Debt, Money Printing and Prosperity

by: Acting Man

As the comical debt ceiling debate rages on, it may be a good time to reflect a bit on what has brought us to this juncture. Readers are probably aware that it now looks as though the deadline set by the treasury earlier this year will indeed be missed.

Reuters reports regarding the latest Congressional antics:

A Republican plan to try to break a congressional deadlock over raising the U.S. debt limit stumbled amid delays and a revolt by fiscal conservatives on Tuesday, narrowing the chances for a deal to avert a default.

A week before a deadline for Congress to raise the $14.3 trillion borrowing limit, lawmakers have held out hope for a compromise even as rival Republican and Democratic proposals have paralyzed Washington and triggered nervousness over the risks of a downgrade to the top-notch U.S. credit rating.

But serious discussions looked to be delayed for several days after Republicans pushed back a House of Representatives vote on their plan originally expected for Wednesday. The deficit reduction plan presented by the House Speaker John Boehner, the top Republican in Congress, had already faced a likely veto by President Barack Obama and a certain death in the Democratic-controlled Senate.

Staffers scrambled to rewrite the Boehner bill after an analysis by non-partisan budget experts found it would not deliver the level of spending cuts it promised. The vote will now be delayed until Thursday at the earliest, meaning Congress will almost certainly be negotiating right up until the Aug. 2 deadline when the Treasury Department has said it will run out of borrowing room.

Analysts say the government may have enough cash on hand to pay its bills until the middle of the month.

If the unnamed analysts are correct in their estimate of the treasury's cash on hand, it actually means the deadline is not August 2 as is widely held, but rather mid-August. The deadline for an actual debt default is in all likelihood still much further away. After all, it is up to the government which types of spending it will cut. Per experience, government will cut those types of spending that will ensure that the ire of the population will descend upon those seen as standing in the way of a resolution. This almost certainly means that bondholders will be the very last in line, as the government will want to avoid doing anything that hampers its ability to borrow once the debt ceiling is indeed raised.

So which bills will the government likely not pay after the deadline has passed? Expect social security checks and similar entitlement spending related payments to be held back, as well as tax refunds and payments due to private businesses. The administration will want to hit voters in their pocketbooks as quickly and thoroughly as possible, so as to draw their ire and mobilize their wrath against the members of Congress deemed to be delaying the process. This is a tried and true method, often applied to get voters to accept tax increases or similar unpopular measures at the local level (municipalities can of course not stop federal entitlement checks from arriving, but they similarly tend to employ methods of cost cutting that are deliberately designed to create effects with an immediately felt negative impact on citizens to get them to acquiesce).

The bond market clearly sees things that way – as we always stress, the bond market is mainly influenced by inflation expectations (i.e., expectations regarding the future rate of growth of CPI) and perceptions regarding economic growth prospects. In fact, the message of the bond market is: all holders of so-called risk assets beware – the outlook for the economy in the wake of the cessation of QE2 is likely far worse than many hope and expect.

[Click all to enlarge]

The yield on the 10-year treasury note once again fell yesterday, even though worries over the debt ceiling debate increased.

Five-year US inflation breakevens, as measured by Bloomberg. This measures the yield differential between generic five-year nominal treasury bond yields and inflation protected treasuries of the same maturity – the resulting number is the expected CPI.

As we noted on Monday in The Debt Ceiling Dance, the so-called debt ceiling is really nothing but a recurring opportunity for vacuous political theater. If anyone should doubt the veracity of this assertion, simply consider the graph depicted below.

The total public debt of the federal government since 1970. Since the beginning of the secular contraction with the blow-off top in the technology stock bubble in 2000, the debt has "gone" parabolic, growing by approximately 145%.

What the graph of the total public debt indicates is that the government has arranged its fiscal affairs precisely along the lines recommended by the adherents of Keynesian thought. Public debt began to explode into the blue yonder with the onset of the secular contraction in the year 2000, as the biggest credit and asset bubble in all of history suffered its first major setback. By massively growing fiscal debt as well as the money supply, the authorities managed to create a second wind for the expired bubble, which resulted in yet another artificial boom from 2002-07, with real estate becoming the asset bubble of choice. The faltering of this boom then was met with an even bigger interventionist response, once again consisting of massive deficit spending combined with an equally massive expansion of the money supply.

This time, the rate of growth of the fiscal debt accelerated even more, while contrary to the 2002-07 boom, the monetary inflation was no longer driven by credit expansion on the part of the fractionally reserved private banking system, but rather direct monetary pumping by the Fed, i.e., outright debt monetization. It is probably no coincidence that in the period beginning in 2000, the true money supply of the US has increased by a roughly similar amount as the public debt, namely by about 155%.

Since both Keynesians and monetarists are big on the empirical testability of their theories (which as we have often pointed out is utter nonsense), they should perhaps slowly but surely begin to ask themselves how it is possible that the economy is still in one of the worst contractions since the Great Depression after their recommendations have been implemented with such gusto. The Keynesians insist that only massive deficit spending can lead the economy back to prosperity, while the monetarists insist that the Fed must print money by the truckload to keep deflation at bay. They hold that this will ensure that the economy is brought back on the path to prosperity. Well, all of this has been done – "in spades." So where's the prosperity? Just asking. Probably it is just around the corner.

The true broad US money supply TMS-2, via Michael Pollaro. This monetary aggregate has grown by over 155% since the year 2000. If money printing could make us rich, we should have arrived in the land of Cockaigne by now.

The biggest concern for economic policy, and hence the number one goal of the interventions recommended by Keynesian economists is supposed to be lowering the rate of unemployment. Keynes famously argued that it would be just fine if the government employed people to bury things in the ground and later dig them up again, even if such employment plainly makes no sense. It definitely would be a shovel-ready task though. So how well have the interventions worked so far regarding this particular goal?

The U3 unemployment rate. Perhaps the "government" didn't spend enough? That is definitely what Paul Krugman would assert.

The U6 unemployment rate, which includes discouraged and marginally attached workers, i.e. comes somewhat closer to representing the true rate of unemployment. The successes of deficit spending and money printing seem rather elusive thus far.

The sorriest economic record of them all – the mean duration of unemployment.

We conclude from the above that Keynesian prescriptions as to how policymakers should deal with economic contractions not only fail the test of sound economic theory, but evidently also fail rather spectacularly in practice. Unfortunately it seemingly hardly matters how many times this is proved – and it has been proved over and over again in the course of economic history since the rise of Keynesianism – the theory and its plainly unworkable propositions continue to be quite popular with the economic mainstream. However, it is to be hoped that the secular economic contraction will eventually discredit interventionist economic theories.

In the above context it should be noted that the small minority of radicals that are accused of deliberately sabotaging the government by holding up a debt ceiling deal do have a very good point when they insist that comprehensive cost cutting measures should be the precondition for their agreement. They will probably not succeed in achieving their goal this time around, but it is important to realize that the deficit spending policy is at a dead end. It has achieved none of its purported aims, while bringing the nation to the edge of a fiscal disaster. That much should be obvious to all by now.