Economics

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Our Policy Conundrum

I have spent much of my time recently lashing away at the notion that either monetary policy [i.e. interest rates] or fiscal policy [i.e. the Federal budget deficit] should be tightened any time soon. Nowhere in the data is there a sign that now is close to appropriate for such a move.

“It is not the absence of good economics and policies, it is the absence of sensible conversation that threatens our economy most.”

But the debate rages on. Quite why I have no idea. Perhaps it is because, as Paul Krugman says, central bankers hate being ‘accommodating’. They much prefer being old curmudgeons. He goes on to add that as far as he can tell the ‘debate’ seems to be one in search of a problem to solve, rather than targeting something we have to deal with now. I tend to agree. The whole discussion has a decidedly artificial air to it.

So, for the sake of clarity let me repeat: we do not need to tighten. Not now, and most likely not next year either.

In fact there is ample reason to believe we interest rates should stay where they are for three whole years.

I realize that I am repeating myself here, so in the interests of balance allow me to pull together a couple of plausible reasons that tightening should occur sooner – in line with what the hawks are arguing.

The most obvious is our national fiscal balance that is now completely out of whack. How you respond to this depends upon your point of view regarding its origins and likely size post-crisis. The hawks see the deficit as a proxy for the debt load it implies. In turn this suggests we need to be aware of the limited appetite there might be for US bonds. Two numbers are bandied about with abandon: the debt/GDP ratio which has surged from the low 40% range up to about 70% and could keep on going higher for a while; and the absolute deficit which stretches away in negative numbers for as far as the eye can see. It is the combination of the two that worries people. It worries me too. The reason being that while short term surges in debt are fine – they are the results of crises – once the crisis abates the debt load should ease. If the Federal deficit remains unchecked that easing will be insufficient and our reliance on the bond markets may stay too high.

Here comes the interpretive part:

People who are hawks look at the ‘history’ of the US and do not see any ability to balance the books. They are therefore concerned that the debt/GDP ratio will stay at some lofty and unsupportable level. Others, me included, look at the same numbers and think that the debt/GDP ratio will come down in due course and that it is an entirely manageable problem.

Let’s do a quick run through the thought process that suggests the problem is manageable.

One aspect the hawks focus on is the cost of carrying the debt. We have to pay interest on the debt so we need to generate wealth to cover it. Assuming that interest rates adjusted for inflation stay within historic ranges – let’s say 2.5% – the implication is that it will cost between 2% and 2.5% of GDP to pay the debt load. That’s a lot of money, but in the context of the economy as a whole it is not a big deal. It is certainly something we could cope with. So debt load is not a problem.

The bigger issue, in the eyes of the hawks, is the deficit. As long as we run a deficit we are adding to the pile of debt we owe and not reducing it. Here the hawks have a big point. In fact I agree with their sentiment in this regard. All countries have experienced debt surges: mostly these are associated with crises of one sort or another. Wars rank high on the list. Depressions likewise. What sets the US apart is that has also had debt surges without a crisis to cause such a surge. Twice in fact. And both in the past thirty years. These are the two events haunting us at the moment and which make the hawks queasy. The two events? The debt spikes caused by the Reagan and Bush supply side budgets. One in the 1980’s and one in the 2000’s. These are the only two examples in American history of a debt binge being unaccompanied by a crisis. They were self inflicted wounds. They also prove, to the hawks, that the US cannot be trusted to be fiscally conservative.

Read that through again. It is very edifying.

The two events that are undermining the US’s reputation for fiscal conservatism were the result of policies and budgets enacted by Republican presidents.

Ironic huh?

Moreover the hawks all seem to be people who cheered on those two events as being stimulative supply side policies guaranteed to kick the economy into high gear.

Both failed. The last one spectacularly.

So the hawkish crowd all appear to be a tad cynical – to my eye – when they cry foul over the debt surge we now have but not those other two. Especially when they use the debt build up consequent to those supply side budgets as evidence the Federal deficit is running away unchecked.

