The New President's Economy Problem

By Justin Fox

In the waning minutes of his only TV debate with Democratic incumbent Jimmy Carter in 1980, Ronald Reagan looked straight into the camera and asked, "Are you better off than you were four years ago?"

It was a defining question of the campaign -- and of late 20th century American politics. It was also pretty easy to answer. The "misery index," a then popular measure that added the unemployment rate to the inflation rate, had skyrocketed during Carter's tenure. Taxes had risen sharply. There were other issues on voters' minds, like the Iranian hostage crisis and those dang cardigans Carter used to wear. But the economy was crucial to Reagan's victory. After taking office, he responded by ushering in a new era in economic policy -- cutting tax rates, slashing regulation and tirelessly preaching the gospel that individual Americans were better suited to make economic decisions than bureaucrats in Washington were.

This election year, the economy is again at the forefront of voters' minds. The misery index is no longer the problem; at 9% and change, it's miles below the 20% of late 1980. But Americans have a new menu of economic woes -- among them a real estate crash, a credit crisis, a broken health-care system and nagging job insecurity. Poll after poll shows a vast majority convinced that the economy and the country are headed in the wrong direction.

The first and most obvious thing to be said is that this represents a big stumbling block for Republican John McCain. He's not the incumbent, so the "four years ago" line doesn't apply directly to him. But history shows that slow economic growth is among the best predictors of a change in party control of the White House -- and right now the economy is barely growing at all.

The bigger issue for voters to wrestle with, though, is not what the economy can do to the presidential race but what the next President can do to the economy. Usually it's not so much. But every once in a while, like when Franklin Delano Roosevelt was elected in 1932 and Reagan in 1980, the effect can be dramatic. Reagan's policies, together with some luck and the inflation-killing zeal of Federal Reserve Chairman Paul Volcker, helped the U.S. economy break out of its 1970s malaise into a new era of flexibility, innovation and growth. And this era didn't end when Reagan left office in 1989. Subsequent Presidents, even Democrat Bill Clinton, followed more or less in Reagan's footsteps.

Economic eras don't last forever, though, and there are signs that the current slowdown is a harbinger of something bigger: an end to America's 25-year love affair with tax cuts and deregulation. A lot of the cracks that have emerged during that time, because of global economic shifts or our own neglect, have become impossible to ignore -- stagnant incomes, a federal budget gone way out of balance, soaring energy prices, a once-in-a-lifetime housing crash and growing financial risks in retirement and from health care.

What it adds up to is a generalized sense of economic insecurity that has dimmed many Americans' optimism about their future. So there's a chance that this election could turn out to be a major economic turning point, just like 1980's was. A significantly new direction in economic policy seems much more likely if Barack Obama (or Hillary Clinton, on the off chance that she returns from the political dead yet again) prevails in November. But throw John McCain together with a Democratic Congress, and who knows what might pop out? Economic trouble begets economic change. Here's what may be in the offing.

INCOME -$991 THE OTHER 99% OF AMERICA COULD REALLY USE A RAISE

If you feel as if you've been going backward, you haven't been imagining it. According to the U.S. Census Bureau, the median American family made $58,407 in 2006. That's $991 less, when you adjust for inflation, than the median in 2000, and indications are that things haven't gotten any better in 2007 or this year.

Recessions -- like the one in 2001 and the one we might be in now -- always reduce incomes. The problem since 2000 is that even when the economy was growing, the fruits of that growth landed almost exclusively in the pockets of the wealthiest Americans. According to economists Thomas Piketty and Emanuel Saez, 75% of all income gains from 2002 to '06 went to the top 1% -- households making more than $382,600 a year.

The gap between high and low earners has been growing since the late 1970s, and until recently, economists attributed virtually all of it to technological and demographic changes that increased the premium paid to those with advanced skills and education. If that were true, the only answer would lie along the arduous path of improving the education and skill levels of American workers. And you certainly wouldn't want to discourage people from getting an education by heavily taxing the rewards for it.

But according to Piketty and Saez, the really dramatic developments have all been at the very, very top -- not the top 1% but the top 0.01%, who now control 5.46% of all income, their highest share on record. (The data go back to 1913.) Most of these people are well educated, but it's awfully hard to portray their riches purely as rewards for education or skill.

Many economists now believe at least two other factors have contributed to the growth in inequality: globalization and Reagan's big cuts in taxes on the rich. Even as it rewards those at the top of their fields worldwide with spectacular paydays, globalization holds down earnings for millions of Americans who compete with workers overseas -- not only lower-skilled factory and phone-center workers but also engineers, lawyers and doctors. Public opinion has reacted to this with increasing distrust of free trade, a wariness that both Obama and Clinton have echoed in their campaigns. But this is touchy territory: trade may distort the income distribution, but economists remain almost unanimous in warning that restricting trade would slow overall growth. There are similar concerns about using the tax code to address inequality, although Princeton political scientist Larry Bartels demonstrates in his new book, Unequal Democracy: The Political Economy of the New Gilded Age, that the redistributive policies of Democratic administrations since World War II succeeded in delivering better income growth to low-income and middle-income Americans than Republican administrations did.

