THE BEAR'S LAIR A triumph of wishful thinking
By Martin Hutchinson
The US budget deficit for the year to September 2009 will be US$1.19 trillion,
8.3% of gross domestic product (GDP), the largest in history, according to the
Congressional Budget Office. To this monster president-elect Barack Obama
wishes to add a two-year stimulus of $800 billion or so. Broad money supply is
rising by 20% per annum and the federal funds target rate is at 0-0.25%.
For the government to run simultaneously monetary and fiscal policies that are
breathtaking in their expansionism and expect to escape unscathed is a triumph
of wishful thinking. The sources
and probable results of that wishful thinking bear examination.
The elements in the wishful thinking mix are clear. The Federal Reserve
expanded broad money two-thirds faster than the growth rate in nominal GDP from
1995 to 2007, then when the bubble burst, accelerated money supply growth still
further. Since September 2008, growth rates of both the M2 and Money to Zero
Maturity (MZM) measures of money supply have been close to 20% annually, while
the monetary base has all but doubled. (MZM is considered a reasonable proxy
for watching the movement of M3, the broadest measure of the money supply.)
After fiscal discipline under president Bill Clinton and House speaker Newt
Gingrich that appears even more admirable in retrospect than it did at the
time, the advent of the porky Dennis Hastert as speaker of the House of
Representatives and the determinedly un-ideological George W Bush as president
caused almost all control on public spending to disappear. Even before the
current downturn, the budget deficit was running at the near-record level of
over $400 billion annually. The first faint murmurings of downturn a year ago
brought an immediate bipartisan consumer tax rebate, which achieved startlingly
little other than to push the budget deficit into new high ground.
Meanwhile, most state and local governments increased spending by more than 10%
annually as politicians rejoiced that the housing bubble and tax receipts
therefrom had inflated their ability to satisfy pork-seekers and interest
groups. Budget deficits at the level of 2006-07 were easy to finance, and
within past parameters, but it was always clear to non-wishful-thinkers that
some day, a recession would arrive and cause chaos.
Policymaker wishful thinking was intensified by the credit crisis. Since they
had not expected a general decline in house prices (and had not known about the
mortgage financiers' own wishful-thinking abandonment of reasonable
underwriting practices in "liar loans" and the like), the scale of the problem
surprised them. The disappearance of the major investment banks, caused mainly
by further wishful thinking about the level of leverage they could manage in a
downturn, caused policymakers to panic. The money markets seized up as bank
capital bases were destroyed, bringing nightmare visions of an economy without
credit availability. A second great depression appeared to loom.
Policymakers believed they had learned the lessons of Great Depression of the
1930s, which were that protectionism and tight money had caused it while fiscal
stimulus had ended it. They thus frantically loosened both monetary and fiscal
policy to avoid Great Depression II. (Regrettably, no comparable effort was
made to fight protectionism, for example by abolishing US and European Union
agriculture subsidies and pushing for a Doha Round global trade agreement.)
Such loose monetary and fiscal policies have never been tried before - for
example, the Bank of England's short-term rate of 1.5% is its lowest since its
founding in 1694. Thus any difficulties such policies may cause were blissfully
assumed to be minor.
The psychological roots of policymaker wishful thinking are many-fold. The long
bull market dimmed memories of recessions - those of 1990-91 and 2001-02 were
both atypically mild. The Clinton administration's success in solving the
1980s' deficit problem suggested that it hadn't been that important or
difficult to solve. Rapid monetary expansion without inflation suggested that
the old monetary cautions of the 1980s were excessive - after all, until 2006
the great maestro Alan Greenspan was still there as chairman of the Federal
Reserve to give expansion his blessing.
Cheap money and rapidly rising asset prices suggested that old verities about
saving for old age were wrong; there was little concern about the perennial US
near-zero savings rate. Indeed, free-market economics in general became
somewhat reputationally tarnished, as globalization's side-effects produced
declining living standards for the US middle class while infinitely enriching
Wall Street. Finally, there was a general disdain for Bush and admiration for
then presidential candidate Barack Obama; as 2008 wore on, the belief grew that
inspirational new leadership could solve all problems.
The wishful thinking consensus ignored some truths and misinterpreted others.
Fiscal stimulus did not solve the Great Depression; it prolonged it - the
experience of Britain, which lacked fiscal stimulus, was much more favorable
than that of the thoroughly stimulated United States.
The ancient verity about excessive money creation causing inflation and asset
bubbles remained true; it was simply counteracted by the effect of the Internet
and modern telecommunications generally, which produced a one-time deflationary
effect on US consumer prices. Saving for retirement is still necessary because
house price rises are limited by the inability of new buyers to afford the
inflated prices. Free-market economics works; Keynesianism generally doesn't
except in rare circumstances.
