Wednesday, December 26, 2012

Wealth, Equity, and The Recovery

This blog has had two previous discussions about the causes of the 2007 recession.  The first was a post on the merits of Keynes, Hayek, and Fisher in providing an answer to the question of what caused the 2007 Great Recession.  Despite the popularity of Keynes and Hayek in popular editorials, the forgotten Fisher provides the best answer.  Our country forgot the lessons of Fisher and encouraged a bubble in real estate that caused the debt-deflation cycle that we have experienced for the last five years.

The second discussion was a post on Roger Farmer on the role of wealth to create a productive society.  Citing Milton Friedman, Farmer provides the evidence that supports the view that employment tracks positively with wealth.  The more wealth we have as a country, the more employment we have.  With more employment comes more growth and more governmental revenues that provide more services and reduce deficits and debt.

My own research supports the Farmer position.  However, instead of talking about wealth, I use the term equity since I use an accounting view of the economy.  When I look at a statement on the Gross Domestic Product, I see something that is similar in large terms to a national income statement.  And if the country has an income statement, there must be a balance sheet.  I found some data and built a balance sheet going back sixty years.  I analyzed it and saw how equity dropped seriously in the 2007 recession and in the years following. 

Equity is important because it creates the leverage that enables all of us to buy houses and cars and other things.  How many of us postponed a great many purchases because we wanted to repair our own individual balance sheets following 2007?  Both Richard Koo and John Taylor termed this effect as a “Balance Sheet Recession” in their discussions of the Great Recession.  If, from a macro view, the national economy is a composite of our microeconomic behaviors, then our 2007 recession and recovery should reflect the goals of rebuilding our balance sheets.

This brings us to the Stimulus package.  If the cure to the recession is to rebuild our individual balance sheets, then stimulus should enable that to happen.  What did the Stimulus package do?  First, it was a limited series of tax cuts.  Most people used the extra money to pay down debt, which is good, but it failed to stimulate.  In other words, the money was used to rebuild individual balance sheets.  Second, the Federal government transferred money to the states to reduce program cuts.  The Stimulus reduced the number police and teachers that would have been laid off without the Stimulus.  While this is a good thing, it is not stimulative.  In short, this action did not create growth.  The third was a package of road and infrastructure improvements that took far longer to implement than was planned, and the growth effect was diluted.  The sum of these parts is that the Stimulus package did not stimulate very much.  

The reason why this happened is because the policy makers of the time from both parties, including many economists, just got it wrong.  The administration assumed that the recession was basically the same as before.  They did not ask if it was different, and the administration recommended that the medicine from before would cure it. 

The first economists who said otherwise were Carmen Reinhart and Kenneth Rogoff in their book This Time is Different.   They referred to 2007 as a financial recession but they did not offer a prescription for curing it.  We had to wait for people like Roger Farmer to offer a suggestion.

We should also note that as the recession continued, people on their own would improve their balance sheets, which has enabled them to begin buying again.  Once we get back to a national debt/equity leverage typical of the years leading up to 2007, then the economy will begin to approach pre-2007 growth levels.

If we knew then what some know now, the recovery would have been different. 

Saturday, December 22, 2012

Roger Farmer on Wealth and Unemployment

I heard a lecture this semester by Roger Farmer who is the Chair of the Economics department at the University of California, Los Angeles.  Dr. Farmer is different from most economists in that he is attempting to address the 2007 recession from a new perspective.  In a previous post I mentioned that there are the Keynesians, and the Hayekians.  There is also Irving Fisher who explained the 1929 depression in terms of a debt-deflation cycle.  Dr. Farmer explains Fisher by pointing us to look at the end result of Fisher, which is wealth.  It is wealth that is lost once a debt-deflation cycle occurs.  This is equity on the balance sheet, and in financial terms, it is that residual value in our own individual financial structures that allows us to borrow in order to buy things.  It is the basis for our own personal leverage.

When the 2007 Great Recession hit lots of personal wealth was wiped out.  Some estimates put it as high as 40%.  This restrains consumption from a Fisher perspective.  However, Farmer makes wealth a more central part of his economic argument.  He bases much of his argument on Milton Friedman, whom he described as a Keynesian.   Friedman stated that consumption is based on wealth and not income, which is counter to a traditional Keynesian argument that wealth is based on income.  I know what you are thinking, but I am just reporting what I heard.

Dr. Farmer presented several graphs that brought his argument into focus.  He traced unemployment through the 1930’s and showed how growth in employment marched hand in hand with the value of the stock market.  He then used this information to build a model of the relationship between the S&P and unemployment over fifty plus years.  He used the first have of the years to establish a foundation of data for the model.  He then used those years to predict unemployment from the 1980’s to more recent years, and the model was incredibly accurate.  He demonstrated that wealth and unemployment move together, and wealth can be used to predict the level of unemployment.   

What are the policy implications of this?  Dr. Farmer proposed a solution that could be received as a “big brother” type of method to stabilize the economy.  He proposed that the Federal Reserve establish an indexed fund of stocks.  The term “index fund” means to buy a set of stocks from the market that mirrors the overall market.  The idea is not to buy a set of winners over loosers.  The fact that the Federal Reserve would buy an indexed set of stocks to stabilize asset values in down cycles would also protect employment from moving to the downside in the proportions that it has in the last five years.

My own personal recommendation is not to tax capital, because taxing capital would retard its growth.  If you want employment to grow, wealth should grow.  

Dr. Farmer has a little book that I recommend to anyone who wants to understand the economy, but who has not the time or the patience to suffer through a college course on the subject.  The book is How the Economy Works and it is available on most bookseller web sites.  Dr. Farmer’s own web site with his mathematically based technical working papers is linked here as well.

The idea that wealth relates closely to unemployment is not a new idea, but Dr. Farmer has been able to put together persuasive evidence that the relationship is real.