According to today’s Mercury News, California’s budget deficit will far surpass preliminary estimates. The Legislative Analyst’s Office is predicting a deficit of $6.3B in FY2009-10, followed by deficits of about $20B for the next five years. Through FY2014-15, the predicted deficits total $109.7B. (Note: that’s almost as much money as six major U.S. banks put aside for bonuses in the first nine months of 2009.)
At least the state is investing in education! Oh, wait…
UC regents recommend 32 percent fee hike
This cannot go on much longer.
In his post below, Julius argues that the government should reflate by providing guaranteed employment rather than by using quantitative easing to sustain inflated asset prices. I couldn’t agree more, and Paul Krugman has also suggested that the government consider programs that create jobs directly:
You can make a pretty good case that just employing a lot of people directly would be a lot more cost-effective; the WPA and CCC cost surprisingly little given the number of people put to work. Think of it as the stimulus equivalent of getting the middlemen out of the student loan program.
Given how many people have been turning to Hyman Minsky’s magnum opus Stabilizing an Unstable Economy for insight about the financial crisis, it’s surprising that government job-creation programs haven’t been part of the policy discussion (at least as far as I can tell). Such programs are actually a central component of Minsky’s policy recommendations. Of course, the recommendations start on page 319 of an admittedly turgid volume, so perhaps most readers had given up by that point. I think it’s unfortunate that Minsky’s ideas haven’t been given more attention, since they could be exactly what we need.
Minsky’s employment strategy seeks to “achieve a close approximation to full employment” without causing “instability, inflation, and unemployment” (p. 343). He proposes that the government act as the employer of last resort by creating an unlimited supply of jobs at a low, non-inflationary wage. These jobs could be created within the New Deal framework of the Civilian Conservation Corps (CCC), the National Youth Administration (NYA), and the Works Progress Administration (WPA); Minsky offers detailed proposals on pages 345-6.
The beauty of Minsky’s approach is that, by setting wages at a low level, the programs neither create inflationary pressure nor crowd out the private sector. When private sector demand for labor rises, workers will happily leave the government programs to take better-paying private sector jobs. The approach also promises to develop human capital and prevent the skill loss and suffering associated with prolonged unemployment. Minsky summarizes the approach as follows:
It is envisioned that WPA, NYA, and CCC when fully developed will, together with normal government activity and private employment, provide income through jobs for all who are willing and able to work. These permanent programs will provide outputs–public services, environmental improvements, etc. that a transfer-payment government does not yield, as well as the creation and improvement of human resources. In our urban centers, where there are concentrations of unemployed and welfare recipients, the improvement of the public environment should be marked. WPA, CCC, and NYA will succeed precisely because they are job programs that perform useful tasks and yield visible outputs. (347)
Why not set these programs up as entrepreneurial ventures, owned and administered by the government, that compete for resources (new employees), thereby creating performance incentives and developing entrepreneurial skills? Call them the Works Progress Entrepreneurs. Perhaps some public-spirited, newly minted MBAs would be willing to help get the program up and running before moving on to lucrative careers on Wall Street.
Those who know me know that since the beginning of this crisis, I’ve been in the Stiglitz/Johnson/Galbraith/Krugman/Calculated Risk/et al. camp, advocating for a restructuring of the banking system. I believe that only through a restructuring of the debt loads plaguing the private sector could the system be reset to support sustainable economic activity and growth. However, such a course of action involves short-term pain and negatively impacts the banking sector’s interests, therefore it was not tried for lack of political will.
That leaves reflation. But is the course of action we’ve taken in the U.S. the best way to reflate? If I may summarize the current response in a nutshell: the Fed has lowered interest rates and supported asset prices through massive QE and a variety of lending programs, while the federal government effected a weak, temporary, and fragmented fiscal stimulus program. This has led to the worst of all possible worlds: assets that are discounting a highly unlikely stream of income, and worlwide bubbles. Deflation is still entrenched, inflation is an unpredictable institutional risk, and economic and financial crashes are likely–especially in the emerging world.
What should they have done? I’d argue essentially the opposite: the Fed should have considered vastly limited asset price support and stuck with moderate interest rates, and made sure that long term rates were also moderately high. At the same time, the federal government should have instituted a massive, durable, and targeted stimulus program, perhaps 3-5 times the size of the current one and including a guarantee work program, as suggested by Galbraith. The money for this project would have come from printing money to limit the real cost to the government. Done deftly this would have limited the likelihood of bubbles, while allowing income to justify asset values. Debts would be repaid and slack taken up, but new debt growth and new business investment would have been limited. The overleveraged condition of the private sector would have thus been remedied and asset prices would be supported (albeit at lower multiple levels). Sustainable economic activity and growth would resume.
I believe that there is still time to institute this latter reflationary policy. The Fed need only start raising rates into the expansion of a massive government stimulus policy, while printing money to cover the cost.
From Bloomberg:
The Federal Reserve repeated it will keep interest rates near zero for “an extended period” and specified for the first time that policy will stay unchanged as long as inflation expectations are stable and unemployment fails to decline.
It would be a reasonable policy if it were coupled with capital controls to keep the easy money from wreaking havoc around the world. No such luck, of course.
The Next Bubble appears to be expanding more quickly than I expected. From Roubini’s comment “Mother of all carry trades faces an inevitable bust” in the Financial Times:
… the combined effect of the Fed policy of a zero Fed funds rate, quantitative easing and massive purchase of long-term debt instruments is seemingly making the world safe – for now – for the mother of all carry trades and mother of all highly leveraged global asset bubbles.
… the longer and bigger the carry trades and the larger the asset bubble, the bigger will be the ensuing asset bubble crash. The Fed and other policymakers seem unaware of the monster bubble they are creating. The longer they remain blind, the harder the markets will fall.
Of course the carry trade to which Roubini refers is the dollar carry trade. Rhetorical question: why can’t the Fed and other policy-makers see this? You’d think they’d be pretty familiar with how bubbles work by now!
The Wall Street Journal has more color in an article today entitled “Fears of a New Bubble as Cash Pours In“. A few tidbits:
The World Bank warned Tuesday that the sudden reappearance of billions of dollars in investment capital in East Asia is “raising concerns about asset price bubbles” in equity markets across Asia and in real estate in China, Hong Kong, Singapore and Vietnam. Also Tuesday, the International Monetary Fund cited “a risk” that surging Hong Kong asset prices are being driven by a flood of capital “divorced from fundamental forces of supply and demand.”
As far as I’m aware, the World Bank and the IMF aren’t given to hyperbole. The facts appear to back them up:
Singapore home prices rose 15.8% in the third quarter, the fastest rate in 28 years. …
The Australian dollar has jumped about 35% over the past 12 months as investors borrow in U.S. dollars to purchase Australian currency. …
Through Monday’s trading, the broad MSCI Barra Emerging Markets Index this year was up 60.7%. Brazil was up 100%, and Indonesia had gains of 102.7%.
I doubted–and still doubt–whether the Fed could rescue the U.S. economy with another massive bubble. The housing bubble was so large and put so much money directly into the pockets of mainstream American that it’s hard to imagine a replacement. It looks like the Fed is going to try anyway, creating asset bubble around the world.