Thursday, December 20, 2007

Hokey Religions

When I started college, I wanted to be in politics. I was already of a Libertarian mindset, and had it in my mind that I could change the world. I picked economics as a major to learn about setting policy, not because I wanted to get into investments. Suffice to say I've fallen from the true faith and am now little more than a money grubbing trader.

Anyway, early in my college career I wrote a paper on budget deficits. Having a Libertarian bias to begin with, I set out to find sources which would conclude that budget deficits were evil. Lawyering? Hey, I wanted to get into politics at the time. Cut me some slack.

Lo and behold, I had no trouble finding academic papers suggesting that the ever growing budget deficit would eventually cause financial Armageddon. I slapped a series of quotes and charts into my own paper, called it research, turned it in and got an A. I became convinced that balancing the budget should be priority #1, and that politicians were tax and spending us straight to disaster.

As I moved further in my studies of economics, I realized that something like the budget deficit was unlikely to have a major impact on the economy in any given year. And as I became more involved in projects involving near-term economic projections, variables like the size of the national debt never worked as predictors. Despite all those sensationalist papers I read at the begining of my academic career, the large national debt was something more likely to slowly eat away at economic potential, and less likely to cause some sudden economic crisis.

If I wanted to get better at forecasting, I had to forget about what I thought should be done and focus on the effect of what would be done. So while politically I'd really like to see the budget balanced, the reality is that we're going to have a deficit this year. I feel my time is better spent considering whether this matters for near-term economic performance rather than railing against the deficit.

So where am I going with all this? Lately we've had a lot of proposals from various sources to alleviate the sub-prime crisis and related contagion. FHA Secure, Hope Now Alliance, Fed rate cuts, the term-auction facility, etc. Politically, if it were put to a referendum, I'd vote against all of it. Well, maybe not the Hope Now which was really just a coalition of banks. But the rest of it, if I were dictator of the world, I wouldn't do anything. I'd make sure the nations depositors knew that the FDIC was well funded and deposits were safe. The most I'd consider doing is increasing the FDIC insured limit at a bank. Other than that, I'd be for letting the chips fall where they may.

I'd privatize Fannie Mae and Freddie Mac. I'd figure out some way of phasing this in as to not cause all kinds of liquidity problems, but we'd start moving in that direction today.

Even the Fed cuts. If I were dictator of America, I'd mandate the Fed be given an inflation target and give the job of banking regulation to some other office. If the inflation target indicated lower rates, fine, but otherwise I'd rather see the Fed stay out of the economy.

But guess what? I'm not dictator of America, and it doesn't look like I'm going to be any time soon. So what I want to see happen is irrelevant. So rather than spend a lot of time thinking about the policies I want, I work on what the impact of policies will be. So while I hated the FHA Secure plan, I have to admit that it will prevent some borrowers from going into foreclosure. The housing market will be more stable, perhaps only to a very small extent, with FHA Secure than without it.

Same with the Fed providing liquidity. I try to think about it as if I'm Ben Bernanke. I've read a lot of his academic work, so I have some basis for how he's thinking. I've also read a ton of papers written by other Fed economists. As a group, they believe in monetarism generally with a neo-Keynesian streak. They belive that while inflation is their #1 enemy, liquidity crunches can cause big problems. They believe that providing liquidity when liquidity is dear can increase stability.

Now I might believe that the Fed contributes to instability at times, forcing them to react in the future. This may be exactly what's happening now, with the Fed having to deal with the consequences of keeping rates too low for too long. Here again, though, it doesn't help me make good forecasts to harp on the mistakes the Fed made in 2003-2005. I mean, its an interesting conversation, but entirely irrelevant to projecting what the Fed is going to do in 2008.

So I say put your personal philosophy aside when making forecasts.

16 comments:

Gavin said...

The FFR during Greenspan's Fed was a secondary concern.. all they can do is instill confidence in banks to borrow from one another to achieve the needed reserve levels.

The main problem during Greenspan's Fed was an outright refusal to exercise his mandate to regulate the creation and distribution of credit.

