Monday, May 21, 2012

Refuting Krugman

Without exaggeration, we can say that Paul Krugman has become the modern Apostle of Keynesianism, philosophically enabling those who seek to indefinitely put off difficult austerity measures. At once, Krugman downplays the very threat of our growing national debt, while actually encouraging politicians to expand their profligate government spending. In spite of his impressive resume, his argument that the United States can grow and inflate its way out of debt, without undertaking significant budget cuts, is riddled with problems so obvious that even a first year economics student would catch them. In his writings, Krugman expresses a nostalgia for the "good old days" of the 1950's, usually seen in some less dynamic conservatives. He presents them as a model for how we should address our fiscal ills. In response to the question "how did (post war) America pay down its debt?" Krugman's responds:

"Actually, it didn't: federal debt rose from $219 billion in 1950 to $237 billion in 1960. But the economy grew, so the ratio of debt to GDP fell, and everything worked out fiscally."

Krugman's overlooks the fact that the diminishing ratio of debt to GDP occurred in the context of an unparalleled economic boom. Between 1947 - 1948, we enjoyed a growth rate of 4.8%, between 1950 - 1953, it surged to 7.5% and for the rest of the decade it hovered between the respectable rates of 3.7% and 3.9%. Even the most optimistic economists do not forecast economic growth anywhere near the aforementioned levels. Among the most obvious differences between the post war economic climate and our own are: 

-With Europe and Japan in ruins, and much of the world living under colonial rule and / or a
state of underdevelopment, the United States was the sole remaining economic power. Whereas we now face stiff global competition from the resurgent  nations of: China, India, Taiwan, South Korea and Brasil. Rising production and consumption in the said nations have pushed up the cost of energy and other commodities, which places a further constraint on the American Economy.

-American industries were largely national and immobile in nature, whereas now, most corporations are willing and able to shift production overseas, which has further eroded our near monopoly on industry.

-The post war economy greatly benefited from: the pent up consumer demand of returning
servicemen, the baby boom, urbanization, sub-urbanization and significant increases in
productivity. None of these conditions currently exist. 

Even if Krugman were correct that the Keynesian stimulus measures of the 1950's were instrumental in promoting economic prosperity and a net reduction in debt, for a myriad of economic reasons, they are no longer effective:

-The booming economy and low base line of debt of the early 1950s allowed the American
Government to pursue continued fiscal stimulus such as the Marshall Plan, increased military
spending, massive infrastructure projects, such as the expansion of the interstate highway system and tax cuts (for all but the highest income brackets). But, given our historically high spending to GDP ratio,  low rate of federal taxation, the Federal Reserve's near zero interest rate policy, stimulus measures undertaken by the administrations of George W Bush Barack Obama have prove to be unsuccessful. Think of it like this: a cup of coffee is a great stimulant for someone who rarely drinks it, but ineffective for the addict who has become accustomed to drinking a dozen cups a day. That individual needs high levels of caffeine to even function and will face headaches and lethargy if they limit their intake through "coffee austerity". 

Nor are massive stimulus measures even sustainable:

-Even Keynes recognized that spending spikes must occur in the context of a low baseline of
spending and debt. This is all the more pertinent, when we factor in the trillions of dollars in unfunded social security, medicare and pension liabilities that awaits us.

-Primarily due to the astronomical growth of entitlements, 'from 1962 to 2010, discretionary
spending as a share of the federal budget declined from 67.5% to 37.8% of total outlays. This has greatly limited our capacity to engage in targeted spending and infrastructure projects and made it all the more difficult to get our fiscal house in order.

-And if we continue our attempts to decrease our debt through inflation, sooner or later or domestic and foreign creditors will increase the cost of borrowing (interest rate) and even their willingness to finance our debt.  

