Our Two Choices

It seems as if our policy choices have been reduced to two.  First, our basic problem is that there is too much debt outstanding, debt of consumers, debt of businesses, and debt of governments…state, local, and national.  According to Ken Rogoff of Harvard (and co-author of the book “This Time is Different”), “By far the main problem is a huge overhang of debt that creates headwinds to faster normalization and post-crisis growth.” (http://www.ft.com/intl/cms/s/0/1e0f0efe-c1a9-11e0-acb3-00144feabdc0.html#axzz1UdDrJfzK)

During the past fifty years of credit inflation, the incentive existed for economic units to increase financial leverage.  Consequently, we have reached an extreme position of financial leverage, one that many believe is unsustainable.  As Rogoff claims, people attempting to reduce this “huge overhang of debt” will not borrow, will not spend, and this will result in a period of time in which economic growth and the expansion of employment will be modest at best, and downright slow at worst.

The resulting policy choice, therefore, is to allow the debt reduction to take place and let the economy adjust to more “normal” levels of debt.  This “adjustment” is going to have to take place some time and the best thing for the future of the economy is to let it adjust naturally for this adjustment must take place sooner or later.  By not allowing it to take place, we just postpone the final day of reckoning.

The second policy choice is to pursue a significantly aggressive program of credit inflation, one that would force people and businesses to return to borrowing and hence to spending.  Such a policy would help to accelerate economic growth and put people back to work.

This argument is based on the assumption that the United States cannot afford the consequences of a long, slow period of debt reduction and a lengthy period of mediocre economic growth.  The cost of following a “do-nothing” policy in terms of human suffering due to the unemployment and social dislocation created by such a policy would be unacceptable.

The second policy has been the approach taken by the Obama administration, arguing for a resumption of credit inflation, both in terms of government deficits and in terms of expansionary monetary policy.  The question that supporters of this policy debate about is the degree of the credit inflation.  The Obama administration, itself, has tended to follow a more modest level of credit inflation whereas its liberal critics have argued the Obama team has been too timid in how much credit inflation should be imposed on the economy.

Here we get into a debate over timing.  The first policy is needed, according to its proponents, because that is the only way the United States will regain its competitiveness and be able to go forward with the finances of its people in a strong position.  Following the second policy would only postpone the adjustments needed and leave the “day of reckoning” somewhere out there in the future.

The supporters of the second policy argue that we cannot allow economic growth to be so low and unemployment stay so high because of the human cost.  We need to address this now and worry about the debt re-structuring problem later.

The concern over the second policy program has to do with the “tipping point.”  Let me explain.

Right now, the debt overhang appears to be the predominant force in the economy.  Consumers, at least a large portion of them, are not borrowing and spending because of the debt loads they are carrying. (The wealthier consumers seem to be going along fine, thank you.) They are increasing savings in an attempt to get their balance sheets back in line.  Small- and medium-sized businesses are not borrowing to any degree, are not hiring people, and not expanding much at all because they have too much debt on their balance sheets and are trying to keep their heads above water.  Many state and local governments are facing real budget crunches and are cutting back on employment and capital expenditures because of their legal obligations. 

The government fiscal stimulus programs initially attempted by the federal government have been ineffective and disappointing, at best.  The efforts of the monetary authorities to generate bank lending have also been exceedingly ineffective despite historically extreme injections of liquidity into the banking system. Those people supporting the “second policy” continue to call for even more credit inflation whether it be for an new round of “quantitative easing” on the part of the Fed or some other innovative uses of monetary policy. 

The problem with the “tipping point” is this: how severe the tipping point will be if/when the new efforts at credit inflation overcome the efforts of economic units to restructure their balance sheets and eliminate the “debt overhang” connected with the past fifty years of credit inflation. 

The current policy makers seem to believe that the “tipping point” can be managed and the adjustment from debt restructuring to further borrowing can become incremental.  That the trillion or so dollars injected into the banking system by the Federal Reserve can be smoothly removed from the banks once borrowing from them picks up steam.   In this way, faster economic growth could resume again and employers could begin hiring workers at a speedier pace.  

The alternative view is that the “tipping point” cannot be “managed” and that once the gates are open, borrowing will only accelerate and credit inflation will get “out-of-control”, given the magnitudes of liquidity already pushed into the financial system.  Does this mean hyper-inflation?

This discussion leads to a question about whether or not the current policy makers can recognize the “tipping point” (let alone anticipate it) and whether or not they can then smoothly remove all the excess liquidity that has been forced into the banking system.

If one is to look at the record of Chairman Bernanke and the Federal Reserve system one cannot have very much confidence that they will be able to recognize a turning point let alone manage their way through the “tipping point”.  Historically, Chairman Bernanke has had trouble recognizing bubbles, stays with a policy stance far too long and then over-reacts.  Take a look at what happened before the financial crisis of 2008.  The “housing bubble” and the “stock markets bubble” in the middle 2000s were not recognized by Bernanke or the Fed.  Bernanke and the Fed fought the “fear of inflation” for too long into the initial stages of the financial collapse.  And, then Bernanke and the Fed had to over-adjust to the financial crisis they contributed to by “throwing open the windows…and the doors…and whatever…at the Fed” in order to “save the world”. 

