It’s sometimes actually worth your time to pay some attention to debates that happen within academic circles. Not the debates in the philosophy departments, those are so Left Bank. The debates in scientific and economic circles though have real world consequences because politicians listen to them and then twist their findings for their own means.
Lately, the sparring between John Cochrane and Paul Krugman has gotten pointed. Cochrane is a classical, Chicago School economist. Krugman is a Tobin trained, Keynesian economist.
Others have pointed out the story of the year for 2011 was debt. They are right. When one looks at microeconomics and sees MF Global, debt was the problem. Europe, debt. The state of State finances, debt. The US budget battle, debt. How one treats and views that debt makes a huge difference on what happens in the future.
Keynesians treat debt as manna from heaven. There are no costs to debt. There are also no opportunity costs to debt either. The money appears, and then costs and opportunity costs are totaled up to figure out the best way to spend it. However, we are finding out that this line of reasoning is incorrect and the market is starting to force them to pay for their errors.
In MF Global‘s case, Keynesian believer Jon Corzine thought that he could “hypothecate” funds and increase leverage over and over without any costs. Instead, what he learned is that there is a cost to carrying too much leverage and the lessons he should have mastered while he was in MBA school really do mean something. He then stole money from his clients to pay for his misjudgement. Not a lot different than a powerful government official raising taxes on taxpayers after they blow a bunch of money on government programs.
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The Europeans have carried on years and years of unfettered spending. Southern Europe loved the idea of the Euro, because it allowed them to carry on their free lunch. In 2012, the rubber will meet the road. Everyone wants to blame the Germans, but all they are doing is bringing financial discipline and actually using real present value figures to realistically look at the mountain of debt they will need to climb.
Many cities and states in the United States have similar debt problems. They built up huge government albatrosses that are unsustainable. The economic downturn has placed gigantic pressures upon their finances. Most are simply biding their time and hoping things turn around. However, in the meantime, producers are fleeing their states and moving to places where the cost of production is much lower. When the economy turns, those states won’t grow as fast on a per capita basis as other places, and the debt burdens they continue to carry won’t change.
Over the past two years, we have had slugfests over what to do with debt at the Federal level. The debt ceiling debate that carried on and on is one symptom of this. Unfortunately, the average person’s eyes glaze over at the size of the numbers we are looking at. Somehow, compartmentalizing and simplifying it down so they can understand it trivializes the issue. The key issue is growth. Unless we grow GDP by a significant factor, the US federal debt is going to overwhelm us.
The cost of financing that debt will increase. Interest rates cannot be artificially held at 0% forever. Behaviors of US taxpayers will change. In many European countries, people simply don’t pay their taxes. If government behavior and sloppy management by the US bureaucracy continue, look for similar behavior out of US taxpayers. First they will flee to the lowest cost states (Alaska, Nevada, Wyoming, the Dakotas, the American south). Then, they will start to take money off shore to shelter it, and begin to simply underpay or stop paying Uncle Sam. The time is now to begin tackling the federal debt crisis. The sand is running out of the hourglass quickly.
How we deal with each of these problems is going to have big consequences in the market. MF’s problem will have a huge effect on how much participation we have in commodity markets, and the efficacy of their pricing mechanism. The macro debt problems solutions will move entire macro equity markets in one way or another. 2011 was a year of marking time. That won’t go on forever.
There really isn’t a compromise between the ways Cochrane and Krugman view the world. People that don’t understand the full depth of the debate want to walk some middle line. However, when it comes to taking money from taxpayers to issue and pay for increasing amounts of government debt, there isn’t a middle line. It’s all math. 2+2 always equals 4. Hypothecate the equation in any way. Sum it, square it, divide it, the root answer is always the same.
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