Friday, December 23, 2011

David Frum is wrong: Deal with the deficit now

David Frum is a moderate Republican. That's not news to anybody. Yet, recently in an interview he was quoted as saying something that most Republicans (even those who think so - and there are a few) wouldn't dare say aloud: That the US shouldn't really care about the deficit right now and instead focus on creating jobs - ie, more stimulus.

He said, and I quote:

"There's lots of time to worry about the deficit. The world is happy to lend the United States money for 10 years at less than 2%. I say keep borrowing as much of that money as you can and use the money to address the immediate trauma of an economy in crisis..."

So, that sounds reasonable enough, doesn't it? If the world is willing to lend you money at less than 2 %, then why not just do it before they change their minds?

What Frum says makes perfect sense in corporate finance. A company can issue bonds (which means borrow money) today and buy back their own stock if they believe the return they have to pay on the bonds are less than the return they have to pay on the stock. You can also borrow money even if you don't need it desperately, just because the rates you can get are really low right now and so you'll certainly find something you can invest in and get a better return on the money than the interest rate. For a company, there is typically an ideal debt level or an ideal debt-to-equity ratio (and the ideal amount of debt is very rarely zero).

For a country on the other hand, you're not really borrowing to get an absolute specific return - who can tell how much return, in %, you get from borrowing and investing in infrastructure? If you can borrow at 2 %, is it then worth it because an investment in infrastructure will yield a return of more than 2 %? Who's to tell? It's obviously a lot trickier for a government than for a private corporation. A government may borrow money for non-financial reasons; it may believe that it is the state's responsibility to provide infrastructure and so borrowing to invest in it becomes justified even if it's not justified financially. The goals of a government are so much more complicated than the goals of a company, and that makes everything governments do more complicated than when companies do the same thing.

There is an important issue that needs to be adressed though: How come the US can borrow at below 2 %?

It doesn't really make sense when you first think about it. The US has a debt-to-GDP ratio that is close to Ireland's level (and Ireland is paying above 8 % on their ten-year bonds). The deficit is both huge and growing, and gridlock in Washington prevents long-term solutions from having a shot at passing. So why then?

1) Lack of options. With the Eurozone on the brink of collapse, those who are looking for a safe investment don't have as many options as they used to. Previously risk-free bonds like the ones issued by Germany and France now carry with them a not-insignificant risk. Other countries which still issue risk-free bonds (like Sweden - who can issue bonds with even lower yields than the US), but there isn't a huge amount of bonds available for purchase, and so it's not a serious option for big pension funds looking for an alternative to American bonds.

2) Lack of information. Believe it or not, but not all investors are that rational at the end of the day. It's impossible to know everything about the marketplace, and so every investor will make decisions that are at best rational based on the information he or she has received. That means that an investor who is not aware of the US fiscal situation will continue to by US bonds like they've always done, never thinking twice about it. Many investors are passive rather than active, and so won't act unless something extreme happens - which means that, if bond yields were to soar because of active investors dumping US bonds, that could unleash a domino effect with passive investors taking a second look and dumping said bonds as well. US bonds has been the default risk-free alternative pretty much since WWII, and so many investors haven't bother to investigate the US economy and really gather information about the US ability to repay its debts. I think a lot of them would be scared if they did, but far too many don't. They assume that once risk-free, always risk-free. This brings us to the next problem:

3) Maths over facts. Sometimes, investors relying too much on their gut feeling can be a problem, but far more often, it's the super-advanced mathematical formulas that cause crises. Traders who trade purely on technical rather than fundamental analysis tend to get wiped out whenever there is a shock to the system that the fancy regression models can't predict. I dont' want anyone to think that I'm an enemy of maths, rather I'm a great admirer of the mathematical science which is why I want it to be used carefully. The fact that the US has never (technically) defaulted ever in the 235 years since it declared its independence makes buying american bonds look very risk-free on paper. How do you estimate the risk of something that has never happened? It's not an easy task for sure. Mathematics tend to be a poor guide in predicting default; sovereign default risk requires fundamental analysis. You need to analyse a country's political stability, tax revenue base, political trends, growth and predicted growth, inflation and so many other things. There's a bit of math, but it's not enough in itself. Depending solely on mathematics will almost certainly make you underestimate the default risk of anything; not just countries. Mathematically, it still kind of, sort of makes sense to buy american bonds at a 2 % yield. It's when you look at non-quantitative factors like, as I mentioned, the political gridlock in Washington that you realize it's not such a good investment.

