Deficits don't matter; entrepreneurs do.

I'll explain the mysterious looking graphic above a little later in this post. For now, I need to spend some time talking about deficits. Wow, they sure are huge, aren't they?

Republicans, unsurprisingly, are already playing the deficit card:

“Who among us would ask our children for a loan, so we could spend money we do not have, on things we do not need? That is precisely what the Democrats in Congress just did. It’s irresponsible.”
—Bobby Jindal, Feb. 24, 2009

President Obama apparently saw that coming:

"With a $787 billion stimulus package in hand, President Barack Obama will pivot quickly to address a budget deficit that could now approach $2 trillion this year. He has scheduled a 'fiscal responsibility summit' on Feb. 23..."
—Wall Street Journal, Feb. 14, 2009

The only problem with the Republicans' and Democrats' concerns about the federal deficit and debt is this: deficits don't matter. Worrying about deficits is barking up the wrong tree — at what is possibly the worst time in our nation's history to be making that mistake. The time our politicians and ideologues are wasting on the deficit debate is preempting a national debate on the only real solution to our economic problems: returning to robust economic growth. The unimportant, time-wasting deficit drivel could end up being extremely costly to our kids and grandkids.

Before going further, I should cover three falsehoods about deficits. Each deserves a lengthier explanation, but for now, I'll be as concise as possible.

Deficit falsehood #1

"Our kids and grandkids will eventually have to pay off the federal debt. Deficits increase the debt, saddling future generations with a bigger number to pay off."

Rebuttal: Anyone who believes falsehood #1 does not understand debt rollover. Bill O'Reilly is one among millions who don't; unfortunately, O'Reilly has a bigger microphone than most, and he has been using it to peddle false fear. What a pinhead.

Deficit falsehood #2

"Deficits cause inflation."

Rebuttal: Unanticipated inflation higher than about 2.5% is undesirable, that's true. But fiscal deficits rarely if ever contribute to inflation. Fiscal deficits are funded by borrowing dollars that already exist; deficits by themselves do not create inflation pressure. Controlling inflation (and deflation) is the responsibility of monetary policy, not fiscal policy.

Deficit falsehood #3

"Interest on the debt buys us nothing."

Rebuttal: That's simply false on its face. Steady, uninterrupted interest payments buy us our nation's creditworthiness — which in turn buys us the ability to supplement tax receipts with dollars from willing lenders — which in turn prevents us from having to cut back on government purchases such as aircraft carriers,  weather satellites, levees, border guards, border fences, bullet-proof vests for our troops, and (last but not least) intelligence systems for preempting such things as the infiltration and simultaneous detonation of suitcase nukes in eight or ten of our large cities. Deficits supplement our government's ability to protect us; surpluses diminish it. (That's the main reason I prefer deficits to surpluses, by the way.) In short, falsehood #3 ("interest buys us nothing") is about as far from the truth as it's possible to get.

The real problem, and the only solution

What if interest on the debt consumed more and more and more of our federal budget? It took 15-16% of the budget in the Clinton years, and 8-10% of our budget during the GW Bush years. But what would happen if paying the interest took a far larger portion of the budget - say, 30% or 40%+ of the budget?

Answer: Well, now THAT would be a problem; it would diminish our government's ability to protect us, regardless of which party was in charge. We DEFINITELY need to keep that from happening, or else we will be sentencing our grandkids to a  disaster. So, that begs the question, How do we keep it from happening?

History holds the clue. For at least two centuries, we've been rolling the debt principal over and over. We've also been paying the interest out of the federal budget, and we've never missed a single payment — even though both the debt and the interest payments have grown tremendously in those two centuries. How did we manage that? More importantly, how might we continue that practice for a few more centuries?

The reason we were able to afford it was economic growth. The mix of available jobs kept getting better and better — as did the paychecks, the things those paychecks would buy, and the overall standard of living. The debt grew and grew, we ran deficits far more frequently than surpluses, but it didn't matter because our economy was growing. Bigger paychecks meant more gross pay, more tax dollars paid to the government, and more take home pay. We could afford more and more of everything, including interest payments to the savers who were happy to keep funding our federal borrowing.

Bottom line: Growth not only raised our standard of living, it enabled us to pay the interest, and to roll the debt principal over. That formula has been working for two centuries (eight generations); why can't it continue working for another two centuries or more? To ask that a different way: What growth rate would we need in order to ensure that we'd remain in good shape indefinitely?

That's what I was asking myself when I read through the assumptions in President Obama's budget. Some have called the assumptions a "rosy scenario." I can't agree with that yet, because I think robust growth is still possible. What I have heard are two things I cautiously agree with: Obama's budget is (1) full of stimulus spending that is supposed to cease once the economy has been stimulated back to the growth path, and (2) full of investments, investments, investments. (Successful investments yield a better future; unsuccessful ones don't. In the private sector, we were careful to vet the proposed investments ahead of time, approve only the ones that seemed to meet the hurdle criteria, then move ahead on those that did. Subsequently, we would enjoy the fruits of the successful investments, and just as important, cut our losses on the ones that didn't deliver.)

