Debt and Deflation

I am, like many, pretty disappointed in the direction the federal government is taking by charging headlong into austerity in the midst of a very serious economic crisis. Yes, I still call it a crisis, what else would you call it when our economy has almost 10% unemployment for such an extended period?  There is a time for austerity for sure, but that is when the economy is on solid footing, not when it is struggling to gain any traction at all.

If you need any proof, look no farther than the latest report from the BLS on personal income which shows that deflation has returned and wages and salaries are falling. Here is Catherine Rampell of the New York Times on the report:

For the first time in a year, consumer prices fell in June, according to a new report from the Commerce Department released Tuesday. The price decline was driven by energy declines, and is just one month’s data point, but even so, the figure is worrisome. The Federal Reserve pays close attention to this price index (more so, reportedly, than to the Consumer Price Index released by the Labor Department); and you may recall that part of the reason the Federal Reserve engaged in quantitative easing was the threat of a deflationary spiral.

The Commerce Department’s report delivered other bad news, too.

Nominal personal income increased by just 0.1 percent in June — and the increase was due to higher government transfer payments (like unemployment benefits) and capital gains income, not wages and salaries.

In fact, private wage and salary income fell in June.

None of these facts bode well for growth in the third quarter of this year, given that the economy is so dependent on consumer spending. And the austerity measures created by the recent debt ceiling deal look unlikely to make things better.

It is hard to see how moving prematurely to austerity does anything but add a couple of years onto the economic malaise we now find ourselves in.

And to me the entire narrative is discordant: the US did not become the economic superpower because of small government alone, it was also because of things like public higher education, government sponsored research, infrastructure and so on.  So let's talk about investment, not just cuts.

The Debt Ceiling

This is the topic I have been avoiding studiously as I am not sure there is anything of value I can add.  My basic take is that allowing a government default would be the stupidest thing the US government has ever done and would convince me our democracy is broken.  So there you have it.

Fortunately there are some exceptionally smart people out there giving more sober analyses.  The best have seen is this piece in Project Syndicate by Simon Johnson.  Here is an excerpt:

WASHINGTON, DC – Leading United States congressmen are determined to provoke a showdown with the Obama administration over the federal government’s debt ceiling. Ordinarily, you might expect House Republicans to blink at this stage of the negotiations, but there is a hardline minority that actually appears to think that defaulting on government debt would not be a bad thing.

These representatives – with whom I've interacted at three congressional hearings recently – are convinced that the US federal government is too big relative to the economy, and that drastic measures are needed to bring it under control. Depending on your assessment of “Tea Party” strength on Capitol Hill, at least a partial debt default does not seem as implausible as it did in the past – and recent warnings from ratings agencies reflect this heightened risk.

But the consequences of any default would, ironically, actually increase the size of government relative to the US economy – the very outcome that Republican intransigents claim to be trying to avoid.

The reason is simple: a government default would destroy the credit system as we know it. The fundamental benchmark interest rates in modern financial markets are the so-called “risk-free” rates on government bonds. Removing this pillar of the system – or creating a high degree of risk around US Treasuries – would disrupt many private contracts and all kinds of transactions.

In addition, many people and firms hold their “rainy day money” in the form of US Treasuries. The money-market funds that are perceived to be the safest, for example, are those that hold only US government debt. If the US government defaults, however, all of them will “break the buck,” meaning that they will be unable to maintain the principal value of the money that has been placed with them.

The result would be capital flight – but to where? Many banks would have a similar problem: a collapse in US Treasury prices (the counterpart of higher interest rates, as bond prices and interest rates move in opposite directions) would destroy their balance sheets.

There is no company in the US that would be unaffected by a government default – and no bank or other financial institution that could provide a secure haven for savings. There would be a massive run into cash, on an order not seen since the Great Depression, with long lines of people at ATMs and teller windows withdrawing as much as possible.

Go and read the entire piece, it is sobering reading.

Credit Ratings and the US Debt

Yesterday Standard and Poor's, a credit rating agency, lowered its outlook on the prospect of the US political system making serious progress on dealing with the mounting debt.  There was no change in the actual rating they give to US treasuries and bonds which remain at AAA, but it hardly matters because no one cares what S&P has to say about US debt.

Why?  Well, the point of the rating agencies is to tell us something about bonds that we don't know. For example, how safe are the bonds of Kenosha, Wisconsin?

But everyone knows about the situation in the US and the bond market sets the price daily.  How risky is US debt?  Check the price on the bond market:

The bond market confirms what everyone knows, the US is not going to default on its debt obligations.  US debt has been a safe haven for money during the global recession.

S&P's announcement has not gone over well with some economists, here is a sampling from the NY Times' 'Room for Debate' feature:

Yves Smith

The Standard & Poor's rating firm should be embarrassed. If there is any political judgment at work here, it is S.&P. falling for politically motivated scare mongering. But given its track record with mortgage securities and collateralized debt obligations, why should we be surprised to see a rating agency relying on conventional wisdom rather than analysis?

The whole premise of the rating is incorrect. The U.S. may eventually experience unacceptable levels of inflation, but the experience of Japan shows that stop-and-start fiscal stimulus is more likely to result in protracted near-term deflation.

Barry Ritholtz

First, I have stopped paying any attention to anything that S.&P. says or does. Its performance over the past decade has revealed it to be incompetent and corrupt – it sold its AAA ratings to the highest bidder. It is the broker who lost all your money, the girlfriend who cheated on you, the partner who stole from you. Since the portfolios we run never rely on its judgment or analysis, we simply do not care what it says about credit ratings.

Barry Eichengreen

Standard & Poor's lowering the outlook for U.S. debt to negative is less the canary in the coal mine than it is another faint reverberation from a familiar echo chamber. The ratings agencies don’t know anything more than people who have read newspapers covering this issue.

They don’t influence market sentiment as much as they reflect it. In saying that U.S. policy makers may not be able to meet the country’s medium-term budgetary challenges by 2013, they are not telling us anything we don’t already know.

Of course Smith and Ritholtz referring to the central role the credit rating agencies (who are paid by banks for their services) had in the mortgage market meltdown and subsequent recession.  These agencies gave AAA ratings to MBS and CDOs that their clients were selling, when in fact they were junk.

Which gets us back to what they agencies are supposed to do - tell less informed investors about the relative risk of investment that they have researched thoroughly. As many have pointed out, however, they make all their money from the very firms whose investment vehicles they are supposed to analyze subjectively. The basic economics of incentives suggests that this is not going to happen. And for these CDOs, it didn't - they rated stuff they didn't understand, and should have been suspicious of, AAA when in fact it was toxic.

Eichengreen is essentially making the same point that I am: S&P doesn't really tell us anything we don't know about the market for US debt and if you want to know how the insiders feel, just look at the market equilibrium prices where there is little sign of a risk premium being charged.

So in the end the S&P announcement got lots of press but was, to me, a complete non-event.