Fiscal Deficits and the Bond Market Vigilantes

Tim Duy is channeling Hamlet, torn between his concern over mass unemployment in a stagnant economy and his fear that an attack on the dollar could be just around the corner. I think he is right that we came close to a disorderly decline in the dollar during the period leading up to the financial crisis, but it’s a big mistake to think that slashing fiscal deficits is any sort of insurance against a return of this threat. On the contrary, big government deficits are exactly the result of credit contraction in the private sector.

Duy gives us a FRED visual on capital inflows to the US economy; I’m reproducing it here.


Inflows ballooned from the mid 90s until the onset of the financial crisis. This was not a period of outsized fiscal deficits, however; it was the private economy (housing but not only) that ran up the tab. When the bubble popped, it was left to the Fed/Treasury combo to transfer debt from those who couldn’t finance it (households and financial institutions) to those who could (taxpayers). Unless you have a plan to turn a chronic current account deficit into a surplus within the next year or two, this is exactly what financial recovery in the private sector means: fiscal deficits. It’s the macro identity.

(Remember, this is not a functional relationship. It has nothing to do with what people want, choices they make, or probable consequences of their actions. It is an identity. If the private sector overall is to pay down its net debt, in the absence of a change in the balance of payments it is equivalent to saying that the government is taking it on.)

What the Eurozone crisis teaches us, in case we didn’t know it from centuries of prior experience, is that it is a country’s external position, whether it borrows from or lends to the rest of the world, that determines how much confidence there will be in its financial assets. Greece ran up fiscal deficits and got hammered. Ireland and Spain maintained orthodox fiscal policies but had private sector debt binges and got hammered. What they all have in common is that they ran up unsustainable external deficits year after year.

And the US? As Fred’s chart shows, the financial crisis brought about a sudden but transitory collapse in our external borrowing, and now it’s back on the increase. In fact, it appears that only the anemic condition of our economy compared to some of the emerging high-flyers, has kept our borrowing below crisis levels.

Yes, we need expenditure-switching—more exports, fewer imports—but we’re not getting nearly enough of it. A softening of the dollar would help, but we would need consent from our main trading partners to accept a drastic reduction in their trade surpluses, and, in any case, it will take years to undo the structuring of the US economy around imported resources and consumer goods. (Adaptation to credit-driven consumption has gone on for so long it may have become a cultural issue. Political economic considerations also apply, as I’ve argued earlier.)

What will do absolutely no good at all is fiscal retrenchment. It will cause hardship for millions and provide no protection against the risk of a future collapse of US asset values. On the contrary, if households respond to a shortfall in income by ramping up their borrowing again, dollar-denominated assets will once again enter the danger zone. Slashing fiscal deficits is like fighting a war by firing on our own troops.

John Taylor on Pawlenty’s 5% Growth for a Decade Claim

Tim Pawlenty may be getting a lot of criticism for his claim that we can achieve 5% growth for an entire decade but John Taylor argues that this “is not some pie-in-the-sky number”. It is a real stretch, however, especially once one looks at all the assumptions that Dr. Taylor has to make to get even close to this “aspiration”. Taylor starts with the recognition that the employment to population ratio is dismally low:

Currently the percentage of the working-age population (age 16 and over) that is actually working is very low at 58.4 percent. In the year 2000 it reached 64.7 percent, so that is at least a feasible number. Raising the employment-to-population ratio to 64.7 means an employment increase of 10.8 percent (64.7-58.4/58.4 = .108) or about 1 percent per year over 10 years, even without any growth of the population. Adding in about 1 percent for population growth (from Census projections), gives employment growth of 2 percent per year.

I have a couple of quibbles with this even if I earlier sang a similar tune. First of all – cutting government purchases now will likely mean less aggregate demand. I guess Dr. Taylor has joined Pawltenty is failing to recognize the Keynesian nature of the Great Recession. Secondly, I had been chastised by a few smart conservative economists for believing we could get back to a 64.0% employment to population ratio so this notion that 64.7% is feasible does seem like a stretch.

