Tuesday, March 1, 2011

Debt, Democracy, and a Double-Dip Economy

We are used to planning for the future knowing that things never work out exactly like we thought they would. Formally or not, we base our plans and actions on highly probable outcomes. I know that whenever I eat pasta I get sauce on my shirt and sometimes in my hair. It is predictable. So I wear a shower curtain at the dinner table. That’s what we do. We plan and prepare for events that have highly likely outcomes. And accordingly we do NOT plan for EVERY possible outcome. Some things are highly unlikely with almost zero possibility. While eating, I might learn that Madonna is going to join us for pasta primavera. For such a possibility I should be wearing only my best shower curtain. But, of course, I don’t because there is no way she is going to show up in Bloomington for dinner at my house. Accordingly we don’t worry about Martians or Charlie Sheen at the dinner table.

But there are events that fit in between the highly probable and improbable and we give them our attention.  We might say that we have a contingency or back-up plan for things that might happen, even if the probability is low. We buy life insurance policies when we are young because it is a prudent thing to do despite the fact that we might live through seven colonoscopies. Business firms hold costly inventories in the case that buying for their products is higher than normal. To NOT prepare for these possibilities is to be imprudent or we might call it risky behavior. NOT preparing for one-in-a-million unlikely events is excusable. Not preparing for somewhat unlikely events is not.

Today we don’t seem to know one unlikely event from the other. A terrorist plot to fly airplanes into tall buildings on US land used to be unthinkable – but now we spend a lot of money protecting ourselves from that kind of behavior. A financial crisis grips the US and the world – something that few of us prepared for but now has governments rethinking regulation and how markets should function. A revolution breaks out demanding democracy in Northern Africa and the Middle East – surely a plot for a futuristic novel but now all of us are scrambling to deal with the likely contagion.  One might argue that we should have known that all these things would happen. But the truth is that not enough people REALLY thought any of them would around the time they unfolded. They were pretty-much black swans. A black swan is a major event with very low probability – sort of like me driving to town without Betty telling me I picked the wrong route.
Today we are pausing to ask about the possibility of another major economic crisis or if such an outcome fits this black swan description right now.  To resolve this issue we have to calculate the probability of another economic collapse.  If a strong downturn is really highly unlikely, then it would be wasteful and costly to try to prevent it. But if it is not a black swan and there is something we could do, then we would conclude that our policy makers have their heads in the sand.

Recent events make me want to revisit the likelihood of another recession. We were cruising along pretty well in the last months – with lots of data pointing to a firmer economy. We are now seven quarters beyond the official end of the last recession.  Risk factors are well known and discussed frequently – the housing market needs more time to heal, government budgets need fixing, and emerging markets are causing threatening price rises of commodities, including oil. But the general consensus of most economists and the stock market is a rosy outlook with a small probability of a recession.

So why is Larry so cranky? I ranted recently about jeopardy – the idea that these risk factors should be given more of our attention. I particularly believe that government deficits and debt need our immediate attention.  Can we handle the debts now? Sure! But that’s not the point.  The point is whether or not we can handle the consequences arising from a few low probability events or shocks.  And last week pointed out how very unprepared we are.  Last week the political disturbances abroad caused oil prices to shoot up and our journalist herd quickly taught us how to spell S-T-A-G-F-L-A-T-I-O-N.  Last week we read and heard again about the 1970s and how and why a large and sustained rise in the price of oil might cause simultaneously higher unemployment and inflation.

A few journalists and economist s wrote more thoughtful explanations about why an oil crisis of the proportions we are experiencing today might not lead to as much economic wreckage as in the recessions of 1974 and 1980. But the point has been made. A black swan flew into our lake and left a big poo-pee. Maybe our economy will stick its nose up and go on with growth anyway. Or – maybe some white swans will join her and make the mess much worse. Right now we don’t know.

But this illustrates our choices. If we had a more normal debt position such an event might knock us around for a while – but having a large chain around our necks make us weaker and unable to deal with a large oil/commodities price shock right now.  If you had six months of earnings saved and in the bank when a bout of unemployment hit you, life would go on. If you have nothing but debts when unemployment strikes that is a much different situation. In that case it really hurts and you have few good options.

If stagflation hits the US – whether because of oil or the prices of other commodities – the US government budget position and debt will worsen even further.  The recession part of stagflation means that tax revenues will decline and spending will increase. The inflation part means many things – but surely interest rates will rise and cause mandatory government spending to increase.  And as most people know – stagflation puts the government and Fed in a no-win battle with inflation and unemployment.  Using traditional demand-focused policy tools, any policy designed to slow the rising inflation will make the unemployment worse. A policy more focused on the recession and unemployment will make the inflation worse. With fragile confidence today, can we really flirt with these outcomes?

