interest rates

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Depression Politics

Are we about to plunge into depression? We could. Very easily. If the policy makers get their way. Nothing could be more ludicrous or dangerous than easing up on stimulus right now. Yet the folks who run our economic policy, and their counterparts throughout the large economies, are openly discussing the ways in which they can start to pull back or reduce their respective stimulus packages. We should all hope as fervently as we can that they do not pull back. That is the way to full throttled depression.

Nothing could be more dangerous to the health of our economy. Nothing. Even the most cursory reading of history tells us that those who have made premature moves to downscale the policy support for an economy in the kind of danger ours still is doom it.

The potential folly is stupendous.

Paul Krugman argues the case succinctly this morning. The risks to recovery are all on the downside. There are no obvious dangers stemming from stimulus. In fact the stimulus has hardly begun to work yet. Any discussion of its ‘failure’ is patently absurd. We are four months into a three year cycle. Yet already the administration is showing its timidity in the face of growing and concerted criticism from its opponents. It is beginning to ‘walk back’ some of its ideas.

All those gardening metaphors have addled the brains of our commentators and analysts. They are breathlessly intoning about ‘green shoots’ as if the recovery is both imminent and robust. They forget that one sharp frost and the whole thing shrivels instantly. And there are abundant signs that frost is likely: the outlook for world trade is bleak to put it mildly, which removes the traditional engine of growth for economies in our situation.

There is a particular misreading of the bond market. I have complained about that before. In summary the mistake that is now pervading the commentariat is that rising bond rates are bad: they demonstrate the market’s ‘fear’ of future inflation. That inflation, it is alleged, stems directly from the huge stimulus flooding the money supply. This is an incorrect reading of the situation. The diagnosis would have credibility in an economy running at or near capacity. Ours is so far from that condition that I am shocked anyone would suggest inflation is a near term threat. The danger from this misdiagnosis is massive. The increased money supply is what is preventing the economy caving in totally. It is providing demand to offset the collapse of private demand. More to the point: even with all this government borrowing the aggregate of state plus private borrowing is less, not more, than it was before. We have a dire excess of savings. People are unwilling to invest or spend. There is no risk of inflation while that circumstance continues.

So let me be unequivocal: the only thing standing between the US economy and full bore depression is active ‘interventionist’ fiscal policy in the form of continued government deficit spending; aided and abetted by ‘unconventional’ monetary policy. Cut back that and you cut away the only legs we have.

Why is this?

Because the economy has fallen into a classic liquidity trap. Conventional anti-recessionary policy – lowering interest rates etc – has no effect. Interest rates are so low they cannot go lower. The economy failed to respond as rates were dropped. We were left with no choice but to break out all the old Keynesian tricks.

The folks who are now talking about the ‘failure’ of the stimulus, or the fear of inflation, and even the corruption endemic in the stimulus, are all driven by a political rather than an economic agenda. They are mounting a last ditch effort to subvert the emergence of a revived Keynseian economic regime. They fear the success of the policies in place because such success would present a stark indictment of the policies of last three decades.

Either that, or they are hopelessly and naively infested with a short term view that prevents them from learning from history.

Then again the mentality that dominates the bond market is the same that brought us the bubble. That alone should tell us we ought to ignore it.

I hope my hyperventilating is an over reaction to the chatter in the financial press. But the hopeless performance of Joe Biden this weekend – where he defended the apparent ‘failure of the stimulus’ – has given me cause for concern.

We are a very long way from safety. Now is not the time for a return to depression politics.

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National Debt Issues

The size of the national debt, as it rises inexorably, has suddenly become the latest focus of fear amongst those who want to find any reason they can for attacking current economic policy. They are wrong to worry. But there seems to be a lot of them, so they are able to stir up emotions and create a debate where there should be none.

Robert Reich tackles them today in his column at TPM, but David Leonhardt adds grist to their mill in his article at the New York Times.

So what’s the deal?

Take a look at Leonhardt’s fancy chart: the change in fortunes for the Federal budget could not be more stark. In a few short years we have gone from an estimated surplus of $846 billion to this year’s forecast deficit of $1,215 billion. That’s about a $2 trillion switch. Expressed as a percentage of GDP it is a nosedive of around 15%. Very ugly. And totally unsustainable.

“The Reagan/Bush legacy turns out to be the elimination of options, and a faux destitution that appeals to the bond market and other centers of anti-government sentiment.”

Reich is correct that the best way to look at the national debt is not in absolute dollar terms, but as a percentage of GDP. By that measure it has risen to well over 70% and continues to rise. The highest it ever reached was just after World War II when it topped out at about 120% after which it came down very quickly in the long post-war boom of the 1950’s and 1960’s. In that light we have a very long way to go. Even with the gloomy outlook that still pervades I doubt that we will go above 100% of GDP any time soon. So in that respect we have plenty of room for maneuver.

OK. So what’s the deal?

