Learning From the Past – Or Maybe Not.

It looks like we are going to repeat the past.  In this case, it’s 1937.  In 1937 the general discussion in U.S. politics had turned to concerns about debt and deficits.  The conservative view that opposed  both the New Deal and efforts to alleviate the Great Depression began to get the upper hand.  Keep in mind that the economy had not fully recovered from the Great Depression and Great Crash of 1929.  But the economy had been growing some in 1933-36 due largely to the New Deal and government deficit spending.  The spending effort was too weak though and the economy struggled to grow.  By 1937 it still hadn’t recovered to pre-crash levels.  But politicians began to claim that deficits were bad and that all that was needed was “belt-tightening” by government.  The result was disastrous.  The economy plunged downward again and only began to resume a growth path once Europe went to war and started placing orders for food, equipment and materiel.

Sound familiar?  We had a great crash three years ago.  We stopped the downward spiral in 2009 due largely to a federal government stimulus program.  But the program was too small relative to the size of the recession. Worse  yet, the stimulus was 40% made up of tax cuts which in a financial crisis are no help.  Even worse, the federal increase in spending barely offset the decline in state and local government spending.  Result: we stopped the crash. We ended the decline. But there hasn’t been enough true stimulus to really recover.  Now in 2011 the stimulus spending is being withdrawn and government spending is declining.  Government employment is dropping significantly every month, putting a severe drag on aggregate demand.

Even the central bank appears to have lost the history lessons.  Reuters ran a story recently called “That 1937 Feeling All Over Again” (bold emphasis mine):

(Reuters) – Federal Reserve Chairman Ben Bernanke, an expert on the Great Depression, once promised that the central bank would never repeat its 1937 mistake of rushing to tighten monetary policy too soon and prolonging an economic slump.

He has been true to his word, keeping interest rates near zero since late 2008 and more than tripling the size of the Fed’s balance sheet to $2.85 trillion. But cutbacks in government spending may end up having a similarly chilling effect on the economy, and there is little Bernanke can do to counter that.

Back in 1937, the U.S. economy had been growing rapidly for three years, thanks in large part to government programs aimed at ending the deep recession that began in 1929.

Then the central bank clamped down hard on lending, and federal government spending dropped 10 percent. The economy contracted again in 1938. The jobless rate soared.

“Regarding the Great Depression. You’re right, we did it. We’re very sorry. But thanks to you, we won’t do it again,” Bernanke said back in 2002 at a conference honoring legendary economist Milton Friedman’s 90th birthday.

Bernanke convenes the Fed’s next policy-setting meeting on Tuesday, facing growing concern that the United States may be slipping into another recession while Europe staggers toward a deeper debt crisis. Standard & Poor’s decision on Friday to lower the U.S. credit rating adds yet another element of uncertainty.

His options are limited.

Nigel Gault, chief U.S. economist at IHS Global Insight, said the Fed could promise to keep interest rates near zero or its balance sheet swollen for even longer than investors anticipate. Or it could buy even more U.S. government debt.

“It is hard to see any of these options as ‘game changers,'” Gault said. “The Fed would be doing them not because it could be sure they would make a huge difference, but because it would feel the need to do something.”

Gault put the odds of another recession at 40 percent.

“Having said that, there are still plenty of headwinds, like Europe. I am also very encouraged to see the upward revisions to the previous months. This report pulls us back from the ledge a little bit.”

HITTING A POTHOLE

Full employment is one of the Fed’s prescribed goals, and it is clearly falling short. Government spending cuts are making matters worse. Friday’s employment report showed a net loss of 37,000 government jobs last month.

State and local governments with balanced budget rules had little choice but to cut jobs in order to make ends meet. The federal government has no such restriction, but its spending outside of defense fell at a 7.3 percent annual rate in the second quarter, crimping economic growth.

Michael Feroli, an economist with JPMorgan in New York, said he had held out some hope that Congress would approve some form of additional fiscal support in the coming months, but the debt ceiling fight showed lawmakers dead set against that.

“It now looks likely that growth could hit a pothole early next year,” Feroli said.

 

And as we all witnessed with the debt-ceiling debate fiasco, both parties in Washington D.C are battling to see who can be seen as the budget cutter.  It’s 1937 all over. Let’s

Government Budget Cutting SLOWS the Economy – That’s Why It’s Called Contractionary Fiscal Policy

America’s attention has been focused lately on the unnecessary debate in Congress over the debt-ceiling law.  Part of the motivation (at least the vocalized motivation) for cutting the deficit and trying to limit the national debt, according to both Republicans and the President, is that supposedly government deficits are holding back the economy. They assert that cutting the government’s spending will somehow stimulate the economy.  This is what all that Republican rhetoric about “jobs-killing spending” is about.  In more formal terms it’s referred to as a policy of “austerity”.   But it’s more than flawed thinking.  It’s flat out wrong.  Cutting government spending when there is significant unemployment and excess capacity will not stimulate the economy.  It will cause the economy to slow down and contract further.  That’s why we economists call it “contractionary fiscal policy”.

