We have a Spending Problem, not a Debt Ceiling Problem

Posted by PITHOCRATES - May 14th, 2011

A Special Bond between the UK and the USA despite a Tea Party

A small group of protestors gathered outside the House of Parliament to protest excessive spending and debt.  It was only a small group that numbered in the hundreds.  A fraction of the thousands that protested the UK’s austerity cuts earlier.  Interestingly, they have been described as ‘Tea Party’ protesters.  Like in the USA.  Interesting because the original Tea Party protests kicked off the American Revolution.  Which ended in American independence from Great Britain. 

A lot has changed since then.  The UK kicked off the Industrial Revolution and created an empire that lasted a hundred years or so.  Then the Americans came into their own and became the world’s greatest economic power.  Took the baton, if you will, from the British Empire.  First the costs of World War I ended the British Empire.  Then the era of Keynesian economics began.  Government grew.  Government spending grew.  First in the UK.  Then in the USA.  And their economies tanked in the Seventies.  High debt.  High inflation.  High unemployment.  Then Margaret Thatcher started fixing things in the UK.  As Ronald Reagan did in the USA.  Things got better.  But old habits are hard to break. 

And here we are in 2011.  Both great nations suffering under unsustainable deficits and debt.  Austerity is now the name of the game.  Some understand this.  Like those few hundred across from the House of Parliament (see ‘Rally against debt’ activists call for more cuts in Westminster protest by David Batty and agencies posted 5/14/2011 on the Guardian).

Hundreds of pro-cuts activists have taken part in a “rally against debt” opposite the Houses of Parliament, in the first Tea Party-style protest to challenge the anti-cuts lobby…

Matthew Sinclair, director of the TaxPayers’ Alliance, said: “There have been lots of chances for other groups to register their protest, and we want to give a voice to people who represent quite a heavy majority who think spending cuts are right and necessary.

The tax consumers protested the austerity cuts.  The taxpayers, on the other hand, are protesting the deficit spending.  For they are thinking long-term.  And know someone eventually has to pay back this debt.  Or someone will at least have to service the debt.  And if it keeps growing, these interest payments are going to become a major budget item.  Requiring cuts in programs today to pay the interest on what they borrowed to pay for programs years ago.

Priti Patel, Conservative MP for Witham, said: “This government is all about deficit reduction. I don’t think enough people realise the extent of the debt facing this country. It is totally unsustainable…

Mark Littlewood, director general of the Institute of Economic Affairs, told the rally: “We won’t put up with this. We are the selfless movement. We’re not asking for money, we’re asking for cuts to make sure our children and grandchildren don’t have to foot the bill.”

It is interesting the use of the term ‘Tea Party’ given our common history.  They don’t recall the Boston Tea Party as fondly in the UK.  No, they don’t celebrate it like they do in the US.  So no doubt it’s the similarities of the movements (protesting out of control government spending) and not the name.  They probably even don’t call themselves a ‘tea party’.

Electoral commission records show that in March, Ukip activists registered the name Tea Party as a political party. It is not yet active, but they said they could field candidates in general elections, byelections and local elections.

Or perhaps they do.  Wow.  They’ve sure come a long way since 1773.  That’s nice.  For as George Bernard Shaw said, England and America are two countries separated by a common language.  There is a special bond between these two nations.  And always will be.  We love each other unconditionally.  Despite the US giving them Madonna.  And the UK giving the world John Maynard Keynes.

The Keynesians versus the Austrians

Governments everywhere love John Maynard Keynes.  Because he empowered governments to spend money.  So ‘borrow and spend’ governments everywhere embrace Keynesian economics.  As do Ivy League intellectuals.  Who tend to have high positions in the US government.  Because they just sound so darn smart.  Who are, at heart, anti-capitalists.   

