Tuesday, February 26, 2013

Bernanke’s Retirement, the Lottery, and Casper the Friendly Ghost

Young Ben had planned on saving for his retirement. But alas, each time he got close to putting a few bucks into his saving account something came up. One time it was Aunt Barb’s lobotomy – another it was Jason’s need for a new ant farm. But Ben was not afraid and he boldly told everyone that his retirement income was already in the bag. After a few JD’s Ben would loudly explain his plan. Upon his 65th birthday he would retire and promptly play the Indiana State Lottery and win upwards of $50,000,000. Surely $50 million would be enough to provide for his retirement years.

That sounds pretty silly doesn’t it? But this is almost exactly what Ben Bernanke and the press are saying about monetary policy. Last week a few members of the FOMC were brazen enough to question when the Fed might begin pulling out some of the zillions of dollars of reserves they pumped into the economy the last five years. Has it really been five years Martha? Wasn’t the recession over in 2009?

Anyway, you would have thought that Oliver had asked for more porridge. The markets had heart attacks and TV anchors gazed at all of us with anguished faces. Pull out the money??? We can’t pull out the money with France in a dither and with US unemployment at 8%! Ben agrees and he assures us that he will know exactly when to pull out all that money. And he will do it in a painless and happy way. Hey guys did you hear that Ben pulled out the money and no one even noticed it. Man that Ben is like the best eco-money surgeon.  He can pull trillions of dollars out of the system without anyone even realizing it. He is better than Casper the friendly ghost.

So what is going on here? Why is Ben Bernanke waiting to begin pulling the money plug? The answer is that it is like Jason’s Ant Farm. When faced with a decision to disappoint your child or save money for retirement, many people’s hearts are tugged. Ben looks around and sees a lot of unemployed workers and he realizes that the second he announces a policy to withdraw monetary stimulus, interest rates will rise and jeopardize spending and economic expansion and along with it employment. Surely when you compare that scenario to waiting a while to remove the money, it seems more humane to leave the money in the system.

So why do his colleagues on the FOMC want to start withdrawing stimulus now? Are they hard-hearted fiends and vampires? Perhaps, but I think not.  They want to help unemployed workers too but like waiting until the last minute to win the lottery to support you in old age – these Fed officials believe that it is better for the Fed to start the process now – instead of later. It is probably true that an announcement to reverse the course of policy of the last five years would result in a rational forecast that interest rates will rise. That expectation alone can start interest rates rising immediately. That doesn’t sound good. But keep in mind that short-term interest rates are basically zero right now. EVERYONE knows this is a temporary situation. The only real question is when they will rise and by how much.

Okay – so rates are going to rise back to something more normal. But how much will they rise? Expectations will drive rates up as soon as the announcement is made. But then what?  First, notice that a policy to begin removing money when there is a ton of it out there might not disturb money and credit markets very much. That is, banks are sitting on so much money that they have plenty of it around for quite a while. Markets will not immediately find money scarce. So this excess supply should help to slow and hold down interest rate increases. Second, the economy is not exactly roaring right now. When the economy surges ahead, this often creates soaring demand for credit that can cause large increases in interest rates. Without a rapid increase in US or global demand, we should not expect much pressure for interest rates to rise. Third, much has to do with inflationary expectations. That is, whenever we think inflation is going to rise in the future, these increases are mirrored in interest rates.  The reason for pulling out the money today is to reduce expectations of future inflation.  So a policy to begin gradually removing monetary stimulus ought to begin an orderly increase to normal levels of interest rates – but one that won’t necessarily reduce economic growth and employment gains.

The bigger risk comes from waiting. By waiting the Fed continues its stimulation of the economy and encourages bubbles. These bubbles are already impacting many prices and encouraging increased financial risk taking. These bubbles raise our expectations for inflation and raise the demand for money as a response to the increase risk and uncertainty generated by not knowing when the policies will change.  We increasingly encourage hostility from our trading partners as our surplus money seeks overseas opportunities and reduces the competitiveness of their exports.

