The Road to Financial Ruin: We Have to Spend Money Now
When just about all economists agree, should we rejoice or be scared? During the Weimar Republic, economists at the Reichsbank argued that printing money to finance a war was "exogenous" to the economy and thus not inflationary. Hyperinflation in the ensuing years proved them wrong. We tend to think we are so much smarter today. Economists know how to run regression models; in the absence of a historic precedent, some economists know how to draw shifting supply and demand curves. But common sense seems to be missing in the toolbox of all but a few.
This past Sunday, President-elect Obama was asked by 60 Minutes where the money would come from for the ambitious projects and stimulus plans:
Question: Where is all the money going to come from to do all of these things; and is there a point where just going to the Treasury Department and printing more of it ceases to be an option?
Obama: Look. I think what's interesting about the time that we are in right now is that you actually have a consensus among conservative, Republican leaning economists and liberal, left leaning economists. And the consensus is this: that we have to do whatever it takes to get this economy moving again that we have to, we're going to have to spend money now to stimulate the economy and that we shouldn't worry about the deficit next year or even the year after. That short-term, the most important thing is that we avoid a deepening recession.
Just about every living soul has advice for our president-elect on where to spend money. Had McCain won the election, things would have been no different; indeed, McCain seemed to enjoy the race to bailouts even more than Obama. Economists are worried about deflation, about imploding asset prices, about demand destruction. They argue that the government must step in where the private sector is falling short. The goal is to prop up demand and preserve jobs. Political considerations on how to spend the money will come into play; it will be interesting to see whether healthcare and education will receive injections as spending in these areas doesn't translate to immediate boosts to employment, spending or investments.
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Many economists (Keynesians) believe that government spending ought to be countercyclical to dampen the impact of boom-bust cycles. In practice, everyone wants to be a Keynesian during bad times, boosting government spending, but there is no mechanism in place to force restraint, say through increased taxes, during boom times. This 'restraint' existed when the gold standard was in place as money was backed by a limited supply of gold. But such restraints were inconvenient and central bankers are now in charge.
There are cushions built into the system already; take unemployment benefits as an example: unemployment benefits reduce the impact of lost wages and stimulate demand during tough times. Note that European countries tend to have more generous unemployment benefits than the U.S.; further in the U.S., most states need to balance their budgets. As a result, when state revenues decline, the downturn in the U.S. economy is particularly exacerbated as government services are cut. There are some that argue that such spending cuts are healthy because the faster we weed out the excesses of the boom, the faster one finds a bottom upon which to have sustainable growth. Further, risk takers might be more cautious if they know that the government won't bail them out, reducing the risks of systemic failures in the first place. Some may even recall that there used to be a breed called fiscal conservatives in Congress, an almost extinct species. Democrats and Republicans alike are all Keynesians these days.
There are two major reasons why we may be setting ourselves up for financial ruin: first, spending is unlikely to lead to a sustainable recovery; second, we cannot afford it.
What started as a valuation crisis that sub-prime mortgage portfolios were kept on the books of financial institutions morphed into a liquidity crisis as financial institutions ceased to trust one another, nor their own balance sheets. The Treasury's $700 billion bailout addresses some of this. But the crisis has since moved to Main Street. Demand for goods and services has been destroyed, not only because of the lack of available credit, but because shell-shocked consumers and companies alike are scaling back their risk appetite. Importantly, even if we found a magic cure to the ills of Detroit and if credit was available to consumers, the car makers have already pre-sold cars years out by having offered zero percent financing on six year loans.
During World War II, government spending was ramped up dramatically. Government spending stepped in as soldiers were abroad. As soldiers returned, government spending was scaled down and the private sector picked up again. This time around, we don't have a war, but too much debt. We are mortgaging our grandchildren because we want to ensure enough Chinese made large screen TVs are purchased. The cure to too much debt is a debt reduction program, i.e. more investments, less savings by consumers. It's possible that a fiscal spending program is going to boost demand. But is it sustainable? Unless real wages are boosted in the process, all we do is create even more debt; growth may falter as soon as the government aid is scaled back. We shall also mention that it is not very easy to scale back government programs once put in place. Social Security, the government sponsored entities (GSEs) Fannie and Freddie, Medicare, Medicaid are all programs that were put in place with the best of intentions and have taken on expensive lives of their own. To compete in the decades to come, the U.S. should invest in intellectual capital, in particular education, rather than subsidizing ailing industries.
