So, is the economy in recovery mode, or not?
Many of you have read in the news that some economists believe that the economy is on a path to recovery. There are positive signs, no doubt. According to the Commerce Department, the economy contracted by only 1% in the second quarter ending in June, as compared to a contraction of 6.4% in the first quarter. Home-sales were up by 11% and jobless claims fell by 1.5% in June, and a widely cited measure of stress in financial markets, the TED spread (the difference between Treasury bills and a three-month LIBOR) is down to pre-crisis historical levels. (See for yourself here).
But this is as we should expect, given the injection of gigantic doses of macroeconomic steroids into the body-economic in the form of fiscal and monetary stimulus. As you probably recall, a macroeconomic stimulus package consisting of a $2.5 Trillion financial sector bailout and a $787 Billion fiscal package was approved in the Spring, and is still being drip-fed to the economy. It would therefore be surprising if the economy did not experience some "defibrillation." And since the stimulus is still in the process of being disbursed and spent, we shouldn't be surprised if things to look up even more in the third and fourth quarter.
But there are reasons to be worried that the recovery, such as it is, is fragile. There are at least two sources of concern. One is the fact that even though we are out of the woods in terms of a systemic financial sector meltdown, credit continues to be rationed by banks. It is still hard to get credit if you need it, for both individuals and firms. A second wildcard is the impact to the economy of the sharp increase in the individual savings rate. The Commerce Department reports that the individual savings rate has shot up from an average of nearly zero to about 5.2%. The decline in consumer spending associated with this is attributable in part to the approximately $14 Trillion in wealth that has been wiped out by the collapse in home values and stock portfolios over the past year. A rule of thumb that economists use to estimate the impact of this kind of wealth effect is that every $1 decrease in wealth translates into a spending decline of 3 to 5%. To envision the possible after-shocks of this change in behavior on the economy all you need to know is that in the recent past consumer spending has accounted for about 70% of U.S. economic activity. The great unknown here is how far the savings rate will go before it stabilizes. 7-8% is a number that many economists expect. But what if it goes to 10%? If the unemployment rate, currently around 9.7%, doesn't improve soon, then this is not outside the realm of possibility.
Under normal circumstances, higher savings rates and lower budget deficits are considered a virtue. But when the economy is in a recession, many of the behaviors that were virtues become vices, so to speak. If everyone decides to save a lot more, then consumer spending shrinks in the aggregate, dealing another punch in the solar plexus to the overall economy. This situation is referred to by economists as the "Paradox of Thrift." The logic for expanded government spending (also referred to as deficit spending) in such a situation is as a temporary replacement for consumer spending.
Nevertheless, all of this is still within the logic of the macroeconomic stimulus. The entire point of such a large stimulus in the teeth of a recession is to unclog the arteries of the financial system, prime the engines of the body-economic, and jolt the economy into a recovery so that when the stimulus spending peters out we are unable to notice the difference because the economy has hit its own stride.
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