I do a ton of reading and comment thread debating about the economy. But I haven’t written much econ on this blog. The following are assorted thoughts that I’ve accumulated over the past year. At the end, I have a few predictions for the future.
The popping bubbles in housing and stocks wiped out ~$15 trillion in paper wealth. When paper wealth falls, people cut spending on durables and luxuries. Consumer spending is producer income. Thus as demand dries up producers lay off workers.
The stimulus was actually much too small. The stimulus size should reflect the size of the fall in the net paper wealth. A stimulus of $15 trillion would have jolted the economy back to life quite quickly. “Stimulus” is entirely a misnomer though. The word “stimulus” indicates that you give some sort of nudge to the economy and then it restarts on its own. What’s really needed is balance sheet repair, not stimulus.
The bulk of the balance sheet repair is now occurring through the automatic stabilizers - unemployment payments and reduced tax collections due to falling income. Every dollar of deficit is a dollar added to private balance sheets.
Obama’s actual stimulus was very small in comparison to both GDP and total net wealth, and thus likely had very little impact. Anyone who thinks they can use inductive statistics to figure out the impact of the stimulus is committing numerology - there is no way to use statistical inference to figure out its impact because there are too many other factors at play.
The stimulus was very poorly targeted, with much of the dollars going to government agencies who were not laying people off anyway. The unemployed are in housing, manufacturing, luxuries, and durables. They generally were not government workers. By funneling so much stimulus through the government sector, a ratchet effect is created whereby every recession the government sector permanently grows while the private sector languishes.
The optimal path to a quick recovery would be to pass a law that multiplies the face value of every FDIC backed account, every money market fund account, and every treasury bill, by 50%. So that you’re not just benefiting the wealthy, maybe also mail a check to every American for $15K.
Money costs nothing to create, so there is no reason not to simply do all the balance sheet restoration at once. The only trick is to distribute the money in a way that is fair and doesn’t create distortions (a way that doesn’t favor rich over poor, poor over rich, profligate over savers, or asset holders over dollar holders, pensioners over workers, government employees over private employees, etc). It’s not easy to eliminate all distortions, but it’s not hard to dramatically improve over the current situation.
For those who think this would risk inflation, see my comments to Winterspeak.
A second best solution would be a tax holiday or a payroll tax holiday.
There is an idea among progressives and economists that public works spending offers the most bang for the stimulus buck. But the Federal government doesn’t have to worry about bang for the buck - it has a printing press with an infinite number of dollars. The constraint on the size of a stimulus is based on how distorting the influx of money is. Publics works spending is much more distorting than simply marking up bank accounts and letting people make the decision about spending. An analogy can be made to the stock market. A stock split that doubles the quantity of stock by giving the new shares to the existing owners is far less distorting than a stock dilution of only 5%.
For those of you who think that there should be no stimulus, and the system should be left to self-correct, read a thread here. There are parts of the economy that had a mis-allocation of resources due to bad credit policies (housing). But other sectors are suffering a drop in demand purely due to the Washington’s and Wall St.’s bungling of the economy. Any deflationary pressures will always pummel the makers of durable goods, even though they did nothing wrong and are still capable of making goods that people want. Washington broke it, not the laid off machinist. If Washington can enact a policy that fixes the problem without causing more pain, then it should enact that policy.
Fed Policy & Quantitative Easing
The Fed has tools to stimulate the economy in the following way: The Fed lowers interest rates. Lower interest rates allow banks to lend to more marginal projects. When banks lend, they create money and give it to the borrower to spend. The spending of the borrower employs people and drives up the prices of goods.
But right now banks are not interest rate constrained in their lending. They are constrained primarily by a lack of willing, credit worthy borrowers. Lowering interest rates has no effect. This is understandable as American balance sheets are in tatters. Promoting more credit is not a good idea. (And lowering interest rates may actually be deflationary, since many Americans earn interest income on government bonds and insured CD’s. Reducing interest rates is equivalent to cutting their incomes).
