The Bureau of Economic Analysis - the statistical arm of the department of Commerce - issued its GDP report yesterday. The result was a cheery
4.3%.
How to understand this? It is simple, as with the early 1970's expansion and the expansion during the Korean conflict - this is a war time boom. War booms don't always spread the prosperity. In fact, quite the reverse, war booms often have something which is a relative of inflation, what David Hackett Fischer calls "a money drought".
No one has repealed the business cycle - that pattern of rise and fall of economic activity from bust to boom and back again. While it has become possible to ameliorate its effects, take the edge off the crash and crunch of recession, and make the booms less about gold rush speculation and more about delivering the greatest good to the greatest number - we still have the business cycle. It is likely that we always will, because the business cycle allows two things: a carnival atmosphere during the boom when people put money down on projects that won't yield a return for them, but which will pay off (very very) eventually - and the retrenchment period when people make hard choices about what is really needed.
For some time people on the left wrote about the terrible recovery - how long Bush's job creation record was under water, how, while the NBER had declared the recession over in late 2001, the recovery didn't really seem to start until 2003. In the last few months many of these attacks have stopped, the country has rejected Bushism, even though the numbers don't seem to reflect the bad mood of the country.
The reason of course is that if we take government deficit spending on the military, the recession did last to 2003 even with the National Bush Ends the Recession folks changed rules. The thing about war time booms is that it doesn't make a lot of people better off. World War I didn't, nor did Nixon's handling of Vietnam. Instead, it creates massive profits for a few well positioned industries, and leaves almost everyone else treading water. If people believe the war is worth it, then they will stick it out. If not, there is an increasing discontent, as there was with Truman in Korea.
Wartime booms suffer from several ills. One is open inflation, but right now by shipping manufacturing and computer services to India and China, inflation is being kept tame. The second is "war profiteering", that is, tose business connected with the war effort charging much higher prices than everyone else - since there is no real competition, nor can these expenses be forgone. The third is shortage of key materials and people.
Right now I will state bluntly that economic statistics are being shaded to put lipstick on the pig that is this economy. That inflation is being counted as economic growth in GDP figures. The amount is not a great deal, but it is enough to make things look better. The same is the case with personal consumption. The real inflation rate is higher than it looks, not just because of housing, but because it does not count the effects of consumer credit. That is, it does not count the real costs that people pay.
However, leaving aside this ornate discussion in econometrics - that is how we measure things in economics, aka how to make sausage with statistics - the problem with this economy is that it is War Boom, and it is engaged in a classical exercise of war boom economies, aka "eating our seed corn".
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The first thing to realize about inflation is that one man's inflation is another man's pricing power. Prices go up because people can raise prices. Now if the amount of money in circulation stays the same, there are two responses. One is that people do without. If food prices are going up, then this is called "famine". The second is that people shift expenditures from other goods to the ones that are going up. They grumble, but they pay.
Now in an economy this second thing isn't necessarily bad. If there are permanently higher profits to be earned in some area, then people in a free enterprise system leave old, less profitable occuapations, and start becoming more profitably employed in new ones. People stop being civil engineers, and start programming computers. People stop being historians, and start writing documentation for software. People stop being psychopathic cat torturers, and start writing user interfaces for Microsoft. And so on.
But what happens if people aren't allowed to shift into producing what is now more expensive, or cannot because of physical limitations. The answer, of course, is that they run down their savings. This increases what is called "the velocity of money", and it decreases investment in everything else. Instead of the economy being what people want to invest in for the future, it becomes about where the people who have pricing power want to park their money for safety. Strangely, it won't be in places that would break their advantage.
This form - pricing power, a protected industry, decreased savings, distorted investment - is called a "money drought". It is the precursor to inflation. It is, in fact, inflation, because what would otherwise be happening is deflation, and this cycle creates some inflationary pressure. It becomes endemic inflation if the government comes in, and rather than addressing the root shortage or bottleneck, simply increases the currency supply by some means. A money drought then, is like a very hot room that is out of oxygen, and inflation is when some foolish monetary authority opens the door.
Back in the old days of gold and silver, everyone could be an inflationist - by shaving a bit of silver or gold off of a coin, and then saving the shavings to sell. Or by engaging in a gold rush and digging up the precious metal. But to really get inflation going, you need to own a bank. And the best kind of bank to own for this purpose is a central bank.
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A central bank is an institution that assures the value of currency and the availability of liquidity. These roles are in conflict. The first says that a unit of currency will remain relatively the same value - that is, that it will remain scarce. The second says that you can count on there being more of that currency when you need it. That is, that it remains plentiful. Something can't be scarce and plentiful at the same time. This is why central banks, since the 19th century, have raised or lowered the rate of interest, to make sure that activity speeds up or slows down. Long before banks were supposed to regulate the economy, they were supposed to make sure that other banks didn't either lend too much money, or didn't run dry of notes when people wanted them.
Of course, at first they weren't very good at this, and either they went too far towards value, or too far towards inflation. But the middle ground isn't much better - it is an era of robber barrons, an era where all the money in society piles up in a few hands. Monetary policy can't easily address this issue. It can do so with a sledgehammer - cause a big enough recession and hope that it stops the pattern of behavior - but this is not, in general the way one wants to do things.
