Federal Reserve Board

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Fact Based Thoughts

For all you worriers out there, and I know there’s quite a few, calm down. It helps to keep the facts in front of you and push those more vivid opinions to one side.

Take, for example, our debt. If you listen only to the opinions, you’d think we lived in a version of the Weimar Republic replete with wheelbarrows needed to move around the useless hyper-inflated currency that we all now own. Or, as Speaker John Boehner in Washington, and Governor Walker of Wisconsin put it: “we are broke”. Really? I wonder why the rates on US bonds are going down? Could it be that those hard headed folks out there who buy and sell our debt, and who stand to lose their shirts if they are wrong, don’t see something that Boehner and Walker do?

No it isn’t possible.

The fact is that the cost of US debt is going down at the moment because world uncertainty is driving investors towards US bonds. The rise in demand for our paper is driving down rates. No one, except for some rabid Republicans with an axe to grind, thinks we face an imminent debt crisis. No one.

Our debt problem is strictly a medium term issue and is caused by the deliberate reduction in government revenues resulting from the infamous Bush tax cuts that are now so hard to undo, and from our awful health care system that is on a trajectory to destroy us whether it is publicly or privately financed. The current crisis is cyclical and so any addition to our debt stemming from it will be contained as we start to grow again. Which is why getting people back to work, and thus paying taxes again, is so important. There is no advantage in getting corporate profits pumped up: big business avoids taxes like the plague. We need honest tax paying citizens back at work. Then our deficit will start to drop.

Muddling the two problems, short term and medium term, will inevitably mean we screw up the former and forget the latter. Unfortunately that’s where our opinion leaders are headed.

Likewise the banks. The fact is that they are not fixed. We are headed back into bubble land. The opinion leaders mostly voted against any hard-nosed fixes for the banks. Now they are all for debt reduction and austerity. Yet the need for austerity is a result of the bank’s foolhardy attempt to destroy themselves by engaging in anti-social and juvenile activities they didn’t understand. The facts tell us that we should never again allow Jamie Dimon and his confreres to play with matches. They are likely to blow us all up. The poor dears cannot help themselves. The taxpayer bail out of the banks may not end up costing us a lot directly, and the opinion makers like Tim Geithner keep harping on that as evidence we should all be pleased. But the facts say something else: the crisis and its enormous social cost is an indirect result of banker lunacy, greed, and regulatory capture. So the fact that we did not fix the banking system is the result of wrong opinions holding sway.

Similarly inflation. The more dramatic of our opinion leaders are almost apoplectic about an imminent burst of inflation. This, they say, is the inevitable result of the Fed’s easy money policy. But look at the facts. Core inflation, which is our best guide for the trend in inflation, is moving down, not up. Short term factors have masked that. Some problems are no doubt out there as worldwide demand rises rapidly to squeeze raw material and commodity prices. But nowhere is that a result of US monetary policy. And, besides, food prices are being driven by shortages due to weather. That’s not a medium term policy issue. It is a short term meteorological issue. But our opinion leaders want us to think we need to tighten and possibly risk our recovery, based on their opinion. No thank you. The facts support continued easy money until we get the economy beyond its current jobless phase. When wages start to jump, that’s when we tighten.

Judging by recent history, another awkward fact, that may be never.

Of course this all just my opinion.

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Ideology, The Fed, and The Blame Game

Here we go.

The next couple of years promise to bring us lots of fun as the newly elected Republicans bring their libertarian notions into the public gaze and out from the shadows where they have lurked hitherto. Today we got off to a good start as Ben Bernanke was quizzed in one committee, while in another we heard from a professor who call Abe Lincoln a tyrant. According to him secession is the only way to bring back the liberties stolen from us by the big bank, counterfeit money socialists who now infest Washington DC.

Fun times indeed.

