The Post Great Recession US Economy

The Post Great Recession US Economy

The Post Great Recession US Economy Implications for Financial Markets and the Economy Philip Arestis and Elias Karakitsos

Philip Arestis and Elias Karakitsos 2010 Softcover reprint of the hardcover 1st edition 2010 9 7 8-0 - 2 3 0-2 2 9 0 4-4 All rights reserved. No reproduction, copy or transmission of this publication may be made without written permission. No portion of this publication may be reproduced, copied or transmitted save with written permission or in accordance with the provisions of the Copyright, Designs and Patents Act 1988, or under the terms of any licence permitting limited copying issued by the Copyright Licensing Agency, Saffron House, 6 10 Kirby Street, London EC1N 8TS. Any person who does any unauthorized act in relation to this publication may be liable to criminal prosecution and civil claims for damages. The authors have asserted their rights to be identified as the authors of this work in accordance with the Copyright, Designs and Patents Act 1988. First published 2010 by PALGRAVE MACMILLAN Palgrave Macmillan in the UK is an imprint of Macmillan Publishers Limited, registered in England, company number 785998, of Houndmills, Basingstoke, Hampshire RG21 6XS. Palgrave Macmillan in the US is a division of St Martin s Press LLC, 175 Fifth Avenue, New York, NY 10010. Palgrave Macmillan is the global academic imprint of the above companies and has companies and representatives throughout the world. Palgrave and Macmillan are registered trademarks in the United States, the United Kingdom, Europe and other countries. ISBN 978-0-230-22907-5 ISBN 978-0-230-27610-9 (ebook) DOI 10.1057/9780230276109 This book is printed on paper suitable for recycling and made from fully managed and sustained forest sources. Logging, pulping and manufacturing processes are expected to conform to the environmental regulations of the country of origin. A catalogue record for this book is available from the British Library. A catalog record for this book is available from the Library of Congress. 10 9 8 7 6 5 4 3 2 1 19 18 17 16 15 14 13 12 11 10 Transferred to Digital Printing in 2014

This book is dedicated to our children: Stefan, Natalia and her husband Tom; and especially to my grandson, Alec (Philip Arestis) Nepheli and Eliza (Elias Karakitsos)

Contents List of Figures List of Tables Prolegomena Preface to the Second Edition viii xiii xiv xxi 1 Introduction 1 2 The Causes and Consequences of the Internet Bubble 23 3 The Current Financial Crisis and the Origins of Excessive Liquidity 41 4 Wages and Prices and the Proper Conduct of Monetary Policy 58 5 Corporate Profits and Relationship to Investment 97 6 Long- Term Risks to Investment Recovery 120 7 The Housing Market and Residential Investment 150 8 Long- Term Risks of Robust Consumer Behaviour 179 9 Foreign Demand 212 10 The US External Imbalance and the Dollar: A Long- Term View 239 11 The Long- term Risks to US Financial Markets 273 Notes 303 Bibliography 310 Index 318 vii

List of Figures 1.1 The stance of monetary policy 6 1.2 The output gap 6 1.3 Headline CPI-inflation 7 1.4 Federal government budget deficit or surplus as % of GDP 8 1.5 Decomposition of Federal budget 8 1.6 Orders inventories gap and production 10 1.7 Real GDP 11 1.8 Real consumer expenditure 12 1.9 Real gross private domestic investment 13 1.10 Real exports of goods & services 14 4.1 CPI all items, headline inflation 60 4.2 CPI, headline & core inflation 61 4.3 CPI, PPI & imported inflation 62 4.4 The PPI inflation chain 63 4.5 Output prices and labour cost 64 4.6 Wages, productivity and unit labour cost in nonfarm business 64 4.7 A naïve inflation model based on money supply and the price of oil 67 4.8 GDP deflator 68 4.9 The rationale of the K- Model (wage price spiral) 74 4.10 Business cycle 76 4.11 US business cycles 82 4.12 The output gap 91 4.13 Headline CPI-inflation 92 5.1 Corporate profits with IVA & CCA as % of nominal GDP 98 5.2 GDP and profits 101 viii