4) The Federal reserve. For those of you who don't know this, the Federal Reserve have in recent years been buying up american bonds en masse. This is called debt monetization and is a common cause of hyperinflation, but in the short term (and when not used excessively) it does reduce bond yields. If the Federal reserve agrees to buy US bonds at 2 %, that means the US can lend at 2 % even though no-one other than the federal reserve are willing to lend money at that rate. Since the Fed has access to the printing presses, the amount of bonds they can buy is virtually unlimited. And all the money (well, 97 % to be precise) that it receives from the US government (those 2 % interest that the government after all has to pay on the bonds) are returned to the treasury, so the actual cost of borrowing is minimal. Right now, inflation is not what investors worry about (slow growth is keeping it down at the moment), but that may change quickly as soon as the economy shows signs of life. Of course, that could take a while.

5) Confidence. This sounds strange to a lot of people, because who really has confidence in the US economy? Quite a few people, after all. This confidence comes from a lot of things, sometimes it's just that some investors are born optimists and believe that eventually, the US government will find a way to sort things out. Surely they won't let it get so bad that default becomes a real option? Believe it or not, but a lot of investors still believe that US politicians take the fiscal problems seriously. They still trust them to do the right thing if things really get serious. This is where David Frum comes in: He is essentially telling us not to take the problem seriously!

Let me ask you a question: Would you rather lend money to an indebted person who was firmly committed to paying them back, or to another indebted person who openly said he had no trouble increasing his already sky-high debt for the foreseeable future? David Frum is openly saying that the US should be the second person and openly state its intention to ignore its fiscal problems. If more influential people start coming out echoing this sentiment, it won't be long until the US will be borrowing at 5-6 %, rather than 2-3 %. If you want to borrow at 2 %, then the last thing you want to do is to give investors a single reason to believe that you're not taking your payback ability seriously! Frum, by bragging about how much the US can borrow at low rates, is unintentionally (I assume) raising the borrowing costs as he spreads doubt (again, unintentionally) about the US fiscal situation.

Comparison: If you're at the bank and they say "Okay, so you have some debt alright, but we trust you so we're willing to give you a 10-year loan at 2 %" and you say "Yes! That's great - though actually, FYI, I don't really care about paying back this loan, as a matter of fact I'm going to go to the bank next door and see if I can get them to trust me as well. Oh, and then I'm off to Las Vegas with my borrowed money" - do you think you'd get the loan? If you openly state your intention not to care about paying it back? Because that's essentially what Frum suggests the US should do, when he says you ought to ignore the deficit.

But... it's for stimulus!

The obvious counterargument from the liberal Frum brigade is that he's not suggesting lending money just because, he's suggesting we should do it to stimulate the economy. So, first of all... how did that work out the last time around?

Here are some cold facts: At the time when the last recession ended, in june 2009, there hadn't yet been any stimulus spending! This was an unusually deep recession, and yet it resolved without any stimulus spending. Yes, the stimulus bill had been passed, but spending money takes time, and by the time the recession ended, basically all of it was yet to be spent. It's completely unfounded to believe that whatever small amounts had been spent had any significant effect on the economy.

Okay, but what about expectations? Maybe the reason why the recession ended was because expectations changed when the stimulus bill was passed? After all, investments and consumption is largely based not on the facts about today, but on the expectations about tomorrow. If you expect the stimulus bill to fix everything, you'll invest even though it hasn't fixed anything yet.

