Stiglitz: The Dangers of Deficit Reduction

A timely column from Nobel economist Joe Stiglitz (emphasis added):

A wave of fiscal austerity is rushing over Europe and America…But despite protests by the yesterday’s proponents of deregulation, who would like the government to remain passive, most economists believe that government spending has made a difference, helping to avert another Great Depression.

…even deficit hawks acknowledge that we should be focusing not on today’s deficit, but on the long-term national debt. Spending, especially on investments in education, technology, and infrastructure, can actually lead to lower long-term deficits. Banks’ short-sightedness helped create the crisis; we cannot let government short-sightedness – prodded by the financial sector – prolong it.

Faster growth and returns on public investment yield higher tax revenues, and a 5 to 6% return is more than enough to offset temporary increases in the national debt. A social cost-benefit analysis (taking into account impacts other than on the budget) makes such expenditures, even when debt-financed, even more attractive.

In those last two paragraphs, Stiglitz is pointing out that if the returns on public spending are greater than the cost of financing them, then the future debt level will actually be lower. The government’s current cost of financing is simply the yield on Treasury debt. As of Friday, the ten year Treasury note yields 3.7%, while thirty year Treasury bonds yield about 4.6%. If publicly financed investments can be expected to return more than those figures, then undertaking them — and adding to current deficits and debt levels — is a no-brainer.

And as long as the yields on the securities of private sector issuers aren’t abnormally higher than those on Treasuries, the argument that the federal government is going to ‘crowd out’ the private sector is without merit.

Of course, it’s debatable (1) whether public expenditures are likely to produce returns of that magnitude and (2) whether future Congresses, Administrations, and Treasury Departments will manage the federal balance sheet appropriately. Unfortunately, no one’s openly debating these points. Instead, we’re treated to pithy but nonstop dogma from both sides, and a peculiar obfuscation by those in the middle, which in all cases overlook the basic financial calculus that Stiglitz reminds us of in his column.

Most importantly for debt and deficit hawks and those who fear higher taxes (those whom econo-nerds would refer to as ‘Ricardian equivalence’ subscribers), when the financial calculus is positive, then the debt service associated with marginal federal spending can be financed organically, via higher growth, rather than through higher taxes.

In short, people on all sides of the deficit issue should be able to agree, at least on financial and economic grounds, that investments yielding more than their cost of financing, when they do not crowd out private sector borrowing or resource demand, should absolutely be carried out.

—

Unfortunately, Stiglitz overlooks his own argument when he writes the following, which make us wonder if he doubts his 5 to 6% return figures, or if he’s just offering a gratuitous slap at the financial sector (emphasis added):

As the global economy returns to growth, governments should, of course, have plans on the drawing board to raise taxes and cut expenditures…

Continuing with his love of taxes:

The financial sector has imposed huge externalities on the rest of society. America’s financial industry polluted the world with toxic mortgages, and, in line with the well established “polluter pays” principle, taxes should be imposed on it. Besides, well-designed taxes on the financial sector might help alleviate problems caused by excessive leverage and banks that are too big to fail. Taxes on speculative activity might encourage banks to focus greater attention on performing their key societal role of providing credit.

As we’ve pointed out elsewhere, the domestic financial sector is going to shrink even without  punitive measures, as demographic composition shifts away from the saving and investing age groups. Well-designed regulation might be a better approach than taxes to constraining financial sector activities to socially beneficial ones (we admit that a ‘Tobin tax’ can be the most efficient approach to regulation under certain conditions, but aren’t convinced that it’s optimal for the financial sector).

And it would be profoundly unjust for the federal government, which so strongly encouraged and underwrote the expansion of mortgage financing (Stiglitz’ “pollution”), to retroactively punish the financial sector, its employees, and its current and future clients for simply following the government’s orders.

Stiglitz also takes a step back from his underlying thesis with this sentence:

Over the longer term, most economists agree that governments, especially in advanced industrial countries with aging populations, should be concerned about the sustainability of their policies.

From a technical standpoint, this isn’t as iron clad as so many of us reflexively believe. First, we have no idea whether an aging population is bound to be a drag on an economy, whether it depends on particular conditions, or anything else. There simply isn’t much historical data available to test such a proposition. Second, if we assume that it is a significant drag, then policies that are seen as unsustainable under “normal” conditions might very well be the most sustainable under those novel conditions. This could include expanded deficit spending and public debt, and/or expansion of money supply.

[To be fair, Stiglitz is almost certainly referring to entitlement spending obligations in that passage, which might be a bird of a different feather. We're just using it as an opportunity to critique some of the conventional wisdom around demographics.]

—

Despite Sitglitz’ inability to break out of his New Keynesian box, or part ways with his passion for higher taxes, we agree wholeheartedly with his essential argument:

…even with large deficits, economic growth in the US and Europe is anemic, and forecasts of private-sector growth suggest that in the absence of continued government support, there is risk of continued stagnation – of growth too weak to return unemployment to normal levels anytime soon.

The risks are asymmetric: if these forecasts are wrong, and there is a more robust recovery, then, of course, expenditures can be cut back and/or taxes increased. But if these forecasts are right, then a premature “exit” from deficit spending risks pushing the economy back into recession. This is one of the lessons we should have learned from America’s experience in the Great Depression; it is also one of the lessons to emerge from Japan’s experience in the late 1990’s.

…we must be wary of deficit fetishism…high-return public investments that more than pay for themselves can actually improve the well-being of future generations, and it would be doubly foolish to burden them with debts from unproductive spending and then cut back on productive investments.

These are questions for a later day – at least in many countries, prospects of a robust recovery are, at best, a year or two away. For now, the economics is clear: reducing government spending is a risk not worth taking. 

