Monday, May 16, 2005

Seven Principles of Macroeconomics

The Bush Administration has avoided recession to date largely because, from shortly after the inauguration, the Federal Reserve created money at a faster rate than the real growth rate of the economy. When the Federal Open Market Committee—the monetary policy arm of the Fed—put an end to this last year, it said that it had ended what it called an "accommodative policy." In plain English, the Federal Reserve had been printing money to finance the neo-conservative excesses of war and tax cuts. In the absence of any self-discipline by the Republican-controlled Congress, expenditures have been exceeding tax revenues year after year, creating record budget deficits that stand in stark contrast to the last years of the Clinton Administration, when the federal government ran budget surpluses that were allowing the United States of America to begin a long, slow process of paying down the national debt, which had skyrocketed during the Reagan Administration.

To clarify where the American economy stands right now, several myths need to be put to their everlasting place of rest; and the best way to do this is to affirm principles of economics. These principles, by the way, are not subject to debate; they are not cause for argument from alternative perspectives; and they are certainly not going to go away because of some "new economy" invented in the fertile minds of neo-conservative radicals clutching their positions of power, their lifer status at think tanks or in academia, or their awards and accolades from their fawning peers.

Principle 1: The Cause of Inflation
Creating money at a rate faster than the economy can absorb it creates inflation. More importantly, it is the only process, under normal conditions, that can cause inflation, which is a rise in the aggregate price level of an economy. Inflation is not caused by the price of one good or service rising; inflation is not caused even by the prices of a bunch of goods or services rising.

And inflation is not caused by an increase in wages. Most notably, raising the minimum wage is not "inflationary," and anyone who says otherwise is just plain wrong.

If prices of goods or factors go up in one sector of the economy, consumers and business will substitute away from the products and factors whose prices are rising to the extent possible; and to the extent that they cannot get away from those more expensive things, they'll just have less income to buy everything else. It is only when the Fed accommodates a price rise in one sector that the substitution and income effects don't deal with the situation. When the Fed pulls a helpful little stunt, it's called "monetizing a price shock," and it makes everyone feel okay for a while; but ultimately, all prices go up, and everybody is back to square one. The Fed's history of providing abnormal liquidity is long and illustrious. In the lifetimes of the most of the readers of this article, the Fed has graciously "provided liquidity" for the Arab oil embargo of the early 1970s, the stock market crash of the late 1980s, and the tragedy of September 11, 2001.

Principle 2: Budget Deficits Do Matter
If the government cannot pay for its expenditures with tax revenues, then it must borrow money. It does this by selling Treasury securities of various terms to maturity. Neo-conservatives claim that federal budget deficits don't matter: since the Treasury securities are backed by the full faith and credit of the United States of America, the government will not default, so there is no need to worry about mounting national debt accumulated through years of fiscal irresponsibility. Some even point out that, as a percent of the Gross Domestic Product, the federal budget deficits are actually fairly modest compared to the debt as a percentage of income of many households.

These arguments are silly. When a household borrows money, regardless of how much, the effect on capital markets isn't just minimal, it's nil. A household simply cannot borrow enough to have any impact whatsoever on the global supply of lendable funds.

But a nation the size of the United States can; and more importantly, it does. Hitting the global capital markets for hundreds of billions of dollars year after year has profound impact not just here in the United States, but everywhere on Earth. The United States will pay whatever interest rate it must to command the money it needs. That means everyone else—from the family borrowing for a new home to the small nation needing money for economic development—must not just meet those interest rates being paid by Uncle Sam, but exceed them, since no other borrower's IOU on Earth is as safe as those Treasury instruments.

Principle 3: Lunch is Served, Sir
But interest rates were so low for a long period of time during the Bush Administration. These low rates propelled a decent economic expansion. How could it be that federal deficits should have been pushing interest rates up, and printing money should have been causing inflation, but neither of these things happened?

