A Bubble Economy

The new dip in economic activity raises some excruciating questions. Is it merely an unimportant blip on the computer screen, a brief weakness on the way to a robust recovery? Or is it an early signal of more stagnation and unemployment? Could it be a symptom of fundamental debility rather than just a temporary relapse?

Establishment economists and their allies are convinced that the recovery is around the corner. The aggressive monetary ease by the Federal Reserve System, they assure us, has laid the foundation for a sustained recovery. After all, for more than three years the Fed has conducted a policy of monetary ease, making an unprecedented series of interest rate cuts. Short-term rates now are at 30-year lows. The banking system is flooded with excess reserves, and the Treasury deficit has soared to lofty levels. This massive application of Keynesian remedies, they are sure, is bound to achieve the long awaited recovery.

An old error is always more popular than a new truth. Old Keynesian axioms are more pleasing to spenders than the admission that this recession may be different from any other in the last fifty years. Indeed, it differs significantly as business profitability has fallen to alarming lows. A thick cloud of political hype is hiding horrendous economic and financial maladjustments which may paralyze the American economy for years to come. The United States today would suffer negligible unemployment and enjoy vigorous economic growth if the Keynesian prescription had its promised effect. Unfortunately, economic growth and prosperity are not and never were circumscribed by government spending, but by business profits and investments. The mainspring of economic life in a private property, individual enterprise order is business profitability; its regulator is business profit.

The U.S. economy is suffering from a variety of ailments, all of which are lowering profits. Surely, profits have risen in dollar amounts, but barely in real terms. They have fallen precipitously as a share of national income. Worst of all, they have plunged in manufacturing industries which hold the key to full employment. Manufacturing profits have tumbled from some 6% of GNP during the 1960s to barely 1.5% at the present. The savage profit contraction is bound to lead to general income contraction.

In a capitalistic system the management of an enterprise is engaged in an unending struggle for improvements in productivity and profitability, in a growing economy with rapid capital formation management agonizes to invest in expensive equipment in hopes of raising labor productivity and lowering business costs. Labor costs per unit of output tend to decline, which causes the demand for labor to rise, especially in the capital goods industries manufacturing the expensive equipment.

In a stagnant economy suffering from capital consumption by various levels of government, management struggles for business survival through plant closings and labor layoffs. Chronic unemployment becomes unavoidable as labor laws and labor unions prevent the necessary reductions of wages and benefits.

in the United States the struggle for business productivity and profitability is proceeding primarily along the line of plant closings and labor layoffs. Business is chafing under payroll tax increases in the form of higher social security taxes, higher state and local taxes, and rising regulatory burdens, all of which are lowering the standard of living. Business is suffering acutely from the adverse consequences of many years of low saving and business investment, especially in the manufacturing industries. The monetary injections and interest rate cuts by the Federal Reserve System are no cure for the dearth of saving and investing.

The chronic weakness of American manufacture is aggravated by the asset and debt contraction which is the legacy of the credit and asset inflation of the 1980s. The failure of more than 3,000 Savings and Loan Associations and some 600 commercial banks merely is a symptom of the financial upheaval. The easy money response by the Fed caused interest rates to plummet to multi-decade lows, which in turn triggered a virtual flight of savers from low-yielding bank and thrift deposits. Having suffered large income losses, many investors sought refuge in the stock market, which then soared to fantastic levels, forming bubbles of greatly inflated value which will cause much financial distress when they finally burst.

The Fed’s reductions in interest rates have made investments in the UnitedStates rather unattractive in terms of yield and price/earnings ratios. Foreign capital no longer is,flooding in, as it did during the 1980s when U.S. interest rates were high, some capital controls were lifted, and foreign banks eagerly established their branches in anticipation of positive U.S. growth. Unfortunately, the “cheap-dollar” and low-interest policy of the Fed has made the U.S. asset markets one of the least attractive in the world. In fact, it has given rise to the danger of dollar crises similar to those of 1978 and 1979.

The present danger to the American economy is not price inflation as it was during the 1970s. Yet low rates of price inflation and low interest rates do not necessarily signal economic health and early recovery; just as in the 1920s, they may hide ominous distortions and maladjustments which in time will need to be corrected. The great price stability of the 1920s, which hid the Federal Reserve escapades of the Coolidge years, was followed by the longest and deepest of all depressions.

Although the economic situation is definitely worse than government officials are willing to admit, it is not likely to turn into another Great Depression. After all, there is no Hoover Administration eager to impose another Hawley-Smoot Tariff Act cutting off foreign imports and exports. There is no U.S. Congress anxious to double the income tax as did the 72nd Congress in 1932; no Roosevelt New Deal that would restrict competition and cartelize major industries. On the contrary, there is a dim awareness that trade barriers should be reduced and business taxes be cut. In lingering recession and painful stagnation, this awareness may turn into firm resolve and, finally, force our policy makers to act. With hope, common economic sense will prevail in the end.

Hans F. Sennholz

The late Hans Sennholz was president of FEE, 1992–1997.