NAVIGATING THROUGH TROUBLED ECONOMIC WATERS

Bill Breakstone, July 5, 2010


BACKGROUND

The United States is currently dealing with three crises—economic, financial and political in nature.

First, on the economic front, we face a period of prolonged joblessness. Officially, the high mark in unemployment was reached in April of this year, at a mark of 10.1%. Since then, the rate has declined to where it now stands at 9.5 percent. However, as the lead editorial in this morning’s New York Times points out: “Even a drop in the unemployment rate, from 9.7 percent in May to 9.5 percent in June, represents a pullback, not an improvement. The rate fell because 652,000 people left the work force last month. Since they were neither working nor looking for work, they were not counted as unemployed. If they had been counted, the jobless rate in June would have been 9.9 percent.” Further, the official data does not take into account those who are working in temporary positions who would prefer full-time employment.

There also is an escalating decrease in aggregate demand. Retail sales are falling, new and existing home sales have resumed their decline, significantly, and auto sales over the past six weeks have fallen off a cliff after rising substantially due to economic incentives which have now expired. To add to these woes, consumer confidence levels have declined significantly.

Our second crisis is of a financial nature. The stock market has dropped to near bear market levels, loosing 16.5 percent since reaching their mid-April highs. A partial explanation of this decline is that the markets are pervaded by a level of uncertainty as to in what direction the economic policymakers are heading, both in America and on the world stage. Prominent in this regard is the apparent emphasis on the part of European Union countries to focus on debt reduction and austerity programs that may stifle the economic recovery overseas.

The third item in the equation is a political crisis here in the United States which has been marked by legislative paralysis and watered-down legislation that will have a less-then-desired effect on regulatory reform. The Congressional opposition is focused on regaining the majority position through the mid-term November elections and the 2012 Presidential elections thereafter. In the process, they are putting aside national priorities and the economic well-being of the Nation to pursue purely political objectives.


THE GREAT DEBATE

Yesterday, Fareed Zacharia hosted two guests in a prolonged 40-minute segment of his excellent program GPS. His lead-in went as follows:

“I believe that we are all watching a major policy experiment unfold, perhaps the most important in decades. You see, the governments of the world’s largest economies seem to be set to begin withdrawing the money that they had started spending last year to rescue their economies. This is happening in the United States, China, Europe, and it is turning into a test of two profoundly different views of economics.”

“The first that is apparently being adopted by the G-20 countries says we have to start paying down our debts because otherwise the cost of borrowing money will get prohibitively high. Today it’s Greece, tomorrow it’s us.”

On the other side are those who are saying this is crazy. Cutting government spending will put the economy in a tailspin. It will lower growth, lower confidence, and it will produce persistent and rising unemployment.”

“So should the government worry more about unemployment today or the bond markets tomorrow?”

“The two most important intellectuals in this debate are Paul Krugman, the Nobel Prize-winning economist, New York Times columnist, Princeton professor on the one hand, and Niall Ferguson, the Harvard historian, business school professor and author, on the other.”

Krugman was first to be questioned. Putting the current state of affairs in perspective, he said “This is—really, this is—we’re –we’ve just experienced the—probably the—only the third really global financial crisis, again, 1873, 1929, and now this one. And we’re responding to it in ways that almost guarantee, unless we do a u-turn on policy, guarantee that this is going to be another period like that.” [The crises of 1873 and 1929 were both categorized as Depressions.]

Asked why he worries so much about unemployment, other than the human cost, Krugman explained: “If a worker’s been out of the workforce for three, four years, it’s going to be very hard for that person to get back in. The job references will be bad. The—the experience will—will be lost. We’ve seen that happen in European countries that had high unemployment and by the time they finally started to get it down again some of the unemployment have basically become structural . . . . if we don’t deal with this now, we may find that 7, 8 percent unemployment is the new normal. The other thing is that each—each year that we go on like this, we’re drifting closer to deflation.”

“We came into this crisis with underlying inflation, around 2.5 percent, which is good. You want a little bit of inflation, gives you more flexibility. That’s now down under 1 percent. It quite easily could be negative by the end of next year.”

Zacharia then stated “I think a lot of people have trouble with, with the United States running a budget deficit of 10% of GDP, with debt to GDP ratios moving up into the 60, 70 percent range, . . . . and yet you’re saying that what we need is more—significantly more government spending” to insure the economic recovery lasts.

To which Krugman replied: “We do have a long-run budget problem. So, you know, the starting point is to acknowledge that, that there is a problem, that if you ask about the state of the U.S. public finances 15 years from now, under current policy, it looks pretty grim. So something has to be done.”

