Wednesday, August 19, 2009
Latent? Not Likely
However, since I'm here now....
A) Take a look at Buffet's op-ed in the NY Times regarding the monetary problem:
The United States economy is now out of the emergency room and appears to be on a slow path to recovery. But enormous dosages of monetary medicine continue to be administered and, before long, we will need to deal with their side effects. For now, most of those effects are invisible and could indeed remain latent for a long time. Still, their threat may be as ominous as that posed by the financial crisis itself.Buffet goes on to point out that the biggest issue relating to the deficit and borrowing is our current account deficit, or the fact that we import far more than we export. If we exported more than we imported, the debt would not be nearly such a big issue. His numbers are pretty good, and of course this explains why no one who understands anything pays any attention to the Treasury's claim that the debt will not be monetized. Of course it will.
To understand this threat, we need to look at where we stand historically. If we leave aside the war-impacted years of 1942 to 1946, the largest annual deficit the United States has incurred since 1920 was 6 percent of gross domestic product. This fiscal year, though, the deficit will rise to about 13 percent of G.D.P., more than twice the non-wartime record. In dollars, that equates to a staggering $1.8 trillion. Fiscally, we are in uncharted territory.
So what will happen?
Well, first we will have to pay higher interest rates on our debt, which will greatly magnify the effect of the deficit. People will lend you money (buy Treasuries) only as long as they are paid interest. And if you monetize the debt, the interest rate will get higher and higher. So the dollar will deflate, which will lead to inflation on all imported items, which will lead either to domestic inflation (if enough money is circulating to allow individuals to keep paying higher prices) or to deflation (debt payments absorb more and more money from the economy as a whole, thus less money is circulating, so individuals have less money, they spend less on discretionary items, which leads to lower profits, magnifies the percentage of income going to pay off debt, and lowers living standards).
Of course, economics dictates that a balance will be reached, and it will. We are currently in a deflationary cycle, in which buying power of the average citizen continues to decline. This means that current account deficit will continue to drop, because citizens will, on average, be buying less of imported items. And as we buy less, corporate profits will continue to be constrained, which will lower domestic corporate income and expenditures. That is the story of the cost-cutting seen at major retailers, which has included much lighter stocking. That is also why China is continuing to pump a bubble. Their exports are not recovering, and they haven't figured out how to raise consumption ex-bubble, thus they are now doing to their own economy what we have been doing to ours. Eventually, it will catch up with them.
I think Buffet's article is very clear, but I disagree with his theory that this process is latent. It is not latent. It is the dominant factor now controlling the economy in tandem with our banks loaded with bad debt. Both factors will decline to suppress consumption and reinforce the deflationary cycle, because we cannot afford to import all those goods:
What you see there is what is happening to our current account. Note that it was in balance up until the 1980s, then steadily worsened, with minor corrections on recessions, and has massively improved over the course of the current recession.
The only way to stop the ever-worsening cycle of domestic deflation is to raise interest rates, and the time to do so is running out. The Fed needs to raise rates about 40-50 basis points (about half a percentage point) this year. In effect, the situation with credit cards (also reflected in incidental credit) is going to continue to raise the cost of borrowing for the consumer. Thus only jobs and higher incomes or writing off huge chunks of consumer debt can reverse the decline in the consumer side of the economy. Those jobs will not appear unless the Fed starts to tighten because business profits will be impaired by higher input costs.
The timing on this is so very tight because the US desperately needs to raise taxes broadly, and it cannot do so without the seeds of an economic expansion or it will produce the next leg downward. But the US will not get a self-sustaining expansion unless energy costs are controlled, and it is now clear that energy costs will not be controlled as long as the dollar's fate is so uncertain.
I'll explain further next.
I've got a question, though.
...if you monetize the debt, the interest rate will get higher and higher....which will lead to inflation on all imported items, which will lead either to domestic inflation...or to deflation....
Won't the effect of higher interest rates on the value of the dollar depend on whether we get domestic inflation or deflation?
If we get domestic deflation, due to higher demand for dollars to pay off debt, the value of the dollar relative to foreign currency will rise. If we get domestic inflation due to Fed efforts to force money into the system, the value of the dollar will fall.
Either way, interest rates rise and the current account deficit would fall. In a deflation because we're spending all our money on debt service; in an inflation, because imports become expensive.
At least, that's the way I understand it.
I didn't read it that way at all. He mentioned the trade deficit as just one of three scenarios for funding the budget deficit. I can't see that he particularly disapproves of it -- by this statement anyway.
Nor, in my opinion, should he. The trade deficit tells us something about the structure of our economy (less manufacturing than before), but is not -- in and of itself -- a bad thing.
After reading your description of the situation above, I can see why you said a depression event was likely. The chances of the Fed and the administration successfully threading the needle on timing their monetary and fiscal policies is very, very small.
Best of luck with your challenges. I appreciate how much effort you put into your blog despite your ongoing challenges. You are truly one who plants trees that will shade others.
This is leading to accelerated credit card defaults as proudly noted every month by Jamie Dimon of Chase Bank during his press conferences.
Who exactly would be hurt if all interest rate charges on EXISTING consumer credit card debt were waived for those intent on paying down their overall consumer credit card debt?
If this drops the default rate, the banks make up what they lose in new interest rate charges on old debt by getting payments in from people who would have otherwise defaulted.
People pay down their debts which makes them more financially agile in the future.
More money will start to steep into local economies as peoples paycheck starts to stretch farther.
It is a win win all the way around.
What do you call a situation where incomes are deflating in nominal terms at the same time that one group of prices is rising steeply?
I call it a Latin American country after a maxi-deval. Import prices go up, domestic (i.e. services) prices deflate, unemployment spikes, and real wages take a big hit, which in turn spurs manufacturing exports.
It does seem to fit the current U.S. situation, doesn't it? What do Latin Central Banks have to do after such a deval? Raise interest rates to get the currency to stabilize, just as you suggest. This is called an "austerity measure", and it was U.S.-imposed dogma during the 90's. Ironic, isn't it?
So MoM, you better learn Spanish!
Links to this post: