Politics & Policy

Lag Logic

It takes time for policies to change economic behavior.

One of the hardest things to understand about economics is that policies generally impact on the economy only with a lag. That is, an action by the government today may not actually affect the economy for months or even years. It takes time for policies to take effect and change economic behavior.

#ad#What this means is that at any given moment in time, policymakers may be reacting to economic conditions established by policies put in place some time ago even as those conditions are in the process of changing. So they often err by basing their actions on the past rather than what is coming.

Unfortunately, the result is that policy often overshoots. Policymakers do too much, with the result that they unintentionally undo whatever good they may be trying to accomplish. The classic example of this is countercyclical policy.

Economists have long known that businesses, workers, and policymakers tend to be slow to recognize the signs of an impending economic downturn until it is well underway. In the early stages, businesses think the slowdown is temporary, so they continue as usual. But eventually, they realize that sales will not recover for some time and begin to pare expenses, reduce inventories, and lay off employees.

For this reason, the unemployment rate lags the business cycle. It does not start to rise until well after a downturn has started. Conversely, businesses are reticent to rehire workers until they are certain that the economy is in recovery, which may be many months after the trough of the recession.

Politicians tend to react to changes in unemployment rather than those in real economic growth when determining whether to initiate economic stimulus. And, of course, the political process is slow and most fiscal policies are slower still to take effect. Consequently, stimulus policies never take effect until it is far too late. Instead of mitigating downturns, they may overstimulate on the upside. Sometimes, this actually sets in motion forces contributing to a later downturn.

Politicians can be forgiven somewhat for their mistakes because economists really don’t know any better. Very, very few economic forecasters ever call a cyclical turn accurately. And those that are able to do so once are almost never able to duplicate the accomplishment. In short, economic forecasting is simply too inaccurate to give policymakers sufficient warning to enact appropriate policies in time for them to be beneficial.

Just as there are economic indicators like unemployment that lag the business cycle, there are also those that lead. One of these is sensitive commodity prices. Based on what these data are showing, the trough of the recession may well be past and we are in the midst of an upturn.

The Commodity Research Bureau publishes the most widely followed index of commodity prices. It fell sharply beginning in early 2001. After peaking at a level of 229 in December 2000, it fell almost continuously to 186 in October 2001, before turning up. The index has risen steadily since and now stands at about 239.

In short, the economy went through a period of deflation, the opposite of inflation. That is, falling instead of rising prices. This fact was not evident to most people because the Consumer Price Index lags far behind the CRB’s index and because the CPI is heavily weighted toward finished goods and services, rather than raw commodities.

However, the same fundamental forces that drive basic commodity prices eventually impact on the general price level. And these forces are what determine the overall level of economic activity. If businesses cannot raise prices and must continually cut them, then profits are going to suffer. This forces cutbacks and reduced investment. The result is a recession.

Therefore, the upswing that we have seen in commodity prices is a strong sign of a turnaround — but of course, with a lag. As prices rise, profitability returns, leading to new investment and the rehiring of laid-off workers. As aggregate incomes rise, sales increase further, leading to economic expansion.

So, for a time, rising prices are good-indeed, necessary for the economy to grow. But the Federal Reserve must be diligent to ensure that a modest and beneficial reflation does not turn into inflation.

I believe that President Bush has wisely chosen a tax plan that is justified even if the economy were booming. Elimination of the double taxation of corporate profits would be desirable under any economic circumstances. By contrast, the Democrat plan can only be justified if the economy is still in recession and will remain there for some time.

The return of “pricing power” is a strong sign that 2003 will be a good year for the stock market and the economy. But it may still take a while before this becomes generally apparent.

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