While Krugman is correct that economic growth was an essential component in the reduction of the debt to GDP ratio, he fails to note other equally important aspects of the equation, that are completely inapplicable to our current situation:

-Deficits were reduced not only as a percentage of GDP, but also in absolute terms. Between 1945 to 1948 $45.553 billion dollar deficit was  transformed into a  $11.796 billion dollar surplusFor the remainder of the decade, the budget vacillated between surpluses and deficits, ending with a $0.301 billion dollar surplus. As a percentage of the GDP, the surplus rose as high as 4.6%, dipping into the negative range during an economic downturn and ending the decade with a surplus of 0.1% .  Fast forward to 2012 and the deficit has risen to a whopping 8.5% of the total GDP.

-In sharp contrast to the rapid increases in debt that occurred during the presidencies of GW Bush and Obama, during the post war period, the debt, in absolute terms, was held relatively constant. In 1946 it was $268.932 billion, by 1948 it had been reduced to $250.381 billion and by 1960, under the pressure of the cold war, it had modestly increased by 13.44% to $283.827 billion. In contrast, we now face $16.334 Trillion in debt! In other words, if we were (as Krugman suggests) to take the 1950's as a model, we would not simply "focus on growth", but also take the necessary steps to eliminate deficits and halt the growth of the national debt. 

-Krugman preaches the need to address economic downturns with Keynesian stimulus measures, with no consideration to how much they have increased the deficit and debt. Coupled with that, he offers outright inflation as a means to reduce the debt. But, interestingly, when we analyze economic records, we find that the leaders of the "golden age" did not hold similar views. For example, of the 4 recessions that occurred between1945 - 1958, the federal government only increased spending twice, while actually cutting it the other two times. And knowing that it would lead to an economic downturn, the Federal Reserve imposed a restrictive monetary policy as a means to avoid inflation. So, it would appear that even when faced with politically damaging recessions, they exercised relative fiscal and monetary restraint. 

-He overemphasizes the role of revenue in the post war fiscal health , while ignoring the importance of reduced spending. Between 1945 - 1949, tax revenues dropped from 20.4% to 14.5% (of the GDP), while outlays dropped much further, from 41.9% to 14.3% (of the GDP). By 1960 receipts and outlays had modestly risen to 17.8% (of the GDP). By 2012 revenues had declined to 15.8%, while outlays had risen to 24.3%. So, in order to return to the fiscal equilibrium of 1960, receipts would have to increase by 12.65% and spending would need to be cut by 26.75%. In other words, in order to restore fiscal health, spending cuts would have to exceed revenue increases by a ratio of more than 2-to-1. Nowhere in Krugman's writings is this perspective expressed. 

In summary, we were able to pay down our post war debt (as a percentage of GDP) with economic growth, but only in the context of  fiscal and monetary restrain that Krugman derisively refers to as "austerity".  And continuing our current levels of spending, based on assumptions that they will lead to economic growth is unthinkably irresponsible. First, the economic, political and demographic climate of the 1950's no longer exist. And any any businessperson can tell you that while a net return on costly investments is never guaranteed, the future payment of the principle and interest used to finance them are. No sane owner of a heavily indebted firm would undertake major investments, without first cutting costs, as a first step to get their fiscal house in order.  This is all the more true for government projects in which costs always exceed estimates and returns rarely, if ever match promises offered by politicians. In other words, we will in all likelihood face serious fiscal costs without any real economic benefits. 

I wracked my brain trying to determine how a man of Krugman's intellectual caliber could present such a poor analysis of the economic history of the 1950s. And even more I wondered how he could use this analysis to draw such obviously irresponsible policy prescriptions for our current economic and fiscal ills. The essential question is not if we as a nation will have to pay down our debt through austerity measures, bur rather who will pay for it? Our generation or the next? The only feasible explanation is that his political mission and party loyalty have superseded his commitment to truth, reason and intellectual honesty. For even great men will ignore knowledge that contradicts their religious like faith, for such faith not only  provides them hope, but also the adoration of their followers. 

