February 24, 2010
Obama's Ides-of-March Moment is NearBy Monty Pelerin
By the end of March, Barack Obama's administration will face its destiny, its Brutus a pawn of the fates.
In Jimmy Carter's presidency, the Wall Street Journal editorialized about "Ratcheting to Ruin." The title derived from the fact that each cycle high in unemployment was higher than previous ones, and each cycle high in inflation was also. "Stagflation" was the neologism coined to describe what up until then was believed to be impossible in the Keynesian world. This period ushered in a new era in both politics and economics. Carter was replaced by Reagan, and Keynes was replaced by Friedman.
Thirty years later, Keynes is back in vogue, Obama has ascended to the White House, and times are reminiscent of the Carter era. The economy is awful. Fear and dissatisfaction prevail. Politicians are held in contempt. There is one major difference -- Carter did not face an "ides of March" event.
In Shakespeare's Julius Caesar, a soothsayer warns Caesar to "beware the Ides of March." The prescient warning did not help Caesar. As Obama approaches his March moment, no warning can change his fate.
Ben Bernanke promised to end Quantitative Easing (the printing of money to stimulate the economy and fund the deficits) by the end of March. Some believe his commitment was a "campaign promise" to ensure his Senate reconfirmation. Others believe it was a real commitment, necessary to maintain a stable dollar. Shortly, the world will find out.
Mr. Bernanke, quite unintentionally and through no fault of his own, will be Obama's Brutus, regardless of his decision. To understand why, some numbers are necessary. Government needs funding this year of $2.0 trillion (that includes the federal budget deficit, off-budget spending, and state and local needs). Private industry needs about $0.5 trillion. Part of the funding will come from the country's savings. Total gross savings (new savings) is estimated to be $1.5 trillion. Assuming all savings is available, a shortfall of $1.0 trillion exists.
This shortfall can be met from two sources:
Another possible source could result from a reallocation of existing savings, as would happen in a major stock market decline. That outcome cannot be quantified. Furthermore, a stock market rise would produce a drain of funds from debt markets. Either effect is one-time, therefore not a continuing source of funding.
As the need for foreign investment increases, foreign willingness to lend is declining. Two reasons are apparent: worries about the sustainability of our deficits/dollar and large foreign needs for capital at home. Martin Crutsinger reports:
The Treasury Department reported that foreign holdings of U.S. Treasury securities fell by $53 billion in December, surpassing the previous record of a $44.5-billion drop in April 2009.
Accuracy in fund flows is difficult to obtain. Foreign investment of all types appears to have increased about $500 billion last calendar year. If all of that were for government debt, then our Fed would have bought, directly or indirectly, another $500 billion. That amount of QE is significant, representing about 25% of government tax receipts. It represents a rise of over 60% in Fed assets using a pre-crisis base. In a normal economy, a monetarist would likely claim that continuation of that expansion rate would result in annual inflation of at least 60% per year. Another 140% increase resulted primarily from Fed purchases of distressed assets from the banking industry.
Foreign funding was insufficient last year and will be even more so this year. The deficit will be larger, and foreign funding will be smaller. QE must be larger. There is no way to fund these deficits without QE.
The problem is bigger than the numbers above might suggest. Budget forecasts show that the problem increases over time. In addition, 40% of existing debt matures in the next year. That means $2.8 trillion of debt has to be refinanced. The Treasury must sell on average $90 billion of debt a week! In five weeks, we need to sell $450 billion. That is equal to the largest full-year deficit in history, at least until Obama's first year.
There are no plans to curb spending or cut deficits. President Obama just increased the debt ceiling by $1.9 trillion. To outsiders, we appear like a banana republic with ICBMs. Does anyone seriously believe that funding based on "the kindness of strangers" is workable much longer?
Bernanke has two options, neither of them good. He can do what he promised and stop QE. Or he can renege on his promise. Either alternative has radically negative consequences for the country, Bernanke's role in history, and Obama's presidency. If Bernanke stops QE, he fulfills his role as an independent central banker. Presumably, that action stops the decline in the dollar and reduces the risk of future inflation. It was the course that Paul Volcker chose in the late 1970s.
Volcker's action was bold, highly controversial, and highly criticized. Volcker's action had the support of President Reagan, who was willing to face short-term unpopularity to fix the economy. Bernanke's task is harder than Volcker's. Volcker stopped the economy dead in its tracks. If Bernanke ends QE, he will stop both the economy and the federal government dead in their tracks.
Without QE, the government will be unable to honor its obligations. Non-payment of Social Security or Medicare or federal payroll or welfare checks or retirement checks, or military payroll, etc., etc., would show up almost immediately. That would jeopardize foreign (and domestic) purchases of additional federal debt, exacerbating the problem.
Bernanke's second option enables the government to continue operating irresponsibly until market forces eventually stop the profligate behavior. Market discipline would likely be imposed in the form of a collapse of the dollar or raging inflation (or both).
Under either scenario, the Obama presidency is destroyed. Obama probably prefers the second option, because it might extend the period before sovereign bankruptcy. However, it might not extend it very much. Foreign bankers have chastised our behavior regularly. If the Fed is perceived as "The Great Enabler" rather than as protector of the currency, a run on the dollar and the dumping of Treasuries could result.
From Bernanke's standpoint, it is not clear which option he might prefer, or if he even has a choice, given Congress' involvement. If he behaves like a central banker and pulls the biggest punch bowl in history away, it would force the government to address its problems before they became more serious.
History will not look kindly on this period regardless of Bernanke's decision. Bernanke never had a chance for a favorable legacy. If he plays his role as a central banker, history may be less unkind, stating, "He did what he had to do." If he chooses to continue QE, it likely will judge him as "The Great Enabler," rating him even less favorably than they did his predecessor.
Obama loses either way. He inherited a difficult situation, but then, via foolish policies, he turned it into a terminal one. At this point, Jimmy Carter may be the happiest person in the country. His lead position in the Pantheon of Shame is in jeopardy thanks to Obama.
For the country, times equivalent to the Great Depression are likely ahead. My guess is that Bernanke chooses (or is forced into) continuing QE. Courage is a rare and dangerous commodity in Washington. Hard decisions occur only in crisis.
When the country is perceived and treated by the world community as the wastrel it has become, then remedial action will take place. Hopefully, something is still salvageable.