A Problem With Large Government Deficits

 When one discusses large government deficits the discussion generally centers on either the ability of the government to finance those deficits in financial markets or the need to “monetize” the debt, thereby creating the possibility of substantial future inflation.

There is another problem that doesn’t get as much attention yet is very, very important for the running of the government.  It is a problem the United States government is now facing. 

If a government (or anyone for that matter) is running a large deficit in its financial budget then the very existence of such an excessive budget restricts the government in what else it might be able to do.  That is, the government’s flexibility in taking on new expenditures is severly limited. 

The United States government is facing this problem in several areas at this very moment.  Let’s review a couple of them.

The United States government is facing tremendous competition from China in international trade and finance.  The United States is very limited in its ability at this time to respond to the initiatives that the Chinese are making in the world…politically and economically. 

“Flush with capital from its enormous trade surpluses and armed with the world’s largest foreign exchange reserves, China has begun spreading its newfound riches to every corner of the world—whether copper mines in Africa, iron ore facilities in Australia or even a gas shale project in the heart of Texas.”  This comes from the article “As China Invests, U. S. Could Lose,” in the New York Times. (http://www.nytimes.com/2011/05/04/business/global/04yuan.html?ref=business)

A “study, commissioned by the Asia Society in New York and the Woodrow Wilson Center for International Scholars in Washington, forecasts that over the next decade China could invest as much as $2 trillion in overseas companies, plants or property…”

The United States government and United States business does not have that much “dry ammunition” to combat such an investment program.  And, as U. S. government policy continues to underwrite a weak dollar, the ability to take on such an investment program internationally continues to fade into the background.  But, other BRIC nations pose such a challenge as well.

Yet, the United States cannot afford to be un-competitive in this area.

Also this morning we read about the plight of United States regulatory agencies: “US Regulators Face Budget Pinch as Mandates Widen.”  (http://dealbook.nytimes.com/2011/05/03/u-s-regulators-face-budget-pinch-as-mandates-widen/?ref=business)  In effect, as Congress has given banking and financial regulators more to do, due to the recent financial crisis, the regulators find that they are finding less and less money to carry out the new charge they have been given. 

Many of us may not be upset with this situation, still it points to the fact that with the large budget deficits forecast into the future, the United States government just cannot commit to fund certain programs people have wanted to see become more aggressive. 

One final situation that has recently occurred.  This has to do with the situation in Libya.  Many have argued that the United States cannot take on more military roles in the world because it just cannot pump up the expenditures on the budget to meet such responsibilities.  Consequently, since it favors military actions in selected spots, such as the one in Libya, it cannot fully participate in the exercise and must get others, like NATO, to carry the burden of the effort.

The question then becomes, “Is this budget constraint keeping the American government from doing things in other areas it believes it should be involved in?”  Like in Yemen or Syria?

The problem is that one can’t do everything…even if that “one” is the richest and most powerful nation in the world and oversees the reserve currency of the world.  And, this is the problem with lots of debt.  It allows “one” to live beyond ones means for a while…but then there is always the possibility that “one” will need to do more…and can’t.

It is an issue of management and discipline.  One cannot constantly push debt limits to the extreme and then expect to be able to go further into debt should the occasion arise at some time in the future. 

Boy, this idea seems “old fashioned”!

But, this is exactly what the United States government has been doing…and it has been doing it for an “extended period”…it has been doing it since the 1960s.  This is the foundation of the credit inflation we have been experiencing for the last fifty years.

And this is the foundation of the decline in the value of the United States dollar for the past fifty years and for the terrible balance of trade situation the United States finds itself in which has led to the surplus of dollars in the hands of the Chinese and others. 

I know…if the value of the dollar declines, the trade deficit should get smaller.  I tried to respond to this issue earlier.  See my post “Does a Decline in the US Dollar’s Value Reduce the Balance of Payments Deficit”: http://seekingalpha.com/article/265072-does-a-decline-in-the-u-s-dollar-s-value-reduce-the-balance-of-payments-deficit. 

The value of the dollar continues to decline because those in international financial markets don’t observe the “management and discipline” in the Unites States government that is necessary to change what goes on relative to the budget of the United States government. 