The reasons I'm cautious about Obama's budget: (1) I'm not so sure the Democrats, including Obama, have the discipline to stop "stimulating" their constituents after the private sector returns the economy to the growth path; and (2) I'm almost certain that the government lacks the discipline or the incentive to kill the loser projects — and there will be losers.

In any case, Obama has laid down the results his budget is expected to produce each year for the next five years. I've placed those assumptions into a financial model that starts now and goes out several generations into the future, to answer the question we defined above: What portion of the federal budget will be required to pay the interest on the debt, assuming we get the deficit down to 3.5% of GDP, and hold inflation steady at 2.5%, both continuing indefinitely?

Well, that depends on the real growth rate the economy achieves. It goes without saying that the current downward spiral (negative 6.2 percent), if it continued, would quickly lead to catastrophe. [Picture the streets full of angry unemployed people in our major cities; they wouldn't care one whit about who Friedrich Hayek was.] The downward spiral must be reversed. Republicans and Blue Dog Democrats, by opposing stimulus and rescue spending, are willing to take a gamble I am not willing to take. 

So, I first loaded this financial model with the five-year Obama assumptions. Happily, his budget says we'll get back to 4.2% real growth by year 5. That's the dark green line below, and it's good news: interest on the debt would require a smaller portion of the budget versus the Clinton years, a larger portion versus the GW Bush years, and would remain level almost forever (even though the model assumes we run deficits indefinitely).

In short, 4.2% growth is very encouraging, if we achieve it. [Many of us will be watching the results closely, and expecting more accountability from government for achieving their advertised numbers.]

But what if steady-state growth turned out to be different from the Obama budget assumption of 4.2%? As you can see, I modeled those scenarios, too. Red lines are bad news, green and blue are good news. I hope these results make it clear that deficits don't matter. When the economy is plummeting, deficits are designed to help us return to growth. When the economy is humming along on a healthy growth trend, deficits are harmless, even desirable. Deficits don't matter, growth does.

A return to robust growth is the change we need. Private sector entrepreneurs are the ones who can deliver it — if we are wise enough to set up the proper incentives for them to decide to get moving.

President Obama and entrepreneurs

Does President Obama know what the word "entrepreneur" means? I'm not so sure. Here's the definition...

entrepreneur: One who starts a business or other venture that promises economic gain but that also entails risks.
—The American Heritage New Dictionary of Cultural Literacy

Does our president understand what types of policies encourage (or discourage) entrepreneurs? His speeches and his budget proposal are not encouraging along those lines. I found the word "entrepreneur" in exactly one of his campaign speeches (June 5, 2008; he used it to describe Senator Mark Warner). His budget only pays lip service to "entrepreneurs" in a few obscure places. It's discouraging that entrepreneurs don't seem to be top-of-mind for our president, even though they are the ones who would conceive and create the higher-paying jobs of the future, the real jobs (as opposed to government jobs) it will take to grow the economy. They'll be the ones employing our grandkids at higher wages and salaries, if only we understand, and set up, the incentives that will reward them for success. [Obama's call for higher taxes on successful Sub-S corporations does not incentivize entrepreneurs, by the way.]

Mark Cuban sounds unsure about Obama as well:

...Obama needs to have the counsel of those who will take the real risk inherent in creating companies and jobs. Those who put their money and lives on the line with their business. Without it, the rules of unintended consequences of any economic policy could hit you in the mouth in ways you never expected. Things like forcing companies from being taxpayers to the underground cash economy, or forcing new hires to be independent contractors to avoid having to pay their insurance or higher matching social security amounts. [His] current group has no one with 100pct of their networth on the line. I promise you that the possibility of losing it all will provide a completely different perspective than any of the “knowledge” the esteemed, learned members of his current advisory team offer.

I hope this isn't a bad omen. We'll see, soon enough. The economy's growth, and the size of government (as a share of the economy) will tell the story within two or three years. Real growth of 4.2% would not only be commendable, it is the change we need; but without entrepreneurs, it's a fantasy. Government "experts" don't have a clue about how to grow a $14 trillion economy at a 4.2% annual pace. I certainly hope Mr. Obama catches onto that before it's too late to meet his budget targets.

Comments

[Steve C]

As of 2009 this line of argument makes you a flaming liberal.

[Optimist123]

Steve C:

Sounds as if you didn't read all the way to the end.

[timwalsh300]

A flaming liberal?

I think it was Dick Cheney who was skewered for saying, "Reagan proved that deficits don't matter!"

[RichW]

Obama seems to have a toxic mix of advisors around him. Deficit hawks who are convinced the way to prosperity is balanced budgets or maybe even surpluses and plain old fashioned liberals who see tax policy as a way to enact to some social justice on the undeserving rich.

I fear the result will be subpar growth for years to come.

[beancounter]

Deficit hawks don't understand economies of scale.

They believe a group's purchasing power is the sum of the individual purchasing powers. So they don't understand how a massive deficit can grow the economy and believe it's just a game of musical chairs.

Imagine if Jindal had called for massive deficits to fuel defense, nuclear power and tax breaks to entrepreneurs. No longer would it be talk about whether to spend, but what to spend on.