Sunday, May 20, 2012

The Growing Boycott Against Fiscal Reality

In the recent Greek Election, left wing parties opposed to austerity measures expanded their parliamentary presence, presenting a very real risk that Greece would not be able to move forward with the bailout agreement. While the Greek Government can certainly can repudiate the agreement that provided billions in desperately needed capital, it can no more escape austerity than a man leaping off a skyscraper could escape the laws of gravity. Rescinding the agreement might free Greece from its current debt, but it would cut it off from all future credit, meaning that it face even greater austerity in the future. And if the Greek Government were to turn to the printing press to pay its bill, it would face ruinous inflation. So, the question is not IF, but rather WHEN an indebted nation must face the music and start living within its means. And the longer we are able to delay austerity, the more its burden will fall on the next generation.

 In France, newly elected President François Hollande shifted focus away from austerity towards a "growth compact". What this means is that he believes (or at least claims) that France and other nations can grow their way out of debt, without enacting difficult fiscal and structural reforms." Rather than scale back the bloated French state, which now consumes 52.8% of the GDP, President Hollande plans to: expand public housing by 500,000 units, "create" 150,000 subsidized jobs for youth, hire 60,000 new teachers, scale back the retirement age to 60 and create an infrastructure bank. All of these may be great programs, but inappropriate for a state facing a serious fiscal imbalance. And the fundamental problem with a "government investment in growth" is that its effectiveness is never certain, the costs incurred are inescapable. To pay for this, President Hollande has proposed confiscatory taxes of up to 75% of the top earners, which may satisfy the covetous impulses of his followers, but will certainly not generate sufficient revenue to address France's ballooning debt.

Not surprisingly, the boycott of fiscal reality has spread to the United States. In multiple blogs, the Keynesian Apostle Paul Krugman downplays the hazards of national debt and eschews the need for austerity stating that "Governments don't (have to pay back their debt) - all they need to do is ensure that debt grows more slowly than their tax base. The debt from World War II was never repaid; it just became increasingly irrelevant as the U.S. economy grew, and with it the income subject to taxation." Refuting this absurd notion merits a separate blog post. To a lesser extent, the core of the Republican Party has partaken in this boycott, through its belief that cuts alone will address the debt issue. Even if this approach were fiscally sound, it would be politically impossible, for the left would clearly use it to support their narrative of "Republican Class Warfare." Only when revenues generated by tax increases were proven to be insufficient, would the nation as a whole would face the reality that bankrupt entitlements must be reformed if we are to save our children and grandchildren from the crushing burden of the national debt.

The Third Industrial Revolution

Must read article from the Economist on the "Third Industrial Revolution"; advancements in the way goods are designed, produced and distributed, that will have a significant impact on economic life. For the United States, the good news is that this may lead to the return of some previously outsourced industries, but do not expect the return of high paying jobs for low skilled workers. Production will increasingly rely on and reward skilled, educated workers.  According to the Economist:

"The revolution will affect not only how things are made, but where. Factories used to move to low-wage countries to curb labour costs. But labour costs are growing less and less important: a $499 first-generation iPad included only about $33 of manufacturing labour, of which the final assembly in China accounted for just $8. Offshore production is increasingly moving back to rich countries not because Chinese wages are rising, but because companies now want to be closer to their customers so that they can respond more quickly to changes in demand. And some products are so sophisticated that it helps to have the people who design them and the people who make them in the same place. The Boston Consulting Group reckons that in areas such as transport, computers, fabricated metals and machinery, 10-30% of the goods that America now imports from China could be made at home by 2020, boosting American output by $20 billion-55 billion a year."

Sunday, May 13, 2012

Ten Reasons Wall Street Should Be Worried ABout The US Debt

Excellent, detailed  article from Forbes. I could not have better stated the hazards
that excessive debt poses better.

Bruce Upbin, Forbes Staff
I manage our tech and wealth teams.

