stimulus

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Green Shoots Watch: Patience Please

There aren’t any.

The problem I have with the economic news at the moment is that everyone seems to be in a hurry to get the recession over with, presumably so that we can all get on with something new. After all this economic stuff is getting boring and detracts from really important things like reality TV shows and summer vacations.

Why, we are beginning to read in the media, is the stimulus not working?

And after a run of extraordinarily tepid data releases all of which engendered breathless analysis that the turning point had been reached even the optimists seem to be in a funk. Wall Street, which houses the more extreme group of optimists, is already getting edgy about the ‘failure’ of stimulus. I can understand why they would feel this way: they have sales quotas to meet and the economy isn’t cooperating. And plenty of them opposed the entire stimulus plan on ideological grounds, so they want to pile on the grief quickly rather than wait and see whether the plan actually works.

Plus today we get poll results telling us that the ‘public’ too is getting concerned. Confidence in the stimulus plan is waning.

So here I go again:

Who cares what the public thinks?

The biggest risks we have are all downside. That is all the significant issues that could tilt the economy off of its current trajectory are ones that would make it worse. I cannot think of a likely event that would spark a rapid burst of growth. We are well and truly stuck in this slow motion unwinding of years of mismanagement and imbalance. It took the best part of thirty years to dig this hole. It will take at least two years and maybe many more before we have healed all the damage.

So we absolutely have to stay the course.

Relapse is highly likely.

Let me recap:

  • The stimulus was too small to start with, it was half the amount needed for ‘quick results’.
  • It was badly constructed: too much went in tax cuts that have little stimulus effect.
  • Even so, it will have an impact: much of which will turn up later this year and early next. The Congressional Budget Office, Washington’s non-partisan score keeper, estimates that the economy will be operating below potential for at least four years, maybe more, but that stimulus will stop it slipping too much further this year before adding to a recovery next year.
  • Meanwhile the economy still is shrinking albeit it at a much slower rate than last last year. The worst is over.
  • But unemployment continues to pile on the agony: mass layoffs reached a record just last month, so all the talk of improvement is an illusion. The data will get worse throughout the year. The green shoots that some saw in those claims numbers last week are very weak.
  • Bank loan losses are about to get worse again: the wave of credit card and commercial real estate defaults is building.
  • The banks are not restored to health anyway: some have raised capital others have merely shifted cash around different buckets on their balance sheets. The usual suspects remain very weak. And the tail of potential losses on all the stupid gambling stuff [aka derivatives] still lingers in the background: a downturn could cause an implosion there and use up what precious reserves have been built leaving the system exposed and exhausted.
  • Consumers are staying away from stores still. They prefer to save rather than spend. So demand is still way off the levels we need to get business back to hiring.
  • Wages are declining: some businesses are cutting wages rather than firing. While this saves jobs near term, it also drains spending power from the economy.
  • Housing is stuck in the doldrums and won’t come back any time soon. Nor should it. We need to build an economy on productive assets not real estate. Most people have forgotten that practically all the growth during the 2000 – 2007 period came from construction and related activities. The rest of the economy was loitering about going nowhere.
  • Trade is dead. Actually it’s worse than dead. International trade bickering is breaking out which could eliminate what chance we have of getting growth from exports.
  • And: we are about to double our national debt just to stay afloat.

In short the only definitively positive activity in the economy is government spending.

That’s it.

The dyke between us and the flood is the stimulus.

Getting bored with it, or thinking it is ‘failing’ is utterly laughable. It is beyond that: it is downright irresponsible.

So, as we watch for green shoots in this week’s data: patience please!

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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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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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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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Stock Market Illiteracy

Sometimes my total disrespect for the stock market leaps to the fore. It is an extraordinarily skittish place and seems to be full of the most short sighted and most easily swayed folks on earth. Analytically? Don’t even go there. Let’s just say that dunderhead isn’t close to the mark. They can’t read too well either. Take today’s data on incomes from the Bureau of Economic Analysis.

It shows that personal incomes rose in April by a ‘surprising’ 0.5%. I put surprising in quote marks because it appears that the market reacts more to the level of expectation than to the news itself. I too am surprised. Will I be doing back flips? No. Will I declare the recession over and the returns to the glory days upon us no? The stock market will and has. Dumb. Very dumb.

The data also shows that disposable incomes rose even more: by 1.1%. For those of you new to this, disposable incomes gives us an after tax view of how wages and incomes flow through to the point at which they can be spent or saved. The market loves that jump in disposable incomes. Presumably the market view is that we are on the cusp of a good old all-American buying binge. Which will drive consumption up, boost profits and hence drive the stock values higher.

Ummm. I wonder if they read line three of the report: personal consumption expenditures, [‘PCE’]. Had they read that far they might have noticed that PCE fell in April by 0.1% A small fall I admit. Almost insignificant. Except that it continues a trend we all, well I did anyway, noticed last month: the strong upturn in PCE of January and February has been followed by two weak months. That upturn was one of Bernanke’s original ‘green shoots’. It has withered entirely away.

This is not good news.

Look deeper into the data:

Most of the rise in incomes comes from obscure things. Wages fell. Rental incomes and transfer payments went up and produced the rise. Not many average Americans get rental income, so even if that continues I doubt it will lead us to the promised land of consumption growth. And ‘transfer payments’? As its name implies that’s income that is being shuffled around the board, it isn’t new. Think: ‘ American Recovery and Reinvestment Act of 2009’. Sound familiar? How about ‘stimulus package’? That’s right the most important factor pushing up PCE was the stimulus package. Hardly a long term improvement.

And how about the upturn in disposable incomes. Same thing. The stimulus package sucked out taxes. Hence ‘after tax income’ shot up. ‘After tax’ equals ‘disposable’. Duh.

Now keep looking at that data: the personal savings rate rose strongly fro 4.5% to 5.7%. Terrific. That’s the highest rate for fourteen years. We need to become more thrifty. We need to return to the savings rates of the 1960’s when families routinely socked away 10% of their incomes for a rainy day.

But not just yet.

First we need to spend every penny we have to get the engine running smoothly again. Then, once we are all back working we can start to save.

So here’s my, apparently contrarian, view: this data makes me a little queasy. Wages are weak and falling. The stimulus had far too much tax rebate in it, $300 billion of the roughly $800 billion, and what there was is now being saved. Just as I predicted. That means the stimulus will have less effect than it ought to have had. In jargon: its multiplier is too low. Just as Keynes would have argued.

The economy’s problem right now is not savings, nor is it incomes – especially when incomes are temporarily distorted by transfer payments and tax rebates. The problem is spending. In the jargon: final demand is too low compared with the economy’s capacity to produce. We have idle resources: closed factories and unemployed workers. We need to get that capacity back in use. Savings don’t help. Nor do lower taxes.

There is nothing new at all in any of this.

It’s just that the stock market suffers from attention deficit disorder and seems to have forgotten. Don’t worry though: there’ll be a new report soon that will send the market careening off in a negative sense. Probably for the wrong reasons.

And that’s why none of us should pay too much attention to the stock market. They can’t read down there.

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