The Federal Budget Debates Focus on Spending Cuts. What Cuts?

I keep hearing about cuts in spending – and how various groups will be hurt by the cuts. This is strong evidence supporting the view that the government spending process never ends. Nothing is ever temporary. Nothing is ever enough. People get quickly accustomed to higher levels of government spending and feel entitled. No wonder they demonstrate in the streets when a program is challenged.

Data I present and discuss below suggest that the period from 2007 to 2010 saw huge increases in the growth rates of government. But that is only part of a story that begins with Y2K. Government spending has been growing about twice as fast as it was during the previous decade. DURING THE 2000s GOVERNMENT GREW TWICE AS FAST AS DURING THE 1990s.  The record shows that virtually every major spending category contributed to this spending bonanza. Since the two recessions of the 2000s contributed to this spending explosion, there is plenty of evidence to support the idea that what was supposed to be temporary was truly not.  When or where did Keynes say it was okay to stimulate the economy with government spending increases and then make the new spending level permanent?

Ideologues in both parties make it difficult to solve this problem. Why? Because they delight in infuriating each other with finger-pointing and guilt tripping. It’s all Reagan’s fault! Look at deficits in the 1980s. It is Bush’s fault – look at the growth of government under his rein. It is Obama’s fault – look at the last two years.

The extremes of each party act in this immature way because they want to stick up for their constituencies. They see the present crisis as a time to help out their labor union friends or stick it to the rich. Others want to gouge Planned Parenthood or get rid of healthcare reform.

But they are missing the point. Neither Planned Parenthood nor unions caused our current problem – a budgetary mess – one that is not simply an issue of the last few years. What I show below is that defense, discretionary non-defense, and mandatory programs have all grown at much faster rates in the last decade and especially in the last three years. I won’t repeat the data about the national debt – you know indebtedness is too high and rising too fast. In my last blog I wrote about jeopardy. While we might be able to sustain high national debt for a while longer – inaction means we raise the possibility of a financial crisis worse than the last one. So we need to get moving.

So why not admit that our immediate problem is not about the needs of special interests – but rather is about attacking a mountain of debt. If government spending rose by about $1 trillion in the last recession and much of that increase was to fight a recession, surely we can find ways to reduce that spending by $500 billion or more in the name of restoring normalcy and greatly reduce the chance that a financial sneeze will turn into a devastating situation with even more draconian policy choices.

I’d like to suggest that we go back to annual government spending  growth rates of about 3-4% – but that isn’t going to get rid of the debt soon enough. Even freezing spending to current 2010 levels isn’t going to provide much relief.  Taking the budget back to levels that existed in 2007 is not as hard as it seems. As the economy improves, automatic stabilizers in taxes and spending should improve the deficit by $200 to $300 billion. That’s a good start and we shouldn’t ignore that contribution. But it isn’t enough.

Automatic stabilizers accounted for $312 billion of the overall budget deficit in 2009 and $359 billion in 2010 – meaning that roughly 25% of the deficit deterioration was caused by the automatic (without legislation) responses of spending and taxes to the downturn. Or put another way – the budget deficit increased by about $964 billion in 2009. The automatic responses or non-legislated changes in spending and taxation to a downturn in the economy accounted for about $279 billion of that increase. The remainder, or $685 billion, was how much legislated policy change contributed to the higher deficit in 2009.

The upshot is that we could return to government spending of $2.7 trillion and a deficit of about $340 billion that existed in 2007 if we focus on legislated spending decreases that total about $700 billion in the coming years. The automatic stabilizer contribution will disappear on its own accord as the economy recovers. While the number $700 billion looks large if we describe it as a cut from the expected outlays in 2011 of $3.7 trillion, they look at lot more reasonable when you realize they are from what was supposed to be a very temporary and is now a very bloated (burp) level of government. If you gain 30 pounds of unwanted fat over the holidays you accomplish very little by saying that you are going to freeze your calorie intake after Christmas. What you need to do is have a plan to eat fewer Twinkies.

The following table summarizes the issue. The first and second columns show that government spending was about $1.8 trillion in 2000 and it subsequently increased to about $3.5 trillion by 2010. That’s an increase of about $1.5 trillion – or an annual compounded growth rate of 6.8% per year.  The third and fourth columns show what federal government outlays “would have been” in 2010 had government spending grown at a compounded 3.6% per year (same as the previous decade) or at 5% compounded per year. These amounts ($2.548 trillion/$2.914 trillion) are clearly less than the actual amount of spending in 2010 of nearly $3.456 trillion. The final column shows the extra or excess spending – actual in 2010 less what it might have been if growing at 3.6% or 5%. As you can see the range is from $542 to $900 billion.  Even if government had grown as fast as 5% per year we would still be able to reduce over $500 billion out of government spending. Friends – this $500 billion is not a cut – even if government had grown at 5% per year for 10 years it would have increased by $1.125 trillion during the decade. Of course if we think government should have grown at only 3.6% per year then we could reduce government spending by $908 billion and still have a government that showed considerable growth for a decade.

Total Fed. Outlays: Actual, Ideal, and Actual Less Ideal  

   (1)        (2)           (3)              (4)              (5)                   

2000     2010   2010 3.6%   2010 5%  Excess3.6/5             

1,789    3,456    2,548          2,914        908/542

Here are some further figures to ponder (All from the Congressional Budget Office http://www.cbo.gov/budget/budget.cfm )

Government Outlays        Compounded annual growth rates

2007 to 2010               8.2%

            2000 to 2007               6.2%

            1990 to 2000               3.6%

It is worth recalling that the increase in government spending after 2007 came at a time when the budget deficit was $342 billion and helped move it to $642 in 2008, $1.6 trillion in 2009, and $1.4 trillion in 2010. CBO estimates a deficit of $1.5 trillion in 2011.

This same decade-doubling pattern of spending growth shows up with respect to discretionary Domestic Non-Defense spending – with the annual rate of spending growing at twice the rate of the 1990s. Discretionary Defense spending also grew rapidly from 2007 to 2010 but it grew less fast than non-defense discretionary outlays and the decade of 2000 appears to be making up for no growth in Defense spending in the previous decade (and of course a reaction to global terrorism).  In 2010 Defense spending was $689 billion or about 20% of total government spending of $3.5 trillion. Domestic Non-Defense spending was about $614 billion or 18% of total government outlays.

Government Outlays: Discretionary Spending         
Compounded annual growth rates

Domestic Non-Defense       Defense

2007 to 2010               10.2%                           7.9%

2000 to 2007               6.4%                             9.3%

1990 to 2000               5.1 %                           -0.2%

The biggest part of the budget ($1.9 trillion in 2010 or about 55% of total spending) comes from what we call Mandatory spending. Between 2007 and 2010 total Mandatory spending increased by 9.5% per year. That compares to 6.2% between 2000 and 2007 and 5.3% in the 1990s. Consider these increases from 2007 to 2010:

            Compounded annual growth rates, 
Mandatory Spending           2007 to 2010

            Total                                     9.5%
             Social Security                    29.2%

            Medicaid                             12.6%

            Social Security                       6.5%

            Medicare                               6.0%

Mandatory spending, as the name implies, is not quickly changed. But since it is a major part of annual federal government spending and the budget deficit, it is too large to be ignored in this discussion. Since these programs are open-ended and change automatically with the economy, we can expect that spending on Social Security, Medicaid, and other programs will a decline automatically as the economy continues to recover. I discussed this above. But it is not unreasonable as we think beyond the next few years into the coming decade that restructuring of Mandatory spending be a key part of a fiscal solution. Evaluations of recent budget proposals show short-term deficit remediation followed by a period of deterioration…because of Mandatory spending increases as the baby boom generation ages.  Any plan that only addresses the next few years is going to be deemed a failure. So why waste time with solutions that are bound to fail? 

