Ev Ehrlich's Everyday Economics

What the —-?

Although the title of today’s entry wasn’t meant to refer to it, the call at first base on what would have been the final out of Armando Galarraga’s pitching baseball’s 21^st perfect game was not the worst call in baseball history.  Don Denkinger’s call on Jorge Orta in 1985 was not only far more obviously wrong – it wasn’t even a bang-bang play –but changed the outcome of the World Series, which is far more severe than marring one player’s individual accomplishment.    Ken Burkhart’s call in the 1970 World Series was particularly egregious as he ended up in the middle of the play, as well as blowing the call.   And Larry Barnett’s failure to call Ed Armbister out for interference in 1975 was not only wrong, but marred perhaps the greatest World Series ever (although I’ll take 1991, thanks, with props to 1960, 1924, and 2001)   

So Galarraga now enters baseball history as one of the three guys to have “asterisked” perfect games.  He’s really the third of the three.  The second is Harvey Haddix’s famed 1959 outing, in which he threw a 12 inning perfecto – 36 up, 36 down – only to lose, 1-0 to Lew Burdette and the Braves in the 13^th on an error, a sacrifice, an intentional walk, and a homer by Joe Adcock that ended up being only a double because he passed Henry Aaron on the basepaths.  The first great “not perfect” game was in 1917 when Babe Ruth, pitching for the Red Sox, walks the first batter, argues the call, gets thrown out by the umpire, and Ernie Shore, who replaces Ruth, picks the runner off and gets the next 26 in a row.   Can you imagine?  It’s a different list  but Galarraga’s on it, and the beauty of baseball is that its devotees keep and respect both lists. 

So much for the sublime.  Now, on to the ridiculous.

For the first time in my career as an economist, I’m getting “the question” – friends, colleagues are coming up to me and with the hushed tones usually reserved for intimate conversations in public places and dope deals, ask me; “What the --- is going on out there?”  The blanks, of course, vary as do the askers.

I don’t take this as a sign that economists are now climbing up the ranks of respectability, leaving lawyers and other reprobates behind, but rather that the daily stream of news is so confusing, so off-the-map, and creates so much volatility – markets and their underlying sentiment taking giant steps in opposite directions with each passing day – that “what the ---“ becomes the only appropriate response.  “What if everybody felt that way, Yossarian?”/”Then I’d be crazy to feel any different.”

So here’s the hyper-condensed version of events that I’ve developed in response to the dominant questions of the moment.

When we last left the Western economies, they were imploding after the collapse of the housing market.  The balance sheet hit created by crashing home values led banks to cut back lending and led consumers to retrench.  This spread the pain and failure to the general economy, which ignited a second stage of financial collapse. 

The second stage was caused by “credit default swaps.”  Over the previous years, banks and other institutions had made bets that many large firms would never go bankrupt.  They did this by buying credit default swaps, a device in which they were paid a nominal amount in exchange for the promise to take a bath if a firm went broke and its securities went unserviced.  As long as big companies never went broke, there was nothing to lose.

Oh well.  It was this second stage that put the ship on the rocks.  Many – almost most – major financial institutions had that kind of exposure.  And the ones who bet the right way – by recognizing that one day these credit default swaps might take a bath – couldn’t collect what they were owed because it never occurred to them that their counterparty (or as we called them back in North Queens, losers) would be unable to pay.  That’s a major oversight -- I don’t lend my neighbor Fitzgerald ten million bucks because I know he’ll never be able to pay it back.  So when Goldman tells you it didn’t need the bailout – horsefeathers.  They received billions of the money that went into saving Bear Stearns, and they got it because they didn’t think about this point.

Faced with the reality of their major banks shutting down, the major governments had two options – do something, or do nothing.  Monday morning quarterbacks on both the left and right are making careers out of critiques of option A, but only a few folks well-removed from reality dispute that Options A was the right move.  (For example, Casey Mulligan argued in the New York Times that it was senseless to spend so much money bailing out banks as pension funds and university endowments could match savers and investors just as well.  And this guy teaches people?  Give me a break.)    Other critics thought that the banks ought to be given the kind of rousing reception that greeted Mussolini at Giolino di Mazzegra, others that bailing out Bear but not Lehman was inconsistent.

