Basically, what's under way is a brutal unwinding of the delusional optimism that reigned during the 1990s--excesses like the hyperinflation in financial assets and the swollen ambitions that led investors and companies to wildly overvalue their prospects for future returns. The stock-market bubble was the most obvious expression of excess, but not the most serious dimension. In an era of Internet fantasies and collective self-delusion, business sectors (and their financiers) overinvested on a grand scale and generally used borrowed money to do so. That is, they built too many factories, shopping centers and office buildings--creating more productive capacity than the marketplace could possibly absorb. Consumers indulged in their own version of wishful thinking, borrowing heavily to keep on buying, hoping the "good times" would last long enough to bail them out.
This legacy of accumulated excesses lies across the American economy like a heavy wet blanket--overcapacity in production, overpriced financial investments, mountainous debt burdens for corporations and households, and thus a deepening reluctance to invest or to consume. Personal debt is now at an extraordinary 130 percent of disposable income, up by nearly one-third since the mid-1990s. Manufacturing is operating at only 72.5 percent of its productive capacity, greater idleness than during the 1990-91 recession and approaching the severity of the 1982 recession. For producers of semiconductors and related electronic components, capacity utilization has fallen to 65 percent. In telecom equipment, it is at 50 percent. That's why there is so little new investment. What company is foolish enough to build new plants when so many existing ones are shuttered? And who would lend them the capital? If consumers run out of capacity to borrow more or can no longer refinance home mortgages, the collapse of aggregate demand will become far worse.
The US economy is unlikely to recover its full vigor until this dead weight from the past is substantially reduced. In the meantime, the struggle of companies (and other countries) to dump their excess production by selling cheap, while also shrinking jobs and workweeks, threatens to make things still worse, eventually tipping into a general deflation of prices. The broader meaning of deflation, however, is that assets of almost every kind, from financial investments and real estate to manufactured goods and commodities, are being revalued downward--slowly, steadily correcting for the falsely optimistic asset valuations achieved during the boom years. The overvaluations, though most dramatic in Japan and the United States, were transmitted worldwide through trade and the hyped-up energies of global investing. In this sense, deflation is already under way and started five or six years ago with the violent financial collapses that swept across developing nations in Asia and that continue to stalk weakening economies on other continents. China, given its burgeoning low-wage output, is now the world's main deflationary engine. Its exports are underpricing Japan's and taking market share away from other poor countries, thus forcing rival producers to lower prices still further (China now has the largest trade surplus with the United States, surpassing Japan). When too many goods are chasing too few buyers, the main game is to make sure someone else gets stuck with the unsold surpluses.
In another era, there would be clamoring voices not only from the political sphere but also from business and finance demanding bold action by Washington. In this era of conservative orthodoxy, there is general complacency and silence, as if everyone agrees that the ugly possibilities will go away if nobody talks about them. Aside from subdued kibitzing of the Fed by selected financial experts, there is no debate on these momentous matters. Governing elites are deeply enthralled by "market fundamentalism" and dare not speak of the alternatives (or perhaps don't even know about them). The principal remedies sound to them like liberal heresies. And they are. This political passivity may give way once the presidential campaign heats up. Howard Dean was evidently the first Democratic candidate to invoke the "d word" when he recently warned Iowans: "If we re-elect this President, we'll be in a depression."
In broad strokes, the government has the power to intervene on three fundamental fronts to remove the depressing overhang from the past. First, the Federal Reserve can deliberately induce price inflation to counter the deflationary forces and excite what Keynes called the "animal spirits" of business leaders. Rising prices will also automatically ease the debt burdens of borrowers by diluting money's real value (that's why creditors always adamantly oppose inflation). Second, Congress and the White House can simultaneously launch a major stimulus program composed of public spending and quick-acting tax cuts, thus running up far larger budget deficits than the Bush Administration has engineered. Whether the money builds schools and highways or hires more schoolteachers, it creates new jobs, incomes and business activity. Finally, if these steps are insufficient, the government may have to intervene more directly and manage a substantial liquidation of debt burdens--either arrange ways to write off failed loans (as it did in the savings-and-loan crisis of the 1980s) or create more lenient terms for the indebted companies and households, much like a banker's "workout" for a financially troubled business.
If this negative cycle worsens to extremes, only the federal government can interrupt it and push the economy in a positive direction. The basic task, as John Maynard Keynes explained in the thirties, is to get the money moving again. The government does this by borrowing idle wealth from the private sector and spending it or distributing it to taxpayers who will--thus putting the money to economic uses and stimulating business activity. Federal deficits, in other words, are an essential element in the solution--very large deficits if you intend to jump-start a $10.7 trillion economy. Yes, borrow-and-spend therapy increases the national debt, but the renewal of economic growth will handle that. (The alternative--doing nothing--means allowing events to take their own course toward destruction and multiplying failures. "Liquidate labor, liquidate stocks, liquidate the farmers, liquidate real estate," Andrew Mellon advised Herbert Hoover after the 1929 crash. "It will purge the rottenness out of the system.")