It is, in many ways, the most important debate of our time. Should governments adopt a policy of austerity or should they try to spend their way out of debt?
Austerity or profligacy… that is the question. It is a complicated and difficult question, one that goes largely beyond my own education and training.
Yet, the debate bears an eerie resemblance to another one with which I am more familiar.
That would be the debate between repression and expression. Those who see increased government spending as the proper therapy for the debt crisis echo the notion that complete self-expression will ultimately be good for your health.
Austerity feels like repression. Profligacy feels like expression. According to our culture, the first is bad and the second is good.
I think it fair to say that most people have only the fuzziest notion of the realities of the current fiscal crisis.
If so, that suggests that they form opinions based on other considerations, namely those that involve cultural values.
As a nation, we no longer value thrift; we value conspicuous consumption.
If we do not have the money, we spend anyway because we have a line of credit. We might not know how we are going to pay off the cheap credit that the bank has graciously given us, but we have a childlike faith that someone, somewhere, at some time is going to come along and pay off our debts for us.
If no one will pay off the debt, we can declare bankruptcy, or default on our loans. This entails being frozen out of the credit markets, thus, being forced to live within our means.
If your lifestyle depends on your access to credit and you suddenly cannot get credit you will be forced to reduce your spending habits, drastically.
At the very least, this is painful. It can also produce self-discipline and lead to a re-establishment of your good credit and a somewhat different lifestyle.
Since our culture values people to the extent that they spend money and since it recognizes their social value in terms of the spoils the accumulate on their trips to the mall, most of us feel that living within our means will alienate us from friends and family and will cause a loss of status and standing.
Obviously, when you default on a loan, whoever loaned you the money will lose his investment. And that will affect his personal balance sheet. If he had been using the interest on the money he loaned you to sustain his own lifestyle, he will have to spend less, thus diminishing economic activity.
If the bank loaned you the money, the bank will be forced to write off the bad loan, thus to take a loss. When the next person asks for a loan the bank will refuse because it does not have the money on hand. If you use a credit line to run a business, and the banks cuts off your credit, you will no longer be able to buy materials, meet payroll, and so on. Thus economic activity will come to a halt.
The issues are easier to grasp in personal terms. They are far more difficult to grasp in terms of the world financial system.
On the side of profligacy we have Nobel laureate Paul Krugman and the voters of France. On the side of austerity we have Angela Merkel and famed Fed watcher James Grant.
Krugman has argued that austerity will produce a depression. If governments stop spending money government employees will lose their jobs, they will reduce their spending, and the economy will grind to a halt.
But, profligate spending only works as long as you can keep borrowing. The Krugmans of this world want rich governments to continue to ensure the liquidity of the credit markets, thus allowing poorer governments to avoid the dread austerity.
The alternative view says that profligate spending cannot last forever, that producing more worthless money will produce so much inflation that no one will want to lend money any more.
After all, why would you accept 5% interest over a year or two when you know that the currency will inflate at a 10% rate?
On April 28 James Grant went into the belly of an organization he has called “the vampire squid,” that is, the New York Fed, to offer his views on the dread deflation. Grant argued cogently that the alternatives are ill-defined. In truth, he said, profligate spending only produces a temporary inflation. In the end it produces the worst kind of deflation.
Anyone who thinks that the choice is between austerity and profligacy has gotten it grievously wrong.
Grant argued that profligacy was instrumental in producing the worst deflation, the deflation of asset prices.
Grant argued that there are two kinds of deflation. In the first, prices decline because business becomes more productive and efficient. Prices on computers and television sets, among other things, have become drastically cheaper over time.
And yet, since central bankers refuse to accept even this level of mild deflation, Grant adds, they “monetize assets and push down interest rates.”
This is like when the bank offers you money at 0% interest for a year. It feels like free money; you feel wealthier; you take the money and you buy something; you to pay up for your purchases because your enhanced credit line is making you feel especially flush.
Thus, merchants and other sellers can charge higher prices because people have access to cheaper credit.
Of course, the time will come—it always does—when the bills come due and the debt must be paid off. At that point, the consumer’s credit dries up and the bank is burdened with non-performing assets.
The result is a rush to sell everything and anything at the cheapest possible price… short sales, foreclosures. This produces the real deflation that Grant sees the Fed engineering.
Instead of waiting to be rescued by another Fed-engineered asset bubble, we should live within our means. For Grant that means a return to the gold standard.
In Grant’s words:
For reasons you never exactly spell out, you pledge to resist "deflation." You won't put up with it, you keep on saying—something about Japan's lost decade or the Great Depression. But you never say what deflation really is. Let me attempt a definition. Deflation is a derangement of debt, a symptom of which is falling prices. In a credit crisis, when inventories become unfinanceable, merchandise is thrown on the market and prices fall. That's deflation.
What deflation is not is a drop in prices caused by a technology-enhanced decline in the costs of production. That's called progress. Between 1875 and 1896, according to Milton Friedman and Anna Schwartz, the American price level subsided at the average rate of 1.7% a year. And why not? As technology was advancing, costs were tumbling.
Long before Joseph Schumpeter coined the phrase "creative destruction," the American economist David A. Wells, writing in 1889, was explaining the consequences of disruptive innovation. "In the last analysis," Wells proposes, "it will appear that there is no such thing as fixed capital; there is nothing useful that is very old except the precious metals, and life consists in the conversion of forces. The only capital which is of permanent value is immaterial—the experience of generations and the development of science."
Much the same sentiments, and much the same circumstances, apply today, but with a difference. Digital technology and a globalized labor force have brought down production costs. But, the central bankers declare, prices must not fall. On the contrary, they must rise by 2% a year.
To engineer this up-creep, the Bernankes, the Kings, the Draghis—and yes, sadly, even the Dudleys—of the world monetize assets and push down interest rates. They do this to conquer deflation.
But note, please, that the suppression of interest rates and the conjuring of liquidity set in motion waves of speculative lending and borrowing. This artificially induced activity serves to lift the prices of a favored class of asset—houses, for instance, or Mitt Romney's portfolio of leveraged companies.
And when the central bank-financed bubble bursts, credit contracts, leveraged businesses teeter, inventories are liquidated and prices weaken. In short, a process is set in motion resembling a real deflation, which then calls forth a new bout of monetary intervention. By trying to forestall an imagined deflation, the Federal Reserve comes perilously close to instigating the real thing.