List of Figures ix 5.3 Contribution of unit profit and volume of sales to total profits 102 5.4 Unit profit and profit margin 103 5.5 Profit margin and unit labour cost 103 5.6 The profit model 107 5.7 Wages, productivity and unit labour cost in nonfarm business 110 5.8 Total profits NFC %YoY 112 5.9 Profit margin and wage price spiral 116 6.1 Business investment and government expenditure as % of GDP 121 6.2 Investment as a % of GDP 122 6.3 Capacity utilisation in manufacturing 124 6.4 Total profits NFC % YoY 125 6.5 Unit labour cost % YoY 126 6.6 Inventory to sales ratio in manufacturing 127 6.7 Total industrial production % YoY 128 6.8 Corporate sector net worth as % of GDP 130 6.9 Corporate sector debt as % of GDP 130 6.10 Corporate debt % YoY 131 6.11 Degree of debt leverage: corporate sector debt as % of internal funds 132 6.12 Long- term debt (securities & mortgages) to total debt 133 6.13 Spread between AAA yield and prime lending rate 135 6.14 Spread between Baa yield and prime lending rate 136 6.15 Interest payments as % of net cash flow 137 6.16 Investment model 139 6.17 Real gross investment 143 6.18 Industrial production 144 6.19 Capacity utilisation short- run equilibrium 145 6.20 US PMI short- run equilibrium 145

x List of Figures 7.1 Residential investment and Fed funds rate 154 7.2 Median new house price 154 7.3 Median price existing homes 155 7.4 Sales of existing homes 156 7.5 Regional house price inflation 157 7.6 Relative median price existing homes 158 7.7 Relative average house price inflation 159 7.8 Debt service burden 161 7.9 Median price of existing homes relative to per capita nominal disposable income 161 7.10 House price inflation (6M MA) existing home sales 162 7.11 Gross, net real estate of households and mortgage debt 163 7.12 House prices, real disposable income and real personal income 164 7.13 House prices, interest rates and debt service 165 7.14 House prices, net real estate and mortgage debt 166 7.15 Sales of existing homes and prices 167 7.16 House prices, existing home sales and real residential investment 168 7.17 The housing market loop 176 8.1 Consumption % YoY 180 8.2 Personal income & wages and salaries (nominal) 184 8.3 Wages & salaries in private industries & government 185 8.4 Other personal income % YoY 185 8.5 Fiscal support to the personal sector 186 8.6 Personal income and disposable personal income (nominal) 187 8.7 Nominal & real personal disposable income 187 8.8 Real personal disposable income 188 8.9 Average weekly hours in manufacturing 189 8.10 Monthly job creation/losses in nonfarm payroll, 6M MA (thousands) 190 8.11 Nominal and real wages 191

List of Figures xi 8.12 Real hourly earnings in nonfarm business 192 8.13 Household net wealth 194 8.14 Personal sector net wealth as % of disposable income 196 8.15 Financial assets and debt of the personal sector 198 8.16 Tangible assets & real estate 199 8.17 Debt service burden 201 8.18 The income consumption loop 209 9.1 US nominal & real effective exchange rate 214 9.2 Japan nominal & real exchange rate 214 9.3 EU exchange rate & competitiveness 215 9.4 US exports determinants 217 9.5 EU exports determinants 218 9.6a The stance of EU fiscal policy 219 9.6b The stance of EU monetary policy 220 9.7 Japan exports determinants 221 9.8 Exports multiplier with respect to OECD industrial production 223 9.9 Exports multiplier with respect to OECD industrial production adjusted for share of exports to GDP 224 9.10 Exports multiplier with respect to competitiveness 225 9.11 Exports multiplier with respect to competitiveness adjusted for share of exports to GDP 226 9.12 Effect on EU exports no euro change (unchanged at Oct. 2000 value) 227 9.13 OECD industrial production (based on US ISM) short- run equilibrium 229 9.14 US industrial production (based on ISM) short- run equilibrium 230 9.15 US PMI short- run equilibrium 230 9.16 US real exports (based on the momentum of US ISM) 232 9.17 EU exports short- run equilibrium 232 9.18 JP real exports (based on the momentum of US ISM) short- run equilibrium 233 10.1 US balance of payments 241

