I am not a prophet, nor do I play one on TV. Nevertheless, I will hazard some conjectures here about certain likely legacies of the current crisis. I focus on fiscal and monetary matters. In a future post, I will deal with regulatory and ideological matters. I will try to avoid mere guesses or hunches about what the future will bring. Instead, I will try to proceed in the spirit that Joseph Schumpeter expressed seventy years ago:
What counts in any attempt at social prognosis is not the Yes or No that sums up the facts and arguments which lead up to it but those facts and arguments themselves. . . . Analysis, whether economic or other, never yields more than a statement about the tendencies present in an observable pattern. And these never tell us what will happen to the pattern but only what would happen if they continued to act as they have been acting in the time interval covered by our observation and if no other factors intruded. (Capitalism, Socialism and Democracy, p. 61)
My speculations rest in part on my past analyses of national-emergency crises and the ratchet effects they produced in various dimensions of economic, social, political, legal, institutional, and ideological life in the United States. We have no assurance that past patterns will continue to prevail in the aftermath of the current crisis, but several broad similarities to this point suggest that we may not be entirely misled if we look to the past as a rough guide to the future.
Certainly one of the most important features of the present crisis is the large increase in federal spending. Between fiscal years 2008 and 2009, net federal outlays increased by almost 18 percent. Outlays dipped slightly in fiscal 2010, but rose again in 2011, reaching a level almost 21 percent greater than the level in 2008. Viewed in the context of the growth of outlays in the decade before the onset of the full-blown crisis in the fall of 2008, outlays since that time appear to have ratcheted up to a higher trajectory, about $300 billion or more above the amount they would have reached if the pre-recession trend had prevailed since 2008. Of course, outlays might eventually converge to their pre-recession trend line, but if so, they would be departing from the pattern followed in previous crises since World War I.
While federal outlays were increasing rapidly, federal revenues were falling equally rapidly. Between fiscal years 2008 and 2009, federal receipts declined by almost 17 percent because of the decline in income and employment. The upshot was that the federal budget deficit exploded, rising from slightly more than 3 percent of GDP in 2008 to about 10 percent of GDP in 2009. Therefore, the government had to borrow about $1.4 trillion in fiscal year 2009. Continued deficits of more than a trillion dollars in each of the following years have sent the public debt skyward almost like an ICBM taking off. As the figure below shows, the debt has increased by about 100 percent in less than five years (between January 2007 and July 2011). Projections indicate that federal debt will certainly continue to increase rapidly in the near term, notwithstanding frequent political promises to bring down the annual budget deficits.
The government’s rapid run-up of debt has proved possible notwithstanding the extraordinarily low yields on its securities for two main reasons. The first is that foreigners, who in many countries had to contend with monetary and fiscal policies just as bad as or even worse than those in the United States, fled the uncertainties of their own situations for the relatively safe haven of U.S. government securities as a means of protecting at least the bulk of the capital value invested. As the chart below shows, federal debt held by foreign and international investors increased from about $2.2 trillion at the beginning of 2007 to more than $5 trillion in October 2011—an increase of 127 percent in less than five years. As a result, such investors now hold almost half of the federal debt in the hands of the public.
In view of the currently negative real yields on most U.S. Treasury securities, foreign holders may well desire to terminate their purchases as fear subsides and government policies are improved in their home countries and as prospects dim for the dollar’s exchange value—that is, the accumulations occasioned by the foreigner holders’ “flight to safety” may be drawn down. If the Treasury loses its usual horde of foreign buyers, it may find itself hard pressed to finance its huge annual deficit without substantial increases in the yields of its bonds.
Pressed between the rock of unwilling bond buyers and the hard place of paying higher rates of interest, the government may well turn to the bottomless pit known as the Federal Reserve System. Indeed, it has already done so in recent years in a big way. As the chart below shows, the Fed first drew down its holdings of Treasuries at the onset of the crisis in swaps and other arrangements aimed at bailing out banks and other institutions that found themselves holding private and agency (GSE) securities with shrunken and in many cases extremely uncertain values. In 2009, however, the Fed increased its holdings of U.S. government securities from $492 billion in the first quarter to $769 in the third quarter. In the latter part of 2010, the Fed began another rapid buildup of its Treasury holdings, and by the third quarter of 2011, it held about $1,665 billion, or an amount equal to roughly 17 percent of the amount in the hands of the public. These two surges pushed the Fed’s portfolio of Treasuries to more than twice the amount it held before the onset of the crisis.
When the government sells bonds and the Fed acquires government bonds, the effect is the same as printing money and handing it to the Treasury. If we view the Fed as a part of the government, which for many purposes is the most appropriate way to view it, the operation is tantamount to the government’s issuance of “greenbacks” (U.S. Treasury notes) during the War Between the States. This sort of action has great potential for general price inflation, and even if significant price inflation does not occur, as it has not during the present crisis so far, the partial (or “other things being equal”) effect of such increases in the monetary base is to diminish the value of previously existing dollars. The chart below shows that the monetary base—roughly the amount of currency plus commercial bank reserves in the Federal Reserve Banks—has ballooned since late 2008, increasing by 211 percent between September 10, 2008, and March 7, 2012.
As the chart also shows, the monetary base had changed slowly and steadily before the current crisis, and the Fed’s actions that caused its explosion during the past three years have no precedents in nature or magnitude. Indeed, if a monetary economist had been given (by divine miracle) a preview of the chart above in, say, 2007, he would probably have concluded that the Fed’s managers were destined to go mad in the near future. I daresay no economist expected such an action (or set of actions). Now that it has occurred, however, it places the Fed in an unprecedented—and extremely dangerous—situation.