Of course the timing problem is exacerbated by the Federal government who seems unable to control future budget deficits. This means credit markets will have to digest $1 trillion or more government bonds each year for the foreseeable future. Normally interest rates would rise as private firms sell bonds that compete with the government for precious private saving. The Fed’s aggressive purchasing of government bonds make it possible for the government to finance its deficits without driving up interest rates. Thus an expansionary monetary policy seems necessary to fund an expansionary fiscal policy. If the government continues on this path it puts upward pressure on interest rates. Clearly a reversal of both fiscal and monetary policies is what we need right now.  

The Fed’s decision to ease up would be very much aided by a prudent fiscal policy. But with or without the proper fiscal change, the Fed does us all a favor by doing the right thing and starting that right now.  Waiting risks another bubble and another explosion. 

Tuesday, February 19, 2013

Debt and Safe-Haven Status

Today we are faced with government debates about the importance of managing national debt. The President’s State of the Union Address did not show a strong movement towards debt reduction. Those of us who worry that growing debt can and will lead to another economic crisis in the US often point toward US fiscal policy performance relative to that of other countries. By any measure, the US has acquired a much larger federal debt in the last several years since the economic crisis began. As recent examples in Greece, Spain, and Italy show – investor worries about debt repayment can spike interest rates, cause rapid outflows of foreign investment, and harm values in equity and other markets.

Those who prefer a very slow approach to debt reduction in the US often point to recent low interest rates, a rising stock market, marginal inflation, and other key macroeconomic indicators as evidence that the US can continue to carry very large debt loads without an investor backlash. But that view is very risky and myopic. The future very much depends on the so-called “safe-haven” allure of a country’s assets and currency. The US and Japan have benefited greatly from being safe-havens. But notice how these reputations can easily erode. Japan’s recent announcements of more vigorous fiscal and monetary stimulus have caused major depreciations in the yen and promise further contractions in asset values.

My blog posting today examines how the US is doing relative to 10 selected countries when it comes to dealing with debt issues. The below Table comes from theIMF (International Monetary Fund’s World Economic Outlook, October 2012. http://www.imf.org/external/pubs/ft/weo/2012/02/pdf/tblpartb.pdf ) and summarizes why I believe the US is ready to follow Japan. The last table column (Management) shows that the US joins only Spain and Japan as countries that have shown no real movement toward national debt management. I have labeled seven countries as having strong management – meaning that since their national debts peaked during the crisis these seven governments have dramatically reduced fiscal stimulus. These are the comparison countries when future investors think about the best and safest places to invest. Below I go into some detail behind the construction of the table.

It is very clear that the US is risking its safe-haven status when so many other countries are moving away from stimulus. One might argue that the so-called “austerity of these seven countries has led to weaker growth and therefore risks a government-induced double dip. But the evidence is not strong on that score. It is true the unemployment rates in Greece and Spain continue to rise but notice that these are two very different cases. Greece’s structural deficit is forecast (See table column 2012) to be lower than its Best (Table Column 1) – while Spain’s has been reduced from its Peak but remains some 5 times larger than its Best value before the crisis. Notice also that Germany and Canada – two countries having strong debt management are expected by the IMF to see significantly lower unemployment rates in 2012 and beyond.The US with strong stimulus continues to struggle with high unemployment. 

  Structural Government Deficits, Percentage of Potential GDP  
                                Best*    Peak      Ratio     2012       Management
Greece                      8.7          18.6        2.1          4.5          Strong
UK                           4.7            9.7        2.1          5.4          Strong
Italy                          3.3            3.6         1.2         0.6          Strong
USA                         2.7            8.7         3.2         6.8          No
Euro area                  2.3            4.4         1.9         2.1          Strong
France                      2.2            4.7         2.1         2.8          Strong
Japan                        2.2            7.9         3.4         9.1          No
Germany                   1.1            2.3         2.1         0.5          Strong
Spain                        1.1            9.0         8.2         5.4          Weak
Canada                     0.5            4.1         8.2         2.9          Strong
Netherlands             (0.1)           4.3          na         2.4          Weak

