Monetary policy looks to be at a protracted standstill - or even arguably becoming less accommodative as purchases of long dated securities draws to a close - despite incoming information that points toward persistently high unemployment rates and an ongoing disinflationary environment. Is policy stability the consequence of changing economic conditions, a perceived ineffectiveness of nontraditional policy, or a willingness of policymakers to be constrained by conventional policy limitations in the absence of impending financial doom? My sense is that all three elements are in play.

It is pretty clear that economic conditions changed dramatically mid-year as inventory correction and policy stimulus brought the recession to a close, at least if measured by growing output. To be sure the sustainability of the gains are in question. I hold little hope that growth could be sustained in the absence of the policy efforts to date, and the Administration is likely starting to realize that it underplayed its hand this year, offering far to little stimulus to effect stabilization from the all important jobs perspective. Calculated Risk sees growing potential for a second stimulus package (in spirit if not in name), the support for which will gain as concerns about midterm elections grow. Still, from the perspective of monetary policymakers, positive growth after such a long recession could only be met with a sigh of relief and, perhaps inevitably, a willingness to pause and assess the implications and impact of policy to date.The problem with pausing, however, is that a combination of maximum sustainable growth and price stability are in fact the Fed's objective, we seem to be falling short on both measures. Unemployment continues to climb, nonfarm payrolls continue to fall, and core-PCE inflation continues to decelerate. Moreover, Fed forecasts suggest that these trends will continue for literally years. Leaving aside inflation fears that seem to be largely contained in a handful of what I think are crowded trades (gold and TIPS), what should the Fed be doing on the basis of actual, incoming data? Have they truly hit the limits of policy? This brings be to an ongoing debate between Paul Krugman and Scott Summner, with the recent participation of Joe Gagnon.

A starting point for further analysis is Krugman's assertion that conventional policy has been brought to a standstill. Zero is zero:

I keep seeing economics articles and blog posts that insist that we’re NOT in a liquidity trap (and, of course, that yours truly is all wrong) because the situation doesn’t meet the author’s definition of such a trap. E.g., the interest rates at which businesses can borrow aren’t zero; or there are still things the Fed could do, like buying long-term bonds or corporate debt, or something.

Well, my definition of a liquidity trap is, purely and simply, a situation in which conventional monetary policy — open-market purchases of short-term government debt — has lost effectiveness. Period. End of story.

Now, if you prefer a different definition of a liquidity trap, OK; call our current situation a banana, instead. But changing the name does not change the essential fact — namely, conventional monetary policy has lost effectiveness.

The loss of conventional monetary tools led Krugman, and many others, to conclude that stimulus efforts should focus on the fiscal side of the equation. In response, Scott Sumner has long argued that more aggressive monetary expansion was needed, to which Krugman replies that at zero rates, more money is ineffective at stimulating output:

A dozen years ago I would probably have agreed. But way back in 1998 I tried to think my way through Japan’s situation with a little intertemporal model, and surprised myself with the conclusion: under liquidity-trap conditions, it doesn’t matter at all what happens to M.

In that model, prices are assumed sticky in the short run, so P is predetermined. What, then, determines Y? Well, it’s a real thing — as opposed to a nominal thing. In the model it’s actually tied down by an Euler condition, by future consumption and the real interest rate (which is stuck thanks to the zero lower bound). Monetary policy has no traction at all against the right hand side of the equation.

Now, the equation still holds. But all that tells us is that any changes in the money supply are offset one for one by changes in velocity. Focusing on nominal spending makes you think that low nominal spending is the problem, a problem with a monetary solution; but actually it’s the symptom, and monetary policy doesn’t matter (unless it can affect expected future inflation, but that’s another story).

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Aid Watch has a stubborn attachment to excellent but possibly hopeless causes…

Madagascar, a country we first blogged about in June and then again in August, may be down to its last few days as regards AGOA, the US preference program that underpins about 50 percent of the country’s $500 million textile industry.  Because of the change of government that took place in Madagascar in March, the US has been steadily threatening to suspend its AGOA eligibility unless the country returns pronto to constitutional government.  A committee consisting of representatives from State, Commerce, Labor, Treasury, USAID, the NSC and the USTR has been deliberating for several days on whether Madagascar’s transgressions merit suspension from AGOA.

With little likelihood that egregious democracy and human rights violators like Gabon and Angola will be suspended from AGOA, it’s hard not to be cynical about why Madagascar has come under such scrutiny for a regime change in which a highly experienced kleptocrat was replaced by a less experienced one.  Or why, suddenly, there is such concern about a return to constitutional government when it’s not at all clear that Madagascar’s leaders over the last 40 years have ever placed the interests of their people above their own.  We can be fairly sure that if Madagascar were pumping oil instead of just looking for it the country’s AGOA status would not even be under consideration. Still, we’re going to try not to be cynical.

