Economy going nowhere

Boston.com / News / Boston Globe / Opinion / Op-ed / An economy going nowhere: "Economic fundamentals haven't changed much in the past few months. The dollar has been weak for more than a year, the worsening trade imbalance is an old story, and oil prices have been high for months. So why the big dip last week?

The immediate precipitating cause is weak corporate profits coupled with ongoing worries about inflation that will likely cause the Federal Reserve to keep raising interest rates. But the Fed has been clear for many months that rates are going up, and a few bad earning reports do not reflect the entire economy.

Stock markets, however, are notoriously vulnerable to herd instincts. In the short run, what you think about the economy matters less than what other traders think.

Recent market behavior looked like a classic tipping-point phenomenon: A majority of investors conclude that other investors think the market is heading south and decide to bail out. When there are more sellers than buyers, stock prices fall. But what of the underlying economy? Are the bad news bears right to be pessimistic? Unfortunately, yes.

The economy has been vulnerable for some time. The recovery has been built on government borrowing at a rate that can't continue. More troublesome, a rising share of this borrowing comes from overseas. That puts pressure on the Fed to keep interest rates higher than it otherwise might to keep the foreign lenders on board and keep the dollar from sinking even lower.

Job creation and job quality have also been weakening. Although the measured unemployment is officially a decent 5.2 percent, the fraction of workers who have given up looking for jobs keeps rising, as does the percentage of long-term unemployed. And worker pay is sagging.

Disposable income is affected not just by flat earnings but by rising costs not fully captured by the inflation statistics. For instance, people are paying a larger share of medical costs that aren't covered by health plans. More adults are subsidizing grown children. Rising interest rates sock home buyers as well as consumers who rely on credit card and home equity loans. So those disappointing corporate profit figures reflect one of the most basic of economic fundamentals: Consumers with less money in their pockets don't rush out and buy products.

We last went through a serious bout of ''stagflation" in the late 1970s. That is a condition that isn't supposed to exist in economic theory -- rising prices and rising unemployment at the same time. That inflation was triggered by high oil prices. For several years, the Federal Reserve's cure of very high interest rates worsened the disease, since the high interest rates added to consumer financing costs and also pummeled business. Inflation was eventually wrung out of the economy, and the long boom of the 1990s and that era's high-flying stock market were both built on steadily declining interest rates and well-behaved oil prices.

No longer. And now there's a new factor: the arrival of China and India as major players. On the one hand, consumers benefit from inexpensive imported products. On the other hand, American workers have trouble competing at the going wage, and earnings are battered down.

The latest wrinkle is that China and India are adding to worldwide demand for raw materials -- oil, but also steel, timber, and all the other ingredients of an advanced economy. The result is that oil prices and other commodity prices are likely to stay high and even rising for the foreseeable future. That adds to consumer costs, shows up in inflation statistics, and prompts the Fed to hike interest rates.

But high commodity prices caused by rising global demand aren't the classic inflation that represents our economy overheating. And it's not cured by tight money. On the contrary, higher domestic interest rates just depress the US economy, but without significantly reducing Asia's appetite for oil and other raw materials.

What to do? There is no easy cure. There are, however, two constructive things the administration might pursue. First, it could stop running the immense deficits that create so much dependence on foreign borrowing. Second, it could get serious about energy self-sufficiency built on new technologies. That would simultaneously create American jobs and reduce dependence on imported oil.

The White House, of course, has no enthusiasm for either policy. What a pity, both for the economy and for the administration's own political fortunes.

Robert Kuttner is co-editor of The American Prospect. His column appears regularly in the Globe."