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July Outlook Part Two

Monetary Solutions vs. Fiscal Problems

When its 2012 fiscal year ends in September, the U.S. federal government will have added more than $900 billion to the nation’s total debt. Over the preceding 12 months, it will have spent approximately$3.8 trillion on entitlements, defense and other programs, while taking in only $2.9 trillion in taxes and other revenue. The shortfall will be made up through borrowing – issuing Treasury securities to domestic and foreign investors.

Over the past few years, one of the biggest buyers of U.S. debt has been the nation’s own central bank – the U.S. Federal Reserve. In normal times, the Fed is a nominal buyer of Treasuries. In 2011, however, the Fed purchased a remarkable 61 percent of net Treasury issuances thanks to monetary stimulus programs like “Quantitative Easing and “Operation Twist.”

The Fed’s highly interventionist approach offers real cause for real concern to economist Lawrence Goodman. Goodman is head of the Center for Financial Stability, a New York-based nonpartisan think tank that promotes knowledge about financial infrastructure and the performance of markets for the benefit of officials, investors, and the public. Goodman argues that while the Fed is well intentioned, its actions are having unintended consequences in the capital markets and creating a false sense of demand for U.S. debt.

OUTLOOK recently interviewed Goodman for his views about deficits, the Fed’s recent actions and the interplay between fiscal and monetary policy.

OUTLOOK: Last year Standard & Poor’s downgraded U.S. sovereign debt for the first time in history, and there is an ongoing sovereign debt crisis in Europe. Characterize the scale of the public debt problem in the world’s advanced economies and the risks you think it poses.

LG: I believe strongly that the fiscal and debt crises in advanced economies are highly challenging and represent a serious threat to the health of the global economy.

I would not underestimate the importance of the sovereign downgrade of the U.S. last year. Analysts at Standard and Poor’s thought long and hard before making the decision to downgrade the U.S. Quite frankly, U.S. fundamentals are significantly weaker than in years past. That is a fact of life. The downgrade is a reflection of reality.

There is a reluctance among officials in Europe and the U.S. to recognize the root cause of the problem. This reluctance and delays in confronting the source of the strain are essentially creating a problem that deteriorates with each passing day.

OUTLOOK: What is the root cause? Do you think it is too much spending or too little revenue or both?

It’s more of a spending problem. Here in the U.S., public spending has increased to 25 percent of GDP. Traditionally it's been 20 percent of GDP or lower. The real trouble is in the future and represented by entitlements and the various contingent liabilities offered by the U.S. government. We need a serious restructuring of entitlement programs as well as an overhaul of our public financial management.

OUTLOOK: What lessons does Europe hold?

LG: The lesson is that advanced economies are not immune from debt crises. I want to be clear that the U.S. is a ways off from experiencing complications similar to those in Europe. But we are beginning to see some dangerous shifts. We are also beginning to see shifts in how the market perceives the U.S. versus alternative investments. We still have time to shift our fundamentals. But now is the time to act.

OUTLOOK: How dependent is the United States on the financial markets to pay its bills?

LG: We did a study where we evaluated the net issuance of U.S. Treasury debt over decades from the 1950s through the present. “Net issuance” is simply the increase in debt, measured in dollars, from January 1 to December 31 – how much more Treasury paper has been issued relative to how much has expired or been paid off.

The lowest increase was 0.6 percent of GDP during the 1960s, and the high, until recently, was 3.9 of GDP percent during the 1980s. Between 2008 and 2011, the net issuance of Treasury debt averaged 9.3% of GDP. So the recent net issuance of Treasury debt is more than double the largest amount relative to GDP previously experienced for an entire decade.

OUTLOOK: Why has it gone up so much?

LG: A couple of reasons. The first is that the government has actively engaged in policies to stimulate the economy by spending and incentives. Secondarily, revenues have fallen coincident with a slowdown in the economy. Lower growth translates to reduced tax proceeds.

OUTLOOK: We've had other downturns, including a very bad one in the early 1980s. Why was this one so much worse in terms of driving higher levels of public indebtedness?

LG: There has been a substantial expansion in public spending as a mechanism to combat recessionary forces. The fiscal effort coincident with the 2007 recession was substantially greater than the 1982 recession, or even the Great Depression back in the 1930s.

