Author: Edward Conard
Title: Unintended Consequences: Why Everything You’ve Been Told About the Economy Is Wrong (Buy the Book)
America is in a time of economic uncertainty not seen since the Great Depression. Bankers and regulators are blamed for putting our financial system at extreme risk, while households are charged with borrowing recklessly to fuel spending. A massive trade deficit is said to put the US at the mercy of those who hold our sovereign debt, even as unemployment climbs amid stagnant economic growth.
Despite all of these accusations, there are a number of significant misconceptions about the true workings of our economy. This book aims to offer a broad, comprehensive view of our economy, and propose unexpected links between economic objectives centered on empirical truths.
For example, skeptics claim that the growth of the US economy came from increased consumption funded by an unsustainable increase in debt. This debt-fueled consumption binge temporarily inflated asset values, explaining why asset prices fell as credit markets froze during the Global Financial Crisis.
On the contrary, the book argues that we should recognize that consumption does not grow productivity, nor does it increase wealth — only successful investment and innovation can do that. Since 1991, the market value of US companies has soared from about 60% of GDP historically to over 100%, showing that investors clearly believe the value of companies has increased.
Many also misunderstand the delicate balance that exists between investment and consumption. Since capital is in chronically short supply, limited resources such as production capacity, know-how, and skilled workers cap the amount of production available to the economy. This limited production is a function of our propensity to consume or invest.
Because the American population is generally more inclined to consume than invest, only a limited amount of equity remains to be invested. As a result, increases in investment yield large average returns through productivity gains and economic growth.
There are also many misconceptions about the role the trade deficit plays in our economy. By selling offshore producers our sovereign debt and using these funds to fuel domestic investment and services, we have spurred innovation that has cut costs and increased asset prices across the board.
As long as the US can continue to deploy capital efficiently at a higher rate than it borrows, this cycle can theoretically go on forever. Likewise, the authors claim that the reallocation of labor costs to more valuable domestic investment has grown the US economy 60% in the last 20 years.
The role of incentives is also underappreciated, as evidenced by the prosperity created during the ’90s that was rooted in an increased appetite for risk. Talented Americans took substantial risks and grew more successful, motivating others to do likewise while workers in risk-averse regions such as Europe and Japan have largely avoided such risk.
The top 10% of income earners account for 40-50% of US GDP, and in turn, invest upwards of 40% of their income toward fueling employment and productivity.
It is also this higher tolerance for risk and a hardworking culture that brought the US to its knees during the Financial Crisis. Innovative practices such as predatory lending and fraudulent syndication were the primary causes of the Global Financial Crisis of 2008. Reckless overuse of short-term debt also played an integral role in the unraveling of the US economy. Borrowing short and lending long can yield prolific gains but can also run the risk of rapid insolvency if panic ensues.
The government’s role in housing policy is another underappreciated aspect of the housing collapse. Over the last twenty years, legislation such as the Community Reinvestment Act and mandates from the Department of Housing and Urban Development spurred lending to sub-prime borrowers.
More funds to buy sub-prime mortgages and lower down payments and increased mortgage security prices, which in turn drove 40% of pre-crisis home price growth according to a recent academic study.
Since then, policymakers and regulators have passed legislation, such as Dodd-Frank, that does not address the issues central to the problem. Increasing capital requirements only wastes precious equity while failing to solve the issues at heart.
Indeed, all policymakers have accomplished since the crisis is to force banks to idle short-term funds, resulting in lackluster investment and high unemployment. Purely political opposition to necessary government bailouts also reduces the dependability of the government and forces banks to hold back from taking profitable risk.
Unless it returns to efficiently allocating private capital and government funds to endeavors that breed innovation, the United States will continue to digress deeper into a possible recession. To get the US economy back on track, policymakers must understand the structural changes that should be adopted to spur investment and risk-taking. Thoughtful immigration policy, lower marginal tax rates, cutting back regulation, and reducing entitlement spending are all important aspects of this effort.
Readers Note: Direct commentary by the author has been included in order to enhance the credibility of the assertions ascertained by Mr. Conard’s expertise. All direct commentary is placed in quotations.
