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If We're Going to Spend, Now's the Time To Do So

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From the NY Times:

President-elect Barack Obama promised Saturday to create the largest public works construction program since the inception of the interstate highway system a half century ago as he seeks to put together a plan to resuscitate the reeling economy.

Mr. Obama and his team are working with Congressional leaders to devise a spending package that some lawmakers suggest could total $400 billion to $700 billion. Some analysts forecast even higher costs. Mr. Obama has said he would direct his team to come up with a plan to save or create 2.5 million jobs in the first two years of his administration.


Mr. Bush and other Republicans have resisted such an approach in part out of concern for the already soaring federal budget deficit, which could easily hit $1 trillion this year. Borrowing hundreds of billions of dollars today to try to fix the economy, they argue, will leave a huge bill for the next generation.

The incoming administration is faced with one of the most difficult policy situations possible. The previous administration never came close to balancing a budget. According to the Bureau of Public Debt, the US started issuing a minimum of $500 billion dollars of net new debt per year starting in 2003. As a result, total federal debt outstanding increased from $5.8 trillion in 2002 to $10.6 trillion today. Another way to look at this is total federal debt increased from 55% of US GDP in 2002 to 72% in 2008. Either way, the previous eight years were marked by fiscal recklessness of the highest order.

Now when the US is in desperate need of a fiscal injection it runs an incredible risk in doing so. Simple market econ: when a country issues a massive amount of debt the possibility of two very negative developments exists. The first is a drop in the country's currency. The reason is simple. Countries issue massive amounts of debt when they are in trouble. The actual issuing of debt is a very strong signal to currency traders that serious problems exist - the kind of problems that may lead to a country declaring bankruptcy. Hence, currency traders sell the currency. This can lead to a big inflationary spike and/or a currency crisis. Thankfully, the US dollar has some room to give in that area. Below is a chart from the St. Louis Federal Reserve of the weighted US dollar index against a broad basket of currencies.


Notice the dollar has rallied a little over 20% over the last 5 months. The reasons aren't important. The point is the dollar has risen and now has some room to give if need be.

The second possible negative development from issuing massive amounts of debt is a spike in interest rates. Again, the reason is straightforward. Issuing a big amount of debt increases the possibility the borrower won't pay the money back. Therefore, lenders will demand an increase in interest rates to compensate them for the increased default risk. The following chart is from the St. Louis Federal Reserve and shows the interest rate on the 10-year constantly maturing treasury (CMT). Thanks to the credit crunch, interest rates are now extremely low:


US interest rates have room to give right now if need be.

I wanted to add an important caveat. There are many people who are now arguing for this large infusion of government spending (I am one of these people). The central argument is "Keynsean" meaning the argument is based on the works of John Maynard Keynes. The argument takes the basic GDP equation which is consumer spending + gross domestic investment + exports + government spending = GDP and assumes a mammoth increase in government spending will lead to increased GDP. Many people are arguing as if the end result is certain. The proponents are arguing with the same degree of certainty as the folks who previously argued that deregulation was the best thing since sliced bread - and we know how that turned out.

Here's the point. I agree that given the severity of the current situation massive government spending is pretty much our only hope right now. But arguing that it is a certainty is unwise. There are plenty of things that could go wrong at this point. As noted above, issuing a ton of debt right now -- against the backdrop of the last 8 years of fiscal recklessness -- is asking for trouble. It's possible that forex traders decide to sell the dollar thinking the US is now a bad place to invest. It's also possible lenders will say, "we want a lot more interest to compensate us for the risk we're taking on." Either of these events could lead to credit agencies downgrading US debt - which would really send things into free fall. If they happen in tandem we're got serious problems on our hands.

In other words -- there is nothing that is certain right now and plenty that is dicey. We have an incredibly difficult road over the next few years. It is precarious at best. Let's hope we navigate it properly.