Some say the world will end in fire,
Some say in ice.
From what I’ve tasted of desire
I hold with those who favor fire.
But if I had to perish twice,
I think I know enough of hate
To say that for destruction ice
Is also great
And would suffice.
—Robert Frost, Fire and Ice, 1920.
Current global macro-economic policy is veering between two strategies: Fiscal austerity, or fiscal spending.
The first camp—fiscal austerity—argues that governments should cut spending, and perhaps even raise certain taxes, so long as those taxes do not harm general economic productivity. The rationale is, the sovereign debt has to be reduced now, as one day, there will be no more buyers for all the debt that’s being floated by countries. When that day comes, the countries will be broke—and broke countries often go up in revolutionary flames.
The second camp—fiscal spending—argues that cutting back and/or raising taxes in the middle of a slowdown is the sure path to macroeconomic suicide. To their way of thinking, the economic slowdown means lower aggregate demand. So the advocates of fiscal spending argue that to cut spending now would further depress aggregate demand—which would further slow down the economy, turning the situation into a vicious cycle: The dreaded Deflationary Death Spiral Freeze-Out. Therefore, to quote Cheney: Fuck the deficit. Rather than tighten its belt, the government should step in and spend more, so as to maintain the level of aggregate demand in the economy, until such time as it is once again back on its feet and able to expand without fiscal stimulus.
The fiscal austerity crowd counter that adding more spending to an already over-spent state will just exacerbate the problem of fiscal over-indebtedness. Indeed, to their way of thinking, adding more debt to the problem will only hasten and make inevitable a final day of reckoning.
The fiscal spenders don’t really have a counter-argument to this. Indeed, some of the more foolish members of the fiscal spenders’ camp argue that, with more spending, the economy will rev up to such a point that it will magically grow its way out of debt—but that’s just stupid; a mirror image of the Laffer Curve nonsense.
It’s not all that surprising, once you realize it: Certain hard-core neo-Keynesians (who argue for even more fiscal spending), and the Reaganaut Supply Siders of the Big Eighties (who argued for even more tax cuts for the rich), really are just twins separated at birth—really stupid twins, who probably should have been smothered in the crib. Both hard-core Neo-Keynesians and Reaganaut Supply Siders basically argue that the greater the fiscal shortfall, the greater the private sector stimulus which will result, said private sector stimulus being the engine which will in time rev up the economy and make up for the fiscal shortfall—an obvious fallacy for anyone who knows basic math.
The more honest members of the fiscal spending camp know this—they know that deficit stimulus will not result in such growth that it will wipe away the deficit through increased tax receipts. But they are also convinced that only government spending will keep the economy from that dreaded deflationary stall. So they hem and haw and equivocate, while all the while seeming to imply—with a weird little twitch—that over time, so as to service that monster debt, the state will simply have to devalue the currency, and thereby give U.S. Treasury bondholders a de facto haircut.
Currency devaluation—or specifically, dollar devaluation—has a lot of obvious benefits in a potentially deflationary crisis. The problem, however, is that it can’t be done by diktat. Roosevelt did it in March of ’33 when he confiscated gold and then repegged the dollar—but that was then, when the dollar was in fact pegged to gold. Since Nixon and the end of Bretton Woods, modern currencies float on nothing but air. So if currency devaluation is to happen, then it can only be done through “controlled” inflation (as if such a thing were possible).
In the fiscal spenders’ playbook—though it is never spelled out—this is the way by which the debt will magically disappear: “Controlled inflation” or “de fact devaluation” or whatever other term is invented for it, will force debt-holders to take the brunt of the shaft, while avoiding the deflationary death spiral. Or so the fiscal spending camp would seem to be implying, but carefully never stating: Krugman et al. are constantly arguing in favor of massive fiscal spending—fueled obviously by massive fiscal debt—but they never bother to give any reasonable alternative explanation as to how the monster fiscal debt will be serviced, aside from leaving the door discretely open for this posited stealth currency devaluation-slash-“controlled” inflation.
Some might argue that devaluation or “controlled inflation” or whatever it’s called is not at all the exit strategy of the fiscal spenders’ camp—after all, they haven’t said that it is. But I would argue that, if the total nominal fiscal debt crosses some as-yet indeterminate ratio of debt-to-GDP—say for the sake of argument two times the GDP—then would there possibly be any other way to service the debt, save by inflation or currency devaluation?
The fiscal austerity camp sees this too—and they give the big middle-finger to a de facto currency devaluation. Because just as the Neo-Keynesians are terrified of a deflationary stall, the fiscal austerity crowd are terrified of asset value destruction.
