John Maynard Keynes is remembered for many quotes and one of the most memorable ones is his claim that “In the long run we are all dead.” Keynes wrote this remark to criticize the belief that inflation would acceptably control itself without government intervention. That is, he argued that the theoretically determined equilibrium of an economy was not a good guide to the future in a very volatile economic situation.
The statement has been used, however, as an excuse for choosing the economic policy of a government based short run outcomes. The most prominent short run outcome sought over the past fifty years has been the maintenance of high levels of employment…or, low levels of unemployment.
The problem is that fifty years of government stimulus, basically credit inflation, aimed at achieving low levels of unemployment have created a cumulative build up in debt and a general attitude toward debt that perpetuates a desire for “more-of-the-same.”
And, over this past fifty years, the purchasing power of the dollar has declined by 85%; the under-employed in the country are in excess of 20% of the working force; and the income distribution has become dramatically skewed toward higher income recipients.
Not surprisingly, the economic and financial crisis of the past few years has been met with calls for more fiscal stimulus and wide-open monetary policy. The result: yearly federal government budget deficits of over $1.5 trillion with an estimated cumulative deficit over the next ten years in excess of $15 trillion. In terms of monetary policy, excess reserves in the banking system have reached $1.2 trillion. All this, of course, to get the economy going again.
Here, however, is where moral hazard enters the picture. The behavior patterns of finance people, developed over the last fifty years, “kicks in” once people see that the same old spending habits of the government are still in place.
I call your attention to the opinion piece by John Plender in the Financial Times this morning, “Bad Habits of Credit Bubble Make Worrying Comeback.” (http://www.ft.com/cms/s/0/26d644be-3ea8-11e0-834e-00144feabdc0.html#axzz1EmwjGnnL)
Mr. Plender begins: “Here we go again. The start of the year in debt markets has been marked by record low yields on junk bonds, declining underwriting standards and a return of the more dangerous innovations of yesteryear such as payment-in-kind toggles which allow borrowers to issue more debt to pay the interest bill. Even covenant-life loans, where normal borrowing conditions are shelved, have made a comeback in the leveraged buyout market and elsewhere, at a time when hapless small and medium sized firms are hard pressed to find credit.
A surplus of savings over investment is thus building up in the system and the US is once again accommodating the savings gluttons with an ongoing commitment to loose policy…No surprise, then, that the search for yield is back in evidence. With Federal Reserve chairman Ben Bernanke keeping policy interest rates at rock bottom, investors are being driven into riskier assets such as junk bonds and leveraged loans.”
Has the “music” started up once more so that people must start dancing again? Someone call “Chuck” Prince, former chairman of Citigroup, to get his “take” on the timing.
Fifty year policies are not just present in the economic policies of government. They exist elsewhere as well. Check out the Tom Friedman’s column “If Not Now, When?” in the New York Times this morning. (http://www.nytimes.com/2011/02/23/opinion/23friedman.html?hp)
Here Friedman discusses energy policy: “For the last 50 years, America (and Europe and Asia) have treated the Middle East as if it were just a collection of big gas stations: Saudi station, Iran station, Kuwait station, Bahrain station, Egypt station, Libya station, Iraq station, United Arab Emirates station, etc. Our message to the region has been very consistent: ‘Guys (it was only guys we spoke with), here’s the deal. Keep your pumps open, your oil prices low, don’t bother the Israelis too much and, as far as we’re concerned, you can do whatever you want out back. You can deprive your people of whatever civil rights you like. You can engage in however much corruption you like. You can preach whatever intolerance from your mosques that you like. You can print whatever conspiracy theories about us in your newspapers that you like. You can keep your women as illiterate as you like. You can create whatever vast welfare-state economies, without any innovative capacity, that you like. You can undereducate your youth as much as you like. Just keep your pumps open, your oil prices low, don’t hassle the Jews too much — and you can do whatever you want out back.’”
Fifty years is a long time. The buildup of fifty years of economic policies and energy policies can result in a lot of excess baggage hanging around that must be dealt with. A fifty-year build up not only requires a major re-structuring of nations and economies, it also requires a huge shift in the mindset of many, many people.
You want the deficit to come down in the short run and monetary policy to be reversed because it is potentially inflationary? It just ain’t going to happen in the near term.
You want an energy policy that is going to immediately get us off of oil so that we can stop subsidizing dictators and autocrats in the Middle East? It just ain’t going to happen in the near term.
And, so on and so on…
What seems to be missing is the leadership to change our mindset and develop a new paradigm that will set us on a pathway to re-structure our economy and our lives. I don’t think we want to dance the same old dance we have been doing for the past fifty years. Yet, it seems as if we have no choice but to start dancing again because the bank has begun to play the music once more.
The leadership just does not seem to be here, either in America, or in Europe, or in Asia. And, no one is strong enough to want to inflict on people the consequences of ‘getting the house in order again.’ I guess one can say, in line with the earlier comments of the mayor-elect of Chicago, Rahm Emanuel, that the leadership in the United States (and in Europe and in Asia) has “”let a crisis go to waste!”
The question that is still unanswered is “Has Keynes’ long-run arrived yet or do we still have to wait for it?” If it has not arrived yet, then it is still to come. Payment will be collected sometime. However, if this ‘long-run’ is still to come then my advice to those that work in financial institutions or in the financial markets is…start dancing again if you haven’t already started for the music has begun once again.
Showing posts with label John Maynard Keynes. Show all posts
Showing posts with label John Maynard Keynes. Show all posts
Wednesday, February 23, 2011
Friday, October 1, 2010
Monetary Warfare: Is An Independent Economic Policy Possible for a Nation?
John Maynard Keynes, after 1917, wanted to achieve full employment for England, but also for other major countries in Europe and the western world. The reason for this goal was that he was afraid of the Bolshevik menace threatening his civilized world.
Thus, beginning with the time that he returned to England from the Paris Peace Conference following World War I, Keynes sought ways that would allow a country to follow an independent economic policy that would primarily focus on full employment for the nation. Before the First World War, Keynes was, like most of his liberal counterparts, a free-trader who believed in capital mobility and flexible exchange rates
Keynes, in essence, developed a policy prescription that is consistent with what is now called the “Trilemma” problem as it is applied to economics. The “Trilemma” problem is that a nation can only achieve two out of the following three policies: fixed exchange rate, independent economic policy, and capital mobility.
Keynes opted for an independent economic policy for a government in order to achieve high levels of employment. He also believed, in his later years, that exchange rates should be fixed. This was ultimately achieved in the Bretton Woods agreement in 1944. This agreement set up the current system of international financial organizations and created a foreign exchange system that stayed in place until August 15, 1971.
The third component of this, international capital mobility, was severely restricted at the time.
What occurred in the 1960s was that inflation increased in the United States due to the fiscal and monetary policies of the government and capital began flowing throughout the world. Thus, the value of the dollar had to float in world markets. Thus, President Richard Nixon set free the dollar on August 15, 1971 and we entered a new age.
Full employment remained a policy goal of the United States government written into law by the Congress. So, the monetary and fiscal policy of the government had to remain independent of what other nations did.
Capital mobility increased as the world became more and more globalized in the latter part of
the 20th century.
