Limits: Models, Governments, and Central Banks

Imagine for a moment that the US Government decided to end all taxation in order to “stimulate” the economy. “Wait,” you might say, “The deficit is bad enough today, how can we let it get any worse?”  A US Treasury Department spokesman says, “Don’t worry.  As the  government, our commercial paper financing captive subsidiary [the Fed] can issue overnight CP at zero percent infinitely/indefinitely.”

But after a little while of doing this, printing money to cover deficits, interest rates rise enough such that a broad coalition of those that need to borrow complain loud enough that the policies get reduced or reversed.  A modern Paul Volcker shows up, blows cigar smoke in the faces of Senators, and refuses to fund the US Government through loose monetary policy.

But the Government is still determined to run huge deficits, and calls upon the Treasury to float US dollar-denominated debt. The market, unused to such large amounts of debt, steepens the yield curve, rapidly, as short rates fall because excess printing of money is over.

Now, people might be grateful that their taxes are gone, as well as the need to be an amateur accountant each April, but that does not mean that they would want to lend to the US Government, so long as they run the place in such a harebrained way.

Eventually, growth in interest payments in dollars would exceed GDP growth, leading lenders to believe that they will never be paid back.  At that point, a lenders strike would ensue, and rates would rise dramatically.  Private borrowers, who pay more than the government to borrow, would scream, and bring political pressure to bear on the government to curtail its borrowing, which crowds out private borrowers.

At that point, the government would have reached its rope limit.  Remember, you can’t get something for nothing — not even governments.  There is always a cost, even if forced onto third parties via monetary inflation, or crowding out in the credit markets, even if those costs appear with significant time delays.

We would be back to my triad of Default, Inflation, Higher Taxes — Choose One.  There are limits to everything on this side of Heaven.  Governments are not omnipotent in regulating economies; indeed, their track record is pretty dim, as is the record of fiat currencies as providing a stable unit of account.

So, as we possibly draw closer to the end of superloose FOMC policy, and with no hint of any real budgetary normalcy in sight, be aware that we are in uncharted waters.  Beware of listening to what mere theoreticians say should happen based on their models.  Their models have never plied their trade in the rough waters we are currently in.

Far better to read This Time Is Different or curl up with your favorite selection of economic history books.  You might get some clues as to what may come, or you might not, but your odds will be better than listening to the mere theoreticians.  The world and national economies at their worst are always more volatile than what the models will say, and governments prove weak when matched against the folly of their failed policies.