The Policies of the Venn Overlap

Points of agreement between Democrats and Republicans are few. They agree that inflation is bad. And they agree that growth is good. But that's about all they agree on. Yeh, they expect the Federal Reserve to fight inflation and Congress to encourage growth. But what Congress does to encourage growth, and how much, and whether and when, is all beyond the overlap. Likewise whether the Fed should tighten or loosen its grip on money, and how much, and when -- these questions are answered differently on the left and on the right. But these points of disagreement are not the problem.

The points of agreement are the problem.

We came out of World War II with too much money in circulation, and little private-sector debt. The money was causing inflation, and the Federal Reserve fought inflation by tightening its grip. Meanwhile, Congress encouraged growth by cutting taxes and stimulating private spending.

The policies worked. The period from 1947 to 1973 has been called a "golden age of postwar capitalism."

As the years passed, the quantity of money in circulation grew less, relative to GDP, and inflation abated. Meanwhile the economy grew, and the use of credit helped it grow. The original post-war conditions -- too much money in circulation, little debt in the private sector -- gradually changed.

By the 1970s, debt had grown to the point that the use of credit was causing inflation. We were getting inflation because there was too much credit in circulation, and more inflation because of the interest costs embedded in the price of everything. And that's what ended the "golden age."

Then, Reaganomics changed things. It put emphasis on the "supply side." It figured the way to improve growth was to improve conditions for producers and production.

Two things Reaganomics did not change were the points of agreement in the Venn overlap: The expectation that the Federal Reserve should fight inflation, and the expectation that Congress should encourage growth. Our policies continued to reduce the quantity of money in circulation, relative to GDP, and continued to stimulate the growth of private-sector debt.

Those policies worked in the "golden age" because we had little private-sector debt, and too much money. Those policies solved the problems of too much money and too little debt. The problems were solved in the 1960s -- so long ago that today it is difficult to think of them as problems at all.

Those problems were solved in the 1960s, but the policies of the Venn overlap did not change. The policies stopped working in the 1970s because the problems were solved in the '60s. Reducing the quantity of money in circulation is good policy when there is too much money in circulation, but it is bad policy when there is too much credit in circulation. Encouraging the growth of private-sector debt may be good policy when there is little debt, but it is foolhardy when there is already too much.

But no one was willing to change the policies that gave us a "golden age." Even today, we depend on the Federal Reserve to fight inflation by restricting the quantity of money. Still today, Congress does all it can to expand the availability and use of credit.

The policies of the overlap do not work, because the economy changed but the policies didn't. This is the reason we cannot stabilize prices. It is the reason we cannot achieve the growth we expect. And it is the reason we have so much debt.

Policy Venn

With apologies to MasterCard, this is a Venn diagram of U.S. economic policy. On the left we have the left, and on the right, the right. Everyone on the right thinks the left is wrong, and everyone on the left thinks the right is wrong. But see the overlap area? In there are the points of agreement between left and right. I think the points of agreement are the problem.

Emmanuel Saez's graph here shows the results of the two policies. The Keynesian years (say 1948-1978) appear as a straight, flat trend. The Reaganomics years (1978-2008) appear as a straight but sharply rising trend.

For the first thirty years after World War II, we tried Keynesian economics. Things went well for a while but ended badly. Then, for the next thirty years, we tried Reaganomics. Again things went well for a while, but ended badly.

There is some problem with both approaches.

I think the problem is in the Venn overlap. The points of agreement are the problem. The points of agreement lead to the growth of debt. Both Keynesian economics and Reaganomics produced great increases in debt.

But the points of agreement are never disputed. The policies of the Venn overlap are part of the plan no matter who is in charge. And since those policies are the source of our problems, our problems never get solved.

Recovery

Excerpts from an Associated Press article of 15 April

CONFIDENCE:
Federal Reserve chairman Ben Bernanke ... has confidence the unfolding economic recovery will have staying power..."


When you don't know how to run an economy, talk about how confident you are. That way you've covered the "psychological factors" at least. And if nothing's wrong but psychological factors, then everything's cool. And since we have no idea what else could possibly be wrong, well, confidence is all we can muster.

THE SAME OLD SONG AND DANCE:
Bernanke ... called on lawmakers and the White House to come up with a plan to whittle down record high budget deficits.... A credible plan to pare the deficit could provide the economy with benefits....


It COULD provide the economy with benefits. Bernanke doesn't really know, but he's hopeful: A "credible" plan could help. If only they could come up with one.

They don't know what's wrong with the economy, and they don't know how to fix it.

THE SAME OLD SONG AND DANCE:
"Addressing the country's fiscal problems will require difficult choices, but postponing them will only make them more difficult," he warned.


How many times have you heard that? Can ya believe they still warn about "postponing" the fix? -- after all this time!

Okay, so we're the richest, wealthiest country in the world, or right near the top. So how come all the economic solutions call for sacrifice? If we're so rich why isn't it EASY to fix the economic problem?

