Kimball Corson's  Instablog

In a nutshell, the answer is because of our large trade deficit and because of our maldistribution of income. Both permanently lower aggregate demand as long as they exist.  Until they are fixed, our recovery can only go up so high, to the new “lower normal.” This will likely leave us with higher employment than we would like and less economic activity than we would prefer.

Because the Fed and government refuse to recognize these facts and continue to extrapolate off old higher normal levels, we will probably see them adopt detrimental expansionary policies that will try to push us beyond our new "lower normal" level into bubbles which will burst, just like housing bubble did. It felt good going up, but was a disaster coming down. However, the housing bubble was in the making for a long, long time because of tax rules and other laws that favored housing purchases over other goods and thereby misallocated resources.

The permanent relative drops in aggregate demand from the trade deficit and from the maldistribution of income are easy to understand. On the former, to the extent we spend a large percentage of our income to buy goods from abroad instead of domestically, domestic aggregate demand will drop and stay down. If we suddenly were to export enough to balance the trade deficit, for example, then we would then have the income or money from our exports to buy more and replace our lost domestic aggregate demand. This is why Keynes said countries with continuing large trade deficits will stay relatively depressed.

On the maldistribution of income problem (60% get 21% of the income), aggregate demand is permanently reduced because lower income households use most of their income to create the aggregate demand for consumer goods and services, but now they have much less income, whereas high income households with more income spend only a small fraction of it on those goods and services and invest the rest in secondary financial markets, driving financial asset prices up. Redistributing income more fairly would increase aggregate demand significantly, but like fixing the trade deficit, it is not going to happen any time soon. Both of these problems are largely off the radar screens of policy makers.

We also need to consider the context of these two problems. We have a huge backlog of unemployment generated over the last twenty years or so from our manufacturing sector, which is a separate problem. We have been exporting jobs for years. The service sector can only absorb so many new employees. This is one reason the new lower level equilibrium will entail higher unemployment than we would like, except perhaps during cyclical boom times around that lower level. It will bother policy makers and politicians immensely and induce them to adopt mistaken expansionary policies that are counterproductive.

Until these two problems – the large trade deficit and the maldistribution of income -- are fixed, we can only hope for a new “higher normal” level of equilibrium; we can't get there . . . except perhaps temporarily on the crest of some new bubble policy makers will generate. Unfortunately, the likelihood that policy makers or politicians will understand or admit the new lower level equilibrium is not good. That is why we had the housing bubble, engineered deliberately by Greenspan and the Fed with the support of many others, including Paul Krugman. They still thought then that they could get back to the old higher normal equilibrium, with further expansionary policies. What will happen when we push the economy beyond our new natural "lower level" equilibrium is that we will get booms and busts that damage us and the economy.

These problems are going to be with us for a good while, I am afraid.

Disclosures: none

Several readers have asked an interesting question, in one form or the other --  Inasmuch as our government has grown so hugely over the last 50 years, are there instances of government growth and  intervention which are harmful to the economy and the people who do not benefit directly?
The Roles of Government in the Economy
To address this question we need to consider the types of government growth and intervention. Basically, they are:

(1)    Financial intervention by the Fed, Treasury or both to address economic slumps;

(2)    Direct ownership or leveraged intervention in specific, troubled companies;

(3)    Intervention to support and correct markets which do not function properly, e.g., health care;

(4)    Intervention to assure fair play and non-abuse in markets

(5)    Intervention to expand the role of government in the economy;

(6)    Congressional intervention on behalf of lobbied for special interests;

The Mixed Record of the Fed and Treasury
Most wouldn’t or shouldn’t dispute (1), at least in emergencies.  Recent financial intervention by the Fed and Treasury, in fact saved us from a major depression.  In the present instance, while many don’t like the debt we have incurred, the truth is we needed drastic action.  The stimulus program of tax relief and infrastructure repair, and the zero interest rate and quantitative easy policies have saved the day. We were sinking much faster than in 1929. These programs stopped that.

In other instances, intervention by the Fed has simply created bubbles, e.g., housing, because the Fed and Treasury do not recognize that our equilibrium level now, from the trade deficit and our maldistribution of income, is a new “lower normal.” They targeting on the old higher equilibrium level extrapolated from the good old days.

In truth, the debt numbers on the books now are staggering.  But they are clearly dwarfed in magnitude by what our losses and the transactional costs from dislocations would have been from the major and fast hitting depression we just avoided. We are clearly better off now than we would have been, the Austrian School and the dooms day guys notwithstanding. It is hard to even imagine the costs of a major, hard hitting depression, fully and completely considered, down to health consequences for the population. What debt we have on the books presently is chump change by comparison.

Item (2), on corporate intervention, is dicey. TARP I and II entailed both good points and bad ones. Taking stock warrants for cash helped the major banks a lot and was good and very profitable for the government, on balance. Simply giving away TARP funds, without serious consideration or concessions in return, was clearly a mistake. More operational concessions and salary and bonus limitations should have been extracted from the banks.  That is clear. As to what to do, the answer is fix what problems we can and move on.  

The government made big mistakes on TARP and all that can really said in its defense is it was rushed, bankers have a lot of political power and the government  used intermediates who were too close to the banks to begin with. A fair criticism, too, is the money was not well spread among the banks. Smaller ones got too little or nothing. Spreading the funds too far, however, risked ineffectiveness. The truth is the TARP programs avoided a large collapse on Wall Street. We learned the hard way from the collapse of Lehman Bros, which created massive damage.  Aside from AIG, GM is much more problematic.  It is clear, however, the government wants out of these interventions as soon as practicable. That is good.
Other Interventions by Government

As for (3), intervention to support and correct markets which do not function properly, health care is the major example, as Kenneth Arrow has shown. We are working on a fix, but for the new health care system we are getting to be effective, we are going to have to learn to get health care costs down. Presently, they are silly. I am sure we will attack that problem in due course. It just takes time and smaller steps. We will build and use a consensus on costs.

Item (4), intervention to assure fair play and non-abuse in markets, is problematic. Too often regulators become the captives of the regulated. Personnel are swapped back and forth too much. This is a long standing problem without a clear solution. Perhaps a policing agency to watch those who regulate and also to keep politicians from direct interference would help. No fast solution here.

Item (5), intervention to expand the role of government in the economy is a growing problem. Many times it is implicitly done to pad the government payroll with supporters and friends, if not relatives. Other times it is done as the behest of Congress or one or more of its members, to expand their own power base of influence.  Other times it is done to convey favors to special interests or to protect them against the public interest. A strong eye—perhaps, the same policing agency -- needs to keep watch here. The role of government should be curtailed where it reasonably can be, not expanded. The correct dictum is the government that governs least governs best. We are getting that backwards.
Congress is the Core Problem of the Economy

Item (6), Congressional intervention on behalf of lobbied for special interests is THE major problem. It has proved that trickle up economics does not work.

(a)   It has created and allowed our maldistribution of income, where the lower 60% get 21% of the income;

(b)   It ignores our large trade deficit and its implications;

(c)   It has funded our wars to keep the defense industry politically placated;

(d)   It revels in pork and ignores the public interest;

(e)   It  looks to enlarge its power base at the expense of society and the economy;

(f)    It takes good care of the wealthy and in turn, members of Congress get taken care of well; sooner or later by those whom they support; and

(g)   It regulates and supervises poorly and ineptly, doing very little well.

By these means, it has jeopardized our entrepreneurial society and is destroying the middle class and small business at the same time.This amounts to the destruction of our economy in no small measure. This should be the focal point of everyone’s attack.

To answer the question, regrettably, there are too many instances of government growth and intervention which are harmful to the economy and to the people who do not benefit directly. Government is moving from being an asset of the people to a liability, and I do not mean just financially.

Disclosures: none.