interest rates

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Interest Rates and Bank Lending – What Lending?

Well not quite none. The point being that loans to businesses by commercial banks have been declining steadily for three months, at something like an annualized 28%. So while a lot of media attention has been given to all the shenanigans banks are playing with their retail customers – people like you and me – the bigger news is that they have put the squeeze on business like no tomorrow.

This is not good.

For about three decades banks had become steadily less important as sources of credit to business. The old fashioned bank loan was replaced a long time ago by things like commercial paper. The reason was simple: after the real estate debacles of the late 1970’s most banks had worse credit ratings than their premier customers. That meant those customers could borrow more cheaply from the credit markets than the banks could. The only problem was that there was no vehicle available for these customers to access those markets. In stepped the investment banks with products like commercial paper and within years most major corporations had dispensed with the traditional banking relationships of yore. The big banks lost both customers and income streams which drove them into searching for other ways to make a buck. The boom in credit cards and so on was partially fueled by this sequence of events.

Fast forward to last year: the market for products like commercial paper is referred to as the ‘shadow banking system’. It is a shadow because it performs the same kind of function as regular banking – moving money from people who have a temporary excess to people who have a temporary shortage – but is beyond the reach of the regulatory system. It is in the shadows.

This parallel ‘shadow’ system was, we were told for years, a wonderful phenomenon imbued with all the usual magical powers that free markets are supposed to possess: it was cheap, efficient, and unbiased. Its capitalist motivation drove it, its advocates claimed, to allocate capital in the most socially efficient way possible. And certainly better than the stodgy banks.

Call me skeptical but the results are in and the shadow banking system looks a lot less robust than it used to. All that cash flowing into mortgage backed securities etc probably wasn’t the wisest, most efficient or socially beneficial allocation available. But that’s just me. Those Wall Street wizards obviously know much more than I do.

The relevant part of this, to our story today, is that the shadow system was what froze up last year. So much for that Efficient Markets Hypothesis.

This freeze left most major companies, and a ton of not so major ones, exposed to cash flow problems. Their most important source of cash dried up and withered away in a few days. They faced a massive liquidity crisis.

In stepped the Federal Reserve Board who, acting as lender of last resort, pumped trillions of cash into the banks in order to flood the economy with liquidity. This flood is why we have so few, if any, bank panics. There have been no ‘runs on the bank’.

Since the Fed has to run things through the banking system, and not through the shadow system where it has no [or little] regulatory control, all this cash went to the banks, who were suddenly awash with cash. They still are.

Before I go on I should clear up what might be bothering you: if all the banks were awash with cash why did we need to bail them out?

That’s because the banks had two distinct problems.

We bailed them out because their assets stunk and were exposed as worthless. Or worth very little. Accounting rules require banks with useless assets to right the value of those assets down to the level that they could command were they sold in a market. These right-downs cut into bank capital. And if you right off enough you eliminate capital and through the bank into insolvency. An insolvent bank is one whose assets are wroth less than it owes its depositors. It was to prevent insolvency that we handed out vast sums of taxpayer money – that cash was used to bolster capital and thus allow the right down of assets without having to close the banks down.

So problem number one was a solvency issue. TARP fixed that. Or has so far.

The second problem is one of liquidity.

This arises when customers ask for their deposits back and a bank doesn’t have enough cash on hand to meet those demands. Ordinarily a bank would sell assets to raise the cash it needs. But in an economy riven through with fear it might not be possible to sell those assets. This would set in motion a classic bank run. A bank subject to this could have loads of good assets to sell and may have tons of capital. It simply doesn’t have cash. It is illiquid.

What’s this got to do with the decline of bank loans?

The problem is that we have masses of liquidity. As I mentioned above the Fed flooded the economy with cash in order to prevent banks runs. The banks, for a very short while back last fall, used that cash to provide loans to businesses. In effect the banks moved back into their old way of doing business: they issued bank loans to customers who had been getting their cash from the now defunct shadow system.

But recently the banks have stopped doing this. They obviously are concerned about making loans to businesses who may not weather the recession. Since the banks are still knee deep in toxic assets they naturally are afraid to add more. So they stopped lending.

Hence that dramatic decline in lending.

