Wednesday, April 2, 2008

Our Troubled Economy

The other day, one of my professors (an economist w/ the Dept. of the Interior) mentioned the media coverage around our current economic situation and suggested that we may be limited in what we can do about it right now. He also mentioned that most media analysis is incomplete, right now. Below is an attempt to piece together the causes of our current troubles based on his take and what I know from my political economy research (focusing on India/China right now, so somewhat applicable).

There seem to be four identifiable causes of our current economic woes. I have outlined these causes below along with problems regarding potential US actions to help the economy adjust.

(1) Spiking commodity prices - particularly in food (wheat and corn) and energy (oil prices), but also in other industrial commodities and heavy industry (steel prices have been gradually rising on balance for a few years now, for example, and other mined commodities like copper and zinc have shown similar price increases). Most of this is due to rising demand from China and India, with biodiesel production having some impact on the food markets. This has both slowed growth and driven increased inflation.
Problem: The devaluing dollar (see #2, below) means that some of these prices are only rising for the US, or rising by a substantially larger margin in the US than elsewhere. The reason is that many commodities (including oil) are dollar-denominated, so the falling dollar keeps prices lower in Europe, Canada, and Japan than they are here. These energy costs also spill over into other sectors (e.g. food costs from transportation) more in the US than abroad. Similarly, the US is still a net food exporter (though less than in the 1990s), so other countries also reap cheaper US food imports in their country - driving up demand for US agricultural goods and continuing to force prices up at home.

(2) Devaluing Dollar - the slumping dollar relative to the Euro, Yen, Pound Sterling, and Loonie (a good historic lookup tool can be found here) has been a long time in the making, as a result of sustained government efforts in the 80s to maintain a strong dollar coupled with a significant and mounting current account deficit sustained over many years (with a number of causes).
Problem: China, the country to which the US trade deficit is the largest, still habitually undervalues its currency relative to the dollar, as we are a major Chinese trade partner and China relies on export earnings to finance domestic industrial transformation. For many countries it would be difficult to keep this up as the dollar devalues, but the Chinese hold 22% of the world's total foreign exchange reserves and can continue to maintain this peg for a significant period of time. This may prolong the devaluation of the dollar relative to the other major currencies.

(3) Post-war Transition - much of the growth in the past few years has been stimulated by significant wartime deficit spending by the government. We are now entering a period of scaling back as a result of somewhat lower conflict in Iraq, and potentially scaling back the troops. The shift from wartime to peacetime triggers frictional unemployment because labor cannot always immediately transfer between activities (see the Bureau of Labor Statistics "Recent Months" output, I focused on 2003-8 and used the chart output, but data goes back to 1996). Notice that the unemployment rate reached a low right as the Democrats consolidated power in Congress and started taking action against the President's war spending (Mid-2006 to Early 2007).
Problem: The war cannot be sustained indefinitely, and wartime spending can trigger inflation anyway. However, there is a limit to what Congress can do to accelerate the process given the lack of cooperation between the White House and the Hill. We're unlikely to see expansions to unemployment insurance or increases in domestic social spending or investment initiatives until the next administration, whoever that ends up being, because of the animosity between Congress and the Executive. Plus, in the current deadlock, the government is strapped for the cash to send a significant stimulus package.

(4) Housing Bubble Burst - This has been in the news a lot lately - and is a combination of outdated regulatory frameworks, trends towards market speculation - especially in real estate (remember the Asian Crisis in 97-98 as an example - both the Thai and Korean real estate bubbles burst), and investors that were bamboozled by supposed "risk-diversification" instruments that were over-hyped at best (risk is part of investment, it doesn't go away just because a mortgage has been fragmented and repackaged with other mortgages). Predatory lending practices probably also played a role (though this is likely exaggerated and sensationalized in the media - it makes a good story). Similarly, the US tendency towards not saving and acquiring credit card debt makes consumers and homeowners more vulnerable, and expands the problems in credit/finance markets.
Problem: The Fed is starting to run out of options. Somewhere between a base interest rate of 1-2%, we hit a "liquidity trap" where fed funds reductions don't do much to stimulate the markets. The current Federal Funds rate is at 2.25%, which means the Fed has about 75 basis points of wiggle room. Beyond that, it can help negotiate bail-outs of major firms to rescue the system from collapse and buy up some of the subprime securities to reduce the risk of many investments in the financial system (it has started to do both). Even these last-ditch responses from an activist Fed will, in all likelihood, only have mild-moderate effect. The Japanese central bank tried similar moves during the 1990s but eventually was forced to wait out the recession as it was unable to rescue all the institutions needing bailouts (here there is a moral hazard question regarding how much the Fed should do to rescue sinking institutions, with some arguing the Japanese tried too many generous bail-outs). Given the historical perspective on similar crises, it's likely that the Fed's actions will only moderate the crisis somewhat.

