Sunday, July 4, 2010

Lets Talk Economics...

There is a lot of talk lately of tightening the belt. Much of that is based upon the notion that we spend too much individually and that we're doing so because of how we see our own government spending. That belt tightening, has now morphed into talk of austerity measures that our government should take in order to avoid the same fate as Greece.

I recently asked some friends & acquaintances via facebook, etc for their thoughts and they seem to echo this sentiment. When pressed, some were able to provide some insights as to why they've drawn their conclusions. As I press further and further, however, the conversation drops off. So, what I've found was that they do indeed have good points. These are things we really need to do -- at some point. When and how do we get there is probably the most overlooked issue and thus underaddressed.

For all the talk of austerity measures, not all of the discussion is based in sound economics and that can be disturbing. This is so because, if one draws circumspect conclusions without sound economic analysis, the implications can affect not just our entire nation but the world.

Lets forget about the world for a moment. There is already talk among economic circles of a double dip recession or even a depression. Not just that, there is also talk of deflation. There is lackluster job growth and the jobs picture remains disappointing. And there is also talk of the federal stimulus being insufficient & thus ineffective (perhaps not effective enough).

If we start a pullback of federal deficit spending, how can this affect the economy?

Well, here is a brief explanation: Gross Domestic Product (GDP) is the measure of what we produce & sell and is essentially the value of what we earn as a country. GDP per capita gives us an understanding of how a particular level of income affects our standard of living. So, for a given level of GDP, if it decreases (c.p.), for the same size population, that translates to a lower standard of living than one is previously used to. The American Consumer accounts for 2/3 of GDP activity meaning they account for 2/3 of the consumption in the economic output. Inflation, the increase of price over time, is a necessary aspect of economic activity as it ensures value is added over time. However, if unchecked it can be damaging. And deflation is generally considered bad as it has the opposite effect as inflation. In economics, one also considers to whom does the benefit accrue. And in the case of inflation, the benefit accrues to the ones adding value. Whereas, deflation transfers the benefit to the purchaser of goods. This then disincentivizes a producer from engaging in economic activity as there is no value added incentives to that producer.

Okay, so as I explain more about economics in the above paragraph, it gets more and more complicated. And it is even more complicated than described here. So, how then can someone take a circumspect notion and make a decision that affects hundreds of millions? This previous post may help understand circumspect conclusions.

So, continuing the discussion... We have about a 9.5% national unemployment rate. The unemployment rate is defined as the number of people without a job and actively seeking employment. The natural unemployment level is around 4 to 5%. Natural unemployment is the number that we're stuck with even during expansionary economic periods. This 9.5% number is a bit dubious as it does NOT take into account those who are so discouraged they've given up looking for work. The real unemployed level may be around 15% or roughly three times the natural unemployment rate and growing. I say growing as there are people (such as high school or college graduates) entering the job market some of whom cannot find a job too.

After laying all of this out, here is an equation that will help illustrate what is going on:

Y = C + I + G + (E - I)

Y = Income or GDP
C = Consumption
I = Investment
G = Government
(E - I) = Net Exports

In order to maintain a certain level of GDP the variables on the right must change levels. Recall that GDP helps determine the level of standard of living for that population. Since consumption accounts for 2/3 of economic activity and approximately 10% less consumers (15% - 5%) are able to make purchases as they are unemployed, the Consumption variable decreases. Additionally, businesses put future economic activity on hold and Investments are down. Its common knowledge that we have a trade imbalance with developing nations such as China and of course we import more oil than we're able to produce. Therefore, Net Exports is negative although less negative than it would otherwise have been as we're not importing as much due to the downturn. Government spending has been high depending upon how you look at it. It is too controversial to get into, but, it has gone even higher to overcome the negative effects of the other variables.

In order for our economy to recover, we need to re-employ some of the unemployed so they can rejoin the ranks of the consumer segment. And this may precede business investments as consumer spending and thus demand must be at a level that initiates this action. There is a point at which government spending can affect Investments as it causes a crowding out effect for funding in financial markets. And that is tricky too. But after all of this, increased government spending has been the means employed to increase the right side of the equation to maintain GDP at or around its level necessary to maintain our standard of living, etc. This is being done at the expense of higher government debts that we will all have to help pay down. This future expense is taking us closer to being like Greece. However, if we don't emerge out of this economic situation and grow, we will be in an even dire situation than now. And it could accelerate our Greece-like experience. To avoid this, we need to emerge from this economic downturn and grow and make some structural changes.

Take a look at this exchange between both sides of the argument here. And this summation also.

This summation aligns closely with what I believe is a good remedy to the problem first proposed: When and how do we get there?

It is important we get this right because, as the world economic leader, what we do now can affect the lives of not just the hundreds of millions in our population, but billions worldwide. Simply put: too much is at stake for us to get this wrong.


Robert H.Hacker said...

If the unemployment is structural and not cyclical government spending will not have the desired effect of growing the economy. In fact the money will be wasted. Old solutions may no longer work and the lack of new thinking in Washington becomes alarming in such a situation.

Kevin Otway said...

That is true. Some of this unemployment may be structural. It is not clear, however, how much is structural and how much is cyclical. So, there may be some waste unless some of these proceeds are spent to counter the structural issues.