[clive999]

As spending increases the national debt as a percentage of GDP, what do you consider a safe maximum for this crisis? 100% 120% or more? (assuming a generous 3% growth from 2010 for 5 years
I ask as it looks like committed spending and a negative -6% growth for first half 2009 looks to make it conservatively 100% of GDP within 2 years
thanks
clive

[Optimist123]

clive:

It peaked at 120% in 1946, and inflation (though predicted by many) never materialized; we grew our way back down to double digits in the 1950s.

That tells me that 120% is not an upper limit. That's why I'm for whatever it takes to reverse the decine and get us back on the growth path.

[Bob]

We'll done, Steve.

We'll have to watch the number of IPO's closely over the next couple of years. That's the best gauge I can think of to monitor successful entrepreneurship. Is that a graph you could construct?

You know, I sure would like some "first things first" behavior from WDC and by that I mean the banking system has to be fixed before we can get back to growth, IMO. The severe uncertainty in the financial markets is a big cause of concern for me. Without private sector risk capital we're really in a world of hurt. I'd really like to see some incentives so folks pay less attention to commodity futures and more to the future of new employers.

[Rich Johnson]

Steve,

I have mixed feelings about "deficits don't matter". In principle I agree. I have a couple of credit cards and I try not to maintain too much of a balance. I have a mortgage and a car payment. Let's call these my debts. I have other outlays such as food, car maintenance, gas -- Operating expenses. Everything works as long as I can service my existing debt. As you say, my income will likely grow over the years and if I increase my debt (obviously there's a deficit in there somewhere)I'll continue to be able to service it. No problem. However, should I take on too much debt by racking up credit cards, buy a very expensive car and take out a second mortgage, I may be come precipitously overextended and not make enough to service that debt.

Unlike a government, I can't print money (legally anyway) so I have a stopping point. The government can print money so it can continue but not indefinitely. Even America has a theoretical limit in this sense.

European nations spend much more of their GDP than does the U.S. but their growth does not keep up with ours. Government spending is necessary but done as it is in Washington I think it impedes growth. Now we will have congressmen and the president micromanaging aspects of the economy because of bailouts. A democratic controlled congress even more than the heavy spending recent republican congresses will spend greater and greater amounts to further their aims. They will promote policies that will impede growth. Their spending will distort actions of the markets and alter the allocation of resources scarce or unscarce. A finite quantity of innovative engineers developing solutions for private sector organizations based on what works and what will sell promotes more growth than the same group working for a government contractor that pursues a technology (such as ethanol) that is economically not viable. Not a great example but an example.

You are absolutely right I believe in your theories about growth and deficits. I just sincerely believe that the spending of elected politicians of wealth created by the private sector stimulates growth much less than would be required by the huge deficits we are currently creating.

Deficit and debt control should not be the main focus. Limiting government to its proper constitutional function (mostly by staying out of the way) would create the best growth.

[Optimist123]

Rich:

Good points, but our dilemma is that both sides are half right, half wrong.

The right wingers view government as the devil. The left wingers view business, especially "corporations," as the devil. Almost nobody is thinking past their ideological dogma -- including, I fear, President Obama. He's too frequently still acting like a presidential candidate, instead of the president. Why doesn't somebody ask him, for example, "why do you think it makes sense to increase ANYBODY's tax rates, or even to announce that you will do it soon, in the middle of a downward-spiraling deflation trap? Deficits don't matter in that situation, so why even announce it? Are you just throwing red meat to your political base -- those who are energized by the class warfare message? If not that, then what is your reason, Mr. President -- other than the evasive non-answer, 'That's what I was elected to do'?"

In any case, Obama sold the stimulus package by repeatedly calling it a "temporary stimulus" to get the economy moving again. We should hold him to the word "temporary," for starters. In which year does "temporary" run out? That's when we should expect the size of government as a percentage of the economy to return to, say, the level of 2008, right? (Presumably he would tell us that "temporary" will end after a specific length of time, as opposed to ending whenever some key economic measure achieved a specified target -- because we already know he prefers calendar goals to performance goals, according to his campaign logic regarding the pullout from Iraq.)

This would have been a good opportunity to write sunset provisions and measurable performance criteria into the various provisions in the bill -- that's been a "change we've needed" for a long time. But we didn't get it, because after selling us on how badly our dire situation called for a big, undefined stimulus bill, he turned the whole thing over to Nancy Pelosi instead of keeping it under control of the White House.

But that's OJT. Not the best timing for that, but so be it. He's very intelligent, able to learn fast, and a good talker. I hope he learns about entrepreneurs (what they do and what motivates them) very soon; if he does, I'm confident he'll be able to think up an eloquent way to explain it to his base, thereby containing the political damage. If he doesn't, and especially if he was just blowing obligatory political smoke when he kept repeating the words "temporary stimulus", then we can all look forward to a generation or two of worse-than-Jimmy-Carter stagnation.

[Higgs Boson]

Everything government touches turns to crap. This won't be any different. You can't spend your way out of a problem that was caused by too much spending in the first place.

