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Is the US Economy Already in Recession?

Economics / US Economy Jan 21, 2008 - 04:29 PM GMT

By: Gerard_Jackson

Economics Figures from the Institute of Supply Management are painting a grim picture. Its PMI (performance manufacturing index) stood at 47.7 in December against 50.8 November. (Anything below 50 indicates a contraction). For the same period production fell from 51.9 to 47.3 while employment remained largely unchanged. Ordinarily this would be enough for anyone ' including me ' to declare the US economy in recession. Unfortunately the situation is not that clear because we have yet to learn what Bernanke will do in the near future.


Last week President Bush hosted a press conference where he announced a stimulus package of $145 billion that mainly consisted of tax cuts.? So will it work? The US is a $14 trillion economy (about 30 trillion if one takes in to account total spending). As a per centage of GDP the package comes in at a mere 1 per cent. In any case, the idea that increased spending on consumption would avert recession is a fallacy. All it would do is misdirect more and more resources and making things more difficult for manufacturing.

Bernanke is in a very tight spot on this one, thanks to his Keynesian training. The standard approach would be a combination of tax cuts and interest rate cuts. Some would argue that cutting interest rates has the same effect on industry as a cut in capital gains taxes. Therefore the US can have the best of both world's in that an effective interest rate cut would increase the amount of capital gains and hence tax revenue, not to mention the revenue from other incomes.

This is thoroughly fallacious. Genuine capital gains are profits, therefore cutting them increases genuine savings which expand the capital structure. On the other hand, interest rate cuts - meaning forcing interest rates below the market rate - expand credit without creating genuine savings. This leads to more malinvestments that will have to be liquidated at a later date. This is called having a recession.

How interest rates influence the pattern of production is not generally known, even among economists. Let us take a simple situation where the market rate of interest is 4 per cent. The central bank now decides to lower the rate to 3 per cent. It does this by expanding credit through the banking system. At 4 per cent a company will borrow $100 million for expansion. By forcing the rate down to 3 per cent it will now pay the company to borrow $133.3 million. (This figure is equivalent to a 4 per cent loan for the company).

(Now it would be nice if there were strict economic laws that could be neatly expressed in formulas as is the case in physics. But economics deal with human action and is therefore a qualitative discipline with its own ineluctable logic. However, as we can see, a hypothetical situation can be created that will mirror to a considerable degree the real world).

While it does not follow from our example that our company will borrow all of the additional $33.3 million the example clearly shows why forcing down the rate of interest encourages further borrowing while adding nothing to savings. (For the sake of simplicity I have ignored the phenomenon of forced savings). All things being equal, the 25 per cent interest rate cut will misdirect production and exert an upward pressure on prices and a downward pressure on the exchange rate

What this means is that Bernanke is snookered. A worthwhile ? worthwhile from industry's point of view ? cut in interest might very well cause manufacturing to expand, cut unemployment further and cause GDP to grow. This is precisely what happened in Australia. The PriceWaterhouseCooper PMI stood at 52 in March 2000: by December it had fallen to 44.2. Manufacturing was obviously contracting but then there was a sudden reversal: by August 2001the PMI had jumped to 51.9 and by December it had risen to 55.4.

The trend was similar for production in general which stood at 42.6 in December 2000 before rising to 56.3 in December 2001. It was the same for the employment index which rose from 48 to 53.5 in the same period. So what happened? The Reserve Bank of Australia cut rates from 6.25 per cent to 4.25 per cent, a full two per centage points. This sent M1 leaping by 22 per cent in 2001 and bank deposits by 25 per cent. This monetary explosion added further fuel to the current account deficit, aggravated our foreign debt and triggered a massive housing boom which we are still enduring.

The consequences for the world of Australia's dangerous monetary policy are insignificant. The same, unfortunately, cannot be said of the US. But that's a topic for another article.

There is near-hysteria about the amount of debt. Reports like the one about Merrill Lynch having to write-off $16 billion in mortgage-related investments is certainly not helping matters. But where in heavens name do all these billions come from? Well, we already know the answer. Furthermore, the economists at Merrill Lynch should also know it. There is nothing new about financial fiascos that are built on excess credit. History, if nothing else, show us that the consequences of continued credit expansion is that ' you guessed it ' people tend to accumulate more debt. Richard von Strigl, an eminent pre-WWII Austrian economist (he died in 1942) observed that when

'.expansion progresses, the greater will become the share of additional credits in the overall volume of credits within the economy. ( Capital and Production , Mises Institute, 2000, first published 1934).

Note: When the recession comes the Democrats and their media lackeys will once again denounce free market policies while the real culprit ' lousy economics ' escapes scot free. Part of the problem is not just the economic illiteracy of journalists but also their political bigotry, of which Marc Moncrief at The Age is a nasty little example. On 19 January he 'reported':

Hard times in the US economy have treated Michigan badly and the state's unemployment rate last month hit 7.6% -' well above the 5% measured nationally. ( The Age , Down for the count-' . 19 January 2008).

That's right, folks, that nasty President Bush and his crummy economy is the cause of Michigan's woes. The following chart clearly shows that the unemployment rate in Michigan began to rise about February 2000, peaked in 2003 after which it was comparatively stable. As Bush was not inaugurated until 20 January 2001 I fail to see how he could be responsible for the state's rising unemployment. Little things like facts, however, will never stop political bigots like Moncrief and that's why he did not tell his readers how the policies of the state's ruling Democrats had badly damaged the economy.

By Gerard Jackson
BrookesNews.Com

Gerard Jackson is Brookes' economics editor.

Copyright © 2008 Gerard Jackson

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