This was supposed to have been the final triumph of John Maynard Keynes, the crisis in which governments actually did what he urged them to do during the Great Depression, the proof that an elite of puppeteers in control of monetary and fiscal policy could make the innumerable actors in economic life march wide-eyed toward recovery.
Keynes’ idea is simple; in fact, it is simple by construction, for it focuses on the very short term within a closed economy. If consumers won’t spend, the government will spend for them; if businesses won’t invest, the government will invest for them; and if investors won’t take risks, the central bank will reduce the yield on low-risk investments to almost nothing.
No forecaster of note a month ago expected the Greek debt problem to threaten the world financial system, yet it has. Nemesis always comes in through the unwatched door. The risk is that lending among international banks may freeze up as it did during the late autumn and winter of 2008-2009, with catastrophic consequences for governments that depend on the banks to fund enormous deficits.
The cost of insurance against European bank defaults is now even higher than after the Lehman Brothers bankruptcy of 2008. This is not a drill. It is a real crisis. Perhaps the European Community will calm things down for the moment. No matter: if they succeed, the crisis will find another outlet soon enough.
The Barack Obama administration, like most of the world’s governments, decided on a massive dose of Keynesian medicine, taking the budget deficit to an unheard-of peacetime level of 13% and keeping short-term interest rates at near zero. It was advised by macroeconomic royalty: Obama’s chief economic advisor Lawrence Summers is the nephew of two Nobel-Prize winning economists, Kenneth Arrow and Paul Samuelson, of whom the latter literally wrote the textbook that trained three generations of economists in Keynes’ wisdom.
And it all seemed to be working. Even some of the bitterest critics of the Obama administration and Keynesian economics in general hailed the coming “V-shaped recovery.” American consumers, right after suffering a US$6 trillion loss in wealth in the form of household equity, and right before the greatest retirement in American history, decided that they did not have to save after all. The savings rate fell and consumer spending rose. American corporations in the S&P 500 index stripped down to skeleton staffs and stopped investing, and declared a 60% rise in profits between the second quarters of 2009 and 2010. And the latest employment data show real improvement in the labor market.
It was Keynes’ “money illusion” writ large. Inflate the currency, and the workingman will still see the same number of shillings in his pay packet, Keynes wrote at the beginning of his 1936 General Theory. Inflation thus will stimulate economic activity. This crude example illustrates a broader principle that might be called “wealth illusion”: reduce the yield on low-risk investments to almost nothing, and investors will have to shift portfolios to riskier assets, stimulating investment and hiring.
As a closed-economy, short-run model, Keynes’ approach has had two quarters of real success, and it behooves the Keynesians to declare victory and go home, as a Vermont senator proposed during the worst of the Vietnam War. After the sovereign debt crisis erupted in Greece and spread globally – to the surprise of this writer as well as every forecaster he knows – the Keynesians must feel a bit like the hero of Pushkin’s story The Queen of Spades, who plays cards on the advice of a ghost, only to win the first two rounds and lose everything on the third. One can imagine Lawrence Summers going as mad as Pushkin’s gambler: “He is in the Obuhovsky hospital, room Number Seventeen; he does not answer any questions, but keeps muttering with astonishing rapidity: ‘Three, seven, ace! three, seven, queen!'”
The trouble is that the world is not composed of closed economies, and investors do not think in terms of the short run – not always, in any event, and not when long-run considerations manifest themselves.
Paul Samuelson’s most gifted doctoral student is the Canadian Robert Mundell, who won the 1999 Nobel Prize in economics. Mundell’s theory is not as simple as Keynes, for it is a global model that casts a weather eye on the long run. The trouble, Mundell observed in a 1965 essay in the Journal of Political Economy, is that markets are not very good at seeing into the future. They may do a reasonable job of evaluating corporate debt (although as the former head of bond research for a major Wall Street firm I am skeptical). But they are very bad at gauging the present value of household income streams.
