Tuesday, August 26, 2003
Fran,
Congratulations on a terrific post. As we've discussed, I'm in complete agreement with you on the causes of the current recession. Unfortunately, I think you might be a little off base on the prognosis and prescription for the economy. Now, I'm going to address these issues in an analytic framework. So, its important to realize that what I'm saying is in reference to the state of the macroeconomy, and is not a reflection of my degree of sympathy with any of the participants in the economy. Saying a quadrapalegic is unfit for manual labor isn't a judgement on the human worth of the quadrapalegic, but simply a description of the situation. Likewise, saying that a number of people are going to be burned alive in a given year (within a statistical likelihood) doesn't detract that one might feel profound sympathy with burn victims.
First of all, I have to say that I think you're a little too pessimistic about the near-term outlook for the economy. For instance, I think your allusion to the Great Depression is a little misleading (although I concede that I doubt that a direct comparison, as opposed to an explanation of panic, is what you were trying for). The Depression largely stemmed from a collapse in consumer spending. As you yourself point out, the consumer spending sector has remained relatively robust. The current problem, as you point out, is in capital investment, which has taken a dive. Whatsmore, unemployment is largely seen as a lagging rather than leading economic indicator, although thats small recompense to the unemployed. When you look at leading indicators, however, you get a different story. The Conference Board's Index of Leading Indicators rose .4% in July, the fourth consecutive increase in the index (Its up 2% since its low in March).
The financial markets also provide a fairly positive outlook for the forward economic climate. Both credit spreads and credit default swap rates have not only stabilized, but even trended downward over recent months. This suggests that investors, at least, feel confident that corporate credit quality is improving. Fortunately, it doesn't look like this improvement is coming from foregoing profit potential. Equity investors have bid up the Dow 24% the S&P 25% and the NASDAQ a stunning 49% from their lows in March. Finally, the (USD LIBOR) yield curve has steepened somewhat, suggesting that investors are assuming more robust economic conditions ahead (essentially, investors are assuming progressively larger increases in interest rates in the future than they were in March). This steepening has largely occurred on the middle and long end of the curve. In short, while economic theory has said for some time that conditions should improve, the economy is now largely providing signals that it is listening.
Now, you may be asking yourself, if things are improving so much, why does everything seem to be getting worse. Well, despite the fact that we talk about the national economy, there are distinct regional differences. Now, from my Fed days, I'm familiar with the Fed's breakdown of regions. The Third District, the Philadelphia region, has a particularly unfortunate behavior. It lags the economy in recoveries and leads it in recessions. That is, a downturn hits Philly before the rest of the country and Philly gets out of the downturn after things are improving everywhere else. The New York region would probably exhibit this quality even more, except that it has a few national-market industries (media, finance, theater, etc.). While the economy in NYC has been hard hit by the recession, a good bonus season could easily turn that around.
These regional differences, though, give rise to the first of my concerns give rise to the first of my concerns regarding your Keynesian stimulus package. Ideally, such a package would run counter to local economic conditions. That is, the regions of the country further behind on the recovery path would receive a larger share of the spending. But that seems a remarkably unlikely outcome, even if we ignore the movement of dollars outside the region of subsidy. A more likely scenario is that the regions with more dynamic (i.e. more upwardly responsive) economies would have the population growth and the unallocated resources to be able to successfully secure the lion's share of the stimulous. But, that's exactly the situation you don't want: certain areas of the country going great guns (and even overheating) while other regions remain in the dolldrums.
In addition to the geographic misallocation, we have to consider the potential for temporal misallocation. The money from a Keynesian stimulous package entered into today wouldn't hit the economy today (well....sorta...rational expectations, and all...), but rather six months from today. Now, if you're right and the economy stays sluggish in the meantime, great. You've just gotten a needed leg up. The problem, of course, is if you're wrong. In that case you introduce a stimulous into a system thats already moving at a steady clip. That's a recipe for overheating and Fed tightening to prevent inflation throwing you back into recession prematurely.
Finally, one needs to consider the possibility of sectoral misallocation. The major portion of your stimulous package goes to the consumer spending sector. But, as we've established, the consumer spending sector has remained robust. The weakness in our economy is in the capital investment sector. A surge in consumer spending might very well bid up prices in industries where there is already sufficient demand (again the overheating argument), while leaving the industries most severely effected by the downturn unhelped. Similarly, the second largest portion of your allocation goes into defense spending, a very specialized industry. To make a long story short, the skill set for an engineer, accountant, programmer, etc. in military projects isn't often a direct transfer from civilian uses. However, military spending has been pretty strong over the last couple of years (as it should be). This, again, leaves us the possibility of overheating in one sector, while leaving the main target sector unaffected.
Basically, I'm convinced that you may be jumping the gun in terms of a stimulous package. Now, I'm just as insecure as any of you about the state of the economy (working in the NY financial markets tends to do that to people). Moreover, I think things like developing advanced weapons or modernizing the federal governments computer systems might be worthwhile goals on their own. But, I'm less convinced now than I was six months ago that we are in a situation that merits the misallocation risks that such a stimulous package would entail. That said, there is a sector with pent-up investment demand that merely requires a regulatory and legal restructuring. I'd suggest that now might be the time for a comprehensive review of the legal, tax, and regulatory framework under which the electric power industry is operating. Lets let them upgrade the grid.
