Sunday, November 16, 2008

the two trillion dollar deficit

I’ve always been a deficit hawk, favoring fiscal responsibility and balanced budgets. It has driven me nuts over the past seven years to see the hard-earned federal budget surpluses bequeathed by Bill Clinton squandered and replaced with over $4 trillion of new federal debt. Future generations of taxpayers got nothing for that debt that they will eventually have to repay (or at least pay the interest on) – it went to the Iraq war and tax cuts for the rich. Among other things, it helped fuel our unsustainable credit binge and reduced our policy options in the (inevitable) event that the bubble burst.

Well, it has burst.

Generals are not the only ones with a tendency to fight the last war. As much as it pains me to write it, this is no time for fiscal responsibility. The time for that was when the bubble was inflating not when we are standing on the precipice of a depression.

Some background on the deficit: For the fiscal year ended September 30, 2008 (fiscal 2008), the US government for the first time in history
added over a trillion dollars to the federal debt. That includes a variety of special appropriations that are excluded from the budget deficit calculations that you generally see reported. Officially, the fiscal 2008 deficit was “only” $455 billion. But that nets out a $183 billion Social Security surplus and it doesn’t include a variety of non-budgeted expenditures and financing operations. To understand the difference, just look at reported federal deficits vs. the increase in the national debt:

For example, it was reported last week that the Treasury would have to borrow $550 billion during the current quarter. Over half a trillion dollars in just one quarter. That includes things like the Fed’s liquidity operations, and it is $408 billion higher than the Treasury estimated in July. Goldman Sachs estimates that the Treasury will have to borrow over $2 trillion in the current fiscal year to fund economic rescue operations. These estimates are almost certainly low. It was reported last week that in October, the first month of the current fiscal year, the federal deficit was over $237 billion. One month. The nonpartisan Committee for a Responsible Budget estimates all the government economic and rescue initiatives, starting with the $168 billion in stimulus checks issued earlier this year, already total $2.6 trillion. Read that again: $2.6 trillion ALREADY committed to rescue initiatives. (The Fed has lent out over $2 trillion to financial institutions – although it isn’t revealing the recipients or any other details like the collateral or loan terms. Bloomberg is suing to get that information.)

By any measure, these are staggering numbers.

So we should be trying to reduce the deficit, right? Wrong. Not now. Not any time soon.

Even as we are struggling to contain the worst financial crisis since the Great Depression, the "real" economy is falling off a cliff. If there was any doubt before, this week's economic news has confirmed that we are in the midst of what will almost certainly be the worst economic downturn since the Great Depression. The Labor Department reported that jobless claims increased last week by a seasonally-adjusted 516,000, only the second time since 1992 that claims have topped 500,000. The four-week average of claims increased to 491,000, the highest level in more than 17 years. Jobs have declined for 10 straight months. Retail sales for October decreased by 2.8% from the previous month and 4.1% from October of 2007. On an inflation-adjusted basis, retail sales declined by 8.8% from a year earlier, the largest such decline since the Census Bureau started keeping records. These figures include a year-over-year drop in autos sales of 23.4%. Retail sales are a key portion of consumer spending and consumer spending accounts for about 70% of the country's gross domestic product.

As Paul Krugman
wrote in the New York Times this week, under these circumstances policy an aggressive fiscal policy is needed:

We are already, however, well into the realm of what I call depression economics... in which the usual tools of economic policy... have lost all traction. When depression economics prevails... virtue becomes vice, caution is risky and prudence is folly.... [T]he effective federal funds rate ... has averaged less than 0.3 percent in recent days. Basically, there’s nothing left to cut.

And with no possibility of further interest rate cuts, there’s nothing to stop the economy’s downward momentum. Rising unemployment will lead to further cuts in consumer spending, which Best Buy warned this week has already suffered a “seismic” decline. Weak consumer spending will lead to cutbacks in business investment plans. And the weakening economy will lead to more job cuts, provoking a further cycle of contraction.

To pull us out of this downward spiral, the federal government will have to provide economic stimulus in the form of higher spending and greater aid to those in distress — and the stimulus plan won’t come soon enough or be strong enough unless politicians and economic officials are able to transcend several conventional prejudices.

