2007-03-04 Bush, Economics 101 and the Prestige
I am no economist but I find it extremely curious that we are hearing all these claims that nobody in the Administration, the Federal Reserve or Wall Street saw the economic meltdown coming. I was perusing my blog and found this post from March 2007.
-------------------------------------------------------------
Every great magic trick consists of three acts. The first act is called "The Pledge"; The magician shows you something ordinary, but of course, it probably isn't. The second act is called "The Turn"--the magician makes his ordinary something do something extraordinary. Now if you're looking for the secret you won't find it. That's why there's a third act called, "The Prestige". This is the part with the twists and turns, where lives hang in the balance, and you see something shocking you've never seen before. 
- Michael Caine as Cutter in The Prestige (2006).
saw the Prestige on DVD this week. It is quite a film, much better than The Illusionist (2006) within the nascent genre of magic thriller I believe.
Watching the film, for some reason I started to note several parallels to the current trends on global financial markets. Volatility has recently spiked in equities, foreign exchange and commodities. And like an ancient soothsayer, I have been trying to detect the trend lines that will portend our economic future.
We all know that the US continues to run massive budget deficits, trade deficits and current account deficits. The current account consists of the balance of imports and exports in goods and services as well as transfer payments such as net investment income. Meanwhile, negative real interest rates (baseline rates of interest minus inflation) introduced after 9-11 and only recently raised have helped to trigger a rapid runup in prices in key housing markets. Basically, the price of risk has collapsed while the prices of assets (including commodities) purchased with debt have spiraled ever higher chased by ever cheaper money in over heating economies.
The Pledge
During his campaign for president, George Bush, as any self-styled economic conservative, pledged to stimulate economic growth by cutting taxes. On June 7, 2001, then President Bush signed the largest tax cut in American history into law.
The Turn
In near total contradiction of elementary macroeconomic theory, Bush now contends that he has grown the American economy, increased employment, reduced the budget deficit and defended the value of the dollar while keeping price inflation under control.
I am afraid that what Bush would have us to see as shocking and unbelievable is in fact precisely that.
The Prestige
Of course, Bush & Co. used large, Iraqi WMD-like, budget surplus claims to make tax cuts appear justified and affordable. In the end, like those now infamous Iraqi WMDs, the surpluses failed to materialize. Among other items, the official baseline budget estimates in 2001 ignored the long-term costs of non-discretionary entitlement programs (e.g., Social Security, Medicare and government pensions.) In fact, projections then of $5.6 trillion in available surpluses even assumed that real discretionary spending would fall by 1 percent per person, per year and that all expiring tax provisions would in fact expire as scheduled. (Yes, those are the same tax cuts that Bush now wants Congress to make permanent even as his mythical surpluses have mutated into very real budget deficits.) And in the end, Bush & Co. even elected to keep the entire cost of its military adventures in Iraq and Afghanistan "off budget." [1] [2]
Last week's seismic events on Shanghai exchanges triggered a veritable tsunami of volatility on global markets, the consequence of which, I predict, will soon become apparent. The carry trade wherein investors borrowed in cheap currencies (chiefly Japanese yen) to invest in higher yielding currencies (e.g., Euros, British Pounds and US Dollars) and assets denominated in them appears to be unwinding. As the Japanese government continues to increase interest rates domestically, it will force "short-selling" carry traders to sell their foreign assets to cover their Yen-debt positions. This has already started to drive up the value of the Yen against the Euro, the pound and of course the US dollar. Further, a strong Yen also hurts Japanese exporters (and their shares) when repatriating profits from overseas operations.
The Chinese appetite for "cheap" dollar assets (especially US mortgage-backed securities) also seems to be waning as defaults in the US sub-prime market rise in line with bank interest rates triggering resets in variable rate mortgages. Of course, the primary US-dollar denominated asset exposed to this rebalancing of investment portfolios against foreign exchange risk are the bonds the US government sells to finance the national debt. Global exporters of all of the oil, cars, computers and plumbing fixtures that we buy from Europe to the Middle East and Asia may decide that they no longer want to run the risk of investing their ever mounting trade surpluses in ever increasing US government debt. Risk in the debt markets will continue to be repriced higher. This is very bad news for a country like the US where the economy is fueled almost entirely by Republican voodoo economics: tax cuts for the rich, massive government budget deficits and ever more consumer borrowing to support unsustainable trade deficits and an inflated housing market. The consequence of the current round of market rebalancing, I predict, will be even more shocking then anything we can currently imagine.
Basically, the US has exported its levers over macroeconomic policy to the central banks of its major trading partners leaving it with very little room for maneuver. In order to sustain economic growth and stave off recession, Federal Reserve bankers need to maintain (or even cut) domestic interest rates. This however would run the risk of driving down the value of the dollar while pumping up inflation and the trade deficit. Conversely, any increase in interest rates to defend the dollar and tame inflation holds the potential of accelerating mortgage defaults and tipping the country into recession. It appears we no longer control our own destiny. Now is the time for a miracle indeed.
Comments