Free Market Showdown: David Frum Poses the Question; Here’s the Answer
Friday, 07/2/2010 - 1:51 pm by Marshall Auerback | 12 Comments
Marshall Auerback presents an alternative to free market ideology for Frum & Co.
Amongst conservatives, David Frum has the great virtue of intellectual honesty, which is why he is generally persona non grata amongst those seeking to curry favor with the Tea Party movement. But he’s right: “For those of us on the free-market side of the debate, the question is even more haunting: What’s our countervailing idea? And if our countervailing idea is tax cuts, what is our reply to the obvious rebuttal that the Bush tax cuts have been in effect through the whole of this crisis, seemingly without effect?”
We have often posed the same question to the deficit hawks and hyperventilating hyperinflationistas: you decry more “wasteful” government spending, more fiscal stimulus, so what is YOUR solution? Debt deflation a la the 1930s? Debt jubilee? Widespread debt restructuring in which bond holders take a hit?
Let’s be clear: The “free market solution”, to use Frum’s terminology, is basically deflation. If households attempt to net save by spending less than they are earning, and businesses attempt to net save (reinvesting less than their retained earnings), then nominal incomes and real output will be likely to fall. Money incomes and economic activity will tend to contract until private savings preferences are reduced (with essential goods and services taking up a larger share of household income as incomes fall), or until depreciation leaves businesses and households inclined to invest once again in durable assets. In the absence of any countervailing fiscal stimulus, common sense suggests that a drop in private income flows while private debt loads are high is an invitation to debt defaults and widespread insolvencies — that is, unless creditors are generously willing to renegotiate existing debt contracts en masse.
Now, I suspect that some of Frum’s fellow conservatives actually think this sort “cleansing” is good. They believe it on both moral and economic grounds. Maybe not all, but a number of the more extreme libertarians with whom I occasionally debate, actually embrace this argument. Fair enough. It’s not something I would advocate, but it has the virtue of being ideologically consistent with many of the tenets of a free market/libertarian orientation.
And to be fair to the libertarians who espouse it, they are undoubtedly correct in arguing that our persistent embrace of moral hazard over the last several decades (all in the cause of bailing out our reckless financial institutions) has put us in a much more tenuous position. Had we responded differently, say, to the Mexican debt crisis of 1995, or the failure of Long Term Capital in 1998, perhaps things wouldn’t have come to this pass. In the words of Hayek, attempts to combat the recession via the embrace of moral hazard has led to “malinvestment” — in the process delaying the necessary and painful process of adjustment (as well as setting us up prospects for even greater problems in the future).
Fair enough. That said, the consequences of embracing this extreme form of “austerianism” right now would be very unpleasant.
But Frum is right: if this is the optimal free market position, conservatives who embrace it ought to be honest enough to express it in the political arena and debate it openly. No more of these secret committees meeting with little or no public scrutiny (The Commission on Deficit Reduction is Exhibit A in this regard). And no more hypocritical lectures from Wall Street investment bankers, the crony capitalist welfare queens par excellence.
So Frum has posed the million dollar question to his fellow conservatives. Although the question wasn’t directed to me, let’s try to answer it from a progressive perspective.
Truth be told, our solution is not more of the same of what’s been on offer, a warmed over version of Rubinomics. The fiscal priorities of the Obama Administration have been horribly misplaced. Instead of trying to revive the productive economy, most of the recovery effort has consisted of cardio-pulmonary-resuscitation for Wall Street. Fearing what it might find if it actually examined the books of financial institutions in detail, the Administration put a select handful of them through a wimpy “stress test” after announcing that none would fail. Rather than closing massively insolvent institutions, it continued to allow them to operate “business as usual” and to cook the books to show profits so that they can pay out big bonuses to the geniuses who created the toxic waste that brought on the crisis. Not surprisingly, given their true underlying state, not many are keen to provide credit just now.
The short term palliative effects of the first stimulus package are wearing off; we are now back to confronting an economy where the underlying diseases remain unaddressed. If and when we finally overcome our obsession with arbitrary debt to GDP ratios, US government “borrowing needs”, “credit issues” and “interest rate risks”, we can focus federal government spending on programs which provide jobs and incomes that will restore the creditworthiness of borrowers and the profitability of for-profit firms.
