The Sequester Is Fiscal Theater, Not Fiscal Policy

The US faces a fiscal crisis due to the demographic implications of healthcare, social security and public-sector pensions. Over the next decade, as the postwar generation leaves the workforce and begins to draw upon government resources for healthcare and pensions, these budget items will grow rapidly at the federal, state and local level. Without drastic and politically unpalatable reform, these expenses will consume government budgets, leaving no room for government services and activities. The consequences will be high structural deficits, and an exhaustion of national debt capacity.

The run-up to the demographic crisis should have been preceded by a strengthening of the national finances in order to leave some debt capacity for the problem. Instead, the country has been running large deficits since as a result of the Great Recession. Federal debt held by the public has grown from $5 trillion in 2007 to $11 trillion today. The ratio of debt held by the public to GDP has risen from below 40% in 2007 to almost 80% today. Without a drastic change in course, the CBO predicts that ten years from now the ratio will climb to 90%, the highest level in postwar history.

Here is the budget arithmetic: GDP has been growing at 4% in nominal terms since the Crash, while federal debt has been growing at 12% over that period (post-crash). The debt is growing 8% faster than GDP, hence the steadily rising Debt/GDP ratio. The deficit represents 30% of federal spending.

Stabilizing (or reversing) the country’s debt ratios will require a major reduction in overall spending, entitlement reform, and substantially higher taxes on the middle class. All of these measures are included in Simpson-Bowles, but that plan is an unpopular orphan. Republicans won’t discuss taxes or global adventurism, and Democrats won’t discuss entitlements or welfare.

Therefore, there will be no fiscal reform, the deficit will remain large (and will grow as Medicare grows), and the fiscal problem will go from being difficult to fix to being beyond fixing. The likelihood of a fix is becoming very low.

Today's children will inherit a country at maximum debt capacity, like Japan is today. While we now enjoy the luxuries of low taxes and high spending, today's  children will not. The pleasures that we receive from spending their money will not be commensurate with the financial squeeze that they will face. The ultimate issue is one of intergenerational morality, or rather immorality.

To avert the coming crisis will require two things: (1) immediate fiscal consolidation; and (2) reform of the nation's healthcare and pension systems. The current state of play in Washington indicates that neither is politically possible. There is no political consensus for lower spending, higher taxes and drastic programmatic reforms. The overall consensus is for low taxes,  a high level of spending, and unreformed entitlements. Both the Simpson-Bowles and Ryan plans were dead on arrival, and no one wants to discuss them.

All of the "deficit reduction" measures taken by the administration and Congress since the crash (including the sequester and its “massive cuts”) have had little  impact on the 10-year fiscal outlook*.

The problem is not only that there is no consensus for reform, but also that the door for reform has almost closed. Too many baby boomers have entered the land of perpetual leisure, and too few have the inclination to die. They won't die for decades, they will vote, and there will be more of them than there will be working taxpayers. To the retired, Medicare and Social Security are Holy Sacraments.

I have argued in the past that a principal cause of the fiscal problem is inadequate inflation and inadequate nominal growth, and this remains my view. Higher inflation would reduce the deficit and flatten the trajectory of the debt ratios. It could also be used to partially erase the debt. But inflation these days seems about as popular as Medicare reform. It's not being debated (not even at the FOMC), and the world would probably explode in flames if the CPI ever went above 4%. So that simple solution is off the table, leaving debt accumulation as the likely alternative.

In the context of the looming fiscal crisis, the sequester is small potatoes**. It only affects a small part of the budget in a small way. I happen to like the sequester from a policy perspective, because it cuts defense by a meaningful number, which is good policy if, like me, you are uncomfortable with gold-plated overseas adventurism. Using fiscal policy to “limit the mission” is a good tactic. I also like the cuts to the bloated non-defense budget as well. Any cut is a good cut if your goal is limited government. But the sequester is political theater rather than real fiscal policy. Simpson-Bowles is real policy, as is the Ryan Plan. But they are not being debated.