Setting that cynicism aside: they have a good point. Structural, long term or permanent deficits are not a good thing. They undermine the trustworthiness of the US government when it says that it can mange its affairs responsibly. Somewhere out there in our projected budgets there must be a balanced set of books. Credibly balanced. With the emphasis on credible.

This is the nub of the hawks argument. We lack credibility. The fiscal mess that Reagan and Bush made has muddied the waters. The US lost its reputation for conservatism. Add in Obama’s social agenda that could add to the cost of running the government and it is easy to see why the hawks coalesce around the debt ratio as a harbinger of doom.

From my point of view I agree with the notion that we need to eliminate our structural budget gap. This means we have to have a debate about our priorities. An open an honest debate. I had hoped that the health care ‘debate’ would be the first step along that road, but I was disappointed. It devolved into a smear campaign so quickly that the big issues and choices disappeared beneath a welter of lies, innuendo, and name calling.

The end result of this debate will have to embody compromise that no one really likes – it is always hard to be enthusiastic about compromise – and will include cuts in favorite programs as well as tax increases. We will have to allocate our wealth more carefully and we will have to encourage thrift. Up to a point. It will mean that we have to get much better at wringing wealth from our resources: higher productivity and less waste. The US extracts less GDP per person from the energy it consumes than any other country. We are wasteful. That shows up in our imports. It detracts from our ability to be productive. This is simple stuff, but if opponents rally against such statements as being somehow ‘un-American’ we will never get to the root of our problems.

Liberals like myself need to understand that our social programs need to be put on a sustainable footing. Most were designed for a population with very different life expectancies and so on. They all need to be updated. That requires a pragmatic flexibility and honesty on the left so far lacking.

Conservatives have to get used to the idea that Americans like these social programs and want to keep them. The free market alternatives just don’t work for most people because of all the reasons that free market economics teaches us: the theories only work because of the utopian assumptions needed to make them tick. Put those ideas into the real world and you get the kind of unfettered capitalism that just ran us onto the rocks. Abandoning people to the whims of free markets exposes them to a turbulence only the wealthy can withstand. It predestines them to failure and undermines their sense of community. So government is necessary. It may be an ‘evil’, but it is a necessary evil. So conservatives need to embrace that fact and cooperate in making government responsive and efficient, rather than gutting it and hoping it fails.[see Katrina].

The deep divide in today’s politics – the incessant culture wars – are preventing this necessary debate from occurring. The focus of those wars on social issues eliminates a central ground existing for economic issues: life is rarely binary, but our politics have become so. The biggest loss appears to be fiscal conservatism. Neither side really embraces it. And as I mentioned above, the biggest irony is that the right wing totally abandoned conservatism in an effort to avoid having to confront the essential left of center tilt of the population with respect to social programs. I think both Reagan and Bush thought they could undermine the credibility of government as an economic force by plunging it towards bankruptcy – this is Grover Norquist’s famous mantra about ‘starving the beast’. What they forgot is that this implies bankrupting the nation along the way. It’s an easy mistake if your perspective is tainted by the view that somehow the government is not part of America. That may be difficult to square with ‘we the people’, but it is the dominant view amongst the hawks now girding for a fight against the Federal deficit. Since to Reagan and Bush the government was the enemy of America, plunging it into a permanent sea of red ink was an act of liberation. Reality is different of course. The government is us. And we are now awash with that Reagan and Bush induced debt.

Along the way both left and right have avoided a conversation. Both have drifted into the illusory world of free markets where magic things happen without any effort by any particular person or group. Reagan, Bush senior, Clinton, and then Bush junior all relied on this illusion in order to avoid having to discuss priorities and deeper problems. The magic would deal with it. We could just sit back, relax, and enjoy the grandeur of the American Dream. We stopped talking about the gritty issues of long term economic growth, competition, or infrastructure, and started living for today alone. That’s why I call it the era of illusion. Maybe self-delusion is more apt. All I know is we forgot to talk about difficult issues. The conversation ended.

