Thursday, September 22, 2011

The Underbelly of Economics No One Talks About

It's the economy, stupid.

Truer words have never been spoken in a political context.

I find it unfortunate that both political parties spend more time in demagoguery than speaking the truth that will set the U.S. economy free. There are a few principles that I'd like to soapbox about for a few minutes:

  1. Supply and demand. It's the basis of capitalism--more demand than supply causes prices to go up; more supply than demand causes the inverse. Scarcity and price are in lock-step. Relatively simple on the whole; it, unfortunately, lends itself to monopoly and supply manipulation (for example--oil companies. They can single-handedly control how much their product costs and their profit margin by artificially restricting supply).
  2. Competition. Another cornerstone of capitalism is competition--more people making the same thing drives the price down; fewer providers of said good or service causes the price to go up.
  3. Productivity. This is the differentiating factor between companies providing the same product or service--the more productive a company's workforce, the lower it can price its product or service (see #2) and use that price advantage to gain marketshare.
  4. Investment. Money used for the development and growth of a company can be spent in a few different areas, such as: equipment (computers, desks, chairs, machinery), facilities (buildings or building improvements, land), labor (employees or contractors), research and development, or marketing.
  5. Taxes. They make the world go round; they're the bane of business and wage-earner alike.
That's really the foundation of our economy. Or is it?
The debate over taxes and the effectiveness of economic stimulus has reached the point where neither side has any new information to add--they just keep repeating the same talking points over and over again, hoping that their arguments will eventually wear someone down into agreeing with them.
That being said, I'd like to start off with my take on how our economy works.
In our credit-based economy, corporations utilize a variety of private investment capital, stock issues, and loans to do everything from acquire inventory to pay salaries. According to monetarists, managing the interest rates on borrowing and the total money supply is the key to managing the speed of economic growth. Higher interest rates and less money in the economy means it costs more to borrow and invest in and grow the company; lower interest rates mean it's cheaper to borrow money in an attempt to grow the company or cover day-to-day expenses.
The Federal Reserve Board controls this core interest rate. As William McChesney Martin, the longest-serving and most notable Federal Reserve Chairman once said, the job of the Federal Reserve is to "take away the punch bowl just as the party gets going," meaning, that raising interest rates and tightening the money supply is necessary in a robustly-growing economy to help prevent bubbles and unsustainable growth.
Martin knew a thing or two about how money worked--he became a partner at A.G. Edwards after having only worked there two years and earned himself a seat at the NYSE. Having studied economics at Columbia for 6 years and been president of NYSE, he understood exactly how capital markets functioned and how to keep an even keel on business.
With those concepts in mind, managing interest rates and money supply are traditionally the only tools that the Federal Reserve has to be able to manipulate the economy (policies such as quantitative easing will be put in the parking lot for the purposes of this discussion).
The problem that our economy now faces is bigger than managing interest rates. If monetary policy was really the cure to economic woes, certainly lowering the interest rate to 0% would cause companies to borrow and invest like gangbusters, since they would have all this free money. Unfortunately, we've seen that monetary policy alone cannot bring a country out of a recession.
Many people credit Roosevelt's Keynes-influenced New Deal with infusing the U.S. economy with enough money to grow out of the problem. While many economists debate whether it's true or not, I think there's strong evidence to support that thought (at least in part).
In current political dogma, Democrats think in Keynesian terms--by injecting massive amounts of cash into public works projects, the government can drive up employment, which will turn the unemployment-collectors into taxpayers. Republicans think in Reaganomic or supply-side terms--that lowering the tax burden on the wealthy and corporations will cause them to spontaneously start investing and hiring more people.
Critics of the Democratic policies point to Obama's stimulus as "failed," proclaiming that hundreds of billions of dollars were spent to achieve minimal growth and have incurred large deficits along the way. Defenders of the stimulus plan point to reports that millions of jobs were at a minimum, saved, and that it sped up economic recovery.
Critics of supply-side economics (such as myself) will point to the fact that income and investment taxes are at their lowest level in decades and that the Fed has set the funds rate near 0% (it's been there for nearly 3 years), and we are still having massive unemployment problems. Defenders of those policies say that we haven't cut taxes to the point where it incents employers to create jobs.
I personally believe that the stimulus package, while large, was not large enough. A good portion of it was actually diverted into investments in Chrysler and GM, which staved off an enormous crisis. I think what we really needed (and still do) is an influx of around a trillion dollars. Most economists believe that, at its best, our economy was flourishing with about a 4.5-5% unemployment rate. In Keynesian economic thought, the stimilus should be big enough to simulate economic output of our nation operating at an optimal unemployment rate. In layman's terms:
Consider our country as having 100 citizens. At our peak output, 95 of them are employed making $1,000 per year, and 5% of them are unemployed. Then, at some point, disaster strikes, and our employment goes to 10%. We now have 90 people making $1,000 per year. The result is that there are 5% fewer people to buy the goods and services we are producing, which leads to fewer products being sold and eventually, layoffs. In Keynesian terms, we would need a stimulus package of at least $5,000 to put that 5% of people back into the labor force and both producing and consuming goods. The world is back at equilibrium.
While that's an overly simplistic view, it illustrates how Keynesian economic theory works. The problem that most economists see with the previous stimulus package is that it wasn't enough to drive the employment of the extra 3 or 4% of the unemployed labor force. Instead, a smaller bill was passed--it may have softened the blow, but we still got hit with a sledgehammer.
Of course, Republicans (and Tea Partiers, in particular) point to the fact that $800bn was spent for nominal effect; Democrats say that it was like a bandaid on an amputation--too little too late.
In order to jump start the economy, Republicans continue the supply-side economic mantra--lowering taxes will create jobs. The problem is the same one that the Fed is having with its monetary policy--the rates are low, but it's not causing investment.
I think that we could have near zero taxes and still not create a meaningful amount of jobs. The problem that we're in now is that we have a workforce fearful of losing their jobs. Corporations have discovered this fear, and have piled more and more work on their employees while cutting pay and benefits. Employees are now working harder for less, driving up productivity and adding to the company's bottom line. As long as companies can continue to squeeze work out of their existing labor force through fear, there's not going to be a meaningful positive change in unemployment.
I believe that the only way out of this downward spiral is a truly massive influx of cash into public sector employment (especially infrastructure) to drive demand for other goods and services to a level that companies are forced to hire more workers to meet that demand. Getting the unemployment down a few points by itself isn't enough--it needs to be large enough to cause us to exceed our current economic output capacity, which will then cause the private sector to create jobs to meet that demand. Employers aren't going to create jobs until they know there will be a sustainable demand for their products and services.
The large anti-government crowd are naive pawns being used by conservative politicians to promote a lower-tax agenda. Unfortunately, most of us will never make the kind of money to be impacted one way or another by increasing the marginal tax rate on income over $1,000,000 or raising the capital gains tax. The trickle-down economic policies don't work--the rich keep their wealth or move it overseas to avoid being taxed; they don't create jobs with it.
In the end, we need a balanced approach--something that neither side of our polarized political system is interested in pursuing.