The good news is the US budget deficit still looks to be plenty large to support modest top line growth.

And as the deficit continuously adds to incomes and savings, the financial burdens ratios continue to fall, and the stage is set for a ‘borrow to spend’, ‘get a job buy a car’, ‘it’s cheaper to own than to rent’ good old fashioned credit expansion.

But most all of that good news may already be discounted by the higher term structure of interest rates and the latest stock market rally.

And there are troubling near term and medium term risks out there that don’t seem at all priced in.

The rise in crude prices is particularly troubling.

Net demand isn’t up, and Saudi production remains relatively low.

So the Saudis are supporting higher prices for another reason. Maybe it’s the wiki leaks, or maybe they just had a bad night in London.

No way to tell, but they are hiking prices, and there’s no way to tell when they will stop.

Crude prices are already up enough to be a substantial tax on US consumers that has probably more than offset whatever aggregate demand might have been added by the latest tax package.

Might explain the weaker than expected holiday retail sales?

Congress will soon have a deficit terrorist majority, with many pledged to a balanced budget amendment.

And the world seems to be leaning towards fiscal tightening pretty much everywhere.

The unemployment benefits program has been extended but benefits still expire after 99 weeks, and less in many states.

Net state spending continues to decline as state and local govs continue to reduce their deficits and capital expenditures.

Catchup in the funding of unfunded pension liabilities will continue to be a drag on demand.

A federal pay freeze has been proposed.

The Fed’s 0 rate policy and qe continue to reduce net interest income earned by the economy.

Bank regulators continue to impose policies that work against small bank lending.

Seems some income has likely been accelerated into this quarter from next year over prior concerns of taxes rising, distorting q4 earnings to the upside and maybe lowering q1 earnings a bit?

Euro zone muddles through with very weak domestic demand, and curves perhaps flattening as markets start to believe the ECB will fund it all indefinitely?

China slows as a result of fighting inflation?

Same with Brazil?

Maybe India as well?

Commodity price slump with demand flattening?

Fed low forever?

Stocks in a long term trading range like Japan?

US term structure of interest rates gradually flattens to Japan like levels?

Relatively weak demand gradually brings on alternatives to over priced crude?

Merry Christmas!!!

15 Responses

  1. Warren,

    Firstly, Merry Christmas.

    I understand your 0 interest rate comment regarding the suppressed interest income earned in the economy but it also reduced the amount of interest expense paid as well. As someone who benefits from lower monthly mortgage payments last year and even lower this year from when I first took out this mortgage 6 years ago, I have benefitted tremendously via an extra $250/month to use towards balance sheet repair and consumption. If this low interest rate policy were effective on outstanding credit card balances rather than just mortgages, I’d have to imagine the stimulative effects (aside from write-downs and lower asset values on the side of investors holding those as assets) would be enormous. Where I am missing the point?

    Also, I tend to agree with Richard Koo in the respect that this is a balance sheet recession for the private sector where poor ALM has led to a fallacy of composition where everyone is trying to repair their balance sheets at the same time. My situation reflects negative home equity and reduced investment values (though these have recently been restored in terms of nominal values). My first priority aside from maintaining employment is to restore my balance sheet from the psychological relief it would bring alone. Then I will focus on buying more assets and increasing consumption. How does a near 0 interest rate policy not support this repair and deleveraging? It supports the asset side of balance sheets while reducing the real burden of the liability side in terms of lower debt servicing payments which directly improves real cash flow. This allows me to restore my balance sheet at a faster rate while not sacrificing as much consumption. Naturally I agree with your comments on fiscal policy as I need a government putting more money into this economy, taking less of it away from me, and supporting employment so that my ALM mismatch does not get worse from the shocks to the economy.

    Your thoughts and insights are always appreciated and I am very much grateful for your past and present commentary.

    1. first, thanks and same to all!!!

      yes, for every dollar borrowed there is a dollar saved, so the propensities are key, and, interestingly, last time I asked fed researchers about this they said they’ve been looking into it and find them to be about the same.

      additionally, however, the govt is a net payer of interest. hence the ‘fiscal channel’ of interest income bernanke, sacks, and reinhart 2004 discuss on the fed’s website.

      and yes, the problem this time has also been that rate cuts have transfered income from savers to banks net interest margins rather than to borrowers. this will adjust with time but it’s been the source of a drain in agg demand for at least a couple of years.

      But assuming propensities are about equal, as the fed researchers indicate, your 250 savings was matched by a saver getting that much less each month. (and even when a pension fund gets less and has no propensity to consume, it does need to raise contributions to keep up with the lower interest rates. and even with a defined contribution fund the employee is seeing his future benefits fall and may be asked for higher contributions due to lower rates.)

      the 0 rate policy reduces interest paid by gov to the non gov sectors.

      and it also scares savers into not spending. (like my parents)

      see ‘0 is the natural rate of interest’ on this website

      1. A few points in response:

        ‘and it also scares savers into not spending. (like my parents)”

        – I am 31 years old. I tend to believe I am more of an inflationary/consumption driver and threat than your parents. I could be wrong and this may be irrelevant anyway.

