Main Street is Dying a Death by a Thousand Spending Cuts

Oct 5, 2010Marshall Auerback

marshall-auerback-100The evidence is everywhere that fiscal austerity only prolongs our misery.

marshall-auerback-100The evidence is everywhere that fiscal austerity only prolongs our misery.

According to the Telegraph.co.uk in an article entitled "Savers told to stop moaning and start spending," Charles Bean, deputy governor of the Bank of England, said, "Savers shouldn't necessarily expect to be able to live just off their income in times when interest rates are low. It may make sense for them to eat into their capital a bit." Mr. Bean also said savers "might be suffering" from the low bank rate, but they had done well from higher rates in the past and would do so again. Encouraging Britons to spend was one reason why the Bank had cut interest rates, he added.

Spend what exactly, Mr. Bean? Why is it that central bankers find it easy to recall the following equation: C (consumption) + I (investment) + G (gov't spending) = GDP (gross domestic product), but they can't seem to learn this one: HU (high unemployment) + HD (high debt levels) + 0 (no interest income) = AZS (almost zero spending).

I know why: because the latter depends on fiscal policy, and central bankers consistently agitate against fiscal policy. This continues despite the fact that expansionary government spending by accounting identity helps to sustain the private sector desire to save. Unfortunately, Charles Bean of the Bank of England fails to understand that today's predisposition to save is a natural reaction to the credit binge that preceded the crisis. Had the increased private sector saving that occurred over the past few years not been accommodated by rising deficits, then the negative income adjustments would have been more severe and the private sector's plans to return some safety margin to their balance sheet positions would have been thwarted. But he and his fellow central bankers appear incapable of acknowledging this fact.

Each week new evidence emerges that categorically demonstrates that the fiscal austerity proponents are clueless about the functioning of real economies and monetary systems. So today in Britain we have a new government committed to significant budget cuts, despite mounting evidence that cuts already undertaken are drastically curtailing their economic activity. The recently released Markit/CIPS UK Manufacturing Purchasing Managers' Indices, which is calculated from data on new orders, output, employment, supplier performance and stocks of purchases, fell to a ten-month low of 53.4 in September, down from a revised figure of 53.7 in August. Similarly, Ireland finds itself in the midst of a major banking crisis -- Anglo-Irish Bank was recently nationalized, for example -- despite the fact that the Irish government has steadfastly continued to apply the fiscal austerian measures urged on it by the ECB. In reality, this is because of the austerity measures it is taking. The budget deficit, as a percentage of GDP, now stands at 32 percent! Those are wartime-type levels of expenditures.

Yet the conditions attached to the European Central Bank's ongoing financial support of Ireland and the rest of the euro zone is continued fiscal austerity. The so-called PIIGS nations remained trapped between Scylla and Charybdis as a consequence of this Faustian bargain with the European Central Bank. If the ECB stops buying national government debt on the secondary markets, those governments are likely to default, and the big French and German banks it is protecting will be in crisis. Alternatively, every day governments like Ireland or Portugal continue with this policy, the more their economies continue to implode. Ultimately there will be mayhem. The euro itself could once again be threatened.

Don't get us wrong: we think such deficits ultimately put a floor on demand and will help the economy recover. But policy makers need to let these economies breathe for a time, rather than crushing them with additional threats of fiscal austerity. Isn't it interesting that the very policy prescriptions designed to eliminate the so-called "scourge of public debt" are actually increasing it? Shouldn't that make our policy makers pause in their enthusiastic embrace of fiscal austerity? Even the high priests of austerianism, the International Monetary Fund, are now conceding in their latest report that these current policies will condemn Southern Europe to death by slow suffocation, as well as leaving northern Europe, the UK, and the US in a slump for a long time to come.

Policy makers here in the US continue to hint at accounting tricks such as quantitative easing on the premise that central banks swapping one financial asset for another will help incite more speculation. That seems to be doing the trick for the stock market. But this does nothing to boost underlying aggregate demand. How about a solution for Main Street?

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Even as the markets continue to make new post-2008 recovery highs, governments continue to construct policies around bailing out fundamentally insolvent financial institutions. These policies ensure that the bankers and others can continue to get their exorbitant and totally unjustifiable bonuses, thereby sustaining the very practices that created the crisis in the first place. Lloyd Blankfein of Goldman Sachs warned that the bank could shift its operations around the world if regulatory crackdown becomes too tough in certain jurisdictions. To which any politician with an ounce of backbone ought to say, "Good! Take your socially polluting activities elsewhere and leave our populations alone."

Of course, they don't do that. The more likely supine response (as we've already seen in Basel III and Dodd-Frank) is a further undermining of any kind of serious regulation. We tinker around the edges but make no fundamental, structural reforms. It's a national scandal that our most elite businessmen and professionals, who have destroyed the global economy through an unprecedented orgy of mortgage and accounting fraud, have to date gotten away with it scot-free and continue to have a major hand in policy making. Equally incredibly, our governments continue to trumpet the "success" of abominations such as TARP along with their enablers in the media.

