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Why the recovery continues to be subpar

April Personal Consumption Expenditures were a bit below expectations, but the story remains the same: consumer spending has recovered from the losses of the last recession, but it is growing at a subpar rate and is about 10% below its long-term trend level, as this chart shows.

It's been a subpar recovery, and that shouldn't be surprising. I've been predicting this since early 2009. Fiscal and monetary policy levers supposedly have been set to max stimulus for over two years now, but policymakers never really understood what they were doing.

Monetary "stimulus" that involves very low short-term interest rates and lots of bond purchases can't create growth out of thin air. Pumping money into the economy only makes sense if the economy is desperately in need of money, which was the case in the latter half of 2008. (At the time, the plunge in commodity and gold prices, the surge in the dollar, and soaring swap and credit spreads were key signs of a shortage of money.) Since then, easy money has only served to weaken the dollar, pump up gold and commodity prices, raise inflation expectations, and (finally) push actual inflation higher. Easy money hasn't done anything to strengthen the economy.

Fiscal "stimulus" that involves massive borrowings to fund huge transfer payments, make-work projects, and subsidize state and local budgets also can't create growth out of thin air. Taking money from those making a lot of it (e.g., corporations which have generated record profits) and handing it out to those not doing very much (e.g., by extending unemployment benefits, funding "shovel-ready" projects, and keeping union and public-sector employees on the job) not only can't create new growth, it destroys growth by creating perverse incentives.

Printing money, making money cheap, borrowing to force-feed spending—it's all an exercise in futility and ultimately counterproductive. Growth only comes when money is spent on things which increase the productivity of labor. Our standard of living rises only if our collective efforts result in more output for a given number of hours of work. Government has a dismal record when it comes to making productive investments, because the incentives are not properly aligned; the profit motive is missing. Force-feeding money to the economy only results in more speculative activity, since it's easier to bet on rising gold and commodity prices than it is to risk setting up a new company and hiring new people. Soaring deficits don't create new demand, they only create fears of huge future tax hikes and that dampens animal spirits today.

What has been working to create growth is the inherent dynamism of the U.S. economy, and the tireless efforts of entrepreneurs and workers who strive to improve their lot in life. Businesses have been busy restructuring, laying off nonessential workers, cutting costs, and boosting their profits. The economy has shifted massive amounts of resources from the troubled financial, housing and construction sectors, and into the up-and-coming mining, technology, and manufacturing sectors. The economy is growing despite the best efforts of politicians to create growth. Financial markets have recovered not because the economy is in great shape, but because the economy is much better today than markets feared.

The good news is that the evidence of stimulus failure is plain to see, and the mountain of debt it created is a lasting monument and a lesson to all. Congress has now shifted its efforts 180ยบ: no longer is the debate about how much to spend on stimulus, but how much spending to cut. We really can't continue on the path of the last few years, and that is a great relief. We haven't yet figured out which path to take going forward, but by trial and error someone in Congress or the White House will figure it out. When somebody does, the magic formula will almost surely consist of cuts to wasteful spending and transfer payments, market-based reforms to healthcare, and lower and flatter tax rates coupled with tax-base-broadening reductions in deductions that will truly stimulate growth.

In short, out with the Keynesians, and in with the Supply-Siders.

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