The Two-Sided Recovery

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

• Construction of Single-Family Homes up 1.5%: http://online.wsj.com/article/SB20001424052748703444804575071003242087756.html#mod=todays_us_page_one.
  
• Fed’s Minutes Show a Rise in Confidence in Economy: http://online.wsj.com/article/SB20001424052748703444804575071542235270442.html#mod=todays_us_page_one.
  
• Factories Get Set to Hire: http://online.wsj.com/article/SB20001424052748704398804575071652158793106.html#mod=todays_us_page_one.

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

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

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

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

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

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

But, we don’t stop there. Closer to home, news about debt problems continue to surface. Over the past month, more and more stories have hit the newspapers about the fiscal problems that states are having meeting their debt obligations. More and more information is coming out about the difficulties that municipalities are having. Note in the Wall Street Journal this morning, “Muni Threat: Cities Weigh Chapter 9”: http://online.wsj.com/article/SB20001424052748704398804575071591602878062.html#mod=todays_us_money_and_investing?mg=com-wsj. Bankruptcy is certainly a way to deleverage!

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

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

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

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

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

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

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

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

Ecomonic Stimulus: Do We Need More?

When the history of the recent financial crisis and Great Recession is written, the basic conclusion that will be presented is that a financial crisis can be ended and a major recession turned around if the government throws massive amounts of money at the economy.

And, even after all this money is thrown at the economy, the calls for more and more stimulus remain. The lead editorial in the New York Times this morning calls for additional stimulus: see “The Case for More Stimulus”, http://www.nytimes.com/2009/10/27/opinion/27tue1.html. The Times struggles to come up with legitimate proposals for additional spending and comes up with only two: extending unemployment benefits and a program to “ease the dire financial condition of the states.” The newspaper bails out with the claim that “To be highly effective as stimulus, cash aid must be targeted to needy populations.” But, the Times can’t do any better than that.

Spending is addictive. Once you start, it is hard to stop.

Another problem, however, is that it takes time for economic systems to work things out. Sure, a “cash for clunkers” program can goose up spending in August, but September turns into a bust.

Real programs take time because the programs not only have to be designed, resources have to be assembled, and the projects have to actually get started. Then the effects of the program must work their way through the economy. “Shovel ready” programs that have an immediate economic impact on a city or a region are really few and far between, as we have seen from the initial Obama stimulus package.

So, what time frame are we looking at for government stimulus to work its way through an economy? Maybe three to five years?

And, how do you measure the effectiveness of the government stimulus? The Wall Street Journal today attempts to provide some idea of how this question might be answered: see “The Challenge in Counting Stimulus Returns”, http://online.wsj.com/article/SB125659862304009151.html#mod=todays_us_page_one. The conclusion of the author of the article is not encouraging.

Then there is the question about whether or not these programs replace or reduce other programs that would have been undertaken at this time. This is the question of the multiplier effect of government expenditures: is it above one or below one. Some of us believe that the multiplier for government spending is below 0.5. Not a very good bang for your buck!

And, what happens when people don’t see any results, or, at best, minor improvements? They start clamoring for more and more stimulus as the New York Times does today. Frustration sets in and people over-react to the situation. They want results and they want them now!

Yes, people and families are hurting. Yes, communities and states and regions are hurting. We don’t like to see the pain and would like to do something about it.

However, sometimes you can only do so much to improve the situation. The abuse that got the economy into this condition leaves no good choices for us to choose from in attempting to get out of the situation.

Was this crisis due to a failure of modern economics? I agree with the economist John Taylor who has written that this crisis actually vindicates the theory developed by modern economics. The problem was that the crisis was created by “a deviation of policy from the type of policy recommended by modern economics.” He goes on to write, “In other words, we have convincing evidence that interventionist government policies have done harm. The crisis did not occur because economic theory went wrong. It occurred because policy went wrong, because policy makers stopped paying attention to the economics.”

