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Doubts about Recovery

Tags Booms and BustsU.S. EconomyBusiness CyclesFiscal Theory

10/08/2003D.W. MacKenzie

The popular press has adopted a more optimistic tone regarding economic conditions. The reasons for this are clear. It appears that the current recovery is picking up pace. Recent reports indicate that second quarter GDP for this year increased by 3.3%, instead of the earlier 3.1% estimate. This is more than double the GDP growth rate from the preceding two quarters. Analysts expect 4% or higher growth for the following two quarters, with some predicting 6 to 7% growth. Falling inventories and strong spending, some say, indicate that this recovery will continue.

Those who comprise the current pool of unemployed labor will surely see this as good news. Unemployment rates have not come down with the recent surge in GDP. Falling inventories will no doubt prompt employers to take on more employees. In trying to assess the merits and shortcomings of this recovery we should, however, consider both the changing composition of GDP and the source of its expansion.

However, this fact is crucial: a considerable portion of this increased GDP has come from increased military spending. Military spending rose 45.8% for the second quarter. This is the strongest quarterly increase in military spending since the Korean War.

Overall economic efficiency does not concern GDP growth per se. It concerns the satisfaction of consumer demand. Increased military spending does not directly satisfy consumer demand. Some might argue that this spending, largely on military operations in Iraq, will improve long term domestic security and satisfy the demand by Americans to avoid future terrorist attacks. Others clearly object to the methods employed by the Bush administration in fighting the war on terror. These objections range from the practical matter of how best to prevent another 9–11 to the moral legitimacy of military foreign intervention.

In any case, does the redirection of available resources into the War on Terror reflect an efficient use of scarce resources? Politics reflects the will of narrow special interests, rather than the general public. There can be no doubt that the Iraq incursion has been good for Haliburton. Has it been good for American consumers overall? The general biases that exist in democratic politics indicate that public policy will favor narrow interests, like corporate interests (i.e. Haliburton) over general interests (i.e. ordinary consumers)1.

It is also the case that many misconstrue the economic effects of such spending. Resources expended on the military could go to other uses. Those who argue that increased military spending stimulates the economy employ faulty reasoning. They say that resources lie idle because of insufficient spending. It is therefore the case that anything that prompts greater spending, even destructive acts, can improve economic conditions. While a superficial look at GDP statistics and Federal spending might indicate to some that this is true, this proposition lacks both sound reasoning and valid evidence.

The recent increases in Federal deficits have certainly drawn funds into particular uses. However, these funds were already available for other private uses, such as private investment, mortgages, and other consumer credit. The Bush administration bid these funds away from these private uses, which arguably would have been better uses. The spending or Demand Side Economics point of view ignores the fact that the resources used by recent increases in military spending have alternative uses, and that there are always others competing vigorously for these, and all other resources. Great thinkers like Bastiat, J.B. Say, Ricardo, Mises, Hayek, and Hazlitt have been pointing to these ideas for centuries. All scarce resources have alternative uses, and since our incomes derive from spending on goods, there are never general deficiencies in spending throughout the economy.

My arguments raise legitimate questions. If the Bush administration is bidding funds away from private uses in credit markets, then why are interests rates so low? If there is sufficient spending in the economy, why did unemployment rise in recent years? The explanation lies within the alternative to spending theories: price theory. Carl Menger founded modern price theory when he developed the notion that exchange values on markets derive from marginal valuations by consumers in markets. Relative prices are what determine the overall efficiency of the economy. One set of prices in particular pertain directly to the trade cycle and unemployment, namely, interest rates.

The popular press often associates changes in interest rates with the Federal Reserve, and rightly so. By varying the rate of money supply growth, the Federal Reserve changes market interest rates. Interest rates are supposed to reflect the willingness of consumers to defer consumption. That is, people spend their income on more and less immediate consumption alternatives. By saving, individuals indicate a willingness to forgo some more immediate satisfactions for some less immediate satisfactions. Rational consumers will equate the expected marginal costs of forgone immediate consumption with the expected marginal benefit of increased less immediate consumption.

