Yesterday, Congress passed legislation designed to avoid the strictures Congress enacted in the summer of 2011 to enable the United States government to borrow in excess of the existent debt ceiling.  These provisions would have allowed the income tax cuts enacted in the George W. Bush era to expire as well as imposed spending limits on defense and discretionary non-defense spending.

There are numerous provisions in yesterday’s bill, summarized by the White House here.  The Congressional Joint Committee on Taxation estimates the increased revenue from the bill to yield $62o over 10 years, far short of the 4 trillion dollars some estimate will be need to generate a sustainable level of debt.  Furthermore, the debt ceiling and expenditure components of the “cliff” will remain subjects of political debate for at least the next two months when further action will be required.  In short, we have  “kicked the can down the proverbial road” again.

Bruce Bartlett, in a New York Times Economix posting yesterday, offers little in the way of enthusiasm regarding the political feasibility of making serious headway in addressing prospective budget deficits now and in the near future.  His argument parallels the time inconsistency argument that  earned Edward Prescott and Finn Kydland the Nobel Prize in Economics in 2004.

The Congress that raises taxes and cuts benefits will suffer politically, while the benefits of lower deficits will accrue to future Congresses.

He goes on to argue that

Historically, what has moved Congress to enact big deficit-reduction packages was the prospect of quick improvement in terms of inflation, growth and interest rates. Given that deficit reduction today is very unlikely to improve any of these in the near term, deficit hawks lack any real payoff from a grand bargain.

Inflation has been low and stable as has expected inflation.

Even though expected inflation has been stable or declining for the past decade, real interest rates for treasuries (see chart below) – market rates minus expected inflation – has been negative for much of the past decade with the exception of the brief positive values in 2005 – 2007 and with expected deflation in late 2008.  If real interests are negative, the crowding effects of public sector borrowing are non-existent; thus, the cost of running deficits has not “spooked” the markets.  Of course, permanent negative real interest rates are not sustainable since few lenders will continue to offer their savings in exchange for reduced future consumption.

In the famous song from The Lion King, Hakuna Matata – there are no worries or no problem.  Of course, such attitudes last only as long as those who lend money to the US government continue to do so.  As Reinhart and Rogoff argue persuasively in This Time is Different: Eight Centuries of Financial Folly, this time is not different.  Financial excesses and repression eventually must be paid for.  We just don’t know when or how severe the price will be.

Much political debate – more appropriate described as hot or even toxic air – attempts to address how poorly the economy has recovered from what Reinhardt and Rogoff call The Great Contraction.  As noted in Professor Gerard’s recent post, R and R argue- as they have done many times before – that recoveries from balance sheet or financial crisis recessions are much slower than those related to “garden variety” declines in aggregate demand.  So what does the current recovery look like?  One way to answer this is to view the four major indicators that the National Bureau of Economic Research’s Business Cycle Dating Committee uses to identify the beginning and ending points for recessionary and expansionary periods.  Fortunately, our friends at the Federal Reserve Bank of St. Louis have done all the hard work.  As can readily be seen below (or more clearly here), industrial production and real retail sales have grown roughly in line with the average of past recessions.  Real income started to grow similar to past history, but for the past 18 months growth has slowed markedly.  The employment growth pattern, however, has shown the least responsiveness to the medicinal help provided by the Federal Reserve and other governmental policies.    This suggests that “financial crisis” related recessions require both more time and different policies than demand deficient recessions not induced by too much debt.  I will have more to say about why in future posts.

Everyone knows that the Dodd-Frank law passed in 2010 to regulate the financial industry is incredibly complex.  As those who took  Money and Monetary Policy last fall learned from alum Jim Lyon, it will take years just to write the implementation provisions.  Furthermore, these provisions will be influenced significantly by those (especially in the banking industry) whose behavior will be affected.

Andrew Haldane, in the most recent Kansas City Federal Reserve Bank symposium in an article entitled “The Dog and the Frisbee”, argues that such complexity is far from optimal in an economic environment in which uncertainty prevails.  He uses the concept of uncertainty in the same way that Frank Knight and John Maynard Keynes did almost a century ago; that is, situations in which assessing the probability of different outcomes is quite low and that risk cannot be easily measured and therefore, hedged against.  Haldane argues for simple rules, such as existed under the Glass-Steagall Act which forbids the mixing of commercial and investment banking.

In a recent blog entry on the EconoMonitor, Ed Dolan analyses this argument in terms of Goodhart’s Law, which suggests that as soon as a particular indicator becomes an explicit policy variable, it loses its predictive power because economic agents change their actions in response to expectations of the  authorities using this indicator for policy action.  Some of you might recall this as a variation of the Lucas critique of traditional monetary and fiscal policy actions.

All of the above is prologue for our next Economics Colloquium to be held next Monday.  Our visitor, 1971 Lawrence alum, Elijah Brewer, will address the topic “Regulating Wall Street:  Did We Go Too Far?“  Be sure to come to his talk at 4:30 PM, Monday, October 8th in Steitz Hall 102.

At last, the level of real GDP has rebounded past its previous peak in the fourth quarter of 2007.  Clearly, the trough for employment was both much deeper and trailed that for GDP.  In contrast, the recovery for real GDP has been more rapid as well.   Financial repression (extremely low interest rates) must be part of the story behind this chart.  Clearly, an increased cost of labor relative to capital induced a capital intensive recovery.

Satyajit Das, in today’s Financial Times, argues that low interest rates generate a variety of economic distortions that expand rather than address structural problems in economies (whether those of the U.S., Europe, or elsewhere.)  These effects are especially pernicious when real interest rates (that is market interest rates minus the expected inflation rate) are negative.  He provides a laundry list of “side effects” to this economic drug of choice.

1.  Encourages the substitution of capital for labor. Is it any surprise that employment has been slow to respond eventhough GDP is now higher than it was at the beginning of the last recession?

2. Encourage the substitution of debt for equity funding

3. Discourage savings, especially when real rates are negative.  Of course, if households have a particular wealth target, low rates could induce additional savings.

4. Create a funding gap for defined benefit pension plans (which means either reduced benefits or attempts to increase returns through more risky financing)

5. Feed asset price inflation through the purchase of risky assets (related to point 4)

6. Reduce the cost of holding money (which inhibits the flow of capital to worthwhile activities)

7. Allow banks to borrow cheaply (from depositors) and achieve their income targets through purchase of governmental securities rather than through lending to the private sector

8. Distort currency values as deviations in interest rates across countries is one of the drivers of short term capital flows

9. Induce a reliance on low interest rates to continuously fuel aggregate demand

For the most part, those who argue for extended periods of low interest rates believe that aggregate demand drives aggregate output. They tend to underplay the importance of structural change in the economy (such as labor market, regulatory, or tax policy reform); such change cannot be addressed by replacing depressed elements of aggregate demand with policy induced aggregate spending.  The day of reckoning is just extended, not cancelled.   Just ask the Europeans.