We don’t know WHAT the AGOA eligibility committee on Madagascar is talking about. (The committee doesn’t actually make the final decision on AGOA.  They make a recommendation to the president who typically announces who’s in and who’s out around Christmas time.)  But we imagine the discussion breaks down in two ways.  On one side, there are the idealists who believe that the AGOA goals of promoting democracy and good governance will never be achieved unless the US gets serious about sanctioning individuals who overthrow democratically elected governments.  After seeing Madagascar’s political leaders backslide, prevaricate and just plain lie about their intentions in on-going negotiations brokered by the AU, SADC and the UN, the idealists are skeptical about whether these leaders – none of whom is a poster child for good governance – are serious about resolving their long standing differences.  The idealists are probably right.  These political adversaries, who have overthrown one another like kids playing leapfrog, despise each other.  We can expect that, AGOA or no AGOA, political friction, back-stabbing and jockeying for position will continue in Madagascar for years to come – just like in most countries.

On the other side of the committee table, there are the realists who recognize that cutting off AGOA is unlikely to have any effect on those behind the overthrow of the previous government but will vaporize millions upon millions of dollars of foreign investment in Madagascar, some of it by US companies, and dump tens of thousands of young female workers trying to feed their kids into the streets.

So what to do?  Cancel AGOA in support of a principle that will do nothing to advance good governance in Africa, or continue it and support workers and investors who had nothing to do with the whole business?  Forgive us for our presumption that this is a fairly obvious call.

This is an interesting test of whether independent observers who actually care about Madagascar have any effect on US government decisions in our democracy, or whether the departments concerned simply act with impunity to pursue their own interests and agendas. The rest is up to you, most esteemed AGOA committee.

Opinions and comments on RGE EconoMonitors do not necessarily reflect the views of Roubini Global Economics, LLC, which encourages a free-ranging debate among its own analysts and our EconoMonitor community. RGE takes no responsibility for verifying the accuracy of any opinions expressed by outside contributors. We encourage cross-linking but must insist that no forwarding, reprinting, republication or any other redistribution of RGE content is permissible without expressed consent of RGE.   

As everyone knows by now, Neil Barofsky, special inspector general for TARP, has a new report out on the decision by the Federal Reserve Bank of New York last Fall to make various AIG counterparties (primarily some very big banks with names you know) whole on the the CDS protection they had bought from AIG to cover their risk on some CDOs. The potentially juicy bit has to do with the Maiden Lane III transaction (New York Fed summary here).

There are a couple of details I can’t quite reconcile (for example, the Fed balance sheet shows initial funding of $29.3 billion, but everyone says Maiden Lane III paid $29.6 billion for the CDOs), but essentially it went like this. The banks had bought CDS protection on $62.1 billion of CDOs (some of those CDOs they owned — some they did not, meaning those were “naked” CDS*). As of November, the market value of those CDOs was $29.6 billion. At that point, the banks already held $35.0 billion in cash collateral from AIG to cover the difference. (If you have a derivatives contract with someone under which your counterparty may have to pay you a huge amount of money, you generally negotiate a term under which the counterparty has to give you money as the trade moves against him, to protect you from default. In this case, a lot of the collateral came from the $85 billion credit line the Fed gave to AIG in September — otherwise AIG would have gone bankrupt because of collateral calls.)

In the transaction (I’m working off the New York Fed summary), first AIG contributed $5 billion to Maiden Lane III and the New York Fed gave it a $24.3 billion loan. Then Maiden Lane III gave all $26.8 billion to the banks in exchange for the CDOs. (The banks accepted $26.8 billion because  they already held $35.0 billion in collateral; together that makes $61.8 billion — as I said, I can’t get $300 million to reconcile.) Then Maiden Lane III gave $2.5 billion right back to AIG (this is the amount by which AIG had overcollateralized). As part of the deal, the banks agreed to tear up the original CDS on the CDOs, so AIG couldn’t lose any more on the CDS (which, remember, are separate from the CDOs).

The controversy is not over paying $29.3 (or $29.6) billion for the CDOs, since that was the market price. The controversy is over whether AIG should have agreed to settle the CDS at 100 cents on the dollar (meaning that the banks get the difference between the face value of the CDOs and their current market value). Bloomberg reported a while back that prior to the government bailout, AIG had been trying to negotiate a settlement at 60-70 cents on the dollar, but that that portion of the term sheet was crossed out in the final agreement. The implication is that paying the swaps off in full was a back-door, off-the-books way of funneling cash to banks that we didn’t want to fail.

The argument for the NY Fed is that the banks had legal contracts that entitled them to the money. AIG might have been able to negotiate a haircut because it was going bankrupt and counterparties will take less money up front rather than risk getting even less in bankruptcy. However, once the government stepped in, it had no way to abrogate the contracts. The Agonist has a long post with much more detail than I have provided, arguing in conclusion that Federal Reserve Bank presidents are technocrats, and technocrats abide by the advice of their lawyers, which was almost certainly that AIG had to pay off the swaps in full. (He says the mistake was bailing out AIG in the first place back in September.)

Various people have argued, however, that the Fed could have negotiated a better deal. The Epicurean Dealmaker argues that, given the considerable powers of the Federal Reserve and the federal government in general, the banks could have been intimidated into accepting a modest haircut.

