Wednesday, July 18, 2012

FINALLY - some one else notes what I've been saying for years: The Fed can't go broke, because it can legally counterfeit money (quantitative easing): There is little question that the States and the municipalities are experiencing a genuine funding crisis, but the crisis stems more from a delinquency of duty on the part of the Federal Government, and could easily be rectified if we were to disabuse ourselves of this ridiculous notion that the Federal Government, as a sovereign issuer of the currency, could ever face a solvency constraint.

Inside the Ravitch-Volcker Report on State Finances

Get Ready for Another Round of Deficit Hysteria


Warren Harding once said, “I have no trouble with my enemies. I can take care of my enemies in a fight. But my friends, my goddamned friends, they’re the ones who keep me walking the floor at nights!"  One can well sympathise with the deceased President every time a well-meaning committee of “responsible people” issue reports purporting to help solve our fiscal crisis.
The latest of these missives from the good and the great of American society is a report released July 17, 2012, from the State Budget Crisis Task force, chaired by Richard Ravitch and Paul Volcker.  As one of the few people to emerge from years of public service with his dignity and honour intact, Mr. Volcker in particular lends credibility to the idea that we are experiencing a genuine crisis in state and municipal finance, but unfortunately he (and the others) operate from a profoundly misguided paradigm, which will lead to “reforms” bound to make the crisis worse.
There is little question that the States and the municipalities are experiencing a genuine funding crisis, but the crisis stems more from a delinquency of duty on the part of the Federal Government, and could easily be rectified if we were to disabuse ourselves of this ridiculous notion that the Federal Government, as a sovereign issuer of the currency, could ever face a solvency constraint.  Governments across the world have inflicted so many self-imposed constraints on public spending, that it has become really hard to see the truth behind public spending, despite the fact that it’s really simple and easy to understand. Naturally, we tend think that a balanced budget, be it for a household or a government is a good thing failing to make a distinction between a currency issuer and a currency user.
So to discuss the Ravitch/Volcker report with some degree of perspective, it is necessary to make one crucial distinction, that between sovereign and non-sovereign countries (in the monetary sense). A country that pegs its currency exchange rate to another currency (or metal) doesn’t have monetary sovereignty as properly definedt; its domestic policy space is constrained by the necessity to maintain the peg. A sovereign currency is one that is not pegged; the government does not promise to exchange its currency to others at a fixed exchange rate. In that sense a sovereign currency is not convertible. The US, like many other developed and developing nations, has been operating on a sovereign monetary system ever since it went off the gold peg in 1973.
As the sole issuer of the unit of account we call “the dollar”, the Federal  Government could easily offset the crisis faced by the States via a per capita revenue sharing proposal.   Otherwise, the states, as users of currency, are in the same position as the various members of the Eurozone members. They are dependent on tax revenues and the capital markets for funding and when questions of solvency arise, then clearly they can be shutdown. This does in effect force cutbacks of the kind envisaged by the Volcker Ravitch report.
But the US government is not similarly constrained.  It is conveniently forgotten now by the very same deficit warriors who were fortunate recipients of bailout largesse in 2008 that there was never a shortage of cash when it came to the trillions devoted to bailing out the FIRE (Finance, Insurance, Real Estate) sector of our economy.   There was certainly no “fiscal crisis” looming for the most part in the mid-2000s either.  In 2005 tax revenues were humming, with a growth rate of 15% per year—far above GDP growth–hence, reducing nongovernment sector income—and above growth of government spending, which was just above 5%.
Such fiscal tightening invariably results in a downturn. When it came, the budget deficits increased, mostly automatically. While government consumption expenditures have remained relatively stable over the downturn (after a short spike in 2007-2008), the rate of growth of tax revenues has dropped sharply. Transfer payments, as expected, have been growing at an average rate of 10% since 2007. Decreasing taxes coupled with increased transfer payments have automatically pushed the budget into a larger deficit, notwithstanding the flat consumption expenditures. These automatic stabilizers and not the bailouts or much-belated and smaller-than-needed stimulus are the reason why the economy hasn’t been in a freefall a la the Great Depression. As the economy slowed down, the budget automatically went into a deficit putting a floor on aggregate demand.