*The Budget Outlook, CBO, 04 Mar 13.

http://www.cbo.gov/sites/default/files/cbofiles/attachments/Presentation_NABE-3-4-13.pdf

**The Budget Control Act of 2011
The BCA specifies automatic procedures to reduce both discretionary and mandatory spending during the coming decade. Those automatic reductions will take the form of equal cuts (in dollar terms) in funding for defense and nondefense programs in fiscal years 2013 through 2021. Under the BCA, the automatic enforcement procedures will reduce budgetary resources for defense programs by $492 billion over the 2013–2021 period. By CBO’s estimate, the automatic enforcement procedures will reduce discretionary defense resources by about 10% in 2013 and reduce the caps on defense appropriations by lesser amounts thereafter, declining to 8.5% in 2021. By CBO’s estimate, the automatic enforcement will reduce nondefense funding (excluding Medicare) by about 8% in 2013 and by declining percentages thereafter, falling to a low of 5.4% in 2021.

The European Kool-Aid Machine Is Still Working

Despite the drumbeat of defeatism from English-speaking economists, and despite three years of disappointing economic results, the Eurozone persists in the execution of its original "Plan A", adopted three years ago:
1. Balance eurozone government budgets by raising taxes and reducing expenditure.
2. Improve external competitiveness with internal deflation and market reforms.
3. Stabilize debt ratios through fiscal consolidation and the (eventual) resumption of economic growth.
4. Prevent speculative attacks and restore market access with credible long-term policies, backstopped by the ECB and the ESM.
5. Remove "exit risk" by the ECB's pledge to buy government bonds in the event of stress.

Now is an opportune moment to assess where "Plan A" stands with respect to probability of ultimate success. At present, all of the troubled countries (except Cyprus) are either in compliance with Troika agreements, or are otherwise implementing (or pretending to implement) fiscal consolidation and structural reform.

The bond market's reaction to progress to date has been positive, with yields declining and limited issuance resuming for a number of peripheral countries. The ESM has not had to make new loans (besides Greece), and the ECB has not had to intervene in the bond market. In the hierarchy of world crises, Europe appears to be moving to the back-burner, outside the spotlight of daily headlines and TV news bulletins.

Is there anything wrong with this picture? Yes, it's completely delusional. The eurozone's financial arithmetic continues to head inexorably in the wrong direction. 

The ECB's zero growth policy (ZGP) is slowly bankrupting the peripherals as their debt grows while their economies and government revenues shrink. The political pressure gauge is the unemployment rate, which has already entered the critical "red" zone for some of the peripherals. The human cost of the ZGP is immense and has not yet fully manifested itself in the political process. Zonal unemployment is now 12%, and zonal GDP is shrinking (yes, the whole zone).

But this is not an acknowledged problem for the eurozone, because employment is not an ECB mandate. Unemployment and growth are irrelevant to the European assessment of the success of Plan A. As far as the ECB is concerned, Plan A is a big success.

Let's agree for the sake of simplicity that the central problem for the eurozone is the growing risk of peripheral government bankruptcy, and that the best index of government solvency is the level and trajectory of the Debt/GDP ratio. This ratio can be forecast as follows: Debt + projected fiscal deficits + bank recapitalizations - debt write-offs = future Debt. GDP + nominal growth = future GDP.

What do we see? We see D continuing to rise due to declining government revenue and inflexible government expense, resulting in large and persistent fiscal deficits. On top of these operating deficits is the cost of unending banking system recapitalizations due to government and private-sector defaults. We see flat nominal GDP growth due to low inflation, lack of export competitiveness and inadequate domestic demand, exacerbated by fiscal austerity. 

Thus, D continues to rise while nominal GDP is stagnant (and shrinking in real terms). All measures of government creditworthiness have steadily declined since 2007. Credit ratings are being pushed out of investment grade as new risk thresholds are breached. (In Europeland, sovereign downgrades are irresponsible, unwarranted, and strongly discouraged.)

Other than further debt forgiveness by unhappy creditor governments and institutions (see: Bundestag), there is nothing visible on the horizon to reverse this process of government insolvency as manifested by the upward slope of the D/GDP ratio. The ECB remains satisfied with ZGP, and studiously ignores its enormous human and economic costs.

The current debate within the ECB governing council is not how to stimulate growth and bring down unemployment, but rather how to exit from further stimulus, since the crisis is over. The perversity of such thinking is remarkable in its indifference to evidence of failure. How much contrary data will it take to prove to the Germans that shrinking economies don't repay debt? (They have a selective memory about German history during the 1920s.)

This year, the eurozone disaster must inevitably grow from a purely economic crisis into a political one as well. The peripheral governments face multi-year depressions and their social safety nets and their "social models" are becoming badly frayed. 

