Our Two Policy Choices

It seems as if our policy choices have been reduced to two. First, our basic problem is that there is too much debt outstanding, debt of consumers, debt of businesses, and debt of governments…state, local, and national. According to Ken Rogoff of Harvard (and co-author of the book “This Time is Different”), “By far the main problem is a huge overhang of debt that creates headwinds to faster normalization and post-crisis growth.” (link)

During the past fifty years of credit inflation, the incentive existed for economic units to increase financial leverage. Consequently, we have reached an extreme position of financial leverage, one that many believe is unsustainable. As Rogoff claims, people attempting to reduce this “huge overhang of debt” will not borrow, will not spend, and this will result in a period of time in which economic growth and the expansion of employment will be modest at best, and downright slow at worst.

The resulting policy choice, therefore, is to allow the debt reduction to take place and let the economy adjust to more “normal” levels of debt. This “adjustment” is going to have to take place some time and the best thing for the future of the economy is to let it adjust naturally for this adjustment must take place sooner or later. By not allowing it to take place, we just postpone the final day of reckoning.

The second policy choice is to pursue a significantly aggressive program of credit inflation, one that would force people and businesses to return to borrowing and hence to spending. Such a policy would help to accelerate economic growth and put people back to work.

This argument is based on the assumption that the United States cannot afford the consequences of a long, slow period of debt reduction and a lengthy period of mediocre economic growth. The cost of following a “do-nothing” policy in terms of human suffering due to the unemployment and social dislocation created by such a policy would be unacceptable.

The second policy has been the approach taken by the Obama administration, arguing for a resumption of credit inflation, both in terms of government deficits and in terms of expansionary monetary policy. The question that supporters of this policy debate about is the degree of the credit inflation. The Obama administration, itself, has tended to follow a more modest level of credit inflation whereas its liberal critics have argued the Obama team has been too timid in how much credit inflation should be imposed on the economy.

Here we get into a debate over timing. The first policy is needed, according to its proponents, because that is the only way the United States will regain its competitiveness and be able to go forward with the finances of its people in a strong position. Following the second policy would only postpone the adjustments needed and leave the “day of reckoning” somewhere out there in the future.

The supporters of the second policy argue that we cannot allow economic growth to be so low and unemployment stay so high because of the human cost. We need to address this now and worry about the debt re-structuring problem later.

The concern over the second policy program has to do with the “tipping point.” Let me explain.

Right now, the debt overhang appears to be the predominant force in the economy. Consumers, at least a large portion of them, are not borrowing and spending because of the debt loads they are carrying. (The wealthier consumers seem to be going along fine, thank you.) They are increasing savings in an attempt to get their balance sheets back in line. Small- and medium-sized businesses are not borrowing to any degree, are not hiring people, and not expanding much at all because they have too much debt on their balance sheets and are trying to keep their heads above water. Many state and local governments are facing real budget crunches and are cutting back on employment and capital expenditures because of their legal obligations.

The government fiscal stimulus programs initially attempted by the federal government have been ineffective and disappointing, at best. The efforts of the monetary authorities to generate bank lending have also been exceedingly ineffective despite historically extreme injections of liquidity into the banking system. Those people supporting the “second policy” continue to call for even more credit inflation whether it be for an new round of “quantitative easing” on the part of the Fed or some other innovative uses of monetary policy.

The problem with the “tipping point” is this: how severe the tipping point will be if/when the new efforts at credit inflation overcome the efforts of economic units to restructure their balance sheets and eliminate the “debt overhang” connected with the past fifty years of credit inflation.

The current policy makers seem to believe that the “tipping point” can be managed and the adjustment from debt restructuring to further borrowing can become incremental. That the trillion or so dollars injected into the banking system by the Federal Reserve can be smoothly removed from the banks once borrowing from them picks up steam. In this way, faster economic growth could resume again and employers could begin hiring workers at a speedier pace.

The alternative view is that the “tipping point” cannot be “managed” and that once the gates are open, borrowing will only accelerate and credit inflation will get “out-of-control”, given the magnitudes of liquidity already pushed into the financial system. Does this mean hyper-inflation?

This discussion leads to a question about whether or not the current policy makers can recognize the “tipping point” (let alone anticipate it) and whether or not they can then smoothly remove all the excess liquidity that has been forced into the banking system.

If one is to look at the record of Chairman Bernanke and the Federal Reserve system one cannot have very much confidence that they will be able to recognize a turning point let alone manage their way through the “tipping point”. Historically, Chairman Bernanke has had trouble recognizing bubbles, stays with a policy stance far too long and then over-reacts. Take a look at what happened before the financial crisis of 2008. The “housing bubble” and the “stock markets bubble” in the middle 2000s were not recognized by Bernanke or the Fed. Bernanke and the Fed fought the “fear of inflation” for too long into the initial stages of the financial collapse. And, then Bernanke and the Fed had to over-adjust to the financial crisis they contributed to by “throwing open the windows…and the doors…and whatever…at the Fed” in order to “save the world”.

Managing a “tipping point”, I would argue, is not one of Ben Bernanke’s strengths. But, governments, I would argue, are not very good at managing “tipping points.”

Where does that leave us? Between a rock and a hard place.

The government will continue to try to alleviate the suffering of those that have been hurt in the Great Recession and its aftermath. The Obama administration and the Democrats and the Republicans will compromise on a policy that can still be labeled credit inflation. The Federal Reserve will continue to look for ways to stimulate bank lending. And, the only way I can characterize this situation is one of HIGH RISK. Volatility is going to continue to dominate the financial markets over the next two years or so for the very reasons I have cited above.

The reason for this is the timing of the “tipping point.” The private sector is going to continue to push for balance sheet restructuring. The government is going to continue to push for more and more credit inflation. This leaves the future highly uncertain. Consequently, markets will move this way and that way until some leadership and stability are brought into the picture.

About John Mason 79 Articles

Professional history: Banking--President and CEO of two publically traded financial institutions; Executive Vice President and CFO of another. Academic--Professor at Penn State University and at the Finance Department, Wharton School, University of Pennsylvania. Government--Special Assistant to Secretary George Romney at Department of Housing and Urban Development; Senior Economist in Federal Reserve System. Entrepreneurial--work in venture capital and other private equity; work with young entrepreneurs in urban environment.

Visit: Mase: Economics and Finance

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