February 02, 2016
Dean Baker
Al Jazeera America, February 1, 2016
View article at original source.
The business press has been obsessed in recent weeks over the volatility in financial markets around the world. Most of the world’s major stock markets have dropped by more than 10 percent from their peaks of 2015. China’s market is down by more than 40 percent from its peak last spring. Interest rates on high risk bonds have soared and the price of oil has fallen by more than 70 percent from its levels of two years ago.
While these movements are dramatic, it is important to remember the financial markets are not the economy. Markets often take sharp turns in ways that have no obvious connection to the real economy. The best example of this is the 1987 stock market crash in which the U.S. markets lost more than 20 percent of their value in a single day. There was no obvious cause for this plunge nor did it have a noticeable effect on the economy. The U.S. economy continued to grow at a healthy pace for the next two and a half years.
This doesn’t mean that the U.S. and the world economy don’t face real problems. It’s just that these problems are not best captured by a deflating Chinese stock bubble and the response of worried investors elsewhere.
The fundamental problem in the world economy is pretty much the same problem it has faced since the collapse of the housing bubble threw the world economy into recession in 2008–2009. The economy continues to suffer from a lack of demand. Prior to the collapse of housing bubbles in the U.S., much of Europe, and elsewhere, the demand created by these bubbles was the engine of growth.
In the United States, residential construction reached a record share of GDP in 2005. In addition, there was a consumption boom driven by the bubble-generated housing equity from the bubble. At its peak, the bubble raised the value of residential real estate in the United States by more than $8 trillion above its trend level. Homeowners spent against this ephemeral equity, pushing saving rates to record lows.
There were similar stories elsewhere. When the bubbles burst, construction plummeted. Instead of home equity being a source of wealth to fuel consumption, tens of millions of homeowners around the world suddenly had mortgage debt that exceeded the value of their homes. The defaults on mortgages translated into trillions of dollars of bad debt, which gave us the financial crisis.
This is a simple, albeit not pretty story. But the key point is that the underlying problem has not gone away. We still have no way to replace the demand that was lost when the housing bubble burst. Originally governments responded with a dose of stimulus that stopped the plunge and restored most economies to growth.
But in the United States, and even more so in Europe, stimulus quickly shifted to austerity, as governments became obsessed with budget deficits. The proponents of austerity insisted that we had to worry about government debt and that we did not have to worry about generating demand in the economy. The argument was that if the government did not generate the demand with budget deficits, then some other actor in the economy would fill the gap.
The problem with this story is that there are no other actors to fit the bill. We can say with some certainty now, that companies will not increase their investment just because the government has reduced its deficit. Nor is it the case that consumers will see a lower deficit as a sign to go on a spending spree. There could be a story that a lower deficit in the United States will lead to lower interest rates, which could lead to a lower valued dollar. That could provide a boost to net exports, which would spur the economy.
However, in a situation where most of the rest of the world economy seems weaker than the United States, we get the opposite story. The dollar is rising and so is the trade deficit. While none of this amounts to disaster, it does mean that we are looking to a future of more of the same: weak growth and a labor market that is not yet tight enough to allow workers to achieve substantial real wage gains.
This all could be reversed quickly if the politicians of both parties gave up their deficit fetishes and were prepared to spend money in ways that could both benefit the country and boost growth. Unfortunately, this does not seem likely at the moment.
The best that we can probably hope for is that they not do anything to make things worse. This is where the Federal Reserve Board comes in. The Fed raised interest rates in December. The purpose of this rate hike was to slow the economy in order to head off inflationary pressures.
If it was not already pretty obvious in December, it certainly should be obvious today. We don’t have any inflation to worry about. The inflation rate is way below the Fed’s target and more likely to go lower than higher in the immediate future. In other words, the Fed was acting to slow the economy for nothing.
Incredibly, Senator Bernie Sanders was the only presidential candidate in either party who seems to have noticed. He criticized the Fed’s actions and urged it not to take further steps to hurt the economy. It would be great if the other candidates, as well as other politicians, joined Sanders criticism. The economy is already growing far too slowly to get us back to full employment. The last thing we should want to see is the Federal Reserve Board jacking up rates to slow it down even more.