The debt hawks are doing us a favor by re-starting the discussion. The problem seems to be that the conversation is all one sided. That, and the facts don’t seem to be important in shaping their views. I fear the great divide has seeped into our economic policy conversation.

So this is our conundrum:

It is not the absence of good economics and policies, it is the absence of sensible conversation that threatens our economy most.

Maybe the bond markets should be worried!

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Are We That Dumb?

Apparently.

The growing consensus in the media and commentariat is that a recovery has begun, that the economy is therefore OK, and so we need to shift our attention to setting the stage for tightening both fiscal and monetary policy. And this tightening had better come soon since there is a tsunami of problems ready to destroy the civilized world if we don’t act now. Or even sooner.

The problem I have with this train of thought is that nothing in the data suggests it’s true.

Nothing.

I have just read Paul Krugman’s blog where he notes the same thing. His conclusion is that we have entered one of those all too familiar periods of US history where the facts and the consensus opinion our not in step. What makes things worse is that, inevitably, it is the facts that lose in such a confrontation. The last time we were like this was during the run up to the Iraq war when no amount of fact checking could persuade the media that an invasion was the wrong course of action.

I just hope this current disconnect does less damage, and that we do not have to be subjected to a string of mea culpas over the next few years as the economy flounders deep in depression.

Because that’s where we will be if this herd mentality infects policy too much.

I fear it may be too late anyway.

The simple fact is that our economy is very weak. The recovery is more technical than real. Jobs are horrendously scarce and the employment outlook is still grim. Don’t just listen to me: the general consensus of economic forecasters is that we will still have an unemployment rate in excess of 8% deep into 2012. Think about that. Nearly three years from now our unemployment rate will be higher than it was when Bill Clinton used a poor economic record to wrest the White House from Bush Senior.

This nugget of information is not exactly top secret, so I would have thought that the current administration would be pulling out all the stops to get unemployment down as rapidly as it can. Winning elections usually focuses political attention on inconvenient things like a lack of jobs.

But no. The Obama folks have fallen under the same spell as the media. All the talk now is of tough action to be taken soon to tighten the Federal budget. Just in case those nasty bond people decide to pull the rug out from underneath us.

Here’s another interesting nugget: PIMCO our largest domestic bond fund, and one of our most successful, just bought up a huge pile of US bonds. That does not sound like an imminent panic. On the contrary it sounds like a vote of confidence.

The only way I can explain the disconnect between the facts and the curious fiction found in the media is that we live in an era of attention deficit disordered reporting. No matter what the crisis is, no matter how deep, nor how difficult it might be to cure, it must not last long. We need new angles and new stories to keep the front page fresh. So, after due time, we must shift our attention to the aftermath of the crisis rather than on its continued existence. After all the fact that we have a crisis is soooo yesterday.

We have reached the Age of Immaturity.

To some degree this explosion of stupidity is being fed by the counter-revolutionaries of the free market brigade. They have manned the intellectual barricades in order to salvage what reputation they can from the chaos their ideas have wrought. This resistance to honest re-appraisal of theory and its concomitant embrace of delusion pervades the entire fabric of all institutions who were fully invested in the free market deregulatory era. Don’t forget that our society became obsessed with stock market watching over the last few years. We gorged on spurious economic and financial data and were spoon fed market based ideology by endless cable TV talking heads all who seem to have grown up in the post Reagan era. Not one seems to have heard of Keynes. And few seem bothered by the prospects of depression. Since nothing lasts long in this fast paced world, the assumption is that the recession cannot last long either. Every news station and cable TV channel pours out daily minutia about the economy and therefore the competition to be on the leading edge of the next story trumps [sorry about the pun] any need to dwell on the current story.

This is why risk management failed us so miserably over the last few years: it got in the way of a good, positive, message.

