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Robert M. Liu

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Economics and Politics
by Robert M. Liu   

Last edited: Monday, July 16, 2001
Posted: Monday, July 16, 2001

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This article deals with such issues as the boom-and-bust economic cycle, monetary policy, fiscal policy, and the impact of politics on business and economic conditions -- as well as on your 401k or IRA portfolio etc.

Economics and Politics

By Robert M. Liu

The Labor Department reported on July 6th, 2001 that America's jobless rate rose by 0.1% to 4.5% as 114,000 non-farm payroll jobs disappeared in June. The number of non-farm payroll jobs fell by 165,000 in April and then rose by only 8,000 in May. So, for the entire second quarter of 2001, the economy lost 271,000 non-farm payroll jobs, mostly in the manufacturing sector, where a total of 785,000 jobs were wiped out between July 1st, 2000 and June 30th, 2001. For quite a while, the economy has been in a recession or slowdown, whichever word you prefer.

When the Bush administration first mentioned the possibility of an economic slump, it was dismissed by the liberal wing of the media (read the left wing of the media) as a ploy to boost the administration's tax cut plan. Furthermore, President George W. Bush was criticized for "talking down the economy" or "talking the economy into a recession". Such economic myths about anyone being capable of "talking down the economy" suggest that as long as we avoid discussing reality, reality will not catch up with us. Apparently, that is not true . At best it is self-deception. The U.S. economy — traditionally an oasis in troubled times and a major pillar for the global economy — remains weak, though it may have hit its bottom in the second quarter. Hopefully, it will begin to recover in the third or fourth quarter of 2001.

More worrisome is the fact that the world economy is also in a recession or slowdown. Japan has been in recession for more than ten years. The European economy is also sluggish, but Europe's central bank recently decided not to cut interest rates because the Euro has fallen so much against the U.S. dollar since its debut in 1999 that inflation has become a real cause for concern in Europe. But is it sound economic philosophy to keep prices artificially stable through monetary policy when market forces suggest there is a reason to adjust prices?

In Latin America, Argentina's financial crisis is spreading, fueling speculation that the government there may have to default on its debt, which amounts to US$128 billion, equivalent to 45% of Argentina's GDP. The Argentine peso is pegged one-to-one to the U.S. dollar. The government uses the currency peg to "fight inflation" but spends much more than it collects in taxes. So, it lives on borrowed money that it may not be able to repay. Obviously, it is in a dilemma. If it ends the peg, the Argentine peso will fall like a rock, triggering run-away inflation. If the peg stays, people will continue to convert their hard-earned life savings into U.S. dollars at the various branches of the state-owned Banco de la Nacion, because they have lost confidence in the peso. How long can any government live on borrowed money? Argentina's only option is to drastically cut spending, since nobody can live on a credit card without making repayment forever.

Economic realities aside, I would guess that in blaming George W. Bush for "talking down the economy", the liberals (read the spin doctors of America's political left wing) knew what they were doing — they wanted Bush to look bad. Their problem is they could only fool the ignorant, because anyone with an elementary knowledge of economic basics should know that the economy has its cycles, its upturns and its downturns. If recent history is a guide, it appears that the U.S. economy has a 10-year boom-and-bust cycle.

For instance, the economy plunged into recession in 1980 but started to rebound in earnest in 1983. By 1984, the recovery became so robust that it caught the eye of the world — nobody could "talk it down". The Dow Jones Industrial Average rose from 800 in spring of 1982 to 2722 in August of 1987. But then, the market crashed in October of 1987 to correct its overbought condition. After meandering between 2000 and 2200 for a whole year in 1988, the Dow suddenly resumed its uptrend in early 1989 as the economy picked up steam. In August of 1989, the Dow surpassed its previous high of 2722. In addition, 1989 was also a great year for the dollar as foreign investors bought up the U.S. currency in order to invest in dollar-denominated assets. On the other hand, the strong economy gave rise to fears of economic overheating and inflationary pressures, causing the Federal Reserve to repeatedly raise interest rates that year. In retrospect, 1989 was actually the last stage of the 10-year economic cycle from 1980 to 1990, but at the time the Fed was more concerned about inflation than the possibility of an imminent recession.

At last, the economy plunged into recession again in 1990, and nobody could "talk it up". The slump lasted throughout 1991 and 1992, costing former president George Bush senior his second term in the White House. While Ross Perot took away conservative votes from Bush senior, Bill Clinton was attacking "trickle-down" supply-side economics, as if Bush senior had brought about the economic downturn. Although Bush senior predicted that economic recovery was in the offing, there was lots of doubt and frustration among the impatient American people, most of whom, unfortunately, were not economists. Yet, shortly after Bush senior left the White House, the economy started to rebound in 1993. Who did the magic: George Bush senior or Bill Clinton or Fed chairman Alan Greenspan?

