How NOT to fix the Global Economy

Month in and month out I keep reading article after article on how to fix the global economy. Let's take a look at two of the recent ones.

Bloomberg is writing Dollar Slump Would Cause Global Economic Havoc, ADB's Ali Says.

Global leaders must find a way to unravel lop-sided trade and investment flows or risk a slump in the U.S. dollar that would create havoc for the world economy, Asian Development Bank Chief Economist Ifzal Ali said.

An international agreement along the lines of the 1985 Plaza Accord "on a bigger scale" is needed to unwind the imbalances that have resulted in the U.S. current account deficit swelling to a record $805 billion and surpluses in China, the rest of Asia and Europe, Ali said in an interview in Tokyo.

"A disorderly unwinding would play havoc not only with the U.S. but with the world economy," said Ali. "What we need is something like the Plaza Accord but on a bigger scale."

A slump in the dollar could prompt U.S. policy makers to raise U.S. interest rates, causing a decline in house prices to accelerate and curbing consumption among the heavily-indebted consumers who represent 70 percent of the world's biggest economy, Ali said. A subsequent slide in corporate investment would have a "chilling" effect on the global economy.

To avoid this, the decline in U.S. aggregate demand has to be as small as possible, growth in Japan and Europe needs to be sustained, consumption has to increase "appreciably" in China and investment has to go up in Asia, Ali said. A trade accord dismantling barriers to international commerce is also important he said.

The 1985 Plaza Accord precipitated an appreciation in the yen that eventually led to an asset bubble in Japan that burst in the early 1990s, leading to a 15-year period of lackluster growth during which the world's second-largest economy had three recessions.

"Japan took most of the brunt of the Plaza Accord," said Ali. "Obviously any such agreement needs to be a lot more sophisticated than that."

What should be obvious (but obviously isn't) is that market forces should be the driving force not "Plaza Accords". Undaunted by the complete failure of the 1985 Plaza Accord that led to "15-year period of lackluster growth during which the world's second-largest economy had three recessions", Ali proved without a doubt he has not learned anything from history by proposing a new accord that "needs to be a lot more sophisticated than that".

The very last thing we need is for "something like the Plaza Accord but on a bigger scale." Should such silliness be attempted, I confidently predict it will prove to be an even bigger flop.

Ali suggests "the decline in U.S. aggregate demand has to be as small as possible". Once again I disagree. With a negative savings rate for close to two years now, what is needed is a dramatic decline in U.S. aggregate demand. The longer we put that off, the worse everything will be in the end. Yes, this means a recession. Unfortunately we are at the point where a recession is sorely needed. It was the attempt to cut off a recession in 2002 that created the housing bubble. The malinvestments in housing have since skyrocketed.

Ali goes on to say "A trade accord dismantling barriers to international commerce is also important". That is about the only thing Ali said that is remotely correct. In reality, however, it does not take a trade accord to dismantle barriers. All it takes is the guts to openly embrace free trade.

The first country that openly embraces free trade regardless of whether or not anyone else does will be a big winner. Instead we see the EU and the US embrace all kinds of protectionist policies on agricultural goods, shoes, underwear, and literally countless other items. Are shoe or underwear tariffs going to bring back manufacturing to the US? At what expense? For the benefit of whom?

Height of Ridiculousness

The height of ridiculousness has to be trade agreements that force Japan to import rice even though its protectionist measures enable Japan to grow all the rice it needs. Please consider Mandatory rice imports pile up in Japan, raising storage costs.

Tuesday, October 10, 2006 at 13:20 EDT
TOKYO � The inventory of rice Japan has imported to fulfill a requirement under an international trade accord reached 1.8 million tons by the end of this August, entailing storage costs of 17 billion yen in fiscal 2005, agriculture minister Toshikatsu Matsuoka said Tuesday.

