Category Archives: government debt crisis

Freddie, Fannie Profits

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The Washington Post reported (a few weeks ago) that Fannie Mae has made large profits that will go to the U.S. Treasury.

I expect these profits to continue, because the business model right now is excellent. The government is saying to mortgage originators:

1. Do not originate any loans that do not comply with our rules.

2. We cannot tell you what the rules are yet, because they are not final (it’s only been, what, 3 years since Dodd-Frank passed?)

3. But Freddie and Fannie have an exemption, so anything they will take you can originate and we won’t bother you.

Freddie and Fannie do not have to worry much about credit risk, because the housing market bottomed out a while ago, so we are unlikely to see another house price collapse.

Freddie and Fannie are borrowing at Treasury rates, so they enjoy a nice, juicy margin. And the Fed is still holding onto a lot of mortgage securities, which helps keep their prices up.

The one fly in the ointment is that Freddie and Fannie probably are exposing taxpayers to more interest-rate risk. That is, all those 4 percent mortgages that the government is holding on our behalf will not look so profitable if the Treasury’s cost of borrowing should go up to, say, 6 percent. That is already the worst possible scenario from a government solvency standpoint. In that sense, from a taxpayer point of view, Freddie and Fannie are risk-aggravating. Meanwhile, enjoy the windfall.

James Hamilton points out that another fly in the ointment is that a lot of Fannie’s profits are actually tax deductions that come at the expense of the Treasury.

What I’m Reading

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New books by Kevin Williamson and by Tim Kane and Glenn Hubbard. Both take as their premise the thesis that the U.S. is on an unsustainable fiscal course. In The End Is Near and It’s Going to be Awesome, Williamson treats this as an opportunity, while in Balance, Kane and Hubbard treat it as a threat. Perhaps it would be appropriate at some point to jointly review them at length.

If I might boil the Kane-Hubbard book down to one sentence, it would be that without a balanced budget amendment to avert fiscal collapse, America will lose its great power status. I can imagine conservatives, thinking in terms of the civilization-barbarism axis, nodding firmly in agreement. However, by the same token, I can picture progressives and libertarians shrugging with indifference.

Williamson appears to be in the latter category. So far (I am less than 1/3rd finished), the book is assembling a standard array of libertarian arguments. Anyone who already resonates to the freedom-coercion axis is bound to like it. My guess is that Williamson is headed toward an embrace of what I have called civil societarianism. So far, it looks as though he is arguing for views that I share, although he expresses them with greater certitude.

Facts About Austerity in the U.S.

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From CBO head Doug Elmendorf. I focused on the 7th slide, comparing 2012 with 40-year averages. The figures are as a percent of GDP.

Category 40-year average 2012
Net Interest 2.2 1.4
All other spending 7.9 9.1
Defense 4.7 4.3
Social Security and Medicare 6.2 7.9
Revenue 17.9 15.8

Pointer from James Hamilton. I hope Mark Thoma will link to me here, because he is forever linking to posts that spin the fiscal data in a way that is very different from how I see it. What stands out to me is this:

Where is the austerity in the budget, i.e., the biggest shortfall in spending from the 40-year average? It is in “net interest.” It is definitely not in domestic discretionary spending (the “all other spending” category).

The “austerity” comes from low interest rates, which cause interest payments to be low. Think about that.

I note that yesterday’s employment report showed that the first four months of 2013, under “austerity,” were much better than 2009, under “stimulus.” I know that other things were not equal. They never are. Any macroeconomist can argue that he is always right, because the interpretation of data has so many degrees of freedom.

Some Sentences

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1. From Reihan Salam.

Right now, we’re stuck in a political debate in which a federal government that spends, say, 24 percent of GDP represents tyranny while a federal government that spends 19 percent of GDP represents a free society, irrespective of state and local expenditures, tax expenditures, off-balance-sheet activities, and the cost of regulatory initiatives. The end result is that we have endless debates over spending levels while ignoring, for example, the shadow nationalization of the mortgage market and the perverse buck-passing dynamic created by cooperative federalism programs that fuels the growth of state and local government.

