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Doom and Gloom

In a comment to this earlier post, Charlie writes:

For all of Russ's doom and gloom, I would love to see some actual predictions, something specific and on record.

My guess is his rhetoric is far bolder than what he actually thinks will happen.

What do I actually think will happen? I have little or no idea and neither does anyone else. Instead, let's talk about what has already happened and then a little bit about what is likely and what is possible.

What has happened already is that over the last ten months, starting with the Bear Stearns collapse, the government has tried to steer and run the financial system. It has poured a few hundred billion dollars into the system and sent a signal for the future that really big mistakes can be forgiven. It has tried to coordinate the merger and acquisition market–marrying Bear Stearns to JP Morgan and Merrill Lynch to Bank of America. The latter appears to be a complete fiasco. The government has bailed out the bondholders of Fannie Mae and Freddie Mac. In short, the government has sent a signal to all future risk takers that sometimes bad decisions will cost you less than they should. And sometimes they will cost you zero.

Will those decisions have negative consequences in the future? I think they will. I can't measure the consequences but logic suggests that future risk-taking will be less prudent.

The Federal budget is about 3 trillion right now. Not sure what that includes from the past 10 months. Some of the actions of the last 10 months involved money creation and some of it was real spending. But either way, we're on the verge of passing an $825 billion increase in spending over the next two years making a large federal government even larger. That is roughly a 15% increase, maybe a little less. The deficit will approach $1 trillion. Maybe higher. Again, not sure what it's running right now. Hard to know.

Many (most) states are broke. Apparently, California cannot meet its obligations and is "delaying" some payments.

That cheerful picture is where we are at the present. That's gloomy enough for me. But wait, there's more excitement to come!

What does the future hold? I don't know, but here are some things that worry me.

If the current stimulus package is ineffective or if it takes time to actually go into effect, what will be the response of the government? Monetary policy is close to impotent. Yes, more money can be poured into the system even if the Federal Funds Rate is zero. Japan tried that too. It didn't work. If the expansion of federal spending doesn't help the economy, will there be a demand for more spending or less? If the auto makers cannot recover in time to pay back their loans, will an Obama administration let them go bankrupt? If China goes into recession or depression, will they continue to buy or Treasuries? I doubt it. What will the Federal government do if it cannot meet its obligations? Cut back on spending or start inflating? I suspect the latter.

So the really gloomy scenario is a situation of rising inflation, rising nominal interest rates, ongoing unemployment, private investment stagnating because of regime uncertainty and on top of all that, everyone expecting a magical wizard of a president who loves them to fix everything.

And you want to know why I'm worried?

What are the odds of the really really gloomy scenario? I have no idea. I do know the odds are much higher than they were a year ago. I used to be a deficit dove. I used to argue that the deficit isn't nearly as important as the size of government. Now both are growing dramatically. So now I'm worrying about both–government's share of the economy and how it's financed. If you spend enough relative to the inflow, you can actually start to call into doubt your ability to repay your debts. That would make me a deficit hawk. We're heading down that road right now.

What really worries me is that our political system is dysfunctional. Put your hand out and Washington will fill it. (Unless you're Lehman Brothers. Too bad they were a rival of Paulson's ex-firm.) Who in Washington is going to say no to the next request?