The conclusion one can therefore draw from this is that continuing “interventionist government policies” may not resolve the current problems but only exacerbate them. For example, if part of the problem is that families and businesses used too much debt and this helped to create the financial bust, then increasing the amount of debt outstanding in the economy is not going to resolve the problem, but may actually make it worse.

Well, throwing everything including the kitchen sink at the problem may bring the financial collapse to an end and help the economy to bottom out. But, what happens next? What happens after this massive amount of money is thrown at the economy?

For this we don’t have an answer although the New York Times does. “Ongoing economic problems are a sign that stimulus needs to be bolstered. Deficits are a serious issue, but the immediate need for stimulus trumps the longer-term need for deficit reduction. A self-reinforcing stretch of economic weakness would be far costlier than additional stimulus.”

More! That’s the answer!

And, people actually say that the talk about all the deficits is harmful to the situation. We are creating massive amounts of debt, but we can’t talk about them? Come on!!!

But, what if all the discussion about future deficits is causing people to spend less? What if the discussion about future deficits is causing people to fear that the Federal Reserve will not be able to reduce the size of its balance sheet and keep money and credit from soaring? What if the discussion about future deficits continues to result in a decline in the value of the dollar? What if the discussion about future deficits weakens American bargaining power among the rising nations in the world, China, Brazil, India, Russia, and continental Europe?

Should we stop talking about the deficit?

Or should be consider that maybe, just maybe, more is not the answer.

A Walk on the Supply Side

Keynesian demand-side economics still rules the minds of the policy makers in Washington, D. C. Their actions and their analysis continually point to their focus on aggregate demand and the “green shoots” that are expected to accompany an economic recovery based on the stimulus of spending.

For over a year I have been arguing that more attention needs to be given to the supply side of the equation. Yes, the growth rate of real GDP has been going down and the rate of employment has been going up. But, the rate of inflation, as measured by the rate of increase of the GDP price deflator has not declined since the fourth quarter of 2007. If it were just a demand side problem, this would not be the case.

I focus on the rate of increase in the GDP implicit deflator because of some of the measurement problems associated with the Consumer Price Index, such as the treatment of housing expenses and energy. Certainly, the CPI should be watched, but in dealing with economic aggregates, I prefer the former.

My point has been that if the problems in the economy were all tied to a substantial fall in aggregate demand, then there should have been a more substantial lessening in the rate of price increases. Consequently, my argument has been that something has happened on the supply side of the economy for the numbers to have been reported as they have been.

I would like to point to two areas of the United States economy that indicates that the problems of recovery may be more difficult to overcome than if the dislocation in the economy were just one of inadequate aggregate demand. The first area is that of industrial output; the second area is the labor market.

In terms of the industrial base of the economy I would like to focus upon industrial production and the industrial utilization of capacity. Industrial production has been declining steadily since the start of the recession in December 2007. At that time, industrial production was growing at about a 2.0% year-over-year rate of growth. By April 2008 the year-over-year rate of growth had become negative. The figures for 2009 are
January -10.8
February -11.3
March -12.6
April -12.7
May -13.4

This certainly shows a continuing weakening in the economy. However, taken by itself I don’t think that it carries more meaning than does the decline in the rate of growth of real GDP which has been declining as well.

Combine this performance with the figures on capacity utilization and one gets a different picture. As expected, total industry capacity utilization has dropped substantially in this recession. In December 2007, the figure stood at a little over 80.0%. In May 2009, capacity utilization had fallen to about 68.0%. This is the largest 18 month decline in the post-World War II period.

But, this is not all. The peak in capacity utilization in the past ten years was only slightly more than the December 2007 figure. But, this peak of the last ten years was substantially below the level of capacity utilization for most of the 1990s which was below the peak utilization in the 1970s which was below the peak utilization in the 1960s. That is, it appears as if we have been using less and less of our capacity on a regular basis since the 1960s.

