Survival of the Fittest Gives Way to Bailout Politics

When economics was just economics, analysts and forecasters had a difficult job. Now that economics has reverted to its original calling, Political Economy, the chore is well-nigh impossible. We are no longer guessing merely at the effect of declining house values on consumption – the wealth effect – or of the jobless rate on consumer confidence. We are now forced to guess what politicians, described by Adam Smith as “that insidious and crafty animal . . . whose councils are directed by the momentary fluctuations of affairs”, will do in response to economic developments.

No, imprudent lending will not bring a bank to the end of its rope, so long as the government provides more for survival – and to tie management’s hands. No, falling car sales will not necessarily force one or more car companies into bankruptcy, as they would in a market free of the long arm of a government beholden to trade unions. No, a weaker currency will not necessarily buoy exports and reduce imports, not when governments can erect barriers to trade. And no, a wave of house repossessions will not necessarily teach the virtue of living within one’s means, when the government is around to force lenders to stay their hands, and create moral hazard on a huge scale.

We do know a few things about the state of the economy. Unemployment is high and rising, with optimists – the term is relative – predicting the unemployment rate will hit 9.5% by year-end, and pessimists expecting it to reach 11.5%. This in response to an economy described by economists at the Federal Reserve Board as being exposed to “downside risks to an outlook for activity that was already weak . . . fragile and unsettled”. Problems here at home are likely to be exacerbated by an acceleration of Europe’s recession, now that France and Germany have refused to stimulate their economies, and Britain is more or less broke. One analyst told me he expects the EU economy to fall off the cliff by the end of the year.

There’s more on the gloomy side, but it is best summed up by looking at the world through the eyes of Nouriel Roubini, the New York University professor who was among the first to predict the collapse of financial markets and the accompanying recession. He expects the contraction to continue for the rest of this year, although at a slower pace than in the fourth quarter of 2008 and the first quarter of this year. And he foresees almost no growth in 2010.

Other economists are cheerier. Larry Summers, the president’s top economic adviser, cites “the anecdotal flow in the last few weeks of things that feel better”. Included in that anecdotal flow is a report that inventories, which have been declining and dragging down growth, now will “have to be built up”, adding to growth in the second half of this year.

And Goldman Sachs looks beyond recent disappointing retail sales figures to report that “personal consumption data in America suggest that consumption has likely grown in the first quarter of 2009, a significant about-face from the steep declines posted in the second half of 2008 . . . Outright contractions in consumption are behind us”.

Note the role of politicians in three of the sectors that underlie this bit of cheer.

Let’s start with banks. Late last week Wells Fargo cheered investors by reporting a $3 billion first-quarter profit, the result of a surge in deposits (insured by the government), a boom in mortgage lending (spurred by the low interest rates created by the Fed), and an injection of funds by the Treasury.

Then there is the housing sector. Lawrence Yun, chief economist at the National Association of Realtors, reports “increases in shopping activity” and in pending home sales (contract signed but the transaction not completed), and almost twice as many Americans think it is a good time to buy a home as believe the time is not right, according to the pollster WIN. If housing is recovering, it is in part because the Fed is operating several programmes to keep interest rates at the lowest level since 1971, and Congress is creating tax-rebate incentives to spur buyers on.

Finally, consider the motor industry. Sales seem to be picking up, partly in response to President Barack Obama’s decision to have the government guarantee the warranties of struggling General Motors – this is the first time an American president has guaranteed our exhaust pipes – and partly in response to the government’s intervention in credit markets to keep the cost of car loans low.

These are merely examples of the extent to which multiple government interventions are driving the economy. So in deciding where we go from here, we have to try to predict what the Fed, the president and Congress will do once a recovery is under way.

For now, there is enough excess capacity to make it unlikely that inflation will take off in the near term. Larry Meyer, a former Fed governor, believes the economy is at an “inflection point”, and that growth will hit an annual rate of about 3% by the middle of next year. However, he does not believe such a return to something like trend growth will trigger inflation because the Fed will take steps to prevent prices from soaring.

He might be right. But inflation can be avoided only if the Fed withdraws cash from the economy as growth takes hold. Summers is confident that such an exit strategy can be executed. History is not completely reassuring, though. Obama will have an opportunity to name a new Fed chairman when Ben Bernanke’s term expires on January 31, 2010, and he might just find one who believes more inflation means lower unemployment, and who prefers the latter. It’s happened before.

Combine that with the antipathy of Congress to spending cuts. Summers said the key is to bring down healthcare costs, but Obama’s budget calls for big increases as the government takes over the sector. In short, it is not difficult to understand why the Chinese are worried that those “crafty animals” in Washington might want to pay off the $1 trillion and more that we owe them with dollars that might not be worth what they are today.