URLs:

http://www.project-syndicate.org/commentary/stiglitz123/English

http://www.ustreas.gov/offices/domestic-finance/debt-management/interest-rate/yield.shtml

Career trades and object lessons

The WSJ carried an interesting story today (subscription required) about hedge fund bearishness on the euro relative to the USD (i.e., a falling euro exchange rate):

Some heavyweight hedge funds have launched large bearish bets against the euro in moves that are reminiscent of the trading action at the height of the U.S. financial crisis.

The big bets are emerging amid gatherings such as an exclusive “idea dinner” earlier this month that included hedge-fund titans SAC Capital Advisors LP and Soros Fund Management LLC. During the dinner, hosted by a boutique investment bank at a private townhouse in Manhattan, a small group of all-star hedge-fund managers argued that the euro is likely to fall to “parity”—or equal on an exchange basis—with the dollar…

Our interest isn’t motivated by the anti-euro call, which is rather conventional and uninteresting (Robert Mundell, one of the intellectual architects of the EMU, has recently predicted movement towards EUR-USD parity, and USD parity is something of an underlying objective of the EMU, if not the ECB).

Rather, it’s in the social and market dynamics involved, and how strongly they illuminate the ongoing importance of financial market regulatory reform.

The WSJ notes that this was an invitation-only event at a private home, and included some major global macro hedge fund players. While that’s not a bad thing per se, it definitely creates some potential market asymmetries and risks:

• Asymmetries to the extent that a small number of players with (relatively) massive amounts of capital and the ability to take highly leveraged bets (that’s the implication of “career trade”) may all be thinking and moving in the same direction; and
• Market and economic risks may because concerted, highly leveraged bets are likely to accelerate what might otherwise be a more orderly return to parity, i.e., one that unfolds over a longer period of time that allows for interested agents to adjust without too much trouble.

That last one is the more interesting point in our opinion, because of what it implies about the theoretical ideal of market efficiency. If EUR-USD is bound to return to parity, is it less destructive to let it “happen naturally”, or is it healthier in the long term to allow levered up speculators to (attempt to) correct mispricings as soon and as quickly as possible?

We have some qualms with the latter approach, because: (1) it may create more market and economic havoc than would otherwise occur; (2) if successful, the “rents” associated with the resulting dislocation (even beyond the mere price adjustment) accrue to a small number of privileged players; and (3) if those bets go badly, the damage could very well spread beyond the hedge funds’ assets (LTCM being the archetypal example).

Of course, those rents accrue to a hedge fund’s passive partners too, so there may be outside institutions that benefit, rather than just the funds’ general partners (emphasis on “may”). But speculators aren’t just messing with an asset class here; they’re impacting the very measuring rods of economic activity and financial obligations, and some of them are able to employ astronomical leverage in doing so, if they desire. 

If the net social costs of that activity are negative, it becomes immaterial who the ultimate beneficiaries of the managing partners’ actions are. It also highlights how critical it is to do regulatory reform well, but soon. Speculators are absolutely critical to financial markets and economies, but optimization requires some degree of financial constraint. How many more ‘object lessons’ will we require on that point?

URLs:

http://online.wsj.com/article/SB10001424052748703795004575087741848074392.html

http://en.wikipedia.org/wiki/Long-Term_Capital_Management

IMPORTANT DISCLOSURES: Symmetry Capital Management, LLC is a state registered investment advisor. The foregoing information is for informational, educational, or entertainment purposes only. It does not constitute an offer to buy nor a solicitation to sell any security, or to engage in any investment strategy.

How do you spell W-I-M-P-Y?

First Congressional jobs bill of 2010 has cleared the Senate:

Senate Democrats Wednesday delivered the first of several promised election-year jobs bills, passing a measure blending tax breaks for companies that hire unemployed workers with highway funding eagerly sought by the states.

The bipartisan 70-28 vote to pass the bill sends it to the House, where many Democrats say it is too puny…

We tend to agree with the House Dems. Among the bill’s measures:

Democrats promise additional measures to create jobs, promising help for small businesses having trouble getting loans, aid for cash-strapped state governments, and subsidies for people who make their homes more energy efficient…

The bill contains two major provisions. First, it would exempt businesses hiring the unemployed from the 6.2 percent Social Security payroll tax through December and give them an additional $1,000 credit if new workers stay on the job a full year. The Social Security trust funds would be reimbursed for the lost revenue.

Second, it would extend highway and mass transit programs through the end of the year and pump $20 billion into them in time for the spring construction season. The money would make up for lower-than-expected gasoline tax revenues…

And the reason it is so wimpy:

But budget deficits are a worry, and future measures are going to be more difficult to pass — especially since a top Senate Democrat has blocked unused authority from the Wall Street bailout program from being used to “pay for” jobs initiatives…

Sen. Judd Gregg of New Hampshire, top Republican on the Senate Budget Committee, blasted the measure for increasing the budget deficit to fund highway and transit programs. He said the measure made a joke of Democratic promises to adhere to “pay-as-you-go” budget rules requiring new spending programs to not increase the deficit.

“I don’t think you get people back to work in this nation by loading more and more debt onto the next generation,” Gregg said.

Sen. Gregg seems like a good man, but he just doesn’t get the underlying economics (unless he believes that the private sector is in robust shape and capable of standing on its own, which means he’s looking at different data than we are). And as we continue to point out, if he and other budget hawks are wrong about the underlying economics, then they are actually going to leave “the next generation” in even worse shape than they would be with more concerted stimulus.

Mark Zandi is cited as estimating that the Senate bill will create roughly 250,000 jobs. That number is unlikely to even make a perceptible dent in structural unemployment. By our back of the envelope calculations, the Senate bill will add about half a percentage point to GDP under the most optimistic assumptions.

We’ll close by calling again on correspondent J. Wellington Wimpy:

“You will gladly pay me today for a job that might be created tomorrow.”

