Can Washington rouse a good morning for America?

Ever wonder how the US got into this predicament? Academics and strategists have been analysing our current financial situation endlessly, but I haven't seen too much probing into the origins of our present problems. In my opinion, you probably have to go back to the end of World War II to understand how we got here. I think policymakers in the US especially failed to recognise the significance of four important events that led to our current challenging set of circumstances.

The first was back in 1980. Europe had recovered and was competing once again in world markets after 35 years of rebuilding. Japan, devastated by the war in 1945, was producing consumer electronics products and automobiles everyone wanted to buy. The US was losing its clear economic leadership and having more trouble competing in world markets. We should have responded to this challenge with an industrial policy emphasising energy independence or infrastructure, but we did not. For example, we could have taken advantage of our abundant supplies of natural gas and used this resource to generate electricity and to provide power for municipal transportation. In this way we could have diminished damage to the environment and reduced our dependence on oil from the Middle East. We also should have begun upgrading the skills of manufacturing workers.

The second event occurred about the same time. In the immediate post-war period, the people of the US had inherited a culture of thrift from their parents and others who had endured the Great Depression of the 1930s, but the 1980s became the 'Me decade' and consumerism and the accumulation of personal debt became widespread.

The third important event took place in 1990, when China and the former Soviet Union moved away from their command economies. At that time India also entered the world economy while continuing to produce goods for its own consumption. Initially we viewed this positively, thinking there would be three billion new customers for American products, without recognising that these countries would be competitors first.

The fourth event took place in the late 1990s and the first decade of the new millennium. It was a policy under which the government and the private sector would enable more American families to own their own home. The basic concept was idealistic; in reality, because of lenient lending practices and ambitious home buyers the policy resulted in many families acquiring homes that were more expensive than they could afford. They did this because house prices were appreciating 10 per cent a year and if they could make the payments for several years, they could then sell the house for a profit and put the money into a unit they could afford more comfortably. This worked until 2007 when real estate prices started to decline, and many found themselves in a house with high monthly payments and a declining value, if it could be sold at all. We all know what happened to the banks and the whole economy then.

All of this can be illustrated quantitatively by looking at the amount of debt added at all levels of the US financial system (government and private) in relation to the growth of GDP. Over the last three decades capital has become less productive.

At the end of World War II the US was the only major industrial country whose manufacturing establishment was intact. Europe and Asia had been crippled by years of bombing. America was the pre-eminent country in the world economically, politically and militarily. It believed itself to be 'exceptional' and the pride derived from that may have formed the foundation of its present troubling circumstances. It thought it had the power to safeguard the world and it was willing to engage in wars in Korea and Vietnam to prevent the spread of Communism and the perceived threat to its way of life.

We also adopted a series of broad social programs.

During this period capital was very productive because of the lack of competitive pressure from others. In the 1950s through the 1970s the economy as a whole had to add less than $2 of debt to produce $1 of growth in GDP. By 1980, however, when Europe and Japan were becoming competitive, it took almost $3 of debt to produce $1 of GDP growth, more than a 50 per cent increase from the previous decade. In addition, the number of people working in manufacturing was declining rapidly. Manufacturing as a percentage of nominal GDP declined from 28 per cent in the late 1940s to 12 per cent in 2008, but the percentage of the workforce employed in factories declined in that period from 40 per cent in the 1940s to 11 per cent in 2010. Service sector employment increased from 40 per cent in the 1940s to 65 per cent in 2010. We were becoming a service economy, and services do not export well so our balance of payments deficit began to expand. The quadrupling of the price of oil in 1973-74 also contributed to this condition. It is worth noting that in January 2012 increases in manufacturing employment exceeded increases in service sector employment for the first time since 1977. Let's hope a new trend is beginning.

Policymakers should have taken action because of this decline in the productivity of capital and the decline in the manufacturing workforce but they did not. They should have designed an industrial plan to develop alternative energy sources, just as they had designed the space program to meet the challenge represented by the Russians launching a satellite into space (Sputnik) in October 1957. As one of his early initiatives, President Kennedy committed the country to putting a man on the moon by the end of the 1960s, and in July 1969 we did it, giving birth to Silicon Valley, the cradle of information technology, in the process. If we had put our talent and resources into an alternative energy program at that time, we would be much less dependent on Middle East oil today, with enormous economic and political ramifications. America has many of the great universities in the world and over the last 40 years we have not taken sufficient advantage of the innovative capabilities they represent. As technology began to play a more important part in both service and manufacturing, policymakers should also have implemented training programs to upgrade the capabilities of the American workforce.

