These are confusing times where intelligent and honest men have radically different opinions about what we should do with the nation’s economic problems. The two principal plans of actions being pursued by Western governments are Quantitative Easing and Deficit Reduction. This article explains why they cannot work.
- Quantitative Easing. This is the option being pursued by the Fed, the Obama government and the Democratic Party and economists focusing on the shorter economic term.
- Deficit Reduction. This is the option sort of being pursued by the Republicans, particularly the Tea Party. The British government and Ireland are also using it. It is also the option for economists focusing on the longer term of sustained US budget deficits.
Quantitative Easing
The fundamental problem we faced in 2006 through 2008 was an asset bubble in real estate. This asset bubble was caused by low cost interest and easy credit terms that permitted a massive increase of real estate transactions; this led to artificially high real estate prices and borrowers with debts they could not repay when real estate prices turned down.
The principal causes of this asset bubble are 1) the Fed policy of low interest rates and, 2) outdated Fed definitions of inflation that prevented the Fed from seeing that an asset bubble was being created. While the banks, investment bankers and other financial intermediaries have their share of responsibility, the Fed failed in a primary objective of the Fed. A principal mandate of the Fed is to prevent inflation. Since the Fed relied on obsolete tracking and control mechanisms for inflation, they did not understand the hard asset inflation danger from real estate finance until it was too late. As the Fed under Greenspan did not see the inflation with their traditional tools, they helped to stimulate the economy with low interest rates thereby creating the problem.
The Fed has taken concrete policy decisions in recent years that have blind-sided them to critical events in the economy. In 1983, the Fed stopped tracking housing prices saying there was too much volatility in housing prices. Since then, they have looked only at rents. If the Fed had continued tracking housing prices they would have had an enormous red flag to alert them to the asset bubble. Likewise, in 2005, the Fed stopped tracking a broader measure of the money supply, M3. What they needed to do in 2005 was to broaden their vision of money supply, not narrow its vision in face of the massive increases in de facto money in non-traditional bank use of asset backed securities. In retrospect, the dangers of uncontrolled de facto monetary creation through these new instruments are obvious.
History will record that both Fed Chairmen Greenspan and Bernanke did not understand the effects of hard asset inflation on the economy. But of course, most of this generation’s economists are guilty of the same mistake. Former Fed President William McChesney Martin had it right when he said the prime responsibility of the Fed was “to take the punch bowl away just when the party gets going”. Greenspan failed critically to not take the punchbowl away when he should have.
This information on the Fed is relevant to this discussion for two reasons. First it is important to know the role of the Fed in our current problems. Secondly, it makes it easier to explain that the present proposed solution will not work. The Fed diagnosed the problem incorrectly in the earlier part of this decade. And they continue to diagnose it incorrectly now. European and Asian economists and politicians increasingly reflect this somewhat controversial opinion. Let’s see the details.
First, let's look at the results of this easy money lending philosophy. JP Morgan this week estimated total new real estate loans of $6 trillion from just 2005 to 2007. Of this $6 trillion, they expect $1.1 trillion will be written off by the financial system, with banks, insurance companies, bond guarantors and bond holders absorbing the losses. This write-off, only in the real estate market, approximates the total stimulus money of the previous two years by the US government. This is relevant because this write-off is, in effect, an anti Stimulus which will tend to negate the hoped for benefits of the government stimulus. These credit write-offs will be one of the major causes of deflation.
As the bubble exploded in 2007 and 2008, we got the ancillary problems of excessive indebtedness, lost jobs and a generally declining economic activity at most levels. It is important to understand that these are results of the real estate asset bubble, not the direct cause of our current problems.
With this problem, the Fed decided to simply make more money available at slightly lower costs for longer-term bonds. While this is an incredibly weak response to a major problem, it seems to be dictated by the negative political attitude towards TARP. However, this will not put more money in the hands of the public to spend. There is no explanation how buying some bonds from big guys will somehow mean this money ends up in the pocket of the consumer. Furthermore, even if the public receives the money, they will not spend it.
A primary purpose of Quantitative Easing is to create some inflation and thereby stimulate consumer spending. Fed Chairman Bernanke hopes for 2% p.a. inflation from Quantitative Easing. Inflation is supposed to create more purchasing by consumers who are supposed to believe that spending today is better than spending tomorrow because it may be more expensive. Quite simply, this is not going to happen.
