The US is the largest economy in the world. Sure China may be number two, but when you consider it in per capita terms the US is near the top and China is closer to 100 in rank. The US has the most integrated market, its labor force is highly skilled and flexible, it has innovative entrepreneurs that are the envy of the world, it has a smoothly functioning and reliant legal system, it preserves and promotes intellectual property creation, it has an higher education system that attracts students and researchers from all over the world, and it has a living environment and opportunities that attract people in much greater numbers than we would like to admit. Add to that a military capacity with power and reach that is truly ominous in comparison to any other country and you have a country that is the equivalent of the NY Yankees in the 20th century.
Yes, the US economy is stumbling and the mood for the future is dour. But many other countries, including China, have conditions that are far worse in many respects. China is strong militarily, but they can’t project power on the other side of the globe like the US has done (rightly or wrongly) in Afghanistan and Iraq. China just commissioned its 1st aircraft carrier! The US has 11 with three more under construction … more than all other countries combined. China’s economy is expanding but they face enormous internal stability problems. They have an immature financial sector, a highly dubious legal system, and the potential for rural-urban migration in future years in numbers that exceeds the population of the US. They also have an aging population entering retirement, as does the US, only China’s is 5 or 6 times larger. And still their per capita income is only1/6th that of the US.
The US unemployment rate is currently over 9%. But is this something the US cannot endure and overcome? The unemployment rate was well over this in Spain and some other European countries during our previous boom years. In South Africa the unemployment rate is 25% … that’s as high as it was in the US at the height of the Great Depression in 1933. Remember, that while 9% unemployment is twice as bad as 5 years ago, there is still 91% of the labor force working. (some will say it is much less because of discouraged workers but I am trying to tell the “glass half filled’ story!) An impressive variety of goods and services that households buy remain on the shelves and while economic growth has slowed, the US economy continues to produce a vast amount of goods and services every year and will surely continue to do so.
So how must it look when a dominant country like the US stumbles economically and rather than looking inside itself to resolve its inner imperfections, instead it looks outside its borders to the things it cannot control and blames others for its problems. By this I mean the new Senate bill seeking to brand China as a currency manipulator. This action looks weak, not strong, … even more so because the target of our accusations is decidedly poorer and weaker than the US. Do people really believe that China can exert so much influence over the US economy via its exchange rate policy as to force the current recession and the loss of millions of US jobs? Not only is this outcome not in China’s own interests, it is not the likely effect merely by running trade surpluses with the US. (see my previous post explaining why the lost jobs argument is specious). Furthermore, even if China let its currency float freely, there is no guarantee that it will rise in value to the level some American observers would like.
Politicians are trying to rally American support around a policy position that has very little hope of generating the intended outcome. They are trying to act tough on China, largely because they have very little else to go home and tell their constituents. Within six months politicians will be campaigning for re-election and what are the accomplishments they can tell their constituents about? Not many! A bill that gets tough with China will give them something to ballyhoo.
There is one reason passage of this bill will create jobs though. What the bill seeks is to allow exchange rate undervaluation to be used in the determination of anti-subsidy actions. These actions allow an industry in the US to obtain higher import tariffs if it can be shown that a foreign government has implemented targeted subsidies on exports and if those exports cause injury to the import-competing firms. These actions require firms to file petitions with the US government, which in turn requires skilled legal assistance. These investigations must be then be conducted by government employees. If these petitions rise in number due to the new law we can count on more lawyer, lobbyist, and government jobs will be required to make the process work. On top of that we can surely expect that the Chinese would immediately file a complaint with the WTO and claim that the US was violating its trade commitments. This will inspire further investigations that will take years to resolve requiring even more Washington lawyers and lobbyists. In fact we may even see the Chinese hiring US lawyers to help them in their dispute with the US (many law firms in DC specialize in helping foreign countries with their trade disputes). Now it is highly unlikely that this bill will create millions of jobs. However, it is virtually certain to create hundreds or thousands of high-paying jobs for Washington lawyers and lobbyists. Is this the best way to devote our economic resources … enabling lawyers to earn millions of dollars arguing that government X violated promise Y and caused harm to firm Z? Hardly! Instead it will make a country that traditionally has championed free trade and free markets, look hypocritical, petty, and weak.
Wednesday, October 5, 2011
The US is the largest economy in the world. Sure China may be number two, but when you consider it in per capita terms the US is near the top and China is closer to 100 in rank. The US has the most integrated market, its labor force is highly skilled and flexible, it has innovative entrepreneurs that are the envy of the world, it has a smoothly functioning and reliant legal system, it preserves and promotes intellectual property creation, it has an higher education system that attracts students and researchers from all over the world, and it has a living environment and opportunities that attract people in much greater numbers than we would like to admit. Add to that a military capacity with power and reach that is truly ominous in comparison to any other country and you have a country that is the equivalent of the NY Yankees in the 20th century.
Friday, September 30, 2011
As economic troubles around the world continue to mount there is increasing pressure upon
politicians to do something forceful to revive their economies while deflecting
criticism from themselves.
One traditional method has always been to blame foreigners for one’s
domestic troubles. In the 1980s
the US blamed Japan and worried that its economic strength would soon lead to a
diminished US presence. Today the
same process is playing out only this time China is the presumed enemy.
This week Senator Schumer from NY introduced another bill that would brand China as a currency manipulator and allow the US to take more forceful action against their presumed unfair trading policies. This action follows on a report issued earlier this month by the Economic Policy Institute indicating that the US trade deficit with China has cost the US 2.8 million jobs. Their line of reasoning is immensely popular and goes as follows: because China fixes its currency at a value deemed too low by US observers, Chinese goods are kept artificially cheap, inspiring larger US imports of Chinese goods. The relatively high $ value makes US goods more expensive to the Chinese thereby discouraging US exports. Thus, if only China would allow its currency to rise in value, then Chinese imports would fall, US exports would rise, trade will be balanced and US jobs will be created. It is a convincing story … except for the fact that is not entirely correct … the errors lie in the parts of the story that are missing, the untold story that make the causes and effects quite a bit more complicated.
Let’s first look at the 2.8 million jobs supposedly lost due to the trade deficit. Now to be fair, if you read the report correctly, EPI doesn’t actually say that jobs are lost, only that the jobs are “lost or displaced.” Displacement is a more accurate term because the jobs are less likely to have been lost due to the trade deficit than they are to have been moved to the non-tradable sectors in the economy. In other words the trade deficit doesn’t cause a loss of jobs as much as it causes a displacement to other sectors of the economy.
To see why let me illustrate the fallacy of trade deficit induced job losses. Between August 2010 and July 2011 the US imported $288 billion more from China than it exported. If trade had been balanced instead, then either there would be $288 billion more in exports (thereby creating millions of jobs) or $288 billion less in imports (creating millions of jobs in import-competing US industries), or some combination of the two. Seemingly the deficit resulted in more money flowing out of the country to buy the extra imports, than flowed back in to buy our exports. That lost money and the corresponding lost jobs is what EPI is counting in its estimate. The fallacy is that the money is not lost and it does not stay in China. What China has done with that extra money is purchase assets in the US. In other words, they have lent the money back to us and are allowing us to use it instead. More technically, any trade deficit (current account deficit really) is offset by a financial account surplus of equal value, implying that our balance of payments with China is always in balance … there is rarely any money lost.
Most of the money that China has lent back to the US has been loans to our federal government. During the past decade China has purchased around $1.1 trillion dollars of US treasury securities. This is money the US government borrowed to finance its deficit spending. In other words, that $1.1 trillion of money was spent by the US government, inducing demand for US products and creating jobs for US workers.
So how many jobs were created by that $1.1 trillion of spending? Well, for that we could use EPI’s own estimates of the job creating effects of fiscal stimulus. Across a variety of articles (See here or here), EPI’s estimates range anywhere from 5,000 to 10,000 jobs created for every $1 billion of additional government expenditures. Because $1.1 trillion of those expenditures were made possible by Chinese loans during the past decade, EPI should conclude that the Chinese trade deficit “created or displaced” 5.5 – 11 million jobs during the past decade because of the added fiscal stimulus made possible by their loans to us.
Thus, using EPI’s methods, but evaluating the FULL effects of the trade deficit with China, could actually lead one to the conclusion that there was a net increase in the total number of jobs. (I’m not saying this happened, I’m just applying their method in a more complete fashion.) It is worth mentioning at this point that if you look at a graph of the US trade deficit with respect to the world, and compare it to the US unemployment rate during the past 30 years a very curious thing is seen: whenever the US trade deficit is rising, US unemployment is falling and whenever the trade deficit is falling US unemployment is rising. This is exactly the opposite of what you would expect if trade deficits really did cause job losses!
