And yes, “financial” crowding out also takes place when financial markets are fully utilised. But they are not

TO BE NOTED: From the FT:

"Will stimulus spending stifle recovery?

May 21, 2009 4:53pm

by FT

By James W Dean and Richard G Lipsey

The enormous stimulus packages hastily put together by governments in most large economies encounter two sorts of criticisms from many conservative economists. Both criticisms are wrong.

The first is that spending will either be hurried and wasteful, or that it won’t come on stream until employment has recovered, and will therefore be inflationary.

The second is that deficit-financed government spending merely replaces spending by consumers and firms dollar for dollar; so-called 100 per cent ‘crowding out’. Critics often fail to point out that these two arguments cannot both be true. If government spending merely replaces private spending dollar for dollar, it does not affect total demand. As a result, it cannot be inflationary.

If “crowding out” is significantly less than 100 per cent, new spending will employ labour and capital that is now idle, and the earnings of workers and investors will re-ignite both consumer and investment spending. To be sure, stimulus programmes should target projects with productive potential. Economies from the US to China are in dire need of new physical and social infrastructure. But even “unproductive” projects are better than none at all if the alternative is to leave labour and capital unemployed.

And if stimulus spending for infrastructure comes into effect after the end of recession, when real resources and financial markets are re-employed, there are adequate monetary tools to contain such pressures. In other words, long-term plans for infrastructure planning can stand on their own merit.

So the key question is whether government spending that comes into action during recession is likely to crowd out new private spending, dollar for dollar. The answer depends on the extent to which real and financial resources are currently under-utilised.

“Real” crowding out occurs when labour and capital are already fully employed so that further spending exceeds capacity and leads to inflation. The logic of the harm done by inflation is well understood. But the logic of “financial” crowding out is less intuitive and more complex.

Simply put, financial crowding out results from rising interest rates when government deficits put pressure on bond markets. This kind of crowding out is most plausible in the US, which began the recession with the biggest deficit in world history. However, relative to national income, it is not nearly as large as that which Britain ran after the Napoleonic wars. And currently, the biggest as a percentage of national income is Japan’s: almost 200 per cent of its gross domestic product. It doesn’t seem to be crowding out private spending as the Japanese long-term interest rate is still only 1.5 per cent.

Nevertheless, skeptics argue that dramatic doubling of US deficits this year and beyond could leave little room for private sector borrowing. If the US deficit stifles rather than stimulates recovery of its private sector, prolonged worldwide recession is inevitable.

The US deficit will be financed in several ways. Much will be paid for simply by “printing money”. The jargon for this is “quantitative easing“, which means, inter alia, that central banks buy new issues of government bonds and pay for them with newly created money. This puts zero upward pressure on interest rates. But it does increase the money supply - thus far, in the US, by some 70 per cent since last year. If this money is not re-absorbed by the Fed when full employment is restored, we will witness inflation and consequent “real” crowding out.

The second way that the US will finance its deficit is by selling bonds to foreign buyers, particularly to large central banks such as those of China and Japan. Though their appetite for dollar-denominated liquid assets may have diminished, it is still enormous. There remains no financial asset as liquid and safe as US Treasury bonds, and for this reason the US dollar has not and will not collapse against the euro or the yen. By the same token, foreign financing of the deficit has not and will not put significant upward pressure on interest rates and thus will not lead to “financial crowding out”.

A third source of financing for the deficits is sales of government bonds to commercial banks. If private borrowers were beating down banks’ doors for loans, and if banks were willing to make loans, then the Fed’s bond sales to banks would indeed crowd out consumer and investment borrowing. But both the demand for and supply of credit have collapsed: indeed, that is the core cause of the meltdown. So the part of the deficit that is financed by bond sales to banks will not crowd out private borrowing.

A fourth way to finance deficits is to sell government bonds directly to firms or households. Under different circumstances this too could crowd out investment or consumer spending, since firms and households might simply increase their savings and reduce their spending by enough to offset the amount of new government spending that is financed by the bond sales. But such a dollar for dollar portfolio shift is highly unlikely. Why would firms, already sitting on high cash reserves and undistributed profits because they are afraid to invest, increase their savings even more because they are offered safe government bonds? An analogous argument applies to consumers.

In short, arguments that deficit-financed stimuli will be crowded out are far-fetched in the extreme, even when the deficit is as large as that of the US. Yes, “real” crowding out happens when labour and capital are fully employed. But the essence of our present problem is that the enormous productive capacity of our economies is dangerously underutilised, not the reverse.

And yes, “financial” crowding out also takes place when financial markets are fully utilised. But they are not: the core cause of our present problem is that credit markets are seriously underutilised, and financial markets have melted down. Financing large fiscal deficits by tapping those markets is much more likely to revive them than the reverse.

James W Dean and Richard G Lipsey are professors emeriti at Simon Fraser University"

As other nations’ surpluses turn to deficits, America will face competition in global financial markets for its borrowing needs

TO BE NOTED: From the NY Times:

"Worries Rise on the Size of the U.S. Debt

By GRAHAM BOWLEY and JACK HEALY

The nation’s debt clock is ticking faster than ever — and Wall Street is getting worried.