This is not a time to be Chairman of the Fed. The Republicans have long had a visceral dislike for anything that smacks of a central bank intent on using monetary policy to solve our unemployment problem. There are rumblings that we will see an initiative to strip the Fed of its dual mandate – on both inflation and employment – and instead restrict it to just inflation. This is in reaction to all the unconventional efforts the Fed has made to help lift the economy over the last two years. In particular opposition to QE2 has crystallized around the dual drum beats of inflation fears and Fed over reach.

So in his appearance before a Congressional committee today poor old Bernanke was grilled relentlessly about the way in which Fed policy was threatening to undermine the economy by stoking uncontrollable inflation.

‰ÛÏMy concern is that the costs of the Fed‰Ûªs current monetary policy ‰ÛÓ the money creation and massive balance sheet expansion ‰ÛÓ will come to outweigh the perceived short-term benefits,‰Û?

This was how Representative Paul Ryan, the lead GOP spokesman, put it. Those costs being a burst of inflation. Not that Ryan backed up his argument with much data about that burst. He simply pointed to rising commodity and raw material prices, and higher bond yields. Since there isn’t any sign of a surge in inflation just yet, he had to limit himself to dark warnings that if, and when, such a surge crops up it would be hard to contain.

I agree. It would be hard to contain. Inflationary expectations, once baked into prices, wages, and contracts, are hard to reverse without vigorous counter measures, usually the inducement of huge slack in the economy sufficient to eliminate both pricing power and expectations simultaneously. Those of us who lived through the Volcker recession back in the early 1980’s can recall the amount of pain needed. We all want to avoid a repeat.

So, is inflation a threat? No. This is a problem for those ideologically inclined to look for it.

Prices are rising in some economies, especially in emerging nations, where demand has increased rapidly. In other places supply constraints caused by crop failures are putting pressure on food prices. These are both real issues and we need to follow them closely. But neither have anything to do with recent Fed policy. And the US economy is not showing much, if any, sign of those problems occurring here. So Ryan’s fears are entirely hypothetical at the moment. Which, unfortunately, doesn’t prevent him from encouraging the Fed to cease its support for the recovery.

We all need to take a deep breath and be sensible here. Core inflation was 0.7% in 2010, and trending down still. In the last year before the recent calamity it was 2.7%. Since 0.7% is both negligible and below the Fed’s target range, there is no current need to react by raising interest rates. At least if you are driven by data. To raise rates now would blunt and possibly reverse the recovery. We should wait a while longer, at least until unemployment has started to trend down consistently.

If you are driven by ideology the story is very different. Hence the Wall Street Journal’s almost daily headlines about inflation fears spreading [From where to where? Perhaps from the editorial page to the front page?] The point being that there is a large group of politicians and others who are motivated not by any facts they can gather, but by an opinion they hold. That opinion being the Fed has no business helping prop up the economy. We should, they say, let the market do its work. We have heard this story before. These folks overlook the inconvenient, but noticeable, fact that it was the market that sent us tumbling into the abyss. It was a private sector failure, not a government policy failure that launched us into crisis.

Or was it?

That is, of course, just my opinion. It would be nice if we could get some objective agreement about what started the crisis boiling up.

Then again, if you read the Financial Crisis Inquiry Report published last week, the ideological divide is so wide there is no agreement about the true causes of the crisis. One side – the Democrats – gave us a dull recitation of events, and ended up blaming banks, deregulation, and the rating agencies; while the other side blamed the government. Actually the Republicans were divided into two factions. One blamed the government. And the other blamed the government even more. Overall the most reasonable comment in the entire 500+ pages of the report came from a lone right wing dissenter who wondered out aloud why American banks and personalities like Greenspan could be blamed, when a real estate bubble blew up in so many other countries too.

No one, apparently, wants to admit that economic policy in the US has been off track for decades and that the entire world was awash with cash needing a home. That cash ended up fueling ridiculous home price increases wherever delinquent bankers could get their hands on it, and wherever lax oversight, a collapse of credit standards, and mass hysteria on the part of home buyers combined to destabilize things enough. Which is to say in plenty of places. Not just in the US.

