Friday, March 21, 2008

The Veil of Money


Eighty years ago neoclassical economists concerned themselves with the “veil of money.” They wished to part the financial curtain that obscured the real economy. We continue to adjust for inflation when observing GDP, so that price changes do not distort our picture of real-output changes. Neoclassical economists knew that financial turmoil affected output, but they relegated that knowledge to the study of business cycles. In the long run, the money supply could rise or fall and inflation would surge or ebb accordingly. Real-output growth, however, depended upon the availability of the factors of production and technology’s advance.

Lately there’s been so much focus on the financial crisis, and the Federal Reserve’s (Fed’s) and federal government’s (fed’s) attempts to deal with that crisis, that these events tend to crowd out other economic news. The Fed’s and fed’s efforts also lull us into believing that the financial crisis is a stand-alone problem. If Fed chairman Ben Bernanke and Treasury Secretary Henry Paulson can rescue the commercial banks and investment banks, then the worst must be behind us.


But this may also be a good time to lift the veil of money and review what’s happened in the real economy lately……

On Monday the Fed reported that (
industrial production and capacity utilization (the operating rate) both fell. They are now below where they were at the end of last fall. Mining, manufacturing and public utility activity is shrinking.

The next day the Census Bureau announced ( that single-family housing starts fell to 707 thousand. You have to go back to the 1990-91 recession to find a lower number. They stood at 1.837 million at the beginning of 2006 and have been declining ever since.

At the start of the month the Commerce Department released its auto-sales figures ( For the first two months of this year the automobile manufacturers sold 15.3 million vehicles at a seasonally-adjusted annual rate. That’s a figure reminiscent of 10 years ago.

Yesterday the Conference Board said ( that its index of leading economic indicators had declined for the fifth straight month. Some of the ingredients in this index are financial, but most are not. Not only is the real economy shrinking, but the economic indicators that forecast the real economy’s direction indicate that the real economy will shrink further.

Even if the veil of financial conditions improves, the real economy beneath that veil is in retreat. The glut of unsold homes is the underlying problem from which all other problems – real and financial – stem. The glut depresses residential construction and the cluster of industries surrounding residential construction. It also erodes homeowners’ wealth as home prices plunge. That further depresses consumption expenditures.

Until the Fed and the feds mobilize a rescue package that deals with the glut of unsold homes, the economy must wait for market forces to gradually remove the glut. But waiting for market forces to correct the problem exacerbates matters as more distressed and foreclosed properties come on the market. Act quickly or suffer slowly, it’s a policy decision.

© 2008 Michael B. Lehmann

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