The structure of our industrial base is changing. We can see that in autos, in steel, and in many other parts of our manufacturing base. It appears as if the weakness in our economy is composed of two things: first the cyclical swing in business; but this weakness is on top of a secular decline in our productive ability. The economy is in the process of restructuring!

This shift is also showing up in labor markets. The civilian participation rate in the labor force for the United States rose from the late 1960s into the 1990s when it peaked a little above 67.0%. The civilian participation rate has declined since late 2000 and has remained below 66.2% since 2004. In terms of the number of people who are not participating in the labor market any more, this represents a large number. People have left the labor force in the last five or six years and this trend has, of course, been exacerbated by the recession. Over the past forty years the rise in the participation rate has slowed down or stopped during recessions, but at no time did it decline as it did in the in the past six years.

Of further interest, the Labor Department reported that separations from jobs in April remained relatively constant as they have for the past two years, but the rate of hiring continued to be quite low. In early 2008 the percentage of the labor force that were separated from their jobs was about equal to the percentage that were being hired. Since then separations have exceeded hirings, as might be expected, causing the unemployment rate to rise.

In terms of those that were separated from their jobs, there was a dramatic shift between those that quit their jobs and those that were laid off or discharged from their jobs. The percentage of layoffs and discharges rose dramatically from April 2008 to April 2009 whereas quit levels dropped substantially. That is, although separation rates did not change much at all during this time, the composition of those being separated from their positions experienced a tremendous shift. This is an indication that there is a structural shift in what is happening in the labor markets.

This information leads me to believe that there is a substantial restructuring taking place in the United States economy. And, a structural shift is a supply side issue and not a demand side issue. In fact, demand side responses can just make a bad situation worse by trying to force people back into positions that companies and industries are attempting to eliminate because the world has changed.

The figures on industrial production and capacity utilization seem to indicate that industry is changing and the numbers from the labor market reinforce that conclusion. Pumping up aggregate demand is an attempt to stop this restructuring or, at least, slow it down.

The problem that policymakers’ face is that they, or we, do not know what the new industrial structure is going to look like. It is impossible for anyone to know. People can make guesses, but that is all they are—guesses. And, in situations like this, it is more likely that the guesses will be wrong rather than being right. It’s just that the future is unknown. The need for the United States economy to restructure just adds another “unknown, unknown” to our list of “known unknowns” and “unknown, unknowns.” My guess is that this restructuring is going to take some time and could be sidetracked by huge government deficits and a supportive monetary policy.

Structural Changes in the Economy, Unemployment, and Inflation

A new concern about the economy has surfaced recently. This new concern has to do with the changing structure of the economy and the impact this change might have on the outcome of government policy.

Specifically, the argument is that the United States economy, and that of the world, is currently going through a transitional change that only occurs once or twice every century. This is the transition that takes place in the productive structure of the economy—a sort of “tipping point”.

There is no doubt that the structure of automobile production is going to be different in the next ten years from what it was over the past fifty years or so. This shift will affect dealers, suppliers, and many other companies that are peripheral to the car-making process. But, changes are also taking place in the way that different forms of energy are going to be provided. Information technology continues to change and we still don’t know what the future looks like in this area. And, these are just a start.

The point is that the world has changed. People that are facing unemployment due to the collapse of the auto industry are not going to find the same employment opportunities in the future that existed in the past, even if the stimulus and bailout packages work. There will be a different focus in energy with new types of jobs becoming available and the old types being less plentiful. Openings in health care are going to be different. And, what about employment in financial services? New jobs might be much more plentiful in government service. And some people are calling for a re-instatement of the military draft.

This changing structure is going to impact many, many people who will need to change jobs, change where they live, and change skills. During times like these, what is called the non-inflationary rate of unemployment tends to increase. This is because the structure of employment has changed and the industry and the economy need to adjust to accommodate this change. Whereas, the non-inflationary rate of unemployment for all workers over the past ten years may have been around 5.0%, this rate, looking forward, may be at 6.0% or more depending upon the restructuring that needs to take place.

