Thursday, June 9, 2011

the economy sucks -- get used to it

The 2012 elections are on the way and the economy will be the big issue. Economics and politics do not mix very well. I take that back; they mix too well. However, what you usually get is a concoction sort of like bad bathtub gin. It feels good but rots your brain.

So what’s going on?
  1. The recession is over and the economy is recovering slowly;
  2. We’re still in a slump;
  3. There’s not much government can do right now to get positive results in the next year or so.
On Tuesday, Federal Reserve System (Fed) Chair Ben Bernanke made a speech stating the obvious and restating the above:
  1. “Overall, the economic recovery appears to be continuing at a moderate pace, albeit at a rate that is…frustratingly slow;”
  2. “the economy is still producing at levels well below its potential;”
  3. “In this context, monetary policy cannot be a panacea.”
Translation: Things still suck and the Fed can’t do anything about it.

This should not have been a surprise to anyone who remembers a little undergraduate macroeconomics and who has been paying attention. Monetary policy works by lowering interest rates to stimulate spending. The problem is that interest rates cannot be pushed much lower by monetary policy. Interest rates do not go below zero. (Like a banker is going to offer to lend $100 and only want to be repaid $98?) There is nothing the Fed can do to stimulate the economy.

(BTW, I found it interesting that the stock market declined Tuesday afternoon on news of Bernanke stating the obvious. The market has since gone back up. In the meantime, some traders needed only a little bit of knowledge to make a quick buck.)

Okay, monetary policy is out and the Fed is benched. Should we try fiscal policy? Time to bring in the President and Congress and see what they can do?

The usual principles-of-economics fiscal policy prescription is to cut taxes to increase household and business spending and/or increase government spending. Economists disagree on the efficacy of this policy and it is controversial. However, let's assume for the sake of argument that the theory behind the policy is correct. Go with me on this.

We've been there, tried that, screwed it up, and don't have another shot at it.

The Obama fiscal stimulus plan of 2009 attempted to implement the policy noted above. Martin Feldstein, chair of the Council of Economic Advisers in the Reagan administration, is also an adherent to the basic model underlying the fiscal policy prescription. In yesterday's Wall Street Journal (June 8, 2011, p. A15), Feldstein outlined how the 2009 stimulus plan mucked the whole thing up:
The administration's most obvious failure was its misguided fiscal policies: the cash-for-clunkers subsidy for car buyers, the tax credit for first-time home buyers, and the $830 billion "stimulus" package. Cash-for-clunkers gave a temporary boost to motor-vehicle production but had no lasting impact on the economy. The home-buyer credit stimulated the demand for homes only temporarily.

As for the "stimulus" package, both its size and structure were inadequate to offset the enormous decline in aggregate demand. The fall in household wealth by the end of 2008 reduced the annual level of consumer spending by more than $500 billion. The drop in home building subtracted another $200 billion from GDP. The total GDP shortfall was therefore more than $700 billion. The Obama stimulus package that started at less than $300 billion in 2009 and reached a maximum of $400 billion in 2010 wouldn't have been big enough to fill the $700 billion annual GDP gap even if every dollar of the stimulus raised GDP by a dollar.

In fact, each dollar of extra deficit added much less than a dollar to GDP. Experience shows that the most cost-effective form of temporary fiscal stimulus is direct government spending. The most obvious way to achieve that in 2009 was to repair and replace the military equipment used in Iraq and Afghanistan that would otherwise have to be done in the future. But the Obama stimulus had nothing for the Defense Department. Instead, President Obama allowed the Democratic leadership in Congress to design a hodgepodge package of transfers to state and local governments, increased transfers to individuals, temporary tax cuts for lower-income taxpayers, etc. So we got a bigger deficit without economic growth.

If I may add to this critique, Obama had no real plan for spending. He handed over the spending decisions to Speaker Pelosi and Congress went on a spending orgy, targeting pet projects rather than targeting those things most likely to stimulate the economy. We could have had more bang for the buck.

2009 was our one big chance to use expansionary fiscal policy. Any further tax cuts or increases in government spending will increase the deficit. "The national debt has jumped to 69% of GDP this year, from 40% in 2008. It is projected by the Congressional Budget Office to reach more than 85% by the end of the decade, and to keep rising after that" (ibid.). Expansionary fiscal policy was mucked up. Now with the national debt levels so high with S&P and Moody's threatening to downgrade the ratings for U.S. government bonds, we can't do it again.

What is needed is a credible plan to reduce government deficits. This would reduce uncertainty about the future and help economic growth over the long haul. However, despite a reduction in uncertainty, these polices will still reduce spending in the aggregate and won't help the economy recover in 2012. They are needed over the long haul but they are no quick fix.

There will be the usual snake-oil-salesman politicians and pundits who will promise a quick fix. Even if the policy is good, don't be conned into expecting good results immediately.

Be blessed.

No comments: