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State of the American Economy: The Simple Version

I was inspired to write this after talking with some of my friend’s parents, and my friend’s parents’ friends, and I guess some of my own friends, over the 4th of July weekend. Most people are very misinformed about what is going on in the economy and the current national debate over what should be done about it. Lucky for you, I am not only an amateur economist (that means I have no masters to serve, so you can trust me), I am also one of the few laypeople in the econoblogosphere who has been trained not only in neoclassical economics but the Austrian school of economics as well (that means I can explain things easily without sounding like a wonk or being biased towards either side of the continuum of economic thought).

7/14 EDIT: this entire article is a hot mess and I am too preoccupied to fix it, so just take it for what it is at this point: a bar napkin explanation of economic policy choices

So here is the story for those of you who don’t know: easy credit led to a glut of investment in unproductive areas of the economy, mainly in housing, but also just generally. The bubble burst, the economy went to shit, people lost jobs. Many (most) of these jobs were in the unproductive areas of the economy. Businesses and industries made adjustments to remain profitable. Some businesses went bankrupt, some industries died, but in essence it was a huge adjustment towards a sustainable equilibrium between supply and demand (the problem in 2004-7 was too much artificially created demand from the aforementioned easy credit, thanks to a mixture of Alan Greenspan and bad regulation).

Flash forward to today: the economy is stuck in neutral. Entrepreneurs and consumers are unsure of the economic future, so when they make decisions as to whether or not to invest in new capital for their businesses (like machines or employees) or new capital for their households (like cars, or well, houses), they have a high degree of uncertainty regarding the value of the variables in their break-even equations and in their inter-temporal preferences. This exacerbates the weak demand caused by the economic contraction.

When we are talking about what the government can do to help the economy, there are generally two accepted answers: increase spending or decrease regulation and taxes. First of all, ignore the deficit. It is a red herring in the debate and is entirely psychological in its effect on the short-run economy. Secondly, ignore anything you think you might have heard about government spending being bad for the economy because it crowds out private investment. There is no crowding out taking place unless the government is spending so much money that it has an adverse effect on interest rates. Right now interest rates are incredibly low, and the downward pressure on interest rates continued despite QE I and II (the 2 government stimulus packages). Crowding out is generally impossible in a situation with low aggregate demand.

If the government increases spending it will increase demand. Decreasing regulation and taxes also increase demand. Trying to say one is the “right way” and one the “wrong way” is ludicrous. They both would work. They both have worked. The problem right now is that we have two political parties. One is a liberal one that is dominated by public employees and organized labor (which gets a lot of government contracts). They will enjoy the largest share of an increase in government spending. The other party is a conservative one that is dominated by private business owners and industrialist. They have the most to gain from a decrease of regulation and taxes.  So both sides are fighting over who gets the spoils of the economic recovery. Each side wants you to believe the other side is full of shit and that the other side’s argument is based on voodoo economics.

I told you to ignore the deficit but let’s come back to it for a second. We do have a big deficit. It is not so big that it is preventing us from borrowing more; it is actually the case that the USA has a position of relative strength in the global economy. We are something akin to the prettiest girl (or boy, whatever) at the dance for people who are grotesquely ugly (sorry, its hard to make that metaphor in a way that won’t offend somebody, and that’s the best I can come up with). We can borrow more money now for very cheap, and we can borrow a lot. Borrowing, however, isn’t the only way the government can finance spending. It can also print more money, which causes inflation, which decreases the real value of debts. Inflation is a win for debtors and a loss for creditors. Thinking of the aforementioned alignment of interest groups between the two parties, it is not hard to see how one side would probably prefer a little inflation and another side would not (but you actually may be surprised to learn how much debt some of the old industrialist are in, and also how solid the balance sheets are for some households).

The Republicans have steered the debate towards the deficit not because it is a pressing issue but because it is a red herring. It has created an environment of political confusion, and is what I mean by the deficit being a psychological warfare tactic being used by the Republicans, against the economy of the United States. Now, instead of increasing spending, decreasing taxes, and letting the economy make a recovery, we are arguing over which way is the “right” way. Yes, the deficit will have to be dealt with, in time, with a serious of spending cuts and revenue increases aka tax hikes. But dealing with the deficit now is stupid, a distractionary tactic run out of desperate and inconsideration for the working people of America. The whole situation has been further aggravated and bumbled by Obama and the Democrats, who seem more interested in pandering to their constituents than considering or explaining the hard science of the situation (and yes, economics is a science, don’t let anyone tell you otherwise), which calls for much more stimulus spending and also less regulation (such as the numerous licensing requirements for jobs such as braiding someone’s hair, driving a taxi, or being a traditional Chinese medicine practioner, and any number of other jobs too numerous to enumerate). This environment of uncertainty doesn’t make it any easier for entrepreneurs or households to make consumption decisions. Hence, the current economic malaise that engulfs us.

I believe that is enough of a framework for you to have a decent understanding of what is going on right now. Don’t believe the talking heads. They all have a book to sell or donors to court, and they all want to say “…but on the other hand” because they don’t really know what is going on and want to hedge their bets so they don’t look stupid later. I am not a bet hedger. Real Talk. Brought to you by Peter Hefti.

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