Policy change needed for state and local investment pools

The invasion of toxic paper into local and state investment pools, read government operated money market funds, has produced a great deal of hand wringing, blame sharing and head shaking, but not enough policy changing.

The federal government is restricted from this type of activity by the Treasury's tax and loan account program, which places federal taxes in commercial banks, but only in safe, liquid accounts. States are not following this model.

This is the policy that needs to be changed, with the object lesson so close at hand.

Two weeks ago we brought the fact that state money market funds, where state and local governments parked their tax receipts, were in jeopardy from the toxic paper purveyed by the financial sector. In the last two days more bad news has come out, focusing on Montana and Florida:

• Marketwatch
• Florida
• Wall Street Journal

Here is our coverage. Notice that no state, or very few, are immune from the unsafe practice of self-operated money market funds. Also listen to the Tom Keene interview with Drexel's Joseph Mason on November 16.

State pension funds and general operating funds nationwide have apparently invested in the toxic paper produced by the unregulated financial markets, according to Joseph Mason, associate professor of finance at Drexel University.

On Bloomberg, Mason made some bone-jarring revelations.

• The CDOs and structured debt for corporations that have similar weaknesses could plague the economy into 2012 and beyond.


• Subprime mortgages are not the only debt with resets to be packaged and sliced (tranched) for the investing animal. Corporate debt, too, has resets coming due.
  


• Why was the contagion in credit markets not confined to subprime? Corporate borrowers are on the hook for the same sorts of problems. This is not invisible to those on the inside. (That is three bullets on the same point. But it begins to reveal why credit markets are seizing up when the problem is advertised to reside only in CDO's holding subprime loans.)
  


• $40 billion has been written down so far, out of at least $400 billion. These resets will be cleared by the end of 2009.
  


• Not only is it your pension fund, it is in your state's general fund. State's run their own money market funds, and have been buyers of the toxic paper.
  


• State money market funds do not have a parent bank to bail them out. They have only the taxpayer. It is the taxpayer's money that is in these money market funds. (Note: The federal government is restricted from this type of activity by the Treasury's tax and loan account program, which places federal taxes in commercial banks, but only in safe, liquid accounts. States are not following this model.)
  


• The bind on state budgets is a direct line into the middle and lower income levels, where recessions are made. Demand Side perspective gives state budgets a full pass-through in the multiplier. That means a hit to the state government is a body blow compared to a hit on the financial sector, which is a jab.
  

The problem is not a liquidity problem. A liquidity problem is where an instrument has a price, but there is no money to buy it. These "credit market innovations" are opaque, so potential buyers guess at what they're worth and then discount the value for the risk of not knowing. Potential sellers don't like the prices. No market. But not because of liquidity.

While everybody who owns this toxic paper is blowing smoke to disguise their irresponsibility, it is coming clear that many states are in significant jeopardy. A short look at one example will also show how big $400 billion is, or $900 billion, or even $1,500 billion -- all figures that have been offered as costs for this debacle -- and what sort of fix they're in.

Florida has an annual budget of $50 billion, according to Mason. Its annual revenues are about $36 billion. (Notice, a large state's annual budget is small compared to the impending problem.) Imagine that Florida has invested in structured debt with tax money in a kind of self-sponsored money market accout. Maybe 4.37% of this debt is in instruments already downgraded to near zero, and maybe another 7.33% is in portfolio credit watch negative. That could be $2.2 billion in the first account, and $3.6 billion in the second account. Maybe this is 12% of the fund.

Consider further that, as Florida, your sales tax revenues are plummeting from the recession and you have no income tax. This is 12% of your annual revenue for 2006. The outlook for 2007 is worse. You have no big brother to bail you out, as the bank's money market funds do, or as the entire financial sector does with the Fed. You have mandated programs like food stamps, health and social services, etc.

Remember that in the Depression, some state's went bankrupt, closed universities and other operations, and paid remaining employees with IOUs.

Be glad you are not Montana, with possibly 20% of its fund in jeopardy.

Which way out of the recession?

The Fed's concern for the economy is reflected in rate cutting. The market likes rate cutting, some because they think it can actually do some good with the economy. Others because it takes more pressure off the debacle in the financial sector.

The Fed's number two man Donald Kohn said yesterday there is still a lot of uncertainty in the market. The uncertainty is they don't know which way to run.

