Sunday, February 8

President Obama's Fiscal Strategy: Let's hurry up and crash the world economy so we can learn exactly where the US stimulus plan needs fine tuning

Tired of wading through wildly conflicting opinions on what U.S. lawmakers should do to stave off a depression in the USA and rescue the economy from recession? I am breaking radio silence again to mention that there's one thing everyone agrees on:

There is no plan for scaring up the trillions of dollars to pay for the combined 2008 and 2009 economic stimulus plans and various TARP plans.

Before you spend money you don't have it makes sense to figure out how you're going to pay for what you can't afford. And it would be nuts to say that because you don't know exactly how much you'll spend in the coming year it's no use figuring out how to pay for it until you know how much you're going to borrow. Yet putting the cart before the horse is exactly what the U.S. government has done: they're first putting into law how many billions are to be spent on aiding banks and the economy, then they'll figure out where to get the billions from.

"We need about a trillion dollars" would be a close enough estimate to start thinking about how to raise huge amounts of U.S. dollars to pay for all the stimulus and rescue plans. The thinking hasn't been started -- at least not in public. That's because there are only two ways for the debt-ridden United States to come up with hundreds of billions of dollars in short order, and neither way is palatable:

Either the Federal Reserve will have to create the hundreds of billions and/or outright borrow the billions on the world financial markets. Here we come to a snag:
[The Fed] can print the money it needs to pay off its debt. In practice it would not literally print dollar bills; rather, the Federal Reserve would purchase its bonds. Still, the effect is the same: The Fed, by "monetizing" government debt, would create vast new supplies of dollars to chase the same goods and services and thus also create inflation.(1)
How much inflation? Nobody can project exactly how much because the situation is unique. The U.S. dollar is the world's reserve currency; about 75% of money reserves held by central banks is in U.S. dollars. So if hundreds of billions of U.S. dollars are quickly injected into the world economy that's in effect allowing huge amounts of dollars to chase the rapidly-dwindling and/or frozen supplies of key commodities.(2) That's another way of saying "global runaway inflation."

What about outright borrowing? How is the U.S. going to do that much borrowing without crowding out other national governments, which are also desperately trying to stave off economic collapse by borrowing in the world financial markets? The problem is already happening, although discussion of it has been studiously absent in the United States. But given the gravity of the problem they couldn't absent the question at this year's World Economic Forum in Davos, Switzerland:
[...] While the focus in Washington has been on putting together a stimulus package that will attract broader political support when it comes up for a vote in the Senate, here in Davos the talk has been about the coming avalanche of Treasury debt needed to pay for the plan on top of the bailout measures approved last fall, like the $700 billion Troubled Asset Relief Program, or TARP.


“The U.S. needs to show some proof they have a plan to get out of the fiscal problem,” said Ernesto Zedillo, the former Mexican president who helped steer his country through a financial crisis in 1994. “We, as developing countries, need to know we won’t be crowded out of the capital markets, which is already happening.”

Mr. Zedillo said that Washington, unlike most other countries, had the option of simply printing more money, because the dollar was a reserve currency for the rest of the world.

Over the long run, that could force long-term interest rates higher and drive down the value of the dollar, undermining the benefits that come with its special status.(3)
There's no "could" about it. It will only make things worse to simply print or otherwise create a trillion or so dollars in the face of the surge of borrowing by European countries that are also struggling to keep afloat.

What does the White House have to say about their refusal to look reality in the face?
American officials maintain they are aware of the challenge. A top White House adviser, Valerie Jarrett, promised in Davos ... that once the stimulus plan achieved its intended effect, the United States would “restore fiscal responsibility and return to a sustainable economic path.”(3)
But no one has any idea when or whether the stimulus plan will achieve its intended affect!

And if the United States has no idea how to pay for the plan -- which, by the way, does not include the cost of interest payments on dollar borrowing because no one has determined how much and what type of borrowing will be needed -- how can Mr Obama's White House promise to restore the U.S. to fiscal responsibility?

What is President Obama's way of dealing with this great cloud of unknowing? He wants Congress to hurry up and crash-test the stimulus plan without knowing how to pay for it, never mind not knowing whether it will work. In his radio speech yesterday Mr Obama demanded speed in passing the stimulus plan on the argument that delay would be catastrophic.(4)

The catastrophe would be to crash the global economy, but I'll concede that would be one way to settle arguments between Obama's economic advisors about which parts of the stimulus plan won't work.

