Fixing the Economy
CUNA's economists debate the merits of government stimulus vs. fiscal restraint.
• John Maynard Keynes believed government stimulus spending is the best way to end a recession.
• Friedrich Hayek believed less government intervention increases consumer and business confidence.
• Voters likely will decide this debate during the November midterm elections.
In 1932, John Maynard Keynes ignited a debate among economists and policy makers that still burns to this day. In a letter to the Times of London, Keynes proposed using federal deficit spending to reduce the length and severity of the Great Depression.
He argued that deficits in consumer and business spending lead to recession and that government intervention is needed to hasten recovery and buy time for confidence to recover. “Government spending will lead to increased economic production,” says Mike Schenk, vice president of the Credit Union National Association’s (CUNA) economics and statistics department. “Demand will create its own supply.”
Soon after publishing Keynes’ letter, the Times printed a dissenting view from Austrian economist Friedrich Hayek. An austerity proponent, Hayek believed government intervention simply prolonged needed economic adjustment and rebalancing.
“Hayek argued for less government intervention and fewer new policies and regulations to decrease uncertainty among businesses and consumers,” notes Steve Rick, CUNA’s senior economist. “That would increase confidence and, consequently, spending.”
Fast forward 78 years. The Obama Administration passed a $787 billion bailout package to stabilize the financial system and sidestep another Great Depression. Detractors say the measures succeeded only in saddling future generations with massive debt.
Schenk and Rick hold the following hypothetical debate to help credit union leaders decide which approach is most likely to fix the economy.
Next: What's the right path?
What’s the right path?
Schenk: The government should extend unemployment insurance benefits and provide more aid to local and state governments to build roads, highways, runways, and bridges. More home buyer tax credits, appliance rebates, and programs such as Cash for Clunkers would also spur consumer spending. So would tax cuts. We need this stimulus.
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Rick: Wrong, Mike. This environment demands fiscal discipline. We should cut spending and raise the economic base to grow tax revenue and reduce the deficit. An increase in deficit-financed spending will just be offset by a reduction in private-sector spending as consumers increase their saving in anticipation of future higher taxes.
Schenk: But we have 15 million unemployed, 9.5 million underemployed, more than three million people who want to work but haven’t looked for a job in the past month, and about one million people who’ve given up looking for work. Unemployment nationally is at 9.6% but the adjusted unemployment rate is closer to 17%.
That means substantial financial hardship for tens of millions of Americans and the potential for huge, long-term societal issues such as big increases in crime, divorce, and substance abuse.
Low interest rates aren’t stimulating the economy because of excessive household debt and banks’ tight underwriting standards. So monetary policy is impotent. We need government intervention to hasten the recovery and buy time for consumer confidence to recover.
Government needs to spend when consumers don’t.
Rick: But government intervention will only prolong the rebalancing needed to fix this economy. We should let market forces work to restructure the size and composition of the economy—further deleveraging, additional saving, asset depreciation, and rising exports.
The French economist Jean-Baptiste Say once said that supply creates its own demand. We need companies to regain confidence about the future so they invest and hire more workers. These new jobs will create the income needed to fund new spending.
Schenk: New jobs? What new jobs? The economy is growing at a paltry 1.6% annual rate. If growth continues at that rate, the economy won’t generate enough new jobs to absorb new entrants into the labor market. We need to create about 150,000 new jobs per month to absorb all of these new workers.
Rick: Let’s not panic. We’re in a self-sustaining recovery. And, in a typical recovery, there will be ups and downs. Don’t worry—the economy will recover.
We shouldn’t interrupt the structural realignment of our economy. We need to move jobs and capital away from the home building, auto, and financial sectors into other sectors of the economy where we expect spending to be in the future, the export sector.
Plus, government consumption and investment has been growing at a 5% to 7% annual clip for the past few years due to the Bush and Obama stimulus plans. That’s a much faster rate than overall economic growth, creating huge deficits. These deficits only create the incentive for people to save more money today because they’re anticipating higher taxes in the future.
Schenk: Spoken like someone who has a job.
Next: Some bright spots
Some bright spots
Rick: Things aren’t all bad. U.S. exports are growing at an annualized rate of 10% to 12%. The BRIC countries (Brazil, Russia, India, China) are expanding and buying more of our products. We can’t stimulate exports more with monetary policy by devaluing the dollar because it’s the world’s reserve currency.
The U.S. economy is shifting from consumption to exports, which is a good thing. We need to stop relying on consumers for economic growth.
Imports have also grown: 29% during the second quarter at a seasonally adjusted annual rate. Consumers must have rising confidence to spend money on foreign goods and services.
Schenk: But imports reduce U.S. economic activity, especially consumer consumption of durable goods. Consumers hunkered down during the Great Recession and saved their money. They wanted to be liquid.