But the actions taken by the new Obama Administration and the other Western governments brought the world back from the frightening paralysis that would have taken place if the banks were shuttered -- lending would not occur, assets would not be exchanged, liquidity not provided for businesses, and further trillions of dollars would be lost.  Time out for an aside – you all owe your asses to the Administration and, yes, Tim Geithner, for keeping themselves focused on the one thing that truly mattered – recreating financial stability.  Like comedy, it wasn’t pretty.  But it avoided reproducing the very same mistakes that made the Great Depression a catalyst for a decade of great film and theater. 

Bailing out the financial system took a lot of money – ultimately, less money than was thought at the time, but that merely means “a lot” of money, as opposed to “psychotropically unfathomable”  amounts of money.  But, in the world of financial bailouts, if they cost a great deal, it means you haven’t spent enough yet.  The real budget hit came from the downturn in the real economy, not the cost of mopping up after the hogs ran through town.  The stimulus was big but sorely needed, and again, some credit is due to the Administration – here I see Summers at work – for understanding that the response had to be commensurate with the problem – enormous.

Which takes us to the present, where the economy is stable and beginning to grow anew.  As I’ve said elsewhere on these pages, I’m optimistic about that growth, and I’ll double-up on my optimism before this entry is out.  But behind the prospects for a meaningful recovery lies the specter of an ocean of government (sovereign) debt.  There was a frightening amount of government debt before this mess, and adding on more makes it all the more unnerving.  I don’t think it’s beyond the pale to expect some U.S. municipalities or even states to default in whole or part of what they owe – heck, California already issues IOU scrip and when that trades below par, that’s already a form of default.

So the issue now is whether all of these sovereign debts will be repaid.  When governments were busy shoveling dollars into the boiler, people put that fear aside, using a variant of what economists call “Tinbergen’s Rule” – that is, one crisis at a time.    But once the crisis appeared to abate – as it does now – there was the morning after question – how is all this debt going to be taken down?

And against that backdrop came the startling revelation this Spring that Greece, with enthusiastic support from Goldman Sachs, had set up currency and perhaps other trades in order to hide the true level of their government’s deficit.  That Goldman would suggest such a thing to a government is outlandish – that the government would take them up on the offer speaks to Goldman’s uncanny craft.   But the news that Greece’s deficit was much larger than previously thought sent a new shock wave through the system.  Would Greece be willing to repay all it owed?  And what about other European countries with debt levels that, in some fashion, rivaled those of Greece – Spain, Portugal, Ireland, maybe even Italy?  Could they, would they, somehow reneg or default?

And so Europe went from a crisis not of their own making – the U.S.-born mortgage/credit default crash – to one entirely of their own doing – the need to stitch together the Eurozone.  The framers of the Euro, 20 years ago, understood that once the individual nations of Europe didn’t have their own currency – pesetas, lire, escudos, drachmas  -- to degrade (by borrowing like madmen), they had to be prevented from degrading the one they now all shared.  They passed rules about limits on deficits, but those rules were impossible to enforce.   When confronted with the choice of temporarily bailing out the high-debt nations or watching the European economy founder and the Euro be abandoned by several of its participants, the Germans, Europe’s official embodiment of rectitude, got pragmatic quickly and started dishing out money.

So now the issue has changed.  The major industrialized nations all owe staggering amounts of money.  Some of it came from the financial bailout, some of it from the Euro-bailout, but most of it is related to the economic conditions that ensued.  Some amount of the ongoing deficits we see will fade if the economy, but most of it won’t.  And cutting deficits is tough – Greece imagines cutting about 2 percent of GDP each year from its deficit for four years  -- that’s going to hurt, hurt badly, and hurt for a long while.  Will their per capita income be higher or lower than today’s in 2020?  I don’t know.  That’s a long time to go nowhere and it requires a population willing to lose that decade because they understand that the alternative is worse.  Imagine Glenn Beck – or Jamie Galbraith – chewing on that one.