The answer is: They don't know HOW to fix the problem. They don't know the easy answer. And nothing they've tried has worked. So they think it's a difficult fix.

It doesn't have to be difficult.

BERNANKE SEES THE FUTURE:

In fact, the odds of a "double dip" recession, where the economy would start shrinking again, have receded, Bernanke said.


Hope so.

THEY SAY THIS ALL THE TIME, AND IT IS WRONG:
... That assessment of consumers -- whose spending accounts for 70 percent of national economic activity -- also appeared more upbeat ...


Assuming the number is right, consumer spending accounts for 70 percent of GDP or 70 percent of output or 70 percent of income, but not 70 percent of national economic activity.

Economic activity is spending. National economic activity is spending in the nation, or spending by U.S. citizens, or something like that. National economic activity is an iceberg. Output is the tip of the iceberg.

Assuming their number is right, consumer spending accounts for 70 percent of the tip of the "national economic activity" iceberg.

It matters.

"Too Big" to fail

It's not that some individual banks got too big to fail.

It's that finance got too big, too embedded in everything, so that if finance fails, the whole economy fails. That's the problem.

The same problem makes economic failure likely. Finance is too big.

Oh, and by the way, we did fail. We called it a "financial crisis."

Policy is key

In the previous post I asked:

What changed in our economy, that brought about this 30-year change in the income gap? Short answer: Economic policy.

Comments on the previous post link to "Striking it Richer" by Emmanuel Saez.

In his PDF Emmanuel Saez writes:

Based on the US historical record, falls in income concentration due to
recessions are temporary unless drastic policy changes, such as financial
regulation or significantly more progressive taxation, are implemented and
prevent income concentration from bouncing back. Such policy changes took
place after the Great Depression during the New Deal and permanently
reduced income concentration till the 1970s.

Policy is key. Saez doesn't finish his thought and say that policy changes since the 1970s allowed income concentration to bounce back. But his Figure 1 shows the bounce. I've eyeballed-in trend lines to emphasize the timing of the policy change.

I love a Parade

The headline reads
Income Gap Grows During Recession

Well, sure. A recession is a time when fewer people do well. So the article's opening statement --

Even as the economy shrank last year, the income gap—the divide between the country’s richest and poorest citizens—kept growing.

-- should come as no surprise. Here's what's outrageous: The economy was mostly growing for the past 30 years, and the income gap was increasing all the while.


Stats reported by the article:

• In 1978, CEOs at the largest U.S. companies earned 35 times as much as the average worker. Today, that figure is more than 300:1, according to the Harvard Business Review.
  
• In 2008, the U.S. Census Bureau reported that income inequality had reached a modern high, with the wealthiest 10% of the population earning 11.4 times as much as the poorest 10%.
  
• Research by Kevin Hallock, a professor at Cornell University, indicates that the trend persists: “From 1979 to 2009, after adjusting for inflation, the highest earners in the U.S. saw dramatic growth in their earnings while the lowest earners now make less than they did 30 years ago.”
  

Note that these stats do not reflect changes over the past two years, which may be due to the recession. The stats reflect a change that occurred over the last three decades.


Get that headline out of your head. The recession is not the problem. It is a problem, yes, but not the problem.

What changed in our economy, that brought about this 30-year change in the income gap?

Short answer: Economic policy.

Why economics is important to me:

A gap between society’s rich and poor can have ugly consequences. Countries with greater income inequality have higher rates of teen pregnancy, infant mortality, obesity, mental illness, drug use, imprisonment, and homicide than countries where wealth is more evenly distributed, according to research by epidemiologists Richard Wilkinson and Kate Pickett.

The things we see as problems of society are almost always, in my view, consequences of economic problems. That's why economics is important. That's why it matters that we get it right.

Financial Reform

In a discussion of financial reform Paul Krugman divides "those who really do want reform" into two camps:

• Those seeking to limit "the size and scope" of banks
• Those seeking to "regulate what banks do, not how big they get"

Krugman's list neglects the biggest and most important camp: those seeking to reduce the size of the demand for credit.

The demand for credit includes not only new uses of credit but also existing credit-in-use, or existing debt. Those of us seeking to reduce the gross accumulation of debt are onto the most essential element of financial reform.

As for myself, I favor all three elements:

1. Limit the size of banks -- not by regulation, but by eliminating the advantage of bigness from the existing tax structure.

2. Limit the scope of banks, or what they can do, essentially by reinstating regulations that were set up after the Great Depression, but which were removed after economic growth slowed in the 1970s.

3. Limit the demand for credit by setting up tax incentives to accelerate the repayment of debt. By reducing the total demand for credit, we reduce the need for finance in our economy, reducing the factor cost of money and freeing up profit and income for the productive sector.

An observation

Scenario 1:

We borrow and spend; the economy grows; we accumulate debt.

Scenario 2:

We borrow and spend; the economy grows; we do not accumulate debt.

Observation:

Scenario 1 works until we reach a crisis. Scenario 2 works, and avoids the crisis.