Wrong policies and volatility

Wrong policies and volatility
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First Published: Wed, Apr 15 2009. 11 01 PM IST

Photo: Stockxpert
Photo: Stockxpert
Updated: Wed, Apr 15 2009. 11 01 PM IST
Responding to ongoing financial and economic turmoil, US politicians wanted to be seen as “doing something” legislatively, even if it was costly and ineffective. This is evident in that the so-called stimulus spending provides more political gains for special interests than economic gains to the whole country.
Meanwhile, political leaders around the world are following the lead and falling over each other to try and put together similar spending packages.
Photo: Stockxpert
Unfortunately, their actions stem from a misunderstanding of the cause of the preceding boom that set the stage for an inevitable recession that is upon us. Hoping for short-term political payoffs, politicians care not that their initiatives will not halt the inevitable adjustments that must occur after the bubbles to restore economic sanity.
Indeed, the current policy response is similar to the course taken both by US presidents Herbert Hoover and Franklin D. Roosevelt that helped turn a recession into the Great Depression. Then, as now, interfering with market adjustment processes will delay the inevitable while deepening and worsening the economic downturn.
At the same time, politicians cravenly used fear of impending economic doom to sway public opinion by comparing the ongoing turmoil with the Great Depression. Despite hyperbole about the severity of the current recession, it is more like the economic contractions of 1973 or 1981. While the decline in economic output in 1929 was 4.7 times greater than in 2008, unemployment also rose very much higher.
A better comparison is with the mess created and left behind by US president, Jimmy Carter. During June 1980, the combined unemployment and inflation rates, known as the “misery index”, hit 22%.
In a single term of office, he managed to create double-digit inflation, double-digit unemployment, double-digit interest rates, shrinking incomes, and increasing poverty. As the US Federal Reserve raised the federal funds rate from 9% in July of 1980 to 19.1%, the 30-year mortgage rate hit 18.45%.
And once again, laws by men are being implemented to supersede economic laws which require that prices and wages much adjust during recessions so that markets can clear. Clearing of markets serves the best interests of the overall community by allowing unemployed labour resources and misused capital assets to be put to productive and profitable use. Only then can there be a sustainable economic recovery.
A critical flaw in the thinking of most policymakers relates to labour markets. Maintaining money wage rates and housing prices will lead to persistent and widespread unemployment.
In the end, the counterintuitive conclusion is that the best antidote for unemployment is for wage rates to fall. And the solution to the housing market is for housing prices to adjust to the new realities.
Allowing wages and asset prices to fall is not “tough love”, nor is it a heartless application of Darwinian survival of the fittest. History shows the most effective and humane response to downturns is for governments to refrain from interfering with asset deleveraging and shedding of labour.
In all events, most workers, given a choice between lower wages and losing a job, might prefer a wage cut. In fact, this may only involve a lower rate of increase in money wages than the rate of increase in prices.
As it is, the so-called stimulus package will eventually reduce the purchasing power of wages, albeit in a less direct manner. Eventually, flooding the banking system with newly created paper money and credit will lead to a massive surge in price levels and a run on the dollar that will cut purchasing power.
With the monetary base in the US up by 107% from 8 August 2008 to 9 January 2009 and the money supply increasing by 40% over the last six months of 2008, a future recovery will almost certainly be accompanied by surging price levels.
So, with or without the stimulus packages, workers will be forced to confront a loss in purchasing power. As mentioned, politicians hope to buy political support by deferring the inevitable.
When other solutions failed to cut unemployment rates during the Great Depression, Roosevelt invoked military conscription. This “solved” the problem by offering low wage rates and having the unemployed masses to do butcher’s work in a global war. Much suffering, and perhaps the eventuality of war, might have been avoided if wage rates had declined under the pressure of market forces at the outset of the recession.
In terms of simple logic, if massive increases in government spending can bring prosperity, then large cuts should cause widespread economic misery. Consider what happened when sharp reductions in public sector spending occurred after World War II.
Between 1945 and 1947, the US cut annual Fed spending from $95 billion to $36 billion, a reduction of 62%. If government spending “multipliers” worked as advertised, the US economy should have collapsed from such a sharp drop.
It turns out that an expansionary effect from changing expectations about future burdens of taxation and government interventions inspired higher consumption and investment. Then the US economy began the longest period of growth and prosperity in its history, suggesting that the best long-term economic stimulus is less government spending, not more!
Christopher Lingle is a research scholar at the Centre for Civil Society in New Delhi and a visiting professor of economics at Universidad Francisco Marroquin in Guatemala. Comment at theirview@livemint.com
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First Published: Wed, Apr 15 2009. 11 01 PM IST