What would be the ultimate outcome for the United States if such a catastrophe occurs? The rest of the world would be so mad at the United States that one sure outcome would be IMF-issued SDRs (Special Drawing Rights) replacing the U.S. dollar as the world's reserve currency.

I do not want to hear Mr Obama say that he's only following the advice of economists in urging speedy implementation of a stimulus plan. Everyone knows that economists can't predict the sunrise three minutes before it happens -- and the few exceptions are considered madmen until after they're proven right:
Recessions are signal events in any modern economy. And yet remarkably, the profession of economics is quite bad at predicting them. A recent study looked at “consensus forecasts” (the predictions of large groups of economists) that were made in advance of 60 different national recessions that hit around the world in the ’90s: in 97 percent of the cases, the study found, the economists failed to predict the coming contraction a year in advance. On those rare occasions when economists did successfully predict recessions, they significantly underestimated the severity of the downturns. Worse, many of the economists failed to anticipate recessions that occurred as soon as two months later.(5)
I doubt that few world leaders, if any, are questioning that Washington needs to take swift action regarding the financial crisis, but I believe you'd be hard pressed to find they're advocating that the U.S. shoot blindfolded in the dark. Before speed must come thinking about the most obvious consequences of the U.S. borrowing or creating hundreds of billions of dollars within a short time.

The bottom line to all the discussion of a U.S. stimulus plan was grimly spelled out at Davos:
“Even before Obama walked through the White House door, there were plans for $1 trillion of new debt,” said Niall Ferguson, a Harvard historian who has studied borrowing and its impact on national power. He now estimates that some $2.2 trillion in new government debt will be issued this year, assuming the stimulus plan is approved.

“You either crowd out other borrowers or you print money,” Mr. Ferguson added. “There is no way you can have $2.2 trillion in borrowing without influencing interest rates or inflation in the long-term.”

Mr. Ferguson was particularly struck by the new borrowing because the roots of the current crisis lay in an excess of American debt at all levels, from homeowners to Wall Street banks.

“This is a crisis of excessive debt, which reached 355 percent of American gross domestic product,” he said. “It cannot be solved with more debt.”(3)
Worse than no solution are the unintended consequences of the U.S. taking on mind-boggling amounts of additional debt.

1) We're Borrowing Like Mad. Can the U.S. Pay It Back? by Greg Ip; January 11, 2009; The Washington Post

2) Jim Rogers; 8 Really, Really Scary Predictions, December 11, 2008, Fortune/CNN Money

3) Global Worries Over U.S. Stimulus Spending by Nelson D. Schwartz; January 29, 2009, The New York Times

4) Obama demands speed on stimulus; Reuters; February 8, 2009

5) Dr Doom, Stephen Mihm's August 17, 2008 profile of Nouriel Roubini for The New York Times Magazine
5:00 PM Updates:
Miss P:
In principle, I agree but I'm not sure we aren't in a very serious deflationary spiral. We just injected, what, a couple trillion in lower rates and bailouts and prices are still declining by 12%. These effects need to be intelligently disaggregated before making a huge macroecon policy move.
Mark Safranski

Yes, and yes. Without "intelligent disaggregation," and given the downsides of injecting huge (more) amounts of dollars into the global economy, we'd be looking at the worst of both worlds: stagflation.
This entry is crossposted at RBO.
11:55 PM ET Update
Dave Schuler quotes from this post in his Why What, When, and How Matters in a Stimulus Package, which weighs in on the U.S. stimulus plan with his trademark methodical approach. He summarizes the major opposing arguments and nails down when the U.S. reached the point of a recession. His comments on the timing the U.S. recession are an important consideration:
As I read their conclusions the current recession began no later than April 2008. If past recessions are any guide that means that some sort of recovery should be in progress no later than the first quarter of 2010, when the downturn will have been ongoing more than 24 months, significantly longer than typical post-WWII economic downturns.

