The Music Has Begun Again, Start Dancing?

John Maynard Keynes is remembered for many quotes and one of the most memorable ones is his claim that “In the long run we are all dead.” Keynes wrote this remark to criticize the belief that inflation would acceptably control itself without government intervention. That is, he argued that the theoretically determined equilibrium of an economy was not a good guide to the future in a very volatile economic situation.

The statement has been used, however, as an excuse for choosing the economic policy of a government based short run outcomes. The most prominent short run outcome sought over the past fifty years has been the maintenance of high levels of employment…or, low levels of unemployment.

The problem is that fifty years of government stimulus, basically credit inflation, aimed at achieving low levels of unemployment have created a cumulative build up in debt and a general attitude toward debt that perpetuates a desire for “more-of-the-same.”

And, over this past fifty years, the purchasing power of the dollar has declined by 85%; the under-employed in the country are in excess of 20% of the working force; and the income distribution has become dramatically skewed toward higher income recipients.

Not surprisingly, the economic and financial crisis of the past few years has been met with calls for more fiscal stimulus and wide-open monetary policy. The result: yearly federal government budget deficits of over $1.5 trillion with an estimated cumulative deficit over the next ten years in excess of $15 trillion. In terms of monetary policy, excess reserves in the banking system have reached $1.2 trillion. All this, of course, to get the economy going again.

Here, however, is where moral hazard enters the picture. The behavior patterns of finance people, developed over the last fifty years, “kicks in” once people see that the same old spending habits of the government are still in place.

I call your attention to the opinion piece by John Plender in the Financial Times this morning, “Bad Habits of Credit Bubble Make Worrying Comeback.” (http://www.ft.com/cms/s/0/26d644be-3ea8-11e0-834e-00144feabdc0.html#axzz1EmwjGnnL)

Mr. Plender begins: “Here we go again. The start of the year in debt markets has been marked by record low yields on junk bonds, declining underwriting standards and a return of the more dangerous innovations of yesteryear such as payment-in-kind toggles which allow borrowers to issue more debt to pay the interest bill. Even covenant-life loans, where normal borrowing conditions are shelved, have made a comeback in the leveraged buyout market and elsewhere, at a time when hapless small and medium sized firms are hard pressed to find credit.

A surplus of savings over investment is thus building up in the system and the US is once again accommodating the savings gluttons with an ongoing commitment to loose policy…No surprise, then, that the search for yield is back in evidence. With Federal Reserve chairman Ben Bernanke keeping policy interest rates at rock bottom, investors are being driven into riskier assets such as junk bonds and leveraged loans.”

Has the “music” started up once more so that people must start dancing again? Someone call “Chuck” Prince, former chairman of Citigroup, to get his “take” on the timing.

Fifty year policies are not just present in the economic policies of government. They exist elsewhere as well. Check out the Tom Friedman’s column “If Not Now, When?” in the New York Times this morning. (http://www.nytimes.com/2011/02/23/opinion/23friedman.html?hp)

Here Friedman discusses energy policy: “For the last 50 years, America (and Europe and Asia) have treated the Middle East as if it were just a collection of big gas stations: Saudi station, Iran station, Kuwait station, Bahrain station, Egypt station, Libya station, Iraq station, United Arab Emirates station, etc. Our message to the region has been very consistent: ‘Guys (it was only guys we spoke with), here’s the deal. Keep your pumps open, your oil prices low, don’t bother the Israelis too much and, as far as we’re concerned, you can do whatever you want out back. You can deprive your people of whatever civil rights you like. You can engage in however much corruption you like. You can preach whatever intolerance from your mosques that you like. You can print whatever conspiracy theories about us in your newspapers that you like. You can keep your women as illiterate as you like. You can create whatever vast welfare-state economies, without any innovative capacity, that you like. You can undereducate your youth as much as you like. Just keep your pumps open, your oil prices low, don’t hassle the Jews too much — and you can do whatever you want out back.’”

Fifty years is a long time. The buildup of fifty years of economic policies and energy policies can result in a lot of excess baggage hanging around that must be dealt with. A fifty-year build up not only requires a major re-structuring of nations and economies, it also requires a huge shift in the mindset of many, many people.

You want the deficit to come down in the short run and monetary policy to be reversed because it is potentially inflationary? It just ain’t going to happen in the near term.
You want an energy policy that is going to immediately get us off of oil so that we can stop subsidizing dictators and autocrats in the Middle East? It just ain’t going to happen in the near term.

And, so on and so on…

What seems to be missing is the leadership to change our mindset and develop a new paradigm that will set us on a pathway to re-structure our economy and our lives. I don’t think we want to dance the same old dance we have been doing for the past fifty years. Yet, it seems as if we have no choice but to start dancing again because the bank has begun to play the music once more.

The leadership just does not seem to be here, either in America, or in Europe, or in Asia. And, no one is strong enough to want to inflict on people the consequences of ‘getting the house in order again.’ I guess one can say, in line with the earlier comments of the mayor-elect of Chicago, Rahm Emanuel, that the leadership in the United States (and in Europe and in Asia) has “”let a crisis go to waste!”

