Saturday, December 19, 2009

Deficit terrorism

An interesting blog makes the case for liberal economics

Second only to theoretical physicists, economists carry a professional mystique of abstruse knowledge in the service of vast power. Vaults full of gold, trillions on "balance sheets", jargon swirling, and schools like the Chicagoans, Austrians, and Keynesians at each other's throats. Those employed at the central bank can create money ex nihilo, with god-like powers! The current crisis has made us painfully aware that while economists may use mathematics (and hopefully arithmetic) for pedestrian activities, the heart of their profession is a kind of psychoanalysis, along with a bit of conjuring. Who will ever forget Gerald Ford's Whip Inflation Now program?


Understanding is a precious commodity, and for all the critique raining down on the current administration, very difficult to come by. We can take it as given that the Republican talking points are, as usual, self-serving idiocy. Yet even discounting that, the situation is murky. I've recently gotten interested in a blog by a liberal economist who takes even Paul Krugman to task for basic blunders of macroeconomics! Not an easy thing to do with a nobel prize winner, but as I said, economics ain't physics.

I am no expert, (as usual), so bear with me (if you like) while I work out below what is going on in our economy, with the guidance of Bill Mitchell (interview), of Australia's University of Newcastle. His blog is something of a firehose of solid economics, indifferent spelling, and tart sarcasm directed at the leading lights of the profession, particularly conservatives who have suddenly found deficit religion, after eight years when "deficits don't matter". Thus Mitchell refers to the "deficit terrorists" of the present day who are prolonging the agony of this economic ... repression? decession? You make the call.

Let's start at the beginning, when the government prints money. Sovereign governments that print their own money and demand that legal tender back for taxes and the like are in a quite special position, relative to those sad-sack organizations like households, businesses, and states, that have to balance their books. Governments can print more money to cover their spending, and indeed have to do so as the economy they are responsible for grows and demands more money at stable value.

The current crisis was a bit of an error by the banks, which have another role in printing money. They make loans on the basis of small reserves, (the fractional reserve system), creating money out of thin air when they make a loan, and destroying that money again when it is paid back, while keeping the interest. Normally, the central bank keeps close tabs on the reserves underlying bank activities, so that this creation is held in check, tracking economic growth. In normal times, (again), tweeks to the interest rate charged to banks for this reserve money controls interest rates throughout the economy, thus lending activity, and thus money creation, and thus inflation.

But a funny thing happened on the way to the current unpleasantness, which was that banks, non-banks, and quasi-banks got into a low-reserve (i.e. overleveraged) lending game through esoteric "instruments" (we wouldn't want to call them loans- loans have standards!). The Federal Reserve completely lost control of the fractional reserve lending system, and the various lending "innovators" blew up when the markets they were overleveraged into began to decline.

Why wasn't this inflation of the bubble accompanied by monetary inflation? Ungodly trillions were being minted by the "banking" system, causing an asset bubble, not money-value inflation. This is perhaps where the psychoanalysis part comes in. Those of us buying houses during this period would call it inflation pure and simple, and of a particularly painful kind. But the CPI was not paying attention, since rental rates were not going up in lock step (one sign of housing market imbalance, incidentally). Most of the economy also had spare capacity for production, and offshoring/importing kept wages low. So as long as most indicators were stable, few businesses were raising prices, and the Fed, keeping its eye on the CPI, wasn't raising rates, and all were happy, except for one or two corners of the economy that were going absolutely bonkers.

Doubtless there is more to the story, but that is as much as I understand. When all that money from "innovative" banking was extinguished out of the system, we were in great danger of spiralling deflation, which prompted the Fed to flood the banking system with extra reserve money, buy up hundreds of billions of questionable assets, and reduce interest rates to zero. The extra reserve money made the banks more secure, (except those saddled with the most toxic leveraged garbage who couldn't cop a bailout from the Goldman, er, Treasury overseers), but it didn't induce them to lend. Lending depends on the customer's future prospects, and prospects suddently turned rather sour, even while businesses were pounding on the doors for money to tide them over this difficult time.