Currently, the United States of America is in a time of economic uncertainty not seen since the Great Depression. Bankers and regulators are taking the blame for putting our financial system at extreme risk. American households are charged with borrowing recklessly to fuel spending. Our trade deficit is said to put the U.S. at the mercy of those who hold our sovereign debt. The United States is now sputtering as unemployment climbs, and economic growth is stagnant.
Despite all of these accusations, there are a number of significant misconceptions about the true workings of our economy. Can providing incentives to shoulder risk to spur innovation increase economic prosperity? Have the actions taken by policymakers in the aftermath of the collapse effectively put our country on the path to recovery? The insights reviewed here hope to show a broad, comprehensive view of our economy, and propose unexpected links between economic objectives centered on empirical truths.
A Brief History of the U.S. Economy
A unique set of circumstances stimulated the United States economy over the last century. Beginning in the 1930s, a decade long depression stifled investment, which was quickly followed by a devastating world war that diverted capital away from the private sector. The economy then emerged in the ’50s with twenty years of under implemented innovation.
The commercialization of television, advertising, new interstate highways, and automated manufacturing created nationwide mass markets. Additionally, the accelerated education of the American workforce advanced the growth in the post-World War II economy. In 1955, the U.S. enrolled 80 percent of 15-19-year-olds in school full time, while only 10-20 percent were enrolled in Europe.
In the 70’s and ’80s, declining protectionism and the commercialization of containerized ocean freight facilitated international trade.
Worldwide markets began to offer economies of scale and comparable quality – especially from the Japanese – catching the United States off guard. As competition grew for products that enjoyed worldwide competition, job growth from the largest companies with the highest paying jobs began to slow. This coupled with baby boomers and women flooding the workforce put downward pressure on wages.
Without an abundance of small firms growing larger due to increased competition and fragmented industries, the 70’s and ’80s began to take on the slow-growth characteristics of a large company. This change dynamically shifted the U.S. economy into a more service-oriented, entrepreneurial mode.
As the world grew increasingly competitive, one might have expected slow growth, flat wages, and an increase in unemployment risk.
However, in the 1990’s the opposite happened. Beginning in the early ’90s and lasting through 2008, productivity increased from 1.2 percent per year to 2.0 percent per year (almost a 70 percent increase). Most of the gains in productivity came from an increase in know-how and not from increased capital invested per worker or education of the workforce. This surge in productivity has had an astonishing impact on U.S. growth. In addition to increasing the standard of living relative to Europe and Japan, the U.S. economy has grown 63 percent since 1991, net of inflation.
In comparison, France, German, and Japan have grown 35, 22, and 16 percent respectively. The U.S. has also added 40 million workers since the mid-80s (about 40 percent), while Europe and Japan grew their workforce by 15 percent. No high-wage economy has done more for workers. Skeptics claim that the growth of the economy came from increased consumption funded by a one-time unsustainable increase in debt. This debt-fueled consumption temporarily inflated asset values, explaining why as credit markets froze, asset prices fell causing the Financial Crisis.
To the contrary, we should recognize that consumption does not grow productivity, nor does it increase wealth. Only successful investment and innovation can do that. Since 1991, the market value of U.S. companies has soared from about 60 percent of GDP historically to over 100 percent even in post-recession values. Investors clearly believe the value of companies has increased.
The Role of Investment
In essence, there are two viewpoints of the government’s role in investment: those who favor income redistribution and those who oppose it. The proponents of income redistribution “point to the steadiness of long-term growth and the loose correlation between tangible investment and innovation as evidence that changing levels of investment and risk-taking play only a secondary role in innovation.”
They are also doubtful of the power of financial incentives and argue that risk will exist no matter the upside. They argue that most of the success attributed to the United States over the last half-century can be seen as a byproduct of an entrepreneurial culture. Opponents of this viewpoint believe that “to achieve rare success, investors must risk capital to fund an inordinate number of failures. And like any game of chance, payoffs for success incentivize investors and employees to take risks and suffer their losses.”
Innovation can grow the economy in two ways: discovering new products and reducing the cost of existing products.
In both cases, no incremental resources are needed to create more value in the economy. Innovation subsequently spurs competition, and thus lowers prices, which is largely captured by consumers. Thus, lower prices are usually a reflection of higher quality goods at a new “quality-adjusted price.” Innovation keeps markets competitive by driving down prices or exiting the market.
