This knol is prompted by a recent question posed on the Institute for New Economic Thinking (INET) community website : “Will public deficit reduction encourage private sector growth, or undermine a needed stimulus to recovery & lead to Japan-style stagnation?” This lead me, in view of my work on BICs, to wonder whether the deficit is really the right metric to focus on and analyze the extent to which it could be misleading.
I argue that the government balance sheet, rather than its cash flow position -from which the deficit is computed – should really be what eyes are focused on. The focus on balance would have and should better focus minds on stimulating high returns investments for sustainable recovery and expansion, some of which I discuss.
BICs enter in the picture because using their methodological prescription would make reliable and practical the complex and almost canutian task of computing the values of the different items on the government balance sheet.
I am gratified that the debate INET moderating team has picked on some of my suggestions and highlighted them in the debate summary(http://ineteconomics.org/blog/inet-community-responds-deficit-debate) as: “As far as new, creative solutions to the debate, a few users, such as kongtcheu, have urged governments to invest in entrepreneurship and clean energy projects, suggesting that these investments will create jobs and growth in the future.”” I think I meant to say more than that.
“You cannot borrow your way out of debt ;
but you can invest your way into a sounder future.”
Deficit & Government Debt
Any non economic expert with basic financial intuition would be surprised at the intensity of the debate in the United States and other developed countries in this year 2010 over the issue of the deficit. After all what exactly is a deficit?
Alternatively stated, a deficit occurs when in any given year, revenues fall short of expenses, forcing the government to borrow money to cover the shortfall, and the difference is called the deficit.
society; Likewise, for companies, in their startup or expansionary phases, revenues typically fall short of outlays without necessarily being the focus of concern.
In this article I argue that the level of the deficit evolved over time to be a central gauge for macro economists and policy makers thanks to analytic simplifications that are not robust and in this instance from which we must step back from, go back to basics to clearly see what policy prescriptions are most desirable under the present circumstances.
Here going back to basics means going back to focusing on the government’s balance sheet.The deficit is simply not the proper metric to focus on, because it can be misleading. This is especially true in view of the government unconstrained ability to cheaply borrow in bond markets and the latent risks of deflation.
Focus on the balance sheet
I initially wrote an article on drawing attention to the issues of this misdirect debt/deficit focus last year as a blog post in response to op-ed articles by Warren Buffet and Paul Krugman in the NY Times The Greenback Effect -Till Debt Does its Part -” Going where the Joneses Go Arguments”. I argued there that equating GDP to the asset on the balance sheet was seriously misguided and fallacious.
I was very gratified to see Richard Koo argue how the failure to focus on the imperatives of the balance sheet of companies in Japan led to severe policy mis-calibrations that caused Japan to loose over a decade of economic growth.
Atomistic entities correctly focus on their balance sheets rather than their cash flow statements from which a deficit might me read. And the logic of their actions carries on to the macro level. Micro entities instinctively do deficit spending because of the greater potential for generating more income in the future, and this creates the intrinsic value of their assets, a picture that is more evident in a balance sheet statement.
The balance sheet allows us to clearly differentiate outlays either as consumption or as investment expenses. When expenses are mostly investments with high return prospects, value is created, regardless of deficit. As Roosevelt said “You cannot borrow your way out of debt ; but you can invest your way into a sounder future.“
Focus on the balance sheet appropriately forces management to focus on value creation or enhancement.
Why then do we have a different metric that focuses attention at the government level? The problem indeed is one of measurability or valuation. While the deficit is straightforward to compute, the value of assets on a balance sheet is not, especially at a government scale.To produce a reliable balance sheet, each asset/liability on it has to be credibly valued and that is not a trivial exercise.
Balance Sheet & The Deficit
So how do we come to see the deficit as meaning anything? Through analytical shortcuts that distorts the perceptions and prescriptions of the uneducated or poorly trained.
One way of making the connection can be phrased as follows. First we take the deficit or surplus as a proxy for loss or income for the government. Then we may assume that value is the discounted value of future income.Therefore deficit means loss of value. But indeed this is a simplistic fallacy and that may lead to equally misguided prescriptions.
However the deficits often happen to coincide with worrying signals on the balance sheet. Indeed in a slowdown, government revenue decreases because there is less income to collect taxes on. Decreases in businesses and individual income in aggregate also reflect a decrease in the value of the asset of those entities and by extension a decrease in the value of government assets.
If this may sound very approximating to the reader, well, when you clear the field of impressive mathematical formulas and computations, this is the type of arguments that are made in macroeconomics. Usually the smart fellow will look at what statistical data seems to suggest and build this type of reasoning around it, and make it respectable and authoritative with mathematical formulas and equations.