And, the consequence of this combination of events left the value of the dollar on its own. And, since the early 1970s, the value of the dollar has declined by about 40% against other major currencies.
The fundamental reason for the decline in the value of the dollar was the credit inflation created by the United States government. The gross federal debt of the United States has risen at an annual compound rate of about 9.5% in the fifty years from 1961. Financial innovation on the part of the United States government has been huge.
The private sector has emulated this governmental behavior as incentives all pointed to increasing amounts of leverage on family and company balance sheets. Again, following the government, financial innovation was everywhere, especially in the area of housing finance.
World financial markets reacted by sinking the value of the dollar…except in a crisis when there was a so-called “flight to quality”. The dollar continues to remain weak and will continue to be weak as long as the United States government follows its policy of underwriting the credit inflation which is undermining the strength of the economy.
But, given conditions of the Trilemma, the dollar must continue to sink as long as international capital mobility continues and the deficit of the United States government is expected to add $15 trillion or more to federal debt over the next ten years. The United States can inflate credit all it wants, but it will have to pay in terms of a falling dollar. The two parts of the Trilemma, flexible exchange rates and the independent economic policy of the government are not really compatible at this time.
For one, this seems to play right into the hands of the Chinese. They are building up enormous international reserves. These reserves are being used to buy productive resources around the world, acquire commodities which they badly need, and increase their political power and influence throughout the nations. (See my post “Monetary Warfare: U. S. vs. China?”: http://seekingalpha.com/article/227632-monetary-warfare-u-s-vs-china.) Yes, we have a major case of mercantilism, here.
And, how does the United States respond? In terms of the policy of the government, it continues to pump things up, just what the Chinese want. And, then the United States government points its finger at China as if it is the bad guy. Well, China is the “bad guy” because it is growing stronger as the United States weakens itself.
The other piece of the picture has to do with what the economic policy of the United States government is doing to its own economy. Well, the results are not good: one in four workers of employment age are under-employed; in industry, capital utilization is between 75% and 80%; and income inequality has increased dramatically over the past 50 years as the wealthy have taken advantage of the credit inflation and the less-wealthy have suffered dramatically from the massive increase in debt leverage. (See my post “Does Fiscal Policy Really Work?”: http://seekingalpha.com/article/227210-does-fiscal-policy-really-work.)
The United States must either get its monetary and fiscal policy in order or it must seek to reduce or prohibit capital mobility. The United States cannot continue to pursue a policy of credit inflation in this era of almost totally free capital mobility without serious ramifications to the strength of its economy. The evidence of this is the current status of the American economy.
The weakness in the economy is what is driving the decline in the value of the dollar. The first conclusion one draws from a declining currency is that the decline is related just to monetary factors, to inflation. However, what we are seeing in the case of the United States is that the U. S. has exported inflation to the emerging nations through the freely flowing capital in the world. The inflation has not shown up explicitly in U. S. prices. But, the inflation has shown up implicitly in terms of the dislocation of economic resources within the United States economy.
That is why I argue that either the United States must change its philosophy about what governmental policy can do or it must seek to reduce or prohibit capital mobility. It cannot continue to support both.
In this mobile global world we live in, we cannot achieve the Keynesian requirement that the monetary and fiscal policies of a country can conducted independently of the rest of the world. Economists have to move on from the Keynesian prescription. The funny thing is, I believe that Keynes would have changed his mind many years ago.
Thus, beginning with the time that he returned to England from the Paris Peace Conference following World War I, Keynes sought ways that would allow a country to follow an independent economic policy that would primarily focus on full employment for the nation. Before the First World War, Keynes was, like most of his liberal counterparts, a free-trader who believed in capital mobility and flexible exchange rates
Keynes, in essence, developed a policy prescription that is consistent with what is now called the “Trilemma” problem as it is applied to economics. The “Trilemma” problem is that a nation can only achieve two out of the following three policies: fixed exchange rate, independent economic policy, and capital mobility.
Keynes opted for an independent economic policy for a government in order to achieve high levels of employment. He also believed, in his later years, that exchange rates should be fixed. This was ultimately achieved in the Bretton Woods agreement in 1944. This agreement set up the current system of international financial organizations and created a foreign exchange system that stayed in place until August 15, 1971.
The third component of this, international capital mobility, was severely restricted at the time.
What occurred in the 1960s was that inflation increased in the United States due to the fiscal and monetary policies of the government and capital began flowing throughout the world. Thus, the value of the dollar had to float in world markets. Thus, President Richard Nixon set free the dollar on August 15, 1971 and we entered a new age.
Full employment remained a policy goal of the United States government written into law by the Congress. So, the monetary and fiscal policy of the government had to remain independent of what other nations did.
Capital mobility increased as the world became more and more globalized in the latter part of
the 20th century.
And, the consequence of this combination of events left the value of the dollar on its own. And, since the early 1970s, the value of the dollar has declined by about 40% against other major currencies.
The fundamental reason for the decline in the value of the dollar was the credit inflation created by the United States government. The gross federal debt of the United States has risen at an annual compound rate of about 9.5% in the fifty years from 1961. Financial innovation on the part of the United States government has been huge.
The private sector has emulated this governmental behavior as incentives all pointed to increasing amounts of leverage on family and company balance sheets. Again, following the government, financial innovation was everywhere, especially in the area of housing finance.
World financial markets reacted by sinking the value of the dollar…except in a crisis when there was a so-called “flight to quality”. The dollar continues to remain weak and will continue to be weak as long as the United States government follows its policy of underwriting the credit inflation which is undermining the strength of the economy.
But, given conditions of the Trilemma, the dollar must continue to sink as long as international capital mobility continues and the deficit of the United States government is expected to add $15 trillion or more to federal debt over the next ten years. The United States can inflate credit all it wants, but it will have to pay in terms of a falling dollar. The two parts of the Trilemma, flexible exchange rates and the independent economic policy of the government are not really compatible at this time.
For one, this seems to play right into the hands of the Chinese. They are building up enormous international reserves. These reserves are being used to buy productive resources around the world, acquire commodities which they badly need, and increase their political power and influence throughout the nations. (See my post “Monetary Warfare: U. S. vs. China?”: http://seekingalpha.com/article/227632-monetary-warfare-u-s-vs-china.) Yes, we have a major case of mercantilism, here.
And, how does the United States respond? In terms of the policy of the government, it continues to pump things up, just what the Chinese want. And, then the United States government points its finger at China as if it is the bad guy. Well, China is the “bad guy” because it is growing stronger as the United States weakens itself.
The other piece of the picture has to do with what the economic policy of the United States government is doing to its own economy. Well, the results are not good: one in four workers of employment age are under-employed; in industry, capital utilization is between 75% and 80%; and income inequality has increased dramatically over the past 50 years as the wealthy have taken advantage of the credit inflation and the less-wealthy have suffered dramatically from the massive increase in debt leverage. (See my post “Does Fiscal Policy Really Work?”: http://seekingalpha.com/article/227210-does-fiscal-policy-really-work.)
