Mark W. Hendrickson
Mark W. Hendrickson is a faculty member, economist, and contributing scholar with the Center for Vision and Values at Grove City College, Grove City, Pennsylvania. These articles are from V & V, a web site of the Center for Vision & Values.
Tough Times Ahead: Gridlock and Quantitative Easing Are Not Enough
Now that the elections are over, attention is turning to the economy.
The stock market rose steadily from the end of August up to the elections. Since the stock market tends to be forward-looking, its recent strong and steady rise suggests that investors have been optimistic. In my opinion, two factors have generated that optimism:
1) The expectation that significant Republican gains in Congress would produce political gridlock, thereby putting the brakes on the Obama/Pelosi/Reid/progressive spending binge.
2) The Federal Reserve's promise of "QE2," a second round of "quantitative easing," the currently fashionable euphemism for creating mind-boggling sums of new money out of thin air.
Sorry to rain on anyone's parade, but I don't believe that gridlock (assuming it happens) and QE2 will be sufficient to turn the economy around. There are several reasons for my tepid outlook.
Surely, gridlock -- a political stalemate between the Democratic president and congressional Republicans -- will change the game. There will be no more enormously expensive and economically crippling legislation, like the mega-non-stimulus and healthcare/insurance reforms that were passed, or the cap-and-trade monstrosity that was barely averted.
To use a medical metaphor, compare the economy to a human body that has been bludgeoned. Obviously, it helps when the bludgeoning stops. But just because additional blows aren't being struck, it doesn't mean the patient is healthy; the patient is still at risk from internal injuries. Our economy urgently needs a trip to the emergency room for radical surgery and intensive care. The government needs to undo the massive damage it has inflicted on the economy over the last several years. It needs to reverse, not merely halt, runaway spending, and to shrink, not just slow, the growth of the federal bureaucracy.
Recently, the Congressional Budget Office released a study projecting total federal spending of $44.5 trillion during this decade. Since we are already choking on $3.7 trillion of spending this year, the implication is that Uncle Sam is on track to spend over $5 trillion in other years later this decade. Will the new Congress, even with the addition of several dozen fiscal conservatives, be able to overcome Obama's resistance to canceling trillions of dollars of planned spending? I doubt it.
Those longing for a return to the economic good times of the 1990s by replicating the gridlock that existed between the Clinton White House and Gingrich Congress need to realize that circumstances are significantly different today. Gridlock tends to preserve the status quo. That was desirable in the mid-1990s, when the economy was healthy and growing; preserving today's economic stagnation, by contrast, is not desirable; it is unacceptable.
Even if Obama and the new Congress surprise us by reducing the annual rate of growth of federal spending to the modest 2.9 percent level that Clinton and Gingrich achieved (highly unlikely, given Obama's ideology), the ticking time bomb of Social Security, Medicare, and Medicaid's unfunded liabilities will continue to push us inexorably onward toward ruin.
At any time, the world's bond investors may demand a higher interest rate to compensate for the risk of insolvency. That would cause the cost of financing our trillions of dollars of debt to soar, consuming hundreds of billions of dollars of tax revenues.
The see-no-evil optimists would say, "Hey, why worry? The Fed will buy all those bonds." That's the purpose of QE2.
The problem here is that bond investors will still demand a higher interest rate to compensate them for the cheapening of the dollar (what we call an "inflation premium") that will inevitably result from the Fed creating so many new dollars to buy the Treasury's debt. In anticipation of QE2, major bond-buyers -- notably the Chinese and PIMCO, the largest American bond fund -- have already started to sell Uncle Sam's bonds. I wouldn't want to bet against PIMCO chief Bill Gross, who is to bonds what Warren Buffett is to stocks. If the exit from bonds becomes a stampede, Katy, bar the door, because QE2 may then go to infinity, as in "hyperinflation." Adios, greenback!
