Why Donald Trump Can't Stop a Recession

A recession may be on the horizon.  The Federal Reserve doesn't think so.  Some others do.  Only time will tell who is right.  But if there is a recession, President Trump can't stop it before the 2020 election. 

The principal tool for the President to fight a recession would be to partner with Congress and put together a package of spending bills that would increase federal expenditures.  This sort of program, called fiscal policy, sometimes includes tax cuts, but not always.  The greatest fiscal stimulus in U.S. history, military spending for World War II, included a massive tax increase and an even greater increase in deficit spending.  The result was both victory in the war and an economic revival at home. 

Today, however, there is an almost complete absence of agreement between the President and the Democrats in the House as to how to deploy fiscal policy.  Although both sides speak of infrastructure spending, agreement on the fine points and details has remained elusive since the President was inaugurated and won't be achieved before November 2020.  For more than the past 20 years, the federal budgetary process has been largely dysfunctional, and it has grown more so as political divisiveness has increased.  With only one full budget cycle remaining before the election, it's simply too late to implement fiscal measures in time.

To make things worse, the President would likely seek a tax cut as part of the stimulus package.  But, having alienated the Democrats by ramrodding through the 2017 tax cuts with nary a shred of consideration for Democratic views, the President has essentially no good will left with the House majority when it comes to tax policy.  The Democrats will agree to tax changes only if there is a substantial rollback of the 2017 cornucopia of tax cuts for the wealthy, and the President won't agree to that.  So no deal on tax legislation is possible.

Of course, central banks can endeavor to combat recessions.  But the President does not control central bank policy.  Monetary policy and other economic management measures such as quantitative easing and the setting of bank reserves lie within the purview of the Federal Reserve.  The President attempts to influence the Fed with shrill demands on Twitter for much more aggressive interest rate cuts than the Fed seems inclined to make.  But the Fed strives to maintain its independence, and the President would be wise to back off.  If the financial markets lose confidence in the independence and integrity of the Federal Reserve, stocks will crater and the economy will get a tummy ache.   Moreover, Fed interest rate adjustments often take 18 months or longer to affect the economy.  Although they may almost instantaneously be reflected in asset prices in the financial markets, they take a long time to wend their way through the processes of the economy.  There isn't enough time before November 2020 for interest rate cuts to have a big impact. 

The prospects for a recession remain uncertain.  Unemployment is at a 50-year low, a remarkable development that no doubt informs the Fed view of the economy.  The stock market is dancing near its all-time highs.  Transportation and manufacturing are slowing, and the business community is pulling back on new investment because of confusion and caution arising from President Trump's trade wars.  It's difficult to tell how things will go.  But if a recession is coming, it's coming.

How to Stimulate the Economy

With current economic indicators mostly signaling a slowdown in the economy--and perhaps a recession--a lot of attention is focused on stimulating the economy. The dialogue revolves around central bank accommodation (via lowering interest rates and bond purchases in the form of quantitative easing) and fiscal policy (i.e., deficit spending).  Fiscal measures are essentially impossible because of political gridlock.  And central banks, having devoted the past decade to accommodation, have only limited ammo left.  So what can stave off recession and renew economic growth?

There's no simple answer.  But one important factor is the availability of inexpensive energy.  Modern life is dependent on vast amounts of cheap energy.  The Industrial Revolution that created our high tech lives was the result of the development of inexpensive ways to harness and utilize large amounts of energy.

Let's begin in A.D. 1700.  Living standards in A.D. 1700 worldwide were about the same as they were in A.D. 700 and 300 B.C.  In other words, things had hardly improved over thousands of years.  But within the 150 years following 1700, people had developed the steam engine and learned how to harness electricity for commercial use.  These developments were followed by new ways to extract large amounts of fossil fuels that could be sold inexpensively.  Then, after 200 years (i.e., by 1900), people had developed the internal combustion engine.  The internal combustion engine could be used widely in transportation, manufacturing and many other ways.  Large scale generation and distribution of electricity became feasible, and the widespread availability of electric motors greatly enhanced living standards.  Economic growth and improvement of living standards accelerated at an exponential pace.  In essence, access to inexpensive energy sources (carbon based fuels and electricity) triggered a monumental amount of economic growth and a phenomenal rise in living standards in a historically short amount of time.  Of course, we now have pollution and other byproducts of the Industrial Revolution to contend with.  But the simple truth is the astounding economic growth of the past 300 years resulted to a large degree from ever increasing access to cheap energy.  Cheap energy and the technology developed to exploit it made modern life possible.   

Why is energy so important to economic growth?  Because energy is a key input into all economic activity.  From manufacturing to transportation to farming to fast food to government offices to hair salons to slimy corporate lawyers peddling excuses for their greedy clients to sordid lobbyists plotting to kill health insurance coverage for all to the performances of rock stars in large arenas, energy is an input into essentially all economic activity.  If the cost of energy is lowered, all economic activity gets a boost and economic growth in all sectors of the economy is facilitated.  

It's no accident that America's economy grew briskly in recent years concurrently with a drop in the price of natural gas, solar and wind energy, and to some degree, oil.  The proliferation of fracking not only has capped the price of oil, but also created demand for a lot of drilling equipment, trucks of various kinds, and so on.  So it boosted the manufacturing and transportation sectors. 

We use enormous amounts of energy stored in the past to make our current lives more comfortable and enjoyable.  We now understand we can't keep relying so much on energy from fossil fuels.  We have to develop more sustainable lifestyles.  However, in order to maintain and improve our lives, we need to continue our access to cheap energy in better ways.  After decades of frustration, solar and wind energy have actually become cheaper than fossil fuels.  That is a very positive development.  More technological advance is needed. 

The policies needed continue the availability of cheap energy would be varied and sometimes controversial.  Increased federal funding of basic research is an obvious one, although the GOP has done much to cut this from the federal budget.  Republicans seem fear science.  But ignorance will not spur economic growth.

Building more gas pipelines is obviously controversial to the NIMBY crowd.  But we do need better distribution systems for gas--and electricity as well.  All the windmills and solar farms in the Plains states won't do much good without power lines to transport the electricity to the big cities that need the power.  These power lines entail a huge NIMBY problem.  But this will have to be dealt with somehow, because distribution systems have to be enhanced if there is to be growth.  We need not bow to big, bullying energy and power companies and give them everything they want.  But we should acknowledge the need for better distribution systems.

Fostering greater fuel efficiency also helps to lower energy costs.  It may not lower the stated price per unit, but it reduces the number of units people have to buy.  So it would help to pursue efficiency as well as reduce unit costs.  One hidden cost of efficiency, though, is people consume more energy when it effectively becomes cheaper--many ordinary cars and SUVs today have engines that are as powerful as those in the muscle cars of the 1960's, since engine technology has improved so much, and people drive more miles per year.  So greater efficiency isn't an improvement if it doesn't reduce the use of fossil fuels.

