In Defense of Deficits

"There is a time for everything,
.... a time to be born and a time to die"

The above quote from Ecclesiastes is very appropriate in describing the currenr economic situation. Only the faint of heart and the misinformed :-) will fear deficit spending under the current relatively weak macroeconomic conditions. Can we spend our way out of a recession? Well yes , if we do it right. It sure beats doing nothing and seeing conditions deteriorate at a rapid rate. And don't fool yourself by thinking that eventually the economy will mend itself. Keynes addressed this question many moons ago when he quipped "In the long run we are all dead".

Another favourite guiding principle of mine: "Don't reinvent the wheel". That is why I will substitute an article written by James Galbraith for what I originally intended to post about the same topic. This is a better article:-) Enjoy.


In Defense of Deficits

The Simpson-Bowles Commission, just established by the president, will no doubt deliver an attack on Social Security and Medicare dressed up in the sanctimonious rhetoric of deficit reduction. (Back in his salad days, former Senator Alan Simpson was a regular schemer to cut Social Security.) The Obama spending freeze is another symbolic sacrifice to the deficit gods. Most observers believe neither will amount to much, and one can hope that they are right. But what would be the economic consequences if they did? The answer is that a big deficit-reduction program would destroy the economy, or what remains of it, two years into the Great Crisis.
For this reason, the deficit phobia of Wall Street, the press, some economists and practically all politicians is one of the deepest dangers that we face. It's not just the old and the sick who are threatened; we all are. To cut current deficits without first rebuilding the economic engine of the private credit system is a sure path to stagnation, to a double-dip recession--even to a second Great Depression. To focus obsessively on cutting future deficits is also a path that will obstruct, not assist, what we need to do to re-establish strong growth and high employment.
To put things crudely, there are two ways to get the increase in total spending that we call "economic growth." One way is for government to spend. The other is for banks to lend. Leaving aside short-term adjustments like increased net exports or financial innovation, that's basically all there is. Governments and banks are the two entities with the power to create something from nothing. If total spending power is to grow, one or the other of these two great financial motors--public deficits or private loans--has to be in action.
For ordinary people, public budget deficits, despite their bad reputation, are much better than private loans. Deficits put money in private pockets. Private households get more cash. They own that cash free and clear, and they can spend it as they like. If they wish, they can also convert it into interest-earning government bonds or they can repay their debts. This is called an increase in "net financial wealth." Ordinary people benefit, but there is nothing in it for banks.
And this, in the simplest terms, explains the deficit phobia of Wall Street, the corporate media and the right-wing economists. Bankers don't like budget deficits because they compete with bank loans as a source of growth. When a bank makes a loan, cash balances in private hands also go up. But now the cash is not owned free and clear. There is a contractual obligation to pay interest and to repay principal. If the enterprise defaults, there may be an asset left over--a house or factory or company--that will then become the property of the bank. It's easy to see why bankers love private credit but hate public deficits.
All of this should be painfully obvious, but it is deeply obscure. It is obscure because legions of Wall Streeters--led notably in our time by Peter Peterson and his front man, former comptroller general David Walker, and including the Robert Rubin wing of the Democratic Party and numerous "bipartisan" enterprises like the Concord Coalition and the Committee for a Responsible Federal Budget--have labored mightily to confuse the issues. These spirits never uttered a single word of warning about the financial crisis, which originated on Wall Street under the noses of their bag men. But they constantly warn, quite falsely, that the government is a "super subprime" "Ponzi scheme," which it is not.
We also hear, from the same people, about the impending "bankruptcy" of Social Security, Medicare--even the United States itself. Or of the burden that public debts will "impose on our grandchildren." Or about "unfunded liabilities" supposedly facing us all. All of this forms part of one of the great misinformation campaigns of all time.
The misinformation is rooted in what many consider to be plain common sense. It may seem like homely wisdom, especially, to say that "just like the family, the government can't live beyond its means." But it's not. In these matters the public and private sectors differ on a very basic point. Your family needs income in order to pay its debts. Your government does not.
Private borrowers can and do default. They go bankrupt (a protection civilized societies afford them instead of debtors' prisons). Or if they have a mortgage, in most states they can simply walk away from their house if they can no longer continue to make payments on it.
With government, the risk of nonpayment does not exist. Government spends money (and pays interest) simply by typing numbers into a computer. Unlike private debtors, government does not need to have cash on hand. As the inspired amateur economist Warren Mosler likes to say, the person who writes Social Security checks at the Treasury does not have the phone number of the tax collector at the IRS. If you choose to pay taxes in cash, the government will give you a receipt--and shred the bills. Since it is the source of money, government can't run out.
It's true that government can spend imprudently. Too much spending, net of taxes, may lead to inflation, often via currency depreciation--though with the world in recession, that's not an immediate risk. Wasteful spending--on unnecessary military adventures, say--burns real resources. But no government can ever be forced to default on debts in a currency it controls. Public defaults happen only when governments don't control the currency in which they owe debts--as Argentina owed dollars or as Greece now (it hasn't defaulted yet) owes euros. But for true sovereigns, bankruptcy is an irrelevant concept. When Obama says, even offhand, that the United States is "out of money," he's talking nonsense--dangerous nonsense. One wonders if he believes it.
Nor is public debt a burden on future generations. It does not have to be repaid, and in practice it will never be repaid. Personal debts are generally settled during the lifetime of the debtor or at death, because one person cannot easily encumber another. But public debt does not ever have to be repaid. Governments do not die--except in war or revolution, and when that happens, their debts are generally moot anyway.
So the public debt simply increases from one year to the next. In the entire history of the United States it has done so, with budget deficits and increased public debt on all but about six very short occasions--with each surplus followed by a recession. Far from being a burden, these debts are the foundation of economic growth. Bonds owed by the government yield net income to the private sector, unlike all purely private debts, which merely transfer income from one part of the private sector to another.
Nor is that interest a solvency threat. A recent projection from the Center on Budget and Policy Priorities, based on Congressional Budget Office assumptions, has public-debt interest payments rising to 15 percent of GDP by 2050, with total debt to GDP at 300 percent. But that can't happen. If the interest were paid to people who then spent it on goods and services and job creation, it would be just like other public spending. Interest payments so enormous would affect the economy much like the mobilization for World War II. Long before you even got close to those scary ratios, you'd get full employment and rising inflation--pushing up GDP and, in turn, stabilizing the debt-to-GDP ratio. Or the Federal Reserve would stabilize the interest payouts, simply by keeping short-term interest rates (which it controls) very low.

