The US Government needs more revenue

Oh dear, Standard and Poors rating agency has maligned the US by dropping its Triple-A bond rating. Strangely enough this event has brought both progressives and conservatives together in maligning the rating agency itself, which is a fair call considering the cluelessness of ratings agencies generally in failing when 2008 hit.

Nevertheless there is a rather huge reason for the US being downgraded. I just played around with another spreadsheet comparing US and Eurozone debt, and I get the following:

Okay, first of all you need to understand that this is an index - everything is assumed at 100 at the beginning.

Secondly, these numbers are based upon total government spending and revenue, which includes Federal, State and Local government. This is to ensure that US oranges are being measured against European oranges. You can find US figures here (on pages 345 & 347 of 360) and European figures here.

Thirdly, also understand that while these figures have been indexed, the difference between Eurozone and US revenue and spending as a percentage of GDP is substantial. In the Eurozone the two figures are around 50% of GDP spending and 44% revenue, while in the US, the figures are around 25% spending and 15% revenue.

Fourthly, the figures for EA17 and EU27 are pretty much the same, which is why I didn't include EA27 (the entire European Union) in the graph.

So what can we learn?

The most important line in that graph is Eurozone revenue, the orange line in the middle. Despite the onset of the GFC, despite the tumult at the so called "periphery", Eurozone revenue has only dipped slightly. This means that the deficit, the space between revenue and spending, has been mainly caused by increased spending. Thus in a recovery, spending would drop off as the unemployed return to work while revenue from income tax would increase.

The second most important line in that graph is US revenue. The financial crisis since 2008 has decimated US tax revenue. Previous to 2008, US revenue and spending were around the same level (though obviously with less revenue than spending) but since then there has been a massive drop off in revenue. And while State and Local governments have certainly added to this, the main offender is the Federal Government. A recovery, therefore, would have to be more substantial for the US to ensure that the deficit is paid down.

This is not to say that Europe isn't in trouble. Nor does it ignore the fact that certain European nations have huge problems. Nevertheless in light of the recent debt wrangles in Congress you can understand the fragility of the US economy, the downgrading of debt and China's angry response to the problem.

However the biggest problem here continues to be the Tea Party Republicans and their decision to flatly refuse any revenue raising policies. When seen in light of the graph above, such an extremist position is seen for what it is: madness.

There's one more piece of bad news: since the chances are high that another recession for the US is on its way, we can expect the US budget deficit to widen even further before the end of 2012. While the debt ceiling has been raised enough to prevent any congressional wranglings before next year's presidential election, the question now is whether the new recession will blow government finances out so badly that another debt ceiling vote is needed before the election. God help us.

Thoughts on the debt deal

This was definitely a compromise solution, but one in which each side calls the other the "winner".

I read quite a few lefty blogs, which is fine because, if you look at the graph showing my political and economic positions, I am a lefty. Now the lefty blogs are all saying that this is a victory for the Republicans. They're also critical of Obama. I've just watched John Stewart and that's pretty much what he said.

But I also check up on Redstate once in a while to look at how the other side feels and they are definitely unhappy too. "Cut, cap and balance" was their mantra and that was not achieved.

I guess the best place to check this is Wikipedia which, ironically (at least to many), has a more dispassionate and factual summary of what was achieved:

• Cut spending more than it increases the debt limit. In the first installment ("tranche"), $917 billion would be cut over 10 years in exchange for increasing the debt limit by $900 billion.
• The agreement establishes a joint committee of Congress that would produce debt reduction legislation by November 23, 2011 that would be immune from amendments or filibuster. The goal of the legislation is to cut at least $1.5 trillion over the coming 10 years and be passed by December 23, 2011. The committee would have 12 members, 6 from each party.
• Projected revenue from the committee's legislation must not exceed the revenue baseline produced by current law.
• The agreement specifies an incentive for Congress to act. If Congress fails to produce a deficit reduction bill with at least $1.2 trillion in cuts, then Congress can grant a $1.2 trillion increase in the debt ceiling but this would trigger across the board cuts ("sequestration") of spending equally split between defense and non defense programs. The across the board cuts would apply to mandatory and discretionary spending in the years 2013 to 2021 and be in an amount equal to the difference between $1.2 trillion and the amount of deficit reduction enacted from the joint committee. The sequestration mechanism is the same as the Balanced Budget Act of 1997. There are exemptions—across the board cuts would apply to Medicare, but not to Social Security, Medicaid, civil and military employee pay, or veterans.
• Congress must vote on a Balanced Budget Amendment between October 1, 2011 and the end of the year
• The debt ceiling may be increased an additional $1.5 trillion if either one of the following two conditions are met:
  
  1. A balanced budget amendment is sent to the states
  2. The joint committee cuts spending by a greater amount than the requested debt ceiling increase.

My understanding is that cuts were achieved and this was done without increasing tax revenue. This is therefore a broad conservative political victory. Conservatives, nevertheless, do not see this as a victory because it doesn't go far enough.

The reason for conservative unhappiness has more to do with their extreme ideological position. Since the onset on the Tea Party and their influence on Republican Party politics, the GOP has, amazingly, become even more ideologically conservative. Minarchism is now the default position of conservatives, which means that any form of government spending outside of military spending and law enforcement must be excised. This form of ideology, however, is backed up by a crazy form of patriotism that sees minarchism as the intended model explicitly advocated by the "founding fathers", which means that any different position (whether it be left wing or centrist) is automatically branded a threat worth "watering the tree of liberty for" (ie the blood of tyrants and patriots resulting from an armed struggle). Add to this the peculiarities of the US congressional system and the only real compromise position is the one which was passed.

As far as the effect on the broader economy, my understanding is that most of the cuts will come in after a two year period, which theoretically allows Obama some breathing space to run for a second term in 2012. The debt limit has been increased to allow for borrowing in the meantime and, all things being equal, should not require another increase until after the 2012 elections. "All things being equal" though is not a good phrase in these dark economic days. I have already predicted that the US will enter another downturn in 2012 and if this occurs the debt ceiling may need to be increased before the election, especially if unemployment ends up in the mid-teens, thus reducing government income tax revenue.

As for the Keynesian approach of pump priming the economy via deficits, this piece of legislation is of no help. My own call for a "Total War / New Deal" type economy (whereby large increases in government spending in health, education and alternative energy are accompanied by large tax increases) is even less likely to occur. Since the US economy's many structural flaws have not been addressed since the credit crunch of 2008, I thus have little faith that the free market will be able to generate jobs and economic growth in the short-medium term.

The 14th Amendment and the potential for economic disaster

The 14th Amendment of the US Constitution is currently being examined and touted as an important factor in the current debate about the government debt limit. I've blogged about this recently but I've had some more ideas about it. Here is the text again:

The validity of the public debt of the United States, authorized by law, including debts incurred for payment of pensions and bounties for services in suppressing insurrection or rebellion, shall not be questioned. But neither the United States nor any State shall assume or pay any debt or obligation incurred in aid of insurrection or rebellion against the United States, or any claim for the loss or emancipation of any slave. But all such debts, obligations and claims shall be held illegal and void.

Okay, the background of this amendment was post civil war. In its original context that first sentence guarantees the payment of debts incurred by the Federal Government in fighting and defeating the South. The second sentence, however, absolves the Federal Government from having to pay debts incurred by the Confederate States of America. The third sentence spells this out even more, permanently settling the question of Confederate debt.

It's the first sentence that applies in this current situation. Obviously the framers of the amendment thought it important not just to guarantee payment of debt by the Federal Government in the successful waging of the civil war, but to make it part of the constitution itself via an amendment. This means that they intended the principle behind this amendment to have an ongoing application.

The question is, what does it mean by debt? Obviously this debt is public meaning that it is owed by the Federal Government. In short it is money owed, and money owed that has been authorized by law. In other words, it is money that the Federal Government owes creditors - so long as it has been authorized by law.

As I pointed out in my recent article, this naturally applies to government bonds. As of the 26th July 2011, the US Government owes $14,342,830,116,551.28 in public debt. But is "Public Debt" in 2011 the same as "Public Debt" in 1868? There is a broader application of this term: there is debt accrued by borrowing, and there is debt accrued by buying. For example, if a government office gets a local company to mow their lawns, they naturally have to pay this local company. If we expand this idea outwards, we see that the Federal Government has legal obligations to pay for goods and services delivered to them by private industry.

But what about entitlements? Are entitlements considered debt? I think not. Entitlements such as Medicare and Unemployment benefits are probably not considered "debt" in this situation. Sadly this means that the 14th amendment does NOT cover money spent on Medicare or other social services.

"Public debt authorized by law" has also been interpreted by various bloggers and experts recently as to apply simply to spending bills authorized by congress. Essentially it means that if congress has authorized spending, then this cannot be invalidated by a debt ceiling... hence the debt ceiling as it stands is unconstitutional. I'm not sure of this broad definition for a number of reasons. The first is that the amendment itself doesn't specify it. The second is that we are talking here about Public debt - debt owed to the Public, ie not the government.