The bond markets. Keeping close to their famous tradition of skittishness the bond markets are beginning to throw a hissy fit at the prospect of endless amounts of government debt. If the red ink flows for ever it will be impossible to sell all that debt: the number of buyers will eventually dry up. Nearer term the fear of such a future is showing up in rising bond yields. The ten year government bond yield has risen quite quickly to around a little under 5%, a level it has not seen for a while. This sudden rise is interpreted by some observers as a warning shot: the bond market, we are told, will not tolerate much more of the current ‘fiscal irresponsibility’. The financial press has jumped on the band-wagon and now there seems to be a rising flood of articles all predicting doom. The dollar will collapse, interest rates shoot up, and the US will fade into the kind of financial oblivion we normally reserve for the likes of Argentina or any one of the infamous ‘banana republics’ of Central America.

Apparently the Obama administration has no choice but to buckle before the desires of the bond market and turn back from its profligate ways. The alternative is disaster.

Not.

As Reich points out there seems to be a small irony here. The bond market was completely quiescent throughout the Bush era. Rates were mundanely low. Ridiculously low in fact. So low that they encouraged our borrowing boom and contributed to the real estate bubble. National debt back then was not regarded with the combination of breathless fear and doom laden fatalism that pervades the press today. Why not?

Even a cursory look at the numbers will show that the majority of the turn around in our budgetary fortunes stems from two factors. Neither of which has anything to do with Obama:

  1. The recession itself has hammered government revenues. There is no surprise here. Of the $2 trillion downturn in the budget, fully $770 billion, or about 39%, is directly caused by the shrinkage of tax revenues due to recession. The interesting point here is that there are two chunks within this number: $291 billion of the shrinkage traces back to the recession of the early 2000’s. Because the recovery of the mid 2000’s was so weak, and because taxes were cut so aggressively at the same time, revenues never rebounded. That $291 became part of the ongoing or ‘structural’ deficit. The bond market should have panicked at this figure. It didn’t. It embraced it. That’s odd. Especially since the lost revenue from the current recession, at $479 billion, is not structural but ‘cyclical’: it will go away as soon as activity picks up, incomes improve, and taxes rise back. Obama had not cut taxes as aggressively as Bush did, on the contrary he has announced tax increases as soon as the economy recovers. That announced fiscal tightening should have re-assured the bond market that this portion of the debt is temporary and therefore not inflationary. It didn’t. That’s also odd.
  2. Of the $2 trillion collapse in our budget approximately $673 billion, or another 34%, is due directly to the tax cuts that Bush made. Those tax cuts failed to generate offsetting revenue – that notion was always bogus – and so permanently added to the deficit. At no time did the Bush administration attempt to address the gaping hole it opened up in our finances. On the contrary Dick Cheney famously declared that deficits don’t matter. That proclamation of fiscal profligacy should have been enough to send bond prices through the floor, and thus yields through the roof. Here was a US official stating that the government cared not one whit about the yawning gap in the budget and thus the rapidly accumulating national debt. Did the bond market react that way? Not at all. Very odd yet again.

The combination of these two factors, neither of which has anything to do with Obama’s agenda, contribute just over 70% of the downturn in our fortunes. Only 30% flows from all the bail out and stimulus activity of the past few months.

And it is the 30% that apparently has now scared the bond market, and which has now captured the attention of all the commentators who are now piling in on the debt fear mongering.

But do they have a point?

Let’s press on with our analysis.

The bond market clearly didn’t worry about the Bush deficits even though they had all the appearance of permanence. Let me repeat: at no time did the Bush administration offer even a hint of a suggestion as to how we were going to deal with those deficits. On the contrary they punted the entire problem of fiscal policy forward in one of the most irresponsible acts of bad government in history.

I spent much of my time during both the Reagan profligacy and the Bush mega-profligacy arguing that deficits do indeed matter. For exactly the reason being cited today by the right wingers as they attack Obama: governments should fund their activities wisely and fully. Neither Reagan nor Bush was wise. But they knew full well what they were doing. They were trying to eviscerate government. It was the ‘starve the beast’ strategy in its full glory. The Republican thinking was that by destroying the government’s revenue stream it would hobble any attempt by a future Democratic regime to expand social programs. More to the point: if the starvation was sufficient the result would be an inability to fund the existing programs and thus enable their rolling back. Don’t forget that the GOP is still fighting a war against FDR and all he stood for. The Reagan/Bush years of disastrous fiscal policy were simply the latest weapons in that war.

But our issue here is the bond market. Where was the prediction of gloom and doom back then? Why wasn’t every uptick in the ten year bond yield seen as foretelling the end of the world as we know it – the way today’s rate increases are. The case for doom was much stronger back then. No one had any policy to reverse the tide of red ink. They didn’t want to.

