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, $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 Britain and the United States’ principal problem 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 last 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. However in 1975 inflation ran at 25% and it remained well into double digits for the next 5 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.
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(The Bear’s Lair is a weekly column that is intended to appear each Monday, an appropriately gloomy day of the week. Its rationale is that the proportion of “sell” recommendations put out by Wall Street houses remains far below that of “buy” recommendations. Accordingly, investors have an excess of positive information and very little negative information. The column thus takes the ursine view of life and the market, in the hope that it may be usefully different from what investors see elsewhere.)