Robert Pozen, in his very worth reading book Too Big to Save?, says (p. 79) that AIGFP could have been forced into bankruptcy without putting the rest of AIG into bankruptcy; threatening to put AIGFP into bankruptcy would have provided the leverage to induce the banks to take a haircut. Lucian Bebchuk, a Harvard law professor, argued back in March that because AIG had guaranteed the obligations of AIGFP, this would constitute a default by AIG — but that wouldn’t affect AIG’s insurance subsidiaries, which could stand alone quite nicely (insurance companies get most of their money from customer premiums, not from debt).

I think that given the state of the world in November 2008, paying the banks off in full was definitely the easy choice — it’s always easier to abide by the contract and pay up, especially when you have very deep pockets. And the fact that it helped out the banks as well was probably seen as another argument for it, given the perceived need within the government to bolster the banks’ balance sheets by any means necessary.

* Apparently there is some controversy about this. In an interview, Representative Peter DeFazio said the following:

“Geithner would not answer my question when I said, ‘Were those naked credit default swaps by Goldman or were they a counter party?’ He said, ‘I will not answer that question.’”

From the New York Fed web site:

“AIGFP, the LLC and the New York Fed have entered into agreements with AIGFP’s credit derivative counterparties to terminate approximately $53.5 billion notional amount of credit derivatives and purchase the related multi-sector CDOs. Of these, CDOs with a principal amount of approximately $46.1 billion settled on November 25, 2008. Settlement on the remaining $7.4 billion is contingent upon the ability of the related counterparty to obtain the related multi-sector CDOs and thereby settle with the LLC and terminate the related credit derivative contracts with AIGFP” (emphasis added).

Opinions and comments on RGE EconoMonitors do not necessarily reflect the views of Roubini Global Economics, LLC, which encourages a free-ranging debate among its own analysts and our EconoMonitor community. RGE takes no responsibility for verifying the accuracy of any opinions expressed by outside contributors. We encourage cross-linking but must insist that no forwarding, reprinting, republication or any other redistribution of RGE content is permissible without expressed consent of RGE.  

First there was Medicare for all 300 million of us. But that was a non-starter because private insurers and Big Pharma wouldn't hear of it, and Republicans and "centrists" thought it was too much like what they have up in Canada -- which, by the way, cost Canadians only 10 percent of their GDP and covers every Canadian. (Our current system of private for-profit insurers costs 16 percent of GDP and leaves out 45 million people.)

So the compromise was to give all Americans the option of buying into a "Medicare-like plan" that competed with private insurers. Who could be against freedom of choice? Fully 70 percent of Americans polled supported the idea. Open to all Americans, such a plan would have the scale and authority to negotiate low prices with drug companies and other providers, and force private insurers to provide better service at lower costs. But private insurers and Big Pharma wouldn't hear of it, and Republicans and "centrists" thought it would end up too much like what they have up in Canada.

So the compromise was to give the public option only to Americans who wouldn't be covered either by their employers or by Medicaid. And give them coverage pegged to Medicare rates. But private insurers and ... you know the rest.

So the compromise that ended up in the House bill is to have a mere public option, open only to the 6 million Americans not otherwise covered. The Congressional Budget Office warns this shrunken public option will have no real bargaining leverage and would attract mainly people who need lots of medical care to begin with. So it will actually cost more than it saves.

But even the House's shrunken and costly little public option is too much for private insurers, Big Pharma, Republicans, and "centrists" in the Senate. So Harry Reid has proposed an even tinier public option, which states can decide not to offer their citizens. According to the CBO, it would attract no more than 4 million Americans.

It's a token public option, an ersatz public option, a fleeting gesture toward the idea of a public option, so small and desiccated as to be barely worth mentioning except for the fact that it still (gasp) contains the word "public."

And yet Joe Lieberman and Ben Nelson mumble darkly that they may not even vote to allow debate on the floor of the Senate about the bill if it contains this paltry public option. And Republicans predict a "holy war."

But what more can possibly be compromised? Take away the word "public?" Make it available to only twelve people?

Our private, for-profit health insurance system, designed to fatten the profits of private health insurers and Big Pharma, is about to be turned over to ... our private, for-profit health care system. Except that now private health insurers and Big Pharma will be getting some 30 million additional customers, paid for by the rest of us.

Upbeat policy wonks and political spinners who tend to see only portions of cups that are full will point out some good things: no pre-existing conditions, insurance exchanges, 30 million more Americans covered. But in reality, the cup is 90 percent empty. Most of us will remain stuck with little or no choice -- dependent on private insurers who care only about the bottom line, who deny our claims, who charge us more and more for co-payments and deductibles, who bury us in forms, who don't take our calls.

I'm still not giving up. I want every Senator who's not in the pocket of the private insurers or Big Pharma to introduce and vote for a "Ted Kennedy Medicare for All" amendment to whatever bill Reid takes to the floor. And if this fails, a "Ted Kennedy Real Public Option for All" amendment. Let every Senate Democratic who doesn't have the guts to vote for either of them be known and counted.