By 1994, the recovery became very robust, and the Dow was poised to break through the 4000 mark. In November of 1994 when the pro-business Republicans won the majority of the seats in Congress, Wall Street cheered, pushing the Dow above 4000 as investors realized the Republican-controlled Congress would block Bill Clinton's spending programs, creating an opportunity to balance the federal budget. Besides, the Cold War ended in 1991 when the former Soviet Union collapsed, allowing the United States to save billions of dollars in defense spending. Since then, the greenback has become the most reliable currency in the world and for good reasons too. These historical events point strongly to the fact that politics has strong implications for business and economic conditions.

Throughout 1995 and 1996 the Dow kept rising. In late 1996, trying to strike a note of caution in one of his most famous speeches, Fed chairman Alan Greenspan said two words "irrational exuberance" in a reference to the rising stock markets, but the Dow continued its upward movement — nobody could "talk it down". It rose above 8000 in summer of 1997 but plummeted to 7000 in October of 1997 on news of Asia's currency crisis. It quickly recovered its losses and rose above 9000 in spring of 1998. Although it fell sharply to about 7500 in autumn of 1998 when Asia's financial crisis spread to the rest of the world, the Dow recovered its lost ground in late 1998. By spring of 1999, it rose above the 11000 mark for the first time in history on a strong economy that enabled corporate America to report good earnings. Then, as always, for fear of "economic overheating" and "inflationary pressures", the Fed stepped in to raise the Fed Funds rate for six times between spring of 1999 and spring of 2000 (from 4.75% to 6.5%). In retrospect, 1999 was actually the last stage of the 10-year boom-and-bust economic cycle from 1990 to 2000.

Yet at the time, the Fed did not exhibit any concern that its repeated interest rate hikes could cause the economy to slow down too quickly. The central bankers were so "vigilant of inflationary pressures" that they decided not to ease in December of 2000 even though the manufacturing sector of the economy was already in recession. As a matter of fact, the economy began to sputter in spring of 2000 when the technology sector showed signs of weakness with tech companies making disappointing pre-announcements one after another. It slowed down sharply in late 2000 when corporate inventories built up in the face of falling demand. But with public attention focused on just how many "pregnant chads" in Florida were "pregnant" enough to show "voter intent", few people realized America was teetering on the edge of recession. What an amazing moment in history! Anyway, it was not a situation where a 6.5% Fed Funds rate could be justified.

Hopefully, the current recession will be less severe or even shorter than the previous ones, since the fundamentals of the U.S. economy are stronger today than before with a far more efficient corporate America that is quick to respond to adversity, especially if the Fed's six interest rate cuts since January 2001 and President Bush's tax cuts begin to show their effects in the second half of 2001. Hopefully, the Fed will cut rates again (and again) to reduce the costs of borrowing money for both businesses and consumers. That would provide more liquidity for the economy and help pull the world out of recession.

Since the U.S. dollar remains firm against the Japanese yen, the Euro and the British pound despite the six rate cuts and since there are more signs of deflation than inflation, some economists see room for the Fed to ease again. Commodity prices are down, not up. For instance, in the late 1980s, the price of gold was way above US$300 per ounce. Now, it is worth only US$266 or so per ounce. Besides, in today's highly competitive market environment, businesses are unable to pass costs (such as taxes, interest costs, labor costs and energy costs) on to the consumer through higher prices. On July 13th, 2001, the Labor Department reported that the Producer Price Index (PPI) (i.e. the wholesale price index) fell by 0.4% in June. Apparently, there are too many goods chasing too few dollars, not the other way around. This is hardly the time to worry about inflation in my opinion, though recently I heard a bank economist say that if the economy heated up, inflation would pick up as well. The fact is the economy is not heating up yet. So, why count the chickens before they are hatched?

For quite some time, I have been wondering how the term "inflation" should be defined. My impressions are that the term is being used very freely. If prices rise, people say it is "price inflation". If wages rise, central bankers say it is "wage inflation". If stock prices rise, economists say it is "asset inflation". According to this "asset inflation" theory, rising stock prices would encourage people to spend more, thereby creating excessive demand and price inflation, and in order to keep this "wealth effect" under control, the Fed would have to raise interest rates. If that is how we define "inflation", then if oil prices go up due to oil cartel supply manipulation, the Fed should raise interest rates to "fight inflation" too. But wouldn't that make things worse? If rising energy costs hurt businesses and consumers alike, rising interest costs would increase the hurt.

Unless we introduce socialist-type price controls "to eliminate inflation" once for all, prices in a free-market economy are supposed to float all the time according to the rules of supply and demand. Except in very special cases (e.g. the California power crisis), businesses which compete with each other in various industries are efficient enough to quickly increase supply to meet demand, bringing prices to relatively reasonable levels. If demand is so great that corporate America must hire more workers to increase production, bringing about a tight labor market that enables workers to demand higher wages, I would call it reasonable wage adjustments for the working class, rather than "wage inflation". Companies which cannot afford to pay higher wages could choose to move their manufacturing operations offshore where labor costs are lower. Over time, globalization will bring wage costs down. So, why raise interest rates (i.e. why use government intervention) to suppress demand instead of allowing the forces of the free market to gradually strike a balance between supply and demand?

