Do we really need all this stimulus?

Prior to the Depression, the conventional thinking was that economic downturns were self-correcting. A fall in consumer spending would cause businesses to cut prices to get people back in the stores. Faced with higher unemployment, workers would accept lower wages, which they could afford because prices were lower, which they would be because businesses would face lower costs now that wages were down. The system would fix itself without the heavy hand of government involvement.

The Depression showed that the process of price and wage cuts was not stabilizing, but instead led to a continued downward, deflationary spiral. Lower wages made it impossible for debtors to repay what they owed, banks collapsed, business and consumers held back spending, which caused further declines in prices, asset values continued to drop, business failures continued to rise, and the economy continued to decline.

Government stimulus in the form of interest rate cuts, government spending programs and plain old money printing were needed. Eventually, this reliance on government spending, borrowing, and money printing contributed to the double-digit inflation of the 1970s and for that and other reasons, government as the solution to economic problems fell out of favor. Now the pendulum has swung again and even the most market-oriented economists are calling out for the need for more government action.

Lost in the conversation about bailouts, infrastructure spending, and a zero percent fed funds rate is the simple fact that the government has been rapidly printing money. The money supply has increased almost 10 percent over the past year. Normally, this kind of monetary expansion would be inflationary. But in this case, we believe that there is a good chance that this will all result in a great offset – inflationary actions by the government will offset the deflationary symptoms in the private sector, producing something close to price stability. Even if the inflationary forces eventually dominate, that would not be the worst thing right now. It would make it easier for debtors to repay their loans, housing prices might stop falling, and businesses and consumers would be a little less cash-poor than they are right now. Eventually, of course, inflation is a problem that will need to be addressed, but that fight can wait for another day.

Percent Change in Money Supply vs. One Year Earlier

Source: Federal Reserve

In the meantime, fiscal policy will be as loose as we have ever seen, with Democrats and Republicans likely to agree on a combination of spending increases and tax cuts totaling perhaps $800 billion over the next two years. Factoring in the decline in tax revenues that inevitably occurs during a recession and the budget deficit will likely rise to $1.2 trillion in 2009, equal to 8.4 percent of GDP. Large as they may seem, it is not that much greater than the 6.3 percent deficit share in 1983 and the increase in the deficit will be not much greater than what happened in 2003 when the budget swung from surplus to deficit following the 2001 recession. For more on the challenges and opportunities facing the Obama administration, see our annual special focus issue.

All in all, the effect of tax cuts, spending increases, money printing, and a fed funds rate which we believe will stay near zero until the end of the year should lift the economy out of its worst downturn since at least the early 1980s. If not, it certainly will not be due to a lack of effort on the part of policy makers.

The Weak Labor Market Continues...

The economy lost 299,000 jobs in the third quarter, with 159,000 of those losses occurring in September. Hurricanes Gustav and Ike inflated the decline, but there is little reason to believe that this was just a temporary setback. Labor market conditions are deteriorating and will continue to do so. Until recently, we found some comfort in the fact that outside of construction and manufacturing, employment was still rising. That is no longer true.

To make matters worse, government added 79,000 jobs in the third quarter which means that the private sector lost 378,000 jobs in the last three months and almost one million since the start of the year. The crises that hit Wall Street in September started hitting Main Street back in January, a clear case of the chickens coming home to roost.

In the past two (relatively mild) recessions, employment fell about 1.5 percent from peak to bottom. In the more severe recessions of 1980 – 1982 and 1974 – 1975, the employment declines were 2.5 percent. So far, we have seen a decline of only 0.6 percent which means the economy could lose anywhere between 1.3 million and 2.7 million more jobs. Put bluntly, the worst is still to come.

Not only are more people out of work, but the depth of their unemployment is greater. Two million workers have been unemployed for more than six months, a 60 percent increase since last September. The portion of the labor force out of work for six months or more is at its highest level in 25 years.

The rise in long-term employment is also tied to the housing slump. If you cannot sell your house, you cannot move to another part of the country where employment prospects might be brighter.

What's Going On With Interest Rates?

The calamities in the financial markets can be summed up by one simple statistic. On September 17, the yield on three-month Treasury bills fell to 0.03 percent, a rate not seen since the Great Depression. It was a stampede to the safety of government securities. Short-term yields recovered somewhat by the end of the month but are still far below their level of two years ago, when the yield curve was inverted.