The fiscal austerity camp freely admits that austerity measures will cut government spending and indeed lead to a slowdown—but they claim it’s necessary to “clean out the dead wood”, or arguments to that effect. They insist that any enforced or triggered slowdown won’t be a self-perpetuating deflationary black hole. The reason, they argue, is because eventually, once overhanging inventory is wiped out either through write-offs or price cuts or just regular old consumption, the economy will reach an inflection point: There will be no overhang left to consume—the economy will have to start producing again, which will naturally lead to the end of any deflationary downward spiral, and an upturn in the economic fortunes of America.
To this scenario, however, the fiscal spenders camp asks the obvious question: How long will this process take? A year? Or a decade? Or maybe two? But we’ve got people hurtin’ now. So once again—fuck the deficit . . .
. . . and so off they go again, both camps arguing endlessly as they spin off into space like a top built out of PowerPoint presentations, PDF papers with more footnotes than arguments, and mathematical equations from all those cool and useless models that sure as hell did not see this mess coming.
These aren’t academic questions here: Both policy approaches are being tried out—fiscal spending on a world-historic scale in the United States, fiscal austerity for-real in the UK, and in-name-only in the Eurozone.
My sense is, both policy approaches will fail, because both are ignoring the elephant in the room—the real culprit responsible for the hole we’re in.
To understand the real culprit, let’s look first at the priorities of both policy camps:
The fiscal spending camp are basically Neo-Keynesian, “saltwater” economists; ‘cause they’re on the coasts. They consider the maintenance of aggregate demand as the primary goal of macroeconomic policy. More demand means more production, which means more jobs, which means more demand—voilà: A virtuous Neo-Keynesian cycle. (They are so into their vicious and virtuous cycles that they remind me of Tasmanian Devils.)
The fiscal austerity camp, on the other hand, are basically Monetarists, with a few Austrians thrown in for flavoring—so-called “sweetwater” economists; ‘cause they’re in Chicago and Middle America. This camp considers the stability of asset prices in real terms to be necessary for the sound running of the economy: Asset price stability means more investment, means more jobs, means more savings, means more assets, means more investment—and so on.
The two camps view it as “normal” for both aggregate demand and asset levels to continuously and predictably (on a macroeconomic level) accrete. When demand and/or assets plateau (or let alone fall), one or the other camp gets into a tizzy—which makes perfect sense: Each camp views either aggregate demand (for the Neo-Keynesian “saltwater” economists) or asset levels (for the “freshwater” austerity camp) as the cornerstone of economic activity, and therefore of economic prosperity. Whatever damages that economic cornerstone is exactly what ought to be avoided—just as whatever benefits that cornerstone is precisely the thing which ought to be implemented or encouraged.
They might as well just print up placards, and go march on either end of Wall Street: “What’s Good For Aggregate Demand is Good For America!!!” on one side, “What’s Good for Asset Levels is Good For America!!!” on the other.
Neither policy prescription is inherently evil—or even inherently wrong. Both policy prescriptions are simply trying to bring back the good ol’ days—when everyone had a multi-million dollar McMansion-slash-ATM, and everyone drove the latest 3-ton urban assault vehicles to go pick up little Junior and little Missy at the private daycare center and soccer practice. In essence, both approaches are seeking a status quo ante.
Neither camp, however, realizes that what they both want is impossible—not because they are contradictory or mutually exclusive: But because the aggregate demand increases and the asset level increases we have experienced over the past 30 years or so were artificial and illusory. Both the massive aggregate demand increases over the last 27 years, and the massive asset level increases over the last 27 years, were both caused by the same culprit: Subsidized money.
Not cheap money—subsidized money.
The prosperity in the U.S. over the last 27 years has not been earned. Those asset levels and aggregate demand levels that formed the basis of the prosperity of the last quarter century were both founded upon now-unpayable debt. That massive debt happened because debt was cheap—because the Federal Reserve, that bastion of free-enterprise, effectively subsidized the cost of money and made the debt cheap.
Rather than let the market determine the cost of money—just as with any other commodity—the Fed basically carried out a Marxist-Leninist top-down policy towards money (How ironic, considering Greenspan’s love of Ayn Rand). This money subsidy kept both economic camps happy—because subsidized money goosed both aggregate demand and asset levels. But subsidized money led to the massive distortions which, over time, crested and broke, causing the near-existential crisis of capitalism we are living through today.
The current crisis was caused by subsidized money. Period.
This shouldn’t be controversial—this is Eccy 101: The price of something is the intersection of supply and demand. If a price is subsidized, then demand will ramp up, often to an unsustainable level if it is an essential good. In every single economy where the price of something essential has been subsidized—be it food, fuel, housing—the result has been messy to the point of disastruous. Why should it be any different when you subsidize money?
