Budget Mess

The CBO projects that fiscal year 2008 will end with a $407 billion deficit, which is more than double last year's deficit and only a little less than double what the CBO was predicting we'd end up with back in January.

Keep in mind also that the federal government just acquired the gigantic institutions of the American housing market, otherwise known as Fannie Mae and Freddie Mac. The CBO doesn't think that this will impact the deficit too much - but it still means that tax payers are taking on a lot of risk they didn't have before.

None of this should be surprising - we're in a recession. Governments are supposed to run deficits during recessions. Still, though - I think I'd be more comforted by that traditional Keynesian logic if we hadn't been running deficits before the recession too!

This is going to tie up any big-spending, big-tax-cutting plans that either candidate has for January (or at least it should tie up those plans). Thankfully, the candidates' proposals so far have been fairly modest; some additions to the deficit, but not an egregious amount. Still - we need to do better than "not egregious".

One more thing - When I was looking for this report on the CBO website, I discovered that Peter Orszag - the director of the CBO - actually has a blog! Pretty cool, huh? It's weird though - it looks like you're not able to comment on any of the posts! Which basically makes it a website, not a blog - but it's still kind of cool that an organization like the CBO actually has one.

Samuelson, etc.

Robert Samuelson is always fantastic for providing big-picture perspective on all matters economic. In some cases, like today's column, he's highlighting the fact that the 2008-2009 recession is not going to be a doomsday depression... he provides a moderating influence. In other cases - such as when he talks about the aging of the baby boom generation and it's effect on entitlements - his big-picture perspective is a call to action from the complacency that grips the country. Either way, he always has something good to say (even if I don't agree with it 100% of the time), and I thought I'd share today's article.

One thing he highlights that is important - the fundamentals of the American economy are strong. We have strong financial institutions (despite the credit crisis), strong housing markets (despite the subprime crisis), and strong labor markets (despite recent job loss). I think if anything is going to unleash a system-level crisis like the Great Depression, it will have to be external. Particularly it might be:

1. Depressions in other major economies (ie, China) that cannot deal with shocks like fuel price increases spreading to the U.S. The series of financial crises that wracked Mexico, Brazil, Russia, Indonesia, Thailand, and South Korea in 1997-98 demonstrated that as economies get more integrated, it's easier for them to spread ailments.

2. A loss of faith in the U.S. dollar, leading to massive dumping of dollar reserves by central banks around the world.

The scary thing is that (1.) both of these scenarios would come up on us fast, and (2.) they both will emerge outside the U.S. economy. BUT - we can do things to prevent both of them as well, and that's where policy should be directed.


In other news, this is a new Urban Institute Tax Policy Center report on the candidates tax plans. It projects that both candidates plans will continue fiscal deficits, but that McCain's will be substantially greater than Obama's. I was just at a release event for the report where the senior economic policy advisors for both campaigns commented on it - the Obama guy disputed the baselines that the TPC report compared their plans to, but came out with the same basic point - even if you use a more reasonable baseline, the difference between the McCain and Obama plans are maintained. I'm a little slow when it comes to tax policy, so I can't comment much more on that - but I've gotta say I was impressed with a lot that both sides had to offer. As Urban analyst Len Burman said at the event - both sides could benefit from borrowing a few policies from the other.

The Downturn - Part 3

So I just traced Krugman's post back through the original blog post that he cites, and I was reading some of the comments - and two, "Ex-Worker" and "dan" (not me), make the same point I do about Krugman only better.

First, they make the basic point that "just because Fannie and Freddie aren't ultimately responsible for the crisis doesn't mean that they're not at risk of experiencing what the S&L's did". That's the point I made in "The Downturn - Part 2".

The second point Ex-Worker and dan make is even better and more interesting... Fannie and Freddie basically subsidized risk taking with public money (federal government guarantees their loans), so they subsidized all the good lending that was out their to do (Fannie and Freddie are pretty responsible in their lending). By bringing down the cost of risk, though, Fannie and Freddie made it cheaper for other less scrupulous lending institutions to take on the bad risks that caused this crisis.

