Tag Archives: Fiscal Policy

The Day Ahead in DC

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A true day of infamy!

Financial reform and fiscal policy…

9:45 am – President Obama speaks on fiscal policy. At the opening of the inaugural meeting of the National Commission on Fiscal Responsibility and Reform.

10:00 am – Permanent Subcommittee on Investigations hearing on the financial crisis. The hearing should run through mid-afternoon.

10:00 am – Fed Chairman Bernanke and OMB Director Orzsag testify on fiscal matters. At the first meeting of the president’s fiscal commission.

12:30 pm – Senate party conference meetings. Following last night’s Senate vote on financial reform, in which Democratic leaders failed to invoke cloture (i.e., close debate) on the question of whether to proceed with debating the bill, both parties must now decide how to proceed. Most observers expect that although Republicans opposed the bill last night unanimously, that unity may not last very long, as many members have a desire to eventually vote for some form of financial reform legislation. Republicans on the Senate Banking Committee and their staffs have been writing an alternative proposal to offer on the Senate floor, though when and even if that comes at this point is unclear. Senate Democratic unity was set back yesterday by one member, Sen. Nelson of Nebraska, voting yesterday with Republicans against moving forward. The ongoing discussions today, and partiuclarly the conference lunches at mid-day, will set the tone for the next steps in the process.

Afternoon – Vote on financial reform? Most observers expect Majority Leader Reid (D-NV) to call for another vote moving forward with Senator Dodd’s financial reform bill as soon as later today, potentially followed by yet another vote tomorrow if today’s vote does not hit the 60 votes required. Following the first cloture vote yesterday, subsequent reconsideration of that vote can be called for at any time.

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Richard Koo on fiscal policy and interest rates

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Met Richard years ago. Seems he’s still confused on fiscal policy:

Bond issues to fund capital injections will not lead to higher interest rates

Right! The CB sets rates. Too bad he didn’t stop here rather than try to explain the process.

Japan’s second round of capital injections was four times the size of the first, and some question the ability of US capital markets to absorb such a large emission of government debt. However, the 1989 S&L crisis demonstrated that funds raised for the purpose of rescuing the financial sector will not lead to higher interest rates.

True!

This is because, unlike fiscal outlays for public works, money spent to rescue the financial system does not reduce the amount of investment funds available in the financial markets.

Huh???

Assume, for example, that the government issues $100 of Treasury bonds to recapitalize a troubled bank.

And then makes a payment to the bank.

The bank receiving the capital injection would credit its capital account by $100 and then invest that $100. In effect, there will be $100 in the market to be invested regardless of whether the government issues debt to rescue the bank.

The $100 gets credited to the banks account at the CB. The bank can leave it there or look for alternatives.

Purchases of alternatives in the private sector cause the banks $100 to be ‘wire transferred’ to another bank.

That means the bank’s account at the CB is reduced by $100 and another bank’s account at the CB is increased by $100.

Because the $100 represents capital, the bank’s investment should be liquid and easily convertible into cash. The asset that best fills this bill is government securities

Ok.

If the bank decides to buy government debt with the money, the government will have another $100 to fund a capital injection.

I assume he means new government debt as he started with the government issuing $100 of bonds and recapitalizing the bank.

Two rubs.

First:

The government would only issue additional bonds if it wanted to (deficit) spend additional funds.

And it if wanted to issue bonds and (deficit) spend new funds, it would do so whether this particular bank wanted to buy the bonds or not. That is, the bank wanting to buy bonds is not the enabling force for (deficit) spending.

Second:

The sale of the original $100 of bonds reduced total bank reserves by $100 and the payment of the $100 to the bank added $100 to total bank reserves. So the initial bond issue and the recapitalization left bank reserves offset each other leaving total bank reserves unchanged. Institutionally, issuing new bonds starts a new series of transactions, and, again, that particular bank is not the enabling force.

If, on the other hand, the government uses that $100 to build bridges or roads, that money will leave the capital markets and be spent on wages or construction materials, producing a corresponding decrease in the amount of investment funds available.

I don’t follow this distinction at all.

In this case, as before, the Treasury borrowing $100 reduces bank balances at the CB by $100, and the Treasury spending $100 as above adds $100 to bank balances at the CB, leaving total bank balances (reserves) unchanged.

In short, money spent on public works projects leads to higher interest rates because it does not find its way back to the capital markets.

Not the case, interest rates go to where the CB sets them, one way or another.


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Posen on Japan and fiscal policy

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Adam is pretty much right on with this.