OUTLOOK: In a recent Wall Street Journal article, you argued that foreign and private investors have become less willing to fund our government. How do you reach that conclusion?

LG: To clarify, I said that at these low interest rates, foreigners and private investors have been less willing to fund the government.

In normal times, the Fed is a net buyer of Treasury paper to carry out its open market operations. But typically those numbers are extremely small – less than 0.4 percent of GDP. One of the unintended consequences of the Fed’s quantitative easing policy has been to push Fed purchases to over 4 percent of GDP, or 61 percent of Treasury net issuance. QE accomplishes the Fed's objective of keeping rates low. But it also crowds out foreigners and the private sector who would ordinarily be stepping in to purchase those obligations – albeit at much higher rates.

OUTLOOK: How are the Fed’s actions impacting the yield curve?

LG: Typically the Fed implements policy by targeting the Federal funds rate or by setting the overnight interest rate to its desired level. But at present the Federal Reserve is active in setting rates across the curve via previous QE and the present “Operation Twist.” So the normal market price discovery that is instrumental to derive market-determined yields has changed substantially due to the presence of a large buyer – the Federal Reserve – in the market. Rates across the curve are artificially low. And that naturally raises future policy management challenges regarding how the Fed exits from this unusual situation for market participants.

OUTLOOK: Is it an overstatement to say the Fed is setting rates rather than the market?

LG: We do have market interest rates, but they are heavily influenced by the visible hand of the Fed. The actions of a large single player are influencing rates across the curve.

The question becomes, what happens if the economy continues to remain sluggish? Will the Fed engage in another round of quantitative easing? And if so, how do they engineer that? And how does that fit with the Fed’s mandate? Conversely, how will the Fed respond if inflationary pressures remain less temporary than many believe? 

OUTLOOK: How are securities market participants affected by the Fed?

LG: In order to help push the unemployment rate lower, the Fed is resorting to unorthodox monetary policies that are highly discretionary in nature. They are acting in a manner that is new and untested for market participants.
The disciplined and rules-based approaches to monetary management that the market has grown familiar with since Chairman Paul Volcker’s days at the Fed gave investors, corporations, and individuals a degree of comfort and a level of certainty. As policy becomes more discretionary, the level of uncertainty increases. At present, uncertainty is clearly restraining economic output. For instance, many corporations are sitting on cash. They are not putting cash to work in part due to many uncertainties muddying potential investment opportunities. One of those uncertainties is Fed policy.

OUTLOOK: Obviously the Fed believes it is doing the right thing. What is the goal of these interventionist policies, from their standpoint?

LG: The Fed believes that price pressures are tilting more towards deflation than inflation, which provides it with the need to engage in unorthodox policies to expand the size of its balance sheet and money in circulation. They believe these policies will be helpful at moving unemployment lower without sparking inflation. The Fed also believes that they can unwind these policies in a smooth and purposeful fashion.

OUTLOOK: What are the dangers inherent in the Fed’s approach?

LG: If the problems in the economy are structural, monetary policy will prove ineffective in reducing unemployment on a sustained basis and the byproduct will be a swollen central bank balance sheet.

The danger relates to the potential for overconfidence by the Fed in its ability to be ahead of the markets. The risks extend beyond the Fed since other central banks around the world – the ECB, the Bank of England, the Bank of Japan – adopted similarly unusually large eases in monetary policy and associated expansion of balance sheets. This complicates the exit strategy for all.

Specifically, two important risks are at play. One is that the bank reserves that have been created by the Fed suddenly spark money demand, putting upward pressure on inflation. The size of the Fed’s balance sheet has increased to $2.9 trillion dollars or roughly three times its pre-crisis size. And those reserves in the banking system can readily be liquefied and turned into money and inflation.

The other risk is that the Fed reduces balances too readily, creating a contraction in money which ultimately becomes deflationary. The issues are multi-fold and complex.

OUTLOOK: Are those significant risks in your view?

LG: The risk that the Fed falls behind the market is not insignificant.