If the Fed embarks in quantitative easing by buying treasuries, the impact will be virtually nothing. It’s simply exchanging one piece of government paper for another. There is no change to private balance sheets. The only impact it could have is if people believe that it is inflating investors could start moving their money away from the dollar into another currency or into gold. This would create inflation in the commodities without stimulating the economy.
If the Fed starts buying assets at market prices, again, there is little impact. If the prices are market prices, then private balance sheets do not change, and private actors cannot increase spending. If the Fed bids up market prices then there will be tremendous distortion, as the Fed will essentially be stimulating in a distorted way that grossly favors owners of whichever assets the Fed is bidding for.
If the bank tried an extreme policy, such as charging negative interest rates on reserves, then the results would be completely unpredictable. It’s possible that you would actually create further deflationary pressures. Since M*V equals NGDP which is equals aggregate demand, a negative interest rate actually reduces M, which could reduce aggregate demand. If I’m a retiree, and I know that my money is a disappearing, I will have to spend less of it so I don’t run out of money before I die. On the other hand, I might decide to dump my dollars altogether, and put my savings in gold. This is equivalent to a dramatic rise in V, which could cause a currency run. Either way its insane to think that charging negative interest rates on bank accounts will suddenly cause people to start buying automobiles.
The deficits and national debt
Deficits and surpluses occur because income tax revenue is naturally more responsive to economic conditions than spending is. In boom times, income rises faster than spending, and the budget approaches surplus. In the bad times, income plummets as businesses and households write off losses. Tax revenue from capital gains disappear almost entirely.
The counter-cyclical nature of income taxes is the one thing keeping our screwed up, rube golberg, financial system from hitting the extremes of depression or hyperinflation. The deficits during recessions help restore the balance sheets of the private sector. The surpluses of the boom years drain excess money and prevent asset bubbles from spiraling into capital flight from the dollar.
The level of debt is not a problem for the U.S. since its debt is denominated in a fiat currency that the government controls. In fact, it is wrong to think of the “debt” as debt at all, it makes more sense to think of treasury bills as dollars with not-valid dates. (Actually the whole monetary system makes a lot more sense if you view all U.S. fiat money as government equity. Greenbacks are normal equity, T-bills are restricted equity, FDIC insured accounts are government stock options, etc. Add them up to get the fully diluted money supply).
Note that this analysis does not apply to countries like Greece who owe debt in a currency they do not fully control.
There is no magic line in terms of “Debt” to GDP ratio that signifies danger. Rather, the “debt” to GDP ratio is determined by a) the propensity to save of the population and b) whether the population wants to save in assets like homes or stocks or less risky government debt.
For example, imagine the Japanese government dramatically raised taxes, cut spending, and halved the national debt. That means the population of Japan would have half their government paper taxed away. The natural response of the Japanese would be to cut spending to restore their previous savings to spending ratio. Thus NGDP would fall. The debt to NGDP ratio would end up the same.
The Japanese have a high debt to GDP ratio because the Japanese people like to save, and like to save in the form of government bonds, rather than buying stocks or houses.
Reducing the national debt in nominal terms is actually impossible. When the government goes into surplus, assets from the private sector are being net taxed away, private balance sheets contract. The contracting balancing sheets will cause people to spend less, which will lower tax revenues.
Those focused on fiscal austerity should concentrate on capping government spending as a percentage of NGDP, rather than worrying about taxes or deficits. Keep a spending cap, and then cut taxes during deflationary recessions and raise taxes and run a surplus when inflation is running too high.
The real problem with the fiscal situation is that there is no hard constraint. The government is allowed to spend irresponsibly without obvious consequences (only subtle, long term corrosive consequences). Hard budget constraints create discipline. Constraints force you to make decisions about what is important and what it is not, and force you to make hard but necessary cuts. Without a budget constraint the politically easy path is always taken, and slowly but surely, the nation fills with zombie industries that exist not because they make quality goods at an affordable price, but because the government finds it too painful to let them die. As Keynes wrote in his Anakin days, “There is no subtler, no surer way of overturning the existing basis of society than to debauch the currency.”
