Reasons for Economic Optimism

I was inspired by Justin Fox's recent post in Time, 5 Reasons for Economic Optimism (he gives 4). Although I differ with him rather sharply on what exactly are the reasons to be optimistic, I agree with his premise: it's vital to look for the ways in which the current economic situation is or will be, for the greatest good. Before I give you my list of reasons, let's take a look at Mr. Fox's list.

1. The Stock Market Is No Longer Overpriced

My response: stocks are still heavily overvalued. The current bear market has taken stocks more than 50% below their peak, to a low of 6548. As of 4/21/09, the dividend yield for the Dow was 3.51%, while that of the S&P 500 was 2.61%. A bear market historically reaches its bottom when the dividend yield is 6 to 8%. The stock market is coming off a 27-year bull market, which took the Dow from 800 to over 14,000. (check out my earlier piece on this) A bull market of this magnitude is not corrected in a few months. As a matter of mass psychology, we'll be near a bottom when the overall consensus is that putting money into stocks is as wise a thing to do as setting fire to your money.

2. The Government Is On The Case

My response: Unfortunately, much of what the government is doing is interfering with the process of adjustment which is necessary to restructure the economy, clear out losses, bring an end to corporate strategies that were essentially unsound, and move the economy toward productive economic activity. Expect the government to engineer massive amounts of inflation, as Greg Mankiw and others believe would be helpful.

3. Consumers Are Adjusting to the New Economic Reality - And Fast

My response: Mr. Fox argues that the speed at which consumers are cutting spending is a good sign, for it will lead to a rebound in consumer spending that will help the economy. Interesting point, but I don't find it persuasive. What we need is more investment, not more consumption. To that end, saving is needed, for ultimately, there is a macroeconomic equality between savings and investment. Though we have been able to avoid that equality for some time because of financial out-flows (i.e. the financing of US current account deficits and budget deficits through foreign buying of financial assets), savings ultimately equals investment. So more saving is good in itself, not only as a sign that the carnage of lower consumption is almost over.

4. Reinvention and Change Are What the US Is All About

My response: It's hard to argue with this one. And Mr. Fox also correctly identifies that many economic activities of the boom years were unproductive: he singles out finance and real estate as two of the big culprits. Unfortunately, he believes this means that the US dollar will continue to be the world's reserve currency forever. Does he fail to see the many signs that the reign of the dollar is nearly over? The strength of the dollar since Fall 08 is only a temporary response to fears of financial armageddon.

* * * * *

OK, so here's my list.

1. Moving from an economy dominated by unproductive activity to one dominated by productive activity will be good for America. For too long, American innovation and entrepreneurship went into venues that were basically deceitful, put others at risk in order to generate profits, or were unsustainable. We've gotten to be masters of finance, real estate sales, and retail sales. It will good for our innovation to be re-channelled into activities based on sustainable growth.

2. As I mentioned above, consumer saving is a good sign. Living with a zero or negative savings rate is unstable and tends to lead to volatile investment. A high savings rate should ultimately lead to a high level of investment. The fact that consumers are spending less means they are facing reality. That's a good thing in itself.

3. The End of Bling focuses our attention less on conspicuous consumption and more on the things that really matter. That will differ for each one of us, but it seems likely that the recession will lead to a decreased level of materialism in society, and an increased understanding that consumption should be in the service of the purpose of our life, not the other way around. Once one's basic survival needs are met, the kinds of things that tend to make people happy in a lasting way are having deep relationships, being able to meet one's responsibilities, and making a meaningful contribution to the world. This crisis offers us the opportunity to re-evaluate our lives.

4. The environment will be a beneficiary of decreased consumption among the rich nations. America cannot continue to consume 25% of the world's resources.

