An Economic Newsletter

For the New Millennium

 

Produced by the New Economic Paradigm Associates

Donald R. Byrne, Ph.D.

Edward T. Derbin, M.A., M.B.A

 

(Volume 2003: Issue 1) August 6, 2003

 

 

Note: To print a hard copy of this newsletter, click on the following link for a PDF download…

Newsletter volume 2003 Issue 1 Complete.pdf

 

 

 

What Recession?

 

I am constantly amazed by students and the public at large when they ask about the recession we are in.  Of course as the data from the Bureau of Economic Analysis shows in Figure 1, we are not in a recession and have not been for over one and one-half years.  As you can see in Figure 1, the recovery began in the fourth quarter of 2001 and has continued through the first quarter of 2003.  All indications are that when the data of the third quarter of 2003 comes out, it will show that this last quarter was a continuance of the recovery /expansion. 

 

(Parenthetically, after over one and one half years of recovery, the exalted National Bureau of Economic Research declared that the recovery had begun in November of 2001.  There is nothing like timeliness to add credibility to an organization’s pronouncements.) 

 

 

Data from Bureau of Economic Analysis, National Income and Product Accounts (U.S. Dept of Commerce)   

 

 

 

 

When I tell my students that and show them the data, they invariably wag their fingers at the unemployment figures.  I then distinguish between the cyclical unemployment, of which there is very little, and structural unemployment, of which there is a significant amount.  Structural unemployment is the flip side of rapid increases in labor productivity that result from restructuring.   The old jobs are gone and will not come back with expansion; new jobs must therefore be created.

          

To a great extent, these increases in productivity are a result of restructuring.  This increases the competitive ability of firms.  It tends to lower their unit labor costs.  Unfortunately for society, the productivity dividend to the public at large does not occur until the structurally unemployed are re-deployed into new jobs, sectors, etc., producing additional goods and services.  None of this was possible before the restructuring occurred since the redundant labor was buried in the cost of the given product.

 

We need a stimulus, not to recover from a recession, but to reap the productivity dividend by re-employing the structurally unemployed in newly created jobs.  As the New Paradigm argues, we can experience a faster real rate of economic growth without serious inflation re-emerging.  Let us hope that the Federal Open Market Committee (FOMC) has learned a lesson from the ill advised policies of 1999-2000.  The greatest defense against inflation is significant competition in the market place.

 

 

Data from Bureau of Economic Analysis, National Income and Product Accounts (U.S. Dept of Commerce)


THE NEW PARADIGM

 

In my public presentations, going back a few years and in my classroom lectures, I began to find the existing macroeconomic analysis of increasing irrelevance.  That analysis is usually referred to as Keynesian demand side macro.  I had similar misgivings about monetarism and its explanation of inflationary episodes.  It seemed that the economic landscape had been gradually evolving and a new perspective was needed.   As I argued several years ago, and has become increasingly apparent of late, the gradual increase in the strength and pervasiveness of competition has been causing profound changes in product and resource markets.  It appeared that firms in a growing number of industries were losing their price power.  Resources such as labor were experiencing declining job security.  Terms such as globalization, privatization, deregulation and commoditization were seen more and more in the literature of business.

 

As economic analysis has always argued, the presence of increasing competition reduces the ability of business to raise revenue by raising price.  As Alfred Marshall pointed out many years ago, that when firms face little competition and thus have monopoly power (when demand weakens), they do not cut price, they cut output.  When John Maynard Keynes developed his new paradigm, published as his GENERAL THEORY (1937), its centerpiece was the downward inflexibility of prices, caused by declining competition in markets. As I point out in Chapter 12 of my text, THE NEW PARADIGM IN ECONOMICS, downward price rigidity in markets due to lack of significant competition causes a bias toward frequent and severe episodes of inflation and recession.  Prices will rise but rarely fall in markets with little competition; an inflationary bias results.   The U.S. was experiencing the growth of cartelistic capitalism from the late 1800s through the Second World War, in both product and resources markets such as labor.  The auto, steel, telecommunications, and lumbering industries all experienced the rise of “big labor” in the form of the UAW, USW, CWA, etc.

 

The markets no longer worked as argued in the neo-classical economic tradition. The late 1920s and much of the 1930s proved that prosperity was not just around the corner.   Keynes’ writings were really geared toward explaining the Macroeconomics of cartel-laced free market capitalism.  Incidentally, that era of cartelism began to decline after the Second World War.  Re-globalization or world trade was reborn with GATT and the IMF fixed exchange rate system.  Deregulation began and continues today.    The Hot, Cold, and Space Wars caused rapid technological change, undermining any efforts to control many markets.  Privatization continues to bring competition into areas such divergent services as garbage collection and education, all formerly the domain of government ownership.

 

We are increasingly experiencing an evolution toward competitive free market capitalism.  Growing competition reduces market power of both firms and the resources they employ.  As costs rise and profits decline, the old remedy of raising prices to increase revenue becomes less and less effective in raising revenue and restoring profits.  Economic theory tells us that as competition increases, price elasticity of demand at each price increases.  The rationality of price increases in terms of maximizing profits declines.  When competition increases, prices become more flexible downward as firms lose their control over pricing.  As prices become less rigid downward and firms have less power to raise prices, the inflationary bias weakens.  As firms lose their power to protect price by reducing output, and output cuts are moderated by falling prices, the recessionary bias is lessened.