Perhaps more interesting is that the deficit terrorists at Peterson keep him on the payroll:

Must We Repeat Japan’s Stimulus Mistakes? (Answer: Not Necessarily)

by Gerald F. Seib

Feb 2 (Wall Street Journal) — Adam Posen, deputy director of the Peterson Institute for International Economics, agrees that Japanese mistakes in executing stimulus spending — perhaps most notably enacting tax increases rather than tax cuts along the way — prevented stimulus spending from hitting the real economy with full effect.

“Most of the time in Japan…they didn’t spend or stimulate even a fraction of what they announced,” he says. “Usually they either raised taxes at the same time they increased spending, thus defeating the purpose, or they promised projects that required state/local government matching funds that didn’t exist, so the money didn’t get spent.” That suggests Washington needs to be sure states don’t have to pull in their horns too severely to improve any package’s chances of success.

Perhaps most important in the long run, Mr. Posen says Japan’s stimulus spending, while it drove up short-term government debt, didn’t lead “to permanent increases in government programs or upward spirals in the debt level.”

The lesson for the U.S. now? “There is nothing inevitable about doing temporary spending that turns into automatic government creep and expansion in a lasting way,” Mr. Posen says.


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Re: Unilateral Fiscal Policy is more Beneficial than a Coordinated Response

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Dear Philip,

Yes, there is a general shortage of aggregate demand.

However, if any one nation uses a fiscal adjustment to restore demand it will be that much better off if the rest of the world does not increase its aggregate demand.

Fiscal adjustments, much like imports, provide benefits and not costs.

Any unilateral fiscal response will restore both domestic output and employment as well as increase imports from nations who continue to suffer from a lack of aggregate demand.

The idea that there is a need for international coordination is continued evidence of a lack of understanding of the world’s monetary systems.

All the best,

Warren

>   
>   On Thu, Nov 13, 2008 at 4:27 AM, Prof. P. wrote:
>   
>   Dear Warren,
>   
>   Many thanks.
>   
>   What you suggest is very true. But not just in the US. Here in the UK
>   and practically everywhere else in the world this is very urgent and a bit
>   overdue. Do you not agree? Would anything along these lines come out
>   from the meeting of the G20 over the weekend, I wonder.
>   
>   Best wishes, Philip
>   


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The upcoming fiscal policy changes

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Another possibility is the Fed doesn’t want to cut rates due to inflation risks, and might see a tax cut as sufficient potential
support for demand to allow them to not cut rates and instead address the inflation issue.

This would be based on the mainstream notion (not mine) that monetary policy is for inflation, while fiscal may function to shift demand from one period to another, depending on the degree of ‘Ricardian Equivalence.’ (The mainstream presumption that agents won’t spend extra income from a tax cut as they ‘know’ there will need to be a tax hike later to keep the budget balanced.) The mainstream (again, not me) would also be concerned that the higher govt. deficit would somehow ‘crowd out’ private borrowing. Nonetheless, the Fed does have reasonably strong empirical evidence for them to believe tax cuts do support demand in the short run.

The Upcoming Fiscal Policy Changes

by NewstraderFX

(Forex Factory) There’s a growing consensus among economists that changes in Monetary policy from the Fed will not be able to do enough by themselves to prevent the economy from going into a serious downturn and that a stimulus from a change in Fiscal policy will be required. The fiscal stimulus in this case will probably take the form of a temporary tax cut.

It’s very likely that the current meetings of the Presidents Working Group on Financial markets (a.k.a. the Plunge Protection Team) have been at least in part for the purpose of discussing the ways and means of how they will work and that the actual cuts themselves will be announced during the State of the Union address. It’s also very likely that momentum for this is going to be building in market participants and that just as with a change in monetary policy, the markets themselves will trade according to the ultimate outcome of whatever happens from a fiscal perspective.

Former Clinton Treasury Secretary Lawrence Summers has been talking about this since November. In his opinion, the economy requires between 50 and 75 $Billion in temporary tax cuts. Martin Feldstein of the NBER is also suggesting that due to entrenched problems in the consumer and banking sectors, monetary policy changes will not have the same “traction” and that “some kind of fiscal stimulus” is now required. There’s a precedent here as well: Bush made a temporary tax cut during the 2001 recession so it seems fairly certain he will want to use the same tactic again. However, the implementation of a fiscal policy change will likely be more difficult from a political perspective because things are very different this time around. Back in 2001, Congress was under Republican control so passing the tax cut was relatively easy. Now that the Democrats have control of the Hill, the actual passage could be far more difficult.

