Opinion: Our economy — where’s it going?
In 1776, Scottish economist Adam Smith published “The Wealth of Nations,” setting the model for free-market capitalism. That same year, the British colonies of North America declared their independence from Great Britain. When these colonies won the War of Independence and formed the United States of America, the Founding Fathers adopted this free-market system for its economy.
The ‘Invisible Hand’
Smith was mainly concerned with the “morality” of self-interest in a laissez-faire system and believed that the economy would be regulated by an “invisible hand.” Laissez-faire is a French term which means “leave it alone.” In the context of Smith’s analysis, it is the idea that the economy would be self-regulated and should be free from interference by the government. This self-regulation would occur because of the laws of supply and demand, which he called the “invisible hand.”
The basics of this theory are easy to understand. If supply is greater than demand, prices will lower. If demand is greater than supply, prices will rise. For example, in 1958, Wham-O introduced the Hula Hoop. As demand increased, Wham-O had to expand its production, hire more employees, increase its shipping costs, and so forth. The price of Hula Hoops increased as demand outpaced production. During the first four months that they were on the market, 25 million of the toys were purchased. Today, the price of a Hula Hoop is low (as a percentage of a household’s disposable income) because the demand for the product is low. In theory, this is exactly how Smith’s concept of the “invisible hand” was supposed to work.
But at that same time as this system was functioning (at least for Hula Hoops), the United States was drifting away from adherence to Smith’s model. In the mid-1930’s, some government officials were swayed by the economic theories of John Maynard Keynes. Keynes believed that government should play an active role in regulating a nation’s economy. Specifically, he advocated increased government spending to offset downturns in business cycles. Of course, at the time, the country was experiencing the Great Depression. The Roosevelt administration implemented huge projects, like the Civilian Conservation Corps, Tennessee Valley Authority, Civil Works Administration, and Farm Security Administration.
The outbreak of World War II brought an end to the laissez-faire policies concerning the general economy. The government created the Office of Price Administration and Civilian Supply (OPACS), and economist John Kenneth Galbraith was put in charge of setting the prices for nearly all commodities produced by American industry. But, when the war ended, so did OPACS.
Federal Reserve System
After several financial panics of the late 19th and early 20th centuries, the Federal Reserve System (a.k.a., “the Fed”) was created to maximize employment, stabilize prices, and moderate long-term interest rates. In times of high inflation, the Fed generally “tightens” money supply. Theoretically, that should lower demand and bring the system back into balance.
For a few recent years, the “cost” of money from the Fed was extremely low because inflation was low. In 2019, the rate of inflation was 1.0 percent, and in 2020 it was 1.23 percent. Last year, the rate started to climb (4.70 percent) and, during the current year, it has been increasing dramatically (9.3 percent).
Consequently, the Fed has tightened the money supply by raising the interest rate five times since the beginning of 2022. According to experts in the field, it is expected that the Fed will announce another, perhaps quite large, rate increase next month. The big question is: Will the rising “cost” of money slow inflation?
When the Fed was created, people who spent money took dollar bills out of their pockets and counted them out to merchants, landlords, service people, and so forth. Even 70 or 80 years later, people wrote checks from their checking accounts, and they had to justify the amount on the checks with the “cash” that they had in the bank. With tens of millions of households doing business in this fashion, the “invisible hand” continued to work (at least most of the time).
But in the 21st century, “money” is illusionary. It’s not represented by greenbacks in the bank or dollars in one’s own wallet. It’s a series of numbers on a strip on the back of a plastic card. This “invisible” money is backed not by cash, but by the cardholder’s credit limit. So long as the cardholder keeps making the minimum monthly payment, she or he can continue buying goods and services with the card (and paying interest as high as 23 percent).
When people spend more than they earn, they create a deficit. When this year’s deficit is added to previously accumulated deficits, that constitutes their debt. Currently, household debt in the United States is at an all-time high. In 2000, the total household debt was a bit over $7 trillion. During the housing bubble of the early 2000s, it climbed to more than $12 trillion. Then the bubble burst because of housing mortgages based on junk bonds.
By 2013, the slow economy caused household debt to shrink to about $11 trillion. Then, lower interest rates were instituted to stimulate the economy, and household debt again began to rise. At the end of the second quarter of 2021, U.S. household debt hit $15 trillion. And extremely low mortgage rates, combined with other buying incentives, continued through the waning phases of the pandemic.
Those hurt most by the current imbalance of supply and demand are the 22.43 million Americans with an income of less than $25,000 per year. But so are most of the tens of millions who are above that level but below the median family income, those who are most likely to qualify for credit cards and are forced to use them for essentials. As their credit card debt continues to accumulate, will raising the interest rate help any of these people? Will it lower inflation or will it create stagflation and serious recession? I think the latter is more likely.
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Jim Glynn is Professor Emeritus of Sociology. He may be contacted at firstname.lastname@example.org.