Ben Bernanke has to know that QE2 cannot possibly produce prosperity. QE2 is another instance of "the money illusion" that all Econ 101 students (at Grove City College, at least) learn: Money isn't wealth, and even if the central bank created a million dollars for every single American, we wouldn't be any richer in real terms.
Yes, it's possible that a flood of new dollars may buoy stock prices, but in terms of real wealth and real jobs for Americans in general, lots of luck. Those pinning their hopes for a vigorous economic turnaround on political gridlock and QE2 are likely to be sorely disappointed.
You've probably seen the headlines about major banks suspending foreclosure proceedings to reclaim houses from borrowers who have defaulted on their mortgages. This has the potential to be hugely disruptive -- a milestone development comparable to the failure of Lehman Brothers in 2008, after which all hell broke loose.
Let me emphasize the word "potential." The core of the problem is that there are serious problems in proving who actually has clear, lawful title to specific houses.
This situation arose because of the last two decades' common practice of "securitization" -- the bundling of large numbers of mortgages into a new interest-paying, tradable security. These securities are then sold and resold, often several times. This has lead to widespread confusion. I read of one case in which no fewer than four different firms claimed to own a particular title, and thus the right to foreclose, on the same property.
Because many judges have blocked foreclosure proceedings on the grounds of unclear title, Bank of America, GMAC, and other financial giants have declared a moratorium on foreclosures until the legal picture becomes less muddied.
Some commentators insist that the problem is nothing more than a few technical glitches that can be easily corrected. Others assert that there has been massive fraud, false attestation (attesting to facts without having ascertained those alleged facts), and forgery (creating documents after the fact to produce a fictitious paper trail). Apparently, the states' Attorneys General feel there might be fire among all the smoke, because all 50 of them have initiated investigations, and many of them appear as though they are about to go on the prosecutorial warpath.
If, in fact, the problem is not easily rectified and the various allegations of malfeasance are sustained, here is what is at stake:
We are looking at a breakdown of the housing market. Would-be buyers can't obtain title insurance or loans to buy property without clear title. The country's entire real-estate market could freeze up, further torpedoing home prices and throwing a monkey wrench into the plans of millions of people who want or need to relocate.
The financial industry could break down. Currently, 4.5 percent of existing mortgages are in some stage of foreclosure. If banks can neither collect mortgage payments nor replace that lost income by selling the related properties, losses could be massive, perhaps catastrophic. Then the bailout issue would be back on the front burner.
If courts rule that "robo-signing" -- lenders mechanically signing off on thousands of foreclosures without taking the time to review the facts of each individual case as required by law -- constitutes fraud, then the resulting tsunami of fines and lawsuits could cripple or wipe out many lenders. Here again, would be a breakdown of the financial sector.
If either the housing market freezes up and/or the financial industry cracks up, then the process of economic recovery itself will break down.
If lenders can no longer foreclose on properties, how many millions of other mortgage-holders will decide to stop making their monthly payments? Anecdotal evidence indicates that there are already hundreds of thousands of "strategic defaulters." These are people who can afford their monthly payments, but have chosen to stop making payments, figuring that, at the very least, they can get away with living rent-free for a year or two before getting evicted. These numbers are bound to soar. The whole "strategic default" epidemic represents a breakdown of respect for law and also for the moral code (of honoring contracts) that constitutes the very heart of a viable economy.
The issue of clear legal titles to property is indispensable to a thriving capitalist economy, as the Peruvian economist Hernando de Soto explained in his bestseller The Mystery of Capital. We either restore the clarity and inviolability of titles to property, or our capitalist system breaks down.
At the center of the foreclosure controversy is an entity named Mortgage Electronic Registration Systems. MERS was hatched by Fannie Mae, Freddie Mac, and other giant players in the mortgage business to speed up the mortgage-backed securitization process and bypass various local property laws. If, in fact, MERS trampled on state and local laws, this represents a breakdown of constitutional federalism and a direct assault on the rule of law.
If all of the breakdowns listed above continue unabated, then we are peering over the precipice at a potential breakdown of social, civil, and political order, too. That's the nightmare scenario. Let's get back on track before it's too late.
