Thursday, April 25, 2013 - Austerians v. Keynesians

Austerians v. Keynesians

by Sinclair Noe

DOW + 24 = 14,700
SPX + 6 = 1585
NAS + 20 = 3289
10 YR YLD + .01 = 1.71%
OIL + 1.79 = 93.22
GOLD + 36.70 = 1469.20
SILV + 1.24 = 24.50

Five years ago the banking system nearly imploded and almost resulted in a meltdown of the global financial system. Three years ago Congress passed the Dodd-Frank financial reforms, aimed at correcting some of the problems of 2008. Dodd-Frank may have included some good ideas, but you had to wade through 2,000 pages to find anything worthwhile. Much of the legislation has still not been implemented, and on the issue of averting another banking system implosion, it really didn't do much; it basically called on regulators to do a better job of catching problems and nipping them in the bud. We all know that's not going to happen.

And so, the biggest banks have been getting bigger than before the financial crisis and it's widely believed that if a big bank were to fail, they would be bailed out.., again. The government considers these banks to be Systemically Important Financial Institutions, which means they are Too Big to Fail. That implied backing has given firms a green light to engage in risky activities that pose a threat to the financial system.

Yesterday, Senators David Vitter and Sherrod Brown introduced legislation that aims to end the implicit guarantee of a government bailout. Brown and Vitter are calling for big banks with more than $500 billion in assets to have capital equal to 15 percent of their assets. Banks with at least $50 billion would have to set aside 8 percent. Community banks, those below the $50 billion threshold, would be exempt because they typically have large reserves.

There are global capital requirements for big banks; known as the Basel III requirements, but that is a risk-weighted measure; the banks can still count very risky assets, although less-risky assets get a higher ranking.

The legislation presents Wall Street megabanks with a clear choice: either have enough of your own capital to cover your own losses or downsize until you are no longer a risk to taxpayers. The banks are opposed to the idea. Shocking, right? The banks claim that if they have to hold enough capital to cover their losses, that means they would have to cut back on lending. This would probably be a better argument if the banks were actively expanding their lending as opposed to actively expanding their proprietary trading.

This is proposed legislation at this time. And even though it has strong populist support, it probably has a snowballs chance in Blythe, in July. However, it should prove a valuable fundraising tool for the politicians willing to oppose it. Brown and Vitter may have honorable intentions, but this is how Congress really makes its pocket and re-election money.

So, five years down the road; no solutions.

For the past five years there has also been a debate about how to lift the economy out of the hole left by the near financial meltdown. One one side were the Keynesians and on the other side, the austerians. The Keynesians, following the ideas of the British economist John Maynard Keynes, wanted to increase government spending to offset weakness in the private sector. The idea is that this stimulus spending would reduce unemployment, create demand, and prop up economic growth. The austerity crowd wanted to cut spending to reduce deficits and restore confidence. The austerians were following the ideas of economists Kenneth Rogoff and Carmen Reinhart, among others, who claimed that if  governments did not cut spending, countries would soon cross a deadly 90% debt-to-GDP threshold, after which growth would be permanently impaired.

This was more than just an academic debate. Japan embraced austerity and its economy stagnated for two decades. Europe embraced austerity and its economy has been battling rolling waves of recessions, and in some countries, economic depression. The most recent numbers out of the Euro-zone show new highs in unemployment for Greece, Spain, and France. Distrust of the Union is at all time highs. On Monday, José Manuel Barroso, the European commission president said the austerity policies being applied, mainly under pressure from Berlin, had reached the "limits of political and social acceptance" and were "unsustainable" in their current form.

Here in the US, we have seen a mix of austerity and stimulus and the results have been mixed as well. We cut back on government jobs; we had the fiscal cliff; we are now facing the sequester. If you don't like the idea of long delays at the airport, sorry but that's just the beginning. The sequester is throwing around 600,000 people out of work according to the Congressional Budget Office. These are people who have the necessary skills to fill jobs in the economy but who will not be working because people in Washington lack the skills to design policies to keep the economy near full employment. It just makes sense that the government needs to address budget issues and eliminate waste and fraud and unproductive programs. Meanwhile, the Federal Reserve has been pumping money into the financial system, but not into the broader economy. The results have been sluggish growth, unsustainable growth. So, QE doesn't seem to be successful, either.

