Category Archives: Teaching Example

Learning From the Past – Or Maybe Not.

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It looks like we are going to repeat the past.  In this case, it’s 1937.  In 1937 the general discussion in U.S. politics had turned to concerns about debt and deficits.  The conservative view that opposed  both the New Deal and efforts to alleviate the Great Depression began to get the upper hand.  Keep in mind that the economy had not fully recovered from the Great Depression and Great Crash of 1929.  But the economy had been growing some in 1933-36 due largely to the New Deal and government deficit spending.  The spending effort was too weak though and the economy struggled to grow.  By 1937 it still hadn’t recovered to pre-crash levels.  But politicians began to claim that deficits were bad and that all that was needed was “belt-tightening” by government.  The result was disastrous.  The economy plunged downward again and only began to resume a growth path once Europe went to war and started placing orders for food, equipment and materiel.

Sound familiar?  We had a great crash three years ago.  We stopped the downward spiral in 2009 due largely to a federal government stimulus program.  But the program was too small relative to the size of the recession. Worse  yet, the stimulus was 40% made up of tax cuts which in a financial crisis are no help.  Even worse, the federal increase in spending barely offset the decline in state and local government spending.  Result: we stopped the crash. We ended the decline. But there hasn’t been enough true stimulus to really recover.  Now in 2011 the stimulus spending is being withdrawn and government spending is declining.  Government employment is dropping significantly every month, putting a severe drag on aggregate demand.

Even the central bank appears to have lost the history lessons.  Reuters ran a story recently called “That 1937 Feeling All Over Again” (bold emphasis mine):

(Reuters) – Federal Reserve Chairman Ben Bernanke, an expert on the Great Depression, once promised that the central bank would never repeat its 1937 mistake of rushing to tighten monetary policy too soon and prolonging an economic slump.

He has been true to his word, keeping interest rates near zero since late 2008 and more than tripling the size of the Fed’s balance sheet to $2.85 trillion. But cutbacks in government spending may end up having a similarly chilling effect on the economy, and there is little Bernanke can do to counter that.

Back in 1937, the U.S. economy had been growing rapidly for three years, thanks in large part to government programs aimed at ending the deep recession that began in 1929.

Then the central bank clamped down hard on lending, and federal government spending dropped 10 percent. The economy contracted again in 1938. The jobless rate soared.

“Regarding the Great Depression. You’re right, we did it. We’re very sorry. But thanks to you, we won’t do it again,” Bernanke said back in 2002 at a conference honoring legendary economist Milton Friedman’s 90th birthday.

Bernanke convenes the Fed’s next policy-setting meeting on Tuesday, facing growing concern that the United States may be slipping into another recession while Europe staggers toward a deeper debt crisis. Standard & Poor’s decision on Friday to lower the U.S. credit rating adds yet another element of uncertainty.

His options are limited.

Nigel Gault, chief U.S. economist at IHS Global Insight, said the Fed could promise to keep interest rates near zero or its balance sheet swollen for even longer than investors anticipate. Or it could buy even more U.S. government debt.

“It is hard to see any of these options as ‘game changers,’” Gault said. “The Fed would be doing them not because it could be sure they would make a huge difference, but because it would feel the need to do something.”

Gault put the odds of another recession at 40 percent.

…

“Having said that, there are still plenty of headwinds, like Europe. I am also very encouraged to see the upward revisions to the previous months. This report pulls us back from the ledge a little bit.”

HITTING A POTHOLE

Full employment is one of the Fed’s prescribed goals, and it is clearly falling short. Government spending cuts are making matters worse. Friday’s employment report showed a net loss of 37,000 government jobs last month.

State and local governments with balanced budget rules had little choice but to cut jobs in order to make ends meet. The federal government has no such restriction, but its spending outside of defense fell at a 7.3 percent annual rate in the second quarter, crimping economic growth.

Michael Feroli, an economist with JPMorgan in New York, said he had held out some hope that Congress would approve some form of additional fiscal support in the coming months, but the debt ceiling fight showed lawmakers dead set against that.

“It now looks likely that growth could hit a pothole early next year,” Feroli said.

 

And as we all witnessed with the debt-ceiling debate fiasco, both parties in Washington D.C are battling to see who can be seen as the budget cutter.  It’s 1937 all over. Let’s

Fracking Can Contaminate Drinking Water

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We should have learned from decades of lying by tobacco companies, but we don’t.  Oil and gas companies have been lying about the “safety” of hydraulic fracturing, “fracking”, of oil and gas wells.  From the The New York Times:

“There have been over a million wells hydraulically fractured in the history of the industry, and there is not one, not one, reported case of a freshwater aquifer having ever been contaminated from hydraulic fracturing. Not one,” Rex W. Tillerson, the chief executive of ExxonMobil, said last year at a Congressional hearing on drilling.

It is a refrain that not only drilling proponents, but also state and federal lawmakers, even past and present Environmental Protection Agency directors, have repeated often.

But there is in fact a documented case, and the E.P.A. report that discussed it suggests there may be more. Researchers, however, were unable to investigate many suspected cases because their details were sealed from the public when energy companies settled lawsuits with landowners.

Current and former E.P.A. officials say this practice continues to prevent them from fully assessing the risks of certain types of gas drilling.

“I still don’t understand why industry should be allowed to hide problems when public safety is at stake,” said Carla Greathouse, the author of the E.P.A. report that documents a case of drinking water contamination from fracking. “If it’s so safe, let the public review all the cases.”