One of these prejudices is the fear of red ink. In normal times, it’s good to worry about the budget deficit — and fiscal responsibility is a virtue we’ll need to relearn as soon as this crisis is past. When depression economics prevails, however, this virtue becomes a vice. ...

Another prejudice is the belief that policy should move cautiously. In normal times, this makes sense: you shouldn’t make big changes in policy until it’s clear they’re needed. Under current conditions, however, caution is risky, because big changes for the worse are already happening, and any delay in acting raises the chance of a deeper economic disaster. The policy response should be as well-crafted as possible, but time is of the essence.

Finally, in normal times modesty and prudence in policy goals are good things. Under current conditions, however, it’s much better to err on the side of doing too much than on the side of doing too little. The risk, if the stimulus plan turns out to be
more than needed, is that the economy might overheat, leading to inflation — but
the Federal Reserve can always head off that threat by raising interest rates.
On the other hand, if the stimulus plan is too small there’s nothing the Fed can
do to make up for the shortfall. So when depression economics prevails, prudence
is folly.

What does all this say about economic policy in the near future? The Obama administration will almost certainly take office in the face of an economy looking even worse than it does now. Indeed, Goldman Sachs predicts that the unemployment rate, currently at 6.5 percent, will reach 8.5 percent by the end of next year.

All indications are that the new administration will offer a major stimulus package. My own back-of-the-envelope calculations say that the package should be huge, on the order of $600 billion.

So the question becomes, will the Obama people dare to propose something
on that scale?

Let’s hope that the answer to that question is yes, that the new administration will indeed be that daring. For we’re now in a situation where it would be very dangerous to give in to conventional notions of prudence.

As far back as July – before the financial crisis fully manifested itself – PIMCO’s Bill Gross, the best bond fund manager in the country, wrote in his monthly Outlook commentary that the next president (who he assumed would be Obama) would and should run a deficit of at least a trillion dollars. His piece, which now looks prescient – and conservative – took the form of an
open letter to President Obama:

You have inherited a mess. Your predecessor, fixated on emulating a former Republican icon from a far different economic era, chose to emphasize tax cuts for the rich and excessive consumption for all Americans. He promoted deregulation and free markets when, in fact, the markets and their institutions needed tough love. Over eight years, he failed to put forth a coherent energy policy. He needlessly invaded Iraq and lowered worldwide esteem for this nation as a symbol of freedom and benevolence.

But enough about W’s spilt milk. I’ve already ticked off so many readers that they’re questioning my Republican Party voter registration. What do I think you should do as the new President to rectify this mess? All I know is that any solution will come with a high price tag. Although your campaign slogan says “Yes we can,” I have my doubts. Granted, you’re going to raise tax rates on the rich, give a break to the lower/middle class and rebalance the scales of economic justice somewhat. I myself won’t enjoy paying that near 50 percent marginal tax rate after you remove the current cap on the payroll tax, but my wealthy neighbors and I in Newport Beach should just look at it this way: we’ve had an eight-year lease extension on the “high life.” Now it’s time to give something back and I suspect we won’t be working any less hard. That ol’ Laffer Curve has a certain logic to it, but it only makes sense at the upper margin. People did work less at confiscatory tax rates imposed pre-Thatcher/Reagan but once they got down to 50 percent or lower, it was all gravy – promoting conspicuous consumption as opposed to higher productivity and overtime at the office. …

Anyway, so you’re gonna do the tax thing, Mr. President, and throw in some form of
universal healthcare to boot … In addition, you’ll need to provide some immediate relief to homeowners … By January, home prices will be down another 10 percent or so and our Japanese-style property deflation will be in full stride. …

But you’ll have your tax bill and your healthcare bill and your housing fix, and somehow it’ll all be paid for by wealthy hedge fund managers, oil companies or, pray tell, a robust economy that’s creating good jobs at home instead of exporting them abroad. Uh, I don’t think so, Mr. President. That’s where the “yes we can” morphs into “no we can’t.” Not that you won’t accomplish most of that – the robust economy and the good jobs notwithstanding. It’s just that you won’t be able to pay for it and it’s better to admit it now as opposed to later. No David Stockman confessions in your administration. You’re smarter than Ronald Reagan and too nice of a guy to distort reality like King George. So let’s start out by dropping all of that “budget neutral” rhetoric and admit where we’re headed. Your administration will produce this nation’s first trillion dollar deficit!

