Ev Ehrlich's Everyday Economics

The Usual Bet

When I first joined Unisys – this is probably September, 1988 – I found myself in a discussion leading to a disagreement with our Chairman over where currency values were going.  It went something like this: We agreed the dollar had been propped up during the summer and would drop against the yen.   The Chairman thought it was in for a beating.  I disagreed, and thought that policy would defend it and stabilize it.  After all, one of us had been Treasury Secretary and the other was a schmuck who had just arrived from Washington.  We agreed to disagree and commemorated our disagreement by betting whether the dollar would fall below 120 yen before Christmas – the winner would give the other a cigar.

By Thanksgiving, my wife, who is a resourceful and talented woman but whose grasp of currency goes as far as the ATM, knew where to find foreign exchange markets in the Philadelphia Enquirer.  And the dollar got as low as – I’m not making this up – 120.4.   Sure enough, on the day before Christmas, the Chairman called me into his office, awarded me one of the lovely Dunhills in his humidor, and told me, “I was right, but it’s a matter of when.”

I tell this story partly because it was a great personal triumph but mostly because when a guy starts in to alibin’, he ought to come clean, and that’s what I’m doing.  In several previous posts, I’ve expressed my optimism that the economy was poised for recovery, and that a backlog of hiring created the possibility of a “jobful” recovery.  On January 30, 2010 – that’s 17 months ago – I posted a piece here called “Jobs Are On the Way,” in which I announced:

Lincoln one told a story about an ancient King who asked his wise men to write a sentence that would be true regardless of time and place. Their answer was: “This, too, shall pass.” The economists who predict no growth, no jobs, no nothing need to go back to that sentence. Yes, the economy has been  abused by tax cuts, wars fought but not paid for, and a financial free-for-all in the housing market. But it’s about to come back. Jobs are on the way.

Was that well-written, or what?  And, it turns out, wrong.  Or, as the Chairman said, it’s a matter of when. I can retell the economic history of the intervening 17 months and tell you why I was wrong, but I’d only remind myself of what Will Rogers:   An economist’s guess is liable to be as good
as anybody else’s.

I’m wearing this hairshirt and standing in the snow at Canossa because I need to settle my accounts before I deliver this opinion:

The guys who want to cut spending dramatically are about to tank the economy.

The economy appears to be slowing down.  The number of jobs created last month, according to the BLS establishment survey, was frighteningly low, even when you accept that the survey has a downward cyclical bias.  Housing prices have resumed their decline and further undermined households’ sense of stability.  Demand is not strong enough to justify expansion of employment and continued weakness in structures – starting with residences – is undoing much of the improvement in other investment.  State and local governments add drag.

The Fed’s quantitative easing program – QE2 – under which it would add $600 billion in liquidity to the economy – created some optimism back in
November, as well as criticism that Fed had lost, in order, its independence, the battle against inflation, and its mind.  The first and third outcomes suffer from an absence of hard evidence, but the second has proved to demonstrably false.  Beyond a food and energy price blip, underlying inflation is still at around 1 percent, below the Fed’s target.  Bernanke says he’s not going to have a QE3, but what the hell else is he supposed to say?

So we’re left with this quandary – the economy is slowing down, and inflation is tame if not submissive.  But the consensus position across the political system – from Speaker Boehner to the White House and through most of the Democratic majority in the Senate – is to cut spending dramatically.

Yes, the nation has a substantial debt – back to that later.  But the debt is not going to be repaid without tortuous pain unless the economy can resume growing and creating income and employment.

We have two alternatives to achieve this goal.  The first is the position found in a letter signed by 150 economists that Speaker Boehner recently presented to President Obama.  Some are first-rate economists, others aren’t.   But a position should be judged on its own merits, even if some of the people who hold it have said one loony thing or another elsewhere.  And the position can be summarized by this squib from the Speaker’s office, noting that the economists in question call for immediate spending cuts to boost our economy and help create a better environment for job creation in America.

So, according to this view, the reason why the economy hasn’t created sustained growth and employment is that there’s too much government spending.  The letter makes that clear:

Excessive government spending and borrowing is playing a central role in our economy’s ongoing struggle to create private-sector jobs – crowding out private investment, sowing uncertainty among small businesses, and eroding confidence that is critical to job growth. To help create a better envionment for job creation in America, we must reverse this spending binge as quickly as possible and free our economy from the burdens of excessive regulation, over-taxation, and runaway spending.