xii List of Figures 10.2 Rest of the world (ROW) net worth (US assets held by ROW less ROW assets held by the US) 242 10.3 ROW net credit market position (assets held by ROW less assets held by the US) 243 10.4 ROW net money market position (US assets held by ROW less ROW assets held by the US) 244 10.5 ROW net equity position (assets held by ROW less assets held by the US) 245 10.6 ROW net FDI position (assets held by ROW less assets held by the US) 245 10.7 Direct holdings of equities held by the personal sector 247 10.8 Total holdings of equities by the personal sector 248 10.9 US stock equity holdings by foreign residents 249 10.10a Net purchases of US equities by US & foreign residents 250 10.10b Capital flows money, bonds & equities (inflows less outflows) as a % of GDP 250 10.11a Three possible equilibria in a non- cooperative game 256 10.11b Inflation and growth in the business cycle 258 10.11c The choice of equilibrium 260 10.12 The euro dollar rate 266 10.13 Real dollar exchange rate long- run fair value & valuation 268 10.14 Real dollar exchange rate short- run fair value & valuation 269 11.1 Asset- led business cycle 281 11.2 10-year Fed funds yield curve 284 11.3 Japan: holdings of US Treasuries 287 11.4 China: holdings of US Treasuries 288 11.5 Long- run valuation of 10-year yield 289 11.6 Short- run equilibrium of US 10-year yield 290 11.7 S&P and profits in logs 294 11.8 Long- term valuation of equities 295 11.9 Real S&P 2008 prices 299

List of Tables 4.1 A naïve inflation model based on money supply and the price of oil 66 4.2 A model of the US GDP-deflator 68 4.3 US business cycles in the post- Second World War period 80 4.4 Cycle characteristics 82 7.1 US housing market multipliers 172 8.1 Sources and disposition of personal income 183 8.2 Personal sector balance sheet 197 11.1 Federal debt and its finance 286 xiii

Prolegomena The issues covered in the book In the last ten years or so there has been a series of bubbles, but judged in terms of their impact on the economy three have been particularly notable, namely the internet, the housing and the commodities bubbles. Do these bubbles have common roots or are they independent of one another? What are the consequences of the bursting of each bubble? What are the similarities and differences? What policies should be pursued to avert future bubbles from ballooning and bursting? These are the key questions addressed in this book. The early 2000s US recession was very mild, in spite of the bursting of the internet bubble, which was one of the worst in monetary history. Equity prices fell precipitously, yet the consumer remained resilient. The bursting of a typical bubble implies retrenchment by the personal and corporate sectors, as falling asset prices create a gap (i.e. an imbalance) between the assets and the liabilities of the private sector. In the euphoria years in which the bubble balloons, both companies and households accumulate disproportionate amounts of debt, induced by rising asset prices. Once the bubble bursts and asset prices collapse, the high level of debt is incompatible with the new low level of asset prices. The moment companies and households accept that the new level of asset prices is permanent rather than temporary, they try to repay their debts and rebuild their wealth by saving more, thereby dragging the economy into a severe recession characterised by asset and debt deflation. This process of asset and debt deflation is a long and painful one, as it usually infects the balance sheet of the commercial banks, which respond by cutting new credit (credit crunch), thereby accelerating the bankruptcies of companies and households. The experiences of the Great Depression of 1876 90, of the Great Depression of the 1930s and of Japan in the 1990s show that the bursting of every bubble has exactly these characteristics and policymakers have little scope to smooth this process. Yet the US experience of the internet bubble was very different. Asset prices fell as in a typical bubble, yet the economy experienced the mildest recession. The personal sector continued to accumulate debt, while the corporate sector reduced it only slightly. Two factors may account for this experience and emergence of imbalances. The first is xiv

Prolegomena xv that monetary policy may have achieved a soft landing of the economy. The second is that investors regarded the bursting of the bubble as a temporary rather than a permanent phenomenon. The two issues may not be independent, however, as the over- accommodative monetary policy adopted in 2001 04 may have transformed the internet bubble into a housing bubble. These are further issues addressed in the book. The lower level of geopolitical risks after the end of the Iraq War, coupled with the subsidence of the governance crisis and the perfect timing of yet another fiscal package in 2003, as well as the accommodating stance of monetary policy in the downswing, combined to create a booming economy in the last nine months of 2003, which put the US economy on a sustainable path to recovery during the course of 2004. The strength of the US rebound was such as to pull with it the rest of the world. Confidence was buoyed and signs that deflation in Japan was coming to an end boosted hopes that the worst was over. The previous three years looked like a nightmare that belonged to the past. Yet, three years later a much worse storm hit the US economy and the world at large with its toll on citadels like China that were supposed to remain immune to this tsunami. The US housing market dropped, causing huge losses in financial institutions that sparked a credit crisis, which spread very rapidly to the rest of the world. The recession was mild at the beginning, but as the credit crisis unfolded a negative spiral emerged between the economy and the credit crisis. As the recession deepened, the credit crisis was magnified with a further impact on the economy. It is in this context that the questions raised earlier on are pertinent. Are the two crises of the early and the late 2000s independent of each other? Or, do they have common roots? What were the reasons for this contagion effect? The First Edition of this book warned that the imbalances from the bursting of the internet bubble were not corrected, but remained like skeletons in the cupboard, ready to be unleashed once there was a rise in long- term interest rates. Have these imbalances been corrected as a result of the current deep and protracted recession or have they been put back in the cupboard, ready to haunt us yet again at the next opportunity? This Second Edition warns once more that the policies pursued have simply brushed under the carpet the imbalances of the various sectors and it is again a matter of time before they strike yet again. So, what are the prospects of the US economy in the near term and the long term? These are further key questions addressed by this book. Equity markets recovered after the spring of 2003 and they went from strength to strength over the following three years. Optimism supplanted pessimism with many people believing that this was the

