Progress on Financial Rescue

In Part III of my 2009 economic outlook series, I made the argument that government would need to inject another $1-1.2 trillion into the banking system to stabilize the economy.  The Wall Street Journal reported today that the Obama administration is considering doing just that.  [subscription required]  Supposedly the plan could be announced in the next couple of days.  This should be viewed as constructive for the markets.  In my view, this makes a massive fiscal stimulus package unnecessary and potentially inflationary and dollar-negative.  While I like the investment focus of much of the package as a blueprint for future government spending focus (transportation infrastructure, energy efficiency, electrical grid, broadband access, electronic medical records), and have no problem with running mild deficits, the magnitude of the deficits we run will be the greatest by far relative to the economy since World War II and serves to put us further in debt to foreign countries when we should be seeking to move in the opposite direction. 


Source: WSJ.  Note: this chart doesn't include potential $1-2 trillion of additional bank capital injections

I don't mind the portion of the deficit allocated to the bank recapitalization, as long as the money is used to buy assets that will be sold eventually while providing a positive return.

2009 Outlook Part III – Shrink the stimulus, triple the TARP

In Part I of my 2009 Outlook series, I wrote about how the US's current economic policy framework is driven by a reaction to the Great Depression, when the old policy framework that favored producers, lenders and exporters collapsed into deflation and shrinking world trade. The policy mix since that time has been designed to favor consumers, borrowers and importers and has been embraced by both parties in different ways. The result has been a promotion of consumption at the expense of savings, a build-up in US indebtedness, and chronic trade deficits. In Part II, I discussed the link between a rising dollar and trade deficits, between trade deficits and a rise in overall indebtedness, and between dollar decline and foreign currency manipulation.

Ideally, an economic policy mix would balance the needs of consumers and producers, importers and exporters, lenders and borrowers. Unfortunately, that is not how politics work. People build up their biases over their lifetimes and they don't let them go easily. Also, we have a peculiar political situation in the US currently, in that the GOP has a traditional policy platform that favors producers and lenders, but those economic policies tend to favor the "blue states" in the north and west coast. The Democratic Party traditionally promotes the interests of borrowers and consumers, but those policies actually favor the economic interests of the "red states" in the South, Rockies and Great Plains. The only economic policy that has retained its traditional regionalism is trade, with the south favoring free trade more than the north. This policy confusion stems from the parties' gradually switching regions from the late 1960s to 2000, when the Red State-Blue State realignment was completed under George W Bush.

In my first two sections I focused on what should be done to fix the economy, which would be to stimulate foreign demand at the expense of US consumption, stabilize currency values, and take action to prevent US trade deficits, even running temporary trade surpluses to reduce our net debt. Of course it's actually more important to know what actually will happen. The people in charge of our economic policy…politicians, fed officials, treasury officials…have all been taught to fight deflation and support demand at all costs. That means large increases in the supply of money and talk of massive fiscal stimulus. These things ARE going to happen, so the important question at this point is whether the programs will work.

After much deliberation, I have come to the conclusion that the government "bailout" of the financial industry is vital and too small, and that the proposed financial stimulus program is unnecessary and potentially counterproductive.

Economic crises are always banking crises

Since the dawn of capitalism, every broad-based economic downturn has been caused by the same thing: contraction of banks' balance sheets. Banks are inherently unstable institutions because they are highly leveraged. They make loans, which are bank assets. They can post these assets as collateral to borrow from each other essentially ad infinitum, so that their assets can far exceed their equity capital. When times are good, banks get overextended by borrowing too much relative to their equity capital and by making overly risky loans. The economist Hyman Minsky described the process of the banking boom-bust cycle as moving from hedge finance (cash flows cover interest and principal payments) to speculative finance (cash flows cover interest but not principal) to ponzi finance (cash flows cover neither interest nor principal, and loans can be repaid only by selling the asset at a higher price). The migration to ponzi finance was evident in the recent real estate and LBO bubble. When the bubble of ponzi finance pops, the cycle runs in reverse from ponzi to speculative to hedge finance. The reverse cycle means valuations (price relative to cash flow) need to fall until the yield is able to service both principal and interest payments.

