Streetwise Professor

May 13, 2009

John Taylor: “The Government Did It”

Filed under: Commodities,Derivatives,Economics,Financial crisis,Politics — The Professor @ 9:02 pm

John Taylor of Stanford gave a very nice keynote speech at the FRB Atlanta Conference on Financial Crises & Innovation.   It was a very different speech than Bernanke’s, and much more critical of government as a cause of the crisis, and a potential source of systemic risk in the future.   Indeed, Taylor listed three major sources of systemic risk going forward that have been featured prominently on SWP as well:

·           Massive expansion of US government indebtedness.  Interestingly, Taylor said that “[t]here is certainly no  stimulus effect from such deficits, and they put a very heavy burden on the not so distant future.”  

·           A dramatic expansion of the Fed balance sheet, and serious questions about the credibility of any Fed promise to withdraw liquidity from the system, thereby leading to a substantial threat of inflation.

·           An undermining of the rule of law, primarily illustrated by the administration’s heavy-handed efforts to subvert bankruptcy law and debt contracts in the Chrysler case, as well as actions on executive compensation and forcing out CEOs.

I couldn’t agree more, obviously.   I think these are all major threats.   The first in particular is becoming greater by the day.   The second will become more acute as the Fed proceeds with various initiatives to acquire securities, thereby ballooning its already bloated balance sheet into the trillions, and as political pressures to avoid doing anything that could abort a recovery bias the Fed towards ease even if and when inflationary pressures become manifest.   The last is a new development, and it bears attention to see whether the government takes any further steps along this path.

Taylor’s overall theme was that massive government failure is a real possibility, and that government is a major source of systemic risk.   Agreed.   This is a message that bears repeating over and over again as regulatory and legislative nostrums are pushed in the coming months.

At today’s session, AEI’s Vincent Reinhart made a point that I’ve also emphasized on SWP.   I’ve said that the biggest lesson of the Great Depression is that people learned the wrong lessons from the Great Depression, and passed useless or counterproductive legislation as a result.   Reinhart said, in a similar vein, that the most important thing going on today is the battle over the narrative as to what caused the financial crisis, because that narrative will determine what policies are adopted going forward.   He stated that the narrative of the Great Depression was wrong, and that as a result the regulatory and legislative response was wrong too.   He fears that the emerging dominant narrative is similarly misguided, and will lead to similarly damaging results.

Taylor’s talk was an attempt to counter the conventional wisdom narrative, and advance a counter-narrative.   Sadly, I think that this is an uphill battle indeed.   But, as Reinhart says, it is a battle that needs to be fought.

As I was getting on the plane to come back home, a reporter sent me an advanced copy of a letter that Geithner has sent to Congress outlining plans for regulation of the OTC derivatives market.  That letter embodies a particular narrative that I believe is particularly, and perniciously, in error.  This illustrates the relevance of Reinhart’s point.  I will deconstruct that letter in detail tomorrow, time permitting.  



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  1. With regard to bullet point #1 above, I would be very interested in your take on the super-Keynsians like Warren Mosler. He comes from a very practical, real world angle it seems to me. I have been somewhat convinced but it could be that my lack of formal econ training holds me back. However, bloggers I respect like Winterspeak are also big fans.

    Deficit spending *enables* private savings
    It’s worth reiterating Mosler’s explanation of how Federal deficit spending enables private savings.

    1. The Treasury sells $100B of government bonds.

    2. Private sector bank balances go down by $100B to pay for those bonds.

    3. Private sector holdings of government bonds go up by $100B.

    4. The Treasury now spends the $100B it just raised by issuing debt

    5. Private sector bank balances go up by the $100B the Treasury just spent.

    So, net net, bank balances are exactly where they were before. The private sector holds $100B new Treasury debt, and the Government has funded $100B of public works (or whatever). The Treasury debt the private sector now holds is savings which pay interest, higher interest, than the bank liabilities (deposits) they held earlier. So private sector savings has gone up by exactly the amount the deficit has increased.

    When the Treasury issues debt, it does not finance the deficit, it just alters the term structure of money that’s out there, because you can either have the Government hold one of your dollars in an FDIC insured account, or you can have the Government hold one of your dollars in an equally zero-default treasury security. No difference, just a new term structure. The term structure is important in that bank deposits can sit at the Federal Reserve account and Treasuries cannot, so the Government issues Treasuries to drain reserves, and thus maintain a positive interbank overnight lending market. In a ZIRP situation (which we are currently in) I don’t see why the Government needs to issue any Treasuries at all, nor do I see why the Government cannot simply ran an overdraft at the Fed.

    Here is Mosler’s high level overview:

    Comment by Matt — May 13, 2009 @ 10:49 pm

  2. John Taylor certainly made three interesting points.
    But the first point is debatable.

    · ” Massive expansion of US government indebtedness. Interestingly, Taylor said that “[t]here is certainly no stimulus effect from such deficits, and they put a very heavy burden on the not so distant future.”

    Well, [t]here IS certainly stimulus effect from such deficits.
    Here is why.
    As everyone knows, new money is created with new debt.
    If a bank buys $1000 Treasury Bill, money supply increases by $1000.
    Now government has $1000 more than before.
    50% of it will be looted by democrats. Republicans, BTW, would loot much less.
    At least, they would build bridges to nowhere.
    Democrats will simply increase welfare and other parasitic communities.
    But the remaining 50%, hopefully – HOPEFULLY ! – will be spent on something useful.
    Production of something useful will create jobs.
    That is stimulus for the economy.
    Looks like John Taylor does not believe that democrats will spend money on anything useful.
    Well, he is entitled to his opinion.

    Now about “a very heavy burden on the not so distant future.”

    Nah… Let’s calculate future value of the present sum.
    Government borrows at very low rates.
    Those rates are lower than current inflation rate.
    Expected inflation rates are even higher than present inflation rates.

    The holders of Treasury securities are very likely to get a negative return, – if we take inflation to the account. In simple words, purchasing power of the income from Treasuries will be lower than inflation. Hence, lost of purchasing power.

    Looks like holders of Treasuries will pay the government for the right to hold Treasuries, not the other way around. Now here is the question.

    Where is “a very heavy burden on the not so distant future” ?

    Comment by Michael Vilkin — May 14, 2009 @ 7:51 pm

  3. Michael. It’s hard to keep up with your, uhm, original theorizing. And, to be honest, I don’t have time to respond in detail to all of your logical errors. So here, I’ll have to leave it at: As Milton Friedman said, the spending is the tax. Your arguments re Treasury holders suffering a loss just speaks to the distribution of the tax burden, not its size. And bondholders are people too.

    I’m sure you’ll disagree (which I might take as a compliment) with them, but my posts from earlier in the year on the stimulus address many of your arguments in some detail. Just search on “stimulus” or “Keynesian” and you’ll find the relevant posts.

    The ProfessorComment by The Professor — May 14, 2009 @ 8:05 pm

  4. Dear Professor, I do agree with you that spending is tax.
    But the point is that some spending might be very good.
    Military spending, for example.
    Military provides funding for high-tech research and development.
    Internet was born this way.
    We can not eliminate all taxes, can we?
    I’d agree that excessive spending is bad, and right now borrowing and spending look very much excessive. Well, democrats need to loot some green, and every country, as they say, deserves its government.

    Comment by Michael Vilkin — May 14, 2009 @ 11:35 pm

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