Guest post: Paul Kasriel on fiscal deficits and inflation

Today I had the pleasure of exchanging a few emails with Paul Kasriel, Chief Economist of Northern Trust. Paul is in my opinion one of the greatest economic forecasters around (you can read him here). I don't think he would disagree if I said he is a great student of Friedman and Hayek, and that he knows what is money and what is inflation. Here is what I asked him and his response:

RK - Some economists argue that money and government bonds are near-perfect substitutes in an investor portfolio. Thus, they conclude, large fiscal deficits will result in higher rates of inflation, whether or not the central bank lets the money supply grow very fast or not. What is your opinion of this theory?

PK - I do not understand the argument. If the government sells the public bonds and the banking system (including the central bank) does not create the credit for the purchase of these bonds, then the public is transferring purchasing power to the government. The public cuts back on its current spending and the government increases its current spending. In contrast, if the banking system creates the credit for the public to purchase government bonds, then the public does not have to cutback on its current spending and the government can increase its current spending. This would be inflationary. In the former case, the Austrian economists refer to this as "transfer" credit inasmuch as purchasing power is transferred from one entity to another. The Austrians refer to the latter case as "created" credit in that the banking system and central bank create credit, much like a counterfeiter, enabling one entity to increase its purchasing power while not necessitating any other entity to cut back on its purchasing power. Perhaps I am missing something in the argument of these economists who believe that government debt issuance is inflationary in and of itself.

Those economists I mention (they seem actually to be a majority of economics scholars), believe that a dollar is a dollar, is a dollar. But if you issue a bond, someone has to cut its spending in order to buy it. Also, why not extend the theory and include AAA rated private bonds to government bonds? And while you're at it, just throw in all investment grade bonds.

To conclude, Japan seems to provide a pretty convincing evidence for Paul's point of view. But as he says, maybe we're missing something?

Links 7/1/10

There have just been too many interesting pieces in the last few days for me to quote them all on this blog, so for once my dear readers, you are going to have to read it all (trust me it's worth it):

• Bill Gross: Let's Get Fisical, also: Time's interview
  
• Tim Duy: Fed Watch: Out of the gate with a bang
  
• a sell signal from Mark Hulbert: Bullishness now at dangerous levels
• From The Pragmatic Capitalist: The ultimate guide to 2010 investment predictions and outlooks

The long-term costs of bailouts and nationalization of mortgage debt on inflation and external debt

After years of reading his weekly commentary, I have finally managed to detect a small mistake (actually two) in John Hussman's otherwise implacable logic. Let's see that paragraph, which is about the consequences of the current and future enormous issuance of Treasury debt:

It may not appear to be costly at present, since risk-averse individuals conscious of credit risks, and foreign countries running massive trade surpluses, are still willing to accumulate the Treasury securities being issued, with no apparent impact. But ultimately, those securities will either stand as claims on our future national production, or they will be inflated away. Either the Treasury securities will retain value, so that holders such as China get to use them to acquire our productive assets in the future, while we ultimately tax ourselves in order to pay off that debt, or we must dilute the ability of those Treasuries to claim real goods and services, which is another way of saying we inflate away the debt.

There are two mistakes here, a tiny one and a more important one. First, it is wrong to say that foreigners will in the future acquire more U.S. productive assets: they already, today, by buying these newly issued securities, receive a higher share of U.S. national income through interest. Interest comes from taxes, which are paid thanks to productive assets. In other words, whether foreigners swap their Treasuries for U.S. equities or stick with their Treasuries, they still claim larger share of U.S. assets.

The second, bigger mistake is to believe that the U.S. can choose to swap an international redistribution of wealth problem (the 'either' part of Hussman's argument) for a national redistribution of wealth through inflation. There is no free lunch. 'Inflating away' the national debt is not a good expression as the debt doesn't really go 'away': it is just swapped for other securities, while the same amount is owed to foreigners.

To be specific, inflation will not resolve anything because it will result in a deterioration in the trade balance (higher pricing power to foreign producers), which itself will result in a deterioration in next external assets (claims on foreign assets minus domestic assets owned by foreigners). When all is said and done, the U.S. NIIP (Net international investment position) would have been the same with or without inflating the debt away, or maybe even worse due to the fact that some foreign producers are better positioned for a high inflation environment (think commodity exporters), and because a collapsing dollar will allow foreign investors to buy U.S. assets on the cheap.

Inflation does redistribute wealth from savers to borrowers inside a country. It does not allow a nation to escape from transferring its wealth abroad. There is only one way to do that: default.

Paul Kasriel: Airplane thoughts

http://web-xp2a-pws.ntrs.com/content//media/attachment/data/econ_research/0912/document/ec121009.pdf

2010 outlook

I briefly mentionned PIMCO's New Normal, which is the company's secular outlook, in my last stock market comment (PIMCO is one of the largest bond management companies). Here are some some excerpts from their latest cyclical outlook. I will then criticize one of their points, well, because it's by bettering the master that one becomes a master... (already attempted here and here).