As the risk of being called a whiner by Vice President Biden, it has to be pointed out that these very same governments hand out little in spending to underpin the real economy, even as unemployment remains in double digits around the globe. Government support for the real economy via fiscal policy is minimal compared to the trillions thrown at the financial sector. But before we see any kinds of real reductions in unemployment, the cries of "socialism" and "intergenerational theft" rise. The fiscal austerians launch counter-attacks to mobilize against further fiscal expenditures that support employment growth. The expansion of fiscal policy is stopped dead in its tracks.

Curiously, progressives have come to be seen as the enemy because they dare to point out the incoherence and incongruity in current government policy.

For all of the recent hoopla in the stock market recently, much of the latest economic data is consistent with a slow to stagnant economic environment. In the US, inventories are rising. ISM new orders are now just barely hovering above 50, which usually marks the onset of falling levels. The same thing can be said of the leading indicator (which has been falling since the second quarter), and the coincident to lagging indicator ratio. Weekly chains store sales continue to slip toward the April/May lows, while mortgage applications for refinancing are also tipping over, despite the recent drop in mortgage rates. Second quarter revisions of GDP were mild, although this probably marks peak profit margins

Overseas, Japan appears to be reverting back into a recession. Additionally, very few people are looking at the direct impact of China's trade policies and how Beijing's mercantilism is beginning to hollow out other countries' manufacturing bases -- not just in the US but also in other parts of Asia (which are also experiencing decelerations in their exports and purchasing manufacturing indices).

Consumer expectations are tipping over, and we are concerned with a relapse back to a low level of confidence, which never improved from the recession lows. Euro zone company and macro data flow are starting to reflect more fiscal retrenchment , and with the euro higher, exporters may find more competition in the quarters ahead.

Message to today's policy makers: the public debt ratio will fall again when growth resumes. Growth will not resume very strongly unless it is continued to be supported by discretionary fiscal stimulus. There is no magical alternative. Hacking away the last vestiges of fiscal support will simply ensure much more misery, unemployment and social turmoil in the years ahead.

Marshall Auerback is a Senior Fellow at the Roosevelt Institute, and a market analyst and commentator.

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Rob Johnson Blasts "Oligopoly-Style" Global Standoff

Sep 30, 2010

With unfailing energy, world-traveler Rob Johnson appeared on The Guardian's podcast "The Business" to discuss the (lacking) morality of large global corporations, how a stronger GOP will hamstring politics, and Obama's upended economic team. "There's an enormous breakdown... in morality that relates to globalization," Rob says.

With unfailing energy, world-traveler Rob Johnson appeared on The Guardian's podcast "The Business" to discuss the (lacking) morality of large global corporations, how a stronger GOP will hamstring politics, and Obama's upended economic team. "There's an enormous breakdown... in morality that relates to globalization," Rob says. The US CEO who has employees all over the world is no longer vested in the benefits for American workers, notes Rob, and the American people have wised up: "85% of Americans think the corporations have too much power".

But while banks have all the power, Congress is held up and likely to get even less done after any GOP midterm victories. Meanwhile, Obama's economic policies are "in tatters," as Rob puts it. "The analogy [of Obama] to Franklin Roosevelt did not materialize in this crisis. And now the public is quite upset with nearly 10 percent unemployment." The real political debate? It's all about the proper role of government in the economy. The GOP, it seems, wants to undo all of FDR's gains in using the government to aid its citizens.

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Rob then sat down with Reuters to explain just how bad the state of American economics really looks to those across the pond. "The administration is in real trouble right now," says Rob. There's high unemployment but no ability to either create more stimulus or see the Fed take more action.

Rather than the Fed considering more quantitative easing, which could heighten competitive currency devaluation, the world's nations need to work together to solve the problems facing the economy, Rob says. After all, if the current "oligopoly-style" standoff between nations continues, who's going to win?

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America's Big Fat Trade Problem

Sep 13, 2010Joe Costello

money-globe-150Don't worry about deficit spending. Worry about that money ending up in China and Brazil.

money-globe-150Don't worry about deficit spending. Worry about that money ending up in China and Brazil.

Come we go burn down Babylon one more time
Come we go chant down Babylon one more time
For them soft! Yes, them soft!
So come we go chant down Babylon one more time
-- Bob Marley

There's an interesting divide in economics: those who understand the importance of industry to industrial economies in an industrial age, and then the vast majority. The first group tend to be, though certainly not exclusively, old New Deal-types. Tom Geoghegan is one of them, and he has a piece in The Nation with some very excellent points on the matter. First, when you are in an industrial era and you have deficits of manufactured goods, then you're going to generate more and more government and private debt. Without addressing the first, you're not going to change the second. Tom addresses the problems this causes for those advocating more stimulus most excellently and succinctly:

When we have a big trade deficit, the feds can't run up a debt just to re-employ Americans. As long as we've so much trade debt, we have to figure that a distressing amount of any stimulus will go ultimately to re-employ the workers in China, Brazil, Japan and even Europe, who fill the gap between the "demand" we pump up and what we actually "supply." When we have a big trade deficit, it means that the more we prime the pump, the more we drain out this distressing amount of our national wealth.

Tom also throws in his hand trying to rescue poor old Mr. Keynes from his supposed disciples, writing:

Indeed, for every kind of debt -- government, consumer, trade -- the Democrats have to be the party that gets the country out of debt. That's the only way to bring back a fair and just economy that lifts the middle class. As debt piles up, even our base is freaking out. Deep down, people grasp that America got into this mess with too much private debt. "Hey, if we're all trying to get our own debt down, how does it make sense for the government to run it up?"