Reflect a moment on an American economy without the financial sector debacle. Isn't that a recession two years ago? Haven't the past two years been built on the housing boom that turns out to have been $1.4 trillion of smoke and mirrors?

The way out of this mess is to create demand for real goods, not sliced and diced securities. Or patched up banks. Or passive housing. As if we needed any more of that.

Will the Fed's rate cut do it? No. Just No. Let's leave the debate for another day.

What will do it, however, is public investment in the saving of the planet. Infrastructure, R&D, world-wide investment. Stuff that needs to be done, that we can do here. That we can do in the developing world. That we can do in labor-intensive and structurally sound ways.

What will not do it is waiting for the market. The market has just shown its competence.

Once omniscient Market seems a little addled

To judge from the National Business Report, the once-omniscient stock market has suffered a little garbling of the proclamation program. Not too long ago the Market was able to, on any given day, assemble and incorporate vast arrays of information with uncanny accuracy.

Perhaps it is still true, but we are lacking the proper priests to translate the oracle's newly cryptic utterances. The panel of experts assembled by NBR last night
was certainly not up to the task. Hold cash, oil should be $60 per barrel and the usual hedge on whether there will be a recession or not. Susie Gharib's panel of experts sounded like a panel of Chicken Littles.

The boom of the last two days had them spooked. And it should, if the assumption is that the Fed's hint of an interest rate cut December 11 was the catalyst for the 500 point rise. The bond market, apparently, has already priced in the cut. It has just forgotten to tell the stock market. Rate cuts as a sign of insecurity are hardly good news. Consider, too, that any effect on the real economy from a rate cut would be at least 12 months out. Does the financial sector really need liquidity? It would benefit more from some corporal punishment.

It appears that the value of stocks, bonds and commodities (and other currencies) is only slightly more clear than the various CDOs and SIVs that are rushing around. In the Supply Side world stocks should be crashing as we enter the recession. After all, debt driven demand has been cut off at the knees.

But it is not a Supply Side world, and the prices of these assets and securities do not reflect anything about their underlying worth. Because they're not worth very much. It reflects only that there is nothing else halfway safe to buy with your dollars. It is inflation driven by an investor class, an investor cult, that no longer has a functioning economy to invest in.

Market Failure II - Immigration

We are more than a little disgusted with all sides of the immigration debate. Who is exploiting who or what? Get tough. Don't get tough. The patent fact is that any problem with immigration is a market failure, a failure of trade policy, and it has several dimensions.

Rather than argue them in the abstract, let us go directly to a specific example and return to the general case when we've put faces on the straw men.

Mexico. In spite of the easily observed facts of the matter, immigration is being debated on the premise that greedy foreigners are trying to steal American jobs. They ought to be minimized, marginalized and deported where possible.

Displaced American workers, both from offshoring jobs and from the competition of immigrants, have much to learn from displaced farm families in Latin America. So-called free trade through NAFTA has meant subsidized American farm products have been dumped on Mexico, cutting prices for the farm products which once supported its agrarian economy. Incomes plummeted and soon entire villages emptied out, with their inhabitants appearing on the border.

This is not a happy circumstance. Mexican families do not like to see their young people disappear, even if they can survive only because of the remittances that begin to arrive. $300 billion per year is the last estimate I heard of money being sent back home by immigrants.

This failure of the market has its roots in the market failure that created Big Agriculture. We will return to that in the next installment of this series.

The failure of the market to distribute economic benefits broadly is essentially denied by free market apologists by the tactic of ignoring it. If pressed, a weak propositions that either the situation is somehow their own fault, or equally preposterous, that more of the same will make it better. Whatever its merit in economic energy, the market fails because of its intrinsic tendencies.

Among them:

• Rewards in a market economy are delivered not to the deserving or the needy or equitably, but to those with power.
• In a market economy, if you don't have money, you don't count.
• If you do have money, you can get more. The more you get, the more you count.

This is, of course, why we have created the "Mixed Economy," with a strong public sector to mitigate market excesses. But that public sector has been co-opted or intimidated and its support eroded by voodoo economics, "the market knows best." Immigration is a clear case in contrast. In some real sense we are going to import the products of those countries or we are going to import their people.