This is another example of how very large corporations, with very deep pockets, can use lawyers, lawsuits, the courts and regulators to their advantage and our disadvantage.

The Market Shrugs Off Rating Downgrade, Market Is Worried About Real Economy.

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It’s now Monday morning, Aug 8.  It’s been roughly 60 hours since S&P downgraded the rating on U.S. government bonds.  In that 60 hours the media, particularly TV talking head channels, have been breathlessly awaiting what they felt was a certain market panic on Monday. Clearly interest rates would go up they said.

They were wrong.  The early results are in.   U.S. government bond prices have  gone up this morning!  That means government bond yields (interest rates) have actually gone down!  The 10 year bond actually dropped from 2.6% yield on Friday’s close to 2.48% at 9:30 am ET on Monday.

It’s really no surprise if you pay attention to real economic events and not listen to the TV media types who think talking in serious tones is a substitute for actually understanding economics.  First, serious investors, the ones who vote with their money in the market already know everything that S&P knows.  In fact, they know S&P has a really bad track record. So the rating doesn’t mean much to them.

What does matter is what choices or alternatives they have for investing their money.  Right now, the signs from the real economy in both the U.S. and Europe are grim.  Europe is struggling to achieve any growth outside Germany with several major economies actually declining due to their governments’ embrace of budgetary austerity.  The U.K. is on the ragged edge of another recession, again due to government cutbacks. The U.S. is barely registering postive growth with only 0.8% growth rate in the first half of 2011.  It’s clear, too, from the debt ceiling debate that the U.S. won’t be seeing much stimulus anytime soon and likely will join the Europeans in austerity budget cutting. Cutting that will only slow the economy further and possibly drive another recession.  So what theses investors know is that economic growth isn’t likely and that’s bad for stocks.  Stock markets aren’t the place to be now.

Further, Europe is continuing it’s slow-motion debt default crisis issues.  In the past week or so the crisis has spread beyond Greece, Ireland, and Portugal. Now it’s Italy and Spain too.  Even AAA-rated France is finding it’s bonds trading at significantly raised interest rates.  Now the debt crises in Europe are real problems because the nations inside the Euro zone don’t have control over their own currency, they don’t have a central bank, and they borrow in some other currency (Euro) rather than one of their own.  This is unlike the U.S.  The problem is the uncertainty the debt crises in Europe are creating.  The global financial and economic system is once again showing great signs of weakness, fragility, and uncertainty – just like 2007 and 2008.

When uncertainty abounds and about the only sure thing is that growth will be weak at best, it’s time to put your money in something safe and wait it out.  The safest thing in the world (in any volume) is still U.S. government bonds.  So what we have is investors moving into U.S. government bonds because they don’t want to be in anything else.  Everything else is too risky.  So we get increased demand for U.S. bonds and that lowers interest rates on those bonds. This is what financial analysts and economists call a “flight to safety”.

S and P: Not the Best Judge of Credit-Worthiness

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The media and the talking heads will no doubt make a big deal about S&P downgrading the U.S. debt from AAA to AA and threatening to go to A in 6 months.  But it’s really nonsense. The U.S. it is not possible for a sovereign nation with it’s own currency, it’s own central bank, and that borrows in that same currency to go into default.  I just heard Faux Fox News say this afternoon that this will cause all of us to pay higher interest rates on home mortgages and car loans!  Honestly, where do they get these people?  Fox claimed that your car loan and mortgage are “pegged” to the 10 year government bond rate.  Nope.  Not true.

Anyway, what we should be doing is taking another look at this whole bond-ratings scam.  Standard & Poor’s basically has a business model where they rate bond issues in return for fees paid by the banks selling those bonds.  There’s no reason or need for them to rate government issues except maybe for obscure municipal bonds where the information for an informed decision isn’t easy to come by.

So let’s recap how S&P has done in the past.  My favorite two highlights are Japan and Lehman Brothers.  In Japan, this is how interest rates (yields) on 10 year Japanese bonds have behaved since Jan. 2000:

It was in January 2001, right about when the yield hit it’s peak of 2.0% that S&P downgraded Japanese 10 year bonds indicating S&P thought the bonds were riskier and should pay an interest rate premium.  Kind of looks like Mr. Market and Ms. Investors didn’t agree.  Not having learned their lesson on the economics of sovereign debt, S&P did it again in January  2011 with another downgrade.  I think S&P needs to throw out their models and go back to school.

Now let’s look at the other side.  In September 2008, the day before Lehman Brothers filed for bankruptcy, S&P rated them “A”.  Two weeks later, even though Lehman had already gone bankrupt, S&P still didn’t get it and defended their rating:

“In our view, Lehman had a strong franchise across its core investment banking, trading, and investment management business,” S&P stated. “It had adequate liquidity relative to reasonably severe and foreseeable temporary stresses.”

Source: CFO Magazine

 

 

 

 

 

 

 

 

 

 

 

U.S. Government Debt Downgraded by S&P. What a Farce. And Non-Issue.

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Yesterday after the U.S. markets closed, Standard & Poor’s downgraded their credit rating on U.S. government bonds.  Previously, the U.S. government had enjoyed for over 70 years the highest possible rating:  AAA.  Now it is “only” going to be AA+.  We should note that the other two major bond-ratings agencies, Moody’s and Fitch’s still rate U.S. debt as AAA.  So what does this mean?  Does it reflect poorly on the U.S.?  Not really. It’s all a farce and it reflects poorly on Standard & Poor’s.

