Yes, we are in the earliest stages of an economic rebound from a bad recession, one of the worst since the Great Depression. Unlike the last hard economic downturn, which occurred at the outset of the 1980s, this one was not induced as a cure for a spiraling inflation that had created economic stagnation. The one through which we have just lived is more pernicious, the result of complex forces that had been building because of monetary, fiscal, and regulatory policies converging with an increasing reliance in the private sector on debt-driven growth.
We still have considerable work to do to repair, reform, and modernize financial and public institutions, but we also must do the same, to the extent that we can, in our own lives, relying less on debt and demanding more of both ourselves and of the public sector that expects more and more from us.
In these very tentative steps of the newly born recovery, the numbers will waver between bad and good, and on some days it will sound from the news stories like we're still in a recession. The oddest part will be that some of the bad news will actually be good news, at least for the long run, and some of the good news might be cause for concern.
Unemployment is as high as it has been in 26 years, and it is not likely to fall significantly for some time to come. Believe it or not, that's good news, if "good" can mean continued hard times for millions of Americans. No one is expected to cheer if, in the months ahead, news analysts keep talking about stubbornly high jobless rates, but a sluggish rebound in the jobs market could very well be the engine for a sustained period of robust economic expansion down the road.
The Great Depression ushered in a Democrat, Franklin D. Roosevelt, as President of the United States, and with his administration came a new kind of economics, set forth by a man named John Maynard Keynes. We call his economic policy prescriptions "Keynesian economics," and greater or smaller parts of it have been used by both Democrats and Republicans ever since. In theory, the policies distill down to some relatively simple ideas. In recessions, the government should run deficits by cutting taxes, spending money on jobs programs, helping the poor and unemployed, and generally stimulating the economy. In boom times, the government should pull back on all the fiscal stimulus by raising taxes to keep the economy from running too hot, pay off the federal debt, and build a surplus; and the government should back off all the jobs programs, big benefits, and grandiose public projects, at least to some extent.
This is called "countercyclical policy," and although it has had an unfortunate bias toward stimulus even in good times, it has unquestionably served to greatly shorten the boom-bust business cycles, make recessions much milder, and cause the periods of expansion to be considerably longer by comparison.
It has a dark side, though, and even Keynes, himself, described the crucial nature of this part. He noted a phenomenon he called "sticky wages," the tendency of compensation to labor to lag behind rising consumer prices and rewards to other factors of production. This stickiness is important because, if prices are rising all around people, but their incomes are not going up in lock step, they will have to work longer and harder to maintain their lifestyles, and it is this accelerating productivity that will propel the economy into a period of expansion without inflation being fed by rising wages and salaries.
That means, if we see the unemployment rate falling too fast in the coming months, the economic recovery will be clipped off before it gets momentum, and here's why. A recent statistic released by the government showed that business inventories are falling, and if this trend continues, companies will have to start boosting output levels to restock. If they do this with their existing workforces and maybe a modest increase in new hires, the workers doing their jobs will work harder, and the companies will see their profit margins start to improve as the inventories are sold; but if the companies have to hire lots and lots of workers to rebuild inventories, competition for qualified workers will heat up, and companies will have to start bidding up wages and salaries.
A rapidly falling national unemployment rate will sound like good news at first, but once wages and salaries start catching up with other rising prices, that means inflation will have begun to take on a life of its own because those rising compensation levels will give households more money with which to buy goods and services, and the increasing demand pressure will start to push prices at the consumer level up even more. Making things even worse, that building demand by households for goods and services will induce businesses to hire even more workers to keep up with the demand that's clearing inventories at an increasing rate.
More workers being hired means more wage and salary increases, which means even more demand for final goods and services, and the cycle begins to take on a self-feeding inflationary aspect.
But all of that is only the prelude to the real problem because inflation, as mean and annoying as it is, pales in comparison to its muscular after-shock, which is expected inflation.