As The Emperor says at every occasion to Salieri and Mozart, “Well, there it is.” Too much spending is crowding out investment – there’s no money left for equipment, structures, and the rest, because the Feds are gobbling it all up.  This, in turn, leaves business owners wondering what the hell is going on, which leads to uncertainty and loss of confidence.   Then there’s the stuff about excessive regulation, but let’s at least agree that’s not a budget issue, before we consider whether what they mean by excessive is Dodd-Frank, cap-and-trade for greenhouse gasses, the health insurance reforms of last year (“government-run health care”), and whatever else.

Is federal borrowing choking off the economy?  To me, there’s a simple litmus test – the interest rate. If the government is borrowing and money stays cheap, it’s hard to argue that its borrowing is the source of the problem; were we to see interest rates rising, then we’d have evidence that government borrowing was bidding away the supply of savings from other uses and we’d have to wonder why we were doing it.

Here’s a picture of the rate of interest on the ten year Treasury bond since 1992.  From 1992 through 2003, the rate is declining on trend; first, because of the progress towards balancing the budget under President Clinton, who was that fateful combination of both lucky and good.  He was good in that he took action against deficits, including higher taxes, despite Gingrichian – or Gingrinchian? – prophesies that he would trigger a recession.  (I wonder to whom Newt gave the cigar when he lost the bet.)  When Clinton departs, Bush gives away the surplus, but 9/11 coincides with a substantial market correction and the economy weakens, allowing the interest rate on the ten-year Treasury bond to fall further.

From 2004 through 2006, the economy is starting to grow again, so the bond yield takes a modest upward path, until the first housing quakes start to hit in 2007 and those investors who can get out – deleverage – do so.  But by January of 2009, the yield has dropped to 2.884 – it had been over 6 in the middle of the decade and still around 5.0 in 2006, the last year the housing market spent on this planet before departing for points unknown.

Now let’s look at the last two years, close up.  The Obama stimulus pushes the rate up in 2009, and keeps it there, a perfect barometer of expectations,  until April of 2010, when the Eurzone falls apart and financial markets are thrown into the kind of uncertainty and eroded confidence that the 150 letter-signers fear.  The rate, like the heart monitor of an emergency room patient, drops to 2.40 in early October of 2010, very close to the 2.30 it reached in January 2009, when the situation was darkest.

The Federal Reserve then stepped in, sensing the danger, and announced its program of quantitative easing – buying up assets from the banking system to put new cash into the economy.  (It was advised to do so by many, including this sign, seen at the Jon Stewart March For Sanity rally that November.)

The announcement of this program, “QE2,” leads the nation’s pulse to rise, partly because they expect inflation to be set off by these asset purchases – although it hasn’t and they haven’t – but mostly because investors expect some response in the economy.  By February the yield is up to 3.75 and there are signs of recovery, but these fail to take root and the recovery falls back, culminating in the recent jobs report and the news that household consumption of goods fell sizably in March and was flat in April after several months of growth.  Thus, by this week, the rate has fallen back to 3.0 percent.

The collapse of bond yields gives the lie to the position taken by the 150 of the Speaker’s economist pen pals.  Government spending isn’t crowding out investment, it’s substituting for it.  Inflation isn’t rising, it’s at worst stationary, and possible falling now that raw materials prices may have crested.  If fear of intrusive regulation is driving these numbers, then perceptions of their intrusiveness seem to be
changing regularly.

And yet, the Speaker and his allies have won the political battle to cut spending now, reminding us that nothing can match the power of an idea whose time has come, even if the idea stinks.

There’s an alternative view.  It argues that while corporations and banks have been stabilized and more (as in the almost $2 trillion of cash sitting on corporate balance sheets ), households are the lagging element in the recovery.  Companies are willing to invest and – for equipment and software – are already doing so at modest rates – but absent households having the wherewithal to buy goods, why invest and hire to make more of them?  If there weren’t a burgeoning federal deficit, a direct stimulus would clearly be in order.  The complication arises in reconciling the two.