Moral of the story:

1. Subsidizing "good loans" isn't going to solve these problems because it will just artificially lower the cost of credit, which is just going to make it that much easier for the bad loans to be made by someone else - the solution is to regulate ALL lending to turn those bad loans into good loans... and yes, this may raise the cost of capital.

2. Just because Fannie and Freddie aren't culpable for bad loans doesn't mean they're not at risk.

BOO-YAH Paul Krugman!

The Downturn - Part 2

Not sure how it's playing in the rest of the country, but Fannie and Freddie are top-of-the-fold news in Washington right now. Not surprisingly, then, Paul Krugman - one of the world's top economists right now, and perhaps the top trade economist - is talking about it on his blog. He kind of puts a positive spin on it the way Samuelson does - and I'm similarly sorta-convinced.

Krugman cites another guy who suggests that Fannie and Freddie essentially took the place of S&L's over the 1990s... this is theoretically bad because S&L's crashed in the late 1980's in a very bad banking crisis. His argument is "yes - they grew, but they were crowded out by other, riskier lenders who are the real risk now". Essentially he's saying that Fannie and Freddie won't follow in the footsteps of the S&L debacle because they aren't at the heart of the REALLY bad lending that's going on.

Fair enough - they're not at the heart of it - but their stock price is still in the dumps and they exist in the context of a very bad credit market! They may not be the source of the problem this time, in the way that the S&L's were in the 80's - but so what? Who do you think is more vulnerable - a large bank with no involvement in the mortgage market that has done some moderately risky lending, or Freddie and Fannie who may also be only moderately risk in their lending but live and breathe the mortgage market! They may not have started the fire, but I don't see how they're not going to get burned! And the problem with that is that Freddie and Fannie are household names - trouble there is a much bigger deal than trouble at some random local lending institution down the street. Krugman is right that they're not the center of the story here in the sense that they're not going to spark anything major... but that doesn't reassure me that much.

The Downturn

OK, so I don't usually feel like posting on the "state of the economy" except as it relates to specific interests of mine (competitiveness, etc.), but it seems necessary to at least provide news updates. If you haven't been paying attention, the economy is looking increasingly bad with every passing day. Now the hopes that this recession may not even happen or that it may be relatively painless are pretty much restricted to the President during his press conference , and the absolutely repugnant comments of McCain's economic advisor, Phil Graham, who provides the obvious solution - "we're a nation of whiners"!

1 - Mortgage lending giants Freddie Mac and Fannie Mae are in trouble. According to Bloomberg.com, they've lost 80% of their stock value in the last year, and Washington is panicking (Freddie and Fannie are pseudo-public corporations... I'm not sure what the deal is specifically, but the federal government has a big hand in what they do). Bernanke assures us they have enough capital that they won't fail, but that doesn't do much for consumer and investor confidence right now.

2 - Banks are starting to fail across the country - in addition to the massive collapse of Bear Stearns that cost a good friend of mine his job - IndyMac, a California based bank, has recently collapsed. And to provide a little bit of perspective, IndyMac is the second larges bank failure since the Great Depression - and technically speaking this recession hasn't even started yet!

3 - Bernanke is justifiably pessimistic in his Congressional testimony this week, and his statements are causing a slump in the dollar. However, most of his pessimism revolves around high inflation , something that economists do not like to see doing a duet with a slowing economy. I heard part of his testimony on NPR, and I think it's sensible - he said that he's not concerned about the solvency of the vast majority of banks... we're not going to see wave after wave of bank failures like we did in 1932 in response to the 1929 crash and subsequent economic contraction. Bernanke said he's more afraid of the possibility that banks won't be able to or won't want to provide the capital that the economy needs to keep growing. The sub-prime crisis made bankers extremely skiddish about risk. If bankers don't take risks, they won't extend credit, and if they won't extend credit the economy won't grow.

4 - Summer isn't nearly up, so oil price relief shouldn't come any time soon (although it shouldn't go too much higher, either... unless we get into another dumbass war).

5 - Robert Samuelson - an excellent columnist for the Post - puts a positive spin on all this, by pointing out that consumer confidence isn't at all in line with our relatively mild unemployment rate (a more technical and diplomatic version of Graham's "we're a nation of whiner's" argument) - but this rubs me the wrong way because the low consumer confidence is the whole point! Low consumer confidence signals weak demand, and if demand is weak you can expect that unemployment rate to tick up in the near future. Samuelson does raise very scary points about international confidence in their investments in the U.S.. If you know me well, you already know my fears about that.

