Cure, effect, cause

A paper from the Levy Economics Institute is arguing (at least theoretically) for an extra US fiscal stimulus of 4% of GDP. That's $600 billion.

The authors say that the effect would be better if this reflation came in the form of additional direct government spending, though they acknowledge that it still wouldn't immediately halt the economic decline:

It is somewhat discouraging to see that even a relatively large stimulus plan will fail to prevent a substantial loss of output. But over the medium term, as the devaluation of the dollar and reduced spending begin to exert a moderating effect on the current account deficit, foreign trade will boost output and employment, providing the impetus for renewed growth.

Karl Denninger begs to differ (though in his case, he's still talking about transfers of money, rather than direct government expenditure):

But now we have reached the point where we need $5 in debt to create $1 worth of GDP. As debt levels rise this ratio goes parabolic and ultimately becomes impossible to sustain. That we have reached a 5:1 ratio means that the game is basically up, and the rapidly rising rate of defaults across all areas of consumer debt mean that this "engine" to fuel "growth" simply can't find any more fuel, despite the desires of the bankers and merchants to "make it so."

The Levy paper has echoes of FDR's 30s rescue, but Denninger is more concerned to compare the present mortgage bubble with the one that led to the Crash of '29:

...we've done this before... We saw, in fact, nearly the exact same pattern of practice, fraud and theft that were featured in the housing bubble during the years just before The Depression, and those "standards" in fact were a primary causative factor OF The Depression!

So maybe both parties are correct.




It's also possible that the Uk has got it wrong even worse than Uncle Sam. $600 bn is about £300 bn sterling, but adjusted for relative population size that's only equivalent to £60 bn pumped into the UK economy. We're already talking about a possible £100 bn-worth of mortgage garbage being swapped by HMG for government bonds - and our current fussing over Gordon Brown's crumbling reputation suggests that Prudence wouldn't dare try to reflate with even more direct government spending.

Besides, we are starting with a higher debt-to-GDP ratio than the USA, a State that consumes a bigger proportion of the economy, and a populace that suffers a significantly lower level of personal income on a Purchasing Power Parity basis.

Maybe that's why the pound is matching the dollar in its downward trajectory, and may even overtake it.

I've been wondering recently whether the ordinary investor of the future will be more interested to play in the foreign exchange markets, rather than stocks whose value is lied about, manipulated by rumour and sovereign wealth funds, and nibbled half to death by fees, commissions, taxes and inflation.

UPDATE - Karl Denninger is emphatic that it can't work:

Sack, no.

You can't spend $600 billion in deficits without it coming back SOMEWHERE.

Government spending is not a net positive. You can't only get to a net positive via growth in GDP.

Debt-initiated spending only returns $1 for every $5 taken on in debt.

Bitter medicine

The Levy Economics Institute runs a range of figures through its economic model and decides that it is pessimistic for the short-to-medium term, but guardedly hopeful for the state of the US economy afterwards:

... the present crisis is already more serious than any that has occurred before in modern times.

... Our projections, taken literally, imply three successive quarters of negative real GDP growth in 2008. Spending in excess of income returns to negative territory, reaching -1.6 percent of GDP in the last quarter of 2012—a value that is very close to its “prebubble” historical average.

... while the rate of growth in GDP may recover to something like its long-term average, all our simulations show that the level of GDP in the next two years or more remains well below that of
productive capacity.

... We conclude that at some stage there will have to be a relaxation of fiscal policy large enough to add perhaps 2 percent of GDP to the budget deficit.Moreover, should the slowdown in the economy over the next two to three years come to seem intolerable, we would support a relaxation having the same scale, and perhaps duration, as that which occurred around 2001.

Our projections suggest the exciting, if still rather remote, possibility that, once the forthcoming financial turmoil has been worked through, the United States could be set on a path of balanced growth combined with full employment.

Soothing noises from the US Treasury re subprime losses

Treasury officials are quoted in Bloomberg, saying that subprime losses don't represent a systemic threat. Another official, Frederic Mishkin, said something similar at the Levy Economics Institute symposium this month (see my blog of 5 July).