Taylor also seems to think we can get back to the 2.7% productivity growth witnessed during the “IT revolution” of the late 1990’s. Count me as being less optimistic. But his last paragraph is where this really falls off the cliff:

You can see how the types of pro-growth policies in the Pawlenty plan would work toward the goal by reducing spending growth enough to balance the budget without tax increases and thereby remove threats of a debt crisis; by lowering marginal tax rates to spur hiring and job growth; by scaling back unnecessary new regulations which impede private investment and higher productivity, and by restoring sound monetary policy to remove uncertainty about inflation or another financial crisis.

The Laugher Curve in its fullest glory! Pawlenty wants massive tax reductions which are not going to be offset by spending cuts in the real world. So his plan if enacted is likely to be deficit increasing. And at some point when we do eventually get back to full employment – this fiscal insanity will lead to crowding-out of investment.

Is US Commercial Real Estate Sinking To New Lows Or Zooming Towards Its Old Peak?

Amazingly enough, the two leading indices of commercial real estate (CRE) in the US are completely at odds regarding this. Broadly based Moody's Investors Service that tracks closing prices of a broad base of CRE finds that as of the end of March average CRE prices were 47% below their peak observed in October, 2007 and still sinking, http://www.calculatedriskblog.com/2011/05/moody's-commercial-real-estate-prices.html .

OTOH, Green Street Advisors who track reported prices of a subset of CRE that is owned by 80 leading REITs find that after peaking in mid-2007, CRE declined to a low point at 60% of that level in November, 2009, when it turned around and is now at 90% of the peak level and readily rising, http://www.greenstreetadvisors.com . The data from this source has led some to even declare that the wonderful performance of the supposedly more free market CRE compared to the ongoing slump in residential real estate shows how government interventions in housing markets have been the source of all our problems, http://www.coordinationproglem.org/2011/06/recalculation-in-the-commercial-real-estate-market.html .

So, what is up? As far back as 10/27/10, Alex Finkelstein at World Property Channel discussed what was already a large divergence between these two at http://www.worldpropertychannel.com/us-markets/commercial-real-estate-1/real-estate-news-green-street-advisors-moodys-investors-service-jeung-hyun-adelante-capital-management-mike-kirby-michael-gerdes-john-maynard-keynes-3388.php . In this he interviewed the directors of research at the two outfits and got the following.

From Mike Kirby at Green Street Advisors, the optimistic firm, he got "Yes, it's subjective" in terms of their approach, which focuses on large individual transactions. Kirby went on to quote Keynes: "We would rather be roughly right rather than precisely wrong," as he supported the idea that by then CRE had already been rising for nearly a year.

From Michael Gerdes of Moody's he got "We are trying to capture the entire market, not just a subset of institutional quality assets."

A bottom line would appear to be that there is a massive divergence within commercial real estate. There are certain regions and sectors where "high quality" CRE is booming, and these are the items that stock the portfolios of the recently rising REITs. However, the larger mass of CRE in the majority of the economy is doing just the opposite and tracking the housing market, if with some lags: down and still falling with no clear bottom in sight.

Pawlenty’s Economic Goal is Almost Right

Benjy Sarlin notes that one GOP Presidential hopeful is being criticized by GOP economists:

Tim Pawlenty drew widespread ridicule from experts across the political spectrum on Wednesday for his wildly optimistic economic plan. Pawlenty unveiled his platform at a speech in Chicago, a combination of tax reforms and budget cuts that he said would yield an explosive economic recovery. The centerpiece of his proposal was setting a goal of 5% economic growth per year for a decade. "Growing at 5% a year, rather than the current level of 1.8%, would net us millions of new jobs," he said. "Trillions of dollars in new wealth. Put us on a path to saving our entitlement programs. And balance the federal budget."But a group of former CBO directors, who are chosen by Congress to analyze the budget from a nonpartisan perspective, are lambasting the number, saying it's completely out of line with any mainstream assessment of the American economy."The trend growth rate is not going to be 5% in the United States," Douglas Holtz-Eakin, director of the CBO under President Bush and a top GOP advisor, told TPM. "The market just doesn't support that. It just doesn't."

Five percent growth for an entire decade may be “out of line with any mainstream assessment of the American economy” but with a GDP gap near 10 percent and potential GDP growing at about 3 percent per year, 5 percent growth for the next five years strikes me as a very laudable goal.

