There is much discussion going on about the state of the economy, or the State of The Union if you will. Some economists argue that we are entering a deflationary cycle – like Japan’s ‘‘lost decade” of the 1990’s. Others believe that the U.S. economy is headed straight into high inflation. Either way, it is likely that this transitional phase is going to be quite a rough patch.
How are deflation, inflation and permanently high unemployment linked to each other? For starters…
… as long as we have to accept high unemployment numbers (with low-price competition from China) the vicious circle of low wages, stagnant incomes, low prices and deep pay cuts will keep inflation at bay. In this economic climate, deflation is more likely than any other scenario.
To fully understand where we are today it might be useful to look back at the onset of this crisis.
A House of Cards
In the fall of 2008 a series of bank and insurance company failures triggered a financial crisis that brought the U.S. economy to its knees and halted both U.S. and global credit markets. The result was an unprecedented government intervention around the globe. Here in the U.S., the government had to bail out the two biggest mortgage lenders Fannie Mae (FNM) and Freddie Mac (FRE). But that wasn’t all. Lehman Brothers, the storied 158 year-old investment bank, was forced to resort to the seemingly unthinkable: declaring Chapter 11 bankruptcy and opening the stage for one of the largest financial disasters in history. The house of cards of financial derivatives collapsed in an instant.
Too Big to Fail
The collapse of Lehman Brothers caught the federal government by surprise. The Secretary of the Treasury apparently underestimated the severity of the situation and chose to let this renowned investment bank fail.
American International Group (AIG) was deemed too big to fail and so the federal government came up with an immediate $85 billion capital injection. While there was originally no common ground between the Democrats and the Republicans as how to deal with the crisis, by the time AIG was in trouble, the Congress was aware that not acting was not an option. The unfolding collapse of the financial system could turn into a 1929-style Great Depression 2.0.
In the climate of fear and mistrust, Bank of America agreed to acquire Merill Lynch in order to save it. This didn’t stem the wave of distress and the news were getting from bad to worse. In a matter of days J P Morgan Chase had to take over Washington Mutual (WaMu), which turned out to be the biggest US bank failure in history. By September 17th 2008, more public corporations filed for bankruptcy in the US than in all of 2007.
In hindsight, the roots of the 2008 financial crisis lay in reckless real estate and in subprime lending deals. Collateralized debt obligations (CDOs) and other complex derivatives promoted the hot-potato-approach to securities. Reckless lenders like WaMu dispersed risks by underwriting collateralized debt obligations they never intended to keep on their books for the long haul. As long as they succeeded in finding someone to dupe, the fraudulent subprime mortgage scheme kept going. Only when subprime mortgage deals collapsed and the financial markets spiraled more and more into the abyss, the federal government stepped in big-style. On 11th February 2009, Congress saw no other way out but to pass a $787 billion bill, the American Recovery and Reinvestment Act.
On national TV, the American Recovery and Reinvestment Act (better known as the “Stimulus Bill of 2009”) was sold to the American public as a bipartisan achievement. But in fact it hasn’t gotten a single Republican vote in the House and after long deliberations in the Senate only three Republicans joined the Democratic majority.
As expected, the Stimulus Bill of 2009 didn’t have an immediate positive effect on the financial markets and the economy. In fact, before things could get better they first started to get much worse. As a result of fear and doubts, which were still lingering in the minds of investors and consumers alike, the Dow Jones Industrial Average saw a steady decline from 9,034 on January 2nd down to 6,547 on March 9th 2009. The bold action of the Congress, the Federal Reserve and the administration appeared to be averting a deeper recession, a 1929-style Depression 2.0.
And so began the look-the-recovery! fallacy. From March 9th 2009 through April 23th 2010, the stock market rallied as evidenced by the Dow Jones Industrial Average, which went from a depressed 6,547 to the 11,205 mark. The recession appeared a mere and distant after-thought, especially because 1st quarter earnings seemed to confirm the bullish market sentiment. After the American Recovery and Reinvestment Act, the Obama administration shepherded the health care bill through the Congress which culminated in a historic 219:212 vote. However, the passage of this landmark legislation marked a turning point for the worse. Companies are now in no mood to hire and banks are in no mood to lend.
At the end of the 2nd quarter of 2010 it became clear that the recovery was too weak and the recession in danger of returning. Today, Noriel Roubini (the doom-end-gloom economist) announced that he believes the risk of that happening is around 40%.
The idea behind the Stimulus Bill 2009, which was supported nearly exclusively by Democrats (only 3 Senate Republicans and not a single House Republican voted in favor of it), was based on the Keynesian theory, which was first spelled out by John Maynard Keynes in “The General Theory of Employment, Interest and Money (1936)”. Keynes argued that when the free market fails during a recession, the government is the lender and investor of last resort. It is up to the government to revive the economy and the best way to do it is to borrow and spend in a way that maximizes the impact of every dollar on real economy. To do this, the money must get into the hands of working consumers who have to eat and pay their bills. Instead, the stimulus was largely used to bail out financial institutions and they used it to speculate in the stock and the Treasuries market, fueling another bubble which is yet to burst.
Many Americans have a deep-rooted aversion to government spending and for a good reason. Too much of a safety net might kill off any incentive to actually work. Especially the extension of unemployment benefits up to 99 weeks can indeed prove counterproductive, because folks get hooked onto government aid for good and loose the ability to pull themselves up by their bootstraps. By the time the unemployed benefits finally run out and the unemployed are supposed to stand on their own feet, the set of skills they can deploy in the marketplace might be no longer desired.
The Nanny State
There are two opposing approaches to solving the current crisis. The Democrats want to borrow/tax and spend, the Republicans want to cut (spending) and cut (taxes).
The Democrats seem to believe that consumers have the tendency to fall victim to predatory business practices unless they are protected by government agencies and regulations. The extreme democratic scenario creates a nanny state and the obvious question is: Why should I care about my future if I can “delegate” most of my responsibilities to the federal government? Bring this scenario to an extreme and the U.S. becomes a second France, only much bigger.
The Republicans favor tax cuts and a small (“lean and mean”) government. They promise lower capital gains, lower income tax rates and lower estate taxes as a way to get out of the economic quagmire. The money the rich would save on taxes would then miraculously “trickle down” the social ladder. They seem to forget tat the national debt will not evaporate through tax and spending cuts; it needs growth which their supply-side economics is not able to generate. The key word is demand.
It’s Only a Trickle
The Democrats argue that Keynes proved the merits of government spending to kick-start the economy but they fail to accept that a truly Keynesian stimulus must be directed to those who have the highest propensity to spend, so that it makes a lasting impact on the real economy. The 10% poorest of Americans are more likely to spend everything they earn. On the contrary, the wealthiest of Americans may decide to hoard any additional income as their immediate needs are already met. This is the main reason why “trickle down economics” has only little or no real effect. Too bad the Democrats screwed up the well-intended stimulus so badly they will be loosing seats come November.
There are two reasons why post-Keynesian inflation will not be a threat to your savings for some time to come. For the economy to overheat you need a strong demand and this won’t happen with massive household deleveraging (which has not yet even seriously begun) and baby boomer’s thrifty retirement. On the other hand, any inflation in developing economies has a negligible effect on prices over here because imports of China’s goods and India’s services are still sufficiently competitive to wipe out a lot more jobs in America. And don’t forget: With the Republicans in charge we could even see European-style austerity. We are definitely looking at deflation for quite some time to come.
Paul Krugman, the New York Times editor with a Nobel Price in economics to brag about, voiced one of the most pointed arguments in “The Conscience of a Liberal: Permanently High Unemployment”. If you want to read something, read this one. Krugman has been right so far.