People want to come to the U.S. because that is where the money is. Are they greedy. No. They are driven here by poverty. Most people would stay in their native countries were it not for persecution or abject poverty.

What used to be called the Third World is not doing well. While some of the world develops, dozens of countries and a billion people fall further and further into desperate conditions. Immigration pressure will only get worse as clean air and clean water become commodities that they cannot afford.

The development model promulgated by the corporate oligarchy and its functional arms the World Bank and the International Monetary Fund, is built on setting up little industries and competing with other countries on the basis of cheap labor. It is a beggar-thy-neighbor race to the bottom.

A very little investment in roads and schools could generate a very great return in the capacity of these countries, providing their basic institutions are not corrupt. Nations ought to be encouraged to organize around the natural base of small (energy-efficient, by the way) small farms.

It is actually we who are so greedy we do not realize the immense benefit of developing these countries from the inside out. Schools, roads, green infrastructure can unlock enormous potential markets. Instead we prefer to destroy those markets by flooding them with the products of American industrial farms or turning them into plantations for the developed world.

Forecast and Commentary from April 2006

I've been bad about bragging without documenting the correct calls of the past. This is from my stint at the Northwest Progressive Institute. I'm dragging those posts to this site and came across it today.

One of the dreadful experiences of understanding a little economics is to watch those approaching retirement vote against schools. They have dollars in the bank, their kids are grown, Why should they worry?

Another is looking at the enormous investment in housing. Homeownership is a beautiful thing, look at the employment and tax revenue coming in, How can we lose?

The May 2006 issue of Harper's has on its cover a man carrying a house on his back. The article is entitled "The New Road to Serfdom." In it there is a graphic I pray is not correct. It identifies 90% of debt since 2000 as being mortgage debt. That would mean only 10% of debt has gone to credit cards, college loans, and oh yeah, plant and equipment.

The current debt-driven economic activity is founded on housing investment. Investment creates jobs up front. Every kind of investment. But investment in essentially passive assets, like housing, does not generate economic well being down the road like productive assets do – education and equipment and so on. It generates interest payments.

The Harper's article is instructive, if a bit pat. It's great if you like charts, because that's what it is - a dozen charts with explanatory captions. It advises of a possibility that low interest rates lure people into enormous debt loads, possibly shackling the owner to his house for decades, making payments as equity shrinks, giving lie to his hope for a valuable asset at the end of his working years.

The situation is similar to the pension crisis. (See the Seattle Times 04.04.06 article.) For dozens of years people worked, in part, for the promise of an affluent retirement funded by the company's pension. Now, one after the other, the corporation's promise has been turned over to the government for fulfilment. The "self-made" men and women wait in line to see what can be salvaged of their expectations.

Bethlehem Steel, US Airways, Kaiser Aluminum, Pan Am, and locally Consolidated Freightways, Lamonts, and Longview Aluminum, have given up their pension obligations to the federal Pension Benefit Guaranty Corporation, which now has $56 billion in assets v. $79 billion in future liabilities.

The point I want to make is that today's sure bet is tomorrow's last place finisher. Do not look at dollars. Dollars are a great medium of exchange, but a lousy store of value. They're a good way to compare goods, as in eggs are expensive, cars are cheap, but it is wrong to assume that both are being measured by a standard unit which has value in itself. They are expensive and cheap relative to each other. The dollar is simply a medium to make the comparison.

If you want your house to be worth something, or your pension to be there, or your stocks to pay off, you need to build an economy that works, with workers who will be able and willing to pay the price you want. It is their demand, not some numbers on a bank statement, that ensures value. You can lock up your greenbacks and bury them in the ground, but without that growing economy, they'll turn to dust no matter how well you wrapped them. There is no "I've got mine, now you guys fend for yourselves." You can be robbed by inflation, crashing stocks, ballooning health care, etc., etc., etc., but at its root it will always be a weakening economy that could have been floated by sound investments and reasonable trade structures.

Taxes for schools will generate economically viable citizens and reduce unnecessary drains on public coffers in the future. These are the people who will buy your house, fund your pension (including Social Security) and make your stocks worth something.

Mortgage borrowing, federal debt, everyone a millionaire... It's a hoax that is often too disturbing to contemplate, so we don't. But someday we'll have to. Our hind ends will get blasted if we keep our heads buried in the sand.

