Archive for the 'Consumer confidence' Category

Aug 16 2011

Too much debt or not enough demand? A summary of the debate over America’s fiscal future

As yet another school year begins, we once again find ourselves returning to an atmosphere of economic uncertainty, sluggish growth, and heated debate over how to return the economies of the United States and Europe back onto a growth trajectory. In the last couple of weeks alone the US government has barely avoided a default on its national debt, ratings agencies have downgraded US government bonds, global stock markets have tumbled, confidence in the Eurozone has been pummeled over fears of larger than expected deficits in Italy and Greece, and the US dollar has reached historic lows against currencies such as the Swiss Franc and the Japanese Yen.

What are we to make of all this turmoil? I will not pretend I can offer a clear explanation to all this chaos, but I can offer here a little summary of the big debate over one of the issues above: the debate over the US national debt and what the US should be doing right now to assure future economic and financial stability.

There are basically two sides to this debate, one we will refer to as the “demand-side” and one we will call the “supply-side”. On the demand-side you have economists like Paul Krugman, and in Washington the left wing of the Democratic party, who believe that America’s biggest problem is a lack of aggregate demand.

Supply-siders, on the other hand, are worried more about the US national debt, which currently stands around 98% of US GDP, and the budget deficit, which this year is around $1.5 trillion, or 10% of GDP. Every dollar spent by the US government beyond what it collects in taxes, argue the supply-siders, must be borrowed, and the cost of borrowing is the interest the government (i.e. taxpayers) have to pay to those buying government bonds. The larger the deficit, the larger the debt burden and the more that must be paid in interest on this debt. Furthermore, increased debt leads to greater uncertainty about the future and the expectation that taxes will have to be raised sometime down the road, thus creating an environment in which firms and households will postpone spending, prolonging the period of economic slump.

The demand-siders, however, believe that debt is only a problem if it grows more rapidly than national income, and in the US right now income growth is almost zero, meaning that the growing debt will pose a greater threat over time due to the slow growth in income. Think of it this way, if I owe you $98 and I only earn $100, then that $98 is a BIG DEAL. But if my income increases to $110 and my debt grows to $100, that is not as big a deal. Yes, I owe you more money, but I am also earning more money, so the debt burden has actually decreased.

In order to get US income to grow, say the demand-siders, continued fiscal and monetary stimulus are needed. With the debt deal struck two weeks ago, however, the US government has vowed to slash future spending by $2.4 trillion, effectively doing the opposite of what the demand-siders would like to see happen, pursuing fiscal contraction rather than expansion. As government spending grows less in the future than it otherwise would have, employment will fall and incomes will grow more slowly, or worse, the US will enter a second recession, meaning even lower incomes in the future, causing a the debt burden to grow.

Now let’s consider the supply-side argument. The supply-siders argue that America’s biggest problem is not the lack of demand, rather it is the debt itself. Every borrowed dollar spent by the goverment, say the supply-siders, is a dollar taken out of the private sector’s pocket. As government spending continues to grow faster than tax receipts, the government must borrow more and more from the private sector, and in order to attract lenders, interest on government bonds must be raised. Higher interest paid on government debt leads to a flow of funds into the public sector and away from the private sector, causing borrowing costs to rise for everyone else. In IB and AP Economics, this phenomenon is known as  the crowding-out effect: Public sector borrowing crowds out private sector investment, slowing growth and leading to less overall demand in the economy.

Additionally, argue the supply-siders, the increase in debt required for further stimulus will only lead to the expectation among households and firms of future increases in tax rates, which will be necessary to pay down the higher level of debt sometime in the future. The expectation of future tax hikes will be enough to discourage current consumption and investment, so despite the increase in government spending now, the fall in private sector confidence will mean less investment and consumption, so aggregate demand may not even grow if we do borrow and spend today!

This debate is not a new one. The demand-side / supply-side battle has raged for nearly a century, going back to the Great Depression when the prevailing economic view was that the cause of the global economic crisis was unbalanced budgets and too much foreign competition. In the early 30’s governments around the world cut spending, raised taxes and erected new barriers to trade in order to try and fix their economic woes. The result was a deepening of the depression and a lost decade of economic activity, culminating in a World War that led to a massive increase in demand and a return to full employment. Let’s hope that this time around the same won’t be necessary to end our global economic woes.

Recently, CNN’s Fareed Zakaria had two of the leading voices in this economic debate on his show to share their views on what is needed to bring the US and the world out of its economic slump. Princeton’s Paul Krugman, a proud Keynesian, spoke for the demand-side, while Harvard’s Kenneth Rogoff represented the supply-side. Watch the interview below (up to 24:40), read my notes summarizing the two side’s arguments, and answer the questions that follow.

