interest rates

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Jobs, Inflation, and Bonds. Mixed News.

The various reports published this week paint a decidedly mixed picture. I haven’t talked about them because individually they are fairly self explanatory, but together they are beginning to make some sense in a different way.

Take today’s unemployment insurance weekly claims report. This is the second week in a row that claims have risen, this time by 7,000 to 473,000. At the same time the four week moving average dropped 5,250 to 472,750. What do we make of this? Obviously there is a slight hitch in the economy’s march towards a better job market. It was never much of a march – more a stagger – but the fact that we have seen two weeks of mild increase after several of decrease suggests that the steam is going from whatever momentum we may have had. The fact that last week’s number and the four week average are virtually identical also supports this notion of the economy having hit a plateau. The critical question then becomes how do we move off the plateau? Up or down?

The evidence all supports a continued improvement, but it is all still fairly weak.

That weak activity also shows up in the inflation figures. The headline number was daunting with a jump of 0.4% in November, but when we parse out the very volatile energy and food parts of the index, prices were unchanged for the month. Plus for the last twelve months as a whole the consumer prices have risen only 1.8%, even with food and energy added back in. Clearly there is little inflationary pressure building in the economy. This is entirely consistent with the overall weak, but improving, tone of the major measures of growth. The energy component of inflation bounces all over the place, which is why we strip it out to get a view of how widespread inflation is within the economy, but we still need to pay it heed. In November energy costs rose 4.1%, which is a huge one month jump, and was fueled [excuse the pun] by a massive 6.4% hike in gasoline prices which have now risen 23.6% since last year. For our purposes, though, we need to watch that broader non-volatile part of the index because it provides a better gauge of the inflationary outlook and therefore Federal Reserve interest rate strategy.

This leads to our third report: the Fed’s own assessment of the economy and its attitude towards rates.

Once again all we seem to hear is caution. The Fed’s view remains very circumspect with an upward bias. This is about as optimistic as they can get given the information they receive from around the country. The key is that the see no inflationary pressure building and therefore see no reason to raise interest rates. This is critical. They would like to keep rates at their current levels for a very long time. I have commented here before that, according to the ‘Taylor Rule’, which is an ad hoc device for setting interest rates given an outlook for unemployment and inflation, the actual rate the Fed would like to have is something in the range of -5%. Since they cannot go below zero they would like to do the next best thing which is to keep as close to zero as they can. Using the consensus projection for the economy and unemployment the Taylor Rule would still be negative as far off in the future as early 2011, so it seems unlikely that Fed policy will change much between now and then. Unless some outside event forces its hand.

That outside event could be brewing up currently. The bond market is going through one of its periodic bouts of jitters. If this uneasiness grows into a more fully fledged panic it could force central banks the world over to react by raising rates. The world economy would then slide quickly into depression.

The jitteriness is being caused by the somewhat sensational collapse of the Greek public finances, and the ongoing fears sparked by the implosion of the Dubai construction spending spree. Neither alone would be sufficient to cause much of a ripple through the market, but together they cause alarm. Particularly when we add in the increasing unease over sovereign debt generally.

There continues to be constant chatter in the world’s financial media about an imminent sovereign debt crisis. This is said to be the logical outcome from all the deficit financing made necessary by the crisis and the attempts by governments to employ Keyensian style policies. Apparently bond holders don’t like Keynes. Or at least we are led to believe so. This leads me to wonder whether bond holders actually think through the consequences of the alternative to Keynes: depression. For that is the stark choice.

If we leave economies to ‘self correct’ – to use the sanitized wording of Milton Friedman and his acolytes – we would have to tolerate a much deeper and longer downturn. The point of which would be to correct the misalignment of resources, to re-arrange asset values, and to force wages down to the point that firms start re-hiring. No one knows how much this adjustment may cost in terms of unemployment or business failure. No one. But advocates of the self-correcting method of recession combat should do us all a favor and comes up with such an estimate. If for no other reason than to stop the bleating in the bond market.