P.S. - In my last post I forgot to mention that Paul O'Neill, the former Treasury Secretary under Bush, also termed "not acceptable" W's 1990 scam with Harken Energy that we covered earlier this year. "Did I ever do an untimely filing of Form F?" O'Neill said. "No. Any other questions?"

It's timely now because W's fellow travelers at Enron are in the dock this week.

Market Failure I - Global Warming

More bad news on the ice melting front, when an American Meteorological Society Panel disclosed that the Arctic and Greenland ice masses are melting faster than expected. Meanwhile oil hits $100 per barrel and the dirty energy economies of China and India boom forward. US production of greenhouse gases goes on unchecked.

Global warming and climate change are huge failures of the market. The market produces the fossil fuels and burns them in ever greater quantity in spite of the clear evidence that they are suffocating the planet. One can hardly say it is a failure of information.

In what ways has the market failed?

One. The market does not include the costs of human misery and planetary demise in the price of its products. This is a complete failure, because "the market" consists of nothing more than the incident of purchase and sale. Costs not captured in this moment are considered "externalities" and passed off to the public sector or to future generations or to those with too little power to resist.

For example, the price of a gallon of gasoline includes the costs of discovery, drilling, pumping, transporting, dispensing, and with the gas tax, building the roads upon which the gasoline is burned. Omitted are the costs of global warming as well as the not insignificant costs of geopolitical chaos, wars and sacrifice for "quote" national interests "unquote."

One could probably compute a total for the State and Defense Departments' efforts in this regard, and then triple it to account for the costs in human terms. But the costs of global warming cannot be accurately determined, because they will be extracted from those who cannot pay cash, and must pay with the pound of flesh or acre of innundated land or plot of parched and barren earth. Eventually "they" will include use all

Were global warming insurance required of gasoline purveyors, one could see the cost entering into the purchase-sale event. It might double. If an insurer could be found. At least one could say the market reflected the real world and the real world costs.

So, One, the market fails to account for all the costs. Or even half the costs. A modest market failure. But now, two.

The market does not produce because it cannot produce the public goods that are needed to address global warming. Its total product is in private goods, from candy bars to cars to houses to all the things our society produces in such abundance that are consumed by individuals or small groups. The market itself can only produce private goods because it, again, consists of the moment of purchase and sale and the product must have a purchaser who is identifiable, isolatable and who controls enough of the benefit to be willing to pay the price.

The market does not produce public goods at all unless the government collects its compulsory fees and contracts with private companies. The government thus creates the market for public goods.

Roads, schools, infrastructure of all types, national defense, courts and prisons. All necessary, but none created by the private market.

We can do this, as we've said in other posts, by regulation -- by strictly describing what can and cannot be sold, from toasters to tractors, in terms of carbon footprint.

Or government can create the market by directly contracting for, say, zero emission locomotives or buses or other government-purchased items. Private business can take a contract offer for a specific product, so long as it has a commitment to sale, and justify the R&D to innovate to the specifications. That is called making the market.

Will the private sector take it on itself, on spec, so to speak, to produce such a thing. No. A complete market failure to produce the innovation by itself. The government must create the market for the products and services that will get us off the carbon cross.

Notably, as far as I am aware, the efforts to massage the market with such things as carbon taxes and cap and trade efforts have had less success than they should be having. Leakage from the system seems to have devalued the carbon credits. It was a noble experiment, it should be refined and continued, but it has not produced the results we need, and there is no time for trusting the next version. Use it in addition to, but not instead of, direct government making of the market.

So two, the market will not spontaneously create the necessary technology. It needs the government to create the appropriate market or that market will never come into being.

Three. The market has completely failed to protect the Commons. The air, water, and ecosystems we all depend on are exploited mercilessly by market actors. Private property is sacrosanct, but the common property is without an entity or institution that will see its rights and the rights of the collective inhabitants of the planet are not trampled upon.

The examples are too numerous to mention. A system upon which the society depends to provide for its well-being must treat this common property with respect. That is not the so-called free market system.

Long overdue: Senate moves on Big Rail

I was very heartened to see the Senate has taken up legislation to open the door to the use of rail. Encourage your Senator to cosponsor.