My problem with Tim Pawlentry is not his policy but with his proposed policies. The GDP gap is due to a lack of aggregate demand. Budget cuts will only serve to further depress aggregate demand.

Republican Revolution

How is it that a minority party can impose its will on the country, while the Democrats were relatively slow to move, even in the midst of the Great Depression? How is it that the Republicans can take the anger that welled up against capital and turn it against labor?

A View From The Puerta Del Sol

I have just returned from nearly a week in Spain, delivering a plenary address at a conference on nonlinear economic dynamics in Cartagena. I also spent a day in Madrid. Spain has the highest unemployment rate in Europe, as high as 40% for youth, and many think that it is the linchpin to maintaining the eurozone, with Germany and the other big countries able to manage defaults and bailouts for Greece, Ireland, and Portugal, but not for Spain. There have been people camping out in the main squares of cities around Spain, and the conservative opposition party has just swept the local elections big time. There was a small group camping out in Cartagena. People there were speaking out and singing in the evening.

However, the biggest group camping out is in Madrid, in its central square, the plaza of Puerta del Sol. I visited this area and walked through the encampment that fills the plaza, actually a long half-oval rather than a square. There were many tents and also tables with people selling stuff and handing things out under canvasses. There signs and all kinds of things, including posters and sculptures and whatnot all over the place, exhibiting a plethora of views and on many issues, not all about unemployment, with green issues and support for Arab Spring demonstraters among other matters focused on. I would also say that while the ideological strand tended more to the left, with many denunciations of capitalism and imperialism, some of it was a lot less clear, with many denunciations of bankers and also of "Europe," possible from either end of the spectrum (there was a particularly bizarre sculpture of a "vampiro banquero"). There were two pictures of Friedrich Nietszche in different spots, whose views and fans have been rather all over the place, and I saw no hammers with sickles.

Emblamatic of the rather foggy, quasi-anarchistic mood and views there was a large poster on the wall of one of the buildings. It showed a nebbishy looking man, sort of like Woody Allen, no beard or moustache, with rimless round spectacles, in an exaggerated military uniform and his right arm clearly raised, although cut off before the image got too far from his shoulder. However, he was also clearly wearing a shirt with a tie, and on his head was an oversized military hat, but with enormous Mickey Mouse ears on it. I could not fully read the label under this image, but it looked something like "Non No Represendar."

Two Propositions about the Austrian Position in the Socialist Calculation Debate

I’ve been teaching the socialist calculation debate again this spring. Each time I return to these arguments, I think I see them more clearly. Here is my latest try at summing up the Austrian position and its implications for potential economic systems, capitalist or otherwise. The web is crawling with Austrophiles, so they can tell me whether I am walking in light or darkness.

1. The key concept is discovery: discovering what consumers need and want, and discovering the true costs of providing these things. Since they are subject to tacitly known and otherwise irreducibly qualitative determinants, values and costs cannot be ascertained apart from the actual processes of producing and marketing, so the technical problem of number crunching—devising algorithms to calculate equilibrium prices and quantities out of cost and demand information—is secondary. Any reasonably efficient economic system has to have processes of discovery, some for costs, others for the value of goods and services as determined by consumers. These processes need to be specified concretely.

2. Discovery requires trial and error. In an economy with a vast number of goods, and with complicated production and consumption relationships surrounding each good, it is inconceivable that trial and error can be sequential. Rather, there have to be many trials simultaneously, along with a process for determining which succeed or fail. That is the role of rivalry (competition) in a market economy, with the market test assessing success and failure. “Cost” is discovered by firms that succeed in being low-cost producers; “value” is discovered by those who succeed in marketing. This information is transmitted via prices to other firms, telling them whether they are producing at- or above-cost, and whether they are producing and selling at- or below-value. Any plausible economic system has to have a structure of multiple, simultaneous trials, a “hard” test that tells enterprises whether their trials are succeeding, and a vehicle for transmitting the results of these tests to all participants—in real time. On top of this, of course, there needs to be an incentive structure that causes those who failed the test to abandon the methods that were retrospectively unsuccessful.