If you take this second definition to be important - PUBLIC debt - then what to make of government spending bills authorized by law? Well so long as the PUBLIC get what they are owed, the 14th amendment will not be broken. But if the Federal Government decides to stop paying its own employees, that is completely different because the money owed to their employees is not public. There are approximately 2.8 million people employed by the Federal Government.

Here's a summary of my thinking on this issue:

• "Public Debt" means money owed to non Federal Government creditors.
  
• These creditors include those holding government bonds, as well as those who have sold goods and services to the government.
• The 14th Amendment prevents the Federal Government from defaulting on money it owes to bond holders.
• The 14th Amendment does not specify whether payment of money to bond holders needs to be paid "on time" or "later"
  
• The 14th Amendment prevents the Federal Government from defaulting on money it owes to private businesses and individuals for goods and services provided.
• The 14th Amendment does not specify whether payment of money to these private businesses and individuals needs to be paid "on time" or later".
• Money for those who qualify for government services and entitlements - such as unemployment benefits and Medicare services - are not considered "Public Debt" since they are not "owed" money they have directly invested or money they owed through the provision of goods and services.
  
• Under the constitution, Congress is responsible for all spending bills.
  
• A self imposed limit on the amount of debt the Federal Government can borrow is within the constitutional powers of Congress.
• The 14th Amendment does not prevent the Federal Government from defaulting on money it owes to itself on the bond market. Intragovernmental debt is not "Public Debt".
• The 14th Amendment does not prevent the Federal Government from defaulting on money it owes to itself via spending bills.
  
• Money owed to government employees and government departments is not "Public Debt".
  

So given that these are true, what happens if the debt ceiling is not passed? We need to assume here that without a debt ceiling, the Federal Government will be forced to spend only as much as it gets in tax revenue. Specifically what might happen here?

• The Federal Government will not default on paying back interest and principal on bonds owed to the Public.
• Social Security payments are likely to be defined as money owed to the Public, so payments will continue.
  
• The Federal Government will not default on paying back money owed to private businesses and individuals for goods and services provided.
• Delays in payments nevertheless may occur.
• The ordering of future goods and services from private businesses and individuals may be cut.
  
• Money for entitlements (Health Care, Unemployment benefits, etc) can be cut.
• Money for defense can be cut.
  

As I have pointed out, I don't think an arbitrary self-imposed debt limit set by Congress is somehow unconstitutional since Congress is responsible under the constitution for spending government money. Also, it won't be a case of a law passed earlier (the debt limit) being superseded by a law passed later (spending bills) since the earlier law was specifically designed to prevent something happening in the future.

So if the debt limit is not passed and is not declared unconstitutional, what we won't see is a default on government bonds but there is a chance that these payments might be delayed. This would be viewed by the market as a form of selective default. Similarly Social Security payments might end up being delayed, as would be money owed to government suppliers for goods and services owed.

But in order to ensure that these obligations are met (either straight away or over time), certain government departments would have to undergo a drastic reduction in spending. We would see the government either retrench or put on furlough tens of thousands of its employees, if not many, many more. Those with unemployment benefits would have them reduced or postponed indefinitely. Those awaiting or needing medical procedures covered by Medicare will have them delayed indefinitely with priority given only to the most severe cases.

As I pointed out in my previous post on this subject, the US Federal Government currently takes in revenue equivalent to 15% of GDP while its spending is equivalent to 25% of GDP. The 10% gap between revenue and spending is shored up by borrowing. If the debt limit is not raised then the Government will have to reduce its spending to meet its revenue. We would see a reduction in spending from 25% or GDP to 15% of GDP, which is a 40% cut in spending. If we assume that bondholders, social security recipients and government suppliers are protected by the 14th amendment then everything else covered by government spending will be cut.

Needless to say this will have a hugely negative effect upon the economy. With 10% of the economy suddenly halting, you could assume that GDP would drop by at least 10%. The knock-on effects, caused by the money multiplier going into reverse, could conceivably double this impact. And this would be the case even without defaulting.

Peak Oil: All signs point to yes

This diagram comes from The Oil Drum:

I was initiated into the world of Peak Oil some time in 2004. Initially I thought it was a bunch of scary tinfoil hat wearing nonsense - partly because some tinfoil hat wearing people were promoting it (not you Dave!). The deeper I dug, however, the more the evidence piled up. The tinfoil hats were replaced by serious looking academics with qualifications from reputable universities and experience working in petroleum geology. They pointed out that data consistently showed that individual oil fields had an oil production rate like a bell curve, and that less and less oil comes out once the "peak" of the curve has been reached  - which usually comes when the oil field is half empty.

The problem was, and still is, that many are under the false understanding that oil supplies will simply run out suddenly. They are buoyed by market reports showing that oil reserves have another 100 years production left in them. Thus they are ignorant of the fact that, when the majority of the world's oil fields reach 50%, worldwide production will drop.

The graph above shows very clearly that this moment has arrived. Depending upon which metric you use, oil production has either reached a plateau now, or reached one about five years ago.

Being an econophile before I understood Peak Oil, I naturally assumed that price signals would motivate the market to increase production. Yet if an increase in production is geologically impossible what happens when demand increases? When supply is constrained and cannot rise to market demands, what happens?

Simple: Production remains the same, while prices skyrocket. The graph above shows this phenomenon so clearly that you would have to be cognitively deficient not to notice. Some time in 2004 the price of oil begins to rise due to increased demand. This demand was not met by an increase in production, as the graph shows. Oil production then simply sits at the same level for some years. Oil producers are literally unable to pump the stuff out fast enough to meet demand. Oil prices double from their 2004 levels. Then they triple. Then they reach a peak in 2008 before demand destruction hits - the Global Financial Crisis.

Since then prices have dropped. But notice that they have begun skyrocketing again.

Many years ago I blogged about a "perfect economic storm" to hit the US. While I didn't know the date I knew that it would happen. I knew that Peak Oil would be the major cause. What I didn't realise was the extent by which the US economy had over-geared itself and when this occurred I became far more worried than I had before. It was as though I had predicted the arrival of the largest category 5 hurricane in history, only to realise that it would be a category 6 hurricane (which doesn't exist of course, but that's not the point).

If there's anyone out there who is still doubtful about Peak Oil, remember this: If an increase in price doesn't lead to an increase in production, then there is something preventing an increase in production. If this phenomenon is experienced worldwide by many different and disparate sources, then production must be limited by more than just human choices.

Scientists have proven the existence of Peak Oil. The evidence is clear and unambiguous. Moreover it has been experienced by the entire world economy for the past 7-8 years. What more evidence is needed?

And until we wean ourselves off oil, the lag on economic growth will continue. Policy decisions needed to be made in 2004 and weren't. They need to be made NOW.

It's so gratifying to leave you wallowing in the mess you've made

Not good news:

Negotiations over a broad deficit reduction plan collapsed in acrimony on Friday after House Speaker John A. Boehner suddenly broke off talks with President Barack Obama, raising the risk of an economy-shaking default.

The epic clash between the White House and Congressional Republicans came a week before the government hits its borrowing ceiling, and set off sharp accusations from both sides about unwillingness to compromise.

A visibly angry President Obama, in a hastily scheduled White House news conference, demanded that Congressional leaders come to the White House on Saturday morning.

“I want them here at 11 a.m. tomorrow,” Mr. Obama said. “They are going to have to explain to me how it is that we are going to avoid default.”

Anyone who has played Sim City 2000 will remember the importance of maintaining a tight budget. But if your city in the game gets to a point where you're running out of money you have a number of serious choices to make in order to balance the budget. One option you have is to cut funding to roads. When you do so, this guy (your roads and transport secretary) pops up and yells at you:

What happens then? As time goes by your roads begin to crack up and become unusable. This is turn reduces economic activity and your own tax revenue even further. It's a short term solution but ends up costing you far more in the longer term. It's a sure fire way to lose to game.

Then, of course, there is that Simpsons episode where Homer becomes the town's sanitation commissioner. He manages to gain this position through an election campaign where he simultaneously lies about the incumbent (and even defames him) and gives outrageous promises to the voters, all with Bono's consent. When the scheme blows up in his face (the yearly sanitation budget is used up in a matter of weeks) he resorts to a scheme whereby funds are generated by taking the trash from various US cities and storing it underneath Springfield. This, of course, turns the town into a smelly, garbage infested hell hole. An emergency meeting is held in the town hall and the people unanimously vote for the previous commissioner (Ray Patterson, voiced by Steve Martin) to retake the job. Patterson saunters on stage to music and then says this:

Oh gosh. You know, I'm not much on speeches, but it's so gratifying to... leave you wallowing in the mess you've made. You're screwed, thank you, bye.