"Oh," some of us will say. "These poor unenlightened ones -- they don't understand Keynes." Maybe we don't understand Keynes. Keynes would never have happily urged a serious debtor country to go deeper into debt. This is not your great-grandfather's Great Depression. In 1936 Roosevelt could and should have gone into debt -- but didn't. We were the biggest creditor country in the world. In World War II we ran up a colossal debt -- but it was a debt to ourselves. We baby boomer kids never even noticed. That's why Keynes was so relaxed in 1936 about our going into debt. But otherwise Keynes spent much of his life trying to get debtor countries out of debt -- Germany, his own Britain after the war. If one looks at his career, it is clear that Keynes never told a debtor country to go deeper into debt.

As he would point out, much of the debt we pile up in Washington has little or nothing to do with putting people back to work. Much of it is just to balance the books. Because we buy more than we sell, we have a trade deficit. So the books have to balance, right? Someone has to make up the difference. Under Bush we had consumers go into debt to do it. But they're tapped out. So now Washington has to go into debt instead.

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He adds:

And why else did the stimulus run out of steam?

It was probably not big enough, but an even bigger one might have run out of steam. The bigger the trade debt, the less punch there is in running up a deficit. You can't just blame the GOP for cutting the stimulus down.

What's more, on this debt to pump up foreign "supply" we also have to pay out interest to foreigners. The deeper in debt we go, the more likely we are to end up in the clutches of foreign creditors. Don't believe me? The time may come on the left that we'll miss the days when we could rail at Goldman Sachs instead of the IMF.

Yes, in ten or so years the renminbi or even the euro (thanks to Germany) could replace the dollar as the world currency in which we denominate our debt, and our fate will be up to central bankers in foreign countries.

This is no joke: a Babylonian-type captivity for our country is but a presidential term or two away.

He calls for increasing exports, but I'd say at this point the US doesn't so much need to increase exports as to simply produce much more of what it consumes, just as the Chinese don't need to import more as much as they need to consume more of what they produce.

Chant down Babylon.

Joe Costello was communications director for Jerry Brown’s 1992 presidential campaign and was a senior adviser for Howard Dean’s effort in 2004.

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Viva La$ Vega$

Sep 2, 2010

Gonna set my soul on fire
Got a whole lot of money that's ready to burn
So get those stakes up higher
I'm gonna keep on the run
Gonna have me some fun
If it costs me my very last dime
If I wind up broke up, well
I'll always remember I had a swingin time
-- Viva Las Vegas

Gonna set my soul on fire
Got a whole lot of money that's ready to burn
So get those stakes up higher
I'm gonna keep on the run
Gonna have me some fun
If it costs me my very last dime
If I wind up broke up, well
I'll always remember I had a swingin time
-- Viva Las Vegas

The WSJ has a must read report from the currency table, which rolls 24/7. The Journal writes,

Currency trading volume around the world has hit $4 trillion a day,...the $4 trillion mark represents a 20% gain from $3.3 trillion in 2007, the last time the global foreign-exchange markets were surveyed, according to the Bank for International Settlements.

....the continued rise in trading reflects the increased globalization of investing. With the big developed economies of the U.S., Europe and Japan struggling, investors are turning toward other markets for returns and generating more foreign-exchange trading in the process.

Now small investors are increasing their foreign-currency exposure. They are piling into mutual funds which make bets on currencies as a core part of their strategy. More broadly, U.S. stock mutual funds that invest overseas have taken in $42 billion over the past year, according to Morningstar Inc.

In addition, exchange-traded mutual funds, whose shares trade like stocks, are making the currency markets more accessible to small investors. There are now 44 currency ETFs, up from 16 in April 2007, according to Morningstar. In 2004 there was only one.

But it gets better. Can you say leverage? Can you say bubble? Boy, just looking at how currency markets are operating, all you can say is thank god for Frank/Dodd, right?

Currency trading usually involves placing bets with borrowed money. That has regulators concerned about individual investors' ability to handle large amounts of leverage, though action has been limited so far.

On Monday, federal regulators backed off a plan to place stricter limits on how much individual investors who trade currencies can borrow.

Currently, investors can borrow $100 for every dollar they invest. The Commodity Futures Trading Commission, which regulates foreign-exchange trading in the U.S., tried to cut that amount to $10.

But after a wave of protests from brokers and individuals, it settled on $50 for every dollar invested, which is the amount of borrowing many large brokers currently allow.

No, no, baby! This place is hot! You can't cut 100 to 1 leverage down to 10 to 1, where's the fun in that? Hell! You can't make shit in this stock market, even with all Ben's pumping!

Kevin Rodgers, global head of foreign-exchange derivatives at Deutsche Bank in London, says funds of all stripes-hedge funds, mutual funds and sovereign-wealth funds -- are seeing the currency markets as a distinct asset class and not just a way to make an investment priced in another currency.

Trading among "nondealers," which includes hedge funds and mutual funds, grew 42% to $1.9 trillion per day...

