In this diary I would like to present a somewhat different (and hopefully easy to understand) view of what is going on in the world economy, and by extension in the US economy. I want to try to explain why what we are doing is not working ... and what needs to change before things can get better on a sustained basis.
To put it simply the world economy is constipated.
On one side of the economy we have those with no money (unemployed workers, governments with huge budget deficits, people under water on their mortgages) on the other side we have those that are almost literally swimming in money (countries with massive FX reserves, companies with record cash on their balance sheets, the well paid undertaxed employed, and banks with record cash on deposit with the Fed).
What we have is a ton of cash sitting on one side and not moving to the other side. To make matters worse as governments run bigger and bigger deficits all the cash just ends up rushing over to the side that already has all the money (corporate profits/FX reserves) instead of continuing to flow and circulate through the economy. The constipation just gets worse.
As anyone who observes what is going on in the economy knows, we have a problem. Those with money have lots of it and are not spending., Those without money have a lot of debt, and are not spending. The solution to the economic problems involves the seemingly simple task of getting the money to flow from the haves to the have nots (instead of continuing to flow from the have nots to the haves.)
This is a problem that has been some time in the making. We need to see where it started to understand how to "unblock it".
How did this happen?:
For some time now China (and some other countries like Japan ... but I'll use China to keep it simple) has been running large trade surpluses. What this means is that China has been selling a lot to the rest of the world. In return it gets foreign exchange (dollars, Euros etc). Effectively this is like an IOU.
In a healthily functioning economy China would use these IUOs to buy things from other countries. But what has been happening is that China has been accumulating these IOUs instead of using them.
Again, in a healthily functioning economy the Chinese currency would appreciate, thereby making its goods more expensive and the goods it buys cheaper. This would mean it would get fewer IOUs (sell less) and would be more tempted to spend the IOUs it has (because goods would be cheaper). BUT China has blocked this by effectively pegging its currency to the US$.
To make matters worse China has instead lent the IOUs back to the US government, allowing the US government to borrow more and at lower rates than otherwise possible - allowing even bigger deficits. This has the perverse effect of keeping Americans spending ... and China accumulating even more IOUs.
The combination of accumulating IOUs, pegging the currency and lending the IOUs back to the US government has effectively bunged up the economy.
The US response:
The US response has been to complain but do nothing. Way back after 9/11 and the tech crash, the US, under Bubbles Greenspan and Spendthrift George, lowered interest rates to try to keep the economy afloat. They succeeded, but also set the stage for the mess we are now in. By lowering rates (and making it easier to borrow) they told Americans to go out and spend and borrow and spend some more. While this had some positive short term effects, it also meant that China just kept accumulating more IOUs as Americans bought more and more ... basically a portion of the money spent was siphoned off and stored at the Chinese Central Bank ... until it was lent back to the US to fund even more spending through debt.
Had rates not been cut there would have been a deeper recession at the time... BUT ... because rates would have been higher people would not have been able to borrow as much, they would not have been able to use their house as an ATM, and even the government may not have been able to give all the tax cuts that it did. The Chinese would also not have been able to accumulate as many IOUs. (Low rates mis price risk and mis allocate capital leading to stupid economic decisions - the decisions happen quickly, the true costs are paid for decades.)
Unfortunately the US continues to run a policy fixated on low interest rates ... trying to force people to borrow and spend (some of the biggest victims of this have been those trying to live off their savings in old age - getting nothing in interest income and tempted into buying riskier stocks to try to get higher returns). Unfortunately whenever they do ... a portion gets siphoned off to the Chinese Central Bank further exacerbating the problem.
The latest US attempt to try to force China to stop "bunging up the economy" has been for the FED to resort to printing money (QE2). Because China has a pegged currency this effectively pumps inflation into China (and the world economy) and thereby makes Chinese goods more expensive (pushing up their costs so they have to raise the prices they charge), ultimately hopefully offsetting the the impact of the pegged currency.
In essence it is a way to weaken the US currency - which indirectly also means a lower US standard of living longer term. So it is a policy that could work, but it will take time and if it does the effects could be "explosive" (extreme inflation) and there is no guarantee you would not get constipated again next week as you have not really changed your diet.
