Monday, October 26, 2009

The State of the Economy and Supply Side Concerns

Several of the aggregate economic indicators are indicating that the economy has bottomed out. Industrial Production seems to have hit a bottom in June 2009 as the year-over-year rate of decline on a seasonally adjusted basis was -13.3%. Since then the negative rates of growth have fallen: in August the rate of decline was -10.4% and in September this rate dropped to -6.1%. The index has actually increased, month-over-month, beginning in July.

The decline in real Gross Domestic Product (GDP) lessened in the third quarter this year on a seasonally adjusted year-over-year basis. The greatest year-over-year decline came in the second quarter of 2009 when real GDP fell at a 3.8% annual rate over the second quarter of 2008. The first look at the third quarter number is to be released on Thursday. According to the Wall Street Journal, estimates for the third quarter over the second quarter annual rate of increase stand at a positive 3.1%. If this quarter-over-quarter rise takes place, the year-over-year rate of decline for the third quarter of 2009 will be -2.4%.

On the surface, it does look at this time as if the third quarter of 2009 will be declared the beginning of the economic recovery in the United States.

That is the good news.

The not-so-good news, to me, is the extent of the recovery. There are some areas we need to keep our eyes on in order to help us understand what is going on in the economy. These are the “supply side” conditions that indicate something else is happening in the economy other than just an economic recovery. They are conditions that tell us that some economic dislocations exist that will have to be resolved in the future if the United States economy is going to become robust once more.

The first of these areas has to do with our manufacturing capacity. Capacity utilization in September of this year stands at 70.5%, up from the trough of about 68% in June. So, capacity utilization has begun to increase.

The problem is that this capacity utilization is at a post-World War II low! But, even more important is that the previous peak in capacity utilization came in the 2005-2006 period but was just over 80% at that time. And, this peak was down from the 85% capacity utilization of the 1995-1997 period and the 1988 period. And, these peaks were down from the 87% capacity utilization of the 1978 period, which was down from the 89% rate of the 1974 period and the 90+% of the middle 1960s.

The United States has seen over the past forty years or so a deterioration of its industrial base. There is a lot of idle capacity that is in place but, for various and sundry reasons, is not being used. We can address some of these reasons in forthcoming posts. The important concern to me is that in the economic recovery we will not even us get back to the 80% range of capacity utilization. The implication of this is that unemployment will not fall as much as we would like and that business investment spending would not be very robust because firms won’t need manufacturing capacity, they already have it.

This would lead one to the conclusion that business spending will not be too strong in the recovery. But, it is a supply side problem, not a demand side problem.

And, speaking of employment, there is an unused capacity problem as far as the labor market is concerned. The official unemployment rate, the total unemployed as a percent of the civilian labor force, stood at 9.8% in September 2009. The rise over the last year is from 6.0% in September 2008.

The total unemployed, plus all marginally attached workers, plus total employed part time for economic reasons, as a percent of the civilian labor force plus all marginally attached workers is 17.0% in September 2009 up from 10.6% in September 2008. That is, there has been a substantial increase in persons who are neither working, nor looking for work but indicate that they want a job and are available, discouraged workers and people working part time who would like to work full time.

There is a lot of unused capacity in the population as a whole. From everything we are hearing, the marginally attached and the discouraged do not have too much to hope for in the upcoming economic recovery and this doesn’t even consider the expected rise in the official unemployment rate.

The conclusion one can reach from these data is that whatever has been going on in the United States for the past 40 or 50 years has not been totally healthy for the supply side of the economy. Basically, the past 40 or 50 years has seen a lot of inflation. Since January 1961, Consumer Prices in the United States have risen by 625%, or, in other words, the real value of a dollar has decline by 86% since then.

One could easily make the argument that whatever went on in the United States over this period, it was a period of extended inflation and that such an environment was not the most productive one for economic resources. This environment resulted in a lot of unused productive capacity, in terms of physical resources but also in terms of human resources.

Current policy is doing what has been done consistently in this period, emphasized a demand side bias. An inflationary policy, created using fiscal and monetary policy to stimulate aggregate demand, has been the response to the economic slowdown. And, the policy attempts to achieve higher rates of employment by putting resources back to work at their old functions. Of course, this cannot be fully achieved as technology and other efficiencies allow new jobs to be created that do not use the old skills, or old jobs to be eliminated and excess capacity to grow. Thus, capacity utilization continues to drop and those in the workforce that are discouraged from seeking a job remain unfulfilled.

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