So EPI’s report is propagating a fallacy. It is suggesting that the trade deficit with China is costing the US millions of jobs. It is inspiring politicians to stoke up populist support against external entities, surely as a way to divert attention from their own mismanagement at home. This is a common political ploy used by politicians many times before. When economic times get rough at home, better to stoke up anger against an external threat, instead of turning attention inward. This political inclination has led to damaging trade wars in the past and even more damaging shooting wars sometimes.
The Chinese economy is currently in a precarious position. Although the impression in the West is that their economy is booming at the expense of ours, in reality the Chinese government may have run out of tools to keep things bubbling along. China is facing rising goods inflation and rising wages. They have a property bubble that looks ready to burst. They face another round of slow demand for their exports and rising anxiety at home. Put that together with a rickety financial sector, a legal system that is years behind the West, and a government that often corrupt and determined to remain in power, and you have an economy and a society that is just trying to keep things together … not one ready to take over as leader of the world.
Even if China responded to US demands right now and gave up defending their currency value, the result might not be what the US hopes for. Suppose for a moment that the Chinese suddenly allowed the yuan to float freely. No more currency manipulation! Because of the new uncertainties in the Chinese economy though and the prospects of property price declines, many wealthy Chinese might take that as an opportunity to move money to the US and other countries. In other words, in the present environment, the effect might be capital flight form China. If that were to occur the yuan would fall even further in value making Chinese goods even cheaper. Stranger things have happened in international currency markets.
My point then is that our ability to adjust simple levers, like the exchange rate value, (or force other countries to do so) and generate improved outcomes such as job creation at home is extremely limited. The world economy is too complex to expect that a simple adjustment in the dollar-yuan exchange rate will suddenly create millions of US jobs. Our politicians would do better to get our own house in order instead of trying to pin the blame for our troubles on other countries. The blame game is a diversionary tactic and US citizens would be smart not to buy into it.
Posted by Steve Suranovic at 4:34 PM
Sunday, September 18, 2011
For a competitive 3rd party to arise it will have to have a unifying theme that can be used to establish positions across a range of economic and social issues. To be effective, that theme will have to attract supporters from the right and the left. Perhaps the best candidate for that unifying theme is the growing disdain the general populace has for special interests. Conservatives and liberals alike complain about the problems caused by special interest politics. Almost everyone can tell a tale about a policy or process that causes them to lose (screws them over) while at the same time benefiting some special interest. Anger arises in people who feel they have been ripped off.
One problem with the special interest issue though is that everyone is a part of some special interest. If you work in a specific industry, you have an industry interest. If you are part a union you have a labor interest. If you are over 65 you have a senior interest and health care interest. In you are male or female, you have a gender interest. If you have faith in a God you have a religious interest. Belong to a particular race and you have a racial interest. If you are an immigrant, a consumer, gay or lesbian, a friend of Israel, or have a child with autism, then you have characteristics that establish a special interest.
It is also natural to support policies that favor your own special interest. If you are a farmer, agricultural subsidies make sense; a worker in an import-competing industry, then protection against Chinese imports makes sense; a senior citizen, then social security and medicare in its present form is an absolute necessity; work at Goldman-Sachs, then government bailouts are needed; if you are poor and unemployed then benefit expansions are good; own your home then the mortgage interest deduction is important; …. I can go on and on.
The main problem with special interest policies is that each one is discriminatory; each special policy bestows benefits on some group of people at the expense of others. Usually supporters of a particular special interest policy will argue that their policy is good for the nation. But, usually that’s not true. Supporters of import protection will say the policy will save or create jobs, but they won’t talk about the higher prices to consumers. Supporters of bank bailouts will say the actions prevent the collapse of the financial sector, but they won’t say much about the risk to taxpayers. Social security and medicare beneficiaries will say that those benefits are only fair because they made payments into the system previously, but they won’t be willing to consider that generous future benefits will have to reduce the disposable income of future taxpayers. Unfortunately everyone considers their own special interest a necessity, or a right, and will argue that the elimination or change in their policy will surely harm the nation.
A potentially successful moderate platform could include a goal to reduce the influence and sway of all special interests. This is the kind of unifying theme that could draw bipartisan and independent support. Unfortunately an effective strategy to reach that goal is elusive. Consider the recent suggestions to simplify the tax code. This is a laudable goal since, as I’ve heard Lawrence O’Donnell on MSNBC say, “everyone knows the tax code is unfair!” The tax code contains all sorts of special exemptions for this or that interest group. Eliminating, or at least reducing, these exemptions are something many people can support. However, because every powerful special interest will fight to retain their handout, it will be difficult, or impossible, for politicians to actually make these changes.
The growth of the lobbying industry is a clear indication of how special interests increasingly control government. That growth makes sense once the government starts handing out more and more special favors. If you are a special interest group and you see others getting special benefits then it only makes sense to hire some representatives for yourself and have them track and attempt to influence the policy changes under discussion by government. If government is writing new rules that favor some over others, one might as well try to make sure some of those rules favor you.
One reaction to this situation has been attempts to limit the influence that lobbyists have over politicians. Campaign finance reform, rules regarding political action committees, and many other examples, are attempts to restrain special interest influence. Despite these rule changes, lobbyists and special interests continue to exert their control
A moderate candidate with a platform to tackle the special interest policies could focus national attention on the problem. Unlike a Republican or Democrat, a moderate candidate would be free to highlight that some special interest policies benefit traditional conservative interests, while others benefit traditional liberal interests. Surely one reason for the continuing growth of government influence in both Democratic and Republican administrations is because each party in power directs policies towards their own special interests. The problem is on both sides of the aisle, which may be why a candidate from either side will be unlikely to tackle the problem.
Lately there has been a lot of talk of sacrificing for the good of the nation. President Obama has said that millionaires and billionaires need to contribute more. A moderate candidate might be the only one who could explain and emphasize that the shared sacrifice all Americans should consider is a willingness to accept the elimination or adjustment of policies targeted at their own special interests. Chances are very good that the benefits each of us will reap when others’ special interest policies are revoked will more than outweigh the losses we will incur by losing our own. The goal should be a government that does not discriminate, rather than the government we now have in which special interest discrimination has become its very foundation.
Posted by Steve Suranovic at 8:51 PM
Tuesday, August 30, 2011
The hype and hoopla about Hurricane Irene this past weekend offers a potential window into understanding the global climate change debate … but not because of claims that this is evidence of climate change itself but rather because the reaction to the hurricane represents a natural human response in this day and age.
As the hurricane developed and approached there was an impressive display of scientific evidence including the satellite images, wind speeds taken by planes flying through the hurricane, the projected paths using numerous simulation models, and the potential strength and wind speeds at various points along the projected path.
Together with the indisputable immediate scientific evidence and the “disputable” projected evidence there came pronouncements of the historic nature of the storm like … “worst storm to hit the East coast in a hundred years.” There also came all sorts of projected effects: storm surges destroying the barrier islands, high winds, downed trees, lost electricity, etc. In New York City, there were scenarios of broken skyscraper windows and storm surges that flooded subways and covered significant parts of Manhattan and Long Island. As is natural, most of the devastation was projected to occur along the coast since as I heard over and over, the storm surge does the most damage and the winds are highest there.
Of course I am sure there are examples of almost all of these effects happening in one place or another because of the storm: windows were broken, storm surges did do damage, floods occurred and electricity was lost. However, the overall extent of the damage was much less than was projected and predicted. What is more notable though, is that the places with the greatest devastation, like parts of Connecticut and Vermont (and I’m sure others) were not the places that were being hyped as the storm was approaching.
Thus while scientific evidence was very useful in predicting the path of the storm and the potential effects it ‘could’ have, science is not precise enough to predict the overall extent of damage that will be caused nor the precise locations that have more reason to worry.
The same might well be true about global climate change; namely, even though scientific evidence is very good at predicting the types of possible impacts that higher carbon emissions might have on the planet, it might not be very good at predicting the overall extent of the damage caused or who is more likely to be affected. As with the hurricane we might expect global climate scientists, and the media that reports about it, to exaggerate or hype the scenarios that are most dramatic. But also, we may expect, as with the hurricane, that the unexpected effects of global climate change may turn out to be more significant than the anticipated and exaggerated ones.