Global Aggregate Demand

The following article (very short) by Bill Gross, the bond king, is a good read especially since we have been discussing consumption. I expect everyone to read it and write a comment.

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Investment Outlook
Bill Gross | March 2010

Don't Care

I haven’t gone to a cocktail party in over 10 years. Granted, perpetually watching Seinfeld reruns on Friday and Saturday nights makes for a dull boy, but the alternative is excruciating. Uh, which would I prefer – solitary confinement or water boarding? I lean strongly in the direction of a warm bed and peace as opposed to a glass full of tinkling ice cubes and a room resonating with high-decibel blather. I suppose the parties wouldn’t be so bad if there was something original to be said, or if “you” had a genuine interest in “me” as opposed to “you,” but let’s face it folks, no one does. The only reason any of us really cares about cocktail conversations is to quickly redirect someone else’s stories into autobiographies that we assume to be instant bestsellers if only in print. If not, if the doe-eyed listener seems simply fascinated by what you’re saying, you can bet there’s a requested personal favor coming when you finally shut up. “Say Bill, I was wondering if you knew somebody at…that could…” Yeah right! But, as my chart shows, 90 seconds into a typical conversation, no one gives a damn about you and your problems – maybe those shoes and that dreadful eye shadow you’re wearing, but not anything audible coming out of your mouth.

During that unbearable minute-and-a-half, however, you’re likely to have covered some of the following topics:

1. Where are you from? (If it’s not a place where I’ve been or have a distant second cousin – don’t care.)

2. How’s the family? (If Johnnie is in advanced placement courses and my kids aren’t – don’t care. Don’t care about your kids’ soccer games either or that upcoming wedding.)

3. Medical problems. (Unless you’re dying from cancer – don’t care. Your artificial hip and kidney stone stories are important only to let me tell you about mine.)

4. How’s work? (Forgot where you work, but it’s a good lead in. Don’t really care though unless you can direct some business my way.)

5. Can you believe Tiger? (Now there’s something I care about, but the wife is only five feet away.)

Actually, the “afterparty” is the best party of all – driving home with your partner and dissing all of the guests. Still, give me a home where Seinfeld roams, I suppose. Boring is better – cocktail parties are so 1990s.

In contrast to those cocktail parties, I‘ve got so much to say in this Investment Outlook that I don’t know where to start. Don’t be lookin’ around for something more important though, like you do at a cocktail party; I need your undivided attention for the full 90 seconds allotted me.

