The battle of the stimulus with the debt
Posted in Uncategorized by demandside on February 17th, 2009 Congress passed the stimulus bill this past week. It is a signal victory for the president, and it will help. But it has to do battle with the looming debt. Not the federal debt, but the overhanging debt of the consumer, and the so-called de-leveraging of the private sector.
We will look at the algebra later on, but now let’s understand the effort to revitalize the economy has to have the government and public goods in the forefront. The private sector is not going to lead us out of this. The best we can do for the private sector is to allocate the costs of the current collapse in proportion to the responsibility and reorganize the needed credit institutions so they can perform for the future.
This is not the strategy being proposed by the Obama Administration, which is hoping to jolt the private sector back to life and recoup the costs of the stimulus-bailout as we move back into a basically consumer-based economy.
Here is Jared Bernstein, chief economist to the Vice President, and formerly of the Economic Policy Institute.
BERNSTEIN
It is clear to me from this that the Administration hopes to get the public goods of infrastructure, education and green energy to restart consumer spending that will then pull us back to the trajectory the economy was enjoying prior to the meltdowns of the housing and financial markets.
This cannot happen because the that trajectory was based on Bushonomics of massive federal deficits, Greenspan one percent interest rates, consumer borrowing for housing and from housing wealth, and so-called innovations in the financial sector that overleveraged and misallocated capital. In particular, risk management was turned over to mathematicians who bungled the job. A subject for another day.
A new economy based on expanded public goods, particularly absorbing public health services from the private sector, which has created an enormously costly and inefficient system, and the infrastructure of environmental survival can work.
Let’s step back a moment. What is the purpose of credit, of borrowing? It is to produce value that will be realized in the future by tapping that value to pay for the cost of the project. We borrow to buy a house we will live in and enjoy. We borrow to buy a car we will use. We borrow to erect a factory to produce a profit. We borrow to finance an education we will use to get a better job and live a fuller life.
The value is clear
Unfortunately, debt has come to be used for consumption. People have borrowed to buy consumption items, items for enjoyment, not those which have a utility value. They have also borrowed to speculate, primarily on the values of their homes. That is, much of the excess borrowing over the past decade was to obtain housing that was only partially a place to live. It was partially a secure investment that could only go up in value. The part that was the investment was speculation, whether it felt like it or not.
Likewise the private financial sector has borrowed to gin up exotic securities based on Frankenstein mathematics, and of course, on the idea that mortgages were impossibly safe vehicles. The private market cowboys have also been eager to financially engineer takeovers and restructurings of companies that create different balance sheets and perhaps better market positions, but not better products.
One suspects the debt overhang in these companies is one of the reasons they are so eager to jettison their workforce in down times rather than hold on to them. Parenthetically, this rational behavior by companies, to “right size” has a crushing effect on aggregate demand when it is as widespread as it is today. Mass layoffs used to be occasional. Now they are several times a week.
In these forms of borrowing, it is easy to see, the future value was not a real value, a functional value, but a financial value based on increases in prices.
Contrast this with the real value of infrastructure or energy retrofitting, for example.
It is almost too easy to see that energy retrofitting a building creates an energy cost savings that is greater than the cost of the retrofit. That is, the savings can easily pay for the job if we can only move them from the future to the present. This is the best use of credit. In this case, we do not even need to factor in the incremental savings inherent in planetary survival.
Likewise infrastructure, public health, public education and the other public goods have an actual value, a use value, a functional value that will be realized when they are in place. The problem is they do not have an easily accessed revenue stream from which the private market can take its debt repayments. The increased value is very real, but it is dispersed over many people and many years. The only practical way of recovering this value for the purpose of debt repayment is a universal, mandatory levy. Taxes.