5/04/2012 @ 3:35PM |6,398 views

Ten Reasons Wall Street Should Be

(Very) Worried About The U.S. Debt

This is a guest post by Michael
Cembalest,  Chairman of Market
and Investment  Strategy for J.P. Morgan
Asset Management. You can
read the entire report as a PDF here.
In August 2011, the United States lost one of its
AAA credit ratings, a designation first bestowed
around 100 years ago, which when combined
with the debt ceiling debate, created one of the
sharpest market corrections in post-war US
history. Financial markets remain concerned
about the ability and willingness of the US
and Europe to tackle their respective fiscal
challenges. With US federal debt approaching
its highest level since the formation of the
federal government in 1789 (other than during
WWII and its immediate aftermath), rating
agencies aretaking a close look at rising US
debt and what thelegislature does to contain it.
The appetite of foreign central banks to
accumulate Treasuries has provided the US
with a reprieve; these entities, plus
Federal Reserve holdings, now account
for half of all Treasury bonds. But monetary
policy in Asia and the Middle East
is subject to change, and we have seen
in Europe the suddenness with which sovereign
debt can be re-priced by financial  markets.
Downgrades, government shutdown  rumors
and political impasse on deficit reduction
have not lost their ability to negatively affect
equity markets, business activity and confidence.
This note details 10 reasons why we believe
financial  markets will take a close look at what
Congress does in the year ahead.

1. Assuming that sequestration takes place as
planned,the Budget Control Act reduces
the trajectory of the debt from the 
CBO’s explosive AlternativeCase,
but does not yet set federal debt
on a sustainable path. Even after
incorporating all phases of the BCA and
assuming expiration of various business
and household tax relief provisions,
future debt ratios still rise into
the mid-80s as a percentage of US GDP.
The CBO Baseline shows a decline in federal
debt since it assumes the following three
policy options: a sunset of all Bush tax cuts,
an end to indexation of AMT to
inflation, and reductions to Medicare
doctor reimbursements which Congress
has agreed to but never enacted. These
three cuts and associated interest savings
would amount to roughly $6 trillion in
deficit reduction over a 10 year period.
However, it remains unclear what political
support there would be to do so.

2. Financial markets are focused on
this issue since large deficits and debt
levels can affect growth. There are plenty
of debates in the economic community these
days (e.g., why haven’t monetary or fiscal
stimulus multipliers behaved the way their
supporters believed they would). One possible
explanationis that fiscal stimulus loses its 
effectiveness when debt ratios rise too high.
In the chart below,  we summarize
Ken Rogoff’s findings that  when debt
ratios in the US and in other advanced
economies have exceeded 90%,economic
growth suffered notably.  With the US
federal debt ceiling now over 100% of GDP
(on a gross debt basis) and projections
of net debt rising above 80%, financial
markets have reason to be concerned.
Supporting Rogoff’s findings is a paper 
prepared by BIS economists for the
Fed’s 2011 Jackson Hole symposium.
In a study of sovereign, corporate and
household debt over the last 3 decades,
the authors find that at around 85% of GDP,
government debt exerts a significant negative
drag on growth. Their conclusion:
“the immediate implication is that countries                                                                                                 with high debt must act quickly and decisively                                                                                             to address their fiscal problems.                                                                                                                    The longer-term lesson is that,                                                                                                                             to build the fiscal buffer required                                                                                                                              to address extraordinary events,                                                                                                               governments should keep debt                                                                                                                             well below the estimated thresholds.”
3. Hoping for growth might not be
the best strategy. The post-Budget
Control Act debt ratio of 85% by 2022
includes the CBO growth assumptions
shown in the chart below. Growth is
assumed to spike to 5% in 2015, and
average 2.7% over the decade. Some argue
that faster growth may bail out the US
from its budget problem, reducing the
need for deficit reduction measures.
It is  true that the US has experienced
growth surges before, and it is always
possible another one will occur. In the
1950’s, real GDP growth averaged 4.3%
for the entire decade [see table in Appendix],
which resulted in debt ratios declining from
80% to 46%. However, the unique economic
conditions and productivity gains of the 1950’s
(e.g., interstate highway, rebuilding of Europe
and Japan) may not be repeated. While we are
hopeful that the US economy recovers more
quickly, if it doesn’t, debt ratios might not
decline below the mid 80’s, risking another
round of rating agency downgrades.