I recall being extremely frustrated as I tried to explain to audiences that the rising deficit would eventually trigger a revolt in the bond market, and that we would either have to rein in spending or expand revenues in order to prevent that. But nothing happened. I was told that the US is able to issue endless streams of debt and that worrying about funding was a trivial problem. Yet here we are, and many of those self same folks are tearing their hair out over exactly the same issues.

So the current hissing sound you hear in the bond market seems very political to me. Not economic. It seems that Republican deficits truly don’t matter – Cheney judged the bond market well – but that Democratic deficits are the road to perdition.

Nuts.

Let’s look at some old fashioned economics.

  • Deficits do matter. In the long run. No country can deficit spend permanently. Structural deficits are like rotten floorboards: they eventually cause a cave in. Not even the US. Eventually the cost of debt will rise to unsustainable levels and the economy will implode.
  • But temporary, or cyclical, deficits don’t matter. On the contrary, they are helpful. They plug the gap in the economy left by the loss of private spending. That’s Keynes 101. That’s why the stimulus is relatively unimportant in terms of its debt impact. The idea is to spend freely up to the point that the economy kicks back into gear. In fact a cyclical deficit acts as a self-correcting device at the heart of an economy: by moving into deficit as a recession begins a rising government deficit pushes against the downturn. Money still flows. the chances of a depression are mitigated.
  • But. At some point the budget must come back to balance and even surplus. A cyclical deficit must be cyclical not permanent. The Reagan/Bush nonsense should never be tolerated.
  • So fiscal policy should be mildly counter-cyclical: pulling back in good times and pressing on in bad times. Old fashioned, but successful.
  • Finally: adding to the money supply by issuing tons of bonds does not ‘assure’ future inflation. As long as the economy is operating well below its capacity – which it is right now – the extra money will be absorbed as additional spending. Inflation only rears it ugly head when money is added while the economy is at or near capacity. That’s why the Federal Reserve Board raises interest rates as the economy gets going. That’s monetary counter-cyclicality. Also old fashioned. Also successful.

Obviously the current flood of debt is horrendous. But, equally obviously, it is necessary. There is a cyclical urgency that preempts longer term considerations here. What the Obama critics are doing, successfully judging by the fearful articles now being written, is to muddle the structural deficits created by Reagan/Bush policies with the cyclical ones created by the recession and thus to sow confusion. They attack Obama policies by pointing to the consequences of Reagan/Bush policies. As if they are the same.

This is the latest incarnation of the ‘starve the beast’ strategy. The huge residual problems bequeathed to us by Bush are now being used as the reason we should not press on with health care reform, add to the stimulus, or bailout the banks. Supposedly we can’t afford it.

Again: Nuts.

We need to fight the near term battle before we can turn our attention to the longer term problem of restoring fiscal responsibility.

Meanwhile we will hear that health care reform is simply not affordable given our impecunious state. Our penury, courtesy of Reagan/Bush, is supposed to act as a bulwark against reform. So we are told by the wise heads in the financial world to stop, not because we discuss reform and decide not to go ahead, but because we simply don’t have the money – whether we want reform of not. The Reagan/Bush legacy turns out to be the elimination of options, and a faux destitution that appeals to the bond market and other centers of anti-government sentiment.

One last thing: yes, bond rates have indeed moved up. The bond market appears to be anticipating recovery, and given its normal worry ridden nervousness it has started to fall prey to fears of things that that don’t exist yet, but which may. Inflation is one. High debt loads are another.

Oddly, structural deficits didn’t seem a concern in the Reagan/Bush era, but now they do.

Yes they do.

One of the dominant themes of the Obama era must be fiscal sense and balance. The administration appears to have heeded the message: that’s why Bernanke already talks about targeting inflation at between 1.5% and 2% and has started to urge restraint on Congress. That’s why Obama’s budget contains tax increase down the road. That’s why ending the Iraq war is so important. And that’s why the focus of health care reform is on cost inflation control. Given this mix of policies the structural deficit can be dealt with even as we reform.

Ultimately, the difference between the two eras is that Reagan/Bush were willing to play dice with the nation’s finances in order to make a political point. But the grown ups are back in town. The new era is one of reconstruction, reform, and stability. That means sustainable growth and, gasp, perhaps even the reduction of debt.

Apparently the bond market hasn’t figured that out yet.

That’s their problem. Not ours.

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Weekend Update: GM, Health Care and GDP

After all the chaos of the past few weeks, the ‘green shoots’, bankruptcies, inflation fears, and the onset of the health care reform campaign, this weekend seems rather quiet. That makes it a good time to recap some thoughts relating to the headline events.

