The Conflicted Economy: Flashing Hot and Cold

The U.S. economy has been flashing conflicting signals of late, with news zig-zagging up and down. Improvement here, weakness there. Good numbers one week, bad the next. They’re signs of an economy struggling to recover, but not quite able to get up enough momentum. So what gives?

It may sound quaint, but I still like to look at the economy in terms of the old textbook formula:

GDP = C + I + G + (X – M)

In case your memory’s a bit rusty, that’s Gross Domestic Product (GDP) equals Consumer spending (C), plus business Investment spending on buildings and equipment (I), plus Government spending (G), plus exports (X) minus imports (M). It may be a little naïve, but I find it a useful way of looking at the economy.

Consumer spending makes up about 70 percent of U.S. GDP – it amounted to about $11 trillion in 2011. These days, consumers aren’t sure what to think, with signs of recovery in the housing markets overshadowed by persistently high unemployment rates. Talk of an impending student loan crisis isn’t helping. It’s hard to expect consumers to rescue the economy when their incomes are stagnating.

Business spending on buildings and equipment only makes up about 12 percent of GDP ($1.9 trillion in 2011), but because it gets multiplied as it flows around the economy, investment spending is particularly important. Right now, businesses aren’t seeing consumer or international demand growing quickly enough to motivate them to spend more on expansion. This continues to drag the economy down, and there are few signs that businesses are going to power a strong recover any time soon.

Government spending makes up 20 percent of GDP, or about $3 trillion. Contrary to most people’s beliefs, 60 percent of that, or $1.8 trillion, is at the state and local levels. Reduced tax revenues caused state and local government to slash spending and employment, and total government employment is still down by more than 1 million jobs since its peak in April 2009. The looming Fiscal Cliff, a pending election, gridlock in Congress, and debt growing at unsustainable rates are all causing uncertainty and unease with consumers and businesses.

Total exports were $2.1 trillion in 2011, while imports were $2.7 trillion, meaning net exports (exports minus imports) actually decrease GDP. Internationally, continuing problems in the Eurozone and concerns about China weigh on the economy as well.

The net effect of all these factors on the economy as a whole is lukewarm at best.

So what needs to happen? In general terms, we need for enough things to start going right to create a self-sustaining recovery, a critical mass of good things or good news. Enough cylinders firing to get the economic engine up to speed.

How best to get there is up for debate. It’s possible – perhaps even likely – that the economy will eventually right itself on its own, without any interference. The trouble is that in the meantime lots of workers will sit idle, and many children may go hungry.

A proven yet controversial solution would be to expand fiscal stimulus until the economy gets going on its own again. The problem there is that this requires expanding the federal debt even more.

The Federal Reserve meanwhile has been doing what it can to stimulate the economy with monetary policy. However, there’s only so much more the Fed can do. Opponents also criticize any Fed attempts to stimulate the economy for fear of inflation, even though there are few signs that inflation is a real concern.

For now, though, it looks like all we can do is sit, wait, and hope.

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