To begin with, let’s get reacquainted with the fundamental economic problem of our age – lack of global aggregate demand – and how we got to where we are today: (1) Twenty years of accelerated globalization incrementally undermined the real incomes of most developed countries’ workers/citizens, forcing governments to promote leverage and asset price appreciation in order to fill in what is known as an “aggregate demand” gap – making sure that consumers keep buying things. When the private sector assumed too much debt and asset prices bubbled (think subprimes and houses, or dotcoms/NASDAQ 5000), American-style capitalism with its leverage, deregulation, and religious belief in lower and lower taxes reached a dead end. There was a willingness to keep on consuming, there just wasn’t the wallet. Vigilantes – bond market or otherwise – took away the credit card like parents do with a mall-crazed teenager. (2) The cancellation of credit cards led to the Great Recession and private sector deleveraging, the beginning of government policy reregulation, and gradual deglobalization – a reversal of over 20 years of trade policies and free market orthodoxy. In order to get us out of the sinkhole and avoid another Great Depression, the visible fist of government stepped in to replace the invisible hand of Adam Smith. Short-term interest rates headed to 0% and monetary policies of central banks incorporated new measures labeled “quantitative easing,” which essentially involved the writing of trillions of dollars of checks to replace the trillions of dollars of credit that disappeared after Lehman Brothers. In addition, government fiscal policies, in combination with declining revenues, led to double-digit deficits as a percentage of GDP in many countries, a condition unheard of since the Great Depression. (3) For awhile it seemed that all was well, that the government’s checkbook could replace the private market’s wallet and credit cards. Risk markets returned to normal P/Es as did interest rate spreads, and GDP growth resumed; it was only a matter of time before job growth would assure the world that we could believe in the tooth fairy again. Capitalism based on asset price appreciation was back. It would only be a matter of time before home prices followed stock prices higher and those refis and second mortgages would stuff our wallets once again. (4) Ah, but Dubai, Iceland, Ireland and recently Greece pointed to a potential flaw in the model. Shaking hands with the government was a brilliant strategy in 2009 when it was assumed that governments had an infinite capacity to leverage themselves.

But what if they didn’t? What if, as Carmen Reinhart and Kenneth Rogoff have pointed out in their book, “This Time is Different,” our modern era was similar to history over the past several centuries when financial crises led to sovereign defaults or at least uncomfortable economic growth environments where real GDP was subpar based on onerous debt levels – sovereign and private market alike. What if – to put it simply – you couldn’t get out of a debt crisis by creating more debt?

You are now up-to-date and I’ve used up all of my 90 seconds, but bear with me, patient reader. I may not be able to get your kid a job at PIMCO, but maybe I could give you an idea or two as to what lies ahead. Let’s explore the last line in the previous paragraph first – can you get out of a debt crisis by piling on another layer of debt? The answer, of course, is that “it depends.” Replacing corporate and mortgage debt with a government checkbook is initially beneficial because the sovereign is assumed to be more creditworthy than its private market serfs. It taxes, it prints, it confiscates wealth if need be and so this substitution is medicinal in the early stages of a financial crisis aftermath – especially if debt/GDP levels are low to begin with. That is the case currently at most G7 countries, with the exception of Japan, although the balance sheets of Germany/France are obviously contaminated by its weaker EU members, and that of the U.S. by its Agencies and other off-balance-sheet liabilities. But based on existing deficit trends and the expectation that not much progress will be made in reducing them, markets are raising interest rates on sovereign debt issuance either in anticipation of higher future inflation, increased levels of credit risk, or both. This places a potential “cap” on the “debt” that supposedly can be created to get out of the “debt crisis.”

The threat of credit deterioration is clearly evidenced in the CDS or credit default market for sovereign countries. Greece has taken the headlines with its 350–400 basis point cost of “protection,” but even Japan and the U.K. approach 100 and the U.S. is nearly half of that. Markets, in fact, are demanding 20–30 basis points of higher insurance premiums for the best of credits relative to levels prior to Dubai and Greece. The inflation component of sovereign issuance is obvious as well. Potential serial reflators such as the U.K. and U.S. both show an increase of 50 basis points in their 10-year notes since the Dubai crisis in late November. While a portion of that 50 may in fact be credit related as pointed out above, the combination of credit and inflationary protection demanded by the market suggests, as Reinhart and Rogoff point out in their book, that government securities following a financial crisis are subject to huge increases in supply and accordingly, significant increases in risk and real yield levels.

It is interesting to observe that over the past few months when investors have begun to question the ability of governments to exit the debt crisis by “creating more debt,” that increases in bond market yields have been confined almost exclusively to Treasury/Gilt-type securities, and long maturities at that. There has even been a developing debate in the press (and here at PIMCO) as to whether a highly-rated corporation could ever consistently trade at lower yields compared to its home country’s debt. I suspect not, but the narrowing in spreads since late November solicits an interesting proposition: Government bailouts and guarantees such as those evidenced and envisioned in Dubai and Greece, as well as those for the last 18 months with banks and large industrial corporations across the globe, suggest a more homogeneous “unicredit” type of bond market. If core sovereigns such as the U.S., Germany, U.K., and Japan “absorb” more and more credit risk, then the credit spreads and yields of these sovereigns should look more and more like the markets that they guarantee. The Kings, in other words, in the process of increasingly shedding their clothes, begin to look more and more like their subjects. Kings and serfs begin to share the same castle.