So, here's the results when the Fed and other central banks started the last bubble by inflating/deflating currency with ZIRP policies, QE, and other methods of pumping money into deflating global assets markets. They are undermining the value of money itself, while the current structure of currency markets allows them much less control than they think. The question is what happens when this bubble pops? The general answer is economic carnage, what that looks like specifically is the real question, and a money maker, that is, if you can figure out how to keep it in a currency with any value.

Viva! Viva! Viva!

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American Paradox

Aug 26, 2010Joe Costello

It's time to stop lashing out at each other and start fighting back against the corporate elites who are dismantling our society.

It's time to stop lashing out at each other and start fighting back against the corporate elites who are dismantling our society.

I'm ready and hyped, plus I'm amped

Most of my heroes don't appear on no stamps

Sample a look back, you look and find

Nothing but rednecks for 400 years if you check

Our freedom of speech is freedom or death

We got to fight the powers that be

Lemme hear you say

Fight the power

Public Enemy

 

To truly appreciate America, you have to understand its paradoxes.  They are great.  The first modern republic birthed in the original sin of slavery.  A nation of immigrants that destroyed the native population, and time after time worries about the next wave of immigrants.  The history of immigrant bashing is old as the republic, always coinciding with economic downturns.  The Know-Nothings of the 1850s worried about the first great mass of German and Irish immigration, and of course the protestant nation worrying about papism.  There were the Japanese interments of WWII.  More recently, in order to get reelected governor of California in 1994, Pete Wilson embraced the anti-immigrant, anti-Mexican Prop 187. He won, but destroyed the Republican party in California.  And of course we have the most recent idiocy in Arizona.  A nation of immigrants, which every once in a while tries to close the door: that's paradox.

If you understand this trait in the American psyche, while it doesn't make it anymore palatable to watch the latest manifestation, it does give you some helpful context.  Especially if you keep in mind that over time, using the principles and practices of this republic's founding, America has been more successful than most in mixing the nationalities of Europe and (more fitfully) other peoples from across the planet into a relatively healthy concoction.  After two hundred years, there is little discrimination based on European nationality.  The great black underclass, many still struggling for economic and cultural equality, fifty years ago stood up and claimed their full rights as citizens, a revolution that shook the entire society atop it.  Even Native Americans have finally gained a little retribution with the casino industry.  So, today as we struggle to incorporate new immigrants -- some from Mexico, an old and continuing struggle, many more recently from Southwest Asia and the Middle East -- we can draw some understanding, though not acceptance, from America's great paradoxical history.

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However, the recent anti-immigrant wave is developing in a new economic environment, one that is very different from much of the past.  The United States from its beginning enjoyed a massive cornucopia of land and natural resources.  It developed into the world's foremost industrial power, and after WWII was far and away the planet's strongest economy.  But in the last several decades, there has been a great change.  The financial system, with the assistance of much of the American political class, began dismantling the American industrial sector and shipping it overseas.  Now, the relationship of the financial sector to the rest of the America has always had some problems, but over the last three decades, their interests have diverged to the point of outright hostility.  It was Wall Street, after all, who profited on both sides, financing the dismantling of American industry and rebuilding it across the planet.  It was also Wall Street who profited most by the resulting stagnation in American wages, replacing good paying jobs with debt.

It's time to end much of the corporate globalization experiment.  There's many reasons for this, and I'll throw out that energy and environmental reasons are amongst the largest.  We need to reform our economy from the ground up, and that importantly means reincorporating into the economy the advantages of locality.  We need to start raising tariffs.  We should start with imported oil; that would be a good signal to rest of the world of the seriousness of our intentions for reforming the American economy.  Of course, no attempt at reforming the American economy can be started without first reforming American politics.  Finance owns our political class.  They have aided and abetted the dismantling of the economy.  Remember in 1992 when Ross Perot talked (I can't more highly recommend watching Ross here) about that giant sucking sound from south of the border?  He was right in hearing, though wrong in direction. That sucking sound was coming out of DC.  If you hear a DC elected official advocate "free trade", immediately vote them out.

Give us your tired, your poor, and your huddled masses yearning to breathe free, but keep your cheap goods.  The country that started the corporate globalization experiment needs to end it -- another paradox.

Joe Costello was communications director for Jerry Brown’s 1992 presidential campaign and was a senior adviser for Howard Dean’s effort in 2004.

 

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Deficit Chicken Littles Miss Another Doomsday Deadline

Aug 17, 2010Marshall Auerback

marshall-auerback-100 China is dumping Treasuries and interest rates remain low.  Will the doomsayers see the error of their ways?

marshall-auerback-100 China is dumping Treasuries and interest rates remain low.  Will the doomsayers see the error of their ways?

In a post titled "China Cuts US Treasury Holdings By Record Amount," Mike Norman makes the excellent observation that while China is moving its money out of Treasuries, interest rates are hitting record lows.  In other words, the sky still isn't falling.  So, Mike wonders, "Where is the Debt/Doomsday crowd?"  He rightly concludes that “They’re nowhere to be found because they can’t explain this. This is a ‘gut punch’ to them. Their whole theory is out the window.  They just don’t understand or don’t want to understand, that interest rates are set by the Fed…PERIOD!!!”