URLs:

http://news.yahoo.com/s/ap/20100224/ap_on_bi_ge/us_congress_jobs

http://654advisors.com/index.php/blog/2010/02/the-hawks-are-circulating/

The Deficit Commission: Hubris or Pandering?

The President signed an executive order yesterday to establish a deficit reduction commission headed by Erskine Bowles and Alan Simpson. Bowles was instrumental in the Clinton administration’s budget negotiations of the late 1990s, while Simpson helped ensure passage of the tax hikes in 1990 that torpedoed the first President Bush’s reelection.

Why do we think the commission is a display of hubris? Because there’s nothing in its mission about better understanding the nature of the problem, i.e., whether enlarged deficits and public debt ever make sense over a longer period of time, and if so, whether those conditions exist today. Instead, it seeks to cram macroeconomic orthodoxy down our throats, presumably in order to fatten up the livers of U.S. taxpayers by the arbitrarily imposed year of 2015.  But we predict that even in five years the fiscal foie gras will still be pretty lean.  According to the Washington Examiner:  

Here are the kinds of steps the panel is likely to consider as it seeks to tackle deficits that never dip below $700 billion under Obama’s budget:

_Raise the retirement age for full Social Security benefits to more than 67 years old and have benefits grow at a less generous inflation rate. Expose more income to Social Security and Medicare payroll taxes.

_Require seniors to pay more Medicare costs out of their own pockets and curb payments to health care providers.

_Raise taxes on people making less than $200,000 a year, requiring Obama to break a signature campaign pledge.

“You’re going to have to do all of the above,” said [Sen. Kent] Conrad. “You’re going to have to do all of the things that people don’t want to do.”

The first one isn’t a terrible idea, though its second part might constitute an overall tax hike on anyone earning over ~$100K per year, depending on how it is accounted for in income taxes.

The second one, although it’s a pressing issue given demographic projections, would have harsh consequences on seniors, not only in terms of out of pocket costs, but also in the availability of Medicare providers; it also renders the economics of a medical education far more difficult (if not impossible) for those who would be willing to administer primarily to the poor and the elderly.

The third one, depending on how big a hike is involved and how far down the income ladder it extends, could have negative economic consequences and profound political implications.

The long term structural issues do present a fiscal challenge. However, policymakers may be getting too far ahead of the problem, and if they are, the consequences could actually worsen the longer term fiscal outlook. And yet the president has charged the commission with lowering public deficits, period, without any consideration of what it could mean to the economy, or whether there’s any truth to his arguments that the government could “run out of money,” or that it’s subject to the same kinds of budget constraints as a household or business.

Obviously, given our take on the role of the federal budget, we would be relieved if the commission turns out to be little more than election year pandering. And the fact that it aims for budget normalization rather than budget balance, and shoots for it in five years rather than one or two, is a good sign. But based on U.S. demographic composition, we think 2018 to 2020 would make far more sense.

If the commission produces hawkish recommendations that are pursued vigorously in the coming years,  our strong dollar call will become stronger yet, and our willingness to wager on a double dip or ‘recession within a depression’ type of event would increase (2012-2013 could be interesting, and not in a good way).

URLs:

Mosler blowing minds (sort of)

Warren Mosler was given a brief spot on CNBC this morning to discuss his version of modern monetary theory, an idea that deserve a wider audience. The cognitive dissonance he induced among the host, a co-hosting economics reporter, and a successful hedge fund manager was pretty apparent. Warren lacks the charisma to make a quick sale, but as the co-host pointed out in the wrap up, it was a start.

The hawks are circ(u)l(at)ing

Two interesting and somewhat discouraging trial balloons have been floated by the Senate recently:

Schumer-Hatch payroll tax break

First, in a NYT op-ed, Sens. Schumer and Hatch propose a payroll tax credit for employers who hire someone who’s been out of work for 60 days or more. This is intended to be a much simpler approach than the disastrous jobs tax credit of the 1970s:

…any private-sector employer that hires a worker who had been unemployed for at least 60 days will not have to pay its 6.2 percent Social Security payroll tax on that employee for the duration of 2010. The Social Security trust fund will then be made whole with spending cuts elsewhere in the budget between now and 2015. That’s it. Simple to understand, and easy to explain.

Simplicity is a reasonable objective, but as described, the proposal is NOT going to stimulate a return to full employment, because it’s fiscally hawkish, i.e., it aims for budget neutrality. Thus, the net economic effect is likely to be somewhere around nil, give or take.

It also gives no payroll tax break to the newly hired employees! That is NOT likely to play well to a frustrated electorate. Warren Mosler’s version of a payroll tax holiday would be fairer and much bolder. As he framed it at a recent Tea Party get together:

I believe that the surest engine for full economic recovery is a full payroll tax holiday. Payroll taxes take away over 15% of everyone’s paycheck, from the very first dollar earned. This is big money- about $1 trillion per year. Half comes from the employee and half from the employer. A payroll tax holiday does not give anyone anything. What it does is stop taking away $1 trillion a year from working people struggling to make their payments and stay in their homes, and businesses struggling to survive. A full payroll tax holiday means a husband and wife earning $50,000 a year each will see their combined take home pay go up by over $650 a month, so they can make their mortgage payments and their car payments and maybe even do a little shopping.

In their op-ed, the Senators also claimed:

Our two-pronged approach would be a far more efficient use of taxpayer dollars than other proposals under discussion, all of which could cost many times more with very little guaranteed improvement in unemployment. [emphasis added]

Taking care to use taxpayer dollars efficiently is a wonderful thing when resources are fully employed and there are sufficient dollars in circulation. But in the prevailing environment, it’s far too hawkish. As some have noted, the key factor that will incentivize hiring is for businesses to see signs of improving demand; tax breaks like this one are unlikely to have more than a marginal effect. And as long as Congress is stingy about deficits and about where taxpayer dollars come from, it could merely reallocate existing resources, rather than raise overall employment.

