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My Narrative of the Current Economy

June 26, 2012

Russ Roberts’ response to Robert Samuelson prompted me to write the following:

Russ, your story is plausible as far as it goes. But I suspect that a problem with a magnitude as least as great as interference in the housing market is that of reliance on government promises that now appear cannot be kept.

Here is my narrative:

Sure, we have has productivity increases in the past 20 years, many of the those productivity increases made us able to supply the goods demanded by a population that thought it was richer than it was: granite countertops, plasma TVs, larger homes, evenn some environmental protection. People thought they were richer not only because they owned homes that were appreciating in value (and would keep on doing so), but also because they had a risk free retirement income in the form of Social Security, Medicare and generous government pensions to rely on in lieu of savings. Both of these led them to spend more on current consumprion than they would have otherwise.

Now, housing prices have fallen substantially and appreciation is no longer seen as source of future income. Similarly, people are realizing that government payments to various classes of seniors are likely to be cut because they can’t be supported without unsustainable tax rates on working people.

The result is to change people’s time preference pretty significantly. Items of current consumption are demanded less (e.g. a nicer car) and savings to support future consumption is valued more (to replace the government promises that now appear ephemeral).

So there are two aspects to our current malaise: a negative wealth effect and the effect of misinvestment in meeting demands for current consumption. There is no obvious reason to believe the consumer perceptions that drove these changes are flawed, so artificial props for demand (especially ones that further undermine faith in future government promises) are pretty clearly not the answer.

What to do?

The best thing government policymakers can do is institute credible reforms that make a scaled back set of future promises sustainable. To the extent this is credible people could again begin to make future plans with more certainty– and perhaps allocate more income to spending.

The big question for markets to answer is how to turn savings into mechanisms that will allow 2 workers to support one senior instead of the much higher ratios of the past. Some possibilities: robots, higher quality goods that require less maintenance. You would think the coming demographic changes would be spawning a frenzy of capital investment to substitute for a growing scarcity of labor.

Of course there are probably some problems with my narrarive, but it’s the best of those I have seen to date.


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