"Fix it, Fix it!" yells the financial pundit on Saturday Night Live's Weekend Update when commenting on the economy. Without being presumptuous I believe that all of us echo this sentiment when we reflect on the disjointedness of the economy. Nothing seems to fit and anxiety is causing a dangerous reluctance among consumers. So that said, what's the fix?
The fix is actually very simple in theory. The run up in prices that occurred during the reckless extension of credit from 2001-2006 was not accompanied with equal wage appreciation. The net result was the extension of credit that the borrower ultimately could not afford. Prices were thus inflated beyond the means of population, and the only possible effects were a fall in prices to meet wages or an increase in wages to meet the prices. On the back of massive foreclosures, repossessions and short sales accompanied by wage deflation caused by a foolish reliance on globalization of labor the former occurred.
Now I realize this is quite intuitive, but the solution is bringing prices and wages into equilibrium. Our choices are 1. allow deflation to continue until the price for goods has fallen to a level where those left with jobs can afford assets in cash or 2. create across the board inflation so that wages increase as well as prices. If number two is picked, the government must slow inflation once prices reach the desired equilibrium least we be faced with run-away inflation.
Choice 1
Deflation is a monster that destroys everything in its path. It is the worst thing that can happen to an economy as it counteracts the whole purpose of free market capitalism, wealth creation. Unchecked, deflation can continue for a decade to a generation stifling innovation and punishing production (see What's Wrong with Our Economy, this Blog). In the quickest summation, prices fall and the population still will not purchase. Businesses fire workers or shutter their operations as they cannot convince consumers to consume. As businesses close, prices fall further and eventually the production of goods is no longer profitable as the market is littered with unsold inventory. More unemployment and wage decreases ensue. Investments, homes and large holdings continue to lose value as the falling wages cannot afford once affordable prices. This destruction in wealth cools more innovation as banks are not comfortable to lend and people with cash wait for prices to fall further. Therefore, wage and price reach equilibrium somewhere down the road of massive wealth destruction. At this point, prices can once again gradually appreciate.
The two problems with allowing this solution is that it can take an extended period of time and civil unrest is very likely. Under this scenario unemployment will be very high before it corrects, 20-35%. Markets will not function normally and frustration of the population will create a dangerous scenario.
Choice 2
Since the Great Depression free market capitalism has bee dominated by a school of thought in conjunction with the battle cry of John Maynard Keynes, "in the long run, we are all dead." The government in using this school of thought has two major tools to set the economy back into equilibrium. The first is monetary policy. With the Fed Funds target rate at one quarter percent, clearly interest rates are not having traction against the massive pull back of financial institutions and consumers. The second tool is fiscal policy.
Fiscal policy comes in two categories 1. direct and 2. indirect spending. Direct spending is literally the government filling in as the spender of last resort and directly spending money to create the recirculation of money in the economy and reflate prices. The second category is usually in the form of reduced regulation or reducing taxes, leaving more money in market participants pockets which they can spend and reflate prices. There is much debate over which of the categories are more effective, but both by definition will stimulate the economy as there are literally more dollars available in the market.
As the dollars are spent, the multiplier effect will take place in which one dollar spent will literally be passed from one participant to another up to eight times. Prices will inflate, and wages should increase with increased profits; that is, so long as corporate policy commits to American labor (see the Float).
Whether one prefers Choice 1 or Choice 2 the limiting factor is time. This commentary shall not attempt to differentiate between any of the alternatives suggested as that is a complex argument for another article. For now I wanted to simply identify the issues we are facing and intelligently explain the possible fixes. Without bias I will close by stating that it is doubtful the American population has the patience and tolerance to undergo what Choice 1 would take to reach equilibrium. For now let it suffice that the market disjunction shall be fixed and the how is literally in Americans hands.
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I would disagree with your assessment about deflation. It is incorrect to assume that deflation automatically would stifle production and cause high unemployment. If wage rates fall more rapidly than product prices, this stimulates business activity and employment.
ReplyDeleteFurthermore, in anticipation of falling prices, entrepreneurs would bid down the prices on the factors of production to anticipated levels, speeding up the adjustment of PPM. An unanticipated price drop will not decrease the return on investment either due to the increased purchasing power of the revenues. Thus wealth creation continues.
You correctly point out that the extension in credit and increase in prices was not accompanied by a similar increase in wages. However, choice #2 of increased spending does not appear to ameliorate this problem. If, as you say, "Prices will inflate, and wages should increase with increased profits," what happens if prices increase faster than wages? This is just trying to maintain the air in the bubble. The problem is the malinvestment, creating more malinvestment will only worsen the problem and lengthen the time it takes to recover. In addition, what happens if wages increase faster than prices? Then unemployment rises.
Deflation would purge unsound investments by liquidating the unsound projects undertaken during the credit expansion and also would restrict the welfare state that depends on inflation. Deflation is the fastest and most direct way to correct the problems of a credit expansion.