GDP, the total value of all goods and services produced, is how we measure the economy.  We can count GDP two ways.  Either we add up the total spending in the economy or we add up the total incomes (wages and profits, mostly).  Government spending is part of that spending – close to 25% in fact.  If the government spends less, it means less GDP.  It also means less income for people because what is one person’s spending is another person’s (or business’s) income.

Across the ocean, the British fell for this silly make believe idea that government austerity would create prosperity.  In 2010 they elected a Conservative government (actually a Conservative-New Democrat coalition).  The Conservatives, led by Prime Minister Cameron and Chancellor George Osborne (equivalent of the U.S Treasury Secretary), began to implement sharp cuts in government spending in mid-2010.  The results have been clear.  And bad.  The Guardian reports the results.  The British economy actually shrank by 0.5% in the 4th quarter of last year.  It barely avoided an official recession when growth in the 1st quarter with 0.5% growth. (the Brits define a recession as two negative quarters).  Now the 2nd quarter numbers are in and the economy is basically dead in the water:  0.2% annual growth rate.

 

Yes, contractionary fiscal policy, cutting the budget, is, well, contractionary. It makes things worse.  If you want to reduce government spending, do it when you have full employment, not when unemployment has been running over 9% for more than two years.  The examples are legion. Britain is only one. Three years ago Ireland thought it could budget-cut it’s way out of the Great Recession/Financial Crisis.  It only made things worse and grimmer in the emerald isle.  Austerity is making things worse for Greece.  There’s really no end to the examples.  What’s missing is any evidence from a developed country that austerity when unemployment is high actually helps.

The Great Recession Was Even Worse Than Thought

In yesterday’s release of the 2nd quarter 2011 GDP numbers for the U.S., the BEA also revised some past numbers.  This is not an unusual event.  It’s routine. But the news and revisions this year were disturbing and sobering.

First, a little about how GDP numbers are reported.  In this day and age of instant info when stock markets report numbers within seconds, we tend to think we should get all our data that quickly.  But it’s a really tough job.  Think about it.  GDP is the total market value of all the goods and services produced in a period of time.  For the U.S., that’s a lot of stuff.  There’s over 300 million of us buying things, making things, providing services, etc. The BEA has to add all that up.  Actually it’s got to find out what we did before it can add them up.  Some of the activity must be estimated.  Hard data on a lot of production isn’t even available until months or even years afterward.  In addition, to estimate real GDP from nominal GDP (nominal is what’s observable at current prices), they have to collect immense data on prices of nearly everything.  Looked at this way,they do a pretty good job.

So what happens is that each quarter they release three “estimates” of GDP and growth rates.  The first version is released at the end of the month after the quarter closes. This is the “advance” estimate.  That’s what we got yesterday, on July 29, for the quarter ending June 30.  Next month in late August they will issue a  revision of this number based on more and better information. Then in late September comes the “final” estimate based on even better analyses.  Then they start over in October with the 3rd quarter “advance” estimate, etc.  But in July each year, the BEA takes the opportunity to revise any of the data for the previous year, and at times for several previous years.  There’s nothing sinister here, just more time allows a better, more precise estimate.  And that brings me to yesterday’s news.

The BEA revised GDP numbers back to 2003.  Most of the numbers from 2003-2007 were pretty much unchanged, but from 2007 there’s a significant revision, a significant downward revision. The change shows that the Great Recession (what I prefer to call the Lesser Depression or Workers’ Depression) in 2007-2009 was much worse than previously reported. Instead of losing close to 5% of GDP in the recession, we lost close to 6% of GDP.  Calculated Risk shows the revisions graphically:

The following graph shows the current estimate of real GDP and the pre-revision estimate (blue). I’ll have more later on GDP.

Real GDP

The revisions also mean (as the graph shows) that we aren’t back to where we were in 4th quarter 2007 yet.  In other words, it’s almost four years after the recession began and we still have an economy that’s producing less goods and services than we did back then.  Keep in mind that our population is close to 3.5% larger now than it was then.  Kind of explains the bad the feelings you’ve been having, huh?

