Malinvestment, Deficits and Structural Adjustments

I wrote a post about six months ago called "Misunderstanding Modern Monetary Theory" on deficits and resource allocation that I was re-reading. I wanted to add some off-the-cuff comments that might be relevant to today’s discussion about the recent deal to re-institute the Bush tax cuts, add a payroll tax cut and extend unemployment benefits. Most of these comments are modified versions of what I originally wrote in the comment section in the Seeking Alpha version of this post.

On the whole, I take a more Austrian/austerian view than the proponents of MMT but they make valid points regarding focusing on real resources and understanding our fiat currency-backed financial system.

The tax cut compromise is going to increase deficits. Clearly deficit hawks in Congress are poseurs because when push comes to shove and they can get their tax cuts/entitlement spending through they vote the other way. Rather than comment on the tax cut deal specifically let me say this: in my view, deficits do matter. However, in the short term, we should be more concerned about the massive under-employment which is now on the verge of leading to a structural problem with millions losing job skills and employability.

When people get side-tracked on the deficit issue, thinking that it has ex-ante relevance in a fiat currency world during a deep economic slump, they are putting the cart before the horse. The issue is deploying all available resources in an efficient non-misallocated way as quickly as possible. If real resources are deployed properly, we can worry about structural deficits which have mostly to do with entitlements and military spending.

The problem is this. In theory, government might be able to help re-deploy resources. In practice, time is often the critical factor. The limits of stimulus are something I pointed out regarding eastern Germany. I find claims that "not enough" stimulus was applied unconvincing if unrealistic politically. Liberal commentators will say "the Germans didn’t apply enough stimulus." Maybe. I certainly think that was true in the U.S. in 2009. But it’s largely un-provable and that doesn’t get you around the fact that it takes time for a large complex economy to re-deploy its resources. There’s nothing government can do about that.

What should politicians do, knowing they will lose office if they sit on their hands? I think some measure of fiscal activism is beneficial in a synchronized economic slowdown – as does the Fed Chairman apparently. To my mind, this downturn is unique in its breadth and depth. Stimulus should be centred on jobs and providing liquidity as credit contracts and companies are bankrupted. However, most of this should be done via automatic stabilizers as you have seen in Germany. That reduces the urge of politicians to play politics. Any way you slice it, though. it’s a tough position for any politician to face.

The point is that there is zero reason for us not to be able to run a cyclical deficit in a deep recession if structural deficits are being cut.What’s the point of fiscal policy if you can’t use it appropriately to counteract upwards of 25% unemployment in cities like Detroit? If you are looking at the deficit then, the focus should be on the structural deficit: entitlements and military spending. I imagine Obama believes this is the point of the much-maligned deficit commission (though there are hidden agendas there).

But, of course liberals want their entitlements and conservatives want their military. This is exactly the problem with creating any government (or corporate) program in the first place. Once they are in place, they develop a constituency whose economic well-being is dependent on their continuation. The vocal minority wins over the diffuse majority. In the private sector, programs eventually get cut because they lose money. In government, lacking a profit motive, these programs just keep on going like the Energizer bunny. I think that’s a strong case against big government, frankly.

In large private sector organizations the same turf wars and political fiefdoms exist as in the public sector. I have been there and I can tell you that it is very difficult to kill pet projects – even ones that lose money – in large corporations for purely political reasons. Let’s not act like the private sector is magically different than the government sector. The politics are the same. The difference is that the profit motive eventually trumps politics in the private sector.

A proper deployment of real resources would include the elimination of excess capacity in autos, real estate, and financial services first and foremost. A proper deployment would also have meant no auto bailouts. This was error number one by both Bush and Obama. That would have meant bankrupting/nationalising large too big to fail banks, of course. Nationalisation is really pre-privatisation administered by a resolution authority. The goal is to fire incumbent management, strip out the bad assets, split the bank up, and sell back into the private sector as quickly as possible – an FDIC process for TBTF banks(see here). This is not an endorsement of current legislation but a suggestion that what the FDIC does every week with smaller banks is what must happen for larger banks as well if they are insolvent. The price of failure in capitalism is bankruptcy.

Eliminating what Michael Hudson calls the rentier class of large organizations that gain advantage through government-sanctioned oligopoly is what is needed. To the degree that the deficit commission entrenches these interests, it is part of the problem and not part of the solution.

Beyond that, I would support the deficit commission’s recommendation to phase in a raising of the age for Social Security and Medicare benefits to 67 or phasing in means testing of Social Security benefits and eliminating the regressive payroll tax exemption above 200,000. This could be phased in so as not to affect anyone within 10 years of retirement. The point is that the demographics speak to a need to curb retiree benefits and this has to be addressed one way or another. In my view, this has more to do with high healthcare costs than anything else because healthcare efficacy in the US is out of line with other developed countries – at least if looking at life expectancy and other healthcare goals (see here).

Regarding stimulus, it should have been more geared toward job re-training especially in Michigan where people would be hit hard by the lack of bailouts. The government could always pay for locally-administered jobs programs run in the private sector to demolish excess housing capacity in areas like Detroit or to fix Americas creaking bridges and tunnels. The government could also offer to pay the re-location expenses of anyone unemployed for more than six months who finds a job in another city above a certain minimum wage threshold (say $35,000 adjusted for cost of living).

These are a few examples. The first list is geared toward reducing future malinvestment The second list is geared toward reducing the real resources devoted to entitlement programs (I didn’t discuss military spending, which should be cut). The third list is geared toward aiding in the redeployment of real resources. I don’t imagine this will solve the structural problems the US has but it will aide the re-deployment of resources that is needed.

On banks, I have heard Simon Johnson claim that bank size offers no benefit above the $300 billion asset size threshold. Let’s double that for the sake of argument to $600 billion. Why couldn’t we have nationalized Citi (and BofA) via a resolution authority. The authority could have cleaned up the balance sheet by separating toxic assets into a bad bank and re-sold Citi in parts of no more than $500-600 billion? The claim is that this is too complicated. I don’t buy this argument.

Special interests have the American political system by the throat and there’s apparently no way to change this absent some sort of complete economic collapse and mass social unrest.