The Monday Morning Economist
Independent Opinion - Unadorned

Fear and Loathing of the Economy 3/09

As economists and politicians squabble over details of the economic recovery, the public is left wondering if what is being done is enough or too much, and so is distressed and confused about the American Economic Recovery and Reinvestment Act.  Banking is a huge part of the problem, and much ink has been devoted to how to fix the banking system.  Whatever the result of that effort, banks will not end up lending on the same terms as they did before the crisis of their making.  It is safe to assume that between 25%-40% of the credit that fueled the Bush economy will not be available in the future, not because there is no cash to lend, instead because the underlying economy is not worthy of the credit.

But you don't need to know about the inner workings of the financial system, what a debenture is, or even what the FDIC does, to know what the future holds for the American economy.  All you need to know is as what the gross economic numbers are and to do some calculations that can be done on a dinner napkin.  And a little history should help, whether you lean to the political left or right.

The chart of U.S. economic activity, below, from Bureau of Economic Analysis data in billions of chained year 2000 dollars (adjusted for inflation), shows some inescapable points about GDP and government spending.

The chart shows:

1) FDR's spending on the New Deal programs, 1933 to 1937, was dwarfed by the spending on WWII

2)  When government spending was reduced in 1937 due to political pressure and in 1945 due to the end of WWII, the GDP decreased hardly at all

3)  The bigger the spending program, the bigger the permanent gains in GDP

No Republican offering of some economic "butterfly effect" recovery can conceivably compete with the undeniable economic impact of billions and  trillions of dollars aimed at both curing the Great Depression and wining WWII.  However government spending is not the entire story.

In 1929, the government spent 13% of GDP.  In 1933, the height of the Great Depression, FDR spent a mere 129 billion dollars, 20% of GDP.  In 1937, due to alarm of the potential of increasing public debt, FDR backed off to spending 18% of GDP.  But in this time, four years from 1933 to 1937, GDP had grown by 30%.

In 1939 government spending started ramping up again for a looming war.  At the peak of WWII, 1945, the U.S. Government was spending 72% of GDP.  And the result was not ruin, the result was a shot in the arm for the U.S. Economy that lasted until the dawn of the Reagan Era.  In the five years from 1939 to 1944 the GDP doubled.  100% growth in five years.

In 1937 government spending was cut and it was cut in 1946 at the end of WWII.  In both instances the GDP fell because government spending is a component of the GDP calculation.   Although the GDP fell, in both cases, if fell only 5%-8%, that after gaining 30% to 100% respectively.

In short, government spending to stimulate the economy works like gangbusters, under the right conditions.

From 2000-2008, the U.S. budgets had been averaging about 17% of GDP, and still running a deficit for some reason.  Oh yeah, "Trickle Down" economics.  Adding a trillion dollars to the 2009 budget will bring government spending up to about 27% of GDP, a bit more than FDR threw at the Great Depression, 20%, and far less than WWII called for, 72%.

So modest to good improvements in economic conditions should be expected to result from the trillion dollar spending package.  One might be tempted to predict that government spending directly increases GDP.  Of course it does.

GDP = consumption + investments + govt. spending + exports - imports

Government spending is part of the GDP.  So increasing government spending has to increase the GDP in exact proportion to the increase in spending.  But the fact that, in these instances, New Deal and WWII, when government spending is slashed the GDP did not fall in proportion to the cuts, is the precise phenomenon that no one is considering except in the most vague terms.

According to the Bureau of Labor and Statistics study <em>Compensation from World War II through the Great Society</em>, January 30, 2003  "<em>Inflationary pressures were created by the shortages of both goods and labor that developed during World War II; the Consumer Price Index (CPI) increased by more than 35 percent at this time.</em>"  The chart above is adjusted for inflation.  So the GDP effects shown in the chart beg another explanation. The answer is a couple of paragraphs on in the same publication "<em>Average hourly earnings of production and nonsupervisory workers in manufacturing more than doubled between 1940 and 1949, with the largest increases during the war years, 1940-44.</em>"

In simple gross macroeconomic terms, the consumers were able to substantially replace government spending when it was curtailed after the war.  The math is that if WWII doubled the GDP, real wages, not attributable to inflation, were able to sustain something approximating an 80% increase in the GDP.  Again, of course, consumer spending is a full equal to government spending in the calculation of GDP.  The remainder of growth, 20% of GDP, was investments and business profits which also spiked up after the war.  A similar effect is observable following the termination of New Deal spending, wages were up and investment followed.