*Best is the government structural deficit from before the financial crisis in either 2005, 2006 or 2007
Peaks came in 2008, 2009, or 2010. Ratio is Peak divided by Best.
2012 is the projected value for 2012 (projected by the IMF as of October 2012)
Management refers to the relationship between IMF structural debt projection for 2012 and the previous Best

A structural government deficit (surplus) is meant to measure the amount of purposeful stimulus coming from that nation’s fiscal policy. It is not the same as the published government deficit figures we usually see. For example, in this table’s first column, the USA deficit of 2.7% of potential GDP means government was intentionally adding stimulus in 2006. The unemployment rate in 2006 was 4.6% -- very close to full employment. So there was little need for stimulus and the structural deficit of 2.7% is pretty small though larger than most of the countries in the Table.

From the countries I selected – the structural deficits are all pretty small before the crisis – except for Greece with 8.7%. Notice that Canada and the Netherlands had pretty close to balance – suggesting near-zero stimulus. Germany and Spain were not far behind.

As the financial crisis and global recession took full force in 2008 and 2009, budget deficits moved automatically larger. I say automatically because we know that when employment decreases and incomes fall – this leads to less revenues flowing into government and more spending on unemployment benefits and other social programs. That is – without any change in legislation or policy – government deficits get larger in recessions. The data table does NOT measure those automatic changes.

During recessions governments believe they must go beyond the automatic stabilizers and do something proactive to stimulate spending, incomes, and employment. The changes we see in the Table are intended policy changes to expand the economy. We see that in the US the structural deficit went from 2.7% to 8.7% of potential GDP. That is, the US structural deficit more than tripled. Of the 10 countries compared to the USA:
·         Japan’s deficit also tripled.
·         Only four countries had a larger Peak deficit than the USA – Greece, the UK, Japan, and Spain
·         Six had a doubling or less of their structural deficits from Best to Peak.
·         Of those six Greece started with a very high deficit.
·         Spain and Canada saw an eightfold increase – though Canada’s came from a very low Best deficit.  The Netherlands had an experience similar to Canada.

Clearly the US was among the countries providing the most intended fiscal stimulus during the crisis. The US is also not among the countries removing that stimulus post-crisis and our leaders seem satisfied with little to no debt management. Should we continue to lead from behind we risk loss of our safe-haven status. Stimulus has not stoked the fires of economic recovery and will only make things worse. It is high time to think of sounder ways to promote stronger growth and higher employment. 

Tuesday, February 12, 2013

Is Government the Problem?

Progressives or liberals believe that through collective action government is the solution – that is it is necessary to reach national goals. President Reagan countered that government is the problem. So which is it…The Problem or the Solution? And why does answering that question matter?

My answer is that it is a false question. It is sort of like having your mother-in-law living with you. She is there for the foreseeable future. If you let her, she will solve some of your problems while creating others. But she is there and you better figure out how to live with her. She isn’t going anywhere!

Government is like that. You would have an easier time getting your mother-in-law to move out than getting rid of your government. In the USA the government is a big mother. It spends a lot of money, it taxes, and it regulates. It is not going to move down the block. It is a waste of time arguing about whether it is the solution or the problem -- when it is both. The more important question is how to make it better.

Let’s start with a decision rule that applies to any institution. The government should solve problem X if (1) the private sector cannot solve X and (2) the government sector can solve X with reasonable efficiency. For example, let X be cancer. The private sector has not been able to eradicate cancer. So should the government try? While criteria (1) is satisfied many of us would wonder why it is that government could do a better job than scientists in pharmaceutical and biotech companies. Thus a government cancer program might not survive criteria (2).

Contrast this case to the famous case of the company emitting pollutants in a stream that another company uses in its production process. The very dirty water creates costs for this second firm who has to filter the water before using it. In the absence of any government pollution programs, the down-stream firm has costs that are not of their own making. Thus the costs and price of the downstream firm are made higher while the upstream firm has no liability. Thus a problem exists that is not solved by the market system. Enter the government. A pollution tax could be levied on the polluter that is in proportion to the costs incurred by the second firm. Thus government pollution regulation might be a solution for this problem if it reduces the amount of the pollution. This looks like a strong case for government action. 