 

This means that episodes of inflation and recession become less frequent and when they do occur, they are less severe in terms of duration and depth.  This moderation of the business cycle also logically means that past patterns of significant and prolonged periods of accelerating inflation like the 1970s are much less likely to occur.  The fears of inflation re-igniting in 1998-2000 were unjustified in the light of the New Paradigm.  Increased competition in many formerly cartelistic markets did not bring about the demand pull inflation characteristic of years back when the economy was experiencing strong and sustained growth.  A recent Ford Motors Economics Staff presentation at a DABE meeting showed that auto prices adjusted for content, have been drifting downward for many years, especially the last five years.  This is a far cry from the sticker shock years of the past, when two price increases per year were common.  Given the huge increase in market share of the transplants, and the corresponding increase in competitive pressures, the reason for the loss of price power by firms in that industry is apparent. 

 

Since the FED engineered recession of 1980-82, we have experienced only two mild recessions.  Bear in mind that FED policies in the 1970s were designed to allow adjustments for two massive oil price shocks, in the hope of avoiding devastating effects on employment.  Unfortunately this led to an inflation rate in 1979 of nearly 15 percent and an annualized inflation of greater that 20 percent in the last two months of that year.  The FED, under Paul Volcker, then made a one hundred and eighty-degree policy turn, and made eliminating inflation their number one policy goal.  Twenty years ago, the economy was less competitive than it is now. Fighting inflation when prices were more rigid downward resulted in a deep and relatively long recession.  Since then, more extensive deregulation, privatization, globalization, and commoditization have reduced a good amount of that downward price rigidity as competition has since become more extensive and significant in markets.  The reduced severity of the two recessions since then can be seen in the BEA data. The most recent recession, in the first three-quarters of 2001, was swamped by the recovery in the fourth quarter of that year, and positive growth for the 2001 calendar year over all.

 

 

 

  Data from Bureau of Economic Analysis, National Income and Product Accounts  (U.S. Dept. of Commerce)

 

 

 

WRONGFUL ECONOMIC POLICIES AND THE RECESSION THAT SHOULD HAVE NEVER BEEN

 

This last recession, short and shallow though it was, should have never occurred.  There are two smoking guns, so to speak, that caused it.

 

The first was the steady rise in the effective tax rate from 1993 through 2000 as can be seen in the chart (Figure 3).  In an Internal Revenue Service report in 2002, the IRS shows that effective tax rates, Federal Income Taxes as a percent of both Adjusted Gross Income and Taxable Income had risen each year from 1977 through 2000.  They go on to say that in the seven years prior to and including 2000, six of those years showed a similar rise in the effective tax rate.  Old Paradigm or New Paradigm, taxes depress the economy by reducing Disposable Personal Income.

 

In 1998 and throughout 2000, the FED through its spokesman, Alan Greenspan, kept saying that the growth rate being experienced could not be sustained without a significant re-igniting of significant inflation.    Furthermore, Greenspan cited irrational exuberance as causing an excessive growth rate in personal consumption.  A major culprit he cited was the Wealth Effect.  And in turn, a major cause of this the wealth effect was the suspicious growth rate in the stock market.  This should have warned all stockholders, institutional or individuals that stock prices had to suffer.  The inflation indices, especially the core rates did not really support such dire comments.

 

 

 

 

 

As the tax burden continued to rise, The FED (FOMC) began a policy of severe monetary constraint in 1999 continued it through 2000.  Give this two pronged constraint of fiscal and monetary policy, the economy began a collapse in mid-2000 and then turned negative in the first quarter of 2001 and stayed negative through the third quarter.  The Fed more or less said it was a pre-emptive action.

 

The lesson of the New Paradigm has apparently escaped the understanding of the fiscal and monetary authorities.  The threat of inflation is much reduced as competition became more pervasive and significant in many markets.  To make things worse, the power of monetary policy re revive an economy that it has caused it to fall into a recession, is indisputable.  That power is somewhat lessened in an economy where prices have become much less rigid downward.  The problem is that the FED’s power to revive an economy is much weaker than it is to slow it down.  Primarily through open market operations, it controls the capacity of depository institutions such as commercial banks to create money and credit.  Restrictive policies cause the capacity to create money and credit to grow more slowly than the demand for money and credit by the public.  This increasing scarcity of money and credit is what causes interest rates to rise.   But the FED cannot conversely force demand for money and credit to rise in a weak economy even when they attempt to flood the system with excess reserves.  Unless profitability in credit creation is there, monetary stimulus fails.  The power of the FED’s monetary policy is asymmetrical.  This is why the long string of the FED actions aimed at lowering interest rates has done little to bring us back to a more robust economy. Heavy tax rates also reduce the demand for credit.  Until more robust growth is achieved, the productivity dividend from restructuring is aborted.

 

To reflect this unfortunate reality, a new term has been coined, Duppies.  It stands for Depressed Urban Professionals.  Several former students of mine are among this involuntary cohort.  In an article by Haggin Geary, a CNN/Money staff writer, appearing on June 17, 2003 examples of the hundreds of thousands of former high-income individuals, once earning upwards of $200,000, are now lucky to earn $20 per hour ($42,000).  Many remain unemployed or have turned to entrepreneurial endeavors.

 

 

 

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