AMERICAN FUTURE

President Hoover on Treasury Secretary Andrew Mellon’s advice for ending the depression:

Mr. Mellon had only one formula: “Liquidate labor, liquidate stocks, liquidate the farmers, liquidate real estate.” He insisted that, when the people get an inflation brainstorm, the only way to get it out of their blood is to let it collapse. He held that even a panic was not altogether a bad thing. He said: “It will purge the rottenness out of the system. High costs of living and high living will come down. People will work harder, live a more moral life. Values will be adjusted, and enterprising people will pick up the wrecks from less competent people”

Mark Sitznagel, who, as the founder and chief investment officer of the hedge fund Universa Investments, could be expected to survive in some comfort (albeit less so than did Mellon) during a lengthy period of liquidation, reiterates Mellon’s advice. In his op-ed (“Christmas Trees and the Logic of Growth“) in today’s Wall Street Journal, Sitznagel draws an analogy between “the coned evergreen trees that form vast forests across the Northern Hemisphere” and “the financial forests of our own making.” At a time when most observers agree that a necessary if not sufficient condition for restoring the eurozone’s economic and financial well-being is for the European Central Bank to become a lender of last resort, Sitznagel says that central banks “are creating a tinderbox by keeping alive many very bad investments.” It’s survival of the fittest — for trees and for investments. Never mind that liquidated investments have human consequences rather larger than do liquidated evergreen trees.

In case the link to Sitznagel’s op-ed doesn’t work, here’s the full text:

The ubiquitous greenery of the season has me thinking conifers and stock market crashes. There is much to be learned from the coned evergreen trees that form vast forests across the Northern Hemisphere. As the oldest trees on the planet, the mighty conifers have survived threats of catastrophic extinction since the time of the hungry herbivorous dinosaurs.

The conifer’s secret to longevity lies in a paradox: Their conquest has been largely the result of episodes of massive forest destruction. When virtually all else is gone, conifers show their strength and prowess as nature’s opportunists. How? They have adapted to evade competitors by out-surviving them and then occupying their real estate after catastrophic fires.

First, the conifer takes root where no one else will go (think cold, short growing seasons and rocky, nutrient-poor soil). Here, they find the time, space and much-needed sunlight to thrive early on and build their defenses (such as height, canopy and thick bark). When fire hits, those hardy few conifers that survive can throw their seeds onto newly cleared, sunlit and nutrient-released space. For them, fire is not foe but friend. In fact, the seed-loaded cones of many conifers open only in extreme heat.

This is nature’s model: overgrowth, followed by destruction of the overgrowth, and then the subsequent new growth of the healthiest and most robust, which ultimately leaves the forest and the entire ecosystem better off than they were before.

Pondering these trees, it is not too much of a stretch to consider the financial forests of our own making, where excess credit and malinvestment thrive for a time, only to be destroyed—and then the releasing of capital into markets where competition has been wiped out. The Austrian school economists understood this well, basing a whole theory around this investment cycle.

After the purge, great investment opportunities are created, from which prolific periods of growth emanate—provided that sufficient capital remains to reinvest into the fertile and now-open landscape.

Suppressing fire, creating the illusion of fire protection, leads to the wrong kind of growth, which then invites greater destruction. About 100 years ago, the U.S. Forest Service took a zero-tolerance approach to forest fires, stamping them out at the first blaze. Fast forward to 1988 when a massive wildfire at Yellowstone National Park wiped out more than 30 times the acreage of any previously recorded fire.

What obviously occurred was that the most fire-susceptible plants had been given repeated reprieves (bailouts, in a sense), and they naturally accumulated, along with the old, deadwood of the forests. This made for a highly flammable fuel load because when fires are suppressed the density of foliage is raised, particularly the most fire-prone foliage. The way this foliage connects the grid of the forest, as it were, has come to be known as the “Yellowstone Effect.”

A far better way to prevent massively destructive fires is by letting the fires burn. Human intervention in nature’s cycles by suppressing fires destroys the system’s natural homeostatic forces.

Strangely parallel to the Yellowstone catastrophe was the start of the federal government’s other fire-suppression policy with the 1984 Continental Illinois “too big to fail” bank bailout. This was followed by Alan Greenspan’s pronouncement immediately after the 1987 stock market crash that the Federal Reserve stood by with “readiness to serve as a source of liquidity to support the economy and financial system,” which heralded the birth of the “Greenspan put.” The Fed would no longer tolerate fires of any size.

From a forestry point of view, the lessons were learned. In 1995, the Federal Wildland Fire Management Policy stated, “Science has changed the way we think about wildland fire and the way we manage it. Wildland fire, as a critical natural process, must be reintroduced into the ecosystem.”