There are many reports in the news, especially in local newspapers and by non-economics reporters, to the effect that this downgrade means higher interest rates.  Some have even suggested that everyone in the U.S. including individuals and corporations and states will pay higher interest rates.  That’s all nonsense.  Not only is a national government not like a household or firm, but bond ratings for governments don’t work like credit ratings for individuals. If you credit score as an individual (those things called FICO scores), then when your credit rating is downgraded you pay higher interest rates for car loans, mortgages, and credit cards.  When governments get downgraded, especially from AAA to only AA+, it doesn’t directly affect interest rates.  Government debt interest rates aren’t really “set” by anybody.  Government debt interest rates are the result of market auctions of the bonds.  If demand for the bonds increases, then prices rise.  In bonds, prices are the inverse of the yield, or interest rate.  When prices go up, then interest rates have effectively gone down.

Lately U.S. Treasury yields (interest rates) have been dropping.  They’ve been dropping regardless of whether you compare now to 3 months ago or just 2 weeks ago.  They’ve been dropping regardless of which maturity (3 month, 6 mo, 2, 5, 10,or 30 year) you look at.  This means that bond prices have been rising. That means there is more demand for U.S. Treasuries.  Not exactly the story of default and risk that S&P maintains, right?  Right.

U.S. Treasury Yields

Maturity Last
Yield		 Previous
Yield
3 Month 0.01% 0.01%
2 Year 0.22% 0.25%
5 Year 1.25% 1.13%
10 Year 2.56% 2.46%
30 Year 3.82% 3.72%
Data as of Aug 5 via http://money.cnn.com/data/bonds
So what does this really mean?  The best, clearest, most direct answers I’ve seen are from Wall Street Journal blogger Mark Gongloff.  Here are some of his answers to questions:

Q:What’s the difference between AAA and AA+? That doesn’t sound so bad.

A: It’s not so bad — and there’s not much difference. Technically, AA+ is considered “high grade” credit, while AAA is “prime.” The likelihood of getting paid back by a AA+ credit is considered “very strong,” while a AAA credit’s likelihood of paying you back is “extremely strong.” See the difference? Me neither.

And the U.S. is a special case, given its status as the world’s largest economy and printer of the world’s reserve currency. If your personal credit score falls, then you will almost certainly have to pay more to borrow. The U.S. can get away with a slight credit-rating downgrade without having to pay more to borrow. In fact, many other large, developed economies, including Japan, Canada and Australia, have lost AAA ratings in the past and not had to pay more to borrow in the long run.

Q:Luxembourg is rated AAA. Is the U.S. really a worse credit risk than Luxembourg?

A: No way. Luxembourg is a great country and a perfectly sound credit risk, but it lacks many of the advantages of the U.S., including the aforementioned economy and reserve currency, along with a very large printing press for that currency. If anything, this downgrade exposes some of the other discrepancies in ratings around the world. Should bonds issued by the European Financial Stability Facility, the entity set up to help bail out European sovereigns, really have a AAA credit rating, for example?

Q:Won’t some investors be forced to sell because of even this small downgrade?

A: Maybe, but not very many. Given the liquidity and relative safety of Treasurys, many regulators and money managers put Treasurys in a special category apart from rating considerations. Other managers are considering tweaking their rules to allow them to keep Treasurys.

U.S. banking regulators have confirmed that the downgrade will not force banks, which have big Treasury holdings, to raise any more capital as a cushion against losses. Short-term Treasury ratings weren’t affected, so money-market funds won’t have to sell

Q:What about foreign investors? Surely they’ll sell.

A: Probably, but they may not sell much. They’ve been trying to diversify their holdings for years, but they keep running up against an impregnable hurdle: They’ve got nowhere else to go. For better or worse, Treasurys are the largest fixed-income asset class in the world, by far, and the likelihood of default is next to nothing. The dollar is, for now at least, the world’s reserve currency, meaning foreign central banks will have to keep buying Treasurys. There’s really no other alternative available.

Q:What is the likely effect on interest rates, then?

A: Very hard to say, given all the cross-currents affecting markets right now. In a perverse sense, this downgrade has come at just about the best possible time for the U.S., despite the turmoil in the markets and anxiety about the economy. Those very uncertainties have driven investors around the world — including foreign central banks — to the safety of U.S. Treasurys, pushing U.S. borrowing costs to nearly their lowest levels in generations. So any increase in rates will come off a very low base. If interest rates rise half a percentage point, for example, that might put 10-year Treasury yields at 3% — still an extraordinarily low rate.

What’s more, the market has been bracing for this downgrade for a while, particularly on Friday, when rumors of it were widespread. It’s possible that most of the increase in yields has already happened. In any event, the history of Japan, et al, suggests that a downgrade might have no long-term impact on borrowing costs at all. Investors will likely respond more to inflation pressures, the direction of short-term interest rates and economic growth than to what one or more rating agencies say.

Remember that S&P are the same folks that told us that bonds backed by sub-prime mortgages were AAA a few years ago.  They are the same people that rated Lehman Brothers debt as “A” the night before Lehman declared bankruptcy. They are the same people that downgraded Japan over 10 years ago and yet Japan still pays lower interest rates on government debt than the U.S. despite having a debt-to-GDP ratio of over 200%, more than twice the U.S.  S&P has no special knowledge of the U.S.’s financial position that you don’t have access to.  They get all their data from the news too.

