Debt Ceiling Endgame

This time is different. There isn't a more dangerous sentiment, yet when it comes to the debt ceiling, this time really might be different. While the Beltway chattering class and Wall Street have up till now blithely assumed that a deal will get done at the 11th hour, they ignore an inconvenient fact: the votes are not there.

It's rather simple. Thanks to their ultra-conservative freshman class, the GOP has been adamant that they will not accept any revenue increases as part of a deal. That is unacceptable to the House Democrats. Normally, the opinion of the minority party would not matter -- except for the fact that perhaps a third to a half of the GOP House caucus have signaled they will not vote for any debt ceiling increase. Furthermore, President Obama desperately wants to wring some -- any -- concessions out of the Republicans so that he avoids the awful precedent of the GOP successfully holding the debt ceiling hostage, and he can then sell a "bipartisan compromise" to the public. For their part, the Republican leadership would be more than willing to come to terms with Obama -- they do not want to be blamed for a government shutdown, let alone an outright default -- but they have quickly discovered that they have very little actual authority anymore. John Boehner can not round up the votes for a deal.

So, the Democrats are demanding increased revenue and the Republicans will not budge. Only the fallout from a technical default will change this dynamic. This is why a deal will not be reached before August 2nd. Already, both sides are laying the groundwork to blame the other for the consequences of a failure to raise the debt ceiling. Essentially, the negotiations have stalled as both sides play the blame game instead.

President Obama has taken to the airwaves to make his case that he has offered the Republicans everything they could reasonably hope for -- and they have still turned him down. He will continue to call on "both sides" to come together and reach a deal. He will chide them. He will keep using metaphors ("eat your peas", "don't leave your homework till the last minute") that cast his opponents as immature children. He will thunder that the United States does not default on its debts. He will warn about the catastrophic effects of default that "he can not prevent" (like Social Security checks not going out).  And, as the deadline nears, he will do this in primetime.

The Republicans, meanwhile, are split. The diehard Tea Partiers have been talking themselves into a debt ceiling breach for months. They welcome it. That leaves the GOP elite stuck trying to figure out a way to deflect blame for a shutdown -- which is what would happen when payments get prioritized -- onto Obama. The latest such effort was Mitch McConnell's plan to give the president the power to unilaterally raise the debt ceiling, unless a veto-proof majority of Congress vote that they "disapproved" of the hike. The immediate howls of protest from the Tea Party, and the House GOP, demonstrate why any such legislative legerdemain is a political non-starter.

So how does this end?

The most important political fact about the debt ceiling is that it is incredibly unpopular. That is what made it such an attractive target for Republican hostage-taking. When Gallup polled the question back in May, only 19% of respondents were in favor of raising the debt ceiling, with 47% opposed. Crucially, only 15% of Independents wanted to raise it.

Seemingly, not much has changed. When Gallup returned to the question a few days ago, respondents were still overwhelmingly against raising the debt ceiling, with just 22% in favor and 42% opposed (and 35% not knowing enough to say). Only 18% of Independents wanted it hiked. But, like spending cuts, not raising the debt ceiling may prove to be more popular in the abstract than in reality. When the question is framed if people are more worried about a potential default or about raising the debt ceiling, the results change dramatically.

Independents are evenly split, up 30 percentage points from the more general version of the question. Asking about default fills in the blanks for the possible consequences of not raising the debt ceiling, which over a third of the respondents in the Gallup polls did not know enough about to answer. Of course, even if a deal is not reached an outright default is unlikely -- but Obama will not mention that. And he has the biggest soap box. The messaging war is his to lose.

As the deadline looms and a deal is still not reached, the media will begin reporting on the previously unthinkable: what will happen if there is a technical default. Sensationalism sells. Independents will move more in favor of lifting the debt ceiling. And once the Treasury starts prioritizing payments after August 2nd, support for ending the standoff will spike among the political middle. 

The GOP will get the blame. Obama will use the bully pulpit to hammer home Republican intransigence and their unwillingness to compromise. The David Brookses of the world will notice.  A technical default will not only cause mounting pressure on the GOP from moderates, but it will also lessen it from conservatives. Tea Partiers will cheer the lack of a resolution. The GOP House freshmen will tout their conservative bona fides. They will say they did the best they could. They stood athwart history, yelling Stop -- only to be stabbed in the back by RINOs. 

