Paul Krugman says it all this morning in the New York Times: “If Spain still had its own currency, like the United States—or like Britain, which shares some of the same characteristics—it could have let that currency fall, making its industry competitive again. But with Spain on the euro, that option isn’t available.” (http://www.nytimes.com/2010/11/29/opinion/29krugman.html?_r=1&hp)
It’s that Trilemma thing again!
The Trilemma problem in international financial theory is that a nation can only achieve two out of the following three objectives: it can participate in the international flow of capital; it can have a fixed exchange rate; or it can conduct an economic policy that is independent of every other nation.
Spain, and other nations in the Euro-zone, is constrained by the first two of these objectives. Being a part of the Euro-currency-system, Spain has, in effect, a fixed exchange rate with all other nations in the Euro-zone. Spain also benefits from participating in the international flow of capital.
Given that these two conditions exist within the Euro-zone, Spain, and all other nations within the Euro-zone, cannot conduct its economic policy independently of every other nation within this currency area.
If Spain could conduct its economic policy independently of every other nation within the Euro-zone it could inflate its debt and currency all it wanted to and just suffer the injustice of seeing the value of its currency decline in the international financial markets. But, this would be “good” according to Krugman because the falling value of its currency would make its industry competitive again.
The problem in Europe, according to this fundamentalist Keynesian preaching, is Germany. Germany is the most disciplined country within the Euro-zone and hence is causing all sorts of problems for Greece, Ireland, Portugal, Spain, and possibly Italy and France. And, when times get tough, discipline wins.
This situation highlights the difficulty in attempting to build a currency area. A currency area has a single currency. So, by definition, a “fixed” exchange rate exists within the area. Unrestricted capital flows are very desirable within a currency area because everyone benefits when capital can flow to its most productive uses.
That leaves one prong of the Trilemma hanging…independent economic programs.
This has always been the “hidden bump” along the road to the formation of a currency area. Governments within the currency area need to conduct economic policies that are consistent with one another. But, governments don’t like to give up this independence.
And, if you have a nation like the Germans who believe in self-control and fiscal discipline, it becomes hard for nations who chaff at self-control and believe in credit inflation to continue upon their path forever.
Keynes realized this problem in attempting to construct his economic model in the 1920s and create the post-World War II international monetary system. Keynes knew that his proposals for debt inflation depended upon nations having the ability to conduct their economic policies independently of one another. And, he was, during this time period, very adamant about having a system of fixed exchange rates. Thus, Keynes advocated controls on the international flow of capital.
Unfortunately for Keynes’ view of the post-World War II environment, international capital flows increased, particularly in the 1960s and have accelerated ever since.
What then has to give? Fixed exchange rates or the ability of a nation to conduct its economic policy independently of other nations?
The United States, in August 1971, chose to do away with fixed exchange rates. The Euro-zone came into existence in 1993 and on January 1, 1999 opted for a one-currency system by introducing the euro to the world. The Euro-zone created a single central bank for the area, the European Central Bank which began business in 1998, but allowed national governments to still conduct their budgetary policies independently of one another.
Thus, countries in the Euro-zone could maintain self-control and discipline, if they so desired, or, they could creates mounds of debt and live way beyond their means, if that was what they wished to do. Governments did not want this choice taken away from them.
Times went well for the Euro-zone and most seemed happy with the existing arrangements. Then, the bond markets got antsy. And, we had the first “debt crisis” in the Euro-zone earlier this year. Band-Aids were felt to be appropriate.
Now, we are in the second “debt crisis” and the bill is coming due. Wouldn’t it be nice, as Krugman suggests, to keep on inflating and just let the value of the currency declining? Remember in the economic model Krugman uses there is no debt and no penalty for piling up more and more debt. No harm, no foul!
Therefore, Krugman believes, Spain should be as fortunate as the United States: “The good news about America is that we aren’t in that kind of trap: we still have our own currency, with all the flexibility that implies.”
America can create debt and inflate its currency all it wants to and no one else can do anything about it!
