End The Fed?

I just finished reading Senator Ron Paul's "End The Fed." The book outlines the controversial libertarian's reasoning for wanting to shut down the Federal Reserve. Headed by Ben Bernanke, the Federal Reserve has the power to print U.S. dollars - a power the Fed has been using frequently in recent years. Paul argues that this is a form of tyranny enabling the Fed to covertly tax Americans by devaluing their money. And he believes the Fed uses this power to serve the interests of "the banking cartel" and "the most powerful politicians in Washington."

Perhaps Paul is correct that our central bank's manipulation of the money supply, interest rates, and asset prices does not benefit our economy. And perhaps it is true that the Fed enables a few powerful interests to enrich themselves at public expense. I increasingly suspect that he is onto something. But surely lowering interest rates does benefit some parts of the economy and can lead to growth and job creation in some industries, even if only temporarily. Paul would have us believe that the costs of monetary stimulus are higher than the benefits. Unfortunately, "End the Fed" provides little concrete evidence to support these conclusions.

Paul's best argument against the Fed is that it has a dangerous power in its ability to print money with little oversight by Congress. This does seem inconsistent with democratic values. But this is not new information. Americans appear willing to grant the Fed this power if the result is a stronger and more stable economy. Supporters of the Fed contend that the ability to change interest rates, help the financial system, and control the money supply is of great value to all Americans. After reading "End The Fed," I am not better able to rebut such assertions.

Paul deserves much credit for raising questions about the merits of our monetary system. His book has at the very least prompted more Americans to begin questioning the status quo. However, he fails to offer sufficient evidence to convince us that the Fed does more harm than good. We need to see some data showing that any gains are offset by economic losses elsewhere. The book does not even provide a theoretical explanation as to why any investment and spending spurred by monetary expansion is bad for the economy. More analysis is needed.

The Irish Bank Bailout

Authorities in Europe are scrambling to put together a bailout for Ireland before financial markets open on Monday. However, the circumstances of this latest bailout are perhaps the most interesting - and eyebrow raising - of the many rescue schemes launched in recent years. Unlike the banks and Greece, Ireland does not actually need any money in the immediate future. The country has already borrowed all the money it will need until the middle of 2011. And unlike most other bailouts, the terms of this bailout will cause the Irish economy to contract because of spending cuts. It is also likely to damage the fiscal position of the government. So what is going on?

Ireland's banks are in trouble. And they need money soon. It is difficult to ascertain how much the banking sector needs to stay afloat, but news sources have been reporting numbers ranging from about 30 to 60 billion USD. Controversy, of course, abounds about the wisdom of bank bailouts. But the logic of supporting the banks in this instance appears especially weak. The standard argument in support of bank bailouts usually goes something like: credit is vital to keeping the economy moving; if banks fail, lending will grind to a virtual halt. In Ireland, this line of reasoning does not hold water. In order to keep the economy moving, the country is giving a bunch of money to banks. In order to bailout banks, taxes are going up and government spending is being severely slashed. The effect of this massive fiscal tightening is to slow down the economy. It just does not make sense.

This looks nothing like the bank bailout in the United States, in which the American government has thus far been able to provide massive fiscal stimulus while also rescuing banks. In that scenario, one can at least argue that the government is trying keep the economy moving. But one cannot convincingly purport that the Irish are trying to stimulate their economy by raising taxes and cutting government spending to fund Irish banks.

Perhaps the more convincing argument in favor of another Irish bank bailout is the notion that by providing liquidity to Irish banks, Ireland and the rest of Europe can avert any further "contagion". If Irish banks fail, investors may next lose confidence in Portugal or Greece. But we have heard that argument before. Just this summer, politicians argued that Europe must save Greece so that other countries do not suffer from a lack of confidence. So Greece was bailed out. But today confidence in Ireland, Portugal, Spain and Greece is nowhere to be found.

Forcing Irish bank bondholders to suffer losses will indeed cause financial turmoil around the world. However, that turmoil will cause less real economic pain than would be caused by forcing European taxpayers to foot an ever growing bailout bill.

Krugman Laments Austerity

Krugman's Sunday blog post is entitled "Lost Decade, Here We Come". In this post he laments that many members of the G-20 have abandoned fiscal stimulus and commenced with fiscal austerity (ie., cutting deficits). He argues that governments should be pouring money into economies now and cutting deficits at some future date. Of course, anyone who has been following the recent travails of Greece, Spain, and Portugal can tell you that things are not so simple: Investors are reluctant to lend money to countries with excessive debts and deficits. Sometimes fiscal stimulus is not an option. Krugman seems to suggest that if countries had only outlined credible deficit reduction policies for the future, then markets would be more forgiving. I am skeptical of this view. Greece did exactly that to no avail, though perhaps Greece's extreme indebtedness makes it a special case. The American stimulus bill already accomplishes what Krugman is talking about: it stimulates the economy now, and automatically reduces spending in the future as it naturally expires.