Congratulations on a terrific post. As we've discussed, I'm in complete agreement with you on the causes of the current recession. Unfortunately, I think you might be a little off base on the prognosis and prescription for the economy. Now, I'm going to address these issues in an analytic framework. So, its important to realize that what I'm saying is in reference to the state of the macroeconomy, and is not a reflection of my degree of sympathy with any of the participants in the economy. Saying a quadrapalegic is unfit for manual labor isn't a judgement on the human worth of the quadrapalegic, but simply a description of the situation. Likewise, saying that a number of people are going to be burned alive in a given year (within a statistical likelihood) doesn't detract that one might feel profound sympathy with burn victims.
First of all, I have to say that I think you're a little too pessimistic about the near-term outlook for the economy. For instance, I think your allusion to the Great Depression is a little misleading (although I concede that I doubt that a direct comparison, as opposed to an explanation of panic, is what you were trying for). The Depression largely stemmed from a collapse in consumer spending. As you yourself point out, the consumer spending sector has remained relatively robust. The current problem, as you point out, is in capital investment, which has taken a dive. Whatsmore, unemployment is largely seen as a lagging rather than leading economic indicator, although thats small recompense to the unemployed. When you look at leading indicators, however, you get a different story. The Conference Board's Index of Leading Indicators rose .4% in July, the fourth consecutive increase in the index (Its up 2% since its low in March).
The financial markets also provide a fairly positive outlook for the forward economic climate. Both credit spreads and credit default swap rates have not only stabilized, but even trended downward over recent months. This suggests that investors, at least, feel confident that corporate credit quality is improving. Fortunately, it doesn't look like this improvement is coming from foregoing profit potential. Equity investors have bid up the Dow 24% the S&P 25% and the NASDAQ a stunning 49% from their lows in March. Finally, the (USD LIBOR) yield curve has steepened somewhat, suggesting that investors are assuming more robust economic conditions ahead (essentially, investors are assuming progressively larger increases in interest rates in the future than they were in March). This steepening has largely occurred on the middle and long end of the curve. In short, while economic theory has said for some time that conditions should improve, the economy is now largely providing signals that it is listening.
Now, you may be asking yourself, if things are improving so much, why does everything seem to be getting worse. Well, despite the fact that we talk about the national economy, there are distinct regional differences. Now, from my Fed days, I'm familiar with the Fed's breakdown of regions. The Third District, the Philadelphia region, has a particularly unfortunate behavior. It lags the economy in recoveries and leads it in recessions. That is, a downturn hits Philly before the rest of the country and Philly gets out of the downturn after things are improving everywhere else. The New York region would probably exhibit this quality even more, except that it has a few national-market industries (media, finance, theater, etc.). While the economy in NYC has been hard hit by the recession, a good bonus season could easily turn that around.
These regional differences, though, give rise to the first of my concerns give rise to the first of my concerns regarding your Keynesian stimulus package. Ideally, such a package would run counter to local economic conditions. That is, the regions of the country further behind on the recovery path would receive a larger share of the spending. But that seems a remarkably unlikely outcome, even if we ignore the movement of dollars outside the region of subsidy. A more likely scenario is that the regions with more dynamic (i.e. more upwardly responsive) economies would have the population growth and the unallocated resources to be able to successfully secure the lion's share of the stimulous. But, that's exactly the situation you don't want: certain areas of the country going great guns (and even overheating) while other regions remain in the dolldrums.
In addition to the geographic misallocation, we have to consider the potential for temporal misallocation. The money from a Keynesian stimulous package entered into today wouldn't hit the economy today (well....sorta...rational expectations, and all...), but rather six months from today. Now, if you're right and the economy stays sluggish in the meantime, great. You've just gotten a needed leg up. The problem, of course, is if you're wrong. In that case you introduce a stimulous into a system thats already moving at a steady clip. That's a recipe for overheating and Fed tightening to prevent inflation throwing you back into recession prematurely.
Finally, one needs to consider the possibility of sectoral misallocation. The major portion of your stimulous package goes to the consumer spending sector. But, as we've established, the consumer spending sector has remained robust. The weakness in our economy is in the capital investment sector. A surge in consumer spending might very well bid up prices in industries where there is already sufficient demand (again the overheating argument), while leaving the industries most severely effected by the downturn unhelped. Similarly, the second largest portion of your allocation goes into defense spending, a very specialized industry. To make a long story short, the skill set for an engineer, accountant, programmer, etc. in military projects isn't often a direct transfer from civilian uses. However, military spending has been pretty strong over the last couple of years (as it should be). This, again, leaves us the possibility of overheating in one sector, while leaving the main target sector unaffected.
Basically, I'm convinced that you may be jumping the gun in terms of a stimulous package. Now, I'm just as insecure as any of you about the state of the economy (working in the NY financial markets tends to do that to people). Moreover, I think things like developing advanced weapons or modernizing the federal governments computer systems might be worthwhile goals on their own. But, I'm less convinced now than I was six months ago that we are in a situation that merits the misallocation risks that such a stimulous package would entail. That said, there is a sector with pent-up investment demand that merely requires a regulatory and legal restructuring. I'd suggest that now might be the time for a comprehensive review of the legal, tax, and regulatory framework under which the electric power industry is operating. Lets let them upgrade the grid.