Yet, there is a conspiracy afoot. Now, Krugman has joined Oliver Stone! The “bad guys” are trying to stifle government spending and constrain the Federal Reserve System. These “bad guys” are trying to “voluntarily put (America) in the Spanish prison.”
Does Krugman advocate the demise of the euro? Krugman doesn’t really see this happening because of the disruption it would create. Therefore, Spain must remain in a prison of its own creation.
Germany has contemplated this move. But, Germany really doesn’t want the Euro-zone to fall apart. (See “Crises Shake German Trust in Euro-Zone”: http://www.nytimes.com/2010/11/27/world/europe/27germany.html?scp=10&sq=michael%20slackman&st=cse.)
Maybe the continuing efforts to provide rescues to member nations may lead to a more unified Euro-zone that realizes and accepts greater coordination of national economic policies. The road to such a solution, however, has many, many bumps and potholes along the way. Countries that have established overly-generous social policies may not be able to reconcile their demands with that of the more controlled nations, like Germany, that support greater fiscal and monetary discipline.
The conclusion to this story is far from over.
Showing posts with label Keynes. Show all posts
Showing posts with label Keynes. Show all posts
Monday, November 29, 2010
Thursday, October 28, 2010
International Capital Mobility: the United States Dilemma
In this globalized world, international capital mobility must be taken as a given.
According to modern international economic theory, if international capital mobility is a given, then there are only two other policy choices left a nation, but that nation can only choose one of the two. The first is a fixed exchange rate and the second is the ability to run an independent government economic policy. By independent is meant that a nation’s economic policy can be run according to the internal goals and objectives of that nation without regard to the economic policy of any other nation in the world.
The assumption has been that a nation can follow an independent path internally so as to achieve high levels of employment as well as other social goals like attempting to put every family in the country in its own home.
The United States began following a fully independent economic path in the 1960s and with the growing mobility of capital globally following World War II, the Nixon administration found it could not continue keeping the value of the dollar tied to a gold standard. In August 1971, President Nixon released the dollar and allowed its value to float.
The basic assumption of this move was that the value of the dollar would adjust in international markets so that the United States government could inflate the economy so as to achieve full employment of its labor force. As credit inflation took place within the country, the value of the dollar would decline causing exports to increase which would keep the labor market fully engaged.
One problem: this assumed that the United States economy would stay competitive with other nations. Unfortunately, this assumption did not hold as the credit inflation within the United States resulted in a deterioration of the competitive base of American industry.
A consequence of this deterioration is that American exports could not keep up with the competition in world markets. As the value of the dollar declined, exports did not expand as the economic model predicted. Charles Kadlec reported in the Wall Street Journal that as the value of the dollar declined dramatically over the 42 years following 1967 “net exports have fallen from a modest surplus in 1967 to a $390 billion deficit equivalent to 2.7% of GDP today.” (http://professional.wsj.com/article/SB10001424052748703440004575548451304697496.html?mod=WSJ_Opinion_LEFTTopOpinion&mg=reno-wsj)
Hello?
Is the market trying to tell us something?
In my post yesterday, I presented information cited by Tom Freidman in the New York Times who focused on a report from the National Academies listing how the United States has declined from being a leader in innovation and technology. The conclusion from this report is that the United States just is not as competitive in the world as it was fifty years ago.
Bloomberg adds further evidence that the world is shifting in terms of competitive action. How do you like this headline? “IPOs in Asia Grab Record Share of Funds as U. S. Offers Dry Up.” (http://www.bloomberg.com/news/2010-10-27/ipos-in-asia-grab-record-share-of-global-funds-as-u-s-offerings-dry-up.html)
“‘What the market needs and wants is a lot more IPOs coming out of China,’ said Jeff Urbina, who oversees emerging-market strategy at Chicago-based William Blair, which manages more than $41 billion. ‘That’s where the growth is.’”
The article states that “Record demand for initial public offerings in Asia is reducing the share of U. S. IPOs to an all-time low as companies from China to Malaysia and India flood the market with more equity than ever.”
Who says the world is not shifting?