Is the probability of stagflation high enough to warrant a faster and stronger approach to US debt problems? I think so. Clearly recent days indicate that the demand for democracy and the impact on oil prices is no longer a black swan.  But is the probability of continued disruption of oil markets high enough to warrant all the difficult political and economic changes that go with a fiscal solution? Clearly the expected payoff of a solution is huge. Imagine the newspaper story detailing the immense losses connected with the following headline – US unemployment rate rises past 10% as the consumer price index reach 6% in 2011. Why don’t we demand more from our representatives in government?  Let’s get this debt under control before the next sneeze becomes pneumonia. 

18 comments:

  1. First: The rising oil and other commodity prices has a lot more to do with growing and emerging middle class economies with more population than all of Europe and North America....and currently limited available supply of those single energy resource. Additionally, a lot of land that would have been used to grow food is now used to grow corn for gas since that pays more. ( a dumb idea) So food and energy sources are playing against each other as demand rises. Couple that together with several revolutions in the countries that either provide oil or grow food and we have inflation ...at the same time technology is quickly eliminating certain types of jobs and restructuring how the middle and upper middle classes do their job and get paid (unless you are a public employee) ...and in the next 10 years we will see an over burdening of the care systems by the Boomer generation. Seems like a perfect storm to me.

    There will be stagflation even if the Government defines inflation excluding energy and food...what else do we buy every day? Oil is used to make products also..not just drive cars and trucks. The alternative sources of energy cannot scale up quick enough to provide relief. Wouldn't it be a good thing if the vast Sahara Desert became a giant wind and solar farm for Europe. Orall of the Precore machines in our gyms were also used to store electricity on long life batteries to power our AC and Heaters at night...loose weight -gain muscle- and cool your house...science fiction. However, YES we need to take politics out of this equation and start being pragmatic. These outliers are no longer remote possibilities ...they are real and usable data. The metrics will show us the real life consequences.

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  2. James,

    I agree with you that energy, inflation, and unemployment are difficult challenges and need attention. In my post I was trying to focus attention on the fact that lack of serious attention to debt explosion makes the country highly vulnerable to many different economic shocks. I used the present oil shock to illustrate how sensitive debt makes our economy to domestic and global changes....but my issue right now is debt and how disingenuous our politicians are about finding a real solution.

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  3. You must have a thing for colonoscopies as you seem to mention them quite often. Perhaps you'd enjoy a trip to Thailand for a prostate exam.;)

    I've heard of Mazola parties, but spaghetti sauce adds a new dimension! Martians, Sheen, and Madonna may not show, but I understand that Lady GaGa is really into spaghetti sauce parties especially in Indiana.

    Black Swan is also a rather tasty lager brewed and sold in Western Australia. It, too, can cause problems if taken in excess.

    Now that I have your attention, let me be perfectly vague. Our policy makers have their heads implanted in a place other than the sand...where the proverbial "sun don't shine"...and there appears to be no chance that they'll be extracting them any time soon. I will also observe that oil and other commodity prices are inextricably (25 cents for that one) linked, and we've helped screw the pooch by using corn as a fuel when as we from the South all know, it's best for sipping. It does make pretty, blue flames when it burns...and it burns all the way down. As a fuel, it doesn't do much except screw up engines.

    What really amazes me....and as a former pilot, I'm easily amazed....is that this administration focuses more on more spending than on getting us out of debt. And the Republican-controlled house...what can you say? It can find only $61B in proposed cuts? Jimmy Carter's legacy is coming back for another visit, I fear, except this round won't be your mother's stagflation.

    Wrap me in a shower curtain, cover me in spaghetti sauce, and call me GaGa.

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  4. Larry, I agree with your comment "but my issue right now is debt and how disingenuous our politicians are about finding a real solution"; but have to point out that it should not come as any surprise. Alexis de Tocqueville's warning that voters would vote for pols promising unaffordable benefits dates to the mid 19th century.

    There was a major change last election and many pols were elected on the promise of significant reductions in the deficit and debt, but all the current budgets I have seen are little more than a joke. While I would not like it I would agree to significant cuts in SS; the only govt program I really get money from. My retirement funds in 401ks and IRAs have taken a hit but unless things get much worse I can get buy.

    But I know lots of peeps who depend on SS, Medicare, Medicaid, and many other govt programs who would never agree, or vote, for a pol who said the freebies are over. I do not like to be put in the position of defending pols, but the reason they are not dealing with the debt (and other serious issues) is they know the voters would vote for someone else if the free money stopped.

    You and I may want things like realistic budget policy; but I am afraid the majority of voters just want free money.

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  5. Dear Crash,

    I agree that we should be doing more for developing cheap energy -- but right now the issue isn't gasohol and its impact on corn on the cob. Right now the issue has to do with the global supply of oil and how the risk of a future significant decline in supply might impact prices. AS usual, once the risk rises prices rise well before the eventuality. It looks like you agree with my last two posts -- neither side really gets it. These are cuts only in the sense that your diet helped you gain only 2 pounds after you recently added 50 to your girth. I hear almost nothing in the way of a real solution to our debt issues.

