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The Election and Economic Policy

Those of you who have read this blog since it started will recall that I set out to express my objection to the economic policies of the Bush regime. They were misguided, ill informed, and fiscally reckless. The Bush legacy is the single largest reason for our current Federal deficit. Remember his reasoning? That the Federal surplus he inherited from Clinton was a misuse of the citizen’s tax dollars. The government should not be taking in more than it spent, so he cut taxes to cure the “problem” of a surplus. Boy did he ever. It was a monumental mistake. Instead of using the healthy economy of the late 1990’s to pay down our national debt, we engaged in a gamble of epic proportions. In effect we bet that the economy would never turn down, and that we would not need to use fiscal policy to save ourselves from a recession any time soon.

Whoops.

History will record the Bush tax cuts as one of our most egregious mistakes.

What made it worse was the cynical way in which it all occurred. The Republicans did not have to courage to balance the budget, as was required if the lost revenue was deemed permanent. That would have meant going to the voters with huge cuts in entitlement and defense spending. So they punted. They made the tax cuts temporary. They were designed to expire slap in the middle of the first term of the next president, long after Bush had faded back to his ranch. Can we all admit this was cowardly and cynical?

What’s that to do with the election of 2010?

Because the entire tone of the election is set against the backdrop of the grand clean up of the Bush chaos. The Democrats failed miserably to deal with the collapse of the economy. That collapse happened on the Bush watch, but the clean up only started in full gear after Obama took office. The bank bail out was a Bush policy, getting unemployment under control fell to Obama. Voters are about to lash out at the failure of Washington to react in proper proportion to the problem. The Democrats were divided and timid. The Republicans obstinate and unrepentant. Policy became a tussle between “No” and “Can’t”. Dither and muddle took hold as inequality soared and unemployment stayed stuck at unacceptable levels. Someone has to pay for the malaise. That means whoever is thought to run the place.

So here we are in 2010 with the likelihood of a return to power of the very party whose policies led to the crisis. During the last two years the Republicans have not uttered one policy statement to suggest they have any ideas what to do. They are simply driven by anti-Obama sentiments. A stalemate is almost inevitable. Obama can prevent any further market magic nonsense, but he will have no power to enact any meaningful remedial policy.

This is a recipe for disaster.

The next clear opportunity for strong economic policy action therefore appears to be 2013 in the first year of the nest presidential term. By 2014 we will be electioneering again, and between now and then I predict a stand off.

Since the economy appears to be headed into a prolonged malaise of weak growth and high unemployment, a political gridlock could not come at a worse time. This means that we will have no response to the rapid rise of Chinese economic power; to lingering unemployment; to inadequate growth; to our festering infrastructure issues; to the imbalances inside our entitlement budget; and to our apparent decline as an economic powerhouse. The American economy will remain the world’s largest and most wealthy, but it will also remain sick. That represents a problem not just for us: we will forgo wealth at an alarming rate, but for the world as a whole: the rest will have to put up with our inertia and endless quarreling.

The impoverishing of our middle class that was set in motion by Reagan and which was accelerated by the Bush tax cuts, will thus continue unabated. Inequality will rise further; profits will be robust; we may fall into deflation; the malaise will be prolonged and painful.

We will pay a huge price for the so called anger about to be expressed in this election. Like a petulant child we are about to lash out and make matters worse instead of being responsible and setting things right.

I remember being vilified by conservatives when I argued that Reagan’s budget deficits would damage our future. I was similarly called out for opposing the Bush calamity. Running deficits is just fine as long as GDP grows more quickly than the debt. Indeed permanent deficits are no problem in that case. But the Reagan and Bush deficits that haunt us now were utterly and cynically destructive. They undermined growth and gutted out our economy. If we want to get angry we should at least get angry at the perpetrators of the problem. They are the ones [Cheney] who told us that deficits don’t matter. And they are the ones about to regain control of Congress on the backs of our anger at the mounting debt they created.

There’s something juvenile about that.

I hope I am wrong.