Summary of Krugman’s argument:

  • Despite the downgrade by Standard & Poor’s (a ratings agency) there appears to be strong demand for US government bonds right now, meaning really low borrowing costs (interest rates) for the US government.
  • This means investors are not afraid of what S&P is telling them to be afraid of, and are more than happy to lend money to the US government at low interest rates.
  • Investors are fleeing from equities (stocks in companies), and buying US bonds because US debt is the safest asset out there. The market is saying that the downgrade may lead to more contractionary policies, hurting the real economy. Investors are afraid of contractionary fiscal policy, so are sending a message to Washington that it should spend more now.
  • The really scary thing is the prospect of another Great Depression.
  • Can fiscal stimulus succeed in an environment of large amounts of debt held by the private sector? YES, says Krugman, the government can sustain spending to maintain employment and output, which leads to income growth and makes it easier for the private sector to pay down their debt.
  • With 9% unemployment and historically high levels of long-term unemployment, we should be addressing the employment problem first. We should throw everything we can at increasing employment and incomes.
  • Is there some upper limit to the national debt? Krugman says the deficit and debt are high, but we must consider costs versus benefits: The US can borrow money and repay in constant dollars (inflation adjusted) less than it borrowed. There must be projects the federal government could undertake with at least a constant rate of return that could get workers employed. If the world wants to buy US bonds, let’s borrow now and invest for the future!
  • If we discovered that space aliens were about to attack and we needed a massive military buildup to protect ourselves from invasion, inflation and budget deficits would be a secondary concern to that and the recession would be over in 18 months.
  • We have so many hypothetical risks (inflation, bond market panic, crowding out, etc…) that we are afraid to tackle the actual challenge that is happening (unemployment, deflation, etc..) and we are destroying a lot of lives to protect ourselves from these “phantom threats”.
  • The thing that’s holding us back right now in the US is private sector debt. Yes we won’t have a self-sustaining recovery until private sector debt comes down, at least relative to incomes. Therefore we need policies that make income grow, which will reduce the burden of private debt.
  • The idea that we cannot do anything to grow until private debt comes down on its own is flawed… increase income, decrease debt burden!
  • Things that we have no evidence for that are supposed to be dangerous are not a good reason not to pursue income growth policies.
  • When it comes down to it, there just isn’t enough spending in the economy!

Summary of Rogoff’s argument:

  • The downgrade was well justified, and the reason for the demand for treasuries is that they look good compared to the other options right now.
  • There is a panic going on as investors adjust to lower growth expectations, due to lack of leadership in the US and Europe.
  • This is not a classical recession, rather a “Great Contraction”: Recessions are periodic, but a financial crisis like this is unusual, this is the 2nd Great Contraction since the Depresssion. It’s not output and employment, but credit and housing which are contracting, due to the “debt overhang”.
  • If you look at a contraction, it can take up to 4 or 5 years just to get back where you started.
  • This is not a double dip recession, because we never left the first one.
  • Rogoff thinks continued fiscal stimulus would worsen the debt overhang because it leads to the expectation of future tax increases, thus causing firms and households increased uncertainty and reduces future growth.
  • If we used our credit to help facilitate a plan to bring down the mortgage debt (debt held by the private sector), Rogoff would consider that a better option than spending on employment and output. Fix the debt problem, and spending will resume.
  • Rogoff thinks we should not assume that interest rates of US debt will last indefinitely. Infrastructure spending, if well spent, is great, but he is suspicious whether the government is able to target its spending so efficiently to make borrowing the money worthwhile.
  • Rogoff thinks if government invests in productive projects, stimulus is a good idea, but “digging ditches” will not fix the economy.
  • Until we get the debt levels down, we cannot get back to robust growth.
  • It’s because of the government’s debt that the private sector is worried about where the country’s going. If we increase the debt to finance more stimulus, there will be more uncertainty, higher interest rates, possibly inflation, and prolonged stagnation in output and incomes.
  • When it comes down to it, there is just too much debt in the economy!