One more thing … because of the hurricane warning and the hype about its potential effects, many people responded by leaving the beach areas, boarding up windows, stocking up on food, water and candles, and staying out of harms way. Surely this contributed to lower overall damage. In a similar vein we might well expect that people will adapt to the effects of global climate change as it slowly impacts the world’s ecosystems. As they adapt to the changes, the overall impacts will be reduced.
Lastly, it is worth highlighting the scale of the differences between these two processes. Predictions about the hurricane involved scientific measurements of a relatively simple weather system, examples of which scientists have had the chance to observe over and over again across decades of hurricane seasons. Global climate change involves measurement of a hugely complex array of variables spread across the globe, other examples of which are scarce, if they exist at all.
My question then is: If we can’t precisely predict the impacts of a hurricane system one week in advance, why should we expect the 50-100 year predictions of global climate change scientists to be accurate representations?
Posted by Steve Suranovic at 11:47 AM
Saturday, August 27, 2011
The Wall Street Journal this week suggests that we should “Expect a Third-Party Candidate in 2012.” The authors claim the US is “in the midst of what we would both call a prerevolutionary moment, and there is widespread support for fundamental change in the system. An increasing number of Americans are now searching beyond the two parties for bold and effective leadership.”
This idea is a recurring theme in American politics especially because there is a large swath of people who do not identify perfectly with the conservative right or the liberal left. These citizens often identify themselves, or are called, unaffiliated, independent, or moderate. From observers firmly ensconced on the right or left, these citizens are sometimes considered unprincipled, confused, or muddled in their thinking!
To be sure, the political opinions of those who consider themselves moderate or independent are highly varied. A good place to explore the diversity of opinion on political issues is a 2011 Pew Research report titled, Beyond Red vs. Blue: The Political Typology. According to that report, 35% percent of voting Americans are classified as “Mostly Independent.” Among these Americans some tend to lean more Republican or conservative on some issues, some more Democratic or liberal. Thus even though there seems to be a large voting bloc in the “middle” of the political spectrum, that does not imply that all of these voters share a sufficient number of viewpoints to form a competitive 3rd party. For example, among the three groups in the survey classified as independent, 73% of the respondents in one group believe businesses make too much profit while only 13% of respondents in another group believed the same.
Nonetheless, if a 3rd party does emerge, it will have to be located in the moderate segment of the political spectrum if it is to be competitive with the prevailing parties. Only a “moderate” platform has a chance to attract enough Democrats and Republicans to one day capture a majority of votes.
But herein lies the dilemma. If moderates and independents do not share a sufficient number of viewpoints, then how can a new 3rd party unite them?
One critical feature of an effective 3rd party is that it has a simple unifying principle that will attract supporters. For example Green parties in Europe elect candidates that have strong environmental concerns. In the US, the Tea Party is effective partly because it stands on one simple principle; smaller government. However, the Tea Party is not a true political party. It has no central organization, and no convention organizing a slate of candidates at different government levels.
For a competitive 3rd party to arise it will have to stand for more than simply a position on one particular issue; instead it will have to have a unifying theme that can be used to establish positions across a range of economic and social issues. In this post, and several others to follow, I will identify what I see as some of the similar characteristics of many moderate-independents and based on this reflection suggest a few unifying principles that could possibly form the basis for a successful third party.
First, I think that most moderates-independents are located where they are on the political spectrum because they recognize that there are valid arguments made by both parties. Sometimes they are convinced by a conservative argument, sometimes by a liberal argument. There is a good reason for this. It seems unlikely to me that in the grand scheme either the conservative policies and positions are 100% correct and the liberals 100% wrong, OR liberals are 100% correct and conservatives 100% wrong. Instead there are strengths and weaknesses to every position and it is more likely that in the grand scheme both sides have some arguments that are stronger than the other side AND both sides have weaker arguments. Also, different people evaluate these strengths and weaknesses differently, which is why reasonable people can come to different conclusions.
In contrast, staunch conservatives and solid liberals (i.e., ideologues) are more inclined to believe that their opinions and positions are 100% correct and whoever disagrees is 100% wrong. Anger and hostility in political discourse arises because individuals can’t understand why others don’t see the logic of their own arguments and beliefs. To the ideologue the truth is crystal clear and any deviation from that ideology is considered unprincipled, ignorant or even traitorous. For example, many staunch conservatives are certain of their Christian principles, that the US is a Christian nation, and in their opposition to abortion and gay marriage. This is why every Republican candidate for President must declare his or her allegiance to these principles to have any chance of capturing the Republican nomination. On the other side, many solid liberals are certain in their belief in science and the ability to use human intelligence to guide the economy and society towards more just outcomes. This is why the left is so quick to discredit any viable political candidate on the basis of a presumed lack of intelligence. These unflailing beliefs also make ideologues inclined to view the opposition as an enemy that must be defeated. Victory presumably means ridding the country or the world of people who think incorrectly from their point of view.
Moderates-independents, on the other hand, are more inclined to accept that the truth is nebulous and that our ability to perceive it is limited. Consequently moderates-independents are more inclined to accept diversity of opinion on different topics. And it is also why independents themselves hold a diversity of opinion.
But a moderate position need not be an unprincipled one. It need not consist of a compromise in which principles are weakened in an attempt to appease the rigid sensibilities of the right and left. Instead a moderate position can be based on the recognition of the diversity of opinion and the search for principles and policies that allow people with different belief systems to live amongst each other. More on how to do this in later posts.
Finally it is worth noting that moderation has a long philosophical history as an ideal worthy of striving towards. Aristotle noted in the Ethics that, “ …virtue is concerned with passions and actions, in which excess is a form of failure, and so is defect, while the intermediate is praised and is a form of success.” For example the mean virtue of courage lies between the deficiency of cowardice and the excess of rashness. Similarly temperance is a mean virtue between the deficiency of insensibility and the excess of self-indulgence. Today’s recommendation that several glasses of red wine per day could improve one’s long term health represents a moderate consumption ideal that lies between the deficient teetotaler and the excessive alcoholic.
I am not suggesting that conservatism is a form of deficiency and liberalism a form of excess, or vice versa, although I am sure many readers would be happy to provide examples why this is the case. Instead I merely wish to suggest that some middle position between extremes can be a virtue. A principled moderate platform that can appeal to people who lean a little left as well as those who lean a little right is possible. Stay tuned for further thoughts on this.
Posted by Steve Suranovic at 1:16 PM
Wednesday, August 17, 2011
For over a year now we have been hearing about the government debt problems in Europe; especially in Greece, but also in the larger economies of Ireland, Portugal, Spain, Italy and even France. Greece’s outstanding public debt is now about 150% of its annual GDP. In Italy it is over 120%, in Ireland about 95%, France 85%, Portugal 82% and Spain 65%.
These worries and figures invite comparison to the US. In the US, total Federal outstanding debt to GDP is almost 100%. Another figure sometimes presented though is Federal debt held by the public, which stands at about 60%. The second figure eliminates the public debt purchased mostly by the Social Security Administration. The so-called trust fund – this is the excess of SS tax revenue over SS disbursements (which have been substantial in past years) – has been invested in US Treasuries.
In any case, because many observers keep mentioning default in Greece and other European countries, and because of the debt ceiling debate in the US, it is worth asking whether the US is in danger of becoming another Greece. The short answer is no.
There is virtually no chance the US will default and be unable to pay back principal and interest on its maturing treasury bonds. This conclusion was no different a month ago before the debt ceiling deal and before the S&P downgrade. As I have explained elsewhere, even if we had not raised the debt ceiling, the US would have continued to pay back principal and interest on its bonds. Other bills would not have been paid, but these bills would have. The simple proof of this lies in the fact that the US treasury market faced no disruption leading up to the debt ceiling deal. That means that the collective opinion of bond holders, which is whose opinion matters most, was that there was no chance of imminent default. In fact, even after the S&P downgrade, which was mild at best from AAA to AA+, demand for US Treasuries rose, indicating that they continue to be viewed a safe haven for investors.
Greece, on the other hand, (and Ireland, Portugal, and Spain), could conceivably default. (Although Greece is perhaps the only place where default is plausibly imminent) But one might ask, if US debt as a percentage of GDP is on a path to the same level as Greece, won’t the US eventually face the same default potential. Again the answer is no!
The important difference is the currency the outstanding loans are denominated in and the source of that currency. In the case of Greece, it has borrowed Euros mostly. However, Greece does not control the number of Euros that are issued; that is controlled by the European Central Bank (ECB). In contrast the US debt is denominated in dollars, and it is the US Fed that is the issuer of those dollars.