Were we to follow the self-correction crowd over the cliff none of us would have a clue as to when we would hit terra firma again. This uncertainty should surely scare the pants off bond holders – conservative and risk averse as they are. So the chattering unease amongst bond traders about how sovereign debt is now high risk seems to put the cart before the horse. The alternative is much worse. They would counter, naturally, that bonds have greater value in a depression than they do during a bout of debt expansion. They would be right. But that greater value is relative, by definition. So my suggestion to all of them is that, if they now see sovereign debt as horribly unstable and thus high risk, they should invest elsewhere. In some of those really safe emerging markets maybe. Or gold. Or … The point being that in circumstances like ours nothing is particularly safe, and undermining bond prices based upon a distaste for policies and their short term ramifications – i.e. high sovereign debt loads – is a self defeating past time fit only for Chicago School economists. We know they all live in never never land. I would hate to think bond trades lived there too.

What do conclude from all of this?

That the economy is growing, but barely. That we have hit a tough patch. That the bond market is getting fearful of the cost of bailing us out and is beginning to waver. Meanwhile the Fed seems bent upon staying the course and supporting growth as best it can.

All in all we are still in the middle of the fight. Nothing is yet cast in stone. If stimulus ‘fatigue’ wins the day we are doomed. Current policies at the Fed and with respect to the Federal deficit are about right. If anything we could do with another bout of stimulus.

Meanwhile hang in there: 2010 is going to be a rough and tumble year that could go either way.

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Citibank; Volcker and The Banks

It seems like an age since I was filling this space with my opinions about the pros and cons of nationalization. In terms of bank earnings it has been an age: the big banks have all done extremely well this past year. Not that they could have fouled up in such a featherbed environment, rigged as it is to their advantage.

Interest rates remain extraordinarily low; the yield curve is tilted sharply upward; liquidity is sloshing about as never before; the government maintains its safety net; competition is severely reduced by the loss of some key players; and efforts to re-regulate the industry look to be tinkering around the edges rather than striking at the heart of what the industry does.

Yes, life is good for the gamblers bankers of America.

Which is why there has been a torrent of repayments of that infamous TARP money. Goldman got the ball rolling and now every one of the big banks who were saved from themselves by our collective generosity have either paid the TARP cash back, or have announced plans to do so imminently.

As taxpayers that’s a good thing: we get our money back. But if you’re a bank shareholder I wonder whether this rush to repay the public is such a good thing.

Take a look at Citibank.

They are paying back their TARP money. This isn’t because they have suddenly become rock solid. Far from it. It is because they want to get out from underneath those annoying rules the government imposed regarding bonuses.

So paying back TARP cash is a jolly good thing if you’re a Citi banker. Not so much if you are a shareholder.

Why?

Because the handing back TARP leaves a hole in the bank’s capital account and thus makes it much less secure. Naturally even the thick headed folks running the bank notice this and have planned to raise capital to offset the TARP cash. This has two effects, neither good.

First, it dilutes the ownership of the existing shareholders. The new shares may fall into the hands of people who currently have no Citi stock. The managers may like this extension of the ownership base, but the existing shareholders will now have to share future profits with a whole bunch of newbie owners: they’ll get less of a share. Having stood by the bank during its dark hours last year and early this, they may find this dilution a less than generous reward.

Second, the TARP money was relatively cheap. The annual cost of capital was low compared with the cost likely to attach to newly issued equity. So the bank’s management has raised its cost of capital, and thus reduced its ability to make the same level of profit from its lending activity as it had with TARP cash. In other words management has deliberately lowered its profit run rate.

So the net effect of the payback seems to be that the bank is no better off in terms of capital. If anything it may be weaker: it could have raised new equity and kept hold of the TARP money for a longer period. The new equity would then have bolstered capital rather than filling the hole left by the TARP repayment. Plus the bank’s future earnings could be depressed slightly by that higher cost of capital.

Capital no better and earning potentially weaker. This doesn’t sound like a good plan.

Except if you are an executive eyeing that big bonus you would have been denied while TARP still cluttered your balance sheet. Then the scheme makes perfect sense.

Then of course is the public indictment that would have followed from Citi being the only bank not to pay TARP back. That would not have looked good. It would have inevitably drawn our attention to what has been unstated all year long: Citi is still in bad shape. Even though it is earning a profit it is stumbling about without a certain hope of survival. It’s recovery will take many years, and one blow from the economy – commercial real estate perhaps – could be enough to finish it off.