In the end, Obama will get a debt ceiling increase. Enough moderate House Republicans (such as they are) will defect once markets and constituents erupt. Entitlements will be mostly untouched. There will be very modest revenue increases. And the GOP establishment will be further discredited in the Tea Party's eyes.  Most importantly, the incentives of the two key negotiators -- the President and the Tea Party (represented by Eric Cantor) -- are such that this scenario seems all but inevitable. A debt ceiling breach lets Obama pass off ownership of the bad economy onto the Republicans, while a showdown lets the Tea Party further assimilate the Republican party. Everybody wins. Except John Boehner.

The Other Output Gap

Has the housing bust reduced our productive capacity? Opponents of fiscal and monetary stimulus argue any pump priming will fail because we simply have too many former construction workers and mortgage brokers ill-suited for the jobs of a post-bubble economy. Until the unemployed pick up new skills, their prior productive capacity will be no more real than the paper wealth created during the boom. To give it a Panglossian spin: this is creative destruction! Interfering with this reversal of bubble-era misallocations will only prolong the admittedly painful process of adjustment -- or so the story goes.

It's an intuitively appealing narrative. Morally, too. We were bad, bad, bad racking up debt during the cheap credit bonanza, and the crash is our penance. Moreover, everyone knows less educated workers have fared the worst during the Great Recession; isn't that prima facie evidence that our unemployment problem is the result of effectively trying to fit a square peg into a round hole? As CNBC's John Carney puts it in an echo of the Efficient Markets Hypothesis:

We're likely performing at exactly the capacity appropriate for a people with the combination of assets, liabilities and skills we actually have. [...] We have relatively less capacity to make what is in demand because so much of our capacity is dedicated to making what's fallen out of favor.

All is for the best! Carney goes on to attack the models of the pointy-headed elites who bemoan the -- in his view, mythical -- output gap between what the economy is and what it could be producing by, of course, introducing his own thought experiment about how the economy works. But what about reality? Is there any evidence to suggest we are suffering from structural unemployment? And -- funny how this works -- if moving labor out of bubble industries is causing unemployment during the bust, why didn't the same happen during the boom, when labor was moving into those industries and out of others?

It's the demand, stupid. Back in the heady days when anyone with a pulse -- and even a few without -- could walk into a bank and walk out with a mortgage, the ranks of the aforementioned construction workers, mortgage brokers and the like swelled. There was no "loss of productive capacity" as people who had previously worked in other fields stampeded into housing related ones, for the simple reason that there was demand for it. Contrast that with the jobs quagmire we now face: unemployment has doubled across nearly all industries since the onset of the Great Recession -- and across all levels of educational attainment as well. With households saving again to pay down their debts, demand for everything has cratered. And those much-maligned construction workers, who don't how to do anything but build houses? They're encountering no greater difficulty in the labor market than the rest of job-seekers. This isn't a case of a skills mismatch; it's a straightforward case of inadequate aggregate demand due to the bursting of a credit bubble.

Which brings us to debt. The paper wealth generated during the housing bubble was certainly a debt-fueled illusion, but the higher output of those years was not. Our workers are no less able; our technical know-how is plainly undiminished. Claiming that we can no longer produce as much because of previous malinvestment is belied by the fact that the downturn has effected every sector of the economy in nearly equal proportion. What has changed is that consumers are deleveraging -- a process, that as Irving Fisher could tell you, can feed on itself. Carney conflates these headwinds on private sector demand with an actual reduction in our productive capacity, which is fine if you are ideologically committed to wishing away government spending, but not so much in the real world.

Fiscal and monetary stimulus can work. Not as much, or as predictably, as we would like, but to insist otherwise is to do so in defiance of facts. Indeed, did workers suddenly learn new skills after FDR took us off the gold standard? Or was it deficit spending that did the trick? Clearly, these are absurd propositions. And yet, mountains of excess reserves coupled with prodigious deficits have stoked fears of (nonexistent) inflation, such that people who should know better have taken to inventing reasons for inaction despite the smoldering jobs crisis. Failure is redefined as success. Ten per cent unemployment is the new "Mission Accomplished"! Warnings of structural unemployment -- despite an absence of any of its markers, like shortages in specific labor markets -- abound. Ideologues, when confronted with changing facts, prefer to change definitions, rather than opinions. The largest "output gap", unfortunately, is between our elites' economic understanding and reality.