        – but it isn’t scaring savers into spending, is it? If it did, wouldn’t that be an argument in favor of a 0 interest rate policy, to force savers into spending?

        – we have actually seen savings increase. Sure, that is aided by government spending and an uncertain economic environment, but would these not be arguments comparable to the ones made (that I do agree with) regarding the inelastic demand for excess reserves? Isn’t the demand to save inelastic? This could also be a reason why high interest rate policies don’t seem to be muting inflation in various emerging markets (aside from attracting even more capital inflows)? I’d almost argue that the demand for savings is inelastic to a degree. Anecdotal, I know, but I am personally increasing my savings rate due to the economic uncertainty, as are many others I know, someone comparable to why banks may be holding excess reserves.

        – We know no matter what there is still an immense amount of outstanding deleveraging still to be done. This is inevitable that it will occur. Zero interest rates allow more cash to go towards addressing this inevitable deleveraging and less to debt servicing, the latter which only prevents more current and future consumption since those payments are all tied to money already spent.

        “yes, for every dollar borrowed there is a dollar saved, so the propensities are key, and, interestingly, last time I asked fed researchers about this they said they’ve been looking into it and find them to be about the same.”

        I don’t disagree with this but have the following replies:

        – The less I pay in interest, the less someone else is able to save, but the more I am able to consume, so someone gets that benefit anyway.

        – The more I pay in debt servicing, the more I pay for past and not current consumption.

        – Isn’t deleveraging, paying back credit money created debt a destruction of money supply? Doesn’t this go in line with Irving Fisher’s debt deflation theory? Isn’t this why we want a weaker USD to reduce the real burden of debt since for the private sector the nominal burden remains, even with reduced corresponding asset values, even if the holder of that debt took a write-down, not passing the benefit of that write-down until either actual default/restructuring occurs and/or payments are indeed made and a write-up occurs? I always viewed this as a form of ‘trapped’ economic benefit that is waiting for one of those events to trigger its release.

      2. Disregard the first two replies, typo filled which I cannot edit, my apologies.

        And I have read the Natural Rate of Interest, think it is fantastic. I agree with 99% of what you say, just some idiosyncracies I think that are illustrative of the unique nature of each type of recession.

  2. I just refinanced for the second time this year, and by my calculations I could now rent out my house for a profit. So maybe the buy/rent equation is turning around. And anyway, I now have $400 dollars more in my pocket each month.

    Merry Christmas, and looking forward to meeting you in the Center of the Universe next month!

  3. Congress will soon have a deficit terrorist majority, with many pledged to a balanced budget amendment.

    “deficit terrorist” is sort of a fluid concept.
    In the Clinton era, and then again in the Obama era, congressional Democrats operated under “paygo” rules. Paygo meant, quite simply, that each dollar of spending or tax cuts had to be matched by a dollar of spending cuts or tax increases… In the Bush years, Republicans didn’t use paygo at all…. But the Boehner Republicans just won an election by fretting over deficits. It would look sort of bad to repeal paygo on day one.
    So instead, they’re neutering it. House Republicans are adding it with something called “cutgo.” Under cutgo, tax cuts don’t have to be paid for, and spending increases can’t be offset by tax increases. The idea is that the only two things you can do are cut spending and cut taxes.

    Man, the Democrats are such a bunch of sad sacks. When they take power, the first thing they do is enact budget rules that handcuff their own fiscal policy. Then they get watch the Republican take power and enact their own budget rules… that handcuff, shackle and gag the Democrats’ fiscal policy, win-win!

    Merry Christmas everyone, and Jim Baird, if we never hear from you agan, its been a pleasure. Vaya con Dios. :o)

  4. Warren,
    Merry Christmas! I will soon send you the latest version (pre-release) of the paper with new features you might find useful

  5. Merry Christmas, Warren, and all. Started reading the site a few months ago and it’s changed my life. Keep up the great work.

  6. “US term structure of interest rates gradually flattens to Japan like levels?”

    I wouldn’t say that the term structure is flat in Japan, but rather that it is currently steep in the U.S. The spread between long and short rates is 2% in Japan, which is the historical average for the U.S. as well.

    Since the advent of CB rate adjustments to manage aggregate demand, you’ve seen larger spreads than you saw prior to this era (when the short term rates were lowered) as well as lower spread levels when the short term rates were increased, but prior to this era, a 2% spread was about average.

    1. If Coburn and crew get their way on imposing austerity, we will all be facing apocalyptic pain. Coburn should go back to being a physician.

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