xvi Prolegomena beginning of a new and long-lasting bull market. Yet in real terms equity markets have never matched the highs of 2000. Consequently, the rapid advance in stock prices between 2003 and 2007 was simply a protracted strong bear market rally. Equity markets peaked in 2007 and fell precipitously in the following two years, hitting a lower bottom than in the early 2000s bear market. At this juncture the expected recovery has triggered a stupendous rally since March 2009. The shares of zombie financial institutions have produced the most stunning returns in the last six months and optimism is again running high that the worst is over and that the expected recovery heralds the beginning of a new and long- lasting bull market. But is such optimism justified? What are the prospects for the US and global stock markets? What are the prospects for bonds? Are bond yields likely to rise in the next few years causing equity prices to tumble, and thereby triggering a future recession? What are the risks that investors should consider when working their investment strategy over the next few years? Should they overweigh equities and dump bonds in their portfolios? What about the dollar? In the six years to 2008 the dollar fell a great deal, but disproportionately with respect to some currencies, like, for example, the euro and the pound sterling. In the midst of the recent credit crisis the dollar strengthened, but it fell again as hopes of a recovery emerged. Is this temporary or is it, rather, the beginning of a new long- lasting downtrend? The prospects and risks to financial markets is yet another issue addressed in this book. As a precursor of what is to follow, this book again warns that the recent advance of stocks is most likely to be another bear market rally that may last for a number of years before it fizzles out yet again. The premise of this book is that unless the various sector imbalances are corrected the world at large will remain in a protracted bear market with bear market rallies that may be strong and lasting for a few years. However, these rallies will fizzle out ultimately with each bottom being lower than the previous one. The reason why these imbalances have not been corrected in every recession is that the excessive liquidity that has financed these successive bubbles has never been drained from the system. In fact, every time a recession occurs the policymakers pump in increasing amounts of liquidity to deflect the asset and debt deflation process. The verdict on the dollar is that unless the imbalances are corrected it will remain on a long downtrend. A weak dollar provides the mechanism through this excessive liquidity is channelled abroad generating world bubbles. The policy debate on how to deal with bubbles concentrates on two polar views. The first is that central banks should leave financial markets to function freely on their own and asset price inflation should not be

Prolegomena xvii the concern of a central bank. However, a central bank should deal with the consequences of the bursting of a bubble. The opposite view is that asset price inflation is as bad as inflation in goods and services and as the latter is in the realm of a central bank so should the control of asset price inflation be. Thus, the policy debate can be summarised as dealing proactively and pre- emptively with bubbles, or reactively with their consequences. The Fed has clearly played with the proactive approach in the early days of the bubble with the familiar irrational exuberance remarks. But in the event, it opted for the reactive approach of dealing with the consequences, as it cut the Fed funds rate aggressively in the early 2000s recession in a way that was not justified by the depth of the recession. The pursuit of such a policy seems to have paid off and it has done a great deal to restore the tarnished reputation of the Fed in the aftermath of the bursting of the internet bubble. But the bursting of the housing bubble has cast doubt on the Fed s approach of dealing with the consequences of the bursting of the bubble and has put back on the agenda the proactive role of monetary policy in dealing with asset price inflation. Moreover, it has sparked criticism that the housing bubble has its roots to this very accommodative monetary policy that was meant to deflect the asset and debt deflation process. The difficulty with a proactive and pre- emptive approach stems from what should be the target for monetary policy, as it would be inappropriate for a central bank to have a target for one of its stock market indices or house prices. The book addresses this issue and makes appropriate recommendations, crucially net wealth targeting, which deals with the consequences of the bubble on the spending decisions of households. This can provide the basis for proactive monetary policy on asset price inflation. How this book should be read and its potential readership The book is particularly relevant to investors in world financial markets, as it addresses the prospects and risks to financial markets emanating from the post- housing bubble US economy. Although it is confined to the US economy it has implications for global markets, given the leading global role played by the US. The book is not just a narration of events and prospects as well as risks to the economy and financial markets, but also offers an in- depth analysis of the thinking process that underlines the sophisticated formation of the investment strategy of major financial institutions. The methodology of the book, therefore, is that it begins with the realities of the US economy, where the factual analysis makes