Markets aren’t worried about the U.S. government finding enough quarters in the sofa to manage its debts – they’re worried that Greece may not have such a sofa, but not us.  They are worried that, down the line, the U.S.’s costly promises to subsidize seniors’ medical care and (to a lesser extent) provide them with pensions, will break the bank.  A foresighted political system would have addressed this, but ours lies just behind Iceland’s during the winter solstice.  If Paul Ryan was “bold” and deserves “credit,” it’s for recognizing that this is the real problem, even if his “solution” -- to turn Medicare into a voucher program – was more meant to enfeeble the state than to provide the elderly with health care coverage.  (Imagine the oldest person in your family trying to find health insurance they can afford.  Now imagine 100 million of them trying.  Next.)

So here’s the plan.

1.            The federal budget should be designed to produce a deficit no larger than this year’s on a cyclically-adjusted basis based on its long-term trend growth rate.  That is, freeze the level of the deficit, agreeing that it can go no higher, unless the economy grows below its long-term trend (of about 2.6 percent).  On the other hand, if the economy grows faster than that, require some retrenchment (which to some extent is guaranteed if there’s less paid out for unemployment benefits and the like).

2.            Address the root of the household consumption problem – the residential mortgage market.  The feds should break up Fannie Mae and sell the pieces – or perhaps distribute them, once the true value of what they hold is considered – to a number of entities greater than the fingers on one hand.  These “little Fannies” should be allowed to refinance existing mortgages at their face value – regardless of housing market prices – at a federal financing window for anyone who has made their mortgage payment for the last 24 consecutive months, at the least up to the level of existing “conforming” mortgages.

3.            This wave of refinancings would give households more confidence and certainty, and would create income in the form of lower mortgage payments.  The government’s exposure would be defined unambiguously, penalties for fraud would be clear and enforceable (fool me twice, shame on me),  and the resulting assets would be held by the “little Fannies” and secondary markets in pre-determined proportions.

4.            The two years imagined here would give fiscal policy a chance to reset itself, particularly since they would include the 2012 election, which would allow the public to speak about taxes, Medicare, Social Security, and other forms of spending and tax expenditures.  My guess is that we will not have a debt default this summer because both parties want to have this issue dominate the 2012 election, even if one of them is proven wrong.  The election would give us a direction about taxes – not just whether to raise rates and on whom – but the nature of the system itself.  Should be shift it from income to  consumption in various forms?  Should we continue to have a separate tax on corporations as opposed to the people who own them?  What do we do with the proliferation of tax deals – from IRAs to home mortgage interest to special treatment of oil and gas – that load so much burden on the tax code?  Once we agree as to form, we can discuss the progressivity of the burden.  I like progressivity.  Others don’t.  I’m right and they’re wrong, of course, but at some point we’ll have to agree.

5.            Finally, social security and Medicare wage taxes paid by employers should be waived for net new hires over those next two years, but within the budget framework suggested above.

There are some other things I’d like to see as well – a national infrastructure bank, for example, but right now they seem secondary.  The question is a larger one – where are we headed?  Laying out a direction like this is a fool’s errand, so at least I’m qualified.  But this kind of discussion presumes that we all share the same goal –reviving the economy and triggering new employment.  I can tell you why this program will work – it crates stimulus, takes minimal risks, provides some certainty in the short term as can be provided regarding debt, and doesn’t slash demand at a critical moment.

I don’t think the 150 letter-writers can do the same.  Their argument, it strikes me, boils down to “cut spending and slash demand,” and while that might not seem smart, it will deliver the economy and the people who inhabit it into a state of grace and ease their furrowed brows.  If interest rates were high or rising, they could point to that as evidence.  But they’re low and falling, suggesting that the problem is not as they define it.

Or, an alternative is that the letter-writers, from such dignified guys as Mike Boskin or Doug Holtz-Eakin down to the guys who think Obama’s a Marxist, really don’t share that goal.  They see the moment as a chance to make government smaller, which is what they want more than a recovery or a growing economy, certainly for the next few years.  Dramatic cuts in spending now would give you the former, but reduce the chances of the latter.  And, I think they know it.  They're prepared to let the economy tank in the short-term if it means that the state will be helped to wither and the President be defeated in 2012.

I’ll bet you a cigar.