Nov 12

Cutting Back on Spending

Posted by Kristjan Velbri | Posted in Economy, General, Politics | Posted on 12-11-2009

/category/general/chart_states_fiscal.gifIt has been evident for a while that local governments in the US have to cut back on spending. While the federal government can run  huge deficits (last year it was around $1.4 trillion), states have to balance their budgets. Although states are reliant on creative accounting and to some extent, illegal practices, they cannot hope to balance their budgets using the same old tricks for much longer because states’ revenues are down dramatically. According to a new report by the Pew Center “the same economic pressures that pushed California to the brink of insolvency are wreaking havoc on other states”.

The first state that comes to mind when talking about fiscal problems is California with its 49% budget hole and a 16.2% drop in revenue. But there are other states out there whose fiscal problems come eerily close to California: Illinois’ budget is off by 47% while Oregon’s revenue has fallen 19%, which is even worse than California. According to the law, states have to balance their budgets just like every enterprise interested in survival (companies can rely on debt, but they have to service that debt and eventually pay it off, unlike the federal government or the government of Japan, for that matter).

What to expect from all of this?

Well, first off, states will most likely use every possible means to raise revenue – meaning more traffic tickets, higher fees, giving out casino licenses (some states are seriously thinking about legalizing gambling to collect taxes) and downright stupid requirements like the one that New York just imposed on its vehicle owners by requiring them to buy new license plates for no other reason than to collect funds. But aside from collecting more taxes, states will start cutting back on vital public services like the maintenance of roads, bridges, waterfronts, levees, railroad crossings – all the while infrastructure is in a terrible shape and needs immediate fixing. This is very sad indeed – while I remain critical of the way the country is run, I am still very much fond of America. I would like to see America recover as much as Americans themselves, but given the current trends I don’t see that happening. It is indeed a sad chapter in American history.

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Sep 05

Special Drawing Rights: Not a Solution

Posted by Kristjan Velbri | Posted in Finance, Politics | Posted on 05-09-2009

During the years that preceded the current crisis, the American economy was booming. But it was not real economic growth for the money that was lent was not spent on investments but on real estate and consumer goods. Now that the bubble has burst, the Unites States administration has decided that the economy needs “stimulation”. The US has been running a budget deficit for well over a decade but with the new stimulus, the cash for clunkers (don’t forget the new “cash for refrigerators”) and many other programs that are supposed to stimulate the consumer who is already dead on the floor, the budget deficit has reached an unprecedented 1.2 trillion dollars (that’s $1,200,000,000,000).

But the US is not the only one that is suffering from the crisis and so it has become difficult for the US Treasury to finance the multiple programs put forth by the administration and the Congress. But where there is a need, there is a solution. The US “solved” the problem of financing with quantitative easing, which in English would means more like “printing money out of thin air”. Of course, once you start printing more money, you decrease its purchasing power. Since the US dollar is the predominant reserve currency of the world, it is easy to see why it makes so many politicians uneasy:

…Malaysian human-rights activist; a Filipino congressman; Zhou Xiaochuan, the head of China’s central bank; and French President Nicolas Sarkozy.

For each of them, the dollar’s role as the world’s so-called reserve currency presents inherent economic instabilities, with dangerous consequences. In both the run-up to the crisis and the crisis itself, an obsession with holding dollars roiled economies around the world. Today, those foreign countries are fearful of dollar inflation, which could decapitate their own bank reserves.[1]

Special Drawing Rights are not a real solution

For months now, political leaders from around the world have been drawing attention to the lack of discipline of the Federal Reserve. Some have even gone to the IMF and purchased special drawing rights (SDRs), the wannabe currency of the IMF. The media has been all over the issue, claiming that this is a real threat to the dollar, when it actually isn’t. Let’s take a closer look at it.

