Posted on 07/08/2009 9:19:30 PM PDT by sickoflibs
A majority of Americans now give President Obama's handling of the economy a negative rating and many economists and city officials are concerned that Obama's gargantuan stimulus effort has not given the expected quick boost to the economy. Some argue this is because funds have been slow in coming due to bureaucratic red tape meant to ensure that the money spent will not be wasted. Jared Bernstein, chief economist for the office of Vice President Joe Biden (who knew that the Vice President needed a chief economist?), is quoted as saying "We're hitting the right balance between speed and oversight." Unfortunately for the American public, sound economics teaches that, regardless of how fast the money is spent or how much oversight is provided by bureaucrats, the money doled out by the stimulus plan will be wasted and will have a detrimental impact on the economy in the long term, because that is the nature of profligate government spending.
From an economic perspective, Obama's stimulus plan is equivalent to a giant welfare scheme. Instead of the money going to lower income Americans, however, it is meant to go to municipal bureaucrats of various stripes. Instead of productive American citizens determining what to do with their own scarce resources, the state is stepping in and dictating how they will be used. Consequently, such spending is essentially government consumption, which is what vulgar Keynesians think we need now more than ever. Such economists are shocked — shocked! — to find out that Americans are now saving any increases in income instead of blowing it on even more consumer goods. Not to worry, however. If private citizens do not consume enough for official tastes, the government always can.
Certainly we can expect that when the government spends a trillion dollars this will provide a positive statistical boost to GDP, if for no other reason that government spending makes up a significant portion of GDP. Where, however, does the state get the money to spend? Ah, as Hamlet might say, there's the rub. There are only three ways the government can obtain funds to throw at all their shovel-ready projects and all three leave in their wake negative economic consequences.
The most obvious thing the government could do to raise the funds to spend on fiscal stimulus is to raise taxes. However, this method is the economic equivalent of robbing Peter to pay Paul. Taxation directly impinges on taxpayers' well-being because they are left with less income from their labors with which to provide for themselves and their families.
Additionally, taxation reduces prosperity in the long run, because it fosters capital consumption over time. Taxation reduces the ability to save and invest in capital, because savings come out of income and as people have less income at their disposal, they have less to save and invest. Taxation reduces the incentive to invest as well, because future rates of return on any investment will be reduced by taxes on positive income. A project that might have netted 10% without new taxes might only net 7% after taxes. If a 7% rate of return is not an acceptable rate for a specific capitalist, he will choose not to save and invest. If saving and investment decreases over time, capital will be consumed. Labor will become less productive, resulting in lower incomes and less prosperity. Not what you want to happen when trying to get out of a depression.
Because taxes are so politically unpopular, governments usually resort to additional ways to raise funds, one of which is borrowing. A good case can be made that government borrowing is more harmful for long-run economic progress than taxation. Although taxation reduces both consumption and investment spending, government borrowing comes entirely from the nation's pool of savings. The money that is lent to the government in Treasury bond purchases is entirely money that was saved and ready for investment. Instead of being invested in productive capital accumulation, however, it is being lent to the government to fund state consumption. When the government borrows, it becomes a major demander of loanable funds, so market interest rates increase, making it harder for private entrepreneurs to gain access to capital for their production. As private capital available for productive enterprise shrinks, our economy becomes less productive and less prosperous.
The other source of funding turned to by the government is monetary inflation. Governments can either create money and spend it outright or they can inject money into the economy through the banking system so that people and banks can use this new money to buy up government bonds, thereby monetizing the debt. This route is preferred by governments who want to borrow more money without all those nasty rate increases.
Monetary inflation produces another set of negative economic consequences. In the first place, when the government increases the money supply, in general people hold more money than they want to at prevailing overall prices. They relieve this excess supply by spending the excess money on consumer and producer goods. Increasing the money supply does not spontaneously increase the stock of these goods; it merely increases the amount of money being spent on the same quantity of goods. Because more money is spent, the demand for producer and consumer goods increases, so overall prices increase and the purchasing power of the dollar falls. There is, therefore, no general social benefit from inflation.