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Thoughts For The Weekend

Here are some snippets to ponder while you wait for the weekend to get under way:

  • The US is pushing for the G20 countries to adhere to limits on their trade deficits. The suggested limit is 4% of GDP. How convenient for the US that its trade deficit is only 3.2%. Some other usual suspects have signed up already: the UK, Japan, France and a few of the others. Major objections are already being launched by the Germans and Chinese. The German surplus is 6.1% of GDP while the Chinese weighs in at 4.7%. For those countries to cut back they would have to kick domestic demand into gear, which is something neither have shown any appetite for recently. On the contrary the Chinese just raised interest rates to slow their economy a tad in order to head off inflation. The confrontation between the importers and the exporters is destined to heat up before any agreement is reached. The issue, meanwhile, is that the ongoing imbalance between the two sides is one reason the global economy is stuttering rather than purring along.
  • I just read that a former regulator here in the US is calling for the government to intervene in the foreclosure mess by kicking out the management of the big banks involved in its creation. That won’t happen, of course, because we are beholden to the banks. They own us. But the idea is fun to churn in your mind: the banks are setting records for their incompetence and the total lack of control they have over their own operations. It appears they have edged very close to committing fraud. They trashed the economy – yes they did it – and they are whining about the horror of renewed regulation. It is time to stop them. But we won’t. The opportunity was back in the peak of the crisis when the government had the chance to take one or two over and break them up. The failure not to do so will haunt us for a long time. At least until the next bank induced crisis. Which, judging by what I see coming from the current management, may not be far away.
  • I have not commented on the British government’s attempt to commit suicide with its economy. The austerity measures they introduced this week are draconian and unnecessary. The authorities there seem to be reacting to a ghost rather than to a real world problem. The cuts are enormous and are designed to shrink the size of government rather than to respond to an economic crisis. So the agenda is purely political. The pretense is, of course, that the budget “needs” to be balanced and that time is against the government. They want to convince us that unless these measures are taken the bond market will react and plunge the country into a funding crisis. They claim the the country is bankrupt. This is ridiculous. The UK cannot go bankrupt the way that either Ireland or Greece so nearly did. Why? It prints its own currency. Neither of the other two do. So they are tied to the Euro, whose value reflects the German economy. They cannot devalue their currency and so are forced to fight the budget war with one arm tied behind their backs. The UK doesn’t have that problem. Which the credit markets seem to have noticed: UK interest rates have not risen despite the rapid run up in debt. Clearly the markets are more savvy than the UK government. The swing deep into the red was a function of the collapse of the UK economy after the big banks hammered it. Prior to that the debt ratios were reasonable. So the goal should be to fix the banking mess, not gut the economy. But that is not part of the political agenda, so austerity wins. They are playing with fire. The odds are now that the UK will fall back into recession. Anyone who wants to know how this will play out should go and study the years 1931 through 1937. Not pretty, but that’s the road the country is on.
  • Finally: gird yourselves for next week’s GDP update. We will get a look at the third quarter numbers on Friday. The consensus is for around 2.0% growth. My guess is that we may fall short of those levels. The imports figures are something to worry about, and they have been a little high over the late summer. That, plus the signs of a slowdown in manufacturing, suggest to me that 2.0% is at the upper end of the range. Still let’s hope not.

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China Frenzy

Just a quick note: you will have noticed that the Chinese raised their interest rates today. They are trying to fend off inflation and a potentially nasty real estate bubble. How I wish we had done the same thing back in 2004/2005. This action will slow their domestic economy, and thus drain some of the global economy’s demand as well. My feeling is that the are trying to get their shot in before Bernanke goes ahead with his next round of easing which I expect right after the upcoming Fed meetings on November 2nd. The Chinese move will mute the Fed’s action somewhat, and make it a little more difficult to inflate the world economy. It is a classic example of two economies working in different directions and possibly offsetting each other. The Chinese would not have been forced into this move had they allowed their currency to float up from its currently rigged state. They want to keep their currency as weak as possible in order to boost exports. That can only reduce our ability to get our economy going and hurts our already abysmal job creation prospects. Meanwhile we want to weaken the dollar vis their currency to inhibit their trade and boost our own. As long as the two economies remain uncoordinated we should expect more of this head butting contest. Hopefully we take a much harder line and ignore all the Chinese protestations about the inflationary consequences of further stimulus: they want contract their demand to avoid overheating, and for the US to help out by going into contraction mode as well. Since we are already depressed that is not a viable option for us. The conflict is growing.

Watch for this to get more heated.

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Currency Wars: The Chinese View

Let’s be fair: the Chinese have a point.

They can rightly claim that the US is trying to inflate the world economy by flooding it with dollars, and that the flood is about to reach tsunami proportions if the Federal Reserve Board goes ahead with its long awaited second round of “quantitative easing”, or QE2 as it has become known as colloquially.The problem is that we face two separate yet intertwined requirements in order to get the global economy back onto solid ground.