Managing a “tipping point”, I would argue, is not one of Ben Bernanke’s strengths.  But, governments, I would argue, are not very good at managing “tipping points.” 

Where does that leave us?  Between a rock and a hard place. 

The government will continue to try to alleviate the suffering of those that have been hurt in the Great Recession and its aftermath.  The Obama administration and the Democrats and the Republicans will compromise on a policy that can still be labeled credit inflation.  The Federal Reserve will continue to look for ways to stimulate bank lending.  And, the only way I can characterize this situation is one of HIGH RISK.  Volatility is going to continue to dominate the financial markets over the next two years or so for the very reasons I have cited above. 

The reason for this is the timing of the “tipping point.”  The private sector is going to continue to push for balance sheet restructuring.  The government is going to continue to push for more and more credit inflation.  This leaves the future highly uncertain.  Consequently, markets will move this way and that way until some leadership and stability are brought into the picture.

United States At Blame for Eurozone Problems?

Recommended read this morning, the op-ed piece by Kenneth Rogoff, “The Global Fallout of a Eurozone Collapse,” in the Financial Times. (http://www.ft.com/intl/cms/s/0/e66a3d7c-9073-11e0-9227-00144feab49a.html#axzz1OaJbLwdu)

“It is ironic that the euro…is suffering from having an overly strong exchange rate, particularly against the dollar, and at precisely the moment when a huge depreciation would be most helpful.”

“I think it would be more accurate to say that markets are more worried... about the US’s lack of a plan A than Europe’s lack of plan B.”

“Unfortunately…the euro is looking very much like a system that amplifies shocks rather than absorbs them.  The UK, which of course did not adopt the euro, has benefited from a sharp sustained depreciation of the pound.  The peripheral countries of Europe are meanwhile stuck with woefully weak competitive positions and no easy adjustment mechanism.  European leaders’ plans to achieve effective devaluation through major wage adjustment seem far-fetched.  The only clean rescue for Europe would be if growth far outstripped expectations.  Unfortunately, post-financial crisis growth is likely to continue to be hampered by huge debt burdens.”

The worst of all worlds for this crisis…stagflation.

And, the United States continues to pound away creating more and more credit inflation for itself and the world…both in terms of monetary and fiscal policies.  (See my post about the Fed’s feeding of world inflation: http://seekingalpha.com/article/273506-cash-assets-at-foreign-related-financial-institutions-in-the-u-s-approach-1t.) 

“The markets are more worried about the US’s lack of a plan A…”

To me the world is seeing the current leadership in Washington, D. C. as little different than any group of leaders in Washington, D. C. over the past fifty years.   For the past fifty years the government debt produced by the United States government has risen at a compound rate of growth of more than 8 percent per year.  Economic growth has averaged a little more than 3 per cent every year for this same 50-year period.  

This is “credit inflation.”

And, the value of the dollar?

In 1961, at the start of this binge, the value of the dollar was pegged to gold.  In August 1971, President Nixon floated the dollar.  With the open capital markets that arose in the 1960s, a country could not independently follow a policy of credit inflation and keep the value of its currency fixed. 

Since the dollar was floated, the general trend in the value of the dollar has been downward with three exceptions.  The first was in the Volcker years of the early 1980s; the second was when Rubin was Secretary of the Treasury in the late 1990s; and the third was in the world rush to quality during the financial crisis of 2008-2009. 

The leaders of the United States have not had a plan to halt the decline in the value of the dollar for the past fifty years.  And, the Obama Administration is no different from any of the other administrations that preceded it since 1961. 

United States government officials have stated their support for a “strong” dollar throughout this time and yet have done little or nothing to stem the decline.

Again, “watch the hips and not the lips!”

And, the longer-term trend in the value of the United States dollar is still downward.

However, in an interdependent world, actions have repercussions elsewhere.  And that is what Rogoff is calling our attention to.  The policy actions of the United States government impact others.  And, the blanket government policy of credit inflation followed by Republican and Democratic Presidents over the last 50 years has come to dominate the world. 

Not only is it exacerbating the sovereign debt problems of Europe, it is spreading inflation throughout the world as the US dollars pumped into the US banking system by the Federal Reserve flow almost seamlessly into commodity markets throughout the world. (Again, see my post from yesterday.)

The irresponsible creation of debt and more debt does come to a limit.  And, as one approaches the limit, the number of options available to the issuer of the debt shrink in number as the desirability of those options also lessen. (“Debt Ultimately Leaves You With No Good Options,” http://seekingalpha.com/article/271651-debt-ultimately-leaves-you-with-no-good-options.)

The United States is experiencing this difficulty as we speak.  There are “things” the government would like to get into but can’t because there is no fiscal room for anything more, and there are “things” the government must get out of but don’t want to because they are in political favor. 

In a world of excessive debt, there are no good choices…period!

Rogoff goes on to talk about whether or not the world will succeed in forming a co-reserve currency system.  This would happen as the benefits of the co-reserve currency system were observed which would result in a trend towards the consolidation of currencies throughout the world. 

