Thursday, September 25, 2008

Cato Institute still believes we're on the gold standard

Article by Steven H. Hanke of the Cato Institute. My comments in italics.

Since 2001, the bush administration has entangled the United States in a war that is undefined in terms of its scope, scale and duration. It has also been interventionist in the domestic economy, overseeing what the U.S. Congressional Budget Office terms a “substantial increase in spending” which has put the economy “on an unsustainable path.”

What's an "unsustainable path?" My guess is he is referring to the spending and why is he saying it is unsustainable? Is the government going to run out of money? That's ridiculous. The Federal Gov'ts spends by simply crediting bank accounts and its ability to do that is unlimited. Will the debt service become unmanageable? Hardly. It is currently about 2% of GDP and even if it doubles, it still represents only a small fraction of our national wealth.

Indeed, according to the CBO’s baseline budget projections issued in September 2008, the federal debt held by the public will grow to $7.9 trillion (in 2008 dollars) over the next decade, a 46% increase over this year’s $5.4 trillion estimate. That would still be only 54% of GDP, which would rank us behind Germany, France, Canada and way, way, behind Japan, which has a public debt that is 200% of GDP! And that’s only the tip of what could be a huge debt iceberg. 

More like a little icicle.

The trustees of the Social Security System estimate that the present value of the system’s unfunded liabilities is $13.6 trillion. A similar present value calculation by the trustees of the Medicare System results in a whopping $85.6 trillion estimate. To put these numbers into perspective, keep in mind that last year the United States generated a GDP of $13.8 trillion.

The assumptions used in these calculations assume a paltry, 1.5% GDP growth rate for the next 70 years and a similarly low rate of productivity growth (about 1.1%), when actual growth over the past 70 years has been more like 2.7% and productivity up around 2.5%. If we come in anywhere near the historical performance, then the shortfalls pretty much don't exist. He also doesn't tell you that annual GDP could by 2075 (where his debt numbers come from) will be $40 trillion and could be as high as $75 trillion if we average a 2.5% annual growth rate.

The Bush administration’s most recent economic intervention—the nationalization of Fannie Mae and Freddie Mac, two giant government-sponsored mortgage finance companies—could cost U.S. taxpayers hundreds of billions of dollars. Fannie and Freddie were not really private nor purely public—perhaps the worst type of hybrids imaginable.

Yes, that's why they failed. It was a bad model. (Basically a bad decision to have privatized them in the first place.)

Indeed, both followed a classic public-private partnership (socialist) business model—one that privatizes profits and socializes losses. This was a train wreck waiting to happen. Not surprisingly, the Cato Institute’s Economic Freedom of the World, 2008 Annual Report records a significant fall in the economic freedom index for the U.S.

Just the pendulum swinging back a bit from a totally unregulated environment, which was pretty much an aberration.

Given these developments and the squeeze that the credit crunch has put on the U.S. economy, some people have been shocked that the U.S. dollar has staged a spectacular rally against the euro. But in the world of exchange rates, it takes two to tango.

Don't know what he means by, "it takes two to tango." Each successive rescue and Fed action caused the dollar to rally against a broader universe of currencies.

Expectations about Europe’s economic prospects have turned negative. Super-negative European expectations, relative to those
in the U.S., have pushed the dollar up by over 14% from July 15 to September 11, 2008. And not surprisingly, commodity prices
(measured by the Commodity Research Bureau’s Spot Index) have tumbled by 9% over the same period. But consumer price and producer price indexes remained at elevated levels, registering year-over year increases in August of 5.4% and
9.6%, respectively.

Both CPI and PPI have started to edge down, reflecting lower commodity prices.

Now the U.S. is on a razor’s edge between deflation and inflation.

Not on a "razor's edge as far as inflation is concerned: We've actually had quite a bit of it. Things reverting to the mean now. Asset deflation underway.

This requires one to think through how each of these scenarios might unfold. The prospect of a debt deflation begins when a central bank pushes interest rates below where the market would have set them. This is exactly what the Federal Reserve did. In July 2003, the Fed funds interest rate target was pushed to a record low of 1%, where it stayed for a year.

Three-month T-Bills near 0%, yet the funds rate remains at 2% and reserves have not built in the system despite over $1 trillion of lending by the Fed. This would suggest the Fed funds rate is still too high.