Also of note: Nikkei QUICK News reports that the #309 10-year bond, the current benchmark, has traded to a yield of 0.920% Tuesday morning, down 2.5 basis points from yesterday's close. This is the lowest yield since August 13, 2003. U.S. Treasuries traded higher overnight and press articles suggest that China is finding the safety of JGBs attractive.

This, from a country with a debt-to-GDP ratio of 210%!

I know what the deficit hawks are now saying -- it is only a matter of time! Yes, and doom-merchants have been predicting the end of the world forever and the Y2K bugs were predicting it then and the gold bugs were predicting Weimar-style hyperinflation by the end of 2009 and… We can just let the “it is only a matter of time” brigade worry themselves sick and leave us in peace.

Marshall Auerback is a Senior Fellow at the Roosevelt Institute, and a market analyst and commentator.

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How I Learned to Quit Worrying and Love Corporate Globalization

Aug 12, 2010Joe Costello

money-globe-150Corporate globalization is in vogue for politicians, but it benefits no one.

money-globe-150Corporate globalization is in vogue for politicians, but it benefits no one.

General Ripper: It's incredibly obvious isn't it? A foreign substance is introduced into our precious bodily fluids, without the knowledge of the individual, certainly without any choice. That's the way your hardcore Commie works.

Captain Mandrake: Tell me Jack, when did you first develop this theory?

General Ripper: Well, I first became aware of it Mandrake, during the physical act of love. A profound sense of fatigue and feeling of emptiness followed. Luckily, I was able to interpret these feelings correctly...loss of essence.

-- Dr. Stangelove

One interesting thing that has happened over the last several decades is a shift in our elites' view of international conspiracies. If you are unfortunately old enough to remember our existential obsession with "international communism," you will remember for the most part it was party line for both parties to look with suspicion on things labeled "international" or "global." Yet a funny thing happened with the rise of corporate globalization: suddenly "international" not only lost suspicion, but was necessary. It's to the point now where a Democratic administration can cut auto workers' pay in half in the name of international competition, and the move is met not only by complete silence but approval from the workers so-called representatives, the UAW.

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The Washington Post has a story about a report released by the Congressional Oversight Panel on the bank bailouts, bringing to light one of the dirty little not-so-secrets -- a good chunk of the bailout money went to foreign firms:

The federal government's effort to stabilize the financial system in 2008 by flooding money into as many banks as possible resulted in a boon to many foreign firms and left the United States shouldering far more risk than governments that took a narrower approach, according to a new report by a panel overseeing the Treasury's $700 billion bailout fund.

They cite as a case study the bailout of insurance giant American International Group. While the Treasury committed up to $70 billion to AIG through its Troubled Assets Relief Program, the report states, much of that money ended up in the coffers of foreign trading partners in France, Germany and other countries. The cash that the United States poured into AIG alone equaled twice what France spent on its total capital injection program, and half what Germany spent.

AIG was a hole big enough to save the world -- call it "loss of essence". (See good piece on AIG by William Greider.) Corporate globalization's impact on the planet has pretty much been the same as nuclear bombs: it entirely rearranges the globe and is good for neither those "controlling" matters, nor those on the receiving end. It is beneficial only in the short-run for the bomb makers. At some point, we will realize this is simple madness.

Joe Costello was communications director for Jerry Brown’s 1992 presidential campaign and was a senior adviser for Howard Dean’s effort in 2004.

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Do Deficits Matter? Foreign Lending to the Treasury

Aug 3, 2010L. Randall Wray

money-globe-150How can we reconcile our lending to China with the interests of the United States?

money-globe-150How can we reconcile our lending to China with the interests of the United States?

Deficit hawks raise three objections to persistent federal government budget deficits: a) they pose a solvency risk that could force to government to default on its debt; b) they pose an inflation, or even a hyperinflation, risk; and c) they impose a burden on our grandkids, who will have to pay interest in perpetuity to the Chinese who are accumulating treasuries as well as power over the fate of the dollar.

I have argued that federal budget deficits and debts do not matter so far as national solvency goes (see here). The sovereign issuer of the currency cannot be forced into an involuntary default. I have also dealt with possible inflation effects of deficit spending (see here). To summarize that argument as briefly as possible, additional deficit spending beyond the point of full employment will almost certainly be inflationary, and inflation barriers can be reached even before full employment. However, I argued that the risk of hyperinflation for a country like the US is exceedingly low, and high inflation will be avoided by every stripe of policymaker the US is likely to appoint.

In this blog I will address the connection between trade deficits and foreign accumulation of treasuries, the interest burden supposedly imposed on our grandkids, and the possibility that foreign holders might decide to abandon the dollar.

Let us set out the framework. At the aggregate level, the government's deficit equals the nongovernment sector's surplus. We can break the nongovernment sector into a domestic component and a foreign component. As the US macrosectoral balance identity shows, the government sector deficit equals the sum of the domestic private sector surplus plus the current account deficit (which is the foreign sector's surplus). Let me stress that this is an identity, beyond dispute. Even those who are worried about the sustainability of continued budget deficits recognize the macro accounting identity (see here). We will put to the side discussion about the behaviors that got us to the current reality -- which is a large federal budget deficit that is equal to a (smallish) private sector surplus (spending less than income) plus a rather large current account deficit (mostly resulting from a US trade balance in which imports exceed exports).