2. From Philip Moeller.

“The best childhood personality predictor of longevity was conscientiousness—the qualities of a prudent, persistent, well-organized person,” according to the two professors (he at the University of California—Riverside, and she at La Sierra University). “Conscientiousness … also turned out to be the best personality predictor of long life when measured in adulthood.”

3. Carmen Reinhart.

it is certainly more difficult for a central banker to raise interest rates with a debt to gross domestic product ratio of over 100 percent than it is when this ratio stands at 39 percent. Therefore, I believe the shift towards less independence of monetary policy is not just a temporary change.

Banks and Government

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The second of my essays on the function of banks. In this one, I talk about their relationship with government.

Think of two friends who walk to a neighborhood bar every Saturday night. On a given Saturday, the first friend may be too drunk to walk without assistance, and he may have to lean on the second friend in order to make it home. The following Saturday, it could be the second friend who needs to be supported in order to get home. However, if both of them get too drunk and try to lean on one another to get home, they may collapse together.

This is how I picture the current situation in Europe. Many European banks are unsteady. They need government guarantees and capital injections in order to stay in business. At the same time, many European governments are heavily indebted and running large deficits. They need banks to continue to lend to them in order to fund their spending.

Read the whole thing. My prescription for addressing the relationship between banks and governments is to try to apply the approach of “limited guarantees, for limited purposes.”

Fiscal Crunch Time

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John Cochrane links to a WSJ editorial and a working paper by Greenlaw, Hamilton, Hooper, and Mishkin. The authors make the point that I have been making, which is that when government has accumulated a lot of debt, an increase in interest rates can be catastrophic. This almost forces the central bank to abandon its inflation-fighting goals when the crunch hits.

On the basis of intellectual history, there is another prominent economist who one might expect to endorse and amplify these concerns. He would dismiss the current low interest rates as Wile E. Coyote market behavior. He would trot out diagrams illustrating multiple equilibria. But that economist seems to have disappeared.

Kyle Bass thinks that this scenario will appear in Japan before it strikes Europe or the United States. If you are familiar with John Mauldin, then you know what Bass is going to say.

Most of the questions that Bass gets are “What should an ordinary investor buy?” Interestingly, I get that question a lot from friends on the left. I think that all of us happen to be at an age, close to 60, where the worst case scenario is that your savings take a big hit. If you were 40, you would figure that your human capital is still your most important asset. If you were 80, you would say that you don’t have to worry about how far your savings will go.

I would say that my worries would go away if the politics in this country shifted toward the right. Presumably, that is not where my friends on the left are coming from. My guess is that they connect their fears about preserving the value of their savings with doubts about the capitalist system in general.

Bass suggests oil wells, apartments, and firms with productive assets. I have shifted in that direction the past couple of years, so anyone who has been betting on the U.S. stock market as a whole has been doing better than I have lately. And I hope they continue to do so. Because there is no hedge against a breakdown of the social fabric, which is what Bass is predicting for Japan. There, if he is correct, the worst case scenario for a 60 year old is about to become reality.

Jeff Sachs on the Administration’s Budget Plans

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He writes,

In effect, he would allow rising outlays on mandatory programmes such as Medicaid and Social Security and debt servicing to crowd out public investments that are vital for America’s long-term economic future…

Mr Obama probably hoped that when the moment of truth arrived, when the spending cuts started to bite, the American people would support higher taxes rather than the spending cuts long called for in his own budget proposals. And perhaps they will still do so. Yet he has never presented an alternative with more robust tax revenues in order to fund a higher sustained level of public investments and services.

Pointer from Tyler Cowen.

I know that the conventional wisdom is that Republicans and conservatives are hopelessly irrational and self-contradictory on fiscal policy. Let us stipulate that such is the case. That does not mean that the Democrats and progressives are rational and coherent. If someone on the left can point me to a budget that does what you want, does not lead to explosive deficits, and does not depend on spending an imaginary dividend of “lower health care costs, through magic,” I would like to see it.

To put it this another way, I think that even if the entire conservative side of the political spectrum were to collapse tommorrow, the left still could not govern.

