What the heck is happening to the US economy? How to get the recovery back on track

How much the rest of the world buys from the US depends on how other economies are faring. And most of the rest of the world is hurting economically. The Japanese are so fed up with their economic situation that they are on their sixth prime minister in the six and a half years since Junichiro Koizumi left office in 2006.  The European debt crisis is in a lull right now, but could still resume full force at any time. In addition to all of its other problems, the United Kingdom is facing a mysterious decline in productivity, explained in Martin Wolf’s Financial Times article “Puzzle of Falling UK Labour Productivity” and the Bank of England analysis by Abigail Hughes and Jumana Saleheen.

The decline in US government spending comes from the struggle of state and local governments with their budgets and at the federal level from the ongoing struggle between the Democrats and Republicans about the long-run future of taxing and spending. Last quarter saw a remarkable decline in military spending that Josh Mitchell explains this way in today’s Wall Street Journal (paywall).

The biggest cuts came in military spending, which tumbled at a rate of 22.2%, the largest drop since 1972. …

Military analysts said the decline likely was a result of pressure on the Pentagon from a number of areas.

Among them: reductions in spending on the war in Afghanistan as it winds down, a downturn in planned military spending, a constraint placed on the Pentagon budget because the federal government is operating on short-term resolutions that limit spending growth, as well as concern that further cuts may be in the pipeline.

The problem is that, absent a big increase in economic growth, balancing the federal budget in the long run requires big increases in taxes or big reductions in spending. But, although opinions differ on which option is worse, tax increases and spending cuts themselves are enemies of economic growth. So the traditional options for balancing the federal budget in the long run all have the potential to make things much worse.

Our problems are so big they need new solutions. In our current situation, the fact that a proposal is “untried” is a plus, since none of the economic approaches we have tried lately have worked very well. In the last few months I have focused my Quartz columns on explaining how the US and the world can get out of the economic mess we are in with new solutions. A recap:

1. One of the new solutions is really an old one, that Congress and the President might be timidly tiptoeing toward too little of: dramatically more open immigration. Done right, this is guaranteed to add to long-run economic growth, as more workers make more goods, perform more services, and contribute to solving our long-run budget problems. And it isn’t just the US that would benefit from more open immigration. Ryan Avent has a must-read article in The Economist arguing that “Liberalising migration could deliver a huge boost to global output.”
2. The long-run budget can be balanced in a way that achieves both the core Republican goals of holding down the size of government and the burden of taxation and the core Democratic goal of taking care of the poor, sick and elderly. Here is how: by using the tax system to back up a program of public contributions to expand the non-profit sector instead of taxes and spending to expand government, or brutal cuts with no compensating way to take care of those in need.
3. For stimulating the economy, the one current approach that has been working at least halfway is “quantitative easing”: the Fed’s large purchases of long-term government bonds and mortgage-backed securities. But quantitative easing is hugely controversial and has an unfortunate side effect of making our long-run government debt problem worse than if we could stimulate the economy some other way. Establishing a US Sovereign Wealth Fund to do the purchasing of long-term and risky assets would give the Fed room to maneuver in monetary policy, and restrict its job to steering the economy rather than making controversial portfolio investment decisions. And a US Sovereign Wealth Fund could stand as a bulwark against wild swings in financial markets. (In addition to the column linked above, I spoke on CNBC’s Squawkbox about a US Sovereign Wealth Fund.)
4. Although valuable, a US Sovereign Wealth Fund is a poor second best to electronic money. It is the fear of massive storage of paper currency that prevents the US Federal Reserve and other central banks from cutting short-term rates as far below zero as necessary to bring full recovery. (If electronic dollars, yen, euros and pounds are treated as “the real thing”—the yardsticks for prices and contracts—it is OK for people to continue using paper currency as they do now, as long as the value of paper money relative to electronic money goes down fast enough to keep people from storing large amounts of paper money as a way of circumventing negative interest rates on bank accounts.)  As I argued in “Could the UK be the first country to adopt electronic money,” the low interest rates that electronic money allows would stimulate not only business investment and home building, but exports as well—something that would lead to a virtuous domino effect as the adoption of an electronic money standard by one country led to its adoption by others to avoid trade deficits. If I were writing that column now, I would be asking if Japan could be the first country to adopt electronic money, since Japan’s new prime minister Shinzo Abe is calling for a new direction in monetary policy. For the Euro zone, I argue in “How the electronic deutsche mark can save Europe” that electronic money is not only the way to achieve full recovery, but the solution to its debt crisis as well.
5. Finally, if electronic money is too radical, the government can stimulate the economy without adding too much to the national debt by giving consumers extra borrowing-power with a government-issued credit card and a $2,000 credit limit to every taxpayer. These Federal Lines of Credit would stimulate the economy at a fraction of the cost of tax rebates. This is a big advantage for countries deep in debt, which includes most major economies. And Lines of Credit are an affordable way to stimulate the economies of European countries such as Spain and Italy that lack an independent monetary policy because they share the euro with many other European countries.

Franklin Roosevelt famously said:

The country needs and, unless I mistake its temper, the country demands bold, persistent experimentation. It is common sense to take a method and try it: If it fails, admit it frankly and try another. But above all, try something.

We are at such a moment again. The usual remedies have failed. It is time to try something new. Any one of these proposals could make a major difference. In combination, they would transform the world.