There is a positive relation between budget deficits and the current account deficit that goes behind the identity. All else equal, the government budget deficit raises aggregate demand so that US imports exceed US exports (American consumers are able to buy more imports because the US fiscal stance generates household income used to buy foreign output that exceeds foreign purchases of US output.) There are other possible avenues that can generate a relation between the US government deficit and the current account deficit (some point to effects on interest rates and exchange rates), but they are at best of secondary importance. To sum up: a US government deficit can prop up demand for output, some of which is produced outside the US-so that US imports rise more than exports, especially when a budget deficit stimulates the American economy to grow faster than the economies of our trading partners.

When foreign nations run trade surpluses (and the US runs a trade deficit), they are able to accumulate dollar denominated assets. A foreign firm that receives dollars usually exchanges them for domestic currency at its central bank. For this reason, a large proportion of the dollar claims on the US end up at foreign central banks. Since international payments are made through banks, rather than by actually delivering federal reserve paper money, the dollars accumulated in foreign central banks are in the form of reserves held at the Fed-nothing but electronic entries on the Fed's balance sheet. These reserves do not earn interest. Since the central banks would prefer to earn interest, they convert them to US treasuries-which are really just another electronic entry on the Fed's balance sheet, albeit one that periodically gets credited with interest. This conversion from reserves to Treasuries is akin to shifting funds from your checking account to a certificate of deposit (CD) at your bank, with the interest paid through a simple keystroke that increases the size of your deposit. Likewise, treasuries are CDs that get credited interest through Fed keystrokes.

In sum, a US current account deficit will be reflected in foreign accumulation of US Treasuries, held mostly by foreign central banks. The figure below displays the top foreign holders of US treasuries. While most public discussion has focused on Chinese holdings, Japanese holdings are of a similar size.graph-l-randall

(Seen here)

While this is usually presented as foreign "lending" to "finance" the US budget deficit, one could just as well see the US current account deficit as the source of foreign current account surpluses that can be accumulated as treasuries. In a sense, it is the proclivity of the US to simultaneously run trade and government budget deficits that provides the wherewithal to "finance" foreign accumulation of treasuries. Obviously there must be a willingness on all sides for this to occur-we could say that it takes (at least) two to tango-and most public discussion ignores the fact that the Chinese desire to run a trade surplus with the US is linked to its desire to accumulate dollar assets. At the same time, the US budget deficit helps to generate domestic income that allows our private sector to consume-some of which fuels imports, providing the income foreigners use to accumulate dollar saving, even as it generates treasuries accumulated by foreigners.

In other words, the decisions cannot be independent. It makes no sense to talk of Chinese "lending" to the US without also taking account of Chinese desires to net export. Indeed all of the following are linked (possibly in complex ways): the willingness of Chinese to produce for export, the willingness of China to accumulate dollar-denominated assets, the shortfall of Chinese domestic demand that allows China to run a trade surplus, the willingness of Americans to buy foreign products, the (relatively) high level of US aggregate demand that results in a trade deficit, and the factors that result in a US government budget deficit. And of course it is even more complicated than this because we must bring in other nations as well as global demand taken as a whole.

While it is often claimed that the Chinese might suddenly decide they do not want US treasuries any longer, at least one, but more likely many, of these other relationships would also need to change.

For example it is feared that China might decide it would rather accumulate euros. However, there is no equivalent to the US treasury in Euroland. China could accumulate the euro-denominated debt of individual governments-say, Greece!-but these have different risk ratings and the sheer volume issued by any individual nation is likely too small to satisfy China's desire to accumulate foreign currency reserves. Further, Euroland taken as a whole (and this is especially true of its strongest member, Germany) attempts to constrain domestic demand to avoid trade deficits-meaning it is hard for the rest of the world to accumulate euro claims because Euroland does not generally run trade deficits. If the US is a primary market for China's excess output but euro assets are preferred over dollar assets, then exchange rate adjustment between the (relatively plentiful) dollar and (relatively scarce) euro could destroy China's market for its exports.

I am not arguing that the current situation will go on forever, although I do believe it will persist much longer than most commentators presume. But changes are complex and there are strong incentives against the sort of simple, abrupt, and dramatic shifts often posited as likely scenarios. I expect that the complexity as well as the linkages among balance sheets ensure that transitions will be moderate and slow-there will be no sudden dumping of US treasuries.

Before concluding, let us do a thought experiment to drive home a key point. The greatest fear that many have over foreign ownership of treasuries is the burden on our grandkids-who, it is believed, will have to pay interest to foreigners. Unlike domestically-held treasuries, this is said to be a transfer from some American taxpayer to a foreign bondholder (when bonds are held by Americans, the transfer is from an American taxpayer to an American bondholder, believed to be less problematic). So, it is argued, government debt really does burden future generations because a portion is held by foreigners. Now in reality, interest is paid by keystrokes-but our grandkids might decide to raise taxes on themselves to match interest paid to Chinese bondholders and thereby impose the burden feared by deficit hawks. So let us continue with our hypothetical case.

