The Skeptical Optimist

Inflation Watch

Some people think deficits cause inflation; some don't. I'm in the latter group, because I think inflation is almost always a result of monetary policy, and seldom if ever of fiscal policy.

But whichever it is, the numbers should start swinging one way or the other reasonably soon, given the unprecedented deficits we're running (...and will continue to run for several years). Either deficits will pull away from the low inflation numbers, or the inflation numbers will start rising with the deficits. It might be a good idea to start watching all the key numbers in one place on a regular basis, so here they are:

The CPI says we're deflating; the other three say we are safely in low-inflation territory.

Another way of saying that: all four indicators say that inflation is not a problem yet. Neither the deficits we have, nor the deficits we know are coming, nor the trillion dollars the Fed has "printed up" are causing any inflation so far. Why? In my judgment, deficits don't cause inflation, so that narrows the mystery down to all that money the Fed printed up. Reason that's not causing inflation yet is because almost all of it is just sitting there, in "excess reserves" in the banking system. (If the Fed printed up a *hundred* trillion dollars and set it down in an inaccessible nook at the bottom of the Grand Canyon, that wouldn't be inflationary either.)

So here's this week's conclusion:

Nothing but a low, safe inflation level so far. If the high-inflation demon is out there, it's still hiding just around the next corner, as it has been for the several decades I've been paying attention.

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

End note regarding the four inflation indicators I picked:
My two personal favorites are the so-called TIPS spread, and the "trimmed-mean" PCE. The TIPS spread is the worldwide bond market's daily judgment on inflation, and the most popular "spread" is the difference between the interest rate on 10-year Treasury notes and the rate on 10-year Treasury inflation-protected securities. The trimmed-mean PCE is the Dallas Fed's massaging of the components in the personal consumption expenditures numbers, and it's a second cousin of "core" PCE.

The Consumer Price Index (CPI) is a must have because it's always in the headlines. The GDP deflator is a bit more comprehensive than the others, but it's also more delayed (...it's more of a rear-view-mirror indicator).

Here are the links to the sources:

Trimmed-mean PCE

TIPS spread components:
 10-year T-Notes, daily
 10-year TIPS, daily

CPI-U

GDP deflator

The Guantanamo solution? Easy.

The Sunday talk shows (ABC, CBS) spent a lot of airtime today on President Obama's Guantanamo dilemma: (1) he promised a million times during the campaign that he'd shut it down, and dutifully signed an order on day 2 to do just that within one year; but (2) unfortunately, no other country, and no state within our country, wants any of the remaining bad guys in their back yard; consequently, $80 million in funding to do it was overwhelmingly blocked by Congress.

What should the President do to save face?

I don't think it's difficult at all—and I can't understand why nobody has suggested it. Maybe it's so simple it's too easy to overlook. The solution is this: Shut down the name "Guantanamo" — then immediately start calling it "Camp Progressive" or "Niceville South." It wouldn't take anywhere near $80 million to do that; a few hundred thousand for new signs and emblems should do it.

Obama could then chalk that up as twin accomplishments, ready for the bumpersticker printing presses:

"Not only did he shut down Guantanamo, he reduced the deficit in the process."

(It's overdue for a name change anyway — now that the "war on terror" is over.)

Back to Clinton-era debt burdens

Anyone nostalgic for Clinton-era fiscal results has something to look forward to. Net interest on the federal debt in the mid- to late-1990s was just under 3% of GDP, and consumed 15% of tax receipts. Investor's Business Daily says it will be returning to (or exceeding) those levels in a few years, based on the White House and CBO projections of Obamanomics. (Interest fell to about half those levels in Bush's second term.) The chart at right is from the IBD article; be sure to read the whole thing.

As usual, GDP growth makes a big difference; IBD made that point at the end of their article:

The biggest difference in the CBO and White House assumptions appears to be economic growth. By 2019, the White House expects that GDP will be 9% higher than the CBO forecast.

The higher growth would generate an extra $480 billion in tax revenue. That would trim budget deficits and, thus, interest payments.

"Protecting jobs": good politics, but...

...it always backfires, and ends up costing jobs. Trade wars tend to break out. But what do politicians care? "Protecting jobs" gets them elected, and that's what it's all about, isn't it?

Supposedly, someone in the administration is keeping track of the number of jobs being "created" -- no doubt for use in the next political campaign. Do you think they'll be properly tracking and deducting the jobs destroyed by the Buy American mantra? Probably not. But I'm confident that objective journalists such as Lou Dobbs will call them on it.

Just kidding. Replace "confident" with "not holding my breath" in the sentence above, and scratch the word "objective."

Read about the "outrage in Canada" in today's Washington Post.

[Many thanks to commenter Harun for pointing this out. I lifted this from the comments under the previous article.]

Fiscal responsibility, and the Obamanomics Report for May 2009

"Fiscal responsibility" is a term nobody ever defines — until today.