Most of the peripheral countries are politically immature with fragile institutional legitimacy. Most of them have undergone multiple regime changes over the past century and few of them have been successfully democratic for longer than a few generations. Few of them have weathered a protracted depression under a democratic regime. Each country has a political inflection point, which will be reached as depression continues. Greece and Cyprus are already politically fragile.

The peripheral states are being stress-tested both economically and politically by the ECB's zero growth policy. As long as the ECB persists in running this sadistic contest, the odds of political failure will steadily increase, and may already be irreversible for certain countries. Europe is not Japan; it is much worse. 

"Our Mandate Is Not Full Employment"

ECB press conference, Jan. 10th, 2013:

Question: The fragmentation in the labour markets seems to be getting even more pronounced, especially in youth unemployment, which is almost 60% in Spain and 8% in Germany. Overall unemployment is over 25% in Spain and a little over 5% in Germany. At what point does this become an issue for monetary policy?

Draghi: Our mandate is not full employment. Our mandate, and our statutory objective, is to maintain price stability.

Question: Jean-Claude Juncker has said that too much fiscal consolidation could have a negative effect on countries like Spain, because unemployment is so high. What can you say about that?

Draghi: This fiscal consolidation is unavoidable, and we are aware that it has short-term contractionary effects. But now that so much has been done, I do not think it is right to go back.

There was a self-congratulatory air at the ECB press conference last week. Draghi took credit for declining bond yields and for “positive contagion” in the financial markets. He acknowledged that unemployment was high, but said that it was inevitable, and would only subside when structural reforms are completed and budgets are balanced. He reminded his audience that “our mandate is not full employment”.

The poor man must be suffering a considerable amount of cognitive dissonance, since the dials on the ECB’s dashboard tell a different story than the happy talk that he is providing:

Economic growth: continuing decline

Unemployment: 12% and rising

Industrial production: continuing decline

Peripheral government fiscal balance: large, persistent deficits

Private sector loan growth: negative

The eurozone is in a persistent recession with high and rising unemployment, large fiscal imbalances, declining industrial production and ongoing credit contraction. The ship is sinking, but “flotation is not our mandate”.

The ECB thinks that its monetary policy has been successful because “inflation expectations for the euro area remain firmly anchored”. This is analogous to the Fed’s satisfaction with its performance during the Depression because the dollar maintained its gold price, and employment was “not its mandate”. The world maybe plunging into catastrophe, but that is beyond our mandate.

In peripheral Europe today, an irresistible force is colliding with an immovable object: voter dissatisfaction continues to build as unemployment rises, while the message from Europe is that the pain must continue into the indefinite future. Stuck between these forces is the political class, which cannot ignore the will of the people but which lacks the intellectual capacity to challenge Europe’s ruinous orthodoxy. Just as the only people who held the key to recovery in the Depression were the “prairie radicals”, so today anyone who would challenge the ECB’s deflationary prescriptions is a left wing radical or, even worse, an inflationist!

The European Right sees the euro and its accompanying depression as a means to “reform” southern Europe and make it more like Germany, while the European Left thought that they were successfully building “socialism in one monetary zone” until things went a bit haywire. There is no one in the eurozone who appears capable of explaining that the cost of “structural reform” is extremely high and in fact counterproductive.

What makes the Germans think that a starving person is more likely to reject unions and the welfare state than one with a full belly? The Germans think that the lesson of their history is that inflation leads to political chaos. It isn’t. The lesson of German history is that deflation leads to political chaos. They have somehow forgotten that 1929-33 was a period of deflation, depression and unemployment.

Europe as a bastion of liberal democracy is imperiled by incompetent monetary policy based upon a willful misreading of economic history. I find it frustrating that a lesson so well understood in the anglosaxon world has been forgotten or was never learned on the Continent. This is at root a cultural problem. Right now, every anglosaxon central bank is either experimenting with reflationary policies or is at least actively debating them. Somebody needs to start translating these websites into European so that these ideas can start percolating.

To give you a flavor of where the ECB stands on the matter of unemployment and unconventional policies, this is what Draghi said last week:

Each central bank has its own institutional set-up, has its own statutory objectives and its mandate. Within this institutional set-up, within the statutory objectives, each central bank tries to steer private sector expectations. As far as our mandate goes, namely maintaining price stability, I think we’ve shown how to do it.

