The Fed Raises the Discount Rate

The discount rate has an effect if banks borrow money from the Fed.  This usually only happens if there is a credit crunch and financial markets are under stress, such as we went through last year.  Currently, it appears that banks are on a firmer footing and there is hardly any borrowing from the Fed by banks.  Therefore, the increase in the discount rate should not have any direct impact on banks or financial markets.  The other interest rate that the Fed controls, the Federal Funds rate (or target rate) has a direct impact on market interest rates that you and I face, but the Fed continues to hold this rate at close to zero (0.25% at the moment).   

There is however the more intangible effect of the Fed signaling that it is tightening its approach toward banks and it views the risk of financial fragility to have subsided.  Also, in the past the target rate and the discount rate have tracked each other very closely.  At the moment it doesn’t seem that the Fed will jeopardize the economic recovery by raising the target rate.  But once it seems like the recovery is “robust”, in the sense of no longer being overly reliant on government stimulus, you can be sure the Fed will raise the target rate.

It is very important for the Fed to be able to raise interest rates when it feels confident that rate increases will not have a negative impact on the economy.  This is because these interest rates are the primary tool of monetary policy in the arsenal of the Fed as far as stabilizing the economy.  Unless the Fed raises its interest rates when it can, it will not be able to lower them when the next recession happens.  In other words the Fed needs to raise interest rates once the economy is on a stronger footing so as to “shore up its ammunition.”

Interestingly, exchange rates went up on the day of the announcement, but fell to their previous level by the following day.  We could interpret this as vindication that the discount interest rate change has had no real negative effects on the economy. 

Creative Destruction and Silicon Valley

Silicon Valley.  According to a recent report, the region, the center of the global technology industry, lost 90,000 jobs from the second quarter of 2008 to the second quarter of 2009. Unemployment is higher than national levels and the worst in the region since 2005, when technology companies were still recovering from the dot-com implosion.  Does this spell the beginning of the end for Silicon Valley?

Industrial clusters are capable of generating self-sustaining economic growth because they are essentially interdependent beehives of economic activity where ideas, infrastructure, and technology are being continuously shared, challenged, and serendipitously recombined to yield entirely new strains of industrial DNA in the form of breakthrough products, processes and services.  To continue with the biological metaphor, it is the network of interconnections among them that transforms a cluster of firms into a “super-organism” that functions as an economic dynamo that is greater than the sum of its parts, throbbing with ideas and resilient to economic vicissitudes.

Silicon Valley is an example of such a high-performance industrial cluster.  Other examples are Research Triangle in North Carolina, Route 128 in Boston, and Fairfax County in northern Virginia.  These clusters are an agglomeration of firms in related products.  These firms have knowledge and technology spillovers between each other and benefit from shared fixed costs of infrastructure and R&D, which translate into economies of scale and scope. 

Once the density of these interactions and synergies between firms cross a threshold, a self-reinforcing feedback cycle is ignited, and an industrial cluster continually attracts more firms, talent, and capital.  Since there is a “threshold effect” before the self-reinforcing virtuous cycle takes off, and this threshold is hard to quantify or pin down, such clusters are fiendishly difficult to replicate by design.

One could argue that Silicon Valley has been a victim of its own success.  Because it has been extremely successful in creating products that have become so useful and popular that they have become standardized, it is now possible to outsource these products to other parts of the world, such as India, China, Israel and Estonia.  We could say that current downturn in the Valley is in large part the result of the relentless pursuit of greater efficiencies and lower costs, a process that was already underway but has been amplified by the recession.

There is reason to expect that Silicon Valley will rebound.  Studies of cities and regions that have gone through waves of creative destruction but have reinvented themselves (Chicago, Boston, New York, London) indicate that a key ingredient to economic resilience is large and deep pools of human capital (skills, education, talent, experience).  Cities with high levels of human capital have emerged from downturns in new incarnations with new products and clusters (software to biotech for example in Boston).  High levels of human capital lead to flexibility and the capability to take advantage of whatever current opportunities are.  To use another biological metaphor, human capital is like a stem cell which can adapt and morph into new products and knowledge. 

Awash in Red Ink

Do budget deficits matter in the same way for governments (such as the U.S.) as they do for individuals such as you and me?

There is one important difference between government budget deficits and individual budget deficits that is worth noting.  At both levels, deficits imply borrowing to bridge the gap between income and expenditure.  An individual like you or me will finance this deficit by borrowing from credit cards, banks, or friends and family.  At some point as we get older our creditors will become reluctant to continue to finance continuous deficits.  This is because we have finite lifespans, and our descendants cannot usually be held responsible for our own debts.  As a result, as individuals we are unable to finance our deficits indefinitely.  At some point, as we get older, we will be compelled to start repaying our debts or declare bankruptcy (which will put a brake on our ability to run ongoing deficits). 