The Austrian school of economics runs contrary to the Keynesian school.  The only thing the Keynesians learned from the Great Depression was that the Federal Reserve caused bank failures by not printing money soon enough.  And that a selloff of assets started a deflationary spiral.  Austrians, on the other hand, say deflationary spirals are good when they correct bad investment by popping asset bubbles.  Because bubbles have to pop.  Eventually.  And the longer you try to sustain these bubbles the more painful the pop will be.  Whereas Keynesians say double down.  When Wall Street was overvalued they pumped bailout dollars into Wall Street firms buying worthless paper assets to sustain their over-priced values (Fannie Mae, Freddie Mac, Lehman Brothers, etc.).  Didn’t work.  And the nation added a trillion to the debt in the process (see The End of Bernanke’s “End Game” by William L. Anderson posted 5/13/2011 on Ludwig von Mises Institute).

Thus, Bernanke’s minions entered the financial marketplace with a bottomless checkbook, purchasing assets that had lost value (like mortgage securities, AIG stock, and the like) in the marketplace. However, in order to make it look as though the markets were fine, the Fed purchased these securities at prices close to their precollapse worth; Bernanke and company were playing the let’s-pretend-this-worthless-paper-is-valuable game…

In the Keynesian analysis, assets are held to be homogeneous, and the economy is believed to be a bland mixture of those assets that are fully employed when the amount of consumer and investment spending is high enough to continue to give the economy “traction.”

When consumer and investment spending flag, however, Keynesians hold that the government must step in by borrowing and printing money in order to revive the spending circle. If the government spends enough, then the economy can move on its own to the point where consumers and investors keep it going — at least until the next crisis. Keynesians call this movement the “circular flow,” although it is more like circular logic, in which the premise is the conclusion and the conclusion is the premise.

What must never happen is a large-scale liquidation of assets, because that would trigger deflation, which would be accompanied by an endless downward spiral and an economy stuck in a “liquidity trap” with falling prices and high unemployment. Thus, in the Keynesian view, the Fed was justified in purchasing these worthless assets, because it prevented their liquidation and preserved at least their “paper” values.

They spent money like no other administration did and it did nothing.  The unemployment rate went up.  And now inflation is starting to tick up.  Not to mention a trillion dollar deficit adding to an already record debt.  A debt so great that they have to raise the debt ceiling to fund it.

Austrians, however, take a much different view. What Keynesians call idle resources, which need only an injection of spending to be reemployed, Austrians call malinvested resources. The different is crucial, because Keynesians believe that the Fed’s actions prevent an economic downward spiral, while Austrians hold that what the Fed has done furthers the economic downturn.

The difference in opinion centers on causality. Keynesians believe that the downturn is created simply by a reduction in spending, while Austrians hold that the recession is caused by the fact that the series of malinvestments created during the previous boom cannot be sustained. The drop in spending is the result of the downturn, not its cause. The difference in beliefs is crucial: in the Austrian paradigm, trying to sustain the boom conditions by injecting new government spending will always end in disaster.

Keynesian economics are demand-side.  People cause recessions by not spending enough.  So government steps in, borrows (and prints) money and spends in place of consumers.  In the hopes this spending will create jobs.  Austrian economics are supply-side.  Because we are, when it comes down to it, traders.  We trade things.  Or services.  So jobs come first.  Then consumer spending.  So the Austrians would rather create an economic environment that will encourage businesses to create jobs.  And see the market direct resources to the best investments.  Not have the government prop up investments that should fail.

The problem with temporary injections of cash is that they are temporary.  Whereas new jobs will be recurring cash injections.  The Keynesian solution is temporary.  The Austrian solution is sustainable.  It’s sort of like Granny Clampett’s cure for the common cold.  You take it and a week or so later the cold is gone.  Of course, the body just healed itself.  Which is how Keynesian economics works.  If the economy recovers in a year or so the Keynesians will take credit.  When it was just the business cycle finally coming around.  Despite being delayed by Keynesian policies.

The Size of the Debt is a Bigger Problem than a Technical Default

All this Keynesian economics has added greatly to government budgets everywhere.  The UK.  The social democracies of Europe.  And the US.  And it’s reaching critical mass.  Hence the protest outside the House of Parliament.  And the Tea Party protests in the US.  Debts are rising to dangerous levels. 