The funny thing is that, as I reflect on my years in banking, the same problem existed back then. The difference between the two eras is that nowadays the stupidity is magnified by the vast array of news outlets. Back then the damage was confined to the banks whose managers fell prey to the good time stories. And there were plenty of them even then.

So here we are rushing full tilt into a group think disaster. The economy is great. The stock market is flying again – that’s all that really matters – and the only hiccup between here and nirvana is the potential threat from the bond market and the falling dollar.

Therefore all serious people will surely act early and firmly to demonstrate our commitment to defending the dollar and balancing the budget. [Does anyone care that the dollar dropped like a stone during the Bush years and that none of these same commentators mentioned it?]

Damn the consequences.

Apparently it far better to sink on a neatly run ship than to float on a messy one. It shows our commitment.

How else do I explain tepid financial reform? Weak stimulus? Dithering on jobs programs? Ridiculous commentary about bond rates?or hysteria about debt levels?

Are we that dumb?

Yes we are.

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GDP: When Is Growth Not A Recovery?

Today’s revised GDP numbers for the Third Quarter are disappointing. You may recall that the original estimate last month was that we saw the economy grow about 3.5% in those three months. As better data has been accumulated, that growth is now estimated to have been smaller, at 2.8%.

While any growth is good, especially after the crisis of the past year or so, this level of activity is scarcely sufficient o keep us treading water on the one big issue we have to fix: jobs.

First let me show you the numbers:

  • Personal Consumption added 2.07% to GDP in the third quarter, compared to a negative 0.62% the prior quarter
  • Private Non-Residential investment reduced GDP by 0.4%; which was better then the second quarter’s -1.01%
  • Residential Investment bounced back a bit, adding 0.45%; it had been-0.67% in the second quarter
  • Inventories showed a big swing, adding 0.87% in the third after having reduced the second quarter by -1.42%
  • Trade was a problem: exports added 1.71% to GDP in the third quarter after being a -0.45% drag in the second; but imports grew rapidly as well to offset that export improvement, imports reduced GDP 2.53% in the third after having added 2.09% in the second quarter
  • Government Spending was positive both quarters: Federal expenditures added 0.65% in the third quarter slightly down from the 0.85% contribution of the second; State spending fell rapidly and has become a drag on growth, it reduced GDP by -0.02% in the third quarter after having added 0.48% in the second.

If you add all these figures together you arrive at the -0.74 reported for the second quarter and the 2.79% announced this morning.

So here’s the problem:

This is just not strong enough to make a goodly dent in our enormous overhang of spare capacity. I was very disappointed to see that both personal consumption and private non-residential investment were both adjusted down from the initial announcement. Even a cursory review of the results makes it obvious that all our talk about an inventory and stimulus led recovery was spot on. The basic economy is still quite weak and shows no real sign of gathering much momentum. The pick up in exports was easily offset by the acceleration in imports as the economy began to suck in more oil and manufactured goods. Plus there seems to be a problem developing in the level of state expenditure: as states struggle to balance their books they will reduce spending which will act a significant drag on the economy. Already the Federal level spending burst is beginning to dissipate, so when we add in the movement in trade and in state spending activity, the burden for the next few quarters shifts decisively to the private sector, which while not dormant is not exactly humming along either.

The big problem is that capacity gap. This is the difference between what GDP would be if we were utilizing all our resources, and its level given the percentage of our resources we are actually using. Currently this gap is huge. We have the capacity to be generating a GDP several points higher than that we are actually producing. Such is the collapse in private sector activity that this gap will take years to close if we meander about at the pace of growth we achieved in the third quarter.

It is this enormous overhang of spare capacity – most of it in the form of unemployment – that makes the economy feel as if it were still in recession, even though the data says it is growing again.

We are simply mired in fear. Consumers are afraid to spend as they struggle with debt loads that now seem out of whack with income and wealth prospects, and business keeps moderating its expectations for the future and refuses to ramp up employment. This is beggar thy neighbor writ very large. Until the fear subsides we will wallow about in mediocrity.

