Thursday, February 18, 2010

The Two-Sided Recovery

The stories continue to come in that the recovery is proceeding. Just looking at the morning papers gives one a feeling that things are on the mend. Note these three stories that appeared in the Wall Street Journal today.

One can even look at the charts of financial data from the Federal Reserve Bank of St. Louis and observe that the Great Recession ended in July 2009!

Yet, there is another side to the recovery that keeps us uncomfortable about where we are going. And, it is this other side to the story that creates the uncertainties of what will ultimately take place over the next five to ten years. It is this uncertainty that, I believe, is currently preventing many to commit more aggressively to the future.

This other side, the dark side, is perplexing government policy makers and sending off mixed signals to the private sector. The economy is recovering, but we need more fiscal stimulus, maybe another $100 billion package, to speed things along the way. The Federal Reserve needs to begin selling securities into the open market and just get back to a portfolio of US Treasury securities, but the banking system…well at least the small- and medium-sized banks…still has major difficulties to overcome, and, the economy is still proving extremely fragile. Starting to tighten up on monetary policy could produce major problems for the banks and for the economy recovery: when should the Fed begin removing excess reserves from the banking system.

Giving into the dark side, however, presents other problems. The federal deficit is projected to be more than $1.0 trillion per year for quite a few years, but this does not include any additional stimulus that might be approved and it assumes that a health care program will not add “one dime” to the deficit. Furthermore, it does not include major environmental programs, energy programs, and other initiatives that the Obama administration wants to “stay the course” on.

Also, questions remain about the Federal Reserve’s “undoing”. With more than $1.1 trillion in excess reserves in the banking system, concern still remains that these excess reserves can be removed before the banking system generates a lending bubble and excessive growth in money and credit. And, this “undoing” is to take place during a decade in which the federal debt may grow by $15 trillion! There is no historical precedent available to give us comfort that the Federal Reserve can “undo” what has been done and what apparently will be done without inflation raising its ugly head.

Yet, inflation is the prescription for the easing of debt burdens, and there certainly are enough debt burdens around. Greece, Spain, Italy, Portugal, and other sovereign nations have garnered a lot of press in recent weeks about their debt burdens.

But, we don’t stop there. Closer to home, news about debt problems continue to surface. Over the past month, more and more stories have hit the newspapers about the fiscal problems that states are having meeting their debt obligations. More and more information is coming out about the difficulties that municipalities are having. Note in the Wall Street Journal this morning, “Muni Threat: Cities Weigh Chapter 9”: Bankruptcy is certainly a way to deleverage!

Deleveraging continues in the private sector. Businesses and households continue to reduce debt loads, willingly or unwillingly, through foreclosure or bankruptcy or by paying down debt as cash flows allow. The bad news is that this deleveraging still seems to have quite a ways to go before it comes to an end. The good news is that this deleveraging is working itself out without major disruptions to the financial system. Most institutions recognize that a major debt problem still exists and that means, hopefully, that there will not be any surprise shocks in the future.

This brings us back to the problem of sovereign debt. The bind here is that nations do not believe that they can begin a process of slowing down debt growth let alone deleverage when their economies are still fragile and in need of fiscal stimulus.

It is here that we get into the conflicting “views of the world” that are clouding the decision making at the present time. The reigning philosophy in governmental circles, as well as in the academic and intellectual world, is that government spending and debt creation is needed to sustain the economic recovery and regain more robust growth in the future. Others are not convinced that this is the case. In this latter view, arguments are made that the current path being followed by many governments, ala’ Greece, are not sustainable and are, ultimately, self-destructive.

For now, for the United States, the betting is on continued fiscal stimulus, substantial deficits, and a Federal Reserve that is unable to “undo” what it has already done. This will be the foundation of a credit inflation that will be consistent with the economic policies of the federal government for most of the past fifty years or so. These policies are the ones that brought about an 83% decline in the purchasing power of the dollar over this time period.

But, as I continue to argue, following this kind of policy has created other problems for the United States (and other Western countries). It has resulted in the growth of under-employment and unused industrial capacity. And, it has resulted in a growing bifurcation of the society.

On this point, the latest edition of The Economist magazine contains the review of an interesting book: “The Pinch: How the Baby Boomers Took their Children’s Future—and Why They Should Give it Back” by David Willetts.” The book focuses on the chasm that has been developing in society over the past 50 years or so, a chasm between the older part of society and the younger part, between the more educated and the less educated, between those that have accumulated assets, primarily housing, and those that have not. .

Willetts argues that the “Baby Boomers” had a “piggy bank”, their own home. Though government help or subsidy or inflation, the “Boomers” were able to own a home (and possibly a second home), build up wealth by means of rising housing prices, and then even borrow against their homes to finance a comfortable old age. The “Non-Boomers” and the younger generation have not been able to access this “wealth machine”, have been unable to finance many of the things the older generation were able to finance, including more education, and face the fact that they may have to work later into life. These individuals, especially the less educated, have had to remain in “legacy” jobs and industries. The bottom line is that these structural problems will have to be addressed, sooner or later.

My concern is that although the economic recovery seems to be proceeding. The forces driving the recovery are not going toward reducing or eliminating the imbalances that have been built up in the economy over the past 50 years. Furthermore, the policymakers seem to be putting themselves into boxes that have very negative implications for the future. As a consequence, we are, at best, heading into an economic and financial future that is not different from the past: credit inflation, and further underemployment, unused economic resources and societal divisions.

1 comment:

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