What if the US managed to eliminate its trade deficit so that it ran a perpetually balanced current account? In that case, the US budget deficit would exactly equal the US private sector surplus. Since foreigners would not be accumulating dollars in their trade with the US, they could not accumulate US treasuries (yes, they could trade foreign currencies for the dollar but this would cause the dollar to appreciate in a manner that would make balanced trade difficult to maintain). In that case, no matter how large the budget deficit, the US would not "need" to "borrow" from the Chinese to finance it.

This makes it clear that foreign "finance" of our budget deficit is contingent on our current account balance-foreigners need to export to us so that they can "lend" to our government. And if our current account is in balance then no matter how big our government budget deficit, we will not "need" foreign savings to "finance" it-because our domestic private sector surplus will be exactly equal to our government deficit. Indeed, one could quite reasonably say that it is the budget deficit that "finances" domestic private sector saving.

Yet, the deficit hawks believe the federal budget deficit would be more "sustainable" if foreigners did not accumulate treasuries that supposedly burden future generations of Americans.

OK, how could we eliminate the current account deficit that allows foreigners to accumulate treasuries? The IMF-approved method of balancing trade is to impose austerity. If the US were to grow much slower than all our trading partners, US imports would fall and exports would rise. In fact, our current "great recession" did reduce our trade deficit-although only moderately and probably temporarily. In order to eliminate the trade deficit and to ensure that we run balanced trade, we are going to need a much deeper, and permanent, recession. By reducing American living standards relative to those enjoyed by the rest of the world, we might be able to eliminate our current account deficit and thereby ensure that foreigners do not accumulate treasuries said to burden future generations of Americans.

Now, can the deficit hawks please explain why we should desire permanently lower living standards on their promise that this will somehow reduce the burden on our grandkids?

I think my grandkids would prefer a higher growth path both now and in the future, so that we can leave them with a stronger economy and higher living standards. If that means that thirty years from now the Fed will need to stroke a few keys to add interest to Chinese deposits, so be it. And if the Chinese some day decide to use dollars to buy imports, our grandkids will be better situated to produce the stuff the Chinese want to buy.

L. Randall Wray is Professor of Economics at the University of Missouri-Kansas City.

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Marshall Auerback Dissects State Budget Woes on BNN

Jul 30, 2010

Thought that deficit hysteria is only a problem on the Federal level? Think again. The Governator is in deep trouble, and so are "48 out of the 50 states", which are all facing fiscal crises, Marshall points out. Part of the problem is due to falling tax revenues and state politics that require balanced budgets, but the larger problem is a lack of chutzpah in Congress to pony up some Federal assistance to state budgets. Lacking that, however, California is taking matters into its own hands and issuing IOUs, which now hold some weight.

Thought that deficit hysteria is only a problem on the Federal level? Think again. The Governator is in deep trouble, and so are "48 out of the 50 states", which are all facing fiscal crises, Marshall points out. Part of the problem is due to falling tax revenues and state politics that require balanced budgets, but the larger problem is a lack of chutzpah in Congress to pony up some Federal assistance to state budgets. Lacking that, however, California is taking matters into its own hands and issuing IOUs, which now hold some weight. They can be used to pay state taxes -- exactly what gives currency value. That's the difference, for example, between the "normal piece of paper" Marshall holds up and the "piece of paper with a dead president on it." The dead president can be used to pay Federal taxes. After all, we're not on the gold standard anymore, Toto.

Meanwhile, although Marshall concedes that there is political dysfunction in California's government, now is not the time for Schwarzenegger to give the smack down. "When you have a fire going on, and a fire engine comes up to your house to put out the fire, you don't complain because of the design of the fire engine." Put out the fiscal fire. Then give the truck a new coat of red paint.

Check out the full interview here.

And check out some of Marshall's latest posts:

The Summer(s) of Our Discontent

The Trouble with Tim's Treasury

The Self-inflicted Insanity of American Unemployment

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Despite Foreign Debts, U.S. Has the Upper Hand

Jul 16, 2010Henry Liu

money-globe-150U.S. public debt as of July 8, 2010 was $ 13.192 trillion against a projected 2010 GDP of $14.743 trillion. As of April 2010, China held $900.2 billion of US Treasuries, surpassing Japan's holding of $795.5 billion.

money-globe-150U.S. public debt as of July 8, 2010 was $ 13.192 trillion against a projected 2010 GDP of $14.743 trillion. As of April 2010, China held $900.2 billion of US Treasuries, surpassing Japan's holding of $795.5 billion. As of 2007, outstanding GSE (Government Sponsored Enterprises like Fanny Mae; Freddy Mac) debt securities (non-mortgage and those backed by mortgages) summed up to $7.37 trillion.

Does this mean disaster for the US? Conventional wisdom is misleading, as the case of China illustrates.

Paulson's Worry

Former Treasury Secretary Hank Paulson revealed in his recently published memoir that in August 2008, while attending the Olympics in Beijing, he was informed by Chinese officials that "Russian officials had [earlier] made a top-level approach to the Chinese suggesting that together they might sell big chunks of their GSE holdings to force the U.S. to use its emergency authorities to prop up these companies." Paulson said while "the Chinese declined to cooperate", the report was nonetheless "deeply troubling," as "heavy selling could create a sudden loss of confidence in the GSEs and shake the capital markets."