Oddly the one hope we had is the government and that now seems to be getting ready to step aside. All the talk in Washington and in the financial media is now fear driven too. Fear of the Chinese bailing out on our debt; fear of the bond market; fear of the dollar sliding some more; fear of a burst of inflation resulting from the money supply binge needed to prop up the banks; and fear of just about anything else you can imagine that could cost money. Except defense of course. Always except defense. These fears are all unfounded, but are easy to exploit politically in the absence of strong leadership.

Compound this fear by adding in a political system that has become totally unresponsive and easily ground to a halt, and we look set of a long period of frustrating and sub-optimal economic behavior.

No one wants to fix the problem.

I think this gridlock is a natural outcome of the crisis in economic thinking itself – where the free market ideology is being uprooted at long last – and in politics where the basic tenets of right wing economic policy beliefs have been overcome by reality.

So we are undergoing a sea change. A shift in worldview away from the Reaganite free market, free wheeling, laissez-faire system towards something that has yet to emerge. The rearguard from the free market crowd is fierce at all levels – in Washington as well as in academia – and it is this rearguard action that is stalling our progress: as an example, it prevents us from moving quickly to implement jobs programs because the free market folks object to more government spending.

Couple this with the health care reform ‘debate’ which has surfaced deep ideological divisions even in the Democratic Party and nothing much gets done. What legislation is passed comes at an increasing cost in terms of time and pent up emnity.

Our political system is teetering on the brink of failure. In particular the gentlemanly rules of engagement in the Senate are breaking under the strain of an increasingly entrenched ideological separation between the parties. The GOP has moved sharply rightward over the last few years and actively uses arcane rules to reduce the Senate to a standstill. The threat of filibuster essentially ends any chance of major legislation by either party. Unless the rules are changed neither will get a coherent program through and the Senate will deteriorate into a farcical debating chamber incapable of addressing big issues. Perhaps this is what the GOP wants. It certainly acts to their advantage currently. But in politics what goes around …. at some point the Republicans will suffer the same. Much of this will go away with time as the old time methods of reaching across party lines evaporate and legislation becomes more party line oriented. For this to happen we need to rid ourselves of the centrists who like to wheel and deal: they trade their votes for bundles of pork barrel spending in their home states. They also like the attention and power they get from being able to hold up action.

This clubbiness is a major deficiency of the American system as long as the nation is deeply divided along cultural or ideological lines. Those divisions are now so deep that reaching across party lines to form consensus on anything significant is just not possible. This slide towards dysfunction has been going on for a while. The American system was never designed to handle or reflect ideological divisions as deep as we now have. It was designed to operate best on a middle ground where there was general agreement on national goals and characteristics. Yes of course horse trading took place, but once that was done most major votes were very lopsided. Now the very notion of horse trading is limited to those few centrists. The Republican central committee has even banned cooperation, saying that it will not support candidates who reach out across the ideological divide.

I don’t know if this is good or bad. I come from a very confrontational style of politics with deeply rooted ideologies, so I am empathic with anything that simplifies party lines. At the same time the American system, which is unique and very parochial in its mechanics, has served well. It is only in the light of the culture wars and social changes of the past thirty years that it has been under strain.

What I do know is that unless the political fog clears and allows us to eliminate anyone’s ability to exploit fear, we are more likely than not to stay mired in the mess we just created for ourselves.

That could result in a ‘lost decade’. Which would be tragic.

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More Debt Hysteria

I have often wondered how easy it would be to write a completely silly article and still get it published. Now I know. Emund Andrews did it this morning. You can read his foolery on the front page of the New York Times.

Yet more debt hysteria I am afraid.

This is getting a little monotonous, but as in any epidemic, we must not let our guard down. We must confront this hysteria front on wherever we come across it. I just didn’t expect to find it on the NYT front page.