The implications are profound. Without credit the economy will have a very difficult time getting back on its feet. In fact it won’t. As long as credit contracts the economy will most likely sputter at best. So that 28% decline in business loans looms very large across any optimistic forecast for GDP growth. I would argue it undermines any credible chance of getting a sustainable recovery at all.

The double whammy of prolonged high unemployment and a frightened banking system will most assuredly prevent long term recovery. All our policy actions need to be targeted at resolving those two conundrums.

You might ask – at least those of you who are still with me – what happened to all that liquidity?

Well.

The Fed flooded the economy with cash. The banks said ‘thank you’ and deposited in the safest place they could. After all the purpose of the cash was to provide liquidity. Where is that safest place? The Fed. That’s right. The banks have deposit accounts at the Fed that they can access to pay depositors when they need extra cash. And that’s where most of the flood of liquidity ended up. Back in the same vaults it came from.

Phew.

Now this represents a different problem.

One that you will be hearing a lot about, especially as the first signs of growth emerge.

Here’s why it’s a problem:

When the Fed prints a ton of money – which it did this year – that money could find its way into the pockets of people who then try to spend it. As I just told you this is not a problem at the moment because the banks have stuffed all that cash in the Fed’s own vaults.

But.

What happens when things start to look good?

That banks will start to lend. Surely you will shout: that is a good thing! Well, yes and no.

As long as the economy is producing lots of things to buy, the answer is yes. The money will be there to let us buy all those new things. But if the economy is producing fewer things than we have the money to buy – there is too much money chasing too few things – then we will drive up inflation. That’s where inflation comes from. Too much cash and not enough stuff to spend it on.

And that’s a huge concern.

All the efforts the Fed made to prevent a liquidity crisis could now turn and bite back as rampant inflation.

This is why we will be hearing arguments from conservative economists that the Fed should raise interest rates sooner rather than later. Rising interest rates will slow that rate at which the banks can shovel all that cash out as loans – loan demand will be reduced because the loans cost more. That would allow the dispersal of all that liquidity without driving up inflation.

The risk of this?

That the Fed moves too soon and raises rates too early. That would kill any incipient recovery. That’s what the Fed did in 1937 with the result that the Depression lasted a couple years longer.

My own view is that the flood of liquidity is nowhere near being inflationary at the moment for two reasons: first, as I have told you, the banks are simply sitting on it and not lending. The trend in bank loans is exerting exactly the opposite pressure – it is deflationary not inflationary. Second: the economy is operating so far from capacity that we are a very long way from being at the point where there is excess cash and no stuff available to spend it on.

Combine these two arguments and I simply cannot see a reason to raise rates any time soon.

But I am not at the Fed.

There is a very strong and growing camp in the Fed that is arguing for a rate increase fairly soon.

I think they’re nuts. Those loan figures support me.

There are only two ways to explain those loan numbers. Either, as I have been talking about here, the banks are sitting on the cash for fear of future losses. Or there is simply no demand for loans. Given the drastic decline in industrial capacity utilization we have seen through this recession, this latter cause is highly probable. Add them together and we arrive at a water tight defense of low interest rates.

Bernanke will have to opine regularly on the virtues of tighter money, but once he’s back at the Fed he’ll have to keep the money spigot wide open.

Our problems are not done yet.

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Back To the Stimulus Debate

It was bound to happen sooner or later. There are growing rumblings that we will need another round of government stimulus, a.k.a. deficit spending, before we can be assured that the economy can reach a sustainable growth path.

The most recent source of the discontent from which those rumblings are emerging is last week’s poor unemployment statistics. With unemployment now at 9.8% and rising it is a certainty that we will go above the 10.0% mark in the next month or two, and there are few if any signs that the outlook for jobs will improve anytime soon.

So, perhaps, it is time to start thinking about adding more fuel to the fire in the hopes it doesn’t flicker out early next year.

There is no surprise in this story. None. It was fairly clear to many observers, including yours truly, that the stimulus package that eventually was passed into law earlier this year was not sufficient. By coming in at a little under $800 billion it was probably about 50% or $400 billion short of the level needed.

That’s an awful lot of money. So we should spend a moment to revise what a stimulus is and how we should calculate it. I realize this is boring, but with the economy hanging on a knife edge we all ought to have an idea of the issues as they start to re-appear in Washington.