Reflections on the GOP Pledge
Last week, thirteen Republicans released a "Pledge to America." What is most surprising to me is its length. At twenty-one pages, it was many times the length of the GOP's hugely successful 1994 "Contract with America." Why ditch a winning formula?
Furthermore, our increasingly unpopular president is known for being long-winded, and his progressive allies in Congress are infamous for concocting ridiculously long bills. Wouldn't a simple, concise list of objectives accentuate the contrast between the two parties?
Instead of sticking to the main theme of reining in an insanely expensive and increasingly intrusive government, the pledge was padded with statements designed to rally the traditionally Republican pro-life, pro-military, and small business constituencies. Yes, those areas are important, but the single issue that unites the largest number of Americans today is the concern that if we don't check runaway government soon, we never will. The too-broad pledge ends up being a hodgepodge of cliched sloganeering. It offers superficially bold but often frustratingly vague proposals, occasionally dubious math, and at least one glaring omission.
Here are some examples of the pledge's faults:
It expresses an intent to "make government more transparent . . . careful in its stewardship and honest in its dealings." But doesn't every party claim this? Why not pledge to drastically shrink government instead?
It also promises "a better America." Who would promise a "worse" America?
It offers "[a plan whereby] the best ideas trump the most entrenched interests." Sure. Then why not put entrenched interests on notice by forswearing earmarks? (This is the glaring omission I spotted.)
It aims to "eliminate wasteful and duplicative programs . . . while still fulfilling all necessary obligations." Everyone promises to trim waste, but it never happens; instead, too-big bureaucracies proliferate and expand. More fundamentally, where do Republicans differ from Democrats on the "necessary obligations" of government?
It seeks to "require congressional approval of any new federal regulation that may add to our deficit and make it harder to create jobs." Why not insert a period after "regulation" and leave out the qualifiers that follow? Currently, rules proposed by federal bureaucracies take effect automatically unless Congress -- which is too busy to even read its own bills, much less reams of bureaucratic regulations -- explicitly rejects them, and so they are almost never challenged. Change it so that no rule proposed by unelected bureaucrats takes effect unless Congress explicitly votes to adopt it.
The pledge suffers from occasional ambiguity. Its proposal to replace Obamacare with reforms like liability reform and permitting interstate sales of health insurance makes sense. But then the Republicans sound just like Democrats when they promise to "ensure [do they mean "mandate?"] that those with pre-existing conditions gain access to the coverage they need."
Remember the promise to eliminate "duplicative" programs? Then why promise "a net hiring freeze" for federal employees instead of reducing the federal payroll after Obama's rapid expansion of it?
The pledge calls for "preventing the expansion of unfunded liabilities." Fine, but simply freezing the amount of those unpayable promises isn't enough. If we don't eliminate many trillions of those liabilities, our financial doom is sealed.
Another intriguing proposal is to require every bill to include a citation of constitutional authority. Do Republicans regard such authority as the letter of the Constitution itself or merely judicial opinions written about the Constitution?
Overall, the pledge is not very bold. The authors' numbers suggest very modest plans for downsizing Uncle Sam. At one point, they write about rolling spending back to "pre-stimulus, pre-bailout levels." That sounds like at least a trillion-dollar cut to me, but then they say that such a step would save $100 billion. Huh?
The pledge has its redeeming features. Invoking the Declaration of Independence at the outset is inspiring. Some of the facts cited hit home -- e.g., how much higher taxes will be next year for middle class families and single moms if the Bush tax cuts expire; the existence of 2,050 federal programs providing economic assistance to Americans.
At best, though, the "Pledge to America" is a mixed bag. Clearly, its Republican authors sought to chart a middle path between Democrats and the Tea Party movement. In that, they succeeded.
