HOME
Treating the Symptoms, not the Illness

"In good times, financial markets embrace capitalism. In bad times, financial markets re-discover socialism." – An Economic Quote Now Regaining Its Popularity

As the US economy went into recession in the middle of the financial crisis, US House Speaker Nancy Pelosi, at a recent Capitol Hill news conference announced triumphantly that a ‘stimulus package’ is coming. "Tens of millions of Americans will have a check in the mail. It is there to strengthen the middle class, to create jobs and to turn this economy around." The plan would send checks of $600 to individuals and $1,200 to couples who paid income tax and who filed jointly. People who did not pay Federal Income Taxes but who had earned an income of more than $3,000 would get checks of $300 per individual or $600 per couple" she said. The ‘stimulus package’ is aimed at re-energising the economy back to its feet. But economists may not necessarily agree that the ‘package’ as it is, alone would be sufficient. To understand this, one needs to understand the key to short term macroeconomic baheviour, simply called as Business Cycles.

Short term fluctuations in macroeconomic output, employment and prices are called business cycles (BCs) resulting the recurring expansion and contraction (leading to recession) of the national economy. Expansion is the normal state of the economy; recessions are rare and brief but are the defining characteristic in a business cycle. The dominant macroeconomic model where BCs are closely watched is the free-market enterprise system.

"Business cycles are a type of fluctuation found in the aggregate economic activity of nations that organize their work mainly in business enterprises."

As the hypothetical business cycle in FIG 1 shows, a full cycle begins with an expansion, where all spheres of economic activity are in a growth phase. The GDP and increases in personal income and unemployment are commonly used measures in this phase. If the economy expands too rapidly, inflation occurs and is measured by price indexes or inflation data. After the inflation the economy begins to slow down and even stagnate (Circled A), leading to contraction of the economy (in a typical business cycle, the downturn into a recession starts with higher inflation). Business activity slows, unemployment begins to rise during points A-B. There is no concrete agreement on when a recession starts but in the US, if there are two consecutive quarterly declines in economic activity as measured by a decrease (or stagnation) in GDP, the economy is said to be in a recession, with severe consequences leading to depression, massive unemployment and a drop in economic activity, with business failures. The government enters, assisting economic levels. The continued recession with stagnation of economy results in depression (points B-C) lasting anywhere between 2 to 9 months (on average) after which a new BC begins. What should be noted here is that a cycle is not limited or impacting on a single economic activity. Also, an economic cycle can last from one to twelve years.

"A cycle consists of expansions occurring at about the same time in many economic activities, followed by similarly general recessions, contractions, and revivals which merge into the expansion phase of the next cycle; this sequence of changes is recurrent but not periodic; in duration business cycles vary from more than one year to ten or twelve years; they are not divisible into shorter cycles of similar character with amplitudes approximately their own."

Business cycles are not unique to a single firm or industry; but affect an entire economy.

A CLOSER LOOK AT STAGES

During the expansion period of the economy, production increases, and as a result, employment increases, increasing the purchasing power of the people. The time lag before manufacturers can give output to meet increased demand leads to increase in prices leading to inflation. As cost increases and profit margins shrink, business activities begin to fall leading to contraction. Prices and costs continue to rise. Liquidation of bank loans, decline in demand for capital goods lead to cancellation of new projects and depression sets in.

The defining movement in a business cycle is the recession. There will be substantial fall in production of goods and services as the economy begins to move towards depression. The effects are mostly on manufacturing, mining and construction sectors. Income levels fall with consumption rates. Despite the fall in output of goods and services, price levels will continue to fall. Producers liquidate inventories. Supply of goods and services increase leading to further fall in prices. Business confidence almost crashes.

MACROECONOMIC INDICATORS

The BCs influence actual GDP (production) rather than the potential GDP. Actual GDP often changes sharply from year to year. The broadest indicator of the three indicators is unemployment. Unemployment, stands for the percentage of labour force that is unemployed in the economy. BCs affect on unemployment rates as well.