“The question is what about now? And if we skimp on supporting the economy now, first of all, we deepen these problems. We make higher unemployment. We reduce the long-tern prospects. Secondly, we do amazingly little to improve our long-run budget position. . . . . Yes, let’s—let’s have serious fiscal adjustment but not until the economy has recovered.”

Critics on the other side of this economic argument have said that Krugman was advocating that public policy should be aimed at getting people to borrow again, even if they were borrowing too much in the first place. Why pump up an unsustainable situation? These people, these companies should be coming back down to more manageable levels of debt, and that’s just going to take a while.

To which Krugman replied: “But why should lots of perfectly good, productive capacity and millions of perfectly productive workers who have things to do that we all need be left unemployed while we do that adjustment? . . . . Why should we have mass unemployment of schoolteachers, of automotive workers, of—you know, of all these parts of the economy that had nothing to do with the bubble but are now caught up in the tailspin as the economy suffers the aftermath of the bubble? Why should these people be left unemployed?”


A BRIEF DIVERSION INTO ECONOMIC THEORY

Nouriel Roubini is a renowned economist, oftentimes referred to as “Dr. Doom” among his colleagues for his persistent warnings of the financial collapse over the period leading up to our current crisis. He is currently a professor of economics at NYU’s Stern School of Business. Along with his associate, Stephen Mihm, is has authored the current economic bestseller Crisis Economics.

Chapter 2 of their book briefly tells the story of what they call “Crisis Economists.” We read about John Stuart Mill, Karl Marx, John Maynard Keynes, and Milton Friedman and Anna Schwartz, whose economic theories are well-known to economic specialists and lay people as well. No need here to make a long essay even more so.

The authors also go on a bit about economists generally referred to as “The Austrian School,” far less well known and read, but equally important, especially in regards to the current debate we’re addressing here. Proponents of their line of thought include Carl Menger, Ludwig von Meises, Eugen von Bohm-Bawerk, the more well-known Frederich Hayek, and his student, Joseph Schumpeter.

The ideology of “The Austrian School” is highly pertinent to the comments that will follow from Zacharia’s other guest, Harvard’s Niall Ferguson, thus some extended quotes from Crisis Economics are appropriate:

“Being an Austrian economist today is tantamount to holding libertarian economic beliefs. Indeed, a deep skepticism of government intervention in the economy—especially in the monetary system—is a pillar of the Austrian School.”

Though he was hardly a libertarian, Joseph Schumpeter developed a powerful theory of entrepreneurship that is often distilled down to a pair of powerful words: creative destruction. In Schumpeter’s worldview, capitalism consists of waves of innovation in prosperous times, followed by a brutal winnowing in times of depression. This winnowing is to be neither avoided nor minimized: it is a painful but positive adjustment, whose survivors will create a new economic order.”

“Austrian School economists make a historical case that the policy response to the recent crisis will eventually give us the worst of all worlds. Instead of letting weak, overleveraged banks, corporations, and even households perish in a burst of creative destruction, thereby allowing the strong to survive and thrive, governments around the world have meddled, creating an economy of the living dead: zombie banks that cling to life with endless lines of credit from central banks; zombie firms like General Motors and Chrysler that depend on government ownership for their continued survival; and zombie households across the United States, kept alive by legislation that keeps creditors at bay and that spares them from losing homes they could not afford in the first place. In the process, private losses are socialized: they become the burden of society at large and, by implication, of the national government, as budget deficits lead to unsustainable increases in public debt.”

”Economists of the Austrian persuasion are also deeply skeptical of the rush to regulate that so often occurs in the wake of a crisis. In their view, too much regulation was the cause of the crisis in the first place, and adding more will only make future crises worse.”

“From the Austrian perspective, the fear now is that the United States is heading down the road that Japan paved in the 1990s, when it responded to its own slow-motion financial crisis by propping up zombie banks and corporate firms and by dropping interest rates to zero, flooding the economy with yet more easy money. The government also ran enormous fiscal deficits to finance the kind of stimulus spending that Keynes prescribed. Instead of allowing “creative destruction,” the Japanese built bridges to nowhere that merely put enormous amounts of debt on the shoulders of the national government. The result, the Austrians maintain, was Japan’s Lost Decade.”

Quite a line of thought, no? AND completely devoid of any concern for human suffering! Compare it to Keynesian theory, where concern for the innocent victims of financial catastrophe is paramount.