The boom-bust cycle would be limited to the primary area of speculation and would not affect the broader economy if it were not for the highly-leveraged nature of banks. If a bank has equity capital equal to 10% of its assets, it could withstand losses equal to 10% of its assets before its liabilities exceed its assets and it becomes insolvent. Of course it's actually worse than that. If a bank started with a capital ratio of 10% and the value of its assets fell 8%, it would have a capital ratio of 2% and for all means and purposes be insolvent anyway, because depositors would remove their money from a bank with such a small capital base. Undercapitalized banks feel the need to sell assets to raise cash and meet depositors' demands, which of course depresses asset values even further and causes more forced selling. Back before the Depression, this would cause banks to collapse, which would wipe out customers' deposits. The vanishing deposit accounts amount to a contraction of the overall money supply, which leads to price deflation. The New Deal financial reforms were designed to prevent deflation by breaking banks up into smaller, more specialized entities that would trade high levels of regulation for the benefit of being able to maintain relatively high leverage.

The above chart from the Economist is forecasting that new regulations will force commercial banks to return to pre-Depression era levels of capitalization. For this to happen, however, either banks' assets would have to decline by 33% relative to the same equity base, or bank's equity would need to increase by 50% relative to the same asset base, or some combination of the two. That would be difficult enough if it was not for another large wrinkle.

The decline of the "shadow banking system"

As commercial banks tottered through crises in the 1980s (Latin American lending, the S&L crisis, the LBO bust), a new, parallel financial system arose that has been dubbed the "shadow banking system". Financial innovations like the money market mutual fund, commercial paper, asset backed securities, structured investment vehicles, derivatives, credit default swaps, collateralized debt obligations, credit hedge funds, and prime brokerage services allowed for the creation of a huge lending function performed by the securities markets and off the balance sheets of traditional commercial banks.

The changing mix can also been seen in this chart I once found (apologies to the authors…I can't remember where) that shows the balance sheets of various sectors of the financial system prior to the financial meltdown.

Here it's clear that the financial intermediaries in the shadow banking system (brokers, hedge funds, GSEs like Fannie Mae and Freddie Mac) are the ones that behaved particularly irresponsibly. At 30:1 leverage, if your assets fall only 3% in value, you are wiped out…which is exactly what happened. Since that time, the federal government has seized the GSEs and the commercial banks have absorbed the balance sheets of the brokers. In addition, the commercial banks have added around $500 billion in loans as commercial paper back up lines were called in and the entire structured investment vehicle universe was shut down. That means commercial banks, before the effect of write-downs in the financial crisis, would have had assets of $16,690 billion, liabilities of $15,419 billion and equity capital of $1,271 billion, or leverage of about 13.1 times equity or a capital ratio of 7.6%. If we include savings institutions and credit unions on the banking sector balance sheet, we arrive at assets of $19,352 billion, liabilities of $17,765 billion and equity capital of $1,587 billion, or a capital ratio of 8.2%.

Economist Nouriel Roubini of RGE Monitor ( has estimated that US banking losses and write-downs in the crisis are likely equal to $1,800 billion. (For the record, Mr. Roubini has been one of the most prescient observers of the financial bubble and subsequent meltdown.) That means assets contract to $17,552 billion, liabilities remain at $17,765 billion, and equity capital becomes negative $213 billion. Just to return the banking system to adequate capitalization of 10%, the banking system needs nearly $2 trillion of total equity injections. So far, there has been $350 billion from the TARP, another $100 billion or so in private and sovereign wealth fund capital and another $350 billion in TARP II funds just approved by Congress (as long as it isn't wasted on trying to prop up housing prices). Maybe there has been another $100 billion in offsetting retained operating profits (I'm being real rough here, I don't know the data). Basically, the banking system of the United States needs another $1-1.2 trillion of capital injections, probably from the federal government, just to be adequately capitalized.