What really annoys me most is the amazing lack of analytical thought going into these articles. They simply seem to be a re-hashing of the same tired, and by now thoroughly debunked story. This is, of course, familiar territory: there is a school of thought out there supporting the notion that repetition can convert a falsehood into a truth. So we are bombarded with ever increasing frequency about the impending perils of America’s debt crisis.

It would nice were there some facts to document this crisis. Apparently I am asking too much.

But a crisis is assuredly is because Mr. Andrews breezily asserts so. Or more to the point he simply wonders aloud about the consequences of said crisis, presumably taking its existence as a given.

So allow me to be boring. Let me talk facts. I realize it’s less inflammatory and makes for a dull headline, but, given the enormous consequences of incorrect policy actions, I think we need to be quite sober when we discuss our national debt.

So without the hyperbole here goes.

Taking a look at the way in which our budget has fallen afoul of the recession we need to pick apart the causes of the rising Federal deficit. That is to say we need to know why we are in debt. To do this we should compare budgets, one put together before the crisis, and one that includes all the actions and expenses of the crisis. Given that we are supposed to be facing a tsunami of debt we need to look out a few years so we can identify when we get swamped. So lets look at our forecast budget out ten years. The ‘before crisis’ budget was about $8.3 trillion better off than the ‘after crisis’ budget. So the hysteria is over that addition of $8.3 trillion to the debt. As a proportion of GDP this addition drives the US debt ratio from about 40% up to around 70% over the ten years – a significant jump. Significant enough to cause all this panic.

Now let’s look at the books:

  1. First we see that projected discretionary spending does indeed increase. Somewhere in the region of $1.3 trillion over that period. This is the category that covers stuff like bail outs and stimulus packages. So this is where Obama’s fiscal folly would be accounted for.
  2. Second we see that debt servicing – the cost of paying interest on all that debt – also goes up. In this case by about $1.5 trillion also. Now let’s be clear here: much of this cost is baked into the numbers because the debt already exists. The Treasury has been active in extending maturities lately to take advantage of low interest rates. But there is also a huge amount of short term debt that needs constant refinancing and so could be re-priced at higher rates. Given that short term rate are practically zero currently any move would be up. But the budget allows for that. So let’s go with the budget figure.
  3. Next comes mandatory spending on things the law says the government has to do. That goes up about $0.8 trillion.
  4. So, thus far we have accounted for a big chunk of the deterioration between the ‘before’ and ‘after’ crisis deficits: $1.3 + $1.5 + $0.8 = $3.6. Hmmmm. The total dent in our finances is $8.3. We have not accounted for over half the problem, and yet we have accounted for all the changes in spending. I wonder what could create that other chunk? We need to find another $4.7 trillion.
  5. Well its the recession stupid. By far the biggest reason our budget appears in the hole right now is because there’s a recession going on. Whoops we forgot about that. Revenues have imploded. Tax intake has dropped like a stone. That’s the big issue here. Revenue decline accounts for over 50% of the debt bulge everyone is getting panicked about. Sorry everyone but we don’t have a spending issue we have an income issue. And a temporary one at that.
  6. Even more: the after crisis budget has a much reduced number for GDP in 2018. That means any ratio of that figure is going to be higher than it would have been had GDP not been reduced. This phenomenon is called arithmetic. So naturally the debt looks a lot worse – that 70% number – when the debt is expressed as a ration of a recession hit and therefore shrunken GDP.

This is why I get annoyed. The tsunami becomes a normal wave when you look at it clearly.

Obama’s reckless budgets are not our problem. The recession is. I thought we knew that by now.

Apparently not.

Once the economy starts to grow much of the deficit melts away of its own accord because Federal revenues will recover. This is not including any tax increases, or even the elimination of the infamous Bush tax cuts that created a far larger deficit issue than all the bail outs and stimulus added together.

This is what we call a ‘cyclical’ debt problem. Bush created a ‘structural’ debt problem by cutting revenues and getting no increases in GDP or cuts in expenditure to offset that loss. The Bush deficits are the permanent bit of our problem.

