(This is the second in a series: the first, How The Economy Worked In the Clinton Era, was about the Clinton economy)

The Bush team came into office faced with basically the same problem that Clinton had – how to pay for foreign goods. The Clintonian solution had been to sell intellectual property; to keep the dollar high; to offer equity investment options; to use labor arbitrage and to use the IMF, World Bank, WTO and other such organizations to keep commodity prices low. (All of this is gone over in more detail in the first article).

When Bush took power the wheels were coming off. The NASDAQ crash had finally occurred and the price of oil had begun to rise (though the price was still relatively low). A recession was clearly on the way and neither could nor ought to have been stopped; the question was what sort of economy should come out of that recession.

Labor arbitrage presented a double edged sword, as it had in the nineties. On the one hand it was a source of deflationary pressure which could be used to keep inflation under control. On the other hand because labor costs were so much lower overseas, pumping money into unprotected sectors of the economy -– those subject to foreign competition -- risked simply creating the money and jobs overseas.

In the 90’s this issue had been dealt with by time pressure and clustering. The problem with outsourcing and offshoring is that it isn’t suitable for quickly changing projects and services. When products aren’t relatively standardized, when they’re still bleeding edge, it isn’t price that sells them -– it’s having the newest and best. Having the cheapest 486’s on the market does nothing for you if your competitor is selling Pentiums and the new killer app requires those Pentiums. Likewise in a rapidly changing field you need to be near a bewildering variety of small suppliers who are capable of quickly adapting to changing demands. Those suppliers tend to cluster geographically and feed off of each other. The knowledge and skill base grows so swiftly that those outside of the area have a hard time keeping up – there is great value to being near the center of the revolution.

More After the Jump

The tech crash erased the option of keeping jobs in American through time pressure and clustering. The liberal solution would have been to try and find a new tech boom, which in the case of the Gore administration would almost certainly have either been a micro and alternative energy boom or a telecom boom.

The Bush administration's solution was different. They made the decision to base the economy on the real estate market. Record low interest rates flooded money into the mortgage market and the housing market boomed. The Treasury department structured its bonds to encourage money to flow into the housing market. (By dropping the 30 year bond, and by flipping most of their debt into short duration bonds Treasury helped make the mortgage market about the only place people who required longer term income could go to get it.)

Money flowed into the housing market not only from the US but from overseas in huge floods. But it wasn’t enough. Housing wasn’t nearly as enticing as the possibility of buying the next Microsoft, Amazon or EBay while they were cheap. Tech stocks had always had the possibility of explosive growth; mortgage-backed bonds were much more limited and with the possibility of currency devaluation, more risky than they appeared on the surface.

The solution to that was typical Bush. The administration played a game of chicken. They made a bet that the major exporting economies of the far east would simply lend the US the money, even knowing that it would most likely be repaid at cents on the dollar. They were correct: Japan, South Korea and China ponied up and bought enough dollars to keep the US dollar from collapsing. All three are export -driven mercantilist economies, and China in particular, using the mercantilist route to industrialize, was willing to pay the price later for the jobs, technology transfer and production facility transfer now.

The next problem to be solved was the commodity problem. Commodity prices had spent thirty years declining, but that downward trend had swung to the upside, led by oil and the energy sector in general.

Oil drives inflation, because it can’t be easily substituted away from. In 2001 the Bush administration looked at the world and what they saw was that the only oil that could be easily brought into the market was Iraqi oil. Iraq had become the world’s swing producer –- or it would be, if all that oil could actually be put onto the market. There were two ways to do this: remove the sanctions, or invade. The Bush administration didn’t trust Saddam with all the money which removing sanctions would give him. So they found an excuse to invade.

The invasion had a number of non-economic ideological bonuses for the primary foreign policy constituency in the administration, but economically it had two main benefits: the release of oil onto the market to drive prices down and undercut inflation; and a boost in jobs in a protected market –- the military and the military/industrial/mercenary complex. Because of security concerns those are jobs, and money, both in the military and in the military industrial sector, which can’t be shipped overseas.