Consider an extreme case. Suppose one day the US Treasury needs to issue $50 billion of new debt in order to finance the government budget deficit and pay back maturing securities. Suppose further that our debt has risen so much that tax revenues alone don’t even cover the repayment of maturing bonds. Suppose also that nobody wants to buy newly issued government bonds - which would allow us to rollover and extend repayment - without demanding an oppressively high interest rate. Well, if the US ever reached that situation, and I should point out that we are nowhere near this kind of scenario, then the problem could be immediately ”solved” and default avoided if the US Fed under Ben Bernanke simply purchased the $50 billion in new bonds. To pay for it the central bank must merely make an accounting notation that says the government now has a $50 billion credit on its account. In this way money is created out of thin air to finance the government’s borrowing and to rollover the outstanding debt. (Note: This power is what drives Ron Paul nuts!)
Now one could say that because the Fed is independent of the federal government, it could refuse to make the transaction. This is true, however, given the problems associated with outright default and the simple ability to “solve” the problem by printing money, it is reasonable to expect that the Fed would relent and money would be printed in this case. This is about as dire a situation we could imagine in the US and in this case it is reasonable to conclude that the US would not technically default.
The same is true in any country that borrows in its own currency and controls the issuance of that currency. Thus it applies to Japan, whose government has debt over 200% of GDP. Japan is unlikely to default on its debt. However, this conclusion does not apply to any country that borrows in a currency that it does not issue. Since Greece does not issue Euros its excessive debt makes it a viable candidate for outright default. The same was true for many other countries in the past: Argentina, Brazil, and Mexico to name a few.
The ECB could offer to buy all the debt that Greece needs to issue to maintain its large budget deficits, however, this would result in an increase in the overall euro money supply and those euros would circulate throughout the euro zone. The ultimate effect of extra money circulating in an economy that is not growing sufficiently fast is inflation. Too much money chasing too few goods puts upward pressure on prices of goods and services. And this would negatively affect all countries in the Euro-zone acting much like a tax on all of the EU’s citizens.
Indeed, any country that finances its deficits by printing money is using inflation as a hidden tax. The alternative to printing money is to raise taxes to balance the budget (or decrease government spending). However, inflation lowers the purchasing power of everybody’s money, which essentially shifts buying power from all citizens to the government in this case. It also effectively lowers the real value of the outstanding government debt. This is because inflation lowers the purchasing value of the repaid principal and interest and creditors get back less than was originally expected. This is sometimes referred to as a partial default. We might also think of it as a “stealth tax” because no one can easily connect the loss of purchasing power to the actions of the government. It is also why it is always the most politically expedient exit strategy for governments.
As a quick example, suppose someone lends the government $1 million for one year at the interest rate of 3%. At the end of the year this person will receive back $1,030,000. But suppose inflation during this period unexpectedly turns out to be 10%. This means that it will now cost $1,100,000 to buy what last year cost $1 million. Thus the $1.03 million returned by the government is actually worth less than enough to keep even. The debtor gains at the expense of the creditor.
Back to the EU, this is one reason the ECB doesn’t want to bail out Greece, Portugal, Ireland, etc. The more it does, the more inflation is likely eventually and the more everyone in the euro-zone have to pay for the excesses of the minority.
One other solution for Greece is to drop out of the Euro zone. In this case they would reestablish the drachma as their national currency. But then what would they do with their Euro debt? The most likely recourse would be to renege on euro repayment and convert them to drachma. Thus a creditor might be told they won’t get paid back in euro but in the equivalent in drachma instead. Of course this would be less valuable to the creditor since drachma could only be used to buy goods in Greece, not in the wider EU, and because the new Greek central bank would be able to lower the value of these drachma by printing money and creating inflation in the economy. In this way the burdens of excessive government borrowing would be shifted to the creditors holding Greek bonds and to the Greek people. Because money is printed, causing inflation, this amounts to a partial default. Again, this is not a technical default because all the bonds will be repaid in full, but they will be repaid with currency that is worth less than originally expected.
Now back to the US. Since the US borrows in its own currency, there is no reason for it to ever technically default. It will always find a way to pay back its outstanding principal and interest. However, because the US can print money to finance budget deficits, it could default partially via inflation. A stealth default is possible. In this case, everyone gets the nominal value of their money back as promised, only those repayments won’t buy as much as originally expected. This is a real worry that China has: the fear that their more than $1 trillion of US debt is eventually paid back with dollars that will not purchase as many goods and services.
Posted by Steve Suranovic at 9:23 PM
Monday, August 15, 2011
One of the main reasons for the unemployment problem around the world is excessive debt. Only when we eliminate the underlying source of our problems will we be able to sustainably reduce the unemployment rate. In my last post about debt I talked about mortgage debt. This post is about government debt.
Consider the Greek debt problem. Examples of Greek government largesse are easy to find on the internet. For example, government workers get some of the best benefits anywhere in the world. All are paid in 14 monthly paychecks per year. (the two extra amount to negotiated bonus payments). Some workers can retire with a full pension as early as age 45. Pensions of deceased military officers continue to be paid to their unmarried daughters for life or until she weds. Some union members were once granted free unlimited transportation on the national airline. The state railroad payroll is 4 times larger than total ticket sales. There are many more examples like this.
To finance these generous benefits, and to remain popular, the Greek government had to borrow enormously. When the economic crisis hit in 2008, Greek government debt had already reached 100% of GDP. This year Greece’s total debt is expected to exceed 150% of GDP, which amounts to over $450 billion. And still the Greek government continues to run large budget deficits to fulfill promises that are clearly untenable.
The situation is a mess and the problem just keeps getting pushed further into the future. One necessary outcome is for Greece’s budget to be balanced quickly or even moved into surplus to reduce their enormous debt. However, if this is done too quickly it could cause sharp contractions in economic activity making it even harder to pay down the debt. The Greek people have already risen up riotously this year (and last year) to protest the proposed cuts in government programs or increases in taxes. After all, profligate or not, the Greeks feel entitled to these promises, just like Americans feel entitled to their Social security, Medicare and tax breaks. They are surely not willing to rein in excesses without a fight. Besides what is excess to one person is another person’s monthly paycheck.
Greece’s government doesn’t want to make the needed budgetary changes (no sane politician would!) because the changes are very painful and unpopular. So the only way to continue the largesse, quiet the protests, and move along is to get someone to lend them even more money. But with a CCC bond rating (worse than junk bond status) they can’t borrow on the private market unless the interest rate was extremely high to compensate for the high risk of default. The risk premium on short term Greek bonds currently exceeds 25% and borrowing at that rate would push up their deficits and debt even faster.
In July 2011, for the second time, the EU stepped in to provide up to $160 billion in loans to allow Greece to continue to borrow at relatively low interest rates and with longer maturities. In essence this is like an increase in Greece’s debt ceiling, allowing it to continue running deficits. However, these EU bailouts are funded by the other EU countries. Thus, if Greece can’t repay these loans, the losses will be borne by taxpayers in the other EU countries.
Of course, in accepting these bailouts Greece is required to bring its budget into balance in a reasonable time period. Interestingly Greece has not been doing a very good job at this. In the first half of 2011 - this is after the bailout loans they received last summer - the Greek budget deficit rose 24%. Of course some of this has to do with the fact that the economy is stagnant and unemployment remains above 15%.
So growth is slow to nonexistent, tax revenues are falling, government promises remain generous, and any attempt to reduce spending leads to massive riots in the streets. So why do they keep getting bailed out?
There are several reasons.
First, creditors - that is, the institutions holding the $450 billion in Greek bonds - want to get their money back someday. (Note it is not the bank’s money in jeopardy.. it is depositor’s money .. that’s the people’s money) If Greece defaults then some creditors may not get anything back. Better to get a deal and wait longer than get nothing. Also, defaults can be disorderly as creditors line up trying to squeeze as much value out for themselves as possible. For example, if Greece owes $50 billion but only $25 billion in cash, who gets paid and who doesn’t? Figuring that out can sometimes take years.
The bailouts amount to promises that creditors will get their money back eventually, but will have to wait longer for it. So the bailouts buy time. For Greece though, the bailouts result in forced austerity, especially for those most dependent on government programs or those who pay taxes ... which, of course, means pretty much everyone, … hence the riots in the streets!