GM:

  1. GM’s bankruptcy is a watershed event for the US. Think of the size: GM employs about 210,000 people worldwide and 91,000 here in the US. It has a staggering 463 subsidiaries scattered across 34 countries. Its monthly payroll bill is $476 million. It provides pensions and health care benefits to 493,000 retirees. It has 11,500 vendors and spends $50 billion a year here in the US on parts etc. Its collapse will ripple throughout that entire mess.
  2. I have doubts about its survival even when it emerges from bankruptcy. This is because GM needs more than a financial re-organization, it needs a brand revitalization which is far more difficult to accomplish. When GM entered bankruptcy it had assets of about $82 billion and debts of about $172 billion. That’s a dead company by any stretch of the imagination. More to the point: even though some of its recent cars have attracted critics adulation – the Chevy Malibu for instance – it suffers from a severely depleted brand reputation. Producing good cars now after decades of undifferentiated duds may not help in the face of the competition now ramping up for the kill.
  3. The entire auto industry is a mess. It suffers from chronic over-capacity and needs to reduce itself to a more profitable size quickly. Presumably the emerging markets of China and India will eventually outpace demand from more mature markets and so innovation and scale advantages are likely to shift similarly. GM’s strong presence in China may aid survival if that is the case.
  4. Offsetting that is the likely continued collapse of its brand here in the US. Its appeal to younger Americans is virtually non-existent. Honda, Toyota, Nissan and now Volkswagen have emerged as the suppliers of choice to younger Americans. Volkswagen is building a new factory here to produce 250,000 cars a year as it seeks to double it market share at GM’s expense.
  5. GM remains a very dull company. The word is that Obama’s auto task force were shocked at the poor quality of GM’s management. It is old fashioned, lacks focus, and too attached to the plethora of brands that sank the ‘old GM’. Heads will have to roll before we can expect a vibrant new GM to succeed.
  6. Even with the drastic reduction in costs that bankruptcy will allow – GM expects to shut fourteen factories – it is still not a low cost producer of cars. It is still burdened with huge pension and health care costs that its competitors do not have to carry, the latest estimate is that each car it will make after bankruptcy will still have to earn $300 just to pay for workers who no longer produce anything.

Overall then I see GM as a 60/40 proposition going forward. All that taxpayer money is designed to give the company a window of opportunity. The macro economic conditions it faces remain daunting. I would not be surprised to see GM going through another bankruptcy procedure a few years from now. Let’s hope not.

“The trade-off between wages and health care costs is the key to getting the average voter’s attention: they are already paying a huge price for the system’s failure”

Health Care:

  1. The interesting fact here is that we have no choice but to fix health care. It simply costs too much. The latest estimates I have seen put the total cost of health care at around 18% of GDP this year. That’s an astonishing number. Worse: no one expects it to get cheaper without radical surgery [sorry about the pun]. Indeed as the baby boomers all age and if they consume health care services at the rate their parents did, that 18% is set to become around 40% within a couple of decades. That will bankrupt the country. So something has to be done and quickly.
  2. A key fact to remember: the impact of health care on wages. It has been catastrophic. Because the US system depends on employers giving health care as a benefit its rising cost has squeezed employer’s ability or willingness to give pay raises. Businesses look at wages and benefits as a sum cost. If the cost of health care goes up that leaves less cash available for raises. Looking at the trend over recent years the aggregate of wages and benefits has risen quite steeply. But practically all that increase has gone to pay for health care costs. None has gone to wages. So incomes have stagnated. Without controlling health care we can expect wages to stagnate, and even have to fall to accommodate the expense. That is not tolerable. The trade-off between wages and health care costs is the key to getting the average voter’s attention: they are already paying a huge price for the system’s failure. They need to stop that getting worse.
  3. The fight will come from the insurance companies who do not want a government provided alternative. In order for them to win that argument it looks as if they will have to offer significant compromises. In particular they stand to lose their ability to refuse ‘pre-existing’ conditions. I am deeply skeptical of the insurers: they have no incentive to offer the kind of comprehensive cost cutting the system needs. Nor do doctors. Somehow if we are to avoid a mandated system, incentives have to be introduced to force rationalization, office cost reductions, reduced test frequencies and duplications, and a better focus on prevention rather than cure. How this can be accomplished without government fiat is very unclear.
  4. Paying for the changes will be easier than many people think. First: the system already costs a vast amount, we can accomplish a fair bit of reform by re-allocating what we already spend, rather than by spending more. Second: there is a growing consensus that health care benefits should be taxed. One of the reasons the current system is so bad is that consumers do not bear its costs directly. So they have no incentive to push back against doctors who over prescribe, or against the waste of insurers bureaucracies. By taxing benefits not only do we raise money for reform, but we focus consumers on the cost of the services they are using. Hopefully consumer activism will disturb doctors and insurers enough for them to provide cost effective rather than lavish service.

Solving our health care mess is a high priority for a number of reasons. We need a better return on our investment: right now we have the least efficient system in the world. We need to spend less in absolute terms: we are on a path towards bankruptcy currently. We need to determine whether we want to have our entire population covered: if so, how? If not, why? Even with the difficulties and entrenched opposition there seems to be widespread support for change. I doubt that the resolution will be bipartisan, but this seems to be one area where Obama has the nerve to use the Democrat’s majority. Let’s hope he gets this sorted out this year. We don’t have the money to keep up the current pace of things.

