The Skeptical Optimist

Bernanke’s response

Ben Bernanke is doing a good job, so far, in carrying out Alexander Hamilton’s sage advice: keep politicians at a safe distance from monetary policy. He’s doing that by the simple act of ignoring a letter he received. I hope he continues using that approach.

However, I have been having a little fun imagining a parallel universe—one in which Bernanke patiently responds to the politicians, in an honest attempt to explain what the Fed is trying to do.

Imagine we are now in Parallel Universe Number Two. Here is Bernanke’s response.

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Dear Sirs:

Thank you very much for your letter. Past Chairmen would have ignored it under the guiding principle of keeping politics at arm’s length from monetary policy. However, I’ve decided break tradition by responding—particularly if my response helps to clear up any misconceptions.

I’d like to explain, as simply as I can, what the Fed is trying to do, in hopes that you will see that we are not on the path of creating Weimar USA; in reality we are trying to help achieve the goal of getting the economy moving again. “Jobs, jobs, jobs” is how everyone likes to put it these days. Please understand that, just as Congress sometimes has difficulty acting in unison, so does the Fed... occasionally. We all know these are difficult times; but we all have responsibilities to act, even if it cannot always be with unanimity.

Please bear with me. My explanation requires four steps and one simple algebraic equation; no calculus, I promise. I sincerely hope you will follow along as I take it one step at a time.

[As an aside, I have read Atlas Shrugged as I presume you have; but one aspect of the plot has always bugged me greatly. It has to do with the part about those little gold coins in John Galt’s intermountain utopia. I’ll get to that later, after covering the four-step explanation I feel I owe you.]

First is the equation that helps us envision how the real economy and the money supply interact with each other. It’s the simple “equation of exchange” we see in economics books. Here it is, below:

Next is a simple, color-coded explanation of each element. I’m sure you’ll all recognize the “P” (price level) component, because when a country makes the horrible mistake of hyperinflating its currency, “P” takes off like a rocket. But there are three other things in the equation of exchange: the money supply, the money velocity, and the quantity of real goods and services exchanged, as shown below:




Most people consider “T” to be the most important element—the total amount of production and exchange in the real economy. It is affected by virtually everything we do in monetary, fiscal, and regulatory policy.

The next logical step: how the Fed can try to help whenever fiscal, regulatory, and past monetary policies have failed to get the real economy (T) moving and growing again at a robust pace. (Whether the Fed should try is a different question; currently the Fed's mandate is to do something about both "P" and "T"; you can change that, of course, but that's the way it is now.)

 

The explanations use the scenario of an undesirable slowdown in real economic activity—today’s situation, including the effect of dormant excess reserves. In the alternate scenario of undesirable inflation, the Fed would reverse its action by “unprinting” money (i.e., by raising its target rate and selling assets as necessary), to keep the price level in line with what we all hope is robust activity in the real economy. 

Lastly, we have the equation to which I believe those who advocate the gold standard are mistakenly committed. Note the conspicuous absence of “T” and “V.”



It says that any increase whatsoever in the money supply is the very definition of inflation. (Never mind that we cannot actually measure the money supply, as the Volcker Fed discovered, after which the Fed began targeting the interest rate instead of the money supply.) The simplified equation says, to understand inflation, there’s no need to think about idle money sitting in excess reserves, and no need to think monetary policy can do anything about any sluggishness in the real economy. No, all we need is a known quantity of money, like the gold coins in John Galt’s intermountain utopia; monetary policy is as simple as that. [My view, and that of many others: it's an oversimplification.]

And that brings me back to the irritating flaw in the Atlas Shrugged plot—one that the economist in me couldn’t help but notice. Presumably, John Galt’s economy would attract many other high-integrity producer-consumers, and the utopian economy would grow due to increases in population, physical capital, human capital, and productivity. But with a known quantity of little gold coins (M) in a growing economy (T), the prices (P) would be forced to fall (deflation)—which in turn would require smaller and smaller gold coins as the economy flourished. Either that, or the economy would surely taper off, stagnating at a constant level of activity in a short period of time. How small could a gold coin get before the economy leveled off and everyone started demanding some new, better way to grow the money supply so that the real economy could start growing again? How much deflationary pain would it take for the citizenry to start demanding the innovation of fiat money, and the controlled, purposeful printing of same, in Galt’s intermountain utopia? Certainly the need for fiat money would cause an entrepreneur to invent it, at least by the time the gold coins got tiny enough to start leaking out of everyone’s pockets from between the stitches, if not long before, wouldn’t it? If not, Galt’s economy would be doomed--definitely NOT what Ayn Rand had in mind.

