How (macro) economists support poor political governance

A “consensus” opinion among economists is that deflation is an evil greater than inflation. Unfortunately, this conventional wisdom has had a pernicious effect on economic policy in much the same way that the global warming “consensus” has distorted climate policy.

But it is no coincidence that in both instances, the main beneficiaries of the outcomes from the selected policies are the operatives of governments. In the case of climate change, governments support research that encourages them to expand their regulatory powers & their sources of tax revenues.

When it comes to inflation, gains to governments come from the fact that they tend to be the largest net debtor in any community. Inflation is advantageous to spendthrift politicians & bureaucrats in reducing the real value of debt repayments. & all the rest of us that save or lend to governments will have lower living standards.

Recently, governments have been aggressively “reflating” their respective economies with “stimulus” spending financed with public-sector deficits & rising debts. & most central banks pursued expansionary monetary policy or pushed interest rates down to historically-low levels. (In the US & Japan, these are at hysterically-low levels, close to zero!)

Economic froth & illusory growth from artificially-cheap credit & massive government spending makes politicians & central bankers leery of being blamed for ending the party. As such, it is tough for them to implement exit strategies that dampen spirits even though it is unlikely that such plans were ever concocted before they embarked on that path.

And so, it is very likely that public-sector spending orgies & artificially-cheap credit tend to lead to rising price levels. Well, there is one other option: sovereign default as Argentina has done several times & as Greece may be forced to undergo. With so much new public-sector debt to fund bail-outs & pay for deficit-financed spending amidst shrinking tax revenues, public-sector defaults seem inevitable in the future.

With falling price levels working against the interests of governments, public-sector officials have strong incentives to halt this process. Given the incentives that public officials face, it is no surprise that inflation occurs much more frequently, lasts longer & has destroyed more wealth than has deflation. With rising price levels working in favor of governments, public-sector officials have weaker incentives to halt this process that constitutes an invidious & destructive tax.

For its part, deflation has reared its ugly head in a few spectacular moments while also being blamed for problems not of its making. For example, the Great Depression is often cited as the worst-case scenario of a deflationary spiral. More recently, claiming that Japan’s economy is in the grips of deflation, the Bank of Japan has pursued a “zero-interest rate” policy along with inflating the money supply.

But considering deflation to be declining price levels, it may be the messenger rather than the cause of economic problems. & it may be the bearer of glad tidings when secular price declines occur due to rising productivity so that overall living standards rise.

It is instructive to note that prior to the Great Depression & the collapse of Japan’s economy in the late 1980s that asset prices overshot their long-term trend. As such, it would be natural for there to be widespread decrease in prices so that they could be realigned with economic fundamentals.

Unfortunately, policy makers in these two instances tried to prop up prices rather than allow the liquidation of ill-fated investments. In turn, it took longer for markets to shake off the impacts of “bubbles” so that economic pain was unnecessarily extended. As such, it is distressing that a similar set of policy choices were made in response to the recession that began in 2008.

It turns out that Japan’s government & central bank have spent almost 20 years tilting against the windmill of so-called deflation when they should probably have embraced it. As it is, demographics are trending in a way that should make deflation the preferred option for Japan’s citizens. With average age rising, an increasing number of retirees on fixed incomes are being supported by a smaller number of workers. As such, deflation will be increasingly advantageous for an increasing proportion of Japanese society.
Policy responses to the current economic conditions provide us with another opportunity to discover the impact of expanding the role of governments in the economy. In most instances, policies that allow deflation to run its course will lead to lower price levels & a lighter tax burden with less regulation. & policies that promote inflation will lead to rising price levels & a heavier tax burden with more regulation

This is all very disheartening. Government officials can be expected to follow a path that makes their lives easier while shifting enormous burdens to citizens & taxpayers. Meanwhile, Mainstream economists will queue up to support more government spending, higher taxes & increased regulations.

