Tuesday, August 14, 2012

Free Money

Could it be that Paul Krugman is right? Instead of arguing about the best way to narrow the federal deficit, we should be widening it! Could it be that John Williams is right? The President of the San Francisco FRB, and a voting member of the FOMC, favors QE3 and thinks that it should be open-ended! I think they are both dead wrong, but it’s hard to argue against their simple and seemingly compelling solutions to our economic woes.

They both seem to agree that the only reason that fiscal and monetary policies haven’t worked so far to revive self-sustaining economic growth and to bring down the high unemployment rate is because everything that’s been done to date hasn’t been enough. If a trillion dollars in government spending and a trillion dollars in quantitative easing didn’t work, then we should have done twice as much. It’s not too late to do that now, in their opinion.

In his 7/27 column for the NYT, Krugman argues that now is the time for the government to borrow as much money as possible because interest rates are near zero. In fact, he argues that “by making money available so cheaply,” investors “are in effect begging” the government to issue more debt. Krugman’s column is titled “Money for Nothing.”

John Williams was interviewed by Kathleen Pender in the 8/10 issue of the San Francisco Chronicle. She writes that “Williams has previously suggested that the Fed, if it embarks on QE3, should consider an open-ended program. With the first two rounds of quantitative easing, the Fed stated how many dollars' worth of bonds it would buy and over what time frame. In an open-ended program, the Fed would leave both parameters open and say that it plans to continue buying mortgage or Treasury bonds until the economy improves.”

I was quoted in Kathleen’s article: “Some economists say the Fed should hold QE3 in reserve, in case lawmakers cannot agree to forestall tax increases and spending cuts scheduled to take effect in January and the economy falls off the fiscal cliff. QE3 'is the only ammunition we have,' said Wall Street economist Ed Yardeni. 'Now is not the time to waste QE3 just because the economy is not growing fast enough or creating enough jobs.' Williams' response: 'We want to position the economy to be strong in advance of that,' he said. 'If you are really worried about running out of ammunition, you want to act more aggressively, more quickly and better prepare yourself for that eventuality.'"

Of course, the reason that interest rates are near zero is because the FOMC has repeatedly promised to keep the federal funds rate near zero through 2014. To make sure that the Bond Vigilantes don’t push yields higher, the Fed has purchased large quantities of Treasury bonds and mortgage-backed securities through QE1, QE2, and Operation Twist. QE3 might be next, and it might be unlimited.

In effect, the bond market no longer exists. It’s been nationalized by the Fed! The Fed’s reckless monetary policies have certainly enabled Washington to pursue reckless fiscal policies. Krugman’s response is that interest rates are near zero because of a “deleveraging shock” that is depressing household and business spending. The right policy medicine is the standard Keynesian prescription of more government spending, in his opinion.

Krugman adds: “You don’t even have to make a Keynesian argument about jobs to see that. All you have to do is note that when money is cheap, that’s a good time to invest. And both education and infrastructure are investments in America’s future; we’ll eventually pay a large and completely gratuitous price for the way they’re being savaged.”

Compelling stuff. I’m almost ready to go over to the Dark Side. However, there are some serious flaws in the case for open-ended fiscal spending funded by open-ended quantitative easing. It violates one of the basic rules of economics: There is no free lunch.

Borrowing at near-zero interest rates may seem like free money, but it isn’t. It accumulates as a mountain of rapidly rising debt. Despite all the talk about government investment in infrastructure and education, the reality is that more and more of government outlays are on deficit-financed entitlements that do not generate any return. Consider the following dismal stats:

(1) Entitlements now account for 60% of government outlays, up from less than 45% in 1987.

(2) About a third of total federal outlays are deficit-financed.

(3) Public debt outstanding rose to a record $15.9 trillion during July. That’s over $100,000 per person in the labor force.

The American Recovery and Reinvestment Act of February 2009 cost $800 billion, yet the number of teachers dropped 313,800 and public construction fell 14.7% since it was enacted. Where did the money go? Hard to say, but some of it probably paid for the pensions of retired teachers and cops rather than for keeping more of them on the job. The decline in public construction suggests that there really were no "shovel-ready" projects in America. Why, pray tell, would spending (squandering) another $800 billion produce a better result?

Money is always free if you can steal it without getting caught. That’s what we are doing to our children. Krugman and Williams are endorsing the Theft of Generations. Perhaps Mitt Romney was right after all: The next President of the United States should be Paul Ryan. The Congressman is 42 years old. He represents the next generation that will be burdened by all the debt (free money) that we are accumulating to pay for the entitlements of the current generation.

No wonder that Ryan’s “Path to Prosperity” plan to wipe out the federal debt by 2063 focuses on reforming Medicare and Medicaid. The former would be privatized starting in 2023, which would exempt anyone age 55 and over. Under the plan, seniors get government vouchers worth about $8,000 to go toward the cost of a private insurer of their choice. By 2034, the eligibility age would increase from 65 to 67.

The coming presidential election is likely to be momentous. Americans may give another four-year term to the current Democratic administration, whose guide book seems to be Saul Alinsky’s Rules for Radicals. Alternatively, the Republican challengers seem to be guided by Friedrich Hayek’s The Road to Serfdom and are promising to take us down a different road, i.e., the path to prosperity. In any case, if we continue to borrow as though government debt is free money, our children will be serfs for sure.

Japan is the poster child for where geriatric societies with generous social welfare programs are headed. There’s plenty of free money in Japan with the 10-year government bond yield under 1%. The government has been borrowing lots of it. The national government debt is at a record 200% of nominal GDP.

An excellent article on this subject in the 8/11 WSJ reported that “Japan, burdened with the highest debt load of any developed nation, on Friday took its biggest step in years to contain the problem, approving a plan to double the national sales tax by 2015 from to 10% from 5%.” Nevertheless, the legislation won’t fix the fiscal problem, as the new revenues will be more than offset by projected outlays. Here’s more from the article:

“The burden of escalating payments for the elderly is falling on an increasingly pinched younger generation of Japanese. While spending on elderly benefits--and the cost of serving debts to fund them--rises steadily, government expenditures on education and science have fallen.

“That is creating irritation among many in their 20s and 30s who have had to make do with low-paying temporary jobs, as companies have responded to two decades of stagnation by reducing the number of young people they hire and cutting pay and benefits.

“One network-news show recently described people in their 60s and 70s as ‘the generation that got away’ before Japan's next wave of problems. Those in their 40s and 50s were ‘the generation desperate to get away.’ Those in their 20s and 30s: ‘The generation that can't get away.’"

By the way, "Money for Nothing" is a single by British rock band Dire Straits, taken from their 1985 album “Brothers in Arms.” It was one of their most successful singles, peaking at number one for three weeks in the US. I wonder if Krugman knows the lyrics, which suggest that if you want to make money without working, learn to play the guitar and play it on MTV.

Today's Morning Briefing: Free Money. (1) Two wise guys: Krugman and Williams. (2) Open-ended fiscal and monetary recklessness. (3) Please borrow more! (4) QE3 and the fiscal cliff. (5) The Fed has nationalized the bond market. (6) Another fix for the Keynesian addicts. (7) No free lunch. (8) Paul Ryan for President! (9) Path to Prosperity vs. Road to Serfdom. (10) Japan's example. (11) Dire Straits. (12) China’s tax data confirm slowdown. (More for subscribers.)

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