Jobs and Outsourcing
Some economists seem to claim that we are in a jobless recovery. The reason we are in a jobless recovery is because outsourcing and technological change have finally caught up with employment. Companies used the recession as an excuse to lay off workers who were no longer needed. The left-center economists tend to view this change as inevitable, and want to invest more in education and job training.
My take is that the definition of recovery is wrong. The “real GDP” number is a terrible way to measure the end of recession. In reality the economy has not recovered. Investment spending and many areas of consumer spending are still quite below the pre-recession amounts. The lack of demand means there is still a lack of employment in construction, manufacturing, etc. Demand is soft enough in other sectors that the other sectors cannot absorb the excess unemployed. In order to actually get a recovery, we need across the board balance sheet repair as I mentioned above.
Outsourcing and technology change in general will not cause unemployment. The country as a whole has improved its productivity and outsourcing by an order of magnitude over the past hundred years, but actually has much higher employment (due to women entering the workforce). Outsourcing and technology change simply alter which jobs people perform.
That said, I don’t think the outsourcing trend is all good. China has been pursuing a policy of currency manipulation to promote its own export industry. The U.S. has failed to respond, and thus key industries have moved overseas. For instance, my 60 year old dad was training the next generation of telecommunication electrical engineers in China. These industries will be very hard to recover, because the knowledge needed to create them is disappearing. The U.S. is living like 16th century Spain and maintaining its standard of living by exporting its own currency. The long term consequences of this could be disastrous.
There is no need to blame China though - they are being smart. Blame our own government for allowing this to happen.
The U.S. should adopt a zero-trade-deficit policy. For every dollar the Chinese government buys, the American government should counteract by buying a Yuan dominated asset. This will force the Yuan up, and the dollar down, and allow our exporters to compete until the trade deficit balances.
Both sides of the debate continue to make mistakes with regards to interest rates. The right claims that the continued deficits create the risk that a treasury auction will fail and interest rates on the national debt will suddenly spike.
Those on the left claim that since interest rates are so low, the government should take advantage of the situation to do more borrowing and to build infrastructure, since borrowing is essentially free for the government right now.
Those on the right think deficits will cause interest rates to rise and thus crowd out private investment. Those on the left say that since interest rates are not in fact rising, there is no crowding out effect of government spending during a recession.
The first thing to understand is that interest rates do not represent any sort of market signal. Interest rates are are so manipulated by government policy that it is impossible to draw broader lessons from them. Government deposit insurance and bailouts have the effect of lowering interest rates and flattening the yield curve. The Fed is also buying hundreds of billions of bonds which also changes interest rates.
Note also that when the government deficit spends, the money it spends is put into a bank account, and that bank then buys bonds to make money in interest. Thus all deficits create the money which is then used to buy bonds. Therefore there is never any danger that government deficits will exhaust the demand for bonds.
Thus it is very unlikely that deficits will cause an interest rate spike, and the government can always keep interest rates down via various manipulations.
That said, the left is wrong to imply that because there is no impact on interest rates, government spending is somehow costless.
Government spending crowds out because it competes for real resources with the private sector. A government construction project will cost a lot of oil. Since there is a fixed amount of oil, when the government deficit spends to buy oil that bids up the cost of oil, making it more expensive for private industry to buy it. Even if the government project only uses utilizes resources that would otherwise idle, the government is still creating an opportunity cost. Instead of restoring private sector output, the government is using the crisis to permanently ratchet its spending upward.
If you believe that before the crisis the country is striking the right balance between federal spending and private spending, and the crisis causes private spending to fall but not federal spending to fall, then the goal of the stimulus should be to restore private spending. The only excuse for an infrastructure based stimulus is if private spending was much slower to take effect. But if anything balance sheet repair is much quicker because a) it doesn’t rely on a centralized bureaucracy to disperse the funds b) it can be much larger since its less distorting.
