The U.S. economy is in the longest and deepest recession and stagnation since the 1930s. The economy peaked in 2007, and the unemployment rate has barely been below 9 percent since then. The 8.5 percent rate reported in January is deceptive because at least 5 percent of the labor force has dropped out because they are unable to find work, and they are not counted in the unemployment rate.
Much of the recent decrease in the unemployment rate is the result of these dropouts, inevitable as the stagnation lengthens. Known as Okun’s Law, this phenomenon is part of typical recessions but is more severe than usual because of this stagnation’s length and severity.
Began Before Obama
This recession did not start with the Obama administration. Gross domestic product (GDP) peaked in real terms well before President Obama’s inauguration in early 2008. The recession started in the housing sector. The common characterization is of a speculative ‘housing bubble’.
This ignores the classical finance theory result that if speculators make abnormal profits, they stabilize relevant markets by buying when prices are low and selling when prices are high, thus adding to demand when prices are low and adding to supply when prices are high, moving prices toward equilibrium.
The housing development and construction sectors contain aggressive and competitive firms. A “bubble” would be short-lived if supply were unconstrained. But housing development and construction are increasingly constrained by local government controls on housing density and land use.
Pushed by Supply Constraints
In California metropolitan areas, and others where the housing supply is highly constrained, housing prices rose about 10 percent per year during the decade, ending in 2007. A family with conventionally measured annual income of $100,000 per year could rationally invest in a million-dollar home with as large a mortgage as it could obtain and make about $100,000 per year in meagerly taxed capital gains, thus doubling their income aside from deductible interest on the unusually large mortgage.
Such investments were rational, provided the family expected the trend to continue a few more years. People were encouraged by advertisements that “housing is your best investment.” Realtors and lenders were also encouraged by government urging the origination of subprime mortgages in underserved neighborhoods.
In this environment, defaults were rare, and not only lenders but also buyers of mortgages and mortgage-backed securities were induced to be highly leveraged. Despite excessive local government density controls, housing supply gradually expanded in response to high housing prices, in good part by building in distant and less regulated suburbs. During the resulting massive drop in housing prices, some lenders and buyers of real estate securities, including Fannie Mae, were threatened with bankruptcy and bailed out with taxpayer money.
As housing prices fell, the Obama administration panicked and bailed out not only homeowners whose homes were worth less than their mortgages but also financial firms that owned large amounts of real estate securities and which were judged too big to fail.
This cycle can legitimately be characterized as a speculative housing bubble, but it was caused by housing supply restrictions imposed by local governments.
Total Failure of Keynesian Moves
As has been amply demonstrated, the Obama administration responded to the recession in classical Keynesian fashion. Government spending has risen to $3.8 trillion, entailing an annual budget deficit of $1.5 trillion and total federal debt of $15.5 trillion, a bit larger than the nation’s gross domestic product. In 2010, U.S. government spending was the highest relative to GDP since 1945. The government forecast is of trillion dollar deficits for the foreseeable future.
The Federal Reserve has acted in similar Keynesian fashion by increasing the money supply by a third from 2007 to 2011.
The benefits of these massive expansions of federal spending and money stock have been approximately zip. Real GDP was barely 1 percent greater in 2011 than in 2007. The unemployment rate is double its 2007 rate, despite large withdrawals from the labor force by discouraged workers.
Debt Comes With Costs
The basic reason for the limit to the benefits of Keynesian deficit financing is a corollary of Milton Friedman’s famous theorem, “there is no free lunch.” Business debt financing is costly because the discounted cost of interest on the debt plus the discounted cost of paying the maturity value of the debt is the same as the value of the debt when it is issued. Businesses nevertheless issue debt because they expect the revenues from the resulting investment to exceed the cost of debt.
The same applies to government debt financing. Although governments rarely pay off the bonds they issue when they mature, they refinance with new bonds. But the same result follows. If maturing government bonds are refinanced by new bonds, the debt becomes perpetual, but the discounted value of the perpetual interest plus the repeated costs of refinancing nevertheless equals the revenue from the sale of the bond.
Indeed, it would be a wonderful world if government debt financing were free or nearly free even though private debt financing were as expensive as usually calculated. Then we could turn over all debt financing to government—housing, business investment, etc.— and we could all be rich!