"How to draw down the inventory and reduce the storage cost is a major challenge for us so we hope to come up with some measures to whet demand for foreign rice," the minister of agriculture, forestry and fisheries told a news conference. The government has been encouraging use of imported rice in processed food so as not to dampen demand for domestically grown rice people eat as their staple food.

Storage costs are 17 billion YEN for rice in Japan! Am I the only one stunned by the stupidity of policies that mandate that? I could talk about trade policy for the next 10 pages and still not finish so I will simply suggest that waiting for an accord to fix trade problems is like Waiting for Godot, or as the bar sign says "Free Drinks Tomorrow".

Let's move on to the next article on How NOT to fix the Global Economy. Unfortunately this article has a very misleading title How to Fix the Global Economy.

The International Monetary Fund meeting in Singapore last month came at a time of increasing worry about the sustainability of global financial imbalances: For how long can the global economy endure America�s enormous trade deficits � the United States borrows close to $3 billion a day � or China�s growing trade surplus of almost $500 million a day?

These imbalances simply can�t go on forever. The good news is that there is a growing consensus to this effect. The bad news is that no country believes its policies are to blame. The United States points its finger at China�s undervalued currency, while the rest of the world singles out the huge American fiscal and trade deficits.

Nothing significant can be done about these global imbalances unless the United States attacks its own problems. No one seriously proposes that businesses save money instead of investing in expanding production simply to correct the problem of the trade deficit; and while there may be sermons aplenty about why Americans should save more � certainly more than the negative amount households saved last year � no one in either political party has devised a fail-proof way of ensuring that they do so. The Bush tax cuts didn�t do it. Expanded incentives for saving didn�t do it.

Imagine that the Bush administration suddenly got religion (at least, the religion of fiscal responsibility) and cut expenditures. Assume that raising taxes is unlikely for an administration that has been arguing for further tax cuts. The expenditure cuts by themselves would lead to a weakening of the American and global economy. The Federal Reserve might try to offset this by lowering interest rates, and this might protect the American economy � by encouraging debt-ridden American households to try to take even more money out of their home-equity loans to pay for spending. But that would make America�s future even more precarious.

There is one way out of this seeming impasse: expenditure cuts combined with an increase in taxes on upper-income Americans and a reduction in taxes on lower-income Americans. The expenditure cuts would, of course, by themselves reduce spending, but because poor individuals consume a larger fraction of their income than the rich, the �switch� in taxes would, by itself, increase spending. If appropriately designed, such a combination could simultaneously sustain the American economy and reduce the deficit.

At least there are a few points in the second article above that I can agree with.

1. These imbalances simply can�t go on forever.
2. No country believes its policies are to blame.
3. Nothing significant can be done about these global imbalances unless the United States attacks its own problems.

The question is what to do about them.

While it may be true that "No one seriously proposes that businesses save money instead of investing in expanding production simply to correct the problem of the trade deficit", the problem (whether anyone proposes it or not) is the second half of the sentence, "simply to correct the problem of the trade deficit".

The fact of the matter is the US is awash in overcapacity on both goods and services. Do we need more auto manufacturing, loan officers, homes built, Pizza Huts, or Home Depots? Again, the answers should be obvious. Adding to the worldwide glut by capacity expansion is simply wrong at this point in time. Businesses have been unwilling to expend their capital on more unneeded production (even as cheerleaders of all sorts have pressed for more expansion) . Unfortunately, however, corporations are blowing the pool of real savings in other ways including mergers, leveraged buyouts, and share buybacks at ridiculous prices.

The reason why "no one in either political party has devised a fail-proof way of ensuring that [people save more]" is simple. The policies of both the Fed and the US government have been asset based, speculation encouraging, "ownership society" claptrap, while doing everything feasible to destroy the US dollar (even to the point of threatening China with 27.5% tariffs).

Such policies encourage risk taking and speculation at the expense of savings. When those policies stop working, asset bubbles crash. The Housing bubble is in the early stages of a crash right now. It was a foolish attempt to rein in the Nazcrash, in conjunction with the ownership society and ridiculous credit expansion that allowed the housing bubble to get as big as it did.