What is the problem created by this shift?

The models used by the federal government in determining what monetary and fiscal policies are appropriate for achieving “full employment” contain the lower estimate for the non-inflationary rate of unemployment. These models are based upon historical data and the “historical data” don’t include the adjustments that are now taking place in the actual economy.

The consequence of using an unemployment figure that is too low?

Deficits will be greater than expected because government tax revenues will be lower than initially projected and the choices for monetary policy will be too expansionary for the new structure of the economy. That is, the employment situation will be worse than expected and the pressure on prices will be greater than expected.

What does this mean for the results that we will be seeing? Well, it means that unemployment will remain higher than what is desired and inflation will also remain higher than desired, even though the pressure on wages will be downward. That is, there will be a greater fall in real wages than expected and this will further dampen consumer spending and cause additional foreclosures and personal bankruptcies.

This can have further repercussions in financial markets as increasing federal deficits and rising unemployment puts additional pressures on the Federal Reserve to monetize the debt. Long term interest rates will not fall under these circumstances even though real resources are seemingly under-utilized.

What is happening here?

To me, what is happening is confirmation of what I was writing about last summer and through the fall and winter. First, the shift in economic activity is coming from the supply side of the economy—and not from the demand side! Most economists (and this is especially so with the reincarnation of the Keynesian school of thought) interpret a slowdown in economic activity as a deficiency of demand. Hence the monetary and fiscal policies that are created aim at restoring sufficient demand to return the economy to full or near-full employment levels.

If the slowdown in economic activity is coming from the supply side, different monetary and fiscal policies are needed to confront the state of the economy. A slowdown in economic activity coming from the supply side needs policies that deal with the structural changes in the economy and these require efforts much different from demand side policies.

Demand side stimulus, in cases like this, often exacerbates the problems because all the demand side stimulus seems to do is try and force the unemployed people back into their old jobs which are no longer available. If the structure of production and employment has actually changed, then these old jobs have disappeared and there is no way that demand stimulus will bring them back into existence. Hence, too much money is chasing too few goods—even though unemployment has increased.

The second factor I have discussed before is that there is too much debt outstanding and that this problem must also be dealt with before economic expansion can begin again. But, if there has been a structural shift in the economy, this situation becomes more problematic because a higher rate of non-inflationary unemployment means that previous debt loads are even more out-of-line with what people can handle than at the rate that was being used before. That is, the debt problem is worse than previously anticipated.

The Federal Reserve and the Obama administration still seem to believe that the problem in the financial markets is one of liquidity. However, the problem is one of solvency and this is a structural problem and not one that is temporary and handled by buying more and more different kinds of securities. The focus on the liquidity available in different segments of the financial markets and on the balance sheets of banks is misplaced. Individuals, businesses, and governments have too much debt outstanding relative to the state of the economy. The auto industry is “painfully” shedding some of its debt. The Treasury Department is attempting to help the banking industry shed some of its debt. Still, there too much debt outstanding and the federal government is adding more and more to this total.

The bottom line is that the changes that have taken place in the United States economy are structural in nature and must be dealt with as such. Unfortunately, the policy makers in Washington, D. C. don’t seem to see it that way. As a consequence, the policies that have been forthcoming may only add to the dislocations that exist in the economy and result in a rate of inflation that only adds to these problems.

Even with the substantial decline in real GDP in the first quarter of 2009, the GDP deflator rose at a 2.9% year-over-year rate of increase. This is worrisome. But, when output falls and inflation rises or stays relatively constant, this is an indication that the supply side of the economy has shifted and not the demand side.

The Clogged Banking System

The Federal Reserve is doing almost everything it can to get commercial banks to start lending again. Just a quick look at the data reveals what is happening in the banking system where the rubber hits the road. Let’s take a look.