The entire idea brings to mind the old Hefty Bag jingo: WIMPY WIMPY WIMPY!!!

Senate jobs bill

Second, Senate Democrats have been circulating a comprehensive jobs bill that includes the Schumer-Hatch proposal. Positive features include extension of unemployment benefits and subsidies. More questionable are the extensions of various expired tax provisions through the end of 2010. Like financing federal expenditures with existing “taxpayer dollars”, sunset provisions will tend to offset any stimulative effects of ‘stimulus’.

From the proposed measures in the bill, it looks like members of Congress, especially Senators, believe that their reelection prospects hinge on budget and debt hawkishness. That might well be true, given that our educational system has done a lousy job teaching economics for generations. If that’s their angle, then they’re as bad as their policy ideas: WIMPY WIMPY WIMPY!!!

It’s estimated that the bill would create 80,000 to 180,000 new jobs in the coming year. We would need 180,000 or so per month to meaningfully reduce unemployment. Taking secondary effects into account, the typical employment multiplier falls in a range of roughly 2 to 4. That means that the overall impact on employment would range from 160,000 to 1.44 million new jobs in 2010. This would make less than an 18% dent in the number of jobs lost in this recession! [We've assumed that multiplier effects are not accounted for in that number; if they are, the package is even more pathetic.]

Admittedly, we’re leaving out private sector employment and the related multipliers, and 1.44 million new jobs would still be a good thing. But the glaring problem is that policymakers seem to believe that the real economy is in the kind of shape it’s been in since the mid-1980s, and that it will do just fine with the federal government contributing a net 20% or so to economic activity. We strongly disagree, and would point out that policymakers in Japan made the same error over their two lost decades. Policymakers need to dramatically raise expectations in the private economy, whether it’s through spending, tax cuts, or a combination of both. Wimpy proposals are not going to get it done.  

If the Senate bill is as good as we get, then our strong dollar call remains in place, and incumbents could face some rough sledding in November. The Obama administration is reportedly trying to work some better features into the bill, but most of them have an undeniable fiscal wimpiness to them, and thus won’t do much to alleviate the stubborn shortage of dollars, income, and employment in the real economy.

As J. Wellington Wimpy might say, “You will gladly pay me today for a job created tomorrow.”

Update 2/14/2010 – Perhaps this description of neo-Keynesian economics explains the cruelty of Hatch-Schumer:  “Tax cuts can deepen a recession if the short-term nominal interest rate is zero, according to a standard New Keynesian business cycle model. An example of a contractionary tax cut is a reduction in taxes on wages. This tax cut deepens a recession because it increases deflationary pressures.”  Good grief. The honorable gentlemen should note that this is just economic theory, which is far from settled (and that economists are probably not a good source of reelection advice). 

URLs:

http://www.nytimes.com/2010/01/26/opinion/26hatch.html?scp=2&sq=orrin%20hatch&st=cse

http://moslereconomics.com/2010/02/04/dallas-address/

http://www.webcpa.com/news/Senate-Democrats-Jobs-Bill-Includes-Tax-Breaks-53257-1.html

http://news.yahoo.com/s/ap/20100210/ap_on_bi_ge/us_what_jobs_11

http://www.newyorkfed.org/research/staff_reports/sr402.pdf

Krugman vs CNBC

A couple of CNBC commentators ripped Paul Krugman for today’s op-ed on budget deficits, with Rick Santelli saying something about lining a bird cage. We aren’t defending Krugman against charges of self-contradiction or factual inaccuracies, but we are definitely siding with him on the economic substance of his argument (the lonely wingnut’s sojourn continues).

Prevailing rhetoric holds that the U.S. government is over extended, and that there’s precious little room for additional economic stimulus. That would be true if US dollars could only be obtained by taking them from people who have them, or by digging new ones out of the ground. In that case, servicing our debts — both private and public — would be quite burdensome. But the reality is that in a modern monetary system, monetary units are simply ledger entries. Whether carried in hand as a Treasury obligation, or held digitally in a bank account, all dollars are created out of thin air by the Federal Reserve in response to demands of the banking system.

The federal government does not have direct control of the Federal Reserve, so its control of money creation is only indirect (if Congress wished, it could wrest control of USD creation from the quasi-private Fed, a measure that a small number of radical but diverse members might like to see). But existing arrangements do not change the basic fact that the U.S. has the capacity to print the money (the non-interest bearing debt) used to service its public debt. That means that the only meaningful constraint on the level of our pubic debt is people’s willingness to accept the USD. And despite the sophomoric rhetoric on that point, people are still overwhelmingly willing to accept USDs.

The claim that Congress is “spending money that we don’t have” is even more egregious. To reiterate: if USDs could only be dug out of the ground, or pulled out of taxpayers’ pockets, then the argument might make some sense. But as long as we have the ability to create USDs out of thin air, then Congress has the ability to spend new USDs instead of existing ones.

The conservative argument against this type of Keynesian activism rests on a couple of key pillars, and under certain conditions, they’re valid: (1) as long as government constraints on the private sector are moderate, an economy will grow at or near full capacity; (2) public demand for capital will always tend to ‘crowd out’ private sector borrowing; and (3) public sector allocation of capital is inevitably distorted, which imposes long run economic costs. 

As long as those assumptions are valid, then Congressional thrift, beyond a basic level of social insurance and national defense spending, is a desirable objective. However:

(1) History doesn’t lend strong support to the idea that an unbridled private sector will always and everywhere produce positive growth; and if monetary policy is constrained by a zero bound (i.e., interest rates can’t go below zero), then whenever growth is below potential, fiscal stimulus is appropriate (and can be enacted in myriad ways that appeal to lefties or righties). This is especially true for long economic cycles, such as the Great Depression, Japan from 1989 until 2008 or so, and several developed western economies since roughly 1999. Judging by the available empirical research, demographic composition could be the main driver of these cycles (and if the effect is strong enough, it might deemphasize the importance of rationality vs behavioralism in theory and policy making).