The foolproof way to encourage more saving is in reality simple. Stop debasing the US dollar. In other terms, we do not need a "scheme" at all, just sound economic policy.

Siglitz solution to this mess is "expenditure cuts combined with an increase in taxes on upper-income Americans and a reduction in taxes on lower-income Americans. "

"Expenditure cuts by themselves would lead to a weakening of the American and global economy. The Federal Reserve might try to offset this by lowering interest rates, and this might protect the American economy � by encouraging debt-ridden American households to try to take even more money out of their home-equity loans to pay for spending. But that would make America�s future even more precarious."

I have to give Siglitz credit for refusing to blame China for all of our woes as many have incorrectly done. I also give him credit for understanding that wealth distribution is a massive problem, but his proposals seem to leave more unsaid than said.

For starters, I am wondering exactly how much and on who the burden of those tax hikes would fall. Where is the income cutoff? Siglitz did not say. Nor did Siglitz give percentages as to how much of this rebalancing should be based on tax policy vs. expenditure cuts.

Before attempting social engineering and wealth redistribution, shouldn't we first see how much can be addressed by cutting expenditures? Look at how much money we have blown in Iraq alone. 1/2 Trillion has been admitted and that does not count future medical liabilities of the wounded. Nor is an end in sight as the president blindly stays the course.

Medicaid is not allowed to bargain down costs. Drug imports from Canada are banned. How much of government spending is pure bloat? 1/4? 1/3? 1/2? 3/4? Even if the answer is on the lower end of that scale, logic should dictate that we start with waste before we start delving into massive wealth redistribution schemes. It should be free market forces that drive wealth redistribution, not massive error prone government policies.

The biggest problem I have with his proposals, however, is that they do not address how we got here in the first place. Unless and until we address the root causes of these global economic imbalances, it is futile to propose redistribution of wealth schemes to fix them.

Root Causes

• The Fed
• Government spending above tax receipts
• Unfunded future liabilities
• Fractional reserve lending
• Bad trade policies
• Bad policies in general

We can not dictate what other countries do so I am leaving foreign countries out of the equation. For similar reasons I do not wish to delve into a debate about returning to a gold standard. The above bullet points are things the US can address itself, right here right now.

Let's start with the Fed.

The Fed does not have control over money supply. For that matter the Fed does not really control interest rates either (except at the short end, and only if the market is willing to oblige). In fact, the Fed is not really in control of much of anything and Hussman talks about it in Superstition and the Fed and Independent Thought.

Although the Fed is not really in control, it can still do a great deal of damage to the economy by encouraging speculation and attempting to micro-manage short term rates. The Fed can encourage borrowing (by setting the FF rate below the real cost of money), but it can force not force borrowing to occur, nor can it dictate where that money goes if there is borrowing. On top of this all is the huge tendency of the Fed to overshoot in both directions contributing to disastrous serial bubble blowing.

We may not be able to fix the global economy ourselves, but we sure can fix our massive contribution to those imbalances.

How to Fix US Caused Imbalances

1. Over the long haul government spending needs to match tax revenues. I would start by cutting off all funding for Iraq, to be phased in over 1 year. This should be enough time to bring the troops home safely. I would also bring home all of our troops from Europe phased in over 3-5 years. Military spending would be cut in half over a period of years.
2. Rework the Medicare/Medicaid bill to allow for group bargaining.
3. Allow drug imports from Canada, the UK, the EU, Mexico, and Australia to reduce Medicaid/Medicare drug costs as well as costs for private citizens.
   
4. Phase out all tariffs and crop subsidies over 10 years. There is nothing magic about the number ten. Five, seven, or twelve might be better. If someone can justify a different number I am open to it.
   
5. Interest rate setting by the fed would go. The Fed does not know the correct "neutral rate" anymore than it knows the correct price of orange juice. Let the Market set interest rates.
   