Here is their cyclical outlook:

Consider the notion of an “escape velocity” for the economy – a forward movement that is significant enough for a sustained economic expansion to set in. There are three contributors. The first is the unprecedented amount of global fiscal and monetary stimulus. This is now in play in a big way. The second is the inventory rebuilding cycle, which is starting to take hold. While these two factors are necessary for reaching escape velocity – and are very much in play, contributing to seemingly robust growth numbers for the third and fourth quarters – they are not sufficient. We also need sustainable private sector demand.
In PIMCO’s Investment Committee deliberations, Bill came up with an analogy of a rocket, which has fired two boosters but needs to fire a third in order to escape the earth’s gravitational force. That third booster, which is the final component necessary to achieve escape velocity, has to come from a source of private demand: either consumption, investment or exports.
When we look at the extent to which the major economies, especially the U.S., are challenged by their balance sheets right now, we are not yet expecting that the third booster is going to fire. As a result, we question the expectations in the marketplace for a V-shaped recovery.

I am holding back on using my model to compute 2010 GDP forecasts until next week (I am waiting for the Q3 GDP release), but for now it does paint a similar picture: relatively "strong" growth (around 2-2.5%) in the next few quarters, followed by a drop later in 2010. But more on that next week. What I want to talk about now is the following, from the same PIMCO piece:

The extraordinarily low fed funds rate has pushed money out of low-risk and “risk-free” assets into higher risk assets, which has led to the bounce in asset prices.

This is a classic rookie mistake which has me thinking that maybe Gross and El-Erian (the PIMCO heads) didn't write that piece themselves, but rather had an intern do it for them (I should have his job). You see, there is no such thing has money flowing out or into anything. Consider this: one day, the whole earth population wakes up and decides to buy (flow into) equities. Well if the transaction is to take place, someone has to sell equities to them, and will thus necessarily flow out of equities. And this, by the exact same amount of money. Another way to say this is that supply equals demand, always. To go further, imagine that all this money that the buyers spent on equities was previously in money market funds. When they sold these money market funds, someone had be there to buy them: in the end, no net amount of money whatsoever has left the money markets. What can change though, is the price at which buyers and sellers can agree to make the transaction, which depends on their respective eagerness to hold (or not hold) equities.

Contradicting McCulley

It is not a great day for me as I am writing this post which is a rebutal to Paul McCulley, one of the persons from whom I have learned the most. He tends to be too keynesian sometimes, and his last month's commentary is one example:

To be sure, we are presently living in an unusual world, in that the Fed is pegging the Fed funds rate at effectively zero. But it is not stimulating robust demand for credit, or alternatively, it is not stimulating bankers to gin up demand for credit by loosening terms and conditions to prospective borrowers. Actually, reality is probably a bit of both: reluctant borrowers and reluctant lenders.

In my opinion this is completely wrong. The Fed's policies have indeed stimulated robust supply of (risk-free) credit from the bankers and robust demand for credit by the Treasury. I don't have a chart at hand showing of how much of the Treasury's recent borrowing has been financed by the U.S. financial system, but I trust that it's the bulk of it.

Thus, we can categorically say that the near-zero Fed funds rate is not, for the moment, fueling an inflationary pace of aggregate demand growth relative to the economy’s supply potential. And neither is the Fed’s Credit Easing, which is the proximate cause for the explosion of excess reserves in the system. Yes, in the fullness of time, zero Fed funds could conceptually re-ignite borrowers’ and lenders’ mojo. Indeed, that’s precisely the Fed’s objective. And if and when that objective is achieved, the Fed funds rate will need to be hiked to temper the re-ignited mojo, so as to prevent the economy from overheating.

This part is way too keynesian even for McCulley. Kasriel finds a correlation of 0.64 between M2 and inflation, and only 0.08 (!) between the output gap and inflation. Also, look at how inflation flamed up in 1934 while the unemployment rate was in the high teens.

Gross' keynesian framework starting to show its limits

Although I have an immense respect for Bill Gross (for both his accomplishments and his thinking), I have always thought he was a bit too keynesian for my taste. Now it looks like the model is being stretched (emphasis are mine):

Trillions will be required in the U.S. alone and it is critical that there be a high degree of policy coordination among all nations, which avoids protectionist measures reflective of failed policies in the 1930s. To date, PIMCO’s Mohamed El-Erian’s imperative of “shock and awe” has been more like “don’t bother us, we’re working on it.” Get moving. Risk being bold – Washington.

(...) Global willingness to accept American dollars is being tested. Granted, the U.S. currency has appreciated strongly against its counterparts during most of this crisis, but technical short covering as opposed to a flight to quality may have been the dominant consideration. Watch the dollar. If it falls hard, there may be nothing policymakers can do to restore the ensuing financial chaos.

http://www.pimco.com/LeftNav/Featured+Market+Commentary/IO/2009/Investment+Outlook+Bill+Gross+March+2009+Hairy+Lips+Sink+Ships.htm

Frankel: Is $800 Billion Too Big or Too Small? Yes.

http://content.ksg.harvard.edu/blog/jeff_frankels_weblog/2009/02/13/is-800-billion-too-big-or-too-small-yes/