There are many other factors besides energy that affect economic growth.  But a lot aren't controllable by any branch of the government.  Energy policy, though, can be implemented through government.

In the 1940's, 50's and 60's, the U.S. had ultra-high marginal tax rates, not that much deficit spending (the government focused on reducing the deficit, not increasing it), a rather inactive Fed, relatively high wages that provided for a comparatively equitable distribution of wealth and income--and an era of brisk economic growth and low unemployment.  This is an era still remembered as a golden age in America.  Why?  Because oil was damn cheap.  What happened after the first OPEC oil embargo in 1973?  A decade of economic stagnation followed by decades of economic uncertainty.  When we had cheap energy, we had lots of prosperity.  When energy rose sharply in price, prosperity as we had enjoyed it went away and still hasn't returned.  We don't need to sell our souls to the fossil fuels companies.  But we need to recognize that our standard of living and future improvements to our standard of living are dependent on access to cheap energy.  And we need to find responsible and sustainable ways to keep that gravy train rolling.

Ask Not What Your Country Can Spend For You

Ask what you can spend for your country.  At least, some folks might like it if you did.  The Federal Reserve is in trouble.  The economy is meandering.  Unemployment levels have reached full employment, but labor force participation levels are low.  The Fed accentuates the negative and projects gloom about employment.  Wages stagnate, and, net of inflation, are lower than a generation ago.  The dollar is strong, which encourages imports while discouraging inflation. The Consumer Price Index is dropping, leading some to conclude that we have deflation.  This conclusion is a classic example of how statistics mislead.  Prices are higher if you take out energy costs.  If the price of everything except energy is going up, and energy is dropping a lot, do we really have deflation?  Or a misleading statistic?

But we digress. The Fed has greatly reduced its quantitative easing measures, since they didn't seem to be doing much good any more.  It's holding short term interest rates lower than a snake's belly.  But it can't do more.  The Fed is now low on ammo and can't expend what it has left; it has to hold something in reserve in case the economy belly flops.

There's no possibility of fiscal stimulus.  The federal government tied its budget into knots with the sequestration law, which requires automatic spending cuts each year through 2021.  Congress and the White House can get around the cuts by passing specific legislation providing for something other than sequestration.  But, given how the daily love fest between Congress and the White House consists of brickbats, but not bouquets, the chance for fiscal stimulus is lower than short term interest rates.

That leaves you, dear consumer.  The U.S. economy is about 70% consumption, and if consumers don't consume, the economy reaches for one of those little airline bags.  So spend, spend, spend.

Right?  Come on, right?

Or maybe not.  Consumers learned the hard way after the 2008 financial crisis that lavish spending and debt accumulation are shortcuts to financial ruin, and that saving improves the quality of your sleep.  Just because the Fed made it cheap to borrow doesn't mean borrowing is a good idea--soda is inexpensive but drinking a lot of it is a very bad idea.  If the Fed can't move short term interest rates above a complete goose egg, you have to suspect that maybe the Fed knows that the economy is a complete goose egg.  In which case, the last thing you want to do is spend freely.

We live with a contradiction:  our individual financial health requires acting in a way that is unhelpful to near term economic growth.  But those who are prudent can get through hard economic times, and it makes sense to put self and family first.  This leaves policy makers with controversial choices--negative interest rates, easing immigration restrictions to bring in educated, ambitious foreigners, and even more hotly debated measures (can you say Ex-Im Bank?).  How likely are these?

The truth is government policy is largely played out.  The economy will have to rise or fall based mostly on its own.  The next surge of growth, whenever that is, will probably come in a rush of technological innovation that may be hard to foresee.  Until then, the economy will likely meander.  If you're building up your savings and preparing for a tough slog, you'll probably be okay.  Ask not what you can spend for your country.  Ask what you can save for yourself and your family.

The Market Dropped 3%, So What's For Dinner?

On Monday, Oct. 19, 1987, the U.S. stock market nose-dived, with the Dow Jones Industrial Average falling 22.61% in a single day.  That was volatility.

Recently, the market has been bouncing around, losing as much as a few percent a day, and edging into correction territory (a loss of over 10% from the latest high).  This turbulence isn't surprising, given the six year age of the longstanding bull market.  Indeed, in the summer of 2011, the market dropped around 17% on account of various investor jitters.  Then, it recovered.  Markets regularly have downturns, even bull markets.

So what does the future hold?  Nothing that anyone can reliably foretell.  The direction of the financial markets today is determined first and foremost by central bank policies.  The key players are the U.S. Federal Reserve, the European Central Bank and the Bank of China.  Predicting central bank policies is difficult in the best of times.  These days, with the data unusually uncertain, central bank policy is harder to predict than one's luck at the  roulette wheel.  This is especially so since politics appears to infiltrate central bank policy, making prediction even harder.  But one thing you can expect is they'll be cautious about doing anything that isn't accommodative.  If the Fed raises rates in 2015, it will probably do so once, and be done with rate raising for quite a long while.

The Chinese stock markets have a bubbly aura, making further volatility in Shanghai and Shenzen likely.  But China's economy is not heavily dependent on rising Chinese stock prices--and neither are Europe's economy or North America's.  Many individual savers in China are getting hosed, but the Chinese economy doesn't rely on domestic consumption. If Chinese investors lose their savings, Chinese manufacturers will still keep exporting to the rest of the world.  So the acid reflux in the Chinese stock markets may, ultimately, have only so much impact and not more.

Keep an eye on the market, but don't miss any meals over it.  If you're nervous, stay the course and don't invest more right now.  On the other hand, if you're feeling lucky, think about adding a bit to your stock holdings as the averages move down.  You know what they say about not letting a good crisis go to waste.

Is there a black swan lurking?  Maybe.  Since China has been the major source of world economic growth in recent years, any major upheaval in China could be the black swan.  What could happen there?  Well, President Xi Jinping has been aggressively consolidating power.  He may be the most powerful leader China has had since Mao Zedong.  But the market turmoil in China, and the recent slowdown in its economic growth, may be causing some to question his leadership.  The secretive nature of China's Communist Party makes it impossible to know for sure how strong Xi's grip on power may be.  While there are no overt signs of change, if Xi is forced out of power and there is a struggle for control in China, then all bets are off and you might want to do some hard thinking about how much risk you care to hold in your portfolio.

Is the Federal Reserve Wrecking Retirement?