Obama Plays Alex Trabek with a Bull in the China Shop

There is much being written and said about the President’s new budget for 2012.  So much is being communicated that it is impossible for most of us to digest it all. In fact, confusion might be the intended strategy – so I have tried to boil it all down to a couple of main points. But let’s start with a silly Davidson story about a bull in a china shop.

“Sir, there is a huge mean bull wrecking your china shop”.  The owner replied, “I don’t see a huge mean bull wrecking my China shop.”  The man protested, “But look around you at the devastation – broken pottery and glass everywhere. Look at that big hairy animal in the middle of the shop.”

The discussion went on… The manager first said the breakage was not so bad and that he had a good insurance policy. He went on to explain that his shop was in a rough neighborhood and he had reported the problem to the police who would search around the neighborhood looking for culprits. He pointed out that even if there was a bull in his shop, that there was really little he could do. While some people might want him to shoot the bull, he would never resort to such violence. And, of course, trying to coax the animal away might lead to it running down the street and injuring other people. The manager decided to move some of his valuables out of the shop. Give me a little credit for not bringing in bull-c___. 

Point one is that even though a bull might be staring him in the face, Obama prefers to pretend like it isn’t there. While he might not believe in American Exceptionality he seems to believe that we can be exempt from the laws of economic gravity that weigh on every other country. If there is one salient and imposing truth about our economy it is that we had a huge and supposedly temporary surge in government spending during the last few years. If temporary changes in the government budget were legislated to counter a decline in private demand that was associated with a recession, then it seems that seven quarters after the end of the recession we would be focused on removing the stimulus. Of course, there is a legitimate debate about how quickly to remove it and I am not against a gradual removal. But I do believe policy credibility is important right now and a slow removal would require two things: (1) a strong statement about its importance and (2) a legislated multi-year process. 

There was no sense of urgency in the discussions of the budget for 2012. Yet this budget or anything like it puts the nation in harm’s way because it ignores what we have known for decades – that we spend too much and save too little. What does it take for our government to face up to reality – especially when other countries are getting the message and doing something about their own financial situations? Jeopardy is a very popular game but the word jeopardy is one I used many times with my kids. You place yourself in jeopardy whenever you make a decision that increases the risk of something bad happening to you. If you drive too fast you get places quicker. It might even be fun and exciting. But driving too fast places you in jeopardy since you might get an expensive citation or worst, you might injure someone.

Government spending and deficits make it possible for a nation’s people to have more now without paying for it now. But it comes at a cost – a future cost. If government deficits lead to critically large amounts of debt for a nation then the nation puts itself in jeopardy. At the moment all might seem well but all it takes is a negative blow to the solar plexus and the country could get doubled over in pain. It seems to me that the experience of the last recession should have been instructive. But apparently it wasn’t informative since we HAVE A MUCH LARGER DEBT BURDEN NOW and we pretend that having deficits of more than a trillion dollars in the coming years are okay. Even worse, while the current budget envisions the debt to GDP ratio slowing, it admits that any remediation is temporary and that it will resume its upward climb because of issues with Medicare and Social Security.

Clearly, then, this budget for 2012 offers no way out of jeopardy since it does nothing to provide a strong statement and action plan for improving the nation’s debt burden. It will be no black swan the next time a sudden macroeconomic shock negatively impacts Main Street or Wall Street or both. If you thought the recent recession was bad, just wait until the bond vigilantes suck their formidable assets out of US markets because we were the last kid on the block to learn from the last recession. 

Some would have you think there is a tradeoff or a distributional issue involved with attempts to solve the national debt problem. For example, the President’s plan has two disgusting features. First, it points its spending axe at programs aimed at those with low incomes. I am sure he knows that these aspects will never be legislated in a split government. He’s already heard a few explicative deletives from his friends on the left about the cruelty of his proposals. Second, he also plans higher taxes on those with incomes above $250,000. After compromising on this issue last year he tries it again because it looks good to his constituents to go after the rich. Of course, this will not be passed this year in a split government.  Much of what he has proposed, therefore, is disingenuous. Worse, it pits the poor against the rich. Yet today there is no real tradeoff. The poor and the rich will do better when the economy improves. It won’t improve until we recognize the bull in the china shop – until we seriously try to fix our real and looming debt burden.

Finally, he continues his theme from the State of the Union Address of proposing more spending on infrastructure and other competition-enhancing measures. It is true that our nation needs to be more competitive in the future. But risking our money on dubious government supported boondoggles rife with crony capitalism and corruption is not the right way to do this. I cannot remember a time in my life when there was more incentive for engineers and scientists and other entrepreneurs to be sequestered in their garages late at night trying to find solutions to so many pressing health, energy, and various high tech issues. The rewards for their successes are infinite compared to the extra pittances the government can hand them. If we do want to very carefully find new ways to support them with better infrastructure we should do it within the confines of a strong national financial and economic plan. These entrepreneurs don’t need handouts. They need a stable financial system with a large pool of saving that comes from both domestic and foreign sources. A bull in the middle of the china shop will do nothing to help American be more competitive. But it will generate a lot of c___ if we continue to ignore it.  

US Policy, Idaho, Onion Dip, and Rising Interest Rates

The news today was full of stories about rising interest rates. Rates are said to be rising because of a growing economy. The impacts of interest rates are one of the most complicated and misunderstood aspects of macroeconomics. Consider the popular discussions about interest rates over the last several years:

·         Interest rates rose before the onset of the current recession – that was bad.

·         Interest rates fell as the recession took hold. That too was bad.

·         The Fed instigated a policy to reduce interest rates further and that was good.

·         Interest rates are rising now and that is bad.

You might be saying – how can all that be true? It is possible only if you understand a little about cause and effect.  Here comes some macrofun! First, interest rates are fundamentally driven by changes in the demand and supply of credit. Whenever the demand for credit (borrowing) outstrips the supply (saving), interest rates rise as borrowers compete in a market that has an insufficient amount of saving available for their needs. The borrowers include households, firms, and the government.

Second, interest rates reflect the impacts of inflationary expectations and risk. If inflationary expectations rise or if financial risk rises – the savers demand a higher interest rate to compensate them for reductions in buying power associated with higher expected inflation and increased risk.

Third, while the above factors cause changes in interest rates, interest rates cause changes in the economy. Economists might use words like – “once interest rates change they create impacts in other markets for goods, services, equities, foreign exchange, etc”. So a full discussion of the impact of interest rates would include all the following:

·                X changes and impacts credit demand and/or supply

·                 Interest rates change

·                  Interest rate changes cause changes in spending, exchange rates, output, employment, etc

With this information and $3 you can get a coffee at Starbucks. You can also see why it is difficult to characterize and forecast interest rate issues. For example, interest rates were rising before the recession largely because spending in the economy was so strong that it created huge demands for credit. That might be considered a good thing because along with the higher interest rates was a very low unemployment rate. We like low unemployment, right? But wait, interest rates were also high because inflation and expectations of inflation were rising and the risk of a financial bubble were increasing. So the Fed decided to tighten the money supply and slow things down a bit. To do so the Fed drained money from the economy by selling government bonds. That added to the demand for credit even further and raised interest rates. The result was a clear realization by us all that housing and stock prices had peaked which quickly created a whole host of negative impacts on both Wall Street and Main Street. THE FED POLICY WORKED in the sense that it stopped the problem of rising spending. Of course, it worked too well since the unintended impacts on a very leveraged and interconnected global financial sector was a financial and real crash. Summary – rising interest rates were a sign of an economy growing too strong and they were bad because they led to a deep and long recession as well as a very weak recovery after the recession.  Whew—all that makes me hungry. Reward yourself with a trip to the refrigerator.