Shrink the stimulus, triple the TARP

Until banking system is adequately capitalized, no matter how much you spend on fiscal stimulus the gears of the economy won't catch (in a forward direction at least). Japan is a conspicuous example of this problem. Japan spent trillions on "infrastructure" spending in the 1990s, running their national debt to over 100% of GDP, with no natural economic expansion to show for it. While Japan's borrowing and spending on infrastructure was better than doing nothing, the country has been mired in a soft deflationary depression for the past two decades. Japan's "zombie" banks and corporations were propped up just enough to slowly work their way out of insolvency, but not enough to expand lending and borrowing. Now asset values in Japan are back to levels not seen since the early 1980s. In the United States, that would be the equivalent of retreating to the values of the early 1990s…think Dow 2,500 and S&P 300.

Besides, the problem in the US has not been a lack of demand, it has been an excess of demand driven by relentless expansion of the financial sector, prolific consumer spending and, at times, prolific government spending. Rather than try to prop up domestic demand at unsustainable levels, the government should instead focus on easing the effect of a decline in consumer spending by figuring out ways to shift the mix of demand to more domestic sources of production. Many of the items in the proposed stimulus package are worthwhile in this regard, and should be part of the long term government spending program. They just won't really stimulate the economy in 2009. If the money is borrowed from abroad, the offsetting capital account surplus will directly cause a current account deficit and be subtracted from 2009 GDP growth. If it is paid for by the Fed's printing money, then it is pure inflation. (I'll leave the rest of my discussion of fiscal policy to Part IV.)

The good thing about the TARP is that it is buying assets that can be monetized at a later date. The US government gets to borrow at 0-3% and purchase preferred stock that pays 5-10%. The banks, after they return to health, can buy back the preferred stock or it can otherwise be sold into the open market. In my view, the government should issue straight preferred with a dividend rate at the high end of that range. This would encourage the banks to repay the preferred stock as quickly as possible, without giving the current common stockholders a super-sweetheart deal when they actually deserve to be wiped out. Because the preferred stock will be repaid, with dividends, it gives the federal government a way to stimulate the economy without adding to the future debt of the United States or further debasing the currency. It would not, however, be great for existing bank common stock holders.

In addition to this capital overhang, I expect the Obama administration and the current Congress to clamp down on the financial system with a new regulatory regime. My assumption is that the regulatory regime will focus on systemic risk and managing bank capital ratios in a counter-cyclical fashion. It will also reign in hedge funds and risk-taking by banks. The golden era of finance in the US will be over, not to return for at least two generations.

The secular decline of finance

One consistent trend in the US economy since World War II has been the rise of finance. While the financial sector got beaten up pretty hard by the Roosevelt Administration in the 1930s and 1940s, it has climbed relentlessly since then. Financial debt to GDP has risen from 3% of GDP in 1952 to nearly 120% of GDP in 2008. The finance sector expanded its balance sheet faster than trend in the late 1970s, early-to-mid 1980s and late 1990s, all of which were major periods of innovation and expansion. While there have been many benefits to the rise of finance, it has also distorted the economy. The US government has practiced an asymmetric "socialism for the rich" with its policies of letting booms run and then fighting downturns by printing money to protect investors. In history, when nations over-luxuriate in the riches of high finance, they experience inflation, deteriorating terms of trade, a decline in the productive economy and high income inequality. It is not dissimilar to the effect of oil wealth.


I work in finance, but nevertheless feel that the US would benefit from a shrinking of the finance sector relative to GDP. I expect the new financial regulatory regime to effectively turn the banking system into a conservative oligopoly, which will dampen both asset and price inflation. This in turn will direct capital away from speculative uses like trading derivatives and gambling on real estate inflation. Capital will instead flow toward investment projects with more of a demonstrable cash-on-cash return on investment.

What does this mean for 2009?