We're now in the 7th year of Federal Reserve induced ultra low interest rates.  The Fed has kept short term rates at zero (actually negative, once you take inflation into account) through monetary policy.  Long term rates fell as well, especially after the Fed devoted years to quantitative easing (i.e., purchasing bonds in the open market).  Those people old-fashioned enough to actually save money have been bedeviled by the near-absence of interest income.  While some have been desperate enough to gamble with risky investments like junk bonds in order to generate more income, many and perhaps most have simply tightened their belts and spent less.  After all, if you're not getting any interest income, the last thing you want to do is spend down your principal.  That's like eating the seed corn--there will be no more harvests once the seed corn is gone.

Insidiously, the years-long pandemic of low long term interest rates has undermined retirements.  Pension funds, insurance companies and other persons and entities trying to provide for America's retirees have historically depended on long term bonds to provide a stable source of predictable income.  Pensions funds, insurance companies offering annuities, and other providers of retirement income tend to have relatively predictable obligations (i.e., the payouts they must make to current and future retirees), and look for predictable sources of funding to ensure that they can meet their obligations.  U.S. Treasury securities, agency bonds and high quality corporates were the bread and butter of retirement funding.  But these same stable long term investments have since the 2008 financial crisis been paying lower and lower interest rates. It's getting harder and harder to finance defined benefits.  While pension funds, insurance companies, municipalities and the like have sometimes turned to stocks and alternative investments, the volatility of these alternatives makes them a poor substitute for the plain vanilla fixed-rate, meat-and-potatoes high quality bond.

Of course, pension providers could contribute more funding to pension plans to make up for the shortfall in interest income.  But how many corporations, states and municipalities do you see leading the charge to put extra profits or taxpayer dollars into pension plans?  Many seem to be looking for spots on the increasing crowded sides of the road to dump current and future pensioners.

Corporations have curtailed and terminated defined benefit pension plans.  States and municipalities are in the process of doing the same.  Multi-employer pension plans are going belly up like fish in a toxic waste spill.  Soon, almost all of America's workers will be left with largely self-funded defined-contribution retirement plans, like the 401(k), or with self-funded retirements using IRAs.  Experience teaches that self-funded retirements are usually not as stable or comfortable as retirements funded with defined benefit pensions.  And that's just for the 40% of Americans who have any retirement savings at all.  As for the 60% who have none (as in zero, zilch, nada), the opulence of life on Social Security beckons. 

To be sure, Fed policy isn't the only reason why interest rates are low.  Economic and political instability in many other parts of the world are driving capital into safe dollar-denominated investments.  Low inflation tends to keep interest rates low.  But the Fed, as the single most powerful force in the money markets, has played a crucial role in eradicating high long term rates.

While Wall Street, corporate America, the 1% and many of the unemployed have benefited to varying degrees from the Fed's suppression of positive interest rates, there is, as economics teaches, no free lunch. There are costs to persistently low interest rates, and much of the cost has fallen on those middle and modest income workers who have or hoped for a defined benefit retirement.  Okay, so we already know the wealthy enjoy a heads-we-win, tails-those-little-people-lose advantage.  But we shouldn't buy into the Fed's story that it's creating stability to prevent a Great Depression.  What the Fed has done is transfer losses and instability that could have manifested themselves in another Great Depression, to many of America's current and future retirees, whose golden years may now be more unpredictable and depressed than they had hoped. 

Economic Consequences of the Mid-Term Elections

The economic consequences of yesterday's mid-term elections will be zero.  In order to boost the economy, the federal government would have to raise taxes, cut spending or both.  Even though President Obama now faces a majority Republican Senate as well as House, he won't agree to major tax cuts and the Republicans won't agree to major increases in spending.  So the fiscal impact of the mid-term elections will be effectively zero.  With the federal deficit lower than the historical average of 3% of GDP, there's room for fiscal stimulus but no political impetus for it.

Modest spending boosts may come from an increased military role for the U.S. in the Middle East.  Trying to suppress ISIS is becoming a game of whack-a-mole.  And American air power may have to target an al-Qaeda affiliate called the al Nusra front as well.  But such mission creep will be constrained as there is no public support for a resumption of ground warfare by U.S. troops.  The defense budget won't provide major stimulus.

Monetary policy is the only real game in town, and central bankers are the croupiers.  The Fed has just ended quantitative easing in the face of 3% plus growth by the economy, but there's nothing that stands in its way if it wants to fire up the monetary printing press again.  Just the push of a few computer keys, and the QE program is up and running again.  The Japanese central bank has recently placed a lot of QE chips on the table, putting a punch bowl on the table even as the Fed takes one away. 

The newly empowered Republicans in the Senate will probably increase pressure on the Fed to step back from accommodation.  That would be a fool's errand, as there is nothing the Republicans could actually do over the next two years to substitute for the loss of Fed accommodation.  If Republican pressure on the Fed slows the economy to stall speed, look for smashing Democratic victories in the 2016 Presidential and Congressional elections.

The Lucky, Lucky Fed

Soldiers want their generals to be lucky.  As capable and knowledgeable as generals may be, they still need luck to win.  And citizens want their central banks to be lucky, because central bankers often fail even if they are capable and knowledgeable.

The Federal Reserve has been very, very lucky.  Unrest in Ukraine, territorial disputes in East Asia, the usual morass in the Middle East, and now nationalist parties winning European elections, have all combined to push U.S. Treasury yields down even as the Fed steadily withdraws its quantitative easing.  Financial markets mavens who confidently predicted that this would be the year of rising interest rates and falling stock prices have had to substitute excuses and explanations for predictions. 

Some still persist in forecasting rising rates and falling stocks.  Perhaps they will be proven correct.  But if you're betting your money on these predictions, remember that you're, at least in part, betting on the Fed's luck running out.  A bet on bad luck is still a bet on luck.  If you wouldn't play the lottery or patronize a casino, why bet on (or against) the central bank's luck?  The smart thing to do is stay diversified, and be patient.  (See http://blogger.uncleleosden.com/2014/05/why-you-should-invest-like-smart-money.html.)  The tortoise tends to be a better investor than the hare.

Emerging Markets: Another Asset Bubble Popping

The emerging markets asset bubble is popping.  Financial markets in China, Brazil, Turkey, Russia, and India have been falling, with no end in sight.  Commodities prices have declined.  And the major stock markets--in Japan, Europe and the U.S.--have been dragged down in consequence.  All because the Fed began to reduce its quantitative easing program.

We've been here before.  Fed easy money policies contributed to the tech stock craze of the late 1990s and the real estate and mortgage bubbles of the 2000s.  Those earlier bubbles popped when the Fed began to withdraw accommodation.  You have to wonder whether the Fed will ever learn:  long periods of accommodative policies inevitably create asset bubbles somewhere, and when the accommodation is reduced, the bubble will pop.  Painfully, since there is no other way for an asset bubble to pop. 

