Thursday, May 19, 2011

Making the Same Mistakes All Over Again

Policy makers continue to base their economic and monetary policies on the contention that the problems “out there” are liquidity problems…not solvency problems.  This focus is highlighted in three articles in the morning newspapers. 

The most direct treatment of this is that of Desmond Lachman of the American Enterprise Institute, “The IMF is making the same mistake all over again”:

Mr. Lachman makes the argument that the policies followed by Dominique Strauss-Kahn and the IMF with respect to the sovereign debt crisis in Europe is that they have treated “the crisis as a matter of liquidity rather than solvency…” The consequence of this approach is that this philosophy has “led the IMF to eschew any notion of debt restructuring or exiting from the euro, as a solution to the periphery’s public sector and external imbalance problems.”

In another article, Scott Minerd, chief investment office at Guggenheim Partners, argues that “There will Be More Monetary Elixir After the End of QE2”: 
The motivation for QE3? “The same motivation for QE1 and QE2: namely, stimulating growth to help employment recover…Looking ahead, the expiration of tax cuts in 2011 and a government deficit reduction program will present real headwinds to growth.  Layer on top of that the fact that 2012-13 would probably be the end of the expansionary portion of the business cycle, and what is left is a recipe for a serious economic slowdown or possibly even another recession.”

And, finally, there is Alan Blinder’s opinion piece “The Debt Ceiling Fiasco,”  To stay within the debt ceiling, Mr. Blinder argues, the government must immediately drop it expenditures by 40%. “Suppose the federal government actually does reduce its expenditures by 40% overnight…That’s an enormous fiscal contraction for any economy to withstand, never mind one in a sluggish recovery with 9% unemployment.” 

“Second, markets now assign essentially zero probability to the U. S. losing its fiscal mind.”  That is, the credit risk built into U. S. government securities is zero and the inflationary expectations that are now built into long-term interest rates are also roughly zero. 

And, what has allowed the United States to get into this position?  Well, “The full faith and credit of the United States has been as good as gold—no one has better credit.”  The federal government has been allowed to increase its debt at an annual compound rate of growth of about 8%, year-after-year for the last fifty years.  “Should the view take hold that threats to default are now a permissible weapon of political combat in the world’s greatest democracy, U. S. government debt will lose its exalted status as the safest asset money can buy—with unpleasant consequences for the dollar and interest rates.” 

That is, the United States government will lose its unlimited privilege to flood the world with debt and liquidity at little or no consequence to itself.
All three of these articles are concerned with the view that the basic problems of the economy have to do with liquidity…and not solvency.

I have argued for several years now in this blog that this has been a major problem in the analysis of the economy and the current financial difficulties we are now going through.   Right from the start of the current unpleasantness, the problem has been diagnosed as a liquidity problem and not a solvency problem.  The TARP program was designed to give liquidity to certain “troubled” assets on the balance sheets of various financial institutions.  QE1 was designed to provide liquidity to banking and financial markets.  So was QE2.  So were the bailout programs, both in the United States and Europe. 

But, liquidity problems have historically been considered to be “short-term” problems.  They have to do with whether or not an asset can be sold into the current market in real time without having to take a discount from market on the price at which it is sold.  In the past, a liquidity crisis should be over, given the appropriate monetary policy, in a matter of weeks, six- to eight-weeks at most. 

Liquidity problems did not and do not exist for three or four years!

Yet, this is what our policymakers are claiming.  They are claiming we are still in the midst of a liquidity crisis and so we must tailor our monetary and fiscal policies to deal with the lack of liquidity in financial markets.

The reason for this approach?  The models that these policymakers and their advisors are using only include debt in a cursory fashion.  The structure of conventional macroeconomic models over the past fifty years has not included debt in any meaningful way and so the existence of large amounts of debt has not really been relevant for analysis.  And, consequentially, the solvency issue does not surface.  

The focus then is placed on the “liquidity” issue, the desire of economic units to want to hold onto cash assets.  If banks and other economic units desire to hold onto cash rather than lend the funds to others or to spend the funds themselves then the economic will falter and economic growth will be tepid at best leading to high rates of unemployment.  This is a “liquidity trap.”

The solution to this problem is to flood the banking and financial markets with so much liquidity that people just can’t hold on to any more liquidity and so either begin to lend the funds or begin to go out and spend the funds themselves.  This seems to be the current thrust of economic policy, at the Federal Reserve…and throughout the world. 

But, what if a large number of economic units are insolvent.  In such cases, even with large amounts of liquidity on their balance sheets, they will not lend, or will not borrow any more, or will not go out and spend this excess liquidity because of their balance sheet problems.  What about homeowners who find that they cannot pay their loans or find that the value of their home is less than what they have borrowed?   What about banks who hold large amounts of delinquent residential mortgages or commercial real estate loans on their balance sheets?  What about businesses that owe way too much debt and have little or no current cash flows to cover the debt?  What about State and Local governments that have obligations far in excess of their current revenues?  And, what about sovereign nations who face similar problems?

If the problems are ones of solvency, liquidity is going to do very little for those who have a negative net worth other than postpone the day of reckoning. 

This is the problem of debt.  America (and Europe) has done a very good job over the past fifty years of inflating people, organizations, and governments, out of their increasing debt burdens.  The inflation of housing prices was a wonderful “piggy bank” for the middle class during this time period.  Maybe, the United States government went a little overboard in trying to push down this “piggy bank” to more and more people who even with the inflation could not support the debt.  The credit inflation did wonders for building up the salaries and pension funds of state and local governments.  Unfortunately, history shows over and over again that there are limits to the amount of debt people can carry.  But this is a solvency problem not a liquidity problem.

Finally, a country whose “faith and credit “ is as “good as gold” can abuse that privilege.  This, too, is a solvency problem and not a credit problem.  And, as we are finding out…once again…solvency problems cannot be postponed forever.      

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