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 ---.”

Hook ‘em, Horns

First, this.  About a month ago, I posed the question, “What are dogs saying when they bark in movies or television programs?” and invited my regular readers (both you and the other guy) to come up with an answer.

One reader did – my daughter and favorite child, Alice.  “It’s easy,” she told me.  “Right behind the actor at whom the dog is barking,” she said, before syntactical remediation, “is a trainer with a piece of steak on a stick.  And the dog is saying ‘Holy shit!  Steak!  Steak!’  And that’s why Eddie (our dog who goes nuts when dogs bark on television) goes nuts – because he hears the dog on television shouting ‘Steak!  Steak!’ and he’s saying ‘Where?  Where?  Where’s the damn steak?’”  Although she didn’t say damn.

Well, you can keep your kids who start their own businesses or go to Harvard or whatever the hell else the Junior Achievers are up to nowadays.  How can you not be proud of a daughter with this kind of native (dare I say it, canine?) common sense. 

A good number of my friends have kids with this kind of strength, and as we age and life becomes a valedictory, it’s a source of ever-growing pleasure.  One of my lifelong best friends’ daughter, for example, just decided to go to the University of Texas (for whom I rooted unsuccessfully against Alabama -- Hook 'em, Horns!) next fall and was invited into its Honors Program, which was a source of much happiness for all of us – until, at least, we read last Sunday’s Washington Post. 

In it, UT economist James K. Galbraith (and therefore putative prospective mentor of the kid in question) argues for getting rid of the Congressional Budget Office, much as he would tell a man with cardiovascular disease to fire his cardiologist – because the news he brings is not to his liking.  And in a world in which the inability of a third-tier tourist-and-remittance economy like Greece to manage its budget takes us to the edge of a global shitstorm, the idea that anybody – let alone the CBO – is “fear mongering” on the deficit needs to be scrutinized carefully.

OK, full disclosure – I worked at CBO from 1977 to 1988 and am proud of the time I served there.  And the place has had a number of smart and honest Directors, people I admire, from all across the political spectrum -- Alice Rivlin, Rudy Penner, Bob Reischauer, Doug Holtz-Eakin.  I wish I could tell you that I’d have written these notes even had I not worked there, but that’s unlikely, as working there gave me an insight into what they do there and why, an insight that appears to have gone unshared with Professor Galbraith.

His piece in the Post reads like this:

 …CBO's projections are indefensible, internally inconsistent and economically impossible. …The CBO predicts that unemployment will fall to near 5 percent by 2014 and stay there. It also expects a rapid recovery in the next few years, followed by a steady 2.4 percent GDP growth rate thereafter. Inflation is expected to stay below 2 percent indefinitely.  But …CBO also projects that short-term interest rates will increase from less than 0.2 percent now to 4 percent in 2014 (and higher later), while rising health-care costs will drive Medicare expenditures ever higher.

Well, let me start there.  In fact, I’m fairly optimistic about where the economy is headed, and I don’t think that’s a bad forecast at all.  The economy has a lot of pent-up demand, credit availability is just getting going again, business are flush with cash, and with burgeoning technological progress and ever-increasing world trade, it’s awfully hard to tell a story about why we’re going to see inflation any time soon.  And even if I didn’t feel that way, at least I’d understand how CBO gets to its forecast – its usual practice is to assume that, regardless of where we start, the economy returns to its long-term trends (the 2.4 percent number that Galbraith derides) and stays there. 

Not good enough for Galbraith:

These things cannot happen together. If the CBO's happy growth scenario is right, with low inflation and low unemployment, why would short-term interest rates rise?

What part of it don’t you get?  Because the country is in hock, son, and as when you borrow a great deal of money, the vig goes up.  Ask Greece.  Besides, if the economy does grow over the next four years, enough to take us back to five percent unemployment, then “real” interest rates – the spread between interest rates and inflation -- are going to take off like a rocket.  That’s because government deficits will still be high, but private investment will have been resuscitated – you can’t have sustained, high growth without it.  With the public and private sectors competing for funds, there’s really no way interest rates couldn’t rise by 4 percent.  If CBO hadn’t pointed out that sustained growth in the face of the deficit is going to lead to higher rates, they’d be a candidate for a urine test.

