The dénouement of deficit fatigue

I just ran a summer re-run post at Naked Capitalism that I wanted to flag here as well. I don’t do re-runs much here but I thought the intro part to the post by Marshall Auerback was important given the debt ceiling debate and Ben Bernanke’s recent testimony before Congress.

I flagged the inevitability of deficit fatigue as early as November 2008. I am sympathetic to the view that these deficits are an attempt to prop up excess credit growth and thus retard full recovery. But I also fear the consequences of a world without any policy stimulus. That is certainly why I advised a more aggressive policy response early both on stimulus and recognition of bad debt. A more aggressive response on these two fronts would have dealt with both structural and cyclical causes of recession.

At this point however my sense is that we are being set up for a severe economic shock unless someone pulls a rabbit out of their hat soon.

Hi all. Here’s another summer re-run I wanted to post at NC, but this time from Marshall Auerback. As you know, there has been a heated debate amongst economists as to what policy makers should do if anything about the loss of jobs and the attendant fall in demand and output in the wake of a large credit crisis. As I see it, there are four schools of thought. If I could give crude labels to them and their advocacy, I would say: a) Keynesians – monetary and fiscal stimulus b) Monetarists – monetary stimulus c) Minskyians/Richard Koo – fiscal stimulus d) Austrians – no stimulus

Marshall Auerback falls into camp three and he presents the argument for fiscal over monetary stimulus below. This post originally ran at Credit Writedowns in September 2010 but I think the concepts are as relevant today as they were then, especially in light of the pullback in both monetary and fiscal stimulus now two years into this interregnum recovery.

Regardless, there seems to be an inevitability about policy decisions at this juncture because we seem to be marching straight down the path I laid out in October 2009 in my post “The recession is over but the depression has just begun”.

  1. The private sector (particularly the household sector) is overly indebted. The level of debt households now carry cannot be supported by income at the present levels of consumption. The natural tendency, therefore, is toward more saving and less spending in the private sector (although asset price appreciation can attenuate this through the Wealth Effect). That necessarily means the public sector must run a deficit or the import-export sector must run a surplus.
  2. Most countries are in a state of economic weakness. That means consumption demand is constrained globally. There is no chance that the U.S. can export its way out of recession without a collapse in the value of the U.S. dollar. That leaves the government as the sole way to pick up the slack.
  3. Since state and local governments are constrained by falling tax revenue… and the inability to print money, only the Federal Government can run large deficits.
  4. Deficit spending on this scale is politically unacceptable and will come to an end as soon as the economy shows any signs of life (say 2 to 3% growth for one year). Therefore, at the first sign of economic strength, the Federal Government will raise taxes and/or cut spending. The result will be a deep recession with higher unemployment and lower stock prices.
  5. Meanwhile, all countries which issue the vast majority of debt in their own currency (U.S, Eurozone, U.K., Switzerland, Japan) will inflate. They will print as much money as they can reasonably get away with. While the economy is in an upswing, this will create a false boom, predicated on asset price increases. This will be a huge bonus for hard assets like gold, platinum or silver. However, when the prop of government spending is taken away, the global economy will relapse into recession.
  6. As a result there will be a Scylla and Charybdis of inflationary and deflationary forces, which will force the hands of central bankers in adding and withdrawing liquidity. Add in the likely volatility in government spending and taxation and you have the makings of a depression shaped like a series of W’s consisting of short and uneven business cycles. The secular force is the D-process and the deleveraging, so I expect deflation to be the resulting secular trend more than inflation.
  7. Needless to say, this kind of volatility will induce a wave of populist sentiment, leading to an unpredictable and violent geopolitical climate and the likelihood of more muscular forms of government.
  8. From an investing standpoint, consider this a secular bear market for stocks then. Play the rallies, but be cognizant that the secular trend for the time being is down. The Japanese example which we are now tracking is a best case scenario.

The relevant points are #4-8 because they are recursive. We have already seen one round through in 2010. My sense is that the pullback in policy stimulus will be greater this go round, in Europe, the US, and in China in particular. This will lead to another round of economic weakness – inviting an even more aggressive policy response.

Here’s Marshall.

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