How To Start An Economic Recovery

Econophile's picture

From The Daily Capitalist

Regular readers of The Daily Capitalist know I think we are headed for a decline in economic growth in 2010 and that the data is starting to show this.

Why isn't our economy recovering? I ask that question often and have written about it many times. Perhaps a better question is: what needs to happen in order to make our economy grow? I offer some solutions.

There are many problems seen as hindering recovery. Here are the common ones I wish to examine:

  1. Too much debt encumbering consumers;
  2. The lack of consumer demand to fuel growth;
  3. Too much debt encumbering banks; and
  4. The government's interference in the economy.

There are a host of other issues that are also important but let me focus on these points and show what can be done to fuel a recovery.

Numbers 1 and 2 (debt/demand) are related.

Our economy is consumer driven and we are reminded over and over again that consumer consumption is 70% of our economy. To put this in perspective, for Germany it is about 57% of GDP.

Our economy is built on consumption which is fine as long as it is supported by real savings, productivity growth, and wage growth. The data reveal that most of the consumption binge of the boom phase of this current cycle was financed directly or indirectly by debt related to rising home values. Personal savings declined to almost zero. Now savings are back up to 4%.

Here is why this is seen as a problem for recovery: PCE will decline as consumers pay down debt and increase savings. Spending drives the economy and the economy will decline.

Is this really a problem?

Saving is a process necessary for a recovery. Consumers are acting rationally to uncertainty and they will give us the signal when they are ready to spend again. About $10 trillion in household net worth was wiped out during the bust. Until consumers see unemployment decrease, wages go up, and their debt go down, they aren't going to spend anyway.

But savings is never bad for an economy. Economists often fail to look at the other side of savings which is an increase in capital necessary to fuel future growth. In a normal cycle, increased savings reduces interest rates, which sends a signal to producers of capital goods that consumers don't want to buy consumer goods right now, and that there is opportunity for them to increase production of durable goods such as machines, homes, and basic equipment. They use the loan funds to pay workers who will spend which, as this capital works its way through the economy, will create new and real economic activity.

While manufacturers have been increasing production in response to normal business cycle activity (inventory recovery; weak dollar advantages), they are just utilizing current capacity. If they wanted to expand, unless they are a large company with access to money center capital, they now report they are having trouble getting a bank loan.

What does this mean? It means they can't expand and hire new workers whose spending will take up the slack from consumers who save. The government and the Fed have confused our ability to make economic decisions because they are artificially lowering interest rates.

What can we do to fix this? Savings is the fix. There is nothing that should be done to prevent this from occurring. In the longer term it will prepare the economy for new growth. See No. 4 for why flogging a dead horse is harmful to recovery.

The question is: why can't we get loans?

Number 3 is that banks have too many bad loans and, as a result, have too little capital.

The Fed and the Administration's economic advisers are very concerned that banks aren't lending. On Monday, Chairman Bernanke in a speech said that getting credit to America's small businesses was crucial to a recovery because they hire half the workers in America and create 60% of new jobs. After he went through his reasons for the credit crunch he came to this startling conclusion:

Though we believe that our and others' efforts are making a difference, we also know more must be done, and that additional effective action requires hearing firsthand from knowledgeable people who can speak from diverse perspectives about the challenges facing small businesses. The insights we obtained from small business owners, lenders, and others in this series of meetings have given us a more nuanced understanding of the problem and will help us identify areas where we might be able to do more. Not surprisingly, these meetings confirmed that facilitating small business financing is not a simple or straightforward matter.

Let me translate this for you: nothing we've done has worked and we don't have any ideas how to make it work.

I have explained in great detail why banks aren't lending in previous articles (e.g., Will We Have Inflation, Deflation, or Hyperinflation?). That is, they made a ton of bad loans as the result of cheap Fed money which created fake wealth in the form of a housing boom. Most of the troubling loans encumbering regional and local banks are for commercial real estate and it is tying up their balance sheets. They are afraid to extend credit to middle America because they know their CRE loans will need to be written down as real estate prices continue to decline and they will need to come up with more capital to satisfy regulatory requirements. Also, it is apparent that when banks do wish to lend, they aren't finding quality borrowers to whom they would like to extend credit.

What can we do to fix this? This one is easy.

Until those bad CRE loans are written down, written off, banks liquidated, banks raise more Tier 1 capital, they will continue to be reluctant to lend and the credit crunch will continue. The government's programs of extend and pretend, delay and pray, mark-to-make-believe, only serve to delay the healing process. Meanwhile valuable capital is locked up in failing or failed banks and the economy can't get credit (unless you have access to the big money center banks or the Fed's discount window). Do away with these policies, get rid of failed or failing banks, let the economy heal itself, and credit will return.

I urge you to read my above mentioned article on the inflation-deflation debate which goes into great detail on this topic.

That gets us to point 4, the government's interference in the economy.

Artificially stimulating spending is counter-productive to a recovery since such economic activity is not based on organic, market based consumer demand. In other words, since the spending is not being generated by increased business activity caused by consumer demand, no lasting economic activity is produced. Once the stimulus spending stop, the effect goes away and the economy resumes its decline. This is what is happening now. It makes no economic sense to encourage consumers to take on more debt after they have just suffered the results of the biggest debt binge in history.