The central bank of the United States is called the Federal Reserve, or the "Fed" for short, and one of its most important responsibilities is to conduct monetary policy. If it allows the growth rate of the money supply to exceed the real growth rate of the economy, that so-called "excess liquidity" will eventually become inflation, since each dollar's value will be watered down, meaning more dollars will be required to buy things. When the Fed wants to help the government pull the economy out of a recession, it will print money at an unusually high rate and use that money to help fund the government's deficit spending. Done right, the Fed can then drain that excess liquidity back out once the economy gets back on its feet. But therein lies the tricky part: interest rates are the "price" of money, so if the Fed, in its effort to prevent inflation, reduces the supply of money too fast, interest rates will rise too much and too quickly, and the economic recovery will be killed in its tracks. We've probably seen this happen in the past. The result is called a "double-dip recession."
On the other hand, if the Fed acts too slowly to claw the overhang of dollars out of the economy, the inflation lingers long enough for both businesses and workers to start expecting it, which means everyone will be pushing up their prices because they want to get in front of everyone else pushing up their prices. This makes the Federal Reserve's job of stopping inflation quite difficult: not only does it have to drain the excess liquidity, but it also has to hold the choke for a while longer to convince businesses and labor that it is serious.
That was what happened in the recession of 1981-82: years of expansionary monetary policy had caused inflation to get so severe by the end of the 1970s that no one believed the Fed would finally deal with it once and for all. So when President Jimmy Carter appointed a tough guy named Paul Volker as Chairman of the Federal Reserve, Mr. Volker had to throttle down the money supply fast and hard, which drove interest rates through the roof, and he had to hold the money supply down for months and months until not only was all the excess money drained out of the economy, but also the entrenched expectations of inflation were flogged out of planning by businesses and labor.
As a side note for history buffs, Jimmy Carter was defeated in the presidential election of 1980. Therein lies a cautionary tale for our current President, Barack Obama: it's good to do the right thing, but if there's going to be pain involved, it's better to do it considerably before voters go to the polls. Unemployment isn't just for the private sector.
Returning to the present, we have a large overhang of dollar liquidity swirling through the economy. Some of this is the result of recent Fed activity to support the economic stimulus package enacted earlier this year, but a huge amount is the result of years of expansionary monetary policy to help pay for year after year of federal budget deficits. The Fed has to drain that liquidity out because it will be the fuel for a spiraling inflation. If the Fed starts that grim work too soon, interest rates will rise rapidly, and the U.S. economy will nose over back into recession; but if the Fed waits too long, seeping inflation will become a flood as unemployment drops too quickly, causing wages to join other prices going up, and the economic recovery will evaporate into a spiral of inflation that will push up every price, including the price of money, which is interest rates.
Inflation-driven increases in interest rates will stagnate the economy, and we will again have, as we did at the end of the 1970s, a bad economic situation called "stagflation," for which the only cure is the old-time gospel of tough, sustained, contractionary monetary policy, which will drop us into another painful recession.
Is this the inevitable path of the current economic recovery? Certainly not.
As long as the unemployment rate drops slowly, the Federal Reserve will have time to keep interest rates low for a while longer to let the economy get back on its feet, and as long as the Fed's eventual pattern of draining the excess dollars out of the economy is carefully planned and not the result of panic-driven work to stop an already-building inflation spiral, we can have a recovery that becomes a genuine economic expansion with reasonably stable prices, sustainable growth in American jobs and, with that, more tax revenues to help close the large federal budget deficits we are now running to get us out of this recession.
It might require the proverbial wisdom of Solomon for our leaders in Congress, the White House, and the Federal Reserve to execute the necessary economic policies at just the right times, but we must hope they know what they are doing and have the will to carry through with their responsibilities.
While the road ahead for American workers may be difficult for some time to come, a sustained economic expansion serves not just our own interests, but those of the generations that will benefit after us.
As much as we want a solid foundation upon which we, ourselves, can stand, we must also appreciate that we are building a bridge to the future for our children. That bridge should be not only strong enough to support their needs, but also wide enough to accommodate their hopes.
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