The SDR is an international reserve asset, created by the IMF in 1969 to supplement its member countries’ official reserves. Its value is based on a basket of four key international currencies, and SDRs can be exchanged for freely usable currencies. With a general SDR allocation taking effect on August 28 and a special allocation on September 9, 2009, the amount of SDRs will increase from SDR 21.4 billion to SDR 204.1 billion (currently equivalent to about $317 billion).[2]

What are these four key international currencies? Could it be that the dollar is one of them?
The percentages of the currencies that make up the SDRs are listed below? Can you guess which one of them is the US dollar? You only get one try, though.
*1st currency 44%
*2nd currency 34%
*3rd & 4th currency, each 11%

Buying special drawing rights to diversify out of the dollar makes no sense because for each dollar you get 44 cents back in the dollar, and just 56 cents back in other currencies. But because the dollar is the reserve currency of the world, the percentage is actually higher than that. Most currencies around the world are backed by other currencies or foreign debt, most of which is denominated in the US dollar. So buying special drawing rights is just a political and economic statement, but nothing more. If a central bank would want to diversify out of the dollar it would not buy special drawing rights, it would most likely buy gold or government debt from Australia, Canada and other countries whose economies are heavily linked to commodities, or in other words, insulated from dollar inflation. In fact, the same countries that have been buying SDRs or have expressed their interest in doing so, have also been active in the gold market. The Russian central bank and the Chinese alike have been hoarding gold, the latter has also been active in the silver market by publicly announcing silver bullion sales for investment purposes on its national TV (remember, anything that is on national TV in China has been previously approved). Whatever talk there is about special drawing rights, always look past the headline and see if there are real signs of diversification.

Special drawing rights purchases are a statement, gold purchases are a materialization of that statement.

1. Quoted from the Wall Street Journal: Inevitable End to Dollar’s Reserve Role
2. Definition from the IMF

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Jun 06

The Politically Incorrect Guide to the Great Depression and the New Deal

Posted by Kristjan Velbri | Posted in Finance, Politics | Posted on 06-06-2009

Politically Incorrect Guide to the Great Depression and the New DealThis week Jim Puplava is interviewing Robert P. Murphy, the author of The Politically Incorrect Guide to the Great Depression and the New Deal. In his book, Mr. Murphy refutes the myth that FDR and the New Deal fixed the economy. In fact, he claims that it’s FDR who made the depression Great in the first place. The interview can be downloaded here.

From the book flap:

No economic myth these days is more pernicious than the myth that the free market caused the Great Depression and the New Deal got us out of it. That, as economist Robert P. Murphy points out is flat-out false. In The Politically Incorrect Guide to the Great Depression and the New Deal he provides irrefutable evidence that not only did government interference with the market cause the Great Depression (and our current economic collapse), but Herbert Hoover’s and Franklin Delano Roosevelt’s big government policies afterwards made it much longer and much worse (just as President Barack Obama’s extraordinary expansion of government promises to do today). Perhaps even more compelling, Murphy exposes the untold story behind the New Deal—how it operated by force, and why what’s really at stake is not only our economy but our liberty. The real “lessons of the Great Depression” are not what you’ve been taught.

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Feb 09

Stimulus Discussion Over?

Posted by Kristjan Velbri | Posted in Economy, General, Politics | Posted on 09-02-2009

burning_moneyThe  leaders of the world run around telling everybody that now is the time for action and the time for discussion is over. The loudest plea for action comes from the new president of the United States, Barack Obama. Of course, in a time of crisis, immediate action is necessary. When a man gets shot, there is not debate over what to do because everyone knows that you need to get the bullet out and the wound closed.

When it comes to the economy, things are far more complicated. President Obama has put forth a stimulus package, titled American Recovery and Reinvestment Act of 2009, which weighs in at around $800 billion. Mr. Obama has repeatedly emphasized the need to invest in infrastructure, education and energy projects to get the economy going again. But according to the Congressional Budget Office cost estimate, only $92 billion would be spent fiscal year 2009 (ending in September 30, 2009), with another $225 billion spent in 2010 and another $159 in 2011. Furthermore, only around $70 billion of that would be spent on infrastructure.

