Saturday, April 03, 2010

Three Imbalances Threaten Long-Term Economic Stability

 You can may have read the following commentary in the Wichita Eagle(3/25/2010):

The Economic Recovery

We are emerging from a financial and economic crisis of historic dimensions. Unemployment reached levels not seen since 1982. America suffered the largest falls in industrial output and housing starts since the "Roosevelt Recession" of 1937-38

However deep the recession, the recovery is well under way. A long list of indicators hit bottom last year and are rising: auto sales (February), durable goods orders (March), real retail sales (April), housing starts (April), and industrial production (June). The fall in global industrial production ended in March as did world trade's in May.

Most economists are sanguine about the long term but judge the current recovery to be fragile and weak. The consensus is wrong. This recovery is solid and broad-based.

Emerging economies (particularly Brazil, China and India) are leading a worldwide expansion. America's longer-term prospects are the real worry.

The Reckoning

Three major imbalances threaten the country's long-run economic stability and prosperity. We went into this crisis with a trade deficit equal to 5 percent of GDP and savings rates near zero. Government deficits equaled 1.2 percent of GDP when unemployment was still only at 4.6 percent. We could finance these imbalances only because the rest of the world was willing to lend us trillions of dollars. That dependence is neither in our long-term economic nor geopolitical interests.

This overdependence on foreign credit led to massive misallocations of America's resources. The housing bubble grew from 2003 and peaked in August 2006. Over that time period, home-building sucked an extra $900 billion in real resources away from the rest of the economy.

Finance and real estate grew to over 20 percent of the economy. Our brightest young graduates found it more attractive to become financial engineers rather than build planes and invent new products. We will be paying for this deadweight loss in higher unemployment and lower economic growth for many years.

The Future

Correcting the imbalances means we must save more and use less of what we produce for ourselves. In other words, Americans face lower living standards

Lower standards of living and a falling dollar will translate into higher domestic prices. If policymakers misinterpret those rising prices and continue to fight structural change with the wrong tools, they will start a vicious policy cycle culminating in the loss of the dollar as the world's reserve currency and unpredictable turmoil.

Where are our policies now? This recession was global and induced a global response. Many nations including America have disinterred the theories of John Maynard Keynes to justify massive government spending programs ("fiscal stimulus") to fight the recent economic recession. Central banks have used the ideas of Keynes' nemesis, Milton Friedman, to justify vanishingly low interest rates ("monetary stimulus") and unprecedented financial market interventions ("quantitative easing") toward the same end. This focus on the short term is crowding out the need for correcting the economy's imbalances. I doubt either Keynes or Friedman would wholly approve of the sins being committed in their names.

And in the Long Run...

What makes a great statesman? Historian J. Rufus Fears found three essential elements. A great statesman clearheadedly identifies and analyzes a major problem. Then he implements a solution that works both in the short run and in the long run. Focusing on the immediate problems of the 1930s, Keynes dismissed "the long run, (when) we are all dead."

Yet in the 1940s, Keynes turned around and engineered a remarkably resilient postwar monetary system. That act of statesmanship produced peace and prosperity for generations. Contrast that with current economic policy, where "in the long run, we are all in the soup."

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