The Buck Stops Somewhere

                                             The Buck Stops Somewhere
   The current roiling among the politicians in our nation’s capitol seems to reinforce Lilly Tomlin’s dictum that “No matter how cynical you get, it is impossible to keep up”. We now have government by puerility. How else can one explain the current possibility of Federal default? Even if an agreement is reached to actually pay our authorized expenditures, it is unlikely the solution will be more than a finger in the dike and the issue will be revisited in the near future. Real consensus seems unachievable as of this date.
   It would be easy to blame the current impasse on the venality and ignorance of politicians. If this is so, we are to blame. Representative democracy doesn’t guarantee good government just representative government. A congressional seat is a virtual sinecure. Since 1990, 90% of congressional incumbents have won their elections .Clearly district voters are satisfied with their representative’s performance (There is an argument that gerrymandering has led to non-representative districts, but that is a topic for another day and another person). Ignorance may play a role: The potential outcomes from the debt ceiling deadlock and potential government default are as poorly understood by our elected representatives as by the public at large.
   The public has an excuse, our representatives do not. We hire them under the assumption that they actually understand the issues they have campaigned on. This assumption is clearly incorrect. For example, on the 13th of October Rand Paul stated (on CNN) that the Republican Party “is not giving the President a blank check to borrow more.” That statement about the debt ceiling is false. I assume he doesn’t understand the issue. Raising the debt limit only authorizes the Treasury to sell bonds to cover expenditures already authorized by Congress and does not represent new expenditures. . These expenditures are part of the current deficit not additional deficit. Government default or the risk of default has no beneficial outcomes, either in the short run or the long run.
   Those who argue otherwise must believe that credit ratings are unrelated to risk and that interest rates are unrelated to risk. This is not true. Default will lead to a fall in government bond prices, hence a rise in interest rates. Even if we narrowly escape institutional idiocy, the penumbra of default risk on Federal securities is no longer zero. Along with issuing new debt to cover expenditures authorized by Congress, the Treasury also rolls over (refinances existing debt by swapping new bonds for old bonds) about $7 to $8 trillion in debt a year. This debt will also have to be offered at higher interest rates.
   Up until now US debt (particularly short-term notes and bills) have been regarded as virtually riskless assets by purchasers. Financial institution and foreign governments have large holding of US Debt (The Social Security Administration is the largest single purchaser). This debt is viewed by the purchasers as a highly liquid asset or as good as money. Introducing uncertainty into the value of this asset affects balance sheets and spending plans of the owners, and has the additional effect of increasing interest rates in general We emerged from WW2 as the world’s major economic power and became the world’s central bank. The world became tied to the dollar standard. We were politically stable and the major force in the world’s economic recovery and the growth in international trade. In this process, our debt became the financial reserve for the rest of the world. We are the largest contributor to both the International Monetary Fund and the World Bank’s Reserves. Many countries, not only Japan and China, hold large reserves of US Debt. This role has been of great benefit to us and the world. It has helped finance the growth in world trade and given us low interest rates, substantial foreign investment and enhanced our political leverage. It’s been a win-win.
   A diminution of this role may benefit the Chinese but not the world. The Chinese are in the position of becoming the world’s default banker if our credit becomes suspect. I see no advantage to a Chinese reserve currency. It will not facilitate world economic growth but will enhance Chinese political power. Many of our politicians have been unwilling to inform voters about the significant issues at play. Instead they have misrepresented the issues, either through ignorance or ideological bias. As voters we should be angry.

Fantasy Island Economics

“There is no limit to the extent to which the Bank of Japan can increase the money supply if it wishes to do so. Higher monetary growth will have the same effect as always. After a year or so, the economy will expand more rapidly; output will grow, and after another delay, inflation will increase moderately….”
Milton Friedman 1998

It took the Bank of Japan 15 years to take Friedman’s advice and now their great experiment is on. Our Federal Reserve Board responded almost immediately to the current crisis and quantitative easing has been the order of the day since interest rates hit an effective lower bound. Currently the Fed is purchasing assets at the rate of about ½ of one percent of GDP per month and they have pledged to continue until a strong recovery is in evidence. The Bank of Japan’s purchase rate is double the Feds, but they have had 15+ years of deflationary pressure and economic stagnation to overcome.

The current economic reality is not incipient inflation, but potential re-recession in the U.S. and stagnation in Europe. The low interest rates for U.S. securities and declining gold prices are evidence that the market expectations are not for economic expansion and inflationary pressures but quite the opposite. Even the gold bugs are getting a whiff of reality.

There are many who deny the wisdom of the Federal Reserve’s response to the financial crisis, even though the response has been well within the framework proposed by Milton Friedman, an economist they revere in another context. What accounts for this philosophical schizophrenia?

The truly antediluvian conservatives have never accepted macroeconomics as a legitimate discipline. Therefore they have ignored Friedman’s monetary research and theoretical arguments for monetary policy. These conservatives believe in what is known as “The Treasury View.” This was the view of British Treasury (the Exchequer) post WW1.

 Simply put, this view regarded monetary and fiscal stimulus as unable to increase real output and employment, but only crowd out private spending. This view only makes sense if the economy’s resources are fully employed. The policies generated by this view resulted in persistent deflation and high levels of unemployment. Great Britain suffered through the 1920’s in a continual recession. We now call that “austerity”.

Since the resurrection of the Treasury View during the current crisis cannot be based on theory or evidence, it must be the result of ideological fantasy. Unfortunately the real world is not Fantasy Island and real people are unemployed and real output is being lost, not just delayed
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There are two salient observations from the Great Depression. First, there is a direct correlation between countries leaving the gold standard and the beginning of their recovery. Second, there is a direct correlation between the aggressiveness of their monetary and fiscal policies (as measured by share of GDP) and their rate of recovery. Sweden had fully recovered by 1934. The US and France were the slowest to recover and had the most conservative economic policies.

The same general observations hold true today. Western Europe’s relatively conservative approach to economic recovery has stalled their growth prospects. The US economic recovery, buttressed by a Federal Reserve’s comparative aggressiveness and modest fiscal stimulus, has the US on a slow growth path, but it is a growth path.

 The current legislative impasse in the other Washington will remain an effective impediment to economic growth. They are not at fault; after all we elected them.