|Can The War On Terror Be Used To Fight The War On Deflation?|
April 15, 2003
International Perspective, by Marshall Auerback
"As we move towards a new Middle East, over the years, I think, over the decades to come, we will make a lot of people very nervous." – Former CIA Director, James Woolsey
Happily, we were wrong: No Stalingrads, no months spent trying to kill the enemy soldier in the ruin next door, no weeks in trench lines, no dreadful siege in which civilians eat rats, then nothing, then die. To quote the French newspaper, Le Figaro, “The Americans have won the war – in only three weeks. It is a victory for George Bush.” As suddenly as his statue was toppled, Saddam’s regime is finished. Iraq, however, remains a country without a government and without order, another awesome task likely to be financed by the long-suffering American taxpayer, given the oft-expressed distaste for any substantive UN role by the administration’s hawks (whose political fortunes in the space of a week have undergone a reversal as stunning as those of Saddam Hussein).
Unfortunately, the American taxpayer, who already faces record-breaking debt, record-breaking trade deficits, reduced government services, a crumbling and under-funded infrastructure, and three major public-sector programs – Social Security, Medicare and Medicaid – expected to double as a share of the economy, is not in an optimal position to fund such largesse. In the words of strategist Chris Sanders of SRA Associates:
“The US Federal government released its Financial Report of the United States Government for 2002 on March 31. This annual document is the result of the government’s attempt in recent years to put its financial reporting on a more practical and businesslike footing. It uses accrual, rather than cash-based accounting, with the express intent of presenting a clearer long-term picture of the government’s actual financial position.
On page four for instance, a clear and simple bar chart shows the dramatic deterioration in the government’s finances in recent years. Although the Treasury Secretary’s terse introductory letter downplays this, making it seem as if it is solely due to the accrual of veteran’s benefits, that is clearly not the case and the bar chart on page 4 shows why. Cash outlays are also increasing rapidly. In any event, the recognition of long-term military benefit liabilities is still a major financial issue. This figure was well over $300 billion in 2001, doubling the cash accounting figure for military spending. That money will have to be raised in the future either by increasing taxes, issuing bonds, or stiffing the veterans. Even the market-challenged economists on Wall Street will have difficulty ignoring the ramifications of using any or all of them. All imply the necessity of raising the national savings rate…
A table on page six called “The Big Picture” puts this matter as starkly as one could imagine. Total government liabilities less assets were more than $31 trillion (that is, over $31 thousand billion) or more than 295% of GDP on September 30, 2002. The report rather coyly says that this does not count the power to tax as an asset, but goes on to point out that discretionary spending aside, the government is obliged to fund a net social security liability of $24 trillion more than anticipated revenue. This is non-discretionary, and makes nonsense of the government’s habitual reporting of its annual deficit gross of the current cash surplus in the social security fund.”
Of course, this has not been the primary focus of the markets recently; the credit markets in particular have loosened markedly and surprisingly of late, and this should not be ignored as it carries the potential to stimulate a short-term spasm of spending growth. That said, mortgage refinancing has fallen off, so it is unlikely that any pickup in spending will come from the consumer sector. If we are going to get a positive spending spasm, it will have to come from the corporate sector, in response to the plunge in high-yield credit spreads and CDS spreads.
How, then, to ensure that growth gets back on track? Can the victory against Saddam be used somehow to jumpstart the war against deflation, proclaimed last November by Fed Governor Benjamin S. Bernanke?
It is worthwhile considering this question in the context of a recent Wall Street Journal article, entitled "Massive Task of Rebuilding Iraq Is Now Confronting U.S.", by Bob Davis. Of particular interest are the two paragraphs at the bottom of the second column of this article:
"Within the U.S. government, a number of agencies are putting together ambitious reconstruction plans. The Treasury is drafting a budget and financial regulation: the Transportation Department is examining highway repairs; the Commerce Department is focusing on a customs service. Even the Federal Communications Commission is getting involved by figuring out what radio spectrum should be allotted for telephone services.
Gen. Garner's group must first tote up the destruction. Estimates of the rebuilding effort vary tremendously - from $20 billion a year for several years to more than $600 billion over a decade..."
The rest of the world doesn't usually think in terms of American electoral timetables, but presidents certainly do (or, at the very least, their advisors like Karl Rove do). And we are now in the second half of this Administration: within six months, the next presidential election campaign will begin in earnest. Yet most American states are living through their worst fiscal crisis ever, as tax revenues plummet well below what they were five years ago. Bush’s recent budget has run into heavy political fire on the domestic front, notwithstanding his foreign policy successes. While this isn't the kind of news that attracts the attention of international news organizations like the BBC, it probably matters more to most Americans than anything being beamed in from the Middle East, as the first President Bush could well advise the current occupant of the White House. Across the country, state and local governments are sacking teachers and police, limiting access to state-funded medical insurance, delaying road repairs. How, then, to parlay the success of the Iraqi operation, so as to ensure that a faltering economy doesn’t sabotage President Bush’s aspirations for a second term?