Oh, and we should drastically curtail the military and stop meddling in other countries.

[Mike H]

First Trust's economic projection is 0.0% for Q2, 3.0% for Q3, and 4.0% for Q4. That comes to about 0.0% for the whole year. If this comes to pass, it will be better than Obama's projection for 2009. 4.0% growth in Q4 of this year would be incredible.

So, if we recover from the velocity collapse quickly, things will be better than the White House currently thinks. Though, I see a problem in the future. In 2011, Obama is planning on crushing increases in taxes. How does he expect 4.0% growth in 2011 in the face of massive tax increases on all investors and entrepreneurs? I guess he has 2 years to learn and turn his tax increases around.

As for the stimulus, on a personal note, the research group I work for is expecting a large infusion of money now that the stimulus was passed. They also expect to have to spend this money very quickly, likely by buying high end equipment. So there is some anecdotal evidence of the stimulus money being used for it's advertised purpose.

[Mike H]

Correction: First Trust is forcasting -4.5% in Q1, so for the whole year comes two 0.625% compared to Obama's -1.2%.

[Chris]

Your fatal flaw is not realizing that most of the "growth" from the past ten or so years was a massive fraud of epic proportions. The only way to achieve the kind of robust growth necessary to make your argument work is through the same sort of fraud that has gotten us into this mess in the first place. The game is over, the jig is up, and all the credit that was overextended needs to be defaulted before real growth can occur again.

[Optimist123]

Chris,

I'm talking about "real" growth -- i.e., not the money side of the economy, the real goods and services side. No flaw there.

[Chris]

You should clarify your position then, because your "deficits don't matter" mantra could well be taken to mean that we should continue to throwing money around to keep the doors open at insolvent zombie banks and futilely attempt to prop up home values in the face of market realities. Throwing money at such non-productive targets *will* lead to catastrophe of some sort (sovereign default, war, chaos, mass poverty, revolution?). If you are specifically saying that money spent on producing real goods and services (and not fraudulent ponzi services) will help get us out of this mess, than you have a point. But to make the blanket statement that deficits do not matter is reckless.

[beancounter]

Well, I believe many people think of only goods as real and services as non-growth or borderline fraud. For example, exorbitant consulting fees.

I wonder if these people would be happier if the USA had gone the Japanese route, exporting easily duplicated widgets.

[Optimist123]

Chris:

Please re-read (at least) the title. "Deficits don't matter" has a semicolon after it; i.e., it is already qualified, right up front. I did that on purpose, to prevent people like you (and I presume your day trading buddies) from taking it out of context.

And if you have just a little more time, like maybe four more minutes, consider reading all the way to the end of the article, to the part about entrepreneurs. (And by "entrepreneurs" I'm not talking about people trying to manipulate *money* to make money, I'm talking about creative people building *real businesses that sell real goods and services and employ real people* to make money.)

The question you deficit doubters need to answer is this: if inflation is held to 2.5% or lower, and real growth is higher than 3%, what other conditions would prevent the US government from being able to (a) sell enough new T-securities to roll the maturing T-secs over -- into a $100 trillion worldwide bond market; or (b) pay the interest on the debt with 15% or less of its annual budget. [By the way, the model I ran assumes 4.0% weighted average interest on the debt -- almost 400 basis points above the current short term rate asked by everyone fleeing to the safety of US federal debt instruments).

Until you can answer that, you and your buddies might want to consider tempering your hysteria. I know that almost everybody is scared to death by the word "debt," but you should know better.

[woodchuck64]

Good financial management for an individual is very different than for a government.
If I could count on being smarter, faster, healthier every decade hence, I would be much less concerned about my personal deficits.

[Chris]

I have read your entire article and I agree with your point about entrepreneurs being the engine for growth, but I disagree that directing stimulus money to entrepreneurs would be sufficient to compensate for the growing debt and deflation. Your idea to focus on entrepreneurs is good but until the bad debt held by the banks is cleared it is moot. Also, your debt model obviously works if every condition you assume turns out to be valid (that's the nature of models). However remember that in early 2007 the rates on both the long and short T's ramped and it only takes one major loss of confidence to start a death spiral. So while I can't say which specific condition would break your model, given the ever diminishing capital of our lenders and the also ever diminishing confidence, I'd say it is entirely possible that your model could explode due to any one of numerous possibilities.

[Optimist123]

"I disagree that directing stimulus money to entrepreneurs would be sufficient to compensate for the growing debt and deflation..."

I didn't say direct it toward entrepreneurs. (For starters, we don't even know who they are; they start appearing when the conditions look favorable for risk-taking. It doesn't yet, and it might be a while.)

I've been saying for months: (1) Fed intervention to stop the deflation is necessary but not sufficient; (2) fiscal action to stimulate the economy, to help stop the deflation trap, is also necessary but not sufficient; (3) return of confidence is necessary, especially in the secondary markets such as commercial paper, and when it returns, the monetary and fiscal actions need to be pulled back.

Anyone who thinks deficit reduction (or avoidance) takes higher priority than any of those three needs to have his head examined.

"I'd say it is entirely possible that your model could explode due to any one of numerous possibilities."

