What Every American Needs To Understand About The Economy

As the United States debates its economic future in light of large government budget deficits, it is important that the public has a clear understanding of how the economy works. A good starting point for understanding how the economy works is to understand how it is measured.

Economies are measured in terms of their Gross Domestic Product or GDP. GDP is made up of personal consumption expenditure, private investment, net trade (i.e. exports minus imports) and government spending at both the federal level and the state and local level. If the size of each of these components is known, it is only necessary to add them together to find the size of the whole economy. In 2009, the United States GDP was $14.1 trillion, according to the Bureau of Economic Analysis (BEA). Of that amount, spending on personal consumption accounted for 71% or $10 trillion; private investment 11% or $1.6 trillion; and government spending 21% or $2.9 trillion, with federal government spending of $1.1 trillion and state and local government spending of $1.8 trillion. Net trade deducted 3% or $390 billion from GDP because exports from the US were $390 billion less than imports into the US.

So, what is the outlook for the US economy? The outlook for personal consumption is bad because the household sector is heavily indebted. Household debt increased from 64% of GDP in 1998 to 97% of GDP in 2008. At that point, millions of Americans became unable to repay their debt, defaulted, were cut off from additional credit and were forced to spend less. The drop in private spending threw the world into economic crisis and caused US unemployment to soar to 10%. Prospects remain discouraging because home prices have fallen by more than 30% on average, meaning that even the Americans with good credit ratings have much less collateral to borrow against. With limited access to credit, household spending will remain depressed.

The outlook for private investment is also bad. Capacity utilization, which measures the extent to which factories are operating relative to their capacity, is roughly 75%. This is one of the lowest levels since records began in the 1960s. Businesses will not invest more at a time when they cannot utilize the capacity they have already put in place.

Net trade has deducted from US GDP every year since 1975 because the United States imports so much more than it exports. There is no reason to expect this to change given current government policies.

That leaves government spending. The figures for government spending mentioned above are actually misleading in the sense that they underestimates the true impact of government spending on the economy. For instance, as classified by the Congressional Budget Office, federal government outlays actually amounted to $3.5 trillion in 2009, three times the figure shown above. The explanation for this large difference is that the amount reported for the federal government in the GDP data provided by the BEA represents only the federal government’s direct purchases of goods and services. It excludes normal transfer payments such as unemployment benefits, Social Security payments, Medicare, and assistance to state and local governments, as well as emergency assistance to the financial sector. In other words, federal government transfers provide significant support to other sectors of the economy, particularly personal consumption expenditure and state and local government. Therefore, the contribution to GDP of those sectors is actually overstated in the BEA data, while that of the federal government is understated.

At a time when government spending is under fierce attack in the United States, every American needs to understand how much of the economy depends on that spending. This year the US budget deficit will be approximately $1.4 trillion. If the federal government were to attempt to balance its budget by spending US$1.4 trillion less in 2011, the reduction in government spending would not cause personal consumption or private investment to increase. To the contrary, both would decline. Personal consumption would decline because less government spending would cause unemployment to rise sharply; and private investment would decline because there would be much lower demand for goods and, consequently, much lower levels of capacity utilization than exist now. Moreover, as consumption and investment declined, tax revenues would also decline, making it necessary for the government to cut its spending even further to balance its budget.

In the past, it was understood that if the government spent less and borrowed less then interest rates would fall since there would be less demand for loans. Lower interest rates would then boost the economy by allowing businesses and consumers to borrow at cheaper rates and to spend more. That is not the case now, however. Short-term interest rates in the United States are very near 0%. They will not go lower if the government spends less. What this means then is that the economy will contract by more than the amount that the government reduces its expenditure – and, perhaps, much more.

Of course, the US government cannot continue to run trillion dollar budget deficits forever. Therefore, if the United States is to avoid eventual economic ruin, we must shift the national debate away from slashing government spending regardless of the consequences and instead discuss how the government could spend that money in a way that generates a high return on investment. In other words, the sensible approach is to shift the government spending away from areas that support consumption to areas that boost investment. A smart investment strategy would allow the United States to develop new, high-tech industries that would boost US exports, reduce US imports, create US jobs and generate significantly higher tax revenues.

It is simple minded to dismiss this idea as “Un-American”. Today, many of the United States most successful export industries, including agriculture and defense, are supported by US trade barriers, direct government subsidies, or both; while, historically, the United States industrialized during the 19th century behind a high wall of tariff protection.

The United States is in crisis. Before we can reach the point where the government can spend less, the country must go through a period where the government spends much more wisely. To simply slash government spending now would result in a depression in the United States and around the world. Just do the math.

13 comments

  1. Richard, I think that your overall idea has incredible merit to it. Instead of continuing to apply band aids to the economy let’s make some decisions on what areas we want to be a world leader in and fund those areas appropriately.

  2. Is this really your blog? I’m thrilled you have decided to share your insights!

    Richard, what would you say to the prospect of the global economy recovering through increased American savings and increased Chinese consumption? I know you do not believe in Bernanke’s savings glut, but I think the idea still has merit (even if the causation isn’t clear). To me it still seems like a meaningful, sustainable economic recovery could happen if the RMB were allowed to appreciate. It seems improbable that we would go back to a gold standard, but genuinely floating currencies could also help solve global trade imbalances, no?

    Again, thanks for writing your blog!