Another implication of the revision is that it clearly shows that the government policy response has been grossly inadequate.  The Obama stimulus program, which was clearly too small to deal with even the recession as we thought it was then, was definitely much, much too little.  Given what we now know of the size and scope of the recession, the government stimulus program needed to be at least twice, perhaps three times, as big as it was.  And, it needed to be more focused on stimulating demand through actual spending instead of having 40% of the money be tax cuts that wouldn’t be saved and wouldn’t help the economy.

Finally, a perusal of the graph shows us two things.  First, we lopped off a big chunk of the economy in 2007-09.  That’s lost opportunity.  It’s lost income. And it’s the 10%+ unemployment rate.  But more disturbing is the fact that the so-called “recovery” since then, a recovery that hasn’t gotten us back to the beginning, is itself running out of steam.  The curve is flattening in 2011.  That’s because the rage in Washington by both Republicans and the President has been for budget-cutting.  Budget cutting is contractionary fiscal policy.  They’re trying to slow down the growth of an economy that’s pretty much already run out of steam.

GDP for 2nd Qtr: Economy In “Growth Recession” – Very Bad News

The Bureau of Economic Analysis released the “advance estimate” of 2nd Quarter 2011 GDP growth.  The numbers are bad.  Worse than most analysts expected.  I’ll let BEA explain:

Real gross domestic product -- the output of goods and services produced by labor and property
located in the United States -- increased at an annual rate of 1.3 percent in the second quarter of 2011,
(that is, from the first quarter to the second quarter), according to the "advance" estimate released by the
Bureau of Economic Analysis.  In the first quarter, real GDP increased 0.4 percent.

A 1.3 percent annualized growth rate is very bad.  Yes, it’s a positive number which indicates real growth and not decline, but it’s not enough to keep people even, let alone putting unemployed people back to work.  What’s worse, the BEA, as part of it’s annual revision process in July of year, revises the past numbers based on better data and better information than what was available at the time.  They revised their estimate of real GDP growth in first quarter 2011 down to 0.4% annualized rate from the previously estimated 1.8%.

Putting both quarters together it means the U.S. economy has grown at a 0.8% growth rate for the first six months of 2011.  As said earlier, yes, that’s a positive number so it indicates “growth”.  But that’s growth in the total or aggregate size of the economy.  During those same six months our population grew at a 1% annualized rate.  So do the math.  The pie is 0.8% bigger but there’s 1% more mouths at the table.  It means less per person.

I’ve mentioned before how economists have an inadequate vocabulary when it comes to describing the condition of the economy.  We tend to use only the terms “recession”, which means decline or negative growth, and “recovery” which technically means “not a recession” or any positive growth rate.  But not all positive growth rates have positive results.

There’s an unofficial term used in economics called a “growth recession”.  A growth recession is when real GDP is growing – the rate is above zero – but it’s too small to really make an improvement in living standards or improvement in employment.  That’s where we’re at now.  We’re in a “growth recession”.  Technically GDP is still growing, but it’s so slow and so weak that unemployment will actually rise.

Today’s news on GDP in first and second quarters has taken many most analysts by surprise.  But it really shouldn’t be a surprise.  The Obama “stimulus” spending program started in 2009, which was way too small to begin with, is being phased out. With it federal government spending in the first six months has actually declined.  The biggest culprit in the weak GDP numbers though is consumption spending by households.  It has come to a virtual standstill at the end of June.  Why?  Well, unemployment is rising again – no jobs, no money to spend.  Unemployment compensation has been cut in many states and many long-term unemployed have run out of benefits.  Again, that cuts spending.  And in Congress, Republicans with Obama’s help have been pushing a cut-spending, cut-deficits agenda.  In economics this is called “contractionary fiscal policy”.  And that’s what we’re getting – a contraction of GDP.  No surprise really.

 

What Happens If Government Debt Ceiling Isn’t Raised? 2 Things That Might, 1 That Will, and 1 That Won’t

Anybody who tells you they know exactly what’s going to happen if Congress doesn’t raise the government debt ceiling before next week is just making it up.  Reality is we don’t know for sure.  As Brad Delong notes (and Krugman and Nick Rowe), economists don’t even have nicely worked-out theoretical models of what happens if the government defaults.  It was just never considered.

Obviously, the devil is in the details. A lot depends on how the Congress deals with it  – the details of any “deal”. Many of the “plans” that have been floated on Capitol Hill to “deal” with the debt ceiling would most likely have consequences not much different from defaulting and not raising the ceiling at all.

And a lot depends on how millions of people think other millions of people will deal with it.  Another reason we have no good prediction of the consequences is because there are millions of investors worldwide involved. And each of them is making decisions based on what they think the other millions of investors will do.  It’s often tough to predict the behavior of 2-3 poker playing partners.  Predicting how millions of investors will place their bets is near impossible.