Opinions and comments on RGE EconoMonitors do not necessarily reflect the views of Roubini Global Economics, LLC, which encourages a free-ranging debate among its own analysts and our EconoMonitor community. RGE takes no responsibility for verifying the accuracy of any opinions expressed by outside contributors. We encourage cross-linking but must insist that no forwarding, reprinting, republication or any other redistribution of RGE content is permissible without expressed consent of RGE.   

Reader Doug Smith was not happy with an article in the Christian Science Monitor yesterday, titled, “Does US need a second stimulus to create jobs? His remarks:

Could you, Edward or someone consider reading this article and responding to it? My sense is that it perfectly captures ‘conventional wisdom’ and, in that sense, is a bell weather for what our nation is confronting when it comes to just how far conventional wisdom lies from real insight that matters.

I am up to my elbows in alligators right now, and Ed Harrison and Marshall Auerback have offered to take this one on, with Marshall’s reaction below.

As an aside, I have to say it has been a bit disturbing to see readers resort to knee-jerk reactions when they see the mention of deficit spending, and then badly distort the arguments made in support of it. Marshall has repeatedly made the point that a government is not OPERATIONALLY constrained in running a deficit. It faces a PRACTICAL constraint, which is inflation. We are so far from having inflation that those concerns seem badly misplaced right now and for the foreseeable future. And before you point to the massive Fed balance sheet, let me remind you of Japan, which has had massive money supply creation and still remains mired in mild deflation (now to me, that suggests we have wrong policy mix, advanced economies rely overmuch on liquidity creation because it’s easy to do, but that’s another topic).

The second issue is that deficit spending is likely inevitable. If you go into Mellonite liquidationist mode, you see collapsing government revenues versus certain minimum government service requirements, made worse by a vast increase in the debt burden in real terms. So the issue is not fiscal deficit versus no deficit; the issue is how much deficit and how to deploy the funds to maximum effect. Marshall argues for trying to compensate for the fall in private sector demand; other might argue for a lesser goal of simply trying to prevent deflation.

From Marshall Auerback:

“First of all, I’m sort of surprised to hear Simon Johnson say this, as he’s made a lot of very astute comments on the financial crisis, but then again, he is an ex-IMF economist and clearly not well versed in Modern Monetary Theory (MMT).

Obama’s attempts at to using the public sector to facilitate private sector debt deleveraging to date have been pitiful. There has been very little focused on creating jobs and a lot spent on the top-end-of-town. If I was to give his stimulus package a score out of 10 for effectiveness it would be around 3/10. Doesn’t that tell you something about the quality of his advisors and the sort of connections they have and the theories they are using to design policy initiatives?

Why design inefficient fiscal interventions that have benefitted Wall Street enormously despite the fact they create very little real output or employment and then turn around with this lame story that the Chinese are to blame because our citizens voluntarily buy the junk they make?

What we desperately need to do is to increase our deficit by several percentage points of GDP and offer public sector jobs to all those who want one. Government as Employer of Last Resort is one idea I have been pushing (along with Randy Wray, Bill Mitchell and a host of other people). As I said in an earlier post,

The U.S. Government can proceed directly to zero unemployment by hiring all of the labor that cannot find private sector employment. Furthermore, by fixing the wage paid under this ELR program at a level that does not disrupt existing labor markets, i.e., a wage level close to the existing minimum wage, substantive price stability can be expected. Other benefits could be provided, including vacation and sick leave, and contributions to Social Security and, most importantly, health care benefits, providing scope for a bottom up reform of the current patchwork health care system.

Obama’s attempts at deficit expansion to date have been pitiful. There has been very little focused on creating jobs and instead have constituted a massive subsidy to Wall Street, in effect providing a direct financial incentive to reward bad behaviour. In spite of their pitiful attempts at apology, the likes of Goldman Sachs understand that better than most. To aid the recovery, Goldman launched a scheme to help 10,000 small businesses, to which it will donate $500m over five years. Some were left unimpressed; Goldman pulled in at least $82 billion … trading just in the 2nd & 3rd quarters of 2009. It has set aside $16.7 billion for pay and compensation so far this year, according to the NY Times.

Why design inefficient fiscal interventions that have benefitted Wall Street enormously despite the fact they create very little real output or employment and then turn around with this lame story that the Chinese are to blame because your citizens voluntary buy the junk they make? How is a revaluation of the yuan going to bring back jobs to America? China should not revalue, certainly not abruptly. Slow appreciation may be optimal, since it keeps the foreign money in. A big appreciation yields a capital gain, and would precipitate both a profits crash in the export sector (social disaster) and a rapid outflow as hot money cashes in and checks out. It would do nothing for the US current account, since (of course) any loss of competitiveness in China would be taken up by other countries.

At any rate, what we desperately need to do is to increase our deficit by several percentage points of GDP and offer public sector jobs to all those who want one. We thus have to aim to ensure public spending fills the gap left by non-government saving (a consolidated position combining the private domestic and foreign sectors) and keeps aggregate demand growing at such a rate that it provides scope for the private savings desires to be realised without compromising our public purpose goal to ensure there is sustained full employment and inclusive income distribution outcomes.