I really do not expect much direct impact from S&P’s decision on financial markets.  It may cause some temporary churn and increase volatility as a few funds might find they are legally required to sell because they must legally only own AAA bonds, but event that’s not likely.  I’m not alone in my prediction here either. Yves Smith at NakedCapitalism and others share my view.  Fortunately banks have been told that the rating change will not affect how bank capital requirements are calculated. Quoting the Wall Street Journal:

Late Friday, federal regulators said the downgrade wouldn’t affect risk-based capital requirements for U.S. banks—the cushion banks must hold to protect against losses. The Federal Reserve, Federal Deposit Insurance Corp. and other federal banking regulators said in a statement the lowering “will not change” the risk weights for Treasury securities and other securities issued or guaranteed by the U.S. government or government agencies.

If you believe S&P, then you must believe that Luxembourg and Leichtenstein are more secure, more powerful economies with a brighter future than the United States.

Is Debt-to-GDP a Good Measure?

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In a previous post, reader Sergei asks

Hello, I appreciate your article, however, I still wondering what is the meaning of the National Debt over GDP ratio? My numbers based on the US debt clock http://www.usdebtclock.org/index.htmlshow me that this ratio currently around 98%. Could you briefly explain what is the meaning behind this number?

Others might find the answer useful, so I’m making a post out of my response.

The “national debt” is the total money borrowed by the national government. It is the sum total of all the bonds and T-bills that have been issued and still outstanding by the U.S. government regardless of who owns (the lender or creditor) the bonds.  In some cases, one unit of the government such as Social Security owns the bonds which means in effect that one part of the government owes money to another part of the government.  In other cases, the central bank, The Federal Reserve, owns the bonds.  For details on the breakdown on the U.S. debt see here.

For centuries, nations have borrowed money and for centuries, there have been national governments that have found themselves unable to pay back the money or at times to even pay the interest on the money they borrowed.  These events are called “sovereign defaults”.   Economists are interested then in the is How much debt is too much?  Can the government bear the interest costs of the debt?  It is much the same kind of question that a bank asks about an individual when making a loan to an individual.  But there are important differences.

In doing this we are trying to compare the amount of debt to some measure of the government’s ability to make the payments.  The debt-to-GDP measure is simply a percentage number using total debt outstanding as the numerator and the size of GDP as the denominator.  We use GDP as a measure of the government’s ability to pay since a government’s income is taxes.  The taxes that can be collected depend on the total of all economic activity. After all, you can’t collect taxes of $1 trillion from an economy of only $500 billion, but it’s easily plausible to collect $1 trillion in taxes from an economy of $15 trillion. The higher GDP is, the more it is assumed the government has an ability to collect taxes and pay the interest.  Thus when the ratio is higher, it indicates that a lot of debt is outstanding and that implies (but only implies, not requires) a lot in interest payments.  So, it is assumed by many that a higher debt-to-GDP ratio means interest payments are likely a  greater burden and thus the chance of eventual default higher.

Using a debt-to-GDP ratio carries two major advantages over just using amounts of debt.  First, it allows us to compare two different countries regardless of their size.  For example, we can compare a small, little country like Greece which has a debt-to-GDP ratio that’s around 153% to a very large economy like say Germany which is around 84%.  Even though Greece has much, much less actual debt outstanding, it’s debt is a bigger burden on it than Germany’s debt is for Germany because Germany has a bigger economy and more ability to pay. Second, using the ratio allows us to compare debt levels of a country from different years.  Debt may be growing in dollar terms but becoming less of a burden because the country’s GDP is growing faster.  This was the experience of the U.S. since World War II.  In WWII debt-to-GDP reached 112%.  Ever since then, the U.S. has had an increasing debt because it almost always ran a budget deficit.  But the debt-to-GDP ratio declined from 1948-1981 because the economy grew so fast.

Why There’s So Much Attention to the Ratio In Recent Years

I’ll let noted economist Robert Shiller explain in his article in Japan Times (btw, this is an excellent, easy to read article – I recommend reading it):

A paper written last year by Carmen Reinhart and Kenneth Rogoff, called “Growth in a Time of Debt,” has been widely quoted for its analysis of 44 countries over 200 years, which found that when government debt exceeds 90 percent of GDP, countries suffer slower growth, losing about one percentage point on the annual rate.

One might be misled into thinking that, because 90 percent sounds awfully close to 100 percent, awful things start happening to countries that get into such a mess. But if one reads their paper carefully, it is clear that Reinhart and Rogoff picked the 90 percent figure almost arbitrarily. They chose, without explanation, to divide debt-to-GDP ratios into the following categories: under 30 percent, 30 to 60 percent, 60 to 90 percent, and over 90 percent.

And it turns out that growth rates decline in all of these categories as the debt-to-GDP ratio increases, only somewhat more in the last category.

There is also the issue of reverse causality. Debt-to-GDP ratios tend to increase for countries that are in economic trouble. If this is part of the reason that higher debt-to-GDP ratios correspond to lower economic growth, there is less reason to think that countries should avoid a higher ratio, as Keynesian theory implies that fiscal austerity would undermine, rather than boost, economic performance.

The Problems With the Ratio

One major problem with the ratio is that people misunderstand it, as Shiller explains.  Many people think that a ratio of over 100% means the country is insolvent or bankrupt.  That’s false and a fallacy.  Many mainstream economists claim to be uncomfortable with ratios of over 90%, but that’s purely an arbitrary pick that reflects ideology more than economic experience.  Japan, for example, has been running a ratio of well over 200% for a decade with no signs of default.  In fact, investors think the Japanese government and economy are solid enough that the Japanese government borrows money at the lowest interest rates in the world.

