Recession over? Not unless we make a major shift.

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By Steven Pearlstein
Wednesday, January 6, 2010

First column. New year. Time to take stock of where we are economically and where we're headed.

At the moment, it looks to many like the recession is over. Most of the job cutting has been completed, businesses are profitable once again, banks have repaired their balance sheets, consumer and business confidence is on the upswing, and a new bull market has begun on Wall Street, all of it suggesting that a full-blown recovery is underway.

Unfortunately, folks, it's not gonna be that easy.

My best guess is that the current upswings in economic output, confidence and financial asset prices are largely a reflection of the extraordinary fiscal and monetary juice provided by Treasury and the Federal Reserve, along with the natural rebound that occurs after a collapse in consumer and business spending like that which occurred in the first half of 2009. The surprising strength of the bounce-back testifies to the wisdom of the underlying strengths of the U.S. economy and the success of the policies, but is likely to peter out as the stimulus begins to wear off and the inventory correction is completed. Economist Paul Krugman probably has it about right when he says there is a one-in-three chance that the economy will dip back into recession, with the "optimistic" scenario that the economy will neither shrink nor grow but bounce along the bottom.

Let's review, briefly, the four potential sources of economic growth.

The most potent, since it is the biggest category, would be an increase in consumer spending, which is as unlikely as it is undesirable. With unemployment almost certain to remain around 10 percent, with wages and incomes flat, and with households busy cutting back on debt-financed consumption, it's hard to see how American consumers can again become the engines of the U.S. or global economies.

A second potential source of growth would be an increase in government spending, but that's also hard to imagine. State and local governments, in fact, are still cutting back spending in response to falling tax revenue, and there's no political consensus for running up bigger federal deficits than we are running now.

The third source of growth is investment, which is finally rebounding after last year's near-total collapse. It is certainly reasonable to expect that profitable businesses will continue to replace aging computers and other equipment. But with so much overcapacity in so many industries -- excess hotel rooms, airplanes, office buildings, shopping malls, cargo ships, aluminum smelters and the like -- a surge in overall business investment seems unlikely. And with 5 million vacant apartments and another wave of home foreclosures on the horizon, don't count on the housing sector to lead the way out of this recession.

Finally, there is trade. For the first six months of 2009, the U.S. trade deficit was running at less than half the rate of the previous year, thereby adding to economic growth. But when the economy began to rebound in the third quarter, so did the deficit, creating a drag on the economy. The persistence of the trade deficit reflects a fundamental reality not likely to change anytime soon: We no longer produce much of what we like to consume, and cannot make up the difference with exports because of trade barriers and an overvalued currency.

So how do we get out of this predicament? By doing what we should have done a long time ago, moving aggressively from debt-fueled consumption to productive investment.

American households are already well into the shift, having gone from a negative savings rate to one that now fluctuates between 4 and 5 percent. Given our reduced wealth and rapidly aging population, that's the least we should be aiming for. Consumption will follow income, not the other way around.

More disappointing has been the performance of businesses, which seem to have used this period more for paying down debt and building up cash reserves than for modernizing equipment and stepping up research and product development. This would be a good time to change the tax laws so big corporations, like small companies, can expense such investments rather than depreciate them over a number of years. This change, long sought by tax reformers, would delay corporate taxes but not reduce them, while stimulating investment in the short run.

Most important would be for the federal government to step up its spending for infrastructure, basic research, clean-energy development and expanded public higher education. After 20 years of badly underfunding public investment, the first stimulus package was a step in the right direction. A second package would create additional high-paying jobs now, while generating higher growth and tax revenues for decades. A boost in government investment would also provide the perfect political cover for moving aggressively to reduce the government's "consumption" spending by reforming entitlements, reducing farm subsidies and business tax breaks, and eliminating underperforming social and military programs.

Given how we got into this mess, we're probably stuck with several more years of slow growth in jobs and income. The only important question is whether we'll use this opportunity to lay the foundation for another generation of sustained prosperity, or get sidetracked by chasing after short-term stimulus and overzealous deficit reduction.

Steven Pearlstein will host a Web discussion today at 11 a.m. at washingtonpost.com. He can be reached at pearlsteins@washpost.com.


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