Why the United States Will Go Into Recession

By: Gerard_Jackson

If my email is anything to go by, there are a lot of worried and confused people out there. Basically most want to know why if the US economy is going to slide into recession. Of course it will. The question is when. I have to exercise caution here because I haven't had the time during the last couple of weeks to take a much closer look at the economic trends. Since Bush won the 2000 election the media has done nothing but report economic doom. For them, predicting a recession is bit like predicting rain a few weeks hence. They one will eventually develop, they just hope Bush is still president when this happens.

Let's start with a few current figures. The Institute for Supply Management Index for January stood at 50.7, up 2.3 from December, and was still expanding. For the same period production had increase from 48.6 to 55.2, a 6.6 per cent jump. The jump in the prices of inputs was particularly revealing having leapt by 8 per cent, up from 68 to 76. This rise is a clear warning sign of inflationary pressure. As we all know, the economic commentariat always focus consumption. Retail sales for strongly suggest that consumer spending is being maintained. Naturally, our commentators believe this will lessen the chances of a recession

If only that were so. It isn't consumer spending that we should be looking at but business spending . We have seen that manufacturing appears to be expanding. But this expansion is being accompanied by inflation. I believe the expansion the rise in prices are the result of Bernanke's loose monetary policy. At the moment the situation has the characteristics of the classic boom-bust cycle , meaning that indicators of recession will first appear in the higher stages of production rather than at the level of consumption.

What needs to be understood is that economics is a qualitative and not a quantitive discipline, meaning that mathematics cannot help to predict the timing of a recession. An Austrian economist can tell us that central bank policies have made recessions inevitable. He can do this because his analytical tools have shown him that money is not neutral and that forcing interest rates below their market level — which is what Bernanke is now doing — and expanding credit creates an unsustainable economic boom while creating malinvestments, investments that are not justified by genuine market conditions.

Anyone aware of these facts can only declare the inevitability of a bust but not the timing. However, once certain symptoms emerge, then we know that the bust is appearing on the horizon. One of those symptoms is not a stratospheric stock market — that is a boom symptom — but other symptoms that tend to be neglected because orthodox economics cannot account for them.

Now the real cause of confusion over the present economic situation has been caused by Keynesian economics and a lack of understanding of economic history which has misled two generations of economists into believing that tight labour markets cause inflation and a falling stock market triggers recession. The same people also argue that a reduction in consumer confidence and spending could also bring about a recession.

Unfortunately economic misconceptions have a tendency take on an independent existence. This is largely why Greenspan was credited by most economic pundits with cleverly using monetary levers to steer the US economy to prosperity while keeping a world-wide recession at bay. But is this so? These people point to the 1987 stock market crash and claim that Greenspan's 75 base point cut in rates in response to the crisis averted a recession. I don't think so.

Movements in share prices, no matter how sudden or severe, cannot in themselves cause recessions. The 1987 crash was a necessary correction, though overdone, in response to the previous slack monetary policies. The reaction of central banks in pumping up the money supply to ward off another "Great Depression" set the stage for another monetary tightening which in turn led to another recession that cost Bush 41 to lose the presidency.

The Fed then held down rates a gain to escape the US banking crisis of the early 1990s, which it helped create in the first place. It then, according to the economic folklore of some, tightened monetary policy through 1996 to 1998. This is not so and confuses any rise in rates with monetary tightening. What matters is whether those rates were below market rates. I would argue that given the size of monetary growth they definitely were. Moreover, the Fed then followed with three rate cuts in 1998. This policy has generated a monetary growth that caused the Fed to flag rate rises. This led to the emergence of the 75-base-points myth, which, according to past evidence, is what was needed to take the heat out of the economy. The plain fact is that no one could possibly know by how much rates should have risen.

But these monetary shenanigans would never have taken place if the major players were genuinely acquainted with the economic history of America between the wars and understood the monetary and real forces that were unleashed by the Fed. The 1920s experienced very tight labour markets, comparatively stable consumer prices and high productivity — though most of the productivity gains occurred in the first part of the decade — yet the country still collapsed into a severe depression. What is not generally recognised is that the period was one in which the Fed's monetary policy was one of credit expansion that artificially lowered interest rates.

The effect of 'cheap money' policies is to cause a stock market boom. When the boom goes off the boil then that's the time to worry. However, many argue that a rise in stock prices is only reflecting realistic profit expectations. As an example, in his book Against the Gods Peter Bernstein reminds us that when the Dow Jones Industrials returned to their 1929 level in 1955 many sold, believing that a crash was imminent. They erred. This is called drawing the wrong lesson from history.

Historical facts have to be interpreted, not parroted or treated as a crystal ball. What these investors overlooked is that the American economy of 1955 was much more capital intensive and productive than in 1929 and that is why the share prices were justified. In other words, income streams justified the share valuations.

By Gerard Jackson
BrookesNews.Com

Gerard Jackson is Brookes' economics editor.

Copyright © 2008 Gerard Jackson

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