In the present circumstances should we be worried by the deficit? Yes indeed, but not because of the deficit itself, but because of the momentous loss of value in the real estate market and proliferating elsewhere that this points to. As pointed out by Jeffrey Benson of the blog Macroeconomic Dynamism “According to the Case Shiller Indices (the most accurate housing gauge available) In 2006, the value of U.S. residential real estate totaled US$ 22.4 trillion. Since this recording the national pricing indices (based on 20 metropolitan areas) has decline 19.87%. This is a loss of asset valuation equal to $4.5 Trillion. To put this loss into perspective, according to the International Monetary Fund the U.S. Gross Domestic Product in 2007 was 13.8 Trillion.”
The Wrongheaded Approaches: Blind budget tightening/Austerity
Does worrying about just the deficit points us to the right prescriptions out of the current predicament? No. In Europe, this is leading to blind budgetary cuts that are likely to increase suffering without necessarily increasing prospect for better days ahead. Germany, with its recent policies indeed appears to be pursuing such a path successfully. However we must remember that Germany is an export driven economy. So by tightening its belt, it reduces its production costs, creating deflationary pressures inside its borders that increase its competitiveness outside. In essence this is growth gained at the expense of trading partners. Others reason differently on that.
Here in the US, so called “Deficit Hawks” are increasingly more vociferous to a wideningly receptive audience.Indeed the idea of living within one’s means simply has common sensical appeal and is a time tested virtue.
From a balance sheet analysis standpoint and from an historical standpoint this analysis is very hard to defend. Indeed most liberal economists and some conservative economists as well are arguing strenuously against such tightening, taking the Great Depression or the Japanese experience as a cautionary tale.
However, there is a case to be made for painful medication. It is through pain, through fear, it is when faced with existential threats that the human mind focuses most acutely and is most creative. Both the first, second and cold war lead to stunning scientific and technological advances and indeed, our dearest internet grew out of military research.
It is from this standpoint that the possibility of economic recovery through spurs of creativity driven by fear or misery that belt tightening policies may yield unexpected benefits. The possibility for such development is hard to estimate, yet cannot be dismissed outright.
The good but suboptimal approaches
Professional economists of liberal tendencies have espoused mostly Keynesian/Rooseveltian solutions to deal with the recession, advocating major government spending without much regard for the deficit.
This logic is mostly sensible and has the weight of history to back it up. To keep the GDP growing, as the private sector retreats, the Government must sustain demand by spending to fill the gap. The question is what type of spending should be done?
The standard professional economists prescriptions out of the crisis are plucked straight out of the New Deal arsenal.
They include consumption support initiatives built around the expansion of welfare programs to alleviate the suffering. In the US, this includes extension of unemployment benefits, food stamps, TANF. etc.
On the investment side, prescription come from the 1930s playbook and include large scale infrastructure development projects, including roads, the building and renovation of schools and government buildings. Many of these projects were decided on and approved in such haste that many prominent economic academics would joke about how at the height of the crisis in the fall of 2008, they would receive messages from government officials asking them if they had ‘shovel ready’ projects that could be funded in the stimulus package.
The most proudly avowed such liberal economists only critic about the stimulus package is that it was not large enough and the failure to pass a large enough package would only lead to anemic recovery that had the potential to make matters even worse. Indeed their criticism and fears seem to have been vindicated.
However such professional economists, Paul Krugman chiefly among them are advocating very sub-optimal prescriptions by having over-learned history’s lessons and being under-aware of economic mutations that have occurred since then or emerging trends pointing towards where tomorrow’s leading economic forces are headed.
While actions to guarantee a minimum floor to the weakest is both morally economically sensible, a significant case can be made and is being made here that the issue with the stimulus was not its size, but rather its targets and composition. Such an analysis will be anchored on a focus on the balance sheet, basic corporate finance principles to select investment projects and Austrian economist pessimism about a central government’s aptitude to comprehensively plan economic activity, tempered by what the lessons of our holistic theorem.
A framework for the right prescriptions
In finance, one creates maximum balance sheet value by allocating resources or investing in the projects with the highest expected returns on investment.
One of the biggest problem with government acting as an investor is that it is often very hard to predict where the next sector that will drive economic growth is likely to be and even more difficult to predict who the driver of economic growth in that sector are likely to be.
A bit of recent history
However, it is axiomatic that the strength of America’s economic might has always lied in entrepreneurship and innovation. In the 1980s as surging Japan seemed to be on the verge of overtaking the United States in economic power, it is through innovation and entrepreneurship that the US prevailed.Japan strategically invested in Robotics, Electronics and manufacturing efficiency, all of which seemed to be technologies of the future. Back then the picture seemed quite uncertain however. Japan was overtaking the US in the leading industrial sectors such as automobiles and Electronics. Having pioneered logistics management concepts such as Kanban ( 看板 ) or Just In Time that were frenetically taught in business and engineering schools, it seemed as if having lost in the military battlefield, Japan was about to win on the economic battlefield.