The Fed artificially fixed the price of money—indeed, this policy was called The Great Moderation. The rationale for this money subsidy was an intellectually bankrupt hodge-podge ideology of Keynesian “pump-priming”, coupled with Monetarist “inflation fighting” bullshit. But then Greenspan, Bernanke, and all the rest of those self-important yahoos were never nearly as clever as they thought they were: That’s why they were all so surprised at the distortional effects of this subsidy, when the chickens came home to roost in September of ’08. That surprise was genuine—they didn’t have a fucking clue what they did wrong: And they still don’t.
Let’s take the distortional effects on asset levels first.
People today moan the fact that investors are constantly chasing returns, leading to serial asset bubbles. But let’s look at the obvious: If the Fed had not subsidized money, then plain vanilla FDIC-insured savings would have been getting decent returns (≥5%). Ten-year Treasuries would have been at average yields of 6% to 8%. We would not have had the asset inflation we’ve experienced since ’83. We would likely not had the fiscal deficits we’ve experienced, either—it would have been much too expensive for the U.S. Federal Government to service those deficits.
Asset inflation really started in ’73, with the first oil shock—but it was part of an across-the-board inflation spike, which was finally brought to heel by Volcker in ’82–’83. Asset inflation as an exclusive phenomenon took off in ’83, then really picked up speed after the ’86 “tax reform”, until the 2007/2008 top.
Subsidized money courtesy of the Fed—coupled with the perverse capital gains tax cut of ’86, which effectively abetted speculators—led to asset inflation on a scale not seen since the Tulipmania. I don’t think this needs much defense—the evidence is all around.
The principal effect of this subsidized-money-and-low-capital-gains-tax-leading-to-asset-inflation phenomenon was that it became more worthwhile to trade than to produce. Since all asset prices were rising, and on top of that the tax code was benefitting asset traders over income producers, it created the perverse financial incentive to outsource American industries.
This is what wreaked the American middle classes. Massive outsourcing, and the loss of manufacturing jobs it produced, wasn’t a case of “economic efficiencies” at work. Nor was it “globalization” at work either. Rather, this was the case of subsidized money wreaking American industries by making it more lucrative to trade away a company than to improve it. With the whole economy chasing returns, it was cheaper to “outsource” manufacturing to “cheaper” countries, since the Fed’s subsidized money, coupled with the lowered capital gains tax, made it more worthwhile to play roulette than to build a doo-dad.
This was on the asset side of the equation. But the Fed’s subsidized money policy (if anyone ever again calls it “cheap money” I swear to God I’m gonna get one of my gold bricks and bash someone’s head in, I swear to God!), also had tremendously distortional effects on aggregate demand.
Again, the obvious: Every consumer got cheap credit. So everyone went out and bought stuff with that cheap credit. Hence aggregate demand continued to rise inexorably—hence the Neo-Keynesians felt satisfaction that there was more demand (the engine of their economic ideology, don’t forget), even as they tut-tutted middle-class stagnation and “jobless recoveries”, and other weird distortions in the economy. Some people tried explaining this middle-class stagnation—of course they failed. They produced papers vaguely talking about globalization and improved efficiencies, but the explanations sounded as bogus as XVI century doctors blaming “the vapors” for a lethal case of pneumonia.
The reason for middle-class stagnation, of course, as well as the stratification of American society, is that the wealthy became traders, and traded away the middle-class jobs so as to benefit from the capital gains tax breaks. The middle-classes didn’t complain much—they were getting offers for new credit cards every week in the mailbox, with which they went out and shopped, shopped, shopped ’til they dropped.
Which they did: The middle-classes are in much worse shape than the macroeconomic numbers show. (This piece is a depressing case in point.)
The subsidized money which the Fed provided made both economic camps happy: It was the financial steroid that provided rapid asset level increases, while bulking up aggregate demand.
The only cost, of course, was that the subsidized money provided by the Fed hollowed out the American economy.
Now, as both policy camps try coming up with a solution to return to the good ol’ days of the status quo ante, it is increasingly and depressingly clear that the status quo ante won’t be coming back any time soon—because the days of status quo ante were all a lie.
So what to do?
If I were absolute dictator of the United States, I would ignore both of these policy “choices”. Instead, for the sake of the long term health of the American economy, and the other world economies intimately connected to it, this is what I would do:
•Allow interest rates to float at the whim of supply and demand. The Fed would provide liquidity, but only at market rates, never subsidized.
•Impose a flat tax across the board of 15% for individuals earning any income over the minimum wage, 25% for corporations, a 20% national VAT, and impose a capital gains tax of 40%, with no loopholes, subsidies, tax breaks or tax write-offs—not even amortization or depreciation.
•Cut government spending to the bare bones, until the budget is balanced. Cut military spending to 10% of what it is today.