I have to say that part of me wants to call the Republicans' bluff and not raise the debt ceiling. To be honest with you it would be the easiest and quickest way for them to achieve their ideological ends. I have already pointed out that such an action would cut federal government spending by around 40% and represent a cut in spending from about 25% of GDP to around 15% of GDP. According to historical notes on the US budget, the last time the US government was that small was 1951 - in other words the Republicans have a once-in-a-lifetime chance to shrink the government to its lowest level in 60 years. Moreover, this would not lead to debt default, as the 14th Amendment protects bondholders.

And it's not as though such a move wouldn't be popular, at least initially. There are many in the US who claim that the Federal Government has no real input into the economy. "Let's shut her down!" some would say, confident that such a move would have no real impact upon the economy and society in general. And as for all those pesky civil servants out of a job, well they weren't doing anything really important anyway. And it's not as though we can't afford to pay them unemployment benefits since such benefits would disappear anyway for everyone once the great spending cut occurs. And with so many people unemployed and not receiving benefits, they would then be able to get off their collective lazy asses and find jobs. Then the economy would start booming again.

Of course these sentiments are nonsense. Anyone with any understanding of the complexity of economics, the effect of government programs and the problems besetting the unemployed would know that such a gigantic cut in government spending would have only a negative impact upon the US. It would cause social and economic pandemonium.

And yet part of me wants to the GOP to do it. I do admit that there is some perverse pleasure in watching an economic collapse unfolding, in the same way that people hang around and watch the aftereffects of an accident.

Nevertheless I do have a rather pragmatic reason for wanting this to occur - the disaster that it brings on the nation (and the rest of the world) will be so damaging that no one would take hard-line conservatism seriously ever again. The disaster would be so horrible that Obama would be re-elected by a landslide and the Republicans would be utterly humiliated in Congressional elections. More than that, hard-line conservatism throughout the world would be discredited in the same way as communism was discredited after the collapse of communism.

And why? Conservatives have painted themselves into a corner. They are just so angry that things like Medicare, NASA, unemployment benefits and the Department of Education exist. It's not just that they don't like big government, it's that they so strongly believe that their understanding of limited government was the same thing believed by the founding fathers that anything, anything which suggests slightly higher government tax revenue or spending is immediately cause for revolution and "watering the tree of liberty". In the words of Grover Norquist, "I don't want to abolish government. I simply want to reduce it to the size where I can drag it into the bathroom and drown it in the bathtub."

Of course I see such people as not just hard-line but extremist. Their ideology has regressed so far that even Ronald Reagan, patron saint of Conservatives, would be labeled a "Republican in Name Only" for many of his policies.

And so this is why part of me wants the Republicans to follow through with the extremist ideology that now controls their party - it would allow them the chance to finally do what they've always wanted to do while simultaneously proving to the rest of America and the world the utter stupidity and unworkability of their policies. Their fate would be to disappear from the political landscape for a long, long time. The world would then become a much better place.

And as their doom descends and the party faithful shrink in horror at what they've done and seek to make amends, the voice of Ray Patterson calls out to them:

It's so gratifying to leave you wallowing in the mess you've made. You're screwed, thank you, bye.

The 14th amendment and the possible government shutdown

Oh dear:

Crisis talks on the United States' debt limit remained deadlocked overnight as negotiations led by US president Barack Obama degenerated into a slanging match.

The president is said to have stalked out of the latest debt talks, which both sides have acknowledged as the most heated yet.

"This may bring my presidency down, but I will not yield on this," Mr Obama is quoted as saying.

The prospects of politicians reaching a deal to raise the debt ceiling are still in question after fifth straight day of talks.

Some econ bloggers have pointed out that the 14th Amendment of the United States renders the "debt ceiling" unconstitutional:

The validity of the public debt of the United States, authorized by law, including debts incurred for payment of pensions and bounties for services in suppressing insurrection or rebellion, shall not be questioned. But neither the United States nor any State shall assume or pay any debt or obligation incurred in aid of insurrection or rebellion against the United States, or any claim for the loss or emancipation of any slave. But all such debts, obligations and claims shall be held illegal and void.

My view is that the "debt ceiling" is not unconstitutional. What is unconstitutional is to default on this debt. Let me explain.

All the "debt ceiling" does is prevent the government from borrowing any more money beyond the previous predetermined limit. Since congress has the power under the constitution to legislate borrowing and spending bills, any self imposed limit on the amount of money the federal government borrows is entirely within their purview.

So what happens when congress doesn't increase the debt limit a "government shutdown" is initiated?

All it means is that the government will have to cut spending in order to fit into the amount of money they do receive. Spending must be cut. And if we believe that the 14th amendment will be followed, then we can assume that paying back interest and principal on money borrowed will not be affected at all. Instead, spending cuts will be made to other areas of government control. Spending on health care will be cut drastically. Military spending could possibly be cut. Social Security spending cuts would only occur if the spending is not considered "government debt".

My spreadsheet tells me the following about US government debts and receipts:

So if revenue represents 16.61% of GDP and spending represents 25.29% of GDP, then any failure to increase the debt ceiling will force the federal government into spending only as much as it gets. This would mean 16% spending instead of 25% spending. In short, it would reduce the spending size of government by around two-fifths. You can imagine how devastating such an action would be upon the economy.

But what about government debt? The last time I checked, interest paid on government debt made up around 2.8% of GDP. Even after a potential failure to increase the debt ceiling, interest on treasury bonds and other debts will have ample room to be paid back.

A failure to raise the debt ceiling will most certainly shrink government spending, but it will not result in debt default. The unemployed will no longer be given payments, Medicare will grind to a halt, NASA will disappear, even social security has the potential to be scaled back... but at least those who lent the government money will get their interest - hardly a cause for celebration.

To summarise the 14th amendment on this issue: The amendment doesn't invalidate a debt ceiling, it just ensures that government debt will be paid off even if any debt ceiling isn't increased.

Gold's Fooled

This is a comment I made at Reddit:

(F)iat money has one unique inherent value: it is far and away the main method of exchanging goods and services.

Switching over the gold, silver or other precious metals that are physically held in vaults while "owners" have currency that is linked to these metals may sound good on paper (no pun intended), but there are problems:

1) Your currency goes up and down in value according to how much gold, silver or whatever is hitting the market. If Russia or China or some other nation suddenly ups production of precious metals, then your currency goes down in value, leading to inflation.

2) Mining companies become the world's central bankers, adjusting inflation according to their production levels but only ever looking after their shareholders.

3) If the economy grows faster than precious metal production, then the result is deflation and increasing levels of precious metal ownership, which would end up becoming a bubble.

4) If the economy grows slower than precious metal production, inflation results.

5) Precious metals are only "precious" because we as humans grant them worth and only do so for reasons of vanity - not because they are inherently useful (the usefulness of gold, silver and other precious metals as an industrial and practical material is minuscule compared to their value as jewelry and such). If we can arbitrarily assign worth to relatively impractical metals such as gold, silver and the like, then we can also arbitrarily assign worth to coins, notes and bank balances.

6) Fiat money is controlled ultimately by a national government (or supranational entity in the case of the Euro) who delegates that authority to a central bank. Commercial banks use fractional lending to create more money by fiat, but their operations can be curbed and influenced by central bank policy (such as raising interest rates, which constrains the money supply and is deflationary, or lowering interest rates, which increases the money supply and is inflationary). So long as price stability is maintained, fiat money has been and will always be more useful than a gold standard (or similar). It is only when central banks give up on price stability that money loses its unique usefulness as a unit of exchange.

($1 Billion will be paid to the first person who interprets the title of this post and the image that goes with it)

Iceland vs Ireland: Which is worse?

Much has been said recently about the contrasting fortunes of Ireland and Iceland. In 2008, both nations were seriously affected by the global financial crisis with both economies declining substantially. Recent commentators, most notably Paul Krugman, have argued that Iceland's response to the crisis has had a better outcome than Ireland's. Iceland, with its own currency, allowed the Krona to depreciate substantially - a process which caused an inflationary bout. Ireland, on the other hand, is part of the Eurozone and while capital flight has been felt in the Irish bond market, the Irish economy has not undergone a currency depreciation - a process which has caused a bout of deflation.

So in order to discover which nation has had a worse economic experience, I have mined some data at official sites. For Irish GDP data, I downloaded the latest Quarterly National Accounts; for Icelandic GDP, I looked up data at Statistics Iceland. In order to ensure harmony between the two datasets (and thus ensure apples are being compared to apples) I cross checked the data with the latest Eurostat GDP release. Then, via a spreadsheet, I have created an Index comparing the economies of the two nations. Here is that index:

As you can see the current situation is hardly good for either nation. According to this index, Ireland's economy has shrunk by 13.4% since 2007 Q4, while Iceland's has shrunk by 11.7%. The advantage that Iceland has over Ireland in terms of GDP is quite small. Moreover, Ireland's economy has been in trouble longer than Iceland's - it wasn't until 2008 Q4 that Iceland's troubles really began while Ireland's had begun 12 months previously.