The left side of course believes that pre-crisis government spending was too low, and thus has no qualms arguing for a government directed stimulus. But instead of saying that “either increasing spending or balance sheet repair will work, but we prefer government spending because it should be higher” progressives falsely argue that government spending is the only route to a quick recovery.
Meanwhile the Chicago school types have such a poor understanding of economics they are unable to respond with convincing arguments.
Deflation, Inflation and Hyperinflation
A while ago when the Fed doubled the amount of Base currency many on the right wing freaked out and thought that it was a sign of imminent hyperinflation. The mistake was the alarmists did not understand the money supply. As we noted before, the money supply of the U.S. really consists of every piece of paper backed by the U.S. government. Thus it includes FDIC insured deposits + treasury bills + cash + implicitly backstopped money market funds. The fully diluted money supply is already over $20 trillion. Thus doubling just the base currency ($1 trillion) will not have much impact. And it has even less impact because that newly created $1 trillion did not end up the balance sheet of anyone who had the ability to spend it.
The amount of monetary inflation (change in NGDP or some other measure of total income) is roughly determined by a) the fully diluted amount of government backed paper b) the multiplier at which assets (like housing and stocks) trade relative to the amount of government paper c) people’s desired paper wealth to spending ratio.
Note that b) and c) affect each other. Falling stock prices cause people to spend less which causes corporate income to fall calling stocks to fall more.
In 2006-2008 two giant asset bubbles popped, dropping total paper wealth by about $15 trillion. The popping bubble created enormous deflationary pressures. Several factors are keeping the U.S. out of a deflationary spiral: a) efforts to backstop the housing market b) unemployment insurance c) the natural counter-cyclical nature of government spending and tax collections d) the Fed backstopping of the money market funds.
That said, when the deflationary pressures subside there is no guarantee that the deficit will fall enough to prevent inflation. Furthermore, there is a palpable sense that investors everywhere are losing faith in the dollar as a reliable store of value. The question is - what is a more reliable store of value? Every alternative store of value - real estate, stocks, gold, etc, - is subject to sharp declines due to credit crunches and panics.
For now the fiscal system still remains counter-cyclical, and capable of cutting short runaway booms. But for how much longer?
The credit system is by no means repaired. The stock market looks as precarious as ever. No small amount of current stock market buy-side demand is generated by corporations borrowing to buy back their own stock. What happens when their balance sheets cannot afford to keep buying stock any longer? Do we get a repeat of the October 2008 stock market crash?
It also occurred to be the other day that the U.S. could face a unique situation in which it faced slight deflation/low inflation at the same time it faced near hyperinflation. How is this possible? Imagine foreign investors and foreign investors lose faith in the dollar, and at the same time American export industries continue to decline. The price of foreign commodities - oil, copper, etc., - along with some export goods (lumber) will rise considerably. Ordinarily a falling dollar might stimulate the export industry and thus create more employment and upward wage pressures. But its not at all clear that the U.S. is capable of recovering its lost industries. The entrepreneurs and skilled machinists who created those industries are gone. The regulations governing such industries are too constricting. Thus you would get rising prices of imported goods, but no internal stimulus. Unemployment would remain high, wages would remain low, “Core CPI inflation” (which measures mainly wages) would remain low, yet commodity prices would shoot upward.
Meanwhile both political parties would continue pointing fingers at each other. The left would argue for further dilution of the currency which would have some local stimulus but make the problem of rising export prices even more acute. The right would argue for austerity which would mean further domestic deflation and hard times for industry. The proper policy of balance sheet repair plus reduction in government control of the economy plus encouragements to export industries would be ignored.
In the next year or two I suspect we’ll see more of the status quo. Very low interest rates, high unemployment, low wage inflation, rising commodity prices.