Whatever estimate is used, the cost of recreating Iraq will be immense, running into billions of dollars. Can this be used to jump start the economy on the home front? Many of those who have opposed this war have done so partly because they haven't trusted the victors to behave well. They express fears that the United States (with Britain tagging along in its wake) will seek to run a colony in Iraq, one which will offer a strategic military base, lucrative contracts to US businesses and the chance for the Americans effectively to run the Iraq oil industry. They anticipate the establishment of a compliant local leadership, made up of Washington stooges.
However well or ill-founded, such suspicions are being fed by the talk of huge contracts accruing to companies such as Halliburton or Bechtel, as well as the administration’s strong links to the oil industry. It is also significant that all of the proposed contracts announced thus far for the reconstruction of Iraq have been granted to American companies (leaving the British Secretary for Industry & Trade, Patricia Hewitt, plaintively lobbying Washington for its share of contracts for British businesses). Such cavalier treatment of an ostensibly loyal ally has left the impression of an administration hell-bent on monopolising the commercial contracts in post-war Iraq - trying hard to make sure French, German and Russian companies, in particular, feel the pain of exclusion from the recent war (even as Russian oil conglomerate Lukoil has threatened years of litigation in the international courts, should its oil concession agreements be ignored by the new regime in Baghdad). Much as it did after the financial crises of 1998, the US could also press hard for changes in global development institutions, such as the IMF and World Bank to make them directly responsive to US foreign policy - all under the guise of a new American model for economic growth around the world, but the country’s own acute economic difficulties might ultimately render this problematic, however superficially just the notion that “to the victors go the spoils of war.”
Presumably, the hope is that such an aggressive assertion of American commercial interests might also have the happy expedient of improving things on the domestic front, where the economy continues to languish. The Fed has tried to remind CNN viewers that it too remains relevant: more articles discussing “unconventional policy measures” are again being openly broached in various press commentaries. Talk of a “Plunge Protection Team” has become deafening, but perhaps not surprising in the current context. That such ideas are being mooted publicly in the immediate aftermath of the war also implies that Mr Greenspan and his colleagues too have battle plans for the War on Deflation should the bounce from the Iraqi phase of the War on Terror prove to have little or no traction.
Keep in mind, for Fed unconventional measures to work, they must be very effective in resetting investor expectations without seeking to panic the public. They must make the unconventional appear as conventional as possible, a logic outgrowth of previous policy (even as the boundaries of moral hazard are further extended). This is clearly easier to achieve during wartime. A war allows Washington to sidestep the usual charge of being hypocritical to its oft expressed free market principles because, after all, unusual measures are usual in war, are they not?
The Fed wants investor and consumers and entrepreneurs to know they are there, ready, willing and able, and they care. They are doing their equivalent of leaflet drops over Basra at the moment to get their message out on the supposition that the more people are primed for unconventional moves, the better they will be received, and the less the Fed will actually have to do. This marks the full fruition of the Fed's expectations management regime that developed over the past decade.
The new trial balloons being floated by publications such as the WSJ are being done so for the very reason that the Fed sees the Fed funds rate as being within 50-75bp of its irreducible minimum (because to go below 50bp would bankrupt the money market mutual fund industry), and Mr Greenspan and his colleagues clearly want people to think they have many arrows left in the quiver. In the words of the WSJ’s Grep Ip, “The Fed has yet to settle on its strategy should it decide the funds rate can't go any lower, although it expects never to get to such a point. But developing and publicizing such a strategy should help prevent excessive pessimism that might lead to severe economic weakness and deflation, which is generally falling prices.”
Of course, one of the paradoxes of the Fed's unconventional approach is that while it is aimed directly at raising final product prices, and therefore aimed at raising nominal incomes and reducing the real burden of servicing existing debt loads, it is also meant to operate on liquidity preferences, expected returns on capital equipment, and consumption propensities in such a way that private sector agents voluntarily and wilfully go into deeper deficit spending mode.
But herein lies a paradox. For monetary and fiscal stimulus to be truly effective, a shift in private sector portfolio preferences toward saving, not consumption is required. We need a return to a net free cash flow position among US firms and households to allow balance sheet deleveraging. For any kind of monetary and fiscal stimulus to be effective, a degree of portfolio readjustment on the part of the private sector is an essential precondition. To get that, we have always been clear that the financial balance equation requires the fiscal balance to go into deficit and the trade balance to head back to surplus. Radical monetization by the Fed does little in a direct sense to produce either of these results. At best, as Governor Bernanke delicately described in his November 21st speech, if the Fed buys foreign government bonds as one of its unconventional measures, they can hope to accelerate the dollar depreciation, which can help improve the trade deficit. More likely, it would just end up exporting deflation to other nations as they stubbornly refuse to adopt pro-growth policies themselves, and so merely loose global market shares.