But the spending was insufficient to create adequate demand to sustain full employment, particularly as the state and municipal level, where falling revenues did necessitate stringent cutbacks.  The Federal government, as the issuer of the currency, did not face a comparable constraint and therefore should have engaged in significant transfers to the states to ensure that state and local employment and activity was maintained during the crisis.
The problem is that the US government (at all levels) is deliberately undermining the growth of its own economy and destroying millions of jobs. In doing so it is worsening the problems associated with the ageing society. It is cutting vital state services, such as education, which are the one major source of future productivity growth for the nation. Skilled labor does not emerge from a schooling system being cut to threads by the mindless application of erroneous budget rules.
State and local government revenues cannot expand when their economies are stagnating or recessing. It is a myopic strategy to attempt to run budget balances by cutting spending in a downward chase of cyclically declining revenue. We have several years of data to confirm that proposition.   In fact, the monomaniacal focus on reducing budget deficits as proposed in the Ravitch/Volcker report tends to throw up a series of perverse policy responses, the oddest of which is that slashing government spending actually increases public deficits and debt. Why? Because when we cut government spending at a time of slowing or non-existent economic activity, the cuts exacerbate the trend. Tax revenues fall, social welfare expenditures (eg. unemployment insurance, food stamps, welfare – the things we call “automatic stabilizers”) rise and the overall deficit increases.
In the aftermath of the Great Recession of 2007, the U.S. government budget moved sharply to large deficits. While many attributed this to various fiscal stimulus packages (including bail-outs of the auto industry and Wall Street), the largest portion of the increase in the deficit came from what economists call “automatic stabilizers”—things like unemployment benefits that have to kick in when a downturn occurs. They had little to do with discretionary spending.
Since 2010, however, it is clear that the public sector overall acted in a counter-cyclical manner with respect to employment (the trough in total is less than the private trough) but has failed so support growth since that time.  Public employment in the US has been contracting overall since September 2010 – which is an astounding result given the extremely high unemployment in that nation.
To solve the state budget crisis, all that was needed was some responsible federal fiscal policy initiatives to buffer the declining state revenues and allow these non-currency issuing levels of government to maintain employment. The fact that the US government has largely failed to do that is an indictment of their fiscal irresponsibility, not those of the states and municipalities (many of which have also been victims of derivatives structures and deals – i.e., predatory finance – which played a significant role in the plight of some regions.
The pro-cyclical government cutbacks introduced by the states and municipalities have introduced a vicious circle of income loss, saving loss, wealth destruction, continuing real estate crisis, loss of state and local revenue, further cutbacks according to the application of their inappropriate fiscal rules (balanced budget amendments).
The pro-cyclical nature of state and local government employment is one of the principle reasons the US recession has endured and will ensure the long-term damage to that nation’s vitality and ability to provide high quality services to its people.
The reasoning in the public debate about the future consequences of government budget deficits is wrong-headed. The capacity of the US to provide for an ageing society amidst the long-term decline in its industry doesn’t depend on cutting in to public spending now – which is patently causing law and order to deteriorate, the standard of public education and health to slip.
Exactly the opposite response is required. Schools need to be revitalised. Communities need to be sure the streets are safe so that businesses will have an incentive to invest. People need to be mentally and physically well.
Let us start with honesty about budget deficits and government debt. There is no honest economic argument against running budget deficits when the economy is below full employment. While we can debate about which programs government ought to fund, and at what level, and about who ought to pay taxes, and how much, there is no legitimate concern about the size of the resulting budget deficit or growth of government debt.
Surely, in a democracy these spending and taxing issues should be decided by the voters, but in a process that is free of all the fear mongering about deficits. The Report here wishes to conceal the truth behind the deficit hysteria by ignoring that the Federal government operates under a very different set of constraints than the state and municipal governments.
MARSHALL AUERBACK is a market analyst and commentator. He is a brainstruster for the Franklin and Eleanor Roosevelt Intitute. He can be reached at