The 'Soft Budget Constraint' Hardens

The fate of the US empire depends on access to debt and the ability to service the existing debt burden at low rates. We could’ve chosen a different path. During the 2000 election, Al Gore spoke of paying down the entire public debt. Perhaps things may have gone a different way in the absence of the Bush/Cheney bloodless coup of 2000.

But now we seem to be committed to sky-high deficits, despite recent talk of health care being ‘deficit neutral’ and plans for reducing the deficit. Even the tough talk hints at the reality: we speak of reducing the deficit, not eliminating it, not running a surplus, not reducing the total debt outstanding. The only thing that qualifies as a plan is to increase the debt at a slightly slower rate than the economy expands, so that the debt burden becomes smaller in relative terms, while growing in absolute terms. The economist James K. Galbraith calls it a ‘soft budget constraint’. But how long can it remain soft?

The Fed has poured money into the US Treasury market, a practice called ‘monetizing debt’; this has made Treasury yields fall across the board. That makes the debt easier to service, but if taken too far, it makes US Treasurys unattractive relative to other investment-grade debt.

Fed chair Ben Bernanke criticizes China for having a ‘savings glut’. While they have been spending more, he warns them, don’t save too much! America, with the exception of government, is not following his advice. Americans have gone from being like the fabled grasshopper who fiddles all day long to the ant who works and saves. (If only finding steady work was that easy. There are now six job seekers for every available job.) A new culture of frugality is spreading to every corner of American society. Americans are planting vegetable gardens, learning to preserve food by home canning, even raising chickens. (Not that the average American is doing all this, but things spread from the leading edge to the center) Fashion designers are bringing out new looks inspired by the 1930s, as designers and artists embrace the new ‘rough luxe’ aesthetic, elevating old, vintage, weathered, used objects.

There is a lot of talk about recovery, but state unemployment figures for September indicate that payroll unemployment declined in 43 states. Pressure is beginning to mount on the Fed to raise rates. A recent Barron’s cover story argues that the Fed should raise the interbank lending rate from 0% to 2%. If the Fed does raise rates, we’ll see how strong the recovery truly is. If that rate increase takes place while states continue to trim spending, residential foreclosures continue to escalate, followed by increases in commercial foreclosures, that looks like the making of the return of the credit crunch of 2008, and the double-dip recession of 2010.

War and Peace

Obama’s surprise Nobel peace prize has caused a reality rift in the US; On the right, Peggy Noonan writes that the Nobel peace prize has always been “an award by liberals for liberals”. She can’t believe Reagan didn’t get one. Yeah, Reagan. The guy who called the Soviet Union “the evil empire” and pushed for the star wars program to militarize space. Bret Stephens wants to give one to Harry Truman. You know, the guy who killed 300,000 civilians by dropping the bomb on Hiroshima and Nagasaki. No serious historian puts forth the claim that this barbarous act was necessary to get Japan to surrender. On the left, Howard Zinn asks, how can you give a Nobel peace prize to a man who’s continued two disastrous wars?

Meanwhile, Australia’s central bank has reversed the course of slashing rates to raise their overnight loan rate by a quarter point. Glenn Stevens, Australia’s chief central banker, warns of the danger of being ‘too timid’ in raising rates. Australia, it seems, wants to avoid the pitfall of being the world’s carry trade sop. Could that award be coming the US? If so, the strategy of borrowing in dollars, then dumping them to buy stocks or bonds in other currencies will weigh on the dollar’s value. The dollar hit a 14-month low recently.

US Fed chief Bernanke and Treasury Secretary Geithner talk of wanting to maintain a ‘strong dollar’ but actions speak louder than words. It seems more plausible that what is wanted is a steadily weakening dollar, which will make the government’s large and escalating debt easier to pay.