Another very serious problem with the ratio is that when the ratio goes up, people assume it is because of deficit spending and borrowing.  In reality, most times when ratios go up it is because a recession or austerity program has shrunken the size of the economy and GDP.  For example, since 2007 the U.S ratio has gone up a lot.  But most of the increase has been because of the decline in GDP, not because of the stimulus spending program.

Finally, the last problem with measure is the very idea that it measures likelihood of default.  The empirical data on the relationship is weak.  Most importantly, default really happens when the debt-to-GDP ratio goes up AND the country borrows in somebody else’s currency (like small developing nations) AND the country has either fixed exchange rates or a gold standard.  These conditions apply to those nations that are part of the Eurozone – the countries that use the Euro as their currency.  These conditions also apply to many smaller developing nations.  These conditions absolutely DO NOT APPLY to large developed nations with their own currencies such as the U.S., U.K., Canada, Japan, Australia, Switzerland, and many others.

So, overall, the ratio is actually a pretty poor measure.  It’s useful in some esoteric technical econometric studies, but as a guide to whether the nation should cutting spending or not, it’s a horrible measure.

For the reader who is curious, data comparing different countries debt-to-GDP ratios can be had from the CIA Factbook here.

Economicshelp.org offers some graphics comparing these concepts for the U.S. historically:

There are different ways of measuring US National debt.

Firstly, there is the actual value of debt. This shows that (even adjusted for inflation) the value of debt has increased significantly over the years

  • In 1900, US debt was $43.6bn (2005 prices)
  • In 1945, US debt was $2347.41 bn (2005 prices)
  • In 2010, US debt was $12032.28 bn (2005 prices)

Though there were a few periods in the 1920s, 1950s and 1960s when the real value of debt was actually being reduced.

gross debt / public debt

from: wikipedia US Debt

The Public debt is the US debt held by private sector.
Gross debt includes debt that the government holds itself.

 

But What About National Debt-to-GDP Ratio? Not a Problem, Really

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In the comments to my post on the extraordinarily weak 2nd qtr 2011 GDP numbers a reader asks for my thoughts about debt-to-GDP ratio and “how can we afford more stimulus”?  Since my response will be a little long and others might be interested, I’ll post it here.

Reader AZLeader asks:

Here are some other GDP indicators I’d value your comments on…

Government spending now is somewhere around 28% of GDP, well above the 60 year average of 18.6% or so.

Spending as a % of GDP is indeed up, but it’s not primarily as a result of discretionary spending going up.  In other words, the so-called Stimulus spending bill didn’t do the damage.  The ratio is up in large part because the denominator (GDP) shrunk.  We lost a huge chunk of GDP.  That has a double effect on the ratio.  When the economy goes into recession and doesn’t recover it reduces the denominator by a big chunk.  But a recession also automatically increases government spending through automatic stabilizers.  Spending on unemployment compensation, welfare, Medicaid, SS disability claims, etc. automatically increases, thus increasing the numerator as well.

Krugman shows this graph from the St.Louis Fed using non-partisan Congressional Budget Office data that compares the changes in spending to changes in the potential GDP over 60+ years.  Potential GDP is the GDP that would be produced if we were at full employment.  It indicates our capacity to produce if we choose to put all our resources (labor) to work.  Any value that’s above 1.0 indicates that spending is rising faster than potential GDP. A value less than 1.0 indicates that spending is might be increasing in total dollars, but it’s increasing less than what the potential GDP is.  When the value is less than 1.0 it means that government spending is having a contractionary effect on the economy. As you can see, the issue in the last few years is that despite the increase in dollars of spending, it’s been peanuts compared to the damage done by the banks’ financial crisis and the ensuing recession with high unemployment.  This part of the reason why I’ve (and a lot  of others) have said the stimulus program was too little and too short.

Government deficit spending last year was about 10.9% of GDP, way over the sustainable comfort level of 2.6%.

There’s two issues here.  First, There’s nothing that says 2.6% deficit as % of actual GDP is “sustainable” and greater than that isn’t.  ”Sustainable” in the sense that we can operate at that level indefinitely might be less than 2.6% or it might be greater than 2.6%.  For private sector entities (you,me, households, corporations, state governments) there’s a real meaning to “sustainable”.  But that’s because ultimately our spending ability is limited by the combination of our earning and borrowing ability.  Borrow too much and eventually lenders say “I don’t think you can pay it back, so pay higher interest rates, the debt begins to spiral up, etc.”.  But for a sovereign national government that creates it’s own currency, borrows using bonds denominated in that currency, and doesn’t strap itself to some fixed exchange rate system (like gold standard), there is no financial limit to the borrowing.  All of the nations that are having debt crises now (or in the past) have either strapped themselves to somebody else’s currency (Greece & Ireland with the Euro, Argentina in 2000 with the dollar) OR they borrowed their money in somebody else’s currency (less developed countries borrow in $ not their own currencies) OR they have  a fixed exchange rate (under the old gold standard 80 years ago).

What matters for “sustainability” is the ability of the economy to produce.  Does it have the  real resources to produce what the government is willing to spend on?  In this sense we see that even a 1-2% deficit-to-GDP ratio might be too high if we were at full employment and had no excess resources.  But the U.S. today has more than 10% of it’s labor force (even more since many would be workers aren’t looking) sitting on it’s hands doing nothing.

Another way of looking at the sustainability and desirability of deficit spending is to compare the interest rate the government has to pay to borrow now vs. the long-term growth rate of the economy.  If interest rates on government bonds were in the 6-8% range or higher (like in Greece and Italy), then large deficit spending might not be sustainable. But the U.S. is borrowing at near record low interest rates, less than 1% for a year.   Borrow at low rates, spend to invest in those things that grow your economy and get paid back later in larger GDP.