And then last week we learned that the Rogoff-Reinhart paper was based on bad arithmetic. Once the error was corrected, the "90% debt-to-GDP threshold" instantly disappeared. The discovery of this simple math error eliminated one of the key "facts" upon which the austerity movement was based. So, you might think the debate is over; the Keynesians have defeated the austerians; stimulus beats sequesters. Not so fast.

Excessive debt is still problematic, just that the specific levels of 90% debt to GDP is not a precise level. And stimulus, at least in the form of Quantitative Easing, hasn't been nearly as effective as we would like. So, what's wrong? The biggest problem is that the stimulus has been coming from the Federal Reserve in the form of monetary policy and not from the government in the form of fiscal policy. The Fed has been stimulating the banks by adding more debt to the financial system; this is the equivalent of putting out fire with gasoline.

And, all the money the Fed has been pumping into the banks, has not trickled into the broader economy.  QE does not actually increase the circulating money supply. It merely cleans up the toxic balance sheets of banks. Ben Bernanke is infamous for suggesting that the Fed could crank up the printing press, or to follow the idea of Milton Friedman, deflation could be cured by simply dropping money from helicopters. A real “helicopter drop” that puts money into the pockets of consumers and businesses has not yet been tried. Why not?

It seemed logical enough. If the money supply were insufficient for the needs of trade, the solution was to add money to it. Most of the circulating money supply consists of “bank credit” created by banks when they make loans. When old loans are paid off faster than new loans are taken out (as is happening today), the money supply shrinks. The purpose of QE is to reverse this contraction.

But QE isn't really a matter of the Fed cranking up the printing press; it is actually an asset swap. The Fed exchanges dollars for the banks' toxic assets. It's a way to clean up the banks' balance sheets; it probably keeps the banks from going bankrupt and creating another financial meltdown, but it does nothing for the balance sheets of federal or local government, or most businesses, or consumers.

Quantitative easing as practiced today is not designed to serve the real economy. It is designed to serve bankers who create money as debt and rent it out for a fee, or use it for trading. Bernanke has long claimed that he needs the help of fiscal stimulus to really stimulate the economy. Maybe, but it doesn't really seem the Fed has done it's part to stimulate the broader economy, rather it has decided that the broader economy takes a backseat to resuscitating the zombie banks. And at the same instance that Bernanke calls for fiscal assistance, the Fed proclaims it's independence from the government. Bernanke has proclaimed this independence on several occasions. The unanswered question is that if the Fed doesn't serve the government, then who do they serve?

For the austerian crowd, their debt limits have been debunked, but even worse, their timing sucks. Cutting budgets while simultaneously propping up the balance sheets of the banksters is a double whammy that drains the life blood of economic growth. The QE stimulus doesn't send money to Main Street and the budget cuts take money away from Main Street. It shouldn't surprise you to learn that this combination isn't working. Money has not been circulating. The velocity of money has now slowed to a near standstill; a mere ratio of 1.54, the lowest in more than 60 years.

So, now that the austerian arguments are in shatters, it would seem a good time to revisit stimulus; not stimulus for the big banks, but direct stimulus. And one of the questions that must be asked is what is the definition of public debt? We know there are big differences in household debts. We know that if we accumulate debt for consumer purchases, we can quickly dig a hole. But if we accumulate debt to start a business or to educate our family so we can get a better job, that debt might be worthwhile. In short, there is a difference between debt and investment.

And one lesson we should have learned from the financial crisis is that we can't count on the banks to facilitate investment in the broader economy. We have a choice to support the banks' toxic balance sheets and their gambling addiction or support investment in the local economy. Of course that would require some legislative and executive backbone; so don't hold your breath.