The 1990s was a favourable decade for capital productivity. In spite of the competitive challenges represented by low labour cost countries in Latin America and Asia, the debt required to increase GDP by a dollar remained at about 3:1. This was because technology played such an important role in the business environment of that period and America was the dominant player in the internet, fax machine, cell phone and handheld e-mail and information retrieval devices.

All this changed in the new millennium. Debt required to increase GDP a dollar increased to more than $5. Money was borrowed to buy overpriced houses rather than for more productive purposes. We were engaged in two wars in the Middle East with uncertain outcomes. The financial crisis of 2008 required an enormous increase in the federal debt to avoid a meltdown of the banking system. In the year 2000, when George W. Bush was elected president, the national debt, accumulated over 200 years, was less than $6 trillion. Today it is $15 trillion. It has gone up two and a half times in only 12 years. During that time nominal GDP increased 50 per cent from $10 trillion to $15 trillion.

The excessive amount of money that went into housing was part of a government-encouraged goal of creating an 'Ownership Society' where most families could realise the American dream and own their own home. Lending standards were relaxed and bank and shadow bank leverage were increased to achieve this objective. The Federal Reserve could have been much tougher on financial institutions providing mortgages to homebuyers than it was. Alan Greenspan believed that the free market would provide the necessary discipline without recognising the extent of the excesses that were building throughout the financial system.

Since 1980 economic policymakers have been focused on maintaining a high level of growth in the US but we have taken on increasing amounts of debt to achieve this. If it takes $5 of debt to produce $1 of GDP growth, the return on that $1 may not be enough to service the $5 and provide a return to the equity investor as well. That may be one reason there is so much cash on corporate balance sheets. The world has become so competitive that it is increasingly hard to find projects that provide a satisfactory return.

The question is what to do about this now. Everyone agrees that government expenditures need to be reduced because we cannot keep accumulating debt at the present rate. We must, however, be careful not to cut government spending too quickly because it represents 25 per cent of GDP and is, in effect, a huge subsidy for the economy. Over the past 60 years federal programs have represented 20 per cent of GDP. The Congressional Super Committee's objective was to cut government expenditures by $1.2 trillion over ten years, or $120 billion annually. A cut in spending of this magnitude could be accommodated by the economy without throwing us back into recession. A cut in spending of as much as $500 billion in a single year would reduce the growth of the deficit, but would put GDP in negative territory.

It is not likely that our budget gap can be closed significantly without some increase in taxes. Over the past 60 years federal taxes have represented 18 per cent of GDP. They are now 15 per cent. With 49 per cent of all working people paying no federal income taxes, it would seem that the base should be broadened. There are also tax preferences and subsidies for oil and gas, real estate and agriculture that will be under increasing pressure to be modified. The top 1 per cent of all income earners already pay 38 per cent of all federal taxes so there is some question already about whether they are paying more than their share. The top 10 per cent pay 70 per cent.

Deductions for mortgage interest, charitable contributions, employer healthcare contributions, state and local income taxes and other aspects of the current tax code also represent opportunities for raising additional revenues, but there are powerful special interest groups as well as political forces that will resist significant change.

Amidst these longer-term problems the economy has clearly regained some of its lost momentum. At the beginning of the year most observers thought real GDP growth of 2 per cent seemed likely for 2012, but now 3 per cent would appear attainable. That should keep payrolls increasing and the budget deficit from continuing to grow, but it's still over $1 trillion annually, and whatever the outcome of the election, we must bring it down or one day the cost of servicing the debt will create a crisis. Right now, at an average interest cost of 2.3 per cent, it only takes about 8 per cent of federal revenues to service the debt, but if the deficit keeps building at more than $1 trillion a year and the average interest rate on government obligations rises to 3 per cent, by 2020 the cost of debt service could rise to more than 20 per cent of revenues. That would crowd out spending on defence, social security and healthcare. Congress must take action to avoid the social problems that would be created at that time.

I am often asked what would be the 'wake-up call' that would get Congress to act on the budget deficit problem. My answer is rising interest rates on government debt. When America only has to pay 2 per cent to borrow for ten years, legislators have a sense of complacency. If the cost of borrowing exceeded nominal GDP growth (2 to 3 per cent real plus 2 to 3 per cent inflation), they might have a greater feeling of urgency.

Byron Wien is a senior managing director of The Blackstone Group and vice chairman of Blackstone Advisory Partners LP.