I gave it a shot a couple years ago, in an article titled “'Fiscal Responsibility' defined at last" -- but even that definition turned out to be too mushy for my taste. If I had it to do over again, I'd add two words to the end of the title: "...sort of."

If you've read more than a few articles at this blog, you already know my position: Growing debt is nothing to fear as long as the economy is growing at or near the same pace as the debt. The proper measure for that was the debt-to-GDP ratio. Recently, I've had to amend that position: It is ALSO nothing to fear as long as we are using it in the short term to get the economy back on the growth track.

But the problem with using the debt/GDP ratio as the measure is that nobody can say how much is too much (or too little); consequently, nobody knows how much runway we have left. Debt/GDP was 120% after WW2, but would that be too much now? Or would we still have some slack even at that level? Who knows? (Not economists, I can tell you that with a lot of confidence.)

I found a measure I like better than debt/GDP. It's the "Net Interest share of Federal Spending." If our monetary policy is successfully controlling inflation, but we are not being fiscally responsible, the interest share of spending will grow in the long run, crowding out things like defense, justice, social security, and health care.

Some things that put upward pressure on the interest share of spending are:

• increasing federal debt
• increasing interest rates on the debt
• "investments" that don't boost the economy

Some things that relieve the pressure are:

• increasing GDP (by far, the best way)
• decreasing interest rates on the debt
• "investments" that succeed in boosting the economy

[I intentionally left "running surpluses" off the second list; for an explanation why, see this article from four years ago.] 

How much is "too much"? I think we have a better indicator with this new statistic. Interest required 15% of federal outlays in the Clinton years, which are loudly touted as a good example of fiscal responsibility. Because of falling interest rates and growing tax receipts during the Bush years, it fell to an even more fiscally-responsible range of 7%-9%. Now the Obama budget calls for a combination of spending, growth, deficits, and interest rates that will take it back up to the Clinton-era level of 14%. No sweat, in my judgment, IF the budget comes true. (Big if, huh?)

So, here's the new chart. I plan to update this one monthly.

Pay no attention to the huge drop in the last six months; it's temporary, and it's due to the huge spending increase that will soon cause the interest payments on the debt to rise, just as the budget predicts. We need to watch how the red line tracks against the budget line.

I will say that if it does level off at 14% in a few years, that will be sustainable, and it will match the level achieved in the Clinton years. But it will require most of the "investments" in the Obama budget to pay off in enhanced growth. We'll see it unfold fairly soon, in any case.

============================
Data sources:
Monthly Treasury Report

Treasury Debt Position Report

Obama budget[*]

[*] The only assumption I had to make was this: The avg interest rate "budgeted" for paying net interest on the publicly held debt will be the midpoint between the budget's forecasted rates for 3-mo T-bills and 10-yr T-notes. 

Mis-remembering Jack Kemp

Jack Kemp’s decades-long message is still being bastardized by partisans on the left. Bob Herbert of the New York Times chose the occasion of Kemp’s untimely death to take a few more whacks at the false piñata of (so-called) “Trickle-down economics.” Here's how he chose to insult Jack's economic message just a few days after Kemp died:

As every scheme imaginable was developed to bolster the fortunes of the rich, ordinary people were left in the humiliating position of waiting for some of the goodies to trickle down to them.

I’m certain of one thing: Bob Herbert is committed to the anti-trickle-down message because of its political effectiveness. And I strongly suspect another thing: Bob Herbert’s commitment to that political message is solidified by financial and entrepreneurial ignorance. (Just an educated guess, though.)

Jack Kemp’s economic message was not only simple, it was unarguable (and always will be):

“People respond to incentives.”

That simple truism is the foundation of supply-side economics. (I wish it had picked up a different name such as incentive economics, growth economics, job-creation economics, or innovation economics—but that’s 20-20 hindsight.) I met with Jack a few times nine years ago, after he had been kind enough to mention my old website in his newspaper column, and that was his message. Simple and unarguable. It was not that “tax cuts are always the solution to every problem.” Nor was it that “tax cuts always pay for themselves,” or “tax cuts will yield greater tax revenue before the next election.” It was simply that “people respond to incentives”: the economy will grow more effectively if we trust the people to make good things happen, given the right incentives.

Nobody could dispute what he really said and really meant, so the left had to put their message-crafters to work. The result was the most successful and formidable redefining of a political opponent’s idea that I have ever witnessed: Jack’s idea, thanks to his crafty opponents, became “trickle-down economics” instead of “people respond to incentives.”

Trickle-down has become the crowd-inflaming piñata the left drags out every election season. Never mind that trickle-down asks us to believe the impossible: that risk-reward happens in reverse order, i.e., that entrepreneurs who’d like to get rich by starting new businesses do it as follows:

(1) they get rich; then...
(2) they start new businesses.

The financially ignorant might fall for that message, but the rest of us understand that entrepreneurs first risk a lot of money (hiring workers, paying suppliers, etc.), with the hope of subsequently attracting enough customers to get rich. The entrepreneur who fails to get rich has paid out all the money to others, and ends up with nothing to keep. The one who succeeds in getting rich (or at least in not failing) is the last to get his or her share of the money success generates. That’s where the phrase “risk-reward” comes from—and they do happen in that order.