Translation: “Employment is not our mandate”. It would be one thing if Draghi were asking for an expanded mandate. But he isn’t, because he evidently believes, with Andrew Mellon, that unemployment is a way to purge the rottenness out of the system, and that people will work harder and live a more moral life. Mellon quit before he was impeached.

I cannot blame Draghi for complying with his insane mandate, but I can blame him for embracing it without a struggle. His leadership is catastrophic.

Confronting Monetary Ignorance At The Wall Street Journal

Once in a while, an op-ed will be so offensive in its obtuseness that it raises my hackles. In this case, the offending column was not written by Thomas Friedman, despite his tireless efforts to make sentient readers pop a gasket. 

Today’s column was written by the esteemed George Melloan, the Wall Street Journal’s patriarch of solid conservative thinking, and of the sound dollar, the bedrock of American prosperity. 

Below is what this confused man wrote, and my parenthetic commentary in italics. Note the nature of his lapidary prose: he speaks in unanswerable platitudes, as if there could be no possible disagreement. Melloan is a theologian, not an economist. He exemplifies the Journal’s inexplicable embrace of austerity, deflation and depression.

Deficits, Debt and the Fate of the Dollar

By George Melloan

January 9, 2013

The year-end "fiscal cliff" tax deal sent shivers through the bond market, driving the price of 10-year Treasurys to the lowest level since April.

So...bond yields rose because of the cliff deal, and not because of the publication of the FOMC minutes which suggested that QE3 could be ended prematurely? Both events happened simultaneously.

There was a good reason. The stubborn resistance by President Barack Obama and Senate Majority Leader Harry Reid to spending cuts left no further doubts about their lack of interest in the nation's No. 1 economic problem, massive federal deficits.

Is the #1 problem overspending, or inadequate nominal growth?

The bond-market decline came despite the Federal Reserve's renewed program to gobble up yet more government debt.

So far, the Fed has bought nothing for the past 20 months. The monetary base hasn’t budged since June of 2011.

Presidents of some regional Federal Reserve Banks are growing nervous about this program, judging from the December minutes of the Federal Open Market Committee, which guides Fed policy. Jeffrey Lacker of the Richmond Fed, Richard Fisher of Dallas and Esther George of Kansas City have been among the most outspoken in voicing fears that continuation of the Fed's manic buying—now running at $85 billion a month in Treasury and agency paper—will ultimately destroy the dollar.

So far the Fed’s balance sheet has been flat, and the dollar has been rising since mid-2011.

The concerns expressed in the FOMC minutes didn't cheer the bond market either.

So which was it: the cliff deal or the minutes?

These are signals of dangerous times. Forget about the next Washington dog-and-pony show on the debt ceiling. The bond market will ultimately dictate the future of U.S. monetary and budgetary policy. Bond markets only obey the law of supply and demand. When the flooding of markets with American debt causes the world to lose confidence in dollar-denominated securities, the nation will be in deep trouble.

Right now, the world is happy with exceptionally low interest rates on dollar securities, so we are not in any kind of trouble. We were in trouble back in 1981  when rates were very high, but that was thirty-two years ago.

The only force standing in the way of that now is the Fed's support of bond prices.

The Fed hasn’t started buying bonds. When it does, hopefully bond prices will fall as inflation expectations rise.

But regional Fed presidents are prudently asking how long that can be sustained.

Which is ironic since the Fed’s balance sheet hasn’t grown since June, 2011. There is nothing to sustain.

Mr. Obama currently is riding high, pumped up by his success in resisting Republican budget-cutting demands during the "cliff" talks. But the deal he muscled through Congress is a hollow victory. His so-called tax on the wealthy will produce scant revenues. The money sucked out of American pocketbooks by higher payroll taxes will curb consumer demand, further slowing already weak economic growth. Only entitlement reforms, which the president refuses to consider, can shrink the deficit enough to reduce the danger it poses.

Wouldn’t faster nominal growth caused by higher inflation also shrink the deficit, and in a less painful fashion? Or is austerity good for its own sake?

The Fed's worst fear is that despite its long-term commitment to buying up government debt, it will lose control of interest rates.

The purpose of QE, if it ever starts, is to raise inflation expectations and, by extension, long-term interest rates. So far the Fed hasn’t been able to do this because its expansionary efforts have lacked scale and credibility. It doesn’t yet have control of interest rates because it hasn’t inflated enough.