That brings me to my second point on “sustainability”.  The budget, government spending, is dynamic.  What GDP is the greatest determinant of what the deficit actually ends up being.  The budget discussions in Washington about 10 year projections are usually static projections.  They assume they can change the spending amounts while keeping the projected path of GDP the same.  Doesn’t work that way.  Running a large deficit relative to GDP, the kind of stimulus I think we need, will raise the deficit-to-GDP number immediately, but the ratio will then automatically decline. Again it’s the automatic stabilizers mentioned earlier.  As people go back to work and unemployment declines, the GDP rises faster.  Those people also pay taxes, so government revenues increase.  Spending in the form of unemployment comp, welfare, disability payments, Medicaid, etc all drop as people go back to work.  The deficit automatically shrinks relative to GDP.  This was how Clinton managed to produce a narrow government surplus at the end of this second term.  He eliminated the deficit completely.  It wasn’t by cutting spending. It was because the economy grew enough to reach full employment.

Government debt is just under 100% of GDP, the highest level in our economy that we’ve seen since WWII where it briefly spiked well above that.

Yeah, so what? Japan’s debt is around 200% of GDP and has been for over a decade.  Government debt is not like private debt.  It doesn’t have to be paid off. Government bonds are really just like government issued paper currency that pays interest.  This is why banks and investors love government bonds.  It’s a way to hold large amounts of cash and still earn interest.  A growing economy also needs a growing money supply and a growing supply of government bonds.  In the early part of this past decade (I forget the year), Australia was running a surplus for a few years.  It was paying down it’s national debt.  The bankers went to the Australian Treasury and the Australian central bank and asked the government to borrow and issue bonds anyway because they needed a larger volume of bonds in existence in order to run the banks.

Through “Intergovernmental Holdings” the U.S. government owns about 1/3rd of its own debt.

Yes.  $4.6 trillion, approximately 1/3,  of the $14.3 trillion total US government debt is “owned” by various other parts of the government.  The biggest chunk is the Social Security trust fund, $2.7 trillion.  The rest is in various other government “trust funds” such as Railroad employees retirement fund, government employees pension plans, highway building trust fund (paid by gas taxes), etc.  These funds reflect special taxes or fees that have been collected that are by law dedicated to a particular purpose, but the government hasn’t spent the money on that purpose  yet.  The accumulation of money in these funds (think of them as pre-payments of special taxes) must by law then be “invested” in the safest interest bearing assets available, which happen to be U.S. government bonds.  Let’s take a brief look at one of these funds: the Social Security trust fund.  The way SS works, dedicated SS payroll taxes are collected each month to pay for this month’s benefits.  (FICA taxes).  Obviously we want benefits to be relatively constant month-by-month.  Grandma wants to know just how much her check will be next month.  But the payroll taxes collected each month vary greatly. So, by the original law, SS Admin was supposed to make sure it always had enough liquid cash on hand to pay 1 year’s anticipated benefits.  This is the trust fund.  In the 1980′s the trust fund was too low – nearly depleted because benefits had been increased.  So payroll taxes were increased.  When the trust fund had fully recovered (circa 1991), the decision was made to continue to collect extra payroll taxes from workers in the 1990′s and early 2000′s in anticipation of the baby boom.  The current $2.7 trillion trust fund represents way more than the law said was necessary.  It represents the baby boomers having already pre-paid their own retirements.

These intra-governmental bonds cannot be traded on the public market, but they are regular debt obligations of the Treasury nonetheless.  To not pay these bonds is to renege on previous promises that people have relied upon.  It also might not be legal, although that is outside my experise.

In addition to the $4.3 intragovernmental holdings, there’s $1.6 trillion in government bonds held by The Federal Reserve.  These are ordinary bonds that The Fed bought from banks (that’s where banks get reserves).  Any interest paid on these bonds goes to The Fed who then sends it back to the Treasury as Fed profits.  This amount could easily be reduced by maybe 1/2 without consequences.

Given these constraints, where can we get the money to fund spending programs like the “stimulus” to create jobs and recover the economy?

As I attempted to describe above, it’s a fallacy to think of the government as having a financial constraint on it’s resources.  Government (again, a sovereign, fiat money, floating exchange rate, government that borrows in it’s own currency) faces no financial constraint.  Government is not like a household no matter how often misguided politicians say it.  You, I, households, firms, corporations, and state and local governments must obtain cash from either income or borrowing before we spend it.  Government does not face that constraint.  Government defines and creates the reserves that can become our spending money.  It has a monopoly on the creation of money.  And money today can be created as fast a somebody at the central bank can type (although we may not want to create it that fast).

Let’s consider what actually happens when the government spends.  The Treasury writes a check and sends it to a contractor, or SS beneficiary, or someone.  That check is drawn on an account at The Fed Reserve bank.  Let’s suppose you get the check.  You got income from the government. You take the check to your bank, let’s say it’s Chase.  You deposit it in your checking account.  You go out and spend the money by using your debit card to buy dinner, thereby helping to create a job and employ a waiter and kitchen staff.  But what happens at the bank?  Chase takes your check and sends it to The Federal Reserve. The Federal Reserve takes the government check and credits Chase’s account at The Fed.  This creates bank reserves.  The Federal Reserve has no limit on how much bank reserves they can create.  They can create all they want.  In the barbarous old days of the gold standard (before 1971), The Fed would have had to make sure it had enough gold on hand before issuing any reserves.  No such limit now.

