Guest Post: On, and Beyond, Deficits

By DoctoRx, who writes at EconBlog Review:Introduction

A few days ago, Naked Capitalism kicked off a series of posts on government deficits with a first-of-two posts by me. My Debate on Deficits, was followed by posts by Marshall Auerback, Rob Parenteau and Dr. Edward Harrison. My initial post was itself a response to Dr. Harrison’s comprehensive essay from a few weeks earlier on broad economic matters; in it, he recommended that the government increase its borrowing in response to his belief that: “The real problem is the debt – specifically an overly indebted private sector”. He pointed prominently to the financial sector balances model to explain his call for more government debt.

IA.

In Dr. Harrison’s essay, the concept of a financial sector balances model was described, per his quote from Mr. Auerback, was that: “the domestic private sector cannot increase savings unless and until foreign or government sectors increase deficits.” (From here on, for simplicity we will exclude foreign flows.)

Being a fan of William of Ockham’s logical razor, I suggested in response that an alternative path was for the private sector to settle its debts within itself. My specific point was in fact simply that there were alternatives that were not covered by the model. Specifically, this model deals with financial dealings between the private and public sector. Ergo, by definition it excluded financial dealings within the private sector.

As there was no attempt to refute that point of mine by any of the three responders, I’m moving on. The model he used was a flow of funds between; mine was debt simplification without any inter-sector flows (earning one’s way out of debt of course being superior to default or principal reduction).

IB.

In trying to understand the apparent illogic of the idea that the government needs to go more in debt for the private sector to go more in surplus, I had an aha! moment. This came when I realized that for obscure reasons, Federal Reserve notes are technically debt obligations of the Treasury. However, their only practical use is transactional. As I have no expertise in this matter, comments are solicited on how this fact may or may not affect the financial sector balances model.

A commenter to one of the above posts pointed out that Canada’s paper money is transactional only and not a governmental debt obligation. In most people’s minds, greater wealth in the private sector can be reflected in more money in circulation to reflect that wealth and productivity. If, however, economists must count that cash as Federal debt, that could explain some of the points of disagreement. Once again, expert commentary would be appreciated.

IIA.

Yours truly is a medical doctor, with a specialty in internal medicine, a subspecialty in cardiovascular diseases, and an overriding interest in disease prevention. I also have extensive experience in the pharmaceutical and financial fields, have filed over 60 U. S. patent applications, and have had 6 books published. I began posting on the Net late last year largely from outrage that the incoming Obama administration was signaling continuity with the Big Finance bailout policies of the Bush team.

Because treating real people has the potential to kill them in more ways than you can imagine, the doctor is admonished thusly: primum non nocere. First, do no harm. In other words, God, fate or nature (take your pick) has given the person a health problem. The physician’s first responsibility is to not make it worse and to not create a new problem. I believe that government needs to be as thoughtful on behalf of its citizens as physicians are supposed to be on behalf of their patients. I also believe that finance has lost its moorings regarding professional standards of prudence, and that it is its responsibility to make its failings up to society by rationalizing the debts it created with borrowers who borrowed not wisely but too well. I and other investors have suffered enough collateral damage from the fallout of the global financial crisis. More debt to be incurred by the people? No way. Let the stock- and bond-holders of the financial companies take all the hits first, till they hit zero if it comes to that (which I doubt will happen on the bond side).

The ramifications of the financial insanity of the past decade and more (it is almost 13 years since Chairman Greenspan’s “irrational exuberance” statement) will not be solved by government pushing a “Send” button to create more “money”. Creation of real wealth- the tangible and human kinds- has little to do with the quantity of money. After all, money has a velocity, and that velocity can very markedly.

In a sense, there is no “economy”. There are only human needs and desires that are satisfied by mutual consent via commercial means when self-help and private, non-commercial means do not suffice. The elevation of GDP as the measure of the nation’s well being is bizarre. When a country has achieved as much material wealth as America and has, in the current Great Recession-ary state, disposable personal income of about $30,000 per capita, then other factors beyond accumulation of material goods are indeed important. Yet the powers that be continue to support in a very large way industries that make the quintessential debt-financed products- homes and autos. All for finance.