(2) When private sector demand for capital is contracting, as can happen in a long down cycle, then public sector demand for capital (i.e., deficits and debt issuance) is beneficial, and should foster rather than crowd out private sector credit demand. However, under certain conditions, this will only work if money creation is supportive of public sector credit demand, i.e, if new money is created to finance the public sector debt (the conservative point of view tends to see this as banana republic monetary policy, but that isn’t always the case). Today, banks are taking advantage of a steep yield curve to borrow funds from the Federal Reserve (which creates new USDs) to purchase higher yielding Treasury debt, i.e., a significant amount of our public debt is being ‘monetized’. While that would be a bad thing in an inflationary environment, it’s a good thing when it offsets deflationary forces. Almost everyone who parrots the prevailing rhetoric is overlooking this dynamic.

(3) Public sector capital allocation is certainly prone to distortion in as much as it is not subjected to competition and the judgement of diverse agents. But asymmetries in the private sector can have powerfully negative effects too (financial crisis, anyone?). And while there’s room in our political system for new institutions designed to allocate public resources more optimally, the existing ones, such as voting, negotiation, and oversight, should do a good enough job in the meantime.

Krugman wrote that “there’s no reason to panic about budget prospects for the next few years, or even for the next decade,” and apparently this has some pundits and analysts pulling their hair out. But if prevailing demographic ratios are going to drive another decade of subpar economic outcomes…then he’s absolutely right!  

When the real economy is humming along, we can leave the creation and allocation of new USDs to the private sector, and rein in public deficits without doing too much harm. But when the state of the real economy is uncertain, as it certainly is now (pun intended), the refusal to finance public spending, investment, and intermediation via the creation of new dollars (within the constraints dictated by inflation objectives and expectations) is inherently deflationary and destructive. And that is what undermines the sophomoric notion that we are “leaving a mountain of debt to our grandchildren.” If the public sector is not active enough to offset destructive forces acting in the economy today, then our grandchildren will be worse off. Like most economic variables, public debt levels mean nothing in isolation. And we shouldn’t just look at it relative to current GDP. We must also look at it relative to opportunity cost, or looked at another way, to future GDP. There are actions that the public sector can take today to favorably impact GDP in the future, but they all require financing, including deficit spending. We should only be frightened of deficits when they are scarier than the opportunity costs imposed by government saving. Today, that is simply not the case.

So Krugman is right to be concerned about the policy outlook, which he has a rather pessimistic view of:

Washington now has its priorities all wrong: all the talk is about how to shave a few billion dollars off government spending, while there’s hardly any willingness to tackle mass unemployment. Policy is headed in the wrong direction — and millions of Americans will pay the price.

We’ve expressed similar concerns since 2H09, but it now looks to us as though the Obama administration is “triangulating” on deficits and the federal debt, with no intention to substantially withdraw fiscal stimulus in the government’s 2011 fiscal year (though again, we’re still trying to figure out how the president’s emphasis on PAYGO fits into this). If we’re right, then the readjustments underway in exchange rates, specifically the Euro and USD, are being driven by the Euro and sovereign debt concerns, rather than from the USD side. That means we should settle into a new exchange rate equilibrium in the coming weeks, at which point risky assets should start to recover. It’s going to be a bumpy ride, but we’ll get there.

URLs:

http://www.nytimes.com/2010/02/05/opinion/05krugman.html

IMPORTANT DISCLOSURES: Symmetry Capital Management, LLC is a state registered investment advisor. The foregoing information is for informational, educational, or entertainment purposes only. It does not constitute an offer to buy nor a solicitation to sell any security, or to engage in any investment strategy. Symmetry Capital Management, LLC is an Amazon.com associate, and earns a commission on sales generated through links from our website. At the time of writing, the firm, its principals, and its clients did not own any securities mentioned, or any securities issued by entities mentioned.

Obama Budget & 4Q09 GDP

We were feeling a little smug about Friday morning’s GDP print, given our argument in 2H09 that growth prospects were probably being under estimated. At 5.7%, it wasn’t quite the six handle that we thought we might see, but barring any significant downward revisions, it was closer than most expected, and nominal GDP did indeed have a six handle.

Interestingly, headline government spending added little to the quarter’s numbers, so there will be an interesting debate over how much of a role ‘fiscal demand’ is playing, but we’re cautious about that for a few reasons. First, the slower pace at which private inventories were liquidated was a large contributor to GDP, but sustainable private sector growth and employment are unlikely as long as inventory building remains anemic.  Second, federal spending was down due to a lower defense spend, while non-defense spending was up 8% versus 7% in 3Q09, so it’s hard to argue there was no fiscal component. Third, it ignores the possibility of lag effects between public sector spending or deficits and subsequent private sector activity. And if we’re right that fiscal expenditures are still playing a role, the GDP data could imply a very healthy multiplier, a possibility sketched out in this recent academic paper.

This leads us to the Obama budget released today, which will be a real tooth gnashing, garment rending piece of work to many. But it looks pretty good to us at first glance (see the criteria on page six of this Idle Speculator), far better than recent rhetoric led us to expect. The deficit is forecast to be a record $1.56T in 2010 and to remain above $1T in 2011, and it’s beginning to appear that Obama is “triangulating” on fiscal austerity measures, or at least on the time frame over which deficit reduction will occur (though it’s not clear how PAYGO fits into this).