In the huge wave of government activity since 2007, there have been a few
genuinely useful actions. Bank capital bases were replaced by capital
injections through the Troubled Asset Relief Program (TARP) - the original idea
of TARP, to purchase dodgy mortgage loans and prop up their price, was a
thoroughly bad one but fortunately reality imposed a better use for the money.
That re-liquefied the US money market, preventing a credit seizure that could
indeed have been thoroughly damaging. Risk premiums will remain high because
risks remain high; that is a healthy reaction to the excesses of past years.
The other government actions in the past year, and those proposed, appear
inappropriate or excessive. The bailouts of mortgage guarantors Fannie Mae and
Freddie Mac and of insurer AIG preserved institutions that should have been
allowed to die - Fannie and Freddie because they have no valid purpose in a
free market, AIG because expanding the credit default swap (CDS) market beyond
any possible economic utility was an action so damaging to the financial system
that its principal perpetrator deserved to perish to warn future potential
Government money would still have been needed to keep the housing finance
market in action as Fannie and Freddie were wound down. However, allowing the
true costs of the CDS disaster to fall on AIG's counterparties would have been
The Citigroup bailout within a few weeks of giving it $25 billion in government
capital was highly damaging to the market's integrity. It would have been far
better to allow Citi to expire and provide modest government help to its worst
The blowup of the Fed's balance sheet, most recently through buying up to $600
billion in dodgy home mortgages, has supported the secondary market price of
mortgages far above where it would stand in a free market; the weekly
announcements of "record low mortgage rates" are an economic snare, trapping
new buyers in houses that are still overpriced.
The more interesting question is where all this wishful thinking will lead. In
the short term, record levels of monetary and fiscal stimulus should produce a
rapid economic blip upwards. If the entire US banking system was still so
lacking in capital or fearful of bankruptcy as to constipate markets, it might
cause a lending stoppage that would negate the effect of rapid money creation.
However, there is no evidence that this is the case; in the weeks since the
bank bailouts, loans have been readily available, probably too much so.
It thus seems that the next few months will see a gradual return to
historically normal levels of monetary velocity. In that case, economic
activity should push sharply upwards. Whether or not president-elect Obama's
fiscal stimulus is implemented in time to add to that effect, the fiscal easing
already in place with the record 2009 budget deficit should be amply sufficient
to boost economic activity further.
Thus after a very weak fourth quarter of 2008, I would expect the first quarter
of 2009 to show resumed economic growth and the second quarter to show quite
strong growth. The stock market will correspondingly be strong, while gold and
to a lesser extent other commodities should rebound in price. (Since both
fiscal and monetary stimuli have been applied on a worldwide basis, their
effect will be global.)
The apparent rapid recovery will cause much rejoicing among the punditocracy.
However, it won't last long. The most probable mechanism for collapse will be
the bond market, whose power was celebrated by political strategist James
Carville in 1993 but has been ignored since.
The combination of reappearing inflationary trends and a soaring budget deficit
will cause "buyers' strikes" at Treasury bond auctions, sending interest rates
through the roof. Indeed, the first such buyers' strike has already occurred,
in Germany, where a 6 billion euro (US$8 billion) 10-year issue on January 7
was only 85% covered by bids. The rise in Treasury bond rates and decline in
prices is likely to prove self-reinforcing, as "safe haven" investors conclude
that the obligations of a nation with 20% monetary growth and a $1 trillion
deficit aren't so very safe after all.
The rise in long-term interest rates will choke off economic recovery while the
resurgence of inflation caused by excessive monetary growth will force the Fed
to reverse its policy and increase short-term rates to some margin above
inflation. The economy will at this point go into a second decline.
The second decline will be concentrated in the real economy rather than the
banking system. Banks will fail, but only those whose operations during the
bubble years were most misguided and whose assets are thus most vulnerable to
the erosion of recession. However, monetary policy will be tight to fight
resurgent inflation while fiscal policy will be tight because the Treasury will
have great difficulty funding its massive deficits.
Hence the second decline will be deeper than the first, and recovery from it
will be extremely slow - the W of recession will be very "lazy". There will be
a severe danger of the US economy sinking either into a decade-long slump, if
public spending is insufficiently restrained, or into a decade of stagflation
if monetary policy is insufficiently tight.
A nastier version of the 1970s is more likely than either the 1930s or the
Japanese 1990s, but does it really matter? Needless to say, the erosion in US
living standards produced by globalization's equalizing influence between rich
and poor countries will be only too apparent during this period of sluggish
growth and insecure monetary values.
House prices will almost certainly sink somewhat further during the second
downturn and the stock market will fall far below its November low, with one
caveat - if inflation is sufficiently rapid, the erosion of real value will be
more concentrated among creditors than debtors, allowing nominal price declines
to be less though the total wealth destruction may be greater.
The emergence from the decade of wishful thinking represented by the dot.com
and housing bubbles was bound to be unpleasant. However, misguided wishful
thinking has made the long-term prognostication considerably worse than
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 2005-09 David W Tice & Associates.)