And, then, in another blow to American pride, we learn that the Chinese have built a supercomputer that has 1.4 times the horsepower of the fastest computer that exists in the United States. (http://www.nytimes.com/2010/10/28/technology/28compute.html?hp)
Maybe, just maybe, the United States needs to take a hard look at the economic philosophy it has based economic policy on over the past fifty years. Maybe an economic policy based upon credit inflation is not productive in the longer run after all.
There is substantial information being produced by the market place to indicate that maybe the predominant economic model in the United States, the “Keynesian” model, does not produce the results that we want. In fact, the information is pointing to the fact that, in the long run, the results that are produced by this model are exactly the opposite of what people were trying to achieve.
However, the real Keynes argued that when the facts seemed to point away from the models currently in use, one should change the models that are being used.
Maybe, just maybe, we should listen to this Keynes and not to the “Keynesian” true-believers that preach the fundamentalist gospel that has dominated economic policy making over the past fifty years.
According to modern international economic theory, if international capital mobility is a given, then there are only two other policy choices left a nation, but that nation can only choose one of the two. The first is a fixed exchange rate and the second is the ability to run an independent government economic policy. By independent is meant that a nation’s economic policy can be run according to the internal goals and objectives of that nation without regard to the economic policy of any other nation in the world.
The assumption has been that a nation can follow an independent path internally so as to achieve high levels of employment as well as other social goals like attempting to put every family in the country in its own home.
The United States began following a fully independent economic path in the 1960s and with the growing mobility of capital globally following World War II, the Nixon administration found it could not continue keeping the value of the dollar tied to a gold standard. In August 1971, President Nixon released the dollar and allowed its value to float.
The basic assumption of this move was that the value of the dollar would adjust in international markets so that the United States government could inflate the economy so as to achieve full employment of its labor force. As credit inflation took place within the country, the value of the dollar would decline causing exports to increase which would keep the labor market fully engaged.
One problem: this assumed that the United States economy would stay competitive with other nations. Unfortunately, this assumption did not hold as the credit inflation within the United States resulted in a deterioration of the competitive base of American industry.
A consequence of this deterioration is that American exports could not keep up with the competition in world markets. As the value of the dollar declined, exports did not expand as the economic model predicted. Charles Kadlec reported in the Wall Street Journal that as the value of the dollar declined dramatically over the 42 years following 1967 “net exports have fallen from a modest surplus in 1967 to a $390 billion deficit equivalent to 2.7% of GDP today.” (http://professional.wsj.com/article/SB10001424052748703440004575548451304697496.html?mod=WSJ_Opinion_LEFTTopOpinion&mg=reno-wsj)
Hello?
Is the market trying to tell us something?
In my post yesterday, I presented information cited by Tom Freidman in the New York Times who focused on a report from the National Academies listing how the United States has declined from being a leader in innovation and technology. The conclusion from this report is that the United States just is not as competitive in the world as it was fifty years ago.
Bloomberg adds further evidence that the world is shifting in terms of competitive action. How do you like this headline? “IPOs in Asia Grab Record Share of Funds as U. S. Offers Dry Up.” (http://www.bloomberg.com/news/2010-10-27/ipos-in-asia-grab-record-share-of-global-funds-as-u-s-offerings-dry-up.html)
“‘What the market needs and wants is a lot more IPOs coming out of China,’ said Jeff Urbina, who oversees emerging-market strategy at Chicago-based William Blair, which manages more than $41 billion. ‘That’s where the growth is.’”
The article states that “Record demand for initial public offerings in Asia is reducing the share of U. S. IPOs to an all-time low as companies from China to Malaysia and India flood the market with more equity than ever.”
Who says the world is not shifting?
And, then, in another blow to American pride, we learn that the Chinese have built a supercomputer that has 1.4 times the horsepower of the fastest computer that exists in the United States. (http://www.nytimes.com/2010/10/28/technology/28compute.html?hp)
Maybe, just maybe, the United States needs to take a hard look at the economic philosophy it has based economic policy on over the past fifty years. Maybe an economic policy based upon credit inflation is not productive in the longer run after all.
