Monday, June 7, 2010

THe Keynesian Comeuppance

During the current economic crisis, most of the major countries have tried to spend their way out - either with government programs funded with new debt or by forcing debt directly into the private economy through guarantees, regulations and action by quasi-government bodies. We discussed the implications for China in Command and Control and for the US in The Federal Funhouse. These initiatives were based on Keynesian economic theory - that government should make up for any shortfall in private demand by spending (likely
incurring deficits) sufficient to stabilize aggregate demand.

This is a temporary band aid at best and the governments and central banks were hoping to buy time and convince everyone that things were OK so they should go out and spend. This was doomed to fail as prior private demand was based on nearly universal lending at suicidal risk levels. One of the key objectives of Financial Jenga was to document the extent of the madness in credit. Enough people have seen through the wishful thinking so that there will be greater caution on the part of both borrowers and lenders for the foreseeable future.

The massive deficits that various governments have run can only be sustained as long as there are lenders out there willing to finance them. Several bond auctions have failed or nearly failed in the last several weeks. Now we see the appetite for debt drying up and some key nations beginning to talk about austerity. A good example is this statement from the G-20 Meeting Communique:

The recent events highlight the importance of sustainable public finances and the need for our countries to put in place credible, growth-friendly measures, to deliver fiscal sustainability, differentiated for and tailored to national circumstances... We welcome the recent announcements by some countries to reduce their deficits in 2010 and strengthen their fiscal frameworks and institutions.
Clearly, the finance ministers are signaling a new mood of fiscal responsibility here - in sharp contrast to the "stimulus" measures that have previously reigned. This change in emphasis is further reinforced by the recent statements from two key European governments. From the UK we have (Prime Minister) "Cameron warns of painful cuts to tackle debt" as a headline. In Germany, Chancellor Merkel is cutting the budget by nearly $100 billion according to Bloomberg. This is not only a sharp contrast with the Keynesian program here in the US, it is a direct slap in the face of Tim Geithner at Treasury and the entire Obama Administration:
German Chancellor Angela Merkel’s Cabinet approved levies on banks, air travel and nuclear-power plants as part of what she called an “unprecedented” round of budget cuts, rejecting U.S. calls to spur growth.


Bux Populi
Austerity is the new watchword and it is showing up first in places where governments either have their backs to the wall or are less under the influence of the banks. Yet even here in the US, where we have the best government the bankers' money can buy, things are starting to change. Actual voters concerned about the rapidly growing deficit seem to be a stumbling block to Congressional spending with less than 6 months until the elections. Web-based My Way News reports:

Obama's proposed $250 bonus payment to Social Security recipients was killed by the Senate. Also gone is an $80 billion-plus Senate plan that promised money to build roads and schools, help local governments keep teachers on the payroll and stimulate hiring in the home improvement industry with rebates for homeowners who make energy-saving investments.

Just last month, deficit concerns killed $24 billion in fiscal relief to prevent state workers from being furloughed. It was a measure that earlier had won initial votes in both the House and Senate.

The battle over extending jobless benefits for up to 99 weeks for the long-term unemployed typifies how the Democrats' jobs agenda has foundered. What originally was a $200 billion measure combining the jobless benefits with renewing popular business and family tax breaks was cut to $115 billion by House leaders after moderate Democrats who are particularly vulnerable in November refused to support it.

The Federal Government has been able to finance large deficits so far. Partially this results from capital flight as Europe's problems become more apparent. Part of the equation is an increased preference for Treasury bonds over stocks and lower-grade private bonds. Finally, there is the large-scale purchases of MBS by the Fed, which has indirectly funded Treasury auctions by putting more money into the hands of bond buyers and Primary Dealers. Despite a very favorable environment for Treasury bond demand, huge issuance pushed yields upward until the recent resurgence of Europe's problems.

The difficulty financing our debt led the Obama Administration to float several proposals for major tax increases in an effort to convince bond buyers that there would be enough tax revenue to support the debt. This included a VAT. Notice how little we have heard about that and other taxes since the Euro crisis made the dollar and Treasuries the only game in town. Even so, the easy period of debt finance is coming to an end - even for the US government. Washington had best not expect to fund large deficits easily into the indefinite future.

A lot of bankers have to be asking themselves a question. If governments are cutting back, who is going to bail me out?