That's why the early-January upward blip in bond yields was a yellow warning light. If Treasury bond prices decline significantly from the artificial levels that massive Fed purchases have supported, several things will happen, none of them good.

If bond prices fall, it will signal that the Fed’s reflationary efforts are gaining credibility. This should spur investment and economic activity.


First of all, government borrowing costs will rise, making it even more difficult to control the deficit.

Lower bond prices will affect bondholders, not the Treasury. However, higher inflation will increase government revenue while shrinking the real value of the national debt. Wouldn’t that be a good thing?

Second, the value of the Fed's gargantuan and growing $2.6 trillion portfolio of Treasury and government-agency mortgage bonds will decline. It won't take much of a portfolio loss to wipe out the Fed's capital base.

The Fed does not mark to market, so there would be no portfolio loss, just as there has been no portfolio windfall as rates have fallen from 15% to 1.5% over the past thirty years.

Without capital of its own, it would become a ward of the Treasury, costing the Fed what little independence it has left to defend the dollar.

Central bank solvency is meaningless in a fiat currency economy, since money is a Fed liability which can be costlessly created. If you were to book the Fed’s money monopoly as an intangible, its value would be infinite. The Fed has plenty of independence and has no responsibility for the dollar’s foreign exchange value, only its purchasing power. You may want the Fed to support the dollar, but it has no such mandate.

Even now, the Fed faces a cruel dilemma. It can let bond prices fall and suffer the unhappy consequences. Or it can keep on its present course of buying up more hundreds of billions of Treasury paper. That course inevitably leads to inflation.

Which is the whole point of the exercise, except that the Fed isn’t buying enough to move the needle on inflation. Were it to ever start buying up “hundreds of billions of Treasury paper”, you might see the needle start to move.

Over the past four years, the damage to the dollar has been partly ameliorated by global investors fleeing weak currencies elsewhere for the relative safety of the dollar. But there has to be a limit to how long that will be true. We already are seeing signs of renewed asset inflation not unlike the run-up that occurred in the first half of last decade. Stocks and farmland are up and housing prices are recovering from their slump.

Are asset prices an element of the price level? If so, we experienced pretty horrible deflation during the crash.

Brendan Brown, London-based economist for Mitsubishi UFJ Securities, reminds us that asset inflation is usually followed by asset deflation, and that's no fun, as the events of 2007 and 2008 testified. More seriously, a rise in the price of assets often presages a general rise in the prices of goods and services.

Which is what Bernanke is praying for, so far to no avail.

Inflation can ultimately destroy the bond market, as it did in 1960s Britain during the government of the socialist Labour Party. No one wants to commit to an investment that might be worthless in 10 years, never mind 30 years.

Right now, the market is demanding the lowest dollar interest rates since WW2, right across the yield curve.

Throughout history, governments have inflated away their debts by cheapening the currency. That process is well under way through the Fed's abdication to irresponsible government.

The Fed is trying (unsuccessfully) to create higher inflation so as to increase nominal growth, grow government revenue, reduce the deficit, and shrink the real size of the national debt. Is that an abdication to irresponsible government? Would you prefer zero nominal growth, such as the BoJ and the ECB have been delivering? Would zero growth help balance the budget?

If Fed policies continue, another huge tax—inflation—will weigh down the American people. The politicians will try to escape public censure, as they always do, by blaming it all on "price gouging" by producers, retailers and landlords. A substantial cohort of the press will buy into that phony rationale and spread it as gospel.

So far the Fed’s policy for the past 20 months has been to talk a lot and do nothing. If it ever takes up QE3 in earnest and starts growing its balance sheet, we will be lucky to see higher inflation and higher nominal growth.

The Fed's dilemma is in fact everyone's dilemma, given the universal stake in the value of the dollar. And all because an American president and a substantial number of senators and representatives don't understand one simple fact: In the end, the bond market rules.

We have no stake in the value of the dollar in foreign currency, other than making sure that it doesn’t get so high as to price us out of global markets (which it has). What we do have a stake in, is more rapid growth and higher government revenue. Cutting spending in order to cope with weak growth is a strategy for depression. Take a look at Europe.

Mr. Melloan, a former columnist and deputy editor of the Journal editorial page, is the author of "The Great Money Binge: Spending Our Way to Socialism", Simon & Schuster, 2009.