I don't think that there is any way out of the general debt deflation until the banking sector is recapitalized with an additional $1-1.2 trillion. There may be some initial euphoria surrounding the stimulus plan, but it will likely be short-lived. There is no way to avoid a continued 15-30% decline in house prices in 2009, outside of hyperinflation. The auto sector needs to shed 20% of its capacity to be remotely viable. There will continue to be liquidations of retailers and large amounts of commercial real estate bankruptcies. The media and consumer internet sectors are saddled with overcapacity as well. The inventory-to-sales ratio has spiked, which will lead to continued discounting throughout the economy. Consumers will continue to increase their savings rates and pay down debts (as they should, economists be damned).

Until I see the TARP increased by $1 trillion, I will maintain a cautious stance, heavily overweighting short term treasuries, investment grade bonds and gold.

Next: Part IV – The recession's end is not near

2009 Outlook Part II – The trade deficit and the US debt machine

This post is a continuation of 2009 Outlook Part I – The Depression's Long Shadow

Our debt problem

At this point it's pretty obvious that the primary problem facing the United States in this financial crisis is our high level of indebtedness and the threat of debt deflation. In order to understand how to get out of our debt problem, it makes sense to look at how we got into the problem in the first place. The operative metric to look at is total debt to nominal GDP.

Of course, there's no real way to know what the ideal total debt to GDP figure is. If as a people we feel our government has gotten better at managing the risk in our economy, that recessions will be less frequent and shorter, that inflation will be consistently low and positive, that interest rates consistently low, and that asset prices will keep rising, we will be comfortable carrying a higher level of indebtedness. That is until we push it so far that the amount of risk increases and the level of indebtedness at which we're comfortable comes crashing down. As can be seen in the chart above, there have been two periods since 1952 during which the level of debt to GDP increased rapidly: (1) 1981-1989, when the level of debt to GDP increased from about 150% to 225%; and 1997-2008, when the level increased from 240% to 340%. If the history of investment manias is any guide, we should expect the financial effect of at least the entire 1997-2008 boom to be wiped away.

In order for our nation's debt to grow faster than GDP, we can (1) borrow money from abroad or (2) increase the leverage in our financial system. Increased leverage in the financial system can be measured by total financial debt to nominal GDP, which I will discuss in a later post. All the rest (consumer, business, government) is in nonfinancial debt to nominal GDP.

The debt stair steps

It's pretty easy to see the pattern in this graph. Nonfinancial debt rose from 120% of GDP to 140% of GDP by the mid 1960s, coming off a pretty low base during the postwar boom. It stays in a range of 135%-140% all the way to 1982 and then shoots to about 180% by the end of 1987. Then it basically stays at about 180% until the end of 1999, after which it climbs to 225% by the end of 2007. These were both about 25% increases.

What did these two periods have in common? They both had tax-cutting Republican presidents who also spent heavily on the military. They both had rapidly falling interest rates. They were both periods during which the US was running large trade deficits. Trade deficits coexist with an inflow of capital, as the current account deficit (mostly the trade deficit) by definition must equate to a capital account surplus (a purchase of US securities).

Why do we run trade deficits?

If the trade deficit is a major cause of our debt problem, it is worth understanding why we run trade deficits. The periods where the trade deficit starts to widen in the early 80's and late 90's clearly correlates with periods of a rising dollar. When the dollar returns to its equilibrium range between 85 and 95 on the real broad trade-weighted dollar index, the trade deficit begins to close.

Why did the dollar rise during those two periods? During both periods there were relatively high real interest rates, plus an explicit policy favoring a stronger dollar. During the 1980's, the US wanted to wring 1970's inflation from the system. During the mid 1990's, Robert Rubin imposed the "strong dollar" policy for no discernable reason whatsoever.

Why was the trade deficit in the 2000's were more severe than the deficit of the mid 1980's, when the dollar spike was more subdued? The answer is foreign intervention.