"Prices" determine the purchasing power and has a direct bearing on living standards. Inflation, in which the price levels of economy increase, affects the purchasing power eroding purchasing power of money. Historical evidence shows that rapid price changes disturb the economic decisions of companies and individuals, people lose their confidence in currency, slows down the economic activity and increases unemployment.

THE US ECONOMY

According to the IMF, the US is the largest country-economy in the world, at $ 13.86 trillion (2007). GDP per capita is $44000 in 2006 (World Bank). According to the IMF, the U.S. GDP grew at an average annual rate of 2.2% over the period 2001-2008 (including its forecast for the current year). Total gross domestic product in the United States in 2007 was about $13.843 trillion. Total population as of February 2008 stood at 303,390,380. Between 45% and 87% of the public plans to either invest their tax rebates or use it to pay down debt. Very large numbers of people used their 2001/2002 rebates to pay down debt.

When did the recession begin?

The final arbiter of when US recession began is the National Bureau of Economic Research committee which usually dates recessions. However, it is on average two years late in announcing that a recession has begun. Therefore, I refer to the other well established sources to this end. In March 2008, the majority of economists (by a 3-to-1 margin) in the ‘Wall Street Journal’ forecasting survey said that the US economy is in a recession. Thereafter, according to Harvard University Professor Martin Feldstein, the latest US recession started in December 2007 at fourth quarter’s (Q4) end. Thereafter, on October 15, 2008, Federal Reserve Bank of San Francisco President Janet Yellen said that the U.S. is in a recession and policy makers’ interest-rate stance is aimed at addressing the risks of a deeper downturn. Thus, it is clear that the US recession is now an ‘economist accepted recession’ and not a mere ‘newspaper recession’.

US GDP

The BCs influence actual GDP (production) rather than the potential GDP. Actual GDP often changes sharply from year to year.

The "quarter to quarter growth in Real GDP" as shown by the US Bureau of Economic Analysis clearly indicates the graphical trend in decline in GDP and starting of the recession in the Q4/2007, where a negative GDP growth is reported. A stagnant trend existed throughout the Q1 of 2008.

The "US Monthly GDP-Latest Estimates" shows an even more clear view of the monthly GDP scenario,4 clearly showing the negative GDP trends (circled), namely Oct -2007 and Nov-2007.

US UNEMPLOYMENT

As stated, the broadest indicator of the three indicators is unemployment. Unemployment, stands for the percentage of labour force that is unemployed in the economy. BCs affect on unemployment rates as well. The table and graph (next page) clearly show the rising trend in the unemployment levels. The pattern is clearly discernible; From Jan-2007 to Nov 2007 it was growing at a slow rate; the second phase begins from Dec 2007 onwards where a steady climb in the rate is clearly evident; this is the recessionary period. It is important to note that the importance of unemployment rate is not limited to being an ‘recession indicator.’ Some strongly believe that the key to recovery is here – rather than the proposed stimulus package (discussed below) by the Bush Administration.

Skepticism is high on refinancing and liquidity plans.

Merrill Lynch investment strategist Rich Bernstein: "Investors have been reluctant to admit that this cycle, unlike 1998’s credit crisis, is imbedded in the real economy. The US government can come up with any number of refinancing and liquidity plans, but households are likely to increasingly default on mortgages and other debts if cash flow is not stabilized via employment."

WILL THIS CAUSE THE

MULTIPLIER EFFECT?

The multiplier theory was suggested by John Maynard Keynes as a tool to help governments to achieve full employment. It measured the amount of government spending for a level of national income that would prevent unemployment.

The more the need for consumption, the greater is the multiplier effect and Keynes expected the government can influence the size of the multiplier through changes in direct taxes such as a cut in the basic rate of income tax will increase the amount of extra income that will be spent on further goods and services.

In the 2008 recession, instead of Keynes "Tax Cuts" approach (1), the US government appears to directly hand out lump sums to US households in the form of a ‘Stimulus Package’ at a cost of $ 146 billion.

