US Economic, Regulatory and Banking History

A RESPONSE: The ingredients are in place for a crisis

Posted on Thursday, February 17, 2011

IT'S a good thing the cacophony surrounding Ben Bernanke’s testimony to the Congressional budget committee last week passed largely unheard in the financial community. Congresswoman Schwartz, in a litany of “what-ifs”, asked Mr Bernanke if he thought it was morally correct for Congress to require America, when faced with hypothetical default, “make payments to foreign creditors the priority instead of paying our social security beneficiaries, our veterans, and US contractors…”. Congresswoman Bass asked similarly “if we [default on federal debt]… would states be able to refinance their debts?”. Mr Bermanke responded simply “I don’t know”.
It is shocking to think the policy leaders of the world’s largest debtor need to threaten default in order to achieve pragmatic outcomes. Austan Goolsbee, Chairman of President Obama’s Council of Economic Advisers, kicked off the commentary in January. He was soon followed by Timothy Geithner, Ben Bernanke, and many more. While all these people despise the notion of default, invariably such incredible talk does have a nasty way of infiltrating future actions. For example, Mr Bernanke told the budget committee the government was not yet technically ready to be able to pay Social Security recipients ahead of some interest payments due to bondholders, but they were working on it and would be ready soon.
There are many ingredients needed to generate a crisis, and America has a good dose of each. In the old days when investors thought emerging markets were risky, a rule of thumb indicator for hyperinflation risk was the size of the budget deficit compared to revenues. A higher ratio implies that larger budget cuts or tax increases are needed, so there is greater risk the government will be forced to print money or default if the economy gets into trouble. For the US federal government this ratio is scary: the government spends twice its revenues, meaning that even if taxes were doubled it is unlikely the budget would be balanced. The ratio only gets worse in the future as entitlement spending rises and the workforce ages.
Long ago Alberto Alesina and Allen Drazen wrote an elegant paper to address a simple question: why do so many nations march headlong into painful hyperinflations/default despite the outcome being abundantly clear to most observers well in advance? Alesina and Drazen’s paper argued that when fractious self-interested groups manage fiscal policy, and each group can prevent reforms from happening, then solutions only come when a terrible pain threshold is reached causing one group to throw up their hands and give in. That group then bears the brunt of the costs of reform.
Yet America has more than a fiscal crisis. Our latest collapse started in our highly leveraged banking system, which is incentivised to over-extend itself (helped by implicit subsidies from the Federal Reserve and politically weak regulators). The purported solution to this is, as Bernanke likes to call it, “smart regulation”. The technocrats and economists who worked on Basel 1 and Basel 2, along with our many dedicated regulators must find it quite frustrating to hear they were simply not smart enough. The reality is that our political system has repeatedly failed to maintain any regulation. This reflects the large financial gains, and the ensuing lobbying and evasion, which inevitably come with any system that relies on top down regulation and which can’t suffer bankruptcy.
So America has the fractious politics, an unsustainable budget, and a potentially reckless financial sector, making it highly prone to future busts. The most common retort to these concerns is to point to Japan’s experience. The Japanese have managed to accumulate nearly 200% of GDP in debt, and they remain on a clearly unsustainable fiscal path, yet they have avoided crisis for the last two decades.
Could we simply build debt for decades and leave solutions to the future? Perhaps, but it is unlikely. Approximately half of publicly held US Treasury bonds are owned by domestic savers, and another 25% are held by the Chinese and other Asians. With the Federal Reserve so explicitly aiming to reduce the returns on these savings each time the nation runs into (self-imposed) problems, it is optimistic indeed to presume that there will not come one day when bond investors and prudent savers simply don’t trust American debts anymore.
Indeed, our financial system is presently being recapitalised through a stealth tax on the same savers that we hope will finance our growing debts. The Federal Reserve embarked on quantitative easing because they wanted to take a bold step to rejuvenate the economy, yet they could not turn interest rates negative so they needed another tool. The Taylor rule which has helped guide policy in the past suggests rates should be near to -5%. This is equivalent to confiscating 5% of a person’s savings each year and then shipping that money to banks and debtors. So while Congress has yet to prioritise who gets paid first in times of trouble, the Federal Reserve has made it utterly clear that prudent savers are first to be taxed.
In his opening statement to the budget committee Ben Bernanke expressed confidence that the budget deficit would eventually be brought under control. He remarked that we shouldn’t believe the long term forecasts of the Congressional Budget Office since creditors will refuse to finance such large deficits. This is refreshingly straightforward: either our current political system will somehow miraculously coordinate a lasting solution to America’s insolvent path, or America will be threatened with a nasty inflation/default as creditors refuse to finance our deficits and financial sector. Some Republicans seem to feel a nation cut off from debt financing, despite a path punctuated with inflation and defaults, might just be a better outcome in the long term. By eschewing our savers, and refusing to deal with the core problems in our fiscal and financial system, our political and financial elites are marching us headlong down that dangerous path. If we can’t have German resolve from within, then maybe we must wait to have it imposed from without.

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