Tuesday, January 22, 2008

Fasten your seat belts please...

Wall Street October 1929

A wave of selling swept through most of the world's financial markets yesterday while the US markets were closed for the M L King holiday. Today the selling in Asia became something close to an outright panic. As of this writing the European markets after an initial wave of frantic selling have stabilized and seem to be holding their breath, waiting for an indication of what will happen when the US markets open in a couple of hours. Barring an emergency and very deep rate cut by the Federal Reserve be prepared for a blood bath. Dow Futures are down over 500 pts.

The sell off has been triggered by growing fears that the US economy is heading into (or may already be in) a nasty recession. Many foreign banks hold massive amounts of American debt (bonds), some of which are probably going to be bad. There is a growing fear that the U S Government may be limited in it's ability to respond to the growing economic crisis. Heavy debt at all levels of American society from private consumer debt (credit cards & high interest mortgages etc.) to corporate and national government are weighing heavily on the economy now. Ever since George Bush took office the United States has been living on the national credit card, with deep cuts in taxes and large increases in spending to finance a shocking amount of pork and two wars. The result is that the national treasury is depleted and we have been receiving warnings that our our country's bond rating could be reduced from the AAA status it has held since 1917 to AA.

In order to finance the wars and ensure that the wealthy are not inconvenienced by higher taxes the US has been borrowing money at record rates (most of those bonds are held by foreign banks) and we have been printing more money. If you or I decided to print money to solve our financial shortfalls we would go to jail. However the Treasury Department does not operate under the rules the rest of us have to follow.

The only problem with this is that money is not immune to the basic laws of economics. The more you have of something, the less it's worth. Case in point; our money (no longer backed by gold for very good reasons) is today backed by public confidence. For decades the dollar has been the store of value in the international financial markets and the de facto currency of international finance. In short term emergency situations you can (and should ) print more money to help give a boost to the economy or keep the lights on at the government. This is perfectly OK as a temporary measure to meet an immediate and urgent need. It is not an acceptable long term answer to a knee jerk aversion to raising taxes or making politically tough decisions to cut spending. If you print more money for a long period of time you will start to loose the short term advantages and run the risk of your currency loosing its value.

Herein lies the quandary we now find ourselves in. As a general rule of thumb it's a bad idea to raise taxes or deeply cut spending during a recession. These are things you want to do during the good times so your finances are in reasonably good shape for the not so good times when you will need to use the national credit card. Also there are some things which one does not finance (at least entirely) by debt. Wars being chief among them. Since the attacks of Sept 11 2001 we have been financing two wars almost entirely through debt. At no time in the history of this country have we ever had an administration that cut taxes during war time.... until G. W. Bush. Between war spending and out of control pork barrel spending by Congress (one of the few bipartisan undertakings in Washington over the last seven years) our debt has now reached proportions that are alarming to the international financial community. Add to this the recent decline in the value of the dollar and evidence of inflation and you have the makings of a perfect storm.

Here we sit, probably in the early stages of an economic recession and the question looms large. What can the government due to help out? Yes the Fed can cut interest rates and inject currency into the markets to help stabilize things. But this runs the not inconsiderable risk of adding to inflationary pressure and further reducing the value of the dollar. Normally this would be a good time for the government to cut taxes at least short term to promote consumption and investment and increase spending in some areas in order to provide relief to people who will need some help to get through the economic tough times. But the treasury is empty. There is no rainy day fund. That was handed over lock stock and barrel to people making over a million a year in the form of tax cuts for the wealthy. We have been borrowing money hand over fist to buy bullets and body armor for troops in Iraq and Afghanistan. Where are we gong to get the money for emergency economic relief without adding to what is already an ocean of red ink?

There is a limit to how long and how much you can borrow, as any one who has ever had to live in the real world and balance their budgets can attest to, before you go over the proverbial financial cliff. So what will the government do? I am not sure. But I do feel fairly confident that they will do something. This is an election year and the appearance of being unresponsive would be political suicide. The problem is that anything that they do might be very temporary in its benefits and something we are going to pay a steep price for down the road a ways. Cut interest rates and taxes and increase spending. Those are the traditional formulas for dealing with a recession. But they are predicated on your national finances being in sound order going into the crisis. Our's are not.

The bottom line... fasten your seat belts. It's going to be a very bumpy landing.

UPDATE: The Fed authorized an emergency interest rate cut of 3/4 percent.


Byzantium said...
This comment has been removed by the author.
Byzantium said...

Ad Orientem,

The gold standard is the only monetary tool that can prevent the government and its central bank from feeding speculative bubbles and distorting the capital structure in the first place. (And from running massive deficits, too.)

Gold was money once. Gold will be money again, as the dollar descends inexorably to its intrinsic value. In theory, paper currency purportedly "backed" by all goods and services available for exchange can work. In practice, fallen man just cannot resist the temptation to inflate.

Anonymous said...

As a percent of GDP, the federal budget deficit is not very high by historic standards - nothing like it was during the Reagan years. See http://www.data360.org/dsg.aspx?Data_Set_Group_Id=409 for a good illustration.

If you consider the Cold War a war (and in terms of defense expenditures it was a big one), Reagan did exactly what you deplore, launching a big tax cut in the early 1980s in the along with a huge increase in defense spending, leading to the highest ever deficit relative to GDP in 1983. This did indeed cause some economic pain in the form of recession, but it was hardly a catastrophe.

Ad Orientem said...

I am an admirer on many levels of Reagan. However there are some myths that have been in bad need of correction floating around. Starting with his record on taxes and deficits. After the massive tax cuts of his fist year in office he raised taxes repeatedly in the years that followed although he was careful to use other terms. He did this when confronted by his own budget and treasury people who warned him that the deficits created by his initial tax cuts were unsustainable.

