Sunday, June 27, 2010

Uncle Sam Should Tap his Credit Line

[This post first appeared on Seeking Alpha.]

Alan Mulally is credited with saving Ford Motor Company by borrowing as much as he could – $23 billion – in 2006, before the credit crunch hit other US businesses, to fund a major turn-around of the company's business. Uncle Sam needs to take a page from Mr. Mulally's book.

Because our private borrowers cannot absorb all the risk-averse capital our massive trade deficit brings in, the Treasury has an opportunity to borrow long-term at rates that seem ridiculously low in light of our national debt and continuing deficits. The money is just lying there. All the Treasury has to do is pick it up.

The biggest obstacle to this tactic is the skepticism of Republicans and their supporters, skepticism that is not entirely unwarranted (even if to some extent disingenuous) but is in any event ill-timed. Waste has been the hallmark of Congressional spending over the years, and conservatives do not want to give the liberal Congress another nickel to waste. But I think we need to think long and hard before passing up an opportunity this good.

Let me make clear that I'm not advocating purely Keynesian deficit spending, at least not as I use the term "deficit." I am advocating issuing a ton of long-term notes and bonds. The use is a separate matter, although I've got some thoughts on that, too. I am proposing three uses of the funds, only one of which is spending of any sort, and that's on investments that add more value to our national balance sheet than they cost.

Extend Maturities.

Low-rate, short-term debt is riskier to issue than low-rate, long-term debt. Short-term debt has to be rolled over and can become high-rate short-term debt if the market refuses to roll it over and the Fed is not willing or able to buy it. If we can get out of this recession, the Fed will want to raise short-term rates in order to prevent the economy from overheating. Hopefully, depression-expert Bernanke will show more restraint than Marriner Eccles did in 1936, but at some point, the Fed must tighten, and when that happens, the Treasury should not be caught with a ton of T-bills to roll over.

There are about $2 trillion in T-Bills now outstanding. So, every 1% increase in the T-Bill rate adds $20 billion to the deficit. The increase in pay-out seems inflationary even as the increased cost of borrowing is anti-inflationary. 5-6% is not an unusual T-Bill yield when the Fed is tightening. That's $100 billion in additional deficit relative to today just to service T-Bills, if we still have $2 trillion outstanding.

If the need to roll over a large amount of bills will hamper the Fed's efforts to slow the economy when it needs to be slowed, one of the best things that we could do with long-term borrowing would be to retire a significant amount of short-term debt, even at the 3-4% difference in interest that would apply right now. And long-term debt can be "repaid" in part by inflation.

Inflating away the debt is a time-honored strategy. See Aizenman and Marion, "Using inflation to erode the US public debt," 2009.) As this table (Joshua Aizenman and Nancy P. Marion © shows, the US has, until recently, matched the maturity of its debt to the magnitude of its debt: the more we owe, the longer-term we have borrowed, and the more inflation has done to repay it.


With our public debt now approaching 90% of GDP, history suggests that we should be at an average maturity of 100 months or so, not the 50 months currently applicable. Whether we can issue enough long-term debt at reasonable rates remains to be seen, but we can certainly issue more than we have, and we should at least be working our way out the maturity curve as far as we can go. I should add that inflation only works to devalue debt to the extent that inflation is not priced into the bonds in the first place. Only when the real rate of return on the debt is below the nominal growth rate of GDP does inflation actually hurt the investor. But there are times when the market under-prices long-term debt, and when that happens, issuers should move quickly to exploit the arbitrage maturities.

Get Rid of Tips.

As of November, 2009, the Treasury had issued $550 Billion worth of Treasury Inflation-Protected bonds, a/k/a "TIPs," perhaps the dumbest idea anyone in government has ever had. That's about 8% of the outstanding Treasury debt. What, really, were they thinking when they came up with this monster? How are we ever going to inflate our way out of debt that is inflation-protected? (I know what they were thinking – a low coupon in a period of low-inflation.) But still. What hubris to think we would never need to monetize our debt, when our very willingness to issue this financial accelerant shouts from the rooftop that we haven't the brains or will-power to escape that fate.

