From Private to Public: A Transfer of Debt

Corporate profits go up in recessions as mass layoffs lower operating costs and reduce corporate debt levels.  Furthermore, the government takes the hit through unemployment insurance benefits, bailouts and lower income and sales tax receipts.

Corporate profits are going up, this is the result of massive layoffs and cutbacks, which also has raised workers productivity levels:

 Debt levels are falling as more people are defaulting and are finding themselves in the 1-in-4 poor FICO credit score of 600 or less:

The financial obligations (total consumer and auto loans plus total consumer debt and mortgage debt) as a percent of disposable personal income (or income after taxes) has shown a semi-significant decline:

Were is all this debt being transfered to? The Federal Governments balance sheet: unemployment insurance claims first skyrocketing and now remaining steady:

Government bailouts also lowered private debt levels and the biggest hit comes from decreased revenue from federal taxes on corporate profits and state income taxes:

But it all adds up to a skyrocketing increase in the public debt:

There has been an effective transfer from the private sector to the public sector.

You know what's not going to occur this June 23rd?

An increase in the Federal Funds rate by the Federal Open Market Committee (FOMC).

Follow around the Federal Reserve's Board of Governors and you get a sense that the Fed is making it blatently clear.  From Chairman Bernanke's testimony to Congress:

"The latest economic projections of Federal Reserve Governors and Reserve Bank presidents, which were made near the end of April, anticipate that real gross domestic product (GDP) will grow in the neighborhood of 3-1/2 percent over the course of 2010 as a whole and at a somewhat faster pace next year.  This pace of growth, were it to be realized, would probably be associated with only a slow reduction in the unemployment rate over time. In this environment, inflation is likely to remain subdued. "

To begin with let us think about what the Fed is mandated by law to do (for a wonderful speech by Frederic S. Mishkin on this):

"to promote effectively the goals of maximum employment, stable prices, and moderate long-term interest rates"

This being said with the employment numbers so weak (with initial claims for unemployment insurance still around 456,000) and inflation not even poking its nasty head up to say hello, there is no way (by law) that the Federal Reserve will raise the Federal Funds rate.  With long-term inflation expectations stable and a struggling labor market why in the world would the Fed raise the interest rate?

Maybe, some should argue, that the zero bound interest rate will cause global imbalances elsewhere as investors search for the greatest yield.  This may lead to a rush of credit to fuel the next great bubble.  This leads me down the road to a third possible mandate: Financial Stability.  Financial stability is one thing, maximum employment and stable prices are certainly another.  The traditional monetary policy interest rate policy is way too blunt to deal with asset price bubbles and other threats to our economy.  So to deal with this problem, lets create a new mandate for the Fed.  Clearly I am not the first person to reach this conclusion- having first read something about this back in November of 2009:

"When it comes to redesigning monetary policy, there is disagreement as to how this might best be accomplished. Wharton finance and economics professor Franklin Allen believes more checks and balances could be built into the Federal Reserve system. “We need to have a third mandate - - a financial stability mandate,” he said."

An adaptive financial stability mandate would give the Fed power to monitor developments in the financial world and allow it to 'quickly' propose regulation to make the growth more balanced.  I know this sounds a little far fetched but why not?  If mortgage origination was such a rampant free for all, then why not have the Fed be alerted of the developments?  The Fed could theoretically be allowed to step in to find gaps in the regulation and the private sector could help:

 "A dynamic regulatory regime is most likely to be realized if it receives non-governmental perspectives on these changes. In addition to disclosing more data to investors and counterparties, exposing supervisory practices and policies to external assessment in a structured way can improve supervision. Such exposure could, for example, reduce the chances of regulators converging around a conventional wisdom that overlooks anomalous data."

If the Fed is allowed to extend credit to failing firms then it should be allowed to adaptively regulate those same firms.  For more on financial regulation, Daniel K.Tarullo of the Federal Reserves seems to be on the front lines.

Welcome to X.U. Economics/ Dangerous Defict

Hello y'all and welcome to the Xavier econ blog. This blog will be maintained by X.U. economics faculty and students, and will provide information on a variety of interesting topics in economics. Unfortunately for the world right now, one of the most fascinating yet dangerously risky current events just happens to be a global debt crises.

The world is on the verge of a global disaster. Just last week we saw Germany ban naked short selling, a sign that things are clearly only getting worse.

Before that investors around the world started closely watching the Greeks and their fiscal dilemma. That is also when I started watching. Greece was the first sign of a much deeper rooted issue. Greece was just the most over-leveraged of the euro-zone economies, and it revealed that countries similar to it would be endangered as well. If we look with our binoculars we can see that across the pond the whole euro-zone is panicking right now, and as they should be. Excessive budget deficits tend to erode confidence in the government. Whether in the United States or Greece the same principle holds regardless of economic status.

Confidence is very important to financial stability because everything is based off of future profits and cash flows. If confidence in the United States ability to pay back its debts and pay off its treasury notes erodes then we have a problem.
If the United States doesn't bring down its deficit:
A. The ratings agencies will see that debt/gdp ratio is outrageous, and will notice that the deficit is ballooning due to:
1. Lack of foreign demand for domestic goods which leads to decreased tax revenue
2. Rising interest rates since the Fed will have to raise the federal funds rate eventually
3. Reduced government cash flows due to a diminishing tax base with the high unemployment
4. Increased health care costs
5. Increased automatic stabilizers like transfer payments

B. The ratings agencies will then decide to downgrade U.S. Government debt which will lead to:
1. An increased budget deficit
2. Much higher interest rates
3. A massive sell off by all the major holders of U.S. Government debt, ( Many pension and insurance companies have it built into their computers to automatically sell bonds that are not AAA rated)
4. A further downgrade of U.S. debt
5. A massive sell off by China

For those of you who are still skeptical (most of you will be) read this speech by our Chairman of the Federal Reserve, it should help put some things in perspective. One thing to keep in mind is that when the Central Bank Chairman warns about fiscal sustainability it is usually a sign of too little will be done and whatever is done will be much too late in the game to make a difference.

As Ben puts it,

"The path forward contains many difficult tradeoffs and choices, but postponing those choices and failing to put the nation's finances on a sustainable long-run trajectory would ultimately do great damage to our economy."