Charge! (Or Not)

Fed Chairman Ben Bernanke testified before congress this week and highlighted one of the big future worries facing the economy.  What will be the impact of all this government borrowing on the near and long term economic look and the financial markets?  Brad Setser put the deficit explosion into perspective in his blog at the Council of Foreign Relations on June 2.

The story is clear. Government borrowing has increased dramatically. It topped 15% of GDP in the last two quarters of 2008. In 2007 and early 2008 it was more like 3% of GDP. But private borrowing has fallen equally sharply. Total borrowing by households and firms fell from over 15% of GDP in late 2007 to a negative 1% of GDP in q4 2008.

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Both charts highlight the risk that worries me the most. In both the early 1980s and the first part of this decade, both the private sector and the government were large borrowers. And in both cases, borrowing rose faster than domestic savings, so the gap was filled by borrowing from the rest of the world. The trade and current account deficit rose. In the early 1980s, the US attracted inflows by offering high yields on its bonds. More recently, it did so by borrowing heavily from Asian central banks, together with the governments of the oil-exporting countries. But now yields are low (even after the recent rise in the yield on the ten year Treasury bond), and need to be low to support a still weak US economy. And China (and others) are visibly uncomfortable with their dollar exposure; banking on their continued willingness to finance a large external deficit seems like a stretch.

The challenge this time around consequently will be to bring down the government’s borrowing as private borrowing resumes.

Nearly every economist blog this week has some discussion of the incredible expanding budget deficit and the need for more and more government banking.  This from Robert Reich on why Bernanke’s testimony this week seemed a nanny talk to free-spending pols on fiscal policy.

My guess is Bernanke is trying to reassure investors he won’t let inflation get out of control in coming years. If he has to, when the economy is safely out of the morass, he’ll crank up short-term interest rates and squeeze the money supply.

But Bernanke also wants to deliver a message to Congress, a message the White House doesn’t want to deliver because it’s politically awkward: Congress will have to raise taxes on the wealthy in order to finance universal health care and reduce looming budget deficits. Such tax increases won’t slow down the economy because the wealthy don’t spend that much anyway (that’s what it means to be wealthy — you’ve already got most of what you need), but may be necessary, at least to ward off inflation fears.

Why the sudden interest in all of this?  Well, economists basically are students of history.  All of our research is based on what happened in the past and trying to find a theoretical frame for those events.  Hyman Minsky was one of the earliest post Keynesian researchers looking into financial crisis.  Since he died in 1966, his database was limited to early financial crisis.  Minsky basically found an emerging pattern of government borrowing after the Great Depression.  This has pattern has be verified by recent researchers into more recent crisis. Basically, the Federal Government responds to downturns by increasing the level of public debt.  They use their expenditures to replace private demand. This is basic fiscal policy.  But, while a depression or deep recession is avoided it comes at the cost of higher government debt and eventual higher inflation.

There are folks now betting on the repeat of history.  This WSJ article talks about the inception of a Black Swan Fund.

A hedge fund firm that reaped huge rewards betting against the market last year is about to open a fund premised on another wager: that the massive stimulus efforts of global governments will lead to hyperinflation.

The firm, Universa Investments L.P., is known for its ties to gloomy investor Nassim Nicholas Taleb, author of the 2007 bestseller “The Black Swan,” which describes the impact of extreme events on the world and financial markets.

Funds run by Universa, which is managed and owned by Mr. Taleb’s long-time collaborator Mark Spitznagel, last year gained more than 100% thanks to its bearish bets. Universa now runs about $6 billion, up from the $300 million it began with in January 2007. Earlier this year, Mr. Spitznagel closed several funds to new investors.

Unlike last year’s sudden market implosion, inflation isn’t an unimaginable event that few currently anticipate. In fact, many fear inflation right now amid government efforts to goose the economy. Universa’s bet, however, is that inflation will reach levels few expect.

By opening the inflation fund, Universa is trying to capitalize on a wave of investor demand for its products, which when they’re right can protect investors from extreme market moves.

The new strategy, designed by Mr. Spitznagel, aims to post big gains if inflation and interest rates take off as they did in the 1970s. Universa will invest in options tied to commodities such as corn, crude oil and copper, as well as options on stocks such as oil drillers and gold miners.

As I was taught by my advanced placement US History teacher in High School, when really needing information, turn to the foreign press.  This commentary in the UK’s FT by Mohamed El-Erian on the sustainability of the current fiscal policy.

These are strong words, and appropriately so given the worrisome fiscal outlook facing the US. By necessity, Mr Bernanke will increasingly be in the business of countering monetisation and inflation concerns.

Indeed, the markets have already fired a couple of clear warning shots in the last couple of weeks, as illustrated by recent moves in US bonds and the dollar.

The chairman’s challenges on this count are neither easy nor amenable to quick solutions. Moreover, as markets increasingly look into the underlying factors, as inevitably they will, they will recognise the difficulty that the government faces in credibly committing to the needed primary fiscal adjustment in the absence of high economic growth.

The bottom line is that we should come away from Mr Bernanke’s testimony with at least two conclusions: the chairman seems more cautious about the growth outlook when compared with other recent public statements; and he wants to push fiscal sustainability issues clearly away from the Fed’s domain and back where they belong, with Congress and the administration. He is correct on both counts. He would have been justified on Wednesday in being even more forceful; and he mostly probably will be in the next few months.

What we are beginning to see are direct arguments for increased taxation, perhaps next year.  This is interesting since most economists believe that we will not see any robust growth in the economy for at least a year if not more.  The unemployment rate will continue to climb for  months to come and this will undoubtedly become topic one for the next set of elections.  That’s why I also will point to Karl Rove’s WSJ editorial today.  (Yes, you can wash your hands after you read it.)  It’s entitled “It’s the Economy, Stupid” and for as much as I despise the bearer of the message, the message rings true.

If the Obama administration were more serious about growing the economy than just growing government, the stimulus would have been front-loaded into this fiscal year.

In addition, the claim made by Team Obama that every dollar in stimulus translates into a dollar-and-a-half in growth is economic fiction. The costs of stimulus reduce future growth. No country has ever spent itself to prosperity. The price of stimulus has to be paid sometime.

Any real improvement in the economy so far is more likely the result of the Federal Reserve expanding the money supply and the Fed and Treasury shoring up the financial sector.

But the Fed’s actions are risky. Easy money and expansionary policies are not sustainable. We may soon be in for a bout of inflation unless the Fed soaks up much of the money it flooded into the system. The government is also likely to hamper private investment as it uses a vast amount of capital to finance its debt. And when the Fed stomps on its monetary brakes, as eventually it must, we’ll get sluggish growth.

The irony for Democrats is that the Fed may hit the brakes in the run-up to the 2010 congressional elections or the 2012 presidential election.

It is becoming clear that the economy is now the top issue. Mr. Obama’s presidency may well rise or fall on it. The economy will be his responsibility long before next year’s elections. Americans may give him a chance to turn things around, but voters can turn unforgiving very quickly if promised jobs don’t materialize.

So, nearly every one from all sides of the political and economic spectrum as well as both sides of the pond is watching Bernanke.  We know that Bernanke knows what the next problem will be because he just told us.  However, closely Bernanke works with Giethner, Summers and Potus, it will still be the latter trio that must negotiate the next mine field. So, my question is, do we put all of our money into Black Swan Funds or trust them to maneuver us out of the danger zone?