Monday, January 17, 2011

A Real Discussion About the Economy, Obama the Comeback Kid?

Note: While much media attention has been paid to the aftermath of the shootings in Tucson over the past week, I do not intend to devote further digital ink to the topic unless issues of policy warrant further discussion. I do not consider the shootings or their aftermath a political issue and condemn unequivocally those on both sides of the aisle who have attempted to make it one. My thoughts are with the victims of the shooting and may Jared Loughner rot in hell.

Our Long Term Economic Future? Look to Our Infrastructure, Science and Education
In the sound-bite world of politics, serious economic discussion rarely takes place. Democrats speak of the need for government intervention to stabilize the economy and get Americans back to work. Republicans talk of the need to reduce government intrusion into private industry and let capitalism drive growth. Both sides largely miss the point most of the time.

Truth be told government intervention is neither inherently bad nor inherently good for an economy. It all depends on the nature of the investment.

Let's start by understanding what drives long-term economic growth. The size of an economy is determined by its Gross Domestic Product, the value of goods and service produced by that country. This is the all-important figure. It determines the value of goods and services that can be divided up amongst the citizens of the country. It is the measure of the wealth of a nation.

So what generates GDP? The simple way that I like to break down the equation is as follows:
GDP = Productivity * # of Workers * # of Hours Worked per Worker

Productivity is the value of what the average worker produces in one hour of work.

But GDP itself is not terribly instructive. The GDP of China exceeds the GDP of both Japan and Germany at this point. But no sane person that has visited all 3 places would call the average Chinese person more wealthy than the average person in Japan or isn't even close. The reason China's GDP is so much larger is simply because it has so many more people, simply from the equation above, there are more workers even though the workers are less productive.

So to estimate how the average American is doing, or the average Chinese person or wherever, we usually use a term called Per Capita GDP, which is simply total GDP divided by the size of the population. This gives a good proxy for the average wealth of a citizen within each country. This changes our equation slightly:
Per Capita GDP = Productivity * Workforce Participation Rate * # of Hours Worked per Worker

So how wealthy the average person in country is can be described by three factors, how productive the workforce is, what proportion of the population works and how many hours each worker works.

So let's talk about how we "grow the pie" and increase Per Capita GDP.

In a typical recession, the last two terms of the equation shrink significantly...that is, you have a lot less people participating in the workforce and a lot less hours worked because you have a lot of unemployed and underemployed individuals. This can hurt. Workforce participation has dropped by over 5% in this recession and hours worked by at least 2%. This leaves a 7% hole in our wealth from where we started.

This is why, in times of recession, politicians spend a lot of time talking about getting people back to work. But the truth is, while this is an important short-term issue, simply employing more people will not spur long-term per capita GDP growth.

The reason is simple -- we hit the practical maximum pretty quickly. The unemployment rate in the US is presently 9.4%. Employing every single unemployed person (a feat that is not practical as unemployment rarely goes below 5% and never falls below 2%) would grow the economy only 10%.

Similarly, increasing hours hits a practical maximum pretty quickly. Hours could increase some now as people who have been forced into part-time work resume full-time work. But returning to pre-recession levels would only increase hours by 2%. Beyond that, who wants to start working 80 or 90 hour weeks routinely? That might spur economic growth, but we'd never be off work to enjoy our wealth. If anything, the social trend is in the opposite direction, with the generation presently coming of age preferring less work at lower pay rather than more work at higher pay.

So taking the last two terms of the Per Capita GDP equation to their practical maximum might yield 10% or even 12% growth if you really stretch it. That is about 2 to 3 years worth of growth in a healthy economy. Then what?

The answer lies in the first term of the equation - productivity. Unemployment and hours trend up and down with financial cycles, but productivity growth is the engine of long-term wealth generation.

So what influences productivity? A lot of things obviously influence how productive various workers in various industries are, but I believe that almost all of those factors can be distilled down to three basic categories:
Infrastructure, Education and Science

Think about what makes you productive in a job. If you are a truck driver, having efficient roads and bridges do. If you are an office worker, productivity tools such as the internet do. Your knowledge and skills, gained through education, most certainly do.

