The panic is spreading. Everyone these days is using the “R” word, and all politicians, whether running for the presidency or not, are scrambling to be the first to come up with a catchy “stimulus” plan. Unfortunately, even the chairman of the FED is prompting such a misplaced policy move. What these fiscal policy enthusiasts are forgetting is what got us into this mess to begin with. The answer is so simple it appears to be totally elusive to those that should know better. The problem is debt: household debt (insane mortgages and wild credit card borrowing); business debt (overly exuberant leveraged buyouts); and government debt (a government spending spree not commensurate with revenue growth). Over the past two years the nation as a whole has spent more that it has “earned”, a phenomenon not seen over the past 50 years. Even in better times the U.S. has had a difficult time achieving a 5% savings rate while the rest of the developed nations have double digit savings rates. A negative savings rate has serious implications and is at the root of today’s economic problems.

A negative savings rate doesn’t just mean borrowing for a new home that is above one’s means. The nation’s mortgage market isn’t the only victim. Negative savings means that the nation as a whole must borrow abroad to sustain our inflated standard of living. We are simply consuming more than we are producing and to do that we are either borrowing from foreigners or selling them American assets. The negative savings rate is the direct cause of the outlandish trade deficit the nation has been enduring. Foreigners are taking the dollars they earn and are buying U.S. debt and assets instead of U.S. goods and services. Regardless of what happens to the value of the dollar, the trade deficit will not disappear until our negative savings rate disappears.

The threat of a recession is real, but it is not just due to the financial crises triggered by sub-prime lending. The bottom line is that the inevitable has finally caught up with us. We simply couldn’t keep spending more than we were earning (consuming more than we were producing). Yet, the economy was counting on the spending spree continuing and when it became evident that is would not, fear replaced the unwarranted optimism that existed as late as this summer.

So now what are the politicians suggesting? Remarkably, some form of fiscal stimulus to try to prop up spending. This might be in the form of a tax rebate so the consumer can keep on spending or a government spending program to “create jobs”. The bottom line is that this won’t work and it is absolutely orthogonal to the direction we ought to be going. The inescapable fact is that any fiscal stimulus package will increase the federal deficit. Since neither households or businesses are net savers, where is the borrowed money going to come from. Answer: foreigners who have already had their fill of dollar denominated debt. Unless peddling $75 billion more to foreigners will convince them to invest less in their own countries or consume less of their own products, each additional dollar used to buy more American debt will be one less dollar used to buy American goods. In that case, the net stimulus will be zero. The trade deficit will widen even further and the dollar will fall even faster since foreigners aren’t really anxious to buy more U.S. debt. All the talk of “stimulus” packages is reminiscent of trying to put out an oil fire by dousing it with gasoline.

So what should be done? The answer is to get monetary policy straight. The FED has been reluctant to lower interest rates because of the threat of inflation and the negative impact lower rates might have on the dollar. The problem is that the FED still hasn’t got straight the difference between monetarized inflation, which they have a responsibility to keep in check, and supply shock inflation, which they can’t do anything about. The current inflation problem is almost exclusively due to high energy and international commodity prices. It is being exacerbated by the decline in the dollar, but that is not because the FED has been “printing” too many dollars, but because we’ve been flooding the world with our debt.

I’m still too much of an old time Chicago economist not to believe that the FED’s own statistic, the money supply, is a relevant measure of tight or loose monetary policy. M1 growth has been negative over the past 6 months and M2 growth has fallen to a modest 5% level. This is certainly not indicative of extremely tight monetary policy, but does suggest that the FED has ample room to be more generous. To bring an economy out of a recession it often takes a federal funds rate at or near zero to promote a rebound. Given the current pace of “core” inflation, that would suggest that federal funds rate should probably be closer to 3% than 4.25%. Furthermore, if this is correct, then there is no point in incrementalizing the rate changes as the FED has been prone to do in the past. Just drop the funds rate down to 3% and be done with it. Will this be inflationary? No, not if we are on the verge of a recession. (Just start bringing rates back up once the economy starts to rebound.) Will this cause a collapse in the dollar? No, because foreign investors are much more interested in the health of the U.S. economy than relative yields of government securities. Our only hope of getting out of the current mess we find ourselves in is for incomes in the U.S. to outpace spending. This is going to take some time, but it won’t happen at all if we are stuck in a recession. We can do this by promoting an economy with higher levels of capital investment and greater exports. Thus, let’s not spend our way out of the potential recession that seems imminent. Let’s work our way out

Dr. Barton Smith
Director, Institute for Regional Forecasting