In my view, the United States government does not have to do much to gain the confidence of world financial markets.  The first thing the government must do is accept the goal of maintaining the value of the United States dollar in foreign exchange markets as its primary economic objective.  (I have discussed this in a post to my Instablog, “What is Needed to Reduce the Federal Deficit”: http://seekingalpha.com/author/john-m-mason/instablog.)

This would allow two things to happen.  First, the United States government could get away from its current primary goal, the Keynesian goal of achieving full employment, which it cannot accomplish anyway. (See my post from yesterday: http://seekingalpha.com/article/267307-the-new-way-of-conducting-business.)  The exchange rate goal incorporates an inflation goal within it.

Second, the government needs to focus on “good” long-term management and discipline in its budgetary practices.   Good, long-term management pays off.  My recent example of this is the efforts led by Treasury Secretary Robert Rubin in the latter part of the 1990s to balance the United States budget.  International financial markets saw this effort; believed that President Clinton and others within his administration supported the effort; and the value of the US dollar began to climb in foreign exchange markets even before a balanced budget was achieved. 

The important thing to note is that the economy also got stronger during this time so that the government achieved not only a greater balance in the budget and a rising value of the US dollar, but it also saw the US economy continue to grow.  International financial markets approved of the “management and discipline” that it believed it saw in the United States government.  Plus, this effort created some room for the Bush 43 administration to add additional “unexpected” expenditures to the budget ,as they were needed, such as the “war on terrorism.

Is the United States on the Right Track?

The debate rages on: is the economic policy of the United States on the right track? On one side of the argument we hear that not enough has been done by the government to get the economy going again and to reduce unemployment. On the other side we hear that the government is creating too much debt and that most attention needs to be given to the reduction of the looming federal deficits.

Which argument is correct?

Well, if we look at the value of the dollar for an answer to this question, it seems as if investors are leaning a little more on the side of the latter.

This chart shows the value of the United States dollar against other major currencies in the world. The grade that is being given the economic policies of the United States government is not a good one. It should be noted that this index includes the Euro and the British Pound, two currencies that have been quite weak against the United States dollar recently.

Since January 2001, the value of the United States dollar has declined by about 26% against these major currencies. At one time, in 2008, the value was about 32% lower than in January 2001, but the ‘flight to quality’ during the Great Recession allowed the dollar to recover somewhat, but it then declined again to its current level as confidence rebounded.

Even with the situation in Greece (and Portugal and Spain and Ireland and…) investors in international markets still seem to believe that the United States government is on the wrong path with respect to its fiscal and monetary policies. Federal deficits totaling at least $15 trillion over the next ten years connected with a monetary policy that is keeping its target interest rate close to zero for an unknown length of time is not a combination that builds much confidence.

It could be argued that these international investors are giving the Obama Administration about the same grade it gave the Bush (43) Administration. If it were not for events going on in other countries, the value of the dollar could be even lower.

In fact, the recent performance of the dollar indicates that the international financial community sees little difference between the performance of the current administration and that of the administrations that preceded it over the past forty-five years of so, going back to 1961. Yes, different administrations pursued different specific policies that represented what they thought was best for the country, but in terms of aggregate policies, there has been little difference overall. The general thrust has been more federal debt and more private credit. The result: an almost constant increase in credit inflation.

Now, there is the threat of a debt deflation as a consequence of the Great Recession, but world currency markets don’t seem to think that a debt deflation is the most likely prospect.

With a government whose gross debt doubled since January 2001 and is projected to double again within the next decade and with a Federal Reserve that has injected $1.1 trillion of excess reserves into the banking system, little confidence exists among international investors that the United States government can “exit” this situation without losing control.

You can say all you want to about the policy differences of the different administrations over the last fifty years, but if you look at the aggregate economic data, very little separates the performance of the Republican and Democratic Presidents. President Nixon, perhaps, spoke for all Presidents of the past fifty years: “We are all Keynesians”.

One could argue that the Clinton Administration was the exception in terms of fiscal policy. And, Paul Volcker had to overcome the fiscal prodigals, Carter and Reagan, to achieve some credibility for the United States in international financial markets.