The United States must either get its monetary and fiscal policy in order or it must seek to reduce or prohibit capital mobility. The United States cannot continue to pursue a policy of credit inflation in this era of almost totally free capital mobility without serious ramifications to the strength of its economy. The evidence of this is the current status of the American economy.
The weakness in the economy is what is driving the decline in the value of the dollar. The first conclusion one draws from a declining currency is that the decline is related just to monetary factors, to inflation. However, what we are seeing in the case of the United States is that the U. S. has exported inflation to the emerging nations through the freely flowing capital in the world. The inflation has not shown up explicitly in U. S. prices. But, the inflation has shown up implicitly in terms of the dislocation of economic resources within the United States economy.
That is why I argue that either the United States must change its philosophy about what governmental policy can do or it must seek to reduce or prohibit capital mobility. It cannot continue to support both.
In this mobile global world we live in, we cannot achieve the Keynesian requirement that the monetary and fiscal policies of a country can conducted independently of the rest of the world. Economists have to move on from the Keynesian prescription. The funny thing is, I believe that Keynes would have changed his mind many years ago.
Monday, July 5, 2010
Jobs and Skills: the Current Mismatch
For at least 18 months, I have been arguing that the United States economy is going through a transition period that is more than just a cyclical slowdown and recovery. My argument has been that the economy is going through a period of restructuring that will take an extended amount of time to work out all the changes that are necessary.
As a consequence, “blunt-edge” efforts to stimulate jobs by means of the fiscal policy of the federal government will not achieve a great deal of success.
The reason for this in many cases is that the fiscal stimulus of the past 50 years has caused companies to keep aging physical capital in use and has resulted in these companies hiring people to perform jobs related to “legacy” technology.
The evidence I have provided for this is the increasing amount of unused capacity in the manufacturing realm and the growth in the number of employable Americans that are under-employed. To be under-employed, one is either unemployed, not fully employed and looking for full-time work, or discouraged and not seeking a job.
I have argued that this is not unlike the 1930s when the United States economy was going through a transition period in which jobs and employment were shifting from rural and agricultural areas to cities and industrial areas. The restructuring that took place accelerated during World War II and did not really calm down until the 1950s and 1960s.
Two reports came out toward the end of last week that support my claim of an economy that is in the process of restructuring. The first was an article by Motoko Rich that appeared in the New York Times on Friday July 2, with the title “Jobs Go Begging as Gap is Exposed in Worker Skills.” (http://www.nytimes.com/2010/07/02/business/economy/02manufacturing.html?_r=1&scp=2&sq=motoko%20rich&st=cse) Rich writes that “Plenty of people are applying for the jobs. The problem, the companies say, is a mismatch between the kind of skilled workers needed and the ranks of the unemployed.” The subheading to the article reads that “Shifts in Manufacturing are Leaving Many as Unemployable.”
The second report came from the Labor Department on Friday, July 3. Although the unemployment rate declined in May to 9.5 % from 9.7% in April, this was because the labor force shrank as more people left the labor force than were added to payrolls: the labor force shrunk by 0.3% while the number of individuals employed dropped by only 0.2% (due to the loss in jobs connected with the collection of Census data).
The official statistics report that the “underemployment” rate has been in the 17% range for the past year or so. I estimate that, currently, about one out of every four or five individuals that are in the employable age group are under-employed. The reason is that there is a tremendous mis-match between what employers need to be competitive in the future and the pool of skills and experience that are available in the labor market. Products are being made differently now than they were several years ago and this trend will continue. The current downturn has provided additional justification for manufacturers to make the changes that they need to make.
Why do they need this added justification?
Well, over the past 50 years, every time there was a recession (and even in periods when there was not a recession), the federal government provided fiscal stimulus to get people “back-to-work.” Back-to-work, however, meant putting people back into jobs that they were in before the workers were laid off. This is what the government wanted to happen.
However, putting people back to work in “legacy” jobs did not contribute to modernization and improved productivity. It did increase employment and reduce unemployment which is what the federal government wanted to achieve.
Now, businesses can use the excuse of the extreme downturn in the economy to justify the changes in who is hired to meet the reality of changes in training, skill levels, and experience that have occurred. And, this transition will not be completed overnight.
We see the same thing in the use of physical capital in the United States. Since the 1960s, the capacity utilization of manufacturers has declined steadily. As with the increase in the underemployed, the employment of the physical capital in the United States has fallen over time.
In January 1965, American manufacturers were working at 89.4% of capacity. The next peak in manufacturing usage (capacity utilization is very cyclical) came in February 1973 at 88.8% of capacity. The following peaks were: December 1978 at 86.6% of capacity; January 1989 at 85.2% of capacity; December 1997 at 84.7% of capacity; and April 2007 at 81.7% of capacity.
Note that the troughs of the cycles in capacity utilization also fell since the 1960s. In December 1982, manufacturers in the United States worked at 70.9% of capacity and in June 2009, they worked at 68.2%. Currently, manufacturers are working at 74.1% of capacity.
In essence, businesses in the United States have been utilizing less and less human and physical capital over the past 50 years relative to the amounts of these productive factors that have been available. And, the policy makers just don’t seem to get it.
From Rich, in the article cited above, “Christina D. Romer, chairwoman of the Council of Economic Advisers, said the skills shortages reported by employers stem largely from a long-term structural shift in manufacturing, which should not be confused with the recent downturn. ‘I do think that manufacturing can come back to what it was before the recession,’ she said.” So, manufacturing will return to the new, lower level of capacity utilization that was achieved at its previous peak level, roughly 82% of capacity. And, this is good?
My guess is that capacity utilization will hit, maybe, 80% at the next peak. We are still talking about 20% of the manufacturing capital of the United States being underemployed, right in line with the 20% to 25% of employable labor in the United States being underemployed.
The fiscal stimulus proposed by “fundamentalist” Keynesian economists will not do the job. Additional, “blunt-edge” governmental expenditures may alleviate some of the current worker distress, but at the cost of postponing the adjustments that need to be made to restructure the economy, the restructuring that is now going on.
The problem with the “fundamentalist” Keynesian view is that it is constructed from a short term perspective. The basic attitude is that which is attributed to Keynes: “In the long run we are all dead.” This approach leads to a focus on only “current” problems. What is not explicitly stated is that we will deal with the longer-term problems when they become current problems.
The difficulty with this: the longer-term problems may require a different “medicine” than did the short-run problems.
Well, one could argue that the longer-term problems have become current. The short-term solution of forcing many companies to continue to employ people in “legacy” jobs and to continue to use “legacy” plant and equipment has resulted in higher and higher rates of worker under-employment and lower and lower rates of manufacturing capacity utilization.
Just more of the same does not seem to be an adequate answer.
As a consequence, “blunt-edge” efforts to stimulate jobs by means of the fiscal policy of the federal government will not achieve a great deal of success.
The reason for this in many cases is that the fiscal stimulus of the past 50 years has caused companies to keep aging physical capital in use and has resulted in these companies hiring people to perform jobs related to “legacy” technology.
The evidence I have provided for this is the increasing amount of unused capacity in the manufacturing realm and the growth in the number of employable Americans that are under-employed. To be under-employed, one is either unemployed, not fully employed and looking for full-time work, or discouraged and not seeking a job.