The Economic Charade of the Irish Bailout

Can Ireland export its way back to solvency? That is the question underlying Ireland’s ostensible recovery budget. The Irish tale is a familiar one: boom, bust, and bailout. Of course, in an era marked by spectacular recklessness, Irish banks distinguished themselves -- perhaps only matched by their government; an ill-considered guarantee of financial sector liabilities in 2008 turned banking insolvency into sovereign insolvency. Austerity followed. Mounting losses -- and some imprudent remarks from Ms. Merkel -- drove up borrowing costs, eventually forcing the joint EU/IMF rescue package, and further austerity. Unfortunately, however, the credibility of the subsequent recovery plan is itself questionable.

Sectoral surpluses and deficits must balance. Consequently, any fiscal consolidation must be accompanied by some combination of a stronger trade position or increased private spending – or the economy will shrink. The Irish budget recognizes this reality, although it is a bit reminiscent of a student working backwards from the correct answer.

Starting from the targeted 2.8 percent of G.D.P. public deficit in 2014, the Irish government strains to make the pieces of the economic puzzle fit. An aggressive export forecast – as much as is credible -- is the second component of the budget. It leaves an implied private sector surplus of roughly 5.5 percent of G.D.P. – improbable, but not implausible. Alas, this misrepresents the economic pressures besieging the Irish government.

The 2.8 percent of G.D.P. government deficit is not in fact a 2.8 percent deficit. Ballooning interest payments (mostly abroad) turn a projected deficit into a primary surplus. Moreover, the balance of trade is not a reliable proxy – which the Irish government assumes is the case -- for the current account for a small, open economy; repatriated export profits from foreign multinationals reduce the headline trade number. Together, these facts conspire to understate the necessary adjustments from the export and private sectors by some 3-4 percent of G.D.P.

Can it be done? With loans outstanding to households still near 111 percent of G.D.P., the burden of this greater adjustment will almost certainly fall on net exports rather than private spending. Monetary union means only “internal devaluation” – deflation – remains as a mechanism to regain competitiveness. Already, Irish unit labor costs have begun to fall after soaring much of the last decade. There is a limit, however, to how far wages can come down in a heavily indebted society; otherwise, Fisher’s debt deflation beckons. Ireland’s best chance is for the labor costs of its main trade partners to adjust upward instead. That is a faint hope in a world beset by nascent trade war.

Critics argue the rescue package amounts to little more than a backdoor bailout of German banks by Irish taxpayers. The truth is even more scandalous. Indeed, Germany has made a profit of several hundred basis points from the bailout. This charade cannot continue. Debts must be restructured to payable levels. Delay only increases the collateral damage to the Irish people – and to the Eurozone’s viability.

The Road to Revolution in Beijing Runs Through Riyadh

Egypt is not Tunisia. Bahrain is not Eygpt. Saudi Arabia is not Bahrain. Such has been the tragicomic refrain from besieged capitals across the Arab world, as protests have put a lie to the illusion of stability that had seemingly prevailed (the same, of course, applies to the PIIGS and the Euro sovereign debt/banking crisis). These hollow protestations certainly belie the reality in the streets, but there is at least a hint of truth here: these are economically disparate societies. Yet none have been spared from unrest; not the rich (Oman and Bahrain), nor the poor (Yemen and Mauritania) nor the middle class (Tunisia and Egypt). Rather, the propaganda of the deed, swarms of unemployed youths, and -- yes -- food inflation have conspired to kindle revolutionary fervor across rich and poor country alike throughout the Arab world. But now the question becomes, will unrest spread beyond the Middle East or will this solely be remembered as the Arab 1989 (or 1848, depending on one's historical perspective)?

Which brings us to China. For the past twenty years, there's been something of a Western cottage industry endlessly predicting the imminent doom of the Chinese regime. And for twenty years, the reports of the CCP's demise have been greatly exaggerated. But at risk of succumbing to the same folly, this time really might be different. Indeed, the Chinese economy seems near a de Tocquevillian moment: doing (very) well, but not well enough. Thirty years of staggering growth have lifted untold millions out of poverty, but, as you would imagine, have also dramatically increased future expectations. And now there are legitimate concerns about a coming economic slowdown -- which Chinese authorities are keenly aware could prove fatal to their rule. 

 The Chinese government aggressively responded to the loss of export demand due to the financial crisis with a stimulus package that dwarfed any seen in the West, on a GDP-adjusted basis. This credit-driven growth, however, seems to have mainly contributed to an unsustainable property bubble. Ghost towns, empty office buildings, and off-balance sheet local government debt - it's all enough to make contrarian hedge funders perk up. To its credit, the Chinese government has tried both to gently deflate the bubble with higher reserve requirements and interest rate hikes, and to ameliorate the squeeze ordinary Chinese are feeling with an increased commitment to building affordable housing -- although none of these measures have yet been much effective.