But that doesn’t matter to politicians and partisans. Votes do. Almost all voters consider themselves “non-rich,” and their votes accrue handsomely to any politician who can make them feel “trickled upon” by “the rich.” It’s called class warfare rhetoric, it’s employed in every campaign season, and it works far more often than not.

The Trickle-down piñata gets dragged out for every election; that’s no surprise. But when Bob Herbert drags that bastardization out for the occasion of Jack Kemp’s death, it’s a tasteless insult.

Is that kind of insult-journalism one of the reasons the nearly-bankrupt New York Times has lost so many subscribers and advertisers? (I wouldn’t know firsthand; I’m not a subscriber or advertiser.)

I miss Jack Kemp because of his economic ideas, not in spite of them. Growing the economy is overwhelmingly important. Jack knew that, and he knew something else few others, including members of his own party, seem to know: growth doesn’t just happen; growth isn’t an exogenous variable (...as Paul Romer would put it). Growth happens as a result of activities undertaken by people. And people respond to incentives.

Do deficits cause higher interest rates? You decide.

We're running huge deficits these days — just in case any of your friends haven't noticed yet. A lot of my friends have noticed, and they don't like those deficits one bit, because they've made up their minds that deficits, especially big ones, cause interest rates to rise.

It's become conventional wisdom, and for good reason. It's based on a common-sense theory: After the government borrows money in the bond markets, there's less money left over for businesses and entrepreneurs to borrow. When borrowable money is scarcer, the interest rates rise.

Who could possibly argue with that logic? Economists call it the "Crowding Out" theory. Alan Reynolds has called it the "fixed supply of bonds" theory. At any given risk level, there's only a fixed amount of bonds that lenders will buy. US Treasuries are as close to risk-free as bonds get, so the government goes to the front of the line, and gets first dibs on the lenders' money. When the supply of near-risk-free bonds runs out, the lenders not only move to higher-risk bonds, but also have fewer dollars to lend; that means interest rates go up.

It's just plain common sense. That's why I was a believer for a long, long time, and that's why it's "conventional wisdom" to this day.

But in 1994, I hit a snag. I decided to research the Crowding Out theory to see if anyone had tested it against our track record of deficits and interest rates. (Why? Because I'd read Dr. Rick Boettger's book, The Deficit Lie, in which he pointed out that the Crowding Out theory was bunk—and I wasn't sure I believed him.)

After a few months of research, I realized that—as plausible as the theory sounds—sure enough, there's a problem: Turns out, it really is a myth. In fact, from the several studies that economists had done, trying their best to find the relationship between deficits and interest rates, the bottom line was this: If there's any correlation at all, it is a weak negative correlation. In other words, whenever deficits got bigger, interest rates got smaller, and vice-versa.

Well, with the huge deficits we're running these days, I thought it would be wise to reopen the question. So I retrieved the monthly deficit and interest rate data from the Fed and the US Treasury, going back to September 1981.

[By the way, there are all sorts of ways to analyze the historical data: nominal interest rates vs nominal deficits, real rates vs nominal deficits, nominal first differences, deficits vs lagged interest rates, and on and on. But I chose to begin by keeping it simple, by just comparing the trailing-12-month deficit to the same month's key interest rates (Prime rate, 10yr Treasuries, and 1yr Treasuries).]

All I was looking for was a correlation indicating a significant positive relationship between deficits and interest rates. But all I could find was more of the same: a weak, negative relationship that merely confirmed what I'd discovered (for myself) fifteen years ago.

Below is a chart of the data. My conclusion is in the caption, but please decide for yourself whether you think bigger deficits cause interest rates to rise, and vice-versa:

I've run every correlation I had time for, and they all indicate a weak negative relationship — including the recent huge deficits we've incurred. I've been hearing for decades that skyrocketing interest rates, driven by deficit spending, are just around the corner. I'm still waiting.

Someone observed once that it's extremely difficult to watch a beautiful theory get murdered by ugly facts. But that's what I've been watching happen to the Crowding Out theory for fifteen years and counting. I guess I'll just have to accept the similar explanations that both Alan Reynolds and Ben Bernanke have given to explain those ugly facts:

The world bond market is a hundred trillion dollars in size—far too large (even now, apparently) for US deficits to have a discernible adverse effect on interest rates.

I'll keep the popular Crowding Out theory in its proper place in the "Plausible-sounding Theories" section of my bookshelf. I like to keep that section in alphabetical order, so I'll put it between the Blue Cheese Moon theory and the Flat Earth theory.

================
ps-
I revisit this analysis every couple years. Here's a link to the last time I took a look:

Pay no attention to the man behind the curtain

================
Also, here are the data sources...

Prime rate.

10yr Treasuries.

1yr Treasuries.

Trailing-12-month deficits: derived from the Monthly Treasury Statement.