The President’s budget will be tough for some to swallow, but as we’ve pointed out elsewhere, the belief that government is always and everywhere the problem, or that it cannot contribute to real economic growth, is based on a massive underlying assumption: that the private sector is always and everywhere able to grow. It’s not hard to reduce that position to an absurd one, e.g., if a natural or biological calamity were to severely impact private sector potential, a government with a monopoly over money creation could pick up some or perhaps all of the slack.

Reality is far more complicated of course, but since demographic ratios came to our attention, it seems patently clear that private sector potential can vary wildly over multi decade periods, especially in economies where a steep fall in childhood mortality occurred at some point in history. Japan is the most recent example of a two decade downswing in potential output, and its policymakers mistakenly approached the problem as a cyclical rather than a secular one. The U.S. and other western nations are roughly ten years behind Japan in demographic terms, so there’s still roughly a decade of slow, no, or even negative growth ahead of us, barring an active public sector (note: “active” can include tax cuts). As we wrote last November:

We’re familiar with the major [economic] catechisms; we’re just not sure that the evidence supports any one of them over another. Structural economic conditions can and do change — age structure is just one example of how this can come about — and different conditions may call for different approaches.

There are several economic measures that, when viewed over the last two decades, support our assessment that demographics are playing a powerful role in the performance of the U.S. economy (and by extension, these measures tend to undermine arguments against Republican budget profligacy in the 2000s). For example:

The year over year decline in state and local income tax revenue has never been so precipitous, and it has become far more volatile since demographic ratios first turned negative in the late 1990s;

The trend in real private inventories has also been declining since the late 1990s; and 

Equipment and software investment has been in a similar downtrend since the late 1990s.

Admittedly, we’re just eyeballing graphs here and speculating on whether they correspond well to more robust empirical analyses. But we’re fairly confident in our speculation, and this has led us to accept that we are in a Keynesian moment, or more accurately, two Keynesian decades with a Minskian moment in the middle. In such an environment, where private sector expectations are pessimistic, the optimal response is for the public sector to pick up the slack in consumption, investment, and intermediation, within the constraints set by inflation expectations (granted, inflation is a messier issue in a world where the USD is the global reserve currency, and based on a first cut view of today’s budget, we believe our tradable goods inflation thesis is back in play).

The Obama budget appears to pick up a healthy measure of private sector slack, and should thus be favorable overall for employment, asset prices, and economic output. The inflation issue will be far more slippery: on the one hand, a well designed federal budget gives the Fed more room to tighten, as private sector expectations improve; on the other, fiscal direction is uncertain, especially beyond 2011, and prone to shocks, so central banks will have to be rather nimble (more nimble than they were in 2003-05 and 2008) to avoid taking an overly easy or tight approach to policy.

Obama’s proposed tax increases on high income households will cause some resentment, but it’s hard to see how the income disparity pendulum could keep swinging on its current arc. The administration might also believe that higher tax rates on higher incomes will be supportive of state and municipal debt financing. We’d feel better about it if there were an accompanying reinvention of the corporate tax code, as we believe that would have some positive second and third order effects on lower and middle class incomes; first order effects could be achieved by instituting a payroll tax holiday as Warren Mosler has suggested.

Unfortunately, we place a zero probability on corporate tax reform happening any time soon (the budget calls for increasing taxes on certain sectors of the economy), and a near zero probability on a long payroll tax holiday. Despite that, the President’s budget does brighten the economic outlook a bit for 2H2010 and 2011, and the possiblity of a double dip might have been pushed back to 2012 or 2013 (which clearly calls the semantics of ”double dip” into question).

URLs:

http://www.bea.gov/newsreleases/national/gdp/gdpnewsrelease.htm

http://faculty.wcas.northwestern.edu/~yona/research/Multiplier-version12.pdf 

http://www.whitehouse.gov/omb/blog/10/02/01/Introducing-the-2011-Budget/

http://654advisors.com/idlespeculation/20100112.pdf

http://654advisors.com/idlespeculation/20091109.pdf

http://research.stlouisfed.org/fred2/graph/?chart_type=line&s[1][id]=ASLPITAX&s[1][transformation]=pc1

http://research.stlouisfed.org/fred2/graph/?s[1][id]=CBIC1

http://research.stlouisfed.org/fred2/graph/?chart_type=line&s[1][id]=NRIPDC96&s[1][transformation]=pc1

http://en.wikipedia.org/wiki/Minsky_moment

http://moslereconomics.com/2010/01/28/tea-party-plan-for-dems-cut-to-the-front-with-tax-cuts/

IMPORTANT DISCLOSURES: Symmetry Capital Management, LLC is a state registered investment advisor. The foregoing information is for informational, educational, or entertainment purposes only. It does not constitute an offer to buy nor a solicitation to sell any security, or to engage in any investment strategy. Symmetry Capital Management, LLC is an Amazon.com associate, and earns a commission on sales generated through links from our website. At the time of writing, the firm, its principals, and its clients did not own any securities mentioned, or any securities issued by entities mentioned.

I’ll see your PAYGO and raise you a double dip

A key objective raised by President Obama in his state of the union address was to address the ‘fiscal hole’ of the federal government. His rationale was that “like any cash strapped family, we will work within a budget to invest in what we need and sacrifice what we don’t.” he asked Congress to reinstate PAYGO, which reportedly helped the federal government “record surpluses in the 1990s,” and advocated investing in people “without leaving them a mountain of debt.” He closed on this point by saying that it’s just common sense.

Culturally, these ideas resonate with Americans. And for a business or household, budget constraints are a matter of common sense (even though we don’t always adhere to them). But there is no budget constraint on a government that can create money, i.e., non-interest bearing debt, out of thin air. The only meaningful constraint to the level of non-interest bearing debt is inflation, which occurs when a government creates more money than the economy requires, causing its non-interest bearing debt to lose value against most goods and services. Thus, while it may score some political points (thanks to our primary educational system’s lack of a financial and economic curriculum?), it’s absurd for the president to embrace the common sense that households and businesses use in setting budgets. The federal government faces an entirely different kind of budget constraint.