Source: Bank Credit Analyst

Clearly, you tend to get foreign official flows into dollar assets when the dollar is weakening. During the late 1980's and early 1990's, foreign official flows accounted for virtually all of the US's modest trade deficit of 1% or less of GDP. During the early 1980's and late 1990's, there was very little official foreign flow, as the rising dollar attracted private investment flows. From 2002 to 2008, however, there was a systematic effort by foreign governments to accumulate dollar reserves to promote a trade deficit in the US. The vast majority of the blame can be heaped on China, Japan and the oil producing countries, who from 2003 to 2008 were contributing 2.5% to 3% of GDP points to our trade deficit each year. Without these flows, our trade deficit would have run at a more modest 1-3% of GDP. What did the majority of these funds purchase in the last several years? Fannie Mae and Freddie Mac agency debt, which flowed into, you guessed it, the US housing bubble.

So we should blame China and Japan for the housing bubble, then, right? Partly, but not completely.

The role of Japan

Japan had a massive investment and real estate bubble in the late 1980s, like our NASDAQ and housing bubbles all rolled into one. When it popped, Japan was unable to stimulate domestic demand, because its consumer base was overleveraged from the real estate bubble. Also, because Japan was a more egalitarian society than the US during the roaring twenties, it couldn't follow the New Deal policy of taxing the savings of the rich to stimulate demand in the middle class. Japan had massive overcapacity in its business sector and a badly damaged banking sector, so it was difficult to stimulate investment there. Japan also suffered from deflation, not only a slow-rolling debt deflation as the government propped up wobbly banks, but also absolute price deflation caused by a strong currency.

The yen doubled in value against the dollar from 1985 to 1988 (at our urging as part of the Plaza Accords) and rose in value against gold all the way into the late 1990s. With domestic demand hobbled and prices falling, Japan instituted a massive infrastructure building program during the 1990s, most of which is now acknowledged to have been wasted on politically-connected projects. By the end of the 1990s, Japanese government debt to GDP has risen to around 100% of GDP. In the 2000s, Japan switched gears to focus on printing money ("quantitative easing") to fight deflation and support exports by holding its currency down. Printing money in the case of Japan meant printing yen to buy dollars. With zero percent official interest rates and an explicit pledge to hold down the currency against the dollar, the Bank of Japan issued a notice to hedge funds to short the yen and buy assets in other, higher-yielding foreign currencies like the dollar, pound, Australian dollar, New Zealand dollar and Icelandic Krona.

Robert Rubin's wave of destruction

In the mid-1990s, a number of Asian countries (ex. Japan) were doing pretty well. Their currencies were pegged to the dollar. They were following the classic development model of running capital account surpluses as they received high levels of investment from abroad. Much of the investment was in the form of dollar-based loans. The dollar spent 8 years in a relatively tight trading range, so that wasn't an issue. With the exception of Japan, most of the world economy was expanding in a relatively balanced fashion and the US was running only modest trade and budget deficits along with stable, low inflation.

In 1995, however, US Treasury Secretary Robert Rubin began cheerleading for a stronger dollar. As the dollar began to rise, it put pressure on emerging market currencies in Asia and Latin America that were trying to maintain currency pegs and had borrowed in dollars. Hedge funds began (rightly) betting that the currency pegs would be broken. Starting with the Thai Baht in 1997 through the Ruble default in 1998, the world currency system collapsed, saddling emerging market economies with huge dollar-based loans relative to their collapsed currencies. The IMF then imposed punishing austerity measures on these countries in exchange for bailouts. Emerging market countries can be forgiven for seeking a different policy path this decade after they were needlessly impoverished in the late 1990s.

The China model

The Chinese witnessed what happened to Japan (rising currency/deflation) and what happened to Korea and Southeast Asia (trade deficits/collapsed currencies) and decided to take a different path. They would emulate the export-based development model successfully utilized by Japan. Instead of allowing their currency to consistently rise over time (which has the effect of raising living standards and holding down prices, but can also lead to an unstable investment bubble and encourages imports and discourages exports), they would hold down their currency. To prevent their currency from rising, the Chinese limit currency convertibility. The central bank recycles export earnings into dollar-based securities, building reserves to protect their currency in times of distress. China has built up more than $1.2 trillion of reserves. Building currency reserves directly promotes a trade surplus for China and a trade deficit (via a capital account surplus) for the country issuing the reserve currency (mostly the United States). Such a strategy can only last so long, of course. Eventually, inflation pressures in China would become too great and/ or the United States would stagger under the weight of its increasing debt load. Both began to happen in 2007, with the US's debt burden becoming the greater of the two forces.