This metaphor doesn’t really answer the critical question of whether a debt crisis can be cured by issuing more debt. The answer remains: It depends – on initial debt levels and whether or not private economies can be reinvigorated. But it does suggest the likely direction of sovereign yields IF global policymakers are successful with their rescue efforts: Sovereign yields will narrow in spreads compared to other high-quality alternatives. In other words, sovereign yields will become more credit like. When sovereign issues become more credit-like, as evidenced in Greece, Spain, Portugal, and a host of others, they move closer in yield to the corporate and Agency debt that supposedly rank lower in the hierarchy. That process of course can be accomplished in two ways: high-quality non-sovereigns move down to lower levels or governments move up. The answer to which one depends significantly on future inflation, the aftermath of quantitative easing programs, and the vigor of the private economy going forward. But the contamination of sovereign credit space with past and future bailouts is a leveler, a homogenizer, a negative for those sovereigns that fail to exert necessary discipline. Only if global economies stumble and revisit the recessionary depths of a year ago should the process reverse direction and place Treasuries, Gilts, et al. back in the driver’s seat.

Investors should obviously focus on those sovereigns where fundamentals promise lower credit or inflationary risk. Germany and Canada are amongst those at the top of our list while a rogues’ gallery of the obvious, including Greece, Euroland lookalikes, and the U.K. gather near the bottom. PIMCO’s “Ring of Fire” remains white hot and action, as opposed to cocktail blather, is required to maintain or regain trust in sovereign credits approaching the rocks. Just last week Bank of England Governor Mervyn King said that it would be difficult to cut government spending quickly, but that there needs to be a clear plan for doing so. Not good enough, Mr. King. Don’t care. Show investors the money, not vice-versa. An investor’s motto should be, “Don’t trust any government and verify before you invest.” The careful discrimination between sovereign credits is becoming more than casual cocktail conversation. A deficiency of global aggregate demand and the potential impotency of policymakers to close the gap are evolving into a life or death outcome for the weakest sovereigns, with consequences for credit and asset markets worldwide.

William H. Gross
Managing Director

How a New Jobless Era Will Transform America

The above mentioned article appeared in The Atlantic issue of March 2010. I would like each of you to take the time (20-30 minutes) to read the 4 pages.

Remember that the reward is in the journey :-)

http://www.theatlantic.com/doc/201003/jobless-america-future

Federal Deficit and Carbon Taxex

Sovereign debt , as a potentially crippling fiscal problem world wide, has risen to the forefront over the past few months. Whether it is the US, Europe, Japan or many other developed and developing countries the sovereign debt watch is on.

The major metrics of a pending sovereign debt crisis that have been in vogue for decades used to be applied only to developing countries. Unfortunately this is no longer the case. The Herculian efforts by governments all over the world; the developed in particular; to avoid a repeat of the debilitating depression of the 1930's has forced these countries to increase substantially their fiscal stimulus programs. In a sense the monetary and fiscal policies adopted by the officials of all of these countries have been very successful. A worst case scenario has been avoided.

But as economics has always taught us, There Ain't No Such Thing AS A Free Lunch; TANSTAAFL. Yes we avoided a deep recession and the top officials can pat themselves on the back for this. But maybe not. Is the cure at least as expensive or maybe even more so than the ailment that it saved us from? That is , currently, the $64,000 question or maybe I should say the $64 billion question?:-)

Often, our efforts at prescribing remedies are counter productive because of what is inherent in problem solving. We always seem to target the symptom rather than the disease. As a result we inevitably move from one crisis to the next as a result of the law of unintended consequences.

In our efforts to save the system and to prevent a major economic depression we proceeded to throw money at the problem in order to generate more final demand and thus put more people to work. What we did not stop to consider is the major question of how are we going to pay back all of these funds that we have borrowed? It seems that we did what we always do, shift the burden onto the future generations. The debt will not come due for some decades ,right? Wrong.Well informed individuals know that more debt implies more taxes in the future and so they take corrective by refusing to own the highly risky debt. Once we find out that the debt service is too large and that we cannot keep on rolling the debt unto the future then we will have no choice but to become deadbeats. That is where we are at the moment. The question is which country is going to go under first? Would it be Greece or would it be one of the other PIIGS? How about the UK, or evn Japan or the US? If any of these countries default would they set up a contagion that will devastate all the current international financial sytem as we know it?

Believe it or not there is a potential mechanism that if adopted could go a long way towards addressing the real cause of this issue and not only the surface phenomenon. The solution that I am about to propose is not new, actually,N.G Mankiw wrote about it in 2007.

"The scientists tell us that world temperatures are rising because humans are emitting carbon into the atmosphere. Basic economics tells us that when you tax something, you normally get less of it. So if we want to reduce global emissions of carbon, we need a global carbon tax. ...