Also think about the game-changers of the past century in the economy and in society. The television. The internet. The microwave oven. Modern plastics. The GPS. You know what these things have in common? They were all technological game-changers that remade the economy and society. And they were all commercializations of basic scientific research carried out by the federal government.

Think about where the country would be without the Eisenhower Interstate System. How about without airports in major metropolitan centers? How about without a universal power grid? All infrastructure investments by the federal government (sometimes in cooperation with state governments.)

Now...think where our economy would be if there were no public schools. I imagine our workers wouldn't be the most productive in the world, as they are now.

Now, think about the major scientific, infrastructure and educational investments the government is making today and how they will spur the growth of tomorrow? NASA? Cut way back. Basic research investment? Its lowest level in decades. Infrastructure spending? Our power grid, air traffic control system and interstate were built in the 1950s. And China has better mass transit infrastructure than we do, to say nothing of Europe.

Education? Subsidies to public universities are falling across the country. Primary and secondary schools are getting squeezed as states and localities face budget shortfalls.

The real debate that we need to be having about the economy is how we can free up funds to invest in infrastructure, science and education. It isn't about the size of government, it's about WHAT it does. The federal government did a world of good in the 1940s and 1950s to set-up 6 decades of prosperity, despite facing down a massive debt following the end of World War 2. I would hope our politicians would look for ways to do the same.

Obama - On the Comeback Trail?
I will publish a full update next week, but President Obama's numbers have moved back to being solidly positive (that is, his approval minus disapproval is significantly greater than 0) for the first time in several months. The spin in the media is that this is due to the lame duck Congress and its productivity.

While I'd like to believe that the American public is rewarding bi-partisanship and is happy about the end of Don't Ask, Don't Tell and a nuclear arms treaty with Russia, as I said before, I find it hard to believe that they a. have been paying close attention and b. care much how many warheads Russia is going to reduce over the next decade.

A far more plausible scenario, in my mind, is that, as it usually is, this is all about the economy. Unemployment is finally starting to fall, the economy has been growing for some time, those who stuck with their investments through the crash are close to being back to even (those who sold at the bottom out of fear have no one to blame but themselves) and fear and panic have been replaced by some combination of hope and greed. In other words, the economy is in full recovery. An economic recoveries lead to popular Presidents.

The link below shows the study I've been promising to link to that demonstrates just how strongly economic conditions dictate results. The incumbent party does well when incomes are growing, poorly when they are not.

The Washington Post article highlighting this study is located here.

All told, if income growth in the election year is 1.5% or greater, the incumbent party generally wins, otherwise they generally lose. You can see that the predictive powers aren't perfect: an incredibly popular former General named Dwight Eisenhower caused the GOP to outperform in 1952 and seize the Presidency from Truman's Dems. The incredible unpopularity of the Vietnam War sank the Democrats in 1968, despite economic conditions at the time (it was so bad, LBJ didn't even bother running for re-election.) A charismatic Bill Clinton dramatically outperformed in 1996 against a lackluster Bob Dole. 2000, while technically correct (Gore indisputably won the popular vote), was a bit of an outlier in terms of the electoral outcome.

But most races are pretty tight to the line. Barry Goldwater's awful campaign in 1964? Turns out he finished right about where he should have, given the economic prosperity. The Reagan Democrat coalition in 1980 and 1984 that supposedly changed the political equation? Turns out he finished right about where he should have both years. John Kerry's 2004 disaster? Right on the line. Obama's Hope and Change in 2008? Right where it should be.

The point is that much as we like to think every election cycle is unique, the odds are that 2012 will play out somewhere close to the line as well. Which means that if incomes grow 1.5% or more in 2012, Barack Obama will likely win a second term. If they don't increase by that much, he will likely lose. If I'm the President, given the track of the recovery, I feel pretty good about that line.

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