•Eliminate Social Security and Medicare/Medicaid, and impose a private but highly regulated pension and health care system, like the ones here in Chile (which are damned good, BTW, and which were also, unsurprisingly, imposed by a dictator—but are still going strong 20 years after he left).
•Cut the Fed’s life-support of the Too Big To Fail banking system, and let those zombies die already. Whie we’re at it, prosecute the banksters.
•Finally—and this is the tough part—let the economy crash: Let the asset prices collapse to sustainable levels, and let aggregate demand collapse to sustainable levels.
If the above measures were imposed, and the U.S. economy were allowed to crash quickly, harshly, unemployment as measured by U-6 would spike to 50% or 60%, and hang around 35% for a good six months before slowly settling to 20% in a year or so—which is where we are now. Half the S&P and all the Too Big To Fail banks would go broke. Imports would evaporate. The idea of America as a consumer society would be gone almost overnight. There’d also be riots and general civil unrest for a year or two, but nothing that terrible—Americans are a remarkably docile people.
What would happen after that? What would the U.S. get for this short-term pain and suffering?
The two thing needed for true long-term prosperity, from where the U.S. economy is today: Asset price levels would collapse. And aggregate demand levels would also collapse.
It would mean that trading—in whatever assets—would cease to be financially beneficial, and instead production would reassert itself as the form of social wealth creation.
It would also mean that mindlessly consuming would also cease to be a macroeconomically beneficial policy priority, much less a personal goal. It might even lead to a truly Green economic mentality—true conservation, as opposed to the pseudo-brand, where buying more and more “green” stuff is supposed to be “helping the environment”, when of course it isn’t.
These measures would all be very painful—adaptation always is. But this approach—what I would call Free Market Redux—would be the healthiest way to rebuild the U.S. economy, and frankly American society.
Of course, no one’s ever going to let me be dictator of the United States. And no one is going to so much as contemplate the need to take the hits that I propose. I’m sure many clever readers are smirking at my “foolish measures”, dismissing them, while they take seriously the two policy prescriptions—fiscal spending versus fiscal austerity—which I outlined above. Both will continue slugging it out, while they both ignore the causes—or rather, the cause—of what brought us here.
Right now, in the U.S., there really is no debate: Fiscal spending on a world-historic scale is taking place. Fuck the deficit indeed.
But don’t be fooled—the deficit is being handled.
While world-historic fiscal spending is going on, a scam which I’d call Surreptitious Monetization is also taking place.
Like all good scams, Surreptitious Monetization is basically simple: The U.S. Treasury is issuing debt, in order to raise the cash to finance this world-historic fiscal spending. The Big Six banks, the Too Big To Fail banks, are dutifully buying up every scrap of Treasury paper . . . while through the backdoor, the Federal Reserve Board is providing liquidity to the banks, precisely so as to buy up this Treasury paper. In the details, it’s insanely complicated, of course—deceptions live or die on how opaque the details of the scam. But in its basic shape, that’s what’s going on: Surreptitious Monetization.
The Big Six banks are dutifully carrying out the game plan, while making themselves rich in the bargain, by way of massive bonuses. A lot of commentators have wondered why the U.S. authorities aren’t cracking down on the banksters bonuses—these commentators don’t seem to realize that the “bonuses” are in essence pay-offs from the Fed and the Treasury to the banksters, to keep them doing what they’re doing: They are effectively colluding with the authorities in their efforts to monetize the national debt.
It’s why there hasn’t been deflation—the Federal Reserve has been pumping cash out into the economy, halting price deflation in its tracks. (BTW, it’s also why the Fed is terrified to open its books to outside scrutiny.) Though there ought to be deflation, there won’t be deflation. Helicopter Ben will be true to his moniker.
Through Surreptitious Monetization, the U.S. economy is being kept afloat—but how will it end? Will the Fed close its windows, bringing about the much-feared Deflationary Ice Age? Or will the Fed continue printing money, until a hyperinflationary firestorm burns us all to a crisp?
At the start of this piece, I quoted Frost’s Fire and Ice in its entirety, drawing the analogy between these two policy camps and the lines of verse. I actually never cared for the poem. It’s always sounded to me like an over-serious limerick—I keep half-expecting to hear the word “Nantucket” crop up in the middle of it. But be that as it may, most readers basically take Frost to mean that he does not know how things will end—it might end in fire, or it might end in ice. But regardless of how it will happen, Frost suggests that it will indeed end—because everything ends, regardless of the manner.
Similarly, I have no idea if we will end in the revolutionary-hyperinflationary fire so feared by the austerity camp, or in the icy freeze-out of a deflationary death spiral as per the fiscal spenders camp.
All I know is how we got here—subsidized money. And all that I am certain of is that our current system will indeed end—one way or the other.