The average worker is likely to see continued pain from such a strategy, as wages continue to fall. Colorado has decreased its minimum wage, as their standard is tied to the CPI, and deflation slightly reduced the CPI last year, mostly due to falling oil prices. However, the weaker dollar places pressure on import prices, such as the prices of goods at Wal-mart and other low-cost retailers relied upon by the lowest-paid workers in the US. During a recession, prices and wages tend to fall, but not necessarily by the same amount. However, certain prices are rising again. Oil is now at $75, and gold is over $1060. We could easily see the worst of both worlds, stagnating economy combined with inflation.

The Fed has injected trillions of dollars of money into the economy, in a bid to prevent deflation. But all that money has to go somewhere; so far it seems to have gone into the stock market, and commodities like copper, oil, and gold. It’s hard to believe that the Fed could reverse course anytime soon and start raising rates like Australia. Imagine what a rate increase would do to the still-weak economy. Without one, the dollar will continue to slide.

Maybe the Nobel peace prize should be given to the economy. As the dollar loses value, the US will find it difficult to finance the imperial adventures in Iraq and Afghanistan; at least, that is my hope, though it hasn’t happened yet.

Bernanke on Financial Innovation

While there are legitimate financial innovations, e.g. the stock market, options, shorting stocks - many financial innovations are merely more sophisticated ways to gamble or rip someone off.

Fed chair Ben Bernanke offers an interesting argument about three financial innovations that he considers worthwhile and important. These are: credit cards, mortgages, and bank overdrafts.

There is a certain wolf-in-sheep's-clothing aspect to Bernanke's speech.

He says, in effect, gosh, some of these financial innovations haven't gone all that well. It's very challenging for regulators, because on the one hand, we don't want to stifle innovation, because that makes all our lives better. On the other hand, sometimes things get out of hand, we ought to consider how these innovations will react when they are "stressed", and recognize that regulation may be needed. Who could argue with these mild-mannered banalities?

Yet if we step back and ask the question, why should the Fed have a role to play in preventing people from getting fleeced? That doesn't seem like the Fed's role. People get ripped off all the time. It seems to me that a better defense against that than the Fed could ever be is this device called the internet. It sure seems like a great way to spread information to other consumers not to do things that end up being a huge rip-off.

And why would the Fed place restrictions on financial activity at all? We already have laws against fraud. What else is needed?

We have to recognize that the Fed has an impossible task: to prevent a house of cards from collapsing. The fractional reserve system is fundamentally insolvent. This is what creates a danger to financial stability in the first place. The reason that somebody not paying their mortgage may mean I lose my job is because banks are running the biggest fraud in history, an epic pyramid scheme that makes Bernie Madoff seem insignificant. And the job of the Fed is to oversee this fraud, to make sure that we keep it up, to continue to shovel an ever-increasing share of society's surplus value into the coffers of the banks. This is why it strikes me as rather disingenuous for Ben Bernanke to worry that complex mortgage products may not ultimately help the consumer. Talk about dodging the real issue.

Ron Paul Grills Bernanke

Here's a good video of Ron Paul giving Fed chair Ben Bernanke the business.

Much has been said about how Ron Paul sounds crazy, conspiratorial, etc., but at least he's up there questioning the economic guru of the day.

Ben Bernanke firmly believes that the reason the Great Depression happened was that the Fed did not act aggressively enough, and allowed monetary policy to tighten, worsening the Depression. In fact, the Fed was quite aggressive. Consider that the Fed flooded the banking system with liquidity, raising the money supply by 10% in a single week. However, this was counteracted by the contraction in bank lending, because banks were in the process of deleveraging.

If that doesn't sound familiar, it ought to.

The very same thing happened in the Fall of 2008. The money supply actually tightened, despite the Fed creating massive amounts of money and injecting it into the system. This is because the money supply is not controlled directly by the Fed, but rather it's a product of the fractional reserve system. If banks lend less, the money supply falls, perhaps as much as $10 for every $1 fall in lending. That's the magic of the fractional reserve system. Banks create and destroy money, and the process is not under the direct control of the Fed.