Second Interview on The Invisible Handcuffs

Richard Estes, "Speaking in Tongues." KDVS, Davis, CA invited me on his program to discuss the Invisible Handcuffs.

The url is:



http://michaelperelman.wordpress.com/2011/06/04/second-interview-on-the-invisible-handcuffs/http://www.blogger.com/img/blank.gif

Interview about the Invisible Handcuffs

Alan Ruff of WORTfm in Madison, WI gave me a very good interview yestersday. This is the first of 3 interviews. I hope to have the url for the next 2 in a day or two.

Access at:

http://www.archive.org/details/MichaelPerelman--InterviewAboutTheInvisibleHandcuffs

A Paranoid Thought: Suppose the Republicans Are Smart

If the Republicans are smart, unscrupulous and want to win in 2012 at any cost, here’s a game plan.

Step 1: Fight like a demon against any fiscal stimulus that would help accelerate economic growth and reduce unemployment. Make up any excuse that sells. If one excuse begins to lose its juice, switch to another; consistency is irrelevant.

Step 2: Wait for the economy to stall or even go into reverse by early 2012.

Step 3: Once it’s too late for policy to have any effect before November, switch gears and demand an emergency program to create jobs, coupled with tax cuts for carefully targeted campaign contributors. Blame Obama for the endless slump and paint yourselves as tireless activists for full employment. Obama then faces the ugly choice between remaining consistent and toughing out the feeble economy or flip-flopping and chasing after your policies.

It’s all hypothetical, of course, except that we’ve been living in Step 1 since the moment McCain conceded in 2008.

The Optimism of a Double-Dip

A crisis is the method by which a capitalist economy partially purges itself of the effects of past mistakes while imposing misery on the masses.

Economists often characterize the outcomes as by the shape of letters of the alphabet. A "V" indicates a quick collapse and an equally quick recovery. "L" suggests a collapse followed by a very weak recovery. And a "W" indicates a double-dip in which the quick recovery is followed by another collapse. Ironically, our previous president was known as "W" will and our present president could be known as zero, which approximates the first letter of his last name.

A V-shaped recovery suggests that the economy was fundamentally strong, allowing the economy to quickly pick up steam. A W-shaped outcome is a telltale sign of an economy that was leaked to begin with, propped up by external support, which was withdrawn prematurely. For example, Roosevelt succumbed to outside pressure in 1937, leading to an expected setback. Under far less pressure, Obama followed suit.



Both the crisis and the recovery can only be understood in terms of the long-term processes that caused the initial collapse. In "The Confiscation of American Prosperity: From Right-Wing Extremism and Economic Ideology to the Next Great Depression" I tried to tell the story of the gradual weakening of the US economy. The book explained how the unusual postwar prosperity was created by a sequence of the Great Depression and then the war. The postwar period up to the late 1960s is often described as The Golden Age because the economy performed better than ever before.

The business class believed that this exceptional performance was the norm. As the economy began to falter in the late 1960s, capitalists set out to restore their sagging profits. During the Golden Age, prosperity also meant that competitive pressures were not strong. In the absence of competitive pressures, business had little need to improve productivity. Management could coast along assuming that high profits were due to their outstanding managerial skills.

Unprepared and unwilling to adapt to the new economic conditions, capitalists set out to remake the economic structure in a way that would allow profits to recover. However, they did so by subtracting from the rest of society, rather than by contributing anything productive. Anything that stood in the way of profit maximization, whether unions, regulation, or taxes, had to be swept away. Business was surprisingly successful in this endeavor, but it did nothing to make the economy stronger. In fact, this strategy undermined economic strength.

Obscene inequality of wealth and income meant that business would be unlikely to prosper by selling goods to the masses. The rise of international competition made that strategy less likely. Instead, business turned to finance, at the same time as the regulatory forces that might have imposed a modicum of rationality were no longer operative.

I use the term Confiscation of American Prosperity to indicate that in this period from the late 1960s until 2007, when the book was published, to indicate that growing profits were not a sign of strength, but an indication of how much capitalism was subtracting, or as Marx would say, vampire-like parasitically sucking away the strength of the economy.