Adam Smith’s inspiration for Hayek’s view on “knowledge problem”

“The statesman, who should attempt to direct private people in what manner they ought to employ their capitals, would not only load himself with a most unnecessary attention, but assume an authority which could safely be trusted, not only to no single person, but to no council or senate whatever, & which would no-where be so dangerous as in the hands of a man who had folly & presumption enough to fancy himself fit to exercise it.”
~~Adam Smith~~

Fight to end exploitation! Up with the class struggle!

Karl Marx was wrong about a lot of things, but he was right (if for misguided reasons) about one thing: the history of man is about the struggle between classes.

Ironically, Marxian portrayal of the “class struggle” as one where the interests of workers are in conflict with those of capitalists allowed a new oligarchy to arise. Under the guise of democracy, a “ruling class” of politicians, bureaucrats & their cronies exploit the “productive class” of entrepreneurs, managers & workers.

This modern ruling class uses the tools of the state (violence & coercion) to maintain power & enriches itself as well as its supporters & employees at the expense of others. The productive class operates in the private sector & relies upon market processes (cooperation & exchange) to improve the lot of others while enriching themselves. It turns out that private-sector workers seeking jobs & paying taxes have more in common with factory owners & managers than they do with the ruling class.

As it is, the backgrounds of many politicians & policy advisors make them unaware of the sacrifices or risks involved in creating a private business & keeping it alive. Some may have inherited wealth or are professional politicians or technocrats that never engaged in entrepreneurial activities involving putting their own capital at risk.

For their part, bureaucrats tend to create a Procrustean nightmare where people must be fitted to rules rather than the reverse. Unable to understand how the stock of wealth of a community is created, they may see it as something that can be redistributed according to their whims. As such, they tend to be unaware & unconcerned about the negative effects of their impositions or intentions.

Left to their own devices & counsel, elected officials & bureaucrats seek new & endless ways to spend more taxpayers’ money. But they are never as imaginative or creative when it comes to finding ways to increase efficiency that saves money.

While the market may not spread gains from economic growth in an equitable manner, government involvement motivated by political opportunism can make matters worse. This is the likely outcome when taxes imposed to redistribute income discourage work, savings & investment.

It is important to understand that governments constitute the non-productive sector since they cannot create wealth nor can they create new jobs. The “best” that governments can do is redistribute income & wealth, but they usually do this badly due to inefficiency, waste or corruption.

Governments can provide an institutional infrastructure with incentives that allow the private sector to create & maintain wealth. As such, governments only play a passive & indirect rather than an active role in creating wealth.

It is also misleading to consider governments as being able to “create” jobs. As it is, governments can only provide an environment that encourages private firms to expand employment.

If governments add public-sector employees, they impose a larger tax burden on the private sector that is less able to offer new jobs. In all events, public-sector employees are a parasitic element of the ruling class that depend upon net additions to the tax pool that only come from private-sector contributions.

As it is, the ruling class of modern governments acts as a public-sector oligarchy that engages in the exploitation of productive citizens engaging in private-sector activities. Ending this insidious abuse requires lower tax rates & restraining the appetite of public officials to spend other people’s money.

The new bubble: public-sector bonds…?

As sure as mainstream macroeconomists failed to anticipate recent financial turmoil, their proposed remedies for “stimulus” will fail to solve problems they were unable to grasp. Likely failures of Keynesian-inspired spending aside, populists & politicos will eagerly grasp at intellectual straws that justify expanding the reach of government in our lives.

Despite this miserable situation, economists as a profession can claim one clear victory in the battle of ideas that has improved the lives of citizens. And this is that decades of teaching principles of economics has convinced citizens & policy makers that inflating the money supply is the fundamental cause behind increasing prices.

While a few “denialists” blame merchants or trade unionists or speculators, most voters know that governments and central banks are to blame for this scourge. Elected officials in countries with a semblance of democracy (excluding on both counts, Venezuela & Zimbabwe) fear being identified as the culprit for lower living standards. Even China’s leaders realize their grip on power depends on being able to dampen the impact and expectations of future price increases.