I have argued that this is not unlike the 1930s when the United States economy was going through a transition period in which jobs and employment were shifting from rural and agricultural areas to cities and industrial areas. The restructuring that took place accelerated during World War II and did not really calm down until the 1950s and 1960s.
Two reports came out toward the end of last week that support my claim of an economy that is in the process of restructuring. The first was an article by Motoko Rich that appeared in the New York Times on Friday July 2, with the title “Jobs Go Begging as Gap is Exposed in Worker Skills.” (http://www.nytimes.com/2010/07/02/business/economy/02manufacturing.html?_r=1&scp=2&sq=motoko%20rich&st=cse) Rich writes that “Plenty of people are applying for the jobs. The problem, the companies say, is a mismatch between the kind of skilled workers needed and the ranks of the unemployed.” The subheading to the article reads that “Shifts in Manufacturing are Leaving Many as Unemployable.”
The second report came from the Labor Department on Friday, July 3. Although the unemployment rate declined in May to 9.5 % from 9.7% in April, this was because the labor force shrank as more people left the labor force than were added to payrolls: the labor force shrunk by 0.3% while the number of individuals employed dropped by only 0.2% (due to the loss in jobs connected with the collection of Census data).
The official statistics report that the “underemployment” rate has been in the 17% range for the past year or so. I estimate that, currently, about one out of every four or five individuals that are in the employable age group are under-employed. The reason is that there is a tremendous mis-match between what employers need to be competitive in the future and the pool of skills and experience that are available in the labor market. Products are being made differently now than they were several years ago and this trend will continue. The current downturn has provided additional justification for manufacturers to make the changes that they need to make.
Why do they need this added justification?
Well, over the past 50 years, every time there was a recession (and even in periods when there was not a recession), the federal government provided fiscal stimulus to get people “back-to-work.” Back-to-work, however, meant putting people back into jobs that they were in before the workers were laid off. This is what the government wanted to happen.
However, putting people back to work in “legacy” jobs did not contribute to modernization and improved productivity. It did increase employment and reduce unemployment which is what the federal government wanted to achieve.
Now, businesses can use the excuse of the extreme downturn in the economy to justify the changes in who is hired to meet the reality of changes in training, skill levels, and experience that have occurred. And, this transition will not be completed overnight.
We see the same thing in the use of physical capital in the United States. Since the 1960s, the capacity utilization of manufacturers has declined steadily. As with the increase in the underemployed, the employment of the physical capital in the United States has fallen over time.
In January 1965, American manufacturers were working at 89.4% of capacity. The next peak in manufacturing usage (capacity utilization is very cyclical) came in February 1973 at 88.8% of capacity. The following peaks were: December 1978 at 86.6% of capacity; January 1989 at 85.2% of capacity; December 1997 at 84.7% of capacity; and April 2007 at 81.7% of capacity.
Note that the troughs of the cycles in capacity utilization also fell since the 1960s. In December 1982, manufacturers in the United States worked at 70.9% of capacity and in June 2009, they worked at 68.2%. Currently, manufacturers are working at 74.1% of capacity.
In essence, businesses in the United States have been utilizing less and less human and physical capital over the past 50 years relative to the amounts of these productive factors that have been available. And, the policy makers just don’t seem to get it.
From Rich, in the article cited above, “Christina D. Romer, chairwoman of the Council of Economic Advisers, said the skills shortages reported by employers stem largely from a long-term structural shift in manufacturing, which should not be confused with the recent downturn. ‘I do think that manufacturing can come back to what it was before the recession,’ she said.” So, manufacturing will return to the new, lower level of capacity utilization that was achieved at its previous peak level, roughly 82% of capacity. And, this is good?
My guess is that capacity utilization will hit, maybe, 80% at the next peak. We are still talking about 20% of the manufacturing capital of the United States being underemployed, right in line with the 20% to 25% of employable labor in the United States being underemployed.
The fiscal stimulus proposed by “fundamentalist” Keynesian economists will not do the job. Additional, “blunt-edge” governmental expenditures may alleviate some of the current worker distress, but at the cost of postponing the adjustments that need to be made to restructure the economy, the restructuring that is now going on.
The problem with the “fundamentalist” Keynesian view is that it is constructed from a short term perspective. The basic attitude is that which is attributed to Keynes: “In the long run we are all dead.” This approach leads to a focus on only “current” problems. What is not explicitly stated is that we will deal with the longer-term problems when they become current problems.
The difficulty with this: the longer-term problems may require a different “medicine” than did the short-run problems.
Well, one could argue that the longer-term problems have become current. The short-term solution of forcing many companies to continue to employ people in “legacy” jobs and to continue to use “legacy” plant and equipment has resulted in higher and higher rates of worker under-employment and lower and lower rates of manufacturing capacity utilization.
Just more of the same does not seem to be an adequate answer.
Monday, May 10, 2010
More on Europe's 'Trilemma'
The name of John Maynard Keynes became prominent once again with financial collapse beginning in 2008 and the “Great Recession” that followed. I would like to introduce his thinking once again to maybe put the idea of the “Trilemma” into a historical perspective.
Yesterday, I wrote of the idea of the “Trilemma” and how it applied to the current situation in Europe (see “Europe’s ‘Trilemma’, http://seekingalpha.com/article/204066-europe-s-trilemma). Today I would like to hold up an earlier example that I believe highlights the difficulties faced by the European Union in attempting to resolve the problems it now faces. The earlier example is that of the United States going off the gold standard in August 1971.
The basic economic framework the world worked within in the 1950s and 1960s was created at the Bretton Woods conference in July 1944. Essentially, the Bretton Woods system was a fully negotiated monetary order aimed at governing monetary relations between member nations. The conference included 730 delegates from all “allied” nations which numbered 44 at the time. Out of this conference grew the International Monetary Fund (IMF) and the body that became the World Bank. These latter organizations became operational in 1945.
Primary among the obligations flowing out of the Bretton Woods system was the obligation for each country to adopt an economic policy that would maintain a fixed exchange rate (within a range of plus or minus one percent) in terms of gold. The IMF would be used to bridge temporary imbalances in a country’s balance of payments.
Historically John Maynard Keynes came to dominate the discussions at Bretton Woods and the resulting agreement that was signed by the participants reflected many of his ideas, some of which he had been promoting for twenty years or so. For more on the role Keynes played in international financial discussions during the 1919 to 1945 period see the book by Donald Markwell titled “John Maynard Keynes and International Relations” (http://seekingalpha.com/article/167893-john-maynard-keynes-and-international-relations-economic-paths-to-war-and-peace-by-donald-markwell).
Keynes was very forceful in promoting two policies he felt were crucial for the peace of the post-World War II period: the first was fixed exchange rates; and the second was independence for nations to follow their own economic policies. What he did not want was international capital mobility. That is, capital flowing freely between countries.
The driving force behind these policies was the worker unrest that dominated Western Europe in the post-World War I period which, of course, included the Great Depression. Of great concern was the possibility that Western civilization, the culture that Keynes was prominent in, was under siege. The problem was the Russian Revolution and the fear of potential Bolshevik revolution throughout Europe in the 1920s and 1930s.
