Beyond Stiglitz - The Feds Biggest Bubble Yet - Government Debt

* Beyond Stiglitz – yesterday I presented the economic thesis of Joe Stiglitz, which he presented at the Cornell Club on Wednesday evening. Joe did a great job illustrating how we got to the current predicament in the economy, and had some good forward looking ideas on what can be done to help alleviate the current situation. However, Joe’s presentation seemed to stop short and was focused mostly on Keynesian type solutions, without dealing with the fine print of the dynamics of the monetary system, which supports the economy. In all fairness to Joe, he did not get into the monetary fine print, nor was he given time to answer about such. I will endeavor to extend the conversation into this realm, which I will forward to Joe, and see what he says or thinks about such.


One of Joe’s recommendations is for the government to enact a second stimulus program. In order not to spend money recklessly, he suggests that Congress make contingent appropriations, which will be triggered if the state and local governments are faced with having to lay-off public employees. For starters, I cannot imagine how such a bill, if passed, would not encourage local governments to direct part of their budget to non-personnel costs, if they knew there was a safety net available for them to cover the costs of their employees. It seems to me to be a sure thing that they will figure out ways to game the system, so their government receives as much Federal money as is possible, in the guise of saving jobs. So the concept of creating a contingency for state and local governments to receive aid would be good cover when they pass the bill, but would almost surely guarantee that the contingency would be used to its fullest extent. This scheme seems reminiscent of the GSE aid bill passed by Congress in the summer of 2008. As then Treasury Secretary, Hank Paulsen said at the time, let’s empower the government with a big gun, and hopefully we will not need to use it. When you do that, you give everyone the cover to pass the law without having to admit that they are actually spending any money. So far the GSE bill has cost the US government over $100 billion to date, unlimited losses through 2012, and up to another $275 billion after 2012. 


If you had told the Congress at the time that this is what the tab would be, I am sure there would have been a different sort of debate, and perhaps, a different sort of bill might have been passed. In fact the GSE bill which was passed allowed holders of subordinated debt to rely on the government to make them whole. I never ever understood why this was allowed to happen. And this also occured at this point in time when the government could have exacted a small price on the holders of not asset backed debt. Some ideas out there would have forced holders of debt to receive 10% of their debt back with a new class of equity, which would have stood above all other, with provisions for senior debt going forward to be backed by the US government. Of course, that did not happen, and the precedent for creating moral hazard took another step forward. As you can tell, I am dead against the way in which the GSE rescue was allowed to occur.


My point here is that passing a bill which involves contingent expenses for the state and local governments, virtually insures that these contingencies will be needed. I do not disagree with Stiglitz’s assessment that more stimulus is needed, in order to support the economy. In fact, Stiglitz pointed out that Christine Rhomer, who is the head of the Counsel of Economic Advisors, had asked for the government to pass a $1.2 trillion stimulus package, instead of the $787 billion package which was promoted by the administration, and ultimately passed.


My main point, and the question which I was not able to ask of the Joe Stiglitz on Wednesday, had to do with the viability of the US government continuing to run deficits in excess of 10% of the GDP, with the cumulative debt likely to exceed GDP in the next couple of years. The associated problem with the prospects of growing debt, has to do with the absolute level of interest rates. Last year, in support of its monetary policies, the Fed took about $7 trillion of duration out of the bond market. Regardless of where that money was invested, this is a vast amount of demand for the fixed income markets, and will not be repeated going forward. With the Federal government in the market with $2.5 trillion of debt sales each of the next couple of years, of which $1.5 trillion is new debt sales and $1 trillion represents roll-overs, there will be pressure for interest rates to trend higher. With the debt load expected to reach $14 trillion by next year, each 1% rise in the average interest rate will cost the US, and us, the taxpayers, $140 billion more a year. I will be the first to admit that it will take a while for the average interest rate on the government debt to rise, but once it starts to move, the impact on the ability of the US government to balance its budget will go down-hill, real fast. 


I feel as if the government is playing “chicken” with its debt management strategy. Of course, let’s consider what the Fed is doing with their purchase of $1.725 trillion of debt securities over the last 15 months. Some folks complain about the interest rate risk the Fed is taking. However, I would argue, that if the Fed never has to sell the securities they bought, or even pay interest on liabilities they might have taken on, then there is real interest rate risk to deal with. But since there is no cost to the Fed for printing money, and there is no imperative to retire the money they have printed, then on some level, there is no risk, except for the influence on the economy in the form of inflation, which printing money entails. The issue which Stiglitz did not address is: at what point in time does interest rates rise, with a possible funding crisis for the US? Faced with such a dilemma, does the Fed monetize another $1.5 trillion of debt? The Fed says they will not, but at some point in time, this might become an imperative of the US government. What say you on this Joe?


And this brings me to the “day of reckoning” at which time the US government will not be able to spend our way out of the hole it has dug. As I read between the lines of Stiglitz’s speech, I would think that he would take inflation, and money printing to counteract the devastating effects which a deflationary depression would otherwise engender. Listening to Stiglitz reminds me of the Keynesian bias which Paul Krugman engenders. Do we embrace the imperative to stabilize the economy, in exchange for a new normal which allows for a certain amount of inflation and money printing? This is reminiscent to what occured in the Weimer Republic in the years leading up to the great hyper-inflation of the early 1920s. In my opinion, we are playing chicken with the markets by our policies which will push our debt level above GDP. Unlike problems with the PIIGS, for which there are larger entities out there who can rescue them, no one country or consortium of countries is big enough to back-stop the US. Part of the reason why I have embraced gold and to a lesser extent, silver and natural resource stocks, is to have an insurance policy for the time when the day of this reckoning is upon us. 


The other question I had for Joe Stiglitz has to do with what path he thinks the Fed will follow, given a choice between fighting inflation, and printing money to support the government’s fiscal deficits. This also ties in with the government’s housing policy. The Federal government is desperately trying to stabilize housing prices, instead of allowing market forces to push pricing down by another 30%. Instead, what is happening, is that housing prices have stabilized for a short bit of time at a plateau. Meanwhile, a backlog of houses with upside down mortgages (the mortgage is worth more than the house), threatens to push housing prices down another significant notch. And since the CPI has a 42% contribution from housing, it is likely that a weakening housing market will mitigate for some time, whatever inflationary effect the grand monetary adventure the Fed is creating. In turn, this will give the Fed the cover to maintain an easy monetary policy, even if inflationary forces are pushing the other 57% of the CPI to higher levels. And depending on how well the government manages to stabilize housing prices, will have much to do with how much, or little inflation the CPI statistic will show. 


Stiglitz did briefly mention that he is concerned that the Fed could be fueling another bubble, which will eventually burst. He did not mention that the bubble the Fed is fueling is in the market for government and quasi government debt. Having spent $1.7 trillion and taken $7+ trillion dollars of duration out of the bond market over the last 15 months, this is the logical conclusion which I draw, and seems to dovetail Stiglitz’s comment about concern that the Fed is going to cause another bubble. And when the market for US treasury debt and quasi-government debt, such as the market for MBS, bursts, the idea that we have the resources to initiate another stimulus package becomes a moot point. This is the conundrum which I see on the horizon. I am going to send this off to Joe Stiglitz, and see what he says.