Deficit spending isn't limitless, but it isn't constrained...
WITH 28 YEARS' experience in global financial market, Marshall Auerback has been an advisor to bond-fund giant Pimco and hedge-fund RAB Capital amongst others.
Now a senior fellow at the Roosevelt Institute, Marshall Auerback is corporate spokesman and a director at the Toronto-based Pinetree Capital. A "hedge fund economist", he believes the Gold Price is likely to remain rangebound in 2011, as he tells The Gold Report here. But – longer-term – the return of "casino capitalism" is setting the stage for new financial bubbles...
The Gold Report: Marshall, let's talk macroeconomics. You, like economist Warren Mosler, believe that government spending is not limited to how much a government can tax the population or borrow. Essentially, you believe government spending is limitless and that deficit spending ultimately creates jobs. Please explain how that works.
Marshall Auerback: That's a slight mischaracterization of our position. It's not so much that people like Warren, myself or some of these so-called "hedge fund" economists like Randall Wray or Jan Kregel, say deficit spending is limitless; we say deficit spending is not operationally constrained by any external or financial constraints.
We don't exist under a Gold Standard. Under the Gold Standard, your spending was limited by the gold in your central bank. If you started running low on gold, then the gold would start to leave the country. Interest rates would rise to attract additional gold inflows whilst higher interest rates would slow down domestic economic activity and thereby prevent overheating. Effectively, it would become a self-correcting mechanism.
That sounds wonderful except that it didn't deal adequately with the huge demand shocks of the sort that we had in 2008, the Great Depression in the 1930s, or several of the depressions that we had during the 19th century. Whereas, as far as government deficits go today, what we argue is that there are no financial constraints – there is a real resource constraint. In other words, inflation is the ultimate constraint.
We shouldn't be constructing fiscal policy with some sort of vague, undefined notion that it's fiscally sustainable. Nor should we define "fiscal sustainability" via some arbitrary number as Kenneth Rogoff and Carmen Reinhart have done in their recent book, This Time Is Different: Eight Centuries of Financial Folly, wherein they say if a debt-to-GDP ratio gets above 90%, then bad things start to happen. That's not an accurate way to look at it because you have to consider the economic context and the institutional arrangements governing the economy. A pure fiat currency regime, as we have in the US or Canada, for example, is vastly different than a country that operates a currency peg system, such as Latvia or Argentina in the 1990s.
The US also experienced six periods of depression that began in 1819, 1837, 1857, 1873, 1893 and 1929.Therefore, every significant reduction of the outstanding debt, with the exception of the Clinton surpluses, has been followed by a depression; and every depression has been preceded by significant debt reduction. The Clinton surplus was followed by the Bush recession – a speculative private debt-fueled euphoria – then the collapse wherein we now find ourselves.
The jury is still out on whether we might yet suffer another great depression. While I cannot rule out coincidences, seven surpluses followed by six and a half depressions (with some possibility for making it the perfect seven) should raise some eyebrows. And, our less serious downturns in the postwar period have almost always been preceded by reductions of federal budget deficits. This brings me back to an obvious point: the federal government is big – especially since WWII – and movements of its budget position have a big impact on the economy. That's the point we are trying to make.
Under the type of regime we have in Canada or the US, there is no inherent reason why any level of government spending should be fiscally unsustainable over a longer period. You have to look at the economic context; clearly, you shouldn't have deficits of the magnitude you have now when you have unemployment down at, say, at 3% or 4%, or if you've got a capacity-realization rate close to 90% or 95%.
Clearly, in these circumstances government spending should be reined in. In fact, it will be because tax revenues rise sharply, social welfare expenditures come down and deficits tend toward balance. This is exactly what happened during the 1990s. However, what we're seeing right now is that the private sector has demonstrated a large propensity to save and deleverage. That decision, in many respects, can be facilitated by the government running larger budget deficits. Absent that, you get 1930s-style debt deflation.
We also tend not to view government spending in isolation the way a lot of people do, but rather on a stock-flow, sectoral-balances approach. If you want government spending decreased, where are you going to get the offset? In other words, is the current account going to move into surplus (as is the case in Asia, for example), or are you going to start seeing private debt increase? Those are the kinds of variables one has to examine.
I think that the real central flaw in most macroeconomic analysis is it doesn't incorporate these sorts of accounting flows when considering government spending. Therefore, you get all sorts of misconceived policy approaches like you have right now across the globe.