Krugman, however, wants even more stimulus. He condemns "deficit hawks" who want near-term spending cuts as guilty of "utter folly." Europe's debt crisis is not a harbinger of things to come in the United States, Krugman asserts. Rather, he attributes the European turmoil to the unfortunate condition of being part of the Euro-zone. It is true that until a few weeks ago, being a member of the Euro-zone did present a special challenge: individual members could not just print Euros to solve fiscal problems as the United States and Japan can do. However, the E.C.B. rendered that point irrelevant when it began creating Euros to buy European government debt a couple weeks ago. Europe can print money too, it turns out, but is still mired in fiscal and economic problems. Krugman's argument that Europe is some sort of especially tough case that is not relevant to the United States is unconvincing. A loss of investor confidence in America's willingness and ability to repay its obligations could be catastrophic for the global economy. We should proceed very cautiously going forward. Deficits should be reduced and spending should be focused on areas that will lead to long-term economic growth: infrastructure, energy independence, and research and development would be good places to start.

Don't Blame the Germans

Greece's financial problems have shaken world markets over the last month. Each time the likelihood of a bailout seemed to increase, stocks rallied around the globe. And each time someone – usually in Germany - suggested that money might not be readily available, stocks sank and Greek bonds plunged. Recent market movements do suggest that a failure to rescue Greece would lead to some sort of sharp downturn in financial markets. But it does not follow, as many commentators assert, that the best policy is therefore to bailout Greece with all due haste. Germany's Chancellor Angela Merkel has taken flak from politicians and media outside of Germany because she has been slow to lend her taxpayers' money to the Greeks. The Economist chastises her:

“The chief culprit is Germany. All along, it has tried to have it every way- to back Greece, but to punish it for its mistakes; to support the Greek economy, but not to spend any money doing so; to treat this as just a Greek problem, when German banks and German citizens, who lend to Greece, stand to lose money too. German voters do not favor aiding Greece. But rather than explain to them why it is in Germany's interest, the chancellor, Angela Merkel, has run scared of upsetting them before a big regional election on May 9th.”

This is a flawed analysis. It fails to account for what would have happened had Germany just offered the funds promptly. Consider the situation a few weeks ago: Greek Finance Minister George Papaconstantinou attempted to allay investors' concern about Greek indebtedness by trumpeting a 3% cut in the deficit and the Euro region's vague “commitment” to offer 45 billion Euros in loans should funds be needed. Meanwhile, large numbers of Greeks took to the streets to protest such draconian thrift. But the harsh reality is that to lend money to a country with a shrinking economy, a deficit of over 10% of GDP, and a debt of over 115% of GDP would solve nothing. In a matter of months, if not days, investors would realize that Greece was still hurtling towards default. And then where would Europe be? They would be 45 billion Euros poorer and Greece would have an even bigger debt problem to deal with. And the political will to pay for yet another bailout would surely be much abated.

That Germany chose another path should not be written off as mere political political posturing. Rather, Germany demanded that Greece submit to an I.M.F. austerity program. Involving the IMF has two major advantages that greatly increase the probability of Greece avoiding default – though some sort of eventual restructuring will still be hard to avoid. The first advantage is that the I.M.F. has expertise in lending to distressed countries and designing austerity programs. The E.U.'s initial attempt to rescue Greece by itself suffered from a lack of coordination and clarity of purpose. The I.M.F., on the other hand, seems to know exactly what it is doing and how it is going to do it. The second advantage of bringing in the I.M.F. is that unlike European politicians, the organization is known for tough quantitative assessments of what is really needed to bring foundering countries back to fiscal self-sufficiency. It now appears that in conjunction with the IMF, Germany will demand a much more drastic 10% cut in Greece's deficit. If this can be accomplished without causing the economy to contract too severely, Greece might just be able to pay its debts. Surely a plan in which Greece's debt will not continue to explode is superior to a scheme that would merely delay and exacerbate the current fiscal crisis.

Yes, it is true that a consequence of delaying the Greek aid package was increased uncertainty and volatility in markets. But that is a cost worth bearing. By delaying the package, involving the I.M.F., and demanding serious deficit reduction, there is now some chance that Greece escapes economic catastrophe. Had Germany not delayed its package, Greece's fiscal situation would have continued to deteriorate, necessitating more bailouts and causing even greater uncertainty and volatility at a later date.