The above sequence of events led to very low interest rates – a mirror image of what came before – falling and low interest rates as a consequence of very weak aggregate demand, lower inflationary expectations, and a Fed that was buying bonds faster than a fox can eat lunch in a Kentucky Fried Chicken Store. Low interest rates were bad because they were associated with insufficient borrowing, weak demand, and the resulting very high unemployment rate. The lower rates were thought to be good because the Fed’s policy appeared to be necessary to resuscitate spending and the economy.

So let’s jump to today’s headlines which announce higher interest rates. Is that good or bad? You might be guessing from the above logic (optimistically assuming that you are still awake) that the answer is yes AND no. And you would be correct. Today’s higher interest rates are the direct result of a stronger economy and rising demands for credit. That’s good. Of course, today’s higher rates are also the consequence of rising inflationary expectations. That’s good news too if you worry that inflation is too low. Of course, if you look at any chart of inflation rates over the last 50 years you will notice that inflation has a tendency to rise beyond its goal value once it gets started moving upward. It isn’t the kind of thing that you can easily manipulate. It is a bit like that potato chip thing. Once you eat one salty, crispy chip with onion dip there goes Idaho.  So rising inflation is considered by some of us to be a problem. Not because we love Idaho but because without better policy we might be back where we were before the latest calamity hit.

Could today’s small interest rate rise really warrant all this concern? After all, Mr. Bernanke says that inflation is below target and we have lots of economic slack and high unemployment.  Bernanke might say – let’s wait until we see that we are clearly growing too fast. But that’s exact the issue. First there is the Idaho thing. 

Second, we have an unprecedented amount of liquidity just waiting to be spent thanks to the Fed’s policies the last years. Third, our government has an unprecedented amount of fiscal stimulus interacting with rising private demands. The firecracker might be wet and hard to light how. But watch out when the sun comes out.

It reminds me of the joke about the guy who falls off the top of a very tall building and as he is flying by the 10^th floor on his way down to the street a person sticks his head out of a window and asks “how are things going?” The guy responds that “things are fine so far.”  Well things are going fine right now as interest rates begin rising. I just hope Mr. Bernanke and our federal government don’t wait until too late to reverse engines. If not for America than please think about the potatoes in Idaho. 

State of the Union -- My Elephant Sat on Sputnik

Like many of you I sat in front of my TV with a bowl of JD and watched the President give his annual lecture to the freshman class – err I mean give his Annual State of the Union Address. This year I missed getting the chance to gaze into the eyes of Nancy Pelosi for an hour or so and was disappointed that Speaker Boehner did not cry one time. I know this post comes a little late but I wanted to have a little time to steal the best ideas from the 8 zillion people who already weighed in on the speech.

One response is that I really should be happy about the speech. I have been moaning about the negative tone of partisan politics and so I should really be elated by the fact that both the left and the right decried the speech a horrible disappointment. If both extremes were unhappy with the President, then it should follow that he took a big dive into the middle thus moving away from the extremes. But unfortunately I don’t see it that way. I think they are both right to be unhappy. And the reason is that the President may have proved to both sides and all of us just how thin his knowledge and experience really are.

Writing in the Financial Times on January 27, Robert Reich spoke for the left when he (Why our Sputnik Moment will fall short) said the following, “What he (Obama) should have done is talk about the central structural flaw in the US economy, the dwindling share of its gains going to the vast middle class, and the almost unprecedented concentration of income and wealth at the top.”  I won’t quote anyone from the right but it was pretty clear they were very disappointed to see him stress increased government spending as the way to improve America’s wellbeing in the future. He acknowledged a national debt challenge but didn’t seem very worried about it.

As one dedicated to the arcane science of simple cause and effect, I share the negative assessments of his speech largely because the president talked about lots of policy but hardly ever told us his view of the exact nature of our most pressing problems – or the causes of them.  While his smile and rhetoric are rare and his solutions dazzle the mind, his absolute lack of any sincere attempt to link his latest policy proposals to any realistic explanations of problems suggests to me that he doesn’t really understand them. Where is David Letterman when we need him – with a top 10 list of America’s worst economic problems?

To elaborate the point – while I don’t agree with Reich about the relative current importance of income distribution issues – one wonders after the speech what Obama thinks about that. Will emulating the Sputnik fervor with respect to education, green energy, and infrastructure alter the relative positions of the rich, the middle class or the poor? If so, can he explain how and why?  So much for people interested in policies to improve income distribution. Don’t we have a housing/financial crisis? Did we solve it already? Is it not REALLY important that our policy somehow connect to this problem? Shouldn’t he have spent a little time on this one thing that seems to have set off the worst recession since the day when bread cost 7 cents a loaf? Of course, if he thinks the housing/financial crisis is over or lacking interest, then maybe he might have discussed the fact that three years worth of federal government deficits are expected to exceed $4 trillion dollars between 2009 and 2011. Or maybe he thinks that’s honky dory and doesn’t need our attention in the coming year.

Reich has his stuff and I have mine – but the real truth here is that our President seems to have jumped on a satellite with the Dallas Cheerleaders and Dr. Phil – with the result a breathtaking lecture that continued his theme of hope and change without any real discussion of cause and effect.

Worse yet, hidden in a smoke screen of working together was an apparent switch to a new horse called competitiveness – without any real attention to what it means and how you get it. You don’t have to be a Republican to wonder what is the connection between some diffuse and rosy mention of improving education and what it really takes for the US economy to be more competitive. Democrat or Republican, you don’t really want to experiment with the people’s money right now betting on a very new horse.  If you were critical in any way of the stimulus story, then imagine what you are thinking about an abrupt turnaround of policy in the name of government policy induced competitiveness.

One more point. One theory is that Obama is weak when it comes to cause and effect. Another one is that he is VERY strong at politics. Notice that by switching horses and by agreeing to discuss details of tax restructuring, education, healthcare, and competitiveness policy—he will turn the spotlight away from him and towards all those folks who will debate themselves hoarse in the time leading up to the next election. Obama comes off looking like the great compromiser and both democrats and republicans will look like warring tribes of the bush.

The cat is out of the bag or you might say the elephant is in the gift shop – Sputnik is a great diversion but I think we would be a lot better off if we just erased our memories of his speech and started over – with some simple discussion of cause and effect and what our most pressing problems are today. 

Bernanke and Blinders: Making Distinctions Between Inflation and Relative Price Change

There were two articles in the Wall Street Journal on Monday about inflation. The articles raise many questions but central to them is the definition of inflation and what policymakers can do about it.

Most of us who are over 50 know what a colonoscopy is. Of course, we know it primarily from the user’s end – and by that you also know what I mean. But (and I do mean butt) most of us know very little about it from the doctor’s perspective. And while we might read the latest medical web sites, we really don’t have the training to understand all that is going on while we lay there on a cold bed with insufficient coverage of our precious parts.

Inflation is a word that most of us know. We feel the impact of inflation when our local grocer raises the price of bread and when a gallon of gas costs more than a double JD on the rocks. And we are constantly reminded about inflation since governments collect facts about price change and the press takes great glee in spreading the news each month. Then we hear that the Fed absolutely hates inflation almost as much as I hate anchovies and we feel somewhat relieved to know that Ben Bernanke and his colleagues are actively watching the numbers and are ready to attack like a head-butt in a Jets game.

Confusion may arise because inflation has two definitions. The first definition has to do with measurement. A price index is an average of prices. Some prices go up. Some prices go down. But the price index averages the ups and downs of all the items and calculates one number describing price change of all the items in the index. Food might be going up by 2% and horse shoes might be going down by 1%. The index doesn’t much care about individual changes because it averages them all together. Most price indexes are weighted – meaning they count some price changes more than others depending on how important the item is. We spend a lot more money on food than on horse shoes – so food prices are more heavily weighted or count more in the price index.

