Seven Principles of Macroeconomics
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 elsefrom the family borrowing for a new home to the small nation needing money for economic developmentmust 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 moneyinterest ratesthrough 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 anythingnot 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.