Wednesday, January 20, 2010

The Recession of 2010

Sustained economic progress and advances in civilization result, fundamentally, from the interest, effort, freedom and opportunity of individuals to legally acquire private property (land and capital) and accumulate wealth. Private property rights-the precondition of all economic progress-gives the individual security and self-worth. Hence, the individual's rational inclination or incentive to combine labor, capital, land and entrepreneurship to produce wealth and accumulate the physical, human, and intellectual capital necessary to make continuing economic progress possible. In other words, given the opportunities to lawfully acquire property and the freedom to accumulate wealth, the individual is motivated to create, to innovate, to produce the goods and services demanded by society, to trade them and earn a profit. That is how we have come to understand the connection between economic freedom and economic growth, and to value the crucial importance of private property rights.

Within a positive environment of institutional stability and technological advances, the degree of individual willingness and abilities is what ultimately facilitates the more productive use of economic resources and the accumulation of capital necessary for future economic growth. A problem arises, however, when morality of behavior, social concerns, and the basic elements of justice are increasingly ignored by the individual in the market place. In other words, it is not the selfish interest, greed or the individual desire for pleasure what creates progress. A society that grants absolute individual freedom on the sole basis of selfish motives would only promote an unsustainable system of capital concentration, exploitation, corruption and social polarization. Progress is not, either, the result of man's natural desire to work hard or of man's concern for his fellow countryman or for mankind. A society that plans solely on those premises is doom to economic disaster or ends up coercing their population to increase the level of production.

It is, then, the degree to which society succeeds in establishing its rules and values what promotes and molds individual actions toward the fulfillments of the desire to own private property and accumulate capital. The more equitable the individual opportunities, the greater are the chances of an individual to compete in the market place. This competition tends to foster innovation, to generate higher levels of productivity, higher profits, more investment, more employment and greater national wealth. Societies that only grant individual freedom and opportunities to a particular sector of the population and invest little or inefficiently in human capital, become dual societies. On one side, a sector develops and progresses until the other sector, which operates at a subsistence level becomes fatigued, unproductive and powerless to sustain the necessary levels of production, income and development. These conditions drag the entire society into the cycle of social unrest that we often see in poor countries.

The most prosperous nations, therefore, are those that can strike a better balance between individual betterment and the social good, prosperity and justice, freedom and order.

Some believe that the natural laws alone explain that the balance of social forces is achieved based on natural conditions such as respect of property rights, good faith, fair transactions and equitable rewards for individual efforts. But the fact is that the economic system cannot be left entirely to self-correcting natural laws, simply because the respect for ownership, sincerity of intention, fairness and the correspondence between individual efforts and rewards are not necessarily natural conditions; at least no more than selfishness, greed, exploitation and corruption.

It is true that individuals are the essential elements of society and that self-interest (motivated by financial compensation, realization, reputation or power) is the driving force of the economy, but the limitations in human capital investment as well as other factors play a significant role on the pattern of income distribution. Since aggregate demand depends on the pattern of income distribution, and production is governed by the pattern of consumer demand, then abnormally unequal income distribution would constrain the level of production and with it the wealth of the nation.

Furthermore, when the private ownership of land and capital is overly concentrated, the economic incentives necessary for economic progress are drastically reduced. This extreme concentration of wealth in the hands of individuals and institutional investors tends to drift away from the production of goods and services as they search for speculative gains. Therefore, to a point, the less polarized the distribution of income, the greater the likelihood of individuals, not only to increase consumption, but also to develop entrepreneurial abilities and increase the competitiveness of the markets

Economic policies, to be sufficient, should comprehensively support the private sector in the implementation of health, education and training programs, aimed at increasing workers productivity and business profits. The resulting increase in income, savings, and capital accumulation would tend to increase consumption, production and employment. This would allow the economy to fully utilize its human and capital resources.

Government revenues would also increase, creating more favorable financial conditions, as interest rates would tend to ease. This would allow for higher levels of investment in capital and would help sustain productivity and profits. The high levels of productivity would tend to keep inflation in check.