xviii Prolegomena good use of available data, fully cited and explained, before the analysis builds upon them to articulate the theoretical background involved in each case. The more empirical aspects of the book then follow. This thinking process is based on a top- down approach, which formalises the view that asset prices, at any point in time, reflect market discounting of how the central bank should respond to the state of the economy, as judged by the latest available information. This thinking process is encapsulated in the macro- financial model, which is an integrated system for analysing systematically macro and financial data that leads to an informed investment decision- making process. The book effectively describes that process by analysing in every chapter one constituent component of the macro- financial model, to which we have just referred, that leads to a synthesis in the last two chapters that deal with the dollar, bonds and equities. The structure of the book follows the rationale of this top- down approach of the macro- financial model. The book, therefore, may be particularly relevant to Chief Investment Officers, portfolio managers, traders and individual investors, who may be interested in the state- of- the- art methodology for the analysis of financial markets and the process of investment strategy. From this point of view, the emphasis in this book is not on the conclusions of the current investment strategy, which, by definition, would be obsolete by the time the book is published. The emphasis is, rather, on the methodology underlying the analysis of financial markets and investment strategy. However, the book is not solely for the benefit of the sophisticated investor. Indeed, it has been written with the economist also in mind, especially the academics, along with those non- economists who are interested in understanding the causes and consequences for the economy and financial markets of the series of bubbles that have emerged over the course of the past ten years. Policymakers may also be interested in the issue, since there are serious policy implications involved. The book has been structured in such a way as to embrace such diverse readership. The reader can get a quick first impression of all the issues covered in the book by reading the summary and conclusions at the end of each chapter. All of the chapters have a similar structure so that an approach to reading the book can be formulated. Every chapter begins with the issues that are explored subsequently. It then offers an analysis of the relevant statistics that form the basis of the analysis. This does not require any prior knowledge and provides easy reading. Yet the analysis is deep enough so that the alert reader can guess the model behind the thinking process. Next follows a lengthy explanation of the relevant parts of the model that are relevant to the issue in hand. The purpose of

Prolegomena xix this section is to provide not a textbook treatment of, say, investment or consumption, but rather a formal description of the variables that should be monitored in order to form an opinion of how, say, companies or households reach their decisions on spending and investment and the risks in the current economic climate. A flow chart explains the interrelationship of the key variables in each chapter, which the interested reader can study independently of the rest of that section. Reference to the work of others is given so that the reader can put the model in perspective, without burdening the book as if it was a review article. We have avoided mathematics, as they are not appropriate for the general readership we have in mind, although the more mathematically inclined economists should not be disappointed by its absence. We have attempted to describe in words formal mathematical relationships and simply summarise the functional forms that hold in the longrun equilibrium, so that the interested reader can form an opinion of the depth of the analysis. Even that simple functional form should not frighten the general reader, who can skip it without missing anything from the relevant sections. For the mathematically inclined reader, though, it might summarise, in a succinct way, the verbal arguments and avoid the confusion that usually arises by verbal explanation. Only our readers can judge whether we have succeeded in this difficult task. Finally, every chapter provides an analysis of the prospects and risks for the relevant section of the economy or financial market. The prospects are evaluated through a projection of the macro- financial model. In this context it is worth mentioning the change of emphasis between the two editions of this book. In the First Edition risk analysis was based on detailed simulation analysis as this was meant for methodological reasons. However, in the Second Edition the scope of the book has been expanded to cover the similarities and differences between the two bubbles and also how asset- led business cycles differ from those in the past. Space limitation has its casualties and the detailed simulation analysis is one of them. One final comment is pertinent. Although in every chapter we describe the appropriate part of the macro- financial model utilised, we do not offer the numerical values of the relevant equations. Instead, we provide a graph that depicts how closely the model can explain the relevant variable and offer the forecast error. We believe that a detailed analysis of the numerical values of the model and its statistical properties would not be satisfactory in view of space limitations. In any case, such an attempt would have detracted from the main analysis, purpose and focus of the project, without adding significantly to the book.