Discussion Question:

  1. What is the fundamental difference between the two arguments being debated above? Both agree that the national debt is a problem, but where do the two economists differ on how to deal with the debt?
  2. The issues of “digging ditches and filling them in” comes up in the discussion. What is the context of this metaphor? What are the two economists views on the effectiveness of such projects?
  3. Following the debate, Fareed Zakaria talks about the reaction in China to S&P’s downgrade of US debt. What does he think about the popular demands in China for the government to pull out of the market for US government bonds?
  4. Explain what Zakaria means when he describes the relationship between the US and China as “Mutually Assured Destruction (MAD)”.
  5. Should the US government pursue a second stimulus and directly try to stimulate employment and income? Or should it continue down the path to austerity, cutting government programs to try and balance its budget?

20 responses so far

Sep 14 2009

Jobless Growth? How could this be?

Economic Growth Yet to Hit Job Market – washingtonpost.com

In AP and IB Economics, we understand the importance of macroeconomics to policymakers, whose primary macroeconomic goal is growth. Economic Growth, defined as an increase in a nation’s total output of goods and service (and therefore the national income), is desidred not only for the sake of growth itself (producing more stuff requires more resources, and may not necessarily make the average citizen better off), rather growth is needed in order to achieve full-employment of a nation’s labor force.

Growth is good. This tenet of economics is rooted in two basic observations: 1. Growth leads to an improvement in the average standard living of a nation’s people, and 2. Growth is needed to employ the growing workforce of a nation experiencing population growth and immigration.

America’s work force is a diverse group of people of all skill levels. 150 million strong, the nation’s workforce requires a healthy national economy with strong investment and consumption to maintain enough jobs to keep unemployment low.   In the last two years, however, the prospect of employment in America has diminished as the number of people out of work has grown to nearly 15 million.

Involuntary unemployment is perhaps the most serious cost of an economic slowdown. A willing and able worker (or 15 million of them!), skilled in mind and body, unable to find prouductive work, represents a monumental failure of a nation’s economy. Policies aimed at promoting growth are in fact aimed at creating employment.

The costs of unemployment affect not only the unlucky  individuals who have have lost their job. Social costs include increased crime and poverty, psychological costs include stress, anxiety, loss of self-image and depression. The economic costs are myriad. Unemployed workers become dependent on the rest of society for support, in one way or another. Benefits for the unemployed payed by the government require greater budget deficits or increased tax burden on the employed. The large pool of jobless citizens seeking work puts downward pressure on the wages of those still working, as employers find it difficult to keep paying high wages while demand for their products has fallen and millions of job seekers are willing to work for less.

The families and friends to whom unemployed workers turn for help find their already stretched incomes spread even thinner. Without steady incomes, the unemployed consume less, putting further strain on an already depressed economy. Deflation can result from unemployment, which can lead to futher layoffs by pessimistic firms, excacerbating the situation and plunging the economy into what’s known as a deflationary spiral.

For all the reasons above, policymakers strive to promote growth. When monetary policy fails to incite spending, the government must pick up the slack, hence the stimulus package so discussed in America today. China’s stimulus of over $500 billion (twice that of the US, as a percentage of its GDP) has had a positive effect on both GDP and the job market.

Employment levels in China began to recover over the past three months in the latest evidence of the rapid rebound in the economy from the international financial crisis as a result of heavy public investment.

Yin Weimin, China’s labour minister, said there had been a modest increase in the number of jobs in the economy during June, July and August, reversing the sharp slump in employment which began last October.

America’s stimlus has also begun to restore growth, but the rise in employment has so far not occured:

Despite an emerging economic expansion, businesses were sufficiently skittish about the future that the job market continued its long, steep decline in August, according to a new government report Friday. The unemployment rate rose to 9.7 percent, from 9.4 percent, as employers shed jobs for the 20th straight month, the Labor Department said.

“Our clients tell us they will not hire in anticipation

of a recovery, but will wait until they see it,” said Jonas Prising, an executive vice president at Manpower, the giant employment services firm. “In a normal recession, people would now start to feel more comfortable and start hiring, but nobody is doing that today. They’ll do it when they see real orders and real business.”

The “silver lining” of the latest unemployment figures is hardly encouraging. The rise in unemployment is not as sharp as over most of the last year. In other words, workers are definitely worse off, but not as badly as they could have been if things were as dismal as they were earlier this year.

While the unemployment rate, as seen on the graph to the right, has risen almost every month since August of 2008, the rate at which the rate has increased has begun to slow. In other words, the economy is probably close to “bottoming out”.

The tally of lost jobs now stands at 6.9 million since the beginning of the recession in December 2007. But the rate of job losses has been declining, if haltingly, since winter. The 216,000 jobs eliminated in August is down from 276,000 cut in July and a peak of 741,000 lost in January.