Well, please keep thinking about it, and let me know just as soon as you identify something other than a failure to return to sufficient real growth that could explode the model.

In the meantime, it might be a good idea to contemplate what kind of government we'd end up with if throngs of unemployed victims of a deflation death spiral pulled the plug on the current government, and all those multicolored day-trading screens went to black. That's what (1) and (2) above are intended to prevent, if that's possible.

[Chris]

So you're asking what problems I have with your model if we assume that the credit crisis has already been resolved and confidence has returned? Too speculative for me... I'll pass.

[DasMortgageReich]

"Well, please keep thinking about it, and let me know just as soon as you identify something other than a failure to return to sufficient real growth that could explode the model. "

You really want to underestimate this and call it a "possibility"? Be my guess.

Up to this point everybody who defaulted did so because they could not renew the current portion of their obligation. The cost of capital is HIGHER than the marginal return of the investment. We are talking private capital here.

How about government?

Listen, 1) the return will be FAR worse than the worst private capital can do. Check out TARP, FRE, FNM, USSR. 2) The current investors in Tsy has expressed DEMANDS that the Tsy market be used only for those seeking safe haven.

If Ben Bernanke does not believe the stick behind this request, he is welcome to try fund this "subsidy" programs.

Life will go on, with or without the so-called democracy.

[Optimist123]

Chris,

No, I'm asking you to defend your assertion ("Throwing money at such non-productive targets *will* lead to catastrophe of some sort") versus my assertion: NOT taking the monetary and fiscal actions now under way would be EVEN MORE LIKELY to lead to the catastrophe of an accelerating deflation trap ending in, say, an overthrow of the government.

Or perhaps you'd like to try defending your guru's apparent position that US Treasury securities will be rejected by the $100 trillion worldwide bond market when we try to roll them over, and to sell new ones, as we attempt to stop the deflation trap(?). If that position can be defended, it would mean a worldwide about-face versus the direction they're fleeing today (i.e., TOWARDS our treasury securities) -- so I'd also be interested in when that about-face will occur. Presumably very soon.

In either case, I'll be ready to assimilate any new information you have to offer as to why I should have a greater fear of today's deficits.

[Optimist123]

Das:

Not sure I understood what you were trying to say. I'll give it a shot, though...

"...the return will be FAR worse than the worst private capital can do."

Right; that means lower interest rates for T-secs, which means lower risk of default.

That argument is working in the wrong direction; the original assertion was the deficits (which create T-secs) are somehow to be feared.

See why you've confused me?

[DasMortgageReich]

http://www.bloomberg.com/apps/news?pid=20601080&refer=asia&sid=a_dsDz145J_A

I would say that qualifies as between rock and a hard place. Today's yield curve is not a good predictor of future interest rate.

===========================

China Needs U.S. Guarantees for Treasuries, Yu Says (Update2)

“In talks with Clinton, China will ask for a guarantee that the U.S. will support the dollar’s exchange rate and make sure China’s dollar-denominated assets are safe,” said He in Beijing. “That would be one of the prerequisites for more purchases.”

[DasMortgageReich]

I am saying the minute you go to the tsy market thinking there's an arbitrage there will not be. There's a large elephant taking a bath in the small pond and he prefers bathing alone for the foreseeable future.

[Optimist123]

Das:

Regarding China...

Their domestic employment depends to a large degree on exporting to us. So it's safe to assume they will continue that policy, which (if successful) will continue the inflow of dollars (to China).

What can they do with those dollars? They have four choices:
1. Buy dollar-denominated real assets from us.
2. Buy dollar-denominated financial assets (eg, T-secs) from us.
3. Buy dollar-denominated goods and services from us.
4. Sit on them, instead of using them (at a minimum) to buy interest-earning T-secs from us.

How does any one of those four hurt us? (Does Yu really prefer to increase his country's unemployment rate, in the event he doesn't extract a guarantee from us? I doubt it.)

[Chris]

With regard to propping up the banks, I suggest to you that 1) we are following the same policy as Japan did in the 90's 2) our big banks are in far worse shape 3) we did not start with massive savings to cushion the blow 4) we will be far worse off and will *wish* that we had only suffered a lost decade. We'd be better off one of the several plans put forward to more or less send the big banks to the wood chipper, and then capitalize either new banks or smaller well managed banks that can step up.

As far as rolling the T's, we are rapidly approaching the point where every dollar borrowed will return less than a dollar of GDP. Would YOU loan money to us at that point? Especially if you are having your own financial crisis at home. Maybe China will keep lending to us if we agree to let them take Taiwan, though. How's that for national security?

Disclaimer: I do not speak for any gurus.

[Optimist123]

Letting incompetent bankers fail is very, very close to the top of my priority list. Avoiding a US version of Japan's lost decade is way up there, too. One of the few things ahead of those two is preventing a deflationary collapse.

That's what (1) and (2) above are all about.

If you are trying to imply that a deflationary collapse is preferable to preventing it, then you and I will simply have to agree to disagree.

[Chris]

Prevent it? Good luck.

What I think is preferable doesn't matter at this point. I'll leave it at that.