Herein are pearls of great wisdom for central bankers today. Central banks are creating a tinderbox by keeping alive many very bad investments, fertilizing them with everything from artificially low interest rates to preferential liquidity to outright securities purchases. As these institutions and instruments overrun the financial landscape, they hamper the economic ecosystem and perpetuate the environment of low growth and high unemployment in which we currently find ourselves.

Seeing periodic, naturally occurring catastrophes as part of the growth cycle requires thinking more than one step ahead, not only longer term but, more specifically, intertemporally. This is perhaps an insurmountable cognitive challenge, both to investors and central bankers in today’s news-flash world. When contemplating the forest, we may intuitively understand nature’s logic of growth. Yet when we look at the seeds of destruction we have sown through current monetary policy, it is clear we are lost in the trees.

Coordinated action by the world’s major central banks was largely responsible for the four percent jump in U.S. equity prices on Wednesday. Even if they didn’t know with certainty the precise nature of the action that would be taken or the exact date on which such a “headline event” would take place, investors who had a concrete reason, above and beyond the logic of the situation, for anticipating this event would have had a significant advantage over those who did not. They could position themselves to take maximum advantage of the event when and if it materialized and position themselves to minimize their losses while waiting for it to take place.

An article (“Wall Street Pushed Federal Reserve for Europe Action” — no link) in today’s Wall Street Journal strongly suggests that there is, in fact, a group of advantaged investors.  These investors, of which there are twelve, are members of the Investor Advisory Committee on Financial Markets, which was established in the wake of the financial crisis to give New York Federal Reserve Bank President William Dudley a pipeline into investors’ thinking.  The Committee and Dudley met on September 27.

Members of the group include some of the biggest names on Wall Street, including Keith Anderson of Soros Fund Management; Mohamed El-Erian of Allianz SE’s Pacific Investment Management Co.; Peter Fisher of BlackRock Inc.; Joshua Harris of Apollo Management LP; Alan Howard of Brevan Howard Asset Management; Deryck Maughan, a former chief executive of Salomon Brothers who now is at Kohlberg Kravis Roberts & Co.; and David Tepper of Appaloosa Management LP.

The Journal article says that:

The Sept. 27 meeting with Mr. Dudley exemplifies the private meetings some Wall Street investors have with top Fed officials, in which they can gain access to potential early clues about Fed actions. Hedge funds have been pushing to get more information about the inner workings of the Fed, according to people familiar with the situation . . .

Later in the article comes this:

There is no indication the meeting had any impact on the participants’ own investments. Minutes of the meeting obtained by The Wall Street Journal include notes taken by Fed staff members—but no record of comments by Mr. Dudley or any Fed officials at the meeting.

The Journal, then, would have us believe that, despite their “access to potential early clues about Fed actions,” there “is no indication the meeting had any impact on the participants’ own investments.“

Strictly speaking, this may be accurate: there may, in fact, be no “indication.” As yet. But who among us is naive enough to believe that the investment decisions of these privileged few were not influenced by the early clues to which they were exposed at the meeting. It’s impossible for their decisions to not have been influenced.

I have a distinctly bad taste in my mouth. I can understand why the Fed would want to meet with investors. But any such meetings should be webcast so that the playing field is level.

When central banks act together, you know things are really bad. They were certainly bad in October 2008, when central banks acted together to reduce short-term interest rates. Here’s how the October 9 issue of the Wall Street Journal reported the story:

The world’s central banks launched a large coordinated attack against the widening global financial crisis, lowering short-term interest rates in unison.

The emergency action, which involved the Fed, the European Central Bank, the Bank of England and others, is a sign that fears that the financial crisis could cripple the global economy are spreading rapidly.

Central banks in the U.S., the euro zone, the U.K., Canada, Sweden and Switzerland each cut short-term interest rates on Wednesday by a half percentage point, noting that “the recent intensification of the financial crisis has augmented the downside risks to growth.” Acting on its own, the People’s Bank of China also cut rates, as did Australia’s central bank, a day earlier.

Three years later, coordinated action is again deemed necessary. According to the Fed, the purpose of today’s coordinated action is to “ease strains in financial markets and thereby mitigate the effects of such strains on the supply of credit to households and businesses and so help foster economic activity.”

As in 2008, the Chinese eased monetary policy simultaneously with the coordinated action of other central banks:

China’s central bank will cut the portion of deposits that banks must hold in reserve for the first time in three years, in a sign of Beijing’s concern over slowing growth in the country and in key export markets like Europe.

On Wednesday evening, the People’s Bank of China said it would reduce the required reserve ratio for all banks by 0.5 percentage points, starting from December 5.