The idea of using taxes to fix problems, rather than merely raise government revenue, has a long history. The British economist Arthur Pigou advocated such corrective taxes to deal with pollution in the early 20th century. In his honor, economics textbooks now call them “Pigovian taxes.”...some taxes align private incentives with social costs and move us toward better outcomes."


I would love to see a carbon tax levied not only in the major industrial countries but all over the globe with all the proceeds dedicated to lowering the sovereign debt. Such a tax could be a first step towards internalizing the negative externalities of all the production inthe world economy. If that leads to less and more efficient production then all of us will be winners.

Bernanke : Exit Strategy

I am sure that all of you recall the discussion that we had a few weeks ago about the balance sheet of the Federal Reserve and the potential exit strategy that is likely to be employed.

Well, if ,for any reason,you failed to appreciate the importance of the issue or if the discussion was not clear then here is your second chance:-) Mr. Bernanke released today a 10 page paper in which he detailed what the Fed intends to do And the following is the NYT coverage. Please read.
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February 11, 2010
Bernanke’s How-To on Rate Increase Lacks a When
By SEWELL CHAN
WASHINGTON — “At some point.” “At the appropriate time.” “When the time comes.”
On Wednesday, the Federal Reserve’s chairman, Ben S. Bernanke, outlined a strategy – but not a timetable – for scaling back the extraordinary measures it began taking in 2007 to prop up the economy as financial markets teetered on collapse.
The Federal Reserve has eased borrowing by lowering short-term interest rates to nearly zero and built up a $2.2 trillion balance sheet by scooping up assets like mortgage-backed securities and even credit card and auto loans.
Eventually, to avoid inflation, both actions will have to be reined in. But Mr. Bernanke, in a 10-page statement, provided few hints as to how long that period will be.
“Although at present the U.S. economy continues to require the support of highly accommodative monetary policies, at some point the Federal Reserve will need to tighten financial conditions by raising short-term interest rates and reducing the quantity of bank reserves outstanding,” he wrote. “We have spent considerable effort in developing the tools we will need to remove policy accommodation, and we are fully confident that at the appropriate time we will be able to do so effectively.”
However, Mr. Bernanke did provide new details a major concern: how, as the recovery proceeds, to gradually shrink the balance sheet, which along with a vast array of assets also includes $1.1 trillion that banks are holding with the Fed.
Mr. Bernanke suggested that a new policy tool – the interest rate on excess reserves, which the Fed began paying in October 2008 – would be a vital part of the Fed’s strategy.
Increasing that interest rate, he said, will have the effect of pushing up other short-term interest rates, including the benchmark fed funds rate – the rate at which banks lend to each overnight.
It is even possible, Mr. Bernanke said, that the Fed “could for a time use the interest rate paid on reserves, in combination with targets for reserve quantities,” to communicate its policy stance to the markets. Since 1994, the fed funds rate has been the much-watched centerpiece of statements by the Federal Open Market Committee, the Fed’s key policy-making arm.
For days, economists have been trying to forecast what Mr. Bernanke would say about the sequence of steps and the combination of tools the Fed will use to tighten credit. On that subject, Mr. Bernanke offered only hints of his thinking.
“One possible sequence would involve the Federal Reserve continuing to test its tools for draining reserves on a limited basis, in order to further ensure preparedness and to give market participants a period of time to become familiar with their operation,” he wrote. “As the time for the removal of policy accommodation draws near, those operations could be scaled up to drain more significant volumes of reserve balances to provide tighter control over short-term interest rates. The actual firming of policy would then be implemented through an increase in the interest rate paid on reserves.”
But Mr. Bernanke suggested that “if economic and financial developments were to require a more rapid exit from the current highly accommodative policy” – that is, if fears emerge about inflation – the Fed “could increase the interest rate paid on reserves at about the same time it commences significant draining operations.”
Along with raising the interest rate on reserves, Mr. Bernanke discussed three other options for draining reserves. The first involves reverse repurchase agreements, in which the Fed would sell securities from its portfolio with an agreement to repurchase them at a later date.
The second involves term deposits – similar to certificates of deposit – to banks. That would convert part of the banks’ reserves into deposits that could not be used for short-term liquidity needs and would not be counted as reserves.
A third tool involves redeeming or selling securities. That strategy could carry risk, as the Fed’s large portfolio of mortgage-backed securities is helping to prop up the housing market and keep mortgage-interest rates low.
Mr. Bernanke did note that the balance sheet would shrink a bit on its own, over time, as assets like mortgage-backed securities and debt guaranteed by Fannie Mae and Freddie Mac are prepaid or mature. “In the long run, the Federal Reserve anticipates that its balance sheet will shrink toward more historically normal levels and that most or all of its security holdings will be Treasury securities,” he wrote.
Mr. Bernanke also reviewed the controversial lending assistance it extended to “help avoid the disorderly failure” of Bear Stearns, which was sold to JPMorgan Chase, and the American International Group, which was bailed out by the government. Mr. Bernanke said that the credit extended under those arrangements totaled about $116 billion, or about 5 percent of the balance sheet.
“These loans were made with great reluctance under extreme conditions and in the absence of an appropriate alternative legal framework,” he said, emphasizing that he did not believe that the loans would result in any losses to taxpayers.
The statement was prepared for a House committee hearing that had been scheduled for Wednesday but was postponed because of snow. Mr. Bernanke decided to release the statement anyway.

