Is There a Way Out of the Monetary and Fiscal Cul-de-Sac?


The background to this year’s central bankers‘ gathering in Jackson Hole is a grim reality: Policies of unprecedented fiscal and monetary super-stimulus have not uplifted the real economy. Instead, they undermine and put in question sovereign credit. Is it conceivable that a “Hamiltonian reflex” will emerge in the USA? Can fiscal and monetary consolidation converge with a productive alignment towards the economic dynamic in Asia and Latin America?

by Michael Liebig

When I read the August 23, 2010 edition of the Frankfurter Allgemeine Zeitung, I was startled. In his “weekly report on financial markets,” Gerald Braunberger wrote that the Federal Reserve’s holdings of US public debt amounted to “$4.500 billion”[i]. I had thought the number would be “merely” $1000 billion. I looked up the Fed’s balance sheet[ii] , but the numbers there didn’t help clarifying the issue. Braunberger is a respected journalist who has gained a solid reputation through his articles and comments on the financial crisis. If he had made a mistake with respect to the “$4.500 billion” figure or a printing error had occurred, the FAZ would have published a correction – but I didn’t see one.

On August 24, the online edition of the FAZ carried an interview with Thorsten Schulte – in my view one of Germany’s best financial analysts[iii]. Schulte said after the 2003-07 Greenspan reflation, we now have “the great reflation 2.0”. Is there possibly a connection to Braunberger’s eerie “$4.500 billion” figure? In his August 14 newsletter Silberjunge, Schulte had pointed to the “revision” of official US statistical data concerning the savings rate: 6.2% compared to the previous figure of 4% – annualized the difference adds up to $264 billion. Wondering whether this statistical “revision” might have to do something with real size of US public debt, Schulte made the following calculation:

From January to May 2010 (that was the time we had the “Greece/Euro Crisis”), the volume of US Treasuries in circulation increased by $656 billion. Foreigners bought $272 billion. That leaves a gap of $384 billion. With a savings rate of 4%, $170 billion could have been bought by American investors, and with a savings rate of 6.2% $270 billion. Still, there is gap of $214 billion or $114 billion – assuming that all US savings went into Treasuries. Strange, indeed. Who bought the rest?

At its August 10 meeting, the Fed’s “Federal Open Market Committee” (FOMC) announced that it will not terminate its “quantitative easing” (QE) policy. That means that the Fed will officially resume buying US Treasuries. The FAZ on August 26 reported that the Fed “will buy Treasuries in the order of $400 billion in the coming 12 months” – roughly a third of the US budget deficit for fiscal year 2011.

The Great Contradiction (and what looms behind it)

At the August 10 FOMC meeting there was one dissenting voice among the Fed governors, Thomas Hoenig, the Governor of the Kansas City Federal Reserve. Hoening was the only Fed governor to criticize Alan Greenspan, when the latter was still idolized as the supreme “magician” of monetary and financial affairs. On August 13, Hoenig gave a speech in Lincoln, Nebraska[iv]. He didn’t mention the QE issue, but noted that the big banks get “free money” – at zero interest – from the Fed which they are “lending back to the government through securities [Treasuries] purchases” – and “are earning a guaranteed return”. No wonder, “the market wants zero interest rates to continue forever,” said Hoenig. Then he presented a few sobering data. Between 1991 and 2008 – under the reign of Alan Greenspan and Ben Bernanke – real US interest rates (interest minus inflation) were around 1% on average. During this time span:

  • Gross federal debt increased from 60% to 75 % of GDP (in 2008)
  • Consumer debt increased from 63% to 94% of GDP
  • “The U.S. increased its debt to the rest of the world dramatically from 4.87% to 24.32% of GDP.”

Hoenig’s numbers stop in 2008. But it’s then that the explosive growth of US public really took off, while the Fed cut the real interest rate to “minus 1 %”. In fiscal year 2010, the budget deficit was officially $1.47 trillion or 10% of GDP; total federal debt reaching $13.7 trillion. In 2011, US federal debt will be more than 100% of GDP.

The explosion of US public debt, along with zero interest rates and QE, was rationalized as the only way to “stimulate” the US economy out of the financial and economic crisis. What is the result of this unprecedentedly strong monetary and fiscal stimulus policy? Unemployment has remained at 9.5% (officially), investment in capital goods is low, the housing market depressed and consumer spending restrained. “We see a weak economy. We see a fragile economy that is growing at a slower pace,” said Martin Feldstein of the “President’s Economic Recovery Advisory Board” in an Aug. 27 bloomberg interview.

In spite of the Fed’s QE and zero interest policies and the giant expansion of public debt, the American economy is stagnating. Yet, the Fed and the Obama administration are determined not only to continue these policies, but to do more of the same. The Fed “is prepared to provide additional monetary accommodation through unconventional measures if it proves necessary,” said Fed chief Ben Bernanke.

The statements of Feldstein and Bernanke were made at the annual gathering of central bankers and academics in Jackson Hole, Wyoming, hosted by Hoenig’s Kansas City Federal Reserve. And the paradox of fiscal and monetary “super stimulation” and stagnation of the real economy is background to the Jackson Hole meeting. But behind this contradiction, another issue is looming: the very credit of the United States.

Weber, Rajan & White

We don’t know what was really discussed at the Jackson Hole gathering; we only know the speeches and other public pronouncements. But it is not difficult to figure out that there were profound policy disagreements.