When tech stocks, and then real estate and mortgage markets, crashed, recession and unemployment followed.  The results included, among other things, higher and higher levels of unemployment and greater inequality of income and wealth over the past 15 years.  When the Fed repeatedly uses its very blunt monetary weaponry to combat economic slowdowns, the rich get richer and everyone else stagnates or declines. 

What will the Fed do in response to the emerging markets downturn?  Initially, nothing.  It will hope that the positive momentum that has emerged in the U.S. and to a limited degree, in Europe, will be enough to maintain overall global economic equanimity.  But if the decline extends for several more months (particularly in major stock markets), expect the Fed to rethink its stance and get the monetary printing presses revved up again.  As we have discussed before (see http://blogger.uncleleosden.com/2014/01/expect-nothing-from-government-in-2014.html), fiscal policy will be darn near nonexistent this year.  Fed easy money policy is the only way for the federal government to combat economic distress.  And even if more money printing means yet another asset bubble a few years down the line, and more income and wealth inequality, the only choices nevertheless remain easy money or easy money.  The Fed's policies are the only game in town.

One might lament that the Fed never seems to learn that too much accommodation leads to yet another asset bubble that pops, causing distress and dislocation that leads to more accommodation, which only continues the cycle.  But the problem is the Fed has little choice.  Congress and the White House mostly stare at mirrors and ask who is the fairest of all.  The business community waits for the federal government to stimulate the economy, reduce its risks and heighten the potential for profits.  The Fed personifies moral hazard:  the rest of the world has learned that, when push comes to shove, the Fed will act.  So there's no need for anyone else to step out front and center and take the lead. 

How do we break this vicious cycle?  Well . . . uh . . . there was once a time--long, long ago--when the private sector would lead the way out of recessions.  Businesses would start to expand, banks would start to lend, investors would start to take risks.  But how likely is that to happen now? 

Beginning the Taper: What Fed Policy Change?

The Federal Reserve announced today that it will begin to taper its purchases of Treasury securities and mortgage-backed securities.  Starting in January, it will purchase each month $40 billion of Treasuries and $35 billion of mortgage-backs, instead of $45 billion and $40 billion, respectively.  A $10 billion drop from $85 billion per month. Whoop-de-do.  That's barely a drop in the bucket.  Yet, after the announcement, the Dow Jones Industrial Average jumped almost 300 points.  A 1.84% increase in the Dow because of a reduction in central bank accommodation?  Financial news stories attributed the stock market rise to a belief that the Fed was signalling that the economy was improving faster than expected.  But there's a much simpler explanation for the exuberance in stocks.

The Fed said that it was likely to keep short term interest rates at zero for "well past" the time when unemployment fell below 6.5%, its previously announced benchmark for starting to raise short term rates.  This is a significant change from previous statements.  It means that the Fed will keep short term rates at zero for a really long time, and it's not saying how long.  Could be forever, since the Fed didn't announce a new unemployment benchmark for raising rates. 

The promise of ultra cheap money indefinitely is to stocks like pouring gasoline onto a fire--instant exuberance.  What the Fed did today was give back with the right hand what it took with the left, and then some.  It's fair to say that the Fed increased net central bank intervention today.  The sharp jump in stocks is consistent with that view.  The relatively minor change in bonds is as well.

But are we surprised?  Did we really think the Fed was going to step out of the picture in a meaningful way?  American businesses and investors have become addicted to heavy doses of monetary methadone from the central bank.  If the Fed began to actually step back, the market would have tanked. 

What happened today is the Fed switched from wearing a blue tie to a paisley tie.  But the change was cosmetic, and net result was more Fed accommodation.  Oh, well. Plus ca change, plus c'est la meme chose.

Are We Stuck With a Powerless Government?

Despite its image as an overbearing ogre, the federal government may be largely powerless these days.  The President has managed to undercut himself with an astonishingly bad non-launch of the federal health insurance exchange.  Is there anyone in his administration with executive or management ability?  Could anyone in his administration succeed as evening shift supervisor at the local McDonald's? 

On the foreign policy front, the President managed to set his foot downrange and pull the trigger over Syria's use of poison gas.  Only an embarrassing intervention by Russia prevented the President from a real morass of a morass.  Now, the administration touts a deal with Iran to freeze its nuclear program, even though it can continue to enrich uranium to the 5% level.  Not very frozen, but perhaps global warming is having an impact.  One wonders whether this deal with Iran is a sign of strength or weakness on the part of the President.

Meanwhile, over on Capitol Hill, Congress remains essentially non-functional.  The Democratically controlled Senate was able to approve the appointment of a few judges by changing its rules, although scowling Republicans made many dire and threatening predictions that the Dems would be sorry for doing this.  Nothing like a love fest to make folks feel collegial.  As for the federal budget and the debt ceiling, they aren't likely to trigger new crises, but will be resolved by kicking the can down the road.

The only institution that seems to be doing anything is the Federal Reserve.  And even it may be losing some of its mojo.  The most recently released minutes of the Open Market Committee meeting in October have been interpreted to mean that the Fed may be thinking about pulling back soon on quantitative easing.  Antacid sales on Wall Street have jumped.  If the efficacy of Fed money printing is diminishing, we may find ourselves in a public policy Sahara with very few water holes.

A powerful government can be scary.  A powerless one can be scarier.  The problem is this isn't a horror movie and we can't get up and leave the theater if we don't like the show.

How the Federal Reserve Defies the Laws of Economics

For an agency run by economists, the Fed seems non-economic.  Its quantitative easing program--now snarfing up bonds at the rate of $85 billion a month--defies one of the basic premises of economics:  the concept of scarcity.  Scarcity is crucial to establishing price.  If something is available in infinite amounts, it has to be priced for free because there's no limit to supply.  Scarcity acts as a constraint, forcing prices up as demand increases.  Price increases in turn compel actors in the market to think and rethink the utility of the thing that's getting costlier, and adjust their use of it.

The problem with the Fed's QE program is that it's paid for with printed money.  In other words, to get the $85 billion it needs each month, the Fed simply makes a few electronic entries into its computer system and, voila, money blossoms.  There is no scarcity.  The Fed doesn't have to get the money from anywhere.  Unlike taxes or borrowings, no one else has less money when the Fed prints some. 

In times past, when central banks pulled such financial alchemy, inflation would flare.  By reducing the value of the currency, buying power would become scarcer and discipline would be imposed.

But today, there is very little inflation--and, indeed, central banks seem to want more.  Thus, there are no constraints on money printing.  And, by all indications, the Fed governors whose voices count intend to keep the printing presses rolling.

Numerous skeptical observers haven't been able to complete the journey to Wonderland and believe that there will be no cost to all this.  And the truth may be that there has been and will be costs.  At the first hints of tapering earlier this year, a number of emerging markets began tanking and some have tanked hard.  Real estate sales have slowed dramatically as longer term interest rates have risen and the real estate recovery may have stalled out.  Gold and silver have fallen sharply, and other commodities prices have eased back. 