Today Mrs. Romer, Chief Shaman of the Obama Administration's Council of Economic Advisors, reported that such stimulus spending is working, that it has achieved a Keynesian multiplier of 3:1, that is, for every dollar spent by the government, three dollars of private economic activity. Further they claim that they have saved or created three million jobs. They also claim that they increased GDP by between 2.7% and 3.2%. The only problem with this report is that it is wrong, misleading, and, how shall I say it, politically motivated. Another way to say it is that they are lying to make the Administration look good.

While Keynesians, such as Paul Krugman, argue for more government spending, there is no believable evidence that this is working now, that more spending will work, or that it has ever worked in the past. It's a fake science.

If government could create economic growth by either printing money or taking your money and spending on government-favored projects, then we'd all be gloriously rich. Of course Japan is the poster child of the failure of Keynesian economics. Professor Krugman told them they ought to spend more too. They did and the results were debt and stagnation.

Here is what Mrs. Romer and her staff are doing. They skew the numbers so that they represent the most favorable result under their faith-based assumptions, and then they claim that the results are caused by government spending. This is a logical fallacy known as post hoc, ergo propter hoc, or, because B event followed A event, then A caused B. I looked on Recovery.gov and they claim there that they have "funded" 682,370 jobs as of March 31. Is Mrs. Romer saying they added another 2.3 million jobs since March?

These Keynesian seem to equate private sector jobs with government jobs. A "job" in the economic sense isn't just paying someone to do something. A private employer will hire a person only if he sees market opportunities that will make him more money. If he hires someone just to be nice, and there isn't enough revenue to support the wages of this employee, he could go broke. His payments would be considered to be charity.

The government has never created a job, if you define a job as wages based on market productivity. If you define a job as the payments by the government to do something, it isn't work based on market forces. It's like welfare.

Now before you jump on me, I will admit that some government workers who maintain the commercial infrastructure, such as our roads, water and power systems, and enforce laws that support private property, personal safety, and commerce (commercial, tort, and criminal natural law--I know this is a big topic but ignore it for this discussion), then you could argue that it is a productive activity. Any job they do could most likely be done by private industry better and more cost effective, but ... we are saddled with what we have.

There is only one thing that the government can do to create jobs: get out of the way of businesses and entrepreneurs who create them.

As I have argued, the only result of government stimulus will be a stagnating economy saddled with a large government debt. The greater the government's percentage of GDP, the less productive will be the private sector (the Rahn Curve). The less productive the private sector is, the fewer jobs they will create.

Let me suggest my fixes for the economy:

  1. Stop all government stimulus programs immediately. They are a waste, create no lasting benefit, and result only in a burden on present and future taxpayers and are a drag on the economy.


  2. Encourage savings rather than consumption. Immediately repeal taxes on interest and dividend income. Allow all citizens to put an unlimited amount of savings into tax free vehicles like IRAs. Tax them only on the cash removed from the vehicle. (I would opt for a different tax structure entirely, but, let's work within the system for now).


  3. End all federal programs that encourage consumption, such as Cash for [Your industry here] and home buyer tax credits or subsidies. End Fannie, Freddie, Ginnie, and the FHA, and the myriad of other government backed loan guarantee programs.


  4. Let banks fail. Require banks to mark-to-market the assets securing their loans, and raise more capital or go out of business. Establish a program similar to the Resolution Trust Corporation (RTC) to quickly dispose of the assets of failed banks. Substantially raise leverage requirements for banks.


  5. End or suspend tax policies that require borrowers to incur phantom income as a result of real estate debt relief.


  6. Immediately raise the Federal Funds rate to stabilize money supply. We are in great danger of creating another boom-bust cycle, actually I think we are headed for a bust-bust (lose-lose) cycle of stagflation.


  7. Pass legislation that would prevent the government from bailing out private institutions. There is no such thing as too big to fail. It is a myth created out of the Great Panic of 2008, when Paulson and Bernanke panicked. We are now suffering the consequences whereby the bailed out institutions are still taking risks yet we are saddled with the cost of these programs. Let Citi or Morgan Stanley or AIG go down and there will be fewer gamblers in the future ("moral hazard"). Don't believe the propaganda that we can't do without them. They confuse Wall Street with the economy.


  8. Immediately cut all government spending 20% across the board, including the military. This should just be the start.


  9. Repeal Obama Care as soon as possible before an entitlement mentality sets in.


  10. Reform the Medicare structure by getting rid of the government as the manager of the system and give the elderly a voucher to spend on private health insurance.


  11. Reform Social Security by capping benefits now, push retirement ages out further, allow private option investment by young taxpayers, and prevent Congress from spending FICA payments.


Do these things, even just points 1 through 6, and I guarantee you that we will see an expanding economy and rising employment. If you want economic stagnation, high taxes, and a further rise in big government, stick with Obama, the Democrats and the Republicans. We know what we need to do.