Deficits and Power

February 2, 2010
News Analysis
Huge Deficits May Alter U.S. Politics and Global Power
By DAVID E. SANGER

WASHINGTON — In a federal budget filled with mind-boggling statistics, two numbers stand out as particularly stunning, for the way they may change American politics and American power.

The first is the projected deficit in the coming year, nearly 11 percent of the country’s entire economic output. That is not unprecedented: During the Civil War, World War I and World War II, the United States ran soaring deficits, but usually with the expectation that they would come back down once peace was restored and war spending abated.

But the second number, buried deeper in the budget’s projections, is the one that really commands attention: By President Obama’s own optimistic projections, American deficits will not return to what are widely considered sustainable levels over the next 10 years. In fact, in 2019 and 2020 — years after Mr. Obama has left the political scene, even if he serves two terms — they start rising again sharply, to more than 5 percent of gross domestic product. His budget draws a picture of a nation that like many American homeowners simply cannot get above water.

For Mr. Obama and his successors, the effect of those projections is clear: Unless miraculous growth, or miraculous political compromises, creates some unforeseen change over the next decade, there is virtually no room for new domestic initiatives for Mr. Obama or his successors. Beyond that lies the possibility that the United States could begin to suffer the same disease that has afflicted Japan over the past decade. As debt grew more rapidly than income, that country’s influence around the world eroded.

Or, as Mr. Obama’s chief economic adviser, Lawrence H. Summers, used to ask before he entered government a year ago, “How long can the world’s biggest borrower remain the world’s biggest power?”

The Chinese leadership, which is lending much of the money to finance the American government’s spending, and which asked pointed questions about Mr. Obama’s budget when members visited Washington last summer, says it thinks the long-term answer to Mr. Summers’s question is self-evident. The Europeans will also tell you that this is a big worry about the next decade.

Mr. Obama himself hinted at his own concern when he announced in early December that he planned to send 30,000 American troops to Afghanistan, but insisted that the United States could not afford to stay for long.

“Our prosperity provides a foundation for our power,” he told cadets at West Point. “It pays for our military. It underwrites our diplomacy. It taps the potential of our people, and allows investment in new industry.”

And then he explained why even a “war of necessity,” as he called Afghanistan last summer, could not last for long.

“That’s why our troop commitment in Afghanistan cannot be open-ended,” he said then, “because the nation that I’m most interested in building is our own.”

Mr. Obama’s budget deserves credit for its candor. It does not sugarcoat, at least excessively, the potential magnitude of the problem. President George W. Bush kept claiming, until near the end of his presidency, that he would leave office with a balanced budget. He never got close; in fact, the deficits soared in his last years.

Mr. Obama has published the 10-year numbers in part, it seems, to make the point that the political gridlock of the past few years, in which most Republicans refuse to talk about tax increases and Democrats refuse to talk about cutting entitlement programs, is unsustainable. His prescription is that the problem has to be made worse, with intense deficit spending to lower the unemployment rate, before the deficits can come down.

Mr. Summers, in an interview on Monday afternoon, said, “The budget recognizes the imperatives of job creation and growth in the short run, and takes significant measures to increase confidence in the medium term.”

He was referring to the freeze on domestic, non-national-security-related spending, the troubled effort to cut health care costs, and the decision to let expire Bush-era tax cuts for corporations and families earning more than $250,000.

But Mr. Summers said that “through the budget and fiscal commission, the president has sought to provide maximum room for making further adjustments as necessary before any kind of crisis arrives.”

Turning that thought into political action, however, has proved harder and harder for the Washington establishment. Republicans stayed largely silent about the debt during the Bush years. Democrats have described it as a necessary evil during the economic crisis that defined Mr. Obama’s first year. Interest in a long-term solution seems limited. Or, as Isabel V. Sawhill of the Brookings Institution put it Monday on MSNBC, “The problem here is not honesty, but political will.”

One source of that absence of will is that the political warnings are contradicted by the market signals. The Treasury has borrowed money to finance the government’s deficits at remarkably low rates, the strongest indicator that the markets believe they will be paid back on time and in full.

The absence of political will is also facilitated by the fact that, as Prof. James K. Galbraith of the University of Texas puts it, “Forecasts 10 years out have no credibility.”

