The United States Economy Will Continue to Grow

I believe, as I have written before, that the United States economy is recovering and will continue to recover. 

However, I also believe that “financial crises are protracted affairs.” (Reinhart and Rogoff, “This Time is Different”, page 224.)

Why don’t I believe that there will be a “double dip” recession, a 1937-38 depression like the one following the 1929-33 Great Depression?

In the case of the 1930s, there were policy errors committed that resulted in the 1937-38 depression: the most prominent one being the effort of the Federal Reserve to eliminate all the excess reserves being held by the commercial banks at that time so that the Fed would have more “control” over the money markets.

Unfortunately, the banks wanted those excess reserves around even though they were not in the mood to expand their lending activities.  As a consequence, when the Fed attempted to remove those excess reserves by raising reserve requirements, the banks cut back even more on their lending activities in an effort to achieve the financial protection they believed those excess reserves brought them.    

This has not happened in the current situation because Fed Chairman Ben Bernanke (a student of the Great Depression era) and the Fed have done just about everything possible to make sure that the banking system is flooded with excess reserves so that a similar contraction of the banking system does not occur.  There are questions about what this means for the future, but we are not at that future yet.

So, I believe that the economic recovery will continue.

The economic recovery, however, will not be robust.  One reason for this is the debt overhang that exists in the private sector.  David Brooks speaks to this point in his Tuesday morning column in the New York Times. (http://www.nytimes.com/2011/10/18/opinion/the-great-restoration.html?_r=1&hp) 

“Quietly but decisively, Americans are trying to restore the moral norms that undergird our economic system.

The first norm is that you shouldn’t spend more than you take in. After an explosion of debt over the past few decades, Americans are now reacting strongly against the debt culture. According to the latest Allstate/National Journal Heartland Monitor poll, three-quarters of Americans said they’d be better off if they carried no debt whatsoever. Not long ago, most people saw debt as a useful tool for consumption and enjoyment. Now they see it as a seduction and an obstacle.
 
By choice or necessity, eight million Americans have stopped using bank-issued credit cards, according to The National Journal. The average credit card balance has fallen 10 percent this year from 2010. Banks, households and businesses are all reducing their debt levels.”

This same phenomenon is occurring in the world of state and local governments, and the non-profit world.

How is spending going to expand within the context of this kind of behavior?

The general fundamentalist Keynesian response to this is that the federal government needs to do more to stimulate the economy.  The argument is that government spending actually needs to be much greater than is being proposed at the present time.  The people that are making this argument also state that the economic recovery in the 1930s was as slow as it was because the government did not spend as much as it should have back then.  Government expenditures will never be large enough for these people. 

But, how is more government debt going to change the picture?  As Reinhart and Rogoff state in their book, “the value of government debt tends to explode” (page 224) in the aftermath of any severe financial crisis anyway.   

The reason is that as incomes drop, tax revenues decline and the government deficit increases. 
But, greater deficits mean greater interest and principal payments in the future, and someone like Robert Barro argues that this will mean more taxes for the private sector in the future so that current savings will increase even further to offset this future obligation.     

Even if the private sector does not fully discount future taxes into their current spending plans, people may just accelerate their efforts to save to provide themselves with more flexibility to manage their financial affairs in an uncertain future world dominated by huge government debts. 

The problem that results from this scenario, in my mind, is that given the behavior of the Federal Reserve System there is lots and lots of cash floating around in the economy, but this cash is not in the hands of those people and businesses that are trying to restructure their balance sheets.  Because, this cash is not in the hands of those people and those businesses that are trying to restructure their balance sheets, the fundamental economic recovery will continue to be modest. 

Thus, you have lots and lost of cash looking for places to invest where there are very few “productive” places for the money to go.  So, money seems to be chasing assets.  However, the uncertainty seems to be causing other problems and this is resulting in increased market volatility. (http://professional.wsj.com/article/SB10001424052970203658804576637544100530196.html?mod=ITP_pageone_0&mg=reno-secaucus-wsj)

“The problem is a lack of liquidity—a term that refers to the ease of getting a trade done at an acceptable price.

Markets depend on there being many offers to buy and sell a particular stock, across a range of prices. But as investors have gotten nervous, many of those offers have dried up. That is causing wider-than-normal gaps between prices showing where stocks can be bought and where they can be sold—the difference between the "bid" price and the "ask" price.

Many big investors, such as hedge funds and mutual funds, which at times can act as shock absorbers for trading because they tend to trade large chunks of stocks, have been on the sidelines. Some hedge funds, for example, say they're not trading as much until they know how much money their clients will withdraw at the end of October, a deadline some clients have to inform funds of intentions to redeem money at year-end. “

In my mind, the economic recovery is going to continue on its slow path.  But, given all the money around and given the general impatience that is attached to this money, wide swings in asset prices are going to continue well into the future, especially if the Federal Reserve really keeps interest rates as low as they are into the middle of 2013.

Patience is not an attribute of traders…and of politicians…but that is another story.

Our Two Choices

It seems as if our policy choices have been reduced to two.  First, our basic problem is that there is too much debt outstanding, debt of consumers, debt of businesses, and debt of governments…state, local, and national.  According to Ken Rogoff of Harvard (and co-author of the book “This Time is Different”), “By far the main problem is a huge overhang of debt that creates headwinds to faster normalization and post-crisis growth.” (http://www.ft.com/intl/cms/s/0/1e0f0efe-c1a9-11e0-acb3-00144feabdc0.html#axzz1UdDrJfzK)

During the past fifty years of credit inflation, the incentive existed for economic units to increase financial leverage.  Consequently, we have reached an extreme position of financial leverage, one that many believe is unsustainable.  As Rogoff claims, people attempting to reduce this “huge overhang of debt” will not borrow, will not spend, and this will result in a period of time in which economic growth and the expansion of employment will be modest at best, and downright slow at worst.

