I read an interesting report this morning, which resonated with some other work I had…
People are allowed to change their opinions or assessments in the light of new evidence. Diametric changes of position are fine and one should not be pilloried for making such a shift in outlook. Quite the contrary. But when the passage of time reveals that a person just recites the same litany despite being continually at odds with the evidence, then that person’s view should be disregarded, notwithstanding the old saying that a defunct clock is correct twice in each 24 hours. The US Congressional Budget Office (CBO) released its latest – The Budget and Economic Outlook: 2018 to 2028 (April 9, 2018) – and various commentators and media outlets have gone into conniptions over it. The economists that have responded – and they come with affiliations from both sides of US politics (although it is hard to differentiate separate ‘sides’ in the US anymore such is the demise of the Democrat Party) – have significantly embarrassed themselves. Their hysteria is not matched with the facts and they have been guilty of invoking these hysterical responses year-in, year-out for many years. A crack in a record, goes click, click, click, click and repeats ad infinitum. Sort of like the nonsensical arguments about US fiscal deficits that have appeared in the US press this last week.
The CBO Report
The full CBO report is available – HERE.
The CBO exercise is to assume “that current laws governing taxes and spending generally remain unchanged” and then project what that means for economic growth, the fiscal balance and the evolution of public debt over the forecast horizon.
The basic conclusions were:
1. “potential and actual real GDP are projected to grow more quickly over the next few years … because of recently enacted legislation … Over the next decade, the unemployment rate is lower …” That all sounds positive as long as the growth is sustainable in environmental terms.
2. “CBO estimates that the 2018 deficit will total $804 billion, $139 billion more than the $665 billion shortfall recorded in 2017”, which relates directly to conclusion 1. Higher deficits at a time when private spending growth is modest will typically increase capacity utilisation and reduce unemployment.
3. “In CBO’s projections, budget deficits continue increasing after 2018, rising from 4.2 percent of GDP this year to 5.1 percent in 2022 … Deficits remain at 5.1 percent between 2022 and 2025 before dipping at the end of the period … Over the 2021-2028 period, projected deficits average 4.9 percent of GDP …”
And so with current account deficits on-going and draining growth, the rising deficit allows the private domestic sector to reduce its debt exposure by increasing its overall saving without damaging over economic growth.
The CBO claim that the 5.1 per cent of GDP deficits “has been exceeded in only five years since 1946; four of those years followed the deep 2007-2009 recession” as if there is something alarming about that.
But it is highly significant in my view that in the – Data Underlying Figures – and hence the analysis, there is no mention of the current account position of the US, as if it is irrelevant in assessing the appropriateness of the fiscal stance.
I could write a lot about the underlying modelling techniques and certainly come up with different estimates to the CBO. But really that is not the important point.
In general, the CBO’s neoliberal bias will lead them to understate the degree of slack in the economy and overstate the structural component of the fiscal balance.
But that is not what I want to consider in this blog post.
The response from commentators has been largely hysterical.
In the lead up to the release of the CBO analysis, a so-called “group of distinguished economists from the Hoover Institution” (Source) – (the distinguished reflecting a state where the English language loses all meaning) – wrote an Op Ed for the Washington Post (March 27, 2018) – A debt crisis is on the horizon.
I guess this was a cut and paste job from stuff this lot (Boskin, Cochrane, Cogan, Shultz and Taylor) have been writing and mouthing for years now.
The authors peddle out the same old predictions:
1. Noting the future could be bright (AI, 3D printing, medical advances, etc), they conclude that “a major obstacle stands squarely in the way of this promise: high and sharply rising government debt”.
2. “For years, economists have warned of major increases in future public debt burdens. That future is on our doorstep” – okay, time is up. It was up many years ago but that doorstep is now forgotten. It has shifted to now.
3. Then the usual take a figure and divide it by the known population and attribute responsibility:
Unless Congress acts to reduce federal budget deficits, the outstanding public debt will reach $20 trillion a scant five years from now, up from its current level of $15 trillion. That amounts to almost a quarter of million dollars for a family of four, more than twice the median household wealth.
4. Then add the “unprecedented in U.S. history” angle.
5. Then lie about causality: “In recent months, we have seen an inevitable rise in interest rates from their low levels of recent years.”
6. Then infer that “treasury debt holders … [will] … start to doubt our government’s ability to repay, or to attract future lenders, they will demand higher interest rates to compensate for the risk.”