Some highlights from the Levy Economics Institute

A few nuggets from the July 2007 Levy Economics Institute conference:

Dimitri Papadimitriou foresees an improving current account deficit over the next three years. Private sector debt should level off as a proportion of GDP. The Congressional Budget Office's forecast and targets for 2010 assume continuing home borrowing, but if this doesn't happen, the model suggests that budget deficit needs to increase to 4.6% of GDP. The alternative is a depreciation of the dollar, which is unlikely because (a) this would increase inflation and (b) China does not wish the renminbi to rise significantly against the dollar. A propos the last, Robert Barbera explained that a renminbi appreciation would raise the price of China's farm products and hit the living standard of its large rural population.

Robert Parenteau looked at US private borrowing: "the prospect of a hard landing should be taken seriously".

Wolfgang Muenchau of the Financial Times thinks that despite having stronger fundamentals than America, Europe is likely to be affected by a US downturn, because European stocks, property prices and interest rates tend to follow America's lead, and a strengthening of the Euro against the dollar would hit European exports and economic growth.

Torsten Slok considered longer-term inflationary pressures in the US: demands for pay raises, an increasing proportion of retirees overstraining the budget, and the possibility of an overheating Chinese economy that would up US import prices.

James Paulsen thought that the US could regain some of its consumer market share through "a long-term sustained contraction of its trade deficit to revive domestic manufacturing".

Frederic Mishkin of the Federal Reserve was relatively relaxed about subprime borrowing, saying that such loans represented less than 10% of all mortgages.

Buffett on trade imbalances

Warren Buffett's 28 February 2007 letter to shareholders is available online, and makes educational and entertaining reading. Here's a pithy extract:

As our U.S. trade problems worsen, the probability that the dollar will weaken over time continues to be high. I fervently believe in real trade – the more the better for both us and the world. We had about $1.44 trillion of this honest-to-God trade in 2006. But the U.S. also had $.76 trillion of pseudo-trade last year – imports for which we exchanged no goods or services. (Ponder, for a moment, how commentators would describe the situation if our imports were $.76 trillion – a full 6% of GDP – and we had no exports.) Making these purchases that weren’t reciprocated by sales, the U.S. necessarily transferred ownership of its assets or IOUs to the rest of the world. Like a very wealthy but self-indulgent family, we peeled off a bit of what we owned in order to consume more than we produced.

The U.S. can do a lot of this because we are an extraordinarily rich country that has behaved responsibly in the past. The world is therefore willing to accept our bonds, real estate, stocks and businesses. And we have a vast store of these to hand over.

These transfers will have consequences, however. Already the prediction I made last year about one fall-out from our spending binge has come true: The “investment income” account of our country – positive in every previous year since 1915 – turned negative in 2006. Foreigners now earn more on their U.S. investments than we do on our investments abroad. In effect, we’ve used up our bank account and turned to our credit card. And, like everyone who gets in hock, the U.S. will now experience “reverse compounding” as we pay ever-increasing amounts of interest on interest.

I want to emphasize that even though our course is unwise, Americans will live better ten or twenty years from now than they do today. Per-capita wealth will increase. But our citizens will also be forced every year to ship a significant portion of their current production abroad merely to service the cost of our huge debtor position. It won’t be pleasant to work part of each day to pay for the over-consumption of your ancestors. I believe that at some point in the future U.S. workers and voters will find this annual “tribute” so onerous that there will be a severe political backlash. How that will play out in markets is impossible to predict – but to expect a “soft landing” seems like wishful thinking.

It's reassuring that Buffett thinks per-capita wealth will increase; this is an antidote to the most extreme doomsters. But it begs the question of how equitably that wealth will be distributed. The transfer abroad of industrial jobs leaves most of their former holders in less well-paid employment, while boosting the profits of large multinational companies (such as Wal-Mart, in which Berkshire Hathaway has close to a billion-dollar stake). From James Kynge's China book, it seems that the gap between America's rich and poor is widening, and the middle class is shrinking. Save and invest while you can.

Buffett is also enlightening on the future of newspapers in the electronic age, and the occasional bargains to be had in insurance. His firm has made money out of carefully-considered reinsurance (including for Lloyds of London) and derivatives. Berkshire Hathaway has gradually moved from being a "growth" to a "value" business, delivering returns increasingly from income earned, and insurance business helps. BH has made a profit from "super-cat" insurance in the past year, but Buffett warns that Hurricane Katrina wasn't the last nor the worst possible.

Note also the warning in the extract about the dollar. Recent falls aren't the end of the necessary decline - see to the Levy report referred to in my previous post.

Global imbalances: new report

Please click here for the July report from the Levy Economics Institute: "Global imbalances: prospects for the U.S. and world economies".