Thursday, November 3, 2011

What we are looking at now

After the real estate and financial bubbles burst in 2008 there was an awful lot of denial, mainly by politicians and pundits but even among many government, business and academic economists who should have known better. (Of course, there were a few who even saw the catastrophe coming, but they were routinely dismissed). The truth all along has been that there was no easy way out from the Great Recession. Serious mistakes were made and somebody would have to pay, the only real question being who.

Government policy, monetary and fiscal, is basically up against the logic of the "misery index". For being quite crude the MI is remarkably effective at measuring the over all health of the economy. Invented in the 70s by economist Arthur Okun, it is calculated by simply adding the unemployment rate to the inflation rate. It tells us that there are basically three tracks the economy can follow after a crash, all bad, and government can pretty much choose its poison.

One track is to do little or no stimulus and let the economy fall to the very bottom with very high unemployment and liquidation of debt through defaults, business failures and bankruptcies. This course may seem to have little to recommend itself but savers would benefit from deflation and capital would be find its way most efficiently to new allocations. This leads, eventually, to the soundest recovery, (if insurrection doesn't happen first).

Another track is that of hyperinflation through very high levels of fiscal and monetary stimulus. This course also features rapid debt reduction but this time by devaluation rather than default. Savers are severely punished but more businesses stay afloat, consumer spending is stimulated and unemployment falls. This sets up the next bubble.

The third way is "stagflation", a middle course designed to avoid the worst extremes, but only the worst extremes, of the other options. Debt reduction is slow with minimal defaults, favoring creditors. This comes at the cost of delaying eventual recovery and there is some permanent residual weakness due to prolonged unemployment. It is what we are looking at now. 

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