Richard B. McKenzie

Economic Therapy: Comforting Pointers for Turbulent Times

Richard B. McKenzie*
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"This recession is not the first or, yet, the deepest this country has faced during the last century, and we are not in a Second Great Depression."
Turbulent times can be good times for economists. The main reason is that many people need help understanding the sources and consequences of the daily disheartening financial and economic news, as well as the pontifications of political leaders who suggest that, unless they are given power to distribute trillions of dollars in bailout and stimulus packages, economic Armageddon may be imminent.

As events have unfolded during the past year and a half, a growing number of people have asked me what I think of the economy. I've learned two things from these encounters. First, questioners seem to want sound-bite answers. Incisive and extended answers can cause their eyes to quickly glaze over. Second, I've realized that what the questioners often want is not so much analysis as therapy—economic therapy, comforting interpretations of events and data that can help to ease their inner sense of dread.

Here is a composite of conversations I've had with former MBA students, friends, and colleagues from across campus in recent weeks.

"Professor McKenzie, I'd like your take on the economy. Things seem frightening. I've spent a small fortune for my MBA, and for what? I was laid off three weeks ago. And all the news I read is bad. Do I have to fear for the future of my children?"

This recession is not the first or, yet, the deepest this country has faced during the last century, and we are not in a Second Great Depression. It's true that the current recession could soon become the worst of the past fifty years, but only because past recessions have been relatively mild. Between 1929 and 1932, the unemployment rate rose from 3.2% to just under 16% (reaching almost 25% in 1933). Today, the unemployment rate is 9.7%, up from 4.7% two years ago. In the 1930s, the poverty rate was above 40%.1 Today, the poverty rate is less than a third of that, with many officially counted poor (and unemployed) people having LCD televisions, cars, and (cell) phones that were unimaginable to even high-income people in the best years of the 1930s, or even the best years of the soaring 1960s.

Many of the unemployed are truly hurting, but virtually none are suffering as badly as the unemployed in the Great Depression. Real per capita gross domestic product and personal consumption expenditures today are both more than six times what they were in 1932 (with both measures very substantially understated today because of the quality improvements in products not included in official statistics).2 Real recreational spending per capita is more than nine times what it was in 1932.3 In the 1930s, many of the unemployed didn't have clean running water. In 1931, the unemployed were giving up meals. Today, many of the unemployed are downgrading from café lattes to tall drips at Starbucks and are sacrificing minutes on their cell-phone plans and meals out. The federal and state safety nets for the unemployed are far more lavish than when the systems were inaugurated in the mid-1930s, with the unemployed in California today having access to 79 weeks of benefits.4

 

To learn more about how home-produced goods are not counted in national income statistics, see National Income Accounts in the Concise Encyclopedia of Economics (CEE). For a variety of podcasts on the Great Depression and the recent recession, see Business Cycles, Recessions, and the Great Depression on EconTalk. See also Great Depression, in the (CEE).

And don't forget that the recent downturn in national production is not as great as official statistics report. This is because many people are switching from market-produced goods (which are counted in national production and income statistics) to home-produced goods (which are not counted). Moreover, we aren't wasting as much time on clogged freeways or standing in store checkout queues.

My admonition: Keep things in perspective. Don't make them worse than they are, and you will feel better.

"How are we going to get out of this mess?"

Be patient. Remember that a recession is the first and necessary phase of a recovery. You can't have the latter without the former. The world economy got way out of whack during the last few years, mainly because of a credit binge fueled by the growing use of mortgage-backed securities. Various government policies encouraged the purchase of those securities, enabling many credit-unworthy people to buy dream homes that were more expensive than they could afford.1

If you choose to do so, you can view the continuing precipitous drop in housing prices, the rising unemployment rate and the falling wages as only bad news, but there is an often-missed glimmer of promise in those statistics: They are evidence that the economy is adjusting—getting back in whack and back on the road to recovery. The less precipitous the adjustments, the more likely it is that the recovery would be delayed and would be less robust.

Sure, a lot of houses and office buildings stand empty today—but they are still there, and I can assure you that there are uses for them. What we need is for their prices to drop so that using them becomes attractive for potential investors, entrepreneurs, and employers. And make no mistake about it, we have not run out of things to do with all the empty buildings. We just need to move them from those who no longer can afford them and no longer have uses for them to people who can use them and can afford them at their lower prices.

"Well, that might be easy for you to say, but I am one of those millions of Americans who can't sell their houses."

Be assured that you can sell your house. I will pay you $100 right now, sight unseen. That's my flippant way of making a more serious point, which is that people can still sell their houses. The only relevant issue is price.

"I know I can sell my house, but only at a major loss, which I can't afford."

Don't look now, but you have already afforded it. You have incurred the loss already because you didn't sell two and a half years ago. This gets back to one of the most important principles in economics: sunk costs are irrelevant for rational decisions. Bygones are truly bygones. If you sell your house for a "loss" today, you will not be incurring the loss today; you will simply be updating your balance sheet. Things that you can't do anything about have a decided positive upside that few recognize: You can't do anything about them! So, don't sweat them. Devote your anxiety to the things that matter, those which you can actually do something about, and finding work is something you can make happen. And I suggest that you not wait on someone to hire you; create your own job.