First we need those countries running trade surpluses to switch to a policy based more on domestic demand in order to absorb the excess savings that they are throwing off. Those excess savings are a result of their focus on production and export rather than on consumption. During the last decade this wave of excess savings sloshed around the world economy and was absorbed only by the creation of asset price bubbles in the importing countries like the US and the UK. The world suffers from a lack of aggregate demand, and while the US, UK, and others cut their debt levels they cannot be relied upon to provide that demand. Someone else must. That would be China, Japan, and Germany principally.

Second we need the importing countries to go in the opposite direction and reduce imports by switching either to lower consumption levels permanently, or by increasing their production and export of goods and services. The US plays the pivotal role in this switch since it is the world’s largest economy and has the world’s largest imbalances.In broad terms what we need to do is to ditch the Reagan illusion and reduce debt while at the same time increasing our focus on basic economic activity in areas such as infrastructure and production. We need to make or build actual stuff rather than play at bankers all the time. It turns out we weren’t very good at banking anyway, but that’ another story.

The problem is that this switch is not easy. We are still deeply mired in a period of debt reduction. That means that the US private sector – households and businesses – is retrenching rather than expanding. This opens the door for a perilous disinflation or, even worse, deflation. We should all expect the Fed to react strongly to any news that the pace of inflation has dropped too low. My own view is that we could do with a solid bout of inflation in order to relieve the stress on debtors and thus make the adjustment to a lower debt regime more comfortable.

Just to make things difficult the likely course of monetary policy is that the Fed will try to lower long term interest rates through QE2, maybe starting this month, but at the same time signal its desire to allow inflation to creep up. In normal circumstances these two movements would be going in opposite directions. Rising inflation should be priced into interest rates by an increase in the “inflation premium” they include. Rates would thus rise, especially at the longer end of the yield curve. But: aggressive QE2 actions would flood the economy with even more liquidity and drive rates down, especially if the Fed announces its intention to keep rates low for an extended period. My bet is that the Fed is looking to get the long term bond yield down to 2.0% and keep it there. If it succeeds there is precious little room for an inflation premium. Do the math: if we expect inflation to edge above the top of the Fed’s target range, which the Fed would dearly love to see happen, then the presumed inflation premium would be bid up to reflect that expectation. Deduct that premium – let’s say it’s 3.0% – from the newly reduced long term rate of 2.0% and we disclose a negative inflation adjusted rate of 1.0%. Lenders would be paying you to borrow, instead of the other way round.

If that doesn’t encourage borrowing I don’t know what will. Which, of course, is the entire reason for QE2.

And this is where the Chinese come in.

QE2 is a massive purchase operation by the Fed. It will enter the money markets and buy up securities. The cash it uses for the purchases will flood the coffers of those selling and, more than likely, they will be tempted to buy new securities or other assets rather than hold onto the cash. As they search for new places to invest they will naturally look for higher returns than those offered in the US, especially as the whole point of QE2 is to lower those returns. So some of the cash, indeed a good percentage, will find its way into foreign markets. Their are two types of such markets: those with high rates of return due to their fast growth – these are typically emerging economies like China, Brazil, and India – and those with lower rates of growth, but less perceptible internal imbalances like Switzerland. This inflow of American sourced cash will tend to drive up asset prices and, or, drive up the exchange rates of those countries. In effect the US is trying to inflate the global rather than face deflation domestically. This is a disruptive policy and flies in the face of what is sensible for those nations affected.

So a battle royal could erupt.

The Chinese would dearly like the US to go through depression as it strips away the Reagan illusion. The US would dearly like the Chinese to accelerate demand rather than stifle it by focusing on exports.

The Chinese have a point. We are forcing the consequences of our thirty years of stupidity on the world rather than taking the medicine we have so often foisted on weaker countries abroad. Thinking back through the Reagan illusion we can identify plenty of occasions when the US forced countries to go through enormous, and often rapid, adjustments. Those adjustments were painful, austere, and deflationary. Exactly what we are now seeking to avoid.

Unfair?

Absolutely.

Likely?

Absolutely.

The US has a great advantage in that the dollar is still, although maybe not for much longer, the world’s currency. The Chinese and others have to be mindful that if they resist their options are limited. The main one being to offset the flood of dollars by buying them up and stashing them in their central bank reserves. That would reduce the impact on their currencies, but would imply a huge run up in dollar based debts that they own. And the ownership of all those dollars gives them a stake in the success of the Fed’s attempted inflation.

So they are damned if they do, and damned if they don’t.