As the Obama administration racks up an unprecedented spending bill for bank bailouts, Detroit rescues, health care overhauls and stimulus plans, the bond market is starting to push up the cost of trillions of dollars in borrowing for the government.

Last week, the yield on 10-year Treasury notes rose to its highest level since November, briefly touching 3.17 percent, a sign that investors are demanding larger returns on the masses of United States debt being issued to finance an economic recovery.

While that is still low by historical standards — it averaged about 5.7 percent in the late 1990s, as deficits turned to surpluses under President Bill Clinton — investors are starting to wonder whether the United States is headed for a new era of rising market interest rates as the government borrows, borrows and borrows some more.

Already, in the first six months of this fiscal year, the federal deficit is running at $956.8 billion, or nearly one seventh of gross domestic product — levels not seen since World War II, according to Wrightson ICAP, a research firm.

Debt held by the public is projected by the Congressional Budget Office to rise from 41 percent of gross domestic product in 2008 to 51 percent in 2009 and to a peak of around 54 percent in 2011 before declining again in the following years. For all of 2009, the administration probably needs to borrow about $2 trillion.

The rising tab has prompted warnings from the Treasury that the Congressionally mandated debt ceiling of $12.1 trillion will most likely be breached in the second half of this year.

Last week, the Treasury Borrowing Advisory Committee, a group of industry officials that advises the Treasury on its financing needs, warned about the consequences of higher deficits at a time when tax revenues were “collapsing” by 14 percent in the first half of the fiscal year.

“Given the outlook for the economy, the cost of restoring a smoothly functioning financial system and the pending entitlement obligations to retiring baby boomers,” a report from the committee said, “the fiscal outlook is one of rapidly increasing debt in the years ahead.”

While the real long-term interest rate will not rise immediately, the committee concluded, “such a fiscal path could force real rates notably higher at some point in the future.”

In some ways, ballooning deficits should not matter. Deficits are a useful way for governments to use public spending to stimulate the economy when private demand is weak. This works as long as a country closes its deficit and pays back its borrowings after its economy starts to recover.

The trouble is that government borrowing risks crowding out private investment, driving up interest rates and potentially slowing a recovery still trying to take hold. That is why the Federal Reserve announced an extraordinary policy this year to buy back existing long-term debt — $300 billion over six months — to drive down yields. The strategy worked for a while, but now the impact of that decision appears to be wearing off as long-term interest rates tick up again.

Then there is the concern that the interest the government must pay on its debt obligations may become unsustainable or weigh on future generations. The Congressional Budget Office expects interest payments to more than quadruple in the next decade as Washington borrows and spends, to $806 billion by 2019 from $172 billion next year.

“You’re just paying more and more interest and having to borrow more and more money to pay the interest,” said Charles S. Konigsberg, chief budget counsel for the Concord Coalition, which advocates lower deficits. “It diverts a tremendous amount of resources, of taxpayer dollars.”

Of course, no one is suggesting the United States will have problems paying the interest on its debt. On Wednesday, even as it announced its huge financing needs for the latest quarter, the Treasury said financial markets could accommodate the flood of new bonds. “We feel confident that we can address these large borrowing needs,” said Karthik Ramanathan, the Treasury’s acting assistant secretary for financial markets.

One worry, however, is that there are fewer eager lenders to buy all that American debt. Most of the world is in recession, and other nations have rising borrowing needs as well. As other nations’ surpluses turn to deficits, America will face competition in global financial markets for its borrowing needs. For the moment, the United States is actually benefiting from a flight to quality into Treasuries brought on by the global financial crisis, which helped reduce rates to record lows this winter. But the influx will not continue forever.

China has lent immense sums to the United States — about two-thirds of its central bank’s $1.95 trillion in foreign reserves is believed to be in United States securities — but it has begun to voice concerns about America’s financial health.

To calm nerves and fill the deficit hole, the government is getting creative. The Treasury is ramping up its auction calendar, holding more frequent sales of government debt and selling the debt in expanded amounts. It is now holding sales of its 30-year bond each month, up from four times annually.

It is also resuscitating previously discontinued bonds, such as the seven-year note and the three-year note, to try to mop up any available money all along the yield curve. There is even talk of issuing billions of dollars of a new 50-year bond, though the idea has not won official approval.

On a second front, the Treasury and the Federal Reserve are trying to bolster the mechanics of the market — to make sure every auction goes smoothly. With such enormous sums involved, every extra basis point on the interest rate the government pays could mean extra billions of dollars for the taxpayer. Earlier this year, when demand was hesitant at a Treasury auction and when a British bond auction went poorly, investors grew nervous that the government might struggle to sell its mountain of debt.

To avoid such an outcome and to keep borrowing costs low, the government is trying to expand the group of firms that bid at Treasury auctions. After the demise of such names as Lehman Brothers, the number of these firms, called primary dealers, has shrunk to 16, the smallest since this elite club was formed decades ago. Now the government is in discussions with smaller firms like Nomura and MF Global to persuade them to join."