Ultimately, the responsibility of all the lax lending policies that created the housing crisis bubble up to one office: Alan Greenspan's. He was ordered to pay attention multiple times as lending standards deteriorated, but refused to act.

Ultimately, Alan Greenspan must go down in history as the worst Fed chairman in the history of our country.

flow5 said...

There are probably many more opinions concerning economic theory then there are different opinions on the theories about any other field. That’s telling. The crucible is whether one’s bent repeatedly works.

James I. Hymas said...

The trouble with predictions of Armageddon via National Debt is that they can be wrong for a long, long time until they are suddenly and unexpectedly right.

In 1994 - remember 1994? I do! - Canadian bond auctions were, for a period of a few months, within a whisker of failing. After that, the politicians found fiscal religion and have trodden the straight and narrow ever since. I can only hope that heresies do not arise again in my lifetime. I don't mind Keynesian schismatics, as long as they're fundamentalist Keynesians and really do intend to offset occasional fiscal indulgences with fiscal penances.

If one can rely on US politicians at that time to follow the Canadian example and shoot the hippo then there is not much necessity to take out much insurance. To the extent that other options are credible, some amount of capital flight is a rational choice.

Mind you, if you're benched against a US-centric index, who cares? Relative returns are all that matters.

don said...

With all due respect, it seems to me you grant too much power to the Fed.

If I understand things correctly, the primary banks are holding on to plenty of money, but aren't lending it out to commercial banks who in turn can lend to businesses and consumers. Thus the TAF - to side step the primary dealers.

Yet, the Fed has been tightening liquidity over the last couple of months, contrary to what is normally done this time of year. This is especially reflected in the net drain in today's TOMA. Even with this the Fed Funds rate today is 3.98%, far short of the 4.25.

So what can one attribute the problem too if it isn't some much about liquidity? Is it that no one wants to lend? Is it really an insolvency problem?

Applesaucer said...

I love your blog and this post was great; two things, however:

(1) You cannot be a Libertarian and support even the existence of a central bank (like the Fed);

(2) The Fed IS the Engine of inflation in the United States -- they create money out of thin air by monetizing debt.

When you look at inflation statistics, look at the years 1913 and 1971 and see if you notice something.

Best,

Applesaucer

James I. Hymas said...

You cannot be a Libertarian and support even the existence of a central bank (like the Fed)

He's right.

This was a ruling of the Supreme Appeals Tribunal of the Enforcement Panels Branch of the Defender of the Faith's office of the International Amalgamated Societies of Libertarians (1972) Inc.

So shape up!

psychodave said...

"I'd privatize Fannie Mae and Freddie Mac"
I dunno about this one AI. I'm walking away from all this thinking it was the private sector that got us into this (very deep) weedhole in the first place.

Additionally, in this post, Tanta's pretty much convinced me Fannie Mae's been performing a true social good, thanks to its quasi-governmental status. Her many responses in the comments, in which I drove her to heavy drinking, were most helpful. The last thing I'd want now is to shove a successful social good into the arms of the private sector.

I'm even thinking of buying some shares. But thats mostly because I'm tired of my li'l sister's superior returns with her Social Choice stock fund and I figured I needed a Socially Redeeming Investment, if only to diversify out of energy.

@hymas Enjoyed your wit on the Amalgamated Societies of Libertarians (1972)

Anonymous said...

It does not matter where the debt sits....what matters the total.

Add up Fed, State, Muni, Mortgage, Consumer and Corporate and look at the total. The TOTAL is what matters...because GDP must support the debt service...and growth in GDP must support the growth in debt service.

Too much debt overall and the financial economy becomes unstable.

The real cause of the depression was the debt buildup in the 20s. In 1929 total debt/credit rose to 270% of GDP.

We never again surpassed 200% until the 90s.

In the 80s...when everyone was worried about deficits, they took their eye off the ball...total debt was not that high.

