Tuesday, August 24, 2010

The Myth of the “Credibility of Markets”

by Marshall Auerback...

It is time to distinguish between the truths and the myths propagated by Wall Street.

A few days ago, I wrote a piece suggesting that President Obama’s attack on the proposed GOP threat to Social Security masked a more fundamental threat posed by members of his own party. Sadly, this analysis appears to be confirmed today in Mike Allen’s politico playbook:

“–ADMINISTRATION MINDMELD: The virtue of action on Social Security is that it demonstrates the ability to begin to affect the long-run deficits. Social Security isn’t the biggest contributor to the problem - that’s still health-care costs. But it could help a little bit, buy time, and strengthens the odds of a political consensus behind other spending cuts or tax increases. Most importantly, it would establish more CREDIBILITY with the MARKETS. The mood of the world at the moment (slightly excessive, from the administration’s point of view) is that if you don’t do anything with spending cuts, it doesn’t get you credibility.” (My emphasis).

This, in a word, encapsulates the Administration’s perverse Wall Street-centric thinking. Credibility with the American people takes a back seat to this amorphous concept called “the markets”, and the corresponding need to maintain “credibility”.

But how are we to divine the true aspirations of the markets? Is this really a legitimate basis for government policy? Private portfolio preference shifts (which are manifested daily in the capital markets) are probably the area least amenable to economic analysis. There are no cookie cutter models here (and economists LOVE models).

Consider the case of a currency: How does one respond to a weaker currency? The conventional response seems to be, “Raise interest rates and eventually you’ll re-attract the capital because you will re-establish ‘credibility’ with the markets”. That was essentially the IMF advice to East Asia in 1997. But, as that experience demonstrated, sometimes raising rates can actually trigger additional capital flight if it is perceived to be a panicked reaction to something. And Japan today clearly demonstrates that low rates per se do not necessarily prefigure a weaker currency. What does a 10 year Japanese government bond yielding less than 1% tell us about “the markets”? Does it reflect approval with a country that has a public debt to GDP ratio about 2.5 times higher than the US?

To paraphrase Milton (the poet, not Friedman), sometimes they also serve who only stand and wait!

Markets are an amorphous concept, which reflect heterogeneity of viewpoints. Some people today are buying gold because they foresee a Weimar style hyperinflation emerging in the face of all of this government spending. Some buy it because they envisage the death of fiat currencies and view the yellow metal as the ultimate insurance policy. Some invest because they consider gold the only real form of money. Some people view it as a barbarous relic and ignore it altogether. How does a government respond to these varying points of view? What’s the right policy response?

The myth that markets, not governments, ultimately determine rates has, of course, been legitimized to some degree by virtue of the fact that our institutional monetary arrangements still reflect archaic gold standard type thinking (whereby a certain amount of gold on hand was required to fund government operations). But we went off the gold standard decades ago. Still we have laws which mandate that all net government spending is matched $-for-$ by borrowing from the private market. So net spending appears to be “fully funded” (in the erroneous neo-liberal terminology) by the market. But in fact, all that is actually happening is that the Government is coincidentally draining the same amount from reserves as it adds to the banks each day and swapping cash in reserves for government paper.The resultant bond market drain is there to ensure that the central bank maintains control of its reserve rate. It has nothing to do with “funding” government operations itself.

If you think that sounds radical then consider the following question posed by my friend, Professor Bill Mitchell: If a government bond auction “fails” (i.e. the government doesn’t find enough buyers for the paper it issues during that particular sale), does this mean that your Social Security cheque is going to bounce? Will national infrastructure projects be suddenly halted because the net spending is not “funded”? Do we have to stop fighting a war in Afghanistan? The answer to all of these questions is the same: Of course not! The net spending will go wherever the Government intends it to go - after all the Government needs no funds to spend because it first creates the currency which is ultimately required to be spent in the real economy. The private sector does not produce dollars (if it did, it would represent a jailable offence called counterfeiting).

More fundamentally, how, pray tell, does one presume that the private sector can net save (in this case, dollars) something it cannot net produce?

Isn’t it true that the government is in a unique position because only it has the capacity to create new net financial assets? Now, granted, this simple observation does not readily apply to the euro zone because the individual countries concerned have effectively ceded that authority, thereby circumscribing an adequate fiscal response to their crisis (a point I have made before). But when the operations of government are examined in this light, it establishes that the Obama Administration’s ongoing fixation with “long term deficit reduction” and “establishing credibility with the markets” is as foolhardy as conducting human sacrifices to placate a deity.

Yet government policy responses today on issues like Social Security or Medicare reflect a misguided belief system and a genuine failure to understand the basis of modern money. Scaling back Social Security will certainly drive unemployment up higher than it is already going becomes it robs people of the very income required to sustain growth. Not a very sensible strategy if you truly care about implementing “change that people can believe in”.

Unfortunately, until these Wall Street-centric beliefs are fully exposed for the myths that they are, we can expect to see more dispiriting headlines of the sort reflected in Mike Allen’s latest politico playbook.

Marshall Auerback is a Senior Fellow at the Roosevelt Institute, and a market analyst and commentator.

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