Secondly the recession caused by the still significant deificits that his successor the elder President Bush inhereited was not insignificant. It was ultimately mitigated by a combination of tough love from the Federal Reserve under then chairman Greenspan and the adoption of much more sound and "conservative" in the true sense of the term, fiscal policies by the Clinton administration.

Say what we will about Bill Clinton (I am not a fan albeit for other reasons), he left the country in good shape financially when he walked out the door to the White House for the last time.


James the Thickheaded said...

I thought LBJ did guns and butter. Same idea.... slightly different form. JFK cut taxes with the ITC.... but I sure don't remember Johnson raising them. Maybe I missed something.

For insight on the last asset bubbles and the not so innocent role of gold.... see http://www.levy.org/vdoc.aspx?docid=969 . It's a story of how the UK's remonetezation - going back on the gold standard - led directly to the Florida real estate boom of the 1920's, the stock market boom and ultimately the Great Crash. No, I don't think gold's such a great solution. The problem isn't just the money supply.. but limiting it to the rate of mining risks deflation. You want your money supply to expand at a rate consistent with real expansion of production.

Suggest sticking on the Levy Institute's sight to read about the natural instability of markets. Normative economics is based on the assumption that the normal model is for equilibrium.... a clearing price that is eminently stable. Minsky counters that stability engenders instability. Those of us who actually work in the markets tend to swing with this... plus a touch of fractal theory :), thank you. But you'll see that coming out of the last recession, these good folks called for a massive stimulus to cure the imbalances in the economy. We got a stimulus... just not of sufficient scale. Yes, it did solve the recession, but it didn't restore the S + I + X imbalances through adding more G. The Levy folks are some of the last Keynesians. They got it right last time... though would have preferred a different form... and they're right again.

I'm no Bush fan, but see the problem with the war is less the financing of it than the waste of our treasure. We are getting not much in return: good will is nada; and hard currency that could have resolved much of the social security "problem"... well... it's been frittered away into bombs that blow up, and hardware that's been RPG'd. Not much left to show for it. I'd have preferred rebuilding our infrastructure, intense post-high school training, and getting our math teachers to actually understand the subject - send them back to learn it. Competition with the rest of the world is on a scale we aren't used to.... so we have to sharpen our game. Call it a golden opportunity missed.

But back on to Mr. Market. So long as we have monetary policy that's anemic relative to the scale of vanishing money.... yes... the supply is up as measured... but the unmeasured capital destroyed in the jack-in-the-box hedge funds... is well, unmeasured and undisclosed. Fact is that no one really knows what the scale of the problem is... and that's what's spooking folks. The scale of liquidation is probably a decent measure of the calls.... but the roll call runs for five years out. Add to this fiscal policy that shy of cutting taxes... faces the hurdle of letting contracts which takes an incredibly long time. Of course, no fiscal stimulus has actually been proposed formally... let alone enacted. And by that time.... Nero will have played a few more bars.

Ad Orientem said...

Thanks for the comment. I generally concur with your opinions the waste of the war in Iraq, which unlike the one in Afghanistan was a war of choice and not of necessity. Your points were well made. I also concur with you and almost all serious economists that the Gold Standard is a bad idea. It was a bad idea in the 19th century and it would be an even worse one today. See my comments in the link from this post.


James the Thickheaded said...


You know there are those who suggest that the wealthy - being the most mobile - will cut out if taxes are raised "unfairly" - however we define that. They do pay about 80% of the tax revenues collected - so they tell us. Applications for the special foreign resident investor exemption from capital gains taxes in the UK continues to mushroom.... so there may be something in this. It's a competitive world. And no, I don't agree with Charlie Rangel that rich begins at $200,000 anymore. I'd put it at the $1,000,000 level used in Clinton's tax policies.

Yes, Guv'nor Bill was a happy time. But the imbalances in our economy became exaggerated in his second term when the combination of a misguided strong dollar policy and restrictive fiscal policy resulted in dissaving by consumers "stimulated" to save their disappearing disposable incomes through cheap Walmart goods... goods so cheap even the Chinese can't make money working for WMT.

Policy blame can be spread pretty widely. And yet the Bushies... well do they really have a policy? I mean I've never seen one. Their presidential advisors have been known to complain they never actually met with him. So maybe the radar just doesn't work when all you're looking for is Cheney (LOL) or another incoming missle.

Yet I do subscribe to generational economics in part too... centering most of our ills in the generation I'm closest too (but not in): The Baby Boom. As Pogo said, "We have met the enemy and he is us". I say the time is coming when we will shift power as we give a stake to those most responsible for getting us out of our mess: the younger folks. The old farts can't agree on music or where to go to breakfast much less how to pay for retirement. So kick it over to those we're asking to support 3 retirees per paycheck. The one consolation is that these kids are pretty fantastic, and the American "can do" spirit is alive and well... if folks will give it a chance.

Meantime, I figure I'm off somewhere in a 3rd world nursing home someday, vainly hoping the nurse will answer my call button, take my yankee dollars (and not like Michelle Bunchen... demand Euros), and wishing I'd focused more of my attention in Spanish class.

Visibilium said...

I'd love to see a gold standard, but I recognize that a monetary system based on gold doesn't eradicate "bubbles". Marrying a gold standard to a 100% reserve requirement would constitute real progress.

Back in the Andrew Mellon days when economic literacy was higher, economists used to talk about the trade cycle and, later, the business cycle. Nowadays, network journalism dilettantes lead the pack in utilizing the anti-theoretical concept of "bubbles".