THE
BEAR'S LAIR The snare of
stimulus By Martin Hutchinson
President George W Bush, Fed chairman Ben
Bernanke and the Democrats in both Congress and
the presidential campaigns agree that a fiscal
stimulus is essential. It now appears that such a
stimulus, of around 1% of gross domestic product,
US$145 billion, will be enacted, perhaps by means
of a rebate of around $1,000 per taxpayer. This is
a fairly small amount, so it may not do much harm.
But does the theory underlying it make any
economic sense at all - as distinct from political
sense, clearly uppermost in a presidential
election year?
It's good to know that the
classics are still read, even at Yale in
the
1960s and that the General Theory of
Employment, Interest and Money was able to
have such a formative influence on the mind of the
young George W Bush. However he doesn't seem to
have got beyond the Cliff Notes version.
Keynesian economic stimulus, in the form of adding
spending or providing a tax cut (something Keynes
generally abhorred) to stimulate the economy, was
intended to be used to stimulate a consumer demand
that had become inadequate and had locked the
economy into a suboptimal equilibrium with
substantial unemployment.
Excessive
savings was Keynes' bugbear; he believed that
excessive saving had been the principal problem
for Britain and the United States in the late
1920s, so that only a demand-side kick could
re-stimulate the economy.
We now know that
Keynes' remedy was basically wrong, even for the
1930s, although certainly the deflationary
below-capacity 1930s was a decade in which it was
both tempting and not very harmful. By the time
Keynes wrote the General Theory, the
British economy had recovered nicely entirely
without the use of Keynesian stimulus. Indeed
Neville Chamberlain, the Chancellor of the
Exchequer who engineered the rapid recovery, had
gone so far as to cut civil service salaries by
10% at the nadir of the Depression in 1931, thus
reducing government spending, basically on the
entirely correct grounds that the option value of
civil servants' guaranteed job security was higher
in an economic downturn.
The Great
Depression was primarily caused not by the 1929
stock market crash but by the Smoot-Hawley tariff
passed in 1930 (a failure that would have been
recognized by Adam Smith in 1776), by the money
supply contraction in 1931-33 (a failure that was
not to be recognized until Milton Friedman and
Anna Schwarz's magnum opus in 1963) and by a
thumping income tax top marginal rate increase
from 25% to 63% in 1932 (a failure that Keynes
would have recognized, but which would appear much
more salient to the supply-side economists of the
1980s.) It was overcome, in Britain though not in
the United States, by a government of the utmost
economic orthodoxy pursuing policies of which
Calvin Coolidge and Andrew Mellon would have
thoroughly approved.
However, even those
who believe in Keynes can hardly suppose a
Keynesian stimulus to be relevant now. Lack of
consumer demand has not been the problem in the US
economy since 1995, quite the opposite. Grossly
excessive consumer demand, caused by an
over-expansionary monetary policy over a period of
12 years, has produced record balance of payments
deficits, a negative savings rate and the transfer
to Asia and the Middle East of one of America’s
most important comparative advantages: readily
available capital at low cost.
At this
point, the long-term need is for a radical upward
re-orientation of interest rates, to a level that
provides savers with at least a 3% real return
over and above the current inflation rate of
nominally 4%. That would reduce US consumer
demand, close the payments deficit, increase US
consumer saving and bring the US economy as a
whole back into balance. It would also increase
the worldwide cost of capital, making it less easy
for emerging markets, most of which are still
somewhat capital poor, to outsource US industries
to their own lower-wage economies. It would also
reduce the excessive US investment in housing and
financial services, both of which sectors are in
the early stages of a very unpleasant downsizing
of their current bloated and carbuncular state.
A major rise in interest rates would also
have the useful side effect of preventing a
resurgence of inflation. Having remained quiescent
over the past decade, in spite of excessive money
creation in the US and worldwide, inflation is now
making a comeback. Even by the heavily massaged
numbers of the Bureau of Labor Statistics, US
inflation is above 4% and likely to remain there.
In China and India, two of the important sources
of cheaper goods in recent years, which have kept
prices down and US industries outsourcing,
inflation is above 7% and shows no sign of
returning to a more tolerable level. The Chinese
and Indian governments are at their wits' end as
to how to control it; not surprising because its
origin is in the excessive money creation of the
US and other Western economies.
However, a
major rise in interest rates we are not going to
get, quite the opposite. Instead the Fed, seeking
as usual since 1995 to provide short-term
palliatives to Wall Street at the expense of the
long term health of the economy, clearly intends
to cut the Federal Funds rate further at its
meeting January 30th, probably by 0.50% to 3.75%
(incidentally, it is interesting that while
interest rates must be increased as slowly as
possible, in increments of no more than 0.25%,
cuts can apparently be as large as the Fed's whim
dictates.)
That will have one effect which
may appear unattractive, but which to the
short-term thinkers of the Fed is beginning to
have a strange allure: it will cause much higher
inflation. Not the wimpy 4-5% inflation from which
we are currently suffering, but a genuine
take-no-prisoners 10-15% inflation.
