Wednesday, September 26, 2012

The Long View

If you were giving an economics speech in March of 2009 and said "the United States has the most dynamic and resilient economy in the world", people would have looked at you like you were crazy and then boo you off the stage. Ditto had you done that at any time in 1931 at the trough of the Depression.

And yet... the DJIA is now over double its value in March 2009 and less than 10 years after the worst economic crisis in the history of the country, the US would embark on a 20 year economic boom of unparalleled prosperity that lifted over a hundred million Americans into the middle class.

Unfortunately, the average American can't comprehend the slow moving nature of the economy. In the midst of our campaign season, both parties wait with bated breath over the release last month's jobs report on the first Friday of every month. Wall Street hangs onto Fed Chief Bernanke's every word to get an idea of what the target rate will be 6 months into the future. And everybody who was ever asked a question similar to "where do you see yourself in 5 years" is conditioned into thinking that 5 years is a long time in their working life.

Campaigns, markets, and working lives might be all short term, but the economy is a long game. It always has been, pithy quotes from Keynes notwithstanding. And this is the perennial problem that plagues the Federal government, because it poses a huge conflict of interest for policymakers.

Elected officials have to balance short term against the long term. And as long as political cycles are shorter than economic (and business) cycles, it will be impossible to reconcile the mismatch between feel good short term policies politicians implement and wise and prudent long term policies that politicians should implement.

The most recent economic crisis, for example, had two major policy thrusts. Both of which had short term benefits and (and as of yet, unknowable) long term consequences. The first was undertaken by the Federal Reserve, which, over the course of a year, injected over 1.6 trillion dollars into the monetary base (M0), an increase of a factor of 2.

Graph of St. Louis Adjusted Monetary Base
Source: Federal Reserve Bank of St. Louis
This will undoubtedly have serious long term consequences because there is a ton of money waiting to be converted into bank loans. M2, which is a measure of the velocity of money (the rate at which M0 changes hands) is still at a relatively tame 9 trillion. But given the amount of money we've poured into the monetary base, it has a potential of reaching to 27 trillion, which would send us into something that's pretty close to hyperinflation, which is something that we need to avoid at all cost. 

We haven't gotten to that point yet because banks are keeping most of their money at their accounts at the Fed. The short term solution to the financial crisis (give the banks a lot of money) staved off a revolution in the financial sector, but now we don't know what lies ahead.

The other major policy change was ARRA (aka the stimulus) and its effect on permanently boosting baseline Federal spending. In 2008, we spent 2.9 trillion dollars and in 2009, we spent 3.5 trillion dollars. The year after that we spent 3.5 trillion again. This year, we'll spend 3.8 trillion. It's as if we passed a stimulus package every year since 2009. 

The Federal government did that in the name of protecting local and state governments from mass layoffs (more severe the ones they suffered) and to pump money into poor and unemployed households to keep buying consumer goods. The result is an increase of 5.4 trillion dollars in the net Federal debt, an increase of 90% since the beginning of 2009.

That money has to get paid back eventually. But it seems like we keep pushing "eventually" further and further away. The Fed is doing its part by buying up long term Treasury debt at extremely low rates. At this point, I'm not sure if we'll ever see a robust "recovery" because any marked pickup in economic activity will force the Fed to hike interest rates, which will immediately make government borrowing much more expensive, which will cut government spending, and send us back into a recession.

The problem is we're fighting long term problems with short term solutions. The decline in real average and median household wealth was over 30 years in the making. Part of it came from companies eliminating their defined benefit pensions in favor of defined contribution retirement accounts. Retirement accounts that most Americans neglected to contribute to. Another part of it came from the stagnation of the workforce's skills in an increasingly globalized world, which happened because of problems in the secondary education system that were 40 years in the making.

Those problems, combined with the inability of the Federal government to reform its entitlements programs, have seriously eroded the country's fiscal position. The things that the government has done only address the short term issues by artificially boosting consumer spending. In medical terms, we're treating the symptoms and not curing the underlying disease. Politically speaking, we can't do it because the electorate is too focused on the short term. 

Think of it in terms of a human being. Nowadays, we don't expect our kids to contribute to the economy in any significant way until they've graduated with a bachelor's degree. Think about what that implies. That means from birth to age 22 (actually for the majority of graduates, it'll be age 23-25), they will essentially be mooching off the toil of the productive members of the economy. That is a hell of a long time to see the beginning of a payoff.

Why then, do we expect our political leaders to be able to turn around the economy within an election cycle?

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