Actually it is worth noting that another way to solve the problem for Greece is an outright default. If Greece defaulted, they would have to first settle with the creditors to decide who will not be repaid (this is a contentious process) and second balance their budget immediately because no one will lend them money for a long while. Thus the austerity will be even more painful in the short run. If Greece receives bailouts, then the austerity still has to happen, but it will be spread out over a longer period into the future. One question worth considering is whether it is better 1) to suffer a greater austerity quickly, resolve the debt problems (basically determine who is getting money back and who isn’t) and move on with a healthy balance sheet, or, 2) to suffer a longer and milder, though still painful, austerity and hope that the economy can grow and change into a healthy one in the distant future?
Perhaps the bigger problem for the world economy, though, is contagion. Many observers say Greece is small and so the problems there don’t matter much. That’s true, Greece is about the size of Maryland. But Portugal, and Ireland, and Spain and Italy are facing similar problems. If Greece’s problems migrate to these other countries then creditors will worry about the value of their loans to these countries too. And these loans are much bigger.
If Greece defaults, maybe the banking institutions can handle the losses. But what if Portugal, or Ireland, or Spain, decides to default? These could be large enough to force innumerable financial bankruptcies and threaten the entire financial system. Or what about the EU and IMF bailout of Greece? Again the values aren’t that large. But, what if the EU needs to lend money to Portugal, Ireland and Spain to keep them afloat too? (Note: they’ve already begun to do this!) How deeply into debt and how much risk are the Germans, French and other EU members willing to bear?
The essence of the true problem then is that numerous financial institutions around the world have taken deposits from its citizens and have saved the money by lending it to governments. Some of that money is in jeopardy of not being returned in full, but no one knows whose money is most in jeopardy or when those losses will materialize. Add on to this the US debt ceiling debate and the downgrading of US debt by S&P and we have financial institutions around the world questioning the true value of an enormous amount of their outstanding loans. It is worries like these, spread across the globe, that prevents the expansion of credit and the necessary risk taking that inspires economic growth. Sure, lending is occurring, but it is mostly safe and highly secured loans. These can keep the economies of the world running in place, but it is unlikely to fuel the rapid expansion we need to bring unemployment rates down.
If we want to solve the unemployment problem, there is no recourse but to alleviate the debt problems. There remains too much risk and uncertainty about the true value of outstanding loans for the world markets to function effectively. This is a reason why a large stimulus program may not work in this environment. Yes extra government spending can increase demand and create a few jobs for a little while, but this probably won’t speed up the debt restructuring. So if after the demand boost runs out, there remains a large number of underperforming loans, then we will also remain stuck in a stagnant economy. Only now we will be stuck with an even scarier level of government indebtedness that in turn could exacerbate the debt problems.
A useful analogy may be to think of the debt problem described above corresponding to a car that has been downshifted into 2nd gear. A fiscal stimulus represents stepping on the accelerator. Yes, the more we step on the gas (the bigger the stimulus) the faster the car goes, but if we remain in 2nd gear we’re in danger of burning out the engine. We can only return to a comfortable highway speed by upshifting to 3rd or 4th gear, and that requires resolving the debt problem first.
Posted by Steve Suranovic at 7:32 PM
Saturday, August 13, 2011
A Politco story released this week regarding comments by S&P senior director Joydeep Mukherji is being used to suggest that Tea party intransigence is the root cause of the debt downgrade. However, I think the finger is really pointing at the Administration instead.
Joydeep Mukherji said the stability and effectiveness of American political institutions were undermined by the fact that “people in the political arena were even talking about a potential default,” “That a country even has such voices, albeit a minority, is something notable,” he added. “This kind of rhetoric is not common amongst AAA sovereigns.”
It is worth noting that had the debt ceiling not been raised then it would have been up to the Treasury under Secretary Geithner, in consultation with the President and Congress, to decide which bills would be paid and which would be suspended. Tea Party Republicans, like Michelle Bachmann, assumed that the government would never default on our debt obligations. It was accurate to say that the government would not have to default since there were plenty of revenues coming in to cover all principal and interest repayments. Instead, the government could have suspended payments on discretionary programs and the effect would be much like a partial government shutdown. These effects would not be small or inconsequential but they would not amount to a default on debt.
However, this isn’t what the administration was saying. In Timothy Geithner’s Jan 6, 2011, letter to Majority leader Harry Reid he implores Congress to reach a deal to raise the debt limit.
He says in paragraph two, “Failure to raise the limit would precipitate a default by the United States.” He also says in the letter that failure to raise the debt ceiling would not be the same as a partial government shutdown. He wrote, “Those government shutdowns, which were unwise and highly disruptive, did not have the same long-term negative impact on U.S. creditworthiness as a default would, because there was headroom available under the debt limit at that time.”
In other words, the reason things would be different this time, is because we would fail to make our interest payments. At the end of the letter, he describes likely economic impacts of failure to raise the debt limit, most of which would clearly be the consequence of an actual default on US debt repayment. Thus, Geithner is strongly suggesting that the US might be inclined not to make some debt repayments if the debt ceiling were not raised.
Or listen to Obama’s Economic advisor Austen Goolsbee in January. He talks about default as if we would not make repayment of our principal and interest and does not make the distinction between discretionary spending and repayment of debt. Clearly he describes as catastrophic the impact of debt default.
But then listen to President Obama later in June. In this clip President Obama seems to equate the term default with not paying some government bills. So, for example, if the government did not pay some social security obligations, one might say the US had defaulted. So maybe when he says default he doesn’t really mean a debt default. However, at the end he asks whether we really would choose to send interest payments to China to avoid default on the debt rather than sending out social security checks. He doesn’t answer the question, but if I had to infer what his preference was based on the way he presented it, I’d have to say he’d prefer to pay the SS checks. The inference is that had the debt ceiling not been raised, the President may have been inclined to “really default” on some interest payments.
These are the voices S&P is more likely referring to, especially since these are the individuals who are empowered to administer the payment of government obligations. The administration could have avoided this criticism by saying throughout the crisis that the full faith and credit of the US would not be impaired EVEN IF we hit the debt ceiling. They then could have explained the serious repercussions if we were forced to go through a partial government shutdown. However the administration didn’t do that. Instead they told the default implication story over and over again and did not accurately reflect the true situation. That is …. unless it really WAS President Obama’s intention to default on debt to avoid a reduction in social security and other government payments!!
Posted by Steve Suranovic at 7:35 AM
Friday, August 12, 2011
In the national conversation about the economy the continual refrain is that we need to create more jobs. However, one of the main reasons for the unemployment problem around the world is excessive debt. Only when we eliminate the underlying source of our problems will we be able to sustainably reduce the unemployment rate.
A little bit of debt is never a problem. Most households borrow money to buy a home and a car and successfully pay back these borrowed funds over their lifetimes. Financial institutions are the vehicle that allows some people’s savings to be used to finance other people’s consumption. It is important to remember that banks receive money from people who say, “I want to forgo consumption today and wait to consume in the future instead.” to other people who say “I want to consume more today and pay it back by consuming less in the future.” These institutions create contracts, what we commonly call loans, which specify the terms of the repayment. These are promises that borrowers have made to pay the money back with extra interest payments according to some predetermined schedule.
Debt becomes a problem whenever a borrower discovers that he cannot repay the lender according to the original contract. Actually, the problem may occur even earlier when the creditor begins to suspect that the borrower will not be able to fulfill the contract.
Consider the US mortgage market. In the US today more than 20% of home mortgages are underwater (over 11 million in number). Because of the collapse of home prices, the home values, which serve as collateral, are less than the value of the mortgages. If a household stops making payments, the bank will foreclose, reclaim the house and try to sell it at the market price to recoup as much value as possible. This process takes time, is costly, and results in the bank receiving much less than the amount of money originally owed. It also means that someone’s savings, the bank depositors for example, will not get back all of the money they lent. This is an example of a partial default: the lender/saver didn’t lose all of their principal and interest, only some of it.
What is the best way to resolve this situation? Well, that depends on whether you are the lender or the borrower. The lender wants the original contract fulfilled; it wants to get all the principal and interest that was promised. The first best option, then, is to hold out and demand full repayment. If the borrower really can’t pay now, one way to fulfill the contract is to agree to an extension. Simply give the borrower more time to pay it back, but of course, charge more interest as well. This way all the money gets repaid with interest, but it takes longer to get it back. This is the second best option for the lender. The third best option would be to renegotiate the contract, agree to a partial default, and accept less than was originally expected. This is what happens in a foreclosure when the borrower is underwater.
