OPM (Other's People Money)

July 21, 2010

These are fascinating times for noneconomists to observe the battle of economic philosophies. We love John Maynard Keynes here in the states. No fiscal stimulus, no matter how inept or costly is to be maligned. Deficits don't matter. Markets are erratic and corrupt; trust in your elected politicians and their desgnated hacks, I mean regulators. No pain for the electorate is tolerable. The Europeans and particularly the British have had it with John Maynard. Dutifully following his precepts have lead to insolvency. Screw stimulus! For that matter, screw entittlements. These fools are going to start paying their bills!

Severe austerity is the word on the eastern shores of the Atlantic. Socialism is being decomissioned. As noted previously, Socialism doesn't work; it fails when you run out of other people's money. Horrors say our esteemed Keynsian economists like Paul Krugman. Paying your bills in the face of a recession is countercylical. This deplorable strategy will lead from recession to depression. Instead say they, these brilliant academics, the solution to a debt-induced delevering economic slowdown is to borrow and spend your way to prosperity. I guess we'll see who's right. The US will borrow and spend and the Europeans will cut and save. Interestingly, this is not the only time when countries in distress have adopted different solutions to their problems. In the early 90', Japan was entering it's eternal deflationary depresssion. Non other than our very own Ben Bernanke jetted across the Pacific to tell them exactly what to do: quantitative easing,(money printing), and fiscal stimulus. They followed his advice to the letter, over and over again. Consequence: deflationary depression. The Canadians were in deep dodo at the same time; bad economy and burgeoning public debt. They took the European approach; cut spending, reduced entittlements and endured the subsequent pain. They got a hell of a recession, significant unemployment but inabout 3 years the lights went on and with their fiscal situation solid, have emerged arguably the best economy of the G7.

Gentle Ben hates deflation! Back in 2003, with the CPI at 1.8%, while riding shotgun for Greenspan,(The Maestro), they took the discount rate to 1% for fear of deflation following the busting of the tech bubble. Net result: the housing bubble. Now, the CPI is 1% less than that prior alarming number, you can bet that old Ben is having some sleepless nights. Cann't lower interest rates because they're already zero. What to do? Quantitative easing!

Not so fast say I. Why not? Because it won't work. It won't work because the US has entered a liquidity trap. Remember the IS curve from your Econ 101? A downward sloping curve with interest rates as the independent variable and output as the dependent variable. The point is that declining interest rates lead to rising production. Alas, what happens when interest rates are zero and so is production/employment/housing/etc. At that point, the Fed is pushing on the proverbial string; it's out of bullets. The Japs repeatedly tried it; it didn't work. What's left; more fiscal stimulus from a bankrupt federal government? I say that the bond market has got it right; ever declining yields strongly suggest minimal economic growth and the spectre of deflation. The equity market will join the party, on the downside in time. This country, unfortunately has a flawed economic model. It's based on consumption fueled by credit(debt). We are in a multiyear process of delevering debt, liquidation of bad debt and contraction of credit. We can take the hit quickly or draw it out but wecann't escape it. The Fed controls short term interest rates; the market controls long term rates. The Fed controls the monetary base(M1) but the credit markets control M2 and M3, both of which are shrinking. Galactic levels of bad debt are in essance, the black hole of $.

-Guga