Monday, August 8, 2011

The Debt Ceiling Debacle and the World Economy

The recent debt ceiling Kabuki theater and subsequent poor critical reception from S&P is a good case study and launchpad into an analysis of the political theater. Using RTBM, we will first look at the economic issues and then at the composition of the ruling class.

The last Real Time with Bill Maher (RTBM) show of the season had a stellar guest line-up. It started with Christina Romer from UC Berkeley who back in 2008, as CEA chair, correctly estimated that the size of the stimulus should have been more than $1.2-trillion. Most economists today seem to agree with her, especially in the light of new data that shows that the collapse 2008 was several orders of magnitude more severe than initially estimated:

Output in the third and fourth quarters fell by 3.7% and 8.9%, respectively, not at 0.5% and 3.8% as believed at the time. (..) In January, total employment was already 1m workers below the level shown in the official data. (eco-blind)

The numbers keep being revised downward:

On a per-person basis, inflation-adjusted GDP stands at virtually the same level as in the second quarter of 2005. America is six years into a lost decade. (eco-down)

You might wonder why a Libertarian blog such as this would fall for the “trap” of the Leviathan stimulus. To that I would respond that libertarianism has many undercurrents and even though I consider myself a right-libertarian I take exception to some “tenets”; I have yet to fully explain my position and my very own brand of libertarianism here. I will just note that according to Scott Sumner, a professor of economics at Bentley University who identifies himself as a "neo-monetarist", Friedman (but NOT Rothbard) would have supported the monetary stimulus.

Gold remains a bet that the world economy as we know it is going the way of the Dodo, while emerging economies have doubled their clout in the past decade.

SpotGoldUSDThe recent S&P downgrade of US credit worthiness will probably push Gold even higher. It’s remarkable that Gold appreciated even more in CAD than in USD, possibly because CAD cannot compete with gold as a “safe haven” especially when USA, Canada’s largest partner (75% of all exports) is going down. Canada itself was downgraded in 1992 and it took a decade to get its AAA groove back. Today, the Economist calls Obama “the underperforming president” just like it called Canada’s leader “Mr. Dithers” back in 2005, prompting his eventual demise from politics.

This particular recovery is far more fragile than previous ones, as the Economist clearly shows, so the bloodletting simply could not be too severe:

US-recessions-and-recoveriesStill, the downgrade is a slap on the face of politicians and their bickering rather than the American economy as a whole, as it should be obvious from the S&P announcement:

The political brinksmanship of recent months highlights what we see as America’s governance and policymaking becoming less stable, less effective, and less predictable than what we previously believed. The statutory debt ceiling and the threat of default have become political bargaining chips in the debate over fiscal policy … [This] weakens the government’s ability to manage public finances..

It remains to be seen whether this will hurt Obama more than it will help him. He has certainly managed to appear as a weak, dithering leader (much like the previous challenger to Bush’s hegemony) but on the plus side, he painted himself in the center, in opposition to “tea-bagger terrorism/blackmail”.

Buttonwood does an excellent job of explaining where each side of the debate is coming from:

Paul Krugman describes the debt deal as a disaster on the grounds that austerity in the economy's current state is folly; Edward Glaeser of Harvard, in contrast, is backing the call for a balanced budget amendment, an approach that would force the government to take a procyclical approach, forcing the government to cut spending at a time of recession. Mr Glaeser argues that

The best argument for balanced budgets is that forcing governments to pay for their spending with current taxes will produce less wasteful spending.

Japan provides an example of how wasteful spending (concreting river beds) has failed to revive the economy. But again, we don't have the benefit of counterfactual analysis; what would the Japanese economy look like if the government had balanced its budget on a regular basis? Richard Koo's book "The Holy Grail of Macroeconomics" argues that the Japanese had little choice in the face of the deleveraging of the private sector.

At the heart of these arguments is the question of whether government spending has a positive or negative multiplier, ie create more or less bang for each buck. Keynesians think the former; neoclassicists think the latter. It seems (to this blogger, at least) intuitive that the impact of a stimulus will be dependent on the initial conditions of the economy; factors such as the size of the output gap and the overall level of government debt will play a role. For example, a government will find it easier to finance a deficit if it starts from a low debt-to-GDP ratio; if it starts from 100%, its borrowing costs will rise, offsetting any fiscal stimulus. This study from the National Bureau for Economic Research illustrates the point; it says that factors like exchange rate flexibility and openness to trade play a role. It also finds that

During episodes where the outstanding debt of the central government was high (exceeding 60 percent of GDP) the …fiscal multiplier was not statistically different from zero on impact and was negative (and statistically different from zero) in the long run.

