The Four Percent Solution

There are many observers claiming to know the solution to the financial and economic crisis that befuddles even the best and brightest. It is pretty straight forward, they say, until the politicos muck things up. The solution will be painful and in modern democracies, politicians tend to sugar-coat the issues for fear of joining the unemployment queues themselves.

At its core, the financial crisis and steep economic downturn are the proverbial chickens coming home to roost. To change metaphors, it is time to pay the piper for the years of Americans living beyond their means. To what extent do Americans live beyond their means? There is a generally agreed upon metric that captures the gap between savings and investment. It is called the current account deficit. That gap is a little more than 4% of G.D.P.

They state the solution is Americans cutting back consumption by 3%-4%. Before the crisis hit, consumption accounted for nearly 70% of GDP. This is well above other industrialized countries and is not sustainable. Politicians are reluctant to deliver the bitter truth to American voters: they need to lower their living standards and reduce future expectations.

This will require a major transformation of America. No more shop until you drop. The economy has dropped. No more super-size me. Less is more. No more living far away from work and commuting in to a metropolis. Re-urbanization is needed and greater use of public transportation. Forget the American dream of a better life your children. We have squandered their inheritance. Home ownership is not for every one. Renting is not so bad. Retirement? We are healthier and living longer than ever before. Forget about going fly fishing and golfing when you are sixty-five. The fish and the links will still be there when you are seventy.

This all sounds reasonable, even if unpleasant. Many of the brightest minds seem to concur. Yet it is disturbing in its simplicity. It places the blame for the crisis on American households. It seems that with over 1.5 million laid off in the past three months and many of the fortunately employed facing pay cuts, Americans are more victim than culprit of this crisis.

Doesn’t the crisis have something to do with the incentive structure in the financial sector that encouraged excessive leverage? Isn’t this crisis inconceivable without the incredible leverage and risks that banks took with OPM—other people’s money?

GDP = C+I+G+ (X-M)

This is the economists’ equation of the gross domestic product, the sum of all the goods and services that are produced, broken down by how they are in turn consumed. If consumption (C) is excessive, what is being suppressed? Surely not government sector (G), which even prior to the crisis, absorbed more than a third of GDP in the US. Exports (X) were running at record levels, and they largely reflect foreign demand. By elimination and by explicit declaration, it is investment (I), which needs to be boosted they argue. This could be done, they say, through various tax cuts for corporations. Essentially, American households need to reduce their consumption and boost their savings, which is the pool for investment.

Not only is this diagnosis of the problem mistaken, but the proposed solution is misguided. Over the last quarter of a century, as President Obama argued in his first press conference, there have been a number of corporate tax cuts and very little investment was forthcoming. And for good reason. There is excessive investment. Technological advancement and consequential productivity growth means we produce more than we can consume.

CSM Worldwide estimates that the world’s automakers can produce 90 million cars a year, but are only producing a little more than 65 million. As 2008 came to an end North American auto plants were running at 70% capacity. Yet because of technological advancement the automobiles which are being produced have more computer chips than the lunar module that landed on the moon, this example may be too old-school, too low tech for some.

Then consider semiconductor wafers. The market research company iSuppli estimated that the fabrication of semiconductor wafers is utilizing 62% of its productive capacity. In the first quarter of 2009, some 9,260 wafers are being produced a month, while capacity exists to produce 14,930.

Prices are telling the same story. US consumer prices fell at a 13% annualized rate in the last quarter of 2008. Yet not all prices are falling. Excess capacity, which is an expression of over investment, is evident in goods prices which fell 4.1% in 2008. The capacity in the service sector is more difficult to measure, but prices for services rose 3% last year.

Insufficient Aggregate Demand

Before Milton Friedman and Anna Schwartz’s “A Monetary History of the United States 1867-1960 (1964), which Federal Reserve Chairman Benjamin Bernanke has endorsed, and emphasized the role of money supply and credit, the competing theory of the cause of the Great Depression focused on insufficient demand, which is the other side of the excess capacity from surplus investment coin.

Boosting savings to increase investment can do nothing but exacerbate this problem in a profound way. Investment would increase our capacity to produce goods. It would not necessarily increase employment significantly. Contrary to the allusions to the de-industrialization of the United States, before the crisis, it was producing more goods than ever.

Even at the end of 2008, a year into the official recession, industrial output was more than twice what it was at the end of the last crisis in the early 1980s, with about 30% few workers. What has become de-industrialized is the American workforce. America creates more white collar than blue collar jobs.

Let’s suppose though that historic experience of corporate tax cuts not leading to an increase in investment is broken, and investment rises. Then what? Capacity has been increased, thus per unit cost of production falls, and the increasing competition leads to intensifying the deflationary forces in goods prices. It may also encourage countries to pursue beggar-thy-neighbor policies, seeking currency devaluations to export their surpluses.

Once Bitten

Once bitten from Tree of Knowledge, there is nothing to do but to keep eating. Once the productive forces have been unleashed, the juxtaposition of means and ends takes place. Rather than produce goods to consume, as was the case in the early days of capitalism, now we must consume more goods to meet our growing production.

We cannot count on investment to lead us out of this crisis. That sector has not led us out of economic crisis or cyclical downturns since before the Great Depression. The choice is really between the consumer and government to spur economic growth. This is not to say that the choices are easy or pleasant, but they are the choices.

While household consumption can be directed away from resource and energy intensive goods, government consumption will ultimately need to rise and absorb the incredible productive capacity.

The real imbalance is not the US current account deficit or gap between savings and investment. It is in our ability to produce more than we can consume. The 4% solution that is being offered instead of the increased government role in the economy will exacerbate this key imbalance. The resolution is not cutting consumption. The resolution is not boosting productive capacity. Rather, the solution will lie with putting the consumption on better fiscal footing, which means boosting incomes instead of credit scores. The solution will also lie with the government consuming or financing a greater share of G.D.P.