Central bank statements:

• U.S. Federal Reserve
• Bank of Canada
• Bank of England
• Bank of Japan
• European Central Bank
• Swiss National Bank

As this post is being written, equity markets are up sharply. It should be kept in mind that, subsequent to the October 2008 central bank action, stocks plunged for another six months before bottoming on March 9, 2009.

We’ve been bombarded with article after article about ringfencing Italy and Spain from Greece’s trials and tribulations, but little or nothing has been said about constructing a financial moat around the U.S. The following  brief post written on November 9th by economist Brad Delong is the exception:

I have been complaining for some time now that Reinhart and Rogoff think that the time is always 1931 and that we are always Austria–that the great fiscal crisis is about to erupt and send us lurching down toward Great Depression II. Well, right now guess what? The time is 1931, and we are Austria.

The Federal Reserve needs to buy up every single European bond owned by every single American financial institution for cash before the increase in eurorisk leads American finance to tighten credit again and send us down into the double dip. The Federal Reserve Needs to do so now.

The Atlantic’s Daniel Indiviglio takes issue with DeLong’s recommendation:

There are a few problems with [DeLong's] plan. First, the Fed generally isn’t in the business of losing money. For banks to escape giant losses, the Fed would have to purchase these securities for some amount greater than where they would trade today. This would create nearly instant losses for the Fed — and losses that would likely be lasting as European debt restructuring or bankruptcies force haircuts on these securities. So for the Fed to help banks here, it would have to take significant losses. Even if this move would serve the greater good, it’s hard to imagine the already unpopular Fed wanting to face the public backlash that would surely result as it bails out the banks and takes on billions of dollars in losses.

This also assumes that banks would go along. Remember, the Fed will likely prefer limit its losses by purchasing these securities for a price that would cause banks to post big losses instead. Banks with European exposure are likely keeping their fingers crossed hoping for a European bailout to minimize losses. So those institutions might prefer to take their chances and hope for the best, rather than take deep, immediate losses by selling those securities to the Fed. The Fed cannot force banks to sell these securities.

He then describes three alternatives: (1) have the Treasury bailout our banks, (2) reduce uncertainty via “extreme transparency,”, and (3) have another round of stress tests. Any one of these, he says, could help:

Although U.S. banks will face losses if some of the troubled nations in [Europe] default, in most cases those losses won’t be big enough cause a large U.S. bank to become insolvent. One way or another, policymakers need to help investors to become comfortable with the exposure of these banks to Europe.

I fail to see how extreme transparency or stress tests would help. Either might clarify the risks to our banking system, but neither would diminish the risks. And, given a choice between having the Fed buy European bonds or having the Treasury bailout the banks, I prefer the former.

It’s about time that our financial columnists start dealing with this national financial security issue. Until they do, expect the policymakers to maintain their silence.

Speak up, Mr. Bernanke! Or is the subject so scary that silence is golden?

In his op-ed in the Wall Street Journal, Ronald McKinnon bemoans the the absence of the bond vigilantes who, during the Clinton administration “served to discipline government spending.”

His opinion is not one that I share. However much downward pressure on discretionary government spending the vigilantes might exert would, in my view, be offset by an increase in interest expense on the government’s debt.

What I do share is McKinnon’s assessment of the economic damage caused by the Fed’s policy of “ultra-low interest rates”:

When interest rates dipped in the past, at least part of their immediate expansionary impact came from the belief that interest rates would bounce back to normal levels in the future. Firms would rush to avail themselves of cheap credit before it disappeared. However, if interest rates are expected to stay low indefinitely, this short-term expansionary effect is weakened.

This is exactly the point I made in “My Solution to the Economic Crisis.”

Now that’s a presumptuous title if I ever saw one. Well, maybe not. The policies being followed by the governments and central banks of the U.S. and Europe clearly aren’t solving the economic crisis. The anemic economic recoveries on both sides of the Atlantic have run out of steam and the world’s stock, credit and commodity markets have plunged in anticipation of worse to come. The markets are telling us that time may be running out to preempt another Lehman moment and a further slump in economic activity that would turn recession into depression. Despite rising investor angst and an ever-growing avalanche of weakening economic indicators, there’s no evidence that the individuals in positions to alter the course of economic events are starting to have second thoughts about current fiscal and monetary policies.

How have the advanced industrial countries of the West arrived at what increasingly appears to be a tipping point?

Immediately after Lehman’s failure, fiscal and monetary policies were loosened in true Keynesian fashion. The West didn’t fall into the financial abyss and the recession didn’t turn into a depression.  Asset values recovered and the recession officially ended in June 2009. The economy ended its 18-month stay in intensive care. As it became evident that the world economy would soon be discharged from the hospital, governments, central bankers, economists and the public refocused their attention to the aftereffect of its stay in intensive care:  ballooning public debt. Preventing financial and economic collapse resulted in the shifting of trillions of dollars of debt from the private sector’s to the public sector’s balance sheet. Rapidly rising unemployment reduced government tax revenue and increased government spending. Government debt-to-GDP ratios rose to unprecedented peacetime levels. With economic recovery underway, concern about the future solvency of government rose to the top of the worry list.