Recall from above that the Federal Reserve was providing an "accommodative" monetary policy for pretty much the entire first term of Bush Administration, effectively printing money to pay bills that should have been paid with hard tax revenues that the Republicans pandered away with one round of tax cuts after another.

Here's the key: interest rates are the price of money. Think about it: to give up using money, a person gets interest on a savings account; to obtain money in excess of income, a person must pay an interest as a fee for having that extra dough. So, when the Federal Reserve pours shiploads of money into the economy, it's doing nothing more than increasing the supply of those greenbacks; and as the supply of anything turns into a flood, its price will go through the floor.

Ah, there's the ticket, then: all that excess money the Fed was cranking out was driving the price of money—interest rates—through the floor, and this was feeding a nice little economic expansion. So even as the Republicans were putting pressure on global capital markets, which should have been pushing interest rates upward, the Fed was pounding out the greenbacks to keep domestic interest rates low.

But why didn't all that money create inflation before now?

Principle 4: Foreign Toasters
"If Americans would only save more money..." or so the whine commences about the low domestic savings rate. That's disingenuous on its face: with domestic interest rates riding rock bottom in recent years, no American in his right mind is going to commit a whole lot of cash to a hole in the ground from which no consumption pleasure can be derived. More to the point, anyway, the cheap imports give Americans a perfect vehicle for saving money while consuming it.

When a dollar goes to a foreign country in exchange for an import, that dollar must eventually return to the United States. This is the necessary balance of capital flows: a short-term, liquid financial asset like a greenback going out must roughly be matched by a long-term investment coming back. The short-term side of the equation is called the "trade account," and the long-term side is called the "capital account" (well, sort of). A negative trade balance must be matched by an equal, positive capital inflow. Thus, by American consumers buying foreign goods, they are effectively saving money in foreigners' central banks; and then those foreigners use the dollars to invest here. And there's one great big, giant target for investment that will offer whatever it must to get the money it needs, and this behemoth needs to borrow lots and lots of money because it can't keep within its budget.

That's right: consumers buy imports and send dollars overseas in the transactions; then those dollars come back as foreign financing of the United States government's budget deficits! And the Americans who are buying imports really are the source of those funds that ultimately go to finance the excesses of the Republicans. The Americans are saving in overseas central banks; and instead of drawing interest, they're getting goods at a discount to what they'd otherwise pay if this capital flows balancing mechanism weren't needed.

Principle 5: That Lunch Wasn't Free, Sir
The Federal Reserve Board has many duties. It is the regulator of banks, it is the lender of last resort to banks, it is the agent of the Treasury for the printing of money. But in its role as the creator and enforcer of monetary policy, it has one and only one job: the maintenance of the stability of the aggregate price level. Period. The Fed is not to trade off the stability of the aggregate price level for anything—not to help the economy out during a rough patch, not to ensure that Republican presidential candidates get elected, not to kill off "irrationally exuberant" stock markets, not to "accommodate" irresponsible tax cuts and wars.

The Federal Reserve is to prevent inflations and deflations from occurring. And when it strays from this path, as it has to prop up the Bush Administration and its shopaholic allies in Congress, it must eventually mend its ways and in so doing proclaim its virtuous duty as the inflation fighter.

Well, here come all of those greenbacks, fresh from their overseas tour at famous central banks around the world. Billions and more billions of them seeping back into the U.S. economy, in their excess making each one worth less and less, therefore causing dollar prices to rise to reflect the eroding value of each one.

The Fed must clamp down on the money supply by lowering its growth rate to something less than the real growth rate of the domestic economy so that the real economy can slowly sop up and get some use out of all those extra bucks.

But remember from above that interest rates are the price of money. Just as surely as interest rates should fall as the supply of money becomes excessive, interest rates should rise as the supply of money gets squeezed.

But that creates a bit of a problem. Rising interest rates are the great killer of economic activity: households won't borrow as much for big ticket items, so businesses will start seeing their inventories accumulating, which will make them cut back on production, which will mean layoffs, which will mean households will have less income, which will mean less buying of more modest goods and services, which will mean layoffs spreading out of manufacturing and into service sectors, which will mean...