We surpassed the previous 1928-29 record (270%) in the late 90s. We are now closing on on 350%(!), and debt is surging in a parabolic blow-off.

The ponzi scheme is up. The growth in GDP per unit of new debt added (sector does not matter) has been falling for years (ie the junkie is getting immune).

So you are right. Federal deficits don't matter. But total debt damn sure does. Once you get to a certain point, instability ensues, and accidents leading to systemic events are sure to follow.

Bill aka NO DooDahs! said...

Hokey religions and ancient weapons are no match for a good BULLWHIP at your side, kid.

Accrued Interest said...

Here is the problem I have with most libertarian candidates. They all are obsessed with money issues. Gold standard and/or eliminating the Fed. Now, if I were dictator, I's eventually look at either eliminating the Fed or putting them on some kind of Friedman-esq path of merely raising the money supply by a fixed amount per year.

But it seems that true libertarians should have MUCH higher priorities. And the risk of shutting down the Fed all of a sudden is very high. I mean, this is all hypothetical, since Ron Paul ain't gonna be president, but I'd have a hard time voting for a Libertarian candidate who makes the gold standard his top priority.

Psycho: I have no doubt that FRE/FNM have done social good. You are kind of making my point for me. I'm philosophically opposed to GSE's as a concept. I think if the government stayed out of it, then we wouldn't have this persistent myth that home ownership is always and everywhere better than renting.

That being said, there is no doubt that FNM and FRE support the mortgage market and home prices. As the market is currently constructed, we can't get along without them.

Anonymous said...

I am fond of pointing out to federal deficit doomsayers that if you came from Mars and looked at a chart of interest rates and the deficit from 1980 onward, you would reasonably conclude that the greater the deficit, the LOWER rates would go...

But I do find the total debt argument an interesting and compelling one---and I agree that that is the worrisome number.

Applesaucer said...

"Here is the problem I have with most libertarian candidates. They all are obsessed with money issues."

Let me explain to you why this is. If the government can print unlimited amounts of unbacked paper money, then it can run chronic and unlimited deficits. If the government can run chronic and unlimited deficits, then it can pay for a great many things then it couldn't have paid for otherwise. This allows the government to do many more things than it could have.

For instance, if the US government could not print any money at all, the only way it could pay for the wars in Iraq and Afghanistan would be to cut hundreds of billions of dollars in other expenditures and or raise taxes. Instead, the government borrows money and the Fed eventually monetizes much of this..or at least stands at the ready to do so to keep interest rates manageable.

So it is not just a "money" issue; it gets to the core of the proper size and scope of government. Not only that -- it's a stealth tax on Americans, as they see every dollar they hold or earn become less valuable.

All you have to do to confirm that this is true is to see how much of US GDP consists of government spending over time -- check the years 1913 (the establishment of the Fed) and 1971 (US walks away from the gold standard officially; unofficially, it had been walking away from the gold standard for quite a while). Check CPI over time, too, looking at the same years.

So it's not just a money issue. The government can do a great many more things than it used to, at a much greater scale -- just because it has no TRUE fiscal constraint. And that is only true because it can print money in unlimited quantities.

If you think this is a feature of "modern society," fine. That's your opinion and many share it. But then I would think that you would also believe that free markets and limited government are "barborous relics."

flow5 said...

There are thoughts that make a person and then there are people that make the thoughts. The status quo is already Hokey.

Keynesian economists who dominate the research staffs of Congress, the Administration and the Fed seem all too eager to pin our economic monkeys on the backs of the monetarists. Monetarism, they say, has failed, whereas actually it has never been tried. Monetarism entails the fulfillment of the following conditions:

