The Deficit – In Practice

Back in the pre-crisis days of 2006, after staring slack jawed at GSE balance sheets for over a year, we penned a semi-tongue in cheek missive titled "In Defense of Deficits." Tracking back to the Clinton administration, we looked at the promulgated "fear" that the surplus was gone forever and a shortage of regular liquid high grade issuance would disrupt bond markets.The 30 year was discontinued and even the 5 year was falling off the screen. So sprouted the credit cycle that culminated with "rolling the dice with sub-prime." (Sub-Prime far too small sector for all the hatred it gets BTW)

In 2007 the Bush administration deficit was a paltry 160B and 1.2% of GDP.  (http://www.bloomberg.com/apps/news?pid=newsarchive&sid=abGA3.0koGV4&refer=us )

The Fed was approaching 14 well telegraphed hikes of the Fed Funds rate and the curve had been flat for months. As Warren Mosler points out in his latest, "the system had insufficient equity to support the credit structure."  Fast forward to yesterday and the Fed's slap down on BAC's penny dividend can be viewed in softer light.

The futility of deficit discussions today is they cannot get past the size of the number. Low is "good" and high is "bad" comes pre-packaged into the debate. The EU situation should be a catalyst to frame the issue differently. CDS is just another trading product dressed up in benchmark clothing. The Fed and their activities should not be excluded from the conversation. The famous Helicopter Speech actually said that setting the rate would be the preferred method of transmission. QE is a much less efficient activity because an IOER regime does not create a new conduit for reserves to flow into the real economy. In fact it creates a repository where the can fester. The $90B interest payment from Fed to Treasury takes place completely inside the government. That 1 payment is $90B that the private sector could not obtain.

The problem is not the deficit (s). The problem is that all debts are viewed as sacrosanct and elaborate shell games are created to perpetrate that myth.  That 10 year yields inside the EU  can be so far from each other while extrapolating 1 year rates geared from the same central bank is a glaring sign of stress.  "Other" sources of funding will either become permanent or collapse, or both. The US term structure indicates a belief that the deficit- to a large degree- will be inflated away. The time to worry will come if and when that belief system breaks down.

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