Nevertheless, one important indicator shows a huge difference between the two: unemployment. The latest figures from The Economist show that Ireland's unemployment is currently 13.6%, while Iceland's unemployment is 7.5%. Another important indicator is the budget balance. The Economist tells us that Ireland's budget balance is -37% of GDP, while Iceland's is only -7.7%. While both nations have serious problems, these figures seem to show that Ireland's is far worse.

Of course one of the reasons why Iceland and Ireland are so different in their experience of the economic crisis is the one that Krugman likes to champion: devaluation. Iceland has allowed the Krona to devalue while the Irish are "stuck" with the Euro. Yet this argument assumes that exchange rate variations don't really matter - at least over the medium to long term. It is obvious, though, that Iceland's GDP has reduced in value in comparison to the Eurozone simply because of the Krona's devaluation. When we factor in the devaluation of the Krona when comparing the two nations, the difference is much starker:

The data for the Krona's performance against the Euro can be found here. I averaged out the monthly mid-range figures for each quarter. For example the Euro-Krona exchange rate for 2007 Q4 was 88.7466926667 while for 2008 Q1 it was 101.325026. I then assigned an index of 100 for the 2007 Q4 and used the math in the spreadsheet to multiply each quarter's decline in currency to the GDP figures.

According to this graph, Iceland's GDP, as measured in Euro, has declined by a whopping 52.1% since 2007 Q4, which is due to a combination of economic decline and currency devaluation. While Iceland's unemployment rate may be lower than Ireland's, holders of the Krona (ie the citizens, businesses and government of Iceland) have had their wealth taken away... not by taxes, not by spending cuts, not by austerity measures, but by the foreign exchange market.

Ireland has a number of choices, none of them good. One choice is to default on debt. Another choice is to take money away from households and businesses in the form of spending cuts and/or tax increases. Iceland, by contrast, has had these choices forced upon them by the currency devaluation. If Ireland had the choice of default, Iceland has already done this as international creditors have lost out on their investment. If Ireland has the choice to take money away from households and businesses, Iceland has already had this done as the purchasing power of the Krona has been essentially halved.

The Iceland/Ireland battle is an interesting one because it lines up different views of economics: Iceland is favoured by Krugman and those who believe in using inflation as a means to reduce real debt; Ireland is favoured by Europhiles and those who believe that currency devaluations and inflation damage economies; Iceland is favoured by those who are not too concerned about sovereign debt default; Ireland is favoured by those who believe that debt should be paid back, especially sovereign debt; Iceland is favoured by those who believe that the Eurozone and its "one size fits all" monetary policy is doomed to failure; Ireland is favoured by those who see inherent advantages in having a common currency and monetary policy which ensures that the currency retains its value; Iceland is favoured by those who believe that monetary policy should be used by central banks to help grow the economy when needed; Ireland is favoured by those who believe that price stability should be a central bank's sole concern, and that fiscal policy should be used by governments to grow the economy when needed.

My bet, of course, is with Ireland - the Eurozone recovery, led by Germany, will create a demand for Irish goods and services, grow the Irish economy and reduce Irish unemployment. Nevertheless it will be fascinating to see how these two nations perform as years go by.

Krugman's inflation suggestion: not a good idea

Paul Krugman is good man. He's brilliant too, and deserves that Nobel Prize he got. Moreover he and I both warned of the coming economic crash. So I respect him.

But since 2008 our paths have diverged. Krugman and Joseph Stiglitz, brilliant though they are, are arguing that a dose of inflation is needed to recover the economy. In the other corner lies OSO, Kenneth Rogoff and those who run the European Central Bank, who argue that price stability must be maintained whatever the circumstances, and that efforts must be made to reduce sovereign debt levels.

One of Krugman's arguments of late is that increasing the money base won't help the economy to recover and points to the experience of Japan, who increased their monetary base back in the 90s without seeing an commensurate increase in inflation (at least not enough to reduce deflation). Money printing will not work during a solvency crisis he argues.

Maybe I'm a little too monetarist to agree with Krugman here. My response to the idea that money printing won't lead to inflation is to naturally point at Mugabe's Zimbabwe and Weimar Germany. Certainly these two examples are extreme but they do provide an extreme example of what can happen if governments resort to seigniorage to fund government spending. You can be assured that if the US government organised a similar scheme with the Fed the result will almost certainly be the same. Moreover, had Japan in the 1990s followed the same policy (Mugabe Zimbabwe/Weimar Germany money printing) the result would've been the same.

So how do I explain the facts around early 90s Japan that Krugman uses as evidence? It's simple: Japan didn't increase the monetary base enough. Erring on the side of caution and concerned that they didn't want hyperinflate, Japan's increase of the monetary base was simply too small to make any impact on M2. Since a central bank can theoretically create an infinite amount of money, nothing really prevented Japan from increasing the monetary base beyond what is shown on Krugman's graph.

This is important to realise because I believe that a new system of monetary policy needs to be created, using some of the more radical monetarist ideas of years past. Moreover, unlike Krugman and Stiglitz, I would argue that the inflation target should not be "high" (Krugman argues for 4% inflation) but should be even tighter than what was practised over the past 30 years. Absolute price stability (whereby there is neither inflation nor deflation over the long term) should be the new goal, and it is something that I have been presenting as a solution for some years now. Certainly at the outset of the financial crisis I asked the question of whether the current system needed to be changed. It seems that the thinking of progressive economists has been "yes", but in the opposite direction to what I would argue.

I had assumed that the question of whether inflation was good or bad was solved once and for all by Paul Volcker, who ended the stagflation of the 70s by raising US interest rates and killing off inflation - a process which put the US into a deep recession but which resulted in a low inflation recovery. Moreover I also remember the post-war commitment to Ordoliberalism in West Germany, which created the Wirtschaftswunder - and the importance of low inflation in creating an effective post-war nation.

My argument is this: the closer an economy gets to price stability, the more scope there is for sustainable growth. Conversely, the further away an economy gets from price stability (and that includes persistent inflation as well as persistent deflation), the more scope there is for something to go wrong.

Of course money isn't the real issue. The real issue is the production of goods and services and, according to Robert Solow, the ability to make them more efficiently over time (the cheaper production of goods and services over the long term leads to real economic growth). Money is important - it is essential - but how an economy produces & consumes and invests & borrows depends upon whether price signals are accurate or not. Of course no economy is perfect and people with money will not make rational decisions - but when money retains value over the long term, people are less likely to use their money for irrational purchases or investments.

As I have pointed out years ago, there are three things to remember about money:

1. It is used as a unit of exchange to purchase goods and services.
2. It is subject to the laws of supply and demand.
3. It is used to measure relative worth.
   

The problem arises when the effects of 2) interfere with the need for 3). If the value of money changes - either through the process of inflation or of deflation - then it no longer functions effectively as a way to measure relative worth.

As an example of this problem I remember reading the biography of Allan Border in which he purchased a car in the early 1970s for around $300, and then sold it in 1978 for the same amount. Of course in the intervening years the level of inflation was quite high, which meant that while he may have felt he had done well in not losing any money in selling it, the reality was that the depreciation of the value of his car matched the depreciation of the value of the currency he used to buy it in the first place.

Of course these arguments seem to be axiomatic - logical presentations without the influence of hard data - and I admit that this is a failing except in two areas: The effect of low inflation in post-war Germany to help create the Wirtschaftswunder; and the need for Paul Volcker to destroy inflation in the early 1980s to bring about a more sustainable economy.

Aiming for higher inflation, as Paul Krugman argues, is exactly the wrong thing to do. It may result in some level of growth but over the long term it will erode America's economy even further. Price stability must be maintained no matter how good or bad an economy is running. It is non negotiable. Economic problems can't be fixed by abandoning price stability, even though many economic problems may remain while price stability is maintained. Other solutions must be found, which puts the onus squarely upon governments to adjust their spending and tax rates (either by expanding or contracting their spending, depending upon how much in debt they are). In many cases it may simply be a matter of waiting until the market sorts itself out.

Other articles of a similar tone:

2008-10-11 Economic Crises still need price stability
2008-10-13 Random thoughts on money (explains some of my thinking in more detail)
2009-01-28 I still believe in inflation targeting

A response to John Quiggan's "Zombie Economics"

John Quiggan, an economist, political commentator and fellow Australian, wrote an article recently for foreignpolicy.com entitled "Five Zombie Economic Ideas That Refuse To Die". His article fits into the same tone that Richard Werner wrote in "New Paradigm in Macroeconomics" in 2005, namely that neo-classical economic ideology (called neo-liberalism here in Australia) has failed to deliver what was promised.

