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Wednesday, February 19, 2020

America and the Liquidity Trap, Part 3

What happens when Congress runs out of cheap money? Hint: it won't be pretty.

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In its latest budget outlook the Congressional Budget Office declares America's return to trillion-dollar deficits. At $1.02 trillion for 2020 and exactly $1 trillion for 2021, the deficit then soars past $1.7 trillion by 2030. 

At an annual inflation rate of 2.5 percent per year this is a 48-percent increase in real terms of the budget deficit, compared to 2020. 

Plain and simple: totally irresponsible. But we probably won't even make it close to the 2030 mark. There are two reasons for this: the fiscal illiteracy among our political leaders, and the end of the bond market as a funding source for the deficit.

Yes, you got that right. The market for sovereign debt is close to saturated, in other words the point where it cannot swallow more debt.

More on that in a moment. First, the political leadership. Expains Michael Tanner in National Review:
what was little more than a footnote amid the noise of impeachment and the continuing chaos of the Democratic primaries, late last month the Congressional Budget Office officially announced that for the first time since 2012, our annual budget deficit will top $1 trillion. Even worse, our fiscal house is set to remain in abominable shape for the foreseeable future: The CBO projects that the deficit will average $1.3 trillion from 2021 to 2030 and that the current $22 trillion gross national debt will reach $36.2 trillion by 2030.
The share held by the public is bound to rise from $17.9 trillion in 2020 to $31.4 trillion in 2030. Adjusted for a 2.5-percent annual inflation rate, this comes out to a 28-percent increase.

Tanner aptly zeroes in on the outright recklessness that is now leading the Democrat candidate field:
The most shameless of them is the self-proclaimed democratic socialist Bernie Sanders, who has proposed $97.5 trillion in new spending over the next ten years. To finance his grandiose plans, Sanders is proposing a variety of taxes on the rich totaling some $23 trillion and more than $74 trillion in additional debt. Think about that: Sanders’ plan would push the national debt over $100 trillion by the end of the decade.
Sanders may very well be as ignorant on economic issues as he seems to be. He may also have listened too much to his economic advisor, Stephanie Kelton, and her Mad Monetary Theory. This joke of an "economic theory" has been practiced in countries like Zimbabwe and Venezuela, with well-known consequences.

Sadly, Sanders is only the tip of the debt iceberg. The entire crop of Democrat candidates want to floor the accelerator on government spending. Some of them want to raise taxes to pay for it, others apparently rely on Mad Monetary Theory to fund their budget binge.

Unfortunately, as Michael Tanner notes, President Trump is not beyond reproach either:
He has signed $4.7 trillion of new debt into law over his first three years in office. If he wins reelection and continues at that pace, by the end of his second term, Trump will end up having added more to the national debt than President Obama. And he will have done it amid relative prosperity, rather than the recession Obama had to navigate.
Well, Obama's recession was not exactly unfortunate. It was largely self-inflicted. He went on a regulatory spree across the country, to all corners of the economy, making it increasingly difficult for businesses to plan for the future, or even keep their doors open. Many industry groups had to massively expand crony-capitalist practices like lobbying to carve out exceptions and other perks from an otherwise business-hostile administration.

That said, Tanner is absolutely right in criticizing Trump for his lax attitude to the deficit. In fact, he quotes the president as saying "Who the hell cares about the budget? We're going to have a country." While I appreciate Trump's optimism about America's future, this attitude is closely reminiscent of what President Reagan expressed in his famous comment that the budget deficit "is big enough to take care of itself." 

So far, though, both Obama and Trump have been able to abscond from the deficit by letting the Treasury borrow handsome amounts on the sovereign-debt market. They have relied on the country having an insatiable appetite for its own debt, and on the world and the Federal Reserve for filling in the gaps when American debt buyers aren't eager enough to lend their money to government. 

That appetite, however, is near the end of the rope. As I explained back in January, we are on the verge of the good old liquidity trap: a point where printing more money will make no difference to the economy.

When government sells bonds to the general public, it borrows liquidity and puts it out in the form of spending. The more bonds it sells, all other things equal, the higher the interest rate will have to be in order to bring people to buy the bonds. The higher rates eventually affect the overall interest rate in the economy, stifling consumer spending and having some negative effect on business investments. This, in turn, depresses growth in the tax base, causing the deficit to expand.

To avoid this, deficit-spending governments like to rely on their central banks. When the European Central Bank, the Bank of England, the Federal Reserve and other central banks lend money to the government, they do so by printing new money with which they buy treasury bonds. Contrary to when the public buys deficits, this leads to lower interest rates (technically the price for money): as money supply grows relative money demand, the interest rate falls.

Lower interest rates, of course, have the opposite effect from higher rates: consumer spending becomes cheaper (as much of it is driven by interest on mortgages, car loans, credit cards, etc) and especially smaller businesses can more easily find good funding deals on investment projects. Many monetary economists therefore encourage money printing as as a stimulative measure. Politicians also tend to prefer central-bank funded deficits to tax hikes.

Mad Monetary Theorists are among the leaders of this line of thinking, but you don't have to go to their extreme to realize what problems you run into going down this path. As I explained in my January article, money demand ceases to expand at some point, regardless of how much lower interest rates get. The reason is simple: at some point consumers reach the maximum of what they can spend, and businesses run out of profitable projects to invest in - especially on credit. 

This is the point where money demand goes vertical, i.e., it does not grow anymore. In a sound economy, this point is equal to the economy's overall capacity cap, i.e., where we have full employment and all factors of production are being used to their maximum.

Problems occur when we reach the "vertical" point earlier than full employment. This has happened in Europe, where interest rates are now negative, without even a hint of positive effects on the economy. 

The reason for the negative rates is that European governments want to fund their deficits at dirt-cheap rates. One of the motivating factors behind this is that the lower rates also will stimulate private-sector activity, drive up growth and eventually generate tax revenue enough to replace the massive money printing. Yet Europe is not seeing this positive effect, and the reason is simple: their government has grown so big that it is crowding out the private sector, depressing growth and causing standard of living to stagnate.

About the only positive contribution has been the scant but visible stimulative effects of deficit-funded government spending. This is, of course, the most inefficient way imaginable for getting any kind of growth in an economy, but in lieu of a dollar, a dime is better than nothing. However, so long as the sovereign-debt market is funding part of the ongoing deficits, it will eventually reach a point where it no longer finds it worth the while to invest in more government debt.

With negative interest rates, we are just about there. Or, as the Wall Street Journal reports, p. B2, February 18 Print Edition, with reference to Japan and its decades-long experiment with sub-zero interest rates:
Daval Joshi, chief European investment strategist at BCA Research, thinks the Japanese experience won't be repeated because there is a hard floor for yields around minus 1%. Beyond that, it makes sense to store bank notes in a vault instead, so central banks can't cut the policy rate much below that without the politically explosive move of abolishing physical cash.
When there are no open-market takers for government debt, all that remains is the central bank. When the central bank has to take full responsibility for funding the budget deficit, the path to hyperinflation is wide open. 

America is not there yet, but unless the president and Congress drastically change their spending habits, we will get there, and way sooner than 2030.
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For America and the Liquidity Trap Part 1, click here.

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