Back in the early days of global exploration, cartographers identified unfamiliar stretches of terrain as "terra incognita," Latin for unknown land. The dismal science of economics is today embarked upon its own terra incognita as we adjust our theories to fit an unfamiliar situation. This is not a mere matter of supply siders versus Keynesians, but something much deeper that strikes to the very heart of economics as presently understood.
For the last century, economics has been basically a tug of war between economic growth and inflation. There was a built-in presumption, based on experience, that too rapid economic growth spurs inflation, which can be deadly. In the late 1970s, inflation roared out of control, eroding personal wealth and transforming long term investments into crap shoots.
Former Fed Chairman Paul Volcker threw the national economy into a tailspin when he hiked interest rates well above traditional levels, but he succeeded in wringing inflation out of the system. We then embarked upon several decades of fairly consistent economic growth. Every time growth flat-lined, the Fed would cut interest rates to spur investment and consumption. When inflation began to peek through the clouds, the Fed would hike interest rates and inflation would recede again. It did seem we economists understood the basic dynamics of the system and, within reason, could control the ebb and flow of economics.
But today, when the economy is stagnant and unemployment is much too high, the Fed's traditional remedy of cutting interest rates -- which are now effectively zero -- has had little if any effect. The latest ISM report that manufacturing has slipped into negative growth for the first time since July 2009, and scant job creation in June, underscores, the weakness in the economy. Even the Fed's innovative quantitative easing, which frees up vast sums of money for investment and consumption, isn't having much effect, either. In this unfamiliar terrain, economists are more concerned about the prospect of deflation than inflation.
I see three basic problems -- the first being fallout from the financial recession of 2008 with respect to the balance sheets of consumers and government entities. The collapse of housing prices destroyed trillions in family assets. The median net worth of families in the United States dropped by 39 percent over a three year period -- from $126,000 in 2007 to $77,300 in 2010 -- leaving family wealth back where it was in 1992, two decades before.
Second, the housing collapse led to permanent damage to our financial and banking system. Banks are not making normal loans because they still have a lot of bad debt on the books and they don't know what future regulatory requirements will be.
And third, the enormous debt of government fosters uncertainty. Everyone is wondering how we can pay this debt down, especially when Congress is tied up in knots and seems unable to function.
There is little more the Fed can do unless it plans to pay people to borrow money. As I see it, the only way out of this morass is a bipartisan long term plan to reduce the federal debt, built upon sensible changes to the entitlement programs, buoyed by near term policies to stimulate growth. Perhaps after the elections this will be possible.
Jerry Jasinowski, an economist and author, served as President of the National Association of Manufacturers for 14 years and later The Manufacturing Institute. Jerry is available for speaking engagements. July 2012