At the Center for Financial Stability, we are working to provide the public and officials with better data to evaluate monetary policy. We now provide measures to evaluate the money supply and the shadow banking system in real time.

OUTLOOK: By holding interest rates low, does the Fed enable the government to avoid making hard decisions about deficits?

LG: Definitely. Borrowing costs have been kept artificially low, so Treasury's interest payments are restrained and there's been a ready source to purchase Treasury obligations. This has certainly had an impact on masking the true cost of funding the U.S. deficit, which in part leads to this greater reliance on, and vulnerability to, financial markets. When the big buyer is no longer present, there is the risk of a price adjustment – that bond prices push lower and yields push up.

OUTLOOK: What impact do the Fed’s actions have on commodity prices?

LG: Commodities are traditionally a hedge for inflation, and there has been a deep linkage between the Fed's activities and commodity prices. Monetary expansions incent market participants to move funds to vehicles that protect against future inflation. So as the Fed has increasingly provided credit, the CRB index has rallied. As these unorthodox monetary policies experience a temporary reprieve, commodity prices fall.

OUTLOOK: The Fed has indicated it could hold interest rates near zero through the end of 2014. What do you foresee in terms of the timing of monetary tightening?

LG: Although it's difficult to have a clear vision out that far, I believe that the Fed will need to push rates to a more normal level substantially sooner than many expect.Fed policy will be a major driver of financial markets over the next several months.

OUTLOOK: Won’t tightening by the Fed then become yet another a drag on growth in the overall economy?

LG: Under the right circumstances, no. In fact, a more certain macro environment could unleash stronger growth despite a move to normalize rates. Low, stable and predictable inflation rates often trigger higher growth rates over a long period. For instance, the period starting in October 1979, when Chairman Volcker moved to tighten money, sparked a period of 25 years with high growth in a low-inflation environment. So I don't see the tradeoff as so rigidly defined especially during this unusual period of time.

In fact, this phenomenon is true on the fiscal front too. The idea of having a credible fiscal policy, where spending is more limited and there's a clear plan on the entitlement front, could actually unleash powerful growth in the U.S. If there's a long-term credible plan to actively limit our debts and address contingent liabilities, namely entitlements, that plan could unleash a tremendous amount of confidence and growth.