TIPs put us in the same bind as short-term bills, because, from an economic perspective, that's what they are. Instead of having to roll them over at a rate set by the Fed and/or the market, Uncle Sam has to roll them over at a rate set by the CPI. Either way, the rate is out of the Government's control. (I assume – but cannot say with authority – that the nominal maturity of TIPs is reflected in the table above, which distorts the maturity upward without providing an enhanced opportunity for monetization. The table should be constructed either without reference to TIPs or with TIPS treated as having a maturity of zero months.)

So long as raising interest rates depresses inflation, then TIPs aren't a problem. But, if raising short-term rates proves inflationary because so much of our debt is short term, TIPs will only make matters worse. Thus, along with taking advantage of current low long-term rates to move the nation's debt out the yield curve, the Treasury should buy back TIPs (and stop issuing them) so that when the time comes to raise short-term rates, the Fed will actually have the flexibility to do so.

Upgrade the Infrastructure.

Not all of the money borrowed should be used to replace existing debt. After all, re-funding debt requires no new money, so it shouldn't put much of a dent in the demand for Treasury paper. The whole point of the exercise is to borrow as much new money as possible at these low rates. That new money should be put to work putting people to work – on rebuilding our obsolete and decrepit infrastructure. Roads, bridges, aqueducts, power grid, high-speed rail, air-traffic control, alternative energy all need attention.

With so many unemployed workers, especially in construction, infrastructure projects are the perfect Keynesian antidote to what ails us. We just need the smarts to use long-term borrowing now (when the money is cheap) to fund the work, even the longer-term projects that won't be done until later.

And we need to get cracking, because Medicare is preparing to swallow all of our cash as fast as we can print it. Indeed, one of the best things we can do for our infrastructure would be to upgrade our healthcare delivery systems in advance of the coming crunch. But more about unfunded obligations later. For now, our leaders need to recognize that the infrastructure needs work, and our workers need work. And money is cheap, so if not now, when?

Saturday, June 12, 2010

Let’s Review

[A slightly edited version of this post can be found on Seeking Alpha.]

Much of this blog has been devoted to macroeconomics – the financial mess and the subsequent recession. The material sea-change change that accounts for these events, I believe, is globalization, the result of ocean-shrinking technologies. Here is a more unified narrative of how we got where we are and what we ought to do next.

The Trade Deficit.

Americans started losing jobs to imports some time ago, but the decline really accelerated with the advent of capitalism in Communist China. That country’s governmental “technology” seems to have evolved from a totalitarian state to an authoritarian one. There is no more political freedom than before, but there does seem to be some de facto democracy, in that leaders are subject to internal criticism based on the results they achieve as perceived by constituents.

Be that as it may, the ability to export to the US and Europe has made capitalism a viable approach to Chinese development. Absent those mature consumer markets, it would have been impossible for China to develop a manufacturing base, as they would not have had the customers for the scale of production that would make the capital investment worth the trouble. But once globalizing technology made capital investment in manufacturing worth doing, and the bosses figured out that there was a political payoff in prosperity, the genie was able to escape the bottle.

International trade is based on comparative advantage. The shrinking of the oceans has given China has a comparative advantage in labor-intensive manufacturing of goods even with the added cost of shipping them here. We in turn have a comparative advantage in capital-intensive manufacturing delivered to China. Consequently, they sell us labor-intensive goods, and we sell them capital-intensive ones.

But our demand for Chinese labor-intensive goods is greater than China’s demand for American capital-intensive ones, and we run a major trade deficit with China as a result. Why do the Chinese tolerate this imbalance? Why don’t they sell somewhere else? The reason, I think, is that the US has a comparative advantage in the distribution of consumer goods. Even with the improvements in China’s physical infrastructure, their consumer is not yet as willing and able as ours to absorb their goods. We are better at distributing goods, relative to producing them, than they are, so they make the goods and we distribute them.