The most relevant implication here is that governments should promote a more comprehensive and proactive approach to maintain economic freedom, equality of opportunities (not equality of outcomes), growth, and stability, while causing the economic fluctuations (business cycles) to be benign and making fine-tuning government efforts of relatively lesser need.

Virtually, the government primary function is that of stabilizing the economy through monetary and fiscal policies. The idea of success, however, is rather narrow as it concentrates, almost entirely, in the "two unhappy possibilities" of unemployment and inflation.

Monetary and fiscal policies, if viewed in isolation and as short run instruments of stabilization could at times produce the most unintended results. For instance, disproportionate massive tax cuts could produce extreme high concentration of capital. Extreme fine-tuning efforts through monetary policy could be deceptive and at times both policies could be contradictory.

Government policies, in general, could be conflicting. One example of the contradictory forces in the USA could be seen in the housing market. As we entered the XXI century the USA government began to expand his social commitment to increase the home ownership of minority groups, while relaxing the accountability of financial institutions. Soon, the real estate industry took advantage of the "easy-credit", laissez-faire environment and set itself to put any kind of deals together. Unscrupulous lenders provided the funds so anybody could buy homes, regardless of their credit qualification; they just passed the risk along, selling loans at a profit to third party investors. Borrowers took out loans at low teaser rates, which they could not afford once these low rates expired and their mortgage payments were in many cases doubled. Scores of lending institutions failed, including the giants Fannie Mae and Freddie Mac; leading to a grim credit crunch.

Another important factor, which contributed to the crash of the real estate market, is the role of the speculator. The speculator, attracted by the real estate boom made immense amount of money in their early investments, then dumping in the market their properties at losses they could afford due to their earlier successes but leaving homeowner with houses worth less than their mortgage.

This leads us back to the issue of high concentration of capital. The ideological principle of income polarization has diverted investment from the production of goods and services into speculative investments, which eventually and inevitably lead to markets failure. For a while, the USA economic policies have tended to favor the highest income earners. This produced a high concentration of capital that was increasingly channeled into the financial markets in search of capital gains. This speculative investment, which elevated stock prices to unsustainable levels, bears the responsibility for the 2008 stock market crash.

That situation led to lower capacity to consume due to lower real income and layoffs. That spiral continued to sink the system rapidly, deepening the recession that started in 2007. The USA central bank, with the hope of stabilizing the economy, kept lowering the interest rate until it almost reached a near zero level. But, as they say: "you can take a horse to water, but you can't make him drink". Banks kept hoarding cash and not taking the risk of lending it.

The U.S. government treated that economic condition like if it was a short-term imbalance. The reality is that, systematically, middle class families were descending into poverty; many continued to add to the lines of the unemployed or underemployed. Numerous factories closed. The government capacity to continue borrowing money grew impaired. The long-term instability became critical. The trend was signaling that the system could loose its capacity for future prominence.

It is imperative, then, that long-term instability be measured and monitored. For that purpose I devised a LONG-TERM INSTABILITY INDEX, which could be called The Lacayo Index. This index combines the measurements of inflation (I), unemployment (U), interest rate (IR), import to export ratio (MXR), public debt growth rate (PDGR), the Gini coefficient for families (GC) as a measure of income inequality, and a measure of the real GDP drop rate (GDPDR). The Long-term Instability Index depicted in EXHIBIT I is the sum of these components:

LONG-TERM INSTABILITY INDEX= I+U+IR+MXR+PDGR+GC+GDPDR

The use of these variables finds its logic in the rationale that they are, ultimately, the consequences of fiscal and monetary policies, as well as the effects of other aspects of public governing. And in turn, the causes of such public administration efforts are often reflected in the political leaders adherence to ideological principles, in their attitude toward accountability and their disposition to submit to morality of behavior, to social concerns and to the basic elements of justice.

EXHIBIT I shows The Long-term Instability Index of the last 62 years for the United States of America.