NY Times Inconsistency

When talking about government debt, commentators often make a distinction between total government debt and net debt held by the public. Total government debt includes monies owed to other government organizations of the same country. For example, the Social Security trust fund owns billions in treasury notes. These billions are included when discussing total debt. But many commentators think that when talking about the size and sustainability of debt, it is more useful to net out such debt. It is the amount of debt the government owes to the public that matters, they say.

Ok, boring, I know. But here is why it matters:

Yesterday the New York Times ran a piece on Social Security that included the following statement:

By 2016, Social Security will begin paying more in benefits than it collects in payroll taxes, according to the annual report of government trustees; reserves in the form of government i.o.u.’s will be exhausted by 2037, after which incoming taxes will cover three-quarters of benefits.

The problem with this statement is that it makes it seem like there is some sort of massive trust fund that will help us straggle along to 2037. And as far as I can tell, a problem that is not a problem until 2037 is not really a problem at all, at least in Washington.

However, the majority of commentary about America's debt does not count money owed to social security as real debt. The thinking is that since the government owes itself the money, it doesn't count. Using this logic, America's total debt of over 100% of GDP is made to look like the much more manageable sub 70% of GDP often cited in the press. I don't have a strong opinion on the right way to classify debt owed to social security and other government agencies. But I do know that you cannot have it both ways. If you think social security has enough money to get us to 2037, then America's government debt is a Greek-like 100% of GDP. If, on the other hand, you think the debt is closer to 70% of GDP, then social security will most likely be broke within 6 years. The NY Times and other media outlets should address this inconsistency in their reporting so that readers can better understand America's budget problems.

The Debt Debate

A debate is raging about government debt. On one side, economists like Paul Krugman argue that large deficits and debt levels above 100% of GDP are nothing to be too alarmed about. This camp cites historical examples of nations successfully clawing themselves back from massive national debt burdens by combinations of tax increases and spending reductions. Of course, for every example of success, an example of failure can also be found. A new book entitled 'This Time is Different,' by Reinhart and Rogoff, chronicles the surprisingly long historical record of debt defaults and introduces its chapter on Sovereign Default on External Debt with the following note:

Policy makers should not have been overly cheered by the absence of major external sovereign defaults from 2003 to 2009 after the wave of defaults in the preceding two decades. Serial default remains the norm, with international waves of defaults typically separated by many years, if not decades.

Reinhart and Rogoff also point out that defaults frequently occur at ratios of external debt to GDP much lower than 100% - indeed, developing countries typically default long before debt reaches 70% of GDP.

What emerges from this debate is that the focus on debt to GDP ratios as a measure of a country's likelihood to repay is misguided because the record is very mixed. A variety of other factors need to be considered: The household savings rate, ease of cutting government spending, demographics, ability to inflate, liabilities not counted in national debt figures (ie. Fannie Mae and social security), state debts, and municipal debts seem like good places to start.

Readers should therefore find little comfort when they encounter claims that if Japan, the United Kingdom and Belgium have historically been able to handle massive debt burdens, so can Greece or the United States. Likewise, they should not conclude a massive default wave is approaching just because current debt ratios exceed those of countries just before they defaulted. Each country is unique and the focus on debt to GDP ratios is woefully narrow-minded.

Consider the United States, for instance: Our debt hole is really much bigger than the 60% debt to GDP ratio often cited. Medicare, social security, municipal pension obligations, and low household savings rates all make the true debt burden much heavier. On the other hand, we have been able to print over a trillion new dollars without causing significant inflation (so far), a long record of political and financial stability, a history of entrepreneurship, and the strongest military on Earth. The question of how much debt a country can handle is extremely complex. Economists and policy makers need to conduct a much fuller analysis as soon as possible so that we can develop a wiser fiscal policy.

Unintended Consequences

The Senate on Wednesday passed a $15 billion jobs bill that offers a tax break to companies that hire people who have been unemployed for at least 60 days. This should help create some jobs. But it will probably also have unintended consequences. Unfortunately, the legislation actually encourages companies to fire existing employees and hire unemployed people to capture the tax credit. This problem will particularly afflict unskilled laborers who require little training and are easily replaced, but have managed to avoid the chopping block despite the current downturn. The tax credit may even trigger layoffs: companies often delay layoffs as long as possible because the costs of rebuilding a workforce once demand picks up in the future are substantial at many firms. By making hiring so much more attractive, this bill likewise makes firing much easier for firms. The Senate ought to have just lowered payroll taxes for all Americans, but by a lesser amount.