So this is the political economy of the moment. Will we transition to a prosperous and sustainable economy based on public goods that involves the T-word or will we cling to the idea that only the private sector creates economic value and jobs? We can have health care that is better even though it is run through a public agency. We can have transportation that is fully functional, cheaper and better for the environment — and incidentally for an aging population. We can have retirement security and personal security that is easier and more reliable.
And notice, we are not talking about the government producing many of these products. Private corporations would contract for a great deal of it. What we are talking about is public goods, goods which are not exclusive and many of which are not used up, versus private goods, which are limited and often quickly consumed. Some public goods we call the Commons. Such as the global environment. The climate is individual only in an apocolyptic bunker. It would be a sad thing if the life systems of the planet were sacrificed because they could not produce a monthly payment for the bank.
Somebody said recently, very indignantly, “It seems like the first thing you should do when you loan money is to make sure they can pay you back.” In the narrow sense, this is true. But although it is hard to remember, the word “mortgage” only four or five years ago meant solid investment with no downside. In the wider sense, the first thing to do is to make sure some value is being created. Creating this value is the first thing. Then there is the potential of getting paid back.
But on the positive side, the president has a very good grasp of the essential points in the short term. At least we’ll be going in the right direction when the next shoe drops. Here is a clip from last Saturday.
OBAMA
News this week with political commentary
Without decisive action, global warming in the 21st century is likely to accelerate at a much faster pace and cause more environmental damage than predicted, according to a leading member of the Nobel Prize-winning Intergovernmental Panel on Climate Change.
IPCC scientist Chris Field of Stanford University and the Carnegie Institution for Science points to recent studies showing that, in a business-as-usual world, higher temperatures could ignite tropical forests and melt the Arctic tundra, releasing billions of tons of greenhouse gas that could raise global temperatures even more—a vicious cycle that could spiral out of control by the end of the century.
“There is a real risk that human-caused climate change will accelerate the release of carbon dioxide from forest and tundra ecosystems, which have been storing a lot of carbon for thousands of years,” said Field, … “We don’t want to cross a critical threshold where this massive release of carbon starts to run on autopilot.”
MARKETS
States
California’s problems have been all over the media
Elsewhere
Kansas has suspended income tax refunds and may not be able to pay employees on time, the state’s budget director said Monday.
The state doesn’t have enough money in its main bank account to pay its bills, prompting Democratic Gov. Kathleen Sebelius to suggest transferring $225 million from other accounts throughout state government. But the move required approval from legislative leaders, and the GOP refused Monday.
46 states are facing shortfalls says the Center on Budget and Policy Priorities.
New gaps of $51 billion (over 10% of state budgets) have opened up in the budgets of at least 42 states plus the District of Columbia.
Japan’s economy contracted …12.7% on an annualized basis in the October-to-December period …
The decline was the biggest since a 13.1% annualized contraction in the January-to-March period in 1974.
“The money is going to sit on the sidelines until [regulators] announce they’re going to do something with these [big banks]. Nobody is going to put fresh capital into the banking business when your major competitor is going to be continuously bailed out by the United States government with more and more money.” Rusty Cloutier, the president and CEO of MidSouth Bank
And finally, the Washington Post reported that a late change in course hobbled the rollout of the Geithner plan. According to several sources involved in the deliberations, Geithner had come to the conclusion that the strategies he and his team had spent weeks working on were too expensive, too complex and too risky for taxpayers.
They needed an alternative and found it in a previously considered initiative to pair private investments and public loans to try to buy the risky assets and take them off the books of banks. There was one problem: They didn’t have enough time to work out many details or consult with others before the plan was supposed to be unveiled.
Demand Side is among those who applauds the rejection of any solution based on bad banks or taxpayers ratifying the bad decisions made by the banks. Bank of America and Citibank, in particular, need to be taken down and restructured into smaller, sounder institutions.
We also do not consider the tanking of the stock market as a negative indicator in the value of a bank reconstruction plan. Bank stockholders ought to be the first — after the management — to suffer.
Now to the core of the meltdown: Housing.
