The Song Remains The Same: Too Much Money At The Top of The Economy
Last year I was of the school that asserted oil prices were a macro- not micro- problem. That is, it was too much money speculating in oil, and not demand. It wasn’t that demand wasn’t outstripping supply, but neither was it the case that we had reached the point were supplies were so squeezed as to justify prices. The prevailing public view was that it was supply and demand for oil; when in fact, it was demand for parked money. This year there is no such choir saying oil supply and demand as spot prices for oil hit $66 dollars a barrel. Everyone knows that money is rushing into oil, ahead of an expected economic rebound later this year. Since no one has good futures, and because last year they were running over 100 dollars a barrel, more buyers are being forced to the spot market.
This dynamic is unchanged since 2004: no one knows what will lead the recovery, but everyone knows it will involve burning more oil. So buy oil. What is important, is that this creates competition for short term and long term treasury bonds. The reason for the collapse of Treasury Rates, was there was no place else to park money. Not in CDs, not in oil, not in futures, not in corporate bonds. So money poured into treasuries, creating a very short term pot of money. The stimulus and TARP fights were really about how to spend this money. Mostly it was spent on bailing out banks; some of it went back as inflationary tax cuts, which became corporate profits, as was predicted. A small amount went to prevent states from raising taxes, and a few droplets went to some actual counter-cyclical spending. That time, as predicted, is now past. That money can now be parked in places other than government bonds, at a higher yield, but backed by the government; so, in effect, government bonds, it will go there.
A month ago Mr Krugman and I sat on a panel convened in New York to discuss the financial crisis. I made the point that “the running of massive fiscal deficits in excess of 12 per cent of gross domestic product this year, and the issuance therefore of vast quantities of freshly-minted bonds” was likely to push long-term interest rates up, at a time when the Federal Reserve aims at keeping them down. I predicted a “painful tug-of-war between our monetary policy and our fiscal policy, as the markets realise just what a vast quantity of bonds are going to have to be absorbed by the financial system this year”.
De haut en bas came the patronising response: I belonged to a “Dark Age” of economics. It was “really sad” that my knowledge of the dismal science had not even got up to 1937 (the year after Keynes’s General Theory was published), much less its zenith in 2005 (the year Mr Krugman’s macro-economics textbook appeared). Did I not grasp that the key to the crisis was “a vast excess of desired savings over willing investment”? “We have a global savings glut,” explained Mr Krugman, “which is why there is, in fact, no upward pressure on interest rates.”
He, and people like Robert J. Barro are part of what can be called "the Treasury School" looking at this crisis: government debt crowds out private investment; with a great deal of government debt, interest rates must rise. However the reverse is the case: parking is crowding out public investment. No good is coming of rising oil prices, other than to restrain already muted demand at a very high cost. There is no exploration being done that would not have been done, largely because there are few places to explore except at high cost.
The "Treasury School" is not a liberal versus conservative argument, there are people on the left who see matters the same way. Likewise, the "Central Bank School" is not a liberal or conservative position either. The central bank school says essentially that prices are too high; that there are excess profits being converted into excess savings; but allowing deflation would be catastrophic. Therefore, the government can soak up the excess savings by spending without altering the actual economy. Bernanke, Summers, Krugman all hold one version or another of this view. This is the "Savings Glut" theory.
However, there is a third viewpoint. In this view, the functioning of the credit bubble has created a vast explosion of dislocation. Prices are wrong throughout the economy, and in a variety of ways. This viewpoint is also not liberal or conservative, it has both liberal and conservative versions, which is why the bill to have greater Federal Reserve Accountability is attracting bi-partisan support. The most visible adherent of this view is Nouriel Roubini, but it includes James K. Galbraith and many others. In this view the fundamental supply and demand loop is broken, and the fundamental means of price setting are broken. "Price Discovery" is not being allowed to happen, because of the carnage it would create; and therefore the economy will remain paralyzed.
Krugman argues a more sophisticated version of the savings glut at this point, saying that the problem is that the mechanism for converting savings, that is risk averse excess profit, into investment, that is risk seeking demand for new production, is broken. However, this mechanism was not a problem when the "savings glut" theory was advanced; and moreover, it was advanced by Bernanke, who had some ability to do something about it, but did not.
The upshot is now that money can rush back into oil, and into stocks, the cost of public borrowing long term must rise. It’s a matter of supply and demand. Previously the supply of safe places to park money was limited, and now it is not. The very decision to put rebound ahead of restructuring is closing the window of change. We are, in essence, right back to where we were before the credit explosion — around 2004 or so — ready to charge up the same hill of loose money from the central banks; going into rent seeking parked money; and choking of expansion, wages, employment, and capital formation beyond offshoring of old capital to lower wage and benefit areas. There is an immediate need for a second round of economic policy, one which actually sits in Congress by another name: the energy bill which is proposing, not "cap and trade" since 85% of all the allowances are to be given away, but "a new NIRA," that is a massive industrial policy based on specific regulation.
More on that, next week.