So why doesn’t the government just spend endlessly with no limit?  Well, there’s no financial constraint on the government spending, but there’s a real resource constraint.  When the government attempts to increase deficit spending it is in effect placing orders for work to be done, things to be produced, and people to be employed (you do the same thing when you spend).  As long as there are unemployed resources to be put to work, the deficit spending is OK.  It stimulates more activity.  But if there are no idle resources then increased deficit spending will produce inflation because the government would be bidding against everybody else for resources.  At nearly 10% unemployment we have plenty of idle resources and that’s why there’s no threat of inflation despite the worries of those who don’t understand the gold standard ended 40 years ago.

There’s one other aspect of deficit spending that’s important.  This is not the result of theory, but rather is pure accounting.  I’ll just give a very brief mention of it here, but there’s a full tutorial here by Randall Wray.  A one page view of this idea is here.  Basically, government deficits are the mirror of the private sector.  There’s three “balances” that must add up to zero.  There’s the government spending vs. taxes balance, called the budget deficit.  There’s the question of whether the private sector (all households and firms together) are accumulating financial assets.  This is called “net private financial wealth”.  It’s the difference between what our private incomes each year and our private spending.  If we spend less than our income, then we are accumulating net financial assets, or in plain language, we’re putting money away in our bank accounts and investment accounts.  There’s a third balance which is the external capital account balance.  Basically it’s like the private net financial asset accumulation except it records how much foreigners are accumulating U.S. denominated financial assets.  If imports are greater than exports (trade deficit), then foreigners are collecting U.S. financial assets, typically government bonds.

Now there’s no way the private sector can create net any new financial assets. If I loan money to you, yes, I create a financial asset on my books.  But you’ve created an exactly offsetting private debt on your books.  In aggregate, the private sector cannot create new financial assets.  That’s because financial assets are things like money, currency, and bonds.  And they can only be  created by government. They can also be gotten from foreigners by selling more exports than imports, but that ain’t gonna happen anytime soon.  By accounting, these three balances must equal zero.  This means that when the government runs a deficit it creates net financial assets that the private sector can accumulate.  If the government creates a surplus.

In simple language, this means that, assuming we run a trade deficit, that a government deficit means the private sector can accumulate financial assets.  If the government runs a surplus, though, it means the private sector must go deeper into debt itself.  See the answer to question 1 here for another explanation. There’s a dramatic historical graph that beautifully illustrates this relationship over the last 60 years.  Unfortunately, I can’t put my hands (mouse, really) on it right now.  When I find it again I’ll update.  The point is that government surpluses, the kind that the Tea Party and many Republicans claim they want as being responsible, can only happen if the private sector as a whole goes deeper into debt.  It’s private debt that got us into the Great Recession/Financial Crisis, not public debt.  In fact, the Clinton surpluses were a small part of it because to create those Clinton surpluses the private sector had to go deeper into private debt – which we did. It was called mortgages, corporate debt, credit cards, student loans, etc.

A long response, but I hope it was worth it and helps.

Government Budget Cutting SLOWS the Economy – That’s Why It’s Called Contractionary Fiscal Policy

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America’s attention has been focused lately on the unnecessary debate in Congress over the debt-ceiling law.  Part of the motivation (at least the vocalized motivation) for cutting the deficit and trying to limit the national debt, according to both Republicans and the President, is that supposedly government deficits are holding back the economy. They assert that cutting the government’s spending will somehow stimulate the economy.  This is what all that Republican rhetoric about “jobs-killing spending” is about.  In more formal terms it’s referred to as a policy of “austerity”.   But it’s more than flawed thinking.  It’s flat out wrong.  Cutting government spending when there is significant unemployment and excess capacity will not stimulate the economy.  It will cause the economy to slow down and contract further.  That’s why we economists call it “contractionary fiscal policy”.

GDP, the total value of all goods and services produced, is how we measure the economy.  We can count GDP two ways.  Either we add up the total spending in the economy or we add up the total incomes (wages and profits, mostly).  Government spending is part of that spending – close to 25% in fact.  If the government spends less, it means less GDP.  It also means less income for people because what is one person’s spending is another person’s (or business’s) income.

Across the ocean, the British fell for this silly make believe idea that government austerity would create prosperity.  In 2010 they elected a Conservative government (actually a Conservative-New Democrat coalition).  The Conservatives, led by Prime Minister Cameron and Chancellor George Osborne (equivalent of the U.S Treasury Secretary), began to implement sharp cuts in government spending in mid-2010.  The results have been clear.  And bad.  The Guardian reports the results.  The British economy actually shrank by 0.5% in the 4th quarter of last year.  It barely avoided an official recession when growth in the 1st quarter with 0.5% growth. (the Brits define a recession as two negative quarters).  Now the 2nd quarter numbers are in and the economy is basically dead in the water:  0.2% annual growth rate.

 

Yes, contractionary fiscal policy, cutting the budget, is, well, contractionary. It makes things worse.  If you want to reduce government spending, do it when you have full employment, not when unemployment has been running over 9% for more than two years.  The examples are legion. Britain is only one. Three years ago Ireland thought it could budget-cut it’s way out of the Great Recession/Financial Crisis.  It only made things worse and grimmer in the emerald isle.  Austerity is making things worse for Greece.  There’s really no end to the examples.  What’s missing is any evidence from a developed country that austerity when unemployment is high actually helps.