xx Prolegomena Data series The data used throughout this book cover the period 1947 2009 and they are either quarterly or monthly as indicated. The data are the official figures as made available by Thomson Reuters EcoWin Pro, a live databank (see www.thomsonreuters.com). The book has been written using the data available at the time of writing each chapter and no attempt has been made to update each chapter as new data has come in, as otherwise the process would have been never ending. Thus, quarterly data have been used up to the second quarter of 2009 and monthly data up to August 2009. Acknowledgements We would very much like to thank Taiba Batool and Gemma Papageorgiou of Palgrave Macmillan, and their staff, for the encouragement and efficiency throughout the duration of this project. We would also wish to thank colleagues at the Cambridge Centre for Economic and Public Policy, University of Cambridge, and at the Departamento de Economia Aplicada V, Universidad del País Vasco, Spain, for comments on a number of occasions on chapters of this book. Also for the comments by the participants to the joint conferences of the two institutions at which chapters included in the book have been presented over a number of years. We are also grateful to a few more individuals. These include, in particular, Epaminondas Embiricos, Jonathan Edwards, John Mather and Lambros Varnavides, who have read the entire manuscript and have made useful comments. We are very grateful to all we have mentioned for their continuous support throughout the period of writing this book. Without their support this project would not have been completed.

Preface to the Second Edition The asset and debt deflation process (or the economics of depression as they are labelled by Krugman, 2008) is little understood and even less appreciated, in both theory and policy. However, it is precisely this process that has been relevant since the early 1990s, first with balance sheet problems in the corporate sector (the 1991 cycle), then with balance sheet problems in the personal sector (the 2001 cycle) and now (the 2008 cycle) with balance sheet problems in the banking and personal sectors. Alan Greenspan, the ex- governor of the Federal Reserve System (the Fed), was the first to recognise that the 1990s were different than what had gone before when he characterised the rally in equities in 1996 as irrational exuberance. Economic theory and business cycle analysis treats the last three cycles (including the current one) as not different from previous ones. Furthermore in dealing with the past three cycles policymakers have also applied the same medicine as in other cycles. The failure of theory and policy to appreciate that asset- led cycles are different from the demand cycles of the 1950s and 1960s and the supply cycles of the 1970s and 1980s has made each of the last three cycles worse than the previous one. This is clearly an unstable situation which give rise to successive bubbles, each one being bigger than the previous one and each recession being worse than the one before. In a nutshell it is excessive liquidity that creates these bubbles and it is policy responses that add further liquidity every time a bubble bursts, which sows the seeds for the next bubble. The return to normality requires that policymakers drain the excess liquidity and allow debt deleveraging, while accepting that the current level of asset prices is not far from equilibrium. In other words, policymakers should stop trying to restore previous levels of asset prices. But this has not happened yet! Hence, more trouble is brewing for the future. In the First Edition of the book, The Post- Bubble US Economy: Implications for Financial Markets and the Economy (Arestis and Kararkitsos, 2004), we described the asset and debt deflation process and assessed its impact on the economy through the K- Model. We claimed that an appreciation of this process requires an explanation of the role of the savings ratio in consumer decisions, which contradicts the principles of the widely accepted Life- Cycle and Permanent Income Hypothesis. xxi