The money that flooded into the economy through the military and through military procurement of goods and services did have a stimulative effect. Unfortunately the failure to secure the Iraq oil fields and pipelines meant that the price of oil didn’t drop. In fact it increased, and the net effect of the military stimulus was to increase oil demand and massively increase market volatility. Increased market volatility made the oil market a good place to park money for traders and investors and that’s what they did for much of the last four years.

The reason is that those traders and investors had a lot of excess cash, and not a lot of investment opportunities. The basic trend of the last twenty five years has been to tax the rich less and to tax investment income less than earned income. Bush pushed this to an extreme, passing a package of tax cuts aimed primarily at rich individuals and corporations. Because there were few productive investment opportunities as there was no new boom, corporations passed most of their profits on to their shareholders –- so the wealthy kept more of their money than ever before and received a great deal of money from dividends.

But their problem was the same as the corporations which had passed them mone; other than the protected sectors -- real estate, health care and the military -- there was nowhere to put their money. Although those sectors were experiencing reasonable growth, returns on investment were generally quite low because there was too much money chasing the investment opportunities.

The growth economy in the world at the time was (and is) China, but China’s investment market was effectively closed, and investment possibilities there were extremely limited. So there was a great deal of money sloshing around, seeking high returns, with nowhere to get them.

That money seized on the commodity markets as a place to find returns, and money flooded into oil and other commodities, helping drive the prices up.

The end state of the Bush economy was commodity inflation, with production good deflation. The deflation was in goods that the US typically sells to the rest of the world: manufactured goods; and because of that decline in prices, margins were shaved to the bone. Those decreasing margins made labor arbitrage to low cost domiciles such as China an obvious play –- there was simply no reason pay inflated US wages.

But the basic nature of the real estate boom was that it was driven by oil. New subdivisions are created further out from metropolitan centers. Each push out, each new subdivision, created more commuters who had to have oil, or rather gas, to get to and from their jobs.

As long as property prices continued to increase that dynamic was sustainable. While a combination of labor arbitrage and anemic demand which made expanding capacity pointless had meant that wage growth under the Bush administration was virtually nonexistent for most Americans, increased spending had been funded through increases in housing prices, which Americans were able to borrow against at record low rates.

That meant that the Bush economy was driven primarily by rising real estate prices. It was sustained by them and they were required in order to maintain basic demand.

And with oil prices rising each new subdivision becomes more and more economically infeasible –- the cost of commuting to work becomes more than the expected value of the house can support.

More than that the rise in oil prices slowly strangles the economy. Because people cannot easily substitute away from oil, it drives out all other forms of spending -- which means consumer spending.

As oil (and natural gas) prices increase, consumer spending must drop unless housing prices are increasing enough to make up the difference.

The Bush Economy was really the housing boom. Many months during the Bush administration, if housing related jobs had been removed from the list, there would have been an absolute loss of jobs (not just less than the population growth rate, but actually fewer gross jobs).

The Bush Economy's fate is tied to the housing boom, and the housing boom was squeezed out by increases in energy prices, which both increased inflation and thus forced the Fed to increase interest rates (and therefore mortgage rates); and made farther subdivisions uneconomical. When housing prices collapse, that will mean reduced consumer spending which will make margins even thinner, making the case for labor arbitrage even stronger. A real collapse in consumer spending could eventually also lead to the far East mercantile economies deciding that the benefit of lending Americans money to buy their goods (jobs and industry now) is outweighed by the cost of doing so in losing most of the value of the money they have effectively loaned to the US.

And that is how the Bush economy works, or rather, worked.

What we're witnessing right now is most likely the collapse of the Bush economy. Both Congress and the Fed are trying to prop the economy up and keep it going till the next election, but odds are they aren't going to manage it, because odds are they can't re-inflate the housing bubble. And without the housing bubble there is no Bush economy.>Meanwhile the Saudis have signaled that they, at least, aren't willing to take losses just to prop up the US economy, and the Chinese are edging for the door and diversifying out of the dollar.

This leaves the Federal Reserve in a classic bind. On one hand, the Fed need to tighten to stop the dollar from deflating and inflation igniting. On the other hand, if they tighten right now they won't just tank the economy and the markets -- they'll drive a stake through their hearts. (The odd thing is that doing so is probably the right thing to do, for all the pain it will cause. More on that another week.)

And the price of oil keeps rising.