Although Frum suggests that “the American federal government moves very slowly,” there are in fact ample stimulus programs that could take effect instantly. The only prerequisite is the necessity of government to start writing checks: Via revenue sharing with the states, the Federal government could ensure that no state and local government has to lay off a single worker or cut back a single existing program, which avoids big losses to communities and enhances the capacity of local government to fight recession. Add emergency revenue sharing to states and cities by picking up increased shares of Medicaid, (which has suffered drastic cuts in eligibility and coverage), and enables states to restore Medicaid benefits to more people, thereby furnishing some general household budget relief. Have government temporarily pay most of the cost of COBRA coverage for laid off people who lose their health insurance, and allow people over age 55 to buy into Medicare. Expand Unemployment Insurance to cover part time workers, extend eligibility period, and increase benefit levels. Roll back tuitions at state universities and community colleges, and increase Pell Grants — contingent on universities not increasing costs to students - -which enables young people to spend the recession in college rather than clogging unemployment rolls or graduating with huge debt burdens. Similarly, colleges are spared the need to cut programs and lay off people in a recession. Professor James K. Galbraith sets out some useful criteria for good stimulus:
1. Open-ended support for the current operations of state and local governments, for the duration of the crisis, including open-ended support for public capital investment. Basically all the resources being released from private residential and commercial construction should be taken up in public building, to the extent physically and organizationally possible.
2. Comprehensive foreclosure relief, through a moratorium followed by restructuring except in cases of demonstrable borrower fraud. There is no alternative to establishing a large retail-level agency to evaluate and restructure mortgages on a case-by-case basis.
3. Increased Social Security benefits, say by thirty percent, and a cut in the eligibility age of Medicare to (say) 55 years of age. The first of these measures would work to offset the cataclysmic drop in equity wealth of the elderly population as a whole, while favoring the poorer members of that population. The second would permit many older workers to retire, while freeing firms from the burden of managing employee health plans for older workers. Since the shift out of private wealth is likely to prove permanent, these increases in publictransfers to the elderly should be permanent as well.
4. A payroll tax holiday to restore effectively the purchasing power of working families. By setting the payroll tax rate at zero (and letting the government write a check to the Social Security Trust Fund for the uncollected sums), tax relief can be delivered at large scale and with immediate effect to the working population. Later, if growth resumes rapidly, this measure could be scaled back.
5. An energy program, under a long-term planning framework adequate to meet the climate crisis, but also sufficient in the near term to reduce demand for oil as the economy recovers and to quell speculation in the oil markets. This is necessary to prevent inflation of volatile commodity prices once the feedback loops start firing in an upward direction.
6. Programs, in the spirit of the New Deal, to hire people to do what they do best, including art, letters, drama, dance, music, scientific research, university teaching and the nonprofit sector, including community organization. (”A Critique of the Geithner Program”, Jan. 28, 2009)
And finally deploy government spending in a way which REDUCES unemployment, rather than arises as a consequence of it. We therefore suggest a new approach: a Job Guarantee Program. The U.S. Government can proceed directly to zero unemployment by hiring all of the labor that cannot find private sector employment. Furthermore, by fixing the wage paid under this ELR program at a level that does not disrupt existing labor markets, i.e., a wage level close to the existing minimum wage, substantive price stability can be expected. Other benefits could be provided, including vacation and sick leave, and contributions to Social Security and, most importantly, health care benefits, providing scope for a bottom up reform of the current patchwork health care system. As we have argued before, the Job Guarantee program should remain a permanent feature of our economy, in effect acting as a buffer stock to put a floor under unemployment, whilst maintaining price stability whereby government offers a fixed wage which does not “outbid” the private sector, but simply creates a stabilizing floor and thereby prevents deflation.
There are good ideas out there, but there is a distinct failure of political imagination and courage to implement them. With any hope Frum’s provocative article will spur a healthy discussion on the possible solutions, rather than a retreat to tired, discredited economic shibboleths.
Marshall Auerback is a Senior Fellow at the Roosevelt Institute, and a market analyst and commentator.
Great piece, Marshall. Thanks.
Posted by Joe Firestone | July 3rd, 2010 at 1:29 am
“The only prerequisite is the necessity of government to start writing checks:”
Are you going to guarantee 1 to 1 convertibility of these checks into currency?
What happens if the spoiled and rich no longer want to “play along” under these new conditons and demand higher intereset rates?
Posted by Fed Up | July 3rd, 2010 at 1:32 am
Hire hundreds of thousands of people (probably several million) to do energy audits of every residence and small business in the country, and finance through a govt-owned bank at guaranteed low rates any projects - no matter how small or trivial - that will pay off in five years at current energy prices.
At the same time, announce that all fossil fuels will be subject to increased taxes equal to $20 / barrel equivalent beginning January 2012, $30 in January 2013, $40 in 2014.
Immediate employment/skills effect, economy spends like crazy to save based on future costs, long-term structural deficit reduced (bond vigilantes will be happy).