This relatively steady performance has weakened the United States internationally and the continued weakness in the dollar indicates that investors think that the current direction of policy will weaken the United States further going forward. This decline, connected with the ascension of the BRICS and other emerging areas in the world, is shifting power relationships all over the globe. The move from the G8 to the G20 captures this change.

The thing is, power cannot stand a vacuum. If the United States is wobbling a little, China, Brazil and others are there to fill in the spaces. Other nations will not stand still so as to allow the United States to dig itself out of the hole that Bush (43) put it in. In fact, by pursuing the same kind of aggregate economic policies that were followed by the Bush (43) Administration, large deficits and extremely loose monetary policy, the Obama Administration, in many ways, just seems to be digging the hole deeper.

Ben Bernanke is even calling for the Obama Administration to produce an “exit” strategy to reduce future federal deficits. But this just highlights the problems that this administration faces. The government must “exit” both an excessively loose monetary policy as well as an excessively prodigal fiscal policy stance. It will be a truly exceptional performance if this administration can pull it off.

Right now, I believe that world markets think that they cannot pull it off. The place to watch is the foreign currency markets: keep your eye on the value of the dollar!

Obama to Tackle Deficit--Next Year!

“This has been the year of coping with the economic mess. Next year will be the year of coping with the deficit mess that follows the economic mess.”
So says Wall Street Journal writer Gerald Seib. (See “Obama Lays Plans to Tackle Deficit,” http://online.wsj.com/article/SB125599128538995091.html#mod=todays_us_page_one.) “The timing is tricky” because next year is an election year, but Obama is going to do it! Yes we can!

The strategy is a two pronged attack with another strong initiative in the wings. The first go at it will be at the president’s State of the Union address. That’s in January.

Following right after there will be the president’s budget proposals. That will be in February.

Then, well, let’s put together a task force—say eight Democrats and eight Republicans and let them address “the nation’s long-term fiscal imbalances.”

Yes, the Obama administration has things under control.

And, the world goes on.

The value of the dollar has declined by about 13% since January 20, 2009. It is possible that it could decline another 5% to 10% over the next six months or so.

Over the last thirty-eight years, since August of 1971, participants in international financial markets have failed to trust governments that ran up huge budget deficits. The general attitude has been that governments that cause their debt to increase substantially through loose or irresponsible budgets will eventually end up having their central bank monetize large portions of their debt.

In the face of such behavior, investors have sold the currencies of these countries until some appropriate response has been forthcoming from the governments running the deficits. More than a few countries have experienced this consequence of their budgeting largesse. Concern has even been expressed about how a group of “unknown bankers” could have such an influence over sovereign nations. (See for example the book “The Vandals’ Crown: How Rebel Currency Traders Overthrew the World’s Central Banks” by Gregory Millman.)

But, the United States government ran massive deficits earlier in this decade and the Federal Reserve supported such debt with extremely low interest rates while it allowed asset bubbles to run their course. During this time period the value of the United States dollar declined by about 40%.

The situation since January 20 has several characteristics in common with this period: large deficits supported by the Federal Reserve with extremely low interest rates. And, as mentioned above the value of the United States dollar has declined by about 13% since that time.

Talk about a strong dollar is a joke at this time. Talk about getting the deficit under control is approaching the same seriousness.

Let’s face it, Obama owns the deficit now.

As is usual in economics, people and markets have a short memory. The past is the past. The current administration has been in office nine months now. It is a “full term” pregnancy! The child, the current deficit and subsequent problems, belong to Obama.

Markets will not wait for additional speeches, even a State of the Union speech. Daily, there is more and more talk about the inability of the Obama administration to make decisions, to act. It only talks and promises.

People and markets don’t want a task force to address “the nation’s long term fiscal imbalances.” How long will that take? Six months, twelve months, or longer?

The markets need some substance. As far as I can see there is no indication that any “substance” is going to be forthcoming soon. Thus, the dollar will remain weak because what reason is there to buy it?

Has the Monetization Really Started?

Headlines on the Wall Street Journal website Thursday afternoon, “Treasurys Climb After Solid Auction.” (See http://online.wsj.com/article/SB123807273254847621.html#mod=testMod.)

Success!