FOMC Minutes: Read 'Em And Weep

FOMC minutes, Dec. 11-12, 2012:
While almost all members thought that the asset purchase program begun in September had been effective and supportive of growth, they also generally saw that the benefits of ongoing purchases were uncertain and that the potential costs could rise as the size of the balance sheet increased. 
Various members stressed the importance of a continuing assessment of labor market developments and reviews of the program's efficacy and costs at upcoming FOMC meetings. 
In considering the outlook for the labor market and the broader economy, a few members expressed the view that ongoing asset purchases would likely be warranted until about the end of 2013, while a few others emphasized the need for considerable policy accommodation but did not state a specific time frame or total for purchases. Several others thought that it would probably be appropriate to slow or to stop purchases well before the end of 2013, citing concerns about financial stability or the size of the balance sheet.

As JFK said in slightly different words "Fooled again." So much for the triumph of monetarism at the Fed. It turns out that the College of Cardinals is not 100% behind the pope.

Bernanke is trying to drive down the real funds rate by raising inflation expectations. If he could get expectations up to say 3%, that would make the real rate -3%, which would be stimulative. The whole point of QE3 is to commit to print money until unemployment falls to 6.5% from its current level of 7.7%, and thus raise inflation expectations. They were supposed to add $1 trillion to the monetary base in 2013. Now they say that "the benefits of ongoing purchases are uncertain and the potential costs could rise as the size of the balance sheet increased." Is that so?

There is absolutely no point in making forward-looking statements unless they have credibility. How hard is that to understand? We should have learned this from twenty years of  “anti-deflationary” policies at the Bank of Japan.

We learned today that Bernanke is still not in charge, and that the cats he has been trying to herd are still running in different directions. It is not “his” FOMC. The committee seems to feel that it is committed to nothing other than to make “continuing assessments”. Don't go out on a limb.

The committee’s forward guidance now has almost no credibility. At any moment, some of the cats can stick their heads up  and say “We think that’s enough”. End of QE3!

There are two ways to conduct monetary policy: offer credible guidance which can by itself change market behavior; or failing that, just go ahead and follow through with whatever it is that you said you were going to do. To offer non-credible guidance while reserving the right to stop expansion at any time is the worst way to do it, as Bernanke knows very well.

I hate to say it, but Bernanke is giving monetarism a bad name. He isn’t doing it right. Now, with expectations up in the air and the monetary base stalled, people are going to start saying that QE3 hasn’t worked and that “monetary policy has lost its efficacy”. Actually, they are already saying that.

So let me remind you of one salient fact: the monetary base stands today at $2.6 trillion. Eighteen months ago, in June of 2011, the monetary base was $2.6 trillion. There has been no expansion of the Fed’s balance sheet since the announcement of QE3, none. And so you may well ask “Will there ever be an expansion of the monetary base?’ And I can only answer, “Definitely, unless the hawks stop it at the next meeting”. There may never be a QE3. It may all have been a dream.

So all of the hoopla about the intellectual sea-change at the Fed now looks misplaced. We don’t have a monetarist Federal Reserve; we have a monetarist Federal Reserve chairman. It’s like the Supreme Court: we don’t have an originalist court, we have an originalist chief justice. The other member get to vote however they please.

This is all very disappointing.

The Bank Of Japan Will Defeat The New Government

“Mr. Abe's economic platform consisted of more fiscal stimulus spending, to be financed by the Bank of Japan directly buying government bonds. In other words, printing money to bring inflation up to a new target of 2%-3%, compared to the BoJ's current target of 1%. But the central bank has expanded the money supply enormously, and demand for credit is so weak that it has been unable to stop deflation.”
---WSJ editorial, “Japan’s New Old Hawk”, Dec. 17th 2012


The Journal is giving the Bank of Japan credit for something it didn’t do. It is unclear where the Journal gets its monetary data for Japan. I get mine from the Fed, which show that money growth in Japan has been weak for twenty years, frequently going negative. M1, M2 and M3 growth rates have been bouncing around a very low mean of around 1% over those years. At present, under the BoJ’s supposedly reflationary policies, broad money (M3) is growing at 2.2%. Nominal GDP and industrial production have declined sharply since the crash.

The Journal is right that the BoJ has been unable to stop deflation, but that is due to its dogged pursuit of deflationary policies. It is now ten years since Ben Bernanke first explained to the Japanese the mechanics of NGDP targeting; only now is the government considering such a program. Twenty years of deflation and deficits have been wasted. Reflation is now the only way out for Japan, given its massive indebtedness.