The Debt the Italians Owe to Themselves

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The Wall Street Journal reports on generational conflict in Italy.

Over the past two decades Italy has run €1.3 trillion in such [primary] surpluses, averaging 4% of GDP a year, says Giuseppe Alvaro, an economist in Rome and an expert on Italy’s national accounts. Public debt has nonetheless risen—it is now €2 trillion—and the austerity must continue. Because much of today’s working population has never benefited from excess public spending, “they may feel rather reluctant to give back what they never received,” Mr. Alvaro says.

Pointer from Tyler Cowen.

As I pointed out in Lenders and Spenders, the problem with deficit spending is that it creates an arbitrary distribution of burden within a country, causing political conflict.

We are very likely to replicate the Italian experience. Local governments are going to raise taxes and reduce services, in order to pay pension benefits to retired government workers. And at some point the Federal government will have to run large primary surpluses, just as Italy has been forced to do, with similar consequences.

In an earlier post, Tyler comments on the observation that few people in Washington are worried about the deficit. Tyler’s riposte:

That is why you should care about the budget deficit.

I have been thinking along similar lines. The arguments that Thoma, Krugman, and others make for not worrying about the deficit are, in fact, a major reason why I worry about the deficit. Conversely, if they would argue in favor of worrying about the deficit, then I might be less worried about it.

Tyler Cowen on Inflation: “Probably Not”

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He writes,

Everything we were taught about the monetary base is wrong in a world with interest on reserves (IOR). A large base can sit there forever. The price level is not proportional to the base, changes in the base, etc. It just isn’t. The broader aggregates, such as M2, haven’t grown so rapidly.

But consider the scenario that worries me. Our debt continues to increase. Nominal interest rates rise, so the government has to borrow more just to finance the debt. Congress wants to avoid having to cut spending elsewhere, and the Fed is asked to do its part.

Tyler points out that the Fed could increase its purchases of Treasuries without increasing the money supply. However, the mechanism for doing this is to raise the interest rate that it pays on reserves. That mechanism does not solve the problem of lowering the government’s interest costs, which is what I think is the nub of the scenario that I am talking about.

My guess is that in practice, for a variety of reasons, when the cost of government debt starts to rise, the Fed is not going to be willing/able to sterilize its funding of the debt, through IOR or any other means. We are going to see both intended and unintended monetary expansion, and that will produce inflation.

As usual, let me say that I am not blaming the Fed or saying that inflation is just around the corner. When really out-of-control inflation emerges, it is a fiscal phenomenon.

Two Articles on Retirement

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First, Sunday’s lead story in the Washington Post.

For the first time since the New Deal, a majority of Americans are headed toward a retirement in which they will be financially worse off than their parents, jeopardizing a long era of improved living standards for the nation’s elderly, according to a growing consensus of new research.

You know you are headed for a low-quality article when it starts that way.

1. First off, that sentence may turn out to be wrong. Living standards for those about to retire may well turn out to be fantastic.

2. To the extent that Americans are potentially outliving their saving, it has a lot to do with the “outliving” aspect. People are living longer.

3. Revealed preference suggests that people think that they are in good enough financial shape to retire. Anecdotes and exceptions aside, the average trend is toward retiring younger, not older. Even though people are much healthier at age 65 then they used to be, and many jobs are less physically demanding.

4. The article never addresses the fact that from an aggregate saving point of view, Social Security is the problem, not the solution. It creates disincentives to work and save, so that we have less output and less capital than otherwise.

Next, a story from Kiplinger’s.

Retiring abroad can offer a host of advantages over buying a condo in Florida. Living expenses can be cheaper, cultural experiences richer and the lifestyle more satisfying — even in some places in Europe.

The article proceeds to list eight inexpensive places. I do not see elderly people wanting to pull up their roots and move to faraway places. If they are willing to do so for a lower cost of living, then that would be a sign that financial issues really are pressing. On the other hand, my guess is that staying for a month in one of the recommended cities will appeal to a lot of people who are looking for relatively low-cost trip.