It’s generally known that the Head of the German Bundesbank, Axel Weber, is opposing both the Fed’s zero interest/QE policy and the Obama’s administration’s “public debt stimulates growth” policy – even though he won’t say so in public. But Weber made his position clear when he broke ranks with the ECB Governing Council and opposed its position to buy (European) government bonds last May at the height of the Greece/Euro crisis.

Another critic of US monetary and economic policy is Raghuram Rajan, an Indian-born economics professor at the University of Chicago (and economic adviser to Indian Prime Minister Manmohan Singh). When Rajan was IMF chief economist 2003-06, he publicly criticized Greenspan.

In the July 28, 2010 Financial Times, Rajan published an editorial titled, “Bernanke must end era of ultra-low rates”, arguing that the Fed is repeating the “same monetary policies that led to disaster” in 2007-08. Rajan puts in question that there is a causal connection between zero interest/QE policies and the stimulation of the real economy. Instead, he argues that the US must improve the “quality of its financial sector, its physical infrastructure, as well as its human capital, all need serious, and politically difficult, upgrades.”

Rajan is not talking about a threat to the credit of the United States through exploding public debt and zero interest/QE policies. William White is a bit more explicit. The Canadian was the chief economist of the Bank for International Settlements (BIS) in Basel until 2008. Like Rajan, he was a critic of Greenspan. Now he works for the OECD in Paris.

In an August 25, 2010 interview with the German Manager Magazin, White said: “The US is not facing a classical state bankruptcy.” But, “of course the currency can be devalued. Then, a part of the debt is gone. Inflation and [currency] devaluation would devalue the debt in real terms.” and, “if creditors, particularly Asian central banks and state funds, would at some point refrain from buying Treasuries at previous levels, the Fed might jump in.” The latter meaning full-throttle QE.

Staying in the subjunctive, White continued: “If the USA lost its reputation as a first-class debtor, if the dollar lost its role as global reserve currency, if the liquidity programs, which keep interest rates low and bond markets booming, pump up the next big bubble,” then the consequences would be “gigantic” and lead to a “global tremor”. I guess, one cannot expect an establishment economist to get more explicit. But White’s conclusion is without ambiguity: “The USA should submit a long-term, credible and verifiable exit plan. The USA won’t be spared telling the world how they intend to deal with the explosion of their public debt.”

US Public Debt: More Oddities

Indeed, sooner than later the willingness of investors to finance the US public debt will erode. Maybe that is already happening.

Both Schulte and Braunberger found some oddities in the positions of the foreign owners of US treasury securities: Britain – including the various British off shore financial centers – increased its holdings of US Treasuries from $180 billion to $350 billion during the first half of 2010 – a near doubling in six months. Also puzzling is that China reduced it holdings of US treasuries by $96 billion during the past 12 months, while Japan increased holdings by almost the same amount. And, Hong Kong – the former British colony, now a special administrative zone within China – increased its holdings of Treasuries from $45 to $145 billion within a year. Also puzzling is that Brazil – owning $161 billion in US Treasuries – has become the 4th biggest creditor of the USA – after China, Japan and Britain and well well ahead of Russia or Germany.

It’s currently impossible to figure out what exactly stands behind these strange shifts in the foreign holdings of US treasuries. But the assumption seems not far-fetched that there are special “arrangements” between the Fed and foreign actors to “sex up” the international standing of US treasuries. And it seems not inconceivable that the Fed is engaging in QE operations far beyond what is publicly admitted. Here we are back to Braunberger’s “$4.500 billion” number.

We Do We Go From Here?

In November there will be mid-term elections in America. It’s difficult to imagine that the social and economic condition in the USA will improve in the meantime. It seems certain that President Obama’s Democratic Party will loose its majority on the House of Representatives and suffer severe losses in the Senate as well. Most likely, Obama will be a “lame duck” president thereafter – at least what concerns fiscal and economic policy.

After November, I think, the United States will enter a painful era of austerity. American public opinion will finally realize that the credit of United States is at stake. The federal budget and new borrowing will be cut down. Last week, I talked to a source in NATO, who told me that the US defense budget will be cut by 25%. I was skeptical, but the source assured me that his information was reliable.

When the United States were de-facto bankrupt in 1791, then-Treasury Secretary Alexander Hamilton insisted that further time buying through political, financial and fiscal tricks were out of question. He said so in his Report on Public Credit: “States, like individuals, who observe their [financial] engagements, are trusted and respected while the reverse is the fate of those, who pursue an opposite conduct.” Hamilton made sure that USA paid the interest and principal of its debt – even to the erstwhile enemy Britain. Over time, the US public debt was consolidated and scaled down, but that was only possible because the sovereign credit of the USA was preserved. Treasury Secretary Hamilton also wrote the Report on Manufactures, giving the state the task to promote infrastructure development and science and technology. Is it possible that we might see an “Hamiltonian reflex” in United States in the next couple of years?

The consolidation of public debt in the USA and the “West” generally should be possible – provided there is a productive link-up with the emerging powers. Remember the “decoupling” debate in 2008? Over the past two years, this issue has been settled. Now it’s for the West to “re-couple” with the economic growth dynamic in Asia, Latin America and maybe Africa. As Schulte told the FAZ, China, India, Brazil and Russia “had a private consumption in 2002 which was merely 14% of what Americans consumed. Since, this this figure has increased to 30%. But let’s keep things in perspective: Today, the private consumption of 2.825 billion people has reached just 30% of what 307 million Americans consume.” Whatever short-term ruptures may occur, the structural growth potential of the world economy should be obvious.

Further articles by Michael Liebig can be found here.


Die Kommentarfunktion für diesen Beitrag wurde beendet.