[beancounter]

Well it's not called China's "nuclear" option for no reason. If China were to mass dump its dollar holdings it certainly would be an act of provocation.

More importantly however is the Chinese government knows its own history. It knows that every dynasty was overthrown by large masses of unemployed peasants. The twenty million Chinese who lost their jobs recently due to factories shutting down immediately received a small transfer payment of 20 dollars. Small to us, but quite enough for a subsistence farmer to buy seeds and be happy. Now, suppose China dumped dollars. Unlike the US where you can reasonably argue government could survive with 10 percent unemployment (perhaps 25 percent using different measures of unemployment) in a socialistic system which prides itself at least in principle on near full employment, extended double digit unemployment would lead to another revolution. Using international standards the Chinese unemployment was a mere 4% in urban areas and you can bet double digits would set off a panic. Another Mao would arise, civil war.

Yu knows dumping even a few dollars could start a global chain reaction. Thinking that the Chinese don't care about their own self-preservation is the same as thinking that the Supreme Leader of Iran doesn't care about his own self-preservation. Except with the Chinese case there's no 72 virgins waiting. Only the Mandate of Heaven, completely unlike the Divine Right of Kings in that poor leaders can and will be removed for poor performance.

It's just political talk with no teeth, like Ahmadinejad saying he wants Israel's destruction. Anybody who buys into it is either gullible or uneducated.

Now even if you completely disregard my line of reasoning as soft and without hard numerical basis (I don't know why) then you have to address that the Chinese debt makes a fraction of our total debt. We owe almost as much to Japan, and half as much to the UK. So why the fear of Chinese all of a sudden? Is it a fear of globalisation? A fear that the "little man" the "Wal-Mart moms" are buying too many "useless" things? Or that people haven't learned to buy what they "need"? Let me tell you those unemployed Chinese citizens would be thrilled to have factories reopen and for Americans to buy more "useless" things, and the Wal-Mart moms would be just as happy spending *their* money on consumer goods. Only the protectionist, wagging his finger at someone else's money would be unhappy. Meanwhile the Wal-Mart mom would be much happier working at service jobs like a restaurant or a financial firm than slaving in a factory aka sweat shop.

If it wasn't for the trade deficit with China you can bet our standard of living would be lower.

[aenimal11]

Sir,

I think you makes some great points, although the assumption that Treasury rates remain constant at 4% concerns me. Did you run scenarios with higher rates?

For one, investors' flight to quality may have created a bubble on T-bills (as Mr. Buffett mentioned in his letter last week). And secondly, I would imagine that taking on a huge amount of additional debt would necessarily raise future interest rates because of (1) the supply glut of T-bills in the market and (2) the fact that the U.S. is more "leveraged", i.e. each $1 in debt has less collateral behind it (especially if these $$ aren't spent wisely!).

What do you think?

John

[Optimist123]

Chris:

I'll take that to mean that deflationary collapse does not bother you as much as deficits and debt do. In which case, we disagree. (And that's my entry for understatement of the year.)

[Chris]

You can take it to mean anything you want, it doesn't bother me. But if that's the way you take it, I can only say you're a fool.

Good luck. You'll need it.

[Optimist123]

John,

Yes, I did a couple sensitivities on the interest rate. At 5%, the Obama line worsens to the Clinton-era level (paying the interest takes 15% of the budget); at 3%, the Obama line improves to the GW Bush-era level (8% of the budget).

Regarding Buffett, I think he (uncharacteristically) chose his words poorly. A "bubble" happens when everybody euphorically rushes to purchase an asset in order to make money; but the rush to T-securities is a fearful rush to a safe asset, to keep from losing money. What if people started moving away from T-secs? If they moved towards private sector investments, then the sooner the better, because that would be a sign that confidence in the economy is returning, and that the threat of deflationary collapse was eliminated. On the other hand, if they moved into another currency (e.g., euros) with no improvement in confidence in our economy, it wouldn't be as rosy, because goods we import from the euro zone would inflate in price.

It all keeps coming back to the bottom line: how well our economy is performing (and is expected to perform), in absolute terms as well as relative to the other economies.

[Optimist123]

Thanks, Chris, I'll take *that* as a big hint that you agree with me: avoiding a deflationary collapse should be top priority -- a much higher priority than avoiding deficits.

If a collapse is avoidable (and that's looking iffy), I have a few ideas how to do it -- which I've already explained at length. Do you have any ideas to add to the list, now that we've dispensed with deficit avoidance?

[beancounter]

I believe he means to say it's foolish to try and stop a deflationary spiral with monetary and fiscal policy because it was tried and failed in Japan. So better to let everything "default."

If you want people to believe quantitative easing or any other government policy can stop deflation you'll need to address the macroeconomic differences between Japan and the USA. I would be half convinced by Japan myself, if it wasn't for the obvious fact Japan is an export economy. The entire Japanese example is worthy of a long post from you (if you have the inclination).

That's assuming of course he doesn't believe deflation is "price fixing."