When its 2012 fiscal year ends in September, the U.S. federal government will have added more than $900 billion to the nation’s total debt. Over the preceding 12 months, it will have spent approximately$3.8 trillion on entitlements, defense and other programs, while taking in only $2.9 trillion in taxes and other revenue. The shortfall will be made up through borrowing – issuing Treasury securities to domestic and foreign investors. Over the past few years, one of the biggest buyers of U.S. debt has been the nation’s own central bank – the U.S. Federal Reserve. In normal times, the Fed is a nominal buyer of Treasuries. In 2011, however, the Fed purchased a remarkable 61 percent of net Treasury issuances thanks to monetary stimulus programs like “Quantitative Easing and “Operation Twist.” The Fed’s highly interventionist approach offers real cause for real concern to economist Lawrence Goodman. Goodman is head of the Center for Financial Stability, a New York-based nonpartisan think tank that promotes knowledge about financial infrastructure and the performance of markets for the benefit of officials, investors, and the public. Goodman argues that while the Fed is well intentioned, its actions are having unintended consequences in the capital markets and creating a false sense of demand for U.S. debt. OUTLOOK recently interviewed Goodman for his views about deficits, the Fed’s recent actions and the interplay between fiscal and monetary policy. OUTLOOK: Last year Standard & Poor’s downgraded U.S. sovereign debt for the first time in history, and there is an ongoing sovereign debt crisis in Europe. Characterize the scale of the public debt problem in the world’s advanced economies and the risks you think it poses. LG: I believe strongly that the fiscal and debt crises in advanced economies are highly challenging and represent a serious threat to the health of the global economy.I would not underestimate the importance of the sovereign downgrade of the U.S. last year. Analysts at Standard and Poor’s thought long and hard before making the decision to downgrade the U.S. Quite frankly, U.S. fundamentals are significantly weaker than in years past. That is a fact of life. The downgrade is a reflection of reality. There is a reluctance among officials in Europe and the U.S. to recognize the root cause of the problem. This reluctance and delays in confronting the source of the strain are essentially creating a problem that deteriorates with each passing day. OUTLOOK: What is the root cause? Do you think it is too much spending or too little revenue or both? It’s more of a spending problem. Here in the U.S., public spending has increased to 25 percent of GDP. Traditionally it's been 20 percent of GDP or lower. The real trouble is in the future and represented by entitlements and the various contingent liabilities offered by the U.S. government. We need a serious restructuring of entitlement programs as well as an overhaul of our public financial management. OUTLOOK: What lessons does Europe hold? LG: The lesson is that advanced economies are not immune from debt crises. I want to be clear that the U.S. is a ways off from experiencing complications similar to those in Europe. But we are beginning to see some dangerous shifts. We are also beginning to see shifts in how the market perceives the U.S. versus alternative investments. We still have time to shift our fundamentals. But now is the time to act. OUTLOOK: How dependent is the United States on the financial markets to pay its bills? LG: We did a study where we evaluated the net issuance of U.S. Treasury debt over decades from the 1950s through the present. “Net issuance” is simply the increase in debt, measured in dollars, from January 1 to December 31 – how much more Treasury paper has been issued relative to how much has expired or been paid off.The lowest increase was 0.6 percent of GDP during the 1960s, and the high, until recently, was 3.9 of GDP percent during the 1980s. Between 2008 and 2011, the net issuance of Treasury debt averaged 9.3% of GDP. So the recent net issuance of Treasury debt is more than double the largest amount relative to GDP previously experienced for an entire decade. OUTLOOK: Why has it gone up so much? LG: A couple of reasons. The first is that the government has actively engaged in policies to stimulate the economy by spending and incentives. Secondarily, revenues have fallen coincident with a slowdown in the economy. Lower growth translates to reduced tax proceeds. OUTLOOK: We've had other downturns, including a very bad one in the early 1980s. Why was this one so much worse in terms of driving higher levels of public indebtedness? LG: There has been a substantial expansion in public spending as a mechanism to combat recessionary forces. The fiscal effort coincident with the 2007 recession was substantially greater than the 1982 recession, or even the Great Depression back in the 1930s. OUTLOOK: In a recent Wall Street Journal article, you argued that foreign and private investors have become less willing to fund our government. How do you reach that conclusion? LG: To clarify, I said that at these low interest rates, foreigners and private investors have been less willing to fund the government. In normal times, the Fed is a net buyer of Treasury paper to carry out its open market operations. But typically those numbers are extremely small – less than 0.4 percent of GDP. One of the unintended consequences of the Fed’s quantitative easing policy has been to push Fed purchases to over 4 percent of GDP, or 61 percent of Treasury net issuance. QE accomplishes the Fed's objective of keeping rates low. But it also crowds out foreigners and the private sector who would ordinarily be stepping in to purchase those obligations – albeit at much higher rates. OUTLOOK: How are the Fed’s actions impacting the yield curve? LG: Typically the Fed implements policy by targeting the Federal funds rate or by setting the overnight interest rate to its desired level. But at present the Federal Reserve is active in setting rates across the curve via previous QE and the present “Operation Twist.” So the normal market price discovery that is instrumental to derive market-determined yields has changed substantially due to the presence of a large buyer – the Federal Reserve – in the market. Rates across the curve are