From the borrower’s perspective it is not clear what the best outcome is. If borrower continues payments for long enough then he can hope the value of the house eventually rises above the mortgage value. But what if the price remains depressed for a very long time? Imagine paying on a $500,000 mortgage every month when the house is now worth $300,000? If that situation persists, it will not inspire household confidence and consumer demand. Furthermore, the household is stuck. The family can’t move anywhere without coming up with an extra $200,000 to pay off the old mortgage. (Imagine 11 million households in this situation to understand why consumer demand and confidence is so low.)
If the borrower walks away from the mortgage and suffers foreclosure they will have to leave the house and move elsewhere, most likely into a rental unit. The household will also suffer a stain on its credit rating for many years. Its reputation will be tainted and the household would have to live for a while without being able to borrow. On the other hand, all of the negative equity will be erased so the household’s balance sheet will immediately look healthier. The family is also free to move elsewhere and is no longer mired in a depressing situation. To use a fishing analogy, this is the “cut bait, and run” approach. One advantage to this latter approach is that both the household and the bank can accept the losses and move on, rather than being mired in a long, drawn out struggle to fulfill, perhaps unrealistic, promises.
One reason for the poor economic performance we now are living with is that there are millions, maybe hundreds of millions of debt contracts in the world, similar to the one described above, that are in jeopardy of full or partial default. That means there are numerous financial institutions that will not be getting back the full amount that was originally promised. Now some people might be inclined to say, “so what if the banks lose money?” That’s fine except for the fact that the banks didn’t use their money to make all these loans .. they used our money. By that I mean any money deposited in a financial institution. It means checking accounts, savings accounts, and retirement accounts, etc. If you engage with any financial institution; a bank, an insurance company, a mutual fund etc. then you have contributed to the pool of savings that has been lent out to someone else. And therefore your money is at risk of not being returned to you in full.
The struggle that is playing out now and will continue for several more years is a struggle to determine who is going to pay more and who less. Banks are struggling to maintain the performance of their loans, so they can preserve value for their shareholders and depositors. They don’t want to be the ones to suffer losses. When banks receive government assistance it is a way of unloading some of their burdens on the taxpayers of the country. It also allows the burden to be spread over a larger number of people and over a longer period of time. This way somebody else pays for the losses incurred due to the decisions of the bank.
With this explanation as background, I can now say, in a very indefinite way, when we will be out of the current crisis. It will be once the number and value of the debt contracts that are in danger of total or partial default becomes manageable. Even in a healthy economy there are non-performing loans. There are always some loans contracts that are not fulfilled. But in good times these losses are just swept into slightly higher interest rates that all depositors and borrowers pay for. No one notices. In financial crises, those non-performing loans are too large to go unnoticed. They threaten bank failures, they threaten bank runs and they cause high unemployment, stagnant growth and a loss of confidence.
Once we clean up most of these nonperforming or partially performing loans, confidence will be restored, consumers will start buying more, banks will start lending more, and the economy will move along at a healthy clip. Only then will the unemployment rates fall in a sustainable way. How long it will take to get there though, is anyone’s guess.
In my next post I’ll discuss the problems with government debt, using Greece as the example. The government debt problems are also excessive but they have slightly different characteristics and raise other issues.
Posted by Steve Suranovic at 9:35 AM
Monday, August 8, 2011
The economic news is riveting this week especially to an economist, but it amazes me all the BS I hear and read about as people are asked to assess the situation. Harry Frankfurt, a Princeton philosophy Professor, wrote a brief treatise titled “On Bullshit” a few years ago in which he tried to answer an obvious question, “Why is there so much BS out there?” One answer he gave was that too many people are expected to have an opinion about matters in which they do not know very much. Another reason must be the 24 hours news and commentary shows that some people are addicted to. It is curious how having more time to report the news does not result in much teaching about how things like the economy work.
So let me mention just a few things that have irritated me in the last few days.
1) I just watched a FOX report on the decline of the market today and they were showing how the market went down even faster while President Obama was making his speech in the afternoon. I’m a novice about stock trading but wouldn’t it make sense that trades that took place at 1:45pm or so are probably based on orders received sometime earlier and that it is unlikely that traders are evaluating the President’s speech, feeling bad about its implications, and then in real time placing more sell orders? Someone please correct me if I’m wrong.
2) I can’t believe how nasty people have been in their comments about S&P. Again I am not an expert on S&P but I do know that they are an independent company that makes risk evaluations on different types of assets. They have been in business for a very long time and they are staffed by a group of professionals that are trained in risk analysis. If they do their job right they should not be swayed by outside opinions of what the ratings should or should not be. Their business is based on their reputation and so they have an incentive to do the best independent evaluation they can provide to maintain that reputation. Their opinion on US debt is just that … their opinion. Yes, they did rate mortgage backed securities as too safe in the past but the risk involved in those was mostly systemic risk that was, and continues to be, very hard to evaluate.
Still it would be professional to treat them like the professionals they are rather than criticizing them as incompetent. Yes, you can disagree and argue that US treasuries are still safe and even S&P would agree that that’s true. Afterall, it is only one opinion.
Two side points. First, I’ve read several stories that some government regulations require that some companies invest in only AAA bonds as evaluated by S&P. Such regulations seem very bad form. I would suspect that rules like that were written to favor important special interests (i.e. S&P) to give them a favorable position in the risk analysis market. This downgrade could act as a wake-up call to eliminate such rules. (not to punish them but as an excuse to eliminate a bad rule) Second, I did think it was very bad form for S&P to announce that any debt deal would need to cut $4 trillion from the deficit to prevent a downgrade. That does suggest an independent agency with too much power to influence policy outcomes. S&P is an evaluator … not a policy recommendation agency, … at least not this branch of S&P. Again I think we can criticize S&P and the whole ratings system but can't people do it in a more professional way?
3) Isn’t there an inconsistency in the statements by the administration? Wasn’t President Obama, Secretary Geithner and Ben Bernanke all claiming a few weeks ago that brinksmanship on the debt ceiling was threatening a US default? Before the agreement was reached I heard news organizations nonchalantly reporting that a deal needed to be made before the US "defaults" on August 3. I wrote in February why regardless of what the “experts” were saying there was really no chance we would default even if the debt ceiling were not raised on time.
OK, so now we get past the debt deal and to the S&P downgrade and we hear the administration saying that there is absolutely no way the US will ever default on its debt! But wait a minute … aren’t we going to get to another debt ceiling vote again at some point … and can’t the same brinksmanship occur, … and if last time you said default was possible … well, then how can you say the US will never default? This kind of wavering cannot inspire confidence in the administration. [BTW, my opinion is that the US is not in danger of default anytime soon, regardless of brinksmanship in the future and the S&P rating at AA+ doesn’t indicate that anyway]
My first two points can be explained by Frankfurt’s hypothesis, the third point cannot. The third point can only be attributed to politics … politics that is very bad for building confidence in our economy.
Posted by Steve Suranovic at 10:07 PM
Sunday, August 7, 2011
As we come out of the debt ceiling debate in the US Congress and face the prospect of a word economy that seems destined to remain in the doldrums for some time to come, the debate over what to do next is heating up. Should we ignore the budget deficit and debt issues and go all in for anther massive government spending program to kick start the economy as economists like Paul Krugman suggest? Or should we follow the conservative track and put a credible debt reduction plan into place while revising the tax code and reducing future entitlement promises?
This discussion is sure to become even more heated due to the S&P downgrade of US Treasury notes and as the US Presidential race kicks into high gear by late this year. For many observers it is difficult to cut through the ideological rhetoric on both sides to decide what is the most appropriate course. Although many economists and political pundits declare that they know the answer, my suspicion is that no one really knows what is the best course to take, including myself.
But just because we must make decisions under great uncertainty doesn’t mean we can’t make decisions. Thus, rather than adding to the interminable ideological platitudes that appear online and on the nightly discussion shows, let me try to offer a more balanced evaluation by highlighting why both approaches have potential to succeed but both are also risky in different ways. I’ll suggest at the end that we might be best served to choose the less risky approach going forward.
I’ll begin with the liberal proposal that we should use Keynesian expansionary policy to put people back to work. The idea is to increase government spending, perhaps massively, especially on “shovel-ready” infrastructure and public works projects. One idea is to create a new Works Progress Administration as was created in the depression years by FDR. The WPA employed millions of unskilled US workers to construct roads and public facilities. According to Wiki, the budget in its first year was almost 7% of GDP. In today’s dollars, that would mean an expenditure of about $1 trillion per year.