Principle 6: The Heartbreak of Recession
As if this scenario isn't grim enough, the labor market in the United States hasn't been all that great for quite some time. President Bush and his minions tout the economic expansion,but seem to be pretty quiet when it comes to that rascally unemployment rate that stays above five percent officially and is some ways higher if discouraged workers are tossed in for good measure.

The great shift in the paradigm for the new breed of conservatives is that recessions can't happen because the over-accumulation of inventories lead-in doesn't happen anymore. Companies are just too darn good at keeping inventories from getting out of hand, what with all of the computerized management systems and just-in-time ordering and the like. But the key has been the sharply lower use of permanent stocks of labor: keeping workers at the farm is inconsistent with flexibility in production, so when they're really not needed, it's better if they can be let go on a moment's notice if at all possible.

The problem is that, once production has been re-aligned for such flexibility, there's not a lot more that can be done once the consumer demand dries up. The paradigm shifts right smack back to where it started, except that there's no wiggle room to adapt to recessionary demand pull-back. The tree that was flexible enough to bend to the ground in a breeze finds the hurricane a good reason to go, "SNAP!"

Principle 7: What Happens When There's No Parachute
Now normally, the federal government could step in when the economy turns sour. Jobs program, extra spending on social stuff, maybe more unemployment benefits, more money for higher education and training programs, a tax cut, perhaps even a decent little war.

Oh, that's right: the federal government has spent itself into a hole, so borrowing more money might push interest rates up even more, which would push the economy into an even deeper recession. Besides, the Republicans are ideologically opposed to make-work jobs programs; and stimulating the economy with another round of tax cuts would just drive the federal budget deficit into even worse territory.

Fortunately, there's always a good war that could stimulate the economy.

Oh, that's right: the United States can't afford another war; and anyway, the armed forces are up to their necks already with Afghanistan and Iraq. So even though we really should plow North Korea and Iran back a couple of decades before they get enough nukes to start mopping their respective regions of the world with threats of nuclear annihilation, we can't.

Well, then, it looks like a no-holds-barred recession is on the agenda.

The Dark Wraith has spoken, and having spoken, hopes his readers are all of good cheer, now.

<< 9 Comments Total
 PoliShifter blogged...

Excellent post. Straight and to the point.

I guess it is no coincidence that the Pentagon is moving to closes a bunch of bases in an effort to "save" 49 Billion dollars.

Military Recruitment is down and over 5,000 soldiers are AWOL....

We could very well be in for a world of hurt in a short amount of time if North Korea and Iran call our bluff.

So, increasing the minimum wage does not cause inflation? You mean we could actually not hire illegals but rather pay Americans a living wage and still buy reasonably priced goods?

Those NeoCons have the propaganda down to an art...

Mon May 16, 01:20:25 PM EDT  
 SB Gypsy blogged...

Good Afternoon, Dark Wraith

I hope that you have recovered from Finals Week. Thank you for more mind-candy.

If prices of goods or factors go up in one sector of the economy, consumers and business will substitute away from the products and factors whose prices are rising to the extent possible; and to the extent that they cannot get away from those more expensive things, they'll just have less income to buy everything else.

Now, in the case of my company, when the price of oil goes up, we get charges called "Fuel Surcharge" from everyone - from the Electric Co. to the Phone Co. to UPS. It seems like everyone who supplies anything to us will pass along the increase in energy price.

There is no way to get away from this by substituting different energy sources. In addition, the
need for energy is so all pervasive, it affects the price of anything you can buy.

In order to stay in business, we are forced to absorb those increases, or raise our prices. If we absorb, we cannot give raises to our workers. We may even go out of business (throwing another 5 people on unemployment).

If we raise our prices,thereby passing the buck along, the companies who use our product must either raise or absorb.