The newly elected Japanese prime minister, Shinzo Abe, has embraced the advice that Bernanke gave Japan ten years ago: to target not interest rates, but either nominal growth or a target level of NGDP. Abe says that he will establish a monetary council, outside of the BoJ, that will set a 2% inflation target and a 3% NGDP growth target. If the BoJ ignores the council, he will take away the bank’s legal independence (long overdue).

I don’t know how to react to Mr. Abe. Most of what Japanese politicians say is meaningless. Japanese governments have been whining about the BoJ for fifteen years, so what’s new? My gut skepticism toward the Japanese political system suggests that one should not hold one’s breath waiting for a meaningful change in Japanese monetary policy. Furthermore, in typical Japanese fashion, the “radical” Mr. Abe has not called for a radical policy:  3% nominal growth will not change Japan’s debt dynamics when its fiscal deficits remain large (and will grow bigger under the new government).

Japan needs a radically reflationary policy now, not baby steps which are too little and too late. Bernanke advocated targeting the level of NGDP that would have occurred had the desired growth path not been interrupted. For Japan, that would be roughly 12% higher than today’s NGDP, not 3%. Mr. Abe is merely demanding that the BoJ do a tiny bit better than it has been.

Furthermore, students of Japanese politics will know that it will only take days for the Japanese media to proclaim Mr. Abe a failure and an embarrassment, no matter what he does or doesn’t do. In a year he will be gone, and the BoJ will still be there, “fighting” deflation.

This means that the Japanese economy will remain stuck in idle for another decade, the yen will remain strong, and the Nikkei (EWJ) will go nowhere.

2013: The Year Of Printing Money

Assuming that the Fed implements QE3 as announced on Wednesday, I expect to see the Dow around 15,000 next Christmas. This is because the Fed’s balance sheet should grow by $1 trillion next year, a 36% increase over where it is now. By yearend, I expect nominal GDP growth to have accelerated from its current 4% to a level closer to 5%. I am therefore bullish about both economic growth and equity prices.

The quantity theory of money holds that nominal GDP growth is a function of money growth, and that money growth is a function of the size of the central bank’s balance sheet. Therefore, the central bank is able to control the level and growth rate of nominal GDP.

However, these are not constant relationships. As interest rates decline, so does monetary velocity, such that it takes proportionately greater increases in the money supply to produce comparable GDP growth. And similarly, the relationship between the central bank’s balance sheet and the money supply is also not linear, particularly as interest rates approach the zero bound. Keynes called these phenomena the liquidity trap in which monetary policy loses its power as the central bank “pushes on a string”.

While monetarist economists concede that these relationships are not linear, they do not accept that a central bank can ever lose its power to grow nominal GDP. And it is a bit ironic that the same voices that argue that monetary policy has lost its efficacy also argue that quantitative easing will lead to inflation. They argue that monetary policy is (a) powerless; and (b) powerful. They are wrong on both counts: monetary policy never loses its efficacy, and the current program of expansion will not lead to high inflation (just as the prior rounds of QE did not, despite dire warnings from the hawks).

No one can reasonably argue that a central bank cannot inflate its currency such that nominal GDP will grow. We have witnessed this phenomenon many times since the invention of fiat money in 17th century France. The central banks of Zimbabwe and Ukraine have been poster children for the power of the printing press, and have both succeeded handily in greatly expanding the size of nominal GDP.

As Bernanke argued to the Japanese, in extremis, there is nothing to stop the central bank from dropping money on the citizenry from the air. In 1933, when FDR decided to inflate the currency, he began to raise the dollar price of gold by arbitrary daily increments until he saw the overall price level begin to rise. He didn’t know very much about monetary policy, but he understood that by printing money he could cause inflation.

Now let’s look at the facts today. Since the crash, the Fed has engaged in two rounds of balance sheet expansion. (Note: I am using the Fed’s balance sheet and the monetary base interchangeably; they are very close in dollars.) In QE1, the monetary base grew by about $1 trillion. In QE2, the base grew by another $700 billion. In QE3, the Fed plans to grow the base by additional $1 trillion. Overall, the monetary base will have grown from $800 billion pre-crash to around $3.6 trillion by next Christmas (while inflation has remained subdued).