[timwalsh300]

Steve,

I agree with beancounter. I think an in-depth comparison between Japan and the US would be very worthwhile... looking at things such as demographics, consumer spending and saving rates, imports vs. exports, any important structural differences in their monetary system... People who fear budget deficits are citing Japan quite often now to justify their position and warn that we will see a similar decade of stagnant growth.

[SkylightMT]

QUOTE "If a collapse is avoidable (and that's looking iffy), I have a few ideas how to do it -- which I've already explained at length. Do you have any ideas to add to the list, now that we've dispensed with deficit avoidance?"

I'm very interested in your ideas, as well, preferably without the implication that those of us who either don't understand yet or might disagree aren't idiots. I'm definitely open to being enlightened.

QUOTE "I believe he means to say it's foolish to try and stop a deflationary spiral with monetary and fiscal policy because it was tried and failed in Japan. So better to let everything 'default.'"

Thanks, Beancounter. Maybe that is what he means.

Does anyone have comparisons between govts that attempted to intervene heavily (and we're not yet as close to "heavy" as China is, per GDP) versus those that let deflationary spirals occur without intervention? Which fared better and recovered soonest?

I think a "lost decade" might be the best we can hope for right now. If that's the worst that happens, I would feel a bit relieved.

I wonder if Japan's lost decade was the result of having the right ideas but not intervening ENOUGH, rather than having the wrong idea altogether.

I wish there were comparative data.

[Optimist123]

Sky,

Glad we can agree, at least at this blog, that being called an idiot does not advance the debate. I can attest that it gets old fast. Take a look at this blog's article about me -- http://tinyurl.com/bmg6kn -- then thank your lucky stars that Karl Denninger, whoever he is, is not and never will be our Fed chairman.

Regarding Japan's lost decade: Because I don't have the time to research the details, I'll have to take Bernanke's word for it. He was asked that same question in today's (Tuesday's) hearing before the Senate Banking Committee. His response was that Japan's government and central bank acted far too slowly, and that we, in contrast, have responded quickly and massively, so we should not have to repeat that problem here (...sorry I don't have the time to review the recording to get the exact quote).

[SkylightMT]

I saw that article by Denniger. I'm afraid I didn't understand it because I don't know enough about economics. I don't even know what IRX is and Wiki wasn't any help.

All I know is that our debt to GDP ratio was at 120% following WWII, and we grew the economy - so the amount of debt didn't seem to be a lasting concern. I don't know why its different this time, if it is (it might be for all I know - but if its different, I would suspect that might be because its so global and so HUGE-thinking about OTC derivatives). I think I remember reading that Japan's debt to GDP was at 210% at one point, and they didn't turn into Mad Maxers.

[Steve C]

The flaming liberal comment was a reference to the change in what "conservative" means as of noon 1/20/09: reigning in spending.

Also this: "I found the word "entrepreneur" in exactly one of his campaign speeches (June 5, 2008; he used it to describe Senator Mark Warner). His budget only pays lip service to "entrepreneurs" in a few obscure places. It's discouraging that entrepreneurs don't seem to be top-of-mind for our president, even though they are the ones who would conceive and create the higher-paying jobs of the future, the real jobs (as opposed to government jobs) it will take to grow the economy. "

One of the refrains of the not-State-of-the-Union address was respect for entrepreneurship and risk-taking and the market. We'll see what actually makes it into bills.

I don't think there's all that much disagreement between the parties on the value of dynamism, at this point. That's a motherhood/apple pie question that no one wants to be on the wrong side of. For what it's worth, tech entrepreneurs seem to either be ok with the Democrats or they're voting for them based on other issues.

It seems to me that the big philosophical divide WRT economics (positing a useful, competent opposition for the moment) is on the scope of entitlements.

[Steve C]

I should have just quoted Will Wilkinson in the first place:

"But Matt evidently thinks policy can’t do much about this. One thing policy can do is to make markets possible, so that there are rewards to ingenuity. That can mean making an illegal market legal, or making a legal market worth investing in by lowering the burden of regulation. Another thing it can do is to restructure intellectual property law to encourage rather than discourage invention. Another thing it can do is not crowd out private investment in innovation, which is the opposite of what Obama plans to do in education, energy, and health care. When I talked to Nobel Prize-winner Edmund Phelps, an expert in failed European attempts to spur growth by subsidizing technological advance and no right-winger, he seemed pretty worried that a lot of new infrastructure spending (much of which will be flat-out unecessary and unproductive) and targeted government spending on “green” technology would in fact adversely affect incentives to innovate. I don’t think he’s wrong to be worried. Matt thinks entrepreneurship is an empty business buzzword, but it is in fact the foundation of economic growth.

I will rejoice the day either Republicans or Democrats find that their interests align with the general good and plump for a serious set of pro-growth initiatives. Until then, I’ll expect the usual constituency service."

http://www.willwilkinson.net/flybottle/2009/03/03/what-policy-can-do-for-growth-and-what-politics-wont/

[beancounter]

It's been 40 years since the Moon Landing and the private sector hasn't accomplished even a fraction of what NASA and even communist Soviet Union did. And what they have are suborbitals and satellite launching companies, the former which was funded by government tax breaks/incentives, the latter which many have gone bankrupt. Why hasn't there been more progress in space, when a single mined asteroid could bring back untold riches for a private consortium?