When we take into account all price changes in an index we get one number. For example, the consumer price index might be 202 this month. Perhaps it was 200 last month. So we would say that consumer prices rose by one percent (from 200 to 202). Or we would say that the inflation rate was 1% this month.

Okay – so the first definition of inflation is a measurement – it is the percentage change of a price index. This measure helps us to understand how far our income is going with respect to a particular basket or bundle of goods and services. Naturally when this measurement is high in a given time period, we don’t like it since it is telling us that our income is not stretching as far as it used to.

The big question is why this measurement of inflation matters for macro or for the Fed. So let’s wake up, do a few pushups, and move on to the second definition of inflation – macro inflation.

Recall that macro is about the national economy or the big picture. Macro is about aggregate supply and demand (If you don’t understand these concepts then I would suggest you go back and read all 60-something posts in my blog. Then you will be REALLY confused, give up, and go back to reading fun stuff.)

The Fed has no magic tool to impact the price of a specific single good or service. If food prices are misbehaving and causing the overall index to increase a lot, the Fed has no food price hammer to knock it back down. The Fed only has an aggregate demand hammer. Using traditional monetary policy to attack food prices would be notoriously inefficient since they would be using a macro tool that impacts ALL PRICES to whack away at food. The Fed’s tools are much better suited to times when the price index is rising because many or most of the items in the price index are rising (or falling) at excessive rates. This discussion gives us to ways to interpret a rise in the price index:

(1)   If it is being caused by only a small number of items, we call this RELATIVE PRICE CHANGE

(2)   If it is caused by many or most of the items rising, then we call that MACRO INFLATION

The hullabaloo in the papers recently is confusing because it is mostly screaming RELATIVE PRICE CHANGE and then wondering what the Fed is going to do about it. The Fed should, I believe, do nothing. Like a horse leading a carriage down a busy street, the Fed should be wearing blinders so it doesn’t get spooked by every little noise that signals a movement in prices.

So here is the fun part. While it is true that the Fed should not be tightening monetary policy because of recent changes in measured inflation – it should be tightening it because of other reasons. First, as the economy continues to improve banks will return to lending and spending and inflation will start to accelerate. Second, there is some risk that the Fed will wait too long to tighten the money supply and an inflation problem would be harder to douse once ingrained. Third, the combination of relative price change and a worry that the Fed will wait too long to address rising inflation can lead to a RISE IN INFLATIONARY EXPECTATIONS.  Fourth, a rise in inflationary expectations today causes behaviors that push up macro inflation today – as workers and other suppliers begin to press for their own wage and price increases. These behaviors are not only bad for inflation but they erode firm profits and could lead to a slowing of output and employment.

In summary – while current changes in the price index are not signaling higher macro inflation today there is, nevertheless, every reason to ask the Fed to immediately begin to lean against inflation. Without a quick return to a normal monetary policy we have the very real risk of a bout of stagflation similar to the kinds we experienced in the 1970s wherein both unemployment and inflation were rising. The only antidote was a virtual squashing of demand by the Fed late in the decade that sent interest rates above 20%. Let’s not go there again please. 

Angel Wings, three mumus, sweat pants, and Monetary Policy in 2011

When do you throw the angel wings away? My Dad threw me into Venetian Pool and told me to start swimming or I would sink to the bottom of the pool like a box of two week old Twinkies. Actually the water in the children’s pool at Coral Gables’ most unique swimming hole was only about two feet deep so my Dad wasn’t as callous as my sentence alluded.  Other parents purchased angel wings for their darlings. The angel wings hold the child on top of the water as they learn techniques of swimming – like moving your arms and legs in a manner that keep you on top of the water. They are a great idea. Once the kid masters the basic idea of swimming without fear of drowning, she can dispense with the wings and get on with trying to beat Mark Spitz’s records. The challenge comes with the more timid kids who are never quite sure their parents weren’t hiding in one of Venetian Pool’s dark and romantic caves making out. These kids were reluctant to give up the security of their angel wings and clearly jeopardized their ability to swim the English Channel. Their parents were faced with a dilemma. If we take the wings away our kid will NEVER learn to swim. If we don’t take the wings away our kid will NEVER learn to swim.

Martin Wolf and Ben Bernanke think that we are all reluctant kids who need our binkies or was that angel wings? Anyway M&B have been arguing of late that it is much too soon to start withdrawing monetary stimulus from the US and European economies. So I ask the question – will withdrawing stimulus now prevent us from ever swimming the English Channel? Or for you non-swimmers, will withdrawing monetary stimulus now mean that the economy will not recover? Or….tada…..will not withdrawing now imply the economy will not recover?

I think a clear and public plan to begin to withdraw the monetary stimulus is necessary right now. Waiting is foolish and will cost us. The reason is simple and relates to the angel wing example. Waiting creates self-defeating habits that are VERY difficult to reverse. Worse yet, reversing the policy too late creates unnecessary hardships. Okay – so let me dive into the deep end and splash around a bit. Sorry. I promise to not discuss angel wings one more time. But if you have never seen Venetian Pool in Coral Gables you REALLY have to see it.

M&B are like caring parents for more than 600 million people. They see an economy in the midst of a recovery, albeit one with less than hoped for employment increases. They see the risks surrounding another economic slowdown and do not want to contribute to an even longer and weaker recovery. Who can fault them for that? I guess I can or I wouldn’t be sitting here typing on a perfectly good day. It seems to me that postponing the inevitable puts central banks into a very bad position. Here is why. First, most of us know that the US economy will move closer to full capacity. At that time the Fed and ECB will need to generate more normal interest rates well above 0.25%.

Second, based on M&B’s unwillingness to raise the policy rate and tighten money after 6 quarters into a recovery, this raises the question as to when they will. Saying NO today means they are raising uncertainty for all of us. We know it is going to come but when? That matters to a lot of people.

Third, while we know it is prudent to raise rates at some point, how do we know they won’t raise them after inflation and inflation expectations have already firmed? Is it possible that we could be another 4-6 quarters down the road and still have a higher than desired unemployment rate yet inflation already starting to boil?  Will M&B continue to stall then? What exactly will it take to get them to remove the stimulus?  

Fourth, if inflation gets ingrained and rises above the Fed’s target this will surely cause longer-term interest rates to skyrocket. Even if the Fed stalls for a while longer – long-term rates will rise with or without a tighter Fed policy. This spike in interest rates without policy will be bad for the economy and the unemployment rate. If inflation jumps again and the Fed is finally impelled to reverse engines and raise interest rates—this could cause long-term rates to rise even higher. Remember 1979/80? Ugh.

But M&B promise to withdraw the stimulus right when it is needed. At the perfect moment when the economy is strong enough and inflation has not yet become ingrained in expectations, they will magically start the withdrawal. They want to do it this way to minimize the risk of hurting the economy with tight money. That is one risk. But what I am suggesting is that they are not considering the other side of the risk equation. History shows us that economic and political forces make it very difficult to identify the perfect time and that central banks often wait too late.  There is no such thing as just-in-time monetary policy and arriving too late has been shown to have disastrous effects.

 It is sort of like postponing a diet. You need to start right after Thanksgiving but you wait until after Christmas. Then you postpone to after New Year’s. But that would ruin your enjoyment of the bowl games. Okay – so you finally start the diet after the Super Bowl. At that point you need to lose a ton of weight plus you need to buy three mumus, four sets of sweat pants, and a small tent.  