Given that the FCIC was ideologically split from the beginning it was always a long shot that it would produce anything useful. Besides it published its findings long after politicians had embarked on whatever ideologically predetermined course they chose.

Personally I go a little deeper and argue that the crisis was the logical outcome of three decades of illusion during which we undertook a sustained experiment in market based solutions to problems; reduced the government’s ability to act as a bulwark; and engaged in social engineering to induce more home ownership than is either sensible or sustainable over the long haul. In the US both political parties are culpable. And along the way no one paid attention to the huge inequality in incomes that inevitably distorted both the shape and source of demand. Of course a whole lot of people did stupid things like overpay and under save with respect to real estate. We were encouraging them to. We gave them incentives to. And getting deeply into debt was the only possible way to keep the “dream” alive: wages were stagnant.

It was this rotten wage performance that drove so many people over the edge, and made them very vulnerable to the siren song sung by the banks and other mortgage lenders who were trying to find uses for the enormous flood of credit slopping about the globe. When regular people felt their living standards under pressure, and when bankers saw an opening for enormous profit, it became a perfect storm. Desperation met lack of scruples. In other words it was government – both inaction in the form of deregulation, and action in the form of housing policy -that did it. And the private sector too. There was fraud, a remarkable collapse in ethics, greed, shiftiness, and plain stupidity. The system went haywire. We collectively lost our minds and created conditions in which predators could stalk the streets uncaring and untouched.

In such circumstances, establishing blame is simply an attempt to meet the ideological need to avoid taking responsibility.

Stagnant wages; excess credit creation; and inequality. Excessive deregulation; unfettered capitalism; and lost ethics. Imbalances all.

We need policies that re-establish balance. Not ideological bun fights over Fed activity.

How the heck calling Lincoln a tyrant fits into anything remotely useful I have no idea. But these are the things we will be hearing about for a while now.

As I said: fun days indeed.

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Details, Details

All we are hearing seeing at the moment are snippets of news rather than headline grabbing insights into the big numbers we all care about. But there are sometimes tell tale signs of what’s in store for us in those details, so here’s a few of them:

Import prices: the price of imports into the US jumped 1.1% in December. That’s quite a movement for one month. The biggest increase came in fuel costs where prices were up 4.1%. Non fuel imports saw an increase of only 0.3%. This continues a trend that could have more wide reaching impact as the newt year or two unfolds. Commodity prices are rising more rapidly than finished goods prices. This is the result of worldwide demand and the continued emergence of countries like China whose economy is sucking in commodities at a prodigious rate. There is nothing nefarious or odd about this. It is the natural progression of development. The simple fact is that the Chinese economy will soon be far larger than that of the US and so we all had better get used to the notion that activity in China, not activity in the US, will set global trends. This, I suspect goes for global standards too: how long will it be before the Chinese market is the one where new products are unveiled? This implies that Chinese standards will intrude into the marketing plans of everyone worldwide. It also implies an ever growing Chinese presence in investment, banking, and economic policy setting. Get used to it.

Meanwhile rising commodity prices ought to be a warning to all industrialized nations that they had better take conservation, waste management, and recycling seriously. It is a long term trend not a short term cycle. More to the point we all need to pay attention to the efficiency of aggregate economies: how much resource does it take to generate a dollar [euro etc] of wealth? Last I looked the US lagged way behind the Europeans in this regard due to its cheap energy heritage. US industry and homes are extremely wasteful and it takes a far greater amount on input to create a similar output. I haven’t looked at the detailed numbers for a while now, but my hunch is that the efficiency advantage still lies with Europe – especially Germany.

