains this decade.² The Dow Jones Industrial Average reached 11,497 eight years ago at the height of the dot com bubble. It now stands just below that level at 11,059.

Such a prolonged period of market stagnation has not been seen since the 1970s, when the Dow hovered just below the 1000 mark from 1966 until 1982. That 16-year stretch was the most infamous period of economic malaise since the Great Depression -- known for oil price shocks, high unemployment and industrial decline.

The big difference between the 1970s and today is that over 20 million Americans have a stake in the value of the stock market through 401K retirement plans.³ Industrial workers 30 years ago didn't care if Wall Street took a bath, provided that they kept their jobs and their pensions were secure. Today's office workers have 401Ks instead of pension plans. After eight years without gains on their savings in the market, some may have to put off retirement far into the future.

Could the 2000s be replacing the 1970s as the new decade of stagnation? Many trends, including record oil prices and rising unemployment, are depressingly similar. Even the dreaded term "stagflation" -- a word that oozes 1970s -- returned last month when the Labor department reported the producer price index rising 9.8 percent over the past year, and economic growth slowed to near zero.⁴

Of course, many of today's factors are different from the 1970s. The unemployment rate is not nearly as high as 30 years ago, and economic growth, while anemic, remains positive. On the other hand, America's savings rate is nonexistent, debt levels are through the roof, and the disproportionately large baby boom generation is preparing to abandon the workforce and bleed Social Security and Medicare to death.

Although commentators often focus on the possibility of a dramatic economic crisis as an end to these problems, the reality may be far less exciting, yet even more harmful in the long-run. A decade with little economic growth can leave the economy in worse shape than a deep recession followed by a return to healthy growth. If the economy were to slide by 12 percent in a single year -- a huge contraction unprecedented since the Great Depression -- and soon return to 4 percent annual growth, the country would be richer after a decade than with a stagnant economy consistently growing at only 1 percent per year.

But stagnation is precisely the risk posed by know-it-all government officials who keep intervening to protect the economy. The very actions that are said to stabilize the economy -- the bailouts of Bear Stearns, Fannie Mae, Freddie Mac, American International Group, the economic stimulus checks and the like -- may prevent much needed corrective shocks from taking place. Worse than another Great Depression would be for America to end up like Japan -- a one time economic powerhouse that has sunken into two decades of stagnation.

America's stability-obsessed financial minders should be careful what they wish for.

Related Web Columns:

Tyranny of the Irresponsible, March 18, 2008

Notes:

1. New York Times, City and State Brace for Greater Demands on Diminishing Resources, September 16, 2008

2. Marketwatch, U.S. Stock Indexes Plummet as Lehman Goes Under, September 15, 2008

3. Investment Company Institute, 401(k) Plan Asset Allocation, Account Balances, and Loan Activity in 2006, 2006

4. Bloomberg News, U.S. Economy: Housing, Prices Raise Stagflation Risk, August 19, 2008