What's Wrong With the Economy?

The verdict is nearly universal - last year's stimulus bill failed. The economy is still dragging and threatening to go into a double-dip recession. The neo-Keynesians explanation is that the effects of the stimulus bill were offset by cuts made at the state and local level by entities that have to balance their budgets. Their remedy is to double-up on stimulus spending.

The neo-Keynsians see the economy as being something like a bicycle coasting along a series of hills. When the bike is going downhill it is fine on its own but there are cyclical business cycles analogous to coasting uphill. When this happens the economy (and the figurative bicycle) slows and a push is needed by the government. This is a very self-contained model and does not account for outside influences. I think it is safe to say that there are a number of such influences.

Economies are partly behavioral. One reason that the current recession is the worst since the Great Depression is because of long-term behavioral changes involving spending and credit.

Two generations ago people saved more and borrowed less. Over the last several decades credit has become increasingly easy to obtain. One example is the layaway. A generation ago people used layaway to buy items. They would put down a deposit and the store would hold the item. The individual would keep making payments until it was paid for and could be taken home. If the payments were not made on time then the item would be put back on sale and the payments to date would be refunded minus a restocking charge.

Most cards were charge cards. You would be presented with a bill showing goods purchased during the month with your card and you were expected to pay it off. The cards were chain-specific and mainly existed as a convenience for customers.

Houses and cars required large down-payments in order to qualify for financing.

Over time this changed. Charge cards were replaced with credit cards and people started carrying a monthly balance. Stored eliminated layaway. The equity needed to finance a house or car dropped almost to zero.

For the past several years interest rates have been at record lows. This was like pouring gasoline on a fire. It accelerated the trend. With house purchases so easy, housing prices outstripped both inflation and reason.

People ran up large credit card bills then refinanced their house for money to pay off the cards. Then repeated the process, knowing that rising home prices could keep this cycle going forever. The national savings rate was at an all-time low and borrowing was at an all-time high. Credit was so easy and so abused that Bankruptcy law was changed in 2005 at the urging of the credit card industry.

At the same time that consumers were binging on credit, the financial industry was glutting itself on the profits from all of this credit. There were multiple dependent bubbles here and a crash was inevitable.

In the wake of the crash and bolstered by any number of stories about the Great Depression, people reevaluated their credit-driven lifestyles. They are saving more and borrowing less. The credit industry has also tightened up. It's harder to get credit these days.

This created a paradox. On one hand, saving more and borrowing less is good for the long-term health of the economy. On the other hand, the only way that we can have a robust recovery is if people spend like it's 2006. That just isn't going to happen. Not only have people changed their habits, for many people there is no going back. If you are among the 20% or so who is unemployed or underemployed then you have to be frugal. It you owe more than your house is worth then you cannot get money out of your home. If you are one of the people who walked away from a home because you owed too much on it then no one is going to trust you for some time.

There is no good way out of this. We are suffering for years, maybe decades, of personal overspending. The best fix is to let things balance out on their own. Eventually the economy will strike a new balance and people will feel comfortable enough to start buying again, although probably not at the rate that they had been. This will take time. There is no quick fix.

Enter the neo-Keynesians. They are believers in big government's ability to fix anything. As they see things, the problem is a lack of spending. They figure that if they can just spend enough money on union jobs and construction projects, consumers will be fooled into thinking that everything is fine and go back to spending more money than they make. Their stated hope is that consumers will return to their bad habits long enough for the economy to recover then rediscover thrift so that the cycle does not start up again.

Not only is this unlikely but the reduction in tax revenues caused by the recession means that the government has to borrow its stimulus money. In effect, the neo-Keynesians are substituting unsustainable consumer borrowing and spending with unsustainable government borrowing and spending.

The obvious reaction of government to a long, slow recovery should be to cut back on expenditures. It will be a long time before the tax base recovers. Adding to long-term government debt now will hobble the government in the future. This will add to the general pain but people understand the idea of cutting back in hard times. Britain's new conservative government announced major cuts and their economy immediately improved.

Unfortunately, the current batch of progressives are constitutionally opposed to government cutbacks. They are intent on expanding government with will take money that they do not have. That locks them into quick-fix solutions that will ultimately just make things worse. Worse, some of the President's recent speeches suggest that he is going to try to force spending by penalizing savings. This could cripple the economy for years to come.