There is only one problem: The stimulus bill wasn't popular with investors, and even less so with employers. Obama quickly lost whatever confidence the market might have had in him by showing off his ignorance when it comes to basic economics. To be fair, John McCain wasn't very trusted either (as he himself had admitted the economy wasn't his strong suit). Even when Obamania was running wild in the rest of the country, employers remained pessimistic and the stimulus bill did nothing to change that. It didn't improve expectations; if anything, it made them worse.

The next question, and this I realize is slightly controversial, is whether or not ending a recession is really an end in itself. Even if we assume the stimulus bill caused the recession to end a few months earlier than it otherwise would; was it really worth over 800 billion dollars? Was it really worth indebting the nation for a generation, just so we could get out of recession a little earlier? Did we really get a good return on investment? Considering that the US national debt has increased by 5 trillion during Obama (most of it because of various forms of "stimulus"), and considering that spending has reached levels it likely will never come down from - how can we justify this, even if we assume the stimulus had some kind of positive effect? It clearly didn't save us from another Great Depression, as such a depression was never going to happen anyway, as proven by the fact that the Great Recession like I said ended before any significant amounts of stimulus money had been spent. "Another Great Depression" was and remains only another example of political scaremongering and propaganda.

Like I said, it's harder to estimate the return on government spending because the goals are not only financial, but since with stimulus spending the main reason is financial, I figure this simple way of calculating whether the stimulus was worth it just might work: It cost the US roughly 800 billion dollars. Let's say it shortened the recession by 3 months (a generous assumption). Did shortening the recession by 3 months lead to an increase by >800 billion dollars in tax revenue? It is generally known that recessions reduce tax revenue, and so a stimulus program that shortens a recession might actually increase tax revenue. But did it increase it by 800 billion or more? Hardly. And so, the taxpayers did not make a profit from the bill, even if it somehow helped. Also, shortening the recession by 3 months didn't cause output in the overall economy (GDP) to increase by 800 billion, and so no matter how you measure it, it clearly wasn't worth it.

There is no way the US will ever recover the 5 trillion dollars of deficit spending that have occured under Obama. Of course not all the stimulus projects have been equally bad; some may have even been good. Yet, as is quite common when the government spends money, most of the stimulus money was wasted and the overall return was negative. When you add in the non-financial costs: The enlargement of government, the increase of bureaucracy, the reduction of independence that comes from borrowing from foreign nations (which is a necessity when you're borrowing large amounts) and the fact that the stimulus creates a culture of dependency among the citizens, the return is even worse.


My basic conclusion is very simple: David Frum is wrong and the US needs to deal with the deficit now.

I am not going to pretend like this is easy, like some presidential candidates have a tendency to do. Cutting government spending is always a painful exercise, which is why we're so reluctant to do it. Yet to do what David Frum suggests and take the easy road would be disastrous, and it would truly be unworthy a nation that calls itself the Land of the Free and the Home of the Brave. Being brave means making sacrifices today in order to ensure the welfare and freedom of future generations.

We will need both parties to deal with these issues, which is why it is so troubling when people who call themselves Republicans openly dismiss the deficit. With friends like that, who needs the Democrats? Like it's not hard enough to get them on board already, now we have to convince the Republicans too? I honestly thought we all agreed that "Deficits don't matter" is the most stupid phrase ever uttered by a Republican, but it turns out I was wrong.

If there is anything we need to understand, it is that deficits do matter, no matter what the interest on your government debt happens to be. Debt is a curse, even if it's not the high-yield type of debt.

Finally, I want to wish every reader a merry christmas and a happy new year. My exams are coming up soon which means less time for blogging, and I don't know when I'll find time to write another post. Hope you can survive without my insights and thoughts for a while. Thanks for reading.


Ohio JOE said...

Marvelous post! Merry Christmas John.

John said...

Thanks OJ :) Merry christmas to you too

Pablo said...

John, I love your stuff but I am going to have to give a full rebuttal to this sometime tomorrow night when I have some time. David Frum is right about this.