S. 772: Railroad Antitrust Enforcement Act of 2007: A bill to amend the Federal antitrust laws to provide expanded coverage and to eliminate exemptions from such laws that are contrary to the public interest with respect to railroads.

The bill's sponsor is Sen. Herbert Kohl [D-WI]

Cosponsors
Sen. Joseph Biden [D-DE]
Sen. Norm Coleman [R-MN]
Sen. Byron Dorgan [D-ND]
Sen. Russell Feingold [D-WI]
Sen. Thomas Harkin [D-IA]
Sen. Patrick Leahy [D-VT]
Sen. John Rockefeller [D-WV]
Sen. Charles Schumer [D-NY]
Sen. David Vitter [R-LA]

I am presuming the bill would move toward the removal of legal shelters to Big Rail preventing the public from fully utilizing rail and rail technology. Rail is domestic infrastructure that can replace imported oil. It is a win on employment, efficiency, economic independence, and environment. Big Rail has run this public good for narrow pecuniary purposes for far too long.

A piece from Oregon Wheat describes the measure as primarily benefiting the heavy commodities that now monopolize the use of the tracks. Senator Kohl is quoted:

Over the past several years, industries that are served by only one railroad have faced spiking rail rates. They are the victims of price gouging by the single railroad that serves them, price increases which they are forced to pass along, ultimately, to consumers. It is time to put an end to the abusive practices of the nation’s freight railroads and force railroads to play by the rules of free competition like all other businesses.

But the problem is much deeper. Railroads have targeted coal and grain and modular imports (containers) as their cargo of choice, and have abandoned thousands of miles of track.

We need to move freight off the roads and back onto the rails. Roads are too costly to maintain for freight. One semi causes 16,000 times as much wear to a road as a car. The use of gasoline and diesel by trucks is a mammoth greenhouse gas problem. Freight corridors used to exist throughout the nation, financed by huge land giveaways to the rail companies. We need them back.

The Oregon Wheat article concludes:

Over the last 20 years, railroad industry consolidation has reached the point where only four class I railroads provide over 90 percent of the nation’s rail transportation. Many industries – known as “captive shippers” -- are served by only one railroad. These captive shippers have faced constantly rising rail rates. In many cases the ordinary protections of antitrust law are unavailable to these captive shippers – instead, the railroads are protected by a series of exemptions from the normal rules of antitrust law to which all other industries must abide.

Current antitrust law protects a wide range of railroad industry conduct from scrutiny by antitrust enforcers. Railroad mergers and acquisitions are exempt from
antitrust law and are reviewed solely by the Surface Transportation Board. Railroads that engage in collective ratemaking are also exempt from antitrust law. Kohl’s bill will eliminate these antitrust exemptions by allowing the federal government, state
attorneys general and private parties to file suit to enjoin anti-competitive mergers and acquisitions. It will restore the review of these mergers to the agencies where they belong – the Justice Department’s Antitrust Division and the Federal Trade Commission. And it will eliminate the antitrust exemption for railroad collective rate making.

An American Public Power Association flier also urges support on the basis of reducing the costs of coal transport.

A CURE flier lists problem and solution.

• The Surface Transportation Board (STB), which is supposed to ensure competitive markets and reasonable prices for rail customers without access to competition, is not doing its job. In fact, rulings from the STB have actually enhanced the market dominance of the railroads, leaving rail customers with no legal recourse.


• The broad antitrust exemptions enjoyed by the railroads prevent customers and state Attorneys General from pursuing legal action against alleged monopolistic behavior.


• Unlike most industries, railroad mergers and acquisitions are not subject to DOJ/FTC review. The STB approves mergers and acquisitions on a simple “public interest” test. The result is a highly consolidated rail industry operating in non-competitive markets, often charging high rates and providing poor service.

A Solution – Under S. 772:

• The railroads would be given six months to review their anticompetitive practices to bring them into compliance with the nation’s antitrust laws. After that date, a plaintiff with standing could bring an antitrust action in federal district court to enjoin railroad practices that do not comply with the nation’s antitrust laws.


• The Attorney General, state attorneys general, and private persons are empowered, where they have antitrust standing, to file suit in federal district court to enjoin railroad actions that violate the nation’s antitrust laws.

