Archive for March 20th, 2009

The Key to Economic Recovery

The Federal Reserve board launched an effort designed to lower mortgage rates and stimulate the economy by infusing money into the system.   I won’t go into the technicalities, but basically this builds on the stimulus to try to get the economy moving forward.

As I scan the analyses of this action, there are two contradictory theories out there of where this will go:

1.  This is very dangerous, and is likely to cause inflation as money is being pumped in the system at a time when debt is high and interest rates are already low.  Inflation during a recession is “stagflation,” and its impact is even more painful and debilitating than either inflation or a recession alone.   For evidence that this theory is accurate, look at the dollar’s value, which fell from around $1.28 a Euro recently to $1.36 today (it hit $1.38 yesterday).

2.  This is necessary in order to actively fight the growing recession, which could continue to spiral into itself if action isn’t taken.   Inflation is unlikely since the rest of the world both needs the US to succeed, and has similar problems.   Moreover, price controls could be implemented to try to limit the effect of inflation (this was done in WWII, and briefly by President Nixon during the recession in the early 70s.)

These two views share a basic economic principle: there are natural mechanisms through which the market will stabilize itself and rebalance.    This view permeates thinking left and right.  A colleague of mine said at the start of all this (in regards to the impact on university spending) “recessions come and go, how do we know cuts they plan now won’t be unnecessary in a year?”   Another colleague scoffed at the negative projections down the line by pointing out that no one had projected what we now face — how can we trust projections?

On the right, there is a chorus of voices that simply think the government should stay out — do nothing, let the market ‘fix itself.’  This is, however, the same market that has given us AIG bonuses (and AIG is very common in its practices) and irrational financial instruments for “investment” that were sold to us as safe.  Trusting the market to take care of itself or worse, us, seems foolhardy at best.   Moreover, while many on the right rely on ideological orthodoxy for their position, they don’t offer much in the way of real evidence on how this will work.   Instead it’s a very basic “the economy will fix itself, given the chance.  All we can do is make it worse.”  This faith in the economy to heal itself may be well placed, but it may also be wishful thinking or ideological groupthink.   We simply don’t know.

Yet government action also seems predicated on faith that the economy can fix itself, and our acts are meant to make the transition less painful to those who would suffer the most, and quicker than it otherwise would be.  The idea here is that governments can help minimize the damage of a deep recession.  Just as a doctor can treat an injury, minimize the pain, and hasten the healing process, so can the government help the public in a recession.   The key is a quick injection of capital to get things moving again and allow credit to flow, followed by structural changes and investments to set up a sustainable, productive economy.   If it works, then within three or four years we’ll be starting to pull out of this; what might have been another great depression will instead be deep, but relatively brief, recession.

There is, however, a third possibility.  What if neither option is effective?  What if sticky prices and wages, lack of good information, panic, greed, and time lags all conspire to prevent any kind of natural market correction, government intervention or not?   There is evidence that this is possible.  In the Great Depression the British tried to muddle through, and avoid the “new deal” policies of FDR.  It didn’t work.   There are debates about whether or not FDR’s policies helped.  I won’t go into those (especially since people tend to side with arguments that fit their pre-conceived ideological positions), but clearly if they did help, they didn’t solve the problem.

What seemed to solve the problem is World War II, but even that is only a partial answer.  World War II helped the US because the war was fought “over there,” and our productive capacity was not targeted by the enemies.  War did not get Great Britain or France out the Great Depression, they emerged even weaker and far poorer than before the war.    Moreover, before the war two economies had seemed to emerge from the Depression stronger, those of the Soviet Union and Germany.   I think we can dismiss the success of the USSR since it was built primarily on slave labor and force.  But in Germany there was a massive influx of government money into the economy.  It yielded a short term boom, even though it was money spent to prepare for a war that would ultimately devastate Germany.

Still, for Germany and the US, spending for war  or war preparation was the cause of  at least a short term economic recovery.  Germany’s couldn’t last, which is one economic reason they went to war.    But the US recovery did last.  It lasted because of decisions made after the war to expand prosperity, and set up a free trade regime designed to foster interdependence and economic links between states.   It was bold and controversial; many were convinced that the depression was absolute proof that capitalism and democracy could not work, and were prone to debilitating crises.

This points us to another possible solution to the current crisis, though a very difficult and unpredictable one.  Since war is not an option at this point for a variety of reasons (moreover, the aggressor usually loses), let’s consider why war preparation was so effective.  It pumped MASSIVE amounts of money into the system.  The US debt ballooned to over 100% of GDP.   That infusion did not cause inflation, in part due to price controls.  It did create a short term boom that was built upon by expanding the playing field through economic partnership with countries in Europe and Asia.  This included a new kind of economy, based on innovation and technology, and set the seeds for the a half century of the largest growth in material prosperity in the history of humankind.

If we follow that model, Obama’s policies may not be bold enough.  Moreover, the key to maintaining success might be to find a way to: a) invest in new technologies; and b) expand prosperity and partnerships to areas not yet enjoying the benefits of market capitalism.   Two thirds or more of the planet has been left out of the ‘prosperity economy’, so there is a lot of potential for growth.    If we look at global warming, environmental crises, and the need to find new energy sources as threats requiring action akin to war (massive efforts supported by government to handle these threats), and then work to build real partnerships with countries in the third world (probably requiring some shared sovereignty to assure they get competent and relatively uncorrupt governance), maybe we could emerge ready for another era of intense prosperity.

Many on the right cry out against such government action.  But if it is appropraite to fight a war to protect a country, why not fight to protect us from non-military threats just as hard?   This fetish some have to see warfare as legitimate government activity and social welfare and non-military actions as illegitimate is irrational.  Governments should be empowered to kill and destroy, but it’s wrong for them to help?   It’ll be difficult to bring most Americans to the point where we see the need to help the third world; many prefer ‘splendid isolation.’   Yet with the growth of terrorism and globalization, what happens there does affect us; globalization is real.

Finally, we can’t expect a return to the hyperconsumerism of the last decade or so — that was unsustainable and spiritually unhealthy for us as a culture and as individuals.  But there is no reason we can’t build a sustainable, functioning economy that this time does not leave out over two thirds of the planet — indeed, involving them will be the key to future success.