As I said, it’s an angle only an economist could conjure up.

In any case, sirs, I hope this response will help to reassure you that the Fed understands the problem, and is trying to do what it can to alleviate it, even though it is not always possible to act unanimously.

Sincerely,

Ben Bernanke
Chairman of the Federal Reserve Bank
United States of America, Parallel Universe Number Two


ps –
Effective fiscal and regulatory reforms would have the potential of eliminating the need for dramatic actioin in monetary policy.

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For the middle class, one less thing to worry about

May we please call a truce in the class war, at least until we fix our much bigger economic problem? 

For details, here's a link to my article at the American Enterprise Institute. 

Social security privatization: a plan both left and right could like

“Privatizing” social security is a lightning-rod idea, guaranteed to stir things up in any political season. It came up again during the Republican debate last Wednesday (9/7/11) and afterwards in the obligatory analyses; both sides predictably dragged out their talking points.

The political right keeps bringing it up for two main reasons: (1) they like the idea of each individual worker owning the future benefits of the retirement safety net he or she has been paying for; and (2) they don’t trust future politicians to keep the promises of past politicians.

But the political left keeps gunning it down, because: (1) they see the stock market as a highly undesirable place to risk the nation’s social safety net; and (2) they dislike the idea of the Wall Street financial vampires sinking their fangs into yet another asset base worth trillions of dollars, collecting the economic rent they charge for their handling services.

Well, I think everybody has a good point or two. And I also think there’s a solution that should make everybody happy. Today, workers earn credits that accumulate on a spreadsheet at the Social Security office; the future dollars those credits eventually yield depend on future politicians keeping the promises of past politicians. Do you trust Barney Frank, or Rand Paul, or Rick Perry (...or their next-generation counterparts) not to devalue those credits in any way after they've been earned, such as by means testing or benefit cutting? Well, I don’t.

So, I propose that we create a new form of U.S. Treasury security: a Social Security retirement bond, a non-transferrable financial asset, issued to individuals based on the credits they have already accumulated for contributing to the system. Those new assets would begin to be convertible only into dollars, commencing only at retirement age. The new system would be one of individual ownership of the earned financial assets, no stock market investing would be permitted, the bonds would be fully backed by the U.S. government, with terms not changeable by future politicians. Experts at Social Security and Treasury could design them such that the total benefits would be no different from the current promises. The only difference, therefore, would be ownership of the bonds by the individuals who earned them; the promised benefits would be locked in at the time they were earned, impervious to any future politicians, immune to Wall Street vampires, and not exposed to the stock market.

Wouldn’t that satisfy both sides, based on their currently-advertised objections to either privatization or the status quo? Each worker takes private ownership of his or her own, government-guaranteed, politician-impervious social security safety net. I bet both FDR and Reagan would have liked the idea, anyway.

USA's debt burden unchanged in ten years

Everybody knows that the level of the U.S. federal debt has been increasing rapidly. Less well-known is that the burden of the debt is the same today as it was ten years ago. Believe it or not.

Although that should be good news, there’s bad news, too: that situation cannot last if the economy continues growing at nothing more than an anemic pace. It only means we have some runway remaining in order to get the economy growing again.

Back to the main point, though. How could the burden of the debt be no higher than it was ten years ago? In short, it’s because the burden of the debt is not the same as the level of debt. The debt burden is the affordability of any given level of debt, not the debt level itself.

A good indicator of the debt “burden” is the portion of federal tax receipts it takes to pay the interest on the publicly-held debt. (The inverse of that is the number of times federal tax receipts cover the interest payments—closely mirroring a widely-used private sector measure for a company’s debt burden, dubbed “Times Interest Earned.”) The two graphs below show both ways of looking at the debt burden (...back to 1998, which is as far back as the Treasury’s website goes with historical data). 




Of course, today’s near-zero interest rates are helping to keep the burden down. Those low rates are largely attributable to the dollar’s status as the world’s favorite currency in a pinch—but the longer it takes to get our economy back on track, the less we can expect to milk the dollar's favored status.

Paying the interest, rolling the principal
People with private-sector financial experience know that the “burden” of debt for a healthy, going concern such as a business or a multi-generation family is the affordability of the interest that must be paid to creditors. Why just the interest? Because a healthy going concern can roll the principal over and over, consistently retiring maturing obligations and replacing them with newly-issued debt instruments. That financial reality is also true of governments presiding over healthy economies. Some examples of going concerns that have been rolling their debt over for many years are ExxonMobil, the last three plus next three generations of a typical family, and the USA’s federal government.