Recently we have seen China again start to let its currency appreciate again (especially since the debt downgrade). They realize that the US is aiming for a stealth default (debasing the currency of the debt they hold), and so they may finally have decided enough is enough. This will ultimately be good for the world, but the adjustment process will be very tough - especially as inflation in imported goods starts to hit WalMart etc. as unemployment stays high and wages stay down.
So what? What next?
The two policies that created the financial mess (artificially low interest rates and the Chinese currency peg) remain more or less in place and continue to constipate the world economy. By not allowing the natural adjustment mechanisms to work and by continuing to mis-price risk we can not get a real recovery.
More government deficits will not cure the constipation. Ultra low rates won't cure it. More tax cuts will definitely not help (money will just flow to the well off sectors).
So what will help?
We need a series of policies that get money "flowing" through the economy (and also stop it leaking out overseas). Essentially we need a dose of ExLax. That simply means getting those with the money to start spending it. Here are some suggestions:
1. Infrastructure, infrastructure, infrastructure. Most of the jobs lost in the recession were construction related (housing), so first of all if you want to get these people back to work, you should start with construction (sewers, bridges, .....). And if you have a choice whether to spend $100 million on payroll tax cuts or on infrastructure ... infrastructure should win hands down. Payroll tax cut money will "leak" (be used to purchase foreign made goods) and so will contribute to constipation. Construction jobs will actually build something and get money moving in local economies.
2. Charge the banks for keeping excess reserves at the Fed (right now they actually get paid for doing this - money for nothing). Banks need to be pushed into making their money "move", either through returning it to shareholders (not the preferred approach) or by say moving back into the mortgage market (to take the pressure off of Fannie and Freddie). No more "parking" their money.
3. Tax the rich. The rich have money but are not spending, so tax some of it. It won't hurt the economy (they can't stop spending what they are not spending), but it will get money that is not flowing to flow. This is fundamental.
4. A temporary tax break on dividends. Companies are sitting on tons of cash but they are not spending because they don't see demand (of course this means giving them tax breaks to hire more etc will not help either). Instead you could make it attractive to return the cash to shareholders ... who may actually spend the money.
5. Scare the Chinese. Make it clear to the Chinese that if they do not let their currency float that the US will continue to "debase" its currency by printing more money. This could force the Chinese to sell their US debt and use the proceeds to actually buy stuff ... stimulating the world economy. (This has been done to a degree and now seems to be slowly working).
6. Move defense home. Money spent on defense overseas "leaks" money out of the country. So spending $20 billion on air conditioning tents on Iraq and Afghanistan is not going to help the US economy, but it will cost it.
There is a lot more but ... overall the intent is to unblock the pools of cash that are sitting there doing nothing. To finish off let's look at some longer term structural changes that are also required.
1. End interest deductibility, including for mortgages. Deductibility encourages loading on debt (not a good thing) and actually makes housing more expensive than it would otherwise be. Cheaper housing would be good for the economy long term.
2. Increase gas prices. The US sends $1 billion a day overseas to pay for imported oil, oil that is often wasted in inefficient cars etc. Decreasing imports is an automatic boost to the US economy.
3. VAT. The US needs a VAT - just like one that every modern economy now has.
4. Higher interest rates. Yes lower rates spur borrowing ... but they also mis-price risk (the root of the crisis). We need to return to normal rates.
Note 1: Please remember that this recession is due in large part to the collapse of a credit boom. These types of recessions tend to be long and drawn out (see Japan) with low growth at times, but little long term progress. The current crop of politicians continue to act as if this were a normal "business cycle recession". The types of recessions are very different and the prescriptions for improvement are very different too. There is no easy way out ... but to make any progress we need to stop doing the things that will not work (and are actually making the situation worse).
In addition the huge build up in debt will act as a brake for years to come. American material living standards overall will decline (the early 2000's were unsustainable and growth was an illusion built on a quicksand of debt) but that does not mean everything has to be bad. A return to sustainable growth, and less consumption may actually prove to be a good thing.
Note 2: We are now seeing the result of "doing almost nothing" to fix the underlying causes of the last recession, as it is possible we are close to another recession, with almost no ammo left with which to fight it. Real restructuring (large defense cuts, higher oil prices etc) is urgently required. Unfortunately the economic powers that be in Washington remain in the pockets of the banks and the well-off. No one is willing to give an honest opinion of what the emperor is wearing.