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“Lavishness is not generosity.”
                                    Thomas Fuller

Commentary & Analysis
We have here a fiscal gridlock – better call for backup …

I would like someone to write in to me and explain my narrow-mindedness, my myopia, or my plain ignorance of fiscal policy

I’ve heard the argument several times before – when the private sector is saving, the public sector needs to balance that savings by spending. The biggest problem is that the US public sector spends even when the private sector is spending.

I recently skimmed through a publication put out by the Bank of International Settlements – The real effects of debt – that discuss why and how debt drives economies these days. I plan to dig into it more another time, but today I wanted to share this one little paragraph that conveys the above point:

At moderate levels, debt improves welfare and can enhance growth. But high levels can be damaging. When does the level of debt go from good to bad? We address this question using a new dataset that includes the level of government, non-financial corporate and household debt in 18 OECD countries from 1980 to 2010. Our results support the view that, beyond a certain level, debt is bad for growth. For government debt, the threshold is in the range of 80 to 100% of GDP. The immediate implication is that countries with high debt must act quickly and decisively to address their fiscal problems. The longer-term lesson is that, to build the fiscal buffer required to address extraordinary events, governments should keep debt well below the estimated thresholds. Up to a point, corporate and household debt can be good for growth. But when corporate debt goes beyond 90% of GDP, our results suggest that it becomes a drag on growth. And for household debt, we report a threshold around 85% of GDP, although the impact is very imprecisely estimated.

It is sufficient, however, to look back at the history of the United States (for which long back data are easily available) to understand how extraordinary the developments over the last 30 years have been. As Graph 2 shows, the US non-financial debt-to-GDP ratio was steady at around 150% from the early 1940s until the mid-1980s. In some periods, public debt was high, but then private debt was low; while in others it was the reverse. Since the mid-1980s, however, both public and private non-financial debt have been moving up together.


Now that the private sector is saving, can they save enough and can the public sector effectively spend and rescue the economy from collapse?

I know there is no agreed upon answer here; but what is the reasoning among those who say ‘yes, the government must spend money now’?

The Treasury delivered $787 billion in stimulus already – The American Recovery and Reinvestment Act – that was aimed at creating jobs. The number of jobs it created is debatable; but its proponents argue that the act helped stave off a deeper recession. They also note that the cost is nowhere near the $787 billion as bailout money has been repaid.

It’s interesting though that we’re reverting to that point in time where stimulus was necessary. Unemployment is still hovering around recent highs and the credit markets are beginning to look cold again. Last night Obama announced a plan to implement $447 billion worth of additional stimulus aimed at creating jobs again. The stimulus will take the form of spending and tax cuts.

In all this I just struggle to see what benefit the original stimulus brought about, unless “the staving off of a deeper recession” more than compensates for the stimulus’ cost to taxpayers.

[It’s no guarantee the stimulus did “stave off” anything. It can be argued, and only argued because today’s politicos wouldn’t risk actually doing it, that a real Austrian School cleansing of the economy would clear the decks quickly set the stage for fresh real growth. And if you think about it, wasn’t a real cleansing exactly what took place under Ronald Regan’s first term, with Paul Volker at the wheel of monetary policy? A forced deep recession with interest rates in the 20% range…it set the stage for a strong U.S. recovery for many years. Of course lest we not forget the number of pages in the Federal Registry (federal regulations) fell by around half during that time too. Oh, one can only hope for hope and change.]

Is it simply a matter of implementing enough stimuli, as die-hard Keynesians profess?

Apparently I am not alone here in thinking more stimulus is the wrong idea. A good portion of Americans feel that fiscal stimulus is a waste and only delaying the inevitable, or even guaranteeing the inevitable will be inevitably more painful. And for this reason Obama’s proposal will undergo serious scrutiny and will struggle to gain traction in Congress. This is no surprise since many Americans are fed up with the public sector.

Luckily, even though fiscal stimulus is unpalatable, the Treasury can call for backup.
Enter the Federal Reserve (yeah, you’ve probably heard of them before.)

According to Morgan Stanley, even though the best course of action would be fiscal stimulus, the Fed will need to step up as it feels increased pressure to come in and rescue the economy. A political gridlock, persistent unemployment, and potential eurozone contagion are among the reasons for the Fed to stay active.

Speaking to the Economic Club of Minnesota yesterday, Ben Bernanke uttered:

“The Federal Reserve will do all it can to help restore high rates of growth and employment in a context of price stability.”

[Open sarcasm …] Oh goody, finally the Federal Reserve might take action to help the economy. [… close sarcasm.]

Really … am I missing something here?

What has changed?

What will change?

Why should more fiscal policy work this time?

Why should more monetary ease work this time?

If the Fed lengthens the maturity of their balance sheet, will that create demand for refinancing and longer-term loans? Or will it simply serve to buoy market sentiment temporarily as the economy slowly tires from treading water? I bet on the latter, at best.

If the Fed reduces the rate at which banks can earn interest on reserves parked at the Fed (0.25%) to below the rate on two-year Treasuries (0.19%), will banks feel the incentive to make more loans? I wouldn’t expect a meaningfully quick change in attitude.

If the government enacts more stimulus, will it revive growth? Will the balance-sheet recession and debt deleveraging not continue?

Source: The Wall Street Journal

Can the government actually do anything to spark meaningful job growth? If so, at what cost? What will the bill look like for the taxpayer IF perpetual fiscal stimulus and monetary ease ever “rescue” the economy?

Are there reassuring answers to any of these questions?

Are there rational answers to any of these questions, because the market doesn’t seem to be acting rationally? But then again, it never does.

Back in June I wrote a piece for Commodities Essential (Market Reality: Rationalizing the Irrational) where I discussed the need to observe global economics rationally (for the good of your sanity) while operating in the irrational reality of the markets. More to that point, this is from Howard Marks of Oaktree Capital:

I never cease to marvel, and complain, about the way investors flip-flop – focusing on just the positives at one moment and just the negatives at another – and the speed at which they do it. But I learned long ago not to be surprised by this phenomenon or expect it to stop occurring, but instead to look past the market’s behavior and assess the underlying realities.

So S&P and Egan-Jones downgraded U.S. debt (while Moody’s and Fitch didn’t). There was one main moving part on August 5th; that’s the day S&P labeled U.S. debt less safe. What was the upshot? A buying panic in U.S. Treasury securities, with the yield on the 10-year note falling below 2%.

As an aside, let’s spend a minute thinking about that reaction. If there had been near unanimity about anything, it was that a downgrade would raise the yield demanded on U.S. debt. Certainly the fact that so many people could be wrong about this supposedly simple linkage should disabuse investors of the notion that they know how markets work. The expected reaction was much more logical than the one that actually played out: after it was labeled less safe, the yield demanded on U.S. debt declined markedly.

The economic headwinds are apparent, obvious, and seemingly critical; but the market has a way of telling us what actually matters.

Will we once again realize that the markets appreciate all the fiscal trying and monetary doing? Maybe so. Based on market price action to President Obama’s new jobs stimulus package, they were less than impressed. But then again, there’s plenty of time left today.

But sooner or later, the boy who cried hope will be left holding the bag.