The money supply (M2) has grown by almost $3 trillion since the crash, for a total growth of 40%. Since the crash, nominal GDP has grown from $14 trillion to $16 trillion, an increase of 14%. The Fed’s plan is that by growing the monetary base by about a third in 2013, nominal growth will accelerate to a level that would allow unemployment to decline to from its current 7.8% to a targeted 6.5%.

Since the immediate recovery period after the crash, NGDP has been growing steadily at a subpar 4%. This third round of monetary expansion, if pursued, should lift that rate to a level above 5%, which is still less than robust but closer to potential (NAIRU).

If the Fed pursues QE3 as announced, inflationary expectations should rise next year as bond prices fall. This should be bullish for equities as returns from the “risk off” trade decline. With cash yielding zero and falling bond prices, equity inflows should rebound.

The equity risk premium today is still attractive at over 4% (earnings yield minus bond yield) and appears to be in solid value territory in a historical context. As the appeal of bonds diminishes, equity valuations should rise and the risk premium should decline.

My advice for 2013 is: Don’t fight Bernanke.

Thank God For Bernanke

The FOMC met this week and made the following announcements:

1. The Fed believes that, without further QE, economic growth will not be strong enough to generate sustained improvement in labor market conditions (i.e., unemployment below 7%).

2. The Fed will continue purchasing additional MBS at $40 billion per month, and will also purchase longer-term Treasuries at $45 billion per month, for a monthly increase in the Monetary Base of $85 billion (3%), or $1 trillion annually (36%).

3. If unemployment does not decline to 6.5%, the Fed will continue its purchases until such a decline is achieved. However, that does not mean that QE3 will necessarily end when unemployment goes below 6.5%.

4. To support continued growth, the Fed will maintain its zero-interest rate policy (ZIRP) for a “considerable time” after the QE program ends and the economic recovery strengthens. (A “considerable time” is understood to mean not before mid-2015.)

5. The ZIRP will continue at least as long as the unemployment rate remains above 6-1/2%, inflation is no more than 0.5% above the Committee’s 2.0% longer-run goal, and longer-term inflation expectations continue to be well anchored (e.g., the TIPS-Treasury spread remains low).

How should we Kremlinologists interpret these announcements? The good news is that Bernanke has managed to hold together his near-consensus in favor of unconventional monetary policy:
1. The Fed will continue QE, and will pursue ZIRP at least until 2015.
2. The Fed has announced an explicit unemployment target of 6.5%, which is the first time that it has operationalized its full employment mandate.
3. The rate of the Fed’s pace of asset expansion will more than double and will,  if pursued through the end of the year, represent a material increase (36%) in the Fed’s balance sheet and the monetary base.
4. The Fed will add purchases of Treasuries to the QE program, which settle much faster than MBS and will have an immediate impact on the monetary base.
4. The Fed is prepared to tolerate a higher-than-target rate of inflation in order to achieve its unemployment target.

The markets have reacted mildly to the announcement, with Treasury yields and gold prices rising to reflect slightly higher inflationary expectations.

However, this announcement should not be interpreted as a decisive victory of Bernanke and his doves over the FOMC hawks. That is because the Fed continues to tie its hands by (1) limiting the scale of its intervention to a modest level compared to prior QEs; and (2) limiting inflation and thus nominal growth. Were the Fed to go all the way and target a nominal GDP level (i.e., a nominal GDP of $X), it would not only tolerate but actually desire above-target inflation. As long as the Fed places a higher priority on its inflation target than on its employment target, it may never achieve the employment target, or at least not very quickly.

This helps to explain the market’s muted reaction. Yes, the monetary base will now start to grow for the first time since QE2 ended in mid-2011; that is bullish for nominal and real growth (especially helpful if the US goes over the fiscal cliff next month). But nominal growth will be limited to the sum of real growth and a maximum of 2.5% inflation, whether or not maximum employment is achieved.
In my opinion, that’s not good enough to get us where we need to go, and it is insufficiently radical to decisively move the needle on inflation expectations.
Bernanke keeps telling us that monetary policy is not a panacea; he is right that timid policies are not a panacea.

However, today's announcement is definitely progress, and the Fed is now intellectually and operationally far ahead of its global peers. And I might add that once the Fed actually begins to grow the monetary base by $85B/mo, that should go a long way toward cushioning the fiscal cliff.