A Little Lesson in Economics
The predominant school of thought prior to the 1930's was the Classical Theory of economic cycles. Many believed that the economy was inherently stable. Government intervention was an unnecessary part of the economy. It was believed that the economy would adjust in periods of economic downturns by lowering prices and wages and thereby produce new periods of growth by producing the demand necessary to sell all products. It based its theory on the ability for prices to be flexible enough to make sure that all supply would be sold and no one would loose their job.
Marx had a different approach to the capitalistic economy. He maintained that not only was government intervention unnecessary, in the end, neither was government itself. Marx stressed that a capitalistic society exploited workers for the good of the capitalists, those who owned the means of production. According to Marx, this situation would exist until the exploited working class revolts against their oppressors, the capitalists. A socialistic interim system would be created to eventually create a system where only one class would exist. Everyone would share equally in the production output and the government would be abolished. Obviously, Marx's theories have failed miserably in Russia, Cuba and even in China. The socialist interim never gave way to the stateless environment.
Yosef Schumpeter envisioned an economy whose growth was propelled by the entrepreneurial spirit. He argued that entrepreneurs created a new supply of goods that consumers would accept to upgrade their standard of living. This new supply would drive a new cycle of expansion. The new goods inherently make the older ones obsolete and thus creates demand for the new ones. (It can be argued that this is the kind of process that is currently occurring with personal computers. Manufacturers and software makers continually create products that need better and better computers; thereby creating continued demand for newer and better personal computers.)
Schumpeter believed that continuous entrepreneurship was necessary to drive growth. An entrepreneur who was only satisfied in selling his existing product would soon find his product displaced by a better product from a competitor, thereby creating more growth. He also acknowledged that the lack of entrepreneurs in any generation would lead to the deterioration of growth. Schumpeter also made clear that credit was necessary in order for innovations to be realized. Without the availability of capital, the entrepreneur could have a difficult time getting the initial resources to launch a new product.
The collapse of the U.S. economy in 1929 proved to classical theorists that their self-adjusting principle was flawed. This flaw wasn't immediately recognized (economists hate to admit mistakes), and while the early 1930's was failing to produce the “self-adjustment”, John M. Keynes was developing an alternative view of the economy. This is a view that is coincident with the U.S. economy today.
Keynes saw the Great Depression as an inevitable outcome of an economy that allows itself to self adjust. Keynes believed that the driving force to economic recovery was demand. If the consumer couldn't create the demand, then it was the government's responsibility to create it. He believed that “policy levers” (like those used by the Federal Reserve today) were necessary by the government to either create demand or to slow down a rapidly expanding economy that could lead to inflation.
Today, the U.S. economy is in a state that by now, under historical measures, would have produced inflationary pressures. The so-called NAIRU, the nonaccelerating inflation rate of unemployment, was accepted by both the Clinton administration and the Federal Reserve to be in the range of 5.8% and 6.5% [in the early 1990's]. Unemployment rates below this would spur inflation – or so was the belief. The Federal Reserve raised interest rates from February 1994 to February 1995, in part, because the unemployment rate had reached the NAIRU. However, the Fed quickly realized that inflation was under controlled despite the continued drop in unemployment. It accepted that lower unemployment was not leading to inflation and proceeded to lower rates.
It is possible that some of Schumpeter's thoughts are at play in our economy today. The wide spread use of computers may have contributed to efficiencies that allows a new rate for NAIRU, or possibly that the NAIRU doesn't exist at all. The entrepreneurial spirit that brought about the wave of personal computers and increased computing power has provided a large period of growth.
Furthermore, a globalization of economies has produced the capacity infrastructure to supply the global economy with larger amounts of natural resources. When some of these economies were in recession, the resultant supply of natural resources had become abundant, thereby lowering prices and contributing to the low inflation environment in the economy that uses a large portion of those natural resources, the U.S, even though consumer demand was high.
The U.S. economy has surpassed the length of the February 1961 to December 1969 expansion. The early 1970s recessions that followed were, in part, brought about by the inflationary forces of an oil embargo. By historical measurements, the U.S. economy seems to be closer to the end of its economic cycle rather than its middle. Will an external event, such as the Y2K computer problem, be the catalyst to initiate a recession? Or will continued reinvestment in changes and improvements in technology continue the expansion? Whatever the outcome, the Federal Reserve and policy makers have their hands full trying to figure out an economic cycle that is creating new historical precedence.
Note that one way to stimulate an economy is to cut taxes…I'll repeat this again….One way to stimulate an economy is to cut taxes [a way of government intervention]. In case any lawmaker forgot, we are in the longest economic expansion of modern times. Many can argue that the economy is over stimulated right now – from stock market gains, etc. If one part of the federal government does something to further stimulate consumer demand (a massive tax cut), another part of the government will move to counterbalance such a stupid move (raise rates)….THAT WAS THE REAL WARNING THAT THE FED DELIVERED THIS WEEK.
Now with this comes a bit of uncertainty…and we all know that the market doesn't like such company…so we have an event that will help to put a lid on any advances, especially since the earnings news is now in the past (for 2-1/2 months, at least).
Alan Greenspan also mentioned another important fact. The best way to further reduce interest rates in this country is to reduce the supply of treasury bonds, i.e. pay down some debt.
Paulo
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