There is a line of thinking that says the TARP repayment is sensible from the public’s point of view: we got our cash back. But what happens when Citi trips up again. Its current management doesn’t inspire confidence and its business model is a convoluted mess. The words ‘Citibank’ and ‘decisiveness’ sit uneasily together. This is a bank being propped up by those extremely favorable conditions I mentioned at the outset. One storm is all it will take to reveal the rot that still remains.

Then what happens?

Presumably Citi comes running back for a new bail out.

This is should not get. Instead it should be nationalized, broken up and sold off in pieces. And its current managers should all be fired.

Interestingly the idea of breaking up the banks is gathering support. Paul Volcker had been, up until recently, a lone voice arguing the case for this idea. Alan Greenspan had joined in, but elsewhere the notion had been consigned to fringe status. Now, however, Volcker’s idea is beginning to attract more support, some of it in Congress. There is hope yet. I have been a big proponent of smaller banks from the beginning of the crisis: they are easier to push through bankruptcy; they are less ‘systemically’ dangerous; they are more agile and responsive to customers; they are less able to rig prices and markets for profit; and the fact that there would be more of them implies greater competition and thus lower prices. All these things are in the public interest. I have yet to see a convincing counter argument presented.

Of course there are variations in the way in which we would break up the banks. Would we break them up along product lines as in the old Glass-Steagall Depression era legislation? Or would we simply break them apart geographically? These details need to be worked out, but one thing we cannot avoid is that the banks have now grown to the point that the phrase ‘too big to fail’ hangs all too easily on the public’s lips. As Volcker has said: too big to fail means too big to exist.

Actually in reality too big to fail implies too big to bail out as well. We cannot afford the banks any longer. They have outgrown our economy’s ability to absorb their losses. By vectoring off into the alternative universe of purely paper transaction making – securitization, derivatives of derivatives etc – the banks have inflated themselves so much that they dwarf the real economy. But it is on the cash flows within that real economy that they rely for the guarantees that keep them afloat. Remove those guarantees and the entire edifice has to shrink rapidly down to be accommodated within the real world.

Let’s keep this simple: the social value of banking is its ability absorb time based risk – ‘intermediation’ – and in its superior ability to allocate capital. The profit motive should provide sufficient discipline to ensure that the banks provide these benefits without destroying their shareholder’s value and thus coming to us for a bail out..

That discipline broke down when the banks realized that they had become too big to fail. This realization led them to take excessive risk for the personal gain of their employees, safe in the knowledge that they had a public safety net to fall into. In other words the moral hazard economists bemoan so much had become a reality.

Since we do not want to remove that safety net: it exists to protect our money when a bank fails we run the risk of fostering ongoing moral hazard, and thus the likelihood of further financial crises. The managers of the banks have little incentive to act in a socially responsible way. At the risk of boring you: bank managers have become poster children for the concept of ‘rent seeking’ behavior.

All you need to know about rent seeking is that is a bad thing. Wherever someone can rent seek the relevant market is subject to imminent failure because the essential dynamics of capitalism have been twisted for personal gain.

So it remains with banking: case in point Citi’s repayment of TARP cash in order to free it up to pay out big bonuses.

The only serious way to keep those safety nets to protect our deposits when a bank fails, and yet get rid of the rent seeking enabled by moral hazard, is to make the banks small enough that we can allow them to fail. In other words we re-introduce a dose of capitalism. Competition is the central mechanism that makes capitalism work. The big banks have grown so large that they can blunt the impact of competition. They have become ‘oligarch’ like. They can distort the rules. In fact some of them – Goldman in particular – won’t play in a market that it cannot distort to its own advantage.

Moral hazard breeds rent seeking, which leads to anti-social behavior. The only disinfectant sure to work is heightened competition and the withdrawal of the too big to fail feature of the current system.

That means breaking up the banks.

Get it done and the economy will benefit enormously.

Meanwhile: if you own Citibank stock, watch it like a hawk. That bank is still very unsteady.