There is substantial information being produced by the market place to indicate that maybe the predominant economic model in the United States, the “Keynesian” model, does not produce the results that we want. In fact, the information is pointing to the fact that, in the long run, the results that are produced by this model are exactly the opposite of what people were trying to achieve.
However, the real Keynes argued that when the facts seemed to point away from the models currently in use, one should change the models that are being used.
Maybe, just maybe, we should listen to this Keynes and not to the “Keynesian” true-believers that preach the fundamentalist gospel that has dominated economic policy making over the past fifty years.
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.
Wednesday, February 4, 2009
This Issue Is Debt! Too Much of It!
Going forward…the primary issue the world is going to have to face is debt…lots and lots of debt. Debt is clogging the blood vessels of the world financial system!
And the proposal to get us out of this dilemma?
Create even more debt!
If the problem is too much debt then the economy has to go through the pain of working this debt off…and this is called a debt/deflation. As people and companies and government reduce the amount of debt on their balance sheets they withdraw from the spending stream…and save…exactly what people and companies and governments are doing at the present time. But, removing spending from the spending stream reduces the demand for goods and services, causes firms to cut people from their employee rolls…and creates a downward spiral in economic activity. The economy engages in cumulative behavior and gets deeper and deeper into a hole.
This is what the people and the government want to avoid…if possible.
The Obama stimulus proposal is a way to get us out of the current economic crisis.
(There is another way that I will discuss below.) Basically, it is an attempt to inflate our way out of all the debt that exists. The Federal Reserve is doing its part in trying to pump up the amount of cash that exists within the system. But, creating money in this way takes time for the inflation to work its way through the system because it must go through banks and other financial organizations. And, this system, right now, seems to be functioning at a very low level.
Keynes saw this problem in the 1930s and proposed a way of getting around the banking and financial systems…create massive amounts of government expenditures and put this spending directly in the economic system…financing the deficits with government debt. Then, as the economic system starts to turnaround and pick up steam…the banking and financial system will pick up some steam and provide the “kicker” to create the inflationary environment needed to reduce the real value of the debt that had been built up…including the debt the government deficit spending just added to the pile.
Therefore, the first way to reduce the amount of debt that is outstanding in the economy is to create more debt so as to un-clog the banking and financial system…create an inflationary environment…and watch the “real value” of the debt decline.
This is a long term process and has several problems to face along the way. One of these is the question of how much spending should the government undertake? The issue here is about what the “multiplier” of government spending really is. I treated this in a post on January 26, 2009, titled “What will be the impact of Obama’s stimulus plan, http://seekingalpha.com/article/116414-what-will-be-the-impact-of-obama-s-stimulus-plan. Another question has to do with the process of enacting the stimulus plan into law. This I treated in a post on February 2, 2009, titled “the Obama Stimulus plan: Why I’m Concerned”, http://seekingalpha.com/article/117878-the-obama-stimulus-plan-why-i-m-concerned.
However, the ultimate issue relates to the amount of debt that is outstanding…in the United States…and in the world. If the amount of debt HAS to be reduced…and it must be reduced in order to get the economy functioning again…then, following this approach, inflation must take place to reduce the real value of the debt. The danger with this plan is that if inflation is not cut off at some time in the future, the incentives in the economy will be to return to a “go-right-on” and “business-as-usual” approach to living. That is…we will be right back where we were around the middle of this decade, where leverage was good and more leverage was even better, especially within an inflationary environment where things need to be kept “pumped up”! If this happens, we will still be addicted and still have the “monkey on our backs.”
Another way to reduce the amount of debt outstanding in the economy is to basically “write down” or “re-write” the debt and not create any more through an enormous fiscal stimulus plan like that proposed by the Obama administration. This would involve a massive restructuring of existing business balance sheets…both financial institutions as well as non-financial institutions. Insolvent institutions…including the auto companies…need to be recognized as such. In effect, existing shareholders in these companies have lost their investment…so much for good governance and oversight. Bondholders will have to accept an exchange…taking “new” debt at, say, 75% or 50% of the current face value…or preferred shares for the debt they hold…or taking an equity position in the company…maybe even warrants.
