Dealing with Deflation and Ameliorating a Recession, Part I

A number of columns have been written recently about dealing with the threat of deflation, including this one by Nouriel Roubini in today's Financial Times, "How to avoid the horrors of deflation". In that column, Roubini writes approvingly of the Fed's programs to purchase commercial paper, mortgage-backed paper and similar programs to increase liquidity and drive down borrowing costs for businesses and consumers.

With the bond market willing to lend the U.S. government funds at such low rates (e.g., 10-year Treasury yields at ~2.7%), why not take maximum advantage of that to stabilize asset prices and support aggregate demand? One fear is that, eventually, this orgy of borrowing will lead to a surge in inflation and interest rates when economic growth recovers, but it would seem that one way to ameliorate this would be to focus on buying assets rather than increasing outright spending.

For example, with many states facing budget shortfalls, instead of just giving money to the states, why not have the federal government buy a special class of 10-year municipal bonds from the states? The rate could be set at 50bps or 100bps over the U.S. government's current borrowing costs, which would still be a huge discount over the states' current borrowing costs in the municipal bond market. According to Bloomberg, yields on 10-year general obligation municipal bonds currently average 4.2%, so if these special municipal bonds sold to the federal government had a coupon rate 50bps higher than current 10-year Treasury yields (2.7%), they would still yield a full 100bps less than current 10-year municipal bond yields¹. The proceeds from these special municipal bonds sold to the federal government would enable the states to make payroll, fund already-scheduled local infrastructure projects, and -- if the federal government purchased a large enough order of these bonds (say, an amount equal to double each state's current budget shortfall) -- to call some of their callable municipal bonds, thus lowering their overall interest expenses and taking further pressure off state budgets.

According to the the Center on Budget and Policy Priorities, estimated shortfalls in state budgets for fiscal '09 total about $80 billion, so it would cost the federal government about $160 billion to buy an amount of special municipal bonds equal to double the states' estimated '09 budget shortfalls. Since these bonds would represent assets for the U.S. government, and the U.S. government would recoup its investment (with interest) in ten years, that ought to temper concerns about this expenditure's long-term impact on inflation and interest rates and assuage the Treasury market.


¹The coupon rates on the municipal bonds are of course what the states are actually paying in interest costs, but I'm using Bloomberg's yields as a proxy, for simplicity's sake.

Saving Money at Starbucks

Today Starbucks is offering free tall coffees to anyone who says they voted¹. Here's another way to save money at Starbucks, similar to the one we mentioned in a recent post ("Lobster Rolls in Lean Times"). Costco sells $100 in Starbucks gift cards for $79.99 (similar to the deal it offers on McCormick & Schmick's gift cards). Starbucks also offers a gold card now, that gives holders a 10% discount on most purchases. If are a frequent-enough Starbucks customer, you probably received a free gold card last month (if not, you can buy one now, or get one free with a Starbucks affinity credit card deal). You can combine these discounts by transferring balances from the Starbucks cards you bought at Costco to your Starbucks gold card. Then you'll be getting an effective 30% discount on your Starbucks purchases<sup>1


1</sup>Ben & Jerry's is offering a similar deal from 5pm-8pm today ("Democracy never tasted so sweet").

²If you bought the Starbucks gift cards at Costco with a Costco American Express card, you'd get 1% cash back on the purchase, so your effective discount would be 31%.

Did the U.S. Economy Grow at a 3% Annual Rate in Q2?

Brian Wesbury of First Trust thinks so. This was his rationale, in his Monday Morning Outlook PDF:

Below we set out the components of real GDP that
comprise our 3% forecast for Q2.

Personal Consumption: We already have full
consumption data for April and May as well as auto sales
and retail sales for June. The only piece missing is June
services. We estimate real consumption grew at a 2.0%
annual rate in Q2. With consumption accounting for 70%
of GDP, real PCE will contribute 1.4 points to real GDP
growth (1.4 equals 70% of 2).

Business Investment: Data through May show
business investment in equipment and software was
unchanged in Q2. However, business construction
continued to boom, suggesting overall real business
investment will grow at about a 6% annual rate in Q2.
With business investment accounting for about 10% of
GDP, this translates into 0.6 points for real GDP growth
(0.6 equals 10% of 6).

Housing: Data on home building suggests a decline
at about a 23% annual rate in Q2. Given that the sector
makes up roughly 4% of GDP, this translates into a drag
of 0.9 points on real GDP growth (0.9 equals 4% of 23).

Government: Federal defense spending and public
construction at all levels of government were unusually
strong, suggesting gov’t spending accounts for 0.5 points
worth of real GDP rather than the 0.3 or 0.4 trend.
Trade: The inflation-adjusted trade deficit has been
shrinking rapidly. Even assuming no additional
improvement in June, net exports will add about 2.0
points to real GDP growth.

Inventories: We assume businesses around the
country reduced stockpiles at an annual rate of $37
billion, the largest reduction since the 2001 recession,
resulting in a drag of 0.6 points to growth.

Second Quarter GDP: = 3.0%

At the end of last year, Wesbury was one of the few economists predicting that the U.S. would avoid recession in 2008. So far at least, he has been right.