But by far the majority of the unemployed workers could be offered a minimum wage job to work on community and environmental care projects for as long as they desired. I would suggest we also raise the minimum wage so that everyone has access to decent housing and health care etc. But the ELR scheme would only be offering a wage to workers who have no market bid for their services by definition. It will give them a job, some income security, will add to aggregate demand and help stimulate a broader recovery and, in itself, will not be inflationary.

Consider these facts:

US capacity utilisation rates are around 70 per cent and even lower in Manufacturing. The official unemployment rate was 10.2 per cent in October 2009

The BLS U6 broader labour underutilisation rate is at 17.5 per cent in October … can I repeat that … 17.5 per cent. That, as Ed Harrison has pointed out repeatedly, is a DEPRESSION-like number.

Foreclosures are still rising and are at dangerously high levels in terms of the viability of the overall housing market

“US children face the worst poverty of all in the in Western world”.

Our children are increasingly being fed by food stamps. In some black neighbourhoods “around 90 per cent live in homes that receive food stamps at one stage or another” .

The US Government is a monopoly issuer of the US dollar and is not revenue-constrained The facts I presented above would tell anyone who knows the slightest bit about how our currency operates that anyone who talks about “neutral deficit” outcome at present is an irresponsible lunatic.

The recognition of the national accounting relationships which underpin modern monetary theory are not matters of opinion. These include (but the list is not exhaustive):

That a government deficit (surplus) will be exactly equal ($-for-$) to a non-government surplus (deficit). That a deficiency of spending overall relative to full capacity output will cause output to contract and employment to fall. That government net spending funds the private desire to save while at the same ensuring output levels are high. That a national government which issues its own currency is not revenue-constrained in its own spending, irrespective of the voluntary (political) arrangements it puts in place which may constrain it in spending in any number of ways. That public debt issuance of a sovereign government is about interest-rate maintenance and has nothing to do with “funding” net government spending. That a sovereign government can buy whatever is for sale at any time but should only net spend up to the desire by the non-government sector to save otherwise nominal spending will outstrip the real capacity of the economy to respond in quantity terms and inflation will result.

Note the last point in BOLD. I do not, as the caricatures suggest, advocate completely unrestrained government spending, paying no heed to inflation. BUT INFLATION IS THE CONSTRAINT ON GOVERNMENT SPENDING, NOT A UNINFORMED IDEAS ABOUT ‘SOLVENCY’.

Consider Obama’s claim that “if we keep on adding to the debt, even in the midst of this recovery, that at some point, people could lose confidence in the US economy in a way that could actually lead to a double-dip recession”.

Where did he get that idea from? Did the moronic Larry Summers read it out to you from Greg Mankiw or something? People have already lost confidence in the US economy – that is why they are not spending. That is why your deficit has risen sharply mostly via the automatic stabilisers as your revenue side collapsed.

We don’t need that revenue to allow you to spend. Not in the least. All I am noting is that in an accounting sense, gov’t revenue has fallen off a cliff and our net spending has risen which is a good thing because the automatic stabilisers are not called that for nothing. They start adding to demand as soon as they start working to push our net spending up.

People who think that investors will lose confidence in the US Government and somehow that will stop them spending even more because your spending is helping to put some semblance of a floor into aggregate demand which is retarding the jobs loss somewhat? If you think that tell Larry to close Mankiw for a while and learn something about how your monetary operations actually work.

The other dubious idea is that the government spending gets conflated with some idea of “fiscal insolvency”.

I can certainly see how government overspending creates inflation, but is that what you mean by “fiscal insolvency” in the sense that the inflation represents the de facto default?

That to me is a separate issue.

The inflation would be from too much aggregate demand and a too small output gap.

That would mean that fatefull day would be an economy with maybe 4% unemployment and 90%+ capacity utilization and an overheating economy in general.

Yves here. I have to interject. I imagine some readers will say, “But what about about 1970s stagflation?” We had inflation BEFORE the stagnation. The economy was overheating in the late 1960s. The 1973 oil crisis both kicked up inflation a notch higher (and labor had bargaining power, so wages would rise in response to inflation, creating a self-perpetuating cycle), and businesses and consumer were hit by the combo of not just higher oil prices but also supply uncertainty. Very different facts on the ground here. Back to Marshall:

Sounds like that’s the goal of deficit spending to me- so in fact you are indirectly confirming that deficit spending does work.

And if we do need to raise taxes to cool things down some day, we can start with a tax on interest income if we want to cut payments to bond holders or a financial transactions tax on the “polluter pays” principle.

Regarding the supposed default alternative to inflation, in the full employment and high capacity utilization scenario that might call for a tax increase to cool it down, I don’t see how default fits in or why it would even be considered. So again, I’m confused by the concept of fiscal insolvency, which would only seem to apply if there was an external constraint, such as a currency board, or large quantities of foreign debt.