For the government to achieve long-term stability it would have to implement economic policies that would avoid extreme capital concentration and income disparity (lower Gini Coefficient) and with that reduce speculative investment and increase productive capital investment. The government would have to concentrate on fiscal responsibility and establish reasonable budget-balancing objectives to avoid negative pressures in the financial markets that could result in higher long-term interest rates. It would have to strive to increase exports to avoid unhealthy trade deficits (lower Import to Expot Ratio) with certain countries and regions; leading to comparative advantages, higher GDP, higher tax revenues, lower Public Debt, and lower unemployment. The Lacayo Index would allow us to measure and monitor government performance in those areas needed to sustain long-term economic growth and stability. The table in exhibit I clearly shows how the policies of each administration affects the seven components of the index. It helps judge the president on how he manages what he receives, how he exacerbates or reverses the economic trends and what his long-term economic legacy is. As the index value of a president increases it indicates that the administration performance in terms of long-term economic instability is worsening.

The 10th column of exhibit I denotes the values of the index corresponding to the last year of each of the last 15 United States administrations. On the last column, these values are tagged with a (+) or a (-) to indicate whether the last year of each presidential term has improved or deteriorated, in term of the Long-term Instability Index, when compared to the last year of the previous term.

What is also clear in The Long-term Instability Index is the accelerated, almost unstoppable decline of the long-term economic trends in the United States: a contracting middle class, the amassing of a colossal public debt, a disproportionate trade imbalance, a falling production and a very unstable approach to fiscal and monetary policy with its consequent long-term instability in the rates of inflation and unemployment. Perhaps political ideology is getting in the way of economic performance. Perhaps economic goals are narrowly established due to political pressures. Perhaps politicians fall in love with a tree and ignore the forest. Whatever the reason, it needs to be realized that a piecemeal approach to economic problems is often damaging. The economic reality of a country requires a comprehensive approach and the simultaneous monitoring of The Long-term Instability Index and the tendency of its components.

Regrettably, we tend to focus on short-term misery indices and other measures of short-term economic performance that do not go beyond the measurements of GDP shortfall, unemployment and inflation, and somehow neglect the long-term implications of economic policies adopted by politicians.

The index takes into account what is left undone in terms of accumulation of the public debt, in terms of income disparity trends, in terms of trade deficits and in term of long-term interest rates which affect mortgages rates. To restore the long-term instability depicted by The Lacayo Index, future U.S. presidents must perform systematically better (lower index values) than their predecessors.

In EXHIBIT II we chart the Long-term Instability Index for a 60-year period (1948-2008). We depict the periods of U.S. recessions (dark bars), which are consistent with the index peaks. On this chart we also mark three economic expansions; the three longest economic expansions in U.S. history, which coincide with periods of decreasing values of the Long-term Instability Index.

From this, however, we cannot conclude that maintaining a decreasing index value would increase long-term economic stability and sustain longer periods of economic expansions. A government could slash taxes, irresponsibly deregulate Wall Street, and the Fed could cut interest rates to stimulate economic growth and reduce unemployment. These could perfectly well reduce the value of the Long-term Instability Index while leaving unattended the long-term implications of severe income disparity, increasing public debt and increasing trade deficits. So, the goal of the government should not only aim at obtaining relative declines of the index value, but to maintain the Long-term Instability Index as close to zero as possible.

The problem with economic instability is that the deeper causes of recessions are ignored. We know that at times government itself has been the cause of recessions by applying contractionary fiscal or monetary policies, as they fear inflation. A prevailing traditional assumption, as we enter a recession, is that consumer confidence is down and that a small tax rebate will do the trick and get the flow of money restarted. At times the government has fought recessions characterized by stagflation by first fighting the inflationary problem with contractionary policies and then reducing taxes regressively to lower businesses costs with the hope of the benefits trickling down to the labor force. But the deeper, more ingrained causes of long-term instability, like capital concentration, monopoly power, and the disruptive capacity of speculation are hardly ever addressed.