But Galbraith isn’t done.

Conversely, if the CBO's assumptions about health-care costs and interest rates are correct, how can inflation stay low? Ballooning interest payments and health-care spending would spur the economy to full employment and drive up prices -- but also slow the rise in debt as a proportion of the nation's gross domestic product.

Hmm...higher interest payments and rising health care costs are forms of economic stimulus?  They seem more like paying more for the same thing, which sounds more like a drag on the economy than a spur.  And as to driving up prices, health care costs have increased sizably in recent decades, but they haven’t led to general inflation – our economy has been free of significant inflation for years despite health care.  And Galbraith appears to think that higher interest rates lead to higher growth and inflation, instead of reflecting higher growth and inflation.  having it the other way is like saying that your pain caused your headache. 

Besides, according to the Bureau of Economic Analysis, which adds up Gross Domestic Product, net interest payments by the nation’s nonfinancial corporations totaled $227 billion in 2009; in an economy worth over $1.4 trillion, these could double in the next four years and add no more than 0.4 of a percent per year to inflation under the asolute worst of conditions. 

…That miraculous return to full unemployment and those higher interest rates both come from thin air. More likely, given the passivity of today's banks, high unemployment and low interest rates will linger, unless the government moves on a real jobs program. And that won't happen, because of fear-mongering about the debt -- buttressed by the CBO.

Ah, well now we get down to it.  Galbraith’s concern isn’t that we’re getting the deficit wrong.  It’s that we might be getting it right -- that is, it's big, but needs to be bigger.  His concern is that we haven’t run a larger deficit-spending program than the one the Administration did last year.  And by pointing out what that kind of a program would cost, CBO is an obstacle to his own policy preferences.  And those preferences are revealed in his last remark:

If we'd had a CBO in the 1930s, Franklin Roosevelt could never have gotten the New Deal off the ground.

There are all sorts of reasons to be concerned about that remark.  For one, it’s just not true.  The largest deficit during the Depression was 4.76 percent of GDP in 1936, less than half of today’s, and lower than the deficit was in 1985 and 1986, during the height of the Reagan Boom, when CBO was in full flower.  Second, we’re seeing in Europe what the consequences of too much borrowing – even if for important policy objectives – can be.  So while the human cost of slow growth and unemployment is frighteningly large, another round of deficit spending might create a crisis of its own. 

In fact, the Administration has had it right, Galbraith’s views notwithstanding, just about from Day One.  It had the courage to implement a massive stimulus program last year that probably saved us from unemployment rates at 12 percent or higher.  We are going to have to pay for that program, and the Administration rightly should be judged on how they deal with it.  But if we have the maturity to confront the problem, restoring some fiscal balance is well within our ability.  Moreover, the Administration’s commitment to “financial stability no matter what it took” worked pretty well – the financial system was pulled back from the abyss and the cost of doing so turned out to be far smaller than expected.  It wasn’t pretty, and we’re still waiting for the kinds of financial regulation that restructure the system to prevent a recurrence, but it worked.  And, again, those who characterized their program as insufficient -- some of whom advocated nationalizing the banking system -- were wrong once again.

Galbraith is among the "didn't do enough" group, but he can’t figure out which side of the argument to take.  The risk in the economy isn’t that rates aren’t going to rise – they’ve got nowhere to go but up.  The real risk is that the economy doesn’t grow the way CBO assumes it will, which means that CBO’s forecast isn’t fear-mongering – in fact, it’s unbridled optimism.  If CBO wanted to fear-monger, they could depict a slower economy with smaller tax receipts, more transfer payments, and less wages, capital gains, and corporate profits to tax.  Instead, they’re showing us what happens if the economy returns to trend.

If Galbraith thinks they’re being overly optimistic, then deficits are going to be larger than CBO projects.  So it’s on him to make the case for more stimulus even though our fiscal mess in even worse than he thinks.  But to argue that the deficit is really going to be smaller than CBO says it will, but that the economy is going to be slower at the same time, and for that reason we ought to have a larger deficit right now, is hard to square.  And throwing out CBO with the spring cleaning won’t make it any easier.