The Fed seems to have not really noticed that monetary policy now affects asset values more than consumer prices.  The tech stock boom and bust, the real estate and mortgage boom and bust, and the 2008 financial crisis can all be traced in part back to very generous Fed easy credit policies.  Central banks may be unable to foster inflation, perhaps for reasons that aren't fully understood yet.  But they can foster asset bubbles, and that's a strong reason for easing out of the QE business.  The last thing we need is to again have more government sponsored asset bubbles.

Is the Fed Losing Control?

In the past two weeks, we heard from Chairman Hyde and then Chairman Jekyll.  A couple of weeks ago, Ben Bernanke made allusions to gradually winding down the Fed's bond buying program, called quantitative easing.  Up to this point, the market had perceived the current round of QE as infinite, a perception that Fed had encouraged by placing no time limts on the program, and offering only the vaguest of guidance as to when QE might end.

But two weeks ago Chairman Hyde frowned and cleared his throat, and the bond bulls began running.  In their panic, they gored many an investor who had drank the Kool-aid however reluctantly and bought risk assets like long term Treasuries, corporate bonds and junk bonds.

Within days of Chairman Hyde's hint that the punch bowl might be taken away, the ten year Treasury note was yielding over 2.5% (up from 1.6% in May) and 30-year mortgages popped up about 1% to 4.5%.  Stocks quivered, but didn't belly flop like bonds.  Alarmed, various governors of the Fed and presidents of Federal Reserve Banks chimed in and suggested that the punch bowl wouldn't be withdrawn any time soon.  Stocks perked up, but bonds continued to pout and mortgage rates kept rising. This was emphatically not what the Fed wanted, since the Fed is resorting to its old trick of trying to revive the economy by bubbling up the housing market.  Even though this is what got us into trouble in 2007-08 with the mortgage crisis, the Fed evidently has an abiding faith in its old tricks.

With the housing rally now threatened, Chairman Jekyll spoke up this past Wednesday (July 10) and made nice nice.  The little toddler of a recovery would need propping up for a long time, he said, before he'd expect it to walk on its own--a very, very long time.  He also said he was sending the senior Fed staff out for a late night booze run to stoke up the punch bowl.

Stocks did a cheery little conga and stepped up to new heights.  This might produce a bit of a wealth effect to boost the economy.  But it will be hardly a smidgen, if the bond market doldrums continue. Bonds barely budged after Chairman Jekyll's attempted love fest.  The ten-year Treasury dallied briefly with the 2.53% level, but then went back up to 2.59%.  Mortgage rates continue to cloud the skies over the housing market. 

Is the Fed losing control?  This is really two questions.  What message is the Fed trying to send?  The most recent minutes it released indicate sharp divisions within the Open Market Committee, and the truth may be that a highly mixed message would be the most accurate.  Bernanke's initial statements two weeks ago may have been an attempt to be transparent and let the public know what the Committee really thinks.  But the Fed got what it perceived as an over-reaction from the market, and has been trying to cover its tracks ever since.

But did the Fed get an over-reaction, or an accurate reaction?  The sharp sell-off in bonds and rise in mortgage rates may have reflected the erstwhile rationality of betting on a continuing rally in fixed income.  Central banks worldwide have joined together and danced the most accommodative bunny hop in the history of banking.  Anyone who anticipated a reversion to the mean in the money markets has been just about rendered CIA-style. Much of the flash crash in the bond markets may have been hedge funds and other big players unwinding leveraged positions betting on more booze for the punch bowl.  Now that the Open Market Committee may be going wobbly on the idea of giving a drunk yet another pitcher of Martinis, bond pros evidently are becoming wary of the hair of the dog that just bit them.  If so, the Fed may have lost control of the long end of the yield curve.

If the Fed no longer has a clear message to send, and can't maneuver the long end of the yield curve any more, it may lose control of the economic recovery.  But perhaps it never really had that much control.  Maybe things looked good for a while because people wanted to believe, and the Fed provided the only federal economic policy they could believe in.  With Chairman Bernanke now a short timer, courtesy of President Obama, it's unclear what anyone can believe in.  And that won't be good for the market or the economy.

Why Did Obama Fire Bernanke?

Okay, President Obama didn't actually fire Federal Reserve Chairman Ben Bernanke.  But it felt like that when the President strongly hinted a couple of days ago that he wouldn't nominate Bernanke for re-appointment.  The stock market followed up with a two-day belly flop of almost 560 points.  Much of that drop was because the Fed announced that it would indeed, contrary to infantile market expectations, eventually take away the quantitative easing punchbowl.  But the backdrop to this announcement was Ben Bernanke's short remaining term as bartender-in-chief.  That creates enormous uncertainty.  The financial markets love Bernanke, even though not all market players will admit it publicly because he was a policy pragmatist (read heretic in the eyes of many purists).  He gave the markets lots of sweets and never let them pout or fuss for long.  He never met an asset class he didn't like and tried to puff them all up.  (That's why virtually all asset classes are dropping now--Sugar Daddy is leaving town.)  With Ben's helicopter thumping away toward the horizon, it gets a lot harder to predict what investments might have actual economic value, so investors renew their love affair with cash.

But why did Obama choose this moment to put Bernanke on the stagecoach going out of town?  Obama is no economist, so it couldn't have been for an economic reason.  The President is a consummate politician, though, so one has to entertain the sneaking suspicion that he did it for political reasons.  A not uncommon reason for pulling the rug out from underneath an incumbent is because you foresee the need to blame him or her for something.  Maybe the President was concerned that the eventual end of QE would cause the markets to fall, and he wanted to be able to blame Bernanke and say he didn't re-appoint him.  But the very act of leaving Bernanke behind in the dust aggravated into prophecy fulfillment the markets' inclination to swan dive.  So, if this was the President's thinking, he may have contributed to the problem he foresaw and could end up taking some of the blame for the market's hissy fit.

The President is having second-term hiccups in a variety of ways--the IRS, NSA, State Dept., and DOJ come to mind.  Is he losing his grip?  Bernanke was the last man standing when it came to federal officials doing something to boost the economic recovery.  Why ax the most highly regarded civil servant in the country?

The financial markets hate uncertainty.  And they've gotten a belly full of it recently.  That's why the last two days have been bad for 401(k) accounts from sea to shining sea.  And the picture probably won't get brighter for months.

Beware of Overpriced Assets

The delirious exuberance of stocks today is reminiscent of the stock market just before its earlier peaks in March and April 2000, and in the fall of 2007.  Prices move up in defiance of risks and uncertainties.  Stock indices set records every week.  Bulls overrun the markets.  Bears have become a seriously endangered species.

