May 29 2008
Archive for May, 2008
May 26 2008
It seem that everyone’s speculating about the US economy today. Recession or no recession, that is the question. The economy has even surpassed the Iraq War as the number one issue in the US presidential race! John McCain, who has publicly admitted that economics is not his strong suit, may just find himself in trouble in a general election where the most important concern among voters is the economic situation.
So what IS that situation, anyway? Is the US in a recession? In other words, has real gross domestic, or total output in the US economy, actually declined over the last six months? Technically, the answer is no. My fellow blogger, Steve Latter, explains this clearly here. What is true, on the other hand, is that the current situation shares many similarities to the global economic slowdown that did occur in the 1970s.
In 1973 OPEC, the newly formed oil cartel consisting at the time of only Arab states, reduced its output of oil and cut off exports to the United States in response to US support of Israel in the Yom Kippur War, in which the Israelis officially occupied the Palestinian territories of the West Bank and Gaza and seized the Golan Heights from the sovereign nation of Syria. To punish the US for its position on this conflict, OPEC cut off supplies of oil to the west, driving gas and energy prices upwards by 70%, triggering a supply shock characterized by a decline in total output and an increase in both unemployment and inflation, a phenomenon known as stagflation: a macroeconomic policy maker’s worst nightmare.
Recently the world has seen a similar (albeit of a different cause) rise in the price of oil and energy prices. Today the rise in energy prices is driven primarily by rising demand, rather than reduced supply (since the 1970s the OPEC cartel has grown to include many non-Arab nations, making it harder to achieve collusion to restrict output and drive up oil prices). Global demand for oil has risen steadily, driven ever higher due to rapid growth in China and other developing nations, and exacerbated by the falling value of the dollar, the currency in which oil prices are denominated.
The supply shocks of today have combined with falling aggregate demand in the US due to weak consumer spending to slow real growth rates to nearlry 0%. So technically, the US has avoided a recession, but the effect on American workers and consumers may be just as painful as the real recession of the 1970s. In order to prevent the “r” word from becoming a reality today, central banks (including the US Fed) have eased money supplies, lowering interest rates, fueling even greater increases in the price level.
…the global weighted average inflation rate will be 5.4 per cent this year, while the global money market interest rate is currently only 4.3 per cent. This means that global short-term real interest rates are negative – at a time when inflation is rapidly accelerating. As monetary policy has been excessively accommodating for more than a decade, inflationary pressures have built up in the global economy.
Central bankers like Ben Bernanke have to make tough decisions sometimes, weighing the trade-off between unemployment and inflation, and determining their monetary policies based on whatever they deem to be the “lesser of two evils”. Rising energy prices have forced firms to cut either cut back their production and raise the price of their products, both actions that result in less overall spending and output in the economy. Falling house prices have led consumers to cut back their own spending, further reducing demand for firms’ output. These factors have all pushed the unemployment rate from around 4.8% a year ago to 5.1% today, which combined with an estimated additional 3-5% of American workers having dropped out of the workforce, (referred to by the Department of Labor as “discouraged workers”) paints a pretty ugly picture of the reality for the American worker today.
The harsh reality of the weak labor market has led Mr. Bernanke and the Fed to pursue an expansionary monetary policy aimed at avoiding further increases in the unemployment rate and decreases in the GDP growth rate. Expansionary monetary policy means lower interest rates, with the goal being increased consumption and investment, both factors that could worsen the inflation problem already experienced thanks to the global supply shock. Evidence indicates that the inflation problem, even in the US where slow growth usually leads to lower price levels, is not going away:
In the US, a survey-based measure of inflationary expectations recently showed an increase to more than 5 per cent. I would estimate there are now several hundred basis points of difference between the current Fed funds rate and an interest rate that would be consistent with price stability in the medium term.
…meaning the Fed, in its attempt to avoid recession and rising unemployment, has created a condition where real interest rates are actually negative, a highly inflationary condition. All this wouldn’t be so bad if wages in the US were rising along with the price level. This however, does not appear to be happening:
The main difference between the situation in the 1970s and now is today’s absence of wage inflation, which explains why absolute inflation rates are a little more moderate. I guess this is probably because of some combination of deregulated labour markets and globalisation. But the lack of wage-push inflation is not necessarily good news. Falling real wages mean falling disposable income and tighter credit conditions mean less borrowing for consumption.