The issue Thursday was a seven-year note sale of $24 billion and this capped the issuance of $98 billion in Treasury offerings this week. The day before, Wednesday, the auction of five-year notes was “tepid” and the market was nervous at the beginning of the day.

But, something else happened on Wednesday. The Fed began its planned purchases of existing securities. In fact, the Fed bought securities that matured between February 29, 2016 and February 15, 2019. Gosh, that’s right in the range of the new issue that sold so well on Thursday. Imagine!

Primary dealers offered the Fed a total of $21.9 billion in Treasury securities that matured in this time period and the central bank bought back $7.5 billion of them. Apparently, this will be the procedure that the Fed will follow in upcoming weeks as the indication is that they will purchase outstanding securities on a regular basis.

The Fed is expected to buy roughly $12 billion of Treasury securities every week until they exhaust the planned $300 billion in purchases as announced last week. Friday, March 27, they are going to be purchasing at the short end of the yield curve with dates running from March 2011 to April 2012. Planned are three purchases next week, with some maturity dates expected to run from August 2026 through February 2039.

One of the prominent explanations for the intermediate-term purchases is that the Fed thinks it will help keep mortgage rates down since most 30-year mortgages have an average life of about seven years. If choosing this maturity just happens to provide liquidity to the market so that the Treasury has an easier time of placing its new issues, well so be it!

So, it looks as if we are on our way.

Where?

To the land of Oz?

We are starting to see the Fed get serious about monetizing the debt. The talking is over and the direct impact on the market is now under way. At $12 billion in purchases every week, this means that for the next 25 weeks or so, the Fed will be entering the Treasury market acquiring more securities. And, this doesn’t include the provision to purchase mortgage-backed securities in large dollar amounts.

On the other side, as we saw with the $98 billion in new issues this week, the “recovery program” will be providing plenty of additional debt to the market during this period of time. Relieving primary dealers of outstanding issues will certainly “grease the wheels” for the Treasury in terms of the additional debt issue that will need to be placed.

So now we are seeing the future. The Wizard is waving his magic hand. Monetizing the government debt! Providing a scheme whereby private interests can make tons of money buying up “legacy assets”! And, a new regulatory scheme to keep the “bad guys” under control! It is a wonder land with a whole new geography.

It’s ironic. Last September, I remember feeling as if the world had changed, shifted, and would not be the same again. The specific time—a Tuesday evening--when I learned that AIG was being nationalized. I just felt different.

I feel that way again. The rules have changed. Maybe better said, the old rules are no longer applicable and we really don’t know what the new rules are—but we know that they will be different.

Will all this work and restore the banking system and speed the economy on to recovery? No one really knows. I guess we are all waiting for a “tipping” point. But the tipping point can mean different things to different people. The administration sees the tipping point producing a recovery. Critics of the administration see the tipping point creating a whole new cycle of inflation.

And, what if no tipping point appears? Well, that will just mean that a greater effort will be put into the attempt to spur the financial system and the economy along.

The most specific thing going right now is what the Federal Reserve is doing. They are purchasing the debt of the government and they are going to continue to do it for a substantial period of time. For today, we see that this effort has helped the Treasury Department place $24 billion of that debt. And, the Fed’s actions will probably continue to ease the placement of the additional new debt in the future.

What we need to look for, in my estimation, is what happens to the value of the dollar in foreign exchange markets. When the Federal Reserve initially announced this program the value of the dollar fell. When this policy of regularly purchasing Treasury securities up to the $300 billion proposed becomes excessive in the minds of currency traders, the value of the dollar will begin to decline again. My guess is that this will happen sooner rather than later.

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.

The Obama Stimulus Plan and the Dollar

All eyes, right now, are on the forming Obama administration and the economic plan they are constructing. We get the word that we can expect fiscal deficits in the neighborhood of one trillion dollars and we can expect large deficits for several consecutive years.

The Federal Reserve is doing all it can to push liquidity into the system and has thrown just about everything it can into the market to get banks lending again and the financial markets functioning. The Fed’s balance sheet has ballooned so significantly, one has to wonder how they can ever re-establish monetary discipline within a reasonable time period.

The concern is, of course, an economic recession or worse and the economic dislocation and misery that accompanies such an experience. As a consequence, very little attention is being given to the dollar.