Why I Want to Turn my Digital TV into a Hat Rack

Here’s a spout. Rose and Merlin were brother and sister. Rose played soccer and generally liked math. Merlin played in the orchestra and loved to photograph orchids. They hardly agreed on anything. Their arguments often got heated.  Rose would say – “you are mean and you called Daddy a monster.” Merlin would retort – “you are a pig and Mommy loves me more than you.” One day they were confronted by an evil visitor from outer space who threatened their very existence.  They were both worried but instead of working together to overwhelm the predator they took the occasion to yell at each other one more time. Rose started –“ if you had washed the dishes last night as required, none of this would have ever happened. “Merlin quipped, yes, but you are fat and ugly.” Rose and Merlin were never seen again.

So you are saying – Larry has clearly gone off the deep end. People have been saying that a long time so there must be another reason for me writing the above paragraph.

I am writing this paragraph after reading and re-reading my own words below and realizing it is possible for people to get the wrong idea – the opposite of what I am trying to say. The bottom line is that we have VERY challenging issues to deal with in the USA.  These are made even harder by a divided government. It is tempting to up the rhetoric but that might make it even harder to find solutions for security, defense, employment, health care and other pressing issues. The below spout is not meant to single out any one side or person.  As most parents find themselves saying – “I don’t care which one of you did it – you both can go to your rooms and right now!”  I am not taking sides here. Both sides can hate me equally!

I am REALLY irritated by the political fighting concerning the Tucson massacre of this past weekend. Some people are being somewhat careful with their words. Some are not. Let’s face it – some people on the left are using this shooting as a way to point a mean finger at their adversaries. They associate what is so far being called a crime by a deranged shooter with statements made by politicians on the right. In private people are saying what they really feel and they are even more ugly and vindictive about their political enemies. I don’t like to use the term political enemy but when I hear the adjectives some people use I cannot help but classify their categorizations of those with differences in political opinions as enemies. Of course, some of those on the right are not exactly making things better as they defend themselves and counter attack.

This is crazy. How many days will we spend listening to talking heads discuss whether or not the deranged killer was motivated by right-wing politicians? How much time will we waste hearing our right-wing friends defend themselves and counter attack and name-call their detractors?

Not all of the discussion is wrong headed if it seeks to protect better politicians and the rest of us from crazies and others who seek to hurt us individually or collectively.

But come on – most of what I am seeing and hearing is not directed that way. Here is what I don’t understand and what I am spouting about.

First, what religion or spiritual body of thought supports this mean-spirited talk?  

Second, why are they wasting our time with useless diatribes? Do we not have real and urgent problems to deal with?

Third, are our politicians so tired of battling the real and tough issues that they find it easier to lob stupid bombs at each other?  

Fourth, do these talking heads have some real data or information that has uncovered a plot by right-wingers to use weapons and other means of violence to take over America?

Fifth, have left wingers never advocated violence against the rich, big corporations, or the powerful?

Sixth, are there not always fringe persons in our free society who seek to incite fear, hurt, and kill the rest of us?

Seventh, would we not all be better off if we worked together to protect us from these crazies?

Rose and Merlin are fictitious people and the story about them is silly. But why do we act like them? The USA allows freedom of speech and we have a right to say intelligent and stupid things. Neither the left nor the right has a corner on the stupid statements. I just wish the rest of us weren’t so often brought into it. What irony. Now that I finally purchased a digital TV I find myself wanting to use it as a hat rack. 

2011 Kickoff

If you are like me you have probably already seen enough college football to last you until next Fall. But then, not many people would admit to being like me so let’s switch our attention to Brett Favre’s sexual exploits. That’s not what I meant. I meant Roethlisberger’s sex habits. No that’s not what I meant.

At this point you have either gone bowling or you are actually reading in excitement. So let me take advantage and switch to the economy and its performance in 2011. I am writing this on January 4^th so not much of 2011 is in evidence but I have noticed that the stock market has been very happy. That makes us retirees and hopeful retirees very happy. But will the fun continue?

That’s the $64,000 question and if that doesn’t date me then holy cow, what else could Edith? Those of you with short-term memories will remember that last year around this time we were very optimistic about the US economy but by spring and the unfolding of too much negative information about gyros and other Grecian statistics, we were wondering if we were in for a double dip – meaning that the US economy would fall from Grace and re-enter purgatory or even worse, you would receive a four-day visit from your closest relatives.

It took a while to climb out of that worrisome economic hole but here were again waiting for another Super Bowl and wondering if the economy will resume a clip fast enough to make a dent in the unemployment rate.   Macro is a great tool but being a practitioner of it doesn’t mean that I can forecast the economy for the rest of 2011. It is too bad that professional talking heads and journalists don’t have some humility because they get us all revved up for nothing but their own fame and wealth. They don’t know any more than we do but they sure look solemn and professional when they tell us about the future.

So if you have nothing better to do let me spend a little time explaining why I am generally optimistic but why I am not betting Betty’s Genesis on any particular outcome. What I do below is to explain why I think we might continue to recover but why there remain challenges that will impact the path of recovery. First, it seems to me that time has helped to heal the economy. While the stimulus policies helped to prevent a more severe downturn the main benefit is that the economy has mostly run its downward course. You don’t spend 10 years in rehab every time you get sick. The economy was not permanently injured by the factors that came together in 2007and thereafter to generate the recession.  The economy got punched and we adjusted to the punch. It was a hard punch so it took a while to digest. The good news is that we are on the mend.  The worst is over. The patient is on an upswing. But let’s not get too crazy.

Second, we still have some lingering problems. For example, housing experts believe that the foreclosure issue is still with us in 2011 (and beyond) and that means that housing prices may have to adjust downward another time or two. Most reports, I believe, see this as an orderly process. I interpret this to mean that housing news is 2011 won’t be good but it won’t interrupt too much the faster growth coming from other sectors of the economy.  I would expand this line of reasoning to include the broader financial system. While regulations have not addressed our problems adequately (too big to fail is one) I think time has helped to resolve the worst problems and debts are being worked off in the private sector.  As long as we don’t learn really bad unexpected news from housing or the financial sector, these sectors will only provide a small drag as we go forward.  Of course, that is one risk factor. If there are new unpleasant discoveries in the financial and housing sectors, then anything could happen.

Third, the big news item right now concerns US government debt and what our leaders in the government are going to do about it. There is the political silliness about extended the debt ceiling. Ignore that. We will not reneg on our national debt and everyone knows that. You guys have really fat wallets and the government has the ability to create infinite amounts of tax revenue at any time. So stop with that nonsense. What does matter is how we deal with reducing the debt. We REALLY need to have a plan and we have one brought forth by a commission at the end of 2010. The plan does not have to create extreme austerity forever and it does not need to create any real austerity until several years hence. But it does need to have an explicit and impossible to wiggle out of plan that reaches into the future. It must have credibility to bring government debt-to-GDP ratios back down to long-term averages.  Should our leaders legislate such a plan in the next few weeks that event will help the economy grow stronger now. Without it, we will lumber forward on the edge of a knife blade until the bond vigilantes get tired of harassing others.

Fourth – whether you call them bond vigilantes or simply grandma and grandpa – any hint of a significant resumption of the disastrous spending and saving performances of either our private or government sectors is going to lead to a economic calamity. Just like your child, presently a freshman  at Spendthrift U who cannot be given your credit card in his second semester,  our nation will not be able to find anyone willing to take the risk of lending us money – that is, buying our stocks and bonds . This eventuality will have the effect of raising interest rates, reducing the values on the stock market, depreciating the dollar and generating very slow growth – if not another recession.