Other areas of potential budget
slippage: projections of military
spending declines are not the same
as structural deficit reduction.
One item in the President’s budget proposal
was an assumed $800 billion in savings
from troop withdrawals out of
Iraq and Afghanistan (so-called
“OCO” spending). While progress has
been made on this front, uncontrollable
geopolitical events could  require OCO
spending to rise again.   In addition, as
shown above, the Budget Control Act
already projects that non-OCO
military spending as a % of GDP will
fall to its lowest level since 1940, barely
above the levels now spent by Japan
and Germany after decades of
demilitarization. As a result, financial
markets may not ascribe a high likelihood
 to deficit reduction achieved through
lower estimates of future military spending.

4. It’s not just rating agencies that
are unnerved by polarization of
political parties.Markets are aware of
the polarization in Congress, a trend that
can be  understood by empirical analysis
of Congressional voting patterns.
As shown below, the polarization
in the House and the Senate is as high
as it has ever been, even higher than
after  Reconstruction, one of the most
acrimonious periods in the country’s history.
A closer look at the Senate in particula
(below, right) shows that the number of party
non-conformists has plummeted.
Without a political middle, there is a
greater risk that the ideological  divide
between the parties cannot be bridged,
leading to intermittent government
shutdowns (or the threat of them)
and market disruptions.
5. Entitlements: where we are now.
Market participants are increasingly focused
on entitlements relative to discretionary
spending. First, some history. When Medicare
was introduced in 1960’s, it was described
as “brazen socialism” in the Senate.
When Truman proposed a national healthcare
program in the 1940’s, the plan was called
a Communist plot by a House subcommittee.
And when President Roosevelt introduced
Social Security in the 1930’s, he was branded
as a Communist sympathizer by Republican
Senators from Ohio, Pennsylvania and
Minnesota, publisher William Randolph Hearst
and Alf Landon (Roosevelt’s GOP opponent
in the 1936 Presidential election). So in
1969 when the US Census found that one
quarter of Americans over the age of 65 lived
in poverty, politicians showed courage
in creating a larger social safety net.

However, it may take even greater 
courage to examine and adjust what
was created. In the late 1960’s, the
government estimated that Medicare
 expenses would grow by 7 times by 1990
(unadjusted for inflation); they grew by 61
times instead. As shown in the table,
healthcare spending has overtaken
education spending (a); entitlements 
have grown sharply compared to growth
in population, household income and
overall government spending (b);
price-sensitive medical spending
(paid out-of-pocket) has collapsed (c);
 and more “productive” forms of
government spending have fallen 
to an all-time low (d). David Walker,
the former Comptroller of the US,
refers to this as the “crowding out”
of productive discretionary programs.

6. Entitlements: where we go from
here.  Markets generally look at financial
statements which are governed by GAAP
accounting, which requires accrual of
future commitments. Countries and states
are not bound by accrual accounting, 
leaving markets to wonder (and sometimes
panic) when they find out what hasn’t been
accrued. The existing federal debt,  
which is already at elevated levels, 
does not include  the present value 
of unfunded future entitlement payments.
Government  agencies have estimated
this latter number at $36-63 trillion,
which is 3-6 times the existing stock of
federal debt helby the public. 
How much would tax rates have to
rise to support entitlements growing
at 5%-7% per year, if nominal GDP
grew at 4%-5%? First, the 2001 tax cuts
would have to expire on all brackets,
and then tax rates would have to be
raised by the same amount on everyone.
At that point, federal debt to GDP would
still be well above 2007 levels, but at
least it would create some borrowing
capacity to fund entitlement payments.
The question is what such a policy would
do to growth and employment.