GDP:

  1. There is far too much focus on short term numbers and not enough on the long term trends. My fear is that all the talk of ‘green shoots’ will distract us from digging into the sources of our problems and therefore stop us from eradicating them.
  2. The banking system needs fixing. It is in an awful mess. It is badly managed and runs on business models that are now proven dangerous. One look at the headlines about government ‘interference’ – usually in the Wall Street Journal – and we can see already that the industry has successfully avoided either taking responsibility for the crisis it started or undertaking reform. The breathless criticism of the FDIC’s suggestion that heads should roll at places like Citigroup, as if that wasn’t blindingly obvious, is an example of this. Indeed the banks have so successfully co-opted government that everyone seems scared to suggest doing much by way of fixing them for fear of failure. failure, that is, of one of the banks. From my perspective the collapse of the banks was a failure of their managers, boards and regulators.
  3. On the subject of banks: I urge you all to read John Lanchester’s excellent article in the latest issue of The London Review Of Books. Apart from being an outstanding summary of the crisis it offers up an actual bank balance sheet from The Royal Bank of Scotland. This balance sheet was released to shareholders just two weeks before the bank fell into the abyss where it currently wallows. The lesson I want to highlight is that nowhere in this balance sheet is there a single clue of the impending disaster. None. That the bank’s auditors, managers, and regulators are not all in jail for publishing such an obviously misleading document is beyond me. Without accountability we will not fix the banking system. That means we will not fix the economy.
  4. Employment. The outburst of optimism that greeted Friday’s employment report is testimony more to our depressed mindset than to any rational thought. It was awful. Just not as awful as the last few. That is no triumph. For anyone to trumpet a turnaround based on one month’s data is just plainly irresponsible. It is silly.
  5. All the vexation about rising US bond rates is similarly off center. There are those who are already despondent over inflation: they are arguing that the uptick in US bond rates over that last few weeks is a sure indicator of the bond market’s anxiety over the level of US debt. That anxiety supposedly is so solidly based that we should stop increasing our debt and start reducing it right now. That’s absurd. These are the same folks who sat back and told us that running up debt was not a problem when the cause was tax cutting. Apparently government spending as a cause throws them into a tizzy. Yes: we will need to cut back as soon as the economy is back on track. No: that’s not yet. A steeper yield curve helps the banks. A modest inflation rate helps deal with debt loads. And until we have an economy operating back near capacity all that increase in money supply gets absorbed as demand and not as inflation. Duh.

Nonetheless we can expect the inflation fear mongers to be out in force over the next few weeks. I imagine this is set to become a regular topic for us to talk about.

So the trilogy of issues to watch for in the next phase of the recession: structural reform of the health care and banking systems; the balance between monetary and fiscal policy; and capacity – which includes the employment outlook.

That’ll keep us busy.

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    High National Debt and Potential Inflation

    There is a lot of nonsense being spoken, by people who should know better, about the level of Federal Debt and its impact on both inflation and interest rates. These people point to the recent run up in US Treasury bond yields as the market issuing a stern warning that we have reached a maximum debt load and that anything more is reckless. They also warn of bond rating downgrades, runs against the dollar, hyperinflation, and all the other consequences of negligent fiscal policy.

    Niall Ferguson I am looking at you.

    First let me frame the debate.

    The combined efforts of the US Treasury and the Federal Reserve Board have resulted in a dramatic surge in US national debt. It has risen from about 40% of GDP and probably will top out around 80% when the dust settles. There is a risk it may go even higher. That opens up all the threats I listed above which are now being trotted out by the so-called fiscal conservatives. In particular they argue that this huge debt load places a terrible burden on future taxpayers either through unbearable tax rates or through equally unbearable inflation and interest rates.

    The major point of evidence they offer is the recent rise in US bond rates and the fact that some of the recent bond auctions have been received poorly.

    I myself have noted both these things.

    But my interpretation differs.

    I do not see the run up in rates as a warning sign that the market is expecting inflation in the future. Bonds that mature in a few years time have much higher risk than bonds maturing in the near term. One of those risks is that of a rise in inflation. So investors typically ‘price in’ an allowance for their ‘expected level’ of inflation. Don’t forget that inflation reduces the value of debt because you are paying back whatever you borrowed in dollars that are worth less: inflation has eroded the purchasing power of those dollars. In order to offset this reduced purchasing power investors need to be rewarded a yield on their investments over and above the short term and ‘risk free’ rate. So longer term bonds have an inflation offsetting component in them. Indeed so accepted is this that we sometimes use the bond price as a measure of expected inflation. I will explain how in a moment.

    So people like Ferguson have begun to chirrup about the rise in bond yields as a sure sign of inflationary expectations building.