They have said that many times but their predictions fail to materialise.
It might be that US treasury bond yields will rise as investors start spreading their portfolios across riskier assets.
But I doubt you would find one serious fixed income investor in the US who believed that the US government was about to default now or later.
7. “More borrowing puts more upward pressure on interest rates, and the spiral continues” – and, as we will see, yields are falling in the US and remain low.
8. Then, do some ridiculous high-school arithmetic as if it is important and draw spurious conclusions:
If, for example, interest rates were to rise to 5 percent, instead of the Trump administration’s prediction of just under 3.5 percent, the interest cost alone on the projected $20 trillion of public debt would total $1 trillion per year. More than half of all personal income taxes would be needed to pay bondholders. Such high interest payments would crowd out financing of needed expenditures to restore our depleted national defense budget, our domestic infrastructure and other critical government activities.
Noting that the interest payments constitute income to the non-government sector.
But the idea that they would financially compromise other components of spending (health, defense, infrastructure etc) is false.
They might in political terms if the views of Taylor and Co were taken seriously. But there is no financial imperative to cut such spending just because income flows to the non-government sector rise.
If the economy hit full capacity (and as we will see below it isn’t close), then the rising interest payments might require the government adjust the composition of its net fiscal outlays somewhat, after some of the stimulus would be lost to rising imports.
But that is a different story altogether to the one being pushed in the Washington Post article.
9. Put it altogether and predict “the specter of a crisis”, which will come “without warning, like an earthquake, as short-term bondholders attempt to escape fiscal carnage”.
And what are these bond-holders actually going to do?
Sell them and take capital losses? Sell them to whom?
And if the bid-to-cover ratios fall on public auctions what do you think will happen then, should the government assess that as being a dangerous situation?
Oh that – the central bank just buys up public debt and controls yields and the treasury spends on. Just like has been done many times in the past.
And the bond-holders – the recipients of corporate welfare – are they really going to walk the plank just because Taylor and Co think they should? Not likely.
10. Finally, use all this spurious assertion to get to the political point they want to make – which the likes of these characters have been making for decades – attack “entitlement spending”.
Yes, social security and medical support for low income earners etc – the US has to get rid of that and rely on the private market for this sort of stuff.
And we know what that would lead to.
Given the respective ages of these authors, I could go back 40 or 50 years in some cases and we would find similar claims being made by one or more of these characters.
A record stuck is a record stuck.
First, these economists failed to see what was happening prior to the GFC.
This was an interview with John B. Taylor (one of the authors of the Washington Post article cited above) from June 2006.
Taylor spoke about the way the IMF has matured to be a more “rule driven” organisation:
And I think that’s one of the reasons people are saying, “What’s the IMF doing? Are they going into obscurity?” Well, they don’t have to do much now because, fortunately, these crises have diminished. As a result, we are moving into a period where people are wondering what the IMF is for.
He then got onto the idea of that the world institutions had finally been able to contain “contagion” when a local crisis occurred.
He said the Asian crisis had “caused a lot of damage” but:
But look at what happened after Argentina defaulted in 2001, and you see there’s no similar jump in spreads anywhere around the world. So it’s a huge difference.
The question is whether it is a lasting phenomenon. I’ve thought a lot about it and written about it. And I think it is a lasting difference. One reason is the more predictable response of the IMF. Second, country policies are better … better monetary policy and fiscal policy. So the policies in a lot of countries are better, and that’s the surest way to stop the contagion. And then finally, I think investors are discriminating more between countries. They don’t automatically think there’s a problem in one country when they see another having a problem.
Then on the long boom:
As for the “Long Boom,” I think I first defined it in the April 1998 Homer Jones lecture that I gave at the St. Louis Fed called “Monetary Policy and the Long Boom.” In that lecture, the empirical phenomenon that I focused on was that the size of fluctuations in the economy has diminished substantially. If you looked back to 1982 from at that time-1997 was the last completed year-you saw what looked like a long boom. You had just one historically very small and short recession-in 1991. So the 15 years from 1982 to 1997 were like a long boom. I asked the question, What was the long boom due to? And I gave the answer that it was monetary policy. I documented how monetary policy had changed since the bad old days of frequent recessions. As long as monetary policy stayed on track, I argued, the long boom would continue.