The Obama stimulus package is clearly about Democratic pork, not stimulating the economy. And even though there is all this talk about renewable energy, only $18.5 B of would be spent on renewable energy and energy efficiency (according to the original plan outlined in the CBO report). And only $4.5 billion would be spent on modernizing the electrical grid, which is the backbone of any developed economy. In fact, it was the high energy prices that led to high inflation and decreased spending in 2008.

Clearly, right now is the time for discussion, not “bold” and “swift” action, especially when considering the span over which the money would be spent. It is important to remember that Obama is good with words, but that doesn’t necessarily mean that he and his administration knows what’s best for the economy as demonstrated by the CBO report.

Spending like there is not tomorrow

Imagine a situation where a man has a cardiac arrest. The doctor gives him two options: either stop smoking, start exercising and eating right; or take drugs that will make him feel better. Now, the obvious choice should be the first one and this is the only viable option in the long term. Taking pills won’t cure him, it will only make the pain go away for a while. Eventually, he is going to have to change his lifestyle.

The economies of the US and many Western countries face a similar decision – they can either cut spending and eliminate inefficient and unsuccessful state programs that are a drain to the state’s budget; or they can print new money, increase taxes and fees and sell more government bonds to finance their ever-increasing spending. Fortunately, the general public is not falling for Obama’s rhetoric and there is some real discussion over his plans in the media. But what we lack right now is a full out discussion over the soundness of Keynesian economics, which is the theory behind the whole spending concept.

Short term fix for a long term problem

The size of the US economy is around $14.3 trillion and spending $90 – 200 billion to stimulate the economy is a drop in the bucket. Financing this enormous recovery package is not going to be easy – the US government can’t really raise taxes, in fact, they are proposing the opposite. So the only two options left are issuing more government bonds or monetizing debt by printing new money. In essence, this is equal to taking away money from the public, thereby decreasing their ability to spend, but this is ignoring the fact that the stimulus package is intended to promote spending! So in essence they are taking the money away only to give it back again! This is like taking a hundred dollars from the right pocket, putting it into the left one and claiming you are wealthier. It’s preposterous!

Eventually the US is going to have to repay all that debt. During 2009, the US has to find buyers for $2.2 trillion dollars worth of Treasury bills and bonds (the size of the US budget for fiscal year 2008 was $2.979 trillion). This will drive the interest rate higher for commercial bonds and will further exacerbate the state of the US economy as companies will cut spending and lay off millions of people. In the short run, the stimulus package might work, although the odds for it happening are increasingly slim. In the long run, the US is deeply in trouble and needs to pull it’s act together by spending less, saving more and actually producing stuff, not only consuming it.

Outlook for the world

Even though I’ve been focusing on the US economy, the outlook for the world is pretty bleak as well. The bank bailouts have only had a mild effect on the economy and the financial sector, but they haven’t had a positive effect of the banks’ willingness to lend money, which is why these bailouts were given to them in the first place. This can be attributed to the “boldness and swiftness”, or in other words, blind impulsiveness. The packages were pushed through in a hurry and there wasn’t much debate about how the money should be used. In the case of the TARP, the outlook is even worse as the Treasury Department doesn’t have to tell anyone how the money has been used.

The economies of the world are interconnected and the whole world has gone through a simultaneous real estate boom and a successive crash. Due to the interconnectedness of the commercial banks, there is not really a great amount of hope out there, the credit market is cold as ice and the current trends point to a decrease in the amount of outstanding debt (meaning that more loans are paid back than are taken out).

More on the Greatest Depression in the coming days, when I will be looking at the data – unemployment numbers, GDP, auto sales, exports etc. Also, we’ll be taking a look a other countries’ statistics.

Further reading:
Arnold Kling: Against the Big Stimulus
Martin Fackler (NYT): Japan’s Big-Works Stimulus Is Lesson
Anthony Gregory: Jobs Government Creates, and Destroys
Richard Benson (FSN): Keynes, Upside Down

What are your thoughts on the stimulus package?

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