A large number of Republicans, Democrats, and independents alike have experience managing private-sector businesses (although an even larger number do not). The ones who do have it can more-easily understand that the true “burden” of debt in a healthy, going concern is the affordability of the interest obligations; debt rollover makes paying down the principal a moot point. The cost of capital is almost always reduced when a mix of debt and equity is employed to finance a firm, and maintaining a constant mix in a growing firm requires an ever-increasing level of debt (...the opposite of “paying down” the debt). ExxonMobil and General Electric have been rolling their debt over for years. A typical multi-generation family rolls their outstanding debts for automobiles and houses into the future; as the older generation pays off its house and car loans, the younger ones take out new loans. The USA has a similar track record; meeting its interest payments with tax receipts and rolling its principal over in the world financial markets have not been problems, are not now problems, and—provided we get the economy back on track—will not become problems.

Those with business experience can more easily understand that the highest priority problem is to get the economy growing again—among other things, to maintain or improve our ability to afford the interest payments. But those without business experience (or those who forgot it) can be expected to continue barking up the wrong tree, insisting on “paying down the debt.” In any case, a healthy economy with robust growth is the root solution to just about every fiscal and monetary issue being debated today: unemployment, the debt ceiling, the deficit, the defense budget, the nondefense budget, unfunded liabilities, paying the interest, and rolling the debt over. If the economy were growing at a clip of 4.5% or more, none of those would be viewed as a major problem.

What a difference a healthy economy makes. Good thing we have some extra runway buying us time to get back to that condition.

Social security versus six-buckle boots

During the Republican debate Wednesday night (9/7/11), I watched Rick Perry really step in it by calling social security a fraudulent “Ponzi scheme”—and not letting go of that stance even in follow-ups. At that moment, it hit me that Perry had obviously missed out on some very important advice I’d heard twenty years ago from a cowboy (...let’s call him Hank). According to cowboy Hank, he had received the advice in question from his mentor, a veteran ranch hand, on rookie Hank’s first day at work:

“When you’re wearin’ six-buckle boots,
don’t stand in eight-buckle manure.”

Too bad Rick Perry apparently never got that advice; if he had, he might have been more careful in the debate. I’ll be very surprised if Mitt Romney and Jon Huntsman don’t ride that one for everything it’s worth for the foreseeable future.

Social security doesn't pass the Ponzi-scheme test. It has a long history of taking in more than enough to cover its outgo. It’s a system in which those who funded it have counted on receiving future benefits from it, and those who managed it were willing and able to deliver them—similar to the system that builds interstate highways, the system that launches weather and military satellites, and the system that builds aircraft carriers and anti-missile Aegis cruisers. In each case the benefits expected, intended, and delivered are some form of future safety (i.e., some form of protection from a future threat or downside). Those are definitely not the characteristics of a “fraudulent scheme”—whether the fraud is concocted by Charles Ponzi, Bernie Madoff, or the Music Man.

The big question about social security, of course, is about its future: will demographics, productivity, and economic growth be sufficient for the system to continue providing current and future benefits to its users—or not? And, if not, what would be the best way to correct the problem?

There are two different ways to correct such a problem: (1) some combination of benefit cuts and tax rate hikes, to reduce spending or increase revenue; or (2) growth in the workforce and in productivity, to increase the revenue side without increasing tax rates. In the past, the main reasons social security stayed in a self-funding mode have been growing productivity in a growing economy that kept a growing number of workers working within a churning macro-mix of jobs requiring an ever-growing level of skill.

If it's not clear by now, I strongly prefer grow-grow-grow. Steve Forbes put it well years ago: “You can’t cut your way to prosperity, you’ve got to grow the economy.” And the growth solution doesn't just apply to social security; it also applies to the affordability of things like weather satellites, interstate highways, and Aegis cruisers.

But, based on what I heard in the debate, I’m guessing Rick Perry prefers cut-cut-cut, chop-chop-chop. In my view, a bad omen for him. It's a six-buckle answer to a problem that is eight buckles deep.

If Neil Were President

Here's a clip from Neil DeGrasse Tyson's response when asked what he'd do if he were president.

One objective reality is that our government doesn’t work, not because we have dysfunctional politicians, but because we have dysfunctional voters. As a scientist and educator, my goal, then, is not to become President and lead a dysfunctional electorate, but to enlighten the electorate so they might choose the right leaders in the first place.

Neil deGrasse Tyson
New York, Aug. 21, 2011

Here's the link to his blog post.


[He has a big following on Twitter.]