Trillions Spent with Nothing to Show but a Huge Debt

* In Friday’s piece, I presented my thesis as to why I think the end-game for the economy is a continuation of the great recession/depression of 2008-2009 as the government’s stimulus programs end over the next 18 months.  In response to that piece, I had an exchange with a reader which I would like to share with you. While I have a strong opinion on how I see this story ending, I would like to be proven wrong, and remain open to conflicting opinions and viewpoints:


Reader: “Of course various long-term deficit reduction proposals are contractionary! (in the same way as running larger deficits is stimulatory). The point is that the contractionary policy would be implemented over time after an expansion takes hold.  Austerity measures would be spread out smoothly, and trim growth over time. If we can’t get any growth in the interim, then the problems are pretty insoluble w/o acute pain.”


Rick: “I think it is remarkable how big our deficits are with such an anemic response to date, and the effects of cutting back on fiscal spending, at least a good part of the cut-backs will certainly throw the economy back into the sewer. I do not think we have enough capital to buy our way out of this hole, and eventually the government will run into funding issues, with rising high real rates of interest, unless the fed systematically monetizes the debt. The Fed says they will not do so, which brings me back to the depression scenario. With the current level of shadow housing inventory and upside down mortgages, as well the high level of unemployment, any further economic contraction will bring us to depression type levels of unemployment. From there other bad stuff will follow, and the great rally in non-agency MBS will prove to be a bad dream…


Reader: “It’s not an anemic response!!   The path absent this would like have been a pronounced downward spiral leading to depression. I can’t prove that but the shock of the financial crisis was probably larger than those precipitating the great depression.


(The economic recovery) isn’t great, but this is what success looks like.  In essence we over-consumed for years.  So we have to under-consume later.  If the transition is sharp, negative feedback takes over and you slide into a depression. If the transition is smoothed by countercyclical policy, then you get a long period of weak growth plus a drag on growth from fiscal retrenchment. The latter is the scenario we face.”


Rick: “I know, but tell me, if you are throwing a trillion and a half at a problem per year, and we are halfway through a 3 year deficit binge with a total debt increase of 4.5 Trillion (expected by fiscal year end 2011), don’t you think there’d be more to show for it? Is the money being miss-spent? I think so! And there are things they are not doing, like encouraging domestic jobs, aka – solar, green etc… Most solar panels are made off-shore – perhaps we should figure out a way to make that a domestic industry, for instance. Add onto that $1.7 trillion of Fed money printing to help keep rates down. If this was 1997, GDP would be up 20% a year, unemployment would be below zero, and the world’s immigrants would be setting up shop in the desserts of California. I agree that all this is saving us from the short term likelihood of a depression, in exchange for a fiscally challenging depression when we cannot borrow ourselves out of the hole, because the budget deficit will be what forces us into the depression. It has the potential to become really bad, with civil dis-obedience and all the ugly sort of stuff a depression brings with it. I am not looking forward to it. In fact, I spend much of my free thinking time, trying to figure out if there is a better way out of what I see as a horrific end-game. I do not. But I do persist in writing, hoping to discover a better outcome.


The difference between now and the 1930s is that the government did very little in the early 30s, banks folded left and right, unemployment got to 25%, and I even believe the fed tightened. If you agree that the US government cannot run 1.5 trillion deficits forever, then the economic let-down from such will bring the economy back to its natural resting place, which is going to be a problem. We are forsaking pain now, and are giving up flexibility in the future to run strategic deficits. The deficits are being poorly spent, and are not in ways to create new industries, and provide a sustainable source of future jobs.”


Reader: “I obviously respect your concerns. But I think they are overdone and reflect hidden assumptions.  One idea is that the public sector allocates resources much less efficiently than the private sector.  America’s university system (one of the most socialized parts of the economy) is one of the only sectors in which we remain world-leading.  The Internet was created by DARPA I believe.


The private sector by contrast allocated an undue amount of capital to residential and commercial real-estate.  I’m not taking a strong stand here but worshipping private sector capital allocations is an anachronism.


There is very little evidence that the exact composition of spending makes much macroeconomic difference.  It is obviously better to build a “bridge to somewhere” than a “bridge to nowhere”, but either way you are employing people and increasing spending.  WW2 spending represented the ultimate bridge to nowhere — building tanks, ships and munitions with no peacetime application — most was never used, and was stockpiled and eventually scrapped. It was necessary though, and decisively lifted the US out of depression.


On macro, the useful economists are neo-Keynesians.  The neo-classical guys cannot explain even simple phenomena like the non-neutrality of money.  Krugman is very competent on macro, as this February 4th editorial in the NY Times suggests.”