artificially low. And that naturally raises future policy management challenges regarding how the Fed exits from this unusual situation for market participants. OUTLOOK: Is it an overstatement to say the Fed is setting rates rather than the market? LG: We do have market interest rates, but they are heavily influenced by the visible hand of the Fed. The actions of a large single player are influencing rates across the curve. The question becomes, what happens if the economy continues to remain sluggish? Will the Fed engage in another round of quantitative easing? And if so, how do they engineer that? And how does that fit with the Fed’s mandate? Conversely, how will the Fed respond if inflationary pressures remain less temporary than many believe? OUTLOOK: How are securities market participants affected by the Fed? LG: In order to help push the unemployment rate lower, the Fed is resorting to unorthodox monetary policies that are highly discretionary in nature. They are acting in a manner that is new and untested for market participants. The disciplined and rules-based approaches to monetary management that the market has grown familiar with since Chairman Paul Volcker’s days at the Fed gave investors, corporations, and individuals a degree of comfort and a level of certainty. As policy becomes more discretionary, the level of uncertainty increases. At present, uncertainty is clearly restraining economic output. For instance, many corporations are sitting on cash. They are not putting cash to work in part due to many uncertainties muddying potential investment opportunities. One of those uncertainties is Fed policy. OUTLOOK: Obviously the Fed believes it is doing the right thing. What is the goal of these interventionist policies, from their standpoint? LG: The Fed believes that price pressures are tilting more towards deflation than inflation, which provides it with the need to engage in unorthodox policies to expand the size of its balance sheet and money in circulation. They believe these policies will be helpful at moving unemployment lower without sparking inflation. The Fed also believes that they can unwind these policies in a smooth and purposeful fashion. OUTLOOK: What are the dangers inherent in the Fed’s approach? LG: If the problems in the economy are structural, monetary policy will prove ineffective in reducing unemployment on a sustained basis and the byproduct will be a swollen central bank balance sheet.The danger relates to the potential for overconfidence by the Fed in its ability to be ahead of the markets. The risks extend beyond the Fed since other central banks around the world – the ECB, the Bank of England, the Bank of Japan – adopted similarly unusually large eases in monetary policy and associated expansion of balance sheets. This complicates the exit strategy for all. Specifically, two important risks are at play. One is that the bank reserves that have been created by the Fed suddenly spark money demand, putting upward pressure on inflation. The size of the Fed’s balance sheet has increased to $2.9 trillion dollars or roughly three times its pre-crisis size. And those reserves in the banking system can readily be liquefied and turned into money and inflation. The other risk is that the Fed reduces balances too readily, creating a contraction in money which ultimately becomes deflationary. The issues are multi-fold and complex. OUTLOOK: Are those significant risks in your view? LG: The risk that the Fed falls behind the market is not insignificant. At the Center for Financial Stability, we are working to provide the public and officials with better data to evaluate monetary policy. We now provide measures to evaluate the money supply and the shadow banking system in real time. OUTLOOK: By holding interest rates low, does the Fed enable the government to avoid making hard decisions about deficits? LG: Definitely. Borrowing costs have been kept artificially low, so Treasury's interest payments are restrained and there's been a ready source to purchase Treasury obligations. This has certainly had an impact on masking the true cost of funding the U.S. deficit, which in part leads to this greater reliance on, and vulnerability to, financial markets. When the big buyer is no longer present, there is the risk of a price adjustment – that bond prices push lower and yields push up. OUTLOOK: What impact do the Fed’s actions have on commodity prices? LG: Commodities are traditionally a hedge for inflation, and there has been a deep linkage between the Fed's activities and commodity prices. Monetary expansions incent market participants to move funds to vehicles that protect against future inflation. So as the Fed has increasingly provided credit, the CRB index has rallied. As these unorthodox monetary policies experience a temporary reprieve, commodity prices fall. OUTLOOK: The Fed has indicated it could hold interest rates near zero through the end of 2014. What do you foresee in terms of the timing of monetary tightening? LG: Although it's difficult to have a clear vision out that far, I believe that the Fed will need to push rates to a more normal level substantially sooner than many expect.Fed policy will be a major driver of financial markets over the next several months. OUTLOOK: Won’t tightening by the Fed then become yet another a drag on growth in the overall economy? LG: Under the right circumstances, no. In fact, a more certain macro environment could unleash stronger growth despite a move to normalize rates. Low, stable and predictable inflation rates often trigger higher growth rates over a long period. For instance, the period starting in October 1979, when Chairman Volcker moved to tighten money, sparked a period of 25 years with high growth in a low-inflation environment. So I don't see the tradeoff as so rigidly defined especially during this unusual period of time. In fact, this phenomenon is true on the fiscal front too. The idea of having a credible fiscal policy, where spending is more limited and there's a clear plan on the entitlement front, could actually unleash powerful growth in the U.S. If there's a long-term credible plan to actively limit our debts and address contingent liabilities, namely entitlements, that plan could unleash a tremendous amount of confidence and growth.

 

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