Reining in the trade deficit

As US demand has collapsed and energy prices have plunged, the US trade deficit has begun to narrow sharply. The problem is that now US exports are falling too. The goal going forward for the US needs to be to figure out how to restore domestic demand without having that demand spill abroad in the form of renewed trade deficits. I'll leave discussing how the mix of demand needs to change for a later post. Foreign countries also need to figure out how to stimulate domestic demand so that they become less reliant on exports to the US and import more from the US. A return to trade balances would at least help stabilize the US's debt to GDP ratio.

The US would bring its debt levels down if it began running trade surpluses. Given the current structure of the global economy, that may be a bridge too far, unfortunately. What the US can no longer tolerate, however, is foreign governments to purposely manipulating trade flows via the building of currency reserves. After 8 years of using diplomacy alone to try to deal with this issue, it may be time for the Obama administration to take a tougher line, perhaps via broad-based tariffs to offset the effect of currency manipulation. While I am a free trader by disposition, we can't stand by and allow other countries to basically cheat our businesses and workers.

A global solution to a global problem

The problem of global trade imbalances and currency instability is a global one, yet most currency and monetary policies are determined at the national level. The US Fed operates as if it serves the US alone. Since the dollar is the global currency, however, the Fed functions as a de facto global central bank. The US allows its currency to fluctuate widely to suit its own purposes, with dolorous effects on emerging market economies and US businesses. Yes, China, Japan and various petro-states are systematically manipulating their currencies, but in many ways these policies are a response to past interest rate and currency instability caused by the US Fed and Treasury.

While the US could seek to punish offending countries with tariffs, such a solution alone could result in retaliatory measures, a collapse of global trade and global depression. Instead, the US should offer to lead a global currency system based on stable currency values. Such a solution would by definition require coordinated global monetary policy, particularly between the US, Eurozone, Japan and the UK. Other emerging countries could allow their currencies to float against, or be pegged to, the major currencies. All currencies would need to be freely convertible and countries would not be allowed to build currency reserves beyond what may be needed to provide for currency stability. The IMF could also return to its traditional role of promoting currency stability. Emerging market countries should be given a seat at the table and most decisions should be made through the G-20 type of group as opposed to the anachronistic G-8.


I hope this essay establishes that (1) a large portion of our national debt problem comes from running trade deficits; (2) a major cause of the trade deficits has been artificial dollar strength, driven by US policy; and (3) that another cause of our trade deficits has been currency manipulation by foreign governments building large currency reserves. To fix the trade deficit problem, US currency policy should be (1) to promote a stable dollar, not a rising or widely fluctuating dollar; (2) to prevent foreign governments from building large dollar reserves; and (3) ideally create a global currency framework that would promote currency stability and reduce global imbalances, particularly by brining the emerging market countries in to the process as major stakeholders.

Next: Part III, shrink the stimulus, triple the TARP 

2009 Outlook Part I – The Depression’s Long Shadow

I've been having writer's block for the past three weeks as I've been trying to sit down and write my 2009 economic outlook. While in normal years, I could assess the state of the business cycle, look at asset prices and make a call. This year, however, we are caught in a web of epochal changes on par with the 1930s and 1940s or the 1860s and 1870s. The entire global economic system is threatening to break down, and for good reason. Since World War II the world has relied on the relentless increase of US consumer demand. The increase in US consumer demand has been driven by a relentless increase in US consumer indebtedness. Both of these forces have been deliberately fostered by US economic policy. Not surprisingly, US economic policy has been driven by the lessons learned in the Depression and articulated by two economic schools of thought, Keynesian and Monetarist. The Keynesian school articulated that the government should step in to fill the void in private demand during recessions. The Monetarist school posited that the central bank should step in to prevent a contraction in credit, and by extension the money supply, during downturns. Since the Depression both methods have been used liberally to fight recessions, mostly successfully, but have also been bastardized for political ends. The Keynesians have used policy to not only temporarily support demand during downturns, but to also promote permanent increases in consumer demand, particularly through the promotion of housing and consumer spending. The Monetarists have used policy asymmetrically, supporting credit during downturns but letting booms run unabated. As a result, dangerous imbalances have built up.