IIB, Prescriptions for a healthy American economy

a. The Merchants of Debt and the Merchants of (mostly empty) Calories have had a parallel rise. Debt and junk food are both addictive but are easily marketed to addicts or prospects. Just as America would be better off breaking the addiction the Merchants of Debt have caused, so would it be better off eating less. Less debt would mean smaller houses that could actually be paid for, and fewer cars that harm the atmosphere and deplete natural resources. Less food production would mean less obesity, and less processing of food would mean less of the modern toxins of salt and refined sugar in our diets. This would then mean vastly less cardiovascular disease, fewer medical expenditures, and a smaller economy. And more walking in general, and more bike-riding to work where practical, would also mean a “smaller” economy. But we’d all be better off. Quelle paradox!

We must not equate a higher GDP with improvement in anything important. What is made, how it is made, for whom it is made, how it is paid for, what the effect on the environment is, and the like are some of the factors that matter.

b. Back to finance.

My blog’s motto is “In equity, veritas”. (The term “equity” relates both to ownership rather than debt; and to fairness rather than, for example, crony capitalism.) Thus, I sympathize with Dr. Harrison’s and Mr. Parenteau’s arguments that private debt is core to our current financial and economic problems.

Yet I disagree strenuously with that viewpoint.

I believe that this country has become “over-financialized”, and that debt is just part of the inappropriate recent primacy of finance over the production of useful, real goods and services. This primacy manifests itself in such ways as:

i. Wasteful merger and acquisition effort, given that the average deal does not meet its stated goals;
ii. The cult of the publicly-owned stock even though the companies are run for the benefit of insiders;
iii. The existence of interest rate swaps reportedly in the hundreds of trillions of dollars of notional value;
iv. The whole credit default swaps mess;
v. The overtrading of vital commodities such as oil, a barrel of which reportedly changes hands over 20 times before anything useful is done to it; and
vi. The entire concept that corporations and government can really promise important retirement benefits, given that the future is unknowable. All new pension obligations should be variable.
vii. Most importantly, strategists should consider that the quantity of new government debt was consciously decided upon to outweigh retiring private debt. Thus the debt-GDP ratio continues to rise, into cloud-cuckoo land. If you liked the last debt cycle, you will love the next one!

My medical-financial view is that global growth became manic this decade due to excessive use of stimulants provided by central banks and Big Finance. Now that the seemingly inevitable crash occurred, the patient has become partially resistant to the same stimulants. If the patient had been allowed to go through withdrawal, the addiction could be prevented from returning. In other words, too much frantic economic and financial activity occured that did not arise from real human needs. People, and therefore the economy, need to rest. That’s a rough medical analogy. Plus, Dr. Bernanke was the doctor in charge well before the crisis. He was guilty of malpractice due to failure to diagnose. Initially he failed to treat with a statin and high blood pressure medicine (continuing the patient’s former doctor’s negligence). Then when the patient had chest pains in 2008, he failed to perform an angiogram. Finally a messive myocardial infarction ensured. Only then, he brought in specialists and all the big guns when the patient was on a respirator, but the patient lived but has suffered permanent harm. In medicine, this us actionable malpractice.

On the other hand, parts of the world such as India that did not get whipped by artificial stimulants are, one notes, normal economically.

c. Depository banks probably should not be publicly traded. (Nassim Taleb believes they should be nationalized.) In any case, they should never have runs due to a falling stock price, but their loans and capital assets should be very plain vanilla. Clearly, depository banks fulfill such a critically important function that FDR’s war against bank holding companies should be revived. Separate them from investment banks. Then, divide investment banks into separate companies. One company would engage in principal trading. The other would service clients. The inherent conflicts inside a Goldman Sachs that engages in both these functions cannot be reliably overcome without that separation.

d. FDIC insurance should be reduced ASAP to limits that protect only the financially needy. There is no societal interest in guaranteeing the loans millionaires make to financial companies (i. e. savings deposits). Perhaps $10,000 per family is an appropriate total amongst all banks, not per bank. If anyone wants more government-provided coverage, that person or entity can simply buy a Treasury. Until a year ago, Australian banks had no deposit insurance– and no bank failures. I would also suggest that if ordinary citizens can rule on life and death matters in trials, they can work along with, or oversee, bank regulators. It’s our capital. We should know how it is being handled.

e. Depository institutions should not hold “Level 3″ assets. Even Level 2 assets are dicey.