    Robert Moss

  3. No doubt it would make sense to spend that government/taxpayer money on something more useful (e.g. infrastructure, high-tech, etc.) than bailing out zombie industries and continuing subsidizing banks. Investing in something that would be valuable in the future too to some extent. E.g. Japan has spent on bridges, highways, etc that are still there and will be there for a long time. Debatable if it was the best use of money, but what will the US be able show in 20 years after all these government spendings?

    However, even if the US spends significant amounts of money in new industries (e.g. high tech, biotech, etc.), that still remains a bet on whether they will be able to gravitate toward a more healthy economic situation (balanced trade, fiscal order, low unemployment). There are quite a few other countries that are also good/could be good in these areas. Japan, Germany, South Korea, India to name but a few have good engineers and in any case they could quickly get access to the new technologies developed in the US at high costs via industrial sabotage so they can produce their own stufff (such as the US did in the 19th and early 20th centuries). Other countries are not far behind technologically and their governments could also direct their fiat money and reserves into these industries if this seemed to be the key to success.

    Also, how many jobs would these new industries generate? Not many more in the short-term for sure. These are more knowledge-based industries and would not require as many workers as traditional industries. A lot of people would remain unemployed and would exercise big political pressure.

    Instead of going down the way of central planning, wouldn’t it be better to slowly cut back on government spending and let the economy heal itself? It would be a utopia to think that the economic transformation can be painless after all the excesses and capital misallocation in the past. A sharp drop in government spending would be dangerous and disruptive. But a gradual cutback could be feasible though. And the resulting free economy would be far more superior and creative than a centrally planned one, and the envy of the world.

  4. The nation is in a debt crisis. Adding more debt on top of that debt, regardless of the intent or purpose, will not achieve anything except hasten the demise of our already failed economy, which is sadly reminiscent of those towns of the old west where the merchants gathered together and schemed of ways to keep the town going after the mines that drew them there have all played out and closed down. We refer to those places today as ghost towns. The U.S. economy is a gutted hollow shell that has been running on the expansion of debt for over thirty years and all the scheming by the merchants, who lived off that debt, to keep it going will fail.

    1. Right you are and nice analogy. I might add that all the Multi-Nationals and Banks and Investment firms we propped up and continue to give favorable status to will most certainly be penetratin the new growth and emerging markets and all too happy to leave the ghost towns of the good old USA behind.

  5. Untill you address the fraud and crimminal activity going on between the government agencies
    such as the recent decision by the cftc to allow the the hugh silver shorts at the Comex to be allowed
    to surpress the silver and gold markets this country hasn`t a chance. All the markets are rigged and and the media is the mouthpiece for the corportist within are government. It`s one big joke.
    The dollar is devalueing and our country has been sold off bit by bit.

  6. When the entire monetary system is debt based, it is not possible to get out of debt. No one is allowed to fail so even the debt system can’t reset through bankruptcy.

    The federal government simply does not have the capacity to predict what it needs to invest in. Suggesting that it should try will just prolong the suffering.

    The only solution is for the enormous parts of the economy that produce and deliver things that no-one wants at prices no-one would pay if they had other choices, to be fail and for the people who work there to find employment in areas that do add real world value.

    These segments will ultimately fail, if the government continues to insist that it can save everyone then all other segments of the economy will go down with the ineffective parts.

    The world is changing, it will change, it must change, the rate of change is not going to slow down any time soon and for anyone to claim they can say anything about the world after the changes enters the domain of arrogance. The constant interventions will only serve to hamper the process and prevent people from adapting on an individual level.

  7. Great read, sadly our government is not putting the money into anything that is going to propel our future innovative or competitive edge. Capitol Hill is squandering our money on zero return projects, unless that changes stimulus is only a dead end road to hyperinflation.

  8. we must shift the national debate away from slashing government spending regardless of the consequences and instead discuss how the government could spend that money in a way that generates a high return on investment.

    Sorry, but high ROI from government spending is an oxymoron. Private investment seeks profit, government spending seeks votes. This is like wishing for a benevolent despot.

    -jcr

  9. The correct response to our crisis is to stop the government from ‘running’ the economy. They have no responsibility nor authority to perform this task, and obviously no expertise. Nowhere in the U.S. Constitution is the Federal government given any authority to set interest rates, nor favor companies, individuals or special interest groups through legislation and taxation. To act otherwise is an attack on equal treatment for all (civil rights) and truly free markets (which wring out excess and smooth out trade). Our failure to follow our own Constitution, aided by currency exchange manipulation, has led us to the sad point we are at today. It is also curious to note that there are no penalties mentioned in our Constitution for failure to follow its edict. I don’t have to wonder why we ignore it.

  10. Looks like the government is going to cut budget deficit in the years ahead, this will results in more job losses and depression. Deflation will set in or hyperinflation will be the thing to come?

  11. The peak of any crisis is identified when each alternative results in higher risk and the likelihood for greater pain. It seems to me we’ve reached that point. Duncan is proposing a moon-shot that directs ‘creditism’ toward a more viable future. It appears most commentors are pointing out the risks and pain of that proposal. Duncan’s premise is for disaster if we don’t make a bold spending move… which, I propose, is the classic sign that we’re at the peak of this crisis. All actions from here on out appear to only delay the inevitable. Maybe the whole system must be destroyed… before its replacement can occur. Sometimes I wish we’d just embrace the inevitable and get it over with. Then, I’m reminded that we should always be careful what we pray for.

Leave a Reply

Your email address will not be published. Required fields are marked *

Subscribe To Richard Duncan's free blog.

Subscribe To Richard Duncan's free blog.

Subscribe to receive the latest economic news and analysis from Richard Duncan.

You have successfully subscribed to Richard Duncan's blog.