In fact, monetary inflation via credit expansion is the source of our present trouble. Artificial credit expansion — credit not funded by savings — creates the business cycle by spawning capital malinvestment. Artificial credit expansion makes many unwise investments (say, in residential and commercial real estate and financial derivatives) look profitable because of the accessibility of cheap credit, so business activity expands, manifesting itself in an inflationary boom. Bad investments, however, are not made economically sound merely because there is more money in existence. These bad investments eventually must be liquidated. The boom resolves itself in a bust whose twin children are capital consumption and unemployment. The moral of the story is that monetary inflation is not a way to sustainably generate economic prosperity.
One thing the government does do, however, by increasing the money supply is discourage saving. This is because, as prices rise, money saved becomes worth less and less, so people are more likely to spend it on present consumption while the spending is good. Promoting consumption is the last thing we need to build up a capital stock that has been woefully depleted thanks to malinvestment. The old economic saw cuts true: there is no such thing as a free lunch, and there is no costless way to fund government spending.
Given that Obama's $798 billion stimulus program is a done deal, the only question is which economic poison will the government pick to drink: taxation, borrowing, or inflation? It turns out that that answer is all three. The government's fiscal response to our current debacle is a near perfect example of what not to do when trying to regain solid economic footing.
While not wanting to be identified as the great tax assessor and, hence, promising to cut taxes for most citizens, Obama is actively seeking ways to increase taxes for a host of Americans. Imposition of a national sales tax is a very live option sitting atop the Obama Administration's policy table. The Administration is also presently considering raising taxes on health care expenditures by taxing employer-provided health care benefits and by decreasing the deductibility of medical expenses. It wants to raise taxes on cigarettes, adult beverages, and sugar-sweetened elixirs such as soda pop, fruit juices, iced teas, and sweetened coffee drinks. Obama has proposed raising corporate taxes by $190 billion over the next ten years. He wants to place heavier taxes on commodities and option traders. Obama even is favorably considering increasing taxes on intangible drilling, an important technique in oil and gas exploration. While taxing these specific groups may be politically doable, it cannot be good for capital accumulation and economic recovery.
It is already conventional wisdom that a huge part of the stimulus program will be funded by borrowing. Who would have thought that in his first year in office, Obama's thirst for red ink would make George W. Bush, himself no foe of government borrowing, look like the frugal presidenté. The U.S. government reported the first monthly budget deficit in an April in over 25 years and a record budget deficit in the month of May. The current year's official deficit is slated to be $1.85 trillion (that's right, trillion)! The good news is that the Obama administration has things under control. They project that next year's deficit will only be $1.25 trillion. When the U. S. Treasury spends over a trillion dollars more than it receives in taxes, it must borrow to fill the gap. In fact, the deluge of government debt has already begun. The national debt has increased by $804 billion in less than five months. Last week alone investors bought $65 billion in long-term Treasury debt.
Not surprisingly, interest rates on Treasury notes have begun to rise. Already this year interest rates on 10-year Treasury Bonds have increased 1.4%, and rates for 30-year fixed mortgages increased to 5.5%, the highest they have been since November 2008. Higher market interest rates indicate, of course, that loanable funds are becoming relatively more scarce and we know that they are being shunted to less productive uses perpetrated by the state. Even Ben Bernanke is publicly confessing concerns that fiscal deficits like the ones being projected for the near future will serve as a serious drag on the economy.
One thing that Bernanke is not concerned about is inflation. Increasing liquidity by expanding the money supply is his drug of choice to prescribe to an ailing economy. From the first quarter of 2008 to the first quarter of 2009, the monetary base increased from $96.2 billion to $820.8 billion, an inconceivable annual rate of 753%. Such a huge expansion understandably sows seeds of fear of hyperinflation. If banks, who are presently sitting on a mountain of excess reserves, began to feel things are closer to normal and begin making loans at pre-2008 quantities (something the government is encouraging) there will be a gigantic increase in the money supply.
Notwithstanding official worries about deflation, Federal Reserve money supply figures reveal that the money stock has already inflated at a noticeably higher rate. The Fed's measure of MZM, money of zero maturity, increased from $8356.8 billion in the first quarter of 2008 to $9385.5 billion in the first quarter of 2009. Additionally, as the table below indicates, the rate of growth in the monetary aggregates accelerated during the last quarter of last year and the first quarter of this year.
