Why the Recession Has Lasted So Long

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Every day, workers change jobs. Businesses start or fail. New products render old products obsolete. People relocate to start afresh. These micro-level disruptions are vital to capitalism's intrinsic capacity for invention and regeneration. We could prevent or avoid these painful choices, but that would scuttle innovation and crush the human spirit a la communism. Only government can engineer shifts so dramatic that these micro-level adjustments accumulate into macro-level hardship.

The most common culprit is inflation-driven malinvestment. As the value of the dollar wanes, so does its certainty as an economic measurement. By distorting either money or its price (interest rates), pursuits that at the micro-level are profitable under one scenario suddenly become unprofitable as macro dials shift. Profits on business activity more or less correlate to interest returns on invested capital as adjusted for risk and effort. At least they should until the scale gets skewed.

You can buy a Treasury bond and earn a 3% return with little effort or risk. It takes the lure of much greater profits to commit that capital to a business, which requires much more effort and entails higher risk. But because of artificially cheap interest rates, the bar gets lowered. In periods of rapid credit expansion, scarce resources are misallocated into sectors that wouldn't otherwise be profitable.

As interest rates fall, people can inexpensively risk someone else's capital and the rate of return necessary to exceed buying a bond falls. So capital gets diverted into pursuits that no longer pass muster once the paradigm adjusts. It's overused, but rate decreases and monetary debasement misallocated capital by inflating a "bubble" which subsequent rate increases pricked. As credit tightened, certain industries experienced harsh corrections. Heavy losses suffered by banks evidence malinvestment's dire effects.

Individuals who made the best decision under existing risk/return parameters saw their hopes dashed as the dynamics changed. We overinvested in personal consumption, new home production and related activities. It's estimated that $2 trillion of capital was misapplied to finance high risk mortgage borrowers. Much of it instigated by government meddling.

When new home construction ebbed, we had too many homebuilders, roofers, plumbers, electricians, real estate agents, etc. particularly in places like Nevada where fewer people now want to live. They were attracted at the micro-level by profits that are no longer available because of macro-level shifts.

The recession occurred because millions of individuals found themselves producing that which they could no longer trade profitably. John Kenneth Galbraith observed, "Recessions catch what the auditors missed." In the boom period, we operated under a framework that the downturn revealed as flawed.

The seeds of this downturn were sown in the 2001 recession. Rather than let the economy heal, Greenspan's low rates encouraged frivolous spending. Consumers never adjusted their spending habits fueling lasciviousness with easy credit despite falling income.

Personal consumption increased every period from 1990 to September 2008. Household debt surged to over 130% of personal income. Prior to the 2001 recession it was closer to 100% and in 1990 was only 77%. Historically, there was always a correlation between interest rates and price inflation. However during the artificial boom, rates remained low even as inflation roared.

We built our economic infrastructure on consumption fooled by exaggerated wealth. Personal savings declined as people thought soaring home prices and stock market gains sufficed. According to the BEA, from WWII until the early Nineties, America saved between 8-10% of its income. Then suddenly we began consuming exorbitantly. From 1993 through 2007, the national savings rate averaged an anemic 2.8%.

It's estimated between 2003 and 2006 as the economy boomed, 3/4 of the growth in GDP was funded by home equity withdrawals. People took on second mortgages, home equity lines or refinanced over-burdened credit card balances by exploiting home value appreciation at historically low interest rates.

The downturn revealed that these gains were driven more by inflation than by a vibrant economy. Even during the preceding boom period, our GDP, when translated into Euros, had plummeted 25% since 2000. When the downturn eviscerated our investment portfolios and home values, many of us realized we had borrowed too much. We financed our overindulgence with cheap debt and a growing trade deficit.

The trade deficit never reflects an economic problem. Countries don't trade. People and companies trade and do so because both parties expect to benefit. For every dollar leaving to purchase cheap materialism, like dollars come back as capital investment offsetting our lack of domestic savings. Although our government's insatiable borrowing appetite frequently intercepts these monies before they can fuel anything productive.

However, the trade deficit reveals a symptom of a societal problem. Somehow we forgot that consumption should correlate to production. The unemployed shouldn't still consume heavily. Low producers shouldn't consume at the same level as better producers. We aren't all entitled to consume whatever we want just because we feel like we deserve it. The recession offered a reality check, but Washington does everything possible to prevent these lessons from being learned.

Businesses catering to discretionary consumer spending should shift gears following the market's new demands. More would, but politicians try to augment Keynesian aggregate demand in order to avoid the recession's painful adjustments. Our economy won't fully recover until we "purge the rottenness from the system" as Andrew Mellon long ago advised.

The recession is how the market redefines itself to the new paradigm. Downturns should ricochet into recoveries. The longer Washington attempts to alleviate the recession with interest rate manipulation and deficit spending, the longer weaknesses perpetuate. Propping-up the failures of the past prevents the successes of the future.

Saving dying companies deprives scarce resources from growing companies responding to the market's evolving demands. Subsidies only delay re-engineering. Bailouts incarcerate capital in flawed business models or production focused on consumer's old wants. TARP and the nationalization of the GSEs ensure risk and return will remain disjointed leading to future malinvestment.

Public works projects or bloated government bureaucracies employ some, but their viability depends on political whim for perpetuity. What happens when budget priorities change? Encouraging additional malinvestment into green energy or other politically correct machinations won't stimulate recovery.

There is little benefit in subsidizing the housing market, especially where we already have abundant houses sitting vacant. Mortgage modifications trap people in locations where the jobs have vanished. Unemployment benefits idle human capital. Unemployment has risen and lengthened in conjunction with rising and lengthening benefits at their longest and most generous levels ever.

Incendiary class-warfare rhetoric threatening heavy taxes and regulatory nightmares stymie new business creation. As capital hides or gets funneled through Washington, business decisions cater to politics rather than markets. Do we really want lobbyists and bureaucrats redistributing our capital or dictating what we may do with what Washington leaves us?

This was the longest recession since WWII because it was also the most interventionist recession. In the eleven previous corrections the average fiscal deficit had been 2.3%. In 2009, the federal deficit exceeded $1.4 trillion, which was almost 10% of GDP. Both numbers represent postwar records already being eclipsed this year when the deficit could reach $1.6 trillion despite a "recovery."

Government spending merely reflects a statistical palliative superficially extending GDP. Too much of the economy has grown dependent on Washington so even as we are now "recovered" their interference persists. That government spending is forecast to continue rising testifies that it was more addictive than curative.

These policies prolonged the downturn and now reflect an albatross weighing down our recovery.


Bill Flax works in the banking industry. This column reflects his views and not those of his employer. Please contact him at billflax2@yahoo.com.




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