Before I begin my critique of Quiggan's article, I need to first point out that I regularly enjoy reading Quiggan's blog. I find his point of view interesting and his arguments compelling. Like Quiggan I have a lot of sympathy towards Social Democracy and its tenets, as well as some of the wars he has engaged in (namely an informed disdain for News Limited and defending the science of global warming). I also need to point out that much of my critique of Quiggan's article is not based upon a defence of neo-classical economics but upon policy that I believe is simply the best choice.

Let me start with Quiggan's first point, that of "The Great Moderation". Quiggan says:

More importantly, central banks and policymakers are planning a return to business as usual as soon as the crisis is past. Here, "business as usual" means the policy package of central bank independence, inflation targeting, and reliance on interest rate adjustments that have failed so spectacularly in the crisis.

Quiggan then goes on to quote Jean Claude Trichet's comments about inflation, namely the importance of maintaining price stability in good times and bad. Quiggan points out that this attitude is "startlingly complacent".

My argument is that Central Bank independence should be maintained and that monetary policy should be geared towards keeping inflation down. Unlike many who argue that an "inflation target" should be set, it is my point of view that absolute price stability be the goal of monetary policy, whereby money neither increases nor decreases in value over the long term. Now while neo-classical and neo-liberal economic ideology argues for strict price stability, my reasons for holding this position do not come from either of these movements but from a much older idelogy - Ordoliberalism. This economic school was developed in Germany in the post war years and was responsible for Germany not just recovering from the devastation of World War Two, but becoming the economic powerhouse of Western Europe.

Let me just do a quick history lesson here. Please be patient.

After the hyperinflation of the Weimar Republic years and the disaster of the Hitler years, West Germany suffered under some very vengeful and short-sighted policy by occupying US forces. Joint Chiefs of Staff Directive 1067, signed by President Truman in 1945, attempted to de-industrialise Germany. Even though Germany did gain some relief from the Marshall Plan, the amount of money they were forced to pay in war reparations was greater than anything they received from the US. In short, West Germany, wrecked from the war, faced the prospect of paying the allies (net) war reparations while being forced to de-industrialise and turn into an agrarian economy. The result was disaster for Germany: poverty went hand in hand with growing inflation. In the years following the end of World War II, poverty in Germany grew worse and worse.

JCS 1067 was eventually overturned and the West Germans were granted the responsibility to look after their own economy. The philosophy that guided them was Ordoliberalism - the idea that the state should regulate the free market in order to allocate resources effectively. It was neither the Democratic Socialism that was embraced by the UK and France in the 1950s nor the Laissez-faire model of the US. One of the tenets of this philosophy was low inflation: Price Stability. The Deutschmark replaced the Reichsmark under this change, and stable prices formed the basis of Germany's growth during the years now known as the Wirtschaftswunder.

What we have learned from economic history is that any major swing towards inflation or deflation leads inevitably to hardship. Deflation beset the world during the Great Depression; Inflation beset the world during the 1970s and hyperinflation has led to ruin in numerous nations, including Ancient Rome, Weimar Germany and Zimbabwe today.

So what level of inflation does Quiggan want? Is 5% inflation too high? is 7%? Is 50%?

Ah, Quiggan might respond, what about the US over the last ten years? They had low inflation and that didn't stop the financial crash did it? To which I would respond by pointing out two things: Firstly that interest rate policy alone will not prevent a crisis from occurring, but is one important part of a whole host of things that should prevent a crisis. If a driver gets injured because another car rammed into him, it would be disingenuous of him to blame it on his tyres.

Secondly, that while inflation was historically low in the US for the past ten years, real interest rates were negative between 2002 and 2005. Many economists have pointed out that the US Federal Reserve kept interest rates too low during this period which, in turn, created the property bubble which burst and helped create the current financial crisis. The Washington Consensus, a neo-classical and neo-liberal text that has guided IMF policy for many years, specifically highlights the need for real interest rates to be positive. Had the US actually kept in lockstep with neo-classical ideas, this period of negative interest rates would never have been allowed. The crisis thus did not stem from a complete adherence to neo-classical ideology but from a deliberate rejection of what I consider to be good policy. If we go back to the car analogy, a driver who has injured himself by driving irresponsibly shouldn't blame the laws that he neglected to follow.

It also needs to be pointed out that the Federal Reserve Bank, unlike the ECB and Australia's Reserve Bank, did not have an inflation target to aim for, but kept markets guessing. The Fed certainly had a goal for price stability, but it was amorphous and opaque. This of course shifts the issue to whether a Central Bank should be independent. The original reason for making a Central Bank independent was to insulate it from political pressure in order to enact monetary policy that would be governed by price stability and not political interference. While I still believe in this, I am also willing to admit that Central Banks are not necessarily immune from market influence. The Federal Reserve, for example, has an unusual amount of employees working for it who once worked for Goldman Sachs. The fact that the market has been able to influence central bank policy does not therefore mean that they should come back under government influence, but that steps be taken to insulate it from all forms of undue influence. In other words, I am advocating a Central Bank that is not just independent, but also transparent and accountable.

To summarise my position on central banks and the current economic crisis: Central Banks should focus upon price stability as their main goal and set realistic low inflation targets (and again let me advocate absolute price stability instead of low inflation targets). Central Banks should be independent of government and market influence, while remaining transparent and accountable for their actions. Jean Claude Trichet, head of the ECB, was quoted by Quiggan as saying this, which I heartily affirm (and which Quiggan criticises):

Keeping inflation expectations anchored remains of paramount importance, under exceptional circumstances even more than in normal times.

There is nothing "neo-classical" or ignorant about this policy. In fact one could argue that had this policy been abandoned during the current crisis, we would be suffering even more.

One last thing before I move on: shouldn't central banks have a wider focus of reducing unemployment and fostering economic growth and not just price stability? To me that question is moot. Worrying about economic growth and the unemployed should be the focus of the government, not the central bank. "Pump priming" the economy through Keynesian stimuli should not be ignored as a policy, and nor should increasing the size of government to bring about a better economy over the long term. These I advocate, which plainly shows just how different I am from the neo-classical mould of "keep government small and let the market do everything", though I would point out that the government needs to control the level of debt throughout this process.

Quiggan's points on modern day monetary policy and the so called "Great Moderation" were my main problem. Now let me move on to Quiggan's other points.

The second point Quiggan critiques is the "Efficient markets Hypothesis". While Quiggan and I agree that letting the market do everything is a silly and dangerous policy, so to would be the idea that the government do everything. Quiggan is not a communist who advocates a planned economy, but his article is light on what he thinks should replace the current crazy "markets are always wonderful" idea. My argument has been that there are sectors of the economy that the government is better suited to controlling and sectors which the market is better at controlling, and that there are even areas where a combination of government and market result in the best outcome. Health Care, for example, has been shown to work best when a government run universal health care system operates alongside a smaller market system aimed at those who wish to pay more for their health. It is this combination of majority government and minority market which works so well in Western European Social Democracies and in countries like Canada, Australia and New Zealand. The US system, in which government healthcare is limited and which the market is dominated by health care companies, has been shown to be less efficient and less effective than the one employed by social democracies.

So while I agree with Quiggan that the "efficient markets hypothesis" is bunk, I would also argue that some markets are efficient while others are not - and those that are not should have some level of government intervention, which ranges from a stricter regulative environment at one end to complete government control at the other end. This again shows my belief in Ordoliberalism.

Thirdly Quiggan points out the stupidity behind Dynamic Stochastic General Equilibrium. I'm certainly in complete agreement with him on this one, as with his fourth point, that of the complete failure of "trickle down economics" to trickle anything down to lower income earners. Median wages in the US have certainly stagnated in the last ten years, and were affected most by Reaganomics, which cut taxes for the rich. While I admit that income and wealth disparity will (and should) always exist, there is a point at which it becomes ridiculous. Aiming for a GINI coefficient of under 30 should be a policy goal for any nation who wishes to intelligently reduce poverty levels.

Quiggan's final point concerns privatization: the selling off of government assets and economic sectors and their replacement by private companies. Again this is one area that I am in partial agreement. There are some government entities that definitely needed to be privatised. In the case of Australia, Qantas, the Commonwealth Bank and Telstra were progressively privatised over many years and I have no problem with these changes. Why should the government compete in the airline industry if private industries can do it better? Nevertheless the privatization debate is grounded on the efficient markets hypothesis, which I have written briefly about above. Privatization might lead to better economic and social outcomes, but then again so might nationalization of some industries. The guiding principle here should be pragmatism and social and economic harmony.

