Behind the numbers

You have a car and you're driving happily along the road on a trip. You enter a freeway and the sign says you can travel at 100kph (or 60mph in America), you put your foot down and accelerate your car to the speed limit. Your tank is full, it's a sunny day, paradise.

I reckon people think of Gross Domestic Product in the same way as a car.

It's simple. You calculate the current quarter's results, compare them with the previous quarter's results, adjust for inflation and voila! If the result is increasing then obviously everything is okay - the car is travelling well.

But I think one of the major flaws in this understanding is what is happening behind the numbers. In other words, what are the specifics?

I would class myself as a fairly conventional economist in this sense. I believe that balance is the essence of understanding how economics work, and that any imbalance will lead to problems.

Angry Bear, a progressive economics blogsite, has today released some rather disturbing figures about America's economy. While the post is ostensibly about President Bush's approval ratings, the author reveals the following statistics:

· U.S. household debt hit a record $11.4 trillion in last year's third quarter, which ended Sept. 30, after shooting up at the fastest rate since 1985, according to Fed data.

· U.S. households spent a record 13.75 percent of their after-tax, or disposable, income on servicing their debts in the third quarter, the Fed reported.

· The trade deficit for last year is estimated to have swollen to another record high, above $700 billion, increasing America's indebtedness to foreigners.

It was that second figure - households spending an average of 13.75% of their after tax income on servicing debts - that got my jaw dropping.

The fact is, of course, that America's economy is growing - but this growth is increasingly dependent upon borrowing. There's nothing wrong with borrowing of course, it's just when growth depends on borrowing year after year after year that problems arise. And the only way that America's economy can grow at the moment is due to its overseas borrowing.

Put simply, America thrives because of an overvalued dollar.

The fact is that America could easily thrive if the dollar was lower, and if the economy was geared towards production rather than consumption, and towards investment rather than borrowing. In fact, given America's level of overseas debt, it would help balance things out if America focused on these areas.

The easiest way to do this would be to increase interest rates and kerb domestic consumption. Although this would have the effect of raising the value of the dollar and making imports cheaper, the net effect would be a brake on consumption. Sectors of the economy which depend upon more international demand, such a manufacturing and mining, would not be directly affected.

A measured, gradual increase in interest rates and a deliberate slowing down of the US economy is actually more preferable than the current high-growth track being taken. Like any "bubble", the US economy is ever more likely to go bust the longer it stays headed in this direction, thus making the problem even worse. Every day that passes without America's economy going into recession will, strangely enough, make the inevitable recession worse.

But I feel that this solution - a measured and gradual increase in interest rates and a deliberate slowing down of the US economy - will not necessarily lead to a recession. It will lead to low economic growth (say between 0.5% and 1.0% per year), but this will ensure that the imbalances are worked out slowly and more methodically than they would if the market was simply allowed to determine when the correction takes place.

The alternative - which appears to be the track currently being taken - will inevitably result in a market correction. At some point, US businesses and households will reach a point where debt is so expensive to service that bankruptcies and defaults will result. There will also be a correction in the value of the US dollar and the Fed will be forced to quickly raise interest rates to keep control of inflation. Recession will inevitably follow.

Given that there are only two alternatives, which is more preferable? To wait for the inevitable correction or to act now to rebalance things? Given the current thinking going on in the White House and in the Fed, it seems that they have chosen the waiting game. Watch out America.

From the Osostrian School Department

© 2006 Neil McKenzie Cameron, http://one-salient-oversight.blogspot.com/

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