The purpose of a government stimulus is to fill a gap that opens up in the private economy. The American economy is somewhere in the range of $14 trillion per year. During late 2007 and throughout 2008 the non-government part of the economy began to shrink rather than keeping on its ‘normal’ 3% per year growth path. The contraction, as we all know, was caused by the collapse of the real estate bubble and the knock-on failure of large financial institutions who had gambled on stupidly underwritten loans and even more insanely constructed financial instruments like Credit Default Swaps and other derivatives.

The cards came tumbling down and, more to the point, three decades of economic illusion suddenly were exposed as fraudulent. America was suddenly aware that its thirty year debt binge and denial about some critical imbalances in its economic system were totally unsustainable.

Three decades of economic neglect and erroneous thinking had allowed those massive imbalances to accumulate. We have lived through three insane binges: the dot-com boom that spawned IPO wealth on paper and little lasting effect, other than the infrastructure of the internet; the stock market inflation that was associated it; and latterly the equally ludicrous real estate price inflation.

None of these were dealt with competently at the national economic policy level. On the contrary, each problem seemed to be met with an urge to reduce the effectiveness of government and to increase reliance on the same private sector that was creating the problem. The era of ‘self-regulation’ and ‘government is the problem’ had a singular worldview and a singular policy option: reduce regulation, and somehow the market will solve all our economic woes.

It was John Keynes who said:

“The ideas of economists and political philosophers, both when they are right and when they are wrong, are more powerful than is commonly supposed. Indeed the world is ruled by little else.”

The problem of the past three decades has been that the ideas were wrong. So now we pay for it.

The collapse was dramatic. By the time the dust settled it became apparent that the economy will have shrunk so much that we will lose about $2 trillion in wealth over about a two year period. That’s big by any calculation.

We were facing the opening up of a vast hole in the private sector: demand was simply insufficient to soak up the available output, so businesses started the inevitable shrinking process that is needed to shift resources away from rotten activities towards the remaining profitable ones, and to eliminate idle capacity.

Jobs were cut.

7.6 million so far and counting.

The textbook tells us that the immediate response by a government when faced by the implosion of the private sector is to reduce interest rates. This should have the effect of making borrowing cheaper and thence stimulating demand. Lower interest rates usually does the trick: after a few months of adjustment cheap money creates an increase in demand and the private sector rebounds.

This was not an option this time.

Why?

Because we had already lowered interest rates close to zero in the early stages of the credit crisis and therefore had no ‘ammunition’ left to shoot as demand cratered. It is simply not possible to have negative interest rates. More precisely it is not possible to have negative ‘nominal’ interest rates. Remember that nominal in this context means unadjusted for the effects of inflation. In truth we have had negative ‘real’ [i.e. inflation adjusted] rates for a while.

Faced with this impotence of the normal ‘monetary’ policy, we have to dust off the Keynesian solution: huge Federal deficits. The idea being this: if private people and businesses are to afraid to spend, then the government should in order to get thing going again. This is that classic pre-1970’s prescription. It was discredited, wrongly, during the stagflation of that decade and replaced by the more modern monetarism of Milton Friedman and then Robert Lucas.

With the Friedman/Lucas school of thought now exposed as intellectually bankrupt – that fight is still raging – policy makers had to resort to the policies of an earlier era.

The big question then becomes how much stimulus is needed?

This is calculated by estimating the lost wealth that needs replacing – in this case that $2 trillion I mentioned earlier, and then adjusting it by the effects of way in which money flows through the economy.

This latter step is tricky.

It requires us to calculate how much impact a single dollar of deficit spending has. Keynes called this the ‘multiplier’ effect. A dollar spent creates an ability for its recipient to spend, which means that the original effect compounds on itself as it keeps on rippling through the economy. This ripple gradually fades away after the dollar has changed hands a few times. Typically the multiplier is thought to be between 1.2 and 1.5. This means that a single dollar of stimulus has the ultimate effect of creating between $1.2 and $1.5 of demand.

Returning to the stimulus earlier this year.

The administration’s experts calculated the lost demand as that $2 trillion and that the multiplier of any stimulus was likely to be about 1.5. Given some fine tuning that meant the stimulus should have been $1.2 trillion.

We didn’t get that.