This
might seem an unpleasant result, for which
ordinary folk might even marginally blame the
sainted Bernanke (though no doubt the Bureau of
Labor Statistics will help to keep the truth as
far as possible from the populace) except for one
thing: it would go a long way to solve the housing
mess.
The housing problem results from the
after-effect of the excessive run-up in house
prices. House prices got too far ahead of incomes,
so there is insufficient natural demand to sustain
them. Once a house price decline began,
speculative demand also disappeared.
To
restore a properly functioning market, prices must
fall to a level at which the overall ratio of
house prices to earnings will cause them to be
bought once again. Even at that level there would
be houses that were too large or poorly built for
the market, mortgages that had been made by
charlatans to fools and folk who simply could not
afford their houses, but in the long run the
market would stabilize. The housing market would
also benefit if stabilization could occur before
too much pain had been felt by most homeowners, so
that the "houses are always a good buy" mantra
could be retained.
Inflation helps this.
Since wages tend to rise with prices, 10%
inflation will produce roughly a 10% annual rise
in wages, which will cause incomes to rise rapidly
towards steadily declining house prices. In real
terms, housing will become cheaper and cheaper.
Within at most a couple of years, incomes will
have risen sufficiently for house prices to bottom
out. Provided mortgage rates remain at the current
6% level, houses would once again be affordable
and would be buoyed by the belief that prices
would never drop too far, or for too long.
It's a clever solution, first practiced
(largely accidentally) by Britain in the 1970s.
There, a building boom in 1971-73 had cause prices
of houses and real estate in general to rise above
their equilibrium level. In 1974, interest rate
rises and a recession caused a serious slump,
which forced the bankruptcy of many homebuilders.
In 1975, however, inflation ran at 25% and it
remained well into double digits for the next five
years. Consequently by 1977 the housing market was
stabilized, and in the next couple of years it
enjoyed another of the speculative booms, fueled
by mortgage rates below the rate of inflation,
that made housing so profitable an "investment"
for the British middle class.
A Fed-fueled
inflation that cushioned the housing decline would
not be cost free, far from it. But the costs would
be medium term and less intimately connected with
the mistaken policies that had caused them. It
would entrench inflation in the US economy,
imposing huge long-term costs. It would enrich
homeowners and heavy borrowers, and impoverish
pensioners, savers and renters, thus intensifying
the Latin Americanization of the US economy.
It would benefit the government at the
expense of its debt-holders, while giving the
banking system a serious problem in the erosion of
its capital base in real terms. And of course, it
would reduce the progress made in the 1980s and
early 1990s toward conquering inflation and
allowing bond yields to decline. Eventually the
market would force bond yields into a savage
increase, which would be hugely damaging to the
economy.
All of those costs are serious
but difficult to pin on one actor in the economy.
In other words, highly tempting to the short-term
thinkers of politics and apparently the Fed. The
Fed is additionally protected by the lack of
public understanding of monetary policy's
importance; when Ron Paul has raised its misdeeds
in Republican debates he has been met by yawns
from the other candidates, the moderators and,
unforgivably, from the media commentators.
The tax giveaway then fits neatly into the
inflationary scenario. It has no beneficial
long-term economic effect, since demand needs to
be suppressed rather than stimulated and a
one-time handout has no effect on the supply side.
However, it gives an additional kick to
inflation for two reasons. First, it prevents a
slowing in demand that might weaken wage pressures
and prevent the acceleration of the wage-price
spiral that is necessary for nominal incomes to
rise to meet the housing market’s fall. Second, it
increases the federal budget deficit, at a time
when that would be widening anyway towards a level
that will itself cause major concern - the excess
demand in the public sector would thus cause
inflation even if that in the private sector
didn't.
The Federal budget moved from a
surplus of $236 billion in 2000 to a deficit of
$412 billion in 2004, a swing of $648 billion, in
what can only be described as a Mickey-Mouse
recession. This time, in a recession that is
likely to be substantially deeper, the deficit is
starting from $163 billion in 2007, so will surely
rise beyond $800 billion, perhaps towards $1
trillion. If galloping inflation hasn't caused a
sharp rise in interest rates, we can thus
thankfully rely on the budget deficit to do so.
As an additional factor, much of state and
local government finance depends on the rapid
increases in property taxes that have been
produced by the house price rises of 2001-06.
Those have now gone into reverse and that reversal
may be severe. Credit default swaps (which pay you
money on a default) on the more profligate states,
notably including California with its overblown
real estate market and feckless state government,
would thus seem excellent investments currently.
Thus the Fed and the administration are
indeed working together on an economic policy.
Unfortunately, they are working on an economic
policy that will produce double digit inflation
and trillion dollar federal deficits as far as the
eye can see. However, that is not their worry.
Bush leaves office next January and will have
maximized the slim probability of electing a
Republican successor. And the Fed will no doubt
succeed, as it has so often in the past, in
blaming somebody else for its mistaken policies.
Martin Hutchinson is the author
of Great Conservatives (Academica Press,
2005) - details can be found at
www.greatconservatives.com.
(Republished with permission from PrudentBear.com.
Copyright 2005-07 David W Tice & Associates.)
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