Fiscal Policy: Tightened

With fear of public sector insolvency having overtaken fear of depression, economic policy was ripe for change. The change has taken the form of calls for and the implementation of increasingly austere fiscal policies. Austerity, its advocates argue, is the path to economic salvation. In every country, those who would rely primarily on reduced spending and those who would rely primarily on higher taxes on the wealthy have something in common: both assume that heightened fiscal rectitude will reduce their government’s debt-to-GDP ratio. By lowering the perceived risk of future insolvency, they aver, the private sector’s confidence will improve. Facing the future more confidently, consumers will buy more and business will invest more. This positive feedback loop involving consumers and business will create a self-sustaining, accelerating economic recovery. That recovery will create more jobs, leading to reduced government spending on unemployment insurance and related items and increased government tax revenues. The budget deficit will contract, borrowing requirements will diminish, the debt-to-GDP ratio will fall, and the real –as well as the perceived — risk of insolvency will vanish.

The ramifications of faith in fiscal austerity as the exit strategy from hard times extend beyond the economic to include the political sphere. Intrinsic to this exit strategy are political disagreements over the mix of spending reductions and tax increases. The issue of the distribution of austerity’s pain came to the fore during this summer’s debate — I use the word advisedly — in the U.S., which heavily contributed to the downgrading of the credit rating of America’s sovereign debt. More significant than that downgrade was the public’s disgust with the spectacle in the House of Representatives. It can’t be doubted that the extreme partisanship so vividly on display further undermined consumer and business confidence in the ability of the government to come to grips with a sputtering economy. This feedback from the political to the economic realm revealed itself in the aforementioned steep market declines, which can best be interpreted as a discounting of further economic weakness.

It’s as simple as that, or is it? Spending decreases and tax increases have something in common: if everything else remains constant, they both drain purchasing power from the private sector.  The “everything else” is the effect of fiscal austerity on confidence. For austerity to boost consumption, the positive impact on the propensity to consume of a reduction in the perceived risk of insolvency in the long-term must exceed the negative impact of the reduction of purchasing power in the short-term. Said another way, for austerity to have its intended effect, it must result in a decline in the propensity to save. Only if this requirement is met will business have an incentive to accelerate hiring and capital investment.

If, as I anticipate, fiscal austerity has the opposite of its intended effect, the circle will be vicious rather than virtuous. Budget deficits, borrowing requirements, debt-to-capital ratios and insolvency risks (both perceived and real) will increase. Confidence will erode. The evidence, as highlighted by the unfolding Greek tragedy, indicates that the adverse outcome is the likely outcome.  But this conclusion doesn’t rest upon Greece, which might be considered an exceptional case. More significantly, as fiscal impetus has turned into fiscal drag, the economies of both the U.S. and Europe have slowed and are now either on the verge of, or already in, a contraction phase.  If governments react to this development by further tightening fiscal policies, they will assuredly produce a second worldwide recession. Should this occur, the 2010s will be remembered by future generations as the decade of the Second Great Depression. As noted earlier, there is at present no reason for optimism that governments and a broad swath of the public understand the predicament we now face. Absent such an understanding, the likelihood of further contractionary fiscal actions is disturbingly high.

Monetary Policy: Loosened

Three weeks after Lehman’s bankruptcy, the Fed lowered the Fed funds rate (the interest rate banks charge each other for overnight loans) to 1.5 percent from 2 percent. Two more reductions were announced by the end of 2008. At year’s end, the rate had been reduced to zero percent (more accurately, for technical reasons, the rate was 0.00 to 0.25 percent). For the first time ever, banks in the U.S. with insufficient liquidity could borrow from banks having more liquidity than they needed without incurring interest expense. One need not look further than this to appreciate the seriousness of the financial situation as seen by those closest to it. The Fed funds rate is still zero percent.

The European Central Bank (ECB) is the equivalent of the Federal Reserve for the 17 countries that employ the euro as their currency. In the eurozone, the “deposit facility” interest rate has the same role as the Fed funds rate. As shown in the following table, the ECB’s monetary policy has been somewhat less accomodative. Most importantly, it has twice raised the deposit facility rate during 2011. Inflation fears were the stated reason for the interest rate increases. Still, at 0.75 percent, the interest rate is far below the inflation rate.