So there we are.  We could have a nice reasonable story for the continuation of the recovery. But there are critical factors which include, at minimum, continued improvements in national saving and no unexpected or severe deterioration in housing or financial markets. With luck we might even see the unemployment rate begin to fall.  There is no magic to getting the unemployment rate back to 5%. In fact, I am guessing that what we call the “natural rate of unemployment” has significantly increased since firms have now found ways to reduce the employment factor in production for three years. Even with a spurt of sales I doubt they will go back to employment levels of 2007.

With households and governments taking years restoring saving balances, economic growth should not be spectacular. That is, do not expect a typical fast-paced recovery now nor in the near future.  Reality suggests that once firms become even more confident and optimistic about the future both output and employment will grow – the GDP gap will shrink and the unemployment rate will fall. This confidence will result from more time passing and the absence of negative surprises. So a gradually improving economy is possible. But those negative surprises with respect to housing, finance, and government debt policies suggest the possibility of something worse.  Time is on our side. Let’s hope our new government in Washington has the sense to minimize and not aggravate those things which will put us in reverse. 

Happy New Year

Many people around the globe celebrated Christmas on Saturday and whether or not you are a Christian Christmas it is a big day for most of us. Those who like to shop love the opportunities December affords. Those who cherish the spiritual part and the giving can feel and share their love of God and their fellow man with great intensity. Those who enjoy parties will get plenty of time to revel and gain weight which they can dutifully plan to shed in the New Year. The rest of you will hopefully enjoy the beauty of winter and the anticipation about what 2011 will bring. Those of you on the East Coast may have enjoyed enough winter!

I am pleased to give you all a really big gift by taking this week off from venting my spleen in my blog. But I do want to thank-you for giving me the chance to spout off in 2010. As you know I retired from Indiana University last January and I was not very sure how the first year would go. As it turned out I got chances to teach for a couple of months in South Korea and Vietnam. Last January I was lucky to share some ideas about macro on a nice little island off the coast of Florida. These teaching experiences kept me connected to macro and teaching. But the blog was my constant companion over this year and it gave me impetus each week to keep up with the latest news and issues. As you know it was a year in which macro could have won an Emmy Award.  There was never a time when I sat at my computer wondering if there was something juicy to write about.

Writing helps me to think in a more organized way. It also helps me get things off my chest. I always feel a lot better when I post a message. I admit that it is a very selfish affair for me. I can only hope that you benefit from my macro-thoughts. For all that I leave you with my thanks and a brief personal message.

My family and especially my parents and spouse always saw and see the world through an optimistic prism. To them, the world’s glass (of JD) is always half full. They never met an enemy and usually interpret difference of opinion and argument as a result of the complexity and changing nature of most phenomena. We might think of an adversary as misguided or misinformed but mostly we believe the interactions with them make us better informed about our own judgments. How boring and cruel a world would be if we all shared the same opinions about everything!

No matter what I might say about an issue or a person or a political party I hope it is taken in this positive spirit. I will do my best in 2011 to respect those who hold different opinions but I hope I never shy away from what I consider to be the right and the wrong of a particular issue or policy. We humans have much more that binds us than divides us and I hope we realize that as we move into an exciting but potentially divisive year.

You might be curious who reads my blog. It is mostly insane people I know pretty well. They include my former students, my recent students in Seoul, Hanoi, and Sanibel Island, and many colleagues. But I also badger various relatives, friends, and neighbors who might have some interest in macro.  I connect with all these people through Google’s Blogspot, Facebook, Linked-In, and Twitter. I also send a personal email to 100 and something people.

Blogspot has a statistics option which lets me know information about those who read my posts. Here are a few facts:

• ·         Since June of 2010 I posted 64 articles on 21 different macro topics (you can see all the topics on the lower right corner of the home page if you scroll down)
• ·         I posted 11 articles on Macro Policy, 8 on Exchange Rates and Policy, 6 on Employment and Unemployment, and so on.
• ·         The most popular articles were Fairy Tales Can Come True (Aug 6), AT&T (July 4), the Myopic Squirrel (Sept 13), The G20 (Oct 28), and Lilliputians(Aug 23).
• ·         There have been approximately 4,000 pageviews – posts that have been read or at least opened
• ·         While 75%of these page views came from the USA, I seem to have readers in South Korea, the UK, Vietnam, Canada, India, China, Germany, Spain, France and Finland.
• ·         Almost half of you used IE to connect but 24% used Firefox and another 25% used either Chrome or Safari.

I look forward to more spouting in 2011! Best to you all.

Nobel Nonsense and President Obama

I was going to take the week off and send you a nice holiday message and then one of my colleagues sent me the link to a Paul Krugman article. I guess I will send you my holiday message later in the week. 

I don’t like to read Paul Krugman articles because it is bad for my blood pressure. This guy has a Nobel Prize in economics which makes you think he might really care about his science but instead he uses his elite position to be the spokes person for one extreme view of economics. With his behavior he gives a bad name to the science and it riles me a bit. I would think that even liberals would be embarrassed by some of his antics.

In “When Zombies Win” http://www.nytimes.com/2010/12/20/opinion/20krugman.html , Krugman uses colorful language to say basically two things. First, Obamanomics didn’t fail – the President simply didn’t try enough economic stimuli. He had the right idea -- he simply didn't do enough of it. Second, he says President Obama, unlike Reagan who stuck with his ideas, has been cast into a spell by conservative zombies and they are going to eat his brain and our economy with it. Really – this Nobel Award winner said that!

To prove that Obama’s stimulus package was too small, he says “government spending on goods and services grew more slowly than during the Bush years, hardly constitutes a test of Keynesian economics.” Wow – talk about a real economic scientist! He uses government spending on goods and services as the only real data pertinent to stimulus in the last two years. Dear Paul – what about government transfer spending? What about government bailouts? What about tax cuts? Does anyone really think he provides a full coffin of evidence about stimulus by measuring only GPGS? I am glad for any college student taking freshmen economics who would not give such an answer on his or her final exam.

Then Krugman says that conservatives are totally discredited because inflation and interest rates have not risen in response to the stimuli. I am guessing that few economists really predicted a rise in inflation BEFORE the economy started to recover in earnest.  Most of us believe that something called the GDP Gap needs to closed before inflation starts rising. We also would not see interest rates rising until the paranoia about slow growth significantly reduced the demand for government bonds. Krugman turned a very legitimate worry or concern about stimulus causing higher inflation and interest rates into a forecast – and one that all his adversaries must have agreed with.  Talk about creating a straw man!  He also says that disinflation continues. Technically, that means that the inflation rate continues to fall.  Does he provide a shred of data or evidence? How much did the inflation rate fall in the last, say six months? Three months?

That Obama had the audacity to praise Ronald Reagan and admitted that some austerity is necessary for historically high levels of deficits and debt, make the President Zombie prey.  Those nasty Republicans made him say “Uncle” and now, according to Krugman, he can never oppose their incessant demands for ghoulish austere economics.

Krugman cites Ireland as an example of why austerity policy is bad. I guess that is the sum total of his knowledge about austerity and the experiences of no other countries matter. I would hope that no freshman university student would write such flimsy answers to important questions. Of course, if you happen to be Irish then you might want to reserve judgment about what did or didn’t help the Irish find their way out of their very tough present economic condition.  

Like Krugman, I don’t like the way Obama supported a tax plan that goes in the wrong direction. As I wrote last week, this won’t create enough stimuli to reduce the rate of unemployment. But Krugman wants more stimuli and that’s where he and I part ways. The US economy is gagging on past stimulus and will eventually swallow and digest it all. At that time the economy will grow – especially if we quickly introduce a fiscal restructuring that deals with future deficits and debt. Krugman might call that austerity but I call it common sense. 