Forecast Friday arrives on Sunday

The most comprehensive presentation of our deviant forecast is now up on DemandSide.Net. It will surprise nobody that we predict bad news for a long time. The short form of the prediction has been up for a month:

We are already in recession.

The various prognosticators trying to see over the horizon by jumping up and down on their statistical trampolines will not get the official word for another three months. But without housing employment, the US would have been in at best a stagcession over the past three years. Now there is no housing, no housing employment, and the consumer spending derived from home equity is gone.

Inflation is guaranteed by the bidding up of commodity prices and the flip side, the falling dollar. Very likely the Fed will panic again, this time to the upside. The same matrons screaming at their husbands during the credit crunch will be screaming just as loud for rate hikes when they see their dollars eroded by the very cut they demanded in the first place.

While some, notably Larry Summers call for additional rate cuts, the likelihood these will produce demand are low in the present environment. The risk is that the Fed will see the inevitable inflation rounding the corner and panic to the upside.

Demand should be generated by government spending on infrastructure and energy projects. The market has proven it is blind to the upcoming global catastrophe. It is time for the government to "make the market" and get us off the dime.

Inflation targets are bad economics

When the Full Employment Act of 1946 passed into law it created the President's Council of Economic Advisers and the Joint Economic Committee, the two most influential economic policy offices in the federal government. The president was given broad authority to utilize fiscal and monetary policy to promote, in what is possibly the most famous phrase in economic legislation, "maximum employment production and purchasing power."

The Act ratified activist government, and the phrase set down the order of priority: (1) full employment, (2) maximum growth, and (3) stable prices. Five years after the passage of the Act, in the so-called Treasury Accords, the Fed (with complicity inside the Treasury) arrogated unilateral control of monetary policy for itself.

Sixty years later the order of priority has been reversed. Activist government is a memory. Markets are run without rules in a bad parody of a mob-run city. The Fed stands like a balding policemen on the sidewalk making sure nobody steals the apples, while the crooks in pin-striped suits run their toxic paper and mortgage scams on the shopkeeper inside. Always pleasant, the Fed holds the door for them on their exit.

Employment is viewed with suspicion, as a potential threat to prices. Production is assumed to be enabled by the hands-off enabling of cowboy corporations. Inflation is a bogeyman.

As we wrote yesterday, the claim that the falling dollar will not result in rising prices is absurd. Not only are the dollar prices of commodity imports like oil and metals raised by dollar weakening, but the prices of domestic goods that have export markets will be bid up. Sooner or later the Chinese currency will have to bend to rising energy prices and environmental degradation.

Typical among the patronizing Monetarists is the following exerpt from a blog (Economist's View, February 7, 2007):

To help with the discussion, let the rule for monetary policy be of the standard modified Taylor rule form: ff_t = a + bff_t-1 + c(y_t-y_t*) + d(π_t - π_t*) + u_twhere ff is the federal funds rate target, y is output, π is inflation, and u is the uncontrollable part of policy. A * indicates the target value of a variable and a, b, c, and d are choice parameters for the Fed. The parameters c and d determine how forcefully the Fed responds to deviations from its output and inflation targets.

(In more general models the deviations might be expected future deviations rather than the deviations today, there are issues about whether to use real-time or revised data, the rule can have additional terms, and there are other issues as well such as what target to adopt when market imperfections are present, but this will suffice.) Barney Frank says we must pay "equal attention to unemployment.” If he means that the Fed should respond as forcefully to deviations of output from target as it does deviations of inflation from target, that is at odds with current monetary theory which states that the best way to stabilize output and employment - Barney Franks' concern - is to respond more forcefully to inflation deviations than to output deviations. Thus, the value of d is around three times as large as c in standard formulations. If he means the Fed should take account of deviations of output from target (or employment deviations), they already do that. As to explicit inflation targeting, the issue is whether to announce the value of π_t*, the inflation target.

Barney Frank is worried this will elevate the importance of inflation deviations, but nothing I know of suggests that announcing π_t*changes the values of d or c. Targeting inflation is a means to an end - that of output and employment stability just as Barney Frank wants - and not an end in and of itself. Both theory and evidence tell us that the Fed can stabilize employment and output around their long-run trends, but it cannot change the long-run trends themselves with monetary policy.

Thus, the best the Fed can do is to stabilize the economy around these long-run trends and that, we believe, requires stable and low inflation and an aggressive response to deviations of inflation from target.