This is where the government comes back into the picture, printing and spending money. Mitchell's basic point is that government occupies a free position versus the private economy, with outflows:

- Direct spending (fiscal)
- Loans of reserve funds to banks (monetary)
- Purchase of bonds, notes, etc. on the open market with printed money (monetary)

And inflows:

- Taxes
- Debt, which is money collected from the private economy in return for IOUs
- Banking reserves called in and liquidated.

What the government does with its money is entirely immaterial. It could burn all the money that comes in the door by way of taxes and debt issues, and print new money for whatever it wishes to spend. The only stricture is that, as the manager of the monetary system of the private sector, the government (encompassing the Fed, Treasury and all the rest) wants to provide net money to the system such that inflation stays low- i.e. the value of the issued money remains stable. One could adopt the motto- "real macroeconomists care about inflation, not debt".

(Incidentally, due to this fundamental connection between the fiscal and monetary arms of government, Mitchell advocates combining central banks into government treasuries, so that they can act in unitary fashion, as they did in the US in this crisis anyhow.)

As a liberal-left economist, Mitchell adds the extra monetary policy aim of generating full employment, which used to be front and center in the US, but has receeded with the ascendence of Reagan and Friedman. Are these aims at odds? That is a critical question, especially now. Mainstream economists believe in something called the NRU, or the natural rate of unemployment, where the economy is producing as many jobs as could be expected without generating excess inflation, considering the number of malingerers and others reporting to be interested in work, but not really worthy of private sector employment.

As you can tell, this is something of of moral, even theological, concept. Leftists tend to think of NRU as zero, since everyone willing to work should get a job, if only a state-supported minimum wage job. The mid-century in the US stands as a sort of golden age in this respect, where for a long period anyone who wanted to work could find a job, during the huge post-war economic expansion. Rightists tend to think, in contrast, that people need to be "motivated" by the specter (indeed, the reality) of joblessness to be in a properly craven postion vis-a-vis business.

But one point is not really in dispute- however one celebrates the "creative destruction" of capitalism, the destruction of families, life savings, and human capital is no one's ideal. The current bubble-destruction cycle has been deeply damaging, especially to those still desperate for work. Their labor is being wasted- flushed down the toilet due to business, government, and monetary policy mismanagement. And their spirits are being crushed.

So far, the Fed has staved off deflation with its trillions of monetary support. But can the Fed, and the government in general, do more? Here we come up against the deficit terrorists, who say that the government is already in hock up to its ears and simply can't do any more. Hogwash! say liberal-left economists such as Mitchell. Is inflation a threat? No- deflation remains the current threat. So not only should the government be spending more money to replace mismanaged and dried-up labor demand, it doesn't even have to issue more debt to do so, but should just spend outright, leaving inflation management as a bridge to cross when we get to it.

Indeed, with inflation in negative territory, the policy goal is to increase inflation, (the customary goal being ~2%), which would best be accomplished by net government spending, either by sending money into the long-term bond markets, (analysis mentioned below), or directly into jobs programs, especially for our crumbling infrastructure and alternative energy needs. As everyone points out, the Great Depression was finally fixed by the biggest and most spectacularly wasteful direct jobs program in history- World War 2.

Issuing debt into the private economy to "finance" government spending simply takes money out of one pocket of the private economy (the rich who buy bonds) to put it into another (fiscal spending by the administration and congress). In normal times, that is a useful tool for monetary stability and for facilitating saving by the private economy , but right now, a great deal of extra money needs to be added- to stave off deflation, to spur economic activity in general, and to reduce the existing loan burden through modest inflation.