Each individual consumer has his or her own personal preferences concerning more and less immediate consumption. Interest rates in free credit markets reflect these preferences for timing consumption. Federal Reserve intervention causes actual interest rates to diverge from interest rates that reflect consumer time preferences.

The Federal Reserve has pursued an aggressive policy in recent years. It has expanded the money supply rapidly, thus driving interest rates below levels that reflect consumer preferences. This has surely had a good affect on GDP statistics. Non-residential investment has risen by 7.3%. and consumer sending, which had been predicted to rise 3.3%, is up by 3.8%. Consumer will spend more and save less when interest rates fall because the financial return on deferred consumption has fallen. Investors will invest more when interest rates fall because the financial returns on investment rise as the cost of paying back credit fall. Ludwig von Mises and Friedrich Hayek recognized this long ago. They also realized that this would lead ultimately to inflation and future recessions.

Mises emphasized early in his career that inflation caused economic discoordination.

As Hayek latter argued, the problem that we face is in how to get individuals to pursue their individual aims so that they are consistent with each other. As a general rule, each individual in a free society forms plans for their future. In order for the plans of many individuals to each fit with each other, each must account for what others plan to do. So, each individual must form plans that contain relevant data from the plans of others. Interest rates inform individuals of an important part of this data. If interest rates are too low, then consumers aim at more immediate satisfactions while investors aim at investing in longer range projects—projects that aim at less immediate satisfactions. Federal Reserve inflation puts the plans of investors at odds with the plans of consumers. This will register, initially, as an economic boom. Since resources are scarce, increases in both demand for consumer goods more immediately, as registered by the 3.8% increase in consumer spending combined with increased investment in satisfying less immediate consumer demands, as registered by the 7.3% non-residential investment increase, will ultimately lead to inflation, an end to the current (albeit nascent) expansion and a subsequent recession.

We have seen this all before. This is exactly what Alan Greenspan did a decade ago. He implemented an aggressive monetary policy to stimulate the economy. This triggered the boom of the 1990's. It also led to the need to end this boom, when it became apparent that continued monetary expansion would lead to increasingly high inflation rates.

There can be no doubt that many have endured real hardship in this recent recession. Inflationary policies will induce a boom, boost GDP statistics, and bring unemployment down rapidly. However, this will also lead to further discoordination in the economy, and another boom-bust cycle. We do not need monetary stimulation to the economy anyway. The desire of each for a better life drives the economy. Each spends their income on more or less immediate plans for consumption. This is all the stimulation that the economy needs, as consumer satisfaction is the goal that we have in mind when considering economic conditions. It is also the case that increased deficits merely redirect the use of scarce resources toward highly questionable ends.

Any emerging optimism regarding public policy and economic conditions should be viewed with suspicion. It is wrong to think of the use of increased deficits and expansionary monetary policy as ways of stimulating the economy. Larger deficits shift the use of resources, in favor of special interests. There are sound economic and ethical reasons to question the merits of these transfers. We should also view the policies of Alan Greenspan with suspicion. These are the same policies, from the very same Federal Reserve Chairman, that gave us the boom-bust cycle of the 1990's, and also the late 1980's.

We should also turn our attention to the critics of tax, spend, and inflate economics practiced by political authorities. In particular, Carl Menger, Ludwig von Mises, and Friedrich Hayek developed sound explanations concerning the importance of relative prices in determining economic conditions. Mises, Hayek, and Olson also developed sound arguments concerning the disruptive affects of governmental intervention. These explanations derive from the common sense of marginal cost-benefit analysis and have been borne out by history again and again. Embracing the free market means accepting its imperfections. It also means avoiding the large-scale discoordination and erosion of individual liberty that comes to us courtesy of political authorities, like President Bush and Chairman Greenspan.

  • 1. See Olson, Mancur The Logic of Collective Action. (Harvard University Press 1965) for a discussion of the general principles that bias policy in favor of narrow interests.

Contact D.W. MacKenzie

D.W. MacKenzie is an assistant professor at Carroll College.

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