It was crucial to Keynes that governments kept workers “fully employed” and not allow their (nominal) wages to decline. To do this, governments had to adopt economic policies that promoted “full employment” and that were necessarily independent of other nations so that they could respond to their internal labor markets.
The way to achieve the autonomy of the economic policy of governments was to fix the exchange rate of the currency.
But, there was a third part of the plan. The international movement of capital needed to be discouraged. Of course, at the time, gold was still an important aspect in the international movement of capital. Coming out of the experiences of the 1920s and 1930s there was grave concern that capital should remain inert, at best. A very lucid exposition of the existence of this attitude can be found in Liaquat Ahamed’s award winning book, “The Lords of Finance: The Bankers Who Broke the World” (http://seekingalpha.com/article/121616-financial-collapse-a-lesson-from-the-20s).
So, in line with the conclusions of the “Trilemma” argument, the post-World War II world implemented just two of the three policy goals. The Bretton Woods agreement created a world in which there were fixed exchange rates and autonomous national economic policies, but discouraged free international capital mobility.
The result: relative stability in the system during the 1950s when governments were generally conservative in terms of their monetary and fiscal affairs. However, in the 1960s, nations began to implement “Keynesian” type fiscal policies (note the “Keynesian” tax cut enacted by the Kennedy/Johnson administration) connected with a monetary policy stance that encouraged inflation (note the inflation/employment trade off in the popular economic model labeled the Phillips Curve). By 1968 or so, we Americans at least, were all “Keynesians” according to President Richard Nixon.
What occurred in the 1960s was the re-ignition of inflation and inflationary expectations as the Johnson administration pursued a fiscal policy that included both “guns and butter.” As inflation and inflationary expectations grew, financial innovation advanced as commercial banks became more international in scope and began raising funds throughout the world through the management of their liabilities. Note, for one, the development of the Eurodollar deposit.
International capital market mobility became a reality!
As a consequence, the Bretton Woods system could not hold. According to the “Trilemma” diagnosis, the world was trying to live with all three of the policy goals connected to the “Trilemma” and one of them had to go.
President Nixon believed that full employment was very important to him in terms of his re-election bid and so the autonomy of his administration’s economic policy could not be aborted. Furthermore, globalization was in its infancy and business and finance were pushing as hard as possible to keep international capital markets expanding. Hence, the fixed exchange rate had to go!
On August 15, 1971 President Nixon announced to the United States (and to the world) that America was going off the gold standard and the value of the dollar would be floated. The world was now different than it was before.
The basic reason I wanted to bring this episode to your attention was to provide some historical backing to the dilemma now facing the European Union. The “Trilemma” problem is relevant to what they are trying to achieve. Ignoring or assuming that Europe can overcome the conclusion reached in the “Trilemma” analysis is foolhardy. Therefore, we shall all be waiting to see how the European Union can resolve their dilemma. Enacting a bailout package is only a stopgap to dealing with the real issues the leaders of the EU face. The problem concerns the absence of real leadership in Europe!
Yesterday, I wrote of the idea of the “Trilemma” and how it applied to the current situation in Europe (see “Europe’s ‘Trilemma’, http://seekingalpha.com/article/204066-europe-s-trilemma). Today I would like to hold up an earlier example that I believe highlights the difficulties faced by the European Union in attempting to resolve the problems it now faces. The earlier example is that of the United States going off the gold standard in August 1971.
The basic economic framework the world worked within in the 1950s and 1960s was created at the Bretton Woods conference in July 1944. Essentially, the Bretton Woods system was a fully negotiated monetary order aimed at governing monetary relations between member nations. The conference included 730 delegates from all “allied” nations which numbered 44 at the time. Out of this conference grew the International Monetary Fund (IMF) and the body that became the World Bank. These latter organizations became operational in 1945.
Primary among the obligations flowing out of the Bretton Woods system was the obligation for each country to adopt an economic policy that would maintain a fixed exchange rate (within a range of plus or minus one percent) in terms of gold. The IMF would be used to bridge temporary imbalances in a country’s balance of payments.
Historically John Maynard Keynes came to dominate the discussions at Bretton Woods and the resulting agreement that was signed by the participants reflected many of his ideas, some of which he had been promoting for twenty years or so. For more on the role Keynes played in international financial discussions during the 1919 to 1945 period see the book by Donald Markwell titled “John Maynard Keynes and International Relations” (http://seekingalpha.com/article/167893-john-maynard-keynes-and-international-relations-economic-paths-to-war-and-peace-by-donald-markwell).
Keynes was very forceful in promoting two policies he felt were crucial for the peace of the post-World War II period: the first was fixed exchange rates; and the second was independence for nations to follow their own economic policies. What he did not want was international capital mobility. That is, capital flowing freely between countries.
The driving force behind these policies was the worker unrest that dominated Western Europe in the post-World War I period which, of course, included the Great Depression. Of great concern was the possibility that Western civilization, the culture that Keynes was prominent in, was under siege. The problem was the Russian Revolution and the fear of potential Bolshevik revolution throughout Europe in the 1920s and 1930s.
It was crucial to Keynes that governments kept workers “fully employed” and not allow their (nominal) wages to decline. To do this, governments had to adopt economic policies that promoted “full employment” and that were necessarily independent of other nations so that they could respond to their internal labor markets.
The way to achieve the autonomy of the economic policy of governments was to fix the exchange rate of the currency.
But, there was a third part of the plan. The international movement of capital needed to be discouraged. Of course, at the time, gold was still an important aspect in the international movement of capital. Coming out of the experiences of the 1920s and 1930s there was grave concern that capital should remain inert, at best. A very lucid exposition of the existence of this attitude can be found in Liaquat Ahamed’s award winning book, “The Lords of Finance: The Bankers Who Broke the World” (http://seekingalpha.com/article/121616-financial-collapse-a-lesson-from-the-20s).
So, in line with the conclusions of the “Trilemma” argument, the post-World War II world implemented just two of the three policy goals. The Bretton Woods agreement created a world in which there were fixed exchange rates and autonomous national economic policies, but discouraged free international capital mobility.
The result: relative stability in the system during the 1950s when governments were generally conservative in terms of their monetary and fiscal affairs. However, in the 1960s, nations began to implement “Keynesian” type fiscal policies (note the “Keynesian” tax cut enacted by the Kennedy/Johnson administration) connected with a monetary policy stance that encouraged inflation (note the inflation/employment trade off in the popular economic model labeled the Phillips Curve). By 1968 or so, we Americans at least, were all “Keynesians” according to President Richard Nixon.
What occurred in the 1960s was the re-ignition of inflation and inflationary expectations as the Johnson administration pursued a fiscal policy that included both “guns and butter.” As inflation and inflationary expectations grew, financial innovation advanced as commercial banks became more international in scope and began raising funds throughout the world through the management of their liabilities. Note, for one, the development of the Eurodollar deposit.
International capital market mobility became a reality!
As a consequence, the Bretton Woods system could not hold. According to the “Trilemma” diagnosis, the world was trying to live with all three of the policy goals connected to the “Trilemma” and one of them had to go.
