Tuesday, February 9, 2010

Two Ponts about Debt and the Economic Recovery

The Internet, print journalism, and the broadcast media contain story after story about the debt problems in the world. A wider audience just learned this week a new acronym: PIGS, or PIIGS if you will. This, we all know now, stands for Portugal, Ireland, Greece, and Spain, or, some include Italy.

The problem is debt!

The solution? Well, we don’t quite know that yet.

How did the problem arise? In my mind, the problem has arisen because of the attitude that has prevailed in the world over the last fifty years or so relative to how governments should conduct their fiscal affairs.

Beginning in the 1960s we saw more and more governments turn to budget policies that could stimulate employment and economic activity through the creation of spending that would add to the aggregate demand in their countries. These policies began with the argument that budget deficits should be produced only when the economy was below full employment. But, governments found these policies so attractive in terms of attempting to get re-elected that budget deficits were produced whether or not the economies of their countries were running below full employment.

This attitude created an environment of credit inflation, as well as price inflation, that did three things. First, it caused economic units to focus on finance and financial engineering. Second, it resulted in structural unemployment as many, many people were hired or re-hired back into “legacy” jobs and not the jobs of the future. This hurt lower income and less educated people the most. (See Bob Herbert’s column in the New York Times: http://www.nytimes.com/2010/02/09/opinion/09herbert.html.) Third, it ended up transferring a lot of the wealth of the country offshore to China, the Middle East, and other places.

There are two points I would like to make about all this credit creation and the piling up of debt.
The first point is that, ultimately, those people, companies, and nations that have little or no debt WIN over those that issue lots and lots of debt.

The situation is similar to that historically called “the Phillips Curve.” The Phillips Curve captured the tradeoff between unemployment and inflation and the economists that developed this tool used it to show how, for a little bit of inflation, a government could buy a lower amount of unemployment.

Milton Friedman destroyed their case by arguing that the Phillips Curve was dependent upon a given assumption about inflationary expectations. He showed that the tradeoff between inflation and unemployment remained stable only if inflationary expectations remained the same.

However, even if people are fooled in the short run, the presence of higher inflation than they expected would eventually lead to an increase in inflationary expectations. Thus, to get the same decline in unemployment the government would have to create a higher level of inflation. The tradeoff resulting in constantly rising inflation, which is what the United States observed through the 1960s and 1970s.

The same type of situation exists for the creation of debt. A company or a nation can benefit from the creation of “more leverage” or more deficit spending. However, as more and more credit is created, people, companies, or nations must issue more and more debt to keep retain or even increase the benefits of their debt creation relative to others. Credit inflation, once started, is self-feeding!

Of course, when the credit bubble bursts, as it did for the world in 2007 and 2008, all the debt built up becomes a huge burden, especially if economies dip into a period of price deflation. The solution to a situation like this? Well, one solution is inflation: make the real value of the debt burden less and less.

Again, the problem is that each cycle of re-flation tends to be greater than those of the past. But, this is the easy way out. Re-flation was the intellectual model that came out of the 1930s and, in its various forms, was incorporated by government’s worldwide beginning in the 1960s.

The problem is that re-flations ultimately never work, because the deeper and deeper people, companies, and nations get into debt, the more and more of them attempt to deleverage. If governments’ don’t want deleveraging to happen then they continue to re-flate. The cumulative effect of this is hyperinflation, and those countries that hyper inflate don’t win. The 20th century has many examples of the consequences of hyper inflation, the German case in the 1920s being the most pronounced.

But, before fully finishing this strand of thought, let me introduce my second point and it has to do with the effects of deleveraging. If the private sector realizes that it is over extended, debt-wise, then it will attempt to pay off debt or at least reduce its debt burden sufficiently so that it can operate once again. But, if economic units in the private sector begin to save more or sell assets in order to pay off debt, aggregate spending declines and this slows down or prevents an economy recovery from taking place.

John Maynard Keynes identified this “fallacy of composition” in the 1930s and labeled it “the Paradox of Thrift.” That is, while it is all well and good for individuals to increase their savings and pay off their debts, the very act of withdrawing spending from the economy reduces aggregate demand and the output of goods and services. So, even though it is good for people to save and pay off debt, individually, it is bad for the economy and everyone becomes worse off because of this prudent behavior.

The thing is, when they get badly burned, lose their homes, lose their jobs, and lose their wealth, people and businesses do “pull back”. And, their standards change. This, to me, is one reason why the stimulus policies of the 1930s were not very effective. They could not overcome the desire of people and businesses to restructure their balance sheets. People had to re-group. One sees the consequences of this in the 1950s: people and businesses were very, very conservative then in the way that they spent and managed their money. The near-term experience that dominated their thinking was the depression years of the 1930s. And, in many ways, this continued into the 1960s for the older generations.

So who benefits during the time that follows the bursting of the credit bubble? Those without a lot of debt!

To me, the creation of debt eventually impacted the world in two ways. First, during the last 50 years or so, many resources were diverted into financial engineering. Even companies that were primarily in manufacturing gave more and more attention to financial engineering. This distracted these companies from what should have been their main focus: manufacturing goods and industrial innovation. The emphasis on financial engineering changed the whole society and many of the best and brightest young people opted out of careers in engineering and applied science and went into the finance industry. Employment in financial firms grew dramatically relative to employment in manufacturing and production.

The second way the world was impacted is through the redistribution of wealth in the world. Massive amounts of wealth have been transferred over the past 20 to 30 years out of the West and into the Far East, the Middle East and Brazil. Who did American companies turn to in the financial crisis for capital? Who is Europe and America now turning for help? Where are we learning about this transfer? See the morning papers for starters: “China Lists $9.6 Billion in Shares of U. S. Companies”: http://www.nytimes.com/2010/02/09/business/global/09invest.html?ref=business.

This is not a winning strategy for those countries, businesses, and people who took on a lot of debt!

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