The financial bubble, despite creating vast amounts of money through Alice-in-Wonderland mechanisms, created only pockets of inflation, not general inflation. The subsequent implosion was so severe that much more money needs to be pumped in- about two trillion more, by one analysis which recommends that the Fed buy that amount of debt from the Treasury, effectively printing that amount of money and putting into the bond market, lowering long-term rates. The point is not to resume the over-inflated ways of the top of the bubble, but to provide the right amount to counteract the whipsaw of private lending contraction, allow the resumption of normal economic activity, and ameliorate unemployment.

[ed.note- Deeper reading of Mitchell's blog informs me that the above prescription, of the Fed buying $2 trillion of treasuries on the open market, would not actually constitute printing money, since the bonds bought would represent private liquid assets that would be extinguished. The result of all this buying would actually be to slightly lower long interest rates, which may be helpful in an indirect way, though already-low rates are not a big spur to lending. Buying this debt from the Treasury would likewise not have any effect unless the Treasury turned around and spent that money fiscally into the economy, like on infrastructure, alt. energy, etc. programs, or through a tax holiday.]

The ~1.5 trillion dollar gap of GDP, due to wasted labor and other resources.

So, do deficits matter? Yes, but mostly from a monetary perspective. The government doesn't need to "finance" its spending with debt. If the monetary system is stable, such financing (or alternately, taxation) is advisable, to keep the net money flows between the government and the private economy stable. (It also may be forced to do so if it has formally separated the central bank from its fiscal adminstration, as we have, even if the central bank then turns around and purchases those debts with created money.)

But it doesn't have to, especially when deflation is the present danger. It can (and should) spend freely without corresponding taxation or debt issuance in a deflationary situation, when the private economy lacks enough money, whether due to trade imbalances, government running net surpluses, or a credit implosion. Interest payments on government debt are certainly an encumbrance on future government spending, and some countries have reneged on such obligations (though never the US). Today's low interest rates are, however, a signal that such debt is, in concrete terms, not a problem now.

Overall, the response of the Fed and the government in general has been better to this implosion/decession than it was to the Great Depression. But the unemployment rate (much higher when one includes the underemployed, discouraged, etc.) says empirically that not enough has been done. That the financial industry should lose jobs after its overexpansion goes without saying, as is true to some extent for the housing industry as well. But the rest of the economy (so-called Main Street) is innocent in this cataclysm, and its suffering is a mark of failure in monetary and fiscal policy. In the future, one can imagine that were this kind of financial implosion to happen again, (heaven forfend!), the government should take even more rapid and forceful steps to replace credit, money stocks, and economic demand so that citizens would not be facing such terrible disruption and chaos.

  • One unemployed person.
  • All that said, who is mostly responsible for our current debt?
  • Frank Rich has a great column on the not-so-great Bernanke.
  • Survivor, for those of you looking for morals.
  • Santa and god- closer than you might imagine.
  • Mr. platitude raises his game.
  • The psychology of denial.
  • Amazing maddening story of abortion in war.
  • A great airline columnist keeps making the case against TSA.
  • Religious zealots run amok in the middle east.

1 comment:

  1. Great blog, Burk.

    Yeah, inflation is soooo not a problem - print some money!

    Printed money is "real" to us in our daily lives, but obviously it just represents potential production. If 10%, conservatively, of the work force is not using their energy and time to contribute to the economy, it seems obvious that it will just prolong a recession.

    Of course, the trick is what to put that potential energy towards. What will provide long-term returns? Can the government decide that?

    I am on your side here, thinking that investing in infrastructure, education, green energy is a no-brainer. Hopefully more will happen.

    I have never thought that way about WWII! I appreciate that perspective. What could be more wasteful than producing war? Not that we always have a choice in the matter.

    I live in OKC, possible the single place in the US which has been affected least by the recession. I remember the 2000-2002 years well - both here and in Austin, but this recession, aside from deflating housing prices SLIGHTLY (and not in my neighborhood) has done nothing but benefit us here. I now have a mortgage at 4.9% which seems ridiculous.

    I feel terrible for those who want to work and face an economy that cannot utilize this potential to create value.

    ReplyDelete