Overnight Interest Rates, 2008-2011

During the 12 months following the end of the recession, real (inflation-adjusted) U.S. GDP grew at a disappointingly slow 3.3 percent — far below the norm for the first year of a recovery. What made this sub-par performance  particularly worrisome was that it happened while short-term borrowing costs in the private sector, reflecting the zero percent Fed funds rate, were at historically low levels. During the summer of 2010, Fed Chairman Bernanke telegraphed the Fed’s intention to implement a policy — subsequently dubbed “quantitative easing” — aimed at stimulating the economy by driving down long-term interest rates. In a speech delivered on August 26, 2010, he said that one of the options for providing additional monetary accommodation was “to expand the Federal Reserve’s holdings of longer-term securities,” and added that he believed “that additional purchases of longer-term securities . . . would be effective in further easing financial conditions.” By the time this policy was implemented in late 2010, market participants had fully discounted its intended effect by driving down yields on longer-term fixed-income securities.

Chart 1.

Chart 2.

Still, the economy refused to cooperate. Real GDP growth fell to 3.1 percent during calendar 2010, two-tenths of a percentage point lower than it had been during the 12 months ending in June, 2010. Growth continued to decelerate during the first half of 2011. The Fed’s reaction to the persistent and growing weakness in the economy was to announce “operation twist” on September 21. In a press release titled “What is the Federal Reserve’s maturity extension program (referred to by some as “operation twist”) and what is its purpose?,” the Fed explained:

Under the maturity extension program, the Federal Reserve intends to sell $400 billion of shorter-term Treasury securities by the end of June 2012 and use the proceeds to buy longer-term Treasury securities. This will extend the average maturity of the securities in the Federal Reserve’s portfolio.

By reducing the supply of longer-term Treasury securities in the market, this action should put downward pressure on longer-term interest rates, including rates on financial assets that investors consider to be close substitutes for longer-term Treasury securities. The reduction in longer-term interest rates, in turn, will contribute to a broad easing in financial market conditions that will provide additional stimulus to support the economic recovery.

For three years, the Fed’s policy has been to deflate interest rates. What began as the deflation of short-term rates has been extended all the way out the maturity spectrum to include 30-year Treasury bonds. This latest interest rate deflation, while helping borrowers — in particular, home owners with variable rate mortgages and first-time home buyers — entails noteworthy risks. The most significant of these risks is its impact on bank profitability. Banks, of course, borrow short and lend long. Accordingly, the outlook for bank profits is at its best when the yield differential between short- and long-term fixed-income securities is large. Operation twist narrows the differential; it “flattens” the yield curve. This new headwind facing the banks comes at a time when another headwind — the eurozone’s sovereign debt crisis — is intensifying, with no end in sight. U.S. banks have an exposure of $650 billion to the debt of Greek, Irish, Italian, Portuguese, and Spanish governments. With the housing market still in the doldrums and the mounting possibility of having to write-down the value of their holdings of eurozone public debt, the flattening of the yield curve could not have come at a less propitious moment. The Fed is betting that operation twist won’t increase systemic risk in the U.S. financial system. It’s a bet that the Fed had better win.

The Problem — And the Solution

The U.S. and Europe are suffering from the same underlying disease: economies that never really recovered from the financial crisis and which will continue to stumble along or soon experience the long-feared double-dip. The European situation is worse, and far more complex. The American states are married; they have one monetary policy and one fiscal policy. The eurozone countries are engaged; they have one monetary policy and 17 fiscal policies. Adding to their problems is the fact that their engagement documents don’t allow them to voluntarily break their engagement or to have other members of their extended family force them to call off their engagement. This is reason enough to conclude that, if a way out of the worldwide economic crisis is to be found, it will start in the U.S.

By now, it should be obvious that credit cost deflation — reducing interest rates — isn’t going to revive the American economy. It should be equally obvious that budget deflation — reducing government spending and/or increasing taxes — isn’t going to revive the American economy, either. If the U.S. is going to lead the industrialized West out of the economic wilderness, it must fundamentally change its fiscal and monetary policies.

We should reverse both of these policies. Fiscal policy should become expansionary. Monetary policy should become restrictive. The eurozone’s sovereign debt crisis provides us with a window of opportunity to do both.