Municipal Bonds: We don’t hear much about local fiscal crises, but they are one of the great threats to the overall US economy. The well known basket cases like California are simply the tip of a very large iceberg. Just yesterday legislators in the state of Illinois were forced to vote for a 66% tax increase in order to rescue their state’s decrepit finances. We are all accustomed to looking at bond spreads in order to detect what the markets think about local finances. The media is full of Greek, Irish, or Portuguese bond prices versus those of Germany or other more secure nations. We can do the same thing here in the US for state issued debt. When we do, we find that Illinois tops the risky list with spreads of about 215 basis points over a AAA bond. California weighs in at 125 basis points, while rust belt stricken Michigan is at 80 basis points. For reference New York City is at 56, and Florida at 40. While I do not expect a rash of defaults on local debt, there is no doubt that the same process of separating good economies from bad economies is going on within the US municipal debt market. It will become harder for some states to issue debt, and the interest cost will start to impinge on local tax rates and opportunities. The last two or three decades has seen reckless budgeting at various local levels here, and there are serious doubts about whether all states and cities can survive without draconian cuts in services. Here in New York the incoming governor is trying to cap property taxes which is a sure sign of future service quality declines. The reason California is in such a mess is that it voted for a similar cap, subsequent to which it was forced to defund all sorts of services, not least its once vaunted public education system which now languishes in disrepair.

I have reported here before, but it bears repeating, that the impact of local government efforts to balance their budgets will be to slow economic growth. Whether this braking effect is sufficient to pull the US as a whole down I doubt. But it will dampen activity, possibly seriously, over the next year or two. This is one reason why I advocated a larger Federal stimulus – but that’s a lost cause!

Portugal, and the Baltics: We read everywhere of the peripheral European countries and their issues. Today the bond market is breathing a little more easily because the Portuguese managed to float a bond issue and thus avoid immediate cash flow problems. But take a look at the price of those bonds. The poor taxpayers of Portugal will be paying through the nose for that debt. For what purpose? So that their creditors don’t take a hit on the old debt. This story is getting repeated time and again. In fact it is getting dull. The banks, via their ridiculous activities threw the world into recession. They were bailed out. That cost an arm and a leg, and sent some smaller countries into recessions so deep that the constitute depression status. And now those countries are being forced to issue debt to cover the cost of the recessions caused by the banks, while earnest bankers opine on the imminence and terrors of possible sovereign defaults. Apparently we must go through hell in order that the banks continue to issue credit so we can pay for the bailouts for the … banks. Am I the only person who finds this circularity both demeaning and insulting?

And please, no more headlines about how well Latvia is doing. Yes its economy is now growing. And, no, it is not a poster child for the benefits of austerity. It’s GDP dropped like a stone. It’s unemployment shot through the roof. It is an unequivocal disaster – witness the mass out migration of its population. Latvia is a poster child for why we do not think austerity is the answer. Not that you could figure that out from the glowing headlines in the Wall Street Journal and Financial Times. It is a success only if you don;’t worry about the people who live there. Which I do.

Corporate Taxes: It didn’t take long before the Obama administration jumped back onto my black list. Today we are hearing rumors that it wants to reduce corporate tax rates. This in an era of all time profit making. I suppose someone in Washington has bought into the old supply side argument and wants to ‘stimulate’ the economy by making business cheaper to do. No doubt we will be told that lower corporate costs will generate jobs. I hear that there is some give and take on the issue and that the lower tax rates may come along with a reduction in the loopholes and give-aways that debilitate the current set up. The US has one of the highest corporate tax rates in the world, but that ignores all those loopholes. The actual rate paid is much smaller. While I understand that corporate tax rates are simply passed along to consumers as higher prices, I find it politically inept to be talking about cutting government revenues – potentially – in the face of a rampant and anti-government Republican House of Representatives. Ny guess is that we are headed for another one of those pyrrhic victories Obama loves to win. So look for a fine bi-partisan hand out to business followed by a zero boost to jobs.

The simple fact is that business is flush with cash. If it wanted to employ it would. It doesn’t need more hand outs. Putting tax cuts on the agenda, even if loopholes are also discussed, is a dangerous ploy. The tax rate will be cut and the Republicans will block the closing of loopholes. The deficit will rise, and unemployment will fester. I think we’ve seen this act before.