BACK TO THE GREAT DEBATE

Fareed Zacharia now points out to his next guest, Niall Ferguson: “So you have an economy that seems to be slowing. Private sector job creation is very low. The consumer, who is 70 percent of the American economy, is spending a little bit more than he or she was a year ago but not enough to get us out of the woods. Interest rates are very low, so the Federal Reserve can’t really pull interest rates lower. What is really left than a second stimulus?”

To which Ferguson answers: “The question which is absolutely crucial here, Fareed, is what is the next move going to be? Are we going to try and play that Keynesian card again and have another fiscal stimulus, or are we just going to come to terms with the reality that there probably have to be tax increases and spending cuts pretty soon if the United States is to retain some kind of fiscal credibility in the international bond market?”

“So in some ways, if you think of a financial crisis as a chain reaction, as something that goes from one phase to another without ending happily and quickly, we’re entering a new and really quite scary phase. Europe is already in this phase. The fiscal crisis, which is the next big phase of the crisis, is happening there now. The worry is that at some point in the next two years something similar is going to happen here and the U.S. is not going to have a Keynesian stimulus option anymore.”

“I would say that the U.S. has a kind of stay of execution while the European crisis unfolds, but at some point the nasty arithmetic will get any country, even the United States, which is seen as, of course, the most attractive, the most safe haven country to invest in. I’ve been saying for a while that U.S. treasuries are a safe haven the way Pearl Harbor was a safe haven in early 1941. It’s safe until it’s not safe. It’s safe until the bond market says wait a second, this isn’t sustainable, we’d like a risk premium. Once you suddenly find your interest payments rising, it’s very quickly a—a shift into a death spiral, a kind of tailspin in which things compound. The Greeks have been there. Spain is there now. Japan could be next. The U.K.’s teetering on the brink. And at some point I think in the next couple of years, the reality will be that the Paul Krugman recipe ends up having costs that exceed the benefits.”


AN ALTERNATIVE PATH FORWARD

Zacharia credits both Krugman and Ferguson with valid points worthy of consideration. However, he sees another choice, and he is far from alone in his position.

“I think the case for government spending in the short term is pretty strong. The private sector is simply not hiring yet. Consumers are also being very cautious. You can’t motivate either of them any further with the traditional tools that used to be used, lowering interest rates, because interest rates are already close to zero. If the government were to slash spending in this atmosphere, it would probably send the economy into a tailspin.”

“So I have a proposal, a kind of grand bargain. Have a second stimulus that is targeted, temporary and effective, and most important, announce the second stimulus coupled with an announcement from the president of a 10-year plan to tackle the budget deficit. This would include significant reductions in entitlement spending, cuts in wasteful subsidies like agriculture, and a new gas tax and a small national sales tax. These measures would dramatically adjust the budget deficit, and they would assure markets that the United States has gotten serious about living within its means in the medium to long run.

“Some will say that we can’t calibrate policy that carefully, that we’re not capable of that level of sophistication. This cannot be true. We are living through an incredibly difficult set of economic challenges, the worst in generations. We have to be able to put forth the best solutions, not simply the ones that are politically feasible.”

“I refuse to accept that the only government in the world that can act sensibly for the long run is a dictatorship in Beijing. President Obama has said that the real need is not for big government or small government but smart government. So here’s his chance to demonstrate that proposition.”


OTHER VIEWS

An article in this morning’s New York Times quotes Mark Zandi, the chief economist at Moody’s Economy.com, as advising the House Budget Committee last week: “It is important—in fact I’d say it’s vital—that you continue to provide additional temporary stimulus to the economy.” But he added, “Once the economy is on a sound footing, it is critically important that you do pivot as quickly as possible and address the long-term fiscal situation.”

The article then goes further: “David M. Walker, the president of the Peter G. Peterson Foundation, an organization that has focused on cutting long-term deficits, said the “myth that we cannot address our current economic crisis and our long-term fiscal crisis at the same time” had become an obstacle to bipartisan agreement. In our view, the answer is to continue to pursue selected short-term initiatives designed to stimulate the economy and address unemployment, but to couple these actions with specific, meaningful actions designed to resolve our long-term structural deficits,” Mr. Walker testified last week to the National Commission on Fiscal Responsibility and Reform, the bipartisan panel named by Mr. Obama.”

Finally, the advice of Roubini and Mihm in Crisis Economics:

“The insights of both schools [Keynesianism and the Austrian School, and really the deficit hawks as well] can be synthesized and brought to bear on the problems we face now; indeed, the successful resolution of the recent crisis depends on a pragmatic approach that takes the best of both camps, recognizing that while stimulus spending, bailouts, lender-of-last-resort support, and monetary policy may help in the short term, a necessary reckoning must take place over the longer term in order to achieve a return to prosperity.”