Of course, much depends on whether the government would apply the correct solution. If the government simply closes the first plant or creates a pollution tax totally out of proportion to the harm – then society might be worse off with the government action.

Why do we care about these two decision rules? We care because it makes no sense to have a government that makes things worse. There are many problems out there. There are many ways these problems can be handled by the private sector. But in some cases, the private sector cannot get the job done. But just because the private sector can’t solve the problem does not mean the government should. Sometimes living with a problem might be better than solving it. Back to the cancer example. Cancer is a stubborn disease. Suppose a government official promises to spend $15 trillion per year to solve cancer? Government is going to raise taxes by $15 trillion per year to accomplish this? You would note that $15 trillion is about the size of the incomes earned by all Americans in one year. That’s a national cancer program that would be destructive. We can’t afford it.

You might say that our government officials are nice people and they would never intentionally waste the people’s money in this way. But then you would be forgetting many things about government. The first thing is that governments are as fallible as are the people who run them. For example, they might spend more on a problem than they initially intended because of human error.  Such a cost over-run in a private firm shows up in lower profits and will get attention quickly. But in government there is not such strong feedback loop for cost over-runs. There are no quarterly profit reports and no stockholders to get annoyed. In government a tally at the end of the year of all spending and taxes might find the government with an unexpected government deficit. At some point the voters might show their displeasure with this but nowadays that seems like a pretty slow and faulty system for cost over-runs.

Second, government officials answer to voters. We might even say that they cater to voters. Voters like the idea that government can provide them with things and they know that a benefit for them will be paid for by the country. If I want my street to be safer it is nice to think that the whole country will help me pay for that safer street. Unfortunately there is a fallacy of composition. If everyone wants a safer street they can’t have one. It would cost too much. So government creates a big problem for the politicians. They want everyone to know that the government is there to help so that they will get votes. But they know they can’t help everyone. This creates a queue for more government spending and a continual demand by voters for more government. It makes no sense for any single household to not participate in the demand for government growth. You are going to pay for it so you will want to get your share of the benefits.

The point is not to say that government is bad. The point is to show that once you set up a government and have it go about solving problems, then you have to be very careful or it will cost and grow more than expected. It takes strong vigilance. It is no accident that most economic calamities and pain often comes after rapid increases in government spending. It is also no accident that restraints on government spending, taxation, and debt are commonplace and that such restraints are often the advice handed to governments experiencing subpar economic activity. The Congressional Budget Office in the USA, the World Bank, the International Monetary Fund, and the Organization  for Economic Growth and Development are just a few of the policy advising bodies that regularly counsel counties to be careful about government growth.

Reagan was right when he looked back at the 1960s and 1970s and said government was the problem. But liberals are also right when they say that government can and should be the solution to pollution, poverty, security, and many other national problems. If they are both right then it shows that there is no free lunch when it comes to decisions about government spending and growth. It means that serious people in and out of government need to decide on the currently correct amount of government – program by program. This is about solving our problems with solutions that don’t bankrupt the country. It is about solving real problems based on real analysis and not on short-term vote getting. Isn’t it amazing when you watch our political leaders how far they are from this kind of rational behavior? 

Tuesday, February 5, 2013

No More Takers

Being economically conservative, it surprises me that conservatives have not been more effective politically. It seems to me that conservatives have a very strong case today but it somehow doesn’t win. I think I know why. It has to do with the word “takers.”

First, winning elections is not mainly about demographics. It is true that we have more people voting who are not white middle age males. But any voting group you can mention is not a homogeneous block. Each group has its liberals, conservatives, and centrists. Obama lost votes in 2010 because he lost centrists. He won more votes in 2012 because he won centrists. In my opinion, Republicans have not forever lost these centrists. They do not have to give up their principles in order to attract them back to Republican candidates and policies. But they do have to change their approach.