TGR: Isn't your approach somewhat counterintuitive?
Marshall Auerback: It's counterintuitive to the extent that we normally compare government spending to household spending. People say we can't spend beyond our means, and that way of thinking fits into people's own intuitive experience. But you and I are not the same as a government. A government is a monopoly. It's controlling the currency. If you and I had printing presses in our basements and we were able to print $20,000 whenever we needed, we wouldn't be debt constrained in the same way that private businesses or individuals are today.
Clearly, a government is in a unique position because it's the only entity that issues currency and, in effect, creates new net financial assets. The household analogy breaks down because we fail to distinguish between users and issuers of currency.
TGR: But if you keep printing money you're going to devalue your currency and no one is going to lend you money.
Marshall Auerback: Not necessarily. That is another flawed argument. By definition, if you are the monopoly, then it's your currency. You don't need to have people lend you money. Again, this is a case where people have the causation wrong.
Consider the argument that one always hears about China "funding" our deficits because they buy our Treasury bonds. Okay, so China decides to sell us a billion Dollars' worth of T-shirts. We buy a billion Dollars' worth of T-shirts from China. And the way we pay them is somebody pays China. And the money goes into their checking account at the Federal Reserve. Now, it's called a reserve account because it's the Federal Reserve, and they give it a fancy name. But it's a checking account.
So we get the T-shirts, and China gets $1 billion in their checking account. And that's just a data entry. That's just a one and some zeroes. Whoever bought them gets a debit. You know, it might have been Disneyland or something. So we debit Disney's account and then we credit China's account. In this situation, we've increased our trade deficit by $1 billion. But it's not an imbalance. China would rather have the money than the T-shirts, or they wouldn't have sent them. It's voluntary. We'd rather have the T-shirts than the money, or we wouldn't have bought them. It's voluntary. So, when you just look at the numbers and say there's a trade deficit, and it's an imbalance, that's not correct. That's imbalance. It's markets. That's where all market participants are happy. Markets are cleared at that price.
Okay, so now China has two choices with what they can do with the money in their checking account. They could spend it, in which case we wouldn't have a trade deficit, or they can put it in another account at the Federal Reserve called a Treasury security, or bond, which is nothing more than a savings account. You give them money; you get it back with interest. If it's a bank, you give them money; you get it back with interest. That's what a savings account is.
The example here clearly illustrates that bonds are a savings alternative that we offer a Chinese manufacturer, not something that actually "funds" our government's spending choices. It demonstrates that rates are exogenously determined by our central bank – not endogenously determined by the Chinese manufacturer who chooses to park his Dollars in Treasuries (credit demand, by contrast, is endogenous).
So, in fact, the bond is offered as a Certificate of Deposit (CD) savings alternative. It's not actually used as a means of funding government expenditure. Bonds are also used to help drain reserves from the banking system. Because, as I said, government spending works toward increasing the amount of reserves in the banking system because when you spend, you credit the reserves into the banking system. If you want to drain those reserves for any particular reason, you issue a bond. People who buy the bond will have their bond accounts credited and their reserve accounts debited. Effectively, they're there as an interest rate maintenance operation or as a reward to enhance savings. But they are not necessarily there to fund.
TGR: If you were Ben Bernanke, what course would you chart for the US economy now?
Marshall Auerback: To me, the more important figure is not Ben Bernanke – it's US Secretary of the Treasury Tim Geithner. Monetary policy per se is a very ambiguous tool in terms of managing aggregate demand. Fiscal policy is more effective. The only thing I'd like to see Ben Bernanke stop saying is that we have to deal with the long-term deficit problems, because I don't think they are problems. I'd like to see government spending reach a point where we start seeing unemployment decrease substantially. If that starts to happen – surprise, surprise – the deficits will start to come down because tax revenues will increase. Social welfare payments will decrease and the economy would be on much sounder footing. I'd like to see a much more aggressive fiscal policy, but see it directed toward genuine job creation rather than a series of financial subsidies for zombie financial institutions.
TGR: John Williams of ShadowStats believes that true unemployment numbers in the United States are somewhere closer to 20%. Where do you peg unemployment?
Marshall Auerback: Williams could well be right. If you look at unemployment coupled with underemployment, you probably get something close to 16% under the so-called "U6" measure. Of course, that discounts the fact that a lot of people have just given up looking for work, so we could be closer to Depression-like levels.
TGR: He actually does take that into account...