The other theme for the past 60 years has been the relentless expansion of the financial sector, first from absurdly low levels after the beating it took during the Depression and the New Deal, then into the massive expansion of the past 30 years. There has been a great deal of innovation in the financial sector, making the US the most efficient allocator of capital in the world. The financial sector has also become dangerously unstable and has magnified the global boom and bust cycles of the past 30-40 years. A series of constantly shifting imbalances has ruled the global economy during this time. Much of this instability has been tolerated because, for the most part, it has been during a virtuous cycle of rising global living standards supported by the US's willingness to lever itself up. Now that the cycle may be turning vicious, we could be in for 10-20 years of serious global crisis if world leaders don't get together to restructure the world economy. Until it becomes clear that such a change is occurring, caution will be the proper stance.

Because of the momentousness of the trend changes underway, I have been forced to break up my analysis into several parts. Part I will set the context of how today's economic policy mix was shaped by the Depression. Part II will discuss the US trade deficit and indebtedness. Part III will discuss consumption and investment and the sources of GDP growth. Part IV will discuss the dollar and inflation. Part V will be a policy manifesto for the new era.

Part I – The Depression's Long Shadow

The effect of the Depression on policy today

There has been a great deal of commentary that has compared today's situation to that of the Great Depression. There are similarities. First, there is the great debt overhang that has built up, resulting in the threat of debt deflation. Second, we are in similar position in the Kondratiev Cycle, moving from the good disinflation to the bad disinflation phase (if you believe in that sort of thing, which I actually do). There is also the high wealth disparity that has built up over the course of a long bull market and the obvious switch from a Republican-dominated government to a Democratically-dominated one.

There are big differences, however, as well. The US's macroeconomic position is much different now than it was at that time. During the early 1900s the United States was in a position more similar to Japan in the 1980s or China today. It was a rising, mercantilist power that ran big trade surpluses and was a net creditor to the rest of the world. It had a relatively small government sector that did not greatly interfere in the private economy. The government had long run balanced budgets and was historically tight-fisted. Most government revenue came from protective tariffs and the use of income taxes was limited. The US had a huge amount of excess production capacity that sat idle when domestic demand was insufficient to take up the slack after world trade collapsed in the Depression. The US was on the gold standard and value of the dollar had remained unchanged vs. gold at $20.67 since the revolution (with blips during major wars), even though the economy had grown many times over, and up to the start of the Depression the general price level was basically the same as it had been in 1800. It is also important to note that debt to GDP wasn't that high at the beginning of the Depression (it went from 140% of GDP at the beginning of World War I to 160% by the end of the 1920s), it was only after a massive collapse in the economy and debt deflation that it rose to 250% of GDP by 1933, as shown here. It was as the economy shrank faster than the nation's debt load, that the ratio of debt to GDP rose.

The policies of the New Deal were designed to correct some of the imbalances that had built up over the previous 70 years. In the era prior to the Great Depression, the core economic policies of the United States were designed to encourage manufacturing production. The primary form of tax was the protective tariff, which encouraged domestic production and taxed consumption of imports. Large trusts were formed to limit domestic price competition. To counter the pressure on laborers' wages, from competition in the 1920s the government passed highly restrictive immigration laws. World War I, however, had thrown the rest of the world system into chaos. During the War, the US lent large sums of money to its allies, which it could then in turn use to by US-manufactured war materiel. The US thus ran very high trade surpluses and built up a stock of European capital. After the War, the allies began to repay their loans, sending money back into the United States. As the money flowed back into the US banking system, it was lent out and supported the great production, consumption and asset boom of the 1920s. When it ran too far, it began to collapse into a classic debt deflation. As domestic demand retreated with the supply of money and credit, the US government tried to keep the party going the only way it knew how: by raising tariffs to support domestic industry, raising taxes to keep the budget balanced, and keeping interest rates high to protect the gold standard.

