This recession (and the subsequent slow recovery) is different.  It is a transformative event.   The economy that ultimately emerges from these difficult times will be fundamentally different from the economy that existed before the recession.

We have seen this before.  It happened during the Great Depression, when the economy was transformed from largely a private enterprise to a partnership of government and the private sector, what is called a “mixed” economy.

It likely will happen again, because the current recession is a demand recession.  Consumers do not have enough money to purchase all of the goods and services that we are capable of producing, and consumer spending is the engine of the economy, representing about two-thirds of economic activity.

There are only three ways consumers can have more money to spend. First, they can save less.  The less they save the more they can spend.  Indeed, this is what Americans have been doing for the last 30 years.  By the mid-2000s the savings rate approached zero.  

The second way that consumers can have money to spend is by borrowing it, and American households also have been doing that over the past thirty years.  In the post World War II era, household debt rose from about 25% of GDP to almost 100%. 

The third way that consumers can have more money to spend is by making more money.  But most workers do not make much more money than they did 30 years ago after adjustment for inflation, and for the past decade growth in real wages for all but the top few percent has been flat or declining. 

In summary, in the past decades demand was not generated by making more money, but by saving less and borrowing more.

The problem is that we can’t save much less and we can’t borrow much more.  Consequently, the only way out of this recession is the third generator of demand – increases in real income – and that is a difficult and long-term process.

It is especially difficult because of two interconnected factors, globalization and income inequality.  Globalization grows the economic pie, by increasing productivity and expanding markets.  However, it hits hardest the working middle-class whose labor rates are curtailed in order to compete with lower paid workers overseas.  Thus, while the economic pie expands, income inequality increases. 

Ultimately, it reaches the point where the standard of living of those at the lower or middle levels of the economic spectrum stops increasing, even though the nation’s wealth may still be expanding.  At that point, you begin to lose the nation’s middle class and you approach oligarchy.

It all comes back to a basic truism, which is that in a vibrant competitive middle-class economy, people earn enough money to be able to afford the goods and services they produce.  But if the middle class is lost and an economy tends toward oligarchy, the middle class can no longer afford to buy the goods and services they produce.  The economy stagnates and becomes less competitive. 

So, in order to come out of this recession and into a period of long-term prosperity, I believe we are going to have to increase demand by increasing the real incomes of a broader swath of our citizens, and we are going to have to do it in the face of increasing globalization which tends to do the opposite by increasing income inequality.

What will happen?  In the past, the government used its traditional means of fiscal and monetary policy to encourage us all to spend as much money as possible. But both fiscal and monetary policy can only increase demand by encouraging us to save less or borrow more, and we can’t save much less or borrow much more.

The government has also done the opposite, and encouraged economic growth by reducing the role of government, and relying on the power of the free market.  The economy grew, but the benefits of that growth went predominately to only a few, with the rest of us mired in stagnation.

In fact, we have tried these two approaches, back and forth, over the past 30 years, in an increasingly partisan conflict. But neither of these approaches has worked adequately, and there is little evidence that they will work any better in the future.  And that is why this will be a transformative recession.

Where will we end up?  No one can say.  What I can say is that if we are smart, we will focus on two things:  We must increase personal income, and we must ensure that the increase is spread across a broad segment of our population.  In the future, economic policies must be judged in terms of those two standards.  In the past, they have tended to be judged by only one or the other....Ed Osborn is a principal in Bingham, Osborn & Scarborough LLC wealth management, 415-781-8535 or www.bosinvest.com.