The arguments against fiscal stimulus and my counter-arguments are as follows:

• Fiscal stimulus doesn’t work — Those who support this argument point to the anemic economic recovery that began four months after the February, 2009, passage of the Obama administration’s $787 billion stimulus package.  Top advisers within the administration wanted a larger stimulus, but political realities prevailed. In particular, Christine Romer, who was then the chairperson of the Council of Economic Advisers argued for a stimulus package of at least $1.2 trillion. As reported in the New Yorker,

The most important question facing Obama that day [in December 2008] was how large the stimulus should be. Since the election, as the economy continued to worsen, the consensus among economists kept rising. A hundred-billion-dollar stimulus had seemed prudent earlier in the year. Congress now appeared receptive to something on the order of five hundred billion. Joseph Stiglitz, the Nobel laureate, was calling for a trillion. Romer had run simulations of the effects of stimulus packages of varying sizes: six hundred billion dollars, eight hundred billion dollars, and $1.2 trillion. The best estimate for the output gap was some two trillion dollars over 2009 and 2010. Because of the multiplier effect, filling that gap didn’t require two trillion dollars of government spending, but Romer’s analysis, deeply informed by her work on the Depression, suggested that the package should probably be more than $1.2 trillion.

Would a $1.2 trillion plus stimulus have launched the economy onto a faster growth trajectory? There’s no way to know for sure; the best I can do is to provide an analogy. The economy is frequently referred to as an engine. An immobilized car needs to be jump-started. If the external power source that’s connected to the car’s battery isn’t powerful enough, the engine won’t start. A more powerful external source will succeed where the less powerful one failed. Returning to the economy, it’s a fallacy to assert that, because a stimulus program of a certain size produced a disappointing result, any stimulus package, regardless of its size, will be unsuccessful.

• Fiscal stimulus is inflationary — In some circumstances, this is true. But not in the current circumstances. Chart 3 shows that the velocity of money — the rate at which money changes hands in the economy — is now falling after a brief, mild acceleration following the implementation of the stimulus program. With a stagnant or contracting economy ahead, it’s more likely that money velocity will decline further than to reverse direction. Another analogy will drive home this point. The Fed has been pouring billions of gallons of gasoline (money) into the gas tank (the economy), but fewer miles (purchases) are being driven (made).

Chart 3.

• The dollar will weaken — Perhaps, but that’s not necessarily a bad thing, as it would improve our export competitiveness. In fact, as shown in Chart 4, the dollar has significantly strengthened against the euro in recent days. Since the last day depicted in the chart, the value of the dollar has climbed further.

Chart 4.

At the beginning of this section, I said that the eurozone’s sovereign debt crisis provides us with a window of opportunity to reverse the directions of our fiscal and monetary policies. Now it’s time to explain why.

To safeguard their wealth from the effects of the crisis, Europeans are selling euros, buying dollars, and using their dollars to buy U.S. sovereign debt — Treasury notes and bonds. Notwithstanding occasional glimmers of hope, the eurozone’s crisis admits to no simple solution and will continue for an extended period of time. Accordingly, our interest rates will remain at or near their current historical lows. This means that federal government interest expense as a percent of GDP will not become a budget-buster. Simply stated, for as long as the eurozone’s sovereign debt crisis continues, the U.S. will not have a sovereign debt crisis. This provides us with an opportunity to implement a very sizable fiscal stimulus program without risking the deleterious side-effects that such a program would normally entail.

Changing our fiscal policy is only a part of the solution. A sizable stimulus program will put more money into more people’s pockets, but will they, in this age of deleveraging, spend it or save it (paying down credit card debt counts as saving)?

Chart 5.

This is where reversing our monetary policy enters the picture. The price of credit has been declining for three years. Consciously or not, this trend has undoubtedly seeped into the minds of American consumers. This credit price deflation provides an incentive to defer major purchases. The best example, of course, is housing. If, in addition to expecting a further erosion of home prices, a family also anticipates that mortgage rates will continue to decline, it has an added incentive to wait.

With the stimulus program boosting economic activity, the Fed should announce that, starting on a certain date and every three or six months thereafter, it will increase the Fed funds rate by a quarter percentage point and reduce its holdings of long-term government securities by a specified amount. Replacing credit price deflation with credit price inflation will provide the incentive to purchase now rather than in the future.

There you have it. My solution to the economic crisis is to implement policies that are the exact opposite of those currently in place. Replacing one without replacing the other won’t suffice. Fiscal stimulus without credit price inflation would put more money into more pockets without providing an incentive to spend. Credit price inflation without fiscal stimulus would further weaken the economy.

Political Realities

I haven’t been looking forward to writing these final words. Setting forth a solution to the economic crisis is one thing; expecting that for now and the foreseeable future it has a snowball’s chance in hell of being enacted is another.  The current momentum favoring fiscal rectitude is irresistible. Public opinion being what it is, opposing it amounts to political suicide. We will continue down the current path until it has been completely discredited. What will it take for public opinion to reverse direction? One way or another and by the end of this year, we will have started to walk down the path, instead of just talking about it. If my analysis is on the money, it won’t be a pleasant walk. Stagflation without the “flation” is the most optimistic scenario I’m willing to countenance. If, as seems more likely, the unemployment rate rises into the double digits as the effects of fiscal stringency accumulate, it will be interesting to see whether either of our political parties changes its mind as election day approaches. The ideological rigidity of the Republicans makes it next to impossible for them to undertake an about-face. So, if either of the parties is to change its mind, it will be the Democrats. For now, all we can do is to wait and see.