And the long boom has continued … And now maybe we’re in one that will be even longer, but that will depend on keeping with the good policies. So this phenomenon of long, strong expansions and short, small recessions was how I defined the long boom. The same phenomenon is now called the Great Moderation, and there is continuing debate about its causes. I continue to point to the role of monetary policy in making the Long Boom, or the Great Moderation, happen. I think there really is something to that.
I could have accessed similar quotes from countless economists who during the pre-GFC period extolled the virtues of self-regulated markets, passive fiscal policy (austerity bias) and inflation-targetting monetary policy.
One year after Taylor was claiming that as long as governments held to their policy stances the long boom would continue the GFC hit? It was easy to see the crash coming but Taylor and his colleagues had disappeared up their own hubris.
They didn’t see the crisis coming because their economic theories did not allow them to see the way the sectoral balances were emerging and the rising private sector indebtedness and increased financial risk. Any commentator that dared challange this ‘new macroeconomic consensus’ was vilified by the Groupthink within mainstream economics.
More recently, just as the GFC was unfolding, Taylor was a leading critic of the US stimulus packages. He hadn’t learned a thing.
On August 31, 2009, he wrote an Op Ed in the New York Daily – The Coming Debt Debacle – that the:
These large deficits represent a systemic risk to the economy … Without spending discipline, damaging tax increases are required to close such deficits … The deficits would also bring a long painful period of high inflation like the late 1960s and 1970s, a period of frequent recessions and persistently high unemployment when people began to lose confidence in the dollar.
His view was representative of the academic noise at the time.
John Cochrane from Chicago University is another serial offender. Several times after the GFC manifested, Cochrane popped up in the popular debate extolling what he claimed are the dangers of deficits.
He often predicted rising interest rates; rising, then out-of-control inflation would soon hit the US economy.
In this blog post – How many more experiments do we need (June 21, 2011) – I considered Cochrane’s argument that fiscal stimulus would drive a dangerous inflationary spiral. It was one of many such articles that has fallen foul of the evidence.
See also this blog post – Accelerating inflation has to be out there somewhere … in the dark or somewhere (September 27, 2011) – where John Cochrane is again warning us of “substantial inflation” breakouts in the “in the next few years” as a result of the deficits.
We are now in the seven years out from those predictions and lots of ‘money’ has been injected into various economies and inflation is benign.
There may be supply-side inflation pressures introduced as a result of energy price manipulation but that is not the type of danger that John Cochrane and his ilk are or were predicting.
So how would we assess the current statements? Should we consider their theories that lead to these predictions as being an adequate guide to the future when they failed to predict and understand the biggest economic event in most of our lives?
Answer: they should be disregarded totally.
Then comes the response from economists aligned with the Democrats.
On April 8, 2018, the Washington Post published this response to the Taylor and Co article – A debt crisis is coming. But don’t blame entitlements.
Yes, the title really summarises the argument presented.
We read that the Democrat-aligned economists (Baily, Furman, Krueger, Tyson and Yellen) agree with Taylor and Co that their is “a serious problem” and:
… ever-rising debt and deficits will cause interest rates to rise, and the portion of tax revenue needed to service the growing debt will take an increasing toll on the ability of government to provide for its citizens and to respond to recessions and emergencies.
None of that is in dispute.
These economists have been senior advisors to Democrat presidents in the past and in Yellen’s case the outgoing central bank governor.
They have influence when Democrats control things.
And they demonstrate exactly why a bounder like Donald Trump, a man totally unsuited to take the highest office in the US, was able to be elected.
They demonstrate exactly why the Democratic Party cannot even beat Trump and why the public debate in the US is so asinine.
All of the Taylor and Co. claims are in dispute. None of them are correct.
The ‘Democrat economists’ are incapable of making any contest and are content to use their access to a leading US newspaper to dilly dally around the edges.
Oh, entitlements are just a bit of the problem sort of arguments.
We need smaller deficits but Trump is wrong to make tax cuts now because “The economy was already at or close to full employment and did not need a boost”.
And all that sort of wishy-washy nonsense that neoliberal progressives make (yes, this cohort exists – they mouth some progressive social policies but are deep-down neoliberal when it comes to economics).
Lets start with the sectoral balances, which helps us in understanding the implications of various macroeconomic policy shifts.
For a detailed discussion of the derivation of the balances, please read the blog post – Flow-of-funds and sectoral balances (November 24, 2015).