Another interesting link that has been drawn is the relationship between investment and productivity. There is a delicate balance between consumption and investment, and Nobel Prize-winning economist Edmund Phelps contends that capital investment is in chronically short supply. The United States is continually in short supply of equity needed to underwrite the downside risk associated with making investments.
Purely limited resources such as production capacity, know-how, and skilled workers cap the amount of production available to the economy. This limited production is a function of our propensity to consume or invest. Because the American population is more prone (in general) to consume rather than invest, there is a limited amount of equity left to be invested. “As a result, increases in investment and risk-taking yield large returns, on average, through productivity gains and economic growth.”
The Role of the Trade Deficit
A number of variables have allowed the United States to increase the consumption of our own resources while simultaneously increasing investments overseas, despite capacity constraints and full employment prior to the crisis. There are many misconceptions about the role the trade deficit plays in terms of growing our economy. When China buys our assets, they have limited options with what they can do to with our dollars.
Due to an emerging, yet largely undeveloped economy, there are few opportunities to put capital to work. By selling the offshore producers our assets (namely sovereign debt), we use these funds to fuel domestic investment and services. Increases in innovation from this increased investment have cut costs and increased asset prices across the board. As long as the United States can continue to deploy capital in an efficient way at a higher rate than we are borrowing, this can theoretically go on forever.
Another issue that is highly politicized is the transfer of labor to places where costs are much cheaper. At prices where labor is essentially free, we can find more effective ways to deploy that capital to increase returns. “Anyone who overlooks these trade-offs might fail to see that over the long term, redeploying our labor from production to investment increases rather than decreases domestic employment.”
Growing the trade deficit facilitates the “dampening effect” of investment by allowing offshore producers to provide limited resources such as labor and capital to meet the growing needs of our economy. If a trade were to be balanced, we would have to decrease our consumption in order to produce goods for other economies instead of increasing domestic investment.
Increased business development from the reassignment of labor costs to more valuable domestic investment has grown the U.S. economy 60 percent since the early ’90s. Countries such as Germany, Japan, and China have proactively sought a trade surplus strategy to buoy employment and suppress their respective currency valuations at the cost of allowing the U.S. economy to grow.
Not surprisingly, the United States has been protective of allowing foreign countries ownership of domestic equity.
This is largely because we do not want the benefits of investment in the hands of others that would not in turn spur growth and innovation within our own borders. “Growing investment only has value to investors if they retain ownership of the future returns.”
Although risk-averse offshore capital is abundant, we run the risk of misallocating this capital to unprofitable endeavors (i.e., subprime mortgage debt). Legislators have consequently been using the inflow of funds to fuel public entitlement spending.
Politicians are largely reluctant to raise taxes to fuel spending because of political backlash, so using the proceeds from our sovereign debt is an attractive option. There is little to restrain public spending when the cash is flowing in so fast.
The Role of Incentives
Few economists would argue that the majority of the prosperity created during the ’90s was due to an increased appetite for risk. “The opportunity to obtain extraordinary wealth is so seductive; it renders the odds irrelevant. As innovation grows more valuable relative to everyday activities, it motivates increased risk-taking and investment, like the payout in any game of chance.”
Compared to countries such as France and Japan, the United States has resources and policies in place to encourage an advantageous incentive scheme for those willing to bear the risk. Low labor redeployment costs, valuable on-the-job training, and lower marginal tax rates all increase the benefit for successful risk-taking.
The culture of increased risk-taking in the ’90s can be observed in the number of young, enterprising people flocking to start-up companies with huge growth potential. The large payoffs and status, more importantly, were powerful enough to make these risk-conscious individuals overcome their logical fear of failure.
As the most talented Americans took risks and grew more successful, they motivated others with the necessary talent to duplicate their success. Workers in risk-averse regions such as Europe and Japan have largely avoided such risk. When the top 10 percent of income earners account for 40 to 50 percent of U.S. GDP, it is not difficult to see how the success from increased risk can drive a productive economy.
A study by the Organization for Economic Cooperation and Development finds that there is significant evidence that shows a negative relationship between higher marginal tax rates and – total factor productivity (innovative know-how). Lower marginal tax rates in the United States have also coincided with an increase in the number of hours worked per week.