Here we have precision rather than accuracy. Two problems:

• Economics has no independent variables, so to try to force inflation to operate in dependence to other variables is simply bad math and bad economics.


• Economics is not a closed system. Leakage is the rule.

The importing of thermodynamic thinking into economics around the turn of the last century was a conceptual error then and has continued to this day as a primary fallacy of the latest Neoclassical economics.

To say that anything is "at odds with current monetary theory" is similar to saying, "We waved at the moon and it went from this side of the sky to the other, so why are you not listening to us?" You will remember the Reagan-Volcker recession of the early 1980s, when "current monetary theory" suggested a simple, painless way of reducing inflation was to reduce the quantity of money, because inflation was simply too much money chasing too few goods. Reducing the quantity of money would bring prices into the comfort zone without pain.

Result, lots of pain. Prices came down after Volcker blinked and oil prices backed off, but not until after millions of unemployed, unwitting inflation fighters, had their lives sometimes permanently damaged.

The idea that price stability in the context of these discussions is intimately associated with anything other than low volatility in prices is not borne out by any evidence, in spite of the neat phrase. The absence of volatility is no indication of stability. Witness the recent financial market collapse after years of non-volatility. In fact, in the case of prices, keeping the lid on will only create pressure that will hurt people and businesses. The falling dollar must be reflected in prices, and translated in an orderly way. Order is stability. Suppression is only building pressure.

We have had hundreds of billions of dollars in trade deficits for decades. Standard economic theory has no explanation for this. The currency is supposed to adjust to keep the trade in real goods and services relatively balanced. The currency is now adjusting. To make the adjustment orderly, we do not ignore it or pretend it is bad. Instead, we should create the conditions for a strong economy which can support its currency by something other than reputation.

All of this would not be so important except for the fact that the Fed has only one tool, or perceives that it has only one tool -- the interest rate. The interest rate is used to hammer down inflation, provide bail-out liquidity for financial sector mistakes, and open demand in the broad economy to counteract downturn.

• As a tool against inflation, it is bad when it is applied to cost-push inflation, because it does not reduce costs, but increases them.


• As bail-out to the financial sector it is bad because the financial sector is not in a liquidity crisis, it is in an information crisis. It is not that there is no liquidity to buy the toxic product, it is that nobody knows what they are worth. (Though it is likely the information is being kept in the closet because the purveyors don't want people to know how badly they've been duped.)


• As a way of opening demand to counteract a downturn, interest rates work after a lag. But of course, the direction is the opposite from that utilized in the inflation fight.
  

One possible silver lining to the financial sector fiasco is that it will prevent the Fed from doing what it wants to do when falling dollar inflation hits their spreadsheets. Of course, the best thing it could do would be to back away from the button and get to work putting some reins on the renegade market.

Samuelson on the current sorry situation

Paul Samuelson, author of the Neoclassical Synthesis, weighed in on the dangerous state of the current market error economy in in New Crisis, Balancing Market Freeedoms (issued the same day as the Fed's economic targets).

.... Today, central bankers and U.S. Treasury cabinet officers cannot know whether current interest rates are too high or too low. This is surprising, but true. The safest bond interest rates are indeed low. But financial panic engendered by the burst bubble of unsound U.S. and foreign mortgage lending means that even a mammoth corporation like General Electric would find it expensive now to finance a loan needed to build a new and efficient factory.

The situation is not hopeless. New, rational regulations that discourage predatory lending and rash borrowing could help a lot. Also, as we learned during the Great Depression, the government's treasury and its central bank must be both the lenders of last resort and the spenders of last resort. Speculative markets will not stabilize themselves.

Is Bernanke's inflation target futile?

Ben Bernanke's end run around Congress and the Humphrey-Hawkins bill last week in setting de facto inflation targets cannot make Barney Frank very happy. Frank is head of the House Financial Committee and a dogged critic of inflation targeting.

Frank sees the determination of the Fed under Bernanke to target inflation as misplaced, and feels the Fed is worrying too much about inflation and not enough about inecome inequality. "We are at the situation where distribution of wealth has become a significant economic issue," he said in July.