The resulting policy choice, therefore, is to allow the debt reduction to take place and let the economy adjust to more “normal” levels of debt.  This “adjustment” is going to have to take place some time and the best thing for the future of the economy is to let it adjust naturally for this adjustment must take place sooner or later.  By not allowing it to take place, we just postpone the final day of reckoning.

The second policy choice is to pursue a significantly aggressive program of credit inflation, one that would force people and businesses to return to borrowing and hence to spending.  Such a policy would help to accelerate economic growth and put people back to work.

This argument is based on the assumption that the United States cannot afford the consequences of a long, slow period of debt reduction and a lengthy period of mediocre economic growth.  The cost of following a “do-nothing” policy in terms of human suffering due to the unemployment and social dislocation created by such a policy would be unacceptable.

The second policy has been the approach taken by the Obama administration, arguing for a resumption of credit inflation, both in terms of government deficits and in terms of expansionary monetary policy.  The question that supporters of this policy debate about is the degree of the credit inflation.  The Obama administration, itself, has tended to follow a more modest level of credit inflation whereas its liberal critics have argued the Obama team has been too timid in how much credit inflation should be imposed on the economy.

Here we get into a debate over timing.  The first policy is needed, according to its proponents, because that is the only way the United States will regain its competitiveness and be able to go forward with the finances of its people in a strong position.  Following the second policy would only postpone the adjustments needed and leave the “day of reckoning” somewhere out there in the future.

The supporters of the second policy argue that we cannot allow economic growth to be so low and unemployment stay so high because of the human cost.  We need to address this now and worry about the debt re-structuring problem later.

The concern over the second policy program has to do with the “tipping point.”  Let me explain.

Right now, the debt overhang appears to be the predominant force in the economy.  Consumers, at least a large portion of them, are not borrowing and spending because of the debt loads they are carrying. (The wealthier consumers seem to be going along fine, thank you.) They are increasing savings in an attempt to get their balance sheets back in line.  Small- and medium-sized businesses are not borrowing to any degree, are not hiring people, and not expanding much at all because they have too much debt on their balance sheets and are trying to keep their heads above water.  Many state and local governments are facing real budget crunches and are cutting back on employment and capital expenditures because of their legal obligations. 

The government fiscal stimulus programs initially attempted by the federal government have been ineffective and disappointing, at best.  The efforts of the monetary authorities to generate bank lending have also been exceedingly ineffective despite historically extreme injections of liquidity into the banking system. Those people supporting the “second policy” continue to call for even more credit inflation whether it be for an new round of “quantitative easing” on the part of the Fed or some other innovative uses of monetary policy. 

The problem with the “tipping point” is this: how severe the tipping point will be if/when the new efforts at credit inflation overcome the efforts of economic units to restructure their balance sheets and eliminate the “debt overhang” connected with the past fifty years of credit inflation. 

The current policy makers seem to believe that the “tipping point” can be managed and the adjustment from debt restructuring to further borrowing can become incremental.  That the trillion or so dollars injected into the banking system by the Federal Reserve can be smoothly removed from the banks once borrowing from them picks up steam.   In this way, faster economic growth could resume again and employers could begin hiring workers at a speedier pace.  

The alternative view is that the “tipping point” cannot be “managed” and that once the gates are open, borrowing will only accelerate and credit inflation will get “out-of-control”, given the magnitudes of liquidity already pushed into the financial system.  Does this mean hyper-inflation?

This discussion leads to a question about whether or not the current policy makers can recognize the “tipping point” (let alone anticipate it) and whether or not they can then smoothly remove all the excess liquidity that has been forced into the banking system.

If one is to look at the record of Chairman Bernanke and the Federal Reserve system one cannot have very much confidence that they will be able to recognize a turning point let alone manage their way through the “tipping point”.  Historically, Chairman Bernanke has had trouble recognizing bubbles, stays with a policy stance far too long and then over-reacts.  Take a look at what happened before the financial crisis of 2008.  The “housing bubble” and the “stock markets bubble” in the middle 2000s were not recognized by Bernanke or the Fed.  Bernanke and the Fed fought the “fear of inflation” for too long into the initial stages of the financial collapse.  And, then Bernanke and the Fed had to over-adjust to the financial crisis they contributed to by “throwing open the windows…and the doors…and whatever…at the Fed” in order to “save the world”. 

Managing a “tipping point”, I would argue, is not one of Ben Bernanke’s strengths.  But, governments, I would argue, are not very good at managing “tipping points.” 

Where does that leave us?  Between a rock and a hard place. 

The government will continue to try to alleviate the suffering of those that have been hurt in the Great Recession and its aftermath.  The Obama administration and the Democrats and the Republicans will compromise on a policy that can still be labeled credit inflation.  The Federal Reserve will continue to look for ways to stimulate bank lending.  And, the only way I can characterize this situation is one of HIGH RISK.  Volatility is going to continue to dominate the financial markets over the next two years or so for the very reasons I have cited above. 

The reason for this is the timing of the “tipping point.”  The private sector is going to continue to push for balance sheet restructuring.  The government is going to continue to push for more and more credit inflation.  This leaves the future highly uncertain.  Consequently, markets will move this way and that way until some leadership and stability are brought into the picture.