The portion of American men working more than fifty hours per week increased from 15 percent for the highest quintile of earners in 1970 to 27 percent in 2006. “Talented Americans worked harder because the payoff was better. Some combination of lower taxes and higher rates of success relative to Europe and Japan motivated the most talented American workers.”
The willingness to take risk is largely a function of wealth, where wealth and equity mean the same thing.
When considering the underlying capital structure of a business, short term debt can only fuel investment if there is equity to underwrite the risk involved. As the economy’s appetite for risk rises and falls, the business cycle is perpetuated through recession, recovery, and expansion. At an individual level, an important driver of risk tolerance is a person’s wealth.
Research finds that there is a strong positive relationship between current income and savings rates. “Federal Reserve and Dept. of Labor surveys show that the bottom 50 percent of income earners consumed 100 percent of their incomes leading up to the Financial Crisis.” On the other hand, high-income earners typically invest upwards of 40 percent of income in equity that fuels employment and productivity.
Additionally, asset prices also influence an appetite for risk. This holds when considering Nobel Prize-winning economist James Tobin’s theory that investment increases when “the price of assets rises above replacement cost and declines when the price falls below replacement cost.” Thus, it is not difficult to see why investors leading up to the crisis would build houses to immediately sell them if the resulting market value was well above the cost to build them.
Managers are also motivated by their investor’s tolerance for risk. Considering most executives are agents of the owners of the firm, there is a delicate balance between an executive’s duty to satisfy shareholders and the long-term value of a stable career. In order to incentivize managers, investors have instituted exorbitant pay-for-performance measures that allow for a higher tolerance for risk taking.
However, because so much of executive’s compensation is tied up in equity locked for a period of around five years, changes in stock price could easily wipe out a CEO’s fortune. Therefore, it is not in the CEO’s best interest to demand increased risk-taking, but shareholders that demand risk often becomes a threatening force.
Interestingly, the Supreme Court decision of Roe v. Wade was a critical point for a transition to pro-investment policy in the 1970s.
The decision mobilized the small social conservative population to join the pro-investment minority in order to form a powerful union that reshaped the landscape of financial and fiscal policy. Drastic decreases in the marginal tax rates, stabilized inflation, and extensive deregulation were all by-products of the newly formed alliance. “They used that power to implement economic policies that incentivized risk-taking.” Those incentives accelerated innovation at a time when up in coming technology magnified their value.
The Role of Banks, Credit Rating Agencies, and Regulators
The U.S. economy has been prosperous because of a higher tolerance for risk and a hard-working culture apt to produce innovation. Unfortunately, these same characteristics brought the world’s most powerful country to its knees during the Financial Crisis. The Financial Crisis Inquiry Commission (FCIC) concluded that “Predatory lending and fraudulent syndication, combined with reckless overuse of short term debt, were the primary causes of the Financial Crisis.”
From a bottom-up perspective, these factors seem to make sense of the Crisis. However, the report avoids analyzing the issue from a top-down view that takes the circumstances in context. When reviewed from this vantage point a differing set of conclusions can be reached.
Predatory lending by mortgage companies and community lenders was cited as one of the chief factors in causing the Financial Crisis. Subprime lending was largely facilitated through adjustable-rate mortgages guaranteed by the federal government. Interestingly, for years adjustable-rate mortgages benefited lenders and borrowers because of the option to refinance under better terms due to home price appreciation.
“Thus, the most important factor related to foreclosures and over-speculation is the extent to which the homeowner now has or ever had positive equity in the home.” Even though only 12 percent of homes had negative equity after the collapse, they comprised 47 percent of all foreclosures. Which brings about a simple lesson in economics: If a homeowner has little to nothing paid down for the home, then it makes financial sense to walk away and default once there is negative equity.
This leaves the lender with the loss and allows the borrower to recover any downside by paying lower rent from suppressed home values. This is exactly what happened in the mortgage market after the collapse, which indicates that the demand for loanable funds was far less than the inflated supply. Therefore, when analyzed from a top-down perspective, advantageous credit standards overwhelmed the market causing a disastrous collapse.
Another interesting question pertaining to the Financial Crisis is why bankers would make risky loans that transfer the downside to the lender.