While the Republicans will blame you for years and label you “Trillion Dollar Obama” in future campaigns, there is in fact not much that you or any other President can do. You’ve inherited an asset-based economy whose well has been pumped nearly dry with lower and lower interest rates and lender of last resort liquidity provisions that have managed to support Ponzi-style prosperity in recent years. Foreign lenders have cooperated by purchasing Treasuries at yields which when combined with dollar depreciation have resulted in negative returns on their money. Even if these charades continue (and they may not), their stimulative effects – their magical powers to transform a 110-pound weakling into a Charles Atlas/Arnold Schwarzenegger mensch of an economy – are gone. What you need now is fiscal spending and lots of it. No ordinary Starbucks will do, Mr. President, you need to step up for a six-pack of Red Bull.

[T]his economy will need an additional jolt of $500 billion or so of government spending real quick. It must replace both reduced residential investment and consumption whose decline has placed the U.S. economy near, if not in a recession. Some quick math for you Sir: gross private domestic investment (machines, houses, inventories) has declined by $200 billion since its peak in late 2006. Due to higher unemployment and energy costs, domestic consumption will soon be $300 billion less than it should be if we are to return to historical economic growth rates. According to that old C + I + G formula (scratch the trade deficit for now) when C + I is reduced by $500 billion, then G should increase by that amount in order to fill the gap. The G, Sir, is you – the government deficit, the fiscal stabilizer popularized by Keynes following the Depression. And since the fiscal deficit for 2008 is likely to press $500 billion even before you take the oath of office, well there you have it: $500billion + $500 billion = $1 trillion big ones …

In the final analysis I wonder why you or anyone else would want to be President in 2009. …

Bear in mind, this was written back in July – a lifetime ago in this economic crisis (and four months before Obama won the election). Gross assumed a $500 billion baseline deficit and $500 billion in fiscal stimulus. Krugman is now assuming the need for at least $600 billion in stimulus – apart from financial rescue operations. Morgan Stanley’s chief economist is now saying the 2009 budget deficit could be close to $2 trillion, or 12.5 percent of GDP (more than twice the record of 6% set in 1983). The limitation is really our ability to intelligently spend the money. These deficit levels are already baked in, and Obama doesn’t even get sworn in until almost three months into the fiscal year. (Although that isn’t keeping the crazy right from pre-emptively blaming Obama for our economic problems. Even though we are already about a year into the current economic downturn, and Obama is still two months away from being sworn into office, Rush Limbaugh is already calling this, “the Obama recession”.)

Conservative pundits are warning Obama and Congressional Democrats not to “overreach.” I’m sure they are offering this advice in the best, long-term electoral interests of their Democratic “friends.” But let’s hope the Democrats don’t take it. The risk is that Obama and Congress don’t do enough. Or that they squander the stimulus on transfer payments and pork. The social safety net needs to be strengthened and a lot of people are going to need temporary help. And a certain amount of pork is inevitable – as AIG (among others) has demonstrated, the private sector wastes a lot of money, too.

Some unnecessary public works projects are probably better for the economy than billions of dollars in Wall Street bonuses. But the need for stimulus comes at a time when we also need to make some very large investments in infrastructure, energy efficiency and alternative energy. It would be a shame if we failed to seize the moment. In this crisis there lies an opportunity.

I passed along this quotation from Obama (from an interview with Joe Klein in TIME) previously. But it is worth revisiting because it summarizes well the need and the opportunity:
“[T]he engine for economic growth for the last 20 years is not going to be there for the next 20, and that was consumer spending. I mean, basically, we turbo-charged this economy based on cheap credit. Whatever else we think is going to happen over the next certainly 5 years, one thing we know, the days of easy credit are going to be over because there is just too much de-leveraging taking place, too much debt both at the government level, corporate level and consumer level. And what that means is that just from a purely economic perspective, finding the new driver of our economy is going to be critical. There is no better potential driver that pervades all aspects of our economy than a new energy economy.”

Let’s hope we are able to seize the opportunity.

And don’t worry about those two trillion dollar deficits.

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