xxii Preface to the Second Edition In this traditional approach the savings ratio moves pro- cyclically it rises in a boom and falls in a recession on the premise that consumers smooth out their consumption in the face of volatile income both in the course of the business cycle and throughout their lifetime. However, we have shown that in leveraged economies this does not characterise the behaviour of households in the real world. In fact, we argued in the First Edition that the opposite is happening; the savings ratio moves counter- cyclically, it falls in the upswing of the cycle, accentuating the boom, and rises in the downswing of the cycle, worsening the recession. This counter- cyclical pattern is built into the K- Model, where the savings ratio depends on the net wealth of the personal sector, job security, income growth prospects and the debt service burden. But rejection of the traditional Life- Cycle and Permanent Income Hypothesis in leveraged economies is only the first step towards the economics of depression. What is also required is an explanation of the net wealth of households and the net worth of the corporate sector. Both of these variables are omitted in any synthesis of current macroeconomics, like the New Consensus Macroeconomics. Including a net wealth effect in consumption and the net worth of the corporate sector in investment is not sufficient. What is required is models for explaining the constituent components of the asset and liability sides of the net wealth of households and the net worth of the corporate sector. In the First Edition an entire chapter was devoted to housing, while its influence on the savings ratio was analysed in the chapter on consumption. Leamer (2007) claims that the current woes in the economy are due to the omission of housing in macroeconomic theory and business cycle analysis, as well as in policy. In the First Edition we claimed that the internet bubble will be transformed into a housing bubble and we looked at the conditions under which the housing market will burst and whether the housing market will experience a soft landing in 2004 and 2005. In subsequent work, Arestis and Karakitsos (2007, 2008), we warned that the boom in the housing market has turned into a bubble and argued that it will burst when the 30-year mortgage rate exceeds 7 percent a condition that has proved sufficient. The third step that is required in the economics of depression is an explanation of the role of financial assets (equities, bonds and the dollar) and their interaction with the real side of the economy and inflation. Financial markets play a key role in creating bubbles. Chapters 9 and 10 of the First Edition were devoted to this task. In this framework, which is exemplified in the K- Model, asset- led business cycles can be understood and appreciated. When excess

Preface to the Second Edition xxiii liquidity is allowed to be generated asset prices (equities in the 2001 cycle and houses in the 2008 cycle) soar and debt leverage is increasing. This boosts the net wealth of households, lowers the savings ratio and stimulates investment and consumption, creating euphoria. In the initial phase of this process inflation declines or simply remains subdued. At some point, though, the economic boom creates overheating and inflation creeps up. The central bank hikes rates to check inflation and by doing so it pricks the bubble, a feature that characterised Japan in the 1990s and the US in the last two cycles. Once the bubble bursts, asset prices fall and what is left is an overhang of debt in the personal and corporate sectors. Whereas access to capital markets eases the required balance sheet adjustment of companies, households try to curb debt and restore the value of their net wealth by raising the savings ratio and cutting consumption. The asset and debt deflation is then unfolding deepening and prolonging the recession. In this framework policymakers should not allow the expansion of credit in the first instance. They are simply mistaken when they look at the low growth in monetary aggregates that makes them feel that everything is alright, as financial innovation is creating the excess liquidity without this being reflected in monetary aggregates. Strict regulation might do the trick, but in a market economy it may be better if the policy makers adopt a net wealth target in addition to the two traditional targets of inflation and the output gap. These were the conclusions of the First Edition and they are still valid now. But whereas future crises can be averted through the adoption of a net wealth target, the way out of the current crisis is an orderly deleverage of the system through the draining of excess liquidity and the acceptance of subpar growth for the next few years. But this is not what is happening. In the Second Edition we have retained the same structure, as it essentially explains the asset and debt deflation process. However, we have tried to make it relevant to what will happen next, in view of the current financial crisis. Thus, we have changed the title of this edition to The Post Great Recession US Economy: Implications for Financial Markets and the Economy. This is because the First Edition was preoccupied with whether the housing market will have a soft landing in the two- year projection of 2004 05. There is a difference, though, in the emphasis between the two editions. Instead of illustrating how the K- Model can be used to make a quantitative assessment of the impact of policy, in the Second Edition we attempt to compare and contrast asset- led business cycles with demand and supply ones. We have done this in a systematic way when we examine in the various chapters the

xxiv Preface to the Second Edition components of aggregate demand, inflation and asset prices (houses, equities, bonds and the dollar). Since policy still holds the key to what will happen next, we have assessed the risks to the economy over the next few years in every chapter by contrasting what should happen if the policymakers allowed debt deleveraging to take place with what would happen if the policymakers attempted to restore asset high prices. From this perspective the following differences have emerged in the Second Edition. The Introduction now puts into perspective the current economic situation and offers an assessment of the opposing policies. Chapter 2 is the same as in the First Edition. It deals with the internet bubble. Chapter 3 is entirely new and is devoted to an in- depth analysis of the current crisis. The remainder of the chapters follow the First Edition, but with the aforementioned change of emphasis and, of course, the full updating of all of them, including chapter 2. 11 October 2009.