So - I've tried to lay out the causes and challenges of the current crisis. It might be worth noting that (1) and (3) bear some similarity to Carter-era stagflation. (4) is similar to financial crises in the 1990s in Japan and then SE Asia (which spread to Russia, Mexico, Argentina, etc.). (2) is a more unique element, at least for the US, as far as I know - partly because of the hoarding of exchange reserves that happened in East Asia following the 1997-8 crisis.

The question then is what we can do about it - which is a complicated issue in itself, and I'm not going to try to answer it here, since most economists seem confused.


Anonymous said...

I think it's presumptuous, at best, to talk about any post-war transition. We're not even close, what with 140,000 troops in Iraq and war drums beating once again in the direction of Iran. Also, your comment about spiking prices of wheat, rice, etc., are accurate, although your pointing at China might as well include other countries. I have always believed biofuels were a ridiculous, costly and dangerous idea. Food is meant to be eaten, not powering cars. For a better understanding of the developing food crisis, I suggest a steely-eyed examination of agribusiness, because it's bound to, um, er, pun coming on, yield fruit.
Other topics...Not too many people appear to post on your fine blog. Maybe you have no readers but perhaps it's that b.s. word verification that you demand so you know who is posting. My suggestion? Get rid of it and take on all comers, especially those, like me, who prefer anonymity. I'll post here right now to say a hearty hello and good to meet you the other night at Comet Ping-Pong. And at risk of sounding like an old letch, your girlfriend is hot. Peace. John

Sean said...

Hey John,

Probably true that it's a bit premature to talk about a full-fledged transition at this point. It might be better analysis to suggest that the economy is now adjusted to the initial military spending increase, and the short-term stimulus has worn off, re-exposing the structural issues with the economy.

As far as the agribusiness issue is concerned, I agree that the model is long-term unsustainable and inefficient - but since economics is about trend analysis, I'm not sure that there have been any major changes in how agribusiness operates. The exception, as you suggest, is biofuels - but the biofuel sector is still relatively small, and of that sector, a significant amount of global production comes from Brazilian sugarcane production - which isn't likely to have a major impact on US corn, wheat, and rice prices - particularly since we already regulate the amount of actual sugar used in beverages as the behest of the corn lobby. On the other hand, there has been a marked increase in demand from three high-growth economies (China, India, and Brazil) for commodity imports of all types - both food and industrial. Biofuels doesn't help the situation, and is certainly not a "green" solution, but I doubt it's the real short-term effect.

Last thing: The word verification actually doesn't tell me anything about who you are, other than that you aren't a spam-bot. It's there to ensure that comments come from humans, not porno websites. Unless I'm mistaken, the actual word verification step doesn't require an e-mail or anything, and I don't require an e-mail for my posts, nor do I moderate comments.

Tom said...

An outside, independent comment! But, someone you met at a local pub w/M? I try to stop in now and again to see what's up, but I'm not a Poli-Sci major, so I don't always comment.

MEW said...


Anonymous said...

Shit. Fuck.
Just writing to see if you really do not moderate the comments.
I was thinking about what you wrote about India, Brazil and China importing more food and then the food riots in Phillipines, Eygpt and Haiti, and I'm wondering if the food won't simply follow the money rather than the hungry. I have fully anticipated fresh water wars in the future but only recently have begun to come around to the idea of food wars. What a relief, though, right? Finally fighting over something truly worthwhile! At least death and destruction will be the end result of people looking for a hot square meal, not just wanting to control oil, territory, religion, etc.
By the way, I think I've started something. The blog is picking up steam. I'm a natural born instigator. John

Sean said...

Sadly, it looks like you might be right on the war concept. Besides, in an international capitalist economy, the food has always followed the money (unless we have excess corn we need to send to Darfur).