In fact, with our countercyclical tax structure, strong growth that follows deficits automatically drives down the deficit, and can even drive it into surplus, as happened in the 1990’s. In that case one must be quick to reverse the growth constraining surplus should the economy fall apart as happened shortly after Clinton ran budget surpluses for 3 straight years.

Opinions and comments on RGE EconoMonitors do not necessarily reflect the views of Roubini Global Economics, LLC, which encourages a free-ranging debate among its own analysts and our EconoMonitor community. RGE takes no responsibility for verifying the accuracy of any opinions expressed by outside contributors. We encourage cross-linking but must insist that no forwarding, reprinting, republication or any other redistribution of RGE content is permissible without expressed consent of RGE.    

Barack Obama has now come clean about his thinking on why his administration has decided to focus first on reducing the deficit and next on jobs. He fears a double-dip recession will occur if foreigners lose confidence in the U.S. dollar, causing interest rates to spike. 

This is nonsense and it demonstrates how much at odds Obama’s economic thinking is with reality. This is the clearest indication that the Obama Administration doesn’t understand how modern money works. In fact, by focusing on deficit reduction, he has increased the chances of a double dip instead of decreasing them.

If he wants to reduce deficits, knowing it will precipitate a double dip and would decrease malinvestment. Fine. That’s not my solution, but it is accurate view of the economics.

What Obama actually said

At issue is whether the federal government’s enormous debt burden in the U.S. could cause investors to lose confidence in the U.S. government and shun its debt.

In an interview on Fox News today, the President said the following:

I think it is important though to recognize that. If we keep on adding to the — Even in the midst of this recovery that at some point. People could lose confidence in the US economy in a way that could actually lead to a double dip recession.

Is this really true though?

How deficits really work

Think of an economy this way: the people in any economy buy goods and services from one another and from the outside. In any given time period, one person, one company or one group/sector might use credit in order to buy more goods and services than it makes in income. It’s like spending future income by using credit. This puts that individual, company or group/sector in deficit i.e. they have spent more money than they have earned. Now obviously, if one sector is in deficit in a given period (i.e. they have spent more capital than they have earned), then the other sectors are in net surplus (i.e. they have received more cash than they have earned).

Let’s give these groups/sectors of the economy names: the private sector, the public sector and the foreign sector.  Giving the groups names makes it plain that if the public sector is in deficit, the combined foreign and private sectors must be in surplus.  Simply put, if you look at all of the households and businesses that make up the private sector and aggregate them together, you can determine if the private sector has a net surplus or a net deficit in any individual time period. And if the private sector has a net surplus, the combined foreign sector and public sector must have a deficit for that time period. The sector financial balances move in concert.

What this means for today is that a government which reduces its deficit in a given time period is forcing an equal reduction in surplus in the private and foreign sectors. So that means, in aggregate, the private sector and the foreign sector will reduce the surplus cash it is taking in over what it spends.

Scott Fullwiler has a good graph depicting how the private sector surplus/deficit moves in concert with the public sector deficit/surplus, the difference being the current account deficit:

We can look historically at how these sector financial balances have moved over time. Figure 2 shows how closely the private sector surplus and the government sector deficit have moved historically, which isn’t surprising given they are nearly the opposing sides of an accounting identity. The difference between them, more visible starting in the 1980s, is the current account balance.

Figure 2: Historical Behavior of Private Sector Surplus and Government Sector Deficit as a percent of GDP

Below, I am now providing figure three from Fullwiler’s post at reader request, as it shows the current account deficit as the missing link since the 1980s.

Unless the increasing current account deficit switches direction violently, this can only mean that reducing the government’s deficit reduces the private sector’s surplus. Net-net, the government’s decreased deficit spending will decrease savings in the private sector. And no deleveraging can occur if savings in the private sector are reduced.

Is that what we want? Reduced private savings means continued high private sector leverage. In the U.S., the private sector has much greater debt burdens relative to the size of the economy than the federal government does. You would think we want the private sector to reduce leverage more than the public sector.

Long-term deficit reduction

What I have suggested is long-term deficit reduction.  If the President is concerned about deficits as far as the eye can see, he might want to look at retiree healthcare costs.  In June I said:

Yesterday, I argued that the United States faced a policy dilemma in avoiding debt deflationary forces while maintaining fiscal prudence.  The reality is that President Obama faces political constraints in Washington right now in regards to budget deficits.  He is not likely to get another stimulus package through the Congress unless he can credibly demonstrate a longer-term deficit reduction outlook.  In my view, this necessarily means changes to Social Security and/or Medicare.

But, of course, President Obama is not going to do that because this would mean cutting Medicare benefits, a political loser.

This looks like Hoover more every day

The President just doesn’t seem to understand how the economy works frankly. Reducing deficits by cutting spending or raising taxes decreases aggregate demand. And it is a decrease in aggregate demand which would induce a double-dip recession. So, the President’s logic just doesn’t work.