The current period of stress, Rogoff argues, is a period of learning.  “Having a smaller number of currencies is a phenomenon that makes a lot of sense economically, economizing on transactions’ costs and leveraging economies of scale.  The real question is whether common currency is sustainable politically.  My guess is that if the current slow patch in global growth does not quickly subside, we will not have to wait long for an answer.”

Building an Exit Strategy at the Federal Reserve--Part Two

Yesterday, I discussed what I saw as the reasoning behind the strategy the Federal Reserve is building to reduce the massive amount of excess reserves that it has injected into the banking system. The basic strategy seemed to be logical and reasonable and consistent with the way that economists usually think. That is, the arguments of economists always contain the assumption: “all other things held constant.” In other words, this is the plan, given that nothing else changes.

In the proposed strategy the Federal Reserve is developing, what is missing that might be crucial to the success of this strategy?

How about the fiscal deficits that the government is in the process of producing?

The deficit for the fiscal year ending this fall recorded the largest deficit in United States history: $1.4 trillion. And, some projections for the next ten years place the cumulative federal deficits around $15 trillion, more or less.

The Gross Federal Debt rose by 11.6% in fiscal 2008 and the estimates published by the government for fiscal 2009 and fiscal 2010 are 22.3% and 15.4%, respectively. The federal debt held by the public rose 15.2% in fiscal 2008 and is projected to increase by 35.4% and 21.9% in the following two years.

A lot of debt is going to be created by our government in the upcoming future and the assumption is that the public is going to absorb greater increases in the amount of debt they hold than ever before in peacetime!

The increases in debt over the past seven years have been of epic proportions. Carmen Reinhart and Kenneth Rogoff, in their informative new book “This Time is Different”, state of this buildup: “Were the United States an emerging market, its exchange rate would have plummeted and its interest rates soared. Access to capital markets would be lost…” They continue, “Over the longer run, the U. S. exchange rate and interest rates could well revert to form, especially if policies are not made to re-establish a firm base for long-term fiscal sustainability.”

Why do the exchange rates of nations that exhibit such fiscal irresponsibility decline?

The answer to this is that, sooner or later, the central banks of these nations have to become active in supporting the placement of the debt and this results in the monetization of that debt.

The question then arises, “Can the Federal Reserve reduce the amount of excess reserves it has injected into the banking system given the market pressures that surround the problem of the placing of the federal debt that is going to be created?”

Let’s look what seems to happening right now.

Some have argued that the Federal Reserve’s policy of “buying everything in sight” has created an asset bubble. The result has been that the prices in many different asset classes now move together: the movements in these asset classes now possess a high positive correlation rather than a zero or negative correlation. Thus, investors can achieve very little diversification across markets. And, as a consequence, the market volatility indexes have risen to remarkable highs.

The extremely low target interest rates, the quantitative easing, and the massive flows of capital into the United States resulting from the accumulation of foreign exchange reserves by foreign central banks keep Treasury bond prices high, prices of mortgage-backed securities high, United States equity prices high, and global asset prices high. (A bubble you say?)

To support the bond market and the market for mortgage-backed securities, that is, to keep interest rates low, the Fed has continued to pump reserves into the banking system. The reserve balances that commercial banks hold at Federal Reserve banks jumped $236 billion from September 30 to October 28 so that they totaled $1.080 trillion on this latter date. Excess Reserves held by commercial banks rose by around $190 billion from the end of August to the end of September, to around $1.0 trillion.

If these security prices are artificially high (and interest rates artificially low) due to Federal Reserve support, what will happen when the economy picks up activity and the Fed has to back off its underwriting of low interest rates? What will happen if this “backing off” coincides with the need of the Federal Reserve to “exit” from its excessively loose policy?

As I wrote earlier, the proposed exit strategy that the Federal Reserve is exposing to the public seems “logical and reasonable” given that “all other things are held constant.” Unfortunately, policy makers do not work in a world in which “all other things are held constant.”

Again, the policymakers are faced with the problem of dealing with the aftermath of earlier policy actions. As I have argued, the irresponsible fiscal policy of the early 2000s and the excessively low interest rates maintained by the Federal Reserve during this time (supported by both Greenspan and Bernanke) created the environment for the financial collapse of 2007-2008. The Bernanke Federal Reserve faced this collapse, to accumulating accolades, by throwing everything it could against the wall to see what would stick. (The lesson Bernanke learned from his research on the First Great Contraction was that in order to avoid a great contraction one had to leave nothing on the table for if one is going to err one must err on the side of excessive ease.)

Now we are faced with the problem of dealing once again with the left-over’s of previous fiscal and monetary policy. We are once again faced with a situation in which there are no “good” policies that are painless. As Reinhart and Rogoff conclude from their massive study of “Eight Centuries of Financial Folly”, pain cannot be avoided once financial folly has been committed.

Let me close once again as I closed my post yesterday: the Fed is in a delicate position. They cannot get out of this situation by “throwing everything it can against the wall.” Let’s just hope that they can find a way to get out of their conundrum with the least amount of negative consequences.