Why the Economy is Addicted to Government Aid

It’s easy to blame politicians, but we’ve all got our snouts in the trough.


Painful as it is, important parts of the economy are slowly healing. Overleveraged consumers are paying off crushing debt and starting to save more. The financial system has stabilized, thanks to the bazookaful of aid fired by the government in 2008 and 2009. Ruthless layoffs and aggressive cost-cutting have left corporate America "in its best fundamental condition in decades," according to strategist Brian Belski of investing firm Oppenheimer. Some day, those improvements might help our kids or grandkids enjoy a return to prosperity.

[See 5 reasons companies still aren't hiring.]

Today is obviously a different story, though. Unemployment is way too high, hiring is pitiful, the housing bust refuses to end, consumers don't want to spend, and instead of gathering steam, the economy seems to be sputtering toward another breakdown. Democrats, Republicans, Tea Partiers, and No Partiers all have their preferred explanations, but if you put politics aside and look at economics, one big problem is clear: Our supposedly free-market economy is addicted to government spending and federal subsidies. And we're now in the early stage of an ugly detoxification.

Go ahead, blame it on [whatever political party you don't belong to]; political mud-slinging is expedient and doesn't require too much thinking. But a better uberexplanation for our addiction to government largesse is that we all like it—and depend on it. The mortgage-interest deduction frees thousands of dollars every year in the typical middle-class family budget. Most Americans factor Medicare and Social Security into their retirement plans. No matter how much the wealthy grouse about taxes and government interference, they sure didn't mind the federal maneuvers that helped produce an 83 percent surge in stock prices between March 2009 and April 2010.

Thanks to the exploding government debt, we're getting close to the tipping point when all the aid we've come to count on gets ripped from the system. Economist Gary Shilling estimates that 58 percent of the American population is dependent on the government for "major parts of their income," including teachers, soldiers, bureaucrats, welfare, and Social Security recipients, public housing beneficiaries, and the employees of government contractors. On current trendlines, that could rise to an astounding 67 percent of the population by 2018. Meanwhile, some economists are calling for even more government stimulus to restart a recovery that's faltering because private-sector demand isn't materializing the way it should be.

[See when the tax hikes are coming.]

Yes, there's something wrong with this picture: In the absence of real economic growth, everybody keeps turning to the government to save the day, whether it's through more aid to the states, extended subsidies, or tax cuts that would necessitate cuts in services that many Americans rely on. But sooner or later, the government spigot will close and major parts of the economy will have to break their addiction to government support. Here are some of them:

Housing. We like to romanticize the home as a hard-earned piece of personal wealth, but the government has been helping Americans buy homes since at least the 1930s, when President Roosevelt created the Federal Housing Administration to help insure housing loans and Fannie Mae to buy mortgages and create liquidity in the housing market. The cherished mortgage-interest deduction dates to 1913, and evolved into something akin to an American birthright in the 1950s and 1960s as homeownership exploded. The other federal mortgage agency, Freddie Mac, came along in 1970, after Fannie Mae had become huge and seemed to warrant a competitor. In the early 2000s, the Federal Reserve added its own fertilizer to the housing market through a long period of unusually low interest rates that encouraged speculation and ultimately helped produce an epic housing bust.

[See 4 reasons to fear deflation.]

Today, Fannie and Freddie are wrecked zombie companies propped up by the government, and cutting or killing the mortgage-interest deduction is likely to be one recommendation proposed by the presidential commission exploring ways to cut the government debt. Yet the housing market is more dependent than ever on the government. With private mortgage firms sitting on the sidelines, the vast majority of new mortgages are backed by Fannie or Freddie, even as they limp along as wards of the state. The Federal Reserve has purchased an extraordinary $1.4 trillion of mortgage debt, to pump money into a dead market, and it could buy more. And the only bright spot in housing over the last year has been a blip in sales that we now know was almost entirely generated by a federal home-buyer tax credit that expired in the spring. With that gone, sales have flatlined once again and prices continue to fall.

The government continues to try to stimulate demand for homes, since housing usually helps springboard the economy out of recession. But it may ultimately take an unwinding of government support to return the housing market to some form of decent health. This could be one of the most painful economic adjustments of the next decade.

Government employment. As a place to work, local, state, and federal government used to be a respite from recession, with stable jobs and benefits generally better than those in the private sector. But government has become top-heavy and out of alignment with the rest of the economy. A recent USA Today analysis found that government employees, on average, earn about $123,00 a year in pay and benefits—twice what private-sector worker earn. That's a huge gap that's largely funded by taxpayers feeling the pain of a lousy economy. And gains in public-sector compensation have risen far faster than private pay, which has been fairly stagnant over the last decade.

[See how the government is swallowing the economy.]

This dichotomy has already produced taxpayer revolts in some municipalities, and those are likely to spread. Battles with public-employee unions to reduce pay and benefits are now erupting much the way that money-losing automakers fought their unions for decades—and finally won deep concessions, when the automakers were on the brink of insolvency. And with federal stimulus aid to states fading, local and state governments are starting to trim their own payrolls, much like private companies have done over the last two years. Over time, the rewards of public-sector work must come back into alignment with those in the private sector—an adjustment that will impact the quality and availability of government services across America.

Jobless aid. Despite some rancorous rhetoric, Congress has been relatively generous to the jobless, passing at least six extensions of the standard 26-week unemployment-insurance benefit since 2008. In some states, the unemployed can garner up to 99 weeks of benefits—almost two years' worth. That's not lavish living, but it's also not a source of income anybody should get comfortable counting on. Every time jobless advocates ask for another extension, it's a tougher fight in Congress, where most Republicans and some Democrats carp about adding to the federal debt. Once the November elections are over, the chorus chanting "no more" could get a lot bigger. If jobless aid diminishes, the tough question is, what then? There will still be millions of unemployed Americans, many out of work for months. With unemployment likely to stay elevated for years and governments running out of money, the only outcome might be a swelling underclass with little money to spend.

[See how jobless aid became dysfunctional.]

Stimulus spending. Like it or not, we probably need more of it. The economy is weakening when it should be strengthening, prompting fears of a "double-dip" recession and even deflation, a phenomenon most Americans have never experienced. If Washington weren't up to its ears in debt already, more stimulus would be a no-brainer. But government spending is growing unpopular, and a dysfunctional Congress seems unable to muster a coherent plan for committed cutbacks later in order to put a little wind in the economy now. So everybody opposed to government stimulus will probably get to see what it's like when the government does nothing as stagnation persists and thriving Asian countries take even more American jobs. As unappetizing as it is, government-sponsored growth will start to look a lot better than no growth at all.