As discussed earlier, economic theory teaches us if the money stock increases, overall prices of goods will be higher than they would be without the increase, because demand for goods will be higher due to increased spending. While it is not always easy to distinguish between relative and overall price increases when price changes are occurring, it does appear that prices of many goods have resumed an upward trend. The national average of the price of regular gasoline has increased by 58 cents since the end of April. It has increased $1.01 since the end of last year. Agricultural crop prices have also been rising steadily this year while reserve grain inventories have shrunk to low levels. Robert Murphy has recently made us aware that the non-seasonally adjusted consumer price index increased at an annual rate of 4.3% last month. All of these trends are consistent with the above mentioned monetary inflation and suggests that, as sound economic analysis tells us, the recent monetary inflation has not provided any real help to the economy in general, but is merely serving to spur increased prices.
The moral of the story is that we are right to be concerned that the Obama stimulus plan will not stimulate economic progress and will not usher in the next age of prosperity. Government spending merely directs scarce factors of production away from their most productive uses. Taxation, government borrowing, and monetary inflation all produce negative economic consequences. Real economic expansion is the product of wise entrepreneurs using capital that is funded by real savings. Such economic progress results in more goods that can be purchased for lower prices. As we are seeing play out before our eyes, the only thing that government stimulus plans stimulate is capital consumption and fewer goods available for higher prices — not a recipe for economic recovery.
The surprise is going to be the dollar strengthening. At this point the widely accepted “can’t fail” trade is to bet against the dollar. Buy gold and commodities and foreign currencies. It’s almost as popular a bet as buying real estate was a few years back. Real estate can’t go down. The dollar can’t go up. Until it does.
The refusal of banks to lend is telling us something. I suspect it’s that the destruction of their capital has been much more extensive than most imagine. Unless they start lending the money supply isn’t going to grow. The Fed can inject a trillion dollars into the banking system, but if there is no appreciable lending it’s not going to affect anything. The countervailing force of massive credit destruction is dwarfing the creation of high powered money by the Fed.
In the 70s we had a rapidly expanding money supply and all the lending you could want. There was no credit destruction to offset it. The smart move was to borrow all that you could, and everybody was trying to do exactly that. This went on until Paul Volcker choked off the creation of new credit in order to break the back of inflation.
Stagflation also has an industrial/manufacturing component: capacity utilization will be maxed out. That’s why expansion of the money supply went straight to inflation during the 70s. There was no excess capacity to come online as demand was stimulated. This is why Reagan’s program was designed to shift the supply curve to the right, to increase the production possibility frontier of the economy, so that new demand would let the economy grow rather than simply drive prices higher.
Today we have excess capacity up the wazoo. There are thousands of excess factories being closed down in China, there are thousands of excess retail stores being closed down in the US. This is a much different environment than what existed during the 1970s. I don’t see stagflation in our future. I think we will see prices fall, but so will incomes. In that fashion our standard of living on average will fall.
I understand the credit destruction argument. Assets disappearing and debt relatively constant on bank balance sheets means deteriorating equity. New reserve borrowing will be used by banks, if at all, to restore asset integrity as a balance sheet class. Purchase of Fed bonds and "safe" assets. No real passion to lend to consumers and struggling businesses and risk more asset decay. Asset decay works to constrict money supply, notwithstanding Fed attempts at stimulus by cutting reserve rates, etc. I'm on board so far.
How does this translate into a strengthening dollar? Scarcity of dollars to borrow? What causes the dollar to strengthen against foreign currencies and commodities? Also, I understand the Reagan era supply side stimulus to sop up excess consumer demand. More goods means stable prices. But, here, consumers are pulling back to clean up personal balance sheets. Aggregate demand is down and stimulating supply would be folly. The supply curve is sliding to the (pardon the pun) left at an accelerating pace as companies are slashing costs and going out of business. The Federal stimulus package seems like an irrelevancy as it only creates an artificial bubble in demand. Capital is too smart for that old trick. Who would invest capital and hire labor to meet an artificial demand signal? Not me.
I am haunted by the fear that the world will shun the dollar because of our current economic mismanagement. This will cause huge price increases in imports, and, as most consumer stuff in America is made elsewhere, consumers will pay a higher price for most goods. This could create an inflationary effect akin to the 1970's oil bump where prices kept rising while the economy slugged along. As always, your thoughts are appreciated.
They are sitting on mountains of reserve cash in an attempt to weather the coming storm.