    Why should inflation be a problem related to huge debt loads? Because governments are notorious for using the debt reducing action of inflation to avoid having to raise taxes to pay back the debts. Historians like Ferguson can point to countless such episodes of ‘inflating your way out of debt’. Using inflation this way is so common that it is almost normal procedure. And that sends shivers down the spines of long term investors: they’re the ones who lose when governments tolerate inflation because of the lost purchasing power it implies.

    If you are a fiscal conservative therefore it is only natural to cringe when there is a surge in debt. And if you are skeptical fiscal conservative you cringe even more because your expectations of government policy is so low to begin with.

    But.

    We are not living through normal times. This is Ferguson’s big mistake.

    US bond rates have been ridiculously low recently. The ‘safe haven’ effect I have mentioned before, which is created when foreign investors rush to by US debt because it is safer than any other debt, has driven US interest rates well below any ‘normal’ level. Indeed, it is well nigh impossible to tell what ‘normal’ would have been over that past six to nine months. Now, however, there are enough signs of improvement in the world economy that the safe haven effect is diminished. People are beginning to liquidate their US bond portfolios and invest in higher yielding securities elsewhere. This has had the effect of raising US bond yields, and depressing US bond prices, which is the same thing, and which is why the Chinese are reportedly concerned about their investments here.

    So this is an entirely different interpretation of what’s going on in the bond market: in fact it is very positive. It says that all those expensive efforts to bail out and stimulate the economy are beginning to have an effect on the credit markets. The policies are beginning to work. Great. We would expect yields to return to higher levels once this happens.

    But have rates risen higher than this positive effect? Do they also reflect higher inflationary expectations?

    No.

    The Federal Reserve Board has let it be known that it would like an inflation rate of between 1.5% and 2%. That is tolerable and consistent with healthy growth. One of the reasons they announced this was the fear of deflation, which as you may recall, was very urgent as recently as earlier this year. So the Fed pegged its own desired inflation rate as a way of nudging the markets to build that level into its long term expected inflation rate. Has the Fed’s approach worked? Yes. One way of checking this is to look at the credit markets and see what the value of ‘inflation-proofed’ bonds are yielding. These bonds are priced in such a way that there is no loss of purchasing power in them because each year their value is altered to reflect that year’s inflation rate. Thus their yields don’t need to have an expected inflation component in them. So if we compare these inflation-proofed bonds with the run of the mill kind the difference in yield, or ‘spread’, between them should give us an accurate measure of what inflation expectations are. Last I looked this spread was 1.6%. Exactly where the Fed wants it to be. And not anywhere near an indicator of impending doom.

    Now I too am a fiscal conservative. I realize that the current fiscal easing cannot go on forever else we would end up in the mess that Ferguson and his ilk are imagining we are already in.

    Plainly I am not as skeptical as Ferguson. Why not? I think there are ways of re-introducing fiscal restraint when appropriate so that the run up in debt is limited to only that necessary to solve our current problems. And I believe that the US still has sufficient credibility to be seen as responsible enough to rein in spending and raise revenues when needed. This is a major point: in large part markets react to the credibility of the policy makers who will determine whether a government will try to inflate its way out of debt. Governments with a poor track record don’t get the benefit of the doubt and the bond market punishes them immediately upon seeing a surge in debt.

    A responsible policy maker starts to signal to the markets that there is a clear understanding of the limits to the amount of debt that can be issued. Central bankers are always making speeches and statements in order to signal such policy matters to the markets. This kind of communication is an essential tool in the arsenal of policy makers: not only does it reinforce their fiscal credibility it also signals a potential change in course.

    So this morning’s intonement by Ben Bernanke during his regular Congressional report becomes important. He issued a strong call for restraint in debt loads. This is from the man who was a primary architect of the debt run up. And it exactly fits my interpretation of what to expect. Bernanke wants to communicate to all quarters that the US has very intention of working its debt down responsibly. Excessive inflation fears, he is saying, are unwarranted.

    And as I pointed out above, they’re not even there. Except in the heads of the folks like Ferguson who disliked fiscal stimulus to begin with.

    This I think is the central issue of Ferguson’s argument: he is so opposed to Keynesian economics that he has latched onto to the ‘impending inflation disaster’ as a way to lambast people like Paul Krugman who have emerged as strongly pro-Keynes.

    There’s a lot at stake here.

    For the past few decades Chicago school monetarism has dominated economic theorizing. In part because of the supposed ‘defeat’ of Keynesian school back in the late 1970’s. I say supposed because I disagree with the diagnosis of the issues and policy results back then. Nonetheless if you are a true monetarist, as Ferguson apparently is, you must be horrified at the prospect of success for fiscal policy. You don’t think fiscal policy works. You think it is self defeating because of something called ‘Ricardian Equivalence’ – which is a theory held by monetarists that says taxpayers are so smart they will automatically increase savings to offset future taxes whenever the government runs a deficit, thus the deficit is robbed of its stimulus properties and has no effect. And, so, you think the only outcome of fiscal stimulus is future inflation, and national ruin. The lens through which you view the world is so restrictive that you are unable to accommodate a pragmatist like Bernanke, let alone a Keynesian like Krugman.