Addendum:

I forgot to mention that I think the rush to pay back TARP by all the other banks is a combination of a domino ‘fairness’ effect – once one was allowed the rest had also to be allowed – and politics. The government can present the repayments as a ‘win’ for its handling of the crisis.

What it cannot do is claim to be reducing the Federal deficit: TARP was never accounted for at its full cost. Rather it was accounted for on a ‘net’ basis. This means that only the money the government estimated would never be paid back made it onto the books as a cost. The rest was accounted for as a loan … which is what it was. This is an oddity in that the government doesn’t usually account for assets and liabilities, it uses a variant of cash accounting and has no balance sheet to speak of. Sometimes it simply doesn’t report things at all – see the Iraq war costs under Bush. This messy accounting has always been a pet peeve of mine, which is why I bring it up!

Update:

Now we read that the Treasury Department is having second thoughts about disentangling itself from Citi. The reason is that the equity issuance – Citi raised about $20 billion in what is the largest single equity issuance ever – needed to refill the hole left by paying back the TARP cash went badly. The money was raised but the market was not impressed. Citi even now finds itself being sued by Abu Dhabi whose investment authority is claiming that it Citi misrepresented its financial condition. The net result of this latest mess is yet another black eye for Citi’s management and a setback for the administration. The former wanted to get out from under close government supervision; and the latter wanted not to be embroiled in a protracted relationship with what could be a dying bank.

The story continues …

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Beware: The Hawks Attack

I understand if few of you know who Charles Plosser is. Most of you don’t even care. Maybe after you understand what he said in a speech yesterday you’ll pay attention.

Plosser is the head of the Philadelphia Federal Reserve Bank. Mercifully he will not have a vote on the Fed’s monetary policy setting committee until 2011, because he is a committed interest rate hawk. He wants to raise rates sooner rather than later, if not now.

His argument is straightforward: the economy is now growing, the crisis is dealt with and we should now start to return Fed policy to its anti-inflation task. That implies undoing much, if not all, the extraordinary ‘pump priming’ the Fed has engaged in over the last year or so. This should be done with urgency and aggression since the threat from a surge in inflation is deemed to be very high.

Plosser uses all sorts of sporting analogies and along the way seems to conflate ice hockey and monetary policy as only a true ‘jock’ could. Generally I find discussing policy issues in terms of ice hockey unhelpful, but apparently Plosser thinks otherwise.

Lets see what he said:

  1. The economy is now safely on a growth track. He expects GDP to grow 3% in the fourth quarter and by that same amount all nest year.
  2. He acknowledges that the stimulus is wearing off and that the inventory adjustment is fading, but he sees consumption as robust enough to carry the load along with a slow bounce back in real estate.
  3. He talks about unemployment in what I consider glib terms. He sees it as lagging the recovery – it always does – and so the fact that it is above 10% and was rising until very recently is of no real concern. It will come back down in due course. Besides there’s not much we can do about it.
  4. There is no immediate likelihood of either deflation or inflation. Both are under control because economic conditions are generally benign currently.
  5. But: inflation is a very real threat in the medium term – two to three years hence. This is because of all that cash sloshing about the economy as a result of the Fed’s various bail out and monetary stimulus actions. This cash represents a real threat since it cannot be absorbed by growth and so will find its way into prices. Hence inflation.
  6. The argument that inflation is not an issue because of all the slack in the economy is dismissed on two grounds: first it is difficult to measure ‘slack’; and second, we have had high inflation during periods of high slack anyway – e.g. the 1970’s.
  7. Apparently the markets agree with this assessment and are concerned about inflation down the road – the highly sloped yield curve suggests a high inflation risk premium for five year and beyond money.
  8. So … drum rolls please … the Fed should begin to rein in its activities; reduce the cash in the system; and raise interest rates. This will get it back to its anti-inflation stance [a.k.a. ‘encouraging price stability’] which Plosser says is the Fed’s raison d’etre.

Where do I begin?

He may be right about GDP growth. I think he is at the higher end of the optimistic forecast range, especially for next year, but let’s allow him his 3% growth rate.