Long term I think we’ll see the further pesoization of the American dollar. There won’t be any sharp hyperinflation. Rather there will be a continuing shift in investing so that people will rely less and less on the dollar as a store of value. Gold prices will rise, stock dividends will fall, housing prices will recover and in a few decades go higher than ever.
The Gold Standard
Some people ask the question: “Should the dollar be backed by a gold standard.” But that is the wrong question. The right question is what will happen.
Any government that is strong enough will want to enact a fiat currency. If the government is greedy it will enact a fiat currency to reap the benefits of seinorage. If the government is benevolent (or thinks its benevolent) it will enact a fiat currency to smooth over economic fluctuations.
The world switched to a fiat currency when the U.S. had enough domestic and international hegemony to enforce the dollar as the global standard. The fallacy that many believe is that gold was made obsolete because of technology and “progress”. They believe that somehow basing a currency off a inert, mostly useless metal is somehow archaic.
But gold is not a natural currency because its shiny. It’s a natural currency because it is the best Schelling point/Nash equilibrium for a group of independent actors to settle on as a store of value. If you have five independent, mutually wary agents (either individuals or governments) trying to negotiate a common store of value, then gold is the default because a) no one can simply print infinite amounts of it b) it has the highest stocks to production ratio, so its has the least amount of dilution from mining.
As the American manufacturing base rots, its military fails at yet another war, and its political system continues to spin in circles, people and nations may start to lose faith in the dollar as a store of value. At that point, the most natural alternative as a reserve currency will be gold.
I broke banking reform into a separate post.
Long term, whatever agency is controlling inflation should pick an NGDP target between 0% and 4% and stick to it. To hit the target, the monetary agency should print money and pay it out to all depositors as an interest-like payment. So if the NGDP target is 2%, any depositor or CD holder in an FDIC backed bank account would have their account incremented by 2% a year, in addition to whatever interest the bank was paying. If inflation was getting to high, inflation can be lowered by increasing taxes without increasing spending.
If the government wants to control interest rates it should set a predictable rate and stick to it. The interest rate on a short term CD or government bond should always be kept at least one or two percentage points greater than the rate of NGDP growth. If the interest rate drops below the rate of NGDP growth the Nash equilibrium for the global herd of investors is to find a better source of value. The search for a collective store of value will create bubbles in stocks, real estate, or gold.
Based on the thoughts above, I have a few predictions:
My strong are:
- There will be no hyperinflation in the next five years. I find the gold-as-nash-equilibrium theory possible, but its unlikely. For reasons of politics and tax treatment, equities still dominate gold as a store of value.
- 10 year treasury interest rates will remain under 5% for the next four years. Interest rates will be under 7% for the next ten years. If and when the interest rates start rising, the deficit as a percent of GDP will be considerably lower than it is now.
- The U.S. government will not default in its debt. The only way default is conceivable is if some tea partiers/Rand Paul conservatives stage a showdown over raising the debt ceiling. Even then, I think the treasury and Fed will find a work around. There will not be a general default.
- Quantitative Easing will not have any measurable impact on the economy. The only impact is that it will exacerbate some fears of inflation and thus the gold price will continue to rise in the next few months.
- In the long run, I expect to see the continued “pesoization” of the American dollar. Long term savers will rely on bonds less and less as a store of value, and continue the move toward equities, real estate, and gold as stores of value.
- In the very long term, gold’s role on the world stage is not finished. It may not happen for fifty years, but eventually I think that some sort of gold standard will be resurrected in at least some part of the world.
One weaker prediction is:
- Deflation will not get worse. The deficits plus automatic stabilizers have halted the decline. Now the deficits will gradually restore private balance sheets. The only reason why this is not a strong prediction is that its clear the banking sector is still not healthy. Mortgage income and down payment requirements are still ridiculous. The government is still trying to juice the market for buying homes. Companies are borrowing a lot of money to buyback stock. What happens if there is another decline in housing prices, and companies need stop buying back stock and instead pay back their loans?