This is probably a sound political strategy for the GOP. With voters weary of heavy-handed, hatch-it-behind-closed-doors-in-the-middle-of-the-night-then-ram-it-into-law-before-anyone-reads-it legislation (not to mention counterproductive "stimulus" plans, in-your-face cronyism, and soaring national debt), 2010 is the Republicans' election to lose. All they have to do is run to the right of Obama and they will make large gains in Congress.
Would the "Pledge to America," even if adopted in its entirety, be enough to turn us off our current road to national bankruptcy? No. But perhaps it will prove to be the first of many steps needed to restore economically sound governance to our country.
A couple of years ago, the terms "too big to fail" and "bailout" were the trendy buzzwords. Currently, the "in" word seems to be "austerity." On both sides of the Atlantic, public officials and media pundits are debating the need for "fiscal austerity programs," i.e., shrinking government deficits by increasing tax revenues and/or reducing expenditures.
The term "austerity" is problematic. It connotes sacrifice and deprivation. While "austerity" programs include cutbacks in some persons' lifestyles, it seems odd to say that learning to live within one's means is a sacrifice. What some call "austerity" is simply the recognition of reality: A society cannot chronically consume more than it produces.
Favoring "austerity" are those worried that today's swollen budget deficits and national debts, if not corrected, will trigger an economic catastrophe through a sovereign debt crisis (i.e., the inability of governments to find buyers for their bonds). Opposing it are those who profess concern about the economic hardship that would be endured by innocent victims, and/or those who believe that the right economic policy is for governments to increase spending and budget deficits even more than they already have.
Traditionally, "austerity programs" have been International Monetary Fund (IMF) bailouts of heavily indebted, virtually bankrupt Third World governments. For governments to obtain a loan, the IMF has required them to get their fiscal affairs in order by reducing their budget deficits.
Today, by contrast, we find that some of the wealthiest countries in the world require "austerity programs." The dangerous indebtedness of the PIIGS (Portugal, Ireland, Italy, Greece, Spain) is well known. This has deflected our attention from the salient reality that the United States has comparable degrees of debt and deficits to those European countries. We, too, are in danger of either a sovereign-debt and currency crisis.
We should be ashamed and alarmed that we are even talking about "austerity programs" for the United States of America. The very fact that we are doing so means that we have lapsed into a Third-World-style quagmire of fiscal incompetence and over-indebtedness. Like a banana republic, we have allowed a self-serving political class to spend tax dollars and borrowed funds to "buy" popularity and take us to the brink of national bankruptcy.
Uncle Sam has behaved like a guy earning $40,000 per year who -- with the help of borrowing -- has been spending $60,000 per year. Obviously, that can't continue indefinitely. In fact, such a person can't repair his balance sheet even if he reduces his annual consumption to $40,000; he has to consume less than $40,000 to be able to serve his debt obligations. So it is with Uncle Sam.
In recent years, our government has gone on a spending binge. As a result, today's economy is sluggish and severely hung over. Yet Keynesian economists like Paul Krugman tell us that we haven't binged enough. We've been belting down doubles, but Krugman says that the cure for our fiscal hangover is to go back to the bar and start chugging triples. No thank you.
Other pundits on the left are calling for tax increases instead of spending cuts. Their primary goal is the redistribution of wealth, and so they object to the alleged unfairness of spending cuts. This raises the issue of whether existing government payments to individuals ever were fair. There isn't space to debate this now, but the overriding problem is this: If federal spending isn't cut significantly, we will end up with a financial crisis and economic crack-up that will cause more economic pain for more people, including those that the redistributionists claim to want to help. What could possibly be fair about that?
It is clear what we must do: slash government spending. Tax rates should not be raised while we are in this weakened economic condition.
What some call "austerity" is simply a return to fiscal sanity and economic reality. We cannot continue to spend more than we produce. The adjustments will be painful, but the longer we wait to bite the bullet, the more painful those necessary adjustments will be.
One more point: The blame for the pain caused by "austerity" belongs, not to those who make the politically difficult decisions to cut spending, but, to those in the past who made politically facile decisions to spend beyond our means. They are the ones who got us into this mess.