He slips right by unemployment as if it is an awkward side issue. While he agrees that it is unfortunately high, he doesn’t perceive the need for any action – unemployment will take care of itself in due course. In this he is correct. What he misses is any notion of whether that timing is acceptable – do we really want high unemployment for the next five years? And, he fails to address the obvious problem that high unemployment could undermine growth through its sapping at both consumer confidence, and more concretely, at wages available for spending. He makes no comment on either of these issues and blithley sidelines the entire jobs discussion as being secondary.

I have warned you about this syndrome before. Its the ‘sound central banker syndrome’. They just love being seen as scrooges. It gives them a puritanical sense of rectitude: they are the bulwark against the follies of mere mortals like you and me who want a more secure future along with a job. In the eyes of central bankers the only security worth fighting for is ‘price stability’. Low inflation. Once this is assured the economy will take care of itself.

This is very laudable. And I agree that stable inflation over the long haul is vital to economic health.

But we don’t have an inflationary threat. There is none. Nada.

This is where Plosser’s ideology takes over.

You see, he’s a Chicago school guy. A proud one too. To those folks economics is really simple: scale back the government so it doesn’t get in anyone’s way; abolish all regulation; let the markets rip; and keep prices stable. Oh, and by the way, it is the Chicago school that teaches that there is no involuntary unemployment. If only those workers would accept lower wages they’d all have jobs.

Given this ideology it is hardly surprising that Plosser neglects to mention that the Fed has two goals in its Congressionally provided charter: price stability and low unemployment.

Conservatives do this all the time: they look at the part of the charter or article they prefer and ignore the other part[s]. They do that with the Second Amendment all the time – the constitution says absolutely nothing about the right to bear arms outside of the context of a ‘well armed militia’. And the Fed is supposed to put equal emphasis on unemployment and inflation.

Finally, Plosser’s notion that a steep yield curve supports his argument is a common hawk position. It fails the test of even mild scrutiny. Medium and long term interest rates are now back to more normal ranges. They are no higher than they usually are in periods of GDP expansion. They are certainly well in line with rates back in the earlier 2000’s. The steepness of the yield curve comes not from high long term rates – which is Plosser’s argument – but from historically low short term rates. Why are those short term rates so low? Hmmm. Banking crisis? Recession? Credit market chaos?

So Plosser’s entire discussion is supposed to lad us to the point of agreeing that raising rates is now, or soon will be, an imperative. But nothing in his argument, not even all that ice hockey jazz, actually supports him. His is an argument looking for a problem.

Presently all the analytical signs indicate that the Fed should keep rates low. Possibly for another year. The so-called Taylor Rule, the rule of thumb analysis that balance the Fed’s two targets of inflation and unemployment, produces a negative Fed Funds rate, as low as -6%, still. This may be off the mark, but at least is has an air of analytical rigor to it. Plosser offers no such rigor, simply an ideological viewpoint. Given a choice between analysis and Chicago school ideology I would prefer to put my money on analysis.

Keep rates down for a while yet.

Are there risks to this? Absolutely. The biggest being that our hyperactive banks will use those low rates to gamble and thus inflate a new bubble. There are signs that this is already happening in emerging market stock and asset prices.

But the downside risk to low rates is more than offset by the damage a rate hike would inflict on our economy.

If you believe, as I do, that growth is fragile, then a rate hike runs the risk of plunging us back into recession. There is too much rubbish still cluttering up bank balance sheets and more is on its way via the commercial real estate market. A second recession could undo all the good work we have done in patching up [but not fixing] the banks. So a double dip recession represents, to me at least, a far more dire threat, than that of excess liquidity slopping about global markets.

Basically it all comes down to whether you think unemployment matters enough to be a focus of policy.

To me it does.

To hawks like Plosser it doesn’t.

So beware: the hawks attack!