Barrier to entry. The cost to launch into space is just far too prohibitive. The private sector is waiting for the government to one day build a space elevator, or for certain technologies to mature.

Now, energy independence is the single greatest threat to national security, greater any 1e13 debt. So it all depends how large the barrier to entry to a hydrogen economy from a hydrocarbon economy is. If you believe the barrier to entry is a hundred feet thick, then massive government interference is required for our civilization to survive peak oil. If you believe the barrier to entry is easily toppled by angel investors, then government interference could mean government management and misuse of funds.

Government interference is necessarily proportional to the level of threat. War leads to the greatest government interference for the survival of a way of life. It is also inversely proportional to time. If you believe we have 30 years to solve the oil problem, then government interference is counterproductive beyond tax incentives. If we have 10, or 5, or 3, then more and more dictatorial governments are necessary to ensure our continued survival.

And yes: successive years of stagflation due to soaring oil prices is a threat to survival. Ethanol is a bad example, because all the criticisms are either non-economic liberal ones (using food for fuel we're making those poor third worlders starve; nevermind sending food to the third world doesn't work that way) or based on a mistaken belief that EROEI slightly less than 1 matters. If you believe that peak oil will hit in 3 years, then ethanol and *any* technology no matter how economically unviable that can be used in current automobiles is absolutely necessary to ensure continued survival of our political system and way of life.

[Steve C]

Here's a pretty good article on this subject by Jim Manzi:

http://www.city-journal.org/2009/eon0303jm.html#

[Optimist123]

Good article by Manzi; that's Jim Manzi formerly of Lotus Development Corp, isn't it?

Phelps knows what an entrepreneur is. Here's something he said after he won the Nobel:

"Why ... is capitalism so reviled in Western Continental Europe? It may be that elements of capitalism are seen by some in Europe as morally wrong in the same way that birth control or nuclear power or sweatshops are seen by some as simply wrong in spite of the consequences of barring them. And it appears that the recent street protesters associate business with established wealth; in their minds, giving greater latitude to businesses would increase the privileges of old wealth. By an "entrepreneur" they appear to mean a rich owner of a bank or factory, while for Schumpeter and Knight it meant a newcomer, a parvenu who is an outsider. A tremendous confusion is created by associating "capitalism" with entrenched wealth and power. The textbook capitalism of Schumpeter and Hayek means opening up the economy to new industries, opening industries to start-up companies, and opening existing companies to new owners and new managers. It is inseparable from an adequate degree of competition. Monopolies like Microsoft are a deviation from the model."

[Harun]

Here are some reasons why I think the deficit hawks have a point, or at least serve a purpose:

1. GDP may not grow fast enough. In that case, would it not be more prudent to manage the deficit to allow lower growth to still be good enough to not increase debt? I'm thinking of entrepreneurs not investing because of high tax rates, or increased regulations...and if we have to have those because the Democrats are in power, then perhaps we should watch the deficit a little, no?

2. One aspect of deficit hawks is to be careful with how money will be spent and why. Yes, because of deflationary fears, spending a bit drunkenly in 2009 and maybe 2010 is okay, but a lot of the stimulus isn't about 2009 or 2010. And, yeah I think deficit hawks might be more willing to spend if it wans't on "more useful things." Watching the purse strings can act as a brake on the growth of government, taxes, and regulation - which usually stifle growth.

I think a major part of this crisis is not financial but psychological - and letting the pols go wild spending on anything they want while hoping they create a climate for growth is asking a lot. If the public does not think that will happen, they won't spend or invest, and that will affect GDP growth.

[Harun]

A thought questions, if we spent a trillion dollars on either one of two things...

a. F-22 fighters
b. funding community organizers

Technically it wont' matter right? Just like digging holes and filling them in, both get money into the system.

But if I were an entrepreneur, option b would be very, very worrying to me, because it implies a much less certain future.

The mere presence of such money also skews incentives to firms to sell to Washington rather then sell to markets.

[beancounter]

Well actually, option b would be far less "scary" than option a, because anybody can declare himself a "community organizer" and create say a tutoring service or a mentoring service -- an entrepreneur's wet dream. You could even call yourself a community organizer and set up a restaurant. Meanwhile you won't see many entrepreneurs setting up a fighter jet manufacturing facilities.

Broken window fallacy only applies when you're breaking your own village's windows. You sure can hire a million guys with pickaxes to destroy things -- or more accurately trained to destroy things -- as long as they're not your own things. Ethics of it aside, defense is a matter of survival.

I do have to take issue with government economic policy not being a success except with war though. I believe the Federal Reserve can take full credit for American economic dominance for the past eighty years. Imagine if deficit hawks had stopped the Marshall Plan or aid to Japan or South Korea. Meanwhile if you truly believe that the prime interest rate encouraged too much credit, then you believe that Americans don't deserve all the things bought on credit such as cars, houses, televisions. We cannot forget that without credit most Americans could not buy even a fraction of the things which separate us from a communist drone.

Free credit must flow again.