In an Op-Ed article in the June 14, 2010 edition of Foreign Affairs by Benn Steil, Senior Fellow and Director of International Economics, and Paul Swartz, Analyst, Center for Geoeconomic Studies, the authors suggest that "with the U.S. needing to sell another $1.3 trillion in debt in 2009, the risk Paulson describes is certainly real."

They point out that over the past decade, foreign ownership of U.S. debt has increased dramatically. Foreign holdings of Treasurys have risen from 29% to 48% of the outstanding stock, while foreign holdings of U.S. government agency and GSE backed debt have increased from 6% to 16%. Virtually the entire increase in both has been accounted for by foreign governments, as opposed to private investors. And one government dominates: China. By the authors' estimates, China has accumulated an astounding $850 billion in Treasuries and $430 billion in agency debt over the decade -- almost half the total foreign government accumulation. (As of April 2010, China held $900.2 billion of U.S. Treasuries, ranking top surpassing Japan's holding of $795.5 billion.)

The authors report that to some, the fear that the Chinese might dump U.S. debt is misguided. "It would be very much against their own interest to do so," Federal Reserve chairman Ben Bernanke said back in 2006. Heavy selling would precipitate precisely the fall in the dollar's local and global purchasing power that the Chinese fear. So the Chinese would not cut off their noses to spite their faces. But the same faulty argument can be made about anyone caught in a Ponzi scheme, the authors warn. No one who finds himself in a Ponzi scheme wants to see it collapse, yet he will still sell because he knows he will be worse off if others sell first.

So, the authors ask, how serious is the risk of strategic, coordinated foreign selling, of the type that could destabilize financial markets? They answer that "Here is where Paulson drops the ball. He tells us only that China rejected the Russian scheme to coordinate the mass dumping of GSE debt. Yet large-scale near-simultaneous selling is precisely what happened. By our calculations, Russia sold $160 billion worth, virtually all of its holdings, over the course of 2008, while China sold nearly $70 billion worth between June 2008, when its holdings peaked, and the end of that year."

And while the fire sale went on, the yield spread between GSE debt and U.S/ Treasury debt soared. From 2003 to 2007 it averaged 34 basis points. When Russia started selling GSE debt in January 2008, it stood at 57 basis points. When China started selling in July, it hit 86 basis points. As GSE debt was widely used as collateral in the U.S. repo market, the rising spread forced U.S. financial institutions to pony up more and more securities to support their borrowing. The government put the GSEs into conservatorship in September. Yet Chinese and Russian dumping of GSE debt accelerated into the fourth quarter of 2008, as did spreads, which peaked in November at over 150 basis points.

This episode highlights the clear risks to the U.S., and indeed the wider world, of growing American dependence on foreign government lending, the authors conclude.

But this is the wrong conclusion. Why? Because the U.S. owes no foreign debt denominated in foreign currencies.

Dollar Hegemony

The authors did not ask why the U.S., while vulnerable, is not critically over a barrel by massive foreign holdings of U.S. sovereign debt. The reason is because U.S. sovereign debts are all denominated in dollars, a fiat currency that the Federal Reserve can issue at will. The U.S. has no foreign debt in the strict sense of the term. It has domestic debt denominated in its own fiat currency held in large quantities by foreign governments. The U.S. is never in danger of defaulting on its sovereign debt because it can print all the dollars necessary to pay off foreign holders of its debt. There is also no incentive for the foreign holders of U.S. sovereign debt to push for repayment, as that will only cause the U.S. to print more dollars to cause the dollar to fall further in exchange rates.

In this situation, the borrower enjoys market power over the lender. This advantage that the U.S. enjoys comes from dollar hegemony, a peculiar condition in global finance in which the dollar, a fiat currency that the U.S. can issue at will, is recognized worldwide as a reserve currency for international trade because of U.S. geopolitical power with which to force the trading of critical basic commodities to be denominated in dollars. Everyone accepts dollars because dollars can buy oil and every economy needs oil. Granted, one can buy oil also with euros and yen, but only because these currencies are freely convertible to dollars, and therefore they are really derivative currencies of the dollar.

But this is not quite a free ride. Although the US is getting low-price imports paid for with paper dollars that it will never have to buy back with gold, this type of trade comes with is a penalty of losing low-paying manufacturing jobs overseas, mainly to China. In recent months, as the Chinese government realizes that a low-wage economy is an underdeveloped economy, it has encouraged Chinese workers to demand higher wages through collective bargaining and strikes. Low-wage jobs then will move by transnational corporations to other underdeveloped low-wage economies such as Vietnam, Indonesia and some countries in Central and Latin American. But this type of trade globalization through cross-border wage arbitrage also pushes down wages in the US and other advanced economies, causing insufficient consumer income to absorb rising global production. This is the main cause of the current financial crises which have made more severe by financial deregulation. But the root cause is global overcapacity due to low wages of workers who cannot afford to buy what they produce. The world economy is plagued with overcapacity as a result. It is not enough to merely focus on job creation. Jobs must pay wages high enough to eliminate overcapacity. Instead of a G20 coordination on fiscal austerity, there needs to be a G20 commitment to raise wages globally.

Click here to read the full article.

Henry C.K. Liu is an independent commentator on culture, economics and politics.

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