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Monday Mash-Up

With the Thanksgiving weekend over and the first taste of the holiday season under our belts – literally after all that turkey – we have a somewhat mixed set of news to deal with. So rather than devote my time to a single topic allow me to surf across the issues:

  1. Dubai: Given all the media ink spilled on the financial crisis that swamped Dubai anyone would have been forgiven were it the first sign of the end of the world. I suppose, given the ongoing fragility of our banks, that any hiccup in the credit markets is worth attention so there is some justification for the fuss. But not too much. The Dubai story can be summed up simply: building exotic stuff like ski slopes in the desert or by the Red Sea is probably a sign of a bubble. It is not a very sound financial transaction. Any bank with a piece of this particular action needs its head tested. Apparently there are several, with HSBC topping the list. None of the banks looks as if it will fall as a result of this folly. The Abu Dhabi government has underwritten the entire shambles. The signs of growing panic on the world’s bourses last week is a shot across our bows: world finance is in dire need of fixing. Dubai simply reminded us of the urgency in getting reform legislation passed as quickly as we can. Having said that I can’t help but wonder what history would have recorded had a bank fallen foul of this folly. Ski slopes in the desert. Really.
  2. Health Care: This is going to dominate the headlines for a while longer. There seems to be no end to the folly either. The latest inanity comes from a Senator Hutchinson. Her problem is that the new mammogram guidelines will be caught up with the public option: she claims that any mammogram undertaken earlier than indicated in the guidelines would not be covered either by the public option or by the private insurers. This she says causes confusion and is a sign of the kind of rationing we can all expect after reform. Naturally she fails to note that a very large number of women cannot be screened, no matter what their age is, under the current set up simply because they don’t have insurance at all. So the rationing argument fails to note the extension of essential coverage to a very large number of people. Besides nowhere is it written in the reform that the public option would not cover early mammograms, especially were doctors to recommend them. So Senator Hutchinson is crying foul over a huge red herring. Why am I not surprised by that? The level of ‘debate’ in this reform process has been staggeringly low. This is one of the most important items on our national agenda and all we’ve been treated to is pandering to a few ‘centrists’; name calling and hysteria from the right; and confusion and a lack of clarity from the left. No one has come clean and told the voting public why we need reform: we cannot bankrupt ourselves on health care. That means making choices and cutting costs. The cheapest system will always be the largest – actuarial costs are lower the larger the population covered. That’s a government program of some sort that includes as many of us it can.
  3. Banking: We are now being treated to the spectacle of international cooperation on the control of systemic risk. Given previous efforts in this regard I hold out little hope of progress. But the back chat is always good for a laugh. For instance: some of the mega banks – those that brought the world to ruin last year – are protesting that they cannot draw up the ‘living wills’ that are being requested from them. The reason? Their businesses are just too complex and so a single ‘will’ would not be adequate. I am sorry … but isn’t this the problem? If their businesses are so damned complex and interconnected that they cannot be killed off easily, they are too complex to manage also. That’s what’s wrong with them. They need to be reduced to simple, maybe smaller, lines of business that we can all understand. My guess is that if you can’t draw up a will for a bank, you can’t draw up a good risk management plan either. I suppose that’s too obvious for these banks to figure out though. In a similar vein I read a very geeky paper written back in 2004 by an MIT professor called Andrew Lo. In it he argued that one failure of our banking system is that it lacks diversity. By this he means all our big banks are the same. So an economic shock that damages one will damage them all. In terms of ecology we have a very thin and fragile ecosystem. A more diverse set of banks, not just smaller banks but banks with different lines of business, would help mitigate the spread of contagion. The entire system would be more robust. This argument seems very sound to me, but it likely won’t get very far in the face of the lobbying power the banks have and the lack of imagination the administration has.
  4. Black Friday and Retail Sales: The first reports from retailers about their sales last friday is decidedly mixed. Apparently there were far more shoppers in the stores than last year. The problem is that they spent stingily. There was a slight increase in dollar sales, but it was far less than the increase in shoppers. So we can either take heart: people were out and about so the siege mentality seems to be lifting; or we can get worried: people are still not spending freely. I think the good news is more likely to come after today: ‘Cyber Monday’. This obnoxious nomenclature refers to the first Monday after Black Friday – in recent years there has been a noticeable surge in online shopping on the first day back at work. Presumably people continue with their weekend holiday oriented spending even from the workplace. The expectation is that online shopping will continue to blossom, and may well carry the season along with it. The most visited online stores remain Amazon and Wal-Mart which is no surprise, and the biggest online shopping surge comes from all those last minute gifts during the ten days before Christmas. Cyber Monday is merely the precursor to that later splurge. Meanwhile we will get detailed November sales reports from the retail industry this Thursday. My guess is that sales rose a little, but not that much. We have a long way to go.