In fact that number never even made it to the President’s desk for consideration. The reason was raw political calculation. The political side of the White House vetoed anything larger than $800 billion on the basis that they saw no way to get enough Congressional support for it. So we ended up with a stimulus that the experts knew was inadequate from the get go. They were hoping it would be sufficient to stave off disaster – which it has – but they knew it may not be up to the ultimate task of re-igniting self-sustaining growth in the private sector. That has also proven to be an accurate guess.

The economy is certainly no growing, the combined effects of the weak stimulus and an inventory correction have ended the recession, but few observers now think that continued growth is assured. In fact, as last week’s miserable unemployment figures indicated, there is a growing threat of a return to recession sometime in 2010.

The political calculus will extraordinarily difficult this time. Opposition to the Obama agenda has solidified. His popularity has fallen. The Republicans have nothing to gain by being cooperative. This is not Obama’s recession, but it is his to fix. The slow recovery has hobbled his claims that a stimulus works. Instead the Republicans are arguing for more of the policies that caused the problem: more market freedom. The resonance with the 1930’s is stunning: the original opposition to FDR came from exactly the same quarter and for exactly the same reason. Some very famous economists – Schumpeter not least – were vehement in their insistence that the market should be allowed to follow its natural course. We have the same today with people like Lucas arguing that any stimulus is wasted money.

It’s as if we hadn’t learned anything from the success of Keynesian economics in the later 1930’s.

So here we are back, not just to the debate of earlier this year, but to the debate of 1934.

That cannot be good.

And it could have been avoided had we had more courage and sense at the critical moment earlier this year.

Hopefully we can get that missing $400 billion stimulus enacted.

I doubt it.

And that tells me next year could be very rough – meanwhile unemployment keeps on mounting. Presumably those opposed to stimulus don’t care about unemployment.

Shame on them.

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Housing Muddle

I commented just two days ago about the state of the housing market. The data that prompted me then was the release of home price trends by the Federal Housing Finance Authority – prices have risen very slightly over a period of a few months which suggests that the market has hit bottom.

But today we find out, from the National Association of Realtors, that the sales of existing homes dropped 2.7% last month breaking the trend of slight increases that had set in over the early part of the summer.

Clearly the housing market remains a muddle.

The importance of today’s number is that it speaks to a pervasive fear held by many if not most analysts: that the economy is growing only insofar as the government stimulus aids it. There is little, if any, self-sustaining growth within the non-government, private, economy. That, obviously, is not good news.

How do we discern this from today’s release?

One of the boosts to home demand over the summer was the first time buyers tax credit included as part of the overall government stimulus plan. All summer long we have been looking at the apparent recovery in housing and wondering to what extent the tax credit was pushing sales beyond where they would be in their ‘unassisted’ state. With this new data in hand we can start to argue that the impetus in housing was very largely due to the government trying to kick start the market. Absent the government and the action looks a whole lot weaker than we had hoped.

Now: let me caution us all. This is just one figure amongst a sea of data. It might be an end of summer aberration. It certainly looks as if some sales were encouraged by the tax credit to take place earlier than the might otherwise have been – people rushed to buy in order to get their credit – so the effect was to bunch the sales for the second half of the year into three months. If that is true we will see weaker numbers next month as well and so on through the rest of the year.

It is hard to pin the drop in sales on interest rates. Mortgages are still relatively cheap. So that is not a cause of a decline in sales.

But perhaps the tighter credit standards are. As banks adopt tighter standards with which to identify qualified buyers inevitably the pool of buyers becomes more restricted. This leads to fewer transactions and could be the reason for the drop in sales reported today. Add in the other factors we have discussed here: unemployment, household debt burdens, weak debt to equity ratios, and a need to re-build savings, and it becomes more clear that the housing market has a long way to go before it can be claimed to be ‘recovered’.

At times like these it is often impossible to pin a movement onto one cause: the entire edifice of the economy has been rocked, so it provides a multiplicity of potential causes. Plus all of them are inter-twined to an enormous degree.

So my best guess is that housing has not recovered to the extent suggested by the early summer data: the market was distorted by the stimulus package. With that said it is not as bad as it was. The price data suggests that some strength is returning. But we are a very long way off being able to say that the market is healed. As I said earlier this week I cannot foresee a truly healthy real estate market until 2015, and maybe not until 2018.

