THE ECONOMY & THE MARKETS

by Bill Breakstone, July 2, 2010

Former Fed Chairman Alan Greenspan appeared on the CNBC program Squawk Box yesterday morning. Hosts Joe Kiernan, Becky Quick and Carl Quintenella, and guests sat in awe as Greenspan made his comments on the state of the economy. Why these TV talking heads should be so humbled by a former official who had such a lack of foresight and philosophical intelligence in dealing with the lead-up to our financial crisis is baffling to me. In any case, the former “guru” of the financial world had little of substance to say, other than he thought that Wall Street was not a good economic indicator going forward. He stressed the importance of the asset value of 401K’s instead, which have increased significantly over the past year.

Well, Alan is getting up there in years, and it seems he relies more on his former reputation rather than on his present insights. The relative value of investor assets speaks of past appreciation. The movement of markets, on the other hand, is an indication of how the financial community views future prospects, even if they are short- rather than long-term.

Greenspan’s thoughts are not what drive me to write this essay. Rather, it is the concerns that many economists and legislators have about our present economic and social outlook.

Robert Samuelson wrote an interesting and highly pertinent op-ed in the Washington Post on June 28th. He wrote: “Almost everyone wants the world’s governments to do more to revive ailing economies. No one wants a “double dip” recession.” Unemployment among OECD countries currently stands at 46.5 million people, up about 50 percent since 2007. “Lengthy unemployment may erode skills, leading to downward mobility or permanent joblessness. But what more can governments do? It’s unclear. We may be reaching the limits of economics. . . . . Granted, the initial response to the crisis (sharp cuts in interest rates, bank bailouts, stimulus spending) probably averted a depression. But the crisis also battered the logic of all major theories: Keynesianism, monetarism and “rational expectations.” Economics has become a shaky science.”

“Consider the matter of budgets. Would bigger deficits stimulate the economy and create jobs, as standard Keynesianism suggests? Or do exploding government debts threaten another financial crisis?”

“The Keynesian logic seems airtight. If consumer business spending is weak, government raises demand through tax cuts or spending increases. But in practice, governments’ high debts impose financial and psychological limits. The ratio of government debt to the economy (gross domestic product) is 92 percent for France, 82 percent for Germany and 83 percent for Britain, reports the Bank for International Settlements in Switzerland.”

This means that the benefits of higher deficits can be lost in many ways: through higher interest rates if greater debt frightens investors; through declines in private spending if consumers and businesses lose confidence in governments’ ability to control budgets; and through a banking crisis if bank capital—which consists heavily of government bonds—declines in value. There’s a tug of war between the stimulus of bigger deficits and the fears inspired by bigger deficits.”

In America, the current administration is concerned about both alternatives, but leans toward its present focus on continuing the fragile recovery and dealing with the deficit two years or so down the road. On the other hand, EU countries have decided to deal with the deficit and their budgets now.

Samuelson comments: “That’s lunacy, writes Martin Wolf, chief economic commentator for the Financial Times. Concerted austerity may destroy the economic recovery. Exactly, echoes Nobel Prize-winning economist and New York Times columnist Paul Krugman, who argues that the U.S. economy needs more stimulus and bigger deficits. “Penny-pinching at times like this . . . . ,” he writes, “endangers the nation’s future.”

“Not so, counters Harvard economist Ken Rogoff. President Obama’s stimulus package may have “helped calm the panic” in 2009, but boosting spending now—raises “the risk of having a debt crisis down the road.” Deficits should be trimmed gradually, he argues.”

Well, more stimulus spending at this point is totally out of the question, despite Krugman’s advice. It’s just a political impossibility, and Obama and his economic team are well aware of that. But as Samuelson says: “The disconnect between theory and reality seems ominous. The response to the initial crisis was to throw money at it—to lower interest rates and expand budget deficits. But with interest rates now low and deficits high, what happens if there’s another crisis?”

Increasing frustration is being aired by economists and financial commentators who lean to the Keynesian side of the argument, as evidenced by Paul Krugman’s op-ed in this morning’s New York Times. As of the opening of Wall Street markets this morning, the S&P index had declined 12% from its mid-May highs, and as I write this at 2:40 P.M., the S&P is off another .65% and the Dow off .70%, both indicators edging closer to bear market levels. More and more people on the Street are seeing the feared “double-dip” as a likely scenario, despite Fed Chair Bernanke’s view that such is highly unlikely. Remember, Bernanke was wrong before—he failed to realize prior to the 2008 crash that the economy was headed towards dire straits.

David Leonhardt wrote a lengthy front-page article in yesterday’s New York Times that highlights the differing views among economic experts as to the best approach that world governments are taking in response to the continuing financial crisis. He looks back to government policy from 1933 to 1937, when economic recovery was short-circuited by increased taxes and budget balancing, which all economists now agree extended the Great Depression until spending leading up to WWII turned the tide. Differences exist between world economies then and now, but no one is sure if the differences are at all meaningful. As I asked in a previous article some three weeks ago, “Is history repeating itself?”

No one has a definitive answer to that question, but the markets are indicating that the path world governments are now pursuing is deeply troubling. And despite the fact that Greenspan discounts the meaning of market movements as a leading economic indicator, we must “listen to what the Street is saying.”



As Leonhardt writes at the conclusion of his piece “We are left to hope that we have absorbed just enough of the 1930s lesson.”