MAYERS
Stronger action would be nice. Demand Side has made this point repeatedly, that putting a floor under housing is the necessary step to stopping the contraction. Unfortunately, the Fed and Bush Treasury concentrated on bailing out the financial institutions and cajoling the financial markets. This is a one house at a time problem, made an order of magnitude more difficult by the innovations of securitized mortgages and exotic designs of mortgages. There was no reason for anything other than a standardized 30-year fixed instrument.
In his forthcoming book, The Crash of 2008 and What it Means, George Soros advocates the Danish system as part of a five point plan to turn things around before it is too late.
The collapse of the financial system started with the bursting of the U.S. housing bubble, he writes, and there is a real danger now that house prices will overshoot on the downside, putting further pressure on the banks’ balance sheets. To prevent this, foreclosures must be reduced to a minimum and house ownership facilitated both for new buyers and current owners.
…
Agreed. Soros argues we ought to go even further than that. With the mortgage financing industry in shambles, we ought to subject it to a thorough overhaul and introduce a new system that is free of the flaws of the current system — the present is a rare opportunity for such a systemic change.
Soros advocates adopting the Danish system, which has proven its worth since it was first introduced after the Great Fire of Copenhagen in 1795. In the Danish system, the service companies retain the credit risk–they have to replace the mortgages that are in default. Our current system has broken down because the originators of mortgages have not retained any part of the risk. They are motivated to maximize their fee income.
In contrast to our reliance on government sponsored enterprises (GSEs)–namely Fannie Mae and Freddie Mac– the Danish is an open system in which all mortgage originators participate on equal terms, and it operates without government guarantees. Yet Danish mortgage bonds are traditionally very highly rated; often they yield less than government bonds.
The system involves mortgage bonds that are highly standardized. They are identical to and interchangeable with the underlying mortgages. House owners can redeem their mortgages at any time by purchasing the equivalent mortgage bond in the market. The mortgage originators are strictly regulated, and their interests are closely aligned with those of the bondholders. They pass on only the interest rate risk to bondholders, retaining the credit risk. That is why the bonds are so highly rated.
The slicing and dicing of CDOs has created such conflicts of interest amongst the holders of various tranches in our current system that neither a voluntary nor a compulsory scheme of reorganization is possible. But, Soros says, a solution is readily available by way of using the GSEs as instruments of public policy rather than leaving them in their limbo dream of shareholders someday emerging with a positive value. They are now aggravating the problem.
It is ironic that the GSEs should provide a route to the solution. In the long run the GSEs should be phased out and their portfolios run off. But that is Soros’ idea.
We will hear what the Obama administration has in mind this week. Something bold and direct is absolutely essential.
History
TODAY:
We take off on the note that while Democrats are resurrecting FDR, one Republican, Rep Eric Cantor of Virginia, the House minority whip who led the fight to deny Obama every GOP vote for the plan, is studying Winston Churchill as a role model.
This is an interesting selection. While Churchill did well in the war, his actions as Chancellor of the Exchequer, essentially Treasury Secretary, during the 1920’s included in the words of John Kenneth Galbraith, “perhaps the single most damaging error of modern economic and financial policy — a hard competition to win.” That was to return Britain to the gold standard at old levels. This forced a deflation, crippled exports and prompted strikes in the coal pits and later the angry General Strike. It may have been the Roaring Twenties in America, but in Britain it was a period of stagnation and unrest.
As an aside, Churchill also initiated the most spectacular military error of World War I, the action at the Dardanelles. Galbraith opines that “No politician of modern times has rivaled Churchill’s ability to go back and forth from desolate error to major success.
More to our point here is the observation of John Maynard Keynes, who said of Churchill “He had no instinctive judgment to prevent him from making [such] mistakes.” Lacking it, he was deafened by the clamorous voices of conventional finance.”