Unknowingly, of course, the WSJ, in an editorial titled “Twist and Sell,” defended a major point in my criticism of the Republican letter to Fed Chairman Bernanke.

We agree with that policy point, but we also think the letter was unwise. The current Fed has been too political in our view, and Republicans should be speaking up for the cause of Fed independence rather than playing tug-of-war with Mr. Frank over Mr. Bernanke.

The WSJ and I share at least one thing in common, namely, support of an independent central bank.

Having received some flack over my umbrage at the GOP’s letter, I feel it to be necessary to more fully explain my position:

• I’m a strong believer in the independence of the Fed. Being independent doesn’t guarantee that the Fed will always make the right decisions; indeed, there are numerous examples of precisely the opposite. But this is true of any human institution. The Fed’s governors, unlike the Supreme Court’s justices, aren’t appointed for life. Despite this difference, the Fed and the Supreme Court are similar in the roles that they are intended to play in our society. While neither is, nor can be, totally immune to, or oblivious of, political passions of the day, they are – and are intended to be – less subject to such influences than are the two Houses of Congress.
• The Republican letter to Chairman Bernanke — which, notably, was sent only a day or two before the issuance of the FOMC statement – is to my knowledge the most blatant public attempt by either of our political parties to influence the Fed’s monetary policy in our history. Regardless of whether one concludes that the Republicans or the Democrats (or both) should be blamed for our dysfunctional political system, the fact is that the inability of the two parties to reach a compromise is putting our already shaky economy at greater risk. The letter admonishes the Fed to forsake any action that is not in accord with the GOP’s economic policies. I view the letter as a shot across the bow. It is a warning to Chairman Bernanke that, if the thrust of the Fed’s policies is not altered and the outcome of the 2012 elections is favorable to the Republicans, he may join the ranks of the unemployed. I doubt that Bernanke will be swayed by this threat. That is not the issue. The attack on the Fed’s independence – in full public view – is the issue. It is politically motivated. The Fed, not just the Democrats, is to blame for our economic distress. In other words, only the Republicans are blameless.
• Early in the Obama administration, Senator McConnell said that his primary objective was to do everything he could to make Obama a one-term president. He said this at a time when the economy was in freefall and the financial system was on the verge of collapse. A stated willingness to work with the president under what were extremely trying conditions would have been far more statesmanlike and might have boosted confidence in the country’s ability to weather the storm.  Nearly unanimous Republican opposition to all of the president’s proposals to help the economy — specifically, the stimulus program and the GM and Chrysler bailouts — and the inaccurate, repeated Republican denials that these programs had saved a single job, along with Senator McConnell’s statement led me to conclude that the party’s game plan was to boost its electoral chances in 2012 by doing whatever it could to keep the economy weak for the duration of the Obama administration.
• In both words and deeds, at a time of great economic peril, the Republican party has given precedence to its future over the country’s future. It has been unwilling to compromise, believing that, by not doing so, its electoral prospects are enhanced. Having successfully minimized the efficacy of fiscal policy to help cure our economic wounds, it is now – as evidenced by its letter to Bernanke – attempting to do the same to monetary policy. Thus, the letter reinforces my conclusion that the Republican party has decided that the weaker the economy, the better its prospects.

Board of Governors of the Federal Reserve System

• FOMC Statement

. . . there are significant downside risks to the economic outlook, including strains in global financial markets.

Financial Times

• Roger Altman, “America and Europe are on the verge of disastrous recession“

Overall, we could be in for a repeat of the experience of 1937, when America fell back into recession after three years of recovery from the Great Depression.

• Charles Dumas, “Spain, not Greece, may be the biggest eurozone threat“

The chances are high of a Spanish asset price slide and banking crisis, with stagnation (at best) or depression, if it sticks in the euro. For Portugal they are close to 100 per cent.

New York Times

• Floyd Norris, “Constraints on central banks leave markets adrift“

. . . the slogan for markets as the International Monetary Fund and World Bank meet this week in Washington could well be, “You’re on your own. Don’t count on anybody to bail you out.”

Spiegel Online

• Romain Leick, “The weakness behind Sarkozy’s European vision“

Thinking about Germany has become a French obsession, because France is worried. It is wondering whether Germany will remain true to the European Union and the euro . Will Germany choose solidarity over discipline? Will Germany ultimately accept the measure that prevailing Parisian opinion considers inevitable and agree to collectivize national debt within the euro zone?

