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Wednesday, July 21, 2010

For you deficit hawks

So, there is a great movement afoot to stymie macroeconomic expansionary policy for the remainder of Obama's term, and if, god forbid, a Republican takes office, clearly for his term (and one term it will be if they attempt to real in the deficit).

So the federal deficit stands at 13 trillion dollars.  Check out the linked site.  It's pretty amazing.  That's a pretty large number, and it's pretty scary for most Americans.  But for all the wrong reasons.  The reasons I've heard counted include inflation, China, bonds, and personal savings.  I'm going to handle some of these in this post.

Inflation--First of all, there's been almost no signs of inflation.  Infact, inflation rates were negative for much of 2009 and are hovering at 2% for most of 2010.  As Paul Krugman has pointed out ad nauseum, the real risk we run is deflation.  That's where prices get so low that production levels decline because firms no longer have the capacity to produce.  Deflation is a nasty spiral, and it's not entirely clear how to get out of it, once the spiral begin.  That's in comparison to inflation, for which we have a number of well practiced tools.  If that's the case, why are so many people worried about inflation?  Well, simple, when debts are so huge, it's been the practice of floating currencies to print more money.  By expanding the money supply, you can pay your debts, up until the point that your currency loses all value.  That's how Germany attempted to deal with WWI reparations.  But there are absolutely no signs of this happening.  2% inflation is exceptionally low.  Remember, in the recessions of the 80s, inflation climbed as high as 14%, in 2006, inflation was higher than it is now, at 4%.  The Taylor rule, pegs good inflation exactly at 2%.

China-Bonds--I'll handle these two together because they're related.  So, to raise the money supply, the Fed sells treasury bonds on the open market.  Commercial banks buy them, but also the central banks of other countries buy them too.  And, as you've no doubt heard, China owns a whole bunch!  Five years ago, they owned nearly 850 billion.  These fears about China have been going on for thirty years, and are a bad hangover from the Cold War.  The fact is, China's been a great bogeyman for U.S. politicians, particularly Republithugs, for years.  And I'm not really sure why.  Is it that they think China will invade?  Such a thing, while catastrophic if it occurred, is so unlikely as to be pure fantasy.  More likely, people are worried over the vast effects that the Chinese exert over our economy.  There are some major levers that the Chinese have, by owning so much debt, not to mention the equities they own in the country and the world, but the most troubling to U.S. politicians currently, is how they devalue their own currency.  So the aggregate demand equation goes as follows.  Aggregate Demand= C+I+G+(X-MI).  That is, Consumer Spending + Investment + Government Spending + Exports minus Imports.  The most popular way to stimulate demand is by becoming an export nation.  No one likes the government to spend, consumers always spend at the Marginal Propensity to Consume (MPC) which is directly related to their income (excepting cheap credit!).  Investment means, new houses and new factories, so it's hard to stimulate that (the only way is through tax credits, which might not accomplish anything anyway).  And that leaves exports.  And there are several ways to stimulate exports.  Have a cheap dollar, and have a cheap labor force.  China values its currency against the U.S. dollar.  But it does so at 8 to 1 (7 to 1 since mid 2009. )

But this nebulous fear of the Chinese, is just that, nebulous.  China doesn't want to change it's relationship with the U.S.  They've attained great wealth through us.  We are their biggest customers!  And if they undermine the U.S. capacity to repay it's debts, they'll be forced to take a major writedown.  A writedown that could destabilize their entire political system (already on the verge of destablizing).

Let's not talk about war.  It's silly.  Plus, both the U.S. and China have spent billions on war plans that will go into effect the minute hostilities break out anyway. 

All of this to say, don't worry about the deficit.  Worry about employment and economic change.

Employment speaks for itself.  The unemployment rate is bad, 9.5%, again worse in the 80s, and full employment is actually around 5% unemployment, but still bad enough to be a game changing issue this November. So new jobs need to be created.  And that means more stimulus.  People are fond of pointing to Japan's lost generation as a benchmark for when increased government spending did not raise aggregate demand--but Japan is very different from the U.S.  Moreover, Japan left its lost generation with state of the art urban areas, transportation of all varieties.  Whereas our infrastructure is still decaying faster than it can be rebuilt, despite the stimulus money already spent.  Moreover, why the hell is Obama building more roads?  Repair the existing, add a lane or two if you must, but the stimulus money really needs to come to expanding urban areas.  We no longer have a factory or agricultural based economy.  To be sure large percentages of our GDP come from those industries, but the largest stake came from our health and finance sectors.  These are urban professionals!

This is where we get down to the real problem here.  Change.  Nothing's changed.  The internet bubble is gone, so is the housing bubble.  How do we spur real change?  Innovation.  Where are the innovators?  They're going to business school instead of engineering school because the payoff's higher.  The U.S. should be dumping a load of stimulus funds on universities.  The coffers of the NIH and the WHO need to be replenished.  Disclaimer: I'm engaged to a graduate student, so I have a financial interest here.  But where is the next thing going to come from?  Not better coffee, not a new brand of food, not a new iPod, or iPhone.  It's going to be game changing when it happens, but it will only happen here if we invest in our human capital.

Enough.  I need to get to work.

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