President Nixon believed that full employment was very important to him in terms of his re-election bid and so the autonomy of his administration’s economic policy could not be aborted. Furthermore, globalization was in its infancy and business and finance were pushing as hard as possible to keep international capital markets expanding. Hence, the fixed exchange rate had to go!
On August 15, 1971 President Nixon announced to the United States (and to the world) that America was going off the gold standard and the value of the dollar would be floated. The world was now different than it was before.
The basic reason I wanted to bring this episode to your attention was to provide some historical backing to the dilemma now facing the European Union. The “Trilemma” problem is relevant to what they are trying to achieve. Ignoring or assuming that Europe can overcome the conclusion reached in the “Trilemma” analysis is foolhardy. Therefore, we shall all be waiting to see how the European Union can resolve their dilemma. Enacting a bailout package is only a stopgap to dealing with the real issues the leaders of the EU face. The problem concerns the absence of real leadership in Europe!
Sunday, July 5, 2009
Deficits and the Declining Value of the Dollar
One of the questions that has arisen from the posts I have put up over the last several months has to do with my statement that the international financial community doesn’t like government deficits and tends to believe that a lack of fiscal discipline will result in an increased monetization of the debt. The feeling that the central bank of such a country cannot, in the longer run, overcome the fiscal imprudence of its national government and act independently of that government has resulted, time and again, in a decline in the value of the currency of the country being examined. The dollar is no exception.
Let’s look at the following information.
Average Yearly Increase in Gross Federal Debt (in billions of dollars)
Nixon/Ford $49.5
Carter $90.2
Reagan $258.6
Bush 41 $359.3
Clinton $232.1
Bush 43 $541.1
Now let’s look at the decline in the value of the dollar from the start of an administration to the end of that administration. I will use the trade weighted index of the United States dollar versus major currencies. The series begins in January 1973. Up until August 1971 the United States had a fixed exchange rate. At that time President Nixon announced that he was allowing the dollar to float in foreign exchange markets and was taking the United States off of the gold standard.
He also announced that “We are all Keynesians now!” meaning that he was going to stimulate the economy with budget deficits (so that he could get re-elected) and to protect against inflation he was freezing wages and prices. He created the Cost of Living Council and the Committee on Interest and Dividends to administer these controls as well as controls on interest rates. As can be seen from the above figures, the Gross Federal Debt increased by an average of almost $50 billion every year during the Nixon/Ford years. This compares with those spendthrifts John Kennedy and Lyndon Johnson who introduced Keynesian economic policies to the United States and who only increased the Gross Federal Debt by an average of less than $10 billion per year.
Change in the value of the dollar (as measured against major foreign currencies).
Nixon/Ford - 1.0 %
Carter - 10.4 %
Reagan - 5.7%
Bush 41 - 1.9 %
Clinton + 16.6%
Bush 41 - 21.6%
Note that the only administration to see a rise in the value of the dollar over the past forty years was the Clinton administration. Note, too, that the only break in the continued increase in the Gross Federal Debt outstanding was during the Clinton administration. As you may recall, the last four years it was in office, the Clinton administration ran budget surpluses.
Also, one can remember the accolades received by Paul Volcker, when he was the Chairman of the Board of Governors of the Federal Reserve System, for bringing inflation under control. Volcker was Chairman from August 1979 until August 1987. Volcker did bring inflation under control and early on this effort was reflected in a rise in the value of the United States dollar. The value of the dollar reached a short term bottom in July 1980 and then, accompanying the decline of inflation in the United States, the dollar rose in value by 55 percent to peak out on March 1985. However, even Volcker could not hold out against the massive deficits that the Reagan administration was piling up and the value of the dollar fell from that peak by 31 percent through the month at Volcker left his position at the Fed. Even someone as strong as Paul Volcker could not fight against the increasing deficits that were being posted by the Reagan administration. The value of the dollar closed lower at the end of the Reagan years than it was at the start.
The only conclusion one can draw from these data is that participants in international financial markets do not like the currency of countries that lack discipline over their fiscal affairs. This, of course, has very strong implications for the Obama administration. With the possibility that the Gross Federal Debt is on a trajectory in which the debt will increase in the $1.0 trillion range per year, at least for the near term, the implications seem clear. There will be continued pressure on the value of the United States dollar in the upcoming years.
The specific argument for this relationship is that increased federal deficits will result in increased monetization of the debt. Increased monetization of the debt will result in an increased rate of inflation. An increased rate of inflation will cause the value of the currency to decline. So, the question being posed by skeptics right now is “where is the inflation?” The time seems more right for deflation rather than inflation.
In the short run it is hard to argue against this logic. The only thing one can fall back on to answer this question is the fact that when budget deficits increase and there is no relief from substantial increases in the debt of the country, participants in international markets tend to sell the currency. What we have seen in the past is that any inflation that results from the massive increase in the debt outstanding can come in many forms that are not all registered in the computed price indices like the Consumer Price Index. Something like the CPI is an estimate, a guess at what is happening to prices. The important thing to remember about massive increases in debt is that they have to go somewhere and where ever they go they will have large consequences. We hope that we can measure these consequences and measure them in a timely manner. However, that does not always happen.
And, where else are we seeing action? India has now joined China and Russia and Brazil in calling for a discussion at the upcoming G-8 conference of the place of the United States dollar in the world’s monetary system. China is tired of continuing to support its currency against the United States dollar. Given the likelihood of a further decline in the value of the dollar, China faces the need to buy more and more dollars and invest in more and more securities from the United States. This, in the longer run, is not in China’s best interest. Nations, other than England and those from the Eurozone, are getting tired of the United States abusing its privilege of having the only reserve currency in the world. Although nothing is going to be done to change the monetary system at this time, this talk is going to get stronger and stronger. And, if the value of the dollar continues to decline in the future, the arguments are going to resonate more and more with others in the world. The basic approach to fiscal policy in the United States over the past 50 years has not been the most productive one in terms of maintaining a sound dollar currency.
Let’s look at the following information.
Average Yearly Increase in Gross Federal Debt (in billions of dollars)
Nixon/Ford $49.5
Carter $90.2
Reagan $258.6
Bush 41 $359.3
Clinton $232.1
Bush 43 $541.1
Now let’s look at the decline in the value of the dollar from the start of an administration to the end of that administration. I will use the trade weighted index of the United States dollar versus major currencies. The series begins in January 1973. Up until August 1971 the United States had a fixed exchange rate. At that time President Nixon announced that he was allowing the dollar to float in foreign exchange markets and was taking the United States off of the gold standard.
He also announced that “We are all Keynesians now!” meaning that he was going to stimulate the economy with budget deficits (so that he could get re-elected) and to protect against inflation he was freezing wages and prices. He created the Cost of Living Council and the Committee on Interest and Dividends to administer these controls as well as controls on interest rates. As can be seen from the above figures, the Gross Federal Debt increased by an average of almost $50 billion every year during the Nixon/Ford years. This compares with those spendthrifts John Kennedy and Lyndon Johnson who introduced Keynesian economic policies to the United States and who only increased the Gross Federal Debt by an average of less than $10 billion per year.
Change in the value of the dollar (as measured against major foreign currencies).