Looking at the figure Total Reserves which is defined as bank reserve balances held at Federal Reserve Banks and vault cash at banks used to satisfy reserve requirements. The year-over-year rate of increase in this figure for February 2009 was 1,538 %. Yes, that’s right, one thousand, five hundred and thirty-eight percent, rounded off! But, this rate of growth is down from the December 2008 year-over-year figure which was 1,823%. Yes, one thousand, eight hundred and twenty-three percent!

In August 2008, before the financial tsunami hit, the year-over-year rate of increase in Total Reserves was – 1%. Yes, that is a negative one percent! And the rate of increase throughout 2008 up to August was modest, at best.

Let’s move up to a larger measure, the Monetary Base, defined primarily as Total Reserves and Clearing Balances at Banks plus the currency component of the Money Stock measures. In February 2009, the year-over-year rate of increase in the Monetary Base was 88%, rounded off. That is, the Monetary Base increased by a little less than two times over the twelve month period ending February 2009. In December 2008, the year-over-year rate of increase was 99%, rounded off.

Going back to August 2008, the year-over-year increase in the Monetary Base was about 2%. Again, the rate of increase in this measure throughout 2008 up to this time was around this magnitude, give or take a percentage point or two.

How did this increase in reserve measures get translated into the Money Stock figures? Well, in the case of the narrow measure of the Money Stock, M1, the year-over-year rate of increase for February 2009 was 13.5%, down from 17.2% in December. In August 2008, the year-over-year growth in the M1 Money Stock was a little less that 2%. The rate of growth of this measure for the earlier part of 2008 was slightly negative to slightly positive.

In terms of the components of the M1 Money Stock, what contributed to this increase in growth? First of all, the Demand Deposit component rose by about 35% on a year-over-year basis in February, but this was down from a little over 59% in December. The interesting thing is that the year-over-year rate of growth of the currency component of the M1 Money Stock was relatively constant through the end of 2008 into February of 2009. For example, the currency component grew at around a 7% rate of growth in December 2008 but grew at a 10% rate in February.

The conclusion one can draw from this is that people and businesses are holding more of their wealth in currency and in demand deposits! That is, the funds that the Federal Reserve is pumping into the banking system are staying in the banking system or going into cash or very liquid transactions balance in the banking system.

One could argue that the public is not spending these cash and transactions balance accounts any more than they have to and are keeping them on hand to meet their uncertain needs for living and conducting business. That is, these holdings are for security in treacherous times.

Just one additional note on Demand Deposit growth and Currency growth: in August 2008, the year-over-year rate of growth in Demand Deposits was essentially zero and the year-over-year rate of growth of currency was slightly over 2%. That is, in August 2008 almost all the growth in the M1 Money Stock measure was coming from the growth in the currency component.

Now, what about the rate of increase in the M2 Money Stock measure? In February 2009 the growth over February 2008 was just less than 10%. This growth rate was exactly the same as the growth in this measure in December 2008. In August, the year-over-year growth rate in the M2 Money Stock was approximately 6%.

The conclusion that one can draw from this is that individuals, families, and businesses are keeping funds in very safe and easily accessible form. Growth in deposit measures or credit measures beyond cash and demand deposits is almost non-existent. People and businesses are attempting to protect themselves, they are not borrowing more than necessary, and they are not spending more than necessary. One guesses that this is not going to change much in the near future.

From the non-bank side of the equation, why should people and businesses be borrowing if they can avoid it? Unemployment jumped to 8.5% in March, and this weekend economists were talking that this number would reach at least 10% before this economic downturn is over.

Furthermore, bankruptcies were up, almost 4% in March and up almost 40% over a year earlier. This measure, too, is expected to rise throughout 2009 and into 2010. And then, housing prices continue to fall. One measure used to judge where housing prices are relative to (estimated) rental payments was reported by John Authers in the Financial Times on last Thursday. He wrote that the ratio of housing prices to rents which had risen by 44% from 2002 to its peak through the credit bubble has returned to about its 2002 level. However, Authers argues that even though it returned to the 2002 level this ratio could still fall another 20% to reach levels of a decade or so earlier.