Even as financial messiahs proclaim a brave new market in spite of the stumbling economic recovery in America and recession in the rest of the industrialized world, let us recall the sources of the last two market busts:  highly overpriced assets.  In the late 1990s, the bubble was in tech stocks.  In 2007-08, housing and real estate mortgages were grossly overpriced.  In both instances, the sheer quantity of inflated assets ensured that when the markets turned, losses would be enormous.  Given the dazzling rise of stocks over the past few years, it behooves us to ask if there is a comparable risk today?

The answer would appear to be yes.  Investors have poured vast amounts of money into bonds of every stripe and variety.  Bond valuations, even of junk bonds, have reached highly optimistic levels.  Bonds are priced for perfection.  If any imperfection appears, losses--and a lot of them--will follow.

The most obvious risk to bondholders is that the Federal Reserve and other central banks will step back from the extremely accommodative policies they have instituted.  This will happen sooner or later, probably sooner in America and later in Europe and Japan.  When it does, bondholders will incur losses, and those losses will be big simply because of the huge amounts of money that have flowed into bonds. 

The Fed seems to think it can manage the process of shifting from quantitative easing to unwinding its $3 trillion plus balance sheet (i.e., quantitative tightening).  Perhaps it can do so without causing severe short-term turmoil in the markets.  But it can't circumvent a basic problem:  when interest rates rise and bond prices fall, a lot of losses will be incurred.  These losses must land somewhere.  They might be shifted from one investor to another by means of derivatives and other hedges.  But someone, ultimately, has to take the loss. 

The fact that losses in the financial markets have to land on someone somewhere wreaked havoc on the world's major economies following the real estate crash of 2007-08.  Investors around the globe who bought mortgage-backed securities, CDOs, CDOs squared, and other such financial alchemy paid the price for drinking too much of the Kool-Aid du jour.  We live with the resulting economic pain even to this day.

The bond markets are like a coiled spring that presents a similar problem. Extremely high prices have been paid for bonds, and bondholders face serious risk of losses when rates rise.  The sheer quantity of potential losses is the scary thing.  Those losses will have to land on someone, somewhere, and that will be painful.  The Fed's quantitative easing program has only exacerbated the risks, and the Fed's near term success in preventing depression has burnished its image of competence, which may have blinded bond investors to the dangers of the market downturn that must take place eventually.  As history repeatedly has demonstrated, the Fed is fallible and its fallibility is accompanied by serious consequences for the financial markets and the economy.

By promoting ultra low interest rates for five years, the Fed has allowed a massive build-up of investment in overpriced bonds.  While central bank intervention in a crisis is to be applauded, a years-long distortion of market forces will surely do bad things, and bad things have been done.  The only question now is when and how we will suffer the consequences.

How Is GDP Financed?

It may seem strange to ask how GDP is financed.  GDP simply measures the total market value of final goods and services that an economy produces.  It is a way to measure national income, not a measure of assets on a national balance sheet. 

But the way GDP is paid for does matter.  If large quantities of borrowed money finance GDP, then GDP in future years may be less sustainable than GDP produced by organic growth (i.e., GDP derived from people and companies spending their earnings, rather than borrowings).  The pauper nations of the EU, mostly located on the southern rim, are good examples.  They borrowed heavily (or their banks borrowed heavily) to finance consumption.  For a while, their GDPs grew.  But debt, unfortunately, has to be repaid.  A nation's whose GDP is heavily dependent on borrowed money will eventually have to pay the piper.  If those payments are burdensome enough, the nation's GDP bubble will burst, and recession will follow.  That isn't hypothetical; look at Greece, Ireland, Cyprus and Spain.  Indeed, look at the EU as a whole, which is sinking into recession even as we blog.

In America, the picture ain't pretty.  Even though GDP is nominally growing, in the first quarter of this year at an annual rate of 2.5%, the question of sustainability looms.  The federal government is constraining its borrowing (partly because of sequestration and partly because of Social Security and income tax increases).  Thus, the federal budget wouldn't be a source of GDP growth. 

But the Federal Reserve's quantitative easing program is.  The Fed is pumping $85 billion a month into the economy through purchases of financial assets.  Over a full year, the QE program would pump $1 trillion into the economy.  That's equivalent to about 6% of America's $16 trillion GDP.  It wouldn't be accurate to say that $1 trillion spent on QE results in $1 trillion of GDP.  Much of the money printed by the Fed for QE is recycled back to the Federal Reserve System in the form of member bank deposits at Federal Reserve banks.  This process is a near wash (except that it gives the depositor-banks riskless profits).  But QE is boosting the economy.  Our stock market--bizarrely exuberant in the face of a tepid economy--needs its regular fix of QE to maintain and increase its high.  The real estate markets seem to be getting a boost from the Fed's purchases of mortgage-backed securities.  Increases in asset values such as these appear to be creating a wealth effect that boosts spending (mostly by the top 10%).  That is probably a primary source of GDP growth today. 

But QE is similar to borrowed money.  At some point, the Fed will start selling down its more than $3 trillion balance sheet.  This akin to debt repayment.  It will remove money from the economy.  When there is less money to spend, there may well be less economic growth.  The Fed is hoping that the economy will be organically growing briskly by the time it goes into QT (i.e., quantitative tightening).  But there's no way to know for sure that will be the case.  The Fed may have to shift to QT because of a rise in inflation, whether or not growth has revived.  Whatever the reason for QT, it will constrain growth.  In some circumstances, it could produce a recession. 

Like toothpaste and genies, QE on the loose isn't easily put back into the place where it came from.  There's no riskless way to execute QT.  It's possible that continuation of the Fed's QE program could stimulate the economy to resume vigorous growth.  But that's far from certain.  And every additional month of QE heightens the risks that our economy is becoming overleveraged.

The Federal Reserve's Obligation to Support Stock Prices

The Dow Jones Industrial Average is setting a new record almost every day.  Stocks are up 10% in 2013, and the year isn't even three months old.  Since the recent closing low on Nov. 15, 2012 of 12,542.38, the Dow has risen over 15%.  Stocks are on a tear and fresh money is coming into a market that's going up at an annualized rate of 50% or more.

A principal reason for the hyperventilation in the markets is the Federal Reserve's ultra lax monetary policy.  Even though unemployment has fallen from over 10% in 2009 to 7.7% now, and the economy has resumed moderate growth, the Fed has spent the last four years swinging its scythe far and wide to cut down any positive interest rates that might sprout up.  At the same time, it has printed shiploads of money through its quantitative easing policies.  An abundance of cash, having few other alternatives, has flowed into stocks.  At this point, the market depends on the Fed to maintain and increase its accommodation.  Moral hazard abounds.  Investors have put their precious savings in stocks relying on the Fed's promise to practically give away money for a really long time.  If the market falters now, the Fed will have to step up and accommodate some more, enough to prop up stocks.  It can't allow investors to suffer a third evisceration of their portfolios in less than 15 years.  If the market stages another major downturn, investor and consumer confidence will surely collapse, sending the U.S. into another recession and putting the U.S. financial system under enormous stress. The stock market has become Too Biggest To Fail.