In my view, inflation is a phenomenon created by government that lives beyond its means and prints too much worthless paper money to fund its spending programs. For instance, if war breaks out, forcing the government to print large amounts of paper money to buy weapons and other supplies for the military, prices will certainly rise quickly. Raising interest rates cannot eliminate the root cause of inflation, because while higher interest rates encourage people to keep their money in banks, the government's printing machines are running overtime to create more worthless paper money. Another example: If populist politicians come into power with promises of a grandiose future for the common people, they are sure to expand welfare spending programs to please their supporters. They can either raise taxes on the rich or print a lot of paper money to fund their welfare spending programs. Either option has unpleasant consequences. While excessively high taxes are sure to scare off the rich, causing the economy to contract, to print excessively large amounts of paper money would certainly cause inflation.

So, I believe the root cause of inflation is excessive government spending (due to war or cold war or grandiose welfare programs or other grandiose spending programs) which necessitates the printing of excessive amounts of paper money. Nor would I call short-term upward price movements caused by temporary supply shortages "inflation". Rather, they are healthy market signals to business executives that it is time to increase supply and make money. When supply increases, prices will fall. That is exactly how the free market works. It would be very wrong to raise interest rates to suppress such short-term upward price movements, because that would kill the much needed "healthy market signals".

However, monetary policy does have an impact on the value of the currency. If the Fed eases too much or too quickly, the U.S. dollar might weaken, causing the prices of imported goods to rise. Still, I wouldn't call such import price increases "inflation", because they may very well reflect the free market's reasonable adjustments. Strange to say, this time around, despite the Fed's six rate cuts since January which have brought the Fed Funds rate down from 6.5% to 3.75%, the dollar remains strong, whereas in 1990 when interest rates fell in America, the dollar fell sharply too. Perhaps, that is because since 1980, the world has changed a lot: First of all, the Cold War is over, allowing America not only to save money but also to make money in former Communist countries. Secondly, the United States not only has eliminated budget deficits but also has come up with budget surpluses, which fact means: THE ROOT CAUSE OF INFLATION DOES NOT EXIST AT LEAST FOR NOW.

If the economy begins to rebound in late 2001 or early 2002 as many economists now expect, the projected surpluses are likely to materialize, facilitating President Bush's tax cuts over the next ten years, which in turn would enhance capital formation, job creation and wealth creation in the private sector, thereby expanding the government's tax revenue base. Good times may be ahead of us despite corporate America's recent set-backs. As to "inflationary pressures", as long as government spending is under control, the root cause of inflation (i.e. the real specter of inflation evoked by the need to print excessively large amounts of paper money) will be kept at bay. The Federal Reserve may become vigilant of deflation rather than inflation, as it realizes the government's fiscal policy, if properly designed, is a more effective weapon to fight inflation. The market (i.e. the free market) is smarter than any of us. The strength of the dollar in the face of falling interest rates is an indication that the market believes: (1) the fundamentals of the U.S. economy are strong; (2) the Bush administration will keep spending under control; and (3) the likelihood of inflation hurting the U.S. currency is low.

A final note about the linkage between politics and business: I have heard people say, "We only want to do business; we only want to make money. We are not interested in politics." Really? The thing is that politics is business. Politics can impact business and vice versa. For example, when Senator James Jeffords of Vermont defected from the Republican Party on May 24th, 2001, single-handedly placing Democratic senators in control of the Senate, stock markets fell sharply, because the defection derailed the Bush administration's business-friendly agenda. Of course, investors didn't like that. Maybe, they are still in shock, wondering whether it is time to put their money to work while Democratic senators introduce bills according to their agenda.

On the other hand, a CNN/USA Today/Gallup poll (conducted on July 10-11) shows President George W. Bush's job approval rating now stands at 57%, compared with 52% in late June. A possible explanation for the slight improvement is that basically agreeing with economists' prediction that the economy will begin to recover later this year, people feel more confident of their own future now. Besides, recently, the Dow stabilized. If it moves into an uptrend, investors will become even more confident. That would help Bush's job approval rating too. After all, nearly 50% of American households depend on their retirement portfolios (such as 401k Accounts and Individual Retirement Accounts) for their future needs, which fact alone tells us why there must be some linkage between the fate of the Dow Jones Industrial Average and that of the president of the United States of America. Economics and politics are so closely related subjects that oftentimes two men who agree with each other on economic issues agree with each other on political issue as well.

The End (July 15th, 2001)

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