Second, conservatives need to give up on this “takers” thing. Hey Joe Taker – you are a selfish meathead. By the way, please vote for me. Really? Calling 47% of them names and then asking them to vote for you? An entitlement is government spending going to a person because a law specifies that that person is eligible for government assistance.  

You don’t have to be a wild and crazy liberal to believe that government help is good for the country. One entitlement is the social security benefit. Most of us who receive this benefit believe we “earned” it by dutifully paying payroll taxes to the US government for half a century – despite the fact that social security is not an insurance program.  We are “takers” in the sense that we receive assistance from the government – but we are NOT takers in the pejorative sense said or implied by some conservatives.

Social security benefits are not a plot to rob the rich, but that does not mean that we cannot discuss and criticize social security. Perhaps we can raise the age of eligibility. Perhaps we can make it more progressive. Maybe we can make it work better. Such critical analysis would be beneficial for social security – and for all government entitlements. The government, like any other organization, is far from being perfect. A poverty benefit might go to a family that has temporary economic problems. They need to be tided over. That seems very reasonable to me. I wouldn’t brand such a family a “taker”.  But a poverty program that somehow creates more poverty rather than less through poor administration or poorly designed incentives – ought to be reformed. Poverty programs should create less poverty – not more.  They should help people escape poverty not be imprisoned by it.

My point is that the whole “takers” issue needs to be ended and replaced with one that is less sensational and more correct. EVERY government spending program and every tax source needs to be reconsidered for reform. Is it crazy and dangerous to admit that government programs can create perverse incentives that lead to unnecessary and damaging government spending growth? Do we not have plenty of data from the last 75 years to show which programs have been successful and which have not? Republicans, it seems to me, have plenty of ammo in that data. They can focus on all those cases where policy has failed to succeed. They can focus on all the examples of unintended consequences. They can focus on the facts and how the facts show that policies have failed.

The third point is once they have pointed out the failures of too much government growth, they can explain the conservative case for improving social outcomes and government services. We are not going to get rid of a government that spends $4 trillion annually. But Republicans can show that they have BETTER policies – better ways to solve the problems of pensions, healthcare, poverty, energy, immigration, and so on. The focus is SOLVING problems. Reagan is famous because he said government was the problem and he explained how slower government growth could solve our national problems. Today’s Republicans need to speak with a clear and powerful voice.

Republican solutions often stem from very different assumptions about human behavior and about how government can impact those behaviors. There is nothing mean or selfish about teaching a person how to fish. There is nothing mean or selfish in pointing out how some programs have done just the opposite. Self-confidence is a great goal. Liberals often point out that self-confidence can be generated or restored though government entitlements. But sometimes these entitlements do the very opposite when they reduce the incentive to go beyond government payments.

This is not about takers. It is about the best way to use government to solve national problems. Conservatives have nothing to be ashamed of – they just need to quit pointing fingers at takers and explain why conservative remedies and less growth in government are the best ways to help people.

Some conservatives will react to the above by saying the game is over. They repeat the idea that the takers are now in the majority. Once in the majority it seems there is no end or limit to how much more they can take from the richer minority. But the data for this assumption is weak. As I said above all the so-called groups of takers include many centrists. These people understand that too much selfish taking hurts the country and often hurts the very people who receive the government benefits. But these centrists will vote for people who appear to have the best solutions. Obama and the Democrats wooed them in 2012. I think Obama’s case is weak and grows weaker each day. But it is the Republicans who must make their case now. They must stop calling people names and get down to the mundane business of showing vividly how and why government programs must be reformed so that we have an effective social state that pays for itself and attempts to solve mankind’s most pressing problems.

Final note. The Wall Street Journal is a library of data, case studies and other forms of evidence that reveal countless failures of government as well as positive advice on alternative solutions. But the WSJ and other similar outlets do not have the same reach as the many more liberal paper and electronic media outlets. Republicans need to find new and better ways to summarize, condense, or otherwise package all this great research and information and disseminate it to a larger public. Quit talking about takers and quit looking down at our people. Let’s raise our collective consciousness about a better way to run this country.