The Risks of Reviving a Revived Economy

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Illustration by Harry Campbell for TIME

The 2% economy—what caused this slow-growth cycle and what might cure it—was the make-or-break issue of the 2012 presidential election. It’s also the most pressing issue for the President now.

Sure, getting Congress to pull back from the fiscal cliff is Job One. But beyond that, we’re actually at a crucial economic crossroads. History shows that four to five years after a financial crisis is usually when a country either moves slowly but surely into a sustained recovery or lapses back into recession. The President can’t control many of the variables involved: the euro zone might dissolve, or China could have a hard landing; either situation could tank growth in the U.S. The President can, on the other hand, determine whether and how the government keeps spending to boost the recovery, who should pick up the tab and which Americans will bear the brunt of the inevitable budget cuts on the horizon.

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There was plenty of talk during the campaign about the extent to which the Obama Administration’s fiscal stimulus and the Fed’s sustained money drops have helped or hurt the economy since 2008. Let’s be clear: it’s the reason we didn’t go into another Great Depression.

Ironically, the stimulus is also a reason the recovery has been so slow and will continue to be for the next three to five years. Harvard economist Ken Rogoff, who along with his colleague Carmen Reinhart has been the best rune reader of the past few years, says that historically during financial crises, “to the extent that you act to slow the deep, sharp economic pain, you also slow the recovery.” As those cold-hearted Austrian-school economists would tell us, terrible pain results in quick adjustment. That’s not an argument for not acting; nobody wanted bread lines or riots after Lehman Brothers fell. In fact, it’s a mark of policy success—and the ability of central bankers to buffer Darwinian economic cycles—that today’s economy feels boringly sluggish rather than frightful.

Now is the moment to start making it more than that. Conservatives argue that the path to growth comes through slashing the deficit as well as red tape and taxes. That would give business money and the motivation to spend it. Businesses and consumers have gotten their balance sheets in order. The government should too. Then companies would have the confidence to invest.

Some cite Sweden as a model. Four years after a similar financial crisis began in 1992, it started slashing public debt, erasing its entire deficit by 1998. Sweden subsequently boomed. The difference, according to the McKinsey Global Institute, which has studied several decades of sovereign debt crises, is that Sweden was already growing strongly—3.5% annually—when it started rolling back public stimulus and focusing on debt reduction. Companies and consumers were ready to pick up the slack.

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That’s not yet so in the U.S. Companies facing economic uncertainty are unlikely to part with the $2 trillion under their mattresses regardless of debt or tax rates. While unemployment has ticked down, the average annual earnings growth of U.S. workers fell to a postwar low in October. You really can’t have a sustainable recovery in an economy that’s 70% fueled by consumer spending when 90% of the income gains since the recovery began have accrued to 1% of the population.

That’s why I think the key to really solving the growth puzzle is tackling inequality. It’s been labeled a social issue. But there is growing reason to think of it as an economic one. International Monetary Fund research shows that countries with bigger wealth gaps tend to have shorter periods of high growth and more volatile economies. That’s in part because they try to mask inequality by expanding consumer credit, which leads to debt bubbles and financial crises. (Sound familiar?) IMF policy wonks actually believe that reducing inequality is as important as, say, free trade in terms of fostering economic growth.

There are plenty of policy choices available—none of them of the Robin Hood variety—to reduce inequality now. Tax reform, including closing of investment loopholes for the rich, would be No. 1. Experts like Rogoff believe that “vast simplification” of the code would make it not only fairer to all taxpayers but also more business-friendly; indeed, a Harvard Business School study found that it’s the convoluted nature of the tax code, not tax rates, that sends business abroad. Also, before the government exits the housing business, a bit more support for mortgage restructuring in the worst-hit areas could help housing and the recovery; there’s still $250 billion worth of foreclosures in the pipeline.

Finally, as we navigate the fiscal cliff, we should think carefully before subtracting any discretionary spending for public education. College enrollment may now be more tied to parental income than aptitude. If we want to get beyond a 2% economy, we’ll have to ensure that more than just the 1% can succeed.

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