(1)The monetary authorities use two tools to control the money supply – legal reserves and reserve ratios. If these tools are to be effective all legal reserves of all money creating institutions have to be in a form which the monetary authorities can quickly ascertain and absolutely control. The only type of bank assets that fulfills this requirement is interbank demand deposits (IBDDs) in the 12 Federal Reserve Banks owned by the member banks (just like the ECB). Similarly the monetary authorities have to have complete discretion over changes in reserve ratios. This is essential since under fractional reserve banking (the essence of commercial banks) these ratios determine the minimum volume of legal reserves a bank must hold against a specified volume and type of deposit liability.
(2)The first rule of reserves and reserve ratios should be to require that all money creating institutions have the same legal reserve requirements, both as to types of assets eligible for reserves, as well as the level of reserve ratios. Monetary policy should require ALL depository institutions to have UNIFORM reserve ratios, for ALL deposits, in ALL banks, irrespective of size…

An even greater impediment to achieving the monetarist goal (omitting the laundry list), involves personnel acquiring a technical staff for Congress as well as the Fed which does’ not confuse the supply of money with the supply of loan-funds; people who can make the proper distinctions between means-of-payment money and liquid assets; know the difference between money creating institutions and financial intermediaries; recognize aggregate monetary demand is measured by the flow of money – not nominal GDP; recognize that interest rates are the price of loan-funds, not the price of money; that the price of money is represented by the price level, that inflation is the most important factor determining interest rates operating as it does through both the demand for and the supply of loan-funds.

The monetary authorities must have sufficient independence to immunize their decisions from all special interest pressures (banking lobbies) including the federal government itself.

This is obviously all too much to hope for, and we can reasonably expect, therefore, continued mismanagement of our money, and more and higher rates of inflation.

psychodave said...

"I think if the government stayed out of it, then we wouldn't have this persistent myth that home ownership is always and everywhere better than renting."
Thanks AI. I'm so used to the private sector wanting in on something good so they can turn it into a landfill, I overlooked the persistent real estate boosterism that the GSEs did participate in.

flow5 said...

The "Federal Deficit":
There are two storm clouds, no longer small and no longer on the horizon, that have the potential at some indeterminate future date to "wash" the U.S. and the Foreign-dollar "down the drain". They go by the name of "foreign trade deficit" and "domestic federal deficit". These deficits have an insidious, if not an incestuous, relationship. Positive interest rate differentials are significantly responsible for the dollar's exchange rate support. And an "overvalued" dollar in turn is the principal contributor to our burgeoning trade deficits.

The viability of the U.S. and Foreign-dollar as international units of account is threatened by the huge trade deficits. Given the present and prospective trade deficits, this situation is not likely to continue for long. Foreigners will simply be saturated with excess dollars.