I believe that the value of the dollar is something to watch, even at a time like this. The reason being is that the value of the dollar captures how international financial markets are interpreting the economic policies of the United States government relative to the economic policies of other nations. The importance of this price is underestimated and I continually go back to the statement of Paul Volcker: “a nation’s exchange rate is the single most important price in the economy.” (Paul Volcker and Toyoo Gyohten, “Changing Fortunes: the World’s Money and the Threat to American Leadership, (New York: Times Books, 1992), p. 232.)

The Bush 43 administration ignored the value of the dollar for most of its time in office and showed contempt for any fiscal or monetary discipline as the value of the dollar declined by more than 40% against a wide range of important currencies. This decline can be seen in the accompanying chart which presents the value of the dollar relative to the Euro. One can see that from 2001 until August 2008 the value of the dollar fell (represented by upward-moving curve).

Place chart here from St. Louis Federal Reserve Bank.
http://research.stlouisfed.org/fred2/series/DEXUSEU?cid=94



One can see that once the world financial crises escalated in September 2008 through the fall that the value of the dollar rose (the value of the Euro falls in this chart) as there was a world wide flight to quality…a movement to the United States dollar. Only recently have we seen some decline as the Federal Reserve has let short term interest rates in the United States fall toward zero and has attempted to further push liquidity into banking and financial markets.

The concern is going forward. How are world financial markets going to accept the Obama team and the monetary and fiscal policies that will be implemented by the new administration? With projections for such huge amounts of federal government debt hitting the market and the stance taken by the Federal Reserve system to basically monetize large portions of this debt, there is concern about what will happen to the value of the dollar and the place of the United States dollar as the world’s reserve currency.

Bush 43 was helped considerably by the willingness of the rest of the world…especially China, India, Japan, Middle Eastern countries and others…to finance the huge deficits it created. The Federal Reserve produced negative real rates of interest and private debt soared, much of it placed off-shore. The United States relied on the savings of the rest-of-the-world to pull off its debt binge. But, international investors responded to this debt bubble by selling the dollar.

It seems as if there are three possibilities for the value of the dollar given the projected large federal deficits. These are:
1. Foreign investors will continue to acquire the debt of the United States and will continue to use the dollar as a reserve currency;
2. Foreign investors will avoid, to one degree or another, absorbing the new debt of the United States and will flee the dollar;
3. The Federal Reserve will have to monetize a major portion of the new debt issued by the United States government and this will not be good for the dollar.

One hopes that the first of these alternatives will come to pass. Unfortunately, with the experience of the last eight years, the international financial community does not have too much faith in the ability of the United States government to act with appropriate discipline. Therefore, it is important to keep an eye on the value of the dollar and see how the world community is evaluating the new administration.

I have said nothing here about the potential effectiveness of the forthcoming Obama stimulus plan. There are still many questions that remain about how effective the plan might be. No one knows for sure. And, no one has an idea about when the banks might start lending again and when the financial markets might thaw. One hope that these policies will have some degree of success.

Still, we need to keep an eye on the value of the dollar. Discipline in Washington, D. C. has been absent for the last eight years. And, as I have said many times, once discipline has been lost…decisions makers don’t have any really good options that are left them. Bush 43 acted as if the rest of the world did not matter. The Obama administration, as much as it would like to throw everything it can at the economy, must not lose sight of how the rest of the world is reacting to what it is doing. A continuing decline in the value of the dollar not only will weaken the role of the United States in the world, but it will also place more and more American physical assets on the sales block to be scooped up by foreign interests.

The rest of the world already is saturated with American debt. How it receives the massive amounts it is going to receive is anybody’s guess. I think watching the value of the dollar will give us a clue.

Trillions and Trillions

Carl Sagan only talked about “Billions and Billions” of heavenly bodies out there in the universe.

Barack Obama, President-elect, talks about “Trillions and Trillions.”

That’s Federal budget deficits, of course.

The Federal Government, according to the President-elect, is going to have to spend and spend and create these kinds of deficits if it is to side-track the economic downturn and put people back to work.

