09 November 2009

There's A Reason They Call It The Dismal Science

The current employment recession has seen the worst job losses since WWII, and is the 2nd worst in terms of the unemployment rate (only early '80s recession with a peak of 10.8 percent was worse).

From here.

Some broader measures of recession pain, like percentage of people who are long term unemployed, and unemployment plus discouraged workers plus involuntarily part-time workers are at post-World War II records. Many states have never seen such high unemployment. On the bright side, there is every indication that our economy is not plunging to Great Depression levels, as it looked like it might at first.

Two more general economic ideas have been bouncing around in my head in the meantime.

* One is microeconomic. Prices are set in our economy by supply and demand. The chain from raw materials to finished product can include losses, although such a chain is not usually sustainable, and widely disparate compensation relative to amount of time spent in labor. A great deal of effort has gone into understanding what drives supply curves, with economies of scale and the like receiving considerable theoretical treatment.

The economics of what lies behind the demand curve is considerably less mature. Usually, economists see demand as derived from a combination of ability to pay and utility, which individuals experiencing diminishing marginal utility as they consume anything in particular, and as they consumer more in the aggreate. But, economic theory tends to get hung up on the notion that the relative desires of consumers of goods and services differ. People have different utility curves.

Common sense suggests that people's preferrences for goods and services have far more similarity, to a considerable level of detail, than rigorous economic theories are comfortable acknowledging. The degree of consensus that people have on the relative desirability of any given set of goods and services is high. Some people are quirky and find one man's trash to be their treasure. Some people have stronger desires to have a high consumption lifestyle than others. But, there is much more variation in ability to afford to consume than the is in relative desire to consume and relative utility from different kinds of consumption. Most people would consumer more and consume higher quality goods and services if they could afford them.

This matters because it implies that (1) prices represent deeper, consensus concepts of value that go beyond mere supply and demand in the abstract, and (2) progressive taxation which assumes that the marginal needs of the rich are less intense than the marginal needs of the poor is more valid that a truly subjective theory of utility would suggest.

* The other idea is macroeconomic. It is common place to note that the American economy (and to a greater or lesser extent the economies of many developed countries), is overloaded with debt. The federal government's national debt is high. Consumer debt reached record levels, while savings have fallen leaving the unemployed and underemployed in more dire straights than they were in the early 1980s recession. Excess business debt drove the collapse of many firms across whole industries. And, foreign debt is high, with foreign countries financing an increasing share of the federal government's national debt and private sector debt. Now, public sector debt is continuing to rise, but consumers are dramatically cutting back on their debt and increasing their savings, and businesses are backing away from extreme levels of leverage.

At the consumer level, the idea is that consumers having engaged in so much debt financing consumption that they need to start consuming less than they produce so that they can pay back their debt.

Does this heuristic idea make sense at a macroeconomic level? The only way that this story of consumption can make sense at the level of the entire U.S. economy is to the extent that we have run trade deficits that are financed with borrowing from abroad, and to the extent that excess inventories have been consumed.

We certainly don't have depleted excess inventories in the U.S. economy. Every indicator points to the opposite conclusion. Newly constructed real estate lies vacant, bringing construction to a halt. Car companies are struggling to reduce their production of cars to match reduced demand for them. Manufacturing has slowed because inventories have built up. Unemployment is a measure of underutilized services. We have far more goods and services floating around in the economy than people are willing to buy. Almost all measures of U.S. economic capacity are being underutilized. Our current economy is slow not because we are unable to produce, but because we are unable to match what we can produce to what people are able and willing to buy.

A trade deficit means we are importing more than we are exporting. In the short term, this is good. We are getting something for nothing. But, in the long run, either the accounting is missing something, or we have to pay the piper. We have run increasingly large trade deficits for many years that are only starting to narrow. At first, the trade deficits merely counterbalanced previous trade surpluses, but we have long gotten past that point. Still, is the current economic funk and drop in consumer demand really driven by foreign financed debts on trade deficit creating purchases (a large share of which is oil consumption), coming due?