The volume of dollar-denominated liquid assets held by foreigners is extremely large. Any significant repatriation of these funds, by reducing the supply of loan-funds, will force interest rates up - thus increasing the federal deficit and the burden of all new debt. These events alone could trigger a downswing in the economy resulting in more unemployment, more unemployment compensation, less tax revenues and larger federal deficits. Truly a vicious cycle.
Perhaps it would be constructive, and enlightening, to discuss deficits in the context of all types of debt, public and private, remembering that “deficit” is simply the term for current debt accumulation, and that credit is the obverse of debt. Deficits, therefore, can be good, bad, or indifferent. For all we know, that credit, properly used, is the “life blood” of a healthy economy.
Any deficit, by definition, creates a demand for loan-funds. The larger the deficit, the higher interest rates will be, or the less they will fall.
Historical data indicate there is no positive correlation between the size of the federal deficits and the level of interest rates. Higher deficits are not associated with rising interest rates, and vice versa. The lack of any positive correlation, however, does not prove that the present deficits do not have a significant effect on interest rates. What the data proves is that, historically, the deficit effect on interest rates has not been a dominant factor. The unanswered and unanswerable question is this: what would the level of interest rates be in the absence of the current unprecedented high deficits? And what would the level of the long-term rates be in the absence of a general expectation of even larger deficits?
Deficits obviously generate a net increase in the demand for loan-funds; the larger the deficit, the greater the demand. That doesn’t necessarily mean interest rates will be higher. But if they are not higher, the only other conclusion is that the deficits are keeping interest rates higher than they would be in the absence of the deficit.
While current deficits increase the demand for loan-funds, the expectation of higher rates of inflation, and larger deficits, decreases the present supply of loan-funds. Lenders, as a group, will not lend long-term except at rates that will compensate for the expected rates of inflation. The, deficit financing impacts on the supply side (as well as the demand side) are pushing interest rates up or retarding their fall.
Those who are wont to minimize the ill effects of the deficit are prone to compare the size of the deficit with nominal GDP, as if the volume of nominal GDP were independent of the size of the deficit. Unprecedented large deficits “absorb” a disproportionately large share of nominal GDP. Present deficits are unprecedented no matter how measured, and the past gives us no reliable guide to the future effects of deficit financing, beneficial or otherwise.
To appraise the effect of the federal budget deficit on interest rates, it is necessary to compare the deficit, not to the debt to GDP ratio (a contrived figure), but to the volume of current savings made available to the credit markets. The 2006 deficit (406 billion interest expense) is absorbing about 23 percent of gross private savings. FY2006 total debt is the sum of: federal and state & local governments, international, and private debt, incl. households, business and financial sector debts, and federal debt to trust funds (44 trillion).
The more alarming aspect of the deficits is not the effect on interest rates but the effect of high interest rates on the level of taxable income and the volume of taxes required to service a cumulative debt now exceeding $9.1 trillion. Both high interest rates and high taxes induce stagflation, thus eroding the tax base and increasing the volume of future deficits.
Without foreign investment, we probably would have already passed the point where the problem of servicing the national debt could be solved without violating the principles of a free economy., That is to say through a non debilitating level of taxation rather than a confiscatory capital levee. Nor can the debt be “inflated away”. The depreciation of the dollar through inflation may solve the debt problems of many private borrowers, but because of the close relationship of interest rates, especially long-term, to the present and/or expected rates of inflation, this avenue is closed to the federal government.
Any given deficit should be evaluated in terms of 1) the size of the deficit in the context of the size of future deficits, and the accumulated debt relative to the means and costs of financing the whole; 2) how the deficit is financed; a. from savings or, b. commercial bank credit, i.e., newly created money; and 3) the purpose for which the deficits are incurred.
Monetizing federal deficits is especially inflationary since only a very small part of the federal outlays contributes to increasing the efficiency of the economy, and to reducing unit labor costs – $ 59 billion for FY2006.
“We are living on borrowed time and borrowed money”. Private, corporate, small business and consumer debt has been growing at unsustainable rates. Unfortunately, we cannot stimulate our industrial capacity with a $536 billion dollar military budget. If you believe these “requisites” are unobtainable, then consider the prospect of managing your investments and running you business in a totalitarian environment.
Based on OMG projections cumulative foreign war funding for all of FY2007 would reach about 549 billion. This includes Operation Enduring Freedom OEF, Afghanistan, and other global war on terror GWOT, operation noble eagle ONE, providing enhanced security at military bases, and operation Iraq freedom, OIF, Iraq.
As noted: the stock of the Federal debt is now approximately 9.1 trillion. By the end of this decade it will probably exceed 11 trillion. That includes $2.2 trillion owed by the U.S. federal government to foreign interests (which represents 46% of all Treasury bonds & notes). The average maturity of the Federal Debt is 50 months (2 & 1/3 years). About 50 percent of the Federal debt is under 2 years. Treasury securities are 18 percent of total debt outstanding.