The question that is still unanswered is “Has Keynes’ long-run arrived yet or do we still have to wait for it?” If it has not arrived yet, then it is still to come. Payment will be collected sometime. However, if this ‘long-run’ is still to come then my advice to those that work in financial institutions or in the financial markets is…start dancing again if you haven’t already started for the music has begun once again.

Bubble, Bubble, Everywhere!

The Federal Reserve just doesn’t seem to get it!

Monetary ease can cause bubbles and not just in the United States. Bubble Ben at the Fed still denies that the Federal Reserve had anything to do with the bubbles in asset prices in the early 2000s in housing and the stock market. Bubble Ben, in 2005, placed blame on the Chinese and other countries for the “Global Savings Glut” that helped to finance the budget deficits of the United States government thereby allowing the interest rates in the America and other countries to be excessively low, causing substantial concern about world inflation and international resource misallocation.

Bubble Ben continues to see price moderation as a problem, just as in 2006 and 2007 he saw inflation as a problem far beyond the period when inflation was a problem. When it comes to price movements and asset bubbles, Ben Bernanke is a lagging indicator!

What is happening in the real world, Ben?

We see the headlines, “Investors Pile into Commodities”, (http://professional.wsj.com/article/SB10001424052748703963704576005933072423242.html?mod=ITP_moneyandinvesting_0&mg=reno-wsj.) “Investors are holding their biggest positions on record in the commodities markets as prices surge…Hedge funds, pension funds and mutual funds dramatically ramped up their holdings in everything from oil and natural gas to silver, corn and wheat this year. In many cases, the number of contracts held for individual commodities now far exceeds the amount outstanding in mid-2008, the last time commodity markets were soaring to records and debate raged about whether excessive speculation was driving up prices.”

We read in the Financial Times, “Crude Oil Tipped to Bubble over $100 a Barrel,” (http://www.ft.com/cms/s/0/cfb5cd58-022f-11e0-aa40-00144feabdc0.html#). “For the first time in two years, oil bulls are starting to outnumber bears.” Have you noticed that the price of gas has jumped $0.30 or so over the past month or two. And, the price of gasoline at the pump is going to continue to rise.

And the same picture arises for worldwide commodity prices, “Material Difference,” (http://www.ft.com/cms/s/0/d1e31d98-023d-11e0-aa40-00144feabdc0.html#axzz17WmrNvT3). “World prices for cotton have risen by 73 percent since the start of June.” This is just one item; one can go to other commodities and see substantial increases. This is sure going to help the economic recovery?

“In other words, a generation that has grown up with food and clothing deflation must now get used to paying more for the shirts on their backs and the bread on their table. The options: less breakfast cereal in the carton and hair-raisingly static-inducing nylon shirts, or pummeled profit margins for the global food and clothing industry.” That is, world commodity inflation is causing cost pressures that must surface somewhere. And, this is going to help the recovery?

And, we are seeing China, Brazil, and India, among other countries, raising interest rates and restricting bank lending so as to combat increasing levels of inflation. Governments are very concerned.

Last week, the Federal Reserve released information about the financial and non-financial institutions that it assisted throughout the world during the recent financial crisis.

Commentators responded by referring to the Federal Reserve System as the “world’s central banker.”

The Federal Reserve System has become the “world’s inflator”!

International financial markets have become so interlinked and flows of funds have become so fluid that pumping up the world’s reserve currency can affect almost every corner of that world. If the Federal Reserve creates an environment in which investors can borrow at 25 to 50 basis points and lend elsewhere at much higher rates, money is going to flow from the United States into these other opportunities.

And, bubbles result...worldwide!

What the Federal Reserve fails to understand is that industry and finance in the United States is in need of a massive re-structuring. Efforts to pump funds into the U. S. economy in a short-run attempt to put people back to work is just resulting in the money going “off-shore”. These efforts are not helping people and businesses de-leverage and modernize; it is not helping them re-structure.

And, these efforts are not helping America compete in the 21st century when its educational system is just producing students that are average or just above average in science, math, and reading when compared with other children throughout the world.

Also, the Federal Reserve does not understand the role it has played in exacerbating the increasing gap in incomes between the highest earners and the rest of the income spectrum.

As a consequence, the Federal Reserve is just producing bubbles everywhere and it is hard to see how this is really going to help us.

A Time of Transitions

Let’s start with the bad news first. I believe that we are in for an extended period of economic adjustment. This will take time for we are at a point where the foundation for the world economy has to be restructured so as to bring us to the start of a new era.

The good news is that the adjustment is taking place in a relatively orderly fashion. Yes, there still remains a lot of work to be done on repositioning portfolios and on the structure of industries. Yes, there will still be some surprises along the way. But, people are systematically working things out. People have, by-and-large, stopped hiding things and are finding out that within the current environment it is best to identify problems, disclose them, and then get to work on them. It just seems that the issues are deep and broad and will take an extended period of time to fully accommodate them.

