Is there anything to debate?

Austerity vs Stimulus.

The debate on financial TV and in the blogosphere continues.

Paul Krugman warns that without massive new stimulus funds we will slip into another Great Depression (the third for those keeping count, after the Panic of 1873 and the Crash of 1929).

The pundit from Parliament, Garth Turner, says "not a chance" and suggests a prolonged, significant recession and deflationary times lie ahead - but no Great Recession.

Back on October 1, I spoke about a period of deflationary times and noted "If deflation takes hold, the stock market will suffer a massive correction, tons more businesses will fail and unemployment will skyrocket beyond what are already substantial highs."

As the stimulus winds down those exact fears are now being expressed. It's a fascinating period of time to be alive. But will events play out that way?

For years economists have had a great philosophical debate about the 1929 Great Depression. Federal Reserve Chairman Ben Bernanke, a self-proclaimed student of the era, has written that it was the Federal Reserve's fault that the 1929 Great Depression took hold because of the way the Fed allowed the money supply to shrink. In fact, Bernanke even apologized on the part of the Fed for “causing the Great Depression.” Bernanke wrote a famous piece explaining that the Fed has a magic instrument, the ability to print money, and that if it were ever necessary he would drop this Fed-created money to the American people from helicopters. With his magic power, concluded Bernanke, there was no way the US could slide into another Great Depression.

Now... two years into the 2008 Financial Crisis, Bernanke has left interest rates at zero, printed over two trillion 'dollars' and backed billions of dollars in stimulus plans. What does he have to show for it? Unemployment remains high, housing stays in the dumps and the national debt has sky-rocketed beyond all reckoning.

So will Bernanke now shift direction? His entire raison d'etre is wrapped in stimulus approach.

While the Austerity camp maintains that what needs to happen is a period of recesssion/depression to consolodate 65 years of unbridled debt expansion... and with US debt levels now pushing above 90% of GDP... is there any question about what Bernanke will do next?

Does anyone think the US Administration will give up and instruct Bernanke to allow the forces of deflation and correction to express themselves?

Does anyone genuinely think Washington will accept a long, drawn-out recession or another Great Depression as the solution to their problems?

Bernanke will do what he has always said must be done. He will do what he has staked his professional reputation on... he will try to print America out of the recession.

And as the individual states, 46 of which are in dire financial shape, slip into insolvency and need to be bailed out... as the burden of social security and medicare encompass and suffocate budgets... people will say Europe is financial kindergarten compared to what's coming for the North American economy.

Austerity? From Bernanke and the American government?

I don't see how anyone could really be unclear on what steps will be taken next.

Which brings us to historian Niall Ferguson. In an interview with Bloomberg TV's Erik Shatzker, Ferguson discusses the bond vigilantes,

"Bond vigilantes are a bit like the people short selling investment banks a couple of years ago. You start with Bear Stearns and Lehman Brothers, you don't get to Goldman Sachs until quite late in the game. In a way the sovereign debtors of the western world are pretty much in that position today. And we are working down the list, starting with Greece, moving on to Spain and Portugal, the UK dodged the bullet by implementing some preemptive measures. Sooner or later the bond vigilantes will get to the US, I don't think it will be this year, but in the absence of any political will to address this problem, this is simply an inevitability."

As to why it is inevitable, Ferguson observes the case of the UK which was the only country in history to manage to grow its way out of a massive debt load:

"Britain after 1815 had two big advantages, it had the only the industrial revolution at that point that was going on in the word and had the world's biggest empire. I don't see anyone in that happy position today."

The outlook:

"Is it going to be inflation or is it going to be default. Right now there is no sign of inflation. We have monetary contraction at an alarming rate, and zero inflation in terms of core CPI, so the option of inflating this debt away doesn't seem to be there right now. What you are left with is therefore default. And I think it is a fair bet that US will default at least on the unfunded liabilities of Social Security and Medicare at some point in the foreseeable future. What the Greeks discovered you are fine until you are not fine with the bond market and if you have a non-credible fiscal strategy of borrowing a $1 tillion a year for the rest of time, never ever again running a balanced budget, at some point the markets are going to get spooked, and I think that point is nearer than Paul Krugman believes. Nothing would spook the markets more than for Paul Krugman's advice to be accepted by the Obama administration. That might well be the trigger."

Interesting times indeed.


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Austerity? Enter Helicopter Ben.

As I said yesterday, a battle is brewing between those who believe in stimulus and those who argue for a return to austerity.

In several articles for his New York Times column, Paul Krugman has argued that those who push for austerity in the face of recession are either doing so for political expediency or out of a “crazy” fealty to archaic economic views. Krugman believes the trillions of dollars worth of deficit spending unleashed by the United States and European governments in the last 24 months is inadequate. He believes our only remedy is to spend more – no matter how much debt results.

Reading straight from the Keynesian playbook, Krugman argues that cutting government spending now will simply send the economy back into recession. He asserts that by flooding the economy with money, i.e. “stimulus,” governments can encourage consumers to spend. Once the spending creates better conditions, so the argument goes, the economy will be better positioned to withstand the spending cuts, tax hikes, and higher interest rates necessary to address the staggering deficits left behind.

