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Pull Back the Curtain

To understand fiscal and monetary policy.

12:00 AM, Mar 30, 2013 • By IRWIN M. STELZER
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There is a great tendency both here and abroad to concentrate on the entertaining features of American politics:

The Federal Reserve

The Federal Reserve

Dan Smith

·     A president who decides to launch a charm offensive, by which he means making himself available to a few Republican congressmen for a timed dinner and mingling with politicians he has studiously ignored for four years;

·     A Tea Party that finds multiple ways of saying “no new taxes,” while nevertheless considering “revenue enhancements”;

·     Republican politicians jousting for their party’s nomination to take on Hillary Clinton in 2016;

·     A leader of the Democrats in the Senate who refuses to allow a vote that would redirect funds from the purchase of new uniforms for airport security personnel to preventing the closure of several airport control towers; and

·     A White House that churlishly responds to spending cuts by ending school kids’ tours of the White House while funding a presidential trip for a round of golf with a resurgent Tiger Woods.

Dig beneath such reports and a different, more serious and more promising, picture emerges, at least on the fiscal front. For the first time in four years Senate Democrats have produced a budget. It differs substantially from the House Republicans’ version, which eschews the trillion or so in new taxes called for in the Democrats’ version, concentrating instead on spending cuts, but it sets the stage for a negotiation that just might—only might—succeed. Republicans, in the Paul Ryan version, have agreed to allow spending to rise at an annual rate of 3-4 percent (close to Obama’s current 5 percent), and to cap military spending, which pleases the president, and the president says he is willing to curtail the cost of the long-term health care and pension entitlements that Republicans fear will convert America into another Greece ere long. Whether he follows through with specific proposals to accomplish this reduction in the escalation of entitlement spending we will find out on April 10, when he submits his own budget to the Congress.

And before scampering back to commune with their constituents during the Easter recess, both parties agreed to include the $1 trillion, ten-year cut forced on them by the “sequester,” in the bill funding the government for the next year.

Both parties agree that some of the loopholes in the tax code—a loophole is a provision denying the Treasury money to which it and non-beneficiaries feel it is entitled—must be eliminated, but differ as to whether the enhanced revenues should be spent or used for deficit reduction. Charles Krauthammer, a Pulitzer Prize winning columnist, suggests that the funds from tax reform be divided evenly between deficit reduction and new spending, an unsurprisingly Solomonic solution that could find its way into a “grand bargain” if the president puts his muscle behind it, even though that would mean adopting the suggestion of a conservative columnist. The road to what might in the end prove to be the chimerical “grand bargain” remains rutted, but it might be passable, especially if the president retains his newly discovered conciliatory tone and succeeds in wooing Republicans unafraid of the primary battles they might face if accused of the crime of compromise.

All of this is playing out against some little-noted progress on the fiscal front. The president’s rout of House Republicans in the battle of the fiscal cliff produced an increase in taxes on “the wealthy” that will bring an additional $700 billion into the Treasury over the next decade. If the caps imposed on spending by the sequester hold, spending will come down by about $1 trillion compared with the levels that would otherwise have prevailed. These cuts—in Washington that means lesser increases in planned spending—are on top of $1.5 trillion in spending reductions agreed by the president and the Congress in 2011. Throw in the lower borrowing costs associated with these lower deficits and you have reductions of almost the $4 trillion that will eventually lower the deficit to about 3 percent of GDP, a level most economists consider sustainable. The Congressional Budget Office estimates that this year’s deficit will come to $845 billion, or 5.3 percent of GDP, half the level in 2009. True, the cuts and tax increases are not falling where they might best contribute to growth, but they are bringing the deficit down, at least until the cost of Obamacare and the demands of the baby boomers hit the budget some years hence. So fiscal policy is less of a train wreck than it was only months ago. If they were of a mind to chortle, Republicans might point out that the current course, if maintained, would result in $4 of spending cuts for every $1 of tax increases, far superior from their point of view to the ratio suggested in the much-hailed Simpson-Bowles proposal.

Which brings us to monetary policy, and Federal Reserve Board chairman Ben Bernanke’s insistence on printing money—$85 billion a month—so long as the unemployment rate remains stuck above something like 6.5 percent. Or until he is convinced that the fiscal tightening described above will not do to the U.S. economy what austerity has wreaked on the Greek, Spanish, Portuguese, and (some say) British economies.

We are now in the third round of such “quantitative easing,” or QE3, which is keeping interest rates down and home-buying and share prices up. Bernanke takes credit for preventing the economy from sinking back into recession, not without some justification. Were he less modest, he also might claim to be the role model for Mark Carney, the new governor of the Bank of England, and Haruhiko Kuroda, the new head of Japan’s central bank—among others. All are captains of their nations’ QEs, battling recessionary headwinds and heading, they hope, for the calm waters of sustainable non-inflationary growth.

Until now, little attention has been paid to just how the Fed might bring this era of easy money to an end. Now, the Fed has changed its policy from we “will” continue buying $85 billion per month to we “decided to” do so, subtly suggesting that at some point it will decide not to. Bernanke has already said that the “rate of flow of purchases … [will] respond … to changes in the outlook.” And William Dudley, president of the Federal Reserve Bank of New York wants to “calibrate” the speed of the Fed’s printing presses “to material changes in the labor market outlook, ... sufficient evidence of economic momentum.”

Small problem: the Fed has consistently overestimated future growth by a non-trivial 1.4-1.9 percentage points, according to former White House chief economist Larry Lindsey. So if the Fed does regulate the volume of purchases to its “outlook,” it is more likely to cut too much too soon rather than too little, too late. Which would be bad news for those who are enthusiastically stocking up on shares, and good news for those who believe the Fed is stoking future inflation by not phasing out its purchase program right now.

But don’t start dumping shares or looking for that new house. One doesn’t have to read between the lines of Bernanke’s speeches to know that he will take considerable persuading before starting to cut purchases of bonds and mortgages. He believes he has what he perceives is the obligation of a central banker to lower the unemployment rate—next week’s jobs report bears watching—and wants hard evidence that Obama’s tax increases and Congress’s spending cuts won’t derail the not-yet-robust recovery, which produced an annual growth rate of a mere 0.4 percent in the final quarter of last year. Until then, the presses will roll, and interest rates will cause continued gnashing of teeth by frugal savers in search of yield.

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