The complexity of the financial crisis and economic recession that begun in 2007--the worst since the great depression--is such that it has politicians and economists alike, puzzled. This crisis will probably occupy intelligent minds for many years in the effort of deciphering what went wrong. We know, however, that institutions have failed and that society has compromised its rules and values. The SEC allowed the proliferation of investors' traps. The FED has, to a large degree, lost its capacity to stabilize the economy through monetary policy. The permissive monopolistic power granted to certain industries has virtually taxed the consumers in detriment of their purchasing power. The play of ideological forces in the branches of government essentially shifted productive capital investment to speculative investment. So bad, that our system has virtually shifted from capitalism to what I elected to call wagerism.

Since the 1980s, in the U.S., money has been gushing to the wealthiest and to institutional investors. The impressive accumulation of wealth has not led to an equally unprecedented economic growth. Instead, it has produced a decline in real lower and middle incomes because of the degree of wealth concentration. Under these circumstances, consumer demand is often depressed; investment is increasingly drifting away form the production of goods and services and channeled into the speculative search of capital gains. There is little incentive for the wealthy investor to go through the complexities of planning, organizing, directing and controlling a business that produces goods and services when they could profitably bet in the rising prices of stocks, bonds, commodities, etc. and only pay a fraction of the taxes they otherwise would. Why invest in capital goods if we could simply bet? Why capitalism if we have wagerism?

High stock prices or the high prices in any speculative market are almost always pushed further upward by astutely fabricated high expectations. In this sense, economic reality and speculative markets are unrelated. Wagerism is characterized by the culture of speculation and is an unstable system that inevitably crashes after every period of artificially inflated expectations and gains. Another characteristic of wagerism is the increasing economic polarization that it imprints in a society. The ever-increasing decline in consumer spending and capital investment, the rising underemployment and income polarization, and the trade imbalances push the system into deeper and more somber tides of speculation.

The great recession that started in December 2007 is clearly marked by the effects of wagerism. The apparent recovery that started in 2009 was plagued with escalating unemployment and underemployment, bankruptcies, foreclosures and the risk of inflation. The Fed has just been throwing money at the problem, since early 2009. Trillions of new dollars has been catapulted into the economy to rescue the failing speculating companies which the Fed deemed "too large to fail." Domestic and foreign banks, hedge funds, mutual funds, large manufacturers, automakers, insurance companies received the bulk of the money distributed as part of the improvised bailout efforts of the Fed.

By looking closely at exhibit II, we observe that, since 1950, on the average, there is a span of approximately 17 months from a low point of the long-term instability curve to the start a of a new recession. Considering the upward extension of the index beyond December 2008, it is possible for a new recession to begin in 2010 in the same fashion as the 1981 slump that began 6 month after the end of the 1980 economic downturn.

Amidst these uncertainties, one thing is patent: The importance of recognizing the need for a comprehensive long-term economic instability indicator that could help establish a stable long-term path. To avoid further failures and human anguish, the U.S. economy should start producing vigorous increases in real GDP with the minimum possible impact on the public debt instead of rewarding ingrate, bonus-hungry Wall Street bankers and other speculators with billions of bailout dollars. Efforts should be aimed at restoring the size of the middle class instead of allowing monopolies to set arbitrary prices, charge fraudulent fees and outrageous interests while confiscating the purchasing power of consumers. Public policies should be adjusted and laws should be reformed to reduce the substitution of capital investment for speculative investment, reducing unemployment, promoting export-boosting enterprises while keeping inflationary pressures and the long-term interest rate in check. This is the time to be concerned about the future of capitalism. Threatened by the possibility of a new recession this year, in our minds linger the thoughts about our capacity to deal with a catastrophic depression and the capacity of capitalism to endure.

Max L. Lacayo has obtained his B.S. degree in economics, he continued his studies at the University of New Orleans where he obtained his M.A. degree in economics, while working as a teaching assistant.

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