Like many post-crash commentators, Quiggan's points are a mix of good and bad. There is no doubt that the previous policy regime needs to be challenged but there is a point at which the proverbial baby is thrown out with the bath water. Marxism and Communism made the mistake of treating capitalism as an enemy that should be destroyed, while modern-day market advocates treat government as a similar enemy. Different ideologies, same blindness. Neo-classical / neo-liberal economics has certainly failed, but in developing alternatives we cannot ignore some of the truths hidden within its failure: Not all markets are efficient, but some are; Not all government programs are efficient, but some are; Price stability won't solve everything, but it does solve some things.

Another graph proving Peak Oil

Take a look at this graph from The Oil Drum:

Those in the past who deny Peak Oil have tended to do one of two things. The first is to attack the actual science behind it, trying to disprove Hubbert's Curve. The second is to argue that there is plenty of slack within oil productive countries to meet demand. What the graph shows is that neither of these are true.

One of the basic tenets of economics - in fact the basic tenet - is that of supply and demand. If demand increases, so should price; if supply increases, prices should drop. What we see in this graph is that from about 2003 onwards, demand for oil was not met by supply. Despite the myriad sources of oil supply all over the world, not enough oil was produced to keep prices down. Between 2003 and 2008, prices essentially tripled. Yet over the same period, supply hardly moved.

So if Hubbert's Curve was wrong, and oil reservoirs can just keep pumping out as much oil as is needed, then why didn't oil producers simply increase production between 2003 and 2008? Moreover, why hasn't production increased since 2005?

And if there is plenty of slack for oil producers and so many new oil projects up and running to take advantage of the high price of oil (which is still historically high despite the worst recession since the 1930s), then why isn't production increasing?

This graph seems to clearly indicate that not only was the theory of Peak Oil correct, but that the peak has already occurred - in 2005.

OSO's pontifications at Reddit

I've realised that some of these are worthy of posting here:

In response to the GOP's "Pledge" about controlling the US budget:

I'm actually a person who has looked at the stats. I know how much the US budget deficit is. I know how much US public debt is. I know the proportions of spending by various government agencies.

So let me summarise from here what the biggest things in the budget are, in order of amount:

1. Department of Health and Human services. (Medicare and Medicaid).
2. Social Security.
3. Department of Defense.
4. Interest paid on money owed

So there are only these four places for the Federal Government to cut into. Everything else represents a very small proportion of government spending. Even if you completely cut funding to NASA, Homeland Security, the FBI, or Department of Education, the result will be negligible.

So what Americans need to ask the GOP is "What are you going to cut spending on to bring the budget back into balance?".

1. Is the GOP going to gut Health and Human services? This means less money for Medicare and Medicaid. Old people especially will be hit by this.
2. Is the GOP going to gut Social Security? Less money for retirees.
3. Is the GOP going to gut Defense? Yeah right I see that happening.
4. Is the GOP going to stop paying debt off? That would mean defaulting on treasuries.

In the end the only real solution is to increase tax revenue, which means increasing taxes. The GOP won't do that. In fact they'll probably cut taxes for the rich again, convinced that maybe this time it might work.

Which means that the GOP will simply put the Federal government further and further into debt. That's what they've been doing since 1981, so we can assume that they'll go with tradition on that one.

In response to predictions of the "end of the world" and the fact that so many have failed:

The thing is that history is replete with instances of societal collapse and population downturns. War, famine and disease have taken away huge proportions of human population.

The "end" is never the "end", unless you're talking about Jesus returning or a massive impact event. The Roman empire ended - slowly and painfully. But people still lived in Rome. Other empires came along and replaced them.

We have around 6 billion people living in the world at the moment. If global warming takes a turn for the worse and agricultural production drops by 95%, it will probably mean the deaths of billions. But it won't be the end. People will still survive. Countries will disappear, governments collapse, borders moved, but there will still be stable governments and healthy people for a minority of the people on earth. And it will be that minority that will eventually flourish to replace the collapse.

So it's not the end of the world, but an end of a chapter.

In response to a Conservative Redditor who is very concerned about radicals taking over the Republican Party:

As a Liberal/Progressive, I like you.

We disagree over spending: I'm happy to increase spending and increase taxes; you're happy to decrease spending and decrease taxes. Both of us, however, oppose the stupidity of continually running deficits.

Even though I'm a lefty I have, like most people, a foot in both camps. I may believe in increasing welfare but I also believe in personal responsibility; I may believe in wealth distribution but I also believe that the talented and the hard working should be rewarded; I may oppose corporate corruption and tyranny but I also oppose government corruption and tyranny.

What saddens me is that conservatives in the US have degenerated into anti-intellectualism, blind ideological adherence and an inability to think critically. Popular conservative commentators reflect this belief.

Conservatism as a set of political beliefs has a lot to offer - seriously it does. But conservatives in the US pose a net threat to America's safety and prosperity.

If the GOP and the Tea Party do not do as well as they hope during the 2010 mid terms (ie control one or both houses of congress) I can see violence resulting.

A further comment on the same thread:

I don't even know who the "extreme radical left" are in the United States. There are certainly a few unreconstructed Marxists out there who still preach class warfare and the need for a people's revolution but they have, as far as I know, almost no influence upon the Democratic Party. Even Bernie Sanders is too right wing for these old Marxists.

There's a few anarcho-primitivists in the environmental movement, but they are too small.

I visit Daily Kos often - it's probably a good place to start in finding out the thoughts and beliefs of the young mainstream left in the United States. Although they support an expansion in government spending to fund universal health care, better public schools and better environmental policies, they are hardly trying to create a communist America. The policies of the Kossacks and those like them in the Democratic party is to move the US into more of a Western European social democracy. They may find the free market problematic and in need of change, but they are not preaching a complete government takeover of private businesses, wealth and property. By all means of measurement, the left in the US is moderate compared to historical progressive policy.

By contrast, the right wing in the US has no real precedent in history. The US right want the government to be turned into Minarchism while maintaining a series of very conservative social laws (eg against homosexuality & abortion, more censorship, etc). The America that the US right wing want is one in which the federal government runs the armed forces, state governments run law enforcement and the legal system is covered by both. Apart from that, the government should do nothing. Education will be run either as a private business or home schooling. The poor will receive no welfare except from the charitable giving of the wealthy. Health care will be provided entirely by private business and insurance agencies, with those who cannot afford it left uninsured or begging for charitable handouts. Social security should be eliminated and people should provide for their own retirement. These policies are a complete repudiation of all that has been learned in the last 150-200 years of Western Civilization. Thus the right wing in the US is historically very radical in its views and not moderate by any way of measuring political and economic beliefs.

And the more radical a belief is, the more likely that violence is to erupt. It erupted on the "left" when communism swept into Russia and China. It is likely to erupt on the "right" in the US due to the Tea Party.

And I finish by promoting Absolute Price Stability on a thread discussing the gold standard:

Fiat currencies are as inherently failure-prone as a car is - it depends upon the driver.

Car drivers can be stupid, they can be smart. If a car crashes it is oftentimes the fault of the driver.

When it comes to fiat currencies, it is up to central banks to control supply to ensure that it matches demand. When the demand for money increases so should its supply. When the demand for money decreases, so should its supply.

Money demand is called Money Velocity.

Basically it goes like this: Money velocity is sped up or slowed down according to the actions of the market and the government; Money supply is increased or decreased by the actions of the market and government when they respond to interest rates set by the central bank.

It is quite possible for a fiat currency to exist without any form of long term inflation. Japan since the early 1990s has had enough bouts of deflation and inflation to ensure that the Yen has neither gained nor fallen in value.

Of course Japan's economy during that period has not been the best, but what it does show is that an economy can function, GDP and GDP per capita can be raised and prices can remain stable even when a fiat currency is being used.

The key here is absolute price stability: ensuring that money neither rises nor falls in value over the long term.

Of course, by this argument, even low inflation targets are too high. The ECB, for example, tries to keep inflation under 2%. They should be keeping it just above or just below zero so that the average over the long term is zero.

As for gold... the problem with a gold standard is that for it to act as a currency it would need to not just retain its value but neither increase nor decrease in value, otherwise inflation or deflation would result. To increase gold supply would require more gold to be extracted from the ground (which would make mining companies de facto central banks) and, once it has been extracted, it cannot be "unextracted". By contrast a fiat currency can be created or "decreated" instantly by the actions of a central bank.

Random thoughts on Krugman and Treasuries

This came to me about halfway through watching Taxi Driver with Robert DeNiro:

Paul Krugman argues that further spending is necessary to stimulate the economy and prevent further contractions. Those who disagree with him, including myself, warn that excess government borrowings (in the form of increasing Debt/GDP ratio) will lead to a deterioration in market expectations that the debt will be paid off. Krugman's response is that if the market is spooked with treasuries, then why aren't bond rates going through the roof? He rightly points out that bond rates have fallen, not risen, in recent months.

My response to Krugman requires a bit of explaining on how bond markets work. When I first began to wrap my mind around bond investing, one thing which seemed incongruous was the fact that bond rates went down when the market purchased them, and went up when the market sold them off. It took me a while to realise that, while bonds are subject to the laws of supply and demand, the price measurement is inverted, which means that the interest rates on bonds drop whenever there is an increase in demand, and increase whenever there is a drop in demand.