This seems to be the current case of the modern Republicans, who cling to a disastrous market fundamentalism and supply side view of the world, even as their major corporate sponsors defect to the demand side. It remains to be seen whether they have the Churchillian ability to reconstitute themselves after their error.
Idiot of the Week
TODAY, NPR’S Planet Money correspondent David Kestenbaum, reporting on conversations with Keynesians about tax cuts.
KESTENBAUM
I think of it as more like seeing a fire erupt in the middle of your town and spreading and calling for the water trucks and they send you a Bentley. Well, a Bently may be very nice and in some rare situations may even be worth owning, but it has nothing to do with a fire. What it has to do with is making you feel better when you’re already comfortable. It doesn’t matter how soon a Bentley arrives, it is going to do very close to zip in terms of dealing with a fire. That’s tax cuts.
We need to stimulate aggregate demand. That is the water. That is the spending on jobs and the future infrastructure, both physical and human. It is not tax cuts. Which leads us into the subject of the multiplier on today’s theory.
Theory/Issue (e.g., tariffs, market failures, etc.) 5 min
As Jeff Frankel put it,
In that light it is ironic, to say the least, that the politicians who are warning against the size of the stimulus bill (”generational theft”), particularly the Congressmen who are voting against it, are mostly the same Republicans who supported the original fiscal policies that gave us the doubling of the national debt: the huge long-term tax cuts of 2001 and 2003 and the greatly accelerated rate of government spending. What we need now is a fiscal policy that maximizes short-run demand stimulus relative to long-run damage to the national debt. Lots of bang for the buck. The Republicans supported fiscal policies that did the opposite. Lots of buck for the bang. They are still doing it today when they argue that tax cuts give stimulus and spending does not. One doesn’t even hear them give an economic argument in support of this proposition. They just close their eyes and endlessly repeat their “tax cut” mantra, like a religious cult that can’t even remember why.
Sez Jeff Frankel, Harvard economist.
As we’ve said before, in theory and in a completely egalitarian society, one person’s spending is the next person’s income. If a new source of income is dropped into the society, part of that income is spent and part is saved. The spent part becomes the income of the next person who saves and spends, in our theory in an identical way to the first person. And on and on. The spending/saving is called the consumption function.
What we’ve described is an unending progression and mathematically it means that the ultimate size of all spending should be equal to the inverse of the consumption function. If the savings rate of our theoretical society is five percent, then the multiplier — the ultimate size of all spending — should be twenty.
Well, this is not a theoretical world. The savings rate in our society is less than five, but the multiplier as described by most reliable authorities is below two. How can this be?
We are not all buying and selling individuals, butchers, bakers, farmers, et cetera, from an earlier age. Instead we are spending on bills and rents and mortgages that are forms of debt. This debt sucks up spending capacity in the current and future terms as quickly and efficiently as savings.
In societies with a feeble social safety net, such as Japan and China, the consumption function is far too low. The consumption function needs to be higher for Keynesian stimulus to work well. Even within the society, some of our spending goes to individuals who do not have the same propensity to spend as everybody else. The wealthy. Wealthy people may save a bigger fraction of their income. And remember, it is income that is the vehicle for this multiplier.
What we need to do for policy clarity’s sake is to convert dollars to jobs. The reason for this is that a much greater percentage of a person’s total income is spent than of an additional increment, particularly in down times. This is the average versus the marginal rate. That is, a person with a new job will end up spending more on current uses. A person with an additional five hundred dollars will end up saving more of it or paying down debt to a greater degree.
What makes more jobs. Government spending or tax cuts? Well, since spending already starts with a job, and as we said at the outset, spending and tax cuts all go into private pocketbooks, it has to be the government spending. It starts with a lead and cannot arithmetically lose that lead. But also in the second round. A job holder passes much more on to the next step than a tax cut recipient as a percentage of the new income.
These first two steps tell the tale of the multiplier. Any debate on this subject is a debate with a flat earther in an era of satellites.
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