Exchange-Rate Mythology and Weak-Dollar Nonsense
If you read the financial press or listen to what politicians say, you have probably heard many times how important it is for the Chinese renminbi (yuan) to strengthen against the dollar. Indeed, it sometimes sounds as though a weaker dollar is the key to a prosperous economic future for Americans. Nonsense!
Let's look at this issue from an individual standpoint. Are you better off with a stronger or weaker dollar? In other words, do you hope to be able to buy a lot or a little with a dollar? Silly question, isn't it?
I first learned the advantage of a strong dollar when I lived in Colombia, South America, as a 19-year-old. When I first got there, I could exchange one U.S. dollar for 16 Colombian pesos. Several months later, I could get close to 20 pesos per dollar. At that exchange rate, I could buy a steak dinner and a beer in a nice restaurant on Carrera Septima, the main street of the capital city, Bogota, for the equivalent of one dollar. For an impecunious college kid, that was a real treat!
A strong currency is a consumer's best friend. Why, then, do politicians fixate on exchange rates and lobby for a weaker dollar?
There are two reasons for this anti-consumer attitude: an obsession with balance of trade data and the problem of debt. Let's examine the trade question first.
We hear the constant refrain that we have such a large trade deficit with China because China manipulates the dollar-yuan exchange rate, keeping the yuan artificially cheap. True, the Chinese do manipulate the exchange rate. But if the yuan were to strengthen significantly over the next several years -- say, even if it doubled vis-a-vis the dollar (although there is no guarantee that it would in a free, unmanipulated exchange-rate market) -- would China's trade surplus with the United States shrink? Probably not.
Nearly 40 years ago, the exchange rate for the Japanese yen was over 300 to a single dollar. Japan was running a large trade surplus with the United States. Some experts believed that the way to shrink the Japanese surplus (i.e., the U.S. trade deficit) was for the yen to appreciate.
Fast forward to the 1990s. The exchange rate was about 90 yen to the dollar. In other words, the yen bought more than three times as many dollars as before. And guess what? The U.S. trade deficit with Japan hardly budged.
In fact, Japan derived some considerable benefits from the stronger yen. For example, since the global market for oil is priced in dollars, the real cost of higher oil prices to the Japanese has been only about 1/3 of ours. Advantage, Japan.
Just as other factors outweighed the impact of the currency exchange rate in the trade balance between Japan and the United States, this has also been the case in recent years with China. Between July 2005 and July 2008, the yuan strengthened 21 percent against the dollar, and yet the annual trade deficit rose from $202 billion to $268 billion.
American imports from China increased by 39 percent during that period in spite of the stronger yuan. In theory, a stronger yuan is supposed to reduce American demand for Chinese goods by pushing their prices higher. In practice, though, most Chinese goods are labor-intensive, meaning that labor is the major component in their price -- yet even if Chinese wage rates rose by several multiples, the goods they produce would still be competitively priced here.
This isn't to say that no Americans benefit from a weaker dollar. The weak buck increases the sales of some exporters. I'm sure they are delighted to contribute to the reelection campaigns of politicians who are weak-dollar proponents, even though most Americans are net losers due to reduced purchasing power.
Besides exporters, the other special interest group that benefits from a weaker dollar is official Washington itself. Throughout history, debtors have favored monetary debasement and depreciation. It is easier to repay debts that way. Since Uncle Sam is the largest debtor in the history of the world, Washington insiders have the strongest incentive to weaken the dollar.
Even though a weaker dollar defrauds our creditors, foreign creditors prefer getting repaid in cheaper dollars to an outright default and suspension of payments, so they will hold their noses and settle for what they get. Through this ethically dubious device, our profligate, dissolute, bankrupt government bleeds the wealth of productive citizens and manages to prolong its misrule for a while longer. We the people are left to hold our noses -- just like the Chinese and our other creditors. *
"Liberty must at all hazards be supported. We have a right to it, derived from our Maker." --John Adams