Paul Krugman, a supporter of this kind of spending, in his New York Times column on Monday, “Fighting Off Depression” (http://www.nytimes.com/2009/01/05/opinion/05krugman.html?em), makes the following statement: “This looks an awful lot like the beginning of a second Great Depression. So will we “act swiftly and boldly” enough to stop that from happening?”

Bush 43, during his reign, created more debt than all the administrations before him. So what is new in the Obama approach? Just size?

One of the things that is new is that the people coming into the Obama government believe in an active government and the ‘planned’ use of the budget to stimulate the economy. The Bush 43 team did not.

As I have said before, the Bush 43 team reminded me of the Nixon team that administered wage and price controls in the 1971-72 period. I remember very distinctly sitting in the room in the White House with George Schultz, Arthur Burns, Maury Stans, and others, watching these people administer wage and price controls with their noses turned up in disgust, doing the last thing in the world they believed in or wanted to do…control wages and prices.

This is the same feeling I got from Hank Paulson and Ben Bernanke…they really did not philosophically believe in what they were doing and really did not want to be doing what they were doing. And, as a consequence, they were not very good at it.

The general approach taken by Paulson and Bernanke in the financial crises was…throw “stuff” against the wall and see how much of it sticks. The important thing was to throw enough “stuff” at the problem so that enough will stick so as to defuse the crises. In performing in this way they did not look like they knew what they were doing…try this…no, try that…no, let’s do it this way…they were not disciplined…more is better…and they did not inspire much confidence.

Now we have a team coming into power that believes in the use of the fiscal tools they are going to inherit and they have confidence that they can use them in a productive way. This is the difference between the Obama team and the Bush 43 team. How the Obama team executes their plans is very important because both international and domestic financial markets need to have confidence in the United States administration, something they have not had for at least seven years.

The lack of confidence in the Bush 43 administration was exhibited in the relatively steady, six year decline in the value of the United States dollar, a decline in value of more than 40%. This lack of confidence grew out of the undisciplined way Bush 43 conducted the monetary and fiscal policies of the country. This lack of discipline in the Federal government set the tone for a growing lack of discipline in financial practices. International markets proved to be correct in that the whole financial structure built upon government, as well as private, debt and inflationary bubbles ultimately crashed.

To recover…confidence must be rebuilt!

This is why the appearance (and reality) of discipline is vital! Yes, the Obama team is proposing deficits that will be measured in the trillions. But, the spending and tax cuts that produce these large deficits must not be just throwing ‘stuff’ against the wall. There must be well thought out reasons for the expenditures and tax relief…there must be oversight and controls to accompany the programs…and there must be thought given to what is going to happen to all this spending and deficits once the corner is turned and the economy and the financial markets stabilize.

I know that this is asking a lot…yet, it was the lack of discipline that got us into the current situation…and, the only long term way to get us out of the current situation is to re-establish discipline over what is being done. If there is little or no discipline in what the Obama administration proposes…confidence will erode…and relatively quickly…and markets will continue to tank. Market support will only come from a belief in the commitment and execution of a believable plan.

The major parts of the Obama spending programs seem reasonable…build infrastructure, health care reform, education, and investment in new energy programs. Major emphasis on these things, however, is not “quick fix” solutions. They represent a commitment not only to government spending, but also to investments in the future that can build intellectual and social capital.

Economists have contended that government spending during the Great Depression never reached a level to really stimulate the economy until the spending connected with World War II came along. But, one of the benefits of the government spending during that war period was all of the innovations and new applications that resulted from the spending and ended up in new industries and further innovation in the post-war period that spurred on economic growth in the future. That is, the government spending did not just support the existing, out-of-date industrial structure of the 1930s (like our current car industry), but created the basis for a new structure, new jobs, and a new life.

There is still concern that the fiscal programs being proposed will have the desired effect on the economy and the financial markets. It has still not been proven that government spending can be substituted for private spending in order to create sustainable growth and permanent jobs. In has still not been proven that the world can absorb all of the government debt that is being created. It has still not been proven that the government can generate all of these deficits and not end up monetizing a large portion of them.

There is still a lot of uncertainty.

Financial markets want to believe in the Obama administration. Financial markets want to believe that the Obama team is competent. Financial markets want to believe that the economic package that is being constructed will work. Financial markets want to see discipline re-established.

However, the numbers are so large…