He is right. In the early years of the Clinton administration, government projections indicated huge deficits — over the “sustainable” level of 3 percent — by 2000. But by then, Mr. Clinton was running a modest surplus of about $200 billion, a point Mr. Obama made Monday as he tried anew to remind the country that the moment was squandered when “the previous administration and previous Congresses created an expensive new drug program, passed massive tax cuts for the wealthy, and funded two wars without paying for any of it.”

But with this budget, Mr. Obama now owns this deficit. And as Mr. Galbraith pointed out, it is possible that the gloomy projections for 2020 are equally flawed.

Simply projecting that health care costs will rise unabated is dangerous business.

“Much may depend on whether we put in place the financial reforms that can rebuild a functional financial system,” Mr. Galbraith said, to finance growth in the private sector — the kind of growth that ultimately saved Mr. Clinton from his own deficit projections.

His greatest hope, Mr. Galbraith said, was Stein’s law, named for Herbert Stein, chairman of the Council of Economic Advisers under Presidents Richard M. Nixon and Gerald R. Ford.

Stein’s law has been recited in many different versions. But all have a common theme: If a trend cannot continue, it will stop.

Currency Reform

Reflections on Currency and the Euro
Steve H. Hanke1

Lars Jonung and Eoin Drea (2010) conclude that the pessimistic stance
taken by most American economists toward the euro in the 1989-2002 period
“was probably fostered by the propensity of U.S. economists to view the euro as a
political project driven by murky motivations and based on an insufficient
institutional foundation.” If most American economists thought the euro was
largely a political project, they were right on target. As one reads thorough
accounts of the birth of the euro, it is clear that politics, not economics, ruled the roost (Brown 2004; Marsh 2009).

This realistic view—that “politics” dominates—does not suggest that one
would take either a pessimistic or an optimistic stance toward the euro, however.
In my experience as an adviser on currency reforms in Europe in the 1990s, I
observed first-hand that politics, and on occasion personal pique, not the
economics of optimum currency areas, dominated, and that this state of affairs
could still produce good reforms.

In Estonia, which established an independent currency in 1992, the
overriding national objective was to exit the ruble zone, and more broadly,
Moscow’s sphere of influence. A currency board was the most effective way to
rapidly accomplish the goal. The driving force behind Lithuania’s similar 1994
currency reform was Prime Minister Adolfas Slezevicius. A currency board
appealed to him because it was a means to move the governor of the central bank
to the sidelines and to impose fiscal discipline on his own Democratic Labor
Party, which controlled parliament. A hyperinflation in Bulgaria in 1997 sparked a
popular outcry for sound money and a currency board, an idea that had been
circulating in professional circles since 1991. Indeed, a Bulgarian-language
knockoff of an old monograph I had written in 1991 (Hanke and Schuler 1991)
made the bestseller list in Sofia during the hyperinflation. Bosnia and Herzegovina
also installed a currency board in 1997. It was mandated by the Dayton/Paris
Peace Agreement of November 21, 1995—an international treaty. Montenegro,
while still part of the Federal Republic of Yugoslavia along with Serbia, dumped
the Yugoslav dinar and replaced it with the German mark in November 1999. This
bold move by then-President Milo Djukanovic; was part of a political strategy to
establish Montenegro’s independence. Like the establishment of the euro,
Montenegro’s embrace of the German mark had politics, not economics, as its
hallmark.

That there was a political rationale and popular support for the currency
reforms that I was advocating made my day. That the finer economic points took a
back seat failed to move me.2 All of the above-mentioned countries continue
today with the monetary policies they established in the 1990s. (Montenegro
switched to the euro when euro notes and coins replaced the German mark.) The
policies were adopted in large part for political reasons, but they have persisted
because they have produced what was anticipated: strong economic results.
My views on exchange rates are based on the distinction between strictly
fixed, strictly floating and pegged regimes. Fixed and floating rates are regimes in
which the monetary authority is aiming for only one target at a time. Although
floating and fixed rates appear dissimilar, they are members of the same freemarket
family. Both operate without exchange controls and are free-market
mechanisms for balance-of-payments adjustments. With a floating rate, a central
bank sets a monetary policy but the exchange rate is on autopilot. In consequence,
the monetary base is determined domestically by a central bank. With a fixed rate,
there are two possibilities: either a currency board sets the exchange rate, and the
money supply is on autopilot, or a country is “dollarized” and uses the U.S. dollar
or another foreign currency as its own, and the money supply is again on autopilot.
From the perspective of an individual country, a monetary union such as the
eurozone is similar to dollarization. In consequence, under a fixed-rate regime, a
country’s monetary base is determined by the balance of payments, moving in a
one-to-one correspondence with changes in its foreign reserves. With either a
floating or a fixed rate, there cannot be conflicts between monetary and exchange
rate policies, and balance-of-payments crises cannot rear their ugly heads.
Floating- and fixed-rate regimes are inherently equilibrium systems in which
market forces act to automatically rebalance financial flows and avert balance-of payments crises.