Of course, the goods-for-distribution trade is inherently imbalanced. If a TV costs $100 to make and $100 to distribute here, then, in terms of international trade, it’s as if American consumers are paying $200 to the Chinese for the TV and the Chinese are paying $100 to Americans for distribution services. No matter how much the distribution costs, the amount going to China exceeds by $100 the amount “coming” to the US . The result is a soaring trade deficit with China and a loss of labor-intensive manufacturing jobs here. Defenders of free trade say that such dislocations are only temporary, that the system adjusts to create good jobs in some other industry in which we have a comparative advantage. It’s just not clear what those are or how quickly they will arise. And in the long run, as the man said, we’re all dead.

And then, of course, there’s oil. Thanks, maybe, to Three-Mile Island, and to our domestic oil industry’s political clout, and our stubborn refusal to do what’s best for us, we cannot get off of foreign oil. If we got as much of our energy from nuclear energy as France, we would not be drilling in the deep water off our coasts. But we are. More to the point, we also have a significant trade deficit with oil producers. The deficit has been cooled by the recession, but the subject today is what caused the recession, not what the recession caused.

The Repatriation Challenge

The trade deficit sends dollars abroad. What are our trading partners to do with them? International trade can be conducted in dollars, so some of the dollars stay off-shore, which is fine with us; we can always print more. But a lot of the money we send abroad is reinvested here. And the larger the outstanding balance grows, the more important those dollars become as a source of capital for US users, and the less so are the traditional sources of capital, domestic banks.

This change in the source of investment capital has changed how money moves in the US. Instead of the proceeds of consumer sales finding their way to local banks and then back out as local bank loans, the money goes abroad and comes back through Wall Street to buy securities backed by the loans that the local banks make. This shift makes retail bankers into loan brokers, whose interest is not in the quality of the loan but in the price it will fetch in the secondary market. That price is a function of the rating on the securities and the demand for securities of any given rating. And the demand is based on the growing reserves held by our trading partners and their appetite for risk.

Foreign holders of US reserves are more homogeneous than the investment public at large; they want very safe paper, and so it has become Wall Street’s job to it or make it. The demand for highly-rated paper was formalized in the Basel II accords, which prescribed capital requirements for banks that have been adopted in several places, including the European Community. Under those standards, a bank needs much less capital to invest in AAA-rated paper than in anything else, so the demand for such paper soared, perhaps beyond what the otherwise applicable risk tolerance would have permitted. The aggregate effect of these changes was tremendous pressure on Wall Street to generate AAA-rated paper.

But there is just so much AAA-quality credit. That problem can be cured in two ways. One way is to pretend that bad risks are good ones. Under the “issuer-pays” business model followed by ratings agencies, that proved surprisingly easy for investment bankers to persuade the agencies to do. But in order to do that, there had to be some investment that could at least ostensibly support that rating. Enter the subprime mortgage. Originated by someone with no stake in their performance and sold by investment banks with no stake in their performance, but bearing AAA-ratings (at least some tranches), these securities poured out of Wall Street to feed the maw of our trading partners’ Basel II-ized banks.

The other way to increase the supply of AAA-rated paper is to invent it from whole cloth. In 2000, Congress passed the Commodities Futures Modernization Act of 2000, which essentially allowed investment banks to make book on the performance of existing securities. A bet that an AAA-rated security will perform can be as safe as the security itself. These derivative securities – another new technology – made possible the processing of virtually unlimited amounts of money, in part because big U.S. institutions like AIG acted as counterparties on the risk.

In the search for people to blame, regulators early on identified the risky bets made by investment bankers with little capital. These bets certainly contributed to the collapse, but the dollars did have to be repatriated, and, in the financial world, leverage is bandwidth: without it, the volume of business that can be transacted could not have kept up with the demand for highly-rated paper. Recent history suggests, however, that if the investment banks had “just said no” to exceeding reasonable leverage requirements, the foreign money would simply have gone into Treasuries, as it does now. Our trading partners really, really don’t want to stop selling to us.

Moral Hazard

TARP and the other so-called “bail-outs” are said to raise issues of moral hazard – the possibility that financiers will continue to take large risks because they know Uncle Sam will bail them out. But the real moral hazard is the one that did us in originally.

