President Barack Obama may be remembered for permanent depression, the way that Leon Trotsky’s name is linked with permanent revolution. Fiscal stimulus combined with near-zero interest rates have proven to be a toxic cocktail for the United States, the macroeconomic equivalent of barbiturates and alcohol. Keynesian spending creates a deficit that sucks all the available capital out of the grassroots economy and transfers it to the Treasury market. Easy funding terms from the Federal Reserve allow financial institutions to make money in government bonds while shutting off credit to the rest of the economy. It’s classic crowding out, in which the government’s misguided effort to spend its way out of recession pushes the productive economy deeper into the hole.
Panic is starting to take hold at the Obama White House over the relentless deterioration of the job market. US jobs in September declined by about 263,000 jobs, worse than the 175,000 drop expected by Wall Street economists. To the 15.1 million on the official unemployment count, add 9.2 million “involuntary part-time workers” and 2.2 million who were dropped from the tally because they had not sought work in the past month, and the unemployment rate would rise to 17.1 million.
That doesn’t include another three million long-term discouraged workers – those who want to work but who have long since stopped looking. That would take the number up to 20%. In past recoveries, a number of economists observed, all the job growth came from small business, but small business is lagging in the present crisis. The financial crisis crushed the entrepreneurs, as surely as Joseph Stalin crushed the kulaks, the relatively affluent peasants.
Obama inherited a crisis, to be sure, but he has made it much worse. America is in the kind of trap into which Japan fell during the “lost decade” of the 1990s, whence it never really emerged. In the Keynesian world of Larry Summers, director of the White House’s National Economic Council, and the Obama economics team, the problem is that Americans save too much and spend too little. To restart the economy, the government has to spend money for them – hence the US$800 billion stimulus package.
There are two things terribly wrong with this notion. The first is that it is simply a matter of what John Maynard Keynes called the “marginal propensity to consume.” Americans have saved almost nothing during the past 10 years, relying instead on home equity that now has vaporized. The proportion of Americans over 60 will jump to 25% from 19% during the next 10 years, an unprecedented shift. Americans must save to compensate for past profligacy, from a lower starting point after the destruction of so much wealth, and with lower prospective returns. The demand for savings is bottomless.
The second problem is that even if the government borrows money, the money has to come from somewhere. Right now it’s coming from households who choose to save rather than borrow, and from the balance sheet of the Federal Reserve or the banks, as well as foreign investors.
A quick walk through the numbers puts the problem in context.
Lenders to the US federal government, first half 2009.
|All Federal borrowing|
(annualized, in $US billions)
|Rest of the world||$545.6|
|Fed balance sheet||$368.1|
Obama’s government borrowed $1.7 trillion at an annual rate, or about 12% of gross domestic product (GDP). Households coughed up less than half of that as they shifted from spending to savings. Foreigners bought $545 billion, a bit less than a third of the total. The Federal Reserve and the banks bought $400 billion worth, or about a quarter of the total.
Household purchases of Treasuries kept spending low and the economy contracting. Even with this massive shift, though, the central bank still had to print money. Most alarming is that the Federal Reserve’s rate of purchase of Treasuries is accelerating:
Federal Reserve monetization of government debt, 2009
|Fed purchases of treasuries|
(annualized, in $US billions)
|Third quarter est||$676.1|
The rest of the world doesn’t want an additional half-trillion dollars worth of Treasury securities each year; it doesn’t want the Treasuries it now has to own. Households can’t continue to put a trillion dollars worth of Treasuries away per year – that’s 8% of all personal income.
That leaves the Fed and the banking system. The central bank bought Treasuries during the third quarter at an annual rate of nearly $700 billion, and provided nearly zero-interest money to banks and broker-dealers, who bought a good deal more. The Fed is buying much more than Treasury securities, to be sure; during 2009, it bought a remarkable $700 billion of mortgage-backed securities in a fruitless attempt to stimulate the housing market.
Federal Reserve total securities holdings
Despite the unprecedented largesse of the Federal Reserve, banks are reducing risk and cutting off the small-business sector in particular. During the third quarter, US commercial banks added Treasury securities to their balance sheets at a $350 billion annual rate. But they cut loans to business at a $300 billion annual rate. Extremely cheap funding makes it possible for a bank to finance the purchase of a two-year Treasury note paying 0.86%, or a two-year AAA municipal note yielding 0.75%, with overnight money costing 0.25%. Cheap money turns the commercial banks into an extension of the balance sheet of the Federal Reserve.
The near-zero interest rate allows banks to shift their balance sheets towards nearly riskless assets, and reduce risky commercial and industrial loans.
US commercial banks’ holdings of Treasury securities
vs commercial and industrial loans, past 12 months
Cheap money has crushed the dollar, and the sinking dollar has buoyed equity prices, perversely enough.
Trade-weighted US dollar vs S&P 500 Equity
Index, 2009 to date
American assets are cheaper to foreign investors, and as the dollar fell against other major currencies, foreign investors bought more American stocks:
In short, the rise in US stock prices has less to do with economic recovery than with the drop in the global price of American assets. The dollar can only fall so far, however, because other currencies can only rise so far before a rising currency parity damages competitiveness. This game seems to be played out for the moment.
This outcome was perfectly foreseeable a year ago; in fact, I forecast just this result last November (see Who will finance America’s deficit?, Asia Times Online, November 13, 2008). I reviewed the difficulties attendant on financing America’s deficit and concluded:
Monetization of debt remains a possibility, and to some extent would only continue the current trend. Total Federal Reserve Bank credit outstanding has more than doubled in the year to November 6, 2008, rising by $1.2 trillion to $2.06 trillion. This reflects loans, securities purchases, and related actions by the Fed to bail out the financial system. If the deflation persists, the Federal Reserve may be compelled to purchase US government debt …
The point of lowering the risk-free rate is to push investors towards riskier assets. In a normal business cycle, falling output leads to lower yields on low-risk bonds, which in turn encourages investors to add risk to their portfolios by investing in businesses. If the safest of all investments, namely US Treasuries, suddenly offer much higher real yields, comparable to the boom years of the late 1990s, why should investors take risk? … If the Treasury tries to spend its way out of recession, the results are likely to be very disappointing.
The parallels between America in 2009 and Japan in 1989 are uncanny. An asset price bubble has collapsed, just before a tsunami of prospective retirements that the asset bubble was supposed to fund. Demand for savings is bottomless, and the government satisfies demands for savings by running a huge deficit and issuing debt. The crippled banking system borrows at an interest rate of zero and buys government securities. And the economy shrivels up and dies.
Japan, though, had one advantage: it knew how to export. There is only one way to drastically increase savings while maintaining full employment, and that is to export. America has neither the export capacity nor the customers. It could get them, but that is a different story. Francesco Sisci and I told it here US’s road to recovery runs through Beijing (Asia Times Online, November 15, 2008).