There may be differences in the tax status of government and private debt financing, but it simply affects who pays the bonds’ costs, taxpayers or the bonds’ issuer, not the magnitude of the costs.
Cost-Benefit Analysis Needed
None of the above implies government should never undertake debt financing. If, for example, there is an infrastructure investment for which the private sector cannot recoup the benefits but whose benefits exceed its costs, all properly discounted, then government should issue bonds to finance the project.
Some decades ago, government rules required benefit-cost analysis of proposed investments, but agencies rarely calculated benefits carefully, and the requirement has fallen into disuse.
Government’s Inflation Addiction
As has been pointed out, some of the massive Obama deficit has been financed by increases in the money supply rather than by issuance of interest-bearing government debt. That is justified on Keynesian grounds when unemployment is high, because inflation is a minor problem. But when unemployment becomes low (how low, macroeconomists debate), increases in the money supply are inevitably inflationary. At the end of 2011, inflation was still modest, with the continuation of high unemployment. But the worst thing about inflation is that governments become addicted to it.
Nearly all U.S. government debt is issued in nominal terms—not adjusted for inflation—and governments are tempted to inflate away the debt by issuing excessive amounts of money. Most governments, including the United States, inflated away part of the large debt issued to finance World War II, and some Latin American and other governments inflate away their debts every 10 or 20 years.
Empty Bag of Tricks
Eventually, buyers of government debt realize the fraud that governments are perpetrating, and they refuse to buy the bonds except at interest rates the government cannot afford to pay. Governments then resort to tricks—compelling citizens to buy their bonds, cutting the face value of outstanding bonds by half, and borrowing directly or indirectly (through the International Monetary Fund) from high-income countries.
But any bag of tricks is soon emptied, by elections, coups, revolutions, etc. Even Israel, which has relatively responsible governments, inflated away substantial debts during the 1960s, partly by persuading loyal foreign Jewish communities to buy its government bonds at large negative real interest rates. The author remembers, during visits at that time, workers quickly buying their groceries on payday because prices would be higher a day or two later.
Debt Ceiling’s a Joke
A final cost of debt-financed deficits merits brief mention. The national government sets legal debt ceilings beyond which the national debt cannot go. The ostensible reason for such ceilings is to restrain the government’s deficit spending. During the Obama administration, that has been a sick joke.
The debt ceiling must be raised every year or so to accommodate large debt-financed deficits. Recently, the result has been partisan wrangling over how much and when the ceiling is to be raised, and an occasional shutdown of government, excepting “essential” services, for a week or so.
Such circuses are expensive because elected and appointed employees must be paid during the wrangling, and legitimate government business must be postponed. A stronger president could avoid these costly annual circuses, since the need to increase the debt limit is obvious absent massive and politically impossible cuts in government spending, tax increases, or both.
Government’s Held Back Recovery
President Obama is contemptuous of private businesses. Throughout his presidency, frequent comments about “Wall Street fat cats,” “millionaires and billionaires,” and proposed increases in taxes on high-income recipients illustrate his attitude.
His two major legislative accomplishments, ObamaCare and the Dodd-Frank financial reform act, have been attempts to bring major sectors of the economy under federal control. Both laws are unpopular, and neither has contributed to improved performance of the relevant sectors. Both have not only delayed recovery of the two sectors, but also have inhibited overall recovery by inducing fears of further government intrusions into the economy.
How many more such intrusions would we have had if the president had not lost control of Congress in the 2010 midterm elections? Recovery accelerated somewhat near the end of 2011 because of the growing prospects that the president will not be reelected in 2012.
Regulatory Surge Continues
Although the legislative assault on business has abated, regulations continue to pour out of the bureaucracy.
Our federal tax system is an international scandal. Large businesses are forced to file returns as thick as telephone books, and small businesses can hardly know whether they are obeying all the relevant laws and regulations. Individuals must compute their tax liability under two separate schedules, and many must employ tax consultants to calculate their tax liabilities.
Regulations are pouring out of the EPA and other federal agencies. Nobody knows the full cost of regulations in terms of compliance costs and inhibited business investments and innovation.
The author’s prediction is that if, as the election approaches, it becomes increasingly likely that Obama will be replaced by a conservative Republican, the result will be a surge in business activity.
Edwin Mills ([email protected]) is emeritus professor of real estate and finance at the Kellogg School of Management at Northwestern University.