On Driving the Economy into a Brick Wall

Last Friday the University of Michigan reported a consumer sentiment measurement of 54.9 for August…down from 63.7 in July.  It has been quite a while since consumers have been so in the dumps.  In fact, consumer disposition has not been this down and out since May 1980, back when Jimmy Carter was making a mess of things in the White House.

No doubt, consumers have a lot of to be worried about.  For example, there’s high unemployment, stagnant to declining real wages, and, of course, those jokers in Washington who can’t seem to do anything right.  But what does this latest consumer sentiment reading really mean?

Axiomatically, negative consumer sentiment will lead to reduced consumer spending.  In an economy where consumer spending accounts for 70 percent of GDP a reduction in consumer spending will lead to little or no growth – or, perhaps, even contraction.  From our vantage point it appears the economy is rolling over.

Sure we could be wrong.  These things take time to fully express themselves.  But in hindsight it will be crystal clear…

Ten years from now, for instance, it will be absolutely evident that the economy’s contortions and flailings in the summer of 2011 are an extension of the Great Recession. Moreover, it will be totally clear that the Great Recession never ended…that all the bailouts and stimulus only temporarily suspended its ultimate collapse while running up the debt.

We wish this wasn’t so.  But, alas, it is…

Financial Crisis vs. Economic Crisis

The simple fact is the United States’ government has taken on too much debt.  They have over leveraged the economy to pay today for promises made yesterday with money borrowed from tomorrow.

Now they are headed for an epic financial crisis that will make the events of the past two weeks seem like a walk in the park.  To avoid – or limit – a massive financial crisis the government must reduce debt…it must deleverage.  But such efforts to minimize a weighty financial crisis in the future could increase the odds of a weighty economic crisis today.

Obviously, the government can deleverage by reducing spending.  They can also deleverage by increasing taxes.  Both of these options would likely result in economic distress, rising unemployment, and low growth.

In the United States a good portion of the economy has become reliant on years and years of ever increasing government spending.  Reducing this money flow would have negative consequences in the short term.  But eventually the economy would adjust and would be better for it.  But initially, cutting government spending will cause immediate pain.

Similarly, increasing taxes reduces economic growth by diverting private capital away from productive investment and to Washington where it disappears into the money sucking pit of government.  Increasing taxes may help reduce the deficit but it could also reduce economic growth.  A smaller economy with higher taxes is worse for the government’s financial problem than a bigger economy with lower taxes.

So ideally, somehow, someway, the government needs to deleverage its balance sheet without upsetting the economy.  If they can pull this off it would be one heck of a trick.  We don’t think this is possible.

On Driving the Economy into a Brick Wall

To correct the country’s finances the economy must be allowed to do what it must.  Clearly, reducing or eliminating government spending in many areas of the economy will further perpetuate the country’s financial problems.  As the economy declines, tax receipts will fall, and the debt problem may become even worse.  Yet attempting to prop it up has gotten us to where we are now, with a stagnating economy and an immense debt burden.

Sometimes changing directions is needed even if it redirects the economy into a brick wall. When unemployment began creeping up in the 1970’s the U.S. Treasury, with backing from the Federal Reserve, did what Keynes had told them to do…they spent money in the hopes of creating jobs.  But instead of jobs, something unexpected happened; they got inflation.  And when they tried it again, astonishingly, they didn’t get jobs…they got more inflation.

Leading economists of the day were flummoxed.  The Philips curve had told them there’s an inverse relationship between inflation and unemployment.  According to their models what was happening was impossible.  But it didn’t matter what their theories said…inflation and unemployment had both gone vertical.

In August of 1979 Paul Volcker took the helm as Chairman of the Federal Reserve.  No time before or since has the Federal Reserve been Chaired by a man who did other than the politically expedient.

Volcker talked tough and acted tougher.  He recognized that before economic growth could return the inflation fire must be snuffed out…even if doing so meant higher unemployment in the short run.  In the face of a wave of criticism, and being burned in effigy on the Capitol steps, Volcker implemented economic ‘tough love’.

Volcker raised the federal funds rate from 11.2 percent in 1979 to a peak of 20 percent in June 1981…sending the prime rate to 21.5 percent in 1981 and the economy into a severe recession.  Remarkably, for two long years, as rates went up, inflation did too.  But, finally, in 1983, inflation was controlled.  Soon after, economic growth returned and unemployment fell.

Today’s challenge faces a similar choice.  To get the nation’s finances in order will require temporarily hurting the economy.  It will also require tough love in Congress to reduce spending even when doing so makes things worse.

We aren’t counting on Congress to have the guts to do this.  Instead they’ll likely continue to kick the can, which will eventually require the Federal Reserve to print money to service the debt.  After that the whole financial and economic system with blow up in a blazing heap.  After that things will really get ugly.

Sincerely,

MN Gordon
for Economic Prism

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