These exchanges would have to be negotiated…but the bondholders would have to understand that, as things now stand, the companies are insolvent and they could get nothing if the restructuring does not take place. Plus, the companies or the bondholders…or the public…really does not want the government to take over these institutions. We do not want state-run companies…financial or non-financial…because the fate of the nation would be much worse with a nationalization of industry than it would with an imposed “re-structuring” of the balance sheets of these businesses…financial and non-financial.
In terms of the consumer…a similar thing would have to take place. The major concern has been related to the housing sector and mortgages. But, we are now seeing a massive wave approaching of defaults on credit cards, car loans, and other types of debt that the consumer has taken on. Similar to the re-structuring of the business sector, the balance sheets of consumers must be re-structured. How we do this cannot really be discussed in this short post, but the idea would be that organizations that have extended credit to the consumer sector will have to take a haircut on the amount of debt that is owed by each consumer and the terms of repayment will have to be restructured in order to make the probability of repayment of the debt realistic. Again, this re-structuring would have to be negotiated…but we are talking here about much lower costs than would accumulate if there were more foreclosures and bankruptcies…more lawyers’ fees…and more costs all the way around. And, this could be done in a much shorter period of time than if all these bad assets had to be “worked out”.
I have given two extreme solutions to the problem of the debt overhang. The fundamental crisis is connected with the fact that there is too much debt in the system. For the system to work this dislocation out we would have to go through a period of debt-deflation. The two extremes presented here are, first, the Keynesian approach which is to inflate the economy and reduce the real value of the debt, or, second, to impose a debt-restructuring on the economy which would allow for a negotiated reduction in the debt loads of all economic units in the system.
People will really not be happy with either of these extreme solutions…or, for that matter…any combination of the efforts. But, once one loses their discipline, as the United States and the world did in the 2000s…there are no good solutions available to get out of the hole that has been dug. All people can do is to “take their medicine” and vow not to let such a situation ever occur again. However, looking back at history, one cannot be very confident that we will maintain our discipline once we get over the crisis.
I would like to make just one more suggestion. There is only one real change I would like to see to the regulatory structure…for both financial and non-financial firms…and that is the imposition of almost complete openness and transparency of the business and financial records of companies. Whatever a company does…it should be open to its owners…and to anyone else that might be interested.
And the proposal to get us out of this dilemma?
Create even more debt!
If the problem is too much debt then the economy has to go through the pain of working this debt off…and this is called a debt/deflation. As people and companies and government reduce the amount of debt on their balance sheets they withdraw from the spending stream…and save…exactly what people and companies and governments are doing at the present time. But, removing spending from the spending stream reduces the demand for goods and services, causes firms to cut people from their employee rolls…and creates a downward spiral in economic activity. The economy engages in cumulative behavior and gets deeper and deeper into a hole.
This is what the people and the government want to avoid…if possible.
The Obama stimulus proposal is a way to get us out of the current economic crisis.
(There is another way that I will discuss below.) Basically, it is an attempt to inflate our way out of all the debt that exists. The Federal Reserve is doing its part in trying to pump up the amount of cash that exists within the system. But, creating money in this way takes time for the inflation to work its way through the system because it must go through banks and other financial organizations. And, this system, right now, seems to be functioning at a very low level.
Keynes saw this problem in the 1930s and proposed a way of getting around the banking and financial systems…create massive amounts of government expenditures and put this spending directly in the economic system…financing the deficits with government debt. Then, as the economic system starts to turnaround and pick up steam…the banking and financial system will pick up some steam and provide the “kicker” to create the inflationary environment needed to reduce the real value of the debt that had been built up…including the debt the government deficit spending just added to the pile.
Therefore, the first way to reduce the amount of debt that is outstanding in the economy is to create more debt so as to un-clog the banking and financial system…create an inflationary environment…and watch the “real value” of the debt decline.
