Sunday, February 24, 2008

Cure the Disease, Not Just the Symptoms

by Ed Lotterman
St. Paul Pioneer Press
Thursday January 24, 2008 1C

Politicians and journalists are missing a key question when talking about ongoing U.S. economic problems: Is the current slowdown in economic activity and decline in asset prices cyclical or structural? Without answering that question, much public discussion is pointless.

Cyclical economic events result from the business cycle, the historical pattern of fluctuation in output, employment and inflation. Structural ones stem from longer-term shifts in the underlying framework of an economy.

This distinction is often applied to types of unemployment. Autoworkers laid off for a few months because auto sales drop during a recession are cyclically unemployed. The thousands of boilermakers let go in the 1950s as railroads shifted from steam locomotives to diesels represented structural unemployment.

The cyclical-structural distinction also applies to budget deficits. If tax receipts fall below outlays solely because a sluggish economy redues income - and sales-tax revenue, the deficit is cyclical. However, if a deficit persists at full employment and high output, the problem is structural.

The key question right now is wehther our economic problems are primarily cyclical - resulting from a long-established (even if not perfectly regular) pattern ofincreases and decreases in output, employment and prices. Or are our problems more fundamental and long-term?

Policies commonly deemed appropriate responses to business-cycle problems - manipulating the money supply, interest rates, taxes and government spending - are ineffective in addressing structural challenges. Indeed, they may make the situation worse rather than better.

We are in the same quandary as Japan was in 1989. That country faced an asset price bubble much greater than ours. Japanese stock prices rose by a factor of five in the 1980s. Real estate price increases were even more extreme.

At prevailing exchange rates, the grounds of the Imperial Palace in Tokyo were worth more than all of California. Ginza district land reached $139,000 per square foot.

But in 1989 the bottom fell out. Stock prices fell 50 percent from 1989 to 1990 and even more in following years. Tokyo home prices fell 90 percent. The crash wiped $25 trillion (in 2008 dollars) off of Japanese balance sheets.

The government treated the crash as a cyclical problem, lowering interest rates and increasing spending on vast public works projects. Japan went from having one of the lowest rations of national debt to GDP among industrialized countries to one of the highest.

Yes, the Bank of Japan was hesitant and erratic in money supply increases. Yes, there was poor coordination of fiscal and monetary policies. But overall, Japan had no lack of Keynesian stimulus. Yet its economy stagnated for more than a decade.

Japan's problems were structural. The economy depended too much on exports stoked by an undervalued yen. RElationships between financial institutions and corporations were too cozy and fraught with conflicts of interest. Financial regulators encouraged hiding losses than writing them off. Major corporations and banks could not go bankrupt, no matter how insolvent. An appreciating yen drew in more foreign investment than the country could absorb.

Traditional monetary and fiscal stimulus addressed none of these problems. Rather it made a bad situation worse.

President Bush repeatedly says that the U.S. economy is fundamentally sound, implying that current problems are merely cyclical. Is he correct? Will the fiscal package that he and other elected officials from both parties propose fix things?

At a very fundamental level and over the long term, the U.S. economy has great strengths. We have enormous natural resources. We have enormous natural resources. We have extensive private and public infrastructure. Most importantly, we have a hard working, skilled, creative and enterprising labor force. There is no bar to our long-term prosperity.

But in the medium term, we are ignoring important structural problems. For three decades, general government spending has exceeded general revenue by large margins - through booms as well as recessions. But the way we finance Social Security obscures the size of the general federal deficit. The national savings rate has fallen to near zero despite repeated tax cuts intended to boost savings and investment. Lenders market credit more aggressively than in any other country or era. Capital markets have created myriad complex and poorly understood financial instruments and new players, such as hedge funds, that are more difficult to regulate. We borrow hundreds of billions abroad while cheap imports suppress consumer inflation, even though the money supply grows faster than output, year after year.

If we ignore such fundamental underlying problems and expect cheaper money and a larger federal deficit to provide a quick fix, we are likely to be disappointed.

No comments:

National Debt Clock