I will not speculate whether the money thrown at the banks was a continuation of the process of confiscation or whether the people in charge actually believed that this misconceived strategy would be sufficient to create a quick recovery. In any case, it did little to the bleeding -- except for the large mass of the public, which had been being bled her for more than three decades, since the end of the Golden Age.

On top of the withdrawal of the federal life support for the economy, the confiscatory strategy has been escalated. The attack on unions, regulation, and taxes is now on steroids. If the previous attack was crucial in creating the present crisis, this all-out attack seems certain to make things considerably worse. A double-dip may be just an ice cream cone and any expectation of a W-like outcome may be overly optimistic.

The Lucas Explanation of the Persistence of the Great Recession: The Barro Objection

Robert Lucas offers the following as one of his reasons for the persistence of the Great Recession:

Likelihood of much higher taxes, focused on the “rich”

Gavyn Davies and Paul Krugman argue that the Lucas attempt to explain the persistence of the Great Recession on purely classical principles lacks credibility with Davies noting:

As yet, there has been no increase in taxation, on the rich or anyone else. Nor have the Obama administration’s medical and financial sector reforms really taken effect. It would take a remarkably far sighted private sector to have already reacted adversely to this set of long term reforms, even if they might do so eventually.

One could argue, however, that the Barro reformulation of Ricardian Equivalence would argue that it is not current taxation that matters but the expectation of future taxes when government spending outstrips taxes. But if one is basing one’s argument thusly, I don’t see what has fundamentally changed in the past few years. We knew back in the 1980’s that Reagan’s fiscal policy has spending outstripping taxes until we got the return to fiscal sanity during the Clinton years. Of course, that changed when a new Administration took office but that new Administration took office in 2001 – not 2009. Professor Lucas does not explain to us why he believes that the Obama Administration signals an even further long-term commitment to more government spending. In fact, the medical reforms he mentions were designed to reduce long-term spending. So if the rich were forward looking ala Ricardian Equivalence, the likelihood of much higher taxes would have been realized well before the Great Recession.

The Macro Identity Cuts the Cant

I’ve been pretty busy, and in lieu of writing a real post, I’ll mostly quote Yves Smith:

The reason most people don’t like government deficits is that they are assumed to crowd out private sector borrowing, thus discouraging business investment. But companies in the US, even in the last expansion, were net savers. That pattern has taken hold in advanced economies, even in many emerging economies ex China, since the mid 2000s, and some as early as the late 1990s. Andrew Haldane, the director of financial stability for the Bank of England, confirmed that companies and investors are taking an excessively short-term perspective, which is leading to underinvestment.

In simple terms, the household sector always wants to save. If the business sector also perversely wants to save, then government needs to take up the slack and deficit spend, otherwise wages and GDP will contract (if you run a big trade surplus, you can escape that conundrum, but that isn’t germane for the US). If GDP contracts, debt to GDP gets worse, not better. Conversely, when the economy is strong and the business sector is borrowing to expand operations is when the government sector should run a surplus.

What she is doing here is simply applying the fundamental macro identity, one of whose forms is that the sum of private and public budget positions plus the current account is zero. I’m increasingly convinced that just starting from the relevant version of the identity eliminates the 90% of economic debate that is nonsense. After that we can start discussing the other 10%—like whether the net savings of the business sector are only due to short-termism. (I think not, but that’s another, longer, more time-intensive post.)

Should We Panic Over the Level of Federal Debt?

Glenn Hubbard thinks our Federal debt problem is worse than it was at the end of World War II:

The US has addressed debt burdens before. Between the end of the second world war and 1960, the nation cut its debt-to-gross domestic product ratio in half from 109 per cent to 46 per cent through economic growth and avoiding additional debt accumulation. The US debt problem is now more difficult. Since 2008, the ratio of federal debt held by the public to GDP has risen from 40 per cent on its way to over 90 per cent by 2020, an alarming increase outside of major wartime experience. Today’s problem is not a past war, but ever-rising future debt burdens unless we take action.