As a result: look for a very tense round of negotiations during November leading up to the Group of 20 meetings in South Korea. If those meetings fail to outline a more cooperative way out of the current global imbalance, the likelihood of a round of hostile policy moves, including tariffs, competitive devaluations, and even capital flow restrictions shoots up.

There is a whiff of war in the air. Currency and trade war.

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Monday Mash-Up

With the Thanksgiving weekend over and the first taste of the holiday season under our belts – literally after all that turkey – we have a somewhat mixed set of news to deal with. So rather than devote my time to a single topic allow me to surf across the issues:

  1. Dubai: Given all the media ink spilled on the financial crisis that swamped Dubai anyone would have been forgiven were it the first sign of the end of the world. I suppose, given the ongoing fragility of our banks, that any hiccup in the credit markets is worth attention so there is some justification for the fuss. But not too much. The Dubai story can be summed up simply: building exotic stuff like ski slopes in the desert or by the Red Sea is probably a sign of a bubble. It is not a very sound financial transaction. Any bank with a piece of this particular action needs its head tested. Apparently there are several, with HSBC topping the list. None of the banks looks as if it will fall as a result of this folly. The Abu Dhabi government has underwritten the entire shambles. The signs of growing panic on the world’s bourses last week is a shot across our bows: world finance is in dire need of fixing. Dubai simply reminded us of the urgency in getting reform legislation passed as quickly as we can. Having said that I can’t help but wonder what history would have recorded had a bank fallen foul of this folly. Ski slopes in the desert. Really.
  2. Health Care: This is going to dominate the headlines for a while longer. There seems to be no end to the folly either. The latest inanity comes from a Senator Hutchinson. Her problem is that the new mammogram guidelines will be caught up with the public option: she claims that any mammogram undertaken earlier than indicated in the guidelines would not be covered either by the public option or by the private insurers. This she says causes confusion and is a sign of the kind of rationing we can all expect after reform. Naturally she fails to note that a very large number of women cannot be screened, no matter what their age is, under the current set up simply because they don’t have insurance at all. So the rationing argument fails to note the extension of essential coverage to a very large number of people. Besides nowhere is it written in the reform that the public option would not cover early mammograms, especially were doctors to recommend them. So Senator Hutchinson is crying foul over a huge red herring. Why am I not surprised by that? The level of ‘debate’ in this reform process has been staggeringly low. This is one of the most important items on our national agenda and all we’ve been treated to is pandering to a few ‘centrists’; name calling and hysteria from the right; and confusion and a lack of clarity from the left. No one has come clean and told the voting public why we need reform: we cannot bankrupt ourselves on health care. That means making choices and cutting costs. The cheapest system will always be the largest – actuarial costs are lower the larger the population covered. That’s a government program of some sort that includes as many of us it can.
  3. Banking: We are now being treated to the spectacle of international cooperation on the control of systemic risk. Given previous efforts in this regard I hold out little hope of progress. But the back chat is always good for a laugh. For instance: some of the mega banks – those that brought the world to ruin last year – are protesting that they cannot draw up the ‘living wills’ that are being requested from them. The reason? Their businesses are just too complex and so a single ‘will’ would not be adequate. I am sorry … but isn’t this the problem? If their businesses are so damned complex and interconnected that they cannot be killed off easily, they are too complex to manage also. That’s what’s wrong with them. They need to be reduced to simple, maybe smaller, lines of business that we can all understand. My guess is that if you can’t draw up a will for a bank, you can’t draw up a good risk management plan either. I suppose that’s too obvious for these banks to figure out though. In a similar vein I read a very geeky paper written back in 2004 by an MIT professor called Andrew Lo. In it he argued that one failure of our banking system is that it lacks diversity. By this he means all our big banks are the same. So an economic shock that damages one will damage them all. In terms of ecology we have a very thin and fragile ecosystem. A more diverse set of banks, not just smaller banks but banks with different lines of business, would help mitigate the spread of contagion. The entire system would be more robust. This argument seems very sound to me, but it likely won’t get very far in the face of the lobbying power the banks have and the lack of imagination the administration has.
