Earthquakes, Man-made and Natural

Mike Smitka

...the source of the red ink is an economy run amok, not a government run amok..."

Most of my analysis is of the Japanese economy; in the next day I'll post more there. One of the lessons from disasters is that decision-making under crisis is imperfect, as is decision-making in general. So we ought not be surprised if a natural earthquake is followed by a man-made one.

At this point in time, the real estate bubble is best viewed as a natural catastrophe; the origins lie in the early 2000s, with regulatory forbearance and too easy of monetary policy as contributing factors in a world with large global imbalances.

Enough said. The issue is to keep from reacting in a manner that generates a second, man-made quake.

One of the consequences the first earthquake, the popping of the bubble, has been a steep recession that cut severely into government revenue -- income taxes are the biggest item, corporate and personal, and incomes have fallen. Meanwhile the government (at the Federal level) automatically raised outlays for unemployment while more people "retired" and began drawing social security. Then there's our wars. So of course the deficit expands, but it's not expansionary, it at best keeps the economy from falling as far as fast.

What happened (and continues to unfold) at the state and local level is similar in that revenues have taken a hit, and will continue to do so, as real estate prices fall. Expenditures are stagnant (ditto sales tax receipts in states and localities where that's relevant), and the income tax story is the same. But unlike the Federal government, institutional factors and "hard" borrowing constraints mean that expenditures get cut. So we're gutting public education and otherwise firing people in the midst of a severe downturn.

The net effect is that despite large deficits the government as a whole is cutting jobs, not providing stimulus. Now (sensibly) a stimulus package was passed [the American Recovery and Reinvestment Act of 2009]. However, about half of it was smoke-and-mirrors, and the other half was only big enough to offset what was happening at the state and local level. (Such detailed calculations don't mesh well with the blog format, contact me if you want the numbers.)

That package however was deliberately temporary -- under the expectation that we'd now be in the midst of a recovery. Well, we're not. Obama listened to a limited circle of "inside" advisors. Those from Wall Street emphasized they could stabilize the financial system, looking back to Black Monday in 1987, while the handful of economists among them drew on a specific set of models that emphasized an economy's tendency towards "normalcy" as well as the efficacy of monetary policy. All of that reflected President Obama's own apparent conservative bent; he's no centrist. (Indeed, if he is to the "left" of his predecessor on economic policy, it's not by much.) Of course the temporary aspect also reflected political reality.

The bottom line is that the Federal government is pulling back on its expenditures even though state and local governments continue to cut. There's no stimulus now.

But our politicians are lawyers, and are not only unsophisticated in approach to budgets, but often show little ability to do basic arithmetic. They focus on red ink and rhetoric, never mind that the source of the red ink is an economy run amok, not a government run amok.

So now we appear poised to "pass" (or pass on) a large expenditure increase that does nothing to help the economy now, and does much to harm it down the road. Federal debt is roughly $15 trillion. A downgrade to our credit rating will raise borrowing costs 50 bp (basis points, .01 percentage points = 0.5 percentage points). Now in the short run monetary policy can and will continue to hold short-term interest rates at zero. But the funding costs of long-term debt will rise, and as our debt is "rolled over" we will end up spending $750 billion a year in addition interest. The other interest rates most closely tied to long-term government bonds are home mortgages. What we need in our current economy is a boost in mortgage rates to cool our overheated housing market, right? But that's not an earthquake, that's slow bleeding.

If the debt ceiling isn't raised, we won't be cutting just a few Federal jobs, we'll be cutting a lot, overnight. We'll also not be cutting social security and unemployment and healthcare checks. Yet some of those most adamant about not raising the debt ceiling claim preach that "confidence" is the real issue. They can't be bothered by the lack of consistency, how can retirees shop for anything if they aren't confident they'll be getting the retirement pensions towards which they contributed for decades?

Now that will be an economic earthquake, and it will entirely man-made.