Whatever the virtues of large scale infrastructure programs, no such program for which spending begins in 2011 or 2012 will have any impact whatever on economic conditions in 2009 or 2010. Consequently, I think that such spending should be dumped from the primary stimulus package to be debated as part of a second bill.
More sound advice from The Glittering Eye:
I believe that some sort of fiscal stimulus package regardless of its merits is a political necessity. However, we should be careful to ensure that we get the most bang for our buck that we can. To my mind that means that the ideal fiscal stimulus package would consist of extending unemployment benefits, expanding the food stamp program, and a permanent reduction in the FICA both on the employer and the employee side. [...]
Feb 9, 1:20 AM Update
I cannot recommend highly enough Martin Wolf's interview last night with John Batchelor; even for the venerable Wolf it was a tour de force in which, under questioning by John and co-host Simon Constable, he laid out with blinding clarity exactly what must be done to save the world economy from collapse. And he did this within the space of a few minutes. It was a spectacular interview -- a credit to all concerned.

Of particular interest to me is Wolf's eye-opening warning that the most obvious and seemingly rational solution (allowing 'bad' banks to go bankrupt) is fraught with danger given the sheer number of insolvent banks worldwide. Wolf is adamant in advising that bad banks be recapitalized or closed. Listen to the interview to hear Wolf enumerate details of his argument.

And I was relieved to hear that Wolf does not think that hyperinflation is a concern at this time, although he was guarded about making a sweeping prediction.

For readers who do not follow London's Financial Times, Martin Wolf is the pink paper's associate editor and chief economics commentator, although that does not speak to the accolades that have been heaped on him over the years. The paper proudly announces that "Every week, 50 of the world’s most influential economists discuss Martin Wolf’s articles on," and they have a right to be proud.

If the U.S. Congress and White House would follow his advice, it would be the best chance the world has of recovering within this decade from financial ruin.

The podcast of the interview, which took place in the third hour of the New York portion of the John Batchelor Show at 9:35 PM, is posted at the show website at this link. Your time listening to the interview will be well spent.

My only trouble with Wolf's observations: When Simon Constable pointed out that the cost for all the global fixes will round up to at least $4 trillion, Wolf replied that spending 4 trillion is "cheaper than a depression."

True, true; 4 trillion is a bargain in that light. But the problem is that it's not 'spending' 4 trillion to stave off a global depression that's problematical; it's 'raising' 4 trillion. As I pointed out in this post, weaker governments can be wiped out trying to compete with the borrowing by more powerful governments seeking to finance their own stimulus and rescue packages.

In his February 3 column, Davos Man, Mr Wolf observes:
[...] Unfortunately, what is coming out of the US is desperately discouraging. Instead of an overwhelming fiscal stimulus, what is emerging is too small, too wasteful and too ill-focused. Instead of decisive action to recapitalise banks, which must mean temporary public control of insolvent banks, the US may be returning to the immoral and ineffective policy of bailing out those who now hold the “toxic assets”. Instead of acting as a global leader, there is resort to protectionism and a “blame game”.

This way lies a catastrophe. I expect little enlightenment from the rest of the globe: the European Central Bank is allowing the eurozone to collapse into deep recession; Japan is in meltdown; China has at least announced a big stimulus package, but it lacks a credible plan for needed structural reforms; and most other emerging countries can only try to stay afloat in these storm-tossed seas.
Staying afloat will demand that the 'emerging' countries ('emergent' more politically correct these days than 'developing') are not elbowed out of the bond markets by more powerful governments borrowing hundreds of billions of U.S. dollars. Avoiding such a catastrophe for the emergents will take great coordination and cooperation between leading national governments.

I note that Wolf's prescription for restoring global financial order, which he summarizes in Davos Man, points up the need for a coordinated approach to the financial crisis: "Act in concert. Even the US cannot solve its problems alone."

Yet, as I underscore in my post, there has not been public discussion in the U.S. about how the American government is to finance its various rescue and stimulus plans; acting in concert with other governments will require that the U.S. first nail down this crucial issue.
Feb 9, 11:15 AM
This entry is cross-posted, in a manner of speaking, at Uppity Woman. Comradess Uppity is so busy these days laboring in the rice paddies that she forgot to add the footnotes and updates to this post, and she crossposted from RBO's cross-post of this post from RBO "due to free graphics" at RBO instead of directly from my post. Ah, but it is reactionary to complain about such trifles. Soon there will be no "I" and "mine" in the glorious United Socialist States of America!

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