Here’s what I find most interesting from in the current data. The unemployment rate’s recent rise may actually be a sign that the economy is beginning to recover. Recovery means growth in output, which should mean less unemployment. However, if workers who have been unemployed for a long time, and have therefore stop seeking employment suddenly feel more optimistic about the prospects of getting a job and begin seeking work again, then the nation’s unemployment rate actually rises! How’s that for “silver lining”? The 216,000 additional people added to the list of unemployed may have already been out of work but since they were notactively seeking employment they were not included in last month’s data.

The tricky thing about macroeconomic policy is this:  Monetary and fiscal policies can put billions of dollars into the nation’s banks and households’ and firms’ pockets through tax breaks, government bailouts, subsidies, infrastructure spending and “troubled asset swaps”… but all the money and income in the world will not lead the nation towards full-employment unless the nation’s consumers and producers feel confident. I teach my students that national income is made up of the sum of wages, interest, rent and profit; its spending consists of consumption, investment, government spending and net exports… but without the “big C” of confidence, expansionary policies aimed at increasing employment will come to nought. Confidence, according to John Maynard Keynes, is an animal spirit, a trait of humans beyond the assumption of rational behavior. Until confidence is restored, America’s output and employment levels will remain low.

Comments Off on Jobless Growth? How could this be?

Sep 29 2008

European banks struggling – government lubrication needed!

European governments bail out more lenders – International Herald Tribune

As the US financial system holds its breath to see if the US government’s injection of $700 billion of liquidity actually results in new lending and restored business and consumer confidence, Europe is beginning to see its own government takeovers of European banks.

Regulators in Britain, Belgium and Iceland swooped in Monday to engineer emergency rescues of three banks with heavy exposure to soured mortgages, echoing moves underway in the United States.

In the latest sign of trouble to hit Europe from the global credit crisis, the Belgian, Dutch and Luxembourg governments announced a partial nationalization of the troubled Belgian-Dutch financial conglomerate Fortis, involving a combined injection of €11.2 billion from the three governments, which take a 49 percent stake…

Meanwhile, the British Treasury on Monday confirmed that it had seized the lender Bradford & Bingley – the third British bank to tumble this year – after no private buyers emerged.

Much as in the United States, several European banks have gotten into trouble as their assets tied to real estate have lost value due to the weak European and American real estate markets. As more and more borrowers are unable to pay their mortgages, banks’ assets decline in value and the banks’ willingness and ability to make new loans decreases. This limits the amount of credit available to households and firms, and with it their ability to make investments in consumer goods and capital. Tighter credit markets mean weaker aggregate demand (less consumption and investment), leading to slower or negative economic growth and rising unemployment.

In the past, when one bank got into trouble with bad assets like those tied to the real estate market, other private banks would come along and bail the troubled bank out, swapping cash for the assets, allowing the troubled bank to continue making loans. But when all banks find themselves in the midst of the same financial crisis, the likelihood of finding a private buyer for a struggling bank is low. This is where the government steps in:

The bailout of Fortis (Belgium’s largest commercial bank) orchestrated by the three neighboring countries (Belgium, Luxembourg and the Netherlands) and the ECB (European Central Bank)… was meant to restore confidence in the bank before the reopening of markets on Monday after a tumultuous week of imploding share values at Fortis. The shares gained 4.8 percent to €5.45 Monday.

In Britain, regulators were unable to find buyers to keep Bradford & Bingley afloat. The lender’s shares are down 90 percent from the peak, touching new depths Friday as an already skittish market punished the company, prompting the talks.

When the private sector is unable or unwilling to purchase the assets of a bank that has experienced a write down of its asset value, the government must intervene to make sure such banks have the liquidity (meaning the hard cash) they need to make loans to borrowers, whose spending is needed to keep the economy going.

In the US, the government has agreed to trade $700 billion in hard, loanable and spendable cash, in exchange for financial assets tied to bad mortgages worth something less than $700 billion. If the swap has the effect the government hopes it will, then lending institutions will feel more confidence and be willing to loan cash to each other and to borrowers (households and firms), spending in the economy will increase (consumption and investment) and aggregate demand will rise, meaning more total output, more employment and higher incomes. In addition, more lending will also lead to an increase in the capital stock, effectively pushing the American and European aggregate supply curves outwards, leading to a more stable rate of inflation (a major worry for both economies as oil prices hit record levels this year).

In spite of the recent round of bailouts in both the US and Europe, confidence among European firms and households is low:

Euro-zone economic confidence plunged to its lowest level in seven years in September, the EU said Monday.

A regular survey of European companies and consumers showed the index of confidence in the economy falling to 87.7, close to a 2001 trough, the European Commission said.

The EU executive warned that the survey carried out in the first two weeks of September may not fully reflect growing gloom in the last few weeks as worries over a U.S. and European recession widened on a financial market crisis.

Industry, services and construction were all more pessimistic than a month ago, it said, while consumer confidence was unchanged from a low level. Retailers were slightly more upbeat about their prospects.

It said industry managers’ employment expectations fell – meaning they believe they may have to cut jobs – although services companies were more hopeful.

Consumers thought that unemployment would increase in future months and expect prices to rise.

The 15 nations that share the euro are battling high inflation as oil prices remain high – although below recent record levels – and increasing fears that a financial crisis will freeze or sharply hike the cost of borrowing.

That would slow growth as companies found it harder to get credit and people faced high costs to buy homes. The U.S. government is trying to stave off tighter credit conditions by buying up hundreds of billions of dollars of bad debt from major lenders

As can be seen, falling confidence and tighter credit markets are evil twins. If the Euro zone economy is to avoid recession, the European Central Bank and the governments of the 15 Euro nations should follow closely events in the US over the next few weeks. The $700 billion injection of liquidity, if successful, will act as lubrication in the engine of the US economy.

Think of it this way: lately, the US economic engine has slowed down. Friction in the financial markets has slowed the flow of cash from households to banks to firms and back to households. In IB and AP Economics terms, the circular flow of money and income has slowed to a halt. To get the engine moving again, cash is needed. Banks with liquid cash are more willing to lend to one another and to households and firms. A healthy economy depends on a well lubricated economic engine, which in today’s world means a functioning financial market.

The government bailouts in the US and Europe are intended to do one thing: lubricate that engine and get the economy moving forward once more.

Discussion question:

  1. Why does the government need to intervene in financial markets? Shouldn’t those who took risks by making bad loans pay for their mistakes and be allowed to go under?
  2. What will it take to turn consumer and investor confidence around in Europe?
  3. How might the crisis in the financial markets affect you and me in the real world?

2 responses so far

Sep 17 2008

So the stock markets are crashing, what’s the big deal?

How Does the Stock Market Effect The Economy? | Economics Blog

Well, a few things… Generally, the fluctuations of the stock market do not necessarily bode ill for the whole economy. Likewise, global fluctuations of stock markets does not mean there is a recession on the horizon. In fact, an old adage says that “stock markets have predicted ten out of the last three recessions.” In other words, a slump in global markets does not always precipitate a slump in the world’s economy. Here’s some impacts the market crashes of the last few days may have, however, explained nicely by Richard Pettinger, an economics teacher in the UK:

Economic Effects of Stock Market

1. Wealth Effect: The first impact is that people with shares will see a fall in their wealth. If the fall is significant it will affect their financial outlook. If they are losing money on shares they will be more hesitant to spend money; this can contribute to a fall in consumer spending. However, the effect should not be given too much importance. Often people who buy shares are prepared to lose money; their spending patterns are usually independent of share prices, especially for short term losses.

2. Effect on Pensions: Anybody with a private pension or investment trust will be affected by the stock market, at least indirectly. Pension funds invest a significant part of their funds on the stock market. Therefore, if there is a serious fall in share prices, it reduces the value of pension funds. This means that future pension payouts will be lower. If share prices fall too much, pension funds can struggle to meet their promises. The important thing is the long term movements in the share prices. If share prices fall for a long time then it will definitely affect pension funds and future payouts.

3. Confidence: Often share price movements are reflections of what is happening in the economy. E.g. recent falls are based on fears of a US recession and global slowdown. However, the stock market itself can affect consumer confidence. Bad headlines of falling share prices are another factor which discourage people from spending. On its own it may not have much effect, but combined with falling house prices, share prices can be a discouraging factor.

4. Investment: Falling share prices can hamper firms ability to raise finance on the stock market. Firms who are expanding and wish to borrow often do so by issuing more shares – it provides a low cost way of borrowing more money. However, with falling share prices it becomes much more difficult.

7 responses so far

May 26 2008

It may not be a recession, but it sure feels like one…

FT.com / Columnists / Wolfgang Munchau – Inflation and the lessons of the 1970s

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.

Discussion Questions:

  1. What is the difference between nominal and real GDP? Which must decline in order for the economy to be in a recession?
  2. What impact do rising energy prices have on the behavior of individual firms?
  3. Why are low interest rates likely to make the inflation problem even worse?

9 responses so far

Next »