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  6. Dear Tom,

    So you and I agree. Here is the critical thing. While some voters do not want to see real cuts that will always be the case. it is the very nature of government. But what is missing is real leadership. I won't give up on that. I am not sure if Mitch Daniels is the best candidate, but he definitely stands for the right approach to government growth and deficits. He is starting to get more attention. Let's see what he and others can muster as the year unfolds.

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  7. I'm thinking that the only way to solve the problem is by NOT raising the debt ceiling. That's going to force some people to make the decisions they've been kicking down the road for too many years....and it's the only way we're going to get anybody inside the Beltway to make a move that might be painful. I can't believe that we continue to elect these morons!

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  8. Crash,

    Raising or not raising the debt ceiling is a red herring. It involves spending that is already legislated. While the politicians seem to argue in earnest they are just playing games because they know they already authorized the spending. What matters more is the authorization of the spending in the bills. If someone doesn't stand up for restrained spending in the legislative process then nothing is gained.

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  9. Red herring and spaghetti sauce.....that's a weird diet you're on, man!

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  10. http://www.hillsdale.edu/news/imprimis.asp

    Sounds like a plan!

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  11. Crash,

    I think the guy writing about returning to the gold standard is on a weirder diet.

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  12. http://www.heritage.org/Research/Reports/2011/03/How-to-Fix-the-Federal-Budget

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  13. Thanks Crash -- an interesting article about how to fix the budget.

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  14. Actually, I kinda like the gold standard, but anything would be better than the dirt standard we are now on.

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  15. Crash,

    The fact that US policy in the 1960s and 1970s contributed to the downfall of the Gold Exchange Standard suggests that it ain't what it is cracked up to be. Even under a pure Gold Standard it is possible for countries to to have terrible policy. While a Gold Standard would put some limits on policymakers in the "long-run" it would not prevent its citizens from suffering greatly from the same kinds of silly irresponsible policies we see today. The only way to stop bad policy is to limit directly what policymakers can do in the name of populism.

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  16. Larry,
    Couldn't agree with you more that debt is the core risk making a drastic economic downturn much more likely given a macro black swan event. In fact, the new Congress' refusal to address debt in a meaninful way ($61 Bn in cuts are not meaningful on a $3100 Bn budget) means the unlikely black swan just got more likely. Since government isn't taking action proactively, it's all the more important that individuals prepare. If the fire does burn down the forest, a least there will be seeds of capital to replant the forest.

    You mentioned bond vigilantes pulling money out which pushes up rates & of course government interest expense up with it. Since this worsens the deficit, it would cause further investors racing for the exits in a vicious cycle. How do you see it all playing out? Wouldn't the FED be forced to step in with QE3, 4, etc...to hold down the jump in rates and the interest expense? If so, the increased monetization of the debt would further grow money supply causing further inflation & erosion of the dollar (importing even more inflation) and further exiting of investors from the U.S. and the dollar. If so, where does it stop? Are we headed toward a 100% monetization and a Weimar scenario if the FED doesn't get another Volcker willing to step away from endless QE's? And even if we got Dr. Volcker back or his protege, is the government patient now even in a strong enough condition to survive the good Doctor's particular brand of surgery?

    I'm thinking that the FED and government might actually want significant inflation so they can make the debt more affordable. Besides that brand of medicine has the lovely side effect of soothing Bernanke's fear of deflation & the politicians' phobia of taking any candy away from babies..I mean voters. Reinhart & Rogoff indicate that inflation has been the preferred prescription of developed country doctors everywhere since the mid-1900's. Of course, with so many U.S. government payouts tied to CPI, the medicine has to administered secretly. (Shhh!! Don't tell anyone.) John Williams with ShadowStats has made a good case that the medicine may already be being administered and that CPI is already significantly understated. Do you follow him? Do you think his case is credible?

    Anyway, interested to hear how you think the patients next bout will start & progress and what medicine you think the good doctors Bernanke & Geithner will prescribe.

    Steve Gutke ('09 Red Cohort)

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  17. Steve,

    It is nice to hear from you. I don't follow John Williams but I will check it out. Thanks for the tip. CPI is just one measure of inflation and not the one the Fed uses anyway. I think they are more prone to follow the PCE deflator. Without reading his reasoning I can give you my basic response -- national indicators are just what the name implies -- they indicate a direction. We all know they are imperfect. Despite technical measure, I think we all know when inflation is getting better or worse. I don't like weighing myself. I feel it is unnecessary. I know when my pants are getting too tight. I don't need a quantitative reading! :-)

    As for the Fed I think Bernanke is enamored with his previous work on the Great Depression. He will come with too little too late. What that means is that we get a bout of inflation and finally the sledgehammer. Since most people do not see Bernanke as an inflation fighter, inflation expectations will be upward mobile and will add to the problem. Right now the only remediation I see for inflation is if the oil mess gets worse and this causes a major slowdown or recession. Of course, Bernanke could change his skin next week and surprise us all. I sure hope so since it doesn't look like Congress is going to do anything less than stupid.

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