Nixon/Ford - 1.0 %
Carter - 10.4 %
Reagan - 5.7%
Bush 41 - 1.9 %
Clinton + 16.6%
Bush 41 - 21.6%
Note that the only administration to see a rise in the value of the dollar over the past forty years was the Clinton administration. Note, too, that the only break in the continued increase in the Gross Federal Debt outstanding was during the Clinton administration. As you may recall, the last four years it was in office, the Clinton administration ran budget surpluses.
Also, one can remember the accolades received by Paul Volcker, when he was the Chairman of the Board of Governors of the Federal Reserve System, for bringing inflation under control. Volcker was Chairman from August 1979 until August 1987. Volcker did bring inflation under control and early on this effort was reflected in a rise in the value of the United States dollar. The value of the dollar reached a short term bottom in July 1980 and then, accompanying the decline of inflation in the United States, the dollar rose in value by 55 percent to peak out on March 1985. However, even Volcker could not hold out against the massive deficits that the Reagan administration was piling up and the value of the dollar fell from that peak by 31 percent through the month at Volcker left his position at the Fed. Even someone as strong as Paul Volcker could not fight against the increasing deficits that were being posted by the Reagan administration. The value of the dollar closed lower at the end of the Reagan years than it was at the start.
The only conclusion one can draw from these data is that participants in international financial markets do not like the currency of countries that lack discipline over their fiscal affairs. This, of course, has very strong implications for the Obama administration. With the possibility that the Gross Federal Debt is on a trajectory in which the debt will increase in the $1.0 trillion range per year, at least for the near term, the implications seem clear. There will be continued pressure on the value of the United States dollar in the upcoming years.
The specific argument for this relationship is that increased federal deficits will result in increased monetization of the debt. Increased monetization of the debt will result in an increased rate of inflation. An increased rate of inflation will cause the value of the currency to decline. So, the question being posed by skeptics right now is “where is the inflation?” The time seems more right for deflation rather than inflation.
In the short run it is hard to argue against this logic. The only thing one can fall back on to answer this question is the fact that when budget deficits increase and there is no relief from substantial increases in the debt of the country, participants in international markets tend to sell the currency. What we have seen in the past is that any inflation that results from the massive increase in the debt outstanding can come in many forms that are not all registered in the computed price indices like the Consumer Price Index. Something like the CPI is an estimate, a guess at what is happening to prices. The important thing to remember about massive increases in debt is that they have to go somewhere and where ever they go they will have large consequences. We hope that we can measure these consequences and measure them in a timely manner. However, that does not always happen.
And, where else are we seeing action? India has now joined China and Russia and Brazil in calling for a discussion at the upcoming G-8 conference of the place of the United States dollar in the world’s monetary system. China is tired of continuing to support its currency against the United States dollar. Given the likelihood of a further decline in the value of the dollar, China faces the need to buy more and more dollars and invest in more and more securities from the United States. This, in the longer run, is not in China’s best interest. Nations, other than England and those from the Eurozone, are getting tired of the United States abusing its privilege of having the only reserve currency in the world. Although nothing is going to be done to change the monetary system at this time, this talk is going to get stronger and stronger. And, if the value of the dollar continues to decline in the future, the arguments are going to resonate more and more with others in the world. The basic approach to fiscal policy in the United States over the past 50 years has not been the most productive one in terms of maintaining a sound dollar currency.
Wednesday, February 11, 2009
The Three Problems We Face: Debt, Debt, and Debt!
The focus is wrong. The focus is on the demand side of the economy. As John Maynard Keynes argued, “most practical men are indeed in thrall to the ideas of some long dead economist”…and that long dead economist is John Maynard Keynes. Niall Ferguson refers to the policy makers of today as “born again Keynesians”! And, so the focus remains on stimulating demand.
As a consequence there seems to be a disconnect between what the policy makers are producing in terms of stimulus and bailout and what others, financial markets and individual consumers and families, are experiencing. The debt overhang is stifling everything and this must be corrected before the contraction can be stopped.
This makes the problem in the economy a “supply” problem and not a problem of demand. It is a supply problem because the response to excessive amounts of debt is to save and to reduce leverage. And, this delevering is a cumulative process and either must be overcome by massive inflation…or, it must work itself out.
The explosion of credit is like a house of cards…with the underlying danger being that once the house begins to collapse…the whole house is affected. Given the incentives created by Bush43, the credit pyramid grew. The increases in government debt and the excessively low interest rates maintained by the Greenspan Fed set the standard for the day. And, the private sector followed…the private sector took on more and more risk…and financed their riskier positions with more and more leverage. The whole credit structure became shakier and shakier.
The problem with a house of cards is that once one of the cards on a lower level is removed…the whole house can come down. Experience teaches us that some portions of the house may not collapse…but, if the card removed is at the base of the house…it will likely be the case that a large amount of the house will fall…
The card that was pulled out of the house of cards this time was housing finance. As we know now the subprime market can be identified as the place where the collapse began. But, this level of finance supported a large component of the house of credit in the form of mortgage-backed securities and then other derivative securities and tools that used this base of mortgages as the foundation of the structure. And, the house began to fall.
Of course, we are waiting for other parts of the mortgage house to fall…those connected with the next wave of interest rate re-pricings connected with Alt-A mortgages and options mortgages that will be taking place over the next 18 months or so. And, this does not include other consumer debt like equity lines, credit cards, car loans and so forth. It also does not include the collapse of the banking system and other components of the finance industry.
As we have seen the collapse in the housing market has spread to other areas of the financial market. Contagion is the word to describe this spread. And, the problem has become a world wide problem with problems in financial institutions and beyond throughout the developed world and into the emerging nations.
What is the response to the existence of too much debt?
Well, there are two. The first response is to create inflation. Pour money into the system and artificially create spending so that resources are put back to work…eventually creating sufficient demand so that prices begin rising again. This is the Keynesian way…reduce the real value of the debt outstanding. And, the only way to do this is by “printing money.” If the banking system seems to be clogged up…why then let the Federal government begin to spend…finance the spending by selling Treasury securities…but sell the debt directly to the Federal Reserve where the central bank will just give the Treasury Department a demand deposit at some commercial bank. That is the demand side response.
The other response to the fact that there is too much debt is for people to pull back their expenditures…withdraw from the spending stream…and pay down debt in whatever way they can. This is what is happening now and this has been called historically a debt/deflation. It is basically the process of delevering the economy so that economic units can return to reasonable debt levels on their balance sheet.
Unless people come to believe that the government is going to create a substantial enough inflation to reduce the “real” value of their debt to reasonable levels…they will not stop their attempt to get their lives back in order with a reduced amount of debt on their balance sheets. This is why this process is a cumulative one…a process that eventually must work itself out before the economy bottoms out and a return to growth can occur.
One of solution to this overhang is to write down the debt. I dealt with this issue in my post of February 4, 2009, “Two Painful Proposals to Reduce Our Excess Debt,” http://seekingalpha.com/article/118475-two-painful-proposals-to-reduce-our-excess-debt, so I won’t go into it further here. A plan like this is politically difficult because writing down the debt of those that over-extended themselves looks like we are bailing out the undisciplined or the scoundrels at the expense of the prudent and honest. Such an appearance carries with it severe political risks.
