Can Washington break the deflationary spiral?

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A lot of economists and commentators are having trouble figuring out what to call our current economic situation. Should it be the Great Recession, the Financial Crisis, the Greatest Depression? I don't really think we'll know what to call it until we get some historical distance from it. And we won't get much historical distance until we figure out why it's continuing and then do something positive to get out of it.

I recently conducted a webinar, "The Economic Outlook for the U.S. and Key Industries."

Webinar: Economic outlook: U.S. and Key Industries from Scott C on Vimeo.

My basic conclusion was that when you have an economy which depends so heavily on consumers for growth -- personal consumption expenditures accounted for 67% of the GDP growth in the third quarter -- and millions of those consumers are unemployed, this creates a deflationary spiral that is hard to escape. Without income from jobs or easy credit for debt-fueled spending, it's hard to see how consumers can drive a recovery.

The Fed does not appear to think that it can do much about unemployment -- at least that's what I infer from its statement that it will take five years to get back to healthy job growth. However, next month, following a presidential jobs summit, Congress is likely to vote on a jobs bill that could contain some or all of the following job creation ideas:

  • Offer a payroll tax holiday. This means temporarily suspending the 12.4% tax on workers' first $106,800 of wages. This would give more cash to employers and workers, who split the tax 50-50. This idea is probably not enough to get a company operating below full capacity to hire more workers.
  • Create a new jobs hiring credit. This would shield employers from $3,000 to $5,000 in taxes per hire. But it won't be enough to overcome excess productive capacity. And unless the criteria for applying the credit are carefully implemented, it could turn into a game where employers could hire, fire, and re-hire workers to keep getting the credit.
  • Help close state and local budget deficits. High jobless rates mean lower tax revenues and big budget deficits -- leading to state and local government deficits of $150 billion in fiscal year 2011 and 900,000 government jobs evaporating next year. The answer? Have Congress add $75 billion to the $40 billion states are already getting from the stimulus package to shrink 2010's $35 billion deficit. This could help save jobs temporarily.
  • Provide public-service employment. This proposal would have federal government create 1.4 million new public-service jobs. Even if this number doubles, it would not be enough to cut into the unemployment problem.

These ideas are unlikely to fix the fundamental problem -- the deflationary spiral of falling wages and spending. We have the economy working at 70.5% of capacity, well below the 82% long-term average. That means that many companies need to cut costs to boost profits, which puts more people on the unemployment rolls. People without jobs can't buy more stuff, which leads to more excess capacity and lower prices to sell off excess inventory.

To get out of this deflationary spiral, we need to create a virtuous cycle instead. Here, a company is operating at full capacity as it strains to meet demand so it hires more staff which creates more people with incomes who can spend more -- thus creating more demand and further straining capacity.

What can Washington do about this? It helped create the technologies that formed the Internet and it could do so again with some luck and carefully targeted research spending. I am not sure exactly what those technologies might be but they would have to be ones that would create a step-function rise in business productivity.

Such opportunities for rapid profit growth would spur business investment, which accounted for only 35% of the third quarter's economic growth. And that -- rather than a consumer-dependent economy -- is the basis for long term growth.

Peter Cohan is a management consultant, Babson professor and author of nine books, includingCapital Rising(due in June 2010). Follow him on Twitter.

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