Are we crashing? No. Is this going to be a cake-walk? That's a definite no as well. This recession will be a memorable one - it's not going to be the easy, two-quarter slump that a lot of people thought it might be. But it doesn't have to be a crisis. It will become a crisis if it gets compounded by:

- A war in Iran that drives up the price of oil
- International investors withdrawing their investment from the U.S. economy in response to (1.) the weak dollar, (2.) poor performance of U.S. assets, (3.) continuing budget deficits.
- Continuing inflation

I think all bets are off if we get into a war with Iran or if inflation hits near double-digits. This could get really bad. Hopefully we pull out of this. We may - I'm not macroeconomist, so I can't assign probabilities to any of these things. We just need to tread carefully for a while.

A real oil crisis...

Not to imply that what we're currently experiencing isn't an oil crisis... but the recent bellicosity of Iran got me worried about a real oil crisis that could hit us. If military conflict starts with Iran, they will in all likelihood seal off the Strait of Hormuz from all traffic - particularly oil tankers. Granted, Iran survives based on it's oil exports, but I'm sure they could manage to sell some to China, and my understanding is they already have a pipeline going north to Tehran, and that winds around the Caspian Sea, west to Europe. So the point is, Iran could seal off the Strait of Hormuz from Iraqi and Saudi oil, and as much oil as they could afford to withhold - and then sell what they need to to the West to keep themselves afloat. The Washington Post Express reported today that 40% of the world's oil passes through the Strait of Hormuz... 40%!!!!! If 40% of the world's oil were taken off the market immediately, it would set off a global depression. Granted, our military would probably be well-fueled from refineries in Iraq that don't have to pass through the Strait.


That would also mean that we would be at war in the territory stretching from Iraq, through the Iraqi border with western Iran, into central Iran and the Tehran region, to the eastern border between Iran and Afghanistan, and into Afghanistan and the Pakistani border region. That span of the globe is around 2000 miles across... roughly the distance from Washington, D.C. to Salt Lake City, Utah would be a war zone.

People - this is how empires fall. We cannot go to war with Iran - I'm more and more worried that we absolutely would not recover from it. And maybe we'd by mired in a dogfight for a decade or two before China or the EU reestablished global stability, but the more I think about this, the more terrible of an idea it sounds like. And honestly, it's not just John McCain's off color jokes that I'm worried about. Who cares about those? I'm more worried that Israel is going to fire off a few rockets at Iranian nuclear facilities like they did to Iraq a couple years back.

The startling thing about this scenario that I've laid out is that nuclear weapons don't feature in it at all. Granted, nuclear weapons would make this hypothetical conflict significantly worse (although if we were to use ours, it might bring it all to a swifter conclusion), but even if there were no nukes, or if ther were nukes and we eliminated the program it doesn't matter -the cost we would pay would be enormous.

OK - this post started as a musing on what an Iranian war would do to the price of oil - but its grown a little beyond that. The American people think they are invincible, but they're not. We can fall just like anyone else. People need to understand how starting a military conflict with Iran would tear this nation apart - the economic crisis would probably rival the great depression, we would be fighting a war against both Sunnis and Shias, inflation would sky-rocket, and the food crisis would only grow worse because of fuel shortages, and you can bet that terrorism would be stepped up as a result. Not to mention what it would do to global confidence that the U.S. could pay off it's debts - and if that confidence slips, countries like China and Russia will want us to make good on our Treasury bonds (which we won't be able to afford). Granted - I'm very much setting out a worst-case scenario, but if we get engaged in this there is no way we'll get out with the same power and prestige that we've enjoyed for the last fifty years. I don't mind sitting in Iraq for a little while longer until things cool down... but we need to move out of the region and show some basic respect for state sovereignty there - even if we don't like the sovereign. If this Iran thing gets pushed any further the risk will be too great, and there cannot be a compromise any more - we would need an Obama administration. As much as I respect McCain, it would be too big of a risk.