Solar Power Looking Brighter Economically

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John Quiggin of Crooked Timber sends us to Grist.org for “Solar Gets Cheap Fast” for good news about solar power.  The cost of producing solar photovoltaic cells (the silicon-based cells that convert sunlight to electricity) has been declining consistently at 20% per year since the early 1980′s.  Solar power is now close to the point where it is cost-competitive with fossil-fuel (coal, natural gas) and nuclear.  When we consider that any new coal-fired power plants will take 5 years or more to build (nuke even longer), then solar is now in the competitive horizon.  This is great news.

It really shouldn’t be news though.  We should have expected it.  Anytime a new product/technology goes into production, per-unit costs generally decline.  And, they generally decline at a predictable rate.  Two micro-economic phenomena combine to produce this predictable declining cost curve.  The first is often described in principles textbooks (although often over-stated):  economies of scale.  As production volumes get larger, often (not always) per unit costs decline because cheaper production technologies become feasible – it’s the phenomenon of mass production.  But another curve is involved.  It’s called an experience curve. Basically an experience curve summarizes how, even with using the same scale technology, as producers get more cumulative experience with producing the item, they produce it more efficiently.  In plain talk it’s called learning-by-doing.  It’s a staple of many business strategies, particularly in electronics.  While the specific improvements aren’t foreseeable ahead of time, the fact that costs will decline is predictable.  In other words, it’s predictable that we will learn.

Socially and economically, the arrival of wide-scale solar electricity generation is a good thing.  Solar electricity generation doesn’t create green house gases or other pollutants. It can be more effectively decentralized, relying less on huge power plants. The systems involved aren’t dependent on the kind of complex safety systems that make nuke power and coal dangerous. It doesn’t require a huge distribution and logistics network to mine/drill and transport a scarce natural resource like coal or gas.  And, solar installations can do double duty.  Unlike growing plants for bio-fuel or strip mining for coal, solar can be generated on top of existing buildings.   Critics often claim that solar is unreliable because “the sun doesn’t always shine”.  But solar system fit well with the demand for electricity.  Demand for electricity peaks in summer when the sun shines the most (think air conditioning). So the condition that creates peak demand for electricity is exactly the condition that generates solar power.  Further, newer solar systems are increasingly capable of generating electricity (albeit not as much) from just daylight even when bright sunlight is not present (does your solar-powered calculator stop indoors?).  Personally I’d rather trust the sun to rise each  day and provide daylight than to trust that engineers have perfect control of the safety of an inherently dangerous and polluting power plant (Fukushima anyone?).

The arrival of cost-effective solar power is also an object lesson in why government subsidies are often justified for new technologies.  Often, when new technologies are invented, the costs (“business case”) are too high to be practical or competitive with existing alternatives, despite the conceptual attractiveness.  We have a “new technology chicken-and-egg”.  Private investors and private firms won’t touch the new technology because it will take too long for costs to decline to a point where they can make the kind of high returns they want.  It’s too risky for them and too-long range.  Private investors and corporations really don’t think very long term.  But, until somebody actually begins producing the item we don’t gain the benefits of economies of scale or learning experience.  It’s at times like this that governments can play a great role.  Governments, by borrowing at the lowest interest rates, can take the long-run view.  They can invest because the benefits will be social and benefit the larger economy later.  Governments have, in fact, been key to creating new technologies and economic growth throughout the last several hundred years.  The telegraph, the telephone, electrical generation/distribution, canals, railroads, improved ocean navigation, computers, networks (including the Internet and World Wide Web that brings you this story), automobiles, aircraft and airlines — all these were dependent upon government early on and would not have happened had it not been for government.

That’s not to say government should always own, operate, and scale up the businesses that do it.  There’s a variety of mechanisms for government to seed and feed new technologies.  But that’s a different discussion.

We’ve Had Class Warfare Since 1980 – The Workers Lost

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Whenever some politician, typically a progressive, begins to talk about redistribution of income,  the more conservative politicians, backed by “serious political pundits” counterattack by claiming “class warfare”.  It’s apparently one of the givens in Washington that any form of redistribution of income, be it by progressive taxes, measures to protect unions, help to the unemployed, or limits on the power of bank executives to pay themselves bonuses from bailout monies, is off-limits.  The problem with this self-censorship of the political debate is that it ignores reality. Class warfare was already launched 30 years ago in the early 1980′s.  The catch is that capital, that is the owners and managers of capital, declared the war and they’ve been winning.


As the graph shows, the share of non-farm income that goes to labor was relatively constant for the 30-some year “golden age” after World War II and until around 1980. It fluctuated significantly with the business cycle, but maintained a long-run relatively constant share. This was consistent with the institutional, cultural, and political economy arrangements of the period. There was essentially a social contract that said labor cooperated with capital to achieve productivity improvements with the understanding that gains would be shared: both workers and owners of capital would benefit. This is basis of the rising real median incomes that I’ve noted elsewhere for the period.

But starting in the 1980′s there was  a shift in American politics.  Initially it was with conservatives and Republicans, but it soon included Democrats. Capital came to be favored. Unions were disfavored. Income taxes were lowered on high incomes while payroll taxes (social security and Medicare) were raised on workers.  The result was a trend where workers found it difficult to keep pace.  In fact, their real incomes didn’t.  If workers were in the lower quintiles, their real incomes actually declined.  Starting in 2000 the trend accelerated.  Workers get less and less of the value of what’s produced.  Corporate profits and financiers get more and more.

Instead of false debates about debt ceilings based on provably false doctrines, I think this is the type of thing we should be debating in politics.  Is this good? I don’t think so. It feeds income inequality.  It’s part of what’s destroying the “American Dream” for hundreds of millions of Americans.