The argument is that an expansion of government demand for goods and services, especially one this extensive, could substitute for the lack of private demand, and put millions of people back to work quickly. With the reduction in the unemployment rate and the rise of economic security, private sector demand might soon rebound. With confidence restored, the new WPA could then be wound slowly down as private sector job creation picks up the slack.
Proponents of this plan argue that a subsequent increase in the deficit and national debt is tolerable if the plan gets the economy growing rapidly. What is more, because interest rates are so low on US Treasuries, the cost of borrowing to finance this plan is almost miniscule.
Of course, such a plan is not without its problems and risks. One such problem is the deficit and debt problems we face. As a hypothetical, suppose the US had had a Federal balanced budget requirement for the last 50 years. Suppose further that several emergencies through the years had forced the government to run periodic deficits in some years that did not get completely paid off in boom periods. Suppose the national debt had built up to say 10% of GDP (about $1.5 trillion). If that were the US debt situation at the start of this recession few economists or political leaders would hesitate to implement a large public spending program.
The lesson we learned in WWII is that a huge government driven demand can quickly put people back to work and inspire a nation to produce again. However, it is worth highlighting that overcoming a recession by revving up a war machine in response to existential threats is not the preferred way to recover from an economic depression. Although unemployment fell to about 1% in 1944 we were also suffering about 2500 military deaths every week. Although we can certainly say we were out of the depression in the midst of WWII, we achieved that feat by enduring an even worse catastrophe.
It is also worth pointing out that the WPA was implemented in 1935 and yet unemployment remained at 19% in 1938, 3 years later, and 14.6% in 1940, 5 years later. On the surface, the massive jobs creation program had seemingly little effect. The spending that followed with the war machine was much more extensive. But one might ask then whether massive government spending to get the country out of a depression is only likely to be as effective when the country faces an existential threat as we did in WWII, but perhaps not when it is just a large public works project.
Nevertheless, the point I am trying to make is that the risk of a massive government stimulus program is relatively low when a country has not borrowed unconscionably in its past. Had the US been in that situation in 2008, there would be fewer objections to a Krugman-style stimulus. But because the US did have a reasonably high national debt to begin with, and because the recession raised the debt at an almost unprecedented pace, and because the seeds of the entire recession was excessive private debt fueling a real estate bubble, a further stimulus at this point in time must be considerably riskier. This is the concern of conservatives, which has inspired the whole debt debate. More on that in a minute …
A second big problem with another big fiscal stimulus at this point in time is the seeming failure of the first stimulus. Reasonable people could argue about whether the $800 billion stimulus bill passed in 2009 had no effect on unemployment or whether it prevented a much higher unemployment rate. If it did the latter, one could say it worked. Unfortunately though, it is impossible for anyone to know what we did not observe (e.g. a 15% unemployment rate without the stimulus) and so the former situation that it had almost no effect is more credible.
Also, if we recall the process by which the stimulus was enacted, it seemed never to adhere to the guidelines put forth by Obama’s own economic advisor Larry Summers that it be timely, targeted and temporary. Instead the stimulus funded State government shortfalls, was spread over several years, and seemed to fund a whole slough of pet projects that were lying in wait for the funding floodgates to open. Most observers on both sides agreed the stimulus was poorly designed. But one reason for that is that any stimulus will invariably be “designed” by the political process and not by some committee of wise experts. A similar outcome is likely if another stimulus were to be seriously considered.
Thus, although the idea of a stimulus is not crazy or without merit, it does carry important risks. We really cannot be sure that it would work effectively and if it didn’t, given that it would place an enormous burden on an already enormous government debt, it could put us into extreme economic jeopardy in just a few years.
That brings me to the other side of the debate. The tea party grew out of a grassroots concern for the growing size of our federal debt and the expansiveness of government. These are not ridiculous concerns or imagined problems. Through history there are plenty of examples of economic ruin caused by the excessiveness of government borrowing, and the often-concomitant increase in money supply to feed an ever-burgeoning government sector. In addition there are real concerns about the effectiveness of an economy in which a substantial percentage is driven by the non-market demands of the government sector. Many people, with good reason, believe that governments do not produce goods and allocate resources as effectively as private markets and thus are concerned about a government sector that keeps getting larger and larger with every passing year.
As with arguments about the effectiveness of Keynesian policy, reasonable people can also argue about the appropriate size of government and when the government influence over the economy is too large. Surely the presence of debt itself is not a problem for a household, a firm, or a government, when its overall size is a small share of either income or wealth. However, if an institution’s debt becomes excessive, the threat of bankruptcy and default or a long period of austerity becomes very real. One dilemma of course is that there is no simple delineation to decide when an institution’s debt becomes too large. Consequently, we have a difference of opinion among economic decision-makers.
Conservative Republicans, and Tea Party members especially, believe the debt has risen to very dangerous levels and that the country faces, either default, high inflation, or serious austerity if the present deficit course is not changed quickly and convincingly. Liberals and Democrats believe the debt, although too high, remains manageable and furthermore that the only chance to revive the stalled economy is by stimulating more government demand with continued short-term deficits. In other words they believe that additional deficits and debt are the only way to jumpstart the sagging economy.
So what’s the answer? As I suggested before, there no way for anyone to know for sure. What we hear on the airwaves and over the internet is just a lot of educated guesses. Further, as the debate heats up with rising stakes in the near future, stubborn intransigence will surely result in even more vitriolic rhetoric. Unfortunately, we are all in for a very unpleasant ride ahead.
Why can’t we discuss policy proposals and offer opinions and ideas without calling the opposing arguments, or the opponents themselves, stupid and inane?
So let me finish this discussion with what I would suggest is a more moderate evaluation of our current economic dilemma.
More fiscal stimulus ala Krugman, could expand demand, reduce unemployment and revive enough private confidence in the economy to reinvigorate rapid growth. The risk is that the positive effects are slow to appear, unemployment does not fall rapidly enough (remember the unemployment numbers after the WPA in 1935), and private confidence does not rebound. If this were the outcome, our national debt might be soon be approaching that of Japan’s at more than 200% of GDP. And with several decades building up international indebtedness (the US is a debtor nation internationally, while Japan is a creditor) the US economy could face several decades of austerity. (It is hard to know what the impact would be and how to describe it, but it would be pretty bad).
On the other hand, taking care of our fiscal deficit and trying to rein in our growing indebtedness, as the Tea party favors, could put our government on a firmer fiscal footing, restore our credit rating, restore confidence in the economy and prevent the calamity of future default and even greater austerity. If this restores business and consumer confidence, soon private sector demand may begin to revive economic growth. The risk is that quick reductions in the government deficit will lower payments to government contractors, federal workers, teachers and doctors, and thereby reduce demand for goods and services in the economy. This could cause an increase in unemployment and reduce consumer confidence even further. Getting to a healthier economy might require a worsening of the economy in the short-run, and what if that short-run is 3-5 years?
The downside of both of these approaches is pretty grim. It is why it is fair to say we are stuck between a rock and a hard place.
If I had to choose between these two approaches I would go with the approach to reduce the government deficit instead of the fiscal expansion path for several reasons. First, I think it is less risky. If the fiscal stimulus program doesn’t work then we’ll have even larger debt and economic problems in the future and it is hard to see how that won’t lead to possibly decades of economic hardship. If the balanced budget approach doesn’t work, we may suffer a little more in the short run, but at least we’ll have a smaller debt burden in the future. Overborrowing is a scourge for households, businesses and governments and it has got to be better in the long term to take every opportunity to reduce the extravagance.
Second, it is always politically expedient to raise deficits. Citizens always like more benefits and lower taxes because it seems like you’re getting something for nothing. Governments perpetuate this myth by first overborrowing and eventually by overinflating to resolve the overborrowing problem. Often, what is politically expedient, is simply the wrong thing to do economically.
Finally, I happen to believe that the private sector does a better job allocating resources to produce goods and services than government do. Government allocations are made for political reasons, and those are heavily influenced by special interests. Those special interests include big business, the military complex, labor unions, and other influential and powerful groups. Since every expansion of government debt involves raising the role and scope of government it is hard to imagine that another fiscal stimulus at this stage won’t have the same effects.
Thus for these reasons I would support politicians’ efforts to rein in the growing budget deficit even though it may contribute to the continuing stagnation of the economy. If legislators could simultaneously overhaul the tax system to take away most of the special provisions that have been given to curry favor with this or that interest group through the years, then maybe they could revive excitement in the private sector and jumpstart the economic engine even sooner. The chance of anything like this happening though is virtually zero because it is never politically expedient to rock so many special interest boats at the same time. But as I said before, if it’s NOT politically expedient, there’s a better chance that it’s the right thing to do economically.