    I don’t recall Ferguson lambasting the Reagan or Bush deficits as inflation inducing disasters. But I may just have not been paying attention. Perhaps he did. Nor do I recall inflation leaping uncontrollably after those two bouts of fiscal recklessness. Again I may have missed the run against the US bonds that surely must have followed.

    In any case Ferguson is totally wrong now.

    Keynesian fiscal policy was our only weapon in the recent fight because monetary policy was already exhausted – interest rates are near zero and can’t go any further down. It also happens to work. And there is no one for one correlation with fiscal stimulus and future inflation as long as fiscal policy reverts to balance when the crisis abates, and as long as demand in the economy is so far away from its long run potential – you will usually stoke inflation if you run deficits when the economy is at or above its potential. But if the actual versus potential demand gap is wide the fiscal deficit stokes demand not inflation. Which is exactly the Keynesian point. It is only when demand gets back close to potential capacity of the economy that fiscal stimulus needs to be reversed. This is when the recovery is well on track.

    So the final dispute I have with Ferguson seems to be how we model the end game. That is how do we fix the budget once we have saved the economy? There seems to be plenty of time for that debate: it is far too premature to tighten just yet. That of all things is a lesson we learned, or should have learned in Ferguson’s case, from the Great Depression: you don’t hit the brakes too soon, otherwise you plunge back into an even deeper crisis.

    Let’s get out of intensive care before we worry about physical therapy.

    An let’s not see ghosts that aren’t there.

    / / , , , , , , , /

    Health Care, Taxes, and Debt

    As we move more into the legislative agenda of the Obama administration, rather than the triage period of economic recovery, several inter-related issues become very prominent. Obama wants to shift the emphasis of health care towards universal coverage, but has to accomplish this against a very strong headwind: the Reagan/Bush legacy of national debt.

    The problem is simple: any attempt to provide universal health care coverage, in other words the move from regarding health care as a ‘benefit’ or a ‘consumable product’ towards a basic ‘service’ akin to a utility will cost serious money. Most estimates put the price tag in the range of $150 billion a year. In the context of the Federal Budget this is a very significant addition to the deficit, although it is trivial when set against the cost of bailing out the banks.

    The original Obama budget used a variety of methods for financing this cost: mainly the termination of the Bush tax cuts at the high end of incomes, and the implementation of much needed cost reductions in the health care industry.

    The problem of cost reduction is of paramount importance. The US system is extremely expensive to run. It absorbs about twice of our national annual income, as measured by its percentage of GDP, than any other health care system in the world. The next most expensive is the French system, which delivers excellent service at half the price. Indeed the French system is arguably superior since it provides more effective basic service to the entire French population, unlike the American system which fails to cover about 45 million people here.

    The problem with the US system is is that its fragmentation amongst a vast number of carriers, insurers and other providers dissipates buying power so costs of things like drugs are not forced down. Yet at the same time it is replete with duplicated costs: all those insurance companies carry large administrative overheads and at the front line of care the lack of automation in doctor offices is extraordinary. By any objective standard the system is horribly inefficient.

    To those who advocate a totally private system this must be a source of frustration: market forces are supposed to drive out costs because doctors and hospitals should be competing on price as well as service. In fact price should dominate the provision of the basic services since most doctors, within their specialties, have little opportunity to differentiate sufficiently to maintain a higher price service. There will always be niches for very high end services, but those are commonplace the world over even in nationalized systems. The problem here is that the typical market forces that should eliminate waste simply don’t work. Consumers do not look at health care as a ‘consumable item’ except for fringe services like cosmetic plastic surgery. And sick people have very little incentive to search for a ow cost provider: they simply go to their regular doctor or head to the emergency room.

    In the American system the true locus of efficiency inducing market forces should be in the cost of purchasing insurance. This is where consumer choice should enter into the equation. But, again, consumers are effectively shielded from the true cost of their choices by the employer provided nature of the service. Because employers provide health care coverage as a ‘benefit’ they find it acceptable to absorb some of the cost. So consumers who get their insurance through the workplace, and that is a large percentage of Americans, do not face the real cost. Thus they have no incentive to demand cost reductions from doctors or insurance companies.

    Couple this lack of effective market force with the unique effects of the American litigious process which adds to overhead costs and the end result is a system that is neither market efficient nor universal. It has none of the benefits of being truly ‘privatized’ and none of the benefits of being truly ‘nationalized’. So it exists as a wildly inefficient hybrid absorbing an increasing amount of our wealth while not producing an equivalent level of excellence: the US ranks very low in most of the basic services that the United Nations uses to measure the effectiveness of health care around the world. This is a scandal given the amount of money we collectively spend on it.

    So a fix is urgently required before we are swamped by the system’s cost and it squeezes out other more productive and wealth generating activities from the economy.

    Hence the need to look at debt loads and taxes.