That, Mundell argued, is why government debt actually may represent wealth: if a well-funded public debt (to borrow Alexander Hamilton’s term) is supported by future economic growth, which implies more employment and tax revenues, then an increase in debt represents wealth. It also might represent hot air. Mundell cited the case of a tax cut that leads to revenue loss, but also to economic growth. If the increase in tax revenues arising from the higher growth rate more than pays the interests on the bonds that the government must issue to cover the revenue loss, the result is an increase in wealth.
That in a nutshell was “supply-side economics,” a term coined by my former businesses partner, the late Jude Wanniski. Wanniski promoted Mundell’s thinking from the bully pulpit of the Wall Street Journal editorial page. The late congressman Jack Kemp picked up the ball and touched it down with the Kemp-Roth tax cuts of 1982 (following enactment of their Economic Recovery Tax Act in 1981), and “Reaganomics” inaugurated a quarter-century economic boom.
When Ronald Reagan took office, the baby boomers were in their 20s or 30s, and the United States had a 10% savings rate, a current account surplus with the rest of the world, and was the world’s largest net creditor. The top marginal tax rate, moreover, stood at 70%, so that a drop to 40% under Kemp-Roth offered an enormous incentive for additional effort. The long-term earnings of American households justified an enormous increase in government debt, which meant that the Reagan administration could run a deficit that in 1982 touched 7% of gross domestic product (GDP) with falling interest rates and inflation.
Reagan tapped enormous growth potential. A dozen new industries waited in the wings for the catalyst of risk capital. At the onset of the 1980s, such gadgets as personal computers and cell phones, now ubiquitous, were relative rarities. Americans were young and ready to take risks. All Reagan had to do was turn the tax switch while Paul Volcker’s Federal Reserve stifled inflation.
The long-term prospects of the United States were excellent. And as Professor Reuven Brenner of McGill University observes, America had a near monopoly on entrepreneurship. Half the world was locked down by communism, “emerging markets” were still the “Third World,” and Europe wallowed in statist obstacles to growth. America was the only viable destination for the world’s entrepreneurial talent.
Americans in the 1980s did what young people are supposed to do: borrow money, buy houses and start businesses. They did this a bit too well, taking the US personal savings rate to zero just before the financial crisis broke out in 2007. The savings rate should go back to 10% to begin to fund the retirement of the boomers. An alternative, of course, is that stock market and home values will show capital gains sufficient to replace these non-existent savings. And Keynesian “wealth illusion” appears to have convinced some consumers that capital gains will pay for their retirements.
Keynes assumed that investors think just one period ahead, and there surely are occasions in which he was correct. The last quarter of 2009 and the first quarter of 2010 was one such period. But the long-term view of Mundell ultimately must be decisive. Issuing lots of government debt is a good idea if the economy can support it. The trouble with Europe is that 40 years from now there won’t be enough Europeans to pay the taxes to fund the government debt. Here is a projection of Europe’s dependency ratios from the United Nations World Population Prospects website, assuming constant fertility:
Europe’s population dependency ratios, 2010-2050
(constant fertility variant)
The elderly portion of Europe’s population will rise from 24% to 49% of the total, an insupportable burden. Who would want to buy 40-year European bonds?
This helps us to answer the question: why Greece? First of all, corruption pervades Greek society to the point that to purge it would destroy the social fabric: all political and social relations are premised on corruption. But it is also the case that the population profile of Greece is much worse than the European average. By 2050, the elderly dependency ratio will rise to a frightening 59%, and the Greek state will be hard-pressed to meet its obligations under any foreseeable circumstances.
Greece dependency ratios (constant-fertility variant)
If not for the extreme cupidity of the Greek authorities, to be sure, investors might have perambulated around Keynes’ short-term view of the world for a bit longer. But a one-period, closed economy model is a very poor description of a global economy in which the long term has a way of turning up as an omen of doom for short-run expectations. The premise of Obama’s Keynesian exercise is that the US can run a deficit equal to 13% of GDP with a savings rate at 2% of GDP, by borrowing the difference from the rest of the world. The “rest of the world” in effect means the world banking system because most countries have adopted the same sort of deficits.