An important difference with the government is that the government has no finite "end-date."  As a result, the government can in principle run deficits continuously, as long as creditors continue to have faith in the ability of the government to pay back its debts on an ongoing basis.  This is the sense in which you may have heard politicians say that "deficits don't matter."  However, this depends upon a very big caveat, which is belief in the ability of the government to honor its committments and not default on ongoing debt obligations.  So far, it seems that international creditors continue to have faith in the US government's ability to honor its debt obligations.  This is reflected in the continuing demand for US Treasury Securities/Bonds by international investors.  Lately of course there is discussion of the government's credibility to honor such debt obligations, in the face of unprecedented deficits.  But so far this has not been reflected in the market.  

Note that there are many instances of governments defaulting on debt obligations.  In the past, Argentina, Brazil, and recently Iceland, have defaulted on international debt obligations. 

  

How does the U.S. government "finance" its deficit?  What about a country such as Ukraine, or Greece?

While the US government is able to finance its deficit via the sale of US Treasury bonds, the problem for many other countries, such as Ukraine or Greece is that international investors are much less keen to buy their debt.  Would you buy Ukrainian or Greek Treasury bonds?  As a result these countries find themesleves in a fiscal strait-jacket.  Having been hit by the global downturn, they find the need for deficit financing to engage in fiscal stimulus, but without the easy access to funds that the US government has.  A last resort for such countries is the International Monetary Fund.  The IMF is a lender of last resort for many countries that need deficit financing but are unable to quickly raise the needed funds.  This is an important function of the IMF, but countries are often reluctant to borrow from the IMF because it comes with strict conditions that countries may find onerous.

In addition, if the US runs increasing budget deficits, it absorbs most of the available liquidity in international capital markets, making credit rationing an even more acute problem for smaller countries. 

The outgoing Czech PM publicly criticized the US budget deficit last year.  The Czech Republic is a relatively "small" trading partner of the US.  Why should such a country be concerned about the US federal deficit?  Later on in the same speech, the Czech PM said something to the effect that the US "has it easy, because they can sell Treasury bonds whenever they want."  This reflects the frustration that many countries feel when they compete for loanable funds with US Treasury bonds.

Virtually all OECD countries are projected to run large government budget deficits in the next year.  If the rich countries (OECD members) run large budget deficits, they will absorb much, if not all, available "safe" liquidity in the global capital market.  This will result in an acute shortage of funds for other less prominent countries which also have deficit financing (stimulus) needs.  This could strain the resources of the IMF and prolong the recovery for many such countries. 

Inflation?

The efficient functioning of a market economy -- the interplay of demand and supply aptly termed the invisible hand by the economist-philosopher Adam Smith back in the 18th century -- depends crucially upon prices serving as accurate signals upon which economic actors such as firms and individuals can base their decisions. Inflation, when prices are changing rapidly due to reasons that have little relationship to economic fundamentals, disrupt the workings of the invisible hand. If individuals and firms do not know what to make of prices in terms of reflecting economic fundamentals then it becomes difficult to make astute economic decisions relating to consumption, saving and investment. Inflation thus has the potential to wreak havoc upon the workings of the economy.

Usually when the economy is on a steady growth path, some amount of inflation is unavoidable. However, what is important in such "normal" times is that the rate of inflation stays low and predictable. As long as individuals and firms know what rate of inflation to expect, and this seems "low," they are able to make decisions and plan ahead. This is why central banks of many countries adopt an explicit "inflation target" (such as say 2%) and make this known to the public. Such an announcement goes hand-in-hand with aggressive tactics such as raising interest rates whenever it seems like inflation is getting close to the upper bound of the target.

At the moment, it doesn't appear that inflation is a concern, given the state of the economy. But it could be, if the economy gathers momentum and the recovery becomes robust. In some sense, though I say this advisedly, this would be a "good" problem to have if it happens in tandem with a faster rate of GDP growth. But tools to combat inflation are severely circumscribed at the moment. Raising interest rates will be quite unpopular, and it is unclear how easy it will be for the Federal Reserve to sell securities and bonds to mop up excess liquidity. And that is the worrisome part.

Inflation-targeting by Central Banks comes with its own set of serious problems (ask Iceland, Brazil, Mexico...).