    I have mentioned here many times that the massive expenditure to save the economy was unavoidable. Deficit spending, while distasteful to those of us who are fiscally conservative, is a necessary evil. It is the only method we have for keeping ourselves from plunging full bore into another Depression. And it seems to be working, although there is growing feeling amongst economists of all political stripes that the stimulus may need another round of spending before we are assured of success. Even Martin Feldstein, hardly a left winger, gets in on the act of advocating more spending. Only the hard core ‘New Classicists’ remain berating the Keynesian drift of economic policy, mainly because the current crisis is an indictment of their theory.

    But, given the mess that three decades of Reagan/Bush profligacy have created, notwithstanding the entirely accidental Clinton surpluses, we are facing almost historic debt levels as a result of the current ‘triage’ approach. And already that is causing nerves to crack in the bond market. The prices of US treasury bonds are dropping at the moment for a variety of reasons:

    • faster economic growth will engender inflation. Bonds will fall in anticipation of inflation: interest rates will climb to compensate for inflation. Higher interest rates means fixed rate US treasury bonds are worth less, hence the decline in price of bonds.
    • the enormous amount, some would say ‘glut’, of bonds being flooded onto the market by the US as it tries to bail itself out needs to be maintained in the market. This is a simple matter of supply and demand. Greater supply of bonds will reduce their price. The result: lower bond prices and higher interest rates.
    • now add in the expectation of funding needed for the Obama agenda, and the supply of bonds seems to grow even more. The result: lower bond prices and higher interest rates.
    • lastly, foreign investors will start to unwind their holding of US bonds, as their respective domestic markets recover and offer higher yielding opportunities for investment. The result: lower bond prices, and higher interest rates in the US in order to maintain foreign investor involvement in the market.

    There seems to be a theme here.

    Even with the Federal Reserve Board’s efforts to reduce the supply of bonds through purchases most estimates put the Treasury’s bond issuance requirements at around $2 trillion this year alone – it has already issued about $900 billion this year.

    In other words fiscal policy is a mess and we need to start to plan to tighten it back up in order to prevent a massive bond market revolt against the US. The jitters last week when Standard and Poor’s threatened to downgrade the UK debt from its AAA status was a strong shot across the bows here as well.

    So what to do?

    Raise taxes.

    There seems to be little appetite for expenditure cutting in Washington. And in truth there is little that can be done in any case. The largest chunks of the budget are each sacrosanct: I doubt, for instance, that defense spending will be reduced substantially any time soon even though it is egregiously high when compared to other nations. The US spends as much on defense [or more properly ‘offense’] than the next ten countries in the world combined, and it is wedded to defense systems that have no place in the post-Cold war era. Yet cutting defense spending seems politically infeasible. Likewise reducing or eliminating entitlement spending: even the supposedly anti-government ideologues like Reagan and Bush balked at that. In fact they added to the spending. The American middle class likes its perks, but doesn’t want to pay for them.

    So in the absence of cost cutting we will have to raise revenues. This means taxes. I have already alluded to the elimination of the upper end Bush tax cuts, but that alone won’t be enough. US corporate taxes are already among the highest in the industrial world and probably need cutting rather than raising – but only if the loopholes are also done away with. This leaves other taxes such as excise and sales taxes. I would wager that the US will end up with a European style Value Added Tax [‘VAT’] in the not too distant future. Given our need to shift our priorities more towards savings, a larger emphasis on consumption taxes surely has to be in the offing.

    But. Lingering in the background of the health care debate is a massive tax opportunity. One that Obama has now begun to turn to, even though he hammered McCain during the election for raising it. Resolving the employer tax exclusion could free up more than enough money to pay for the entire edifice of universal health care – some estimates put the extra revenue that abolishing this loophole would provide at $300 billion a year. Serious money . Huh? I can hear you all asking. What is that? It seems that way back during World War II the government put a lid on wages in order to control costs and it simultaneously introduced a ferocious tax on ‘excess profits’. After the war businesses that started to make good money again were faced with rising profits and no ability to raise wages. So they turned to giving away health benefits in lieu of wages. Why? Because the wartime legislation also excluded the cost of employer health care coverage from taxes. So providing health care was subsidized by the tax exclusion. And, as usual, the continuance of a tax subsidy distorts the market: decades later we have a mangled health care system because businesses can reduce their tax bill by offering health care as a ‘benefit’.

    So there you have it: our fiscal constraints will dictate in large part the next phase of the Obama agenda. The costs of unwinding the Reagan/Bush binge are enormous and threaten to undermine any attempt to rationalize our health care system. With some imagination and a little political courage we can accomplish both at the same time. Indeed I see them as firmly intertwined. We spend too much on health care, and we ned that money to get our house back in order.

    Welcome to the era of change: cost cutting and fiscal responsibility. That’s very conservative. And it’s a huge change from the past three decades of waste and illusion.

    Change we can believe in? Or simply change we need?

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