Posted by Steve Suranovic at 10:55 AM
Monday, May 9, 2011
Paul Krugman has an interesting piece in the NYT today titled The Unwisdom of Elites. In it he argues that policy elites are increasingly blaming the slow recovery and the other economic problems we face today on the general public. He writes that "the policies that got us into this mess weren’t responses to public demand. They were, with few exceptions, policies championed by small groups of influential people." He goes on to point the finger squarely at President George Bush and Alan Greenspan, among others. His conclusion at the end is "We need to place the blame where it belongs, to chasten our policy elites. Otherwise, they’ll do even more damage in the years ahead."
I agree with much of Professor Krugman's analysis but I think there is a worrisome unstated implication. If Krugman's analysis is right about "elites" then we should ask whether the problem disappears when a new set of elites are brought into power. For example, Krugman has been vociferously arguing for the past few years that we need a larger fiscal stimulus and that there is little need to worry about the size of our budget deficit in the present circumstances. But Krugman is clearly among the policy elites on the Democratic side; especially as a Nobel prize winner in economics and a prominent NYT pundit. If we followed Krugman's advice on things would we avoid the pitfalls of undue influence of wise elites? Or, would we simply be substituting one set of elites for another?
In my view the policy elitism problem is prevalent on all sides of the political spectrum. Republicans may give away more to businesses through deregulation and tax cuts whereas Democrats give more away to businesses via favorable regulatory regimes and tax increases with tax break carveouts. In other words, influential groups seek to influence outcomes no matter which party is in power ... all in the name of "we know better than you what is best!"
Many say we need to impose more regulations to reduce the influence of powerful business groups. The problem is that any regulatory changes always go through the same political choice process that always alters the proposals into something more amenable to the special interests.
Posted by Steve Suranovic at 12:24 PM
Tuesday, April 26, 2011
Tuesday, April 5, 2011
We read a lot about excesses these days: excess government spending, excess budget deficits, excess money supply expansions, excess foreign exchange reserves. One other excess worth watching in the US is excess bank reserves over and above the banks’ required reserves. These excess reserves could unleash a torrent of economic activity and spark the rapid inflation that some say is imminent.
Here’s how inflation would arise. Under a fractional reserve banking system, a bank is allowed to lend only a fraction of the money deposited in checking, savings and other accounts. In the US, large banks must hold 10% of deposits as cash or reserves at a Federal Reserve bank. (reserves are like a checking account the banks have with the Fed). The remaining 90% they can lend out to businesses or consumers. When they do, those loans are spent by the borrowers and ultimately deposited back into the banking system. These newly created deposits can stimulate further lending up to the 90% limit, thereby creating even more deposits. Since deposits are spendable by their holders they represent a part of the money supply in an economy. And since the lending of excess reserves has a multiplier effect on total deposits, it also increases the money supply several times over. There is a limit though, and in a simply situation, the total money supply increase from a one dollar increase in deposits would be the reciprocal of the reserve requirement, or (1/0.10 = 10) ten times. In other words, a one dollar increase in excess reserves can cause a ten-fold increase in the money supply. Finally, if the money supply increase is too rapid compared to the growth of GDP, then inflation will arise.
Normally, and by normally I mean in every month from Jan 1959 to August 2008, banks lent almost all of their excess reserves (the data is here). The reason is simple; by charging an interest rate on loans that exceeds the rate paid to depositors, banks make a profit. Once the financial crisis hit in September 2008 though, things changed. Suddenly banks were holding on to excess reserves rather than lending them out; the risks were too great. In successive months excess reserves exceeded required reserves by two, three and four times. That trend continues today. In the latest Fed report excess reserves in the US banking system topped 1.3 trillion dollars. This means excess reserves are almost twenty times required reserves. Never before has this occurred.
But is this dangerous? What is the problem?
The main problem is a potential one; namely the inflationary impact if these reserves were quickly lent out to the public. If this were to occur the US money supply could rise ten times the excess reserve level, or by well over 10 trillion dollars. For comparison sake the M1 money supply currently is about 1.8 trillion dollars. Putting more than five times the current money supply into circulation suddenly is certainly enough to cause a severe hyperinflation.
However, this is not happening yet. The inflationary effect of the Fed’s expansionary monetary policy (like the QE2) has not occurred in part because these lendable reserves remain unlent. That could change soon though especially since inflation is unlikely to occur until after economic growth begins to pick up steam. In other words, good news today that our economic troubles are passing may be the harbinger that unleashes these reserves and spurs the inflation that so many people worry about.
But this inflation is not a foregone conclusion. The Fed has an important new tool at its disposal to prevent the rapid expansion of loans. Beginning in late 2008, as the financial crisis hit, the Fed implemented a new rule allowing it to pay interest on excess reserves held by banks at the Fed. This means that the Fed essentially changed excess reserve holdings from a checking account for banks into a savings account. To prevent lending from rising too rapidly, and thus to stem the inflationary pressures, the Fed can simply raise the deposit rate on excess reserves. This power gives the Fed considerably more leverage to control the outstanding money supply and thus allows it to control inflation more effectively.
Let’s only hope the Fed can manage these excesses as adeptly as they promise.
Posted by Steve Suranovic at 4:08 PM
Friday, February 25, 2011
In Alan Blinder’s commentary today, "The Economic Silly Season is Upon US," in the WSJ, he emphasizes how “silly” legislators have become in their proposals and debates. It is true that politics often does seem absurd, but rather than pointing fingers and calling people silly, it would behoove us to try to understand the constraints imposed in the political system that lead legislators into these silly positions and statements.
For example, after Blinder explains how any reduction in the national debt requires a cut in expenditures and/or an increase in taxes, he suggests that it is silly to simply command the debt not rise by refusal to increase the national debt ceiling. Although he accepts that this approach may be a tactic to force necessary cuts, he argues that it might also damage the creditworthiness of the US government in order to achieve something the Congress has the power to do anyway.
This conclusion ignores the political realities though. Although Congress has the power to balance the budget and reduce the national debt, individual legislators have little personal incentive to vote to do so since it would open them up to damning criticisms in their next election campaign and threaten to thwart their own personal goals. This is a reason why some “device,” like a refusal to raise the debt ceiling could force the changes and allow legislators some political cover from future criticism. Any action that will effectively reduce the deficit must be politically palatable to a majority of voting members to have any chance of passage. Having some scapegoat to point the finger at is sometimes effective. Most States have the statutory requirement to balance their budgets … and this rule provides the necessary leverage to tie legislators’ hands. It provides the political scapegoat that is needed in most instances. In this way legislators can truthfully say, “I didn’t want to cut your benefits, or lay off workers, or raises taxes; but the law made me do it!”
Refusing to raise the debt ceiling might also provide political cover since it would force unpalatable cuts in spending to comply with the law. Critics of this approach, including Blinder, argue that it would damage the creditworthiness of the US government. However, for several reasons this outcome seems highly unlikely.
For example, there is little to no chance that a refusal to raise the debt ceiling would force a default by the US government on its debt. Interest payments on the debt, while sizeable, would surely be considered a top priority, precisely because maintaining these would be necessary to assure investor confidence. In other words, if the debt ceiling is raised the US government can and will continue to service its debts and live up to its previous commitments. Because investors will recognize this same strong incentive, it is unlikely they will flee US treasuries, unless of course they naively begin to believe the hyped-up rhetoric of the fearmongers.
At the same time a refusal to raise the debt ceiling would force the US government to balance its budget right now! That would mean making drastic cuts in spending or raising revenues. Basically it would force a pay as you go system in which spending must equal revenues … and if the revenues are not there, then they cannot be spent.
Given the size of our current deficit these dramatic changes in spending are likely to cause severe pain and disruption in the short run. It would be similar to a household having its credit cards cut up and forced to live solely on its annual income. Although the effect would surely be painful to endure, the household is likely to emerge healthier financially in the long run. The same may be the effect of the US government.
I am not convinced myself that refusing to raise the debt ceiling now is the best way to force the changes that legislators are politically disinclined to make on their own. However, I do think it is important to realize that imposing hard constraints, such as refusing to raise the debt ceiling, is precisely the kind of silliness we need in order to get our legislators to implement more sensible policies.
Posted by Steve Suranovic at 9:58 AM