In fact, two-thirds of the US deficit, according to available numbers, has been financed by foreign banks during the last quarter of 2009 and the first quarter of 2010. This is clear from the Treasury’s data on international capital flows, which shows $50 billion to $60 billion a month worth of purchases of US Treasury securities from abroad, almost all of it from London or the Caribbean, that is, offshore banking centers. US banks meanwhile are adding Treasuries to their portfolios as fast as they shed commercial and industrial loans.
Data is not available on international banks’ holdings of Greek, Spanish, Portuguese or Italian bonds, but it is a reasonable supposition that the weak sisters of southern Europe have been financed by bank treasuries just as the United States has. During the past several weeks, it seems clear that banks have tried to reduce holdings of weaker southern European sovereigns and increase holdings of Treasuries, so that US rates have fallen while southern European rates have risen.
Financing long-term purchases with short-term leverage in countries that cannot hope to repay their debt at the 40-year horizon turns out to have been a dicey idea. In September 2008, when the banking system was about to fail due to the collapse of its investments in US mortgages and similar things, governments bailed out the banks. But who bailed out the governments who bailed out the banks? The banks bailed them out, by buying their paper. That is why banks that hold large amounts of weaker sovereign paper may go bankrupt all over again. The stronger governments therefore will support the weaker governments. But there is a limit to how long the charade can continue.
Reality has a way of impinging. The Greeks know very well that their situation cannot be fixed by a dose of austerity, and have staged a national tantrum that Aristophanes would have enjoyed staging. The Germans know that they need every penny of their own tax revenues to pay for their own elderly dependents, who will comprise 61% of all Germans in 2040 (again assuming constant fertility). The vehemence of the political response in both countries is a signal to the market that something is very, very wrong. So is the British inability to elect a government.
Once the long term casts its chill shadow on present expectations, investors are shocked – shocked – to encounter financial scams that they previously had ignored. Estimates are now circulating in the press that the United Kingdom actually has public debt equal to 150% of its GDP, rather than the 53% figure usually reported, if unfunded pension fund liabilities are taken into account.
That is the future cost of caring for at least part of the United Kingdom’s aging population valued in present pounds. The same could be said for California, whose unfunded pension liability might be $450 billion rather than the $50 billion reported, depending on whether one expects the funds to earn 8% a year, as the pension funds claim, or only earn the government bond yield. That is just a complicated way of saying that if the bubble continues forever, everything will be fine, but if it doesn’t, everything will go pear-shaped.
And that becomes a self-referential question: if you believe in the bubble, it will continue, and if you don’t, it won’t. That, I surmise, explains a 10% price drop in US stock market indices in a matter of minutes last Thursday. A slight change in attitude can dry up the vast reserves of liquidity of the US stock market.
At every inflection point of the financial crash, governments stepped in and announced that they had solved the problem. The crisis began in July 2007; central banks stepped in to provide liquidity in August, and the Fed cut interest rates in mid-September. The consensus stated that the crisis was over and that bank stocks were cheap. Then came the Bear Stearns failure in March 2008, in which the remnants of the firm were sold to JPMorgan. Financials briefly soared, before resuming the long slide that led to Lehman Brothers’ failure in August 2008. The George W Bush administration announced a $700 billion bank bailout in September 2008, and financials rallied, before crashing again in early 2009, amid rumors of a general bank nationalization. More bailouts followed, and this time, an extended rally.
Europe’s finance ministers are proposing yet another bailout for weaker European sovereigns. Perhaps it will hold; perhaps the wave of panic will continue from the Aegean to the Bay of Biscay and up along the Thames. What matters is that the markets have seen the man behind the curtain and never again will believe in the wizard and his bubble in quite the same way.