But even as sovereign debts have become riskier, investors have raced to buy them, because in the midst of a financial crisis, there’s little else to buy.  But when you add the precariousness of government debt to the staggering quantities of it that’s been snapped, you get the ultimate bubble – not a “housing bubble” or a “dot.com bubble” or a “leverage bubble” but a sovereign debt bubble­ – the possibility that government debt instruments are wildly overvalued because they haven’t been priced to reflect the true probability of default.  And like any bubble, when it pops, it’s going to be a bitch; can you imagine the carnage when and if a government announces it’s only going to pay back X percent of the face value of its securities?  Or declare an interest-free holiday for itself?  People generally walk around thinking “well, that couldn’t happen” until the moment it does.  Think of the nanosecond in which Fannie and Freddie turned from makers of orderly markets to oceans of suck.  Now apply it to Treasuries.  Man.

With that said, and while fully cognizant of all the risks involved, I think that the world economy will most likely escape this trap, when all is said and done.  And I base that on a short list of factors.  For one, the political processes outside the United States are probably capable of dealing with the unrewarding task of fiscal retrenchment, particularly in Parliamentary systems that have greater continuity and discipline.  Second, my earlier remarks to the contrary, markets aren’t being caught by surprise as they were with mortgages and credit default swaps – investors are paying attention to sovereign debts, and the credit rating agencies, which screwed up royally last time, are both chastened and attentive.  The spreads among government instruments are responsive to new developments, and we’re probably beyond the point at which such a debt is regarded as “risk free.”

But even more importantly, to me, we live in a world bereft of inflation or inflationary pressure.  Pervasive technological change is reorganizing the world economy, and hundreds of millions of people, particularly in Asia and the former Soviet Bloc, are being integrated into it.  It is very hard to tell a convincing story about how costs – particularly wages – are going to rise to create overall price pressures, and resources such as oil are now far less important than they used to be in triggering economy-wide price changes – a dollar of GDP now takes about half the oil it did back when OPEC could bring the world to its knees.

This is important because the most rudimentary way to manage too large a stock of government debt is to print money to pay it back.  This is frowned on for two, interrelated reasons.  First, it causes inflation – you know the old saw, “inflation happens when too much money chases too few goods.”  Well, regardless of the universality of the proposition, too much money can lead to higher prices, so it bears watching.  Second, when debtors print money, their currency falls in value, which makes its foreign debts harder to pay (since your currency fell in value relative to the currency in which you have to repay), which perpetuates the loop.  But inflation is going to be hard to sustain in today’s world – I’m far more bothered by the prospects of deflation than inflation. 

And you can’t have a “run” on the dollar, or the Euro, or whatever else unless there’s something to run to, and there isn’t.  All of the “advanced” economic areas and their currencies have the same basic problem – too much debt, slow growth, aging populations, and so on.  You can’t abandon all of these currencies at once – where do you put the money?  Some might argue that it will end up in gold, but gold’s historic role as a way to store value when inflation east away the value of paper money.  Are investors really going to flock to gold when there’s no inflation on the horizon?  I doubt it.

So we have a historically old problem – governments taking on too much debt – in a radically new historical setting – a deflationary world environment.  That means we will have more latitude to manage economic growth and expand the supply of credit while trying to work out the overhang of government bonds around the world.  And it means that we can use monetary policy to keep the economy moving while we tighten on the fiscal reins.

But these circumstances also suggest one final economic policy item to me.  By next year, with the recovery underway and jobs back in the plus column, it would be very, very wise to raise taxes.  A well thought-out tax increase would show global investors that the U.S. was capable of overcoming its own bipolar lunatic fringe and acting responsibly, and that the dollar was still the safest place to be in a scary global economy.  Interest rates here would drop and stay low, investment would increase, and we would be better off.

The tax increases that were part of the Clinton budget package in 1993 were greeted with derision by those who claimed they would lead to a recession – and those critics included some in our own Administration.  I recall heated conversations in which the other side of the debate mocked the idea of “crowding in” – freeing up resources for better uses by cutting deficits.  But they lay the basis for a decade of growth.  The 2011 tax increase – and hopefully reform – would do the same.   It will be some very heavy lifting.  But it’s a better answer to our circumstances than more “what the ---.”