That's the way I see it. To some degree they can't lend, their capital has been too badly damaged. The new cash is needed to restore their capital and isn't free to be loaned.
And those that do have free reserves are wary of lending in this environment. They may hold extra reserves against the possibility of new waves of loan losses.
How does this translate into a strengthening dollar? Scarcity of dollars to borrow?
Yes. The money supply is determined by the willingness of local banks to make loans against their fractional reserves. The Fed can supply banks with high-powered money and encourage them to loan, but it can't make them loan. It's the 'pushing on a string' problem. Think of the Fed's actions as being arithmetic increases in the money supply, and local banks' actions being geometric. The real action is at the local level, not at the Fed level. And at the local level credit is scarce. Even a return to normal lending will seem like a credit crunch after the casino atmosphere of the last decade.
What causes the dollar to strengthen against foreign currencies and commodities?
This is a global credit crisis. Foreign central banks are going to be trying the same tricks that the Fed is trying, with no greater success. The dollar will continue to look better, or at least less-worse, than the alternatives.
Commodities will be driven by demand. They need real demand for price rises to stick. Real demand won't show up until the next upswing in the business cycle.
The Federal stimulus package seems like an irrelevancy as it only creates an artificial bubble in demand.
Yes.
This will cause huge price increases in imports, and, as most consumer stuff in America is made elsewhere, consumers will pay a higher price for most goods.
The big worry continues to be oil and energy. Oil is a huge portion of our import bill. A responsible political class, which we are in no danger of meeting, would be building nuclear reactors and otherwise increasing our electrical supply. This won't solve the problem of vehicle fuel but it would protect the economy to some degree in one of our greatest vulnerabilities.
Shakespearean in quality!
I fear the cost push of import driven inflation ala' the 1970s. oil back then but consumer goods and oil now a days.
I'm stuck on the massive debt thing. Pelham points out we have massive asset destruction on bank balance sheets but the government (state, local and Federal) is piping up massive debt at the same time. I think these offset each other to some extent. But, the decaying assets (bank loans) get written off and disappear. The government debt is a more permanent obligation and I don't see a default. So, government debt crowds out, or, better, displaces private sector debt. We end up with massive debt and no money in the system! Not a great lifestyle. Maybe its time to consider migration to a less insane country...
Let's take the basics: We had a $14 trillion economic (GDP) in 2008, of which 70% is consumer spending. The rest is government and exports.
The consumer has spent two decades pulling forward demand via credit - that is, through the chimera of extracting home equity and charging up the credit cards. After the 1981 recession this really started to accelerate; prior to that point most Americans lived largely off their paychecks, rather than pulling out the "magic plastic card" any time they wanted to buy something. Checks were common as was good old-fashioned cash.
In 1981, US GDP was $3.1 trillion dollars.
In 1992 it was $6.3 trillion, a double.
In 2005 it was $12.4 trillion dollars, another double.
Doubling in roughly 12-13 years. Not bad, right?
Let's look at it a different way, this time in "current" (not inflation-adjusted, since GDP isn't) dollars.
In 1981 the per-capita income in the US was $8,476.
In 1992 it was $14,847, a 75% gain.
In 2005 it was $25,036, a 69% gain.
Notice anything?
Its not really that subtle, is it?
GDP slightly more than doubled in each of those above periods, but per-capita income lagged, and the lag rate is increasing.
Now let's norm it for population growth: We've added about 30% to the population in the same time frame. This makes per-capita GDP go from $13,700 to $41,000, and when you check again, you see the ratio of GDP to income is about the same.
But what are we spending?
In 1981 we spent $1.941 trillion, or $8,600 per capita, about $200 more than we made. That is, we barely spent more than we made - this was the start of the "gluttony of credit."
But in 2005 we spent $8.694 trillion, or $29,000 per capita, or about $4,000 per person more than we made, or a spending deficit of some sixteen percent!
How's that possible?
We haven't been spending income - that is, human productivity, as is clearly obvious. We're pulling forward demand through the use of credit and as we have continued to do it we have started to pay interest on interest; ergo, the amount of debt being taken on has exploded in an exponential spiral!
The following graph makes clear "how we did it": http://market-ticker.denninger.net/archives/1212-Morning-Madness-Economic-Fundamentals.html
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