• David Böcking, “Belligerent Berlusconi Toys With Europe“

Italian Prime Minister Silvio Berlusconi refuses to recognize that his country is in trouble. Vast debt, sluggish growth and rising borrowing rates indicate that Rome too may be infected by the euro-zone debt crisis. But the EU has few tools at its disposal to get Italy to take action.

• The World from Berlin, “Italy’s chief problem is its own government“

Prime Minister Silvio Berlusconi blasted Standard and Poor’s on Tuesday, saying its downgrade of Italian debt was politically motivated. German commentators tend to agree, but they say the real problem is Berlusconi himself.

VoxEU

• Michael Bordo, “A fiscal union for the euro: some lessons from history“

The single European currency is the first of its kind – a union where monetary policy is decided centrally and fiscal policy decided nationally – something that many argue is the root cause of its troubles. This column looks to history to find examples of federal states with a common currency but without the frailties currently being exposed in the Eurozone. The main lesson: No bailouts.

The FOMC statement was released minutes ago. Compared to its August 9 statement, there are two important changes in the wording of the FOMC’s view of the economic situation.

• “Significant downside risks” to the economic outlook has replaced “downside risks” to the economic outlook.

• The significant downside risks include “strains in global financial markets.” In the August 9 statement, there was no reference to strains in global financial markets. Clearly, this is a reference to the developments in the eurozone.

The following are the relevant quotes from the August 9 and September 21 statements:

• August 9, 2011

The Committee now expects a somewhat slower pace of recovery over coming quarters than it did at the time of the previous meeting and anticipates that the unemployment rate will decline only gradually toward levels that the Committee judges to be consistent with its dual mandate. Moreover, downside risks to the economic outlook have increased.

• September 21, 2011

The Committee continues to expect some pickup in the pace of recovery over coming quarters but anticipates that the unemployment rate will decline only gradually toward levels that the Committee judges to be consistent with its dual mandate. Moreover, there are significant downside risks to the economic outlook, including strains in global financial markets.

American history since the founding of the Federal Reserve System in 1913 is replete with efforts to influence its actions. With this letter to Chairman Bernanke, the Republican party has taken attempts to politicize the Fed to a new high. In no uncertain terms, the letter demands that the Fed abstain from any further efforts to stimulate the economy, claiming that previous efforts — in particular, quantitative easing — have backfired. While it’s true that some responsible — and some irresponsible — individuals have made such an argument, this isn’t the majority viewpoint.

If there was any remaining doubt that the Republican party wants the economy to remain sick in what I hope and pray is a misguided effort to win control of the presidency and both houses of Congress next year, this purposely overt attempt to politicize the Fed should eliminate it.

Dear Chairman Bernanke,

It is our understanding that the Board Members of the Federal Reserve will meet later this week to consider additional monetary stimulus proposals. We write to express our reservations about any such measures. Respectfully, we submit that the board should resist further extraordinary intervention in the U.S. economy, particularly without a clear articulation of the goals of such a policy, direction for success, ample data proving a case for economic action and quantifiable benefits to the American people.

It is not clear that the recent round of quantitative easing undertaken by the Federal Reserve has facilitated economic growth or reduced the unemployment rate. To the contrary, there has been significant concern expressed by Federal Reserve Board Members, academics, business leaders, Members of Congress and the public. Although the goal of quantitative easing was, in part, to stabilize the price level against deflationary fears, the Federal Reserve’s actions have likely led to more fluctuations and uncertainty in our already weak economy.

We have serious concerns that further intervention by the Federal Reserve could exacerbate current problems or further harm the U.S. economy. Such steps may erode the already weakened U.S. dollar or promote more borrowing by overleveraged consumers. To date, we have seen no evidence that further monetary stimulus will create jobs or provide a sustainable path towards economic recovery.

Ultimately, the American economy is driven by the confidence of consumers and investors and the innovations of its workers. The American people have reason to be skeptical of the Federal Reserve vastly increasing its role in the economy if measurable outcomes cannot be demonstrated.

We respectfully request that a copy of this letter be shared with each Member of the Board.

Sincerely,

Sen. Mitch McConnell, Rep. John Boehner, Sen. Jon Kyl, Rep. Eric Cantor

In the early 1950s, General Motors’ “Engine” Charlie Wilson famously said that what was good for GM was good for the country. Now, some 60 years later, the Republicans are saying that what they perceive to be good for their party is good for the country. Lacking knowledge of the future, I can’t say with certainty that the economy will go to hell if the Fed, fearful of its post-2012 future, follows their advice. I am now certain that the Republicans would gladly send the economy through the wringer if  they thought that doing so would help them take over the government.