This is a long term process and has several problems to face along the way. One of these is the question of how much spending should the government undertake? The issue here is about what the “multiplier” of government spending really is. I treated this in a post on January 26, 2009, titled “What will be the impact of Obama’s stimulus plan, http://seekingalpha.com/article/116414-what-will-be-the-impact-of-obama-s-stimulus-plan. Another question has to do with the process of enacting the stimulus plan into law. This I treated in a post on February 2, 2009, titled “the Obama Stimulus plan: Why I’m Concerned”, http://seekingalpha.com/article/117878-the-obama-stimulus-plan-why-i-m-concerned.
However, the ultimate issue relates to the amount of debt that is outstanding…in the United States…and in the world. If the amount of debt HAS to be reduced…and it must be reduced in order to get the economy functioning again…then, following this approach, inflation must take place to reduce the real value of the debt. The danger with this plan is that if inflation is not cut off at some time in the future, the incentives in the economy will be to return to a “go-right-on” and “business-as-usual” approach to living. That is…we will be right back where we were around the middle of this decade, where leverage was good and more leverage was even better, especially within an inflationary environment where things need to be kept “pumped up”! If this happens, we will still be addicted and still have the “monkey on our backs.”
Another way to reduce the amount of debt outstanding in the economy is to basically “write down” or “re-write” the debt and not create any more through an enormous fiscal stimulus plan like that proposed by the Obama administration. This would involve a massive restructuring of existing business balance sheets…both financial institutions as well as non-financial institutions. Insolvent institutions…including the auto companies…need to be recognized as such. In effect, existing shareholders in these companies have lost their investment…so much for good governance and oversight. Bondholders will have to accept an exchange…taking “new” debt at, say, 75% or 50% of the current face value…or preferred shares for the debt they hold…or taking an equity position in the company…maybe even warrants.
These exchanges would have to be negotiated…but the bondholders would have to understand that, as things now stand, the companies are insolvent and they could get nothing if the restructuring does not take place. Plus, the companies or the bondholders…or the public…really does not want the government to take over these institutions. We do not want state-run companies…financial or non-financial…because the fate of the nation would be much worse with a nationalization of industry than it would with an imposed “re-structuring” of the balance sheets of these businesses…financial and non-financial.
In terms of the consumer…a similar thing would have to take place. The major concern has been related to the housing sector and mortgages. But, we are now seeing a massive wave approaching of defaults on credit cards, car loans, and other types of debt that the consumer has taken on. Similar to the re-structuring of the business sector, the balance sheets of consumers must be re-structured. How we do this cannot really be discussed in this short post, but the idea would be that organizations that have extended credit to the consumer sector will have to take a haircut on the amount of debt that is owed by each consumer and the terms of repayment will have to be restructured in order to make the probability of repayment of the debt realistic. Again, this re-structuring would have to be negotiated…but we are talking here about much lower costs than would accumulate if there were more foreclosures and bankruptcies…more lawyers’ fees…and more costs all the way around. And, this could be done in a much shorter period of time than if all these bad assets had to be “worked out”.
I have given two extreme solutions to the problem of the debt overhang. The fundamental crisis is connected with the fact that there is too much debt in the system. For the system to work this dislocation out we would have to go through a period of debt-deflation. The two extremes presented here are, first, the Keynesian approach which is to inflate the economy and reduce the real value of the debt, or, second, to impose a debt-restructuring on the economy which would allow for a negotiated reduction in the debt loads of all economic units in the system.
People will really not be happy with either of these extreme solutions…or, for that matter…any combination of the efforts. But, once one loses their discipline, as the United States and the world did in the 2000s…there are no good solutions available to get out of the hole that has been dug. All people can do is to “take their medicine” and vow not to let such a situation ever occur again. However, looking back at history, one cannot be very confident that we will maintain our discipline once we get over the crisis.
I would like to make just one more suggestion. There is only one real change I would like to see to the regulatory structure…for both financial and non-financial firms…and that is the imposition of almost complete openness and transparency of the business and financial records of companies. Whatever a company does…it should be open to its owners…and to anyone else that might be interested.
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