In contrast the bail outs and stimulus spending is temporary. Yes they added to our debt. But the deficit won’t stay that way. It will shrink as soon as we get going. Leaving us the Bush debacle to fix. If we have a debt problem it’s that one, not the one caused by recession.

I hate having to belabor all this, but it is vital we separate the issues so we can deal with them sensibly.

The US has long term fiscal problems. It has Social Security and Health care costs that need controlling. More importantly, ever since Reagan began to use the Social Security surplus to offset the regular budget deficit we have managed to avoid looking at the true gap in our everyday spending. Reagan was the first president to use a combined budget. Up until then we saw two budgets: one for the everyday stuff, and one for Social Security. So for thirty years we have been bamboozled into thinking our budget was in better shape than it is. That way we could avoid having to cut or control costs. This was vital to Reagan because he wanted to inflate defense costs and hide the impact – basically he used debt and Social Security income to fund defense. The key he wanted to get around was having to raise taxes to pay for that defense build up. His great twin legacies were the loss of truthful accounting and the illusion that borrowing could go on interminably.

The irony now is that it is his ideological successors who are raising the panic about deficits and debt – these are the very folks who looked away during the Reagan and Bush debt frenzies.

So there you have it.

Yes our debt ratio will get worse. We’ve just been hit by a horrendous recession. Duh. And, yes we can pay for it – it is all very manageable – as long as we get our economy humming again. It will take a few years for the debt levels to fall back to more ‘normal’ levels, but frankly we haven’t had ‘normal’ levels for three decades anyway, and we might not get back there for three more decades.

The key is to remember why the debt ballooned, and to keep our focus on the really big job at hand. That is to get the economy growing sustainably. That means jobs. It might even require more debt. The number one task right now is still recession fighting. We can begin the switch to fiscal rectitude afterwards.

Let them eat cake is not a particularly palatable economic policy, but it is the logical outcome of this bout of debt hysteria. If we get our priorities backwards and look to balance budgets and reduce debt loads before the economy is safely back on track then we run the risk of repeating the 1930’s. Allowing the bond market – or rather the supposed bond market since the actual one doesn’t seem too worried at the moment – to take priority over things like jobs programs is dooming us to a decade of horrendous human cost. That road is known to us. It is an ugly one.

Which is why we need to defang this hysteria before it sweeps us in the wrong direction.

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Whacky Bond Markets

With deficit hysteria now growing with each passing day the risk that our leadership will blink and do something really dumb like raise interest rates gets larger. You all know how stupid I think such a move would be, but, hey, this is the all-knowing bond market we are talking about. You know that place inhabited by ultra smart, uber brilliant investors who hone their computer analyses and are invariably right about absolutely everything.

Like mortgage backed securities.

I suppose I am not allowed to point out the fallibility of the gods of Wall Street.

They seem to have such short term memories.

So do all the commentators who pay attention to them.

Let’s be honest we need to sell bonds. That makes the folks who buy them pretty important right now. We need to keep them all happy. To an extent.

You see investing is a two way street. We need them to buy our bonds so we can spend like crazy and bail ourselves out of the economic mess created by the insanity of the big banks and other investment companies who failed to analyze risk properly back in the run up to the big credit bust of 2008.

And they need us. Where else are they going to park their cash? There is a limit to the places all that investment can go right now. Think about it: the private sector is simply not investing. It is hoarding cash. Part of that hoard finds its way into our bonds. I realize that most of the stash goes into Treasury bills, which most folks regard as cash rather than as investment. But for the longer term investor US bonds are a safe bet. After all the possibility of a US default on its debt is just absurd.

Or not.