Of course, the Chinese government is nothing if not vigilant when it comes to threats to its "harmonious" society. With soaring food inflation fueling simmering discontent over endemic corruption and abuses of power, the state was quick to shut down the copycat "Jasmine Revolution" Chinese web activists tried to organize several weeks ago. For Westerners quick to pounce on any evidence of discord in the Middle Kingdom -- including US ambassador Jon Huntsman, who conspicuously showed up at the pre-arranged protest site in Beijing -- the abortive demonstrations were certainly disappointing. The, perhaps unsatisfying, reality seems to be that there simply isn't widespread support for Tunisia-style protests in China. After a century of nearly unfathomable hardship, the Chinese people are loathe to force out a regime that, while undeniably corrupt, has delivered near miraculous growth and improvements in living standards. Put simply: despite indignation about abuses of authority, few are willing to risk killing the golden goose.

But that calculus changes with $200-a-barrel oil. The perturbations in the oil market due to the nascent civil war in Libya disrupting its supply reveals just how little spare capacity exists today. Libya only accounts for approximately two per cent of global production, but even asking the Saudis to dip into their (questioned) spare capacity to meet that shortfall stretches the market thin. Of course, Libya (and possibly Algeria) are only a sideshow to what a full-fledged revolution in Saudi Arabia would mean for oil prices. While it's certainly unclear whether protests will materialize in either Riyadh or Jeddah on the Saudis' scheduled "Day of Rage", it seems much more likely that its Eastern province will erupt. Like neighboring Bahrain, which itself has been gripped by demonstrations, Saudi Arabia's Eastern Province is home to an aggrieved, restive Shia majority -- and just so happens to be where its largest oil fields are located. Indeed, Saudi security forces have already clashed with protesters in the eastern city of Qatif, firing on them with rubber bullets a day ahead of the "Day of Rage". Prolonged unrest in the Eastern Province clearly has the potential to send oil prices parabolic, which in turn would torpedo the global economy.

The Chinese government would hardly be alone in being vulnerable to an unexpectedly bad economy due to an oil shock. The not-so-dirty secret of the Great Recession is that everywhere it has left in its wake the social preconditions for revolution: un-and-underemployed young men (in China, these are the so-called "ant tribe"). Regimes from Azerbaijan to Vietnam could very well be on the proverbial chopping block. Oil would be the revolutionary transmission mechanism, giving an economic push to already combustible milieux across the globe. The usual caveat that protests certainly do not guarantee a revolution is worth remembering; the shadow of Tiananmen and the simple truth that all revolutions come down to whether the army will fire on protesters casts a pall over any such discussion. Still, don't be surprised if a new line comes out of Beijing during the coming months: China is not Saudi Arabia.

Uh Oh: Kevin Hassett Likes Obama's Business Tax Credit Proposal

How do I know Obama's proposed business investment tax credit won't do much to stimulate the economy? Kevin "DOW 36,000" Hassett thinks it's a great idea.

Indeed, Hassett makes quite the case for this latest round of giveaways to Corporate America growth-oriented tax policy:

Because the benefit of expensing depends on the time value of money and interest rates are currently quite low, one might think that expensing would have a small effect now. Nevertheless, all but the most prominent firms have to pay interest rates that are much higher than Treasury rates today when they borrow.

Actually, Hassett had it right the first time. This latest measure won't do much. Just ask incoming CEA chair Austan Goolsbee, whose academic work included looking at such tax credits:

Econometric research has commonly found that tax policy and the cost of capital have little effect on real investment. [...] For policy makers interested in using tax policy to stimulate investment or, especially, to smooth business cycle fluctuations, the results are not promising.

Which makes you wonder, who exactly is telling Obama this is good economic policy? Or (more likely) is this just a ploy to appear less "anti-business" with midterm season in full swing?

Quantitative Easing Or Helicopter Drop? What Should Ben Bernanke Do?

A lonely nation turns its eyes to you, Ben Bernanke.

Double dip fears run rampant (despite a better than expected August ISM number). Fiscal stimulus is waning -- much of it undone by draconian cuts at the state and local level. Housing looks poised to go cliff-diving again now that the homebuyer's tax-credit has expired. And, of course, unemployment remains stubbornly high.

The high priests of economic orthodoxy assure us if we just embrace fiscal austerity or higher interest rates that we can ward off the dangers of debt deflation. Which is to say, they are incoherently grasping at any justification to foist contractionary policies onto a weak economy, all in order to fight the specter of incipient -- only in their minds -- inflation.