  5. Debt Hysteria: By now I have thrashed this to death. No one should be surprised by the never ending warnings of debt doom from the deficit hawks, but it does get tiresome. Here’s the deal: deficits are fine as long as they represent a response to a crisis. That’s because a government’s revenues tend to go way down in a crisis, just as its expenditure goes up. Things get all out of balance. Think of it as a dampening effect on the private sector’s fear driven shut down. The problem deficits are those that are gratuitous. These do not act as dampeners. On the contrary they tend to act as accelerators. A big government deficit during non-crisis times acts to inflame rather than retard the economy’s own direction. Such deficits add to the debt without having any beneficial impact. They should be avoided at all costs. Governments should keep a balanced budget – or close to – during economic booms so that they can spend freely during recessions and offset the private sector’s collapse. This is not what we have done in America. We have run up huge deficits as a permanent feature of our fiscal policy and thus boxed ourselves in just when we need to go hog wild. The oddity is that the deficit hawks all seem to have been fine with the gratuitous deficits of the 1980’s and 2000’s, but are now in panic over the very sensible deficits of today. Politics gets in the way of sound economics far too often. This is an egregious example. An example? The cost, or the interest we pay on our national debt. The hawks are in a tizzy over its rising cost, which looks set to grow to over 3% of GDP over the next year or two. This upward trend will be accelerated as interest rates rise from their current low levels. Is this a big deal? Well, not really. The projected level is close to that we saw back in the years of George Bush senior, when we were digging out from underneath the Reagan debt load. It was manageable then and it will be manageable now. Still the hysteria lingers on as a convenient ideological tool to fight the Obama agenda [whatever that is!].
  6. The Dollar: The debt hysteria is paralleled by a dollar panic. Often the two coalesce. Usually the same people occupy the two positions. And, again, ideology laps over the underlying arguments. The dollar has fallen and looks set to continue its decline. The drop so far this year has been in excess of 16%. Those who pay attention to these things will notice that this decline is not quite as large as that we witnessed during the Bush years, but it is significant. There are a couple of thing going on here. First the dollar was unduly strengthened by the financial crisis as foreign investors crowded into dollar based assets because they deemed them safer than the more speculative currencies they were invested in previously. Second: as the crisis has subsided this trend has been reversed and revealed the longer term decline that the gains made during the panic had masked. This long term decline is a result of the steady rise of solid alternatives to the dollar, especially the Asian currencies, and the endemic deficits that the US has run for the past thirty years. The dollar is finally wearing out its welcome. The deficit hawks have a point here, the flood of US debt will inevitably act to cheapen the dollar. My take on this is: good. Let the dollar decline. That way we can slowly erode the value of the debt ,and pay it back in cheaper currency. This is a time honored way in which debtor countries like the US avoid a default. In effect they ‘default’ over time. The world used to need a strong dollar so that international trade and investment could be secure and stable. Nowadays there are better ways to achieve that same goal: most likely a package of currencies including the dollar, the euro, the yen and various other Asian currencies. It might even include the ‘standard drawing rights’ quasi-currency from the IMF. In any case the days of dollar hegemony seem numbered. So it goes for all currencies, especially when the issuer becomes a major debtor. It is a little noticed historical oddity that the US is the first world power to be a debtor rather than a creditor. Throughout history, starting with the Roman Empire, the world’s foremost political power has also been a lender to the rest of the world. The US is a borrower. It maintains its standard of living by borrowing rather than through creating wealth. Sometime this ability has to end as the world gets sated with US debt. The financial crisis and the fiscal imbalance that resulted from it seems to have brought that date forward. So look for a continued steady decline in the dollar – over the long haul of course because there will always be short term blips back up as the adjustment to a new regime is worked out.

So there you have it. My ‘Monday Mash-Up’.

Lots to think about as we wait for the economy to slip into a higher gear.

This holiday season is crucial. Let’s hope it goes well.

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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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