US House Speaker Nancy Pelosi, D-California, at a Capitol Hill news conference:

"Tens of millions Americans will have a check in the mail. It is there to strengthen the middle class, to create jobs and to turn this economy around." The plan would send checks of $600 to individuals and $1,200 to couples who paid income tax and who filed jointly. People who did not pay federal income taxes but who had earned income of more than $3,000 would get checks of $300 per individual or $600 per couple."

However, opinion surveys in 2008 March found that upto 87% of the public plans to either invest their tax rebates or use it to pay down debt11. With the steady rise of inflation post March, this percentage can only grow upwards. In fact, if more than 80% of the US public are unwilling to spend their tax savings, will they even spend what they receive on a check? Thus, the "checks in the mail" are less likely to be used for spending and thereby, to the economy is less likely to be stimulated. Therefore, any calls for the multiplier effect should be viewed with high skepticism.

US INFLATION

Inflation, in which the price levels of economy increase, affects the purchasing power, eroding power of money. Historical evidence shows that rapid price changes disturb the economic decisions of companies and individuals, people lose their confidence in currency, slows down the economic activity and increases unemployment. The United States has lost 760,000 jobs in the past nine months, according the US Bureau of Labour Statistics estimates.

The graphs below illustrate how the inflation rates soared from end of Q4/2007 onwards as the US economy entered recessionary cycle.

What Caused the Crisis?

It is incorrect to say that one can correctly judge the trigger-exact reason for a recession – especially for one that is as complex as the 2008 recession, where a host of multifarious and interwoven factors have been at play. It is strongly believed that the increase in consumer debt to about $ 943 billion, is the strongest contributory factor (per capita debt: $3,112.19). This consumer debt growth, in turn, has its roots in the last US recession in 1992. In its aftermath, the Federal Reserve artificially expanded credit and investment, but was not backed by increase in voluntary household saving. The instrument from this expansion has been transferred to the market by the banking system as newly created loans at extremely low interest rates. This fueled a speculative bubble in the shape of a substantial rise in the prices of capital goods, real-estate assets, and the stock market, where indices soared. However, this bubble is not based on voluntary savings (healthy for economy) but artificial expansion (unhealthy for the economy). Entrepreneurs use these artificial funds for investment but with the pretentious confidence that their funds are from savings.

Nevertheless, Nouriel Roubini, president of Roubini Global Economics had foreseen the US recession back in August 2006. His diagnosis: "The decline in investment in the housing sector and inventories that are not moving." He highlighted US National Association of Realtors data that stated "sales of existing homes fell 4.1% in July, while inventories soared to a 13-year high and prices flattened out on a year-over-year basis".

"By itself, this slump is enough to trigger a U.S. recession: its effects on real residential investment, wealth and consumption, and employment will be more severe than the tech bust (dot com bust) that triggered the 2001 recession. Housing has accounted, directly and indirectly, for about 30% of employment growth during this expansion, including employment in retail and in manufacturing producing consumer goods."

In order to protect the banking and finance sector, the state, through the Federal Reserve, has intervened with a ‘bailout package’ of $700+billion and to cushion the negative recessionary effects on households and stimulate the economy, the Bush Administration has unleashed a ‘stimulus package’ though it is yet to be seen whether the ‘bailout’ and the ‘stimulus package’ are a treatment for symptoms rather than the disease itself. The only clear lesson from the chaotic US economy, so far, is the financial bailout affirming the popular economics saying that "in good times, financial markets embrace capitalism. In bad times, financial markets re-discover socialism."

(The writer is a Research Officer with the Social Indicator-Centre for Policy Alternatives, Colombo 3. His email is josephonline@gmail.com)

Google
www island.lk


Copyright©Upali Newspapers Limited.


Hosted by

 

Upali Newspapers Limited, 223, Bloemendhal Road, Colombo 13, Sri Lanka, Tel +940112497500