And I am not re-assured to learn that Tim Geithner is going to discuss this all over dinner with “leading business leaders”. When was the last time he had dinner with “regular people”? My guess? Never.

The Beige Book: This is the dossier put together by the Fed as it gathers local and anecdotal information from around the country. It forms a vital part of the background for policy makers because it fills local detail into the overall context. The latest version was made public today, and was fairly encouraging. This is especially true for employment where local reports suggest that businesses are, at last, hiring not just to replace workers previously fired, but to expand as well. In other words the long drought may be over. Bear in mind this “data” is often more opinion than fact. Still, experience shows that it usually contains germs of truth. If that holds, then the jobs market will improve this year. Whether that improvement is enough to bring unemployment down quickly I doubt. Look at it as a first step. In the meantime the Fed reports that real estate and tight credit are still the biggest drags on growth. There’s nothing new there.

So, as you can see there are number of details we can find useful as we try to understand where we are headed. One or two, like the municipal debt problem, and the Beige book data are worth following. They could turn out to be very important indicators down the road.

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Inflation: Hoenig’s Folly

Drip, drip, drip. Another month goes by and still no sign of the upheaval wrought by all that reckless Federal Reserve Board money printing. Today’s news that core inflation checked in at 0.1% last month is no surprise to those like us who aren’t trying to conjure up false fears. But to those such as Thomas Hoenig this is one more disappointing data point.

What point is there to being the heroic defender of stable money when inflation persists in staying low, and the reckless Fed is producing stable money despite you?

Of course, as Paul Krugman says today, now would be a good time to think through what we mean by “money” in the context of a modern economy. Whatever it is, we don’t seem to have enough to make Hoenig’s ghosts a reality.

No matter. I expect the fearful drumbeat to continue. And I expect our hyper critical media to repeat it.

Folks: we are stuck deeply in a rut caused by a lack of demand. We have massive over capacity, as witnessed by our high unemployment rate. Households aren’t spending at a strong rate. Businesses have practically no room to pass higher costs along to consumers. Therefore higher inflation is a way off. Let’s focus on the big picture here and not tell tall tales to one another.

Besides I think Krugman’s right: we have no idea what we mean by “money”. Not that it plays much of a role in orthodox economic theory, but that’s another argument.

Sigh.

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Austerity Ex Machina?

Horace urged ancient poets not to rely on god like miracles to resolve the complications within their plots. Fast forward a couple of thousand years and we have all forgotten his advice. Apparently we have discovered the ultimate economic fix-it device we can pull from the machine and resolve any manner of crisis: austerity.

Admit it, it feels good having this Swiss Army knife policy.

Feels good, that is, to sleep safely in the knowledge that no matter what ails the economy all we have to do is impose, with a suitably grim voice, a repressive set of policies and our economy will perk right up. At least for some people. We can’t expect, any longer, to please everyone.

Exhibit A: look at Ireland. Well don’t, because the austerity magic isn’t having the results it is supposed to. Spreads on Irish debt have scarcely fallen from the near panic levels reached a couple of weeks ago despite the awful and regressive nature of the whipping handed out the the Irish public. It’s almost as if the market in its infinite wisdom doesn’t believe the Irish crisis is solved.

You and I know it isn’t, but we aren’t omniscient market makers. They were supposed to look on happily at the sight of Ireland pummeling its own, and breath a deep sigh of relief. Those bank creditors at the heart of the problem will emerge fairly complete, having managed once again to foist the entire risk onto the local population. It’s funny how that seems to be a recurring theme recently: banks take risks. Banks make illusory profits. Bank managers earn big bonuses from said profits. Bank creditors earn large returns from said profits. And when said profits are revealed to be an illusion: hey presto! The only way to save the world is to impose austerity on various unsuspecting passers by. Bonuses are not repaid. And creditors absolutely must be paid in full. It is the way of the world.

Not my world.

But then again, as many of you have pointed out, I tend to be rather simple minded about these things.