Instead, given the government’s power to create money, common sense would hold that the amount of money supplied to the economy should be equal to the amount of money required by the economy (please note, this simplification is not an attempt to resurrect the policy prescriptions of old school monetarism). Thus, the proper approach to budgets at the federal level is to ask whether there is currently a surfeit or deficit of USDs in our economy. Given the number of private financial commitments that were entered into in the past decade, and dramatic declines in economic activity, it’s difficult to argue that there’s currently a surfeit of dollars. And if recent political rhetoric is any indication, dollars are likely to become scarcer in the years ahead (it would be ironic if, instead of inflation, deflation became the motivating force behind a move away from the USD as global reserve currency).

The president did set forth some positive ideas, such as a zero capital gains tax on small business investment, capital investment incentives for companies of all sizes, and infrastructure investment. Assuming these are financed at least in part by new money creation, they would help to prevent a renewed liquidity crunch. But to the extent that they are “offset” by cuts or freezes elsewhere in the name of closing fiscal gaps and filling in budget holes, or by higher taxes on other activities, the net short term effect on the economy will be nil or worse. And like Japan, we’ll be in for our second lost decade out of two. As we’ve pointed out, leaving future generations without a “mountain of debt” sometimes means leaving them with equivalent (or greater) opportunity costs. We should strive to avoid both of those outcomes. To do so, we have to rethink the cultural common sense that debt is always and everywhere to be avoided.

From an investing standpoint, if vigorous policy actions follow the path being laid out by the rhetoric and “common sense” emanating from so many quarters, then the USD will continue to strengthen, the real economy will stagnate or weaken further, and nominal asset values will fall for all but the highest grade government paper. In that scenario, we would be lucky to tread water and leave only 16% of the country underemployed.

Mr. President, I’ll see your PAYGO and raise you a double dip recession.

RELATED READING (file under confirmation bias): 

We’re well aware that our current view of things puts us shoulder to shoulder with some members of the “loony left”, but the macroeconomics of this stuff are fairly straightforward. Our lonely wing nut sojourn continues, placing us in lockstep with one Mr. Paul Krugman: http://krugman.blogs.nytimes.com/2010/01/26/obama-liquidates-himself/.

The Fed is seeking an exit strategy from its liquidity programs and low interest rate policy. The impact of that exit can be either muted or amplified by Congressional actions. If Congress becomes hawkish, there is no reason for the Fed to do so. If they both begin tightening, it’s hello 1937: http://www.bloomberg.com/apps/news?pid=20601015&sid=aXeUAV7_bz_o

An excellent idea from Warren Mosler — a full payroll tax holiday — that has yet to fall on the radar of federal policymakers: http://moslereconomics.com/2010/01/28/tea-party-plan-for-dems-cut-to-the-front-with-tax-cuts/. Here’s how Mosler describes the cause of poor economic policymaking: “…so-called economic experts have confused themselves and their political masters with contrived explanations for the way the economy works, and their limited vision has limited the range of policy choice. The result has been a monumental economic and social disaster caused by an obvious shortage of aggregate demand. The spending power needed to make mortgage payments, car payments, and do a bit of shopping- all of which would fix the economy and end the financial crisis- just isn’t there.”

Marshall Auerback writes that “Any kind of spending cuts in the middle of the worst recession since the Great Depression is insane.  What we are beginning to see is the return of Herbert Hoover and the ‘liquidationists.’” http://www.newdeal20.org/?p=7731

Ed Harrison posts an email exchange with Auerback, in which the latter wrote: “What the US government is now in danger of repeating is taking its economy down the fast track to a double-dip recession.  With investment still flat, consumers trying to increase their saving ratio and net exports making a negative contribution to growth – the President and his advisors evidently believe the persistently high unemployment is something the private sector has to deal with.”  http://www.creditwritedowns.com/2010/01/what-president-obama-can-do-to-improve-the-economy.html. As we’ve noted elsewhere, the demographic research of folks like John Geanakoplos, Diane Macunovich, and Ajay Kapur implies that for the next decade, the U.S. private sector is not going to behave as the baby boomer decades have conditioned us to expect. Hence the case for a more activist — and just as importantly, ‘self-financing’ – public sector. ‘Self financing’ today means the Federal Reserve creating the dollars that enable primary dealer banks to absorb Treasury offerings at auction via direct bids.  For that process to continue, the federal government must continue to issue debt, rather than shoveling dirt on the people and institutions that are still near the bottom of our deep ’fiscal hole’.

Jonathan Zasloff writes (TOH Krugman) that “At some point someone must make an argument for government.” http://www.samefacts.com/2010/01/politics-and-leadership/obamas-self-inflicted-lobotomy-proceeds-apace/  Why are Democrats today so afraid to make that argument? Like the health care debacle, could the lessons learned in the Clinton years be ill suited to today? As for the GOP, our take is that by harping on government in all its forms (besides those forms that help favored firms and industries collect their share of rents from the rest of us, of course), Republicans leave the door open to the development of increasingly socialist policies. In fact, if our take on the state of the private sector in the coming decade is accurate, they will practically mandate it.