It has been called a liquidity crises but liquidity is not really the problem. There is still plenty of money available but lenders have little confidence that debts will be repaid. The spread between Baa-rate corporate bonds and 10-year Treasuries increased to almost four percent. Even the relatively low risk LIBOR market was affected, as rates shot up almost 150 basis points, a troubling development since so many adjustable rate mortgages are tied to this rate. What this really means, however, is that credit markets are still working as they should, with yield spreads reflecting perceived risks of default. Inter-bank loans are considerably more risky than they were just a few weeks ago.

For the foreseeable future, Treasury yields will remain low but that will be of little help to borrowers seeking funds. It is a classic case of “crowding out” in which money flows into government debt and away from private sector investment. And less business investment today means less economic output in the future – a polite way of saying that the US economy is in recession.

Why Does the U.S. Have a Trade Deficit?

The United States has an annual trade deficit with the rest of the world of about $700 billion. Most Americans view this as evidence that the U.S. is either not competitive in the world economy or that foreign producers are benefiting from unfair trade deals. But America does not have a competitiveness problem. It has an oil problem. Each year, the U.S. imports about 4.5 billion barrels of crude oil and petroleum products. At an average proce of $120/barrel, U.S. imports total $540 billion. In other words, about 75 percent of the U.S. trade deficit is really an oil import deficit. Outside of oil imports, U.S. exports and imports are close to equal, hardly a sign of a country that can't compete internationally.

In fact, U.S. exports have been growing at a rapid pace, rising 90 percent over the last six years, from $1 billion to $1.9 billion. Over the same time, imports have risen from $1.4 billion to $2.6 billion, widening the deficit. But again, oil explains much of the increase in import spending due to the quadrupling of oil prices and little change in oil consumption.

Oil and the Dollar

One driver of the increase in U.S. exports has been the decline in the value of the dollar. Since 2002, the dollar fell almost 40 percent against an index of other major currencies. The dollar has declined for the simple reason that the U.S. has been flooding the world with its currency through monetary expansion, government deficit spending, and consumer dollars spent on imports. The more dollars there are in the world, the less each dollar is worth.

Value of the Dollar and Oil Prices

While the decline in the dollar has helped U.S. exports, it has worsened the oil problem. One reason why oil prices have increased so much is because the dollar has fallen so much. If the dollar is worth less, then foreigners -- in this case oil-exporting countries -- demand more dollars in exchange for a barrel of oil. About half of the increase in the dollar price of oil is due to the decrease in the value of the dollar.

Policy Implications

What does this all mean? First, it means that general arguments against foreign trade are largely groundless. Certainly it's true that some American jobs are lost as a result of imports into this country, but American jobs are also gained because of the rapid growth in exports. Remember, taking out oil, the U.S. has essentially balanced trade. Moreover, the current rise in unemployment is mainly due to the decline in the housing market and the contraction in the credit markets, something that is an entirely home-grown problem.

At the same time, the oil deficit problem strengthens the argument for reducing oil consumption and encouraging the use of alternative sources of energy. Currently, the U.S. uses about 8 billion barrels of oil and other petroleum products a year, 3.5 billion produced domestically and 4.5 billion imported. Even if the U.S. were to increase its oil production to 4 billion barrels a year (no easy task) we would still be importing half our oil. The problem would lessen, but oil imports would remain a major negative for the U.S. economy.

Reducing oil consumption, on the other hand, could result in a one-for-one decline in U.S. oil imports. High gas prices are doing some the work for us, but given the inelasticity of gasoline demand, it's an expensive way to cut down on our use. Hybrid cares are the rage now, understandably, and some small pure electric cars are heading to the market. Longer term, electric cars will likely become more powerful and there is also the possibility of hydrogen-fueled vehicles as well.

What about ethanol, produced from U.S.-grown corn. Its production cuts down on our use of oil, but its hardly a panacea. First, ethanol production requires a lot of resources -- land, water, etc. Second, it's not the most efficient bio-fuel available. Cane sugar-based more efficient and cheaper to produce than corn. Brazil is the world's leading producer of sugar cane ethanol and uses it to satisfy about half of its automotive fuel demand.

But the importation of Brazilian sugar cane is restricted in the U.S., as protection both to U.S. sugar and ethanol producers. Consequently, our sugar imports are low and our oil imports are high. Not a great trade, that one.