Of course, the Fed would deny that it has any obligation to support stock prices.  Legally speaking, that's true.  But the U.S. Treasury had no legal obligation to support Fannie Mae and Freddie Mac, yet it nationalized them in order to prevent a collapse of the financial system.  The Treasury Department had no choice, given that the market had implicitly assumed that Fannie and Freddie were federally guaranteed.  By relentlessly inflating stock prices, the Fed has put itself in a comparable position.  It has implicitly guaranteed that stocks will not suffer a major collapse. 

The Fed is already honoring its implicit guarantee.  It's stated that the most recent round of QE (call it "QE Unlimited") will go on until unemployment falls to 6.5%.  The market has risen about 10% since the Fed announced this target.  A gnawing risk of the Fed's current policy mix is inflation, and the Fed has said it will step back if inflation flares.  But the question is whether it actually will.  Having drawn investors back into stocks after the market crash of 2007-08, the Fed may hesitate to take away the punch bowl if doing so will precipitate another bear market and recession. 

 Of course, it can't leave the punch bowl at the party forever.  But, given the pickle it's currently in, it may let the party go on too long.  We are at a crossroads in the history of central banking.  If the Fed pulls off its current maneuvers and nurses the economy back to health while keeping inflation in the 2% range, it will have established the paradigm for monetary management of the economy for decades and perhaps centuries to come.  If it fails, however, central banking as we now know it will likely become a thing of the past.

Maybe the Fed Won't Sell Off Its Balance Sheet

A major question overhanging the financial markets is what will the Federal Reserve do with its $3 trillion and growing balance sheet?  The conventional wisdom is that, eventually, it will have to sell off much or most of its holdings, lest the Inflation Monster come roaring out of its lair.  The specter of $1 trillion, $2 trillion or perhaps more of Treasury and mortgage-backed securities hitting the bond markets would send a shiver down the spines of many a market player.  Even a suggestion that such sales are impending could induce interest rates to pop and stocks to drop.  All the Fed's hard work to stimulate the economy could circle down the drain as rising borrowing costs smack down home purchases, consumption and corporate investment. 

To avoid such a scenario, maybe the Fed will simply not sell off its balance sheet.  In the often strange alternative universe of the Fed, where massive money printing isn't perceived as an inflationary threat until the Monster is tearing into our throats, this might make sense.  Once the Fed stops purchasing Treasury securities and other debt in the open markets, it can simply hold the assets on its balance sheet until they are paid off.  It would remit the interest and principal payments to the U.S. Treasury.  This would reduce the amount of taxes that the Treasury would need to squeeze from harried citizens, aiding their ability to consume, while lessening the threat of its balance sheet to the stability of the financial markets.  If the Fed were to sell its assets in the open markets, it would compete against private interests for capital.  If it were to hold its assets and remit the proceeds to the Treasury, more capital would be available for private investment. 

Sounds too easy?  It would be too easy if the truckloads of printed money that the Fed has dumped into the economy inflates the dollar at substantially more than today's low rate.  But the velocity of money today seems driven by little more than a three-cylinder, two-cycle engine.  The economy is hardly growing any faster.  Unless economic growth rises above the fast side of brisk, selling off the Fed's balance sheet will threaten the recovery.  The Fed may well be tempted to take advantage of today's low inflation rate, and simply hold its balance sheet until maturity.  We'll see.

Consider a House To Hedge Against Inflation

The housing market, having walloped the bejesus out of tens of millions of Americans, may seem an unlikely hedge against inflation.  But history shows that home prices tend to move up briskly during inflationary times.  During the 1940s, inflation burst out, driven first by World War II rationing and then by pent up consumer demand after the war.  Consumer prices moved up about 72%.  Census Bureau data indicates that housing prices moved from a national average of $2,938 in 1940 to $7,354 in 1950 (unadjusted for inflation).  That's an increase of 150%.

During the stagflation of the 1970s, consumer prices rose 112%.  Housing prices rose from a national average of $17,000 in 1970 to $47,200 in 1980, an increase of 178% (unadjusted for inflation).  You can find Census Bureau data on housing at https://www.census.gov/hhes/www/housing/census/historic/values.html.

The data show that housing prices rose faster than inflation during two of the most inflationary decades in the past 75 years.  Of course, the sales prices of houses don't tell the entire story.  You can't directly compare prices of housing against prices of stocks or inflation-adjusted bonds like U.S. Treasury TIPS, because housing requires periodic lawn mowings, plumbing repairs, new roofs, maintenance of HVAC systems, and replacement of dishwashers.  It's also taxed locally every year, and sometimes hit up for special assessments if the water or sewer systems need to be gussied up.  But you'd directly or indirectly bear those expenses anyway if you rented.  So owning a house and capturing the upticks in value might work out well for you during inflationary flareups. 

Why would housing be such a good inflation hedge?  Professional economists might be tempted to wheel out a wagon load of regression analyses to demonstrate their erudition.  But the simple and obvious explanation is that a hard asset with substantial utility will have significant value no matter what the paper currency is doing.  A house provides shelter, warmth, indoor plumbing, and a private place to pig out on high fat, high sugar, low nutritional value junk foods while long-term parked in front of a 124-inch TV, parboiling your brain without the neighbors seeing what a couch burrito you really are.  Market forces will adjust the paper value of that hard asset upward when the fiat currency is going haywire.

At the moment, inflation seems to be spotted about as often as the ivory-billed woodpecker.  But that doesn't mean it's extinct.  History shows that inflation can be quiescent for long periods of time, and then burst forth like an oil well blowout.  Inflationary pressures right now are doing a fan dance, often out of sight but still faintly visible in profile.  Ultimately, unless the Fed and other central banks can repeal market forces, their massive money prints and asset purchases of recent years will eventually inflate paper currencies.

 Housing, like politics, is first and foremost local.  Some markets would make mediocre investments no matter what (like areas with high unemployment).  Some types of housing, like condos, may not be ideal for inflation hedging.  Their values tend to be less stable than that of the 4-bedroom, 2 1/2 bath Colonial with the white picket fence and English sheep dog.  A house isn't a substitute for sensible investment diversification.  Stocks, TIPS and perhaps other assets might also play a role as reasonable inflation hedges in a well-diversified portfolio. 

It's hard to have confidence in housing after the free fall in prices of recent years.  But investment success can often come from buying disfavored assets.  Buying bubbly assets like bonds (especially junk bonds) isn't likely to be the epitome of financial perspicacity.  Home sweet home, be it ever so humble, may work out better if inflation rears its ugly head.