I read the Krugman article, and my synopsis is this:


1>  The current hysteria about the deficits is more political posturing by the Republicans than anything else;


2>  Ten years out, the interest on the Federal debt will only  be 3.5%, about the same as when Bush was President, according to Obama’s budget;


3>  The government should be doing more to create jobs, and in fact, Krugman believes that greater deficit spending is in order to achieve that end;


4>   The fact that the US government can easily finance its debt at relatively low interest rates, is testimony to the fact that the deficits and the debt is not a problem.


Let me address some of Krugman’s points:


1>  I agree that the Republicans have become modern day Cassandra’s, and will do anything to get the public to think the Democrats are flushing our future away;


2>  When Krugman embraces Obama’s budget projections as gospel, this is where I diverge from believing what is to come. As I stated earlier in my dialogue, I do not like the types of deficits we are running, ie – building bridges to nowhere, as opposed to a meaningful strategy to develop new industries within US borders;


3>  Much of the stimulus package is going to state and local governments to keep municipal employees, including teachers on the payroll. Obama calls this saving jobs. While that might be the case, the bottom line is that state and local governments need to down-size their staffs in an orderly fashion. I do not think it is a good long term plan to rely on a permanent $200 billion going to the states and municipalities, from the Federal government, just because.


An interesting case study is developing across the country as it pertains to states and municipalities dealing with their budget crises. Vallejo California, a city just north ofSan Francisco, recently filed for bankruptcy. According to bankruptcy law, this invalidates all contracts the city has with its unions. Instead of trying to cut back on pensions and benefits which the city is paying its unionized employees, it is leaving the police department largely untouched. As a consequence, it is sacrificing much in the quality of life for this modest sized city. How stupid is that? On the other hand, you have newly elected Governor Christie of New Jersey, who is taking on the teachers union, to get them to go along with paying a modest 1.5% of their health care costs, the same as other state employees. Instead, the teachers union wants the state to raise the top tax rate from 8.9% to 10.5%. There is a great piece on Governor Christie in this weekend’s WSJ editorial section. The bottom line is that there is much which needs to be done on the state and local level to manage their expenditures. There are ways for these entities to balance their budgets without firing everyone. Yet Obama is giving the states the cover to maintain bloated budgets by virtue of the stimulus package subsidies. This will not continue indefinitely.


In my opinion, this reader, Krugman and many other economists do not appreciate the dire consequences of the severe deflationary headwinds which will continue to buffet the country for the next few years. 


Or perhaps, they do, and the only solution in his playbook is to just spend money. This is where I come away with the idea that it is imperative for us to finance the development of new domestic industries. Other than subsidies which will encourage solar manufacturing in the states, I also like T Boone Picken’s idea to make it required that truckers use the plentiful supply of domestic natural gas, instead of gas. Aside from cutting back on a big chunk of our oil imports down, this will create jobs as we build an infrastructure to accommodate the distribution of natural gas for auto use. I am not an expert on any of these topics, but I like the idea that our stupidly high deficit should be spent to create new domestic industries. This will go a long way to starting to create new jobs, as opposed to encouraging excessive spending within broken systems which need to be fixed.


One last comment about the debt markets not having a problem with financing the government deficit. We just ended a 15 month period during which the Federal Reserve bought $1.725 trillion of government debt, with a total duration of approximately $7.5 trillion. That is an unprecedented buying program. As the Fed’s program has just ended, many market participants have placed massive bets that domestic interest rates (treasury and agency MBS) rates will rise sharply. Given the prevalence of these short positions, my best guess is that interest rates will fall over the next couple of months, which is my way of being a contrarian, given the negative sentiment to the bond markets. In time however, I expect rates to rise, likely later this year, or into 2011.


* Trading points – Stocks – Friday’s Goldman Sach’s SEC lawsuit kicked stocks off their perch. As I have been harping on over the last few weeks, the technical picture for stocks was becoming increasingly over extended, from a technical perspective. For instance, the Put Call ratio on stocks has gotten to its lowest level in 10 years, indicating that more people are buying calls than puts, in over 10 years. (There is a whole pile of other technical indicators which are bearish too, but I will not elaborate here). Consistent with the end to the bullish market seasonals, which are expected to end this month, I have been on alert for a market top. To that end, my real time trade recommendations (ask if you want to be on this distribution), went 50% short the market at 1210 on the S&P on Thursday, and 100% short around 1191 on Friday. The Goldman Sachs story is just a conveniently timed event which should result in a more significant correction beyond Friday’s action. I have been wrong about demanding that when the long awaited (bearish correction) will begin over the past couple of months, but this could be it. Apart from some long dated options, and un-leveraged short positions, most of my short positions are leveraged, with tightly controlled stop losses. Just a word of caution if you are following this recommendation.