The FCIC report claims that syndicated securities such as CDOs (Collateralized Debt Obligations) unethically portrayed the underlying assets as less risky than they actually were. Again, from the top-down viewpoint, this hypothesis entails a few questionable assumptions. Why would banks syndicate risky securities if they were holding 40 percent of all mortgages and home equity loans on their balance sheets?
Why would the price dictated by the market not be an accurate assessment of the sentiment of investors? “No investor can logically demand either a different or a more accurate assessment of the price than the markets.” It is also unrealistic to suggest that the professional investors buying these securities did not understand the inherent risk of what they were purchasing.
Credit rating agencies such as Moody’s and Fitch have also come under heavy fire over the suspect ratings placed on the syndicated securities. As for the FCIC commentary on this subject, the commission sheds no light on the fact that investors recognized the innate differences between CDOs and other corporate securities. This difference was reflected in the way the securities were rated and perceived.
“Columbia University banking expert Charles Calomiris argues that institutional investors were well aware that rating agencies were rating CDOs using a different scale from the normal corporate bond ratings.” At times before the collapse, there was an 18 percentage point difference on the rate of default between Baa-rated CDOs and related corporate debt. It is hard to believe that this went overlooked by professional investors.
Each rating agency had proprietary methods for rating these securities, and while they are all different, they largely came to the same conclusion regarding the risk. In retrospect, we can see that rating agencies underestimated the amount of CDO equity necessary to ensure creditworthiness, just as they did with the underlying mortgage-backed securities. “But the ability to enhance the creditworthiness of debt by funding loans with additional equity and mezzanine debt is not, on its own, evidence of fraud.”
The Role of Short-Term Debt and Government Policy
Short-term debt played an integral role in the way the economy began to unravel in 2007. Bankers failed to realize that a 30 percent drop in home prices would cause a run on banks despite adequate capital buffers to stave off fatal losses. This was magnified by lax policy allowing banks to fund dangerous, sub-prime CDOs with wary short-term debt. Borrowing short and lending long can yield prolific gains but can also run the risk of rapid insolvency if panic ensues.
To help curb the threat of withdrawals, the U.S. government made implicit and explicit guarantees to maintain fluid credit markets and stable asset prices. “As the chief beneficiary of avoided recessions, why wouldn’t the government, on behalf of the economy, provide these guarantees?” Despite the 15-20 trillion dollars in government guarantees doled out during the Crisis, the Treasury expects to earn a profit.
This is largely because the government buys illiquid assets at fire-sale prices in times of despair and sells them once the business cycle recovers. However, government guarantees do not address the risk associated with the moral hazard that was present during the Crisis. “To reduce the risk of moral hazard, insurers like the government must charge the insured for the true cost of the guarantees.” The price the government chose to impose on banks was the implicit threat of watching them fail, which happened in the case of Bear Stearns, Lehman Bros., AIG, Wachovia, and Washington Mutual.
With short-term funds piling up on banks’ balance sheets, large institutions were eager to devote resources to securitizing mortgages because of access to debt and equity markets. Funding no- money down sub-prime mortgages became easy because of investors’ eagerness to buy subordinated debt mezzanine and equity tranches. Although, with homeowners having nothing at stake, defaults began to increase, and investors fearfully bailed out of mortgage-backed securities.
Another aspect central to the magnitude of the housing collapse is the government’s role in housing policy.
Over the last twenty years, the government used legislation and mandates to spur lending to sub-prime borrowers. Legislation such as the Community Reinvestment Act and best practices instituted by the Department of Housing and Urban Development created government- financed intervention into mortgage markets on a massive scale.
Data from the Federal Housing Finance Agency shows that between 2001 and 2007, “Fannie Mae and Freddie Mac bought about two-thirds of the non-conforming loans and almost half of all low-quality loans with FICO scores less than 660 and identified down payments of less than 20 percent.”
An increase in the supply of funds to buy sub-prime mortgages reduced down payments and increased mortgage security prices. Rising security prices, in turn, spurred momentum investing, adding to the magnitude of the panic. A study by two professors at the University of Chicago estimates that 40 percent of home price growth is attributable to the increased availability of sub-prime lending.
Preventing Another Bank Run
After markets began to collapse in 2007, banks began to move quickly to sell assets at fire-sale prices to fund withdrawals. Eventually, when banks could no longer fund these withdrawals, they were declared insolvent. Since then, policymakers and regulators have passed legislation, such as Dodd-Frank, that does not address the issues central to the problem.