Most of the articles that have been peppering the news media speculating about the effects of default focus heavily on interest rates. Example: today’s NYTimes.  If you’re a banker, corporate treasurer, or hedge fund manager, that’s your biggest concern.  But there’s other more significant ways either default or any major spending cuts deal will affect everyday folks like you my readers.  There’s likely three ways either a default or a drastic cut in government spending (cut in deficit) will effect everyday folks.  So while we can’t predict exactly how things will play out, here’s a guide to where the possible dynamics are.  Here’s what we know:

  1. Interest Rates – Nobody knows for sure.  A majority of economists and bankers believe that a government default will raise interest rates on government bonds.  Accepted theories on interest rates then imply that all other interest rates would likely also go up a similar amount.  But this is far from certain.  Japan has had debt levels more than twice as high as the U.S. for well over decade.  Ratings agencies have down-graded Japanese debt.  But Japan still enjoys interest rates lower than the U.S.  I’ve read analyses by respectable economists and Wall Street types that pose plausible scenarios in which markets don’t raise interest rates at all, or that only government debt rates go up but private debt doesn’t.  I’ve even read scenarios wherein interest rates might slightly decline – although they are already so low there’s not much room to go lower.  Right now the markets aren’t showing any indication of higher rates. Anybody tells you they know what will happen to interest rates is telling you more than they know.  In fact, they’re telling more than what’s knowable now.
  2. Ratings on Government Debt – The bond ratings agencies, Moody’s, S&P, and Fitch, are threatening to downgrade US bonds from AAA to a lesser rating. Separate from any impact on interest rates, a downgrade might cause bond market turmoil and a lot of trading.  This would be because pension funds and other entities are often required by regulations and laws to keep a certain % of assets in AAA rated securities.  If US bonds are down-rated, then pension funds might have to sell their bonds and go into something else.  Nobody knows what that else might be or whether there’s enough of that something else to satisfy the demand.  As Krugman observed, when the bond ratings agencies speak, they have a lousy record.  They thought sub-prime mortgage securities were AAA because the banks said they were.  The agencies have been dead wrong about Japan.  Quoting Krugman: “when S&P or Moody’s speaks, that’s not the voice of “the market”. It’s just some guys with an agenda, and a very poor track record. And we have no idea how much effect their actions will have.”
  3. Government Spending Cuts & GDP. This one we know for sure.  If the government cuts it’s spending significantly at this time of high unemployment & low demand, it will slow the economy, depress GDP, and raise unemployment.    How much?  Here’s a quick rule-of-thumb, back-of-the-envelope calculation.  The GDP is now roughly $15 trillion.   Of that $15 trillion, $3.8 trillion comes from federal government spending.  $150 billion is 1% of GDP. So every $150 billion in spending cuts that the government does this year means a drop of 1% in GDP.  Right now, projections are that the government deficit in August alone will be close to $140 billion.  So, if the government has to suddenly cut it’s spending to match tax receipts (an instant balanced budget), it means the GDP shrinks by 1% every month.  In 2008-09, GDP only dropped by approximately 6% in total.  An instant balanced budget with no increase in borrowing will mean a recession more severe than 2008-09.  What will that do to unemployment?  According to estimates of Okun’s law, every 1% drop in GDP will bring a half percentage point increase in the unemployment rate.  So if we instantly balance the federal budget by cutting spending as many Tea Party members want, we will decrease GDP by 5% and unemployment will rise to around 11.5 – 12% by Christmas.
  4. Business Confidence.  Many Tea Party types and others are claiming that a balanced budget and no increase in the national debt will “restore business confidence” and unleash economic growth.  Hogwash.  Won’t happen.  Can’t happen. Hasn’t happened before.  This is the “growth from government austerity” pitch that has been made to Ireland in 2009.  Ireland did it and has only slowed further and had unemployment rise.  The Conservatives in the UK promised that budget cuts last year would stimulate the economy.  Hasn’t happened.  The UK economy slowed and is dead  in the water now.  In fact, we don’t have any recorded episodes of a major developed country stimulating it’s economy and reducing unemployment as a result. That’s because cutting spending is contractionary fiscal policy, which is, well, contractionary.  Government spending creates jobs and incomes just as much as private spending.  Right now, with high unemployment, we have too little aggregate spending in the economy.  Businesses are not spending because they fear the government’s budget.  They’re not spending because nobody’s buying – there’s no demand. Instead of wagering that government austerity will bring growth and employment, you’re better off betting on pigs flying.  The odds are better.