In other words, if during a market day bond rates drop from, say, 2.8% to 2.7%, this means that there has been an increased demand for bonds. If the bond rates increase from, say, 2.8% to 2.9%, this means that there has been a decreased demand for bonds.

Bonds, like all investments, are driven by supply and demand. Moreover they are also subject to basic market failure which includes investment bubbles.

Many economists, Krugman included, warned the world that property prices in the US had developed a bubble and that a correction was overdue. In 2007 the market corrected and house prices began falling, which eventually led to the 2008 credit crisis and the subsequent "Great Recession". Those who predicted that property prices would not fall, or who then argued that the correction would be minor (Bernanke - I'm looking at you) were left with egg on their face. Moreover, market "experts" pre 2007 argued very strongly that the rise in property prices would continue and that the market was NOT going abandon it. Their reasoning was simple: "if the market was spooked, then why are property prices still rising?"

Let me just repeat that:

"If the market was spooked, then why are property prices still rising?"

Now compare that to what Krugman is saying:

"If the market is spooked, then why are bond rates falling and not increasing?"

I suppose you might guess what I am trying to say: Krugman's argument that the market will not be spooked by an oversupply of treasuries (due to increased deficit and government spending) is based upon the same logic that kept the market believing that the property prices will continue to increase, namely that the market obviously knows what is good for it. Paul Krugman, amongst others, knows just how limited and stupid the market can become but argues that, in the case of treasuries, the market does know what it is doing.

The property bubble between 2002 and 2007 was caused by a market failure. Too much money invested into one sector in too quick a time led to an investment bubble that popped and lost a lot of people a lot of money. In the same way US treasuries have developed an investment bubble. The market has dropped rates down to around 2.5%. With such a drastic increase in demand for bonds, the potential for a correction grows daily.

And what happens when investors lose confidence in both US shares and US bonds? A drop in the value of the US Dollar.

Krugman vs Rogoff and Reinhart

I think Krugman is mistaken in this post.

The Rogoff/Reinhart study looks at multiple countries and discovers that growth tapers off once gross debt exceeds 90% of GDP. This argument is not based upon one single episode of US post-war experience but upon multiple countries since the 19th century. Irons and Bivens argue that "The empirical findings of GITD are very unlikely to be relevant to the United States economy of today" which is akin to saying "What applies to everyone else does not apply to America". Sadly this is just another way of expressing American exceptionalism.

Does Krugman really believe that America's single experience of High gross debt after WW2 completely cracks open the Rogoff/Reinhart argument? It seems likely that he has not read the paper at all.

To reiterate: Rogoff/Reinhart examine multiple countries over many years and have come to the conclusion that high gross debt badly affects GDP growth. Their research is NOT based simply upon one period of US history but upon dozens of different countries. To argue that this does not apply to the US is magical thinking, based upon American exceptionalism.

(posted in comments)

Common Misperceptions?

Austerity means cutting spending.

No, though this is one way it can be achieved. The other way is through increasing tax revenue by broadening the tax base and/or increasing the tax rate. Any policy which results in smaller fiscal deficits can be termed austerity. Progressives who worry about the US Federal deficit but don't want to cut services only have one option: raise taxes.

Deflation is always bad.

No. Stable prices should be the number one priority of monetary policy (conversely, smoothing out economic peaks and troughs should be the priority of fiscal policy). Yet prices naturally increase or decrease due to changes in supply and demand. The goal of monetary policy should therefore be to ensure price stability over the long term. This has actually been achieved in Japan, where the inflation index has hovered around 100 since 1993, implying that prices have been more or less stable in Japan for the past 17 years.

Which leads me to my next misperception...

Japan has a problem with deflation.

Not so. If stable prices are the goal then the Japanese Central Bank has done admirably. There has been neither inflation nor deflation over the long term in Japan since 1993. Any period of deflation has always been balanced out by a period of inflation. But is this really a good thing? Isn't Japan a basket case of an economy? My next misperception...

Japan's economy is permanently in ruin.

The following graph is from here.

Since 1993, the Japanese economy has grown. Not only has it grown, but GDP per capita has increased during that period. Both measurements indicate that GDP growth and GDP per capita growth can exist during a period of absolute price stability.

Of course the figures in the graph above do show periods of economic contraction. Certainly the 1997-2000 period was difficult, as was 2008 and 2009, but the trend is most obviously upwards.

And measuring GDP per capita is important when you consider that Japan's population has peaked and is at the point of shrinking - I have argued before that shrinking populations don't have to be seen as a bad thing for the economy.

Busting the Myth of European Debt

Everyone's concerned about European debt levels. People have also pointed out that the US is in a better position than Europe. The data do not bear that out:

Gross US debt was 86.4% of GDP in 2009
Gross EU16 debt was 78.7% of GDP in 2009
Gross EU27 debt was 73.6% of GDP in 2009

US Budget deficit was 10.3% in 2009
EU16 budget deficit was 6.3% in 2009
EU27 budget deficit was 6.8% in 2009

In short, yes be worried about Greece, Ireland, Spain and others. But both the Eurozone (EU16) and the European Union as a whole (EU27) is in a more fiscally sound position than the United States. This should be a major determining factor behind risk analyses of European government bonds in comparison to US Treasury bonds.

Data information:

• US GDP in 2009 was $14.2563 Trillion. Source: Fred GDPA.txt
• Gross government debt in 2009 was $12.31134967751203 Trillion. Source: Treasury Direct debt for 2009-12-31.
• Government debt as percentage of GDP is 86.4%
• US Budget Deficit in 2009 was $1.471295 Trillion. Source: MTS0110.txt. Data collated into spreadsheet here.
• US Budget Deficit in 2009 was 10.3% of GDP.
  
• EU16 and EU27 data available in summary table from Eurostat. Source: Provision of deficit and debt data for 2009 - first notification.
  
• Eurostat Provision of deficit and debt data for 2009 states on page 2, footnote 1: "Government debt is the consolidated gross debt of the whole general government sector outstanding at the end of the year (at nominal value).", which corresponds more or less to gross debt levels recorded at US Treasury Direct website. (ie: apples are being compared to apples)

I like Obama and I agree with Keynes. But US government debt needs to be paid off sooner rather than later.

Despite the fact I am increasingly finding my own economic understanding being challenged and improved upon through the views of others, I am yet to change my mind over the issue of government debt. I therefore find myself in one of those uncomfortable "middle" places between ideologies and ideas in which I find myself agreeing with people whom I usually disagree with and disagreeing with those whom I respect.

This is the situation: It is my view that US government debt is a serious problem. It is the prime reason why I publish a "debt watch" every month, since hard data is essential in informing my view. Yet by holding the "debt is a problem" view I find myself aligning with populist conservative economists who deride Keynes and hate government while at the same time I find myself disagreeing with people like Paul Krugman and Obama supporters who see the stimulus as a good thing.

For the record I am not dismissive of Keynesian economics. As a non-American I have seen "automatic stabilisers" such as welfare payments and unemployment benefits being enacted by governments and have even benefited from them directly. I have no problem with government deficit spending during recessions, all things being equal of course. Yet it is that last phrase - "all things being equal" - which is the qualifier that has made me oppose the Obama stimulus package and to align with deficit hawks.

So, what is so "unequal" about the American situation? The problem is that for Keynesian economics to work over the course of the business cycle, any deficit run during recessions must be balanced out by surpluses during expansions. This causes a virtuous cycle, whereby increased tax revenues during expansions pay off the debt accrued by the government during recessions, while also creating net government savings once the debt has been paid off. These savings should then, of course, be used as emergency funds to be tapped when the economy moves back into recession. The idea is that over the course of the business cycle, government deficits are balanced out by surpluses, and the amount of debt accrued is balanced out by the amount of savings.

What is obvious though is that this process falls apart when governments act irresponsibly. Irresponsible actions in this case involve governments running deficits and accruing debt during economic expansions. Since 1981 the United States has run up huge fiscal deficits not just during recessions but during expansions. For this I blame the rise of Supply-side economics and the populist tax complainers who advocate it. The idea that reducing taxes would magically produce more tax revenue has destroyed the fiscal standing of the US government since the early days of Reagan.

Yet it seems to me that some non-supply siders have their own magical thinking to deal with. There's no doubt that the Obama stimulus has boosted the economy, but it is illogical to assume that such a boost in economic growth would provide enough increases in tax revenue to pay off the stimulus in the first place. Despite the presence of multipliers, the end result has been and will continue to be a net increase in debt levels. Those who believe otherwise are merely replicating the error of supply-side economics, except that the deficit is created by spending increases instead of tax cuts.