Combine these factors with the constant roll-over of some of the long-term debt and it becomes obvious that the burden of higher interest rates will be compounded. The burden becomes a function of the major portion of the debt, not just the current deficits. The burden, in fact, becomes exponential. In other words, if the trend is not stopped, the debt inevitably has to be repudiated.
The Administration and Congress have it within their power to stop the deficits, and stop them they must. Here are five suggestions: (1) Begin a comprehensive reduction in armaments, a reduction so large it will enable our country to cut in half its outlays for the military. (2) Postpone for an indefinite period the pension “colas” for postal workers, the military, the federal civil service, and for social security recipients. Start paying out military pensions when military personnel reach the same retirement age applicable to social security recipients. (3) Revise the corporate income tax to 30% (currently 35%, the 2nd highest in the world) to make it competitive with other countries (which average 30%). (4) Enact a top personal income tax of 25% (currently 28%) and exclude tax breaks and enact relief for the poor (bottom rate was raised from 11% to 15%). This will introduce a modicum of fairness in the tax system, and will result in larger revenues partly because marginal rates will be lower. (5) Tax all pension income including social security. If a fair tax system is enacted, the burden of taxation will be no heavier on social security recipients that on other taxpayers.
These five proposals, of course, are in addition to current efforts to keep Medicare, Medicaid, farm and other subsidies under control. In addition, and supportive of the same objectives, are these recommendations: (1) Pursue all available means to preserve and expand free markets. Monopoly pricing is perhaps the most important factor generating unemployment and economic stagnation. (2) Amend, or better yet, repeal the DIDMCA of 1980. Give the Fed powers commensurate with its present responsibilities. That is to say: the power to constantly monitor and control the legal reserves and reserve ratios of all money creating institutions; and the exclusive power to examine and control, through examination, all money creating institutions.
Given these powers the Fed can legitimately assume the obligation to insure the liquidity of theses institutions.
If the monies represented by the deficits are spent on projects which increase productivity and reduce waste, the deficits are beneficial no matter how financed. The initial inflationary effects of bank financing are quickly overcome by the larger output and lower unit costs. Debt incurred which reduces unit costs of production and promotes the health and welfare of the population obviously is “good” debt.
Debt incurred to finance transfer payments (interest, pensions, etc.) is of dubious quality.. Any enterprise, private or public, is in dire straits if it has borrowed in order to make such payments.
In the context of the above analysis, what are the conclusions to be drawn with respect to the management of the burden of the national debt?
Prorating the federal deficits over the entire spectrum of federal expenditures, it can be said that virtually all of the current deficits are attributable to defense spending, military and civil service pensions, interest on the debt, and welfare and unemployment benefits. Social security is not included in the above list since only a very small proportion of social security benefits are financed from nonsocial security taxes. From an economic standpoint, only interest is “untouchable”.
With the federal debt now approaching 9.2 trillion and the projected interest expense for FY2006 = $406 billion, and current and prospective deficits approximating $250 billion, it should be obvious – if the debt is not to be repudiated and all dollar obligations consequently made worthless – the deficits must be markedly reduced.
Only direct controls can cope with this problem. Which is just another way of saying that we will, to a greater or less extent, have to resort to a “command” economy to cope with the debt problems we have so cavalierly created? The “feel good”, spend-beyond-your-means days are strictly numbered.
The interest expense paid on the National Debt is the third largest expense in the federal budget $ 406 billion . Only Defense $ 536 billion and income redistribution (The Departments of Health and Human Services, HUD, and Agriculture (food stamps)) are higher. (You may note that social spending is the largest item in our federal budget. Off budget, $ 1.986 trillion is owed to social security trust fund, $ 327 billion for Iraq war, Social Security $ 554 billion, Medicare $ 343 billion, and Medicaid. $ 192 billion, income security funds $ 216 billion, defense $ 536 billion, and other government trust funds $ 3.498 trillion.
Up until now we have ameliorated our unnecessary self-imposed economic hardships largely through massive transfer payments to non-productive recipients. Deficit financing by the Federal Government provided the principal source funds. As we all should know, there is a finite limit to this “remedy”.
But the alternative is a country whose economy will be forced into an increasingly totalitarian mold, and the freedoms which we are presumably arming to defend will be lost.

Anonymous said...

applesaucer- -
you mean this?
C:\Documents and Settings\James\Local Settings\Temp\Inflation_cumulative.mht

And yet....

1929-1939 might meet your approval in terms of inflation. The Depression years of course.
Probobably the best American years of the 20th century were 1940-1960. Moderate inflation,
Some might pick 1993-2000. High inflation. For decades.

So where is the message?