fiscal policy

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Who Cares What the Public Says?

Unless we want to replicate the disaster that is the Californian budget on a national scale we should pay no heed at all to the views of the general public when it comes to fiscal policy. That’s harsh. But true. California, you will recall, messed its budget up by incessantly adopting the fiscal consequences of all those infamous propositions. Its constitution forced its budget to behave the way the public wanted. The consequence has been disaster.

There are a number of polls now floating about at the moment saying that the public is leery of the administration’s willingness to add to the federal deficit as it bails out banks, auto and insurance companies, and spends on its stimulus plan. The news media have begun to fill columns with all sorts of dire statements about the national debt rising uncontrollably, the bond market’s hysterical reaction, and the massive prospective cost of the health care reform now being debated. The public’s reaction is predictable enough already! The public wants balanced books: that’s the safe way to household survival after all.

Add in the pot stirring partisan sniping from the Republicans and the scene is set for a backlash against the entire array of government policies now underway. I can only imagine the additional fury were the general public more aware of the fairly well hidden costs of the Federal Reserve Board’s unconventional monetarypolicy.

Yes this is an expensive process. And yes the deficit is growing at a rapid pace. The future holds some daunting problems as a result.

But.

We only have one choice.

Cutting back on the federal deficit now, or even in the next year or so, in order simply to get our books in order would be catastrophic. We already have an example of what the result would be: the Great Depression.

One of the key lessons learned from the 1930’s is that balancing the budget is exactly what we should not be doing. The Japanese learned that the hard way back in the 1990’s. A key problem the US encountered back in the early years of the Great Depression was that as the economy appeared to improve policy makers tightened things up far too rapidly and far too much. The result was to plunge the economy back down again. A recovery only became permanent as European defense spending caused by the war created huge demand here. Without the war the recovery would have been much weaker and more tortuous.

This seems counter-intuitive to many, hence the poll numbers.

The issue is this: the economy lacks sufficient demand to keep its resources active. This results in factories being idled and rising unemployment. Normally the ‘shock’ that causes the drop in demand comes from outside: e.g. oil prices spiking in the late 1970’s. The textbook policy response is to lower interest rates and thereby stimulate activity. Both the shock and the response in these circumstances are confined to the private sector. Usually the Federal Reserve Board succeeds in fending off or reversing a recession simply by easing monetary policy: increasing liquidity in the economy and lowering interest rates.

But in extraordinary moments like the current crisis that policy won’t work.

Interest rates are already at zero. There is no way rates can go down further. This is not a normal recession either: the shock came from within the system itself. It was self-inflicted. The collapse of the financial system and the bursting of the house price inflation bubble stunned consumers into a sudden burst of savings. The wipe-out of wealthcaused bybanking folly made us all too cautious. So the private sector started to shrink as spending dried up.

I have thrown the phrases ‘liquidity trap’ and ‘paradox of thrift’ around before. Both describe our circumstances accurately.

A liquidity trap exists any time an economy has low interest rates but no desire to invest or spend. People save instead. Fear grips society as unemployment rises. Rates decreases are not possible so policy makers hands are tied. A paradox of thrift is simply the situation where people start to save more than usual, that lowers their consumption, which lowers sales and hence causes businesses to contract by firing workers, which makes everyone else save even more. All that savings effort becomes self-defeating for the society as a whole. And the gap between actual demand, and potential demand widens inexorably. Remember that the whole objective of public economic policy is to keep things humming along at or near potential capacity since that where we experience full employment.

But we have fallen far from capacity: maybe as much as 9% below, balanced right on a knife edge with depression on one side and a very slow recovery on the other.

When the private sector contracts in this way, and normal monetary policy is rendered useless, we have no option other than to resort to huge deficits. Governments have to print and spend money to offset the huge drop in the private sector. If they don’t do this then the decline accelerates out of control until it reaches a logical conclusion. That conclusion is reached when consumption can no longer be postponed. Even the most thrifty have to spend occasionally, and even those who are trying to save need to re-stock used up assets and supplies. In the days before modern economics gave us the way with which to avoid these massive declines, depressions ended only when demand reappeared in this ‘natural’ way. It is in this way that we can speak of markets being ‘self correcting’. If we are happy to endure the implied collapse and the long term nature of the decline along with the human and economic cost, then by all means balance the budget and keep government out of the process.

That all this is unknown to the general public is not at all a surprise. Why would it be?

But it is well known to all policy makers, even those who abhor Keynes and all he taught.

And it is why we should carry on with big spending and huge deficits until we are sure the recovery can sustain itself. That will be sometime next year.Then we can focus on getting the imbalances that threaten to throw us off course eliminated. In particular we can then address the deficit.

Until then: who cares what the public says?

I hope Obama doesn’t.

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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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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.

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Europe, Deflation Fears, and Us

This morning’s New York Times carries a very disturbing report on the Spanish economy. In particular it highlights what appears to be the onset of a bout of deflation. Apparently retailers throughout the country are now having to cut prices in order to encourage any kind of spending, and the rate in the reduction in price levels is now reaching an alarming pace. The most disturbing aspect of the Spanish situation is that their unemployment rate is now up at 15.5% and is heading higher: it might easily reach 20%. The combination of unemployment at those levels and falling prices is exactly the combustible mix that characterized the Great Depression so events in Spain bear considerable attention.

And Spain is not alone: other European countries are facing disastrous economic declines as well, not least Ireland which is arguably worse off than even Spain.

So the obvious question becomes: could we also fall into this deflationary and high unemployment trap?

A quick answer would be no.

