The best way to identify problems associated with the presented data
is to view them in terms of historical norms. According to the
article "Economists Expect Solid Economic Growth This Year" by Kevin
L. Kliesen, The Federal Reserve Bank of St. Louis (January 2005)
http://stlouisfed.org/publications/re/2005/a/pages/growth_overview.html,
the long run rate of growth in real GDP is about 3.5%. Therefore, GDP
growth of only 1.5% for the last two years is well below average,
suggesting that growth is potentially too sluggish, and the economy is
operating below its potential.
According to the article "Inflation -- A Historical Perspective" by
Bill Lussenheide, Investment Warrior Report (2003)
http://www.investmentwarrior.com/Archived%20Articles/120403.htm,
statistics collected by the US Department of Labor show "...an
inflation rate that has ran at a 3.3% annual rate over the last 90
years. Since 1972, the inflation rate has ran at a 4.78% annual
clip." Therefore, an inflation rate ranging from 1-2% during the last
two years is quite low. In fact, as inflation rates in the United
States touched these levels during the last economic downturn, Alan
Greenspan, the Federal Reserve chairman, expressed concerns about
deflation developing.
"Labor Market Info Classic" Office of Workforce Development, State of
Ohio (2005) http://lmi.state.oh.us/laus/LAUS-CurrentLaborForceEstimates.htm
has a graph that depicts seasonally adjusted unemployment rates from
1997 through April of 2005 for the United States. Even during the
peak of the recent recession, United States unemployment rates did not
exceed 6.5%. Therefore, an unemployment rate that has increased from
6.5% to 7.3% is high by historical United States' standards.
Federal Reserve officials put forth the notion of a neutral Fed Funds
Rate of being somewhere between 3% and 5% ("The Neutral Fed Funds
Rate" by N. H., The Washington Post (September 26, 2004)
http://www.washingtonpost.com/wp-dyn/articles/A49316-2004Sep25.html.
This is "[t]he level at which the Federal Reserve's federal funds
rate, the overnight rate charged between banks, neither stimulates nor
slows economic growth." Therefore, the federal funds rate target of
3.5% is neutral rather than stimulative.
"US Government Budget Surpluses and Deficits: 1970 - 2004" by Pekka
Hirvonen, Global Policy Forum (April 2005) displays data in both table
and graphical form. As one can see, except for the period 1997-2001,
the United States budget deficit has not been less than $100 billion
since 1981. Therefore, a budget deficit of $60 billion, up from $50
billion the year before, is extremely low by recent standards.
The problem fundamentally appears to be that growth is too slow. The
absence of normal levels of growth has created high levels of
unemployment. The combined effects of slow growth and high
unemployment have likely contributed to the increase in the budget
deficit because of a reduction in tax receipts. However, compared to
historical norms, the budget deficit is quite low. The present level
of the federal funds rate is not conducive to promoting growth, and
inflation is presently not a threat to the economy.
In a situation, the opportunity exists for both fiscal and monetary
stimulus to be employed to encourage economic activity and promote a
return to a normal level of growth. Although the budget deficit has
been growing, there is ample room for tax cuts and/or increased
government spending to promote economic activity. Tax cuts make more
money available for individuals and businesses to spend, while
government spending pumps money into the economy to pay for business
activity. Although both can increase deficits in the short term, the
increased economic activity over the long run, combined with a
decrease in incentives when they are no longer needed, should leave
the government' is budget and stronger shape than it was before.
Because inflation is currently low, not only will increased fiscal
stimulus be minimally harmful, but the Federal Reserve can also afford
to lower interest rates to provide monetary stimulus. Lower interest
rates allow businesses and consumers to reduce their interest
expenditures and to acquire loans under better terms. The ability to
borrow money at attractive rates makes it more likely the businesses
and consumers will make investments and purchases, thereby increasing
economic activity.
As economic activity increases through the use of stimulus,
unemployment will drop as businesses need to hire more people. This
in turn provides more people with money to spend and increases
government tax collections. Once the economy returns to more normal
levels of growth, then the fiscal and monetary stimulus can be removed
to forestall the rise of inflation.
Excessive stimulus that leads to high rates of inflation is the
greatest danger posed by engaging in fiscal and monetary stimulus.
The government is less concerned about inflation because it decreases
the effective burden of the national debt, but high rates of inflation
can be very damaging to economic activity. High rates of inflation
are very harmful to consumers, particular those on fixed incomes.
Therefore, once the economy has revived, managing the removal of
stimulus to guide it to a soft landing rather than overheating or a
return to malaise is a critical process.
Despite the risk of inflation, however, action must be taken because
of the high and growing rate of unemployment. Social stability is
significantly dependent upon people's ability to earn a living.
Inadequate economic growth to provide everyone who wants a job with a
reasonable chance of finding one is very undesirable. Furthermore,
continued deterioration in the government's finances is likely to
occur without either an increase in growth or increased taxes.
However, increased taxes would further dampen economic activity,
potentially creating a "death spiral" of higher taxes and less
economic activity. Therefore, given that the government's finances
are in reasonable shape, the Fed funds rate is neutral and well above
the historically low rate of 1% seen recently, and the economy is
potentially at a risk of slipping into deflation, it is appropriate
that both fiscal and monetary stimulus be used to promote economic
growth and avert deflation.
In many ways, the situation described is not unlike that faced
recently during the recession of 2001-2003. In this case, the Federal
Reserve and Congress both acted aggressively to provide the economy
with significant monetary and fiscal stimulus. These actions help
prevent the collapse of the stock market bubble and the terrorist
attacks of 9/11 from wreaking more economic havoc than they did. At
present, however, there is a risk of inflation and of a housing bubble
having been created by excessive stimulus. So far, though, it seems
clear that the risks of the present are much easier to live with than
the conditions during the worst of the downturn.
Sincerely,
Wonko |