6. One of the reasons the Fed is not in control of money supply is that credit dwarfs monetary pumping by orders of magnitude. One step in curing the problem is to eliminate fractional reserve lending (again over time) at perhaps 5-10% a year. To do that the Fed should gradually raise bank reserve requirements.
7. Currently a mammoth amount of credit is created out of thin air by the GSEs. GSEs should be eliminated as soon as possible, perhaps over a period of 3 years. In addition all government policies, including tax policies, that favor one asset class over another, especially homes, should be abandoned. One of the primary reasons homes are not affordable is 300 or so government programs designed to make housing affordable.
   
8. The Bankruptcy reform act needs to be rewritten. Credit card companies might be a lot more careful about who they lend to and how many credit cards they allowed if they bore more responsibility for their lending. Making people debt slaves forever as the current bankruptcy law attempts to do only encourages more reckless lending. As it sits, the current law is going to backfire big, in perhaps unknown ways when a credit contraction occurs.
9. As I said earlier, the first country that openly embraces free trade will be a big winner regardless of what any other countries do. Once again the shock effect of doing that all at once could be too great. But a phase out of ALL tariffs over a 10 year period would be a positive thing.
10. Scrap the Davis-Bacon Act on prevailing wages immediately. It's a real porker, especially in an age of global wage arbitrage.
11. Outlaw campaign contributions greater than $1,000.
12. Amend the constitution to allow Line item vetoes.

The above twelve points are really just a starting point for what needs to be done. Nonetheless they represent an enormous leap from where we sit now.

Would there be a great deal of pain associated with the above proposals? Yes, but in aggregate they would all make us more competitive in the global economy. Besides, there is going to be a great deal of pain anyway.

I keep returning to a favorite quote from The Wisdom of Ludwig Von Mises.

"There is no means of avoiding the final collapse of a boom brought about by credit expansion. The alternative is only whether the crisis should come sooner as a result of a voluntary abandonment of further credit expansion, or later as a final and total catastrophe of the currency system involved.

It is too late to stop the crack-up boom. We have already had two of them, with each bubble bigger than the one that preceded it: the Dot-Com internet bubble, followed by a global bubble in housing. How we address those bubbles may make the difference between a series of steep recessions over a number of years (starting now) or an out and out depression sometime later. The outcome is uncertain at this time, but the longer we put of addressing the real issues, the worse the ultimate medicine will taste.

Mish addendum:
The above article was posted on Whiskey & Gunpowder Wednesday afternoon. It was also the subject (among other things) on a HoweStreet podcast Wednesday evening. To hear the podcast please click on the above link and look in the left hand column. In general, it is Mish Wednesday on HoweStreet.

Apologies for the late notice but for anyone in the Chicago area I will be on a panel at The 30th Semi-Annual CHICAGO NATURAL RESOURCE CONFERENCE & EXHIBITION October 13th & 14th, 2006 at the Rolling Meadows Holiday Inn.

October 2006 Presenters:
HARD CREEK NICKEL, LOGAN RESOURCES, LARGO RESOURCES, ACSENDANT COPPER, ETRUSCAN RESOURCES, CANDENTE RESOURCE CORP, STERLING MINING, QUEENSTAKE RESOURCES, METALORE RESOURCES, MINERA ANDES, CRYSTALLEX, HOUSTON LAKE MINING, DOUGLAS LAKE MINERALS, CANACO RESOURCES, IGC RESOURCES, MAX RESOURCE CORP, FISCHER WATT GOLD, APOLO GOLD & ENERGY, AND KENRICH-ESKAY MINING

Other Panel Members:
Peter Grandich-editor THE GRANDICH LETTER
Dr. Mike Berry-editor mikeberry.biz
Jason Hommel-editor silverstockreport.com
Bob Moriarty-editor 321gold.com
Clyde Harrison-Brookshire Funds
Dave Skarica-editor Addicted to Profits

Please stop by if you can.

Mike Shedlock / Mish
http://globaleconomicanalysis.blogspot.com/