In its most general version, moral hazard is the risk that a party to a bet will act so as to change the odds. The notion is usually applied to insurance, where insured people tend to take greater risks because the damage will not fall on them, but the idea applies as well to any immunity to consequence, e.g., politically mandated bail-outs, and it applies to any bet that can be rigged.

Every sports fan knows that when serious money is bet on an event, the temptation to fix the event becomes very strong. This blog started with a rant about Credit Default Swaps issued to speculators, who then worked to bring down the subject credits. That they did, and the cards fell, and the trouble began. Fortunes were lost, spending fell, credit froze up, and recession set in. The Congress is still working on financial regulation legislation, but it is not likely that it will go as far as is necessary to get rid of that sort of betting.

The moral hazard created by naked short-side bets was a major factor in the recent financial upheaval. I find it sadly ironic, then, that the solution to the problem – TARP – is so often criticized for creating moral hazard.To create a total collapse of our financial system, the taxpayer had to bail out failing banks and insurance companies, and, to the consternation of the torch and pitchfork crowd, their politically unworthy counterparties. The payments to the counterparties were somehow taken by demagogues as proof that the bail-outs were unnecessary or, at least, unnecessarily generous. But the bail-outs could only have succeeded as bailouts if they stopped all the dominoes from falling.

Carpe Diem

As Rahm Emanuel is said to have said, a crisis is a terrible thing to waste. The amount of money going abroad has declined by reason of the recession, but the US is still running a large trade deficit, and money is still coming here looking for a home. But now, with the ratings agencies credibility gone and the “AAA-rated” brand destroyed, the only AAA-credit that anyone trusts is Uncle Sam’s. Thus, despite a spiraling Federal deficit, foreign banks and American savers are lending money to the Federal government at historically low interest rates.

This change in financial appetites should not be wasted. The government should seize the opportunity to undertake massive public works projects, putting people to work using funds borrowed now (and not later, when the permits are granted and environmental impact statements are done, and interest rates have risen in anticipation of the work starting). This opportunity to upgrade our infrastructure may not come again. I don’t for a minute believe that such projects can be sold on the rational basis that exists for doing them. But I have infinite faith in our politicians’ ability to find some other reason to do what material conditions demand be done. By the middle of 2011, it will be clear to President Obama that the jobs lost to cheap labor are not coming back.

Lowering taxes will not help. That’s a supply-side solution, and the only problem with supply is that we cannot compete with China, for reasons that cannot be fixed by lowering our taxes. Obviously, reducing business taxes would make us less uncompetitive, and that might be part of a strategy we could use, but the real problem is that globalization has put the comparative advantage in labor-intensive goods across the shrunken oceans, and nothing we can do in the way of domestic incentives can fix that. All we can do is replace the ocean moat with tariff walls. I really think we should do that. Let China grow its domestic markets to where its employees live as well as ours. Then we can get rid of the tariffs and compete on quality.

Thursday, June 3, 2010

Pretext and the Middle East

Can you name one person who’s opinion of Israel was changed by a careful review of the recent boarding incident? I can’t. The purpose of the attempt to run the Gaza blockade was to embarrass Israel – to give people who hate Israel a media window to lie some more, and to give people who would like to hate Israel an opportunity to pretend they know something now that they did not know before. But no one who knows the Middle East believes for a minute that the people on the Mavi Marmara were seeking anything other than a violent confrontation that would end in the deaths of people who could be colored as humanitarians.

The mission was a success, just as 9/11 was a success. The media, including the American media, so famously controlled by "The Jews," are falling all over themselves to condemn the Israeli action. Some are unsympathetic to the blockade, but that’s a separate matter. The facts of this event are still the facts of this event.

I have no problem, by the way, with the tactics the anti-Israeli forces are using; they are at war and are no more obliged to be truthful than any other combatants. But I can criticize the media for allowing the tactic to work. This account by Israel’s ambassador to the US, albeit obviously written by an advocate, just sounds more credible to me than the rantings of Israel’s enemies, not because of the evidence adduced – evidence can always be planted – but because this is how asymmetrical war is fought.

I keep thinking of Lenin’s remark about how the capitalists would sell the Soviets the rope they would use to hang us. I wonder if Osama hasn’t said something similar about ink and the Jews.