To summarize, a large amount of money is to be injected into the economy by the Fed purchase of some longer-term bonds, which will lower the interest rate earned on these bonds. Probably not much of this money will get to consumers to spend more which limits its effectiveness. Then, if some of the money gets to the consumer, a small increase in inflation is supposed to stimulate the consumer to buy today as opposed to paying more tomorrow.
In today’s environment, Quantitative Easing simply will not achieve the desired results of increasing spending by the consumer. Let’s look at the expected results.
- Two percent inflation will not cause more spending of people heavily in debt and without jobs. Slightly lower rates of long-term bonds will not affect their spending habits. Two percent annual inflation does not change your spending habits if you are on the verge of losing your house, as is the case for more than 9 million American families. Nor will it change the spending habits of the more than 20% of Americans which are unemployed or underemployed and not earning what they need to maintain their lifestyle. We see that the vast majority of American’s approaching retirement age or in retirement do not have any reasonable prospect of living decently in retirement based on their savings and pension plans. Most Americans are maxed out on their credit cards and other credit sources. They must repay and not spend more. The people mentioned above, the vast majority of the consumers, will not be spending for a small increase in inflation. The people who spend more will do it not because of Quantitative Easing, but because they view they have no choice; Quantitative Easing is unnecessary for these people.
In addition to the basic issue that Quantitative Easing does not work, we have these new problems that come from Quantitative Easing
- History is rife with inflation going out of control by trying to create just a “little inflation”. We already see this in the price of gold, oil and other commodities plus the devaluation of the dollar.
- Those approaching or in retirement are losing the ability to earn on their savings. These retired or near retired people are foolishly piling into high-risk bonds to generate some income, given that a CD today produces virtually no income. Our Quantitative Easing and low interest rate policy will probably be looked at retrospectively as causing a large part of retired citizens to enter into poor investments in a futile effort to generate income for their old age.
- Politically, doing Quantitative Easing will remove pressure from the issue of solving the budget deficits problem. A year delay in dealing with the deficits problem because of Quantitative Easing means over another trillion dollars added to the deficits, making the deficit problem even greater for the US. The US deficits will eventually increase the borrowing costs of the US government.
- Finally, the write-down of over $1 trillion on the US real estate portfolio will, in practice, wipe out the monetary effect desired of a new $500 billion or $1 trillion of Quantitative Easing. Furthermore, keep in mind, this trillion dollars of losses is related only to the real estate loans of 2005 through 2007; the losses on loans prior to 2005 are in addition to these losses.
Quantitative Easing may defer a year or so the day of reckoning, but it will not solve the problem. Ultimately, we still must face that Quantitative Easing cannot resolve the problem. Quantitative Easing will not avoid deflation and its consequent effects.
Deficit Reduction
When your family budget is a little out of balance, one can take measures to put it back into balance. But when it becomes hopelessly out of balance, most private individuals end up going broke publicly, or at least paying a great deal more to be able to place their debt. This is essentially what is happening to the US government and most of the European governments with the significant exclusion of Germany. A good read for the details of the US budget problems is in the book by the former Comptroller of the US Currency, David Walker, Comeback America. US public deficits are seriously out of balance and there appears little prospect for a politically viable reduction plan.
The Republicans are pursuing this as a campaign issue. However, they provide no details and probably at the moment of truth they will not be able to provide a credible program that the country can approve. The Republicans are currently trying to create the image that they are the party of fiscal responsibility. But the last time the budget was balanced was in the time of Democrat Bill Clinton and the deficits were staggering under Republican George W. Bush.
A fascinating description of the problems of the budget deficit reduction is contained in this week’s Bloomberg Businessweek. Alice Rivlin, who is head of Obama’s Bipartisan Budget Reduction Panel, is stymied six weeks before the mandated report due date because the Republicans took tax reform off the table and the Democrats took Medicare and Social Security off the table. No meaningful Deficit Reduction conversations can be held if you cannot discuss income tax policy, Medicare and Social Security. While Americans traditionally meet around the political center, we are now moving to the extremes on both sides of the political spectrum that makes infinitely harder to reach political compromise on the critical issues.