In not doing those things you get the three US ideologies of the Era since the New Deal: free trade Globalism, Keynesianism and Monetarism.

We encourage open world trade, even if other countries manipulate our willingness to do so with mercantilist policy. We use government policy to encourage increasing domestic demand: deficit spending, policies that support consumption at the expense of saving and investment, and policies that encourage borrowing money to buy houses. We manipulate the money supply to support ever-rising indebtedness and prices.

The policies of the New Deal were appropriate for the situation the country was in then. Reduce the value of dollar to fight deflation. Establish the SEC to increase investor confidence. Establish the FDIC to prevent bank runs. Establish home loan banks to support housing prices and financing. Break up the highly concentrated financial system to reduce risk. Use government money to invest in infrastructure when private investment demand dried up. Establish Social Security and unemployment insurance to reduce consumer risk so they consume more. Encourage unions to fight for higher wages. Use the progressive income tax to tax the large pool of savings at the high end to support policies that help lift domestic demand. Encourage investment in rural areas. Be (somewhat) willing to run government deficits to support demand when private demand is not present.

The road to excess

These policies all made sense at the time and most still do. The problem is that the constituencies that support these policies became more powerful as time moved on and the policies have gotten pushed too far. Even now, when it is obvious that as a nation we need to save more and spend less, that we have too many houses relative to demand, that we consume more than we produce, that our debt level has risen to 350% of GDP from 150% as recently as 1980, that we have seen our currency fall 98% vs. an ounce of gold since FDR took office…what are we doing? We are seeing our policymakers insist that the cure lies with policies that spend money we don't have, try to support housing prices, try to encourage more consumption, try to encourage more lending and borrowing and devalue our currency further to maintain a positive level of inflation. Let me use pictures to drive the point home:

How does a country whose demand exceeds production by 5% of GDP suffer from a lack of demand?


Why should over-indebted consumers be encouraged to keep consuming?

How exactly are we supposed to support home values when they are still 30% above their long term trend?

How does a country whose currency has lost 95% of its value relative to gold in the past 40 years have a deflation problem?

What the current situation means for policy makers

In an effort to prevent near term collapse, we are doing exactly the opposite of what we need to do as a country to get ourselves out of our mess. Instead, we are fighting, spending literally trillions of dollars, just for the privilege of staying in the mess we're in. It is madness.

We need to balance our policies to reverse or halt these trends. We need policies that:

  1. Improve the terms of trade for the US to run a trade surpluses or a neutral trade deficit
  2. Encourage domestic saving at the expense of consumption
  3. Roll back policies that favor residential investment at the expense of business investment
  4. Encourage a sound dollar, zero to low inflation, and a sound, stable financial system

Because these are the types of policies that exacerbated the Great Depression, they are despised by the elites that learned about the Great Depression in graduate school. It is no longer fashionable to study the period between the Civil War and the Great Depression, even though in many ways it was America's economic golden age. I would argue that cyclically, today we are in a period more similar to the depression of the 1840s, after Andrew Jackson's experiment with wildcat banking (read paper money and hedge funds), Manifest Destiny and the yeoman farmer (read real estate speculation), and low tariffs, open immigration and the support of large-scale agriculture and mining. Out of this collapse would rise the northern-based Republican Party, which favored sound money, internal improvements and infrastructure investments, high tariffs, restricted immigration, the support of manufacturing, and, oh yeah, the abolition of slavery. The blueprint for success is there for the taking.

Next: Part II – The trade deficit and the US debt machine