State unemployment insurance tracker at Pro Publica (TOH Credit Writedowns) shows how critical federal government support currently is for many states: http://projects.propublica.org/unemployment/

George Soros thinks that premature budget tightening could be bearish for gold prices: http://www.telegraph.co.uk/finance/financetopics/davos/7085504/Davos-2010-George-Soros-warns-gold-is-now-the-ultimate-bubble.html. Reminiscent of Jon Nadler’s argument last fall against gold: http://654advisors.com/index.php/blog/2009/11/a-gold-bears-comments/

Finally, in what might be a mirror image of our loney wing nut position, Bill Gross seems to be exhibiting a profound case of anti-Keynesianism: http://www.pimco.com/LeftNav/Featured+Market+Commentary/IO/2010/February+2010+Gross+Ring+of+Fire.htm

Bookstaber: ‘Controlled Burn’

Rick Bookstaber put forth an interesting argument about easing debt burdens on the public and private sectors through “controlled burn” inflation. If creditors aren’t willing to take large enough haircuts, that’s pretty much what you have to do to get aggregate credit burdens to a more manageable or desirable level.

There are a lot of misperceptions around this issue. FDR allegedly devalued the dollar c. 1934 by repegging it to gold at $35, instead of the $20 that prevailed before WWI. But if you look at the historical data, the USD was powerfully deflationary in the years leading up that action. And at best, the repegging only stemmed the rate of deflation. It did not create any inflation at all. In fact, the more closely we look at the data, the more closely aligned we become with folks who argue that the New Deal didn’t go far enough.  Paul Krugman’s warning in 2008 is looking fairly prescient:

…Barack Obama should learn from F.D.R.’s failures as well as from his achievements: the truth is that the New Deal wasn’t as successful in the short run as it was in the long run. And the reason for F.D.R.’s limited short-run success, which almost undid his whole program, was the fact that his economic policies were too cautious.

[I would add that other FDR actions were too bullheaded and hasty, errors that Obama also risks repeating.]

During the recent crisis and recession, plenty of pundits argued that USD devaluation would be the order of the day. We saw some risk of that, but not as much as those who pointed repeatedly to the Federal Reserve’s unprecedented balance sheet expansion of 2008-2009, or the federal government’s enlarged deficits. That’s because those factors are meaningless if the private sector is not taken into account (i.e., the effects of monetary policy and public and private sector borrowing are not independent). If there’s intensive deleveraging and a rising desire for saving in the private sector, then expansive actions by the central bank and federal government are merely going to absorb some slack. Ony if they absorb more slack than exists will there be any risk of inflation.

Unfortunately, of late, the messages coming out of almost all political quarters is that the slack in the real economy is going to increase — and that means higher deflationary risk, and conversely to Bookstaber’s argument, rising real credit burdens. That, in turn, will lead to credit after shocks and rising unemployment. Granted, to the extent that people’s nominal income stays the same, real incomes rise in a deflationary environment, so this would be good news for pensioners, savers, and highly valued employees. But we shouldn’t overlook the real opportunity costs that deflation implies.

We see a threat of increasing slack because there’s a rising chorus of fiscal hawkishness all around us. Today, Rep. Chris Van Hollen, chairman of the Democratic caucus, told a CNBC interviewer that the government ”need[s] to get every penny back” from TARP. Yesterday, Republican Rep. Jeb Hensarling said that the election of Scott Brown was a sign that voters cared about debt and deficits (to be fair, he did mention lowering capital gains and payroll taxes, but debt and deficits seemed to be on the top of his mind). Today, a CNBC commentator referred to “your [taxpayers'] money” leading into a report on pending transportation spending. Policymakers are treading the line between semi-sensibility and madness.

First, Congress and the Administration should look forward. That requires changing the regulatory framework in a way that will prevent excessive systemic fragility in the future, and that’s the direction that Obama laid out in his remarks yesterday, with Paul Volcker, who imposed a massive deflationary contraction as Fed chairman in the early 1980s,  smiling in the background. But all else equal, this will lower overall credit capacity, and demanding full repayment of TARP will will make it worse. In order to avoid a double dip, the federal government has to act as the borrower of last resort, i.e., run larger deficits. To us, that’s the real problem with the path being laid out by Obama and Democratic leaders — taking with one hand, and not giving with the other, means economic contraction, all else equal.

Second, debt and deficit hawkishness could not be more untimely. We should pay serious attention to where and how public expenditures are directed, but we need to be honest about the need for significant deficit financed expenditures. Looking at underlying demographic structure, we probably shouldn’t concern ourselves with lowering the federal debt until the end of this coming decade.

Finally, the dollar is ”our money” in the sense that we use it to pay our tax liabilities to a government that has monopoly power to create it. Better yet, it creates it out of thin air (yes, if that power is abused or misused, it can lead to inflation, even hyperinflation, but the risk of such an outcome right now is very, very low). If fiscal policy does indeed swing in a more hawkish direction, then there’s going to be a surfeit of monetary units. And the more we taxpayers or our elected representatives grab for ”our money”, the worse it’s going to get. This ‘chartalist’ view is also somewhat complicated by the fact that our money creation process is controlled by the quasi-public Federal Reserve system. That means that the federal government can only issue interest bearing debt to finance its deficits. It sells those securities to primary dealer banks at auction. And the primary dealers rely on the Federal Reserve system to create the monetary units (the non-interest bearing debt of the U.S. government) that are used to purchase its interest bearing debt.

Keeping those last three sentences in mind, consider that:

• The President intends to tighten the tax and regulatory collars on the banks
• Fed Chairman Bernanke’s confirmation by the Senate is now in serious doubt
• Government spending and investment are especially critical in this recession (see here and here)
• Policymakers are clearly signalling that they’re going to get serious about “fiscal responsibility” 

The clear implication is that USDs are more likely to increase in value. So while Rick Bookstaber is right about the ability of inflation to lower existing debt burdens, it looks to us like we’re headed in the opposite direction, at least for now. The consequences will be discouraging to just about everybody.

URLs:

http://rick.bookstaber.com/2010/01/controlled-burn-inflation.html

http://www.aei.org/article/26390

http://www.nytimes.com/2008/11/10/opinion/10krugman.html

http://research.stlouisfed.com/recession/gdpdata.html

http://research.stlouisfed.com/recession/indicators.html