The following graph shows the annual sectoral balances from 1960 to 2017. I then used the CBO’s projections from 2018 to 2028 to extrapolate the balances out to 2028 (the dotted segments):
1. Blue line – Government fiscal balance as a percent of GDP.
2. Green line – External balance as a percent of GDP.
3. Grey line – Private domestic balance as a percent of GDP.
The facts are obvious.
1. The US has a persistent and fairly stable current account deficit of around 2.5 to 3 per cent. CBO does not expect that to change very much.
2. The fiscal retreat in the recent years saw the private domestic balance shrink to nearly zero.
3. The projected movement in the fiscal state allows the private domestic sector to save overall and provides the conditions for that sector to start reducing its massive debt exposure, which, after all, was the cause of the GFC.
4. If the fiscal deficit falls below the current account deficit then the private domestic sector starts to dissave overall – spend more than it earns and starts accumulating increased debt.
5. From the graph, there is not much leeway before that private domestic sector overall leveraging starts to occur, given the size of the external balance.
6. The on-going fiscal deficit is thus not only underpinning growth but also allowing the private domestic sector to deleverage its financial position (save overall).
When the likes of Taylor and Co demand fiscal surpluses they are simultaneously (but not saying) demanding that the private sector debt position increases and that sector dissaves overall.
That is not a sustainable position and would lead to a renewed crisis.
The Federal Reserve Bank publishes a monthly data series – Industrial Production and Capacity Utilization – G.17 – which provides an indication of how much of the non-labour productive capacity is being utilised.
They define “Capacity utilization for Total Industry (TCU)” as:
… the percentage of resources used by corporations and factories to produce goods in manufacturing, mining, and electric and gas utilities for all facilities located in the United States (excluding those in U.S. territories). We can also think of capacity utilization as how much capacity is being used from the total available capacity to produce demanded finished products …
the capacity index tries to conceptualize the idea of sustainable maximum output, which is defined as the highest level of output a plant can sustain within the confines of its resources … The capacity utilization rate can also implicitly describe how efficiently the factors of production (inputs in the production process) are being used … It sheds light on how much more firms can produce without additional costs. Additionally, this rate gives manufacturers some idea as to how much consumer demand they will be able to meet in the future.
Clearly, when capacity utilisation rates are high, the inflation risk from demand side pressures (that is, spending pressures) increases.
Firms, typically, keep some spare capacity in reserve as a normal strategy so that they can meet unexpected spikes in demand without losing market share. So what might be considered a normal full capacity load will be less than 100 per cent.
In fact, the average rate of capacity utilisation since this data series was first published in January 1967 has been 80.3 per cent, although the mean rates were much higher in the 1960s and 1970s, before the Monetarist (neo-liberal) era started suppressing growth rates.
The following graph charts the evolution of this data series from January 1967 to February 2018. You can clearly see the cyclical swings associated with recessions.
It is interesting to note that each subsequent recovery since the 1990s has levelled off below the previous level, which is consistent with the observation that the neo-liberal era has been associated with stifled growth rates and elevated levels of excess capacity.
But even in the current recovery, capacity utilisation rates are still below 80 per cent and over the last few months have been heading south again, indicating that firms have increased idle equipment and machinery and plenty of non-inflationary capacity available to meet increased spending growth.
Since Trump was elected the capacity utilisation rate has moved up marginally from 75.4 per cent to 77.6 per cent in February 2019.
It is still well below the most recent peaks.
The conclusion is that there is ample productive capacity in situ to handle the current levels of spending and output without any need to expand productive capacity.
Inflation and inflationary expectations
If the arguments presented in the two cited Washington Post articles were to be treated seriously then we should already sese inflationary expectations pushing up quickly – and they should have done some several years ago.
The Federal Reserve Bank of Cleveland provides the most current series on inflationary expectations and the real interest rate that is available.
In October 2009, the Bank released a discussion paper outlining – A New Approach to Gauging Inflation Expectations. It is a non-technical version of this 2011 paper – Inflation Expectations, Real Rates, and Risk Premia: Evidence from Inflation Swaps.
The latest data from the US Federal Reserve Bank of Cleveland released yesterday (April 11, 2018) – Inflation Expectations – suggest that the:
… latest estimate of 10-year expected inflation is 1.98 percent. In other words, the public currently expects the inflation rate to be below 2 percent on average over the next decade.
This is hardly a sign that the ‘market’ expects inflation to accelerate in the next decade.