Shakespeare 's Comedy Plays Out in the US Government

On Sunday I watched CNN until I thought I was going to choke from excessive theatre. If Shakespeare was alive he would have applauded loudly at the farce we call Washington. I am not sure which play the current cast of characters would best fit – A Comedy of Errors or All’s Well that Ends Well? I won’t say a lot more about these plays since I read the Clift Notes versions at best as a freshman at George Tech in 1911 and don’t want to give away my total lack of understanding of the arts.

But you have to admit without actually being a Buddhist monk that these politicians are missing the big picture. No matter how you look at this thing what was once billed as a renewal of the Bush tax cuts is now the world’s most laden Christmas Tree. The unfolding legislation is a really bad deal for all of us. Yet the stage production repeated with excruciating analysis by the press and Internet conveys how and why it is of the utmost urgency. I don’t agree.

As many of the Ds and Rs and journalists hold hands and sing one more kumbaya we are lulled into a warm sensation that this compromise bill is going to stave off a double dip recession and be just what Dr. House ordered to reduce the unemployment rate.  But are we really holding their feet to the fire? Will the bill do what we hope? Here are some things to think about.

•      The bill, even with all the new ornaments they are adding, will amount to a very small stimulus. It mostly keeps tax rates the same in 2011 as they were in 2010? How is that a stimulus? How is that going to significantly reduce the unemployment rate?
•     The bill in any manifestation will definitely add to the government deficits in coming years. These additions to an already bloated government debt pile certainty leads to even more uncertainty about interest rates and the soundness of federal, state, and local governments. Of course, you can translate that business uncertainty into a virtual certainty that you, I, and Mr. Jones are going to pay higher taxes at some point in the future. 
•      This bill does absolutely nothing to reduce the explicit and implicit debt obligations coming from Social Security, Medicare, and Medicaid. And it does nothing to reduce or control healthcare costs for those who actually pay for their healthcare.
•      Have you heard of bond vigilantes? This terminology is a colorful description of the people and institutions that make their living trading bonds. Call them geeks or greedy they have the tools and rights to decide when bonds are no longer a good deal. Most of us buy bonds and hold them to maturity. But sometimes we decide to sell them before maturity and it is these bond dealers who form a market so we can do that. We like them when they buy the bonds we no longer want so that we can buy villas on the Croatian coast. Anyway, as the US debt gets a big as Roseanne Barr’s belly, we recognize that there are way too many bonds out there and this should lead to a fall in the price of bonds. Knowing that – a lot of us want to sell these bonds before they lose too much of their value and the bond vigilantes are leading the charge with their faithful dog, Rin Tin Tin. No offense to Lassie. As bonds become as cheap as kimche in Korea, the returns on the bonds soar. Another way of saying this – it takes a much higher interest rate return to get people to hold all this kimche. Viola (or to you unsophisticated people who cannot spell in European, Walah) – the higher interest rates then act as an impediment to people who want to buy new houses and firms who want to buy new equipment. It generally slows things down.

So let’s summarize the above. This new legislation will not be a big enough stimulus; it will make the US debt larger; it will create more uncertainty; it will raise interest rates; and it will reduce spending on housing and investment. Hmmm.

You might be fuming at this point and say, LARRY, IF WE DO NOT PASS THIS BILL WE WILL GO DIRECTLY INTO A DOUBLE DIP recession. The capital letters implies that you are yelling at me or that you hit the Caps Lock key by accident. It is taken for granted by EVERYONE that if we let tax rates rise in the coming year that we will go directly without collecting $200 dollars to the square titled “Recession”.  So I have two things to say about that. First, this is not 2007 and we are not in free fall. While the economy is not growing as fast as we would like right now, it is growing and we are not in the same kind of panic situation as we were a couple of years ago. We do not need desperate policies. There are plenty of green shoots showing that the US economy is improving and as I have said in many past posts – we need to heal the housing markets and financial problems before the economy really picks up. This recent legislation does nothing directly to heal housing or finance. As I said above, passage of this bill does very little while creating very large risks.

Second, I am not advocating doing nothing. In fact, I would go along with some well-placed stimulus as long as it was coupled with Angelina Jolie.  That’s not right. I mean so long as some stimulus was coupled with a plan for long-run fiscal balance. I don’t need the long-run plan to start impacting us today. Too much austerity right this minute might not be good. But I do need the Plan to be legislated tomorrow with its first real impacts starting a few years from now. By legislating a plan today with impacts starting tomorrow – means we all can start planning today. That longer-term plan could have some elements of very short-term stimulus within it. But the longer term plan must show how we are going to pay for it in the future.

A good friend of mine had knee replacement surgery last week. He needed some pain medicine to get through the first week of recovery but soon he can get by without it. He knows that he has ahead of him several weeks of lingering pain and tough rehabilitation. By any definition, that plan for rehabilitation is tough and nothing to look forward to. But he knows that it is the only way to a recovery that allows him full use of his knee and leg. We in the USA can pretend that we don’t need a rehab plan yet, but the truth is that our government is giving us pain pills and are afraid to have us think about the future. We are better and tougher than that. We need better leadership and we need to make sure they know that. It is easy for them to legislate another round of morphine. Let’s not let them do that without also being very clear about what we need to grow again. 

The Fiscal Circus Has Two Rings

Now that Congress is making a little traction with a framework for fiscal policy, let’s not get carried away with dangerous partial solutions. It is one thing to keep the patient out of pain with an injection – it is quite another thing to apply the remedy to his problem. So let’s not get so excited about the easy part until we see the rest of it.

Any good circus has more than one ring.  In Ring 1 we have Congress working on an extension of the Bush tax cuts beyond 2010. That’s akin to a shot for the pain. In Ring 2 we have the serious stuff – a solution to fix our debt problems and therein address unemployment and economic growth.  It seems strange that the public has been so divided about Ring 1 since it is the easy one. Both democrats and republicans have joined hands in a holiday chorus and are singing a Hail Mary designed to focus on a possible deficiency of aggregate demand in the short-run. They had their little spats. The Ds don’t like it when stimulus includes the behaviors of high income earners – while the Rs don’t like the stimulus coming largely from the lower ends of the income scale. But let’s face it – they both get to go play on the monkey bars and jungle gyms at recess if they pass something before January 1. The public is going to shower them with love and kisses for saving our nation from a tax increase in a slow growth period with high and stubborn unemployment.  So it is unsurprising that they will find a consensus on the Bush Tax Cuts.

I am not against Ring 1 and am not against the general notion of keeping tax rates low right now. But I do see this as akin to a good dose of Demerol with no surgeon in sight. Ring 1 is okay so long as there is real action in Ring 2. This conclusion is based on one simple point – the Ring 1 solution will do little to reduce the unemployment rate without a satisfactory solution from Ring 2. Ring 2 contained the National Commission on Fiscal Responsibility and Reform. It went home with a few trout in the boat but not enough to start a real fish fry in Congress. It is true that 60% of the members of the commission voted yes to the spirit of a feasible but imperfect compromise law to attack our escalating government fiscal woes, but that wasn’t a strong and clear enough message.  Ring 2 is in limbo right now. The surgeon is not to be found.  Even if the Commission failed to get the required number of votes, it is still possible that the President and Congress can continue the work in Ring 2. So all is not lost.

While all is not lost, nothing yet is gained from a compromise in Ring 1. After all – in reality an agreement to leave the tax cuts in place for next year or beyond is simply a vote for NO CHANGE. The agreement keeps taxes from rising by keeping them the same as where they were in 2010. If we want 2011 to be better than 2010 then it takes some change. So the big question is – what needs to be changed?

Bernanke, Geithner, and many others still believe that the earth is flat. Oops, I mean they still believe that the problem with the US economy is deficient spending. So the kinds of change they are promoting in Ring 1 are fiscal and monetary policies that would stimulate more household spending.  They also believe that the economy has been very unfair to the average person so their preference is to help people with middle or lower incomes spend more. They don’t want to help Gazillionaires.