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Libor Settings, Eur, and UK leading the way lower…

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Currency TERM Today Monday Friday Thursday Wednesday Tuesday
USD ON 4.40 4.4175 4.3025 4.30 4.34 4.4325
  1M 4.94875 4.965 4.99625 5.0275 5.1025 5.20375
  3M 4.92625 4.94125 4.96625 4.99063 5.057 5.11125
EUR ON 3.8275 3.98875 3.85875 4.04625 4.055 4.05
  1M 4.58813 4.92375 4.93375 4.935 4.945 4.9225
  3M 4.84875 4.94688 4.94688 4.94938 4.9525 4.92688
GBP ON 5.5975 5.5975 5.600 5.60875 5.685 5.7000
  1M 6.49125 6.54125 6.5925 6.60375 6.74625 6.73875
  3M 6.38625 6.43125 6.49625 6.51375 6.62688 6.625

Seems coordinated – move working as expected.

The sizes should be unlimited- it’s about price and not quantity – the size of the operations doesn’t alter net reserve balances.

All they are doing/can do is offering a lower cost option to member banks, not additional funding.

Bank lending is not constrained by reserve availability in any case, just the price of reserves.

Bank lending is constrained by regulation regarding ‘legal’ assets and bank judgement of creditworthiness and willingness to risk shareholder value.

The Fed’s $ lines to the ECB allows the ECB to lower the cost of $ funding for it’s member banks. To the extent they are in the $ libor basket that move serves to help the Fed target $ libor rates.

Regarding the $:

As per previous posts, when a eurozone bank’s $ assets lose value, they are ‘short’ the $, and cover that short by selling euros to buy $.

The ECB also gets short $ if it borrows them to spend. So far that hasn’t been reported. There has been no reported ECB intervention in the fx markets, nor is any expected.

When the ECB borrows $ to lend to eurozone banks it is acting as broker and not getting short $ per se. It is helping the eurozone banks to avoid forced sales/$ losses of $ assets due to funding issues. If the assets go bad via defaults and $ are lost that short will then get covered as above.

‘Borrowing $ to spend’ is ‘getting short the $’ regardless of what entity does it. So the reduction in credit growth due to sub prime borrowers no longer being able to borrow to spend was ‘deflationary’ and eliminated a source of $ weakness.

The non resident sector is, however, going the other way as they are increasing imports from the US and reducing their deflationary practice of selling in the US and not spending their incomes.

Portfolio shifts- both by domestics and foreigners- out of the $ driven by management decision (not trade flows) drive down the currency to the point where buyers are found. The latest shift seems to have moved the $ down to where the the real buyers have come in due to ppp (purchasing power parity) issues, which means that in order to get out of the $ positions the international fund managers had to drive the price down sufficiently to find buyers who wanted $ US to
purchase US domestic production.

These are ‘real buyers’ who are attracted by the low prices of real goods and services created by the portfolio managers dumping their $ holdings. They are selling their euros, pounds, etc. to obtain $US to buy ‘cheap’ real goods, services, real estate, and other $US denominated assets.

Given the tight US fiscal policy and lack of sub prime ‘short sellers’ borrowing to purchase (as above), these buyers can create a bottom for the $ that could be sustained and exacerbated by some of those managers (and super models) who previously went short ‘changing their minds’ and reallocated back to the $US.

Seems US equity managers are vulnerable to getting caught in this prolonged short squeeze as well.

It’s been brought to my attention that over the last several years equity allocations us pension funds- private, state, corporate, etc – have been gravitating to ever larger allocations to non US equities, and are now perhaps 65% non US.

This is probably a result of the under performance of the US sector, and once underway the portfolios are sufficiently large to create a large, macro, ‘bid/offer’ spread. The macro bid side for the trillions that were shifted/reallocated over the last several years was low enough to find buyers for this shift out of both the $ and the US equities to the other currencies. And the shift from $ to real assets also added to agg demand and was an inflationary bias for the $US.

Bottom line – changing portfolio ‘desires’ were accommodated by these portfolios selling at low enough prices to attract ‘real buyers’ which is the macro ‘bid’ side of ‘the market.’

When portfolio desires swing back towards now ‘cheap’ $US assets and these desires accelerate as these assets over perform they only way they can be met in full is to have prices adjust to the ‘macro offered side’ where real goods and services, assets, etc. are reallocated the other direction by that same price discovery process.

more later!

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