So back to what we have: the money drought and a war boom. A money drought isn't inflation, and it isn't deflation. Instead, it is a situation where more and more people just can't seem to get ahead. They have less and less income that they can decide what to do with it. They feel pressed on all sides. War booms produce money droughts - whether the government is inflationary or deflationary, the net result is that ordinary people can't make progress during the war.
What this configuration means is that when the war boom spending ends, so too does the war time expansion. More over, instead of people returning to work and producing civilian demand that has been "pent up", we will, instead see a painful "adjustment". Adjustment is the term economists use to describe a situation when a whole bunch of poor bastards find out that they will never work again, because their skills are no longer useful.
Because monetary policy does not address money droughts very well, the reality is that a money drought is best addressed by fiscal policy and by regulation. That is how one spends money and how one structures the economy. Normally economists focus on monetary policy, because for regulating the business cycle itself, monetary policy is more effective than fiscal policy or regulation. While some counter-cyclical spending is useful, to "prime the pump", generally it is better to make sure the economy is running, and letting the action of millions of people determine what should be done. The government is better off providing a safety net so that people don't make decisions out of fear - and by lending for projects that will take decades to materialize - the "public good".
There is a growing realization in Washington DC that many of Bush's price support programs - that is price supports for defense contractors, drug companies and construction companies - are going to have to come to an end. There is, in fact, something very medieval about the whole ghoulish situation: Bush, like a medieval king, borrows huge sums of money from banking houses - in our case China and Saudi Arabia - to wage a war. He gives a great deal of that money to his friends to keep them happy at home while he prances about the Holy Land on his crusade. The war goes badly, doesn't deliver the promised loot. And there comes a point where the king either has to accept bankruptcy, go to war again to try and loot a different country, or pass the ruin on to others. Medieval kings seldom accepted bankruptcy. Bush is going to leave that decision to others.
That is, there is a growing realization in Washington DC that fiscal policy is out of order. That our spending priorities are not working very well. To some extent this is definitional to a war boom. Wars don't allow investment in civilian things. But it goes farther than that, it is being realized that the war itself has been mishandled, both in fighting the war, and in handling what used to be called "the home front". Largely the home front in this war has been to keep mortgages cheap, allow private people to hock themselves up to their eyeballs, and have a constant churn of terror alerts.
There is also a realization that the money nominally spent on the war has been misspent - we've spent enough money to get victory in Iraq, but billions of dollars have simply evaporated in corruption and mismanagement. Ironically, the reason we have not "won" in Iraq is that we didn't spend enough on a push to win the war. In the waning days of the Civil War, Lee thought of going guerilla, and even had his close advisors urge him to do it, Grant worried about the same thing. After all, Lee was the government in the Confederacy more than their elected representatives. In the last days of World War II in the Pacific, Allied commanders worried that Japanese military commanders would turtle up in their small stations all over the region, and die to a man unless they were ordered by the emperor to surrender. Guerillas have a hard time winning, but the often can prevent the other side from winnning. By not smashing Saddam's army, and by not hiring the remains back - the first was done to limit US deaths, the second because of the cost and the hope that we could turn Iraq into a compliant kleptocracy - Bush has turned the war exactly into a long running affair that should have been avoided.
Decisions like this have economic consequences. Like Hitler before Barbarossa, Bush-Rice-Rumsfeld didn't plan to be on the offensive as long as they have. They aren't the first commanders to make the mistake of thinking it will be an easy short war. They managed to take Baghdad, but not secure it. Thus a war spending plan - which delivered a huge jolt of debt fueled corporate profits, and simultaneously took away good places to invest them - has left the world economy shaking with the caffiene of tax reductions for the rich - that is borrowing - without enough to do. This is "a shortage of investment supply". Right now India and China are the only places that it is really worthwhile to invest - which means that the global straw of investment can't be any wider than what you can sink into China and India. Since these economies are small, that means that the global supply of investment is also small. Home electronics are going to get dirt cheap, cloths are dirt cheap, and so will customer service centers in india be dirt cheap. But that is it.
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So let's tie this together:
We have a war boom from borrowing.
We also have a money drought from unbalanced fiscal spending, and the fact that people can't enter the oil business where the profits are quickly.
We have a shortage of investment supply because there is only so fast we can find oil, and develop China and India.
Since most economist are microeconomists, macroeconomists, or econometricians, they are looking for the problems in the wrong place. The indicators show that we there is some imbalances in micoeconomics, there are some macro problems - and there is a great deal of focus on econometric gamesmanship. But looking at the econometric problems nowhere close to explains why people are unhappy. Instead the problem is a meso-economic one, that is, we are handing power to a small number of people, and instead of creating a situation where that power shifts, it continues to pile up. The solution to mesoeconomic problems is either to turn them into macro problems, or to confront them with government policy. The wrong answer is to turn them into macro problems, because these are hard to root out, and create nasty situations like high inflation or deep recessions.
The right answer is to attack the mesoeconomic problem head on. To say "enough is enough" and move to a new policy regime. And that is going to be the topic of my diaries for the next few weeks - how to address the meso-economic problems we face. How to take pricing power, investment supply and savings and move them around.