Thursday, October 9, 2008

The wrong problem?

First, the problem was unemployment. Then, it was oil prices. Then, it was the sub-prime mortgage mess. Then, it was the credit markets. Now, it's the global banking system.

Could it be that the real problem is a simple crisis of confidence?

Chicago Graduate School of Business Professor of Finance Amir Sufi says that government officials missed the point. Every major recession in the past 100 years have been preceded by a drop in consumption, or consumer spending. There is no hard-and-fast reason for this, other than human psychology. Like a gaggle of birds on a wire, when one bird flies off, a few more follow, and then the whole flock peels off. It's herd mentality, but it is a perfectly reasonable reaction to envrionmental threats: better safe than sorry. Except when the "safe" move has the unintended consequence of collapsing the global economy.

John Mauldin makes a similar case, though with more of a supply-side view:
"[T]the key is consumer spending. Personal income fell 0.1% in April, with wages and salaries down a larger 0.4%. Real disposable income also fell 0.4%. This leaves it up just 0.4% annualized over the past three months, which is not supportive of significant increases in consumer spending. As we noted last weak, retail sales and discretionary spending is down."
Mauldin argues that hourly wages are the horse that pulls the cart of consumer spending, and changes in those wages predict economic malaise.

I don't know about that. But it makes sense to me that consumer confidence drives consumption, which in turn drives growth (or lack of it). After all, money's only value comes from an agreement between you and I that this 2-cent piece of paper is worth a dollar, or twenty dollars, or several million dollars (if the piece of paper is a stock certificate, for example).

So it makes sense to me that loss of confidence in that piece of paper's value could easily drive us to stop spending on frivolous things, and reserve our spending only on essential goods and services. That is the drop in consumption that leads to recession. At least, according to Sufi, and folks like Simon Johnson, former chief economist of the International Monetary Fund, is a professor at the MIT Sloan School of Management.

What can the government do to promote confidence in our paper money, so that more people will buy stuff?

Yeah, good question. But I am pretty sure that bailing out companies who then spend the money on resort spa junketts is not going to help.

Oh, and we just gave AIG $38 billion more.

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