Well, that is the good news; now for the bad news.

The downside of this triumph is that governments that once destroyed value by inflating their currencies now destroy value by issuing excessive amounts of debt. This occurred Argentina in the late 1990s when profligate populists handcuffed domestic monetary policy to the dollar but borrowed & spent like there was no tomorrow.

Taxpayers and government officials view public-sector debt to be a less painful response to deficits rather then raising tax burdens on current income earners. This is a rational preference for current taxpayers that know that future taxpayers must cover interest-rate costs on currently-issued government debt.

And so new debt issued to combat yesterday’s financial turmoil is creating a new set of imbalances arising from excessive government debt-to-GDP ratios. With the US federal government’s $1.6 trillion deficit along with deficit spending in the 2011 budget, America’s public-sector debt-to-GDP ratio is expected to rise to 77%.

According to the IMF, the ratio of public-sector debt to GDP for the US government will increase to at least 85% by 2014. In turn, Moody’s has signaled that this would warrant a downgrade in the federal government’s bond ratings.

But the US is not alone, Germany’s ratio of public-sector debt to GDP is expected to hit 82%; France’s is put at 85 percent, Italy’s at 126% & Japan’s at 144%.

Such massive public-sector debts will increasingly “crowd out” private-sector borrowing. & it will also put a crimp on borrowing by local or state governments as well as governments of developing countries, a prospect that may not be all bad!

This latter point is borne out in the US given that commercial & industrial loans are down 18% over the past 12 months (even if cause & effect are not clear). While American commercial banks reduced their loan book by $350 billion or a bit more than 1/5 since early 2009, they purchased $300 billion of Treasury securities.

The IMF estimates that an increase of 10 percentage points in the debt-to-GDP ratio reduces long-term growth by a quarter of a percentage point. In turn, projected increases in debt ratios imply that long-term annual growth would drop by 0.6 percentage points in the euro zone, nearly one percentage point in the US & 1.3 percentage points in Japan.

Free market capitalism was resilient enough to shake off shocks like 9-11 as well as dot.com & other asset price bubbles. But its greatest test may be the coming public-sector bond bubble.

Tyranny & “good will”

“Of all tyrannies, a tyranny sincerely exercised for the good of its victims may be the most oppressive. It would be better to live under robber barons than under omnipotent moral busybodies. The robber baron’s cruelty may sometimes sleep, his cupidity may at some point be satiated; but those who torment us for our own good will torment us without end for they do so with the approval of their own conscience.”
~~ C. S. Lewis~~

The other shoe (no, make that a BOOT) is about to drop

Commercial property poses the next big bump in the road for Pollyanna’s that see a recovery just around the bend. With up to $1.4 trillion in commercial real-estate loans to be refinanced this year, the US commercial real estate market may follow the bloodbath seen in residential property.

Fitch Ratings reported that in 2010 about $475 billion of commercial real estate loans in the US will reach maturity. Attempting to roll-over these loans will create stiff competition for scarce financial funds.

Elizabeth Warren, head of the Congressional Oversight Panel, stated that almost 50 percent of planned rollovers involve a borrower owing more than the property is worth. And with many loans secured by properties written based on assumptions about rental growth that have not borne fruit, there is a growing probability of default.

This problem was brought into high relief during a visit to Los Angeles early last year when a friend took me on a tour of brand-new & fully-finished office towers. Problem was they were empty!

Fitch also reported that delinquencies on commercial real-estate loans supporting commercial mortgage-backed securities (CMBS) ended at 4.71% in 2009, a near 5-fold increase over 2008. CMBSs provide a crucial source of liquidity for the market and are formed by pooling mortgages, rating them and selling them on to investors.

The fat lady ain’t sang yet; and the recession ain’t over, until it is.