Tuesday, July 06, 2010

The Problem with the US Economy

In his latest Op-Ed column in the New York Times, Paul Krugman makes the point that the US needs to continue transfer payments and extension of unemployment benefits to those who are suffering the worst of this economic recession (the poor AND jobless). Krugman is right that engaging in "austerity" by cutting these transfer payments is "penny-pinching in the midst of a severely depressed economy" and "is no way to deal with our long-run budget problems."

Krugman is addressing that group of Republicans who dogmatically oppose everything that the Democrats bring to the table (including financial regulation) simply because they are Republicans and that is what Republicans do (oppose the democrats) and not because they have any genuine understanding of what "Austerity" is. That word has been bandied about too much and has been misunderstood and conflated (wrongly) with genuine fiscal conservatives (like Roubini) who understand that releasing life support too quickly will plunge the economy back into depression (unlike the phony republican 'austerians', who ran massive budget deficits during times of prosperity with their misguided wars, and who pushed for the kind of deregulation that got us into the GFC in the first place). It is unfortunate that the Republicans have hijacked and adulterated the fiscal consolidation argument to further their dogmatic agenda (and have fooled many people in the process), but at least in the context of this blog post we can call them out on their bullshit.

In the medium to longer term, however, even if the US were to extend benefits and continue fiscal stimulus, there are massive structural problems with the financial system and the long-run budget problems.

Finreg reform as it looks to be passed makes but cosmetic changes to the system which in its current state looks more fragile to blowups than before the crisis. Banks have become too-bigger-to-fail and nothing much has changed with regards to the compensation systems that continue to incentivise bankers to misallocate capital and create risk, when what they should be doing is properly allocating capital and reducing risk. Meanwhile bankers are encouraged by the fact that US$500b+ of stimulus went into bailing out their broken institutions, much of which finally ended up in their own bonus packets. At the same time the absence of proper reform encourages the same dysfunctional behavior. In my opinion I dont see why banks cannot be broken up now into their component parts, with the utility type banking separated, regulated and insulated from the more risky activities, which can be left to blow themselves up but not at the expense of tax payers. The profitable arms of the banks can be divested, the proceeds from which can be used to recapitalise the weaker arms. No further bailout would be necessary to execute such a restructuring.

Alas the probability of such radical reform is zero. Regulatory capture means that politicians bow to the whims of the bankers who fund their campaigns. Dumb Republicans are opposing the finreg bill simply on the basis of "too much governmental interference in industry," when it is precisely their deregulatory stance that led to this mess in the first place. It's capitalism on the upside and socialism on the downside for bankers who will never have to bear the fallout of their actions.

This leaves a distorted economic system where much of the fiscal stimulus, which is ordinarily used to cushion the blow of a downturn on the poor and the jobless, has ended up in the hands of those who needed it the least. At the same time, a lack of fiscal reserves means that the treasury has to fund the fiscal stimulus packages by expanding the budget deficit to record highs, further adding to a mountain of public debt that sees no sign of diminishing any time soon. While the US govt has been able to keep its AAA credit rating intact through the course of this crisis, this rating cannot be taken for granted in the mid to long term. US govt spending, if not diverted from its current trajectory, is fundamentally unsustainable in its current form and needs restructuring. And if the Senate refuses to claw back damages from the bankers who wreaked havoc on the economic system, then the rest of society has to pay the price. This means either higher taxes or lower spending.

Higher taxes are politically toxic, for various reasons (you know the American narrative - Boston tea tax and the revolution). Military spending is a sacred cow that isn't going to be culled anytime soon. Obama's recent healthcare bill already means that the US government has expanded healthcare coverage to millions more americans at the cost of tax credits to help these Americans pay for their healthcare expenses. This leaves social security and other entitlement spending as only line items on the budget where the US govt can make immediate cuts. However, most of social security spending is mandatory and cannot be cut without a major overhaul of the regulation. Krugman's complaints make him a champion for the poor, but even if the US did go ahead and extended benefits to the unemployed, this would hardly put a dent in the longer term structural budgetary problems facing the US.

See http://en.wikipedia.org/wiki/2010_United_States_federal_budget

It is these long term structural budgetary problems that are the focus of the fiscal consolidationists, led by Nouriel Roubini. Unlike Roubini, however, these structural budgetary constraints are far away from the minds of the phony "austerians" that Krugman is railing against. The truth of the matter is that genuine long term Austerity will involve a major overhall to the entire US budget and structural changes to military spending, health care spending, social security spending and the taxation system. It will also require, as mentioned above, a radical overhaul to the financial system to claw back damages that were inflicted by bankers on the American economy, and to prevent them from doing the same in the future. None of these Austerity and reform measures are going to happen. All the talk made by politicians (both Democrats and Republicans included) about cutting budget deficits is empty and hollow - genuine change just isn't on the cards.

But as the saying goes, you can't have your cake and eat it. The US government cannot continue to pile up on its mountain of debt indefinitely. Sooner or later the bond market vigilantes will wake up in the US and stop lending to the fiscal trainwreck that the US is starting to become. When that happens, either America is going to have to default on its debt and impose real Austerity, or it will have to print its way out of its fiscal problems. Neither situation is pretty, but both are serious possibilities. Meanwhile, the bankers that got us into this mess in the first place will be the ones profiting from the financial distress that is eventually to come our way.

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