  4. Black Friday and Retail Sales: The first reports from retailers about their sales last friday is decidedly mixed. Apparently there were far more shoppers in the stores than last year. The problem is that they spent stingily. There was a slight increase in dollar sales, but it was far less than the increase in shoppers. So we can either take heart: people were out and about so the siege mentality seems to be lifting; or we can get worried: people are still not spending freely. I think the good news is more likely to come after today: ‘Cyber Monday’. This obnoxious nomenclature refers to the first Monday after Black Friday – in recent years there has been a noticeable surge in online shopping on the first day back at work. Presumably people continue with their weekend holiday oriented spending even from the workplace. The expectation is that online shopping will continue to blossom, and may well carry the season along with it. The most visited online stores remain Amazon and Wal-Mart which is no surprise, and the biggest online shopping surge comes from all those last minute gifts during the ten days before Christmas. Cyber Monday is merely the precursor to that later splurge. Meanwhile we will get detailed November sales reports from the retail industry this Thursday. My guess is that sales rose a little, but not that much. We have a long way to go.
  5. Debt Hysteria: By now I have thrashed this to death. No one should be surprised by the never ending warnings of debt doom from the deficit hawks, but it does get tiresome. Here’s the deal: deficits are fine as long as they represent a response to a crisis. That’s because a government’s revenues tend to go way down in a crisis, just as its expenditure goes up. Things get all out of balance. Think of it as a dampening effect on the private sector’s fear driven shut down. The problem deficits are those that are gratuitous. These do not act as dampeners. On the contrary they tend to act as accelerators. A big government deficit during non-crisis times acts to inflame rather than retard the economy’s own direction. Such deficits add to the debt without having any beneficial impact. They should be avoided at all costs. Governments should keep a balanced budget – or close to – during economic booms so that they can spend freely during recessions and offset the private sector’s collapse. This is not what we have done in America. We have run up huge deficits as a permanent feature of our fiscal policy and thus boxed ourselves in just when we need to go hog wild. The oddity is that the deficit hawks all seem to have been fine with the gratuitous deficits of the 1980’s and 2000’s, but are now in panic over the very sensible deficits of today. Politics gets in the way of sound economics far too often. This is an egregious example. An example? The cost, or the interest we pay on our national debt. The hawks are in a tizzy over its rising cost, which looks set to grow to over 3% of GDP over the next year or two. This upward trend will be accelerated as interest rates rise from their current low levels. Is this a big deal? Well, not really. The projected level is close to that we saw back in the years of George Bush senior, when we were digging out from underneath the Reagan debt load. It was manageable then and it will be manageable now. Still the hysteria lingers on as a convenient ideological tool to fight the Obama agenda [whatever that is!].
  6. The Dollar: The debt hysteria is paralleled by a dollar panic. Often the two coalesce. Usually the same people occupy the two positions. And, again, ideology laps over the underlying arguments. The dollar has fallen and looks set to continue its decline. The drop so far this year has been in excess of 16%. Those who pay attention to these things will notice that this decline is not quite as large as that we witnessed during the Bush years, but it is significant. There are a couple of thing going on here. First the dollar was unduly strengthened by the financial crisis as foreign investors crowded into dollar based assets because they deemed them safer than the more speculative currencies they were invested in previously. Second: as the crisis has subsided this trend has been reversed and revealed the longer term decline that the gains made during the panic had masked. This long term decline is a result of the steady rise of solid alternatives to the dollar, especially the Asian currencies, and the endemic deficits that the US has run for the past thirty years. The dollar is finally wearing out its welcome. The deficit hawks have a point here, the flood of US debt will inevitably act to cheapen the dollar. My take on this is: good. Let the dollar decline. That way we can slowly erode the value of the debt ,and pay it back in cheaper currency. This is a time honored way in which debtor countries like the US avoid a default. In effect they ‘default’ over time. The world used to need a strong dollar so that international trade and investment could be secure and stable. Nowadays there are better ways to achieve that same goal: most likely a package of currencies including the dollar, the euro, the yen and various other Asian currencies. It might even include the ‘standard drawing rights’ quasi-currency from the IMF. In any case the days of dollar hegemony seem numbered. So it goes for all currencies, especially when the issuer becomes a major debtor. It is a little noticed historical oddity that the US is the first world power to be a debtor rather than a creditor. Throughout history, starting with the Roman Empire, the world’s foremost political power has also been a lender to the rest of the world. The US is a borrower. It maintains its standard of living by borrowing rather than through creating wealth. Sometime this ability has to end as the world gets sated with US debt. The financial crisis and the fiscal imbalance that resulted from it seems to have brought that date forward. So look for a continued steady decline in the dollar – over the long haul of course because there will always be short term blips back up as the adjustment to a new regime is worked out.

So there you have it. My ‘Monday Mash-Up’.

Lots to think about as we wait for the economy to slip into a higher gear.

This holiday season is crucial. Let’s hope it goes well.

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