The three major rounds of QE in the US were dated as follows:
- Quantitative Easing 1 (QE1, December 2008 to March 2010) – This was announced on November 25, 2008. The program was expanded on March 18, 2009 as described in this FOMC press release.
- Quantitative Easing 2 (QE2, November 2010 to June 2011) – The FOMC announced on – On November 3, 2010 – that it “intends to purchase a further $600 billion of longer-term Treasury securities by the end of the second quarter of 2011, a pace of about $75 billion per month.”
- Quantitative easing 3 (QE3, September 2012 and expanded on December 2012 and terminated in October 2014) – The FOMC announced on – September 13, 2012 – that it “agreed today to increase policy accommodation by purchasing additional agency mortgage-backed securities at a pace of $40 billion per month”. This would continue “If the outlook for the labor market does not improve substantially”. This phase was expanded on – December 12, 2012 – such that the FOMC “will purchase longer-term Treasury securities … initially at a pace of $45 billion per month”. QE was terminated in the US in October 2014.
Those phases are depicted by the shaded areas in the following graphs.
The graphs show the evolution of inflationary expectations (PEX) and the actual annual inflation rate from January 2005 to April 2018.
The first graph shows the one-year ahead inflationary expectation while the second shows the expectation over the 10-year horizon (in other words, what people in the US think inflation will be over the next decade).
It is hard to mount an argument that the QE episodes or the sustained fiscal deficit have increased inflationary expectations in any significant manner.
The last phase (QE3) didn’t alter short- or long-run inflationary expectations one iota – they remain low and anchored despite the massive increase in the asset-side of the Federal Reserve balance sheet and the commensurate swelling of bank reserves.
And despite the fiscal deficit increase that has been predicted for some months now.
The graphs are interesting because they show that long-term inflationary expectations have remain fairly stable around the Federal Reserve’s 2 per cent anchor.
Even during the early years of the crisis, when the actual inflation rate fell sharply to negative territory, the long term inflationary expectations were stable around the US Federal Reserve’s implicit inflation target.
The shorter term expectations which pick up a lot of the month to month fluctuations in energy and housing prices etc were much more volatile and followed the actual inflation path.
There has been no clear break in behaviour of the long term series since downturn in both the recession and recovery phases.
This suggests that market participants despite all the noise coming from the conservatives judged that growth would return given the fiscal stimulus and realised that QE would do very little in that regard.
They thus judged that the long-term trajectory of the price level would not be distorted by these policy interventions and the different growth experience over the last 7 years.
Taylor and Co and their Democrat partners in the deception are just plain misguided on this matter.
Their arguments have no credibility.
So what about bond yields? Taylor and Co and the neoliberal Democrats both claim that yields would rise given the ongoing and rising fiscal deficit because market participants will lose faith in the capacity of the government to repay the debt.
The following graph shows the daily 10-year US Treasury yields from early 1990 to April 10, 2018.
Despite the on-going fiscal deficits, yields have fallen rather dramatically reflecting the increased demand in the bond markets for government bonds (as safe havens).
To give a closer view, the next graph shows the same yield from the beginning of 2016 to April 10, 2018. As the US economy has recovered, private portfolio diversification into riskier private assets has seen a small increase in yields.
But even with the knowledge of the increased deficits, the ‘markets’ have increased their demand for 10-year Treasury bonds and the yields have started falling again as a consequence.
There is absolutely no evidence that the fiscal deficits have resulted in rising yields.
Let us be absolutely clear:
1. The private bond markets have no power to stop a currency-issuing government spending.
2. The private bond markets have no power to stop a currency-issuing government running deficits.
3. The private bond markets have no power to set interest rates (yields) if the central bank chooses otherwise.
4. Sovereign governments always rule over bond markets – full stop.
I examine this in more detail in this blog post – The bond vigilantes saddle up their Shetland ponies – apparently (February 18, 2018).
While I would not support the increased US fiscal deficits under current policy proposals from Donald Trump, I would welcome increased deficits if the policy mix was skewed towards introducing a Job Guarantee, improving public infrastructure, expanding the welfare support and improving schools and hospitals.
It is not the deficit or the public debt I would be worried about.
But that is a different discussion to the rabid hysterics that Taylor and Co and their Democrat rivals have engaged in over the last week or so.
Their arguments carry no credibility at all.
That is enough for today!
(c) Copyright 2018 William Mitchell. All Rights Reserved.