Most descriptive reviews of the current Great Recession don't point very strongly to demands for payment from foreign creditors of U.S. consumers and firms to be a driver of this downturn. Instead, the descriptive reviews point to a widespread domestic and domestically financed housing bubble, and to excessive, mostly domestic, overpromising and overleveraging in the complex parts of the finance sector. The complexity provides a place to look for foreign creditors placing a squeeze, very indirectly, on U.S. debtors. But, one would expect this to emerge more clearly if this was really the driving force behind the current state of the U.S. economy.

It seems more plausible that distortions in investment and housing prices driven by market failures caused the U.S. economy to invest its productive resources in the wrong things, and that the current recession is instead a classic "correction" in which we are realigning what we make in our economy with what we actually need. The problem is not so much consumer overspending, as it is excessive consumer spending in sectors like housing at the expense of consumer spending in other sectors (perhaps health care) where our needs are more urgent. This view is entirely consistent with massive excess inventories in many parts of our economy, and points to causes of the current recession driven by microeconomic distortions that are almost invisibile at the macroeconomic level, rather than macroeconomic consumer binging on a global scale.

In other words, in the pre-financial crisis boom, our increased productivity was an illusion because we were producing things that our economy didn't actually need, just as the Soviet Union did, to a greater extent, before its planned economic system collapsed.

Why care? Because different views regarding what is driving the recession suggest different solutions.

If the problem is a merely a decline in consumption, programs like the cash for clunkers and new home buyers credit make sense. We want to prop up consumption in sectors of the economy where consumption has collapsed.

But, if the problem is consuming the wrong things, however, this approach to government intervention merely sustains the pain. We ought to be pointing stimulus money at goods and services that we were underconsuming in favor of things like houses and cars before the financial crisis, rather than at trying to sustain dysfunctional spending. In this view, a big ticket, front loaded, health care reform bill may make better sense than stimulus designed to prop up construction, or the automobile industry, or other kinds of manufacturing. Yes, we need more consumption, but we need to encourage consumption of what we really need, rather than what we were previously encouraged by a broken mixed economy to spend too much on, like homes and home improvements.

The hard part, of course, is figuring out what we were spending too little upon before the financial crisis. Price bubble collapses and layoffs have made very clear what we were spending too much upon, but limits in our ability to ramp up production of goods and services that were being underconsumed as a result don't make themselves as obvious. Empirically, perhaps the most useful measure would be to look at who is not laying people off. Boosting economic capacity in those sectors would make more sense than sustaining overcapacity that the market is doing its level best to eliminate.

Further complicating this endeavor is the apparent trend that the public sector or heavily government funded sector is laying people off more slowly than many parts of the private sector. Is this because government spending reacts to the state of the economy more slowly than the private sector, or is this because we have simply been underspending on government provided or funded goods and services, like road and bridge repair?

There is a good case to make that fundamental underspending on government funded parts of the economy is driving relatively slow declines in government employment as the more financial and political causes of this trend.

The U.S. has one of the smallest public sectors in the developed world. The entire nation received a shock when a major urban bridge collapsed for want to maintenance. We have more people who aren't receiving health care than any major industrialized nation. Government services like public schools in new real estate developments typically take time to catch up with population growth, and we have experienced a long period of new real estate development. Our population is aging, and a large share of the old are heavily dependent upon government payments from Social Security, Medicare, SSI, and Medicaid; while older American have low rates of poverty due to these safety nets, those in the middle are less affluent than those in social welfare states with more generous government run or mandated pension plans.

It is also notable that public concern about overall levels of taxation in the U.S. are at a near record low. In most of recent U.S. history, a larger share of people have felt that they are overtaxed.

At any rate, in whatever form it takes, stimulus should advance the process of getting the U.S. economy into a "corrected" state, rather than retard it.

1 comment:

Michael Malak said...

Since it is widely accepted that the next bubble to burst is commercial real estate, the logical place for stimulus dollars is to give occupants of commercial space tax credits to offset property taxes (which are not adjusting downward fast enough due to the usual reassessment lag and due to stubborn landlords not yet admitting lower rents or sale prices). Such tax credits would keep commercial space occupied and preserve jobs.

I say this only as a short-term solution of course. We have Keynesian economy now, and we have to work with what we have. The long-term solution is a fully-reserved gold standard.