5. The financial crisis will end the international hegemony of the US dollar, and encourage nations to consider sound, honest money, based on an item of real value. The natural choices are money based on gold, silver, copper, or other metals. There are other possibilities for backing money, including a basket of commodities. (These are less desirable to me, for reasons I'll describe in a future post) Moving away from a world monetary order based on fiat currencies will be good for the US and good for the world, because fiat currencies are essentially dishonest.

6. The crisis will end US military adventurism in the Middle East and elsewhere. The reason for this is that as the dollar loses its status as a reserve currency, we will not be able to afford to continue to occupy Iraq, Afghanistan, or any other country. We will have to dramatically cut all government spending, for deficit spending will no longer be an option. When we have to balance the budget, these foreign military adventures will simply become untenable. They were only possible based on the unrealistic idea that we wouldn't have to pay for them. Americans are not motivated enough to go to war in distant lands when they realize it will mean fewer schools, hospitals, roads, and smaller pensions.

So take heart America! This crisis will return us to our core values.

Inflation Coming Soon

Wow. Greg Mankiw has written an unusually provocative argument in favor of inflation, even outright monetary destruction. Addressing the problem that the Fed can only push rates to zero, (and if that doesn't stimulate lending, what will?) he writes:

Imagine that the Fed were to announce that, a year from today, it would pick a digit from zero to 9 out of a hat. All currency with a serial number ending in that digit would no longer be legal tender. Suddenly, the expected return to holding currency would become negative 10 percent.

That move would free the Fed to cut interest rates below zero. People would be delighted to lend money at negative 3 percent, since losing 3 percent is better than losing 10.

I am shocked by how reckless his proposal is. Unbelievable. The way out of the financial collapse is to basically render useless one-tenth our money. (As Mankiw no doubt realizes, in practical terms this wouldn't work, since the overwhelming portion of the money supply is not attached to paper notes. Only about $800 bil of the money supply is paper currency, while M3, the broad measure of the money supply, is nearly $15 tril)

Imagine if stimulating the economy were as easy as Mankiw suggests. If destroying 10% of our money is this good, why not destroy 50%? Why not simply build immense fires and burn all our paper Federal Reserve notes that we call money? What a fantastic stimulus that would be.

Destroying money through inflation will not cause a stimulus of any kind, it will cause chaos. Inflation introduces distortions into the economy. Businesses cannot easily calculate future returns; inflation transfers money from worker to employer, from saver to borrower, from the poor who tend to be far away from the money-generating mechanism, to the wealthy and well-connected, who tend to be nearer to the source, and hence can spend their income before prices rise.

Because Greg Mankiw is a towering figure in the economics establishment (professor at Harvard, chair of the Council of Economic Advisors under Bush, influential blogger and textbook author), and because this interesting article appears in the NY Times, (where it is immediately heralded by Paul Krugman) I suggest that Mankiw is striking a chord that will resonate with the central banking and political establishment, which no doubt sees the logic of inflation.

Though the CPI indicates that deflation has been our recent history, that will not last under a determined attempt to produce inflation. Remember, the Fed can print money and drop it from Helicopters. The Fed can write the US government a check for a trillion dollars. (The Fed can even write me a check for a trillion dollars, but I'm afraid I will not stop blogging.) If the Fed wants inflation, the Fed will get inflation. Mankiw simply says what needs to be said to ease the way toward that inflation.

By the way, it is completely wrong to say that inflation will stimulate bank lending. Banks are extremely reluctant to lend under inflationary conditions, unless interest rates are fully flexible, indexed to inflation and all other relevant conditions. Does that sound familiar? That is what an adjustable rate mortgage is all about. But even if rates are fully adjustable, there are two additional problems:

1) what if raising the rate high enough to cover the bank and ensure that the loan is profitable destroys the borrower?

2) how many borrowers are willing to borrow with such uncertain costs of borrowing?

If inflation was such a reliable way to stimulate bank lending, Zimbabwe would've become the world's banker, instead of the world's most recent example of the failure of central banking.

Within a year, we'll see double-digit inflation rates.