So, in either instance (absorb or raise), I see higher prices and weakening wages. As these percolate through the economy, everyone who uses energy in any form will be hit.

We have less money, and what money we have will not buy as much as it used to. I thought that was inflation, no?

Mon May 16, 01:21:42 PM EDT  
 SB Gypsy blogged...

Hi Neoconcrusher,

He wants to save 49 bil?? And here I thought he was closing Groton sub base to spank Connecticut for voting for Kerry!

I think if Groton does close, I may need to cultivate a taste for Spam!

Mon May 16, 01:30:25 PM EDT  
 oldwhitelady blogged...

Dark Wraith, Good afternoon, I guess you got the finals all read and scored?
In reading your post - terrific, as always, I now understand that Principle 2 : because of the
Uncle Sam's borrowing , the interest rates we pay go up. Isn't that a double edged sword!
We're paying the taxes to pay back US borrowing, and we get stuck again with our own.
As far as good cheer goes - Yes, considering all the possibilities, sure.. good cheer.

Mon May 16, 02:16:05 PM EDT  
 Dark Wraith blogged...

Good afternoon, Old White Lady.

You've got it: one way or the other, we pay the piper for excesses at both the personal and the national levels.

In the case of overspending by the federal government, the pressure on interest rates makes them higher than they would otherwise be; and if we print too much money to nullify that effect, we then pay through higher inflation down the road, which itself eventually causes interest rates to go up. But even worse, sooner or later, the Federal Reserve has to stop the inflation by reigning in the money supply, which drives interest rates through the roof.

And of course, racking up a nice, juicy national debt is a great gift to our children.

The Dark Wraith spreads joy throughout the Blogosphere.

Mon May 16, 06:14:31 PM EDT  
 PoliShifter blogged...

SB Gypsy

I think there is a little bit of "spank the states" going on with the Bush Administration. I wonder if anyone has analyzed the base closures to see if they are happening mostly in States that voted against Bush.

I live in California and a lot of people here think Bush hates California, coincidently, we are getting a good share of base closures and no help protecting our borders.

Mon May 16, 06:38:17 PM EDT  
 Dark Wraith blogged...

Good evening, SB Gypsy.

That's a good issue you bring up. You see, as long as money is being printed faster than the real economy can grow, prices can be passed along the supply chain clear to the consumer level. The main problem comes when the over-printing ends, but there are problems along the way, too, the primary one being that the overhang of money doesn't get distributed evenly throughout the economy. The truth of the matter is that wages and salaries have not kept pace with inflation for a long time, which means that real purchasing power has eroded more and more.

But back to your point, suppose that Mr. Wholesaler passes its cost increases on to the next level, Ms. Retailer. Ms. Retailer can do several things: she can pass the entire increase along to Mr. Buyer; she can pass some of it along to Mr. Buyer; or she can just eat the whole cost increase and leave Mr. Buyer right where he was with respect to price.

Now, Mr. Buyer isn't going to like to see the price of Ms. Retailer's product going up, and he has several alternatives.

First, he could buy an alternative product. If what he's buying has lots of alternatives, he's going to dump Ms. Retailer's product like it's a hot potato. Ms. Retailer realizes this, so if she has lots of competitors, she's not going to be able to pass along much, if any, of her cost increases.

Second, if what Mr. Buyer is purchasing doesn't have many substitutes, he's stuck, especially if it's something he really has to have. (Not surprisingly, we call these goods necessities.) In this case, he's going to have that much less money to spend on all the other things he buys. That means the demand for all other products goes down, and when demand pulls inward, prices pull inward, as well. This is what was going to happen during the Arab oil embargo of the early- to mid-1970s: the price of gasoline shot up, which made everyone poorer since they didn't have a lot of money for other goods and services in their lives. This meant other companies couldn't pass along their price increases, and the whole economy began to spiral into serious recession.