Our chart shows the federal debt held by the public (DHP) to GDP ratio as well as total Federal Debt (TD) relative to GDP from 1939 to 2011 (projected) as reported in table B.79 of the Economic Report of the President 2010. Note that this 90% projection for DHP/GDP in 2020 is not as high as the ratio for 1945 but it is entirely possibly that TD/GDP will reach 120%.

Why would the Federal debt problem be more difficult now or even in 2020? This topic has received substantial attention of late – with a couple of mentions to Paul Krugman and the CBPP . Paul talks about debt arithmetic, which is reminiscent of Sargent and Wallace’s Unpleasant Monetarist Arithmetic . Let’s pessimistically assume that by 2020 we have a steady state real interest rate equal to 4% and real growth equal to 3%. If we could obtain a non-interest surplus to GDP ratio equal to or greater than 1.2%, then we could avoid a debt explosion and in fact might even see the debt ratio decline over time.

Glenn argued that we enjoyed a reduction in the debt ratio from 1945 to 1960, which is true. In fact, the debt ratio continued to decline during the 1960’s and 1970’s despite the Vietnam War spending and the various recessions we had during the Nixon, Ford, and Carter Administrations.

The CBPP chart shows that the explosion in the public debt ratio discussed by Glenn Hubbard comes from three primary sources: (1) the Bush tax cuts (I don’t exactly recall Glenn objecting to these when he worked for the Bush Administration); the two wars started at a similar time; and (3) the recession and fiscal policy moves designed to limit the recession. Robert Barro back in 1979 noted that the US economy often saw jumps in the debt to GDP ratio as the result of major wars and recessions but for its history up to then, long-term fiscal policy tended to retire this debt over time. Ah but this was another example of the Cheshire Cat in economics – as soon as an economist documents this tendency for long-term fiscal responsibility, we get the Reagan tax cuts which were not accompanied by meaningful spending cuts. So the debt ratio rose dramatically until the fiscal discipline movements of the 1990’s – which were in part defense spending cuts and largely tax increases – began to show up in a debt ratio that began to decline. At least until we had the fiscal irresponsibility of the Administration that Glenn Hubbard served.

We should, however, mention the elephant in the room which is the projected increase in Federal spending on health care. The Administration that Glenn Hubbard served made the problem worse as it added a prescription drug benefit without adding any revenues to pay for it. The current Administration managed to pass health care reforms that would tend to limit this growth in spending but with no support from the Republican Party. And yet it is this same Republican Party that not only refuses to consider any revenue increasing measures but wants to cut taxes even more.

We should close with admonition that fiscal discipline during a weak economy does not necessarily improve the situation with a hat tip to Brad DeLong .

There Was Neither Medicare Nor Medicaid In 1958

So what, you might ask? Well, the word is out that the most recent year tax revenues as a percent of GDP were as low as they are now was 1958, http://www.usgovernmentrevenue.com/downchart_gr.pap?years1900_2010%units=p&title=Revenue%20%20percent%20%20GDP . This might explain why in the push for a balanced budget, while cutting taxes even further, the Ryan plan seeks to drastically cut Medicare by turning it into a premium support voucher system, with the elderly having to cover most of their expenses out of pocket. Back in 1958, both the old and the poor had to pay for all their own medical care. What a paradise!

So, if there was neither Medicare nor Medicaid, what was in the budget back then? Of course, government spending was lower as a percent today, those Eisenhower budgets generally being close to balanced, although as 1958 was a recession year, there was a deficit in that one. Well, the much bigger item in percent terms was national defense. After all, it was the Cold War, and the year before the Soviets had beaten us into space scarily with their launching of Sputnik.

But, we need to pay respect here to this drive to lower taxes. After all, we could go back further to when there was no Social Security either, and defense was lower, you know, maybe 1917 when we were just getting into WW I and that darned debt ceiling first got installed, only four years after the federal income tax was adopted, an even greater paradise!

Or, better yet, go all the way back to a century ago before there was a federal income tax. After all, newly possible prez candidate Rick Perry wants to get rid of it. And, hey, in the logic of the political supply siders who constantly tell us that revenues always go up when tax rates go down, this would be the ultimate solution for our budget woes and debt ceiling and all that, since zero tax rates should make the revenues higher than any other possible outcome, gosh darn it!