And, why should the banks lend? For one, they still have a ton of questionable assets on their balance sheets. And, if these banks are worried about their solvency, they need to work these assets out and not add more and more new assets to their balance sheet. Their focus needs to be on regaining financial health now, not expanding their balance sheet and reducing capital ratios further.

And, we still have the commercial real estate problems to go through, as well as the problem implied in the credit card area due to the rising delinquencies in that sector. Furthermore, there are two kinds of mortgage loans that are going to reprice over the next 15 months or so. Analysts are afraid of what this might do to foreclosures and bankruptcies given the rise in unemployment and the decline in household incomes. Also, there are the surfacing problems connected with state and local government finance. This has not really gathered much attention to date.

The Federal Reserve has been pushing about as hard as it can. Yet, the monetary stimulus is not working its way through the banking system. This is obviously a problem. But, banks in the condition described above don’t really want to lend, and consumers and businesses are in the process of consolidating and strengthening their balance sheets and have little incentive to re-leverage themselves at this point.

The Keynesian solution to this dilemma is, of course, government spending, the more the better. The intent of this spending is to get the banking system unclogged. Whether or not this government spending can actually accomplish this is still to be determined? So, we still are faced with enormous amounts of uncertainty. And, this uncertainty, in my mind, is not going to go away soon.

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.

How Effective Might the Stimulus Plan Be?

The Obama stimulus plan totals $825 billion. This plan is a combination of spending plans and tax relief. The dollar amount needed to be large, we are told, because the American economy is tanking and a lot of effort needs to be exerted to stop the decline and re-establish positive growth once again. Of course, we were told similar things when the legislation relating to the TARP was introduced. We have also been told that the number needs to be large because we don’t really know how much stimulus will be needed to jump-start the economy so we need to throw a lot of cash at the problem in hopes that the effort will be large enough to do the job.

The problem is…how much extra spending will $825 billion of stimulus create in the economy. In the simple Keynesian model this $825 billion will generate something more than $825 billion as new investment and new spending is created from the initial stimulus. The word going around is that the Obama economists are using a “multiplier” of 1.5. Thus, $825 billion in new spending and tax cuts will actually result in another $412.5 billion in spending raising the total affect on the economy to $1.2375 trillion…a hefty sum.

On Thursday, the Wall Street Journal printed an opinion piece by Harvard economics professor Bob Barro (http://online.wsj.com/article/SB123258618204604599.html?mod=todays_us_opinion)
who argued that the “multiplier” might be something different from 1.5 and might even be as low as zero! Barro contended, supported by his research, that even in times that are most favorable for the multiplier to be toward the higher end of this range, war times, the multiplier comes out to be no higher than 0.8. That is a stimulus plan that totaled $825 billion, could only expect to produce about $660 of real Gross Domestic Product not $1.2375 trillion. But, he adds, this estimate of 0.8 is probably optimistic.

Why would the final impact of the stimulus package be less than the amount of the stimulus package itself? There are several reasons. For one, the government expenditures could be expected to be a substitute for private investment or other private expenditures. Furthermore, whether or not the tax cuts are spent is another question. In the recent Bush43 tax rebate program much of the rebate money either went into savings or it went to pay off existing debt. In a poll released in the middle of last week, pollsters found that, on average, people would apply 70% to 75% of any tax relief from the stimulus plan to savings or to paying off existing debt. So there are arguments…and empirical support…for the contention that the “multiplier” may not be as high as 1.5 and might realistically be below 1.0.