So what should be done about income disparity? In an April Gallup poll, 68% of respondents said wealth "should be more evenly distributed" in the U.S. -- the highest percentage saying so since Gallup started asking the question in 1984. A smaller majority, 51%, agreed that "heavy taxes on the rich" were needed.

To the extent they talk about it at all, the two parties take different approaches to closing the income gap. Obama in particular has been explicit about wanting to shift more of the income-tax burden away from the middle class and onto those making more than $200,000 a year, while McCain has spoken mainly about creating better job-retraining programs for those displaced by globalization. Another potential path, although it hasn't been a theme in the campaign so far, would be a big effort to repair the country's crumbling infrastructure -- which would create lots of jobs that couldn't be outsourced overseas and would also deliver long-term economic benefits. In any case, the income gap is an issue that's been danced around for too long. It's time to address it.

TAXES $500 billion THE BILL FOR THE DEFICIT IS DUE. YET EVERYONE'S FOR TAX CUTS

In general, we levy taxes not to ease income inequality but to fund government. They haven't quite been doing the job lately: for the 2008 fiscal year, which ends in September, the government will probably spend $500 billion more than it takes in, a deficit of 3.5% of GDP. That should shrink when the economy starts growing again, but it's not going to disappear without either big cuts in spending or substantial tax increases.

And make no mistake, somebody is going to have to pay those bills someday. The message many Republicans took from Reagan's successes of the early 1980s, and still preach today, is that tax cuts pay for themselves. That's nonsense -- Reagan's rate cuts for the rich may have paid for themselves, but the 1981 tax package as a whole (which included cuts for the poor, the middle class and corporations) clearly did not. The real lesson of the 1980s was that the U.S. can get away with running far bigger deficits than anyone thought possible while still enjoying strong growth and low inflation.

We've seen a bit more evidence of this in the 2000s, but it can't go on forever. There comes a point at which government debts grow so large that they start to weigh on the economy, through higher interest rates, bigger debt payments, a weaker currency, etc. Reagan and George W. Bush had the advantage of starting out with a relatively small debt as a percentage of GDP. The next President won't be quite so lucky.

The reductions in tax rates on income, capital gains and corporate dividends that President Bush pushed through in 2001 and 2003 are due to expire in 2010. That could prove a tough blow for a still wobbly economy to weather, but it would help shrink the deficit over time.

Both Democratic candidates say they'd let most of the Bush cuts expire. Both also want to end the U.S. occupation of Iraq -- the cost of which has ballooned the Bush-era deficits -- although extricating ourselves certainly won't be free either. On the other hand, both are itching to spend more on everything from increased college aid to better broadband connections.

McCain wants to stay the course in Iraq. And despite his admirable record of fiscal probity in the Senate, his campaign statements about the deficit have been less than convincing. He wants to extend the Bush tax cuts that he once opposed -- and add a few more of his own, saying he'll make up the difference by cutting "wasteful spending." But even eliminating the pork-barrel congressional earmarks that McCain has long criticized would make only a dent in the deficit.

The deficit quandary is one for which none of the candidates have an entirely convincing answer -- at least not yet. Unlike the current President, though, the winner in November may be forced to arrive at one once in office.

ENERGY $4 a gallon BURNING FOSSIL FUELS AND MONEY ISN'T AN ENERGY POLICY. LET'S GET ONE

One of the biggest factors in making paychecks seem smaller in recent years has been the sharp increase in energy prices. There's very little a President can do to change this in the short term; the summer gas-tax holiday proposed by McCain and Clinton would put just a few dollars in the pockets of all but the biggest gas hogs. Where Presidents (and Congress) can have a big impact is in the long-term trajectory of energy prices and their effect on the economy. Elected officials can do this by steering Americans away from oil and toward other energy sources and conservation measures -- or by failing to do so, which has been the laissez-faire policy of the past quarter-century and has helped land us in our current sorry situation.

What makes doing the right thing on energy difficult is that it would almost inevitably involve raising costs now, with higher taxes on oil, increased subsidies for other energy sources or higher energy-efficiency standards for vehicles and homes -- or all three. Economists tend to prefer the first of these approaches because taxes on gas, oil or fossil fuels in general tamp demand and allow the market -- rather than members of Congress -- to sift out the best alternatives.

As a rule, presidential candidates not named Ross Perot don't propose fuel-tax hikes. Interestingly, though, to fight global warming, Clinton, McCain and Obama are all in favor of a carbon-cap-and-trade regimen, which would raise the price of fossil fuels just as surely as a direct tax would. Almost in spite of ourselves, we may end up with a semi-rational long-term energy policy. It won't make gas cheaper anytime soon -- or perhaps ever -- but in the long run, it could strengthen the country's economic prospects.

