Last Friday, the University of Michigan announced a concerning consumer sentiment index of 54.9 for August, a significant drop from 63.7 in July. This marks a troubling low in consumer confidence that hasn’t been witnessed since May 1980, during a tumultuous period in the White House under Jimmy Carter.
Clearly, there are numerous factors contributing to this grim outlook. Elevated unemployment rates, stagnant or decreasing real wages, and a sense of disillusionment with governmental leadership are just a few reasons for consumer concerns. But what does this latest reading on consumer sentiment actually indicate?
Generally speaking, negative consumer sentiment tends to result in decreased consumer spending. In an economy where spending accounts for 70% of the GDP, any decline in this area could hinder growth or even lead to contraction. From our perspective, it appears the economy is beginning to weaken.
Of course, we could be mistaken. Such trends often take time to materialize fully. However, looking back a decade from now, it may become unmistakably clear that the fluctuations in the economy observed in the summer of 2011 are merely a continuation of the Great Recession. In fact, it may be evident that the Great Recession never truly ended—that all the bailouts and stimulus efforts only postponed the inevitable collapse while increasing our national debt.
Regrettably, this is the unvarnished truth.
Financial Crisis vs. Economic Crisis
The harsh reality is that the U.S. government has amassed too much debt. They have excessively leveraged the economy to finance current promises with borrowed funds intended for the future.
Consequently, the nation is on the brink of a monumental financial crisis that will make recent turmoil seem trivial. To mitigate or avert a significant financial meltdown, the government must address its debt—this process is known as deleveraging. However, efforts to minimize future financial catastrophes could exacerbate economic issues in the present.
Clearly, the government can reduce debt by cutting spending. Alternatively, it can increase taxes. However, both strategies are likely to inflict economic pain, leading to rising unemployment and stagnant growth.
In the United States, a substantial segment of the economy has become dependent on years of escalating government expenditure. Reducing this inflow of cash would have immediate detrimental effects. Over time, though, the economy would adjust and benefit in the long run. Yet, the short-term consequences of slashing government spending would be painful.
Similarly, boosting taxes stifles economic growth by diverting private investment into the ever-expanding maw of government bureaucracy. While higher taxes might assist in deficit reduction, they can also hinder economic progress. A smaller economy burdened with high taxes may be more detrimental to the government’s financial situation than a larger economy operating under lower tax rates.
Ideally, the government needs to find a way to deleverage its balance sheet without disrupting the economy. Achieving this would be a remarkable feat, and we’re not very optimistic about its feasibility.
On Driving the Economy into a Brick Wall
To rectify the nation’s financial situation, the economy needs the freedom to correct itself. Clearly, cutting or eliminating government spending in certain sectors will only deepen financial woes. As the economy contracts, tax revenues will decline, exacerbating the debt crisis. Yet, attempts to prop up the economy led us to our current stagnation and overwhelming debt burden.
At times, a change in direction is necessary—even if that means heading directly into a wall. In the 1970s, as unemployment began to creep higher, the U.S. Treasury, supported by the Federal Reserve, followed Keynesian principles and invested heavily to stimulate job creation. Instead of job growth, they faced an unexpected surge in inflation. When they tried again, they encountered even more inflation without the anticipated jobs.
Respected economists were confounded. According to the Philips Curve, inflation should inversely correlate with unemployment, making the observed trend impossible according to their models. Yet, despite their theories, both inflation and unemployment skyrocketed.
In August 1979, Paul Volcker stepped in as Chairman of the Federal Reserve. He was unique in his resolve to prioritize economic stability over political expediency.
Volcker was forthright and assertive. He understood that before any genuine economic recovery could occur, inflation needed to be controlled—despite the short-term consequences for unemployment. Enduring immense criticism and being pilloried by some, Volcker took drastic measures.
He raised the federal funds rate from 11.2% in 1979 to a staggering peak of 20% in June 1981, which drove the prime rate to 21.5% and plunged the economy into a brutal recession. Astonishingly, for two long years, while interest rates rose, inflation persisted. However, by 1983, inflation was brought under control, paving the way for renewed economic growth and a drop in unemployment.
Today’s challenges mirror these past dilemmas. To bring the nation’s financial matters into order will require tough decisions that may momentarily harm the economy. It will necessitate a strong political resolve to cut spending, even when such actions may worsen current conditions.
Unfortunately, we are not optimistic that Congress will find the courage to take these necessary steps. Rather, they will likely continue to defer action, ultimately leading the Federal Reserve to resort to printing money to manage the debt. The eventual fallout could be devastating for the entire financial system, leading to greater societal turmoil.
Sincerely,
MN Gordon
for Economic Prism
Return from On Driving the Economy into a Brick Wall to Economic Prism