Most economists use “fixed” and “pegged” as interchangeable or nearly
interchangeable terms for exchange rates. For me, they are very different
exchange-rate arrangements. Pegged-rate systems are those where the monetary
authority is aiming for more than one target at a time. They often employ
exchange controls and are not free-market mechanisms for international balanceof-
payments adjustments. Pegged exchange rates are inherently disequilibrium
systems, lacking an automatic mechanism to produce balance-of-payments
adjustments. Pegged rates require a central bank to manage both the exchange rate
and monetary policy. With a pegged rate, the monetary base contains both
domestic and foreign components.

Unlike floating and fixed rates, pegged rates invariably result in conflicts
between monetary and exchange rate policies. For example, when capital inflows
become “excessive” under a pegged system, a central bank often attempts to
sterilize the ensuing increase in the foreign component of the monetary base by
selling bonds, reducing the domestic component of the base. And when outflows
become “excessive,” a central bank often attempts to offset the decrease in the
foreign component of the monetary base by buying bonds, increasing the
domestic component of the monetary base. Balance-of-payments crises erupt as a
central bank begins to offset more and more of the reduction in the foreign
component of the monetary base with domestically created base money. When
this occurs, it is only a matter of time before currency speculators spot the
contradictions between exchange rate and monetary policies and force a
devaluation, interest-rate increases, the imposition of exchange controls, or all
three.

During the ramp-up to the launch of the euro, I served, among other things,
as an officer of a hedge fund. Given my views on exchange-rate regimes, the
period provided many profitable trading opportunities. After all, the Exchange
Rate Mechanism (ERM) was a system of pegged exchange rates. When a pegged
system experiences trouble, typically a country’s interest rates rise, its currency
slumps, or both. With this in mind, I was either selling deposits in a “weak”
currency country or shorting other European currencies against the German
mark. As an example of my thinking (and trading), in January 1992 I wrote:

Within the next month, the market will push sterling to its lowest point
in the ERM band. Facing that eventuality, there are four possible British
policy responses: 1) allow sterling to be devalued to about DM2.5 and
eventually allow interest rates to come down a bit; 2) defend sterling and
restore a central rate of DM2.95 by increasing interest rates a full
percentage point to 11.5%; 3) negotiate a realignment of the ERM along
the lines we suggest; or 4) bring back (God forbid) exchange controls.
Rational as options 1) and 3) might be, we believe that the Brits have
invested so much political capital in the ERM and the ridiculous DM
2.95 that they will grudgingly choose option 2) and raise interest rates.
Sell March three-month sterling deposits. Place stop at 90, good
anytime. (Hanke 1992)

As it turned out, that was a profitable trade. But my judgment about what
the United Kingdom would do with the pound caused me to miss the big trade on
Black Wednesday, September 16, 1992, when the government floated the exchange
rate, in effect devaluing, rather than raising interest rates further.
That said, there were paydays associated with bets against the ERM pegs.
The most notable one occurred at the end of July 1993, when France’s pegged
rate, dubbed the franc fort, came a-cropper (Sulitzer 1993). In consequence, the
ERM’s narrow band was widened from 2.25% to 15% around the central rates.
I considered the euro sound from a technical perspective, because it
requires a fixed exchange rate rather than pegged rates among member countries,
but my policy views concerning the euro were generally skeptical during the euro’s
ramp-up phase. The basis for my skepticism was the idea that a strong euro would
in the long run require a strong central state, as Robert Mundell (2000) has
suggested. While I agree with Mundell’s diagnosis, I did not, and do not, consider a
strong central state desirable. For me, the European Union and the European
Commission represent additional political and bureaucratic layers that will impede
much-needed European economic liberalization.

While I was skeptical of a common currency for Europe, I favored European
currency unification via currency boards (Hanke and Walters 1990). And I
was not alone. During a May 1990 meeting in East Berlin with Karl Otto Pöhl,
President of the Bundesbank, he confirmed that we shared the same vision (Marsh
2009, 131) and encouraged me to press ahead. Such a unified currency approach,
with the German mark as the anchor, would have given Europe monetary
stability, while at the same time it would have avoided the ratcheting up of the
state and bureaucratic powers that have accompanied the euro.

References
Bogetic, Zeljko, and Steve H. Hanke. 1999. Cronogorska Marka. Podgorica,
Montenegro: Antena M.
Brown, Brendan. 2004. Euro on Trial: To Reform or Split Up? New York: Palgrave
Macmillan.
Hanke, Steve H. 1992. The Walters Critique. Friedberg’s Commodity and Currency
Comments, 26 January.
Hanke, Steve H. 1996/7. A Field Report from Sarajevo and Pale. Central Banking
7(3).
Hanke, Steve H., Lars Jonung and Kurt Schuler. 1992. Monetary Reform for a
Free Estonia: A Currency Board Solution. Stockholm: SNS Förlag.