You see, I naively thought that these creditors knew they were taking a risk, and that they therefore knew that they stood to lose if their bets didn’t turn out too well. In the case of Ireland the bets were a spectacular failure. So, the creditor losses should be spectacular also. Right?

Apparently not.

Which only goes to show you that after all those years in banking I clearly missed something.

That risk/return trade off we all talk about has been twisted about a bit. It now reads my return/your risk. It’s a lot more fun that way. As the Irish are learning. And when you sink under the consequences of accepting all that risk, when the creditor errors pile sufficiently high, the serious people – those high minded public figures appointed to protect the system from itself – pull austerity from the machine in order to clean up the mess.

Exhibit B: America. Yes, the USA is awash with plans to whack away at its “debt crisis”. It used to be that the only certainties in life were death and taxes. Now we know better. That we are facing an existential debt crisis trumps those. It is taken for granted that, unless Americans rein in their debt, their economy will follow, inexorably, the path trodden by the profligate Irish. Please don’t even mention the Greeks, no one wants to mimic them.

So slash away we must. And slash away the plans certainly do. I must admit I am taken aback by the zeal with which some of these serious people go about swinging the axe. It’s almost as if they enjoy the work. We are told, in no uncertain terms, that we simply cannot go on looking forward to the level of entitlements we are used to. This is even before most of us have had a chance to get them. It turns out there is a shortfall in Social Security seventy-five years from now. Yes, seventy-five years is a long time, and I know that the cynical amongst you might be snickering a little over the sight of serious people making solid projections out over the best part of eight decades. But darn it, this is a problem. Those projections are accurate to within a few tens of billions either way. Given this accuracy, it is urgent that we raise the retirement age, reduce pay outs, and switch to a different index to ensure future increases lag behind general inflation. Now.

We must also hammer away at health care costs, although we must not do this in the context of anything resembling a European style plan. Oh, and we will exhort Congress to behave itself when it hands out the goodies to local voters, especially those who donated to the re-election funds.

Along with this we will amend the tax code to eliminate all the middle class deductions and we will reduce the top rate of tax to increase the incentive for our wealthy people to work harder. I think this is meant to help the bankers who lent to Ireland.

Finally we will try very hard to slow the growth in defense spending. My suggestion is that the US changes its targeted defense spending ratio from being bigger than the next nineteen countries added up, to being only larger than the next seventeen countries added up. I particularly liked the clause that suggests we limit the annual war budget. This is presumably like the annual Christmas party budget. I pity future presidents being so limited – we can only afford a small war this year. What a shame.

Now, you sense my humor. But this is a serious subject. Why, I ask, are we pulling austerity ex machina, when the biggest single issue is getting demand pumped back up? Is austerity all we have?

If, as I believe is true, much of our debt problem stems from the collapse of revenues due to the recession and the consequent massive slack in our economy, how does deflating the economy help? Should we not be inflating it? Perhaps there is a long term debt problem, but seventy-five years seems a long way off, and given the unerring accuracy of our predictions as recently as 2005/2007, I suspect that no one, not even the folks hunched over those massive economic models at the Fed, have a clue what the debt will be like that far away. Come to think of it, if there is one group whose predictions I would discount fully it is the macroeconomic modeling crowd. They can’t even predict their own birthday next year.

As an aside: this makes me wonder whether there isn’t an “efficient birthday hypothesis” wherein any day I say is my birthday becomes my birthday simply because I said so. If it is, it must be so.

But back to austerity: surely we have to separate the near term problem from the longer term. Getting people back to work may actually cost us something. That will add to the debt. But as those people crank up their spending, taxes will rise, GDP will grow, and the debt will appear to be more manageable. Then, and only then, will be able to focus on the size of that longer term problem. We have a demand problem, not a supply problem. And definitely not a fiscal problem – have you checked US Treasury bond rates lately? We can finance this fix. So we should.

Aah! All this ‘if that, then the other’ is too complicated. And we tried stimulus already and look how that ended up. So we should keep economic policy simple.

Hence, austerity ex machina.

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