The fact is that public debt in the US is now just over 58% of GDP and debt servicing represents 2.7% of GDP. Just over 19% of Federal government spending is dedicated to debt servicing, an amount which easily exceeds anything spent on NASA, Education or the Environment combined.¹ Debt servicing is only exceeded in size by defense spending, health and human services and social security. Alarmingly, this amount will only increase the more the economy expands, since an expansion will create a higher interest rate environment and force the government to pay even more on money owed.

It is debt servicing which is the real killer behind running large structural deficits over a long period. As more and more debt is accrued by a government, more and more money is spent on paying interest. As time goes by this increase in debt servicing "crowds out" spending on other government programs: education spending gets cut, science gets cut, health care gets cut, environmental protection gets cut, welfare gets cut - and all getting cut without any actual decrease in government spending since these cuts are being balanced out by an increase in debt servicing. And of course who is the beneficiary of government debt servicing? Investors - households and businesses who fronted the billions of dollars in the first place to lend to the government. This is, of course, the rich, mainly. If there is one government policy that rewards the rich over the poor over the long term, it is having a structural deficit adding to increasing national debt levels.

If a household goes into an unsustainable debt spiral, they end up being declared bankrupt. Bankruptcy can also apply to businesses, but businesses also have the option of dissolving. Both the borrower and the lender in this situation are "losers". Sovereign governments do not have the option of bankruptcy or dissolution. Too much debt can be controlled through inflationary seigniorage (since the government controls the money supply) or by defaulting. Markets respond to the threat of default by dropping sovereign debt investments and thus causing a rise in bond rates (eg the recent problems with Greece).

Bankruptcy, dissolution, inflationary seigniorage and defaults are processes which cause massive economic damage. If a sovereign government inflates its debt or defaults, the pain and damage is passed on to the market and to households and businesses, who in turn are rendered bankrupt or are dissolved and the problem escalates. So while the government may survive, the people and businesses it supposedly serves ends up badly hurt.

The US is not close to defaulting on its debt, but it is closer now than at any other time in history. The reason why I believe the Obama stimulus was a bad move was not because I somehow oppose Keynes or have embraced Grover Norquist, but because US debt levels were already too high for such a stimulus package to be sustainable. One of the problems that caused the great financial crisis was lax US fiscal policy, so it seems illogical to assume that loose fiscal policy can be used to solve it. While this may seem merely axiomatic, it is nonetheless important in my thinking on the issue.

One response from stimulus supporters in the face of this complaint can be summed up in one word: Hoover. Didn't Hoover make the depression worse by cutting government spending, and didn't Roosevelt make the depression better by increasing government spending via the New Deal? My retort? I agree - but neither Hoover nor Roosevelt was lumbered with government debt the size and proportion of which Obama was lumbered with when he took office in 2009. Debt levels were already too high before the great financial crisis hit, and they have grown even higher throughout.

At some point the US must deal with its debt decisively. The government must agree to run fiscal surpluses over a long period in order to pay off the "national credit card". Supporters of Obama's stimulus argue that the economy must recover first and that any changes must occur later rather than sooner. I disagree. I can't see the US economy returning to its pre-GFC glory for some time. Financial market imbalances have gone on for too long and have messed up too much money for things to return quickly to 2005-style balance sheets. Unemployment is unlikely to drop below 7% for the next few years and there is always the threat that a second credit crunch might hit and make the current recession even worse. After all, there has been a domino effect of sorts - the subprime crisis of 2007 leading to credit crisis of 2008 leading to the European sovereign bond crisis of 2010 leading, inevitably, back to US households and businesses, a process which looks like it is already hitting with further drops in house prices being experienced.

Yet if I got my way, what would result? Let's say Obama rings me up and says "OSO, you're a wise man. Tell me what to do and I will do it." Well apart from awarding myself a few million dollars to feather my own nest I would:

• Increase taxes, especially on the rich.
• Introduce a Market Capitalisation tax to tax public companies according to their market wealth.
• Cut defense spending by 25% (Iraq and Afghanistan would be handed over to the United Nations and troops brought home)
• Leave spending levels where they are proportionally for the next five years.
  

In short, I would aim to run an immediate fiscal surplus of around 1% of GDP, and then sit back and wait as this surplus increased over time.

Of course such an action would result in an economic contraction. It would push the US into a deep recession. Yet the alternative would be an even deeper and even more damaging recession later on. Moreover, forcing the country into a recession is exactly what Paul Volcker did when he began work as Chairman of the Federal Reserve and it was he who is seen by many as the real reason behind America's 80s recovery and expansion (and not Reagan). If Volcker can cure the economy via harsh monetary medicine then so can Obama and Congress cure the economy via harsh fiscal medicine. Of course such a decision by Obama and Congress (acting on my wise counsel) would push the US into a far worse recession than Volcker ever did, but Volcker's recession resulted from, and cured, 10-15 years of monetary madness, while an OSO directed recession would result from, and would cure, some 30 years of fiscal madness.

The point is, though, that a reckoning has to occur. Had George W. Bush in his first term of office decided to keep taxes where they were and run more Clinton-inspired fiscal surpluses, the current GFC would probably be much milder, or may have never occurred at all. Had Clinton and the Gingrich Republicans in the second half of the 90s been less concerned with White House interns and more dedicated to running fiscal surpluses, the current situation would be even less severe. Had Walter Mondale been inaugurated president in 1985 on the back of fixing Reagan's fiscal stupidity with tax increases (one of his actual election promises that seemed crazy at the time but quite prescient in hindsight), we'd probably never be in this predicament in the first place.

The thing about learning from history is to ensure that we don't repeat the mistakes of the past. In 1996 Australia had 8% unemployment and government debt levels of around 20% of GDP (which at the time was quite high, but is quite low in comparison to other nations now). Despite the economic torpor of the time, the new conservative government chose to cut spending and aim for a surplus within a few years. The immediate result was predictable - the economy barely grew and unemployment increased. But as years passed the economy grew more strongly, unemployment dropped and the government began running regular, healthy budget surpluses. By the mid 2000s the Australian government was debt free.² Comparing Australia to the US has its problems, but there is no doubt in my mind that this conservative government (under PM John Howard and treasurer Peter Costello) did Australia a great favour through running constant, incremental contractionary fiscal policy. Not only did Australia manage to avoid going into recession in 2001 but it has also avoided recession throughout the GFC. The economy has expanded almost continually from about 1994 until the present and unemployment, once always lower than the US, is nearly half the US rate. There are certainly other factors involved (eg the resources boom) but even when those are factored in, there is no doubt in my mind that intelligent fiscal policy has provided Australia with a huge safety net to turn too once the GFC hit - PM Kevin Rudd instituted a stimulus package which has created the potential for economic overheating, a problem certainly NOT experienced by most western countries at this moment. The point I am making here is that Rudd' stimulus, on the back of over ten years of fiscal prudence and the retirement of government debt, was quite sustainable and probably saved the country from recession. Obama's stimulus, by contrast, was not, and will come back to bite.

If the US government institutes fiscal policy of the sort that I am suggesting, the result would be a sharp but short term contraction which, on the back of the current recession, would obviously be quite damaging. Nevertheless this is the harsh medicine that America must swallow if a) it wants to rebalance its fiscal state over the long term, and b) if it wants the government to not expand in its size. This last point can obviously change, and I would not be unhappy if the US instituted:

• A NHS-style universal health care system.
• Building enough renewable energy plants to exceed total US electricity demand.
• Massive industrial biochar production aligned with afforestation programs.
• Doubling public transport infrastructure
• More money into public education
• And other OSO-approved polices that would make me happy.

Of course I would not oppose such spending, but spending of this sort would probably double the size of the US government and for that to succeed without adding to the deficit, it needs to be accompanied by tax increases - tax increases which result in more revenue that is needed to pay for the spending increases. The issue here is not whether government spending should be expanded (I think it should) but whether a surplus should be run (which is absolutely essential). Given that the US hasn't as yet reached my own enlightened levels of social and economic understanding, whatever increases in government spending are enacted should always come second to the need for a fiscal surplus (or, more properly, the need for debt to be paid off over the long term which will, in the short term, require a reduction in the deficit).

<sup>1: MTS Report April 2010, Table 3, "Budget Outlays - current fiscal year to date": Department of Defense-Military $396,452 million, Department of Education $61,232 million, Department of Health and Human Services $503,984 million, Interest on Treasury Debt Securities (Gross) $224,414 million, Environmental Protection Agency $5,586 million, National Aeronautics and Space Administration $10,781 million, Total Outlays $1,998,847 million

2: Debt free here in a net sense. A bond market for government debt was still needed and still continues to operate. Government surpluses since the mid 2000s have been directed instead to a "future fund" which allowed government savings to eventually exceed debt levels. So Australia still had gross debt but no net debt - at least until the GFC hit and returned the government into net debt, although at a very low level.</sup>