Posted by GA | July 3rd, 2010 at 5:31 am
For fed up, I think you miss a few points. First, the Government “checks” are mostly not checks, but actual mark-ups to private accounts in banks. When they are checks, banks, as a practical matter will always accept them and when they clear, then the private accounts will be marked up in value, dollar-for-dollar. Finally, once accounts are marked up, money in those accounts is exchangeable for paper currency if anyone wants to carry around all that paper.
On the question of increasing debt from the increased Government spending, there is no problem because Government 1) can spend without funds to cover the spending and 2) can spend without later issuing debt or collecting taxes to cover the spending. Here is a provocative piece on the ability of Government to spend without issuing debt: http://neweconomicperspectives.blogspot.com/2009/11/memo-to-congress-dont-increase.html
Posted by Joe Firestone | July 3rd, 2010 at 10:03 am
Joe Firestone & Fed Up,
I think both of you are missing the real issue. The “proposal” described in the link is not a serious proposal but a facetious description of what is already happening. The point is, whether the Treasury issues debt or not is irrelevant, provided that the Fed stands ready to buy that debt (as it does now, in effect).
The problem is, what will happen when the recovery finally takes place? Suppose that, at some point in the future, banks begin to lend normally again, and the recovery proceeds to the point where we start to approach full employment. To put a lid on the recovery and avoid inflation, the Fed will do one of two things (and probably a bit of both): it will sell Treasury debt back into the market, causing a (possibly large) increase in the rates the Treasury has to pay for new borrowing, and, to prevent banks from lending too much, it will raise the interest rate it pays on excess bank reserves, which will also have the effect of increasing the Treasury’s borrowing costs. (Also, since the Fed’s profits go into the Treasury, any interest it pays on reserves is indirectly an expense to the Treasury, so when the Fed pays interest on reserves, it is just like the Treasury paying interest on T-bills.) It doesn’t really matter which of these two things the Fed does; they have essentially the same effect. If we were to suppose that, today, the Fed were to start financing government expenditures directly instead of having the Treasury issue debt, it would simply mean that the Fed will have to rely on the second option (raising the rate it pays on excess reserves) when the time comes for its exit strategy.
I would argue a couple of things that mitigate this issue, however. First, notwithstanding what many at the Fed have said, the right time for an exit strategy will not come until at least several years from now, and provided that the Fed is careful about how it eases into the strategy, and provided that the government is careful to pacify the bond market by keeping an eye on its long-term budget problems once the recovery starts to run its course, the exit should not be too expensive.
Second, the Fed does have a third option for its exit strategy: it can raise reserve requirements. Increased reserve requirements essentially amount to a tax on banks (and indirectly, on their depositors) — requiring banks to hold onto reserves instead of lending them at a profit. It has a couple of advantages over other taxes, though. First, it doesn’t require an act of Congress. And second, it doesn’t (if done at the right time) have a detrimental effect on the economy’s productive capacity.
Posted by Andy Harless | July 3rd, 2010 at 11:12 am
Andy,
1. The Fed is not buying Tsy’s to keep rates low, unlike the ECB. Go look at the Fed’s data–Tsy’s held are only $120B more than 1 year ago, and 1/4 of that is an offset to increased currency. And, if you go look at the past month, for instance, the Fed has purchased a total of about $150M only in Tsy’s, and ALL of those were of the inflation indexed variety. Indeed, the total holdings of Tsy’s stands at $776B as of the end of June, the SAME amount as of the beginning of the calendar year.
2. Interest rates on Tsy’s are low mostly because the current and expected fed funds rates are low. Certainly the Fed COULD target Tsy rates if it wanted to as you suggest they are doing now (operation twist, part II, as an earlier blog from Marshall and Rob Parenteau called it), but it has not been doing so.
3. No Fed exit strategy is necessary, as I explained here a year ago: http://neweconomicperspectives.blogspot.com/2009/07/loans-asset-purchases-and-exit.html
4. I hardly think that the policy recommendations put forth by Marshall and Jamie are anywhere near what is “currently happening.” Were you joking?
Posted by Scott Fullwiler | July 3rd, 2010 at 12:10 pm
Marshall,
Interesting post as always. I would argue that the types of policies you propose always make good sense in the teeth of deflation risk.