One month’s data doesn’t prove that view to be correct, but it helps support the argument.

Housing remains rotten. Just not quite as rotten as this time last year.

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Housing

I haven’t commented on the state of the housing market lately so this morning’s release of the monthly home price data compiled by the Federal Housing Finance Agency gives me a chance to rectify that.

The news, like so much of what we see and hear at the moment, is very slightly improved over that of earlier this year. Is that good? Well not great, but moving ever so slowly in the right direction.

The FHFA collects data only on homes financed through the agencies that comprise the government mortgage provider network: Fannie Mae, Freddie Mac, and the various Federal Home Loan banks. The data is useful because it based upon repeat sales – in this way it resembles the Case-Schiller Index – and so tracks prices for the same house through time.

On this basis the FHFA estimates that home prices rose 0.3% in July, which is the latest month for which it has compiled data. This follows an increase of 0.1% in June, and makes three consecutive months of gain. That’s the good news.

On the negative side I am concerned that the June number was revised down from 0.5%, and year on year prices are still showing a decline: this July’s figure is down 4.2% from last year’s and is 10.5% off the 2007 peak.

None of these numbers are as dramatic as those of the Case Schiller Index which shows a 15.4% decline in the last year alone.

Since the two indices are calculated on such different sets of homes they cannot be compared directly and we are left simply to remark on any similarities in trends.

Both are showing the same kind of slope: down sharply last year, continued down early this year, and now a noticeable ‘bottoming out’ effect with prices up and down month to month , but with a very small positive movement discernible.

So is the housing market on its way back to health?

That depends on what you mean by health.

I don’t see a way for the market to rebound with anything like the intensity of activity we saw during the height of the bubble. Those absurd days are gone – mercifully. With all the key market actors severely burned by the experience it will be a while before we return to the years of reliable double digit price increases – without strong re-regulation of the banks I cannot eliminate the possibility entirely, but I have to assume that even the banks are reticent to lose a ton more money on rubbish real estate loans. So funding will be less available and credit standards will, hopefully, return to something like respectability. This will limit the cash flowing into housing and so dampen all that Greenspan ‘exuberance’.

Just as important: buyers are now cramped. The tighter credit standards will inevitably limit the number of eligible buyers for each home, so with demand decreased another source of exuberance is eliminated. Buyers are also struggling with debt burdens accumulated during the silly season of earlier this decade. With wages flat lining for a long time now, and under pressure currently, affordability becomes critical. The significant drop in prices already has made homes much more affordable than they were, but I question whether we have made sufficient adjustment for the market to recover completely.

My suspicion is that prices have dropped enough to eliminate only the effects of the ridiculous financing – sub-prime mortgages being the obvious example – we saw during the bubble years. Those kinds of loans increased the ability for people to buy homes by expanding the number of ‘creditworthy’ buyers. The result was not just to enable more people to buy houses, which was the positive social effect that was touted by the de-regulators of the past decade or so, but it also drove prices way up beyond ‘normal’ levels of affordability. Add these two effects together and we produce a market glutted with demand and overpriced at the same time.

The next step in rounding out the picture is to understand that this state of affairs stimulated construction. In fact real estate construction became our biggest single source of job growth throughout the Bush era. When the bubble finally burst we ended up with a massive over-construction of homes – supply is way out of whack with demand. The inventory of unsold homes is slowly being whittled away, but it remains at historically high levels.

Adding all this together we can now answer the question about the health of the housing market: it is suffering from a humongous hangover. And like anything or anyone in that situation it is both turgid and volatile at the same time – it is very sensitive to loud noises. ‘Fragile but increasingly steady’ just about captures the picture.

Very slowly life is returning to normal. There are huge geographical differences: the prize for the worst hit locality has just shifted from California to Nevada: the mountain states are still seeing quite large price decreases, whereas the Pacific coats has begun to firm up a bit. Even Florida has hit bottom, but it could begin to fall some more if the overall economy doesn’t get going soon.

Sellers of existing homes seem to be in shock at the prices they now have to accept as reasonable. The prevailing price level is so far down from its peak that some sellers appear willing to try to wait for a rebound rather than sell now. This creates a kind of ‘grey’ inventory – homes that the owners would like to sell, but which are not listed as for sale officially. In Manhattan this problem is particularly acute – it almost doubles the inventory of homes for sale.