But that's where the Fed, trying to be helpful, steps in: it "adds liquidity" to the economy by over-supplying money. The extra dollars allow people to afford not just the higher gasoline and other energy price, but they can also afford prices of other goods and services going up, too. That means other companies can then start to pass along their cost increases; and lo and behold, the aggregate price level—not merely the prices of some goods and services—begins to rise. The extra money has allowed Mr. Buyer to pay for everything he needs, so all of the Ms. Retailers can push their cost increases along to him. And even more importantly, Mr. Wholesaler doesn't have to worry about Ms. Retailer finding other suppliers who aren't getting so expensive.

But it gets worse: because Mr. Wholesaler has passed along cost increases every month for a couple of years, now, Ms. Retailer is going to start marking her prices up to Mr. Buyer in advance of cost increases she sees. After all, Mr. Buyer has eaten them so far; and by moving the cost increases forward so they reflect expectations instead of what's already happened, Ms. Retailer is no longer chasing her costs incurred last month with price increases this month.

That's where the cancer sets in: expectations of inflation. When the expectations get embedded in an economy, the Federal Reserve can declare that its days of over-printing money are finished, and no one's going to be the first to believe it and stop moving expected price increases through the chain of distribution.

That's when things get really ugly, and that's what happened after the Fed finally, after years of excess, clamped down on the money supply at the end of the 1970s. No one believed it, so the Fed had to be overly restrictive for a long, long time until everyone finally accepted that the Fed had gotten its act together.

But that was way back then.

The Dark Wraith cruises out to get some dinner now... Spam and bread, of course.

Mon May 16, 06:50:43 PM EDT  
 J. G. P. blogged...

Hello from Spain. I agree with you, Dark Wraith. As an economist, the current American situation is a complete deja vu. Act I: More defense spending, less taxes for the rich, just like the Reagan era. Therefore it will end up in the same way: interest rate hike and recession. Act II: A new administration custs back defense and raises taxes, just like the Clinton presidency. We have already seen this play. It is just boring this re-run.

Fri Jun 03, 10:10:44 AM EDT  
 StealthBadger blogged...

The discussion of interest rates explains why the newspapers were all excited by the interest rates, but my stepfather with the economics degree was incredibly dour. It also explains why there is very rarely a surprise when the Fed announces a rate change.

Well, here come all of those greenbacks, fresh from their overseas tour at famous central banks around the world. Billions and more billions of them seeping back into the U.S. economy, in their excess making each one worth less and less, therefore causing dollar prices to rise to reflect the eroding value of each one.

Here, did you mean that the price of the dollar falls, as in that if another currency is holding steady during the change in the dollar's value due to inflationary pressure, it takes less of that currency to purchase a dollar? Or am I getting terminology wrong?

The problem is that, once production has been re-aligned for such flexibility, there's not a lot more that can be done once the consumer demand dries up. The paradigm shifts right smack back to where it started, except that there's no wiggle room to adapt to recessionary demand pull-back. The tree that was flexible enough to bend to the ground in a breeze finds the hurricane a good reason to go, "SNAP!"

As a computer consultant and general geek, this is the bane of my existence. People want me to set this sort of thing up for them, or to help them push back the payroll calendar a day to gain interest income, or to automate "routine" tasks so they can fire one person from the IT department and spread out the remaining workload (and then end my contract, of course), and it's dispiriting to tell them that what they're doing is like walking up to a car, pulling off the bumpers, gagues, seat belts, air bags, windshields, lights, horn, and gas cap (at the very least) and expecting to have a reliably functional vehicle. The depressing part is where they say "oh, it's not that bad."

If anything, Sarbanes-Oxley at least forced companies to keep records, and to at least give lip service to disaster recovery. Speaking of which - if you want Schadenfreude, a High Availailability test is definitely the evening's entertainment for you - walking in behind the server racks and randomly yanking out cables to see if the failsafes and redundancies are really working is always an eye-opener (you can guess how well that goes. Oh, the horror stories). This is why you always plan to fail one of these tests, just in case. Because you usually do.

Tue Jan 31, 01:45:14 AM EST