It took the emergence of the Internet, laid down on freedom of private initiative framework, leading to mp3 formats and listeners and products such as the iPod to make the dominant electronics listening devices such as the walkman obsolete. All of a sudden, areas were Japan led the way became relatively negligible share of the economy and unable to regenerate themselves through radical innovation, Japan now seems on the path of steady slide in economic importance on the global stage. The recent announcement that China had overtaken Japan as the second economic power in the world and which was received apparent contemplative shrug is in this regard telling.
There is indeed very little evidence that the protectionist policies advocated by economists at the time in the US and Europe or the economic policies to ease the Japan out of its economic slump since the 1990s have changed macro-dynamics for the better.
As a result, the most efficient policies should be aimed at fostering and rewarding strategic innovation without micro managing it. These may take the form of grants, tax credits, loans and in some instances direct investment.
There is a this time an apparent consensus that green technologies will drive economic activity and innovation in the world. China has made great strides in this regard and the US government is actively doing everything it can to further the development of this industry, to the cheer leading advocacy of strategic analysts. For instance, any New York Times Oped page reader would be gratified to read Thomas Friedman frequent exhortations for focused investments in Entrepreneurship and Renewable/Clean energy (See most recently: Broadway and the Mosque). These are all fine and good. But it is very hard to forecast beforehand where the next leaders in innovation are likely to be. As Max Planck would say “The man who cannot occasionally imagine events and conditions of existence that are contrary to the causal principle as he knows it will never enrich his science by the addition of a new idea”.
There is the piece by Edmund Phelphs, “The Economy Needs a Bit of Ingenuity” where he proposes to create a First National Bank of Innovation — a state-sponsored network of merchant banks that invest in and lend to innovative projects (Another great idea!); This one would help make it possible to have innovative projects financed on a massive scale by something other than rarefied venture capital and angel investors out of reach to the non connected entrepreneurs.
What is noteworthy here is that these highly interesting ideas often come from non professional economists.
Minimizing the role of (non-creative) intermediaries
To be sure, there are a large number of government programs that are supposed to incentivize innovation.
Within the umbrella of the Small Business Administration, there is the Small Business innovation Research Program (SBIR) and Small Business Technology Transfer and Research (STTR) whose funding ceiling were recently raised, and funding increased; there are the Small Business Investment Companies, there is the Department of commerce newly created TIP program; there is the Economic Develpment Authority. These programs are all well intended, but their scope is and – because of the exacting role played by non creative intermediaries – can only be limited. Bureaucratic requirements, funding uncertainties, the limited frequency of solicitations all reduce the macro impact of such policies, to the point where most likely its biggest beneficiaries are the various administrators and service providers, rather than those the policies actually targeted.
It is much easier and straightforward for the average non-connected person in 2010 to obtain $500K in student loans to finance studies of dubious value than to obtain loans and grants to fund an entrepreneurial project.
Indeed it is the cost of such intermediaries that has inflated the importance of the financial sector and the health care industry without any measurable comparative improvement in longetivity.
Especially with the advent of the internet, there are a very large number of ways in which the government can provide assistance to small innovators on a large scale and without much undue friction. The administration can build infrastructure to achieve that and its relative success at passing reforms eliminating unnecessary intermediaries in the student loan granting and management process show that promising reform is possible here too.
The focus on making the right kind of investments should have been the main driver of the conversation on stimulus efforts since the end of 2008. After $787 Billion in stimulus and yet more than 9% unemployment, let’s hope it becomes the focus.
Our point here is that if the government balance sheet was the focus indicator, more effective stimulus would have come with less trial and error, geared towards all kinds of high returns investments, and some of the dogmatic and nonsensical and outdated arguments would not have had any meaningful audience.
But effective tools need to be available to make reliable valuations of such large and complex portfolios seamless. This is one more area where my work on BICs can provide distinctive value.
(Work in Progress -This is a first draft that will be edited overtime)
- This quote is reminded to me courtesy of Bob Herbert's op-ed piece August 14, 2010 in the NY TImes:
- Note here that what when Richard Koo states minimization of debts as a new concept, he seems to miss some basic sign handling issue. Minimizing a negative quantity equals maximizing its opposite; the value of the firm is the difference of assets minus liabilities, therefore minimizing debt (liabilities) indeed maximizes value. I don't know if it is intentional and meant to stress his explanation of Japan's predicament
- See Krugman:http://krugman.blogs.nytimes.com/2010/08/24/what-about-germany/ who argues that it is not austerity policies that are driving German recovery and David Brooks: http://www.nytimes.com/2010/08/27/opinion/27brooks.html?_r=1&ref=davidbrooks
- To be fair, Japan's relative economic decline has more to do with population decline and aging.