Economic Commentary

The U.S. economy is at a time in which the recession is supposed to come to an end. Will this happen? Let's take a look.

First, the good news (of which there is precious little). The financial crisis is behind us. Less than a year ago the financial markets in the United States came perilously close to failing but heroic action by the Federal Reserve and the Treasury Department staved off a collapse. The actions of these two institutions has put them into uncharted waters the consequences of which remain to be seen as Congress wrestles with financial reform and regulation. Just this week two experts on the Federal Reserve, Alan Metzler and John Taylor, urged Congress to go slow on granting additional powers to the Federal Reserve that would take it far away from its traditional role as regulator of the money supply and short term interest rates. Another announcement just yesterday from Citigroup told us of executive changes at the highest levels that, it was hinted, were prompted by urging from the Treasury and the FDIC that they were desirable things to do. That is, the Treasury (us taxpayers) is now a major owner in the Citicorp bank and in a position to dictate personnel changes that might not have occurred if the decisions had been left to the existing management team. The Treasury is a stockholder in most of the major banks which is the first time this has happened in many a year. Problems still remain in the banking sector to be sure. The banks are not lending at anything like the levels needed to help the economy get out of the recession. Commercial paper markets are being kept alive by the Federal Reserve. Several hundred billion dollars worth of "toxic" paper remain on the books of the major banks that will, at some point in the future have to be written off as losses. There is still far too much uncertainty in Wall Street and financial markets cope with uncertainty badly. But, collapse was averted and we can be thankful for that.
Sadly, what you just read is all the good news to be had as we start the second half of the year. How are things going in the economy as a whole? Badly! In no particular order of inportance let me remind you of several basic facts about the economic system now in place in this country. Long run economic growth arises from three factors: increases in the quantity and quality of the labor force, increases in the quantity and quality of the capital equipment that labor works with and increases in technology that get diffused throughout the system such that the productivity of both labor and capital is increased. There is no longer any dispute among economists about these factors although there is still some disagreement as to the relative importance of the three elements of growth. Our problem now is that in the short run business cycle time frame these three growth factors are essentially fixed. The labor force, capital stock and technology in place in 2009 are essentially the same as those in 2008 and will be the same in 2010. So, what drives the system in the short run? Spending. We know this intuitively. In a profit driven system like ours no rational business firm is going to incur costs of production to supply a product that no one is ready to buy in the market place. If we are building a lot of houses, condominium complexes, apartment complexes, hotels, motels, office buildings , etc. as we were in 2005 all of the structures need carpet so there is a lot of spending on carpet. That means that in Dalton, GA, where 85% of all the carpet in the United States is manufactured those mills will supply a lot of carpet. They will buy a lot of labor, raw materials, energy,etc. that generates the incomes out of which the income receivers can buy carpet. If, as is the case just now, there are very few buyers of carpet those mills in Dalton will shut down and lay off the workers. They won't buy dacron filament and the chenical companies that supply filament will shut down the factories and lay off the workers. Spending drives the system.
There are four spenders that buy all the final goods and services produced in the U.S. economy: households, business firms, governments and foreigners. This spending is measured every quarter by the Bureau of Economic Analysis in the Commerce Department. Net spending by foreigners is a small percentage of the total and is, in fact negative for the U.S. with its perennial balance of payments deficit. Governments, local, state and federal typically spend about 25% of the total and 80% of all the spending on goods and services in this country is done by the private domestic spenders, households and business firms (net exports run -5%). Private spending is the key and of the total spending business firms account for about 20% and the rest is done by households. This total spending is called "aggregate demand" by economists and for the past fifty years the household sector has routinely accounted for 67-70% of aggregate, or total demand. Household spending, economists say, drives the system in the short run.
That household spending depends on three things: spendable income, debt levels and household expectations. So, if spendable incomes are rising, household debt levels are low and households feel good about the economy households will buy a lot of stuff and business firms will supply a lot of stuff and the economy grows at about 3% per year, in real terms, unemployment is low and inflation is low. If, instead, spendable income is stable or declining, debt levels are high and households are worried about the economy, especially jobs then those households cut back on spending. They buy essentials. They postpone big ticket items that require tham to go into debt. They save more (households can save more only by spending less). The grim reality is this, of the 75,000,000 households in this country living off of earned income (the other 40,000,000 households live off of Social Security, private pensions, savings, etc.) almost 67,000,000 have no income except that derived from someone in the household having a job. Almost all non-wage income (rents, interest and profits) go to the richest 10% of the households. The reason economists are so gung-ho about full employment is because that level of employment maximizes spendable incomes by households.
In the past sixteen months the unemployment rate has gone from 4.8% to 9.5% which is the worst experience with this rate in many years. We have lost 9,000,000 jobs since the start of the recession. The actual underutilization of labor is much worse than the unemployment rates would indicate. People who have lost their jobs are not going to buy a new car or a new house, or new appliances. People who are worried about losing their jobs are going to cut back on expenditures as drastically as they can. The economy grinds to a virtual halt. We had negative economic growth in the last quarter of 2008, the first quarter of 2009 and we will have negative growth in the second quarter of this year when the data are published at the end of this month. I think we will still be in a negative growth phase in the second half of this year although at slower rates than in the recent past.
So, the economy is still in trouble and will stay in trouble for another several quarters. I worry that the first half of 2010 is going to be far too slow but I am cautiously optimistic that the second half of next year will see things get better.

JULY 2010