Of course, if the Fed thought more like America’s pre-eminent civilian military strategist, Vice President Cheney, or some of the other architects of the American war plan in Iraq, as soon as the economy and stock market shows a post-war bounce they would immediately cut 50-75bp and maybe even announce one of the "unconventional measures" they have been pondering, for good measure. They cannot afford to let the post-war bounce fail, so they should use all their ammo to make it stick and stick hard. Instead, though, being the bureaucrats they are, they will sit back and watch whatever modest bounce unfolds, and then they will be forced to use their remaining ammunition in a futile cause after the markets and the economy have started to clearly roll down, and anything they do will smack of panic rather than pushing a rolling train downhill.In an administration conspicuous with so many foreign policy heavyweights, the comparative dearth of any kind of heft on the economics side is striking. Newly appointed Treasury Secretary Jon Snow’s recent comments on the US current account sadly indicate that little has changed since the resignation of Paul O’Neill. There is clearly a crying need for someone to fill that conspicuous void.
Step forward Messrs. Cheney, Rumsfeld, Wolfowitz, Feith and Perle, the so-called "hawks", or the "neo-cons", or whatever you want to call the group of people in Washington who have long believed in the possibility of democratic transformation of the Middle East. For them, the last few days have brought about as comprehensive a vindication of their views as anyone in politics could dream about.
No longer eccentrics, they now stand at the heart of a successful (so far) foreign policy. Will this be extended to economic policy? The Bob Davis WSJ article cited above suggests that the Rumsfeld/Cheney/Wolfowitz wing might be prepared to fill this void in economic policy making, in effect developing its own Plan B to displace the Fed's more questionable and inflation prone Plan B, and so wrest the engine of economic policy away from the Fed (whose credibility remains at a low ebb) and into the hands of the Department of Defense, particularly should the requisite post war bounce in the macro data fail to get any traction.
We know these individuals want to make Iraq a shining example of democracy and capitalism in the Middle East, with the hope this will point the way to disaffected younger generations in Saudi Arabia and elsewhere that are easily recruited by fundamentalist organizations. We know they do not want the UN to run the show given the American and British sacrifice required to affect this regime change. We know Iraq is estimated to require $25-100b in infrastructure repair just to keep the newly liberated Iraqis from turning on their liberators if the lights don't come back on soon and the water does not start running again. Just getting Iraqi oil wells running again will require substantial new investments. If we take all of these pieces of the puzzle, and we appreciate the fervently held vision driving the neocon wing in the Administration, we could see a Marshall Plan proposal for Iraq and Afghanistan emerge as the new Plan B. The idea here would be to use the US fiscal budget to rebuild Iraqi infrastructure, while tying most of the contracts let out to US multinational firms.
The selling point to Congress would be the sooner we create the basis (namely, sufficient infrastructure) for a 100 entrepreneurial flowers to bloom in the desert, the faster we can get our troops out, so the more money we save from having to occupy Iraq and Afghanistan, which is at the end of the day a pretty unproductive US federal government expenditure. The beauty of the plan is not only does it appropriate the spoils of war for Fluor, Bechtel, Halliburton, et al, but it would tend to increase the US budget deficit while reducing the current account deficit, producing exactly the result required to rectify US financial imbalances. All, by the way, ostensibly without begging the inflationary consequences of the Fed's Plan B.
Will this work? The war in Iraq has conclusively demonstrated that for the foreseeable future America no longer faces any limitations in a strictly military sense. But as we have noted before, the country’s Achilles Heel remains its debt (in marked contrast to the country’s position after World War II when it unleashed its last Marshall Plan). However superficially attractive the notion of an aggressive America-first type plan, the country still does need European and Asian support to cushion the inevitable portfolio balance adjustment which must come about domestically. Even liberal internationalists, such as Tony Blair, having seen the use of force come to a decent end in Kosovo and (finally) in Bosnia, who supported this war, express a profound sense of anxiety that the Administration has been recklessly indifferent to the imperfect but irreplaceable structures of international order built over sixty years. They are unlikely to accommodate these aspirations, let alone the so-called “Axis of Irrelevance”, which met last week in St. Petersburg. At the very least, the rest of the world is not going to sit back supinely and allow the world’s largest debtor to gobble up the world’s richest petroleum reserves without a fight. Consequently, economic multilateralism is almost certain to be foisted on the Bush administration, regardless of the aspirations of its hawks. America is dependent on foreign capital and on overseas sources of oil; its companies have extended their supply chains to every corner of the earth; and it badly needs the help of other governments to combat global terrorism. To flex its financial muscles at a time like this would only be counter-productive. However strong the position of the neocons appears to be right now, however superficially attractive their policy aspirations, it is inevitable that their objectives will be frustrated in the absence of broader international support.