We cannot afford the massive fiscal stimuli that we are likely to see proposed in the coming months. It is one thing for China to inject $586 billion into its domestic economy as they have a budget surplus as well as enormous reserves. This money will be spent on infrastructure spending, potentially allowing the country to reposition itself in a world that will be more dependent on domestic economic activity than sales to the U.S. We estimate that the U.S. will need to finance about US$2 trillion in 2009. Who will finance this debt? There is less trade with Asia, so there will be fewer dollars to be potentially recycled into the U.S. economy. And Asia now needs its foreign currency reserves to finance its domestic spending programs. We don't think Asia will be financing the upcoming U.S. fiscal spending spree.
In the absence of Asian buyers, borrowing costs should go up. Specifically, longer dated Treasury bonds should fall in price, boosting long-term financing costs not just for the government, but also all private sector debt including mortgages. But that's exactly the opposite of what policymakers want: after all, policy makers want homes to be affordable, interest rates to be low. In our assessment, this challenge won't stop policymakers from trying to beat the system. In particular, the Federal Reserve (Fed) has, in recent months, instituted a number of programs to prepare for exactly this scenario. In a simplified form, the Fed may just go out and buy the debt the Treasury needs to issue. This may happen outright and is called 'monetizing the debt'. But it looks like the Fed is pursuing a slightly more elegant variant of the same idea: as part of the recent bailout, the Fed was granted authority to pay interest on deposits with the Fed. In a world where interest rates approach zero, the Fed now has a tool to put a floor under the Federal Funds rate; the Fed hasn't stopped there. The Federal Reserve Bank of St. Louis publishes excess reserves in the banking system on a weekly basis (column 4 in table H3 of the Aggregate Reserves of Monetary Institutions). These are reserves beyond the minimum capital requirements; during normal times, these reserves hover at around $2 billion; since late September, excess reserves have increased dramatically from week to week; as of November 5, excesses reserves stood at $363 billion. This reflects cash provided by the Fed to the banking system: the Fed is literally throwing cash at banks. The published data show that banks are hoarding the cash. Financial institutions do not lend because they don't trust the health of consumers or that of many businesses. The Fed can provide all the money it wants, but the Fed cannot force lending.
If you think about this from the bank's point of view, what would you do with hundreds of billions if you don't want to lend to the private sector? How about buying government securities? Banks are in the business of borrowing short-term lending long-term: the cost of borrowing is very low, allowing banks to engage in a very profitable trade lending to the government. U.S. financial institutions are about to embark in the greatest carry trade of all times, all with money freely provided by the Fed.
This solves many of the problems: the government can spend as much money as it wants as the Treasury's bonds will be purchased by banks that in turn receive funding from the Fed. This cycle keeps the cost of borrowing low for the private sector; eventually, Goldilocks will come back to life and we will live happily ever after. And just in case there are some out there that believe that one can't square the circle, the Fed will introduce an official inflation target to signal to the market that monetary policy will be tightened in case inflation takes the upper hand. That threat alone will ensure the money markets will behave.
In our humble opinion, it won't work. We would like to point your attention to the Panic of 1908 - 100 years ago, there was a law that restricted New York City (NYC) from paying no more than 4.5% on debt it issued. Because investors considered it risky to extend a loan to NYC, there were simply no buyers for the debt. Only after J. Pierpont Morgan (the then 70 year old founder of what is now known as JPMorgan Chase) said he would provide a loan to the city did others come forward (including international investors). We see a direct parallel to what's happening now, although the tools are different: if you keep interest rates artificially low, buyers will abstain. It may be profitable for U.S. banks that receive free money from the Fed to buy the debt, but foreign buyers in particular may simply stay away. Given the enormous current account deficit, we see a severe drop in the dollar as the logical reaction to the policies in place.
A substantial drop in the dollar seems to be in the interest of policy makers. A lower dollar could boost exports. Conversely, for China it is a unique opportunity to lower the cost of imports to allow their currency to appreciate. If China does not act, we will build the same imbalances once again. However, it is questionable whether at the next crisis China will have the luxury to launch a massive stimulus. Further, if policymakers don't want housing prices to fall, inflation may be welcome as the cost of goods and services will float higher, reducing the cost of housing relative to everything else.
Fiscal spending is part of the problem, not the solution. At this stage, the dynamics over the coming years are shaping up. Investors may want to consider whether to take advantage of the panic buying of U.S. dollars to diversify their holdings. Typically, when a currency appreciates, the money is invested broadly in an economy; in recent months, most of the money flowing into the U.S. was invested in short-term Treasury Bills. We very much doubt that all this money will stay in the U.S. once the panic abates. Indeed, whereas just about everyone seems to be concerned about deflation, the risk of not only inflation, but hyperinflation increases with every step taken down this road.
We manage the Merk Hard and Asian Currency Funds, no-load mutual funds seeking to protect against a decline in the dollar by investing in baskets of hard and Asian currencies, respectively. To learn more about the Funds, or to subscribe to our free newsletter, please visit www.merkfund.com.