Of course, the US and Britain would fall into that category. However, Paul Krugman interpreted the paper (admittedly on the basis of a slightly earlier version than the link provided above) as favourable to the Keynesian case, arguing that

this piece by Ilzetzki et al is interesting, and offers a wide range of multipliers depending on a country’s situation. The question for the United States is which estimate is most relevant.I’d say it’s the fixed exchange rate estimate. Yes, I know, we have a floating rate. But they explain the relatively high fixed-rate number by pointing to Mundell-Fleming, which says that fiscal policy is effective under fixed rates because it doesn’t drive up interest rates (capital flows in). We’re in a similar position for a different reason: fiscal expansion doesn’t drive up rates because we’re at the zero bound.

Oh, we’re also relatively closed. The thing is that both the fixed rate and closed multipliers are around 1.5 — which so happens to be just about the number assumed by Christina Romer in her analysis for the Obama administration. Just saying.

Anyway, we may have more of a test case of Keynesianism over the next couple of years. The authorities have thrown both monetary and fiscal stimulus at the problem since 2007, so it is hard to tell which policy has had what effect; indeed, hard to tell whether the effects are combining positively or cancelling each other out. But now the US has joined the fiscal austerity club, monetary policy will have to do all the work. It is hard to see the Fed (or the Bank of England) raising rates in the next 12 months. We will be able to compare the Anglo-Saxon experience with that of the euro-zone which is enjoying/enduring fiscal and monetary tightening.

UPDATE: On the US joining the fiscal austerity club, see the IMF's latest report, dated even before this package.  "Under the staff projections, expiration of temporary stimulus programs, lower defense spending and new deficit reduction measures will help reduce the federal deficit by 3¾ percent of GDP over the next two fiscal years,subtracting roughly 1 percentage point from GDP growth in both 2012 and 2013." (The reference is on page 17). And if you look at the IMF's June fiscal policy monitor (see page 3), the US is closing its cyclically-adjusted deficit at a faster pace than the euro area over the next year (1.4% reduction against 0.6%).

Sadly, the emerging consensus is that with the exception of Germany, most other countries are facing a period of prolonged downturn and we face a minimum 3-5 year “serious downturn”. Economies and governments are in worse shape than in 2008, having spent most of their ammunition in hastened and insufficient “surge” (or “stimulus” as surges are called at home). The Economist tries to calm down spirits with an article titled “that 30s feeling”. When they wrote that article, Athens was feeling the pinch of right-wing rioting (via Paul Krugman, CTV):

In Greece, alarm is rising that the twin crises of financial meltdown and soaring illegal immigration are creating the conditions for a right-wing rise — and the Norway massacre on Monday drove authorities to beef up security.
The move comes amid spiralling social unrest that has unleashed waves of rioting and vigilante thuggery on the streets of Athens. The U.N.’s refugee agency warns that some Athens neighborhoods have become zones where “fascist groups have established an odd lawless regime.”

An excellent prop to the monetarist view and debunking of the myth that hyperinflation directly caused the rise of Nazism:

There is a striking irony to the current situation in the euro zone. It's often assumed that hyperinflation gave the world the Nazis; that's wrong. The hyperinflation ended in 1923, and the German economy and political system functioned fairly well from then until 1929. The rise of the Nazis was precipitated by the stunning economic collapse that began in 1929, but which intensified significantly in 1930 and 1931. During the recovery years, the German economy accumulated a significant amount of debt, as lenders rushed to take advantage of the boom. When the economic crash hit, Germany found itself squeezed on two sides. The economy was crushed by an intense cycle of deleveraging and austerity, as the government struggled to maintain market confidence.

Now, even London is burning, much like Vancouver only a month ago. But let’s do away with the gloominess and continue on with Bill Maher’s show.

Sources / More info: wiki-kabuki, eco-blind, eco-down, eco-friedman, eco-downgrading, eco-obama, eco-tail, eco-shift

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