However, if the debt levels have to be reduced at some time…this overhang of excessive debt is going to have to be worked out one way or another. Half-way plans are not going to work. (See my post of February 9, 2009, “Obama Stimulus Plan: Bailout or Wimp Out?”, http://seekingalpha.com/article/119347-obama-stimulus-plan-bailout-or-wimp-out.) The government in Washington, D. C. is going to have to bite-the-bullet sometime…the question is just whether they are going to do it now…or do it later when things get worse.
And, let me just re-enforce my argument of above. Ultimately, this is a supply side problem…not a demand side problem. The attempt to pull off a demand side victory hangs on the balance of when inflation can be restarted and how much inflation can be generated to significantly reduce the “real” value of the debt.
The problem with this effort, however, is that an inflationary environment is one in which the incentive is to add on more debt…just what we are trying to get away from. Hasn’t the experience of the 2000s convinced us that this is not what we want to do?
The problem with supply side solutions is that they take time and are not as showing as are demand side “stimulus plans.” Also, they tend to be directed toward those individuals and organizations that are under a dark cloud these days. For example, there is the proposal put forward by Bob Barro to eliminate the corporate income tax. (See “Government Spending is No Free Lunch,” http://online.wsj.com/article/SB123258618204604599.html?mod=todays_us_opinion.)
The stock market did not respond well to the initial showing of the Obama Bank Bailout plan presented by Tim Geithner yesterday. To me this plan is sending mixed signals…mainly because it is on the tepid side. We have a demand side plan…the Obama Stimulus Plan…and we have a plan to cushion the problem of excessive debt…the Obama Bank Bailout Plan. The two plans don’t seem to mesh and give off the signal that the administration has not yet got its act together. The question then becomes…will it get its act together?
The debt issue must be dealt with…and firmly. At this time…firmly is not a word I would use.
As a consequence there seems to be a disconnect between what the policy makers are producing in terms of stimulus and bailout and what others, financial markets and individual consumers and families, are experiencing. The debt overhang is stifling everything and this must be corrected before the contraction can be stopped.
This makes the problem in the economy a “supply” problem and not a problem of demand. It is a supply problem because the response to excessive amounts of debt is to save and to reduce leverage. And, this delevering is a cumulative process and either must be overcome by massive inflation…or, it must work itself out.
The explosion of credit is like a house of cards…with the underlying danger being that once the house begins to collapse…the whole house is affected. Given the incentives created by Bush43, the credit pyramid grew. The increases in government debt and the excessively low interest rates maintained by the Greenspan Fed set the standard for the day. And, the private sector followed…the private sector took on more and more risk…and financed their riskier positions with more and more leverage. The whole credit structure became shakier and shakier.
The problem with a house of cards is that once one of the cards on a lower level is removed…the whole house can come down. Experience teaches us that some portions of the house may not collapse…but, if the card removed is at the base of the house…it will likely be the case that a large amount of the house will fall…
The card that was pulled out of the house of cards this time was housing finance. As we know now the subprime market can be identified as the place where the collapse began. But, this level of finance supported a large component of the house of credit in the form of mortgage-backed securities and then other derivative securities and tools that used this base of mortgages as the foundation of the structure. And, the house began to fall.
Of course, we are waiting for other parts of the mortgage house to fall…those connected with the next wave of interest rate re-pricings connected with Alt-A mortgages and options mortgages that will be taking place over the next 18 months or so. And, this does not include other consumer debt like equity lines, credit cards, car loans and so forth. It also does not include the collapse of the banking system and other components of the finance industry.
As we have seen the collapse in the housing market has spread to other areas of the financial market. Contagion is the word to describe this spread. And, the problem has become a world wide problem with problems in financial institutions and beyond throughout the developed world and into the emerging nations.
What is the response to the existence of too much debt?
Well, there are two. The first response is to create inflation. Pour money into the system and artificially create spending so that resources are put back to work…eventually creating sufficient demand so that prices begin rising again. This is the Keynesian way…reduce the real value of the debt outstanding. And, the only way to do this is by “printing money.” If the banking system seems to be clogged up…why then let the Federal government begin to spend…finance the spending by selling Treasury securities…but sell the debt directly to the Federal Reserve where the central bank will just give the Treasury Department a demand deposit at some commercial bank. That is the demand side response.
The other response to the fact that there is too much debt is for people to pull back their expenditures…withdraw from the spending stream…and pay down debt in whatever way they can. This is what is happening now and this has been called historically a debt/deflation. It is basically the process of delevering the economy so that economic units can return to reasonable debt levels on their balance sheet.
Unless people come to believe that the government is going to create a substantial enough inflation to reduce the “real” value of their debt to reasonable levels…they will not stop their attempt to get their lives back in order with a reduced amount of debt on their balance sheets. This is why this process is a cumulative one…a process that eventually must work itself out before the economy bottoms out and a return to growth can occur.
One of solution to this overhang is to write down the debt. I dealt with this issue in my post of February 4, 2009, “Two Painful Proposals to Reduce Our Excess Debt,” http://seekingalpha.com/article/118475-two-painful-proposals-to-reduce-our-excess-debt, so I won’t go into it further here. A plan like this is politically difficult because writing down the debt of those that over-extended themselves looks like we are bailing out the undisciplined or the scoundrels at the expense of the prudent and honest. Such an appearance carries with it severe political risks.
However, if the debt levels have to be reduced at some time…this overhang of excessive debt is going to have to be worked out one way or another. Half-way plans are not going to work. (See my post of February 9, 2009, “Obama Stimulus Plan: Bailout or Wimp Out?”, http://seekingalpha.com/article/119347-obama-stimulus-plan-bailout-or-wimp-out.) The government in Washington, D. C. is going to have to bite-the-bullet sometime…the question is just whether they are going to do it now…or do it later when things get worse.
And, let me just re-enforce my argument of above. Ultimately, this is a supply side problem…not a demand side problem. The attempt to pull off a demand side victory hangs on the balance of when inflation can be restarted and how much inflation can be generated to significantly reduce the “real” value of the debt.
The problem with this effort, however, is that an inflationary environment is one in which the incentive is to add on more debt…just what we are trying to get away from. Hasn’t the experience of the 2000s convinced us that this is not what we want to do?
The problem with supply side solutions is that they take time and are not as showing as are demand side “stimulus plans.” Also, they tend to be directed toward those individuals and organizations that are under a dark cloud these days. For example, there is the proposal put forward by Bob Barro to eliminate the corporate income tax. (See “Government Spending is No Free Lunch,” http://online.wsj.com/article/SB123258618204604599.html?mod=todays_us_opinion.)
The stock market did not respond well to the initial showing of the Obama Bank Bailout plan presented by Tim Geithner yesterday. To me this plan is sending mixed signals…mainly because it is on the tepid side. We have a demand side plan…the Obama Stimulus Plan…and we have a plan to cushion the problem of excessive debt…the Obama Bank Bailout Plan. The two plans don’t seem to mesh and give off the signal that the administration has not yet got its act together. The question then becomes…will it get its act together?
The debt issue must be dealt with…and firmly. At this time…firmly is not a word I would use.
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