Now in the US the Keynesians are threatening doom and gloom if we don’t raise the debt limit.  Because that’s the problem.  Not the spending.  Which they don’t see as a problem (see What If the U.S. Treasury Defaults? by James Freeman posted 5/14/2011 on The Wall Street Journal).

Mr. Druckenmiller says that markets know the difference between a default in which a country will not repay its debts and a technical default, in which investors may have to wait a short period for a particular interest payment. Under the second scenario, he doubts that investors such as the Chinese government would sell their Treasury debt and take losses on the way out—”because I’ll guarantee you people like me will buy it immediately.”

Mr. Druckenmiller was once a fund manager for George Soros.  And he helped Soros short the British pound in 1992.  So he knows a thing or two about government finance.  And he’s more worried about the high debt level than a technical default.

Mr. Druckenmiller had already recognized that the government had embarked on a long-term march to financial ruin. So he publicly opposed the hysterical warnings from financial eminences, similar to those we hear today. He recalls that then-Secretary of the Treasury Robert Rubin warned that if the political stand-off forced the government to delay a debt payment, the Treasury bond market would be impaired for 20 years…

Mr. Druckenmiller notes that from the time he started saying that markets would welcome a technical default in exchange for fundamental reform, in September 1995, “the bond market rallied throughout the period of the so-called train wreck . . . and, by the way, continued to rally. Interest rates went down the whole time, past the government-shutdown deadline, and really interest rates never went back up again until the Republicans caved and . . . supposedly the catastrophic problem was solved.”

Back during the government shutdown in 1995, the bond market actually rallied.  Why?  Because investors are worried about being paid back.  High and growing debt levels decrease those chances.  Serious debt reduction talk increases those chances.  Ergo, the technical shutdown lets investors know that someone is serious about the nation’s long term debt paying ability.  Hence the bond market rally. 

He’s particularly puzzled that Mr. Geithner and others keep arguing that spending shouldn’t be cut, and yet the White House has ruled out reform of future entitlement liabilities—the one spending category Mr. Druckenmiller says you can cut without any near-term impact on the economy.

One reason Mr. Druckenmiller says he spoke up in 1995 was his recognition that the first baby boomers would turn 65 in 2010, so taxpayers would soon have to start supporting a much larger population of retirees. “Well,” he says today, “the last time I checked, it’s 2011. We don’t have another 16 years this time. We’re there. I don’t know whether the markets give us three years or four years or five years, but we’re there. We’re not going to be having this conversation in 16 years. We’re either going to solve it or we’re going to find ourselves being Greece somewhere down the road.”

Some have argued that since investors are still willing to lend to the Treasury at very low rates, the government’s financial future can’t really be that bad. “Complete nonsense,” Mr. Druckenmiller responds. “It’s not a free market. It’s not a clean market.” The Federal Reserve is doing much of the buying of Treasury bonds lately through its “quantitative easing” (QE) program, he points out. “The market isn’t saying anything about the future. It’s saying there’s a phony buyer of $19 billion of Treasurys a week.”

It’s all smoke and mirrors.  Once the quantitative easing ends in June, interest rates will go up.  Adding to the interest on the debt.  Which will only get greater should they increase the debt ceiling.  And refuse to cut spending.  As in commit to entitlement reform.  Their future, in a word, is Greece.  Only without anyone being big enough to bail them out.

QE3, Anyone?

Some people get it.  The responsible ones.  The ones paying the taxes.  And the ones buying the bonds.  The debt is the problem.  Which means any deficit is a problem, let alone a trillion dollar deficit.  And there is really only one option that is doable to fix these problems.  Entitlement reform.  There will be no economic repercussions.  Other than a riot or two.  Perhaps.  Which is not that big of a concern for the politicians.  Their greatest fear is the next election.  Because there are so many people collecting these entitlements, cutting them will have an effect in the voting booth in the next election.

So the Keynesians will no doubt say, “QE3, anyone?”  And fiddle while the US economy burns down.  Rather that than admit that they are not important.  Or needed.

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