What is Really Wrong with the Economy?

The “Hair of the Dog” is Delaying our Economic Recovery

Have you ever been out on the town and had way too much to drink? So much so that when (if) you wake up the next morning you feel so bad that no matter what you do, it seems the only way you will ever get better is to die? Well, that is what happened to our economy. The reality is that there is nothing wrong with the economy. It is simply temporarily reacting to the overindulgent abuses we’ve heaped upon it through our irrational misbehavior.

Don’t get me wrong, drinking alcohol is not a bad thing. Doctors even suggest that moderate consumption of alcohol (especially red wine) can be good for one’s health. But drinking too much can often be a problem. That is the reason why regulators require alcohol companies to put “drink responsibly” in all their ads. If we were to follow that rule and drink responsibly (we may not have as much short-term fun), we would never have to deal with the pain of the dreaded hangover.

If those who impact our economy – business, government and consumers – had been constantly warned to “act responsibly,” our economy would not be suffering the painful hangover it is now. But unfortunately the hedonistic message was to “party”—not to be responsible.

In the aftermath of acting irresponsibly — both fiscally and drinking immoderately — we are tempted to speed the return to normalcy by a shot of the “hair of the dog.” In a drinker’s parlance, that means consuming alcohol (typically a Bloody Mary) to reduce the pain of a hangover. For politicians, the superstition is to pump money into the economy to make things feel better. In either case, however, the result is more wishful thinking than established fact.

Economics 101

The cardinal rule among economists is that availability of capital is essential to the growth of an economy, and in difficult times, some reasonable amount of capital infused into the economy can jump-start and stimulate a recovery. Politicians, who need a strong economy to maintain they place and power, are only too happy to follow this rule. The problem is that in perilous times, such as the current recession, politicians often become drunk with power, and they can infuse to excess.

For most of our economic history the vehicle used to infuse capital for growth or to withdraw capital from an overheated economy has been the tax system. The theory was that reducing taxes would leave capital in the private sector that would be used to stimulate the economy. The belief was that, even with lower tax rates, the new growth would create revenues sufficient for government to cover the cost of the tax cuts. By the same token, it was believed that when the economy was overheated to an extent that caused damaging inflation, the solution was to withdraw capital – through higher taxes or increased interest rates – from the economy.

The first actions of Presidents Kennedy and Reagan – a Democrat and a Republican – both of whom entered office with the economy in the doldrums was to push for tax cuts. When Richard Nixon was in office he sought to control an unstable economy by raising taxes. President Carter attempted to control runaway inflation by allowing interest rates to rise to over 18 percent. To some extent, each of these actions achieved its objectives.

Then came the 1990s and the new millennium when the politicians came to believe that if a little capital infused into the economy stimulates growth, then a lot of cheap capital could produce boom times forever. This worked for awhile, but the “dot-com” crash of 2000 should have been the canary in the coal mine. It was, but we didn’t listen.

In an attempt to continue the party time attitude, the Bush administration, with the complicity of Congress, pushed through the largest tax cut in our history and reduced the cost of capital to virtually zero. (Worse, at the same time huge amounts of capital were being artificially pumped into the economy by the costs of two wars.) For a while these actions certainly created party time for the economy. But just as too much booze turns party time into pain time, so too the actions of government to make too much cheap capital available turned good times into bad times.

The actions of government allowed – indeed encouraged – businesses and consumers to take irrational actions that could not be supported by the reality of the core economy. In essence, the good times were on borrowed time, because they were supported by borrowed money. Companies and consumers went into hyper growth and consumption, not because of capital they had earned or saved, but on borrowed money. Banks made irrational loans because the government continued to dump virtually free money into the system and in many cases even guaranteed the loans. Companies made irrational investments because they lost respect for the value and cost of real capital. Consumers made irrational purchases because of the assumption that their investments (401K) and the “equity” in what they buy (homes) will multiply ad infinitum. The party had to and did end. And just as binge drinking leads to a painful aftermath, we now know that binge borrowing does the same.

The Politicians Continue to Chugalug

Companies and consumers seemed to have learned their lesson, but unfortunately the government has not and that is the real reason we continue to be mired in a sluggish economy.

A hangover is debilitating and painful, but in time our body will recover. That is, unless we continue to indulge in the same things that made us sick in the first place. When the party came to an end, the reaction was not to let the economy heal itself, but to bail out the most egregious offenders and to pump more capital (aka, stimulus) into the system. This action dulled the pain of the hangover, but is a short-term solution that does not repair the core of the economy.

People are worried about the value of homes. They are wishing and waiting for them to return to what they were before. The have a long wait. Today’s values are real. The “values” of yesterday were artificial. The fact is the value of today’s homes are substantially higher than they were 15 yrs ago. If the economy had been allowed to naturally support itself and grow organically, we would be more than satisfied with today’s values. It is like the old story of the guy or gal we met in a bar who seemed so attractive when viewed through beer-goggles, but are what they are in the bright light of reality.

The same story is true for all elements of our economy. Instead of the business and government stimulating real growth through innovation and creativity, i.e. alternative sources of energy, government, business and consumers took the easy path to short term fun and now we are all paying the price.

And the Moral of the Story …

We’re not all are paying the same price. The important moral to learn in this economic calamity is not the price paid by those companies and consumers who have failed, but rather those who have survived and even thrived. The bulk of the companies and consumers who are suffering now are getting what they deserve. (The sad story should be reserved for those who have been harmed through no fault of their own.)

It you look at companies and consumers who have survived – even done well – in this economy they are those who did not fall prey to the excesses of the times. They did not take risks that could not be managed. For the most part, they financed their operations and growth with retained earning and reasonable leverage. They did not make loans to consumers with questionable credit. They did not buy a home they did not need or could not afford, simply because they could. They did not drain the equity in their home to buy things they did not need. They did not borrow money to make money.

In short, they didn’t over indulge. They acted responsibly. It is a good lesson for us to learn. There is nothing wrong with our economy that a little “rational exuberance” won’t cure.

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