So far the potential hyperinflation that this explosion of the monetary base might normally have been expected to produce has not occurred because the banks have simply absorbed almost all of it in the form of increases in their reserve balances at the Fed. As the chart below shows, commercial banks historically held their excess (that is, not legally required) reserves close to zero, because such reserves had no yield and hence entailed an opportunity cost equal to the yield the banks could realize by using those funds to make loans and investments. With the onset of the crisis, however, the demand for bank loans has fallen greatly and the banks’ fears about the safety of loans and their worries about their balance sheets have grown, with the result that as the Fed has pumped money into the financial system by purchasing securities, the sellers have deposited the proceeds of those sales in their banks accounts and the banks have parked the money at the Fed, which sweetened the deal slightly, beginning in late 2008, by paying a small rate of interest (which soon settled at 0.25 percent). Thus, more than $1.5 trillion now sits in excess reserves at the Fed.
Because the banks have acted so bizarrely during the past three years, the money stock has not grown very much. As the chart below shows, M2 increased substantially during the macroeconomic contraction, then leveled off in late 2009 and early 2010 before resuming a more rapid rate of increase in late 2010. Between September 29, 2008, and February 20, 2012, M2 increased by 22.6 percent. This increase in just 41 months is not negligible, but it is only a tiny fraction of the increase that would have occurred if the banks had acted in a normal way during this interval.
The increase in M2 that has occurred since the onset of the recession has had little effect on the general price level because the public’s demand for money to hold has increased substantially. Equivalently, we may say that the velocity of monetary circulation—the ratio of GDP to money stock—has fallen substantially. As the chart below shows, M2 velocity has fallen by about 16 percent since the recession began, and it now stands at the lowest value it has attained since the 1950s. We live in unusual times, indeed. An increase in the public’s demand for money to hold also occurred in previous postwar recessions, but not to the extent that it has occurred recently.
In view of the foregoing evidence, what should we conclude about the likely fiscal and monetary legacies of the current crisis? First, the federal government is unlikely to reduce the budget deficit very much as long as it can continue to sell its bonds at anything near their current high prices (and consequently low yields). Even if foreigners grow skittish about the dollar’s exchange value or regain their courage enough to make more investments in their home countries rather than parking their money in Treasuries, the government will continue to run extraordinarily large budget deficits—and therefore to sell extraordinarily large amounts of bonds—as long as it can sell its debt to the Fed; that is, as long as it can effectively monetize the debt.
The Fed shows complete willingness to continue bankrolling the Treasury. The Fed’s gigantic accumulation of Treasuries—more than $1 trillion in the past three years—speaks much louder than anything Ben Bernanke might say about an “exit strategy.” Indeed, the Fed seems to have painted itself into a corner. If the public begins to wind down its current extraordinary demand for money to hold and pushes the velocity of monetary circulation back toward its pre-recession levels, the Fed will face accelerating general price inflation. To slow this inflation, it will need to sap money from the financial system. But how can it simultaneously withdraw money (to slow inflation) and inject money (via purchase of new federal debt)? Moreover, as the commercial banks begin to feel more comfortable about their balance sheets, they may dive into their mountain of excess reserves at the Fed and increase the volume of their loans and investments, which will add additional fuel to the fire breaking out because of increasing monetary velocity. How the Fed will resolve this dilemma I do not know. At present, the Fed’s managers talk as if the problem either does not exist or will be easy to deal with when the need arises, but such talk amounts to whistling past the cemetery.
The ratchet in the government’s outlays probably will not be eliminated in the near or intermediate term. The president, Congress, and the leadership of both major parties are firmly wedded to the government’s spending as much as it can get away with. Political leaders talk about reining the government’s profligacy, but their actions belie their words. Every cow in the budget turns out to be sacred when someone tries to wield an ax.
The prospect in the aftermath of the crisis—which, to be sure, is not yet over and may take a nasty second-dip before it ultimately passes—is for significantly bigger government in fiscal terms (and, as I shall argue elsewhere shortly, in regulatory, statutory, and ideological terms as well). Federal taxes may return to their postwar average of 18 percent of GDP, but with the federal government’s outlays stuck at 23 or 24 percent of GDP, we will have to endure deficits of 5-6 percent of GDP for a long time.
We will also have to endure a huge, ever growing amount of federal debt and, sooner or later, a grave threat that the Fed, in monetizing additions to the debt, will be unable to keep the lid on accelerating general price inflation. Therefore, probably the best we can hope for is stagnation: slow or no real economic growth, probably accompanied by chronically large numbers of unemployed and underemployed persons sustained in part or entirely at taxpayer expense. The worst outcome would be hyperinflation, which would be utterly ruinous. The most likely outcome in my view is for a long period of stagflation: little or no real economic growth, accompanied by troublesome (and probably quite variable) rates of general price inflation—something like the 1970s, though with less real growth. How this scenario fits into the currently more globalized economy is anyone’s guess. Much depends on how irresponsible foreign leaders will be in their policy actions—and we may count on most of them to be as horrible as possible. In these circumstances, Americans will have to put up not only with unsatisfactory performance of the economy, but also with great uncertainty about what the next quarter or the next year may bring. All in all, our most likely prospect seems fairly ugly, but with luck we may escape complete ruin.