This set off a credit boom which fueled a massive increase in leverage. Over the past year, we have witnessed financial stress, a stampede to deleverage and an economic slowdown. These events could be the precursors of a classic debt deflation.

Other factors led to the credit boom as well, like changes in ERISA statutes that allowed pension funds to invest in CDO's, CDOs-squared, etc. Now commodities.

It would take the following course:

Debt liquidation would lead to distress selling. As loans are paid off, a contraction in demand deposits would ensue. This would slow down the velocity of money circulation. This would cause a fall in the general level of prices. This would lead to a further fall in the net worth of businesses and an increase in bankruptcies.

All of the above pretty much occurring and it is the mechanism the Fed was counting on to bring inflation pressures down.

A fall in profits, often resulting in losses, would also occur. This would lead to a reduction in output, trade and employment. These losses, bankruptcies, and unemployment would generate pessimism and a loss in confidence.

These waves of pessimism would result in more hoarding and further reductions in the velocity of money circulation.

To some extent all true, however, government spending and exports still maintaining some level of aggregate demand. Economy logged a 3.3 percent growth rate in the second quarter and we have yet to see back-to-back negative quarters, let alone a single, yet sharply negative quarter.

The debt deflation process would eventually run its course, but only after asset prices have hit bargain basement levels.
Economists of the Austrian school of economics term this type of debt deflation a “secondary deflation”. If the forces of a
secondary deflation are strong enough, a central bank’s liquidity injections are rendered ineffective by what amounts to private sector sterilization. When people expect prices to fall, their demand for cash increases and soaks up central bank liquidity injections.

The central bank pretty much "sterilizes" its own liquidity injections to a certain degree because it targets interest rates. Therefore, any increase in reserves that puts downward pressure on the Fed funds rate causes he Fed to drain most or all of those reserves. That is why reserves in the system and the monetary base have not grown at all in the past year. A big chunk of that liquidity has been removed.

The Fed would also supply reserves as necessary to satisfy demand for cash by the public.

This phenomenon characterized Japan’s economy during most of the 1990s. But what if the Federal reserve—fearing a secondary deflation, as they feared (incorrectly) a mild deflation in late 2002—pushed the Fed funds rate lower (now it’s 2%) and turned on the inflation switch by monetizing more debt? Given the growing mountain of government debt, there is virtually an unlimited potential.

Again, T-Bill yields suggest the funds rate is still too high, so does the lack of growth in reserves and the monetary base. In addition, there is no direct link between inflation and the overnight lending rate. Up until now inflation has pretty much been an oil story. If the Fed cuts rates that doesn't create a shortage of oil.

It’s a scenario worth thinking about.

Not really.

To appreciate how the process would work in the extreme, consider what’s happening in Zimbabwe, the first country to realize a hyperinflation (an inflation rate of 50% or more per month) in the 21st century. The government of Zimbabwe issues debt and the Reserve Bank of Zimbabwe monetizes it by printing Zimbabwe dollars. While the RBZ produces a lot of currency, statistics on the quantity of currency in circulation and the inflation rate are in short supply. 

This is a ridiculous example. Oil imports are roughly equal to about 40% of Zimbabwe's GDP and oil is priced in dollars and Zimbabwe is not the issuer of dollars, the U.S. Federal Reserve is. Any country that does not spend and borrow in its own currency is at risk of hyperinflation if their income and debts are not carefully balanced. The U.S. is a completely different case. We borrow and spend in our own currency and we are the
monopoly issuer of that currency. Moreover, our trade deficit represents a tiny fraction of our GDP. This is not the case in Zimbabwe.

The most recent official data for currency in circulation were for January 2008, and inflation data were last released for June 2008. To remedy that shortcoming, I have developed a hyperinflation index for Zimbabwe. As indicated in the accompanying table, the monthly inflation rate on September 5, 2008 was 9,914%. That’s a whopping annual inflation rate of 36 billion percent. To effectively trade currencies, commodities, or for that matter, any assets, traders must build alternative scenarios—like those for deflation or inflation. To give the scenarios life, probabilities must be attached to each of them. The resulting array can then be used to inform, in part, one’s trading activities.

Analysis and understanding must be correct too!

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