g. If lenders want to obtain insurance on a big loan, then let CDS’s be regulated as standard insurance products with reserves, etc. And make it as illegal for the insurer to resell them as it is for them to resell any insurance product. No holder of a CDS should ever be in a position to profit from the failure of the debt.

h. Most interest rate swaps are little more than line extensions as well, take advantage of the borrower, and serve no business need that is worth the cost of purchasing the swap and the ongoing attention it requires.

i. The “G30″ that is so influential in financial and governmental circles has (had) Jacob Frenkel, an AIG VP, as its CEO. I pay no attention to anything it says. Everything it says is for the greater good of Big Finance.

j. Problems with Dr. Harrison’s and Mr. Auerback’s calls for more government debt include:

i. Just as we should be cautious about taking on debt as individuals and on the corporate level, government should if anything be our better angels and be even more cautious. Borrowing more and more from hard-working Chinese et. al for routine expenditures such as those on the elderly is, to put it mildly, a bad idea. Either raise taxes or cut expenditures. I’m not arguing for one path or the other, rather to just be honest about it. Government can print money but should be restrained in doing so.

ii. No matter how many people try to define Federal debt strictly as current obligations, here is Wikipedia on the subject: “The U.S. government is committed under current law to mandatory payments for programs such as Medicare, Medicaid and Social Security. . . The present value of these deficits or unfunded obligations is an estimated $41 trillion. This is the amount that would have to be set aside during 2008 such that the principal and interest would pay for the unfunded commitments through 2082.” What’s enshrined in the law is, indeed, the law. Where is the gold in the vault to meet these commitments?

Dr. Harrison, in his response to my post, wrote: “The governments unfunded liabilities for social security and healthcare are akin to General Motors’ unfunded pension liabilities. GM’s unfunded liabilities are germane to a credit crisis only to the degree they flow through the income statement and, thus, require credit financing in real time.”

But . . . GM had to pay a higher price than Toyota when purchasing credit in part because every lender to GM raised the price of said credit in part because of said unfunded liabilities. GM might not have gone bankrupt had it not been for those unfunded obligations. As I read it, Dr. Harrison is supporting my point.

The same Wikipedia entry has a nice summary of the government’s obligations regarding Fannie and Freddie and the other bailout costs. I would expect that the surging low quality FHA debt should then be added to that amount.

The truth is that the net Federal obligations are extremely high, and all-in debt obligations relative to GDP are at all-time record levels for this country. The Ockham’s razor solution involves simplification of our obligations to one another and to foreigners at as many levels as possible. This solution is therefore opposite to one involving creation of more government debt obligations. If my favored solution entails 1% economic growth instead of 2% is irrelevant. Things are now getting like the emperor who had another set of “clothes” made that were just as see-through as the first set. Let’s get this mess cleaned up and move on. Government’s been “stimulating” this recession using debt financing since Q2 2008, when it was only a mild recession.

k. In contrast to all the environmentally unfriendly economic activities that count as good things in the sanctified GDP print, and all the corporate-friendly, person-unfriendly efforts that go on in this economy, there are insufficient efforts on truly useful activities. These include the fields of medical technology, public health, pro-environment activity and research, education at all levels, specific literacy efforts, vocational retraining, urban renewal, food production close to where people live, etc. If America made more of an effort to press its advantage in biotech and medical devices (etc.), and made a “First to the Moon” type race on alternative energy (more intensive than what has been enacted to date), it could regain world leadership in economic sectors of the future and develop an export economy with good jobs at home. In turn, this economy could lead the world toward a healthier and cleaner tomorrow while leading to an intrinsically strong dollar.

Conclusion:

In the waning months of the Clinton Presidency, I lunched with a friend and his friend (call the friend of a friend “DC”). The two of them were discussing a business venture they controlled that tied into some governmental telecoms license arrangement. DC, as it happens, was the 3rd generation scion of a very tied-in Washington family. His daughter sat next to Chelsea at Sidwell Friends at the time. With sadness in his voice and demeanor, he mentioned that he and his family had never seen Washington so “for sale” as then, with the true bipartisan spirit having taken hold in that respect. Worse than the Watergate era? Yes, for sure.

Does anyone think things are cleaner lately?

A government that is “for sale” will want to expand its power. That is ultimately why in real time I oppose that phenomenon.

In gargantuan America, smaller and simpler is, for me, today and tomorrow, beautiful.