Friday, 13 August 2010

The Emperor Has No Clothes

The Federal Open Markets Committee (FOMC) on Tuesday, downgraded its assessment of the pace of the economic recovery from “moderate” (in June) to “more modest than anticipated.”

The Federal Reserve took a symbolic step toward additional easing of monetary policy. The Fed will “keep constant” its securities portfolio, reinvesting the principal payments from agency and mortgage- backed securities in long-term Treasuries, according to the statement released following yesterday’s meeting. Much of the economic commentary following FOMC’s meeting suggested the Fed had embarked on a second round of quantitative easing, familiarly known as QE2.

The Fed committed to, for the moment, is to maintain the size of its securities portfolio at $2.05 trillion rather than engage in passive tightening by allowing the balance sheet to shrink due to principal payments and maturing debt. How can it be quantitative easing when the quantity remains the same? Well, the Fed will buy some $100 billion to $200 billion of Treasuries a year to offset the maturing Mortgage Backed Securities.

The decision to substitute Treasuries for maturing MBS will be welcome news to those Fed officials who want the central bank to get out of the credit business and return to a “Treasuries only” policy.

Another option for the Fed would be to raise the cost of not lending. Banks now earn 0.25 basis points on their reserves. Reducing or eliminating the interest on reserves would, at the margin, entice banks to buy securities or make loans, expanding the money supply.

Some Keynesian economists say any further stimulus over the next few years won’t affect US’s ability to deal with deficits in the long run. Hmmm….not really…

“The Emperor has no clothes”

We have heard the children's story by Hans Christian Andersen entitled, "The Emperor's New Clothes". It is a very interesting story about human nature. An Emperor who cares for nothing but his wardrobe hires two weavers who promise him the finest suit of clothes from a fabric invisible to anyone who is unfit for his position or "just hopelessly stupid".
When the swindlers report that the suit is finished, they dress him in mime and the Emperor then marches in procession before his subjects. The Emperor cannot see the cloth himself, but pretends that he can for fear of appearing unfit for his position or stupid; his ministers do the same. A child in the crowd calls out that “the Emperor has no clothes” and the cry is then taken up by others. The Emperor cringes, suspecting the assertion is true, but holds himself up proudly and continues the procession.

The Emperor, i.e.the delusional that continued loose fiscal and monetary policies will expand the economy and consequently increased tax takes in the future will pay for it. The US fiscal gap is projected to be grow to 14% according to IMF if current policies are pursued.

What is a Fiscal Gap?

The infinite-horizon fiscal gap measures, in present value terms, a country’s excess of total expenditures—including those arising from its commitments to spend in the future—over available current and future resources. It is commonly defined as the current federal debt held by the public plus the present value in today’s dollars of all projected federal non-interest spending, minus all projected federal receipts. Simply put, can the government continue to pay its bills.

An adverse fiscal gap implies that the federal government is violating its budget constraint, meaning that it will not be able to finance its expenditures at some point in the future.

…..and the IMF says

Last month, the International Monetary Fund released its annual review of U.S. economic policy. It’s summary on U.S. fiscal policy:

“Sizeable fiscal actions would be needed to close the U.S. fiscal and generational imbalances. Under current policies, the United States federal debt is projected to grow rapidly due to a combination of large budget deficits before and during the crisis, as well as, over the medium term, demographic factors and healthcare inflation. As part of the medium term adjustment, the authorities would need to raise taxes and/or cut transfers (i.e. social security benefits) substantially to avoid an undesirable escalation of the debt-to-GDP ratio. The longer the wait, the larger the necessary adjustment will be and the greater the burden on future generations.”

The U.S. fiscal gap associated with today’s federal fiscal policy is huge for plausible discount rates. It adds that “closing the fiscal gap requires a permanent annual fiscal adjustment equal to about 14 percent of U.S. GDP.”

Fiscal overview

Revenue - $ 2.381 trn
Expenditure - $ 3.552 trn
Deficit - $ 1.171 trn
As % of GDP - 9%

Debt - $ 9.6 trn going up to $ 14.9 trn in 2015

Rising from 64% of GDP to almost 100% of GDP in 2015. And the likely increase in debt servicing costs are going to drive the deficit higher!

The IMF report essentially calls for substantial deficit reduction. To put 14 percent of gross domestic product in perspective, current federal revenue totals 15 percent of GDP. So the IMF is saying that closing the U.S. fiscal gap, from the revenue side, requires, roughly speaking, an immediate and permanent doubling of personal-income, corporate and federal taxes as well as the payroll levy set down in the Federal Insurance Contribution Act. Or a combination of tax hikes and spending cuts….something has to give…

Such a tax hike or spending cut would leave the U.S. running a surplus equal to 5 percent of GDP this year, rather than a 9 percent deficit as it is now. So the IMF is really saying the U.S. needs to run a surplus now and for many years to come to pay for the spending that is scheduled. It’s also saying the longer the country waits to make tough fiscal adjustments, the more painful they will be.

Demand siders say forgoing this year’s 14 percent fiscal tightening, lowering taxes and spending even more, will pay for itself, in present value, by expanding the economy and tax revenue.

Simple arithmetic shows that this is not true. The fiscal gap is like the government’s credit-card bill and each year’s 14 percent of GDP is the interest on that bill. If it doesn’t pay this year’s interest, it will be added to the balance. Eventually will lead to a debt trap...

The country’s fiscal position needs immediate redressal and no longer can it pursue the no- pain, all-gain solutions. Put simply, “The Emperor has no clothes”…….

………….can it become like Greece?

The longer the current loose monetary and fiscal policies continue into the future, more likely will we see a dramatic increase in tax rates, interest rates and consumer prices. That would be a slippery slope, one that is then too difficult to climb from and U.S. fiscal shape may well be…… worse than Greece!!


  1. I look this from a slightly positive angle. :>

    The fact that the Fed is not reducing the total security holdings but set a floor on its security holdings implies that, strictly speaking, it is not quantitative easing. QE occur when the central bank set an exogenous varaible(e.g. certain percentage of GDP) and commit to print money until that target is achieved. That said, QE will have a graeter conviction than the current quantitative policy Fed chose to adopt. I read it as an implication that the Fed is not seriously worried about a second recession. If they were, they would have had either expanded the quantitative policy or adopted QE instead.

  2. Sophie, Yes indeed, they are not expanding the Q.E. yet but have not shut that option either...they were supposed to exit/reduce their position thru allowing amortisation / maturities of the MBS. Instead, they will use the maturing secs to be replaced by UST's....QE is just one tool...

    I think the FED is indeed concerned about the slowdown in growth though not yet of a double dip....talks of another stimulus is worrisome given the state of cannot indefinitely spend their way out of trouble....:(

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