Curiously the person leading the banner for a return to austerity is the recently reformed former Fed Chairman Alan Greenspan. In a recent Wall Street Journal editorial, Greenspan argued that the best economic stimulus would be for the world’s leading debtors (the United States, UK, Japan, Italy, et al) to rein in their budget deficits. Greenspan explains that because lower deficits will restore confidence, diminish the threat of inflation, and allow savings to flow to private-sector investment rather than public-sector consumption, the short-term pain will lead to gains both in the mid and long-term. Rather than redistributing a shrinking pie, this approach allows the pie to grow. Greenspan’s view has been echoed loudly in the highest policy circles of Berlin, Ottawa, Moscow, Beijing, and Canberra.

But while Alan Greenspan may have had a profound conversion, current Fed Chairman Ben Bernanke has not.

Insiders suggest that Bernanke is waging an epochal battle behind the scenes for control of US monetary policy, struggling to overcome resistance from regional Fed hawks for further possible stimulus to prevent a deflationary spiral.

Fed watchers say Bernanke and his close allies, key members of the five-man Board, are quietly mulling a fresh burst of asset purchases, if necessary by pushing the Fed's balance sheet from $2.4 trillion (£1.6 trillion) to uncharted levels of $5 trillion.

The dispute has echoes of the early 1930s when the Chicago Fed stymied rescue efforts.

"We're heading towards a double-dip recession," said Chris Whalen, a former Fed official and now head of Institutional Risk Analystics. "The party is over from fiscal support. These hard-money men are fighting the last war: they don't recognise that money velocity has slowed and we are going into deflation. The only default option left is to crank up the printing presses again."

Mr Bernanke is so worried about the chemistry of the Fed's voting body – the Federal Open Market Committee (FOMC) – that he has persuaded vice-chairman Don Kohn to delay retirement until Janet Yellen has been confirmed by the Senate to take over his post. Mr Kohn has been a key architect of the Fed's emergency policies. He was due to step down this week after 40 years at the institution, depriving Mr Bernanke of a formidable ally in policy circles.

"The US recovery is in imminent danger of stalling," said Stephen Lewis, from Monument Securities. "Growth could be negative again as soon as the fourth quarter. There is no easy way out since fiscal stimulus has already been pushed as far as it can credibly go without endangering US credit-worthiness."

All these developments have prompted the Royal Bank of Scotland's credit chief Andrew Roberts to warn RBS clients to prepare for 'monster' money-printing by the Federal Reserve.

"We cannot stress enough how strongly we believe that a cliff-edge may be around the corner, for the global banking system (particularly in Europe) and for the global economy. Think the unthinkable," Roberts said in a note to investors.

Societe Generale's uber-bear Albert Edwards said the Fed and other central banks will be forced to print more money whatever they now say, given the "stinking fiscal mess" across the developed world. he said.

In light of all of this... is it any wonder people are concerned for their financial future?

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Crossroads

So the OMG-20 confab is over.

And the world leaders have had a chance to reflect on the situation in the Western world's economy.

For the last two years the economic policy of the West has been all about preventing deflation and curing recession by pouring vast amounts of public money into the system in a belief it would ignite a new era of prosperity.

It hasn't.

At best the economy of the West has merely muddled along.

Of course this isn't the way it was 'supposed' to play out. Usually 'stimulus' applied after a steep recession leads to a snappy recovery, like it did in 1983-84 after the Reagan tax cuts.

But as I have said on numerous occasions, we still do not fully appreciate the depth, breadth and scope of the 2008 Financial Crisis. A deep economic earthquake has occurred. And the full reprecussions are still not appreciated or understood.

Do you remember when the West started pouring money into this?

Under George W. Bush, Congress was told that a "timely, targeted and temporary" spending program of $150 billion was urgently needed to boost consumer "demand".

When the Democrats assumed control in Congress, they continued with the idea.

And the stimulus produced a slight increase in GDP growth in mid-2008, but it didn't stop the financial panic and second phase of recession.

That lead to the second round of "stimulus". $862 billion worth in February 2009. At the time a pair of White House economists famously promised that this spending would keep the unemployment rate below 8%.

It didn't.

The US jobless rate is still 9.7% and the GDP estimate for first quarter growth has been reduced again, this time to 2.7%.

And what do the Americans want to do now?

Why... more 'stimulus', of course.

The problem is the Western world's Keynesian political consensus is falling apart.

In Europe, the bond vigilantes have attacked the finances of Greece, Portugal and Spain, with Britain and Italy next in line.

Politicians are scrambling away fromt the 'stimulus' mindset to one focused on cutting spending and raise taxes.

Britain has introduced an austerity budget and Germany's Angela Merkel sees vindication for keeping her country's stimulus far more modest than other Western nations.

In America many Republicans and Democrats are rebelling against a third round of stimulus. The original White House package of jobless benefits and aid to the states had to be watered down several times, and the latest version failed again in the Senate late last week.

Some will argue that the world has now reached a Keynesian dead end.

But other's suggest the spending/debt party may have only just begun.

More on that tomorrow...

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