But what about a strike on U.S. government debt?  As you probably surmised from the above, if the U.S. private sector is increasing its savings, there is automatically a greater domestic bid for U.S. treasury securities.  So, it is a misnomer to say the U.S. is dependent on foreigners, thinking that this must continue. If the private sector saves more, a larger percentage of government bonds will be bought with domestic savings. In Japan, interest rates did not spike when the government increased deficit spending for this very reason.

The only question we have to ask ourselves is whether we want to reduce debt by:

1. The Liquidation Scenario. decreasing aggregate demand and precipitating a major depression in order to liquidate zombie companies and malinvestment. This would cause a massive wave of defaults and decrease debt burdens significantly through bankruptcy and debt repudiation. or;
2. The Glide Path Solution. increasing aggregate demand by maintaining government spending while trying to liquidate zombie companies and malinvestment. This would allow the private sector to decrease debt burdens significantly over time through increased savings. It also has the benefit of reducing dependency on foreign sources of capital. The downside is a major increase in government debt, the spectre of big government and a long muddle through.

As I have said previously, the Obama Administration is doing neither of the above. It has opted for a third Herbert Hoover solution:

• The Hoover Status Quo. decreasing aggregate demand and precipitating a double dip recession in order to reduce government deficits. This would cause a wave of defaults and decrease debt burdens through bankruptcy and debt repudiation. Meanwhile they will try to prop up zombie companies and maintain malinvestment. This would simultaneously prevent the private sector from decreasing debt burdens through increased savings and maintain dependency on foreign sources of capital – all without ending the spectre of big government.

I have advocated the glide path solution. But I see the liquidation scenario as much better than the present path – especially since, with the present course, we are witnessing crony capitalism on a massive scale. The problem with the liquidation scenario is a lower standard of living and the prospect of geopolitical tension, social unrest, poverty, and war.

The Herbert Hoover solution we are now using leads to a Japanese outcome at best or a Great Depression outcome at worst.

Obama: Debt Could Fuel ‘Double-Dip Recession’ – FOXNews.com

Update: I have already addressed the potential for added stimulus in a previous post, “I am now moving from multi-year recovery to a double dip baseline“. I see this as a non-starter because it would mean ‘tax and spend,’ which would jeopardize moderate Democrats who this deficit reduction policy is looking to protect.

Opinions and comments on RGE EconoMonitors do not necessarily reflect the views of Roubini Global Economics, LLC, which encourages a free-ranging debate among its own analysts and our EconoMonitor community. RGE takes no responsibility for verifying the accuracy of any opinions expressed by outside contributors. We encourage cross-linking but must insist that no forwarding, reprinting, republication or any other redistribution of RGE content is permissible without expressed consent of RGE. 

My meetings in NY and DC were fairly different from the meetings I had in February.  This time around I got the impression that far more people in the US (although still a minority) understand how risky the Chinese recovery has been and how trade tensions are likely to result as a consequence of the stimulus.  In fact I have the sinking feeling that over the next two or three years I am going to find myself spending an awful amount of time thinking or writing about trade disputes between China and the rest of the world.Regular readers know that for me the key source of China’s high savings and trade surplus is the large excess of the growth rate in national income over household income, caused in large part, I believe, by policies that systematically transfer income from the household sector to investment, SOEs and large producers.  Until these policies are reversed I do not think it is meaningful to talk about China’s rebalancing.  Just before President Obama came to China President Hu gave a speech which my friend Dan Rosen in his November 13 Rhodium Group report described as a “stirring speech about a policy big bang to promote consumption-led growth.”  Dan is skeptical, and I am adamant – a surge in consumption will not happen except perhaps briefly as a consequence of government subsidies and anticipated consumption.

In Washington I had the chance to meet someone I admire a great deal, Nick Lardy at the Peterson Institute, and although I shouldn’t put words in his mouth so as not to misrepresent him, I am glad to say that he seems to agree with the analysis of Chinese high savings as a consequence of policy-related constraints on household income growth, although he thinks currency undervaluation may have a greater impact on high savings than low interest rates, whereas I think it is the other way around.  In fact more generally I think this argument has become increasingly influential, and more and more analysts seem to be taking it up, both inside and outside China.

In that light I read earlier this week a fascinating and perhaps important article by Hung Ho-Fung in the current issue of the New Left Review, in which he argues that China’s development model has left it dangerously vulnerable to changes in US demand, and that these polices include repression especially of rural income.  According to Hung:

The PRC’s urban-biased development model, then, is the source of China’s prolonged ‘limitless’ supply of labour, and thus of the wage stagnation that has characterized its economic miracle. This pattern also accounts for China’s rising trade surplus, the source of its growing global financial power. However, the low wages and rural living standards that have resulted from this development strategy have constrained China’s domestic consumer market and deepened its dependence on the global North’s consumption demand, which increasingly relies on massive borrowing from China and other Asian exporters. As those other exporters have been integrated with China’s export engine through the regionalization of industrial production networks, the vulnerabilities of the Chinese economy have turned into weaknesses of the East Asian region as a whole.