Rising prices for energy, transportation and food have put American households in a tough situation. In the past, periods of inflation have often been characterized by rising wages, meaning the full brunt of nominal price level increases was not entirely born by the American worker. Today, on the other hand, a recession has thus far been avoided, but the combination of record numbers of “discouraged workers”, rising unemployment and inflation may make the pain of our current economic situation just as real as recessions of the past.
In the words of billionaire investor and economic sage Warren Buffett just today:
“I believe that we are already in a recession… Perhaps not in the sense as defined by economists. … But people are already feeling the effects of a recession.”
“It will be deeper and longer than what many think,” he added.
- What is the difference between nominal and real GDP? Which must decline in order for the economy to be in a recession?
- What impact do rising energy prices have on the behavior of individual firms?
- Why are low interest rates likely to make the inflation problem even worse?
May 22 2008
What do you believe is the most direct cause(s) of the weakening of the dollar? Is it the trade deficit and/or spending deficits along with increased borrowing overseas? Is it offshoring? Tax cuts? And how direct is the causality of this to oil and commodity prices?
Of course I’ll give you full credit in the post for educating me more on this subject. Thanks in advance !
Below is my reply. I am posting it here for posterity, and because I think it may include one possible explanation of the weak dollar within the grasp of IB and AP Econ students:
Keep in mind, I’m no expert here, only a high school economics teacher… but let me just share a few thoughts about one cause of the weak dollar.
I think something you’ve forgotten to mention in your email is the role that the mortgage crisis has had on the dollar. Much of the debt from the sub-prime mortgage market was held by overseas investors. As home foreclosures picked up late last year, confidence in these mortgage-backed securities plummeted and demand for these American assets fell, thus demand for dollars among foreign investors has fallen with it, depreciating the dollar.
I think the housing market is at the core of a lot of our woes right now. In my econ class we talk about the “wealth effect” of falling home prices on consumer spending. Besides disposable income, the main determinant of overall consumption in the economy is the level of “wealth” among households. Of course, Americans’ greatest source of wealth is their homes… and the reason home prices have fallen is a simple supply and demand story, which is within the grasps of anyone who knows how supply and demand interact to determine price in a marketplace.
Low interest rates during the late Greenspan era spurred a period of new home sales, which drove prices up, spurring a building frenzy which shifted supply out. As long as demand increased more rapidly than supply, the illusion that house prices would continually rise was believable, thus buyers could be convinced that an adjustable rate mortgage (ARM) was the perfect type of loan for them. But the rising prices were unsustainable, and when the Fed began increasing interest rates a few years ago, demand for new homes declined, right as inventory was at an all time high. Naturally, home prices began to stabilize then fall, and as the “adjustable” part of all those “sub-prime” ARMs kicked in, monthly payments became too much for some Americans to bear. In an attempt to liquidate their now unaffordable houses, millions of Americans put their homes for sale, while thousands began to default on their loans, both which combined to shift supply ever further outward, putting even more downward pressure on home prices.
The story continues from here: falling home prices mean less “wealth” which means less consumer spending which means less total output in the economy which means less demand for workers which means rising unemployment… aka, RECESSION! And that’s where we are today.
So, as you can see I think the housing market is at the core of our problems. The weak dollar too, as demand for American homeowners’ debt has declined among foreign investors. Now, in the face of a recession, the Fed has lowered interest rates once again to try and stimulate new spending and investment, further exacerbating the dollar’s decline, as lower returns in the US bond market divert investors out of dollars and into more secure investments, such as… you guessed it, OIL.
The falling dollar had encouraged investors to look for stable investments, such as commodities like oil, copper, coal, etc, driving demand and prices for these commodities up, contributing to the cost-push inflation that has accompanied America’s economics slowdown.
So yes, it’s all connected… rising unemployment, sluggish growth, rising price levels and falling real wages. At the core, however, is the housing market and the “irrational exuberance” that led to a speculative building and buying spree over the last six years: a bubble which began bursting late last year and continues to have a ripple effect across the economy.
Bush’s tax cuts and deficit spending just made this whole mess even worse. I did a blog post a while back about the trade deficit with China, budget deficits and the value of the dollar, you can read that here: “Excuse me China, could you lend us another billion?”
Okay, that’s all I’ve got for you today… I hope some of these observations are useful!