Intense political disapproval stemming from the bailouts has led policymakers to implement actions in Dodd-Frank that hinder the Fed’s ability to act in a crisis. This inability to act by the federal government is presumably supposed to reduce risk and moral hazard.
Although, realistically all that has happened since the legislation was passed is a reluctance by banks to lend long-term and borrow short-term funds. Businesses have also cut costs and refused to hire in the face of uncertainty, while consumers slash spending and borrowing.
“Until we find a way to put short-term debt back to work, the recovery will remain slow, and unemployment will remain high.” Simply demanding more equity to backstop bank losses and diverting equity to underwrite risk elsewhere will not decrease unemployment or put precious savings to work.
Economic policies such as lowering marginal tax rates on successful risk-taking will allow investors to accumulate equity and spur innovation.
Increasing banks’ ability to foreclose on homeowners in default would curb the damage done by delinquent homeowners. As previously mentioned, heavy scrutiny should be placed on banks for borrowing skittish short-term capital to fund securitizing risky assets. Instead of placing blame on fraudulent lending, credit ratings, and incentive schemes, citizens should question why sub-prime home ownership was cheered while it was overinflating our economy.
The most far-reaching proposal to prevent a run on banks would be for the federal government to sell mandated insurance to financial institutions. The reliability of explicit government responses would provide transparency in the markets while decreasing unnecessary risk. To maintain proper accountability, the government should also sell a portion to the public.
To this point since the Financial Crisis, all policymakers have accomplished is forcing banks to idle short-term funds, resulting in lack-luster investment and high unemployment. Increasing capital requirements only wastes more precious equity, while failing to solve the issues at heart. Politicizing opposition to necessary government bailouts also reduces the dependability of the government and forces banks to hold back from taking the profitable risk.
Although lower marginal taxes on those who shoulder risk to spur the economy would undoubtedly benefit consumers/wage earners, the majority of the gains fall in the lap of the wealthiest Americans. Therefore, are we not better off heavily taxing the rich to redistribute income to the most unfortunate among us? Or should we continue to grow prosperity through capturing the upside of successful investment?
If the tradeoff were between fruitless consumption by the rich or helping feed the poor, the answer would be simple. But that is hardly the case. The wealthiest Americans consume only 60 percent of their income, while 40 percent is invested in a valuable way that also benefits everyone. “The top 5 percent of income earners, for example, pay close to 50 percent of all federal taxes.”
The income invested by the wealthy is far more at risk of capturing value from investments than the gains that society benefits from. One form of this benefit is the so-called buyer’s surplus that is gained because of innovation that captures value for consumers well above the price attached to products.
Although the poor capture disproportionately less value from investment, the publicized 44 million people in poverty is a poor indicator of those who are supposedly disenfranchised. Of this 44 million, 16 million are children, and almost 19 million do not work at all. As a proportion of all people in the United States, hardly anyone that works full-time lives in poverty. Thus, the majority of these people are net benefiters of the government while providing no benefit to the economy even though they are capable of doing so.
It is also extreme to believe that consumption by wealthy individuals is invaluable to society.
If increased wealth spurs the incentive to invest income, then every 40 cents of incremental income is captured by society. Some proponents of income redistribution argue for a progressive consumption tax and conciliatory reduction in taxes on investment.
Although, if the rich feel as if consumption is the real return on bearing risk, then they will no longer feel the need to put valuable equity to work. “With diminished payoffs for risk-taking, workers might head to the beach rather than bearing the burden of increased responsibility, as they have in Europe.”
If we as a society view income redistribution as social insurance, then we must ensure that those receiving the benefits are able to pay the actual cost of the premium. The United States will cease to become prosperous if we heavily tax those willing to prune the economy by providing the same level of governmental services despite contribution.
If we designed the insurance to scale with contributions, those who sacrifice the most for the economy would be chief beneficiaries. Ironically, the chief beneficiaries would be illegal immigrants. For those in favor of redistribution because of a moral obligation, the United States should then be helping those who are poor across the world, not just within our borders. “Because surely, morality doesn’t recognize geographical boundaries.”