Hung goes on to make a point that I wish many more would make.  When people like me warn about continuing domestic imbalances within China and the difficulty that China will face in its transition, we are often attacked for “blaming” and criticizing China.  Monday I was at a conference consisting of many prominent European and Chinese (and a few American) analysts who were discussing global imbalances.  At the end of one panel a member of the audience, who turned out to be from the Ministry of Commerce, demanded the right to make a rebuttal and set off on a fairly strange harangue in which she lambasted, to everyone’s bemusement, any attempt to assign China responsibility for any aspect of the crisis as well as any suggestion that its fiscal stimulus was worsening the underlying imbalances.  China has not, apparently, made even minor policy mistakes at all in the past decade and especially in the past year.

The nationalist argument

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This excerpt comes from the blog News from 1930 which gives us a day-to-day account of what was being reported in 1930 before the worst of the Great Depression hit.

“The unemployment situation in New York is critical. Unless it is speedily met, we face a winter of hunger and distress for families whose bread-earners are without work and without funds. The great majority of family men now unemployed are asking not for charity, but for a job. In the richest city of the world, where the vast majority are at work, it is unthinkable that anyone should be permitted to starve. The Emergency Employment Committee is composed of New York business and professional men, formed at the request of experienced welfare organizations of the city. It is raising funds which will be used by these organizations to give temporary work to heads of families and to relieve distress caused by unemployment without regard to race, creed, or color.” Followed by endorsement from Pres. Hoover and appeal for funds.

Sen. Smoot denies tariff is retarding business recovery, says it has saved thousands of jobs and helped maintain wages and preserve farm purchasing power; points out only one country has increased its tariff since US adopted revisions; says question now is whether tariff is high enough, not whether it is too high.

I find the parallels to present day frightening to say the least. Let’s hope for some serious divergence.

Opinions and comments on RGE EconoMonitors do not necessarily reflect the views of Roubini Global Economics, LLC, which encourages a free-ranging debate among its own analysts and our EconoMonitor community. RGE takes no responsibility for verifying the accuracy of any opinions expressed by outside contributors. We encourage cross-linking but must insist that no forwarding, reprinting, republication or any other redistribution of RGE content is permissible without expressed consent of RGE. 

How can the stock market hit new highs at the same time unemployment is hitting new highs? Simple. The market is up because corporate earnings are up. Corporate earnings are up because companies are cutting costs. And the biggest single cost they’re cutting is their payrolls. So they let people go and, presto, their balance sheets look better and their stock prices rise.

In the old-fashioned kind of recession decades ago, big companies laid off people with the expectation of rehiring them when the economy turned up. Then a few recessions back, companies started laying off people for good, never rehiring them even when the economy recovered.

In the Great Recession of 2008-2009, companies are going a step further. They’re using this sharp downturn to cut payrolls even below where they were when times were good. Outsourcing abroad, setting up shop in China and elsewhere, contracting out, replacing people with software and automated machines – they're doing whatever it takes to get payrolls down so earnings bounce up.

Caterpillar earned $404 million in the third quarter, or 64 cents a share. Analysts had expected only 5 cents. Caterpillar’s stock is up 165 percent since March. How did Caterpillar do it? Not by selling more bulldozers. It did it by cutting over 37,000 jobs.

The result, overall, is an asset-based recovery, not a Main Street recovery. Yes, the economy is growing again, but the surge in productivity is a mirage. Worker output per hour is skyrocketing because companies are generating almost as much output with fewer workers and fewer hours.

The Fed, meanwhile, has become an enabler to all this, making it as cheap as possible for companies to axe their employees. Money costs so little these days it’s easy to substitute capital for labor. It’s also easy to buy up foreign assets with cheap American money. And it’s now blissfully easy for Wall Street to borrow money almost free and buy all sorts of interests in foreign assets, especially commodities. That's why we're seeing the prices of foreign commodities and other assets go through the roof.

At the same time, the Treasury continues to be fixated on keeping banks afloat. The Administration's mortgage mitigation efforts are lagging. Small businesses are starved of credit. The White House has announced a "jobs summit," which is better than nothing but not nearly as good as pushiing immediately for a larger stimulus, a new jobs tax credit, and a WPA-style jobs program.

The Fed and the Teasury have, in effect, placed a huge bet on a recovery driven by asset prices. That’s a bad bet. The great disconnect between the stock market and jobs is pushing stock prices way out of line with the real economy. This isn't sustainable.

No economy can recover without consumers. Yet American consumers, who constitute 70 percent of the U.S. economy, are facing mounting job losses as well as pay cuts. They’re in no mood to buy and won’t be for some time.

Where is this heading? No place good. Without a major shift in policy -- both at the Fed and in the White House -- the economics point to a big stock-market correction and a double dip. The politics point to substantial losses for Democrats next year.

Opinions and comments on RGE EconoMonitors do not necessarily reflect the views of Roubini Global Economics, LLC, which encourages a free-ranging debate among its own analysts and our EconoMonitor community. RGE takes no responsibility for verifying the accuracy of any opinions expressed by outside contributors. We encourage cross-linking but must insist that no forwarding, reprinting, republication or any other redistribution of RGE content is permissible without expressed consent of RGE.