There is ample historical evidence deficit reduction does not work, either politically or practically. Herbert Hoover was essentially voted out of office for trying to impose fiscal discipline at the start of the Great Depression. Now we have the case of Ireland trying to cut its budget deficit. The reductions of revenues vastly outpaced the reductions of spending for the cuts they tried. The British also have decided to go forward with a deficit reduction plan. While most Americans want to cut expenses, they just do not want to cut the expenses relating to their personal life, particularly with the short-term negative effects on individuals.
On balance, the US is unlikely to be able to agree upon real reductions in spending that could preserve the low interest cost currently paid by the US government as interest on US dollar borrowings. But equally important, there is ample evidence that at this stage of entitlements and legal commitments you cannot cut the expenses without worsening your actual income. This issue is seen historically and statistically in the outstanding book This Time is Different by Carmen Reinhart and Kenneth Rogoff. This book gives clear historical support why this is so, both in historical terms and now with statistical data. They have collected the statistical information for every financial crisis in recent history.
This Time is Different says,
This Second Great Contraction (the problem we are discussing) is a far deeper crisis than others in the comparison set, because it is global in scope, whereas the other contractions since World War II were either country specific or at worst regional.
This Time is Different continues with
the value of government debt tends to explode; it rose an average of 86% in the major post-World War II episodes. The main cause of debt explosions is not the widely cited costs of bailing out and recapitalizaton of the banking system. In fact, the biggest driver of debt increases is the inevitable collapse of tax revenues that governments suffer in the wake of deep and prolonged output contractions. Many countries also suffer from a spike in the interest burden on debt due to interest rates that soar.
Reading this outstanding book makes it clear that the US problems are profound. The US will need years to pass through this problem. This Time is Different´s “Index of Financial Turbulence” makes clear that this is simply a classic economic crisis. The only thing unique about this crisis is not its character or composition, but rather the magnitude of the problem.
In short, budget cutting cannot be done politically and it will not work at this point anyway. Those economists that are in favor of Quantitative Easing almost unanimously support the position that federal expense reduction will worsen the federal deficit.
What happens if neither Quantitative Easing nor Deficit Reduction work?
Economies are self-adjusting. If prices are too high, competition will bring prices down. If the quantity of product offered for sale is too great in physical volume, there will be a reduction of supply offered, be it by bankruptcy or voluntary elimination of manufactured items in question.
The Great Depression was approximately a decade long from start to finish (not the bottom which happened several years earlier). This time will probably be similar, perhaps a little longer.
However, the thrust of this article is not to predict how long the downturn will last. The thrust of this article is that the two principal strategies to “solve the problem” will not work.
Conclusions and Summary
Quantitative Easing cannot work because it is liquidity and interest rate related action whereas the problem is an income and spending issue for Americans. Deficit Reduction will not work either in political terms or in practical terms because the reduction in income to the government will be greater than the reduction in spending. The US, Japan, England, and the Euro based countries are going to have to suffer the most serious downturn since 1929 and there is the chance that it will be worse than 1929. In the next decade or so, the US and European economic world leadership will be moved to, or at least shared with, China, Brazil, India and other Asian countries.
People willing to face practically the consequences of the evolving downturn will be able to find many good strategies to ameliorate the effects of the downturn, and even take advantage of it. The vast majority of Americans working in relatively low paying positions will have the hardest time surviving in the new economy with reduced living standards. The relatively few Americans working in the finance area have been particularly adept to adjust to new realities, and even benefit from them.
While this article has focused on the US, these same three problems are equally true in Britain. See this week’s WSJ Article that shows Britain to be split over how to deal with these same three problems of Qualitative Easing vs. Deficit Reduction vs. the self-adjusting process. It appears we are going to see the practical effects of Qualitative Easing in the US. It appears we are going to see the practical effects of Deficit Reduction in Britain. As both of these efforts fail, we will go to self-adjustment, even though there will be continuing ineffective efforts at the government level to solve the problem. Self-adjustment implies roughly a decade a difficult times for the vast majority of people in the US, Japan and Europe. Even so, this writer expects Self Adjustment to move from an almost unthinkable possibility today to a broadly accepted reality during the next two to four years.
Disclosure: No stocks are mentioned.