REAL ESTATE $80 billion A HOUSE IS THE AMERICAN DREAM -- BUT THE TAX BREAK IS COSTLY

Some 1.5 million U.S. homes fell into foreclosure in 2007, and the number will probably be even higher this year. Congress is debating a bill aimed at slowing this tsunami, but the window to act is rapidly closing. Next year the focus is likely to turn to preventing a rerun of the real estate debacle. An exact repeat is already unlikely; bleeding banks have toughened lending standards, and the Federal Reserve is tightening its mortgage rules, squeezing out most of those "no doc" mortgage mills.

The mess has also caused some economists to question why we subsidize housing so heavily in the first place. The tax deduction for home-mortgage interest alone costs the government about $80 billion a year, and most of that benefit flows to the wealthiest 16% of taxpayers, according to the Tax Foundation. It also means we're subsidizing bigger houses and home-equity loans, possibly at the expense of other investments that might deliver a bigger economic bang. Money spent on a factory, a piece of equipment or a software program can pay off in higher growth and productivity. A house just sits there.

Several countries have dropped the mortgage-interest deduction in recent years, with no noticeably adverse effects, but there's no indication that any of our presidential candidates are contemplating such a move. What is likely to be on the next Administration's agenda are measures to restrain Wall Street -- which, by buying and repackaging hundreds of billions of dollars in dodgy home loans, played a key role in bringing on the housing bubble and bust.

Current Treasury Secretary Hank Paulson has already proposed a sweeping revamp of the financial regulatory structure. What hasn't really been answered yet -- but could be by a new Administration -- is whether we need an entirely new regulatory approach. Ever since Reagan took office, the approach has been to get out of the way and let financial markets work their magic. Now that it's clear just how much of this is black magic, there's a case to be made that financial innovation -- especially when it's targeted at consumers -- could do with much stricter oversight.

FINANCIAL SECURITY 47 million uninsured HEALTH CARE AND RETIREMENT SCARE YOU? YOU'RE NOT ALONE

Ronald Reagan uttered another line in that 1980 debate with Jimmy Carter that has entered the history books: "There you go again," he chastised his opponent. What's less well remembered is what that was in response to. Carter had been making the case for national health insurance and said Reagan had once opposed Medicare. Reagan objected that Carter was misrepresenting his position -- he had simply opposed a particular Medicare bill. But Carter was absolutely right that Reagan wasn't for universal health care -- or for any other government effort to socialize risk.

In the seminal PBS series Free to Choose, which aired in 1980 and may have helped set the mood for Reagan's victory, economist Milton Friedman argued that economic freedom was just as important as all those freedoms written into the Bill of Rights. This went on to become perhaps the most consistent theme of the Reagan economic era: giving Americans the freedom to succeed or fail on their own economically was a good thing. And it is probably a good thing. But not an unmitigated good. Economic security matters to Americans too. And finding ways to offer more of it may be the basis of the next big economic-policy revolution.

Economic changes over the past three decades -- many the result of government decisions -- have "left working families up and down much of the income spectrum living with fewer economic protections, bearing more economic risk, chancing steeper financial falls," writes Los Angeles Times reporter Peter Gosselin in his new book High Wire: The Precarious Financial Lives of American Families. This Great Risk Shift from governments and corporations to individuals, as Yale political scientist Jacob Hacker labeled it in the title of another book on the subject, has become one of the defining economic realities of our age. Some aspects of it are still in dispute: economists can't seem to agree on whether jobs really have become less secure than they were. But others are undeniable. "No one argues that Americans aren't shouldering more of the risk on health care and retirement than they used to be," says Hacker.

That you're-on-your-own ethos is already beginning to change -- a little. In 2006 Congress passed a law that has brought positive changes to the 401(k) savings plans that for many Americans have replaced pensions. But the majority of private-sector workers in the country aren't offered a 401(k) or a pension, according to the Employee Benefit Research Institute. All three candidates have talked of creating a new system of portable retirement accounts for those who don't get one through employers, with Obama's plan the most ambitious.

Then there's health care, which has become perhaps the biggest source of financial worry and occasional disaster among middle-class Americans. A 2005 study found that half of all personal bankruptcies in the U.S. were attributable at least in part to medical costs.

But there's real hope on this front. It is possible to conceive of a system that brings the 47 million uninsured into the fold, improves medical outcomes and costs less than what we've got now. It's possible to conceive of because many other wealthy countries already have such systems. Figuring out exactly how to make universal health care work in the U.S. is a matter better left to its own lengthy magazine article. But if you're looking for big economic change from the next Administration, this is the form it's most likely to take.

The key, really, is to accept what works about the existing U.S. economy and attack what doesn't. Reagan never dismantled the core elements of the New Deal, and the new President needs to take care not to thwart the dynamism unleashed by Reagan. But putting off change won't be an option much longer.