Taking Stock: Economy and Government on July 2, 2009

It is 18 month since the official onset of the current depression (as I continue to regard it), and almost six months since the inauguration of President Obama. It is a good time to take stock--to take the pulse of the economy, but also of the new Administration's efforts to speed economic recovery.

A few statistics will help set the stage for analysis. On January 20, inauguration day, the Dow Jones Industrial Average was 8300; it closed that day at 7900. Today, July 2, five months and two weeks later, the DJIA closed at 8300. There have been ups and downs in between these notes, but what is so striking is that the Dow has not risen significantly even though the panic that gripped the nation between September and March has dissipated. Evidently the problems of the economy go deeper than panic, just as the financial crisis of last September was a crisis not of liquidity, borne of panic, but of solvency, reflecting tremendous losses of personal and corporate wealth.

The unemployment rate was 7.2 percent on January 20; it is 9.5 percent today. The underemployment rate has risen from 14.8 percent to 16.8 percent. An interesting statistic, emphasized by Paul Krugman, is the decline in the aggregate number of hours worked per week. In January, it was almost 3 percent higher than it had been in 2002; it is now 1 percent lower.

Most other economic indicators also reveal a deterioration in the economy, although the rate of decline has slowed, as of course had to happen at some point. The media tend to focus on month to month percentage changes in the indicators, but a more illuminating comparison is with the same month in the last pre-depression year, which was 2007. If some indicator, like employment or housing starts, was 100 in May 2007, 70 in May 2009, and 80 in June 2009, the May-June change is strongly positive at plus 14 percent; but the indicator is still 20 percent below its pre-depression level. Similarly, the DJIA has risen by about 5 percent since the close on January 20, but is 42 percent below its 2007 peak of 14,200. The unemployment rate was 5.7 percent last June (before a mild recession became a depression), the underemployment rate was 10.3 percent, and the aggregate number of hours worked per week was 107.

The Gross Domestic Product (the market value of all goods and services produced in the economy) is unchanged since the end of 2007; since the inflation rate in 2008 was 3.8 percent, and average annual real growth in the economy is about 3 percent, the economy is operating at almost 7 percent below trend. On the one hand, this exaggerates the real decline in potential economic output, because unemployment and underemployment shift some resources from market to nonmarket output; for example, people eat at home more, substituting home production of meals, which is not included in estimates of GDP, for the purchase of restaurant meals, which is. On the other hand, and of vastly greater significance from the standpoint of utility (welfare, happiness, preference satisfaction), a severe economic downturn produces great anxiety on the part of all who lose their jobs, suffer a loss of income, or fear such losses.

Another statistic of significance is the increase in the personal savings rate: from 4.6 percent to 6.9 percent since January of this year--but in 2007 it was less than 1 percent. The significance of these increases lies in the fact that money saved is diverted from money spent to buy goods and services, and the decrease in spending results in reduced production and therefore employment, and reduced employment leads to a further reduction in spending. Low personal savings rates in the early 2000s, coupled with the housing and stock market booms, meant that people's savings were heavily concentrated in housing and stock. When the market value of those assets plummeted, people found themselves with inadequate assets relative to debt, and curtailed spending. The ensuing recession became a depression when the financial crisis of last September froze credit, resulting in further reductions in spending. The banks were saved, but credit remains extremely tight.

There are some indications of incipient recovery, including upticks in manufacturing and sales of durable products and housing starts. But as long as unemployment (and underemployment) is rising and housing prices (a major store of value) and personal consumption expenditures are depressed, the economic prospects are uncertain. There have been too many false dawns and overoptimistic predictions, including by government officials. An example is the emphasis on unemployment as a "lagging indicator" of depressed economic conditions. It is true that unemployment often continues increasing after an economic recovery begins. The standard explanation is that firms prefer not to incur the cost of hiring or rehiring workers until they are sure that demand for goods and services is increasing. An alternative explanation is tacit collusion: firms may hesitate to expand output as demand rises, hoping their competitors will follow suit, since the more slowly supply rises in response to rising demand, the faster prices and profits will increase. But it is only after a depression is over that one can recognize an increase in unemployment as a lagging indicator. It would have been ridiculous to observe the steep decline in employment in 1930 and be reassured that, since unemployment is a lagging indicator, the depression was over. It had just begun.

Every sign of incipient recovery, moreover, causes long-term interest rates to rise, which in turn retards the housing recovery because mortgage interest rates, an important part of the cost of buying a house, are long term. Because the government has committed enormous sums of money to fighting the depression ($2.6 trillion, with another $7.6 trillion planned, or in guaranties), against a background of chronic budget deficits and ambitious long-range spending programs by the Obama Administration, there is concern that an economic recovery will touch off serious inflation, which might result in a tightening of credit by the Federal Reserve that might kill the recovery. Every bit of bad news, of course, reduces concern about inflation, by pushing off the prospect of it into the more distant future. There is still some fear of deflation, since the Consumer Price Index has been essentially flat for the last year, as sellers cut prices ferociously to retain customers. Because the purchasing power of the dollar has not declined, people who incurred debt in the last few years, thinking that inflation would make it easy to repay, are experiencing disappointment, and in many cases bankruptcy.

We should consider how the new Administration has done in fighting the depression. Continuing the policies of the Bush Administration, it seems to have stabilized the banking industry and limited the decline in credit availability. The enactment of the $787 stimulus program (Keynesian deficit spending) in February was an important confidence-building measure, as I explained in my book, though the program itself was poorly designed and has had as yet virtually no impact (other than the psychologivcal--but that is very important) on the economy. The government-managed bankruptcy of General Motors and Chrysler have kept those firms alive, albeit at great cost, and the cost includes not only the $60 billion or so of direct or indirect government subsidy but also an implicit commitment to further support, at least of General Motors, and an acute danger of increased government interference in private business.

Other depression-fighting programs by the Administration, notably the $75 billion mortgage relief program and the program of subsidizing the purchase of securitized debt from banks, have fizzled.

The high-handed treatment of secured creditors in the Chrysler bankruptcy, the firing of the CEO of General Motors by the government, the overambitious program of financial regulatory reform recently announced by the Treasury Department, and the financially reckless medical program being pushed in Congress by the Administration are retarding economic activity by unsettling the economic environment in which business has to operate. Active investment--the expansion of productive capacity--is a risky activity at best, and when government makes it more risky by its fiscal and regulatory policies, the amount of active investment is likely to fall.