Marshall Auerback: He does, but most conventional statistics do not. There are people between the ages of 55 and 65 who will likely never find decent long-term employment again. It's a tragic position. I don't see it getting sorted out given the current configurations of policy and the current political configuration in the US Congress.
TGR: You've penned a number of articles about the economic situation in the EU. In one entitled, The United States of Europe, or Full Exit from the Euro?, you discuss the growing disconnect between various EU countries and the possible end of the Euro as a currency. How is the situation in the EU with the Euro affecting the Gold Price?
Marshall Auerback: I think it has had a benign impact on the Gold Price in that we've got a situation wherein the very existence of a major currency union has come into question. I think a number of people have decided to Buy Gold as a consequence, as a kind of insurance policy. They've said, "We don't know if we're going to have a Euro. We don't know if we're going back to a debased drachma or a Portuguese escudo, so let's Buy Gold." It helps to create a marginal bid in the marketplace.
In fact, the overall macroeconomic backdrop has been very positive for gold in the sense that we've now destroyed the myth of the omnipotent central banker. I think a rising Gold Price is generally associated with a vote of no confidence in the official sector. There's also been concern about all this so-called monetary expansion being a precursor to some form of hyperinflation, which I think is highly misconceived. But all those things have helped gold in the short term.
TGR: What about inflation's impact on the Gold Price?
Marshall Auerback: I don't think inflation per se is a problem. Food and energy price increases have been significant and they are real. I'm not trying to diminish their importance; but in the absence of income and job growth, people have to heat their homes, fuel their cars and feed their families. That just means more discretionary income is tied up in those areas, which means less discretionary income for retail, restaurants, etc. I think the ultimate impact is deflationary rather than inflationary.
Also, the high rates of unemployment are not going anywhere. Labor has no pricing power. There's no generalized increase of consumer price inflation. As that perception grows, the marginal bid could be taken out of the gold market for a while, which is why I am cautious on the Gold Price short term.
In addition to that, there's a growing perception that the European monetary union countries are beginning to get their collective act together in dealing with this so-called solvency problem. If they do, that takes another marginal bid out of the gold market. In the short term, I think other commodity areas are more interesting than precious metals – notably the agricultural and energy sectors – and Pinetree is positioning itself accordingly.
TGR: In light of those thoughts, how do you see gold and silver performing in 2011?
Marshall Auerback: I think the Gold Price is actually going to be rangebound this year. Ultimately, I can see it going much higher because I think the response to these crises will be the creation of yet another financial bubble, which would enhance the value of gold. But right now, we're in this benign spot wherein we've got inflation, which looks to be under control, and the Eurozone doesn't look like it's about to blow up. It wouldn't surprise me if gold fell back to the $1100 level and consolidated for a while before it took off again. These things never go in a straight line.
TGR: What are those ranges?
Marshall Auerback: Let's say $1100-1450; that would be my guess, but it's not a house view. We have a very heterogeneous shop at Pinetree and I'm sure various people have different views.
TGR: Do you have any closing remarks you'd like to share with our readers?
Marshall Auerback: Well, I think we're building the conditions for a new bubble in a series of asset classes. I say that because we've got decent, but not booming, aggregate demand. We've still got high rates of unemployment, so pricing pressures are still fairly minimal. Corporate balance sheets are cashed up to a degree they haven't been in years and corporate profitability as a percentage of GDP is the highest it's been in years. But because the external environment is still relatively uncertain and companies are not inclined to invest substantially in their businesses, they will probably take a lot of that cash and buy back their shares. That's not a superb environment if the ultimate goal is see the unemployment rate go from, say, 10% down to 6%, but it's a very good environment for financial assets, so we could see a 25-30% move higher in the markets this year.
The other point I want to highlight is that so many CEOs and managers, with compensation packages that are largely predicated on stock market performance, are getting this "casino capitalism" behavior. By that, I mean the stock market is not used as a way to help finance productive assets; the market is just there to help improve a company's share price. In many instances, accounting approaches are there to flatter short-term earnings.
It's what my friend, Professor Bill Black of the University of Missouri at Kansas City, who gave testimony regarding the Lehman failure, calls "control fraud". I'm not saying all these companies are frauds, but that sort of thing often takes place near the end of a cycle. My guess is that it could be a fairly benign year for financial assets. I think we are setting the stage for a new bubble because, basically, we used the last crisis to re-establish the status quo rather than making structural changes that would make our economy more productive in the long term.
TGR: Thanks very much for your time.
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