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     Jan 14, 2009
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 imitators.

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 highly salutary.

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 affected counterparties.

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 necessary.

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.)


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