In the United States, and some other developed countries, a lot of wealth has been lost. Layoffs are taking place or will take place in many major industries…I’m thinking of financial services and motor vehicles as starters. The housing industry is depressed and some experts think that house sales and the decline in housing prices may continue in and through 2009. Prices for oil and other commodities continue to rise. Consumer confidence has reached a 16-year low. This is a time of transition.

Perhaps the greatest transition underway is that in the field of energy. Transitions always hurt a lot of people. Major transitions are just that much worse. Yet, many agree…this transition has to take place…sooner or later. The United States, and much of the world, has done almost everything it can to postpone the day of reckoning, have band-aided the existing system here and there, and have protected the current economic structure as much as it could. Maybe that day is here.

Transitions hurt. Did I say that before? It is going to hurt many, many people to move on to the new way to power the world but maybe it is time for the United States, and others, to deal with the energy problem seriously and encourage the transition. Humans are problem solvers. Humans are great innovators. Look what has happened in terms of Information Technology over the past 50 years! Look what has happened in terms of the biological and physical sciences over the past 50 years! We can only be optimistic about what humans can do to solve problems.

Yet, over the last 50 years, politicians have provided incentives to the energy industry to maintain existing energy platforms. In doing so, they raised the “switching costs” of moving on to other energy platforms because the incentives have been structured away from innovation and change. Sure, the day would come when new sources of energy would be forthcoming, but the politicians creed is to keep getting re-elected in the current environment…the transition to these new sources and the disruption accompanying the transition will come on someone else’s watch.

Maybe we should celebrate oil selling for $135 per barrel. Maybe we should celebrate gas at the pump selling in excess of $4.00 per gallon. Maybe we should hope that prices go even higher! The transition is here! Let it happen!

My concern is that efforts will be made to alleviate the short run pain of the energy problem and drug the world once again so as to maintain the status quo for a little longer. It seems that the United States, and the world, only move on issues like this when there is a crisis. It seems as if times like this are the only times when pain is sufficiently wide-spread to gain the attention of politicians and others in positions of leadership. Do we really want to provide another narcotic release from the pain and postpone attacking the real problem? Drugs are addictive but if health is to be achieved the addiction must somehow, sometime be broken.

The new energy platform…whatever that platform will be…will result in a substantial change in the way people live their lives. I can’t predict what the new platform will look like. I don’t believe that anyone can predict what the new energy platform will look like. As an economist all I can say is that relative prices will change, incentives will be altered, and innovation will take place. What exactly this will mean for life on this planet is currently a mystery.

Individuals, as early as the 18th century talked about computing machines. But, who predicted the changes in life that the mainframe computer brought about in the 1950s and 1960s? Who predicted the creation of the personal computer and how it would alter how people worked in the 1980s? Who predicted the development of the Internet and how it would change how people lived and worked in the 1990s and beyond? And so on, and so on…

This adjustment will take time and the transition will be painful for individuals, for businesses, for industries, and for governments. I talked about a 50-year periods in terms of other transition cycles. Maybe…just maybe…we need to bite-the-bullet and move on into the future.

There is another transition that needs to take place and this is as good a time as any to accept the need for it and move forward with it. This is the transition the United States must make to become a full economic partner of other nations in the world of the 21st century. Other nations have gone through the transition the United States must go through and it is painful. But, why should the people of the United States postpone this adjustment if it can be accomplished from where we are now? Why can’t the United States move from where it is and change its way of conducting economic policy?

The period of the liquidity crises has been passed in this policy cycle. It appears that further adjustment of portfolios and expectations are proceeding in an orderly fashion. However, the full adjustment back to robust economic health is expected to be slow and painful. The United States government must not disrupt this transition back to health. But, it must act in a way that allows this adjustment to take place while bringing discipline back into its operations. The value of the dollar must be protected and supported, especially during this time when other central banks throughout the world will probably be raising their short term interest rates. Thus, the Federal Reserve must walk a fine line between not further disrupting the economic re-alignment going on and fully supporting the value of the United States dollar. Trust must be re-established in international financial markets that the Federal Reserve is fully cognizant of its responsibilities with respect to its currency and will fight the good fight against inflationary pressures. The relatively weak economy should help in this fight although the battle against worldwide commodity inflation will make the adjustment just that much more difficult.

The new President and his administration must also bring fiscal discipline back to the government. Again, this will be difficult and cannot be fully achieved in the near term. It is hard to see how the Bush tax cuts can be rescinded within the current environment. It is hard to see how other tax cuts can be implemented anytime soon. New programs? Well, prudence must rule the day. Any new president is going to be limited in what can be accomplished in the near term if this fiscal discipline is going to be achieved. If the transition is going to be made, however, it should be done now and not postponed indefinitely.

The reality of the situation is one in which the United States is going to have to work with others in the world. It cannot act independently of other nations in either energy policy or in terms of economic policy. Our period of transition is here…in many areas. The past is no guide at this time and we must not try to hold onto it. We must be open to the future while helping people through the pain of change.