The threat to save or pay back debt is real…not only for consumers…but also for businesses. Some economists who have studied recessions and depressions talk about a period of time called a debt/deflation. In periods like these the future looks bleak…and economic units…consumers and businesses…try to pull back and restructure themselves on a sounder financial basis. That is, they want to reduce the leverage that is on their balance sheet and get away from owing money. The first concern has to do with being unemployed or faced with going out of business…economic units want cash or, at least, near-cash items so as to be able to bridge a period when cash inflows might be low. And, if there is a possibility of deflation, people want to reduce the amount of debt on their balance sheets because the real value of debt and debt payments increase when prices are falling.

Some “Keynesians” have tried to incorporate these ideas about debt/deflation into their economic models. Hyman Minsky was one of the most prominent economists to explicitly discuss the impact of the capital markets on economic expansions and contractions. However, most of the empirical models used by policy makers do not take account of capital market effects on economic activity. (For a discussion of the economic model used for policy forecasting in the Federal Reserve see “Ben Bernanke’s Fed: The Federal Reserve After Greenspan” by Ethan S. Harris, Harvard Business School Press.) It is hard to contemplate “multipliers” as high as 1.5 if one considers these capital market issues.

For people to spend or borrow (if they could borrow) they need to have at least a somewhat optimistic view of the future (even for the possibility of inflation) to maintain or increase spending by either reducing savings or by borrowing. The obvious psychological impact hoped for from the stimulus package is that economic units will have enough confidence in the future or will even be willing to borrow and pay back loans with cheaper real dollars to keep spending or even increase spending. The Obama team is intending to use the rest of the TARP funds released by the Congress ($350 billion) to get people borrowing again.

Of course the concern about achieving this latter effect is the concern over the creation or the re-enforcement of moral hazard in the economy. If the government continues to “bail out” not only financial institutions but businesses, families, and other economic units, these economic units will continue to take on more and more risk in the future because they know that the government will supply a safety net to protect people from their foolish bets. The economists who argue from the viewpoint of the debt/deflation hypothesis contend that sooner or later the economy will take on so much debt that the debt/deflation cannot stop until people finally work off their extreme financial imbalances and return to more normal debt loads and positive amounts of saving. Some of these economists believe that this time has arrived and the economy cannot be turned around until economic units have worked off their excessive debt burdens and taken on a more conservative view of their economic future.

To get a zero multiplier (see the Barro article and Barro’s textbook “Macroeconomics: A Modern Approach” published by Thomson South-Western) one must argue that economic units will anticipate the increased real economic costs, real future taxes, or inflation that result from the way in which the stimulus package is financed and re-arrange their economic and financial activities to be able to cover the future government levies. A zero multiplier means that for every $1.00 the government puts into the stimulus plan, economic units will remove $1.00 from the spending stream. Thus, the $825 billion stimulus plan would increase real Gross Domestic Product by…ZERO DOLLARS!

What is the alternative to the type of stimulus plan proposed by the Obama administration? Barro argues that things must be done to encourage business commitment and innovation. His favorite idea is to eliminate the federal corporate income tax. If people are to be put back to work again…businesses must be hiring. In order to do this the energy and the foresight of the American business community must be put back to work again. The concern with massive public-works programs is that they will just substitute for the innovation and entrepreneurial leadership that still exists in the country and could produce real growth but needs to have the appropriate incentives.

So, what will be the impact of the Obama stimulus plan? You take your guess…I’ll take mine. My guess is that the multiplier is less than 1.0 and is maybe as low as 0.4. A reason for this pessimistic view of the multiplier is that we are at the stage where people/families and businesses finally have to fully restructure their finances to get balance sheets back into some form of conservative position. After many, many years of chasing dreams through betting on rising inflation with increased leverage and new financial instruments…the economy finally needs a break…needs to catch its breath and settle down for awhile.

I could be wrong. The American government could throw so much money at the economy that rising inflation and increased leverage becomes “the thing” again. If such is the case…then we are just postponing for another time, dealing with the monster that the government has created in the first place.