The reason is that the US has taken some extraordinary measures that the Europeans have not. For instance, the Federal Reserve Board has pursued a very aggressive monetary policy from the beginning of the crisis. It started by reducing interest rates quickly and when that failed to produce the normal or expected response it adopted a series of highly unusual, some might say unorthodox, policy steps such as beefing up its own balance sheet by buying securities from private investors. Such purchases have the effect of putting more cash into private hands and therefore increasing the nation’s money supply,i.e. the total amount of cash and cash equivalent money in circulation. In theory this should boost economic activity, or more likely prevent further contraction.

In conjunction with the Fed’s creative activities, the US has also gone on a binge of deficit spending, which is the classic ‘Keynesian’ response to a fall in demand in the private sector – recall that ‘recession’ is simply a term used to describe an economy that is shrinking, and that the shrinkage is, in turn, usually caused by a drop in demand for goods or services by private consumers.

Traditional economic theory teaches that the Fed’s ‘normal’ monetary policy, cutting interest rates, should be sufficient to return a shrinking economy to growth. This is because lower interest rates encourage a new bout of borrowing, which means that cash is freshly available for boosting spending.

A moment’s thought of that traditional policy will immediately lead you to see the reason the current crisis is so difficult to deal with.

It relies on lending.

Without healthy banks the drop in interest rates will have little effect due to the fact that there are no banks prepared to lend. So the recovery effort stalls at the first hurdle.

Plus, this time consumers are so snake bitten by declining home values and collapsing stock prices, both of which are wiping our household savings, that the amount of effort needed to get people out borrowing and spending again is beyond the reach of normal policy.

This is particularly true because we went into the crisis with interest rates already fairly low: so there was not much leeway for aggressive interest rate cuts before we reached zero. And interest rates cannot go below zero.

All this is familiar on both sides of the Atlantic.

What is different in Europe is their resistance to running a Keynesian style fiscal policy, i.e. going into deficit spending to stimulate demand; and this is coupled with a level of denial, until quite recently, about the true situation in the larger European countries like France and Germany. Since the European Union acts as a single entity for monetary policy purposes, through the European Central Bank, countries like Spain are left to fend for themselves. They have to comply with the central monetary policy and so have to rely heavily on fiscal policy at their local levels.

It is easy to get a little haughty at this point and criticize the centralization that seems to have caught Spain in a terrible vice. But we should all recall that the US also has huge regional differences in its economic performance: just look at the damage being wrought in Michigan by the auto industry collapse; or in Nevada, California and Florida by the real estate collapse and our air of superiority should evaporate quickly.

In fact much of the beneficial effect of the Federal stimulus package is being entirely offset by highly restrictive policies being enacted at the state level. Just as cash is pumped into the economy by the Feds local jurisdictions are cutting back on spending and therefore negating the Fed stimulus.

In this regard, the only reason that California is not being touted as an economic disaster of Spanish proportions is that no one sees it as an independent country! Its budgetary crisis, which is of epic proportions, gets treated as a local disturbance rather than a national implosion.

With home and stock prices still falling [or at least remaining weak]; with lower demand reducing commodity prices – things like oil are costing less because consumption has fallen faster than output; and with unemployment likely to rise well into next year the scene is set for deflation here too.

And that fear has been sufficient for some, myself included, to urge the Fed to induce a bout of inflation. Some of you may have noticed that Ben Bernanke actually went on record as saying the Fed was targeting a 2% inflation rate over the medium term. This was his way of letting the credit markets know that he was prepared to stoke inflation rather than allow deflation set in.

How would he do that?

By pumping tons of cash into the economy. If the money supply grows faster than the potential growth rate of the economy we normally get inflation. As of now the economy is running well below its potential, so all the cash being injected will simply lift activity towards that potential rather than result in inflation. The tough part comes when the economy starts growing again and the money supply remains higher than needed – as it would given all the Fed’s extraordinary efforts of late. The ‘neat trick’ the Fed is trying to pull off is to signal its intention to produce modest inflation, and hence calm deflationary fears, while at the same time attempt to judge the right moment to rein in money supply to prevent inflation exploding.

Rather them than me.

Unfortunately for Spain they are tethered to the less expansionary policies of the European Central Bank and the highly conservative fiscal policies of its largest trading partners. It is in awful trap. And deflation is an almost inevitable result of it having to contract its economy severely to achieve a rebalancing rather employing the kinds of tools we have here.

So, coming back to the question of whether we can expect a Spanish style crisis here, the long answer is also no.

But there is no room for complacency: our political willpower to pursue the necessary bailouts and stimulus has been wafer thin at times. Raging on about the future costs of ballooning Federal deficits, or about the cost of saving the banks, and debating the efficacy of government spending at times like these are corrosive to that willpower.

In other words, we could easily become like Spain.

We dodged the big one because we did the ‘right thing’. Let’s hope we have the sense to keep on doing it.

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US Budget Deficit Creeps Up

The BBC reports that the US budget deficit rose unexpectedly in May. Here’s their report: US budget deficit higher in May

There are some “technical” factors making the increase temporary: the medium term outlook is still for a slight improvement for the current fiscal year.

We shouldn’t get excited though. The very existence of a deficit after several years of good economic growth is a disaster. Good fiscal policy dictates that in the good years of a business cycle the deficit should be minimal, or even eliminated as it was in the late 1990’s. It shouldn’t be anywhere as big as it is. Even though as a percentage of the total economy the deficit is smaller than that of the terrible Reagan budgets, it is still too large. All the signs are that the economy is beginning to slow down from its hectic pace of the past few quarters. If that’s true then the deficit will start to grow again. When that happens rates will go up making the economic slowdown worse, and possibly driving us into recession.

That will be the consequence of the reckless policies of the current Administration. Deficits do matter.

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