Solidifying government guarantees and pursuing trade and immigration policies to reduce the volatility of U.S. employment were the two most effective tactics in the wake of the Financial Crisis. Since then, precious short-term funds sit idle as the economy sputters with sluggish growth and high unemployment. Although initiatives to put idle capacity to work have increased domestic employment in the short-run, long-term structural issues have not been addressed.
Without efficiently allocating government funds and private capital to endeavors that breed innovation, the United States will continue to digress deeper into a possible recession.
Policymakers bought whole-heartedly into the Keynesian theory to spend their way out of the Financial Crisis.
Proponents of fiscal stimulus believe that by restoring confidence in the markets through temporary government intervention, the economy can stimulate adequate growth.
Opponents argue that because of the structural changes that need to be made to our fiscal and monetary policy, simply reallocating funds between sectors does not truly increase risk-taking necessary to spur growth. An important factor relating to the impact of government stimulus is the multiplier that magnifies the effect of government spending.
Economists placed a great deal of confidence on the impact that the stimulus would have on improving the economy.
However, many experts are beginning to realize that economists were flying blind when trying to determine the effect of spending trillions of dollars. “That’s hardly the kind of certainty upon which trillion dollar investments should be justified-especially in these risky times.” “Stimulus exhausts precious resources, scares off productive risk-taking, leaves structural problems unresolved, and accumulates a mountain of debt in its wake. “If taxpayers failed to realize that the stimulus would leave a bill without producing permanent results, it’s hardly lost on them now.”
If policymakers are unwilling to remove the risk associated with another bank run and government stimulus has not put the U.S. back on track, what can be done to reduce unemployment? Policies to reduce the volatility of domestic unemployment during economic downturns would be a viable solution in the near term.
For example, idling off-shore workers by restricting imports or demanding that off-shore producers buy more of our goods would keep less-skilled workers employed. Understanding the benefits of cheap off-shore labor and redeploying capital to profitable domestic endeavors can also drive growth. “Pragmatic immigration and trade policies could contribute significantly to reducing unemployment in recessions.”
Government initiatives that spend money in ways that do not put the U.S. on a sustainable trajectory have also hindered our recovery. “Investments in green energy and lengthening unemployment benefits rather than hiring displaced workers to create value increases the fear of future tax increases.”
By extending unemployment benefits, those people who are out of work have delayed recovery by not allowing labor and capital to be reallocated. People will not rush back to work if they are receiving government benefits that cover the cost of living.
Harvard economist Robert Barro estimates that the current administration’s extension of unemployment benefits from 26 weeks to 99 weeks has increased unemployment from 6.8 percent to 9.5 percent. Outrageous government spending will only put future generations at risk, especially those future risk takers forced to pay draconian taxes because the previous generation failed to have them in mind.
Before the Financial Crisis, the United States economy was operating at almost full capacity. Employment was at a near low of 4.6 percent, and the S&P 500 was climbing towards 1,565. Productivity gains and a healthy appetite for risk spurred innovation that bred Google, Facebook, and Amazon. The rest of the world in the meantime slowed their work effort and ushered in an era economic ambivalence.
A healthy trade deficit has allowed the U.S. to innovate and put risk-averse short term capital to work. Moving manufacturing labor costs offshore freed up capital space and reshuffled domestic unskilled labor to more useful services. The trade deficit also eliminated capacity constraints that would have forced the U.S. to decrease investment due to increased consumption.
The ever-changing United States’ demographic will make it more difficult to pursue an investment-based strategy. Millions of retirees and children of poor immigrants will drastically increase consumption at the cost of increased taxes and income redistribution. It will be up to policymakers to understand that increased employment and growth will not occur unless risk-taking begins to increase.
Regarding the Financial Crisis, a lack of transparency in the market or a breakdown in regulation was not necessarily the root cause. “The inherent issue was logical economic policy that put risk-averse savings to work to maximize employment.” The extensive damage done by withdrawals and the threat of bank runs are testaments to the importance of explicit guarantees to keep confidence in the financial system.
To get the U.S. economy back on track policymakers must understand the structural changes that should be adopted to spur investment and risk-taking. Thoughtful immigration policy, lower marginal tax rates, cutting back regulation that does not create opportunity, and reducing entitlement spending are all ways to get the United States back on track. “If there was ever a time to step up and make the right choice, this it.”
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