So why, under the pressure of all that increase in wages, did the economy not collapse or businesses and Wall Street go bust simultaneously?  The answer is simple, people had more money to spend and powered investments, production and profits.

WWII was a time when wealth was transferred to the working class, in huge amounts.  The post war period, nominally lasting until the early seventies, saw tremendous American growth and prosperity precisely because of the transfer of wealth that was set up by WWII.  Destroying the manufacturing base of Europe didn't hurt either, but that is another story.

In 1980, the Reagan Era began to reverse the economic effects of WWII.  Wealth began moving more to the wealthy again, as it did in the 1920s.  The middle class has been systematically shrunk and the economy has been showing the effect of this trend for years now.  So much so that, beginning with Reagan, the CPI has been cooked to mitigate the public's perception of inflation and, using CPI as the GDP deflator, to show economic growth where there was none.

President Obama has the challenge of restoring the pre recession levels of economic activity.  In order to do that, some means of replacing 2 trillion dollars per year in consumer outlays that have been fueled by credit must be found.

The Reaganites tend not to believe that a retrenched credit market will be a problem.  They would, it seems, prefer an L shaped recovery, with economic activity contracting to 1995 levels with an additional 30 million people to feed, clothe and house.  Fine.

For those of us who do not want to go back to 1995, the short term answer is to replace lost consumer spending of 2006-2007 levels with government spending.  But that will not be enough, because, if at the end of that government spending program, the consuming public is still not able to support 2006-2007 levels of spending, the recession will just start over again.  It will start over and be worse, as debt service for the money required for the stimulus package will add to the public burden.

In order for the stimulus package to have any effect in the long term, nothing is more important than getting an across the board wage increase, as happened in WWII,  in some fashion to the working public.  Nothing is more important, not infrastructure or private investment or anything else.  Realistically, if this is not done now, the economy will not recover. 

The President has some surreptitious plans in this regard, as I noted in <a href="">McCain Will Raise Your Taxes</a>.  Pushing the tax burden back onto the rich will help.  And that is as simple as arguing that they must either pay their workers more or pay their worker's taxes instead.  The current version of Obama's tax plan will return about $600/year/worker, or 100 billion dollars a year to the economy, funded by raising taxes on the top 5% of individual earners, bumping up capital gains and cleaning up corporate taxes.

Private borrowing in the U.S., pre-recession, was about 2 trillion/year.  It is very hard to say what 2009 lending levels are like, so for simplicity assume zero.  What is needed now is some plan to raise the aggregate buying power of 167 million workers by some fraction of 2 trillion.  A more normalized credit market will serve some 66% of the 2 trillion dollars needed, assuming about 33% of the Greenspan easy money policy era loaning will disappear.  So of the 2 trillion dollar shortfall, about 666 billion in wage increases will be needed, about 4,000 dollars/year/worker.  Without this increase, and absent continued government spending, the economy will contract as surely as gravity attracts a bowling ball.

The minimum wage is scheduled to go up from $5.15 to $7.25 by July of 2009.  That is a nominal increase of about $4,000/year/worker.  Unfortunately, the most populous states already meet or exceed that minimum wage and only 2.3% of the workforce is currently paid the federal minimum.  Still, some 4 million workers will get an additional $4,000/year by July 2009.  This will add 16 billion dollars to the economy.

If some 666 billion dollars is needed to redress the loss of easy credit and 116 billion is provided for by the Obama tax plan and increases in minimum wage, about 550 billion must come from somewhere else.  Some investment growth will follow increasing demand from the injection 116 billion into the economy. Historically, investment tracks at about 20% of increased demand.  This will add another 23 billion to the GDP bring the deficit in economic activity down to 527 billion.

The stimulus package is probably adequate if followed on by what can only be called redistribution of wealth.  Alone, it will only delay the effects of economic contraction.  That is the hard reality.  The political reality is that no government action capable of giving everyone a $3,000/year raise is possible given the blindered legacies of Milton Friedman.  So it is up to the Obama administration to lead the way through a political minefield to get some measure of what the economy needs done, namely, getting more money in the hands of the working class.

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