Then we have to add to inventory newly constructed homes that the builder is not listing for sale because to sell at prevailing prices would undermine the financing arrangements that underpin the construction. This effect has released a flood of condominiums in New York City as rentals rather than as sales, creating yet another distortion in the market that makes perceiving the market’s health very difficult.

Further: much of the ‘recovery’ in prices we have seen this year was driven by the tax incentives for new buyers: this helped arrest the decline in qualified buyers for a while. That effect will now fade away and thus reveal any underlying trend it may have masked.

Lastly: given the very difficult job and therefore income position that the population at large finds itself in, it becomes extremely hard to predict a sustained and steady recovery in prices. There will be pockets of strength: all those Goldman Sachs bonuses will inevitably continue to distort New York real estate prices, but the general trend will be one of very slow gains.

We are only now at the bottom of the cycle and there are no sources of strength that justify a bold forecast: affordability is still low; credit is less available; households are financially weak and risk averse; sellers are shell shocked over prices; foreclosures are high and rising – this puts downward pressure on prices; many owners are stuck with negative equity and therefore cannot sell – this reduces potential inventory for sale; builders are still sitting on piles of unsold homes; and the banks are evaluating their loans to builders – I foresee a burst in loan losses and commercial real estate bankruptcies that will distort the market next year.

As I said this is one heck of a hangover.

Prices will stabilize – I think they need to drop a little more [another 5% to 10%] for a solid rebound to take effect. Without a further decline things will have to wait for personal incomes to grow to bring affordability back into normal ranges, and that looks unlikely for a year or so.

All of which implies that this morning’s data is a very accurate reflection of the market: very weak price recovery coupled with big geographical variation and no real evidence of strength.

That’s the way I see real estate for a few quarters – maybe years – yet. I doubt we will return to the price peak of 2007 for many years to come: somewhere between 2015 and 2018 looks about right for that. Meanwhile housing will underperform as an investment, and there will be plenty of deals.

Buy a home certainly, but invest somewhere else.

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Deficits As Far As The Eye Can See

The sea of red ink is swelling at an awesome rate. One of the reasons that Obama pushed forward his announcement about Bernanke was to drive the various reports issued yesterday about the Federal Deficit off the front page. At least that’s my guess. If it was his plan he failed miserably: today’s Financial Times has a banner headline announcing the impending doom of civilization – apparently – because of the new estimates of the deficit.

“The economy, like the law, may grind slowly, but grind it most assuredly does.”

Both the administration’s own estimate, from the Office of Management and Budget [OMB], and that of the non-partisan Congressional Budget Office [CBO] point in the same direction: that the Federal Deficit is both huge – in the order of $1.6 to $2 trillion this year alone – and long lasting. There isn’t a year in the next decade where the deficit is projected to be eliminated.

That is, of course, assuming a continuation of current policies.

I have hammered away at this issue before: I have two beefs with the folks who are running around in near panic when they read about this deficit.

One: where were you when the roots of the deficit were laid by the tax cuts of the Bush administration? If you didn’t panic back then you shouldn’t be upset now.

And

Two: this level of debt is entirely manageable in an economy the size of the US – focusing on the growth of the deficit misses the point that the economy also grows over the same time. The statistic we should pay attention to is not the size of the deficit but its ratio to the economy. Running around in panic about a massive deficit is plainly silly if the economy is even more massive and makes paying off the debt quite easy.

Nevertheless the media fumes away at the size of the deficit as if it is the be all and end all of policy. And those who are of a right wing persuasion chuckle that it means the end of Obama’s reforms: after all how can he pay for reform if we are already in hock up to our eyeballs?

First let me state unequivocally that I think run-away deficits are a very bad thing.

But.

There is a big difference between a temporary or ‘cyclical’ deficit, and a permanent or ‘structural’ one.

Our issue is simple: we have both kinds – cyclical and structural – rolled into one right now.

Obviously the cyclical deficit results from the recession. Not only have we had to spend hundreds of billions of dollars to keep the economy afloat, but Federal tax revenues have fallen dramatically as unemployment has risen and business has fallen. So we had to pay for the stimulus and bail-outs by borrowing. No big deal. This is a good thing. It is both sensible and pragmatic economic policy that we can afford. There is no good having the world’s highest credit rating if we don’t use it when we need to.