7. How long will China keep buying? 
US Treasury markets have benefited 
substantially from the appetite of Chinese
and other central banks to accumulate
Treasury bonds. As shown below, China’s
purchases of $1.5 trillion in Treasuries
and Agencies is unprecedented, even 
when compared to other industrializing
countries with managed exchange
rates. While China has prospered
by doing this (keeping its exchange
rate cheap and exporting more),
it is a policy that carries substantial risk,
primarily in the form of higher Chinese
inflation. As a result, it would be risky
to expect this pace of reserve accumulation
to last forever. Eventually, the US Treasury
will once again have to rely on private markets
to finance its deficits and stock of debt.
Japan has been able to sustain high federal
debt and low interest rates, but it has a stock of
domestic buyers prepared to hold them:
93% of all Japanese government bonds 
are held by Japanese locals.

8. Risks to the status of the dollar
as the world’s reserve currency.
The primary reason that China accumulates
Treasury bonds is that its central bank
is looking for large, liquid, secure places
to put trillions of their own currency.
The most sensible place to find such
an investment: the world’s reserve
currency. The percentage of global
reserves held in dollars has not changed
much recently (around 65%), nor has
the percentage of global FX transactions
denominated in dollars (85%).
However, financial markets are
well aware of the catalysts that 
led to the end of  reserve currency
status over the last few centuries.
In general, they are: an over-extended
fiscal budget, too much money-printing,
declines in productivity, military
adventurism and the inability to adjust
to changing times, circumstances and
adversaries. Financial markets
understandably look at the actions of
the Congress and the President on
issues like these. Congress’ actions
will be an important marker on the
timeline of the United States and its
ability to sustain its economic primacy
of the last 100 years. For the record,
as shown in the chart above, that’s
about as long as most reserve currencies last.

10. The risk of premature fiscal
tightening does not preclude 
Congressional work on the long term
deficit issue.At a recent event we held with
Pete Peterson regarding his foundation’s
mission on budget dynamics, he reiterated
his view that the reported choice between
“jobs and deficit reduction” is a false one.
There has been a lot of debate around
what to do regarding the fiscal cliff facing
the US next year (see first chart below).
Current law would impose one of the
largest fiscal drags in decades. Economists
Larry Summers and Brad DeLong have
argued against too much fiscal consolidation
right now, asserting that (a) additional
government spending can ease the long-term
budget constraint in conditions similar
to today’s, and (b) tightening policy now
would risk permanent loss of human capital,
lower labor productivity growth and lower
trend growth. Let’s assume they are right,
and that now is not the time for current
law to be imposed in full. That doesn’t
mean that progress cannot be made on
the longer term entitlement issues like
Social Security and Medicare.
The risk of inaction should be
considered as well; in the second chart,
the Government Accountability Office
estimates rising net interest costs over
the next few decades under different
budget assumptions. While we consider
the CBO’s Alternative Case too pessimistic,
the risk is that it falls somewhere in between,
consuming a greater and greater share
of government tax revenue. We have added
a line showing the current share of education
spending for context.
9. What economic model does the United
States want to use? This chart below reflects
the implicit fiscal dilemma of the last decade:
the US mixes a European style welfare state with
a libertarian tax regime. The result is that even
after an economic recovery boosts tax receipts,
the IMF projects the US structural deficit to still
be around 4.4% in 2013.

My son recently asked me what I thought was
the most important document in US history.
There are a lot to choose from, but of all the
possibilities, I picked GeorgeWashington’s
Farewell Address, written in 1796. The relevance
of Washington’s warnings regarding the importance
of unity, the threat of political factions, the
importance of the separation of powers,
the dangers of permanent foreign alliances
and the need for public morality and education
have not diminished with time. One entire
section in Washington’s Farewell Address
is devoted to the use of public credit, and
Washington is quite clear about what he
thinks about Congress passing the buck
to future generations:
“As a very important source of strength and                                                    security, cherish public credit. One method                                                           of preserving it is to use it as sparingly as possible…                                        avoid accumulation of debt, not only by shunning                                         occasions of expense, but by vigorous exertions in                                          time of peace to discharge the debts which                                                  unavoidable wars have occasioned, not                                                       ungenerously throwing upon posterity the                                                      burden which we ourselves ought to bear.”