But with short-term rates up against the zero bound, what ammo does the Fed have left to support the fragile recovery? Here are the usual suspects of unconventional policy tools:

1) Resume quantitative easing. It's debatable how much banks substituting one non-interest bearing asset for another helps the real economy. Additional cash seems likely to either pile up as excess reserves, filter into the markets or get arbitraged via more Treasuries. Still, it's better than nothing.
2) Credibly commit to a higher inflation target in the medium-term. Targeting a 4% inflation rate over a prolonged period obviously not only makes holding cash less appealing, but also reduces real debt burdens. Of course, Messrs. Fisher and Hoenig would do everything in their power to undermine such a project to return to 1980s-level inflation.
3) Buy longer-dated Treasuries. Pushing down yields on longer-dated Treasuries makes other, riskier assets more attractive. Even just credibly threatening to buy up longer-dated Treasuries could be enough, if yields aren't already too low.
4) Eliminate IOER. The Fed currently pays out 0.25% on excess reserves, but why not cut that down to zero? Or even impose a penalty rate? Banks would pile into other short-term assets and increase their vault cash, but at least some of that otherwise idle money would leak into new loans (although there could be some unintended consequences vis-á-vis money market accounts).

Those are just the more conventional "unorthodox" measures the Fed could pursue. Another option would be quantitative easing to non-banks, i.e. direct lending. This is where monetary and fiscal policy meet. The key is that it would entirely eliminate the excess reserves problem, though it would introduce the question of favoritism -- an issue the Fed would be loathe to raise given the recent assault on Fed secrecy.

Still, the radical idea of the Fed giving money to businesses and households rather than to banks liable to sit on it holds some appeal. The so-called helicopter drop would accelerate the deleveraging process, effectively papering over bad household debt. Indeed, from what we know about lump sum tax rebates, we would expect households to save/pay down debts with their one-time check from the Fed. So a good portion of this newly minted money would still end up at the banks, just as with quantitative easing, though it would come at the cost of reducing the banks' claims on households.

But wouldn't this debauch the currency? If the Fed gave away free money, essentially accepting anything as collateral, they wouldn't have the assets to sop up the excess liquidity and prevent out-of-control inflation on the other side. This is the issue some have raised with the Fed accepting MBS as collateral: the Fed is holding MBS at inflated values, so when it comes time to sell that paper, the Fed won't take out as much money as it put into the system -- hence, inflation.

This is where the Treasury comes in. As MIT professor Ricardo Caballero points out, the Treasury could simply transfer T-Bills to the Fed to sell, basically the reverse of monetizing the debt. The Fed would never countenance such extreme action but it's worth remembering that Ben Bernanke circa 2002 was correct: a determined Fed should be able to reverse deflation. Too bad he's not running things nowadays.

Welcome To Tim Geithner's Recovery

In economics, as in war, simply declaring "Mission Accomplished" does not make it so. Reality is stubborn. But that didn't prevent Tim Geithner from taking to the New York Times to celebrate our "recovery" in a transparent effort to gin up increased confidence.

In effect, Geithner saluted policy-makers for avoiding a replay of the 1930s, settling instead for a prolonged period of stagnation, á la Japan's Lost Decade; what PIMCO dubs the "new normal". What a salutary result! Implicit was a rebuke of those worrying about the possibility of a double-dip: after all, the economy grew at a rate of 2.4% 1.7% in the second quarter of 2010. Modest but still tangible growth, no?

Of course not. The economy is clearing slowing. The inventory bounce is fading. Fiscal stimulus is waning. Republican obstructionism eliminates any hope of further spending. Cuts at the state and local levels will actually bring about fiscal contraction over the coming months. The Fed frets that further action could spike inflation. At best, Bernanke & Co. won't withdraw the little monetary stimulus they have provided, at least in the short term. In short, the second derivative is slumping. It's conceivable that the first derivative could reverse itself over the next few quarters. But even that is largely irrelevant. Whether the economy grows at a rate of minus or positive one-percent, there still will not be enough growth to add enough jobs to alleviate our now persistently high unemployment. We have simply arrested the freefall and called it a recovery.

And there are still, of course, rather massive tail risks to our fragile "recovery". Housing in the U.S. is on a downward trend again. Europe's banking/sovereign debt problems (they are one and the same) still hover like a specter over the continent. And China's housing bubble could pop to devastating effect.

Welcome to the recovery, indeed.