Here’s the fun part:

The activity in those notorious Credit Default Swaps on sovereign debt – i.e. the debt of a country rather than a company – has picked up a goodly pace. And not just on the places you would expect: Russia, the Ukraine, and so on are fairly weak economies with a track record of playing fast and loose with the bond markets. No the real action is now in CDS’s on US and UK debt. Spreads have widened a bit recently indicating that someone, somewhere, is a little nervous that the US will default on its debt. So those people are buying insurance in the form of CDS contracts just to be safe. That way when the US implodes totally and refuses to pay back its debt these wise folks can collect their money anyway.

Very clever.

And where do they buy these insurance contracts? Who is it that will be left standing even after the US has crumbled into ruin?

The big banks.

Ummmm.

Would these be the very same banks that rely on the US for bail out cash?

Yes they would.

Let me ponder this for … oh … all of a second.

Someone pays the big banks to provide them insurance against a default by the very Treasury responsible for shoring up the same big banks.

No I know I can be dumb sometimes, but help me out here. If the US Treasury defaults on its debt, just how stable will those banks – or any others – be? More to the point will they be there the day after in order to pay up on the CDS contracts?

Didn’t think so.

This is just one more example of the whacky way in which analysts and commentators get their proverbials in a gigantic twist.

So obsessed are they, and much of the financial media, with US debt levels, that they have taken leave of their senses. They actually think that Goldman Sachs, for example, is more credit worthy than the US itself. That would the same US that bailed Goldman out last year.

Not happening.

But because the analysts and commentators are getting hysterical about debt they no longer think of simple things. They are fixated on that debt level and see the end of the world all about them. We read silly articles about the US going the way of Argentina. We read about the urgency of tightening the Federal deficit and raising rates even though that would precipitate a Depression. We read about the profligacy of the US government and about its enormous unfunded liabilities.

And some people read all that and rush out to buy CDS coverage against their US bond portfolio.

I have a bridge I would sorely like to sell these people.

They would probably buy it if they knew Goldman Sachs was selling it. But they’d never buy it from its actual owners, because the owners are a government. And governments are the problem to quote my favorite incompetent president.

Sorry to be so sarcastic. But really. These are the self same geniuses who nearly sank the world economy. They bought toxic assets with unfounded glee and abandon. They packaged and securitized their mothers for all I know. Their credibility is zero. And now they bitch about the debt levels we need to reach in order to straighten out the mess they made.

Ugh.

On a serious note. For those of you who want to track just how the grown ups feel about our fiscal condition – which means turning off cable television – keep an eye on the spread between US bonds and the inflation proofed version of the same. That spread gives us a good indicator of just how much risk there is perceived to be in US debt. Not much given the latest data. Or you can take a peek at the US bond rates themselves: not very high at all. Or, for the truly daring, take a look to see if Goldman’s debt costs more then the US treasury debt does. Which is thought of as the riskier?

Get my drift?

Here’s the thing: yes our debt levels are shooting up. Hello: we have a crisis to deal with! Much of the deficit creating that debt stems from a drop off in revenues: people who are unemployed tend not to pay much income tax. Profits tend to be weaker in recession so businesses pay less tax too. Duh! Top that off with the need to bail out the banks and kick the economy into gear and we end up with an awful debt level. But it isn’t permanent. The deficit starts to drop off the minute the economy grows. So the ratio of debt to GDP peaks and then falls as soon as we get going again. GDP growth itself will lessen the ratio as long as we don’t keep our foot on the accelerator after the recovery is well established. And no one I know is saying we should. On the contrary I think there is too much premature talk of tightening. That moment is still someway off. We all want fiscal conservatism down the road. That means taking a good hard look at the budget and cutting some stuff out. It also means raising taxes at some point. Sorry folks nothing’s free.

If there’s one thing that the years of illusion should have taught us it is that the Federal budget should be balanced now and again, especially in years of good GDP growth.

Yes Messrs Reagan, Bush, and Cheney: deficits do matter. They always did.

Meanwhile let the bond market have its whacky moments. At some point as we pay down debt we will start to hear the lament of the late 1990’s: we need more debt! After all where are the investors going to get a safe return?

CDS coverage on US debt.

Please!

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