Reducing the Deficit: Should the Fed Monetize the Federal Debt?

Desperate times call for desperate measures.  We've seen yet another dysfunctional mess from the political process, and have to think expansively.

The recent fiscal cliff deal was largely a failure.  It raised taxes on most Americans, while doing virtually nothing to reduce federal spending.  While income taxes were not increased for the middle class, Social Security taxes were increased for all workers at all income levels.  The well-off (the $400,000 plus crowd) face a higher income tax rate of 39.6% (20% on qualified dividends and capital gains) and wealthy dead people now pay a 40% tax rate (instead of 35%) on the portions of their estates exceeding $5 million ($10 million for married couples).  The automatic spending cuts required by the cliff were deferred for two months (except for $24 billion in cuts that do go into effect), so spending largely continues apace.  Presumably, there will be a second face off over spending cuts when the President asks Congress to increase the debt ceiling in the next few weeks (even though the White House insists it won't negotiate over the debt ceiling).

One thing to take away from the cliff deal is that spending cuts are really hard to agree on--so hard that the Dems and Republicans simply kicked the can down the road.  But they will be even harder to agree on two months from now.  The Republicans have lost significant leverage by agreeing to tax increases now.  The tax side of the fiscal cliff has been resolved, more or less favorably to the Democrats (although some liberal Dems are still unhappy).  What incentive do the Dems, who control the Senate, now have to agree to spending cuts?  Of course, the Dems would agree to some spending cuts (the defense budget would be their target number one).  But Republicans are focused on hurting core constituencies of the Democratic Party through Social Security, Medicare and Medicaid cuts.  With the Dems having largely won on the tax issues, they have little reason to make concessions on the social safety net.  Even if the President is willing to give the Republicans some of what they want (which he seems to be), he may have a problem in the Senate, where Social Security, Medicare and Medicaid were stoutly ring-fenced and defended during the fiscal cliff talks.

Realistically speaking, we shouldn't expect our dysfunctional elected government to find grand solutions to the fiscal deficits.  Due to a variety of bad and intractable political dynamics, that simply won't happen.  We have to look elsewhere for solutions.

The next logical candidate to get the hot potato would be the Fed.  The central bank has played a central role in combating the Great Recession, not without some success.  In the course of its massive quantitative easing programs, it's accumulated a balance sheet of close to $3 trillion.  This total is likely to grow as the Fed continues to purchase debt on the open markets.  Slightly over half of the balance sheet consists of U.S. Treasury securities.  Total federal debt is about $16 trillion.  Thus, the Fed holds about 10% of all federal debt.

Why not have the Fed simply forgive some or even all of the U.S. Treasury debt it holds?  In other words, it would declare that the Treasury wouldn't be required to pay the debt.  That, by definition, would reduce the federal deficit by reducing the amount of federal debt outstanding.  And it's what happens anyway.  When the Fed receives debt payments from the Treasury (usually consisting of interest payments), it simply remits those funds back to the Treasury Dept. (except for a small amount retained to finance the Fed's budget).  Debt forgiveness by the Fed would simply expand on what happens in the ordinary course.   

Of course, such debt forgiveness would be tantamount to monetizing the debt, and has the potential to be inflationary.  But precisely what the heck do we think is going on now?  When the Fed launches repeated quantitative easing programs, with ever more asset purchases but not the tiniest hint of when, if ever, it would unwind its Brontosaurian balance sheet, it has functionally monetized the debt.  With the economy expected to be a sick puppy for years, reality is the Fed may hold a lot of its current inventory of U.S. Treasury securities until they mature.  When they mature, it will remit the principal payment it receives from the Treasury back to the Treasury (or use the funds to make more open market purchases of Treasury securities).  The federal debt has been monetized, even though no one on the government's payroll is going to admit it. 

Such debt forgiveness wouldn't fully resolve all the deficit problems.  But it could reduce the scope of the crisis, and would amount to little more than accurately accounting for what is actually going on.  If inflation flared, the Fed could suspend debt forgiveness and raise short term interest rates, combating inflation as it traditionally would.  But as long as inflation is subdued, debt forgiveness could contribute to resolving a problem that politicians clearly won't be able to solve, at least not comprehensively.

Ultimately, the best solution to the deficit problem is to boost economic growth.  Greater growth means higher employment levels and more income and corporate profits to be taxed.  If the economy were growing briskly and unemployment were around 5%, we probably wouldn't feel we have a deficit crisis.  Housing seems to be stabilizing, although its long term prospects remain clouded.  So we can't count on housing to be the engine for growth.  Measures the government could take include:  (a) rebuilding infrastructure--this is something the government has historically done well, and should do more of given the crumbling state of our infrastructure; (b) loosen up immigration restrictions for well-educated people and people who can invest substantial capital in America to create jobs--we need more innovators and entrepreneurs; (c) improve education, not by handing out loans to anyone who has a pulse and a signature (there's way too much student debt already, and it will be the next big debt bubble), but with measures to make education more efficient and inexpensive, like expanding Internet-based educational programs.  Achieving greater economic growth will take time, but it's a lot easier than trying to use the political process to agree on budget cuts. 

Pan Europeanism's Gambit

It would appear that a group of key European leaders combating the EU financial crisis have coalesced around the banner of Pan Europeanism.  Mario Draghi, head of the European Central Bank, has positioned the ECB to start financing struggling EU governments.  This is a paradigm shift from past ECB policies, and moves the ECB toward the money printing mode of the Federal Reserve and the Bank of England.  Recently, Angela Merkel, Germany's Chancellor, has spoken of cutting Greece a break on its austerity obligations under the terms of the EU's bailout for that nation. Such magnanimity is at rather sharp odds with her tough stated positions not many months ago.  The recent election in France of Socialist Francois Hollande shifted the EU's political center of gravity toward more accommodative measures--Hollande's notion of austerity is to raise taxes on the wealthy and give them a taste of austerity. 

The award of the Nobel Peace Prize to the European Union may be the latest move in the gambit to persuade skeptical northern European taxpayers of the need to keep the EU together.  The point is that failure to stay together will raise the specter of another continental war.  Although actual war seems highly unlikely in today's non- and often anti-militaristic Europe, the subliminal message is clear. 

The Nobel award is like a mutual admiration society of Pan Europeanists high fiving each other. The political in-crowd on the continent has to be very pleased with itself at the moment.  But the baseline problem for saving the EU remains whether or not northern European taxpayers are prepared to foot the bill for keeping the whole shebang together.  If not, the $1.5 million or so that comes with a Nobel Prize won't matter.  An interesting question is who will the EU select as its representative to receive the award.  Here's betting it's Angela Merkel, who needs political cover.