The deeper problem is that we have inherited a nasty structural deficit from the lunacy of the Bush tax cuts. They were insane at the time and they are hurting us deeply now. As economic policy those tax cuts were a disaster: they did not help the economy at all. Supporters of Bush simply deny the reality of the statistics: after those tax cuts the economy turned in its worst post-war performance. Wages stagnated, employment faltered, and only profits boomed. More importantly this awful set of results came at a massive cost. The federal budget fell into a long term, and permanent, deficit. There was no attempt to close the gap. None. Why? Because no one would vote for the kind of budget cutting that is needed. So the cynicism of the Bush era is wretched. Anyone who supported those tax cuts is disqualified from commenting about our current situation unless they first tell us how to remedy the damage done back in 2001/2003.

So we face two different problems: reversing the cyclical deficit, and undoing the structural deficit.

The first is relatively easy: as the economy rebounds revenues will recover to narrow the annual gap quickly. After two or three years the cyclical gap will have been eliminated. this will leave us with the cyclical debt incurred during recession to pay off, but in the context of a healthy and growing US economy that additional cyclical debt is, while not trivial, easily managed.

Getting rid of the Bush era damage is another matter entirely. That will involve expanding the revenue base – raising taxes – and controlling costs right across the board. As a nation we simply cannot remain profligate the way we were during the entire Reagan/Bush era. It is absurd for the world’s richest nation to rely on deficits to keep up its spending habits. We need to reconstruct the economy around thrift and fiscal rigor. And, however we might not like it, that means higher taxes.

Neither the OMB nor the CBO forecasts include tax increases of any substance. American politics is so bizarre that it is very difficult to have an adult conversation about fiscal responsibility: it is assumed that the electorate will revolt both against taxes and spending cuts, so nothing gets done about either.

Frankly that’s childish.

We, the people, cannot have it both ways. The cynicism of the Reagan/Bush era was that voters were told repeatedly that they could. And we bought the lie because it was wrapped in silly imagery and a near xenophobic mythology about American greatness.

Too many nations have travelled the road to penury before us for their history to have no relevance. At some point reality bites and cuts away the myth leaving an electorate irate and feeling betrayed by its leadership. We are fast approaching that point.

I have said repeatedly that I do not think the current level of debt is something we should worry about. Our economy is big enough to absorb the debt and sustain the repayments.

But that goes only so far. We cannot keep adding to the debt ad infinitum. There is a limit that even we cannot breach. Sometime within the next five years we will need to address those Bush errors. And fix them. Fiscal responsibility will have to be re-asserted. This country has lived in a debt riddled dream world for the best part of thirty years: we have deliberately underfunded key parts of our infrastructure – education is an obvious example – in order to maintain the pretense that we are still creating wealth the way we did prior to the first oil shock. It was an illusion. We became addicted to debt because other countries were willing to pump cash into us so that we could continue to buy their goods: China, Japan, Germany and the big oil exporters are key examples of this. They underspend just as much as we overspend. They are just as addicted to our debt as we are.

But that game is now at an end.

Those big exporters cannot continue to underspend if they want to grow for precisely the same reason we can no longer overspend: we need to control our debt. The more debt we pile up the less it is worth. That drives interest rates up. It is this potential effect that has the Financial Times all a-twitter today. They are misreading the data in the short term, but their point is valid long term.

Eventually we will reach the tipping point where no one wants our debt. The wheels well and truly come off the Reagan/Bush illusion at that point. A grown up country tries to avoid that eventuality.

Are we grown up enough?

Looking at the puerile and poisoned nature of our political process – the ‘debate’ over health care reform is a national embarrassment – I must admit to a certain pessimism.

Have we got the stomach to cut into Social Security – maybe by raising the retirement age; reduce our offense defense spending back to manageable levels – maybe by exiting all the Bush wars and fending off the military/industrial complex that has totally captured our purchasing process; and limiting discretionary spending sufficiently to get a balanced budget with only small tax increases? If not, then at some time we will face draconian tax increases. The economy, like the law, may grind slowly, but grind it most assuredly does.

I know which outcome I would prefer.

Whether we are adult enough to get there I will leave you to ponder.

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