Another group sees it differently believing that aggregate demand is deficient because firms are hiring too few workers despite some signs of economic revival. Until firms start hiring more, no amount of stimulus is going to be effective. So all we need to do is figure out why firms are so reluctant to hire.  Or in other words, despite the fact that output has gone up in the last five quarters, employment has barely budged.  Why are firms not hiring? Without a significant resumption of hiring stimulus cannot work. First, the unemployed have few resources to spend. Second, even the employed people are reluctant to spend because until hiring picks up they are not sure that they won’t be the next to move to the unemployed pool.

Consider what happens when you hire a new permanent worker. First, the person must be trained. Second, the firm makes an implicit if not explicit contract to continue employment. If nothing else there is a goodwill gesture made on the part of both parties. Third, the firm will increase what it pays into the state unemployment pool. Fourth it will add to the payroll tax paid. Fifth the firm will probably incur expenditure for various benefits – including healthcare and pension. These are not entered into lightly.

Consider the alternative to hiring an additional new worker. Don’t hire anyone! When sales pick up it is possible to work the existing workforce harder. The firm can expect more output during the regular day or it can pay more for overtime. The company might also think harder about how to employ its workers. It might be possible to change its business practices in such a way that the same amount of labor can accomplish more in a given day. Clearly there are financial incentives for firms to not hire more workers. Buying a machine that makes existing workers more productive means not having to pay additional payroll taxes, healthcare benefits, pension benefits, etc.

So why would firms hire more? I love this question because it gets to the heart of economics since it is all about marginal benefits and marginal costs. According to marginal analysis, you hire another worker when the marginal benefit to the firm of one more worker exceeds the extra costs of one more worker. That is, the firm hires more if the increased employment increases its profits.

In a capitalistic system, firms are free to make hiring decisions and they generally hire more to capture higher profits. The government policy question, then, is as follows. If you want more spending, you need more employment. If you want more employment firms need to expect higher profits. Sales are expanding now so you would think that this would lead to higher profits. While profits are rising now the question is for how long? Firms would like some certainty that the recent short-term profits will not vanish as soon as they arrived.

And this is why Ring 2 is so important. To create the increased profit certainty that firms require will take increased attention to the things that might threaten future profits. Historically high government deficits and debt are real threats and all the current fuss over government instability in Europe points to how corrosive this can be. Government could go a long way to reducing profit uncertainty by crafting a solution for the government fiscal mess. This, of course, brings together the recent explosions of debt caused by stimulus legislation, health care, and by the ongoing and fully expected fiscal requirements of Social Security, Medicare, and Medicaid.  It is one thing to make a decision about the future of the Bush tax cuts – it is quite another thing to help firms better understand the tax and other regulatory impacts on them of dealing with the next 20 years of fiscal challenges.

Until you solve Ring 2 we will get no bang from Ring 1. Until you solve Ring 2 you get no decrease in profit uncertainty and no real commitment to hiring. Take no pride in a solution to the Bush tax cut extension until they get on with the real business of government. 

A Keynesian Wolf misleads about the Euro

I thought I had finally settled the debate about the euro crisis with my last post (ha ha) and then along comes this piece by Martin Wolf in the Financial Times (December 1, 2010). http://www.ft.com/cms/s/0/259c645e-fcbb-11df-bfdd-00144feab49a.html#axzz16y45YdFO

My previous post argued that the euro might depreciate more but it would surely not implode. Wolf is a great writer and I usually like to disagree with him because he is a not-so-closeted Keynesian and I am neither closeted nor Keynesian. This article irks me more than his usual writing because it epitomizes really good analysis based on a really wrong premise. His article illustrates what is wrong with much of what is written these days and helps me try to live up to my goal for this blog – to spout off.

The title of Wolf’s article is “Why the Irish crisis is a huge test for the eurozone” and he concludes that by joining the eurozone, a country consigns itself to credit crises. His words of advice to countries that give up their own currencies to be part of something like a eurozone, “… be careful what you wish for: credit crises would replace currency crises – and these are likely to be even worse.” 

He has an elegant explanation for all that. He begins with the premise that it is inevitable that countries with “divergencies in relative costs” would have international trade imbalances. That is, without flexible exchange rates a country with a bump in relative costs would soon find itself less competitive and would soon have a structural trade deficit. A depreciated currency could have come to the rescue and offset the cost change and restore its competitiveness. Sans an exchange rate depreciation in countries like Greece and Ireland, each would be stuck with a trade deficit implying a need to borrow from abroad to finance their trade deficits. This means a larger foreign debt and should a country have trouble meeting the debt at some point – wham bam thank-you mam – a credit crisis would occur. Then –oh my goodness – national prices would fall worsening the credit crisis – and that makes it much worse than a currency crisis might have been (if the country had its own exchange rate).

Since you know I love to use analogies – Wolf’s point is like saying that you can solve the morning after problem for the drunk by taking aspirin instead of Ibuprofen. We can spend until hell freezes over debating which drug is more effective for a hangover (I prefer a nice strong Bloody Mary myself). We might even find that one of them is better for hangovers. But the only real solution for a hangover is to not drink so much and to not dance to 1970s disco music like John Travolta wrapped in colorful beads with a lampshade on your head. My point is that Wolf is writing about “effect and effect” rather than “cause and effect”. His defect is in his focus on effects without causes. He shifts our attention away from the real problems to a choice of medications.

When this very intelligent man analyzes the issue of the euro, why does he not once – not one single time – does he not go back to the idea he starts with – the cause of it all – the change in relative prices? Why – because he is a closet Keynesian. They usually ignore the original problem. They see any problem as an excuse or some clever ploy to get the government involved by spending more. After all – there are so many things the government could be doing if they just spent more!

If a rise in relative costs and prices causes a country to lose competitiveness – I ask – then why cannot this country work directly on reducing its relative costs and prices? Would it be impolite to even ask this question?  If a country is made more vulnerable because its households go on a spending spree and forget to save; if a country’s government goes on an economic development spending binge that reduces national saving available to corporations; if a country’s companies get lazy and don’t invest in the right technologies or products – in all these cases its competitiveness will be reduced. But notice that in all these examples of cost disadvantage there is a direct cause that could be directly addressed if politicians had the cough-cough sincere interest or kahunas to investigate. But that is too hard for them to do. All that discussion of details might not fit on the teleprompter. Rather than take a real educational and leadership role about a complicated problem – it is much easier to advocate a policy to increase government or household spending.

In this particular case Wolf is blaming the problem on a single currency. If the poor babies only had their currencies back then the boo boo would go away. NO IT WOULDN’T AND READING ANOTHER CHAPTER OF DR. SUESS WON’T HELP IT GO AWAY. If those weakened countries had their currencies back their exchange values would plummet towards zero and contribute to a generally hysterical situation. The rapidly declining currencies would lead to large and rapid outflows of portfolio and real capital. Declining currency values would make it more impossible to pay off their debts.  Maybe you have read about past currencies crises? They do happen – and it seems to me they happen a lot more often than credit crises.

But I don’t want to get sucked into Wolf’s trap. It isn’t about the currencies. It is all about the CAUSES of competitiveness changes. If countries lose competitiveness for fundamental reasons then their leaders ought to decide what those reasons are and address them. Debating whether European nations would be better off with or without the euro misses the target, misleads, and misdirects our energy. Policymakers should not be discussing a euro break-up. They should be discussing the regulatory, housing, financial, spending, and saving practices that led to their current predicaments. If leaders don’t get this right then they ought to be replaced. I hope our own policymakers in the USA get this message too or 2012 could be really interesting.