In 1998 it made perfect sense to bail out LTCM. In 2003 it made perfect sense to leave rates at 1% for a “considerable period”. In 2004-5 it was logical to raise them at a “measured pace”, for any other “exit strategy” risked stifling a weak recovery. Obviously, even that kid-gloves exit was a bad idea, and bailing out almost all of the fixed income markets in 2007-2008 was cookbook stuff. The exit of removing fiscal stimulus and QE in 2010 was a terrible idea. The inevitable jobs programs and monetization of structural deficits of 2011 will be good. The exit from those…
We know what the right policy is. But what is the right strategy? That’s a different question. Moral hazard is not a moral issue but an ecological one. We have “environmental disturbances”, and the government induces actors to increasingly adopt a dominant strategy (lack of insurance against tail risk). The lack of diversity makes us all more vulnerable to the next environmental disturbance. The stakes keep rising and rising. Where does it lead? I don’t hear that question being answered. (btw, Macroresilience Blog is great on these issues).
I am not a sociologist, but I will make one observation. Argentina went through myriad economic crises without the fabric of society breaking down. That fabric succumbed only when the government made a commitment that society universally put their faith in. The “dominant strategy” of holding wealth in dollar accounts and writing contracts in dollars suffused the web that linked individuals together. When the commitment failed, trust evaporated: crime and insecurity appeared as never before.
So many interventionist arguments, including Andy Harless’ above, depend on each crisis being but an accidental interruption in the workings of some great organic growth machine. If instead of “trend growth”, we have an economy that is propped up by larger and larger societal gambles, then “exit” always seems like a bad solution. So more gambles, until the limit of whatever resource (in this case faith in currency) is reached, and the system fails.
What I would love to hear is not what happens when your proposals succeed (the so-called “exit plan”), but what happens if they fail to spark sustained growth, again and again. Do the strategy’s benefits outweigh the risks? That would be an interesting discussion to have.
Posted by David Pearson | July 3rd, 2010 at 12:14 pm
Technical point:
Businesses may “net save” in national accounts terms by reinvesting less than their retained earnings, but they don’t net save in net financial asset terms. The latter is the MMT consistent meaning.
Businesses only net save in financial asset terms if net investment (gross investment minus depreciation) is negative.
Posted by anon | July 3rd, 2010 at 6:08 pm
David,
I will gladly have the discussion on my proposals’ potential failure, if we ever get to the stage where they have any likelihood of adoption. I am almost certain that they would be overwhelmingly more popular amongst the vast majority of Americans (minus the rentiers, of course) than the policies which were adopted by the Obama administration. Sadly, if one is to judge from today’s NY Times, even the so-called “political advisors” like David Axelrod, now embrace the hair shirt economics advocated around the globe. Obama and his fellow Democrats always manage to turn Bush disasters into their own: Social Security, Afghanistan, TARP.
Do we really have a two party system?
Posted by Marshall Auerback | July 3rd, 2010 at 10:16 pm
Marshall,
You underestimate your persuasiveness. I do think some form of monetization of structural deficits will be U.S. policy for the as far as I can forecast. Today it seems the deficit hawks are in ascendancy, but that is a function of coincidence. We happen to have undergone a decent inventory-led bounce spearheaded by now-waning fiscal stimulus. During that bounce, most of Washington convinced themselves that we will recover, and that our problems are therefore long-term in nature (the effect of debt and deficits). When the Administration argues that we are on the road to recovery, it is hard to also argue we risk having a second national emergency on our hands. As a result, they left themselves with no “Plan B” in the case of a double dip. A case of democrats being done in by their own spin, if you will.
Battling rising unemployment will pose a political challenge in the senate, but not an insurmountable one. Witnessing destitution makes for fear, and fear compels action. I share your cynicism about our one-party “crony state”, but I also think that, had Obama been elected in 1932, he would have been much more FRD-like. After all, even FDR tacked left in early 1933. The Democratic Party’s platform in 1932, endorsed by FDR, called for a balanced budget and a 25% cut in Hoover’s “reckless spending” policies. Obama is no FDR, but he will probably become more FDR-like.
Posted by David Pearson | July 4th, 2010 at 11:17 am
Great post, Marshall. I would be nice if these where the kinds of thing being debated instead of the “necessity” to adopt austerity either immediately (hawks) or eventually (doves). Nero is fiddling while Rome burns.
When you say, “That said, the consequences of embracing this extreme form of ‘austerianism’ right now would be very unpleasant,” you are downplaying the result, which would be more than “unpleasant.” People forget that the army was called out during the Great Depression to turn away the peasants marching on Washington with torches and pitchforks, and that an unsuccessful putsch was mounted against FDR, unsuccessfully. Deflation is nothing to fool with politically and socially.
Posted by Tom Hickey | July 4th, 2010 at 8:18 pm
And don’t forget a major increase in the Earned Income Tax Credit (while simultaneously increasing its “salience” be delivering it in weekly paychecks.
Posted by Steve Roth | July 5th, 2010 at 2:27 pm