There has been a slight recovery in consumer consumption lately, but we’re coming off a very low base. Weak fundamentals—few new jobs, low income growth, high unemployment, limited access to credit, and low consumer confidence—are restricting sales. We need government deficits to offset low private spending and investments.
Rick: You fail to recognize that many factors support consumer spending. In August, 67,000 new private sector jobs were created. And consumers are fixing their budgets after years of taking on too much debt and not enough savings.
Plus, there has been significant debt reduction due to mortgage refinancings. Many Americans have refinanced their homes due to low interest rates, which frees up cash flow.
Schenk: You neglect to say that we had a net loss of 95,000 jobs in September. And consumer credit outstanding is dropping by $5 billion to $15 billion per month. That’s the fastest pace of deleveraging in the history of the U.S.
We need public borrowing to offset some of this consumer deleveraging. When consumers pay off their debt and don’t spend, the economy slows down. The government should be borrowing and spending to get the economy going.
Rick: We need deleveraging. Consumers built up too much debt from 2003 to 2007 and it’s time to pay this off.
Schenk: Banks could help. They’re sitting on $1.1 trillion in excess reserves. The Fed is trying to stimulate the economy by buying bonds from banks and injecting cash in them, but banks are just sitting on the cash. Let’s spend it to prevent a double-dip recession.
If banks don’t want to lend money to the private sector because they’re worried about defaults, the government should step in and borrow some of this money to build new roads, bridges, and highways. Let’s put those unemployed carpenters, construction workers, and electricians back to work.
Rick: We just need time. We need to give employers time to start hiring during the next few quarters. Then tax revenue will rise, unemployment benefit payments will fall, and the deficit will decline.
Next: Housing construction uncertain
Housing construction uncertain
Schenk: Speaking of unemployment benefits, let’s talk about all of those unemployed construction workers and electricians. There has been a massive drop in housing construction during the past three years.
The government needs to step in and support housing because the industry is still contracting and losing jobs. There are millions of unemployed carpenters.
Rick: Not so fast. Government intervention just changes the timing of home purchases, not the amount of purchases. So intervention wouldn’t stimulate more purchases, it would just pull them forward.
Plus, too much capital was invested in home building and appliances, and we need to correct for that. The markets have self-correcting mechanisms for this. The housing market is showing signs of moving forward (“Housing market risks and strengths,” p. 36).
Recent government programs such as Cash for Clunkers and the appliance rebates just delay the ultimate day of reckoning. Why do you think General Motors and Chrysler went bankrupt?
From 2003 to 2007 the auto industry sold 16 million to 17 million cars per year. That led to overinvestment in the auto sector. When they went from annual sales of 16 million to nine million in 2009, they couldn’t survive.
This is the restructuring that must take place as we reduce the number of workers and factories in the auto sector.
Schenk: Your empathy is overwhelming. We should help these unemployed auto workers by extending unemployment benefits, increasing training, and moving them to other fields.
Next: ‘Animal spirits’
Schenk: It’s all about the animal spirits—that’s Keynes’ term for consumer confidence. If people don’t have confidence, they won’t spend and businesses won’t invest.
American consumers are still in recession mode—they don’t believe the recession has ended and they’re not spending. They’re hoarding cash.
This leads to a liquidity trap, where money is being trapped in banks which aren’t lending, households that aren’t spending, and businesses which aren’t investing.
Government spending and permanent consumer tax cuts would improve consumer confidence, which would unleash this liquidity trap and bring a flood of money into the economy, increase spending, and get things going again.
Rick: For once you’re right. There is a crisis of consumer confidence and animal spirits are low. But what we need is clarity on taxes, regulations, energy, and health-care costs.
People need to know what their future taxes will be and that we won’t have a fiscal crisis in the near future because of excessive deficit spending.
Companies won’t make long-term business plans if they don’t know what their costs will be in labor, energy, regulations, or taxes. It’s time for the government to provide clarity.
Next: Housing market risks and strengths
Housing Market Risks and Strengths
There are several reasons to be hopeful about the U.S. housing market in the months ahead, according to CUNA Senior Economist Steve Rick:
• Thirty-year mortgage rates are low, averaging 4.5%;
• Falling home prices have led to record levels of housing affordability;
• Private sector job growth has improved; and
• Public and private foreclosure mitigation efforts are reducing the number of foreclosures and decreasing the market’s housing supply.
But dangers still lurk on the horizon:
• Expiration of the housing tax credit in April. That pulled forward a lot of home buying that would have taken place during the second half of this year. That could lead to weaker second-half sales.
• Rising foreclosure sales. “We expect 2.5 million homes will be put on the market in 2010 due to foreclosures,” Rick says. “More homes on the market will lead to a further reduction in home prices, which will lead to more Americans owing more on their homes than their homes are worth.”
• Buyers will expect lower home prices in the future. This will delay their purchase decisions.
• Unforeseen events, such as war in the Middle East, could cause a double-dip recession that could lead to a housing market crash.