Tuesday, October 27, 2009

Allan Meltzer On Excessive US Deficits & The Weakening Dollar

I've written quite a few posts recently regarding what I believe is the arrival of the US at a new tipping point involving the weakening dollar, excessive deficits and externally-held US debt, taxation, additional social spending programs, and coming inflation. As I explained in an email to a friend recently, for the first time in thirty years, I'm genuinely concerned that the predictions of the dollar's and US's economic and, eventually, military superiority's decline, are now within view of coming true.

In fact, with all the government intervention of the past year, posts focused on cases of firms chalking up consistently superior total return performance have declined. Instead, the most interesting topics seem to be the economics of the dollar and deficit spending, and massive government intervention in the private sector of the US economy.

In last Friday's Wall Street Journal, respected Carnegie Mellon political economy professor Allan Meltzer weighed in with a reinforcing editorial entitled "Preventing the Next Financial Crisis."

The crisis to which he refers is not a private sector banking crisis like last year. Instead, he begins his editorial,

"The United States is headed toward a new financial crisis. History gives many examples of countries with high actual and expected money growth, unsustainable budget deficits, and a currency expected to depreciate. Unless these countries made massive policy changes, they ended in crisis. We will escape only if we act forcefully and soon."

Echoing others, and my own concerns, Meltzer then observes,

"Massive purchases of dollar debt by foreigners can of course delay the crisis, but today most countries have their own deficits to finance. It is unwise to expect them, mainly China, to continue financing up to half of ours for the next 10 or more years. Our current and projected deficits are too large relative to current and prospective world saving to rely on that outcome.

Worse, banks' idle reserves that are available for lending reached $1 trillion last week. Federal Reserve Chairman Ben Bernanke said repeatedly in the past that excess reserves would run down when banks and other financial companies repaid their heavy short-term borrowing to the Fed. The borrowing has been repaid but idle reserves have increased. Once banks begin to expand loans or finance even more of the massive deficits, money growth will rise rapidly and the dollar will sink to new lows.

Many market participants reassure themselves that inflation won't come by noting the decline in yields on longer-term Treasury bonds and the spread between nominal Treasury yields and index-linked TIPS that protect against inflation. They measure expectations of higher inflation by the difference between these two rates, and imply long-term investors aren't demanding higher interest rates to protect themselves against it. But those traditional inflation-warning indicators are distorted because the Fed lends money at about a zero rate and the banks buy Treasury securities, reducing their yield and thus the size of the inflation premium.

Further, the Fed is buying massive amounts of mortgages to depress and distort the mortgage rate. This way of subsidizing bank profits and increasing their capital bails out these institutions but avoids going to Congress for more money to do so. It follows the Fed's usual practice of protecting big banks instead of the public.

The administration admits to about $1 trillion budget deficits per year, on average, for the next 10 years. That's clearly an underestimate, because it counts on the projected $200 billion to $300 billion of projected reductions in Medicare spending that will not be realized. And who can believe that the projected increase in state spending for Medicaid can be paid by the states, or that payments to doctors will be reduced by about 25%?"

There you have it. Meltzer does a great job of ticking off the sources of unease many, including me, feel about the current monetary and fiscal situation. It truly feels like a nearby bomb, the timer on which is finally, after some 60+ post-WWII years, nearing zero.

On the matter of who owns this mess, Meltzer, in a genuinely bi-partisan vein, writes,

"The Obama administration chooses to blame outsize deficits on its predecessor. That's a mistake, because it hides a structural flaw: We no longer have any way of imposing fiscal restraint and financial prudence. Federal, state and local governments understate future spending and run budget deficits in good times and bad. Budgets do not report these future obligations.

Except for a few years in the 1990s, both parties have been at fault for decades, and the Obama administration is one of the worst offenders. Its $780 billion stimulus bill, enacted earlier this year, has been wasteful and ineffective. The Council of Economic Advisers was so pressed to justify the spending spree that it shamefully invented a number called "jobs saved" that has never been seen before, has no agreed meaning, and no academic standing."

And there's the rub. Anyone with a brain who has been watching federal government behavior since Reagan's exit from office knows that both parties have allowed our society to rack up huge debts to finance promises which are simply unable to be kept.

Having come of age in business during the Reagan years, with Volcker at the Fed, I never really thought that the lessons of the Carter, and post-Carter years could be forgotten, or simply denied. But, as Meltzer concludes,

"One reason for the great inflation of the 1970s was that the Federal Reserve gave primacy to reducing unemployment. But attempts to tame inflation later didn't last, and the result was a decade of high and rising unemployment and prices. It did not end until the public accepted temporarily higher unemployment—more than 10.5% in the fall of 1982—to reduce inflation.

Another error of the 1970s was the assumption there was a necessary trade-off along a stable Phillips Curve between unemployment and inflation—in other words, that more inflation was supposed to lower unemployment. Instead, both rose. The Fed under Paul Volcker stopped making those errors, and inflation fell permanently for the first time since the 1950s.

Both errors are back. The Fed and most others do not see inflation in the near term. Neither do I. High inflation is unlikely in 2010. That's why a program beginning now should start to lower excess reserves gradually so that the Fed will not have to make its usual big shift from excessive ease to severe contraction that causes a major downturn in the economy.

A steady, committed policy to reduce future inflation and lower future budget deficits will avoid the crisis that current policies will surely bring. Low inflation and fiscal prudence is the right way to strengthen the dollar and increase economic well being."

I feel like I'm economically much older than my years, because I recall arguments concerning Arthur Burns' ineffective reign at the Fed. His inability to pre-empt inflation during the LBJ "guns and butter" years of the Vietnam war and the Great Society program spending.

Even this morning, as I write this, I have listened to CNBC's senior economic moron, Steve Liesman, argue that commodity price inflation has no information value for the coming storm of CPI inflation.

Milton Friedman reminded us that

"Inflation is always and everywhere a monetary phenomenon."

With the recent explosion of US dollar liabilities and the Fed funding our debt, Meltzer is clearly correct on the need for the Fed to begin tightening now. Burns' ineptitude was a classic example of waiting too long, then watching the inflation genie escape and run rampant for more than a decade.

Let's hope we are not going to experience that again, along with losing the dollar's reserve currency status.

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