AUGUST
2012

 

By
Larry DeBoer
 
Professor of
Agricultural Economics
Purdue University

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8-23-12

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What Will Break the Vicious Cycle?


The unemployment rate is high, above 8 percent for the fourth year in a row. To bring the unemployment rate down, the economy has to grow more than 2.5 percent per year (measured by inflation-adjusted gross domestic product). Jobs must be created for the unemployed and for all those graduates entering the labor force each year. GDP grew at a 1.5 percent annual rate in the second quarter. Not enough.

One reason GDP isn't growing fast enough is because consumers aren't spending. Household spending is by far the largest part of GDP, more than 70 percent of the total. Consumer spending grew only 1.5 percent in the second quarter, too. If consumers don't spend, GDP doesn't grow, and unemployment doesn't fall.

But one reason consumers aren't spending more is that unemployment is high! It's not a good idea to buy that new fridge if you fear for your job. If unemployment is high, consumers won't spend, so GDP won't grow, so unemployment won't fall, so consumers won't spend and so on. It's a vicious cycle.

There are a couple of traditional ways to get out of a vicious cycle. Monetary policy is one. The Federal Reserve expands the money supply and reduces interest rates, which causes households and businesses to borrow and spend more. The added spending gives businesses a reason to produce more goods and services and hire more employees. Unemployment goes down, consumer spending gets a boost and the economy takes off. Vicious cycle broken.

The Fed has tried and (probably) kept the recession from getting worse. But now interest rates are already really low. The Fed's policy rate (the federal funds rate) is near zero, as low as it can go, and corporate bond rates and mortgage rates are at record lows. Will still lower rates help? Plus, an expanded money supply could threaten inflation. A little inflation might actually help, but some policymakers fear worse than that. It's not clear that the Fed will step in, and it's not clear how much help it would be if they did.

Fiscal policy is another traditional way out of a vicious cycle. Congress and the president agree to cut taxes and increase federal spending. Businesses respond by increasing production and hiring. Unemployment falls and consumers increase their spending some more. Again, vicious cycle broken.

We tried fiscal policy a couple of times. We cut taxes during the Bush administration in 2008 and passed the stimulus package during the Obama administration in 2009. Again, these measures (probably) kept the recession from getting worse. But now our federal budget deficit is large, and our national debt is rising. Congress is so divided that more stimulus seems out of the question. In fact, unless Congress acts, we're scheduled to do the exact opposite in January 2013, cutting spending and raising taxes. If we jump off that "fiscal cliff," we'll be back in recession.

How about trade? Maybe the rest of the world will buy more of our exports. Businesses would increase production and hiring, unemployment would fall and consumers would spend.

That's not likely. Europe is on the edge of recession. China's growth is slowing from "blistering" to merely "ridiculously fast." Our exports aren't likely to grow much faster.

So how will the vicious cycle be broken? Maybe like this. Young people grow up and form families; they work for a while and want to buy houses. Gradually, they buy up that big supply of houses left over from 2006. Gradually, the price of housing quits falling, stabilizes and then starts rising. Rising home prices make households feel wealthier, and gradually they begin to spend.

Households pay down the big debts they took on in the 1990s and 2000s. Gradually, their debt payments fall as a share of their incomes. When their debts are finally low enough, their borrowing and spending begins to grow again, gradually.

Both of these things are happening. We're down to a five-month supply of homes, the lowest level since 2005. Home prices appear to be turning around. Debt payments as a share of income have been falling since 2007 and are now as low as they were in 1996.

How will we break the vicious cycle? Gradually. We'll wait it out.

 

 

Writer: Larry DeBoer
Editor: Olivia Maddox