Moreover, asset prices across many categories, not just housing, have fallen. You can surely buy more shares of GM and might be able to buy more shares of SPYDRS (meaning shares in a trust that buys only the Standard & Poor's Index of 500 companies) with the remaining equity in your house than you could a year or two ago (depending on where you live). The real issue you face now is deciding which asset—housing, stocks, or something else—will give you the greater rate of return in the future.

"But I and tens of millions of other Americans are hurting because the market value of our 403(b) and 401(k) retirement plans have tanked. My investments have fallen by over 30%."

I feel your pain. The market value of my financial portfolio has been halved over the last year or so, but are we not both exaggerating our financial misfortune? Don't you agree that, given the rot at the core of our financial system widely unrecognized a year or two ago, stock market prices then were unsustainable? If so, you are using an overly inflated portfolio value to compute your downfall. Moreover, is there not a good chance that the market has significantly overreacted to all the bad news (which is why so many homeowners and sophisticated developers are not now selling out)? If so, the long-term value of your financial portfolio is right now greater than its current value. You very likely are less wealthy than you were two years ago, but not as much as you have suggested (especially when you take account of any defined benefit retirement plan you have; they've gone up in value, substantially). Besides, if you don't get spooked by the current troubles, and many others do, your wealth could rise more rapidly over your career than it would have if the crisis had not emerged. Why? The rate of return on investments will be greater as investment funds become scarcer. And one more point: Your financial portfolio, while down, might be able to buy more house than it could have two years ago.

"The people in charge in Washington seem to be out of control, spending money they don't have. Is this not a danger?"

You bet. If the bailout and stimulus packages could have the wondrous Keynesian "multiplier" effects that Obama and his advisors claim, then maybe we ought to route the entire GDP through Washington, creating unchecked prosperity with the wave of politicians' fiscal wand.6 These very bright people could well do more harm than good, but I am still optimistic because there are close to 240 million adult Americans who have information on their local problems that the Obama administration can't have, and most of them are working hard to solve their problems. Some of them will create whole new products, if not industries, as they view the unemployed workers and empty office buildings as opportunities to put millions of heretofore untapped ideas to work. Five years from now, many creative Americans will thank their lucky stars for being laid off over the past year. Maybe you will, too.

And remember that Americans are returning to an old economic religion: They are taking their credit worthiness seriously. They are paying off their credit card balances and actually saving for a change. Even banks show signs of having learned a thing or two, that real risks come with risk premiums on their investments and they need to up their credit standards. These changes will be (as such changes have always been) a seedbed for economic recovery by this time next year.7

"But, Professor McKenzie, you've got to feel the pain of all those people who were planning on retiring this year or the next and now can't. What's your take on their problems?"

 

See McKenzie on Prices for a podcast with Richard McKenzie on EconTalk.

I have a very personal take: A year and a half ago, I was contemplating retirement in July 2009. I've changed my plans for two reasons. One is obvious from what I've already said—financial. I won't now be able to retire to the luxury lifestyle that I had planned. The other reason may not be so obvious. Times are interesting for economists. Why miss out on the opportunity to teach the important lessons that appear every day in the morning papers—lessons that need to be re-taught time and again, often painfully?


Footnotes
1.

Moore, Stephen and Julian L. Simon. 2001. It's Getting Better All the Time: 100 Greatest Trends of the Last 100 Years. Washington, D.C.: Cato Institute, chap. 4.

2.

Carter, Susan B., Scott Sigmund Gartner, Michael R. Haines, Alan L. Olmstead, Richard Sutch, and Gavin Wright, editors. 2006. Historical Statistics of the United States. Cambridge, U.K.: Cambridge University Press, vol. 3, pp. 25 and 243 and Bureau of Business and Economic Research, University of New Mexico, accessed September 21, 2009 at http://bber.unm.edu/econ/st-gsp5.htm.

3.

Carter, Susan B., Scott Sigmund Gartner, Michael R. Haines, Alan L. Olmstead, Richard Sutch, and Gavin Wright, editors. 2006. Historical Statistics of the United States. Cambridge, U.K.: Cambridge University Press, vol. 3, p. 255.

4.

Lifsher, Marc. 2009. "California is poised to extend unemployment benefits." Los Angeles Times, March 27, 2009 accessed on September 21, 2009 from http://articles.latimes.com/2009/mar/27/business/fi-unemployment-california27.

1.

For one of the best accounts of the various government inducements for low-income and ethnic groups to buy more houses than they could have been able to afford under prudent lending standards, see Norberg, Johan. 2009. Financial Fiasco: How America's Infatuation with Home Ownership and Easy Money Created the Economic Crisis. Washington, D.C.: Cato Institute.

6.

I have an extended discussion of why the bailouts and stimulus expenditures will not have the advertised effect in McKenzie, Richard B. 2009. "We're in a policy bubble, which, too, will burst." Orange County (Calif.) Register, February 9, 2009 accessed September 21, 2009 from http://www.ocregister.com/articles/federal-government-dollars-2308156-policy-country.

7.

I give more details on my arguments for a strong recovery in 2010 in McKenzie, Richard B. 2009. "Strong recovery is coming." Orange County Register, June 14, 2009 accessed on September 21, 2009 from http://headlines.ocregister.com/articles/prices-30360-recovery-good.html.


*Richard McKenzie is the Walter B. Gerken Professor of Enterprise and Society in the Merage School of Business at the University of California, Irvine (mckenzie@uci.edu). His latest book is Why Popcorn Costs So Much at the Movies, And Other Pricing Puzzles (Springer 2008).

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