Free Markets, Free People


The “Economics” of Obama’s First 100 Days, Part 2

In addition to Bruce’s post below, chartng the rise in debt since Pres. Obama took office, I think it’s important to look at whether we can find historical parallels, and try to identify how closely such parallels may apply to the current economic situation in the US.  Fortunately, a historic parallel–and a very close on at that–comes easily to hand.

Does this look familiar?  If not, it probably will...

Does this look familiar? If not, it probably will...

The chart on the right is a comparison of how Japan’s increase in debt since 1989 compares with the performance of the Nikkei stock index.

As the authors of the chart point out:

[I]f large increases in government debt were the key to economic prosperity, Japan would be in the greatest boom of all time. Instead, their economy is in shambles. After two decades of repeated disappointments, Japan is in the midst of its worst recession since the end of World War II. In the fourth quarter, their GDP declined almost twice as fast as that of the U.S. or the EU. The huge increase in Japanese government debt was created when it provided funds to salvage failing banks, insurance and other companies, plus transitory tax relief and make-work projects.

In 2008, after two decades of massive debt increases, the Nikkei 225 average was 77% lower than in 1989, and the yield on long Japanese Government Bonds was less than 1.5% (Chart 6). As the Government Debt to GDP ratio surged, interest rates and stock prices fell, reflecting the negative consequences of the transfer of financial resources from the private to the public sector (Chart 7). Thus, the fiscal largesse did not restore Japan to prosperity. The deprivation of private sector funds suggested that these policy actions served to impede, rather than facilitate, economic activity.

They say that insanity can be defined of repeating past actions with the expectation of a different outcome.  If so, how do we characterize the current government activity in response to the economic situation?

Happily–if that is the appropriate word–we may be able to put to rest fears of hyperinflation.

The bottom line, however, is that it is totally incorrect to assume that the massive expansion in reserves created by the Fed is inflationary. Economic activity cannot move forward unless credit expansion follows reserves expansion. That is not happening. Too much and poorly financed debt has rendered monetary policy ineffective.

So, we’ve got that going for us.

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3 Responses to The “Economics” of Obama’s First 100 Days, Part 2

  • … it is totally incorrect to assume that the massive expansion in reserves created by the Fed is inflationary. Economic activity cannot move forward unless credit expansion follows reserves expansion. That is not happening.

    That seems a little myopic.  If the government prints more money to cover more government spending, then there’s been no increase in lending, but inflation will happen anyway.  If the government prints massive amounts of money to cover massive amounts of government spending, again there’s no expansion of credit, but hyperinflation is likely. 

    I guess, in short, it’s not reserves we need to be worried about; it’s the federal mint being used to pay for government programs for which there is no other source of income, and which will n0t generate any.

    • I see your point, but it’s actually a lot more complicated.  The first thing you have to keep in mind is the velocity of money, i.e., the frequency at which it is used in transactions.  The Fed really has no control over it, and, outside of credit expansion, no real way to measure it.  Indeed, this led to the back-to-back 1981-1982 recessions, because after the 1981 recession, when the M1 and M2 numbers grew signifigantly faster than Volcker thought was wise, in terms of his inflation-fighting stance at the Fed, they clamped down on the money supply targets again, which forced rates higher, and plunging the economy back into recession in 1982.

      But, though M2 growth had been signifigantly higher than the Fed wanted, the fact was that no one was doing anything with that money.

      If the velocity of money is too slow, the M2 expansion doesn’t lead to inflation.  After all, inflation is when too much money is chasing too few goods.  When velocity is low there is no “chasing”, since there’s no signifigant increase in aggregate demand for goods.  Thus, lack of demand, rather than an increase in the supply of money, becomes the dominating factor in prices.
      In terms of what we see above, the explanation seems to be that what happens is that the increase in public sector debt absorbs the extra money and crowds out private investment and credit expansion, while not increasing aggrgate demand to any noticeable degree.  In that case, money simply has no velocity in the private economy, i.e. there’s no demand for private goods and services, so inflation is restrained.

      I guess you could make the argument that the massive increase in money prevents massive deflation, rather than kicks off hyperinflation, by counteracting the collapse in demand via rechanneling it into public debt.  I wouldn’t make that argument, but you could.  I’d probably be more inclined to the “hamster exercise wheel” argument, which is that the massive increase in M2 is simply absorbed by the massive increase in debt.  The government injects massive amounts of money into the economy, then promptly extracts it again through the sale of securities, much as the Fed does by selling securities to banks to reduce the money supply.

      If so, that implies that they could cut out the middleman by doing neither. 

      The above is relly fantastically simplified, but that’s more or less the essence of it.

      • If the velocity of money is too slow, the M2 expansion doesn’t lead to inflation.  After all, inflation is when too much money is chasing too few goods.  When velocity is low there is no “chasing”, since there’s no signifigant increase in aggregate demand for goods.  Thus, lack of demand, rather than an increase in the supply of money, becomes the dominating factor in prices.

        OK, I see the point about velocity, and I understand that inflation is consumer driven.  Frankly speaking (you must want to say that all the time, huh?), I just misunderstood the original point about an expansion of credit being necessary for inflation where there has been an expansion of reserves (i.e. the money has to get from the reserves into the economy somehow).  I somehow ignored the proviso that there has been an expansion of reserves and balked at an expansion of credit being the necessary driver of inflation. 

        In any case,  it’s rather sad soup to realize that the primary thing saving us from inflation (since it’s pretty much a given that money supply will have to expand dramatically) is the fact that consumers aren’t spending enough (i.e. the economy is shrinking).  I think the most recent CCI was trending positive, but economic activity is still pretty low compared YoY.  At the same time, the savings rate is basically staying the same. 

        Putting it all together, doesn’t that suggest that, while consumers aren’t stimulating the economy, they also aren’t going deeper into debt (which, I guess, stimulates the financial industry)?  Which, in turn, suggests the tautological proposition that the expansion of our economy is largely based on the expectation that the economy will continue to expand.  Some of that is to be expected (taking out student loans in the expectation of higher salary upon completing a degree, for example), but maybe what the market is correcting for now is the unrealistic expectation that it will just keeping rising as it had done steadily since the early 80′s.  The folly of foregong savings now (a folly I know all too well) because one expects to see ever higher returns in the future is being laid bare.

        I’m just processing here … I understand this is kinda old hat for finance people like yourself.