In February Frank told the Financial Times that Bernanke "has a statutory mandate for stable prices and low unemployment. If you target one of them and not the other, it seems to me that will be inevitably be favored." Transparency may be a smokescreen. "When you make it more transparent, you enhance its importance.... But when you make it public, you lose flexibility."

The Fed is mandated by statute to pursue two objectives for monetary policy -- low inflation and maximum employment. These two goals have become known as the "dual mandate." Absent an official or implicit employment target, an implicit target for inflation -- such as that issued November 19 by Bernanke -- seems to contradict the Fed's responsibility.

In a July 17 hearing, Frank's House committee heard economists weigh in on the subject.

Harvard University's Bejamin Friedman told the committee:

"The idea that economic policy should pursue price stability as a means of promoting more fundamental economic well-being, either currently or in the future, is not ground for pursuing price stability at the expense, much less the exclusion, of ... more fundamental economic well-being.

"It would be a mistake for the Federal Reserve to organize its monetary policy within an inflation-targeting rubric."

According to a Market Watch report by Greg Robb, "Friedman disputed the Fed's suggestion that an inflation target would improve transparency. He added that many of the world's central banks that have inflation targets "avoid any reference to the possibility of tension, even in the short run, between their inflation objective and any real outcome."

In the same July hearing, according to MarketWatch:

Prof. James Galbraith of the University of Texas said that inflation was killed by globalization in the early 1980s and would only come back if there was a collapse in the value of the dollar.

He said Bernanke should assure Congress "that interest rates will not be raised solely on the evidence of low or falling unemployment."

In fact, Bernanke's de facto inflation target is not only usurping Congressional power, but is inevitably flawed. As we will blog tomorrow, any effort to keep the falling dollar from appearing in higher inflation can only suppress the economy. The prices of imported manufactures from countries with flexible exchange rates must rise with the falling dollar, but more importantly, so will commodity imports like oil and metals. The strengthening of exports is good news for manufacturing companies and their employees, but it is no respite from higher prices. The prices of those goods with export markets will be bid up, and will rise for domestic consumers.

Keeping the lid on prices can be done only by suppressing wage rates. We've written the past two days that this is the Fed's preferred method, but its effect in the upcoming climate will only be to exacerbate the downturn.

Stiglitz: Wall Street Hypocrisy, Business as Usual

In a note available at Project Syndicate, Joseph Stiglitz reminds us of the ineptness, sometimes tragic ineptness, of Wall Street and the IMF. This account bears strikingly synchronous tones to our recent "The Economic Fallacy of Free Trade" in the PolicyIndex.

Ten years after the Asian Currency Crisis ...

.... Looking back at the crisis a decade later, we can see more clearly how wrong the diagnosis, prescription, and prognosis of the IMF and United States Treasury were. The fundamental problem was premature capital market liberalization. It is therefore ironic to see the US Treasury Secretary once again pushing for capital market liberalization in India – one of the two major developing countries (along with China) to emerge unscathed from the 1997 crisis.

It is no accident that these countries that had not fully liberalized their capital markets have done so well. Subsequent research by the IMF has confirmed what every serious study had shown: capital market liberalization brings instability, but not necessarily growth. (India and China have, by the same token, been the fastest-growing economies.) Of course, Wall Street (whose interests the US Treasury represents) profits from capital market liberalization: they make money as capital flows in, as it flows out, and in the restructuring that occurs in the resulting havoc. In South Korea, the IMF urged the sale of the country’s banks to American investors, even though Koreans had managed their own economy impressively for four decades, with higher growth, more stability, and without the systemic scandals that have marked US financial markets with such frequency. ....

The contrast between the IMF/US Treasury advice to East Asia and what has happened in the current sub-prime debacle is glaring. East Asian countries were told to raise their interest rates, in some cases to 25%, 40%, or higher, causing a rash of defaults. In the current crisis, the US Federal Reserve and the European Central Bank cut interest rates.

Similarly, the countries caught up in the East Asia crisis were lectured on the need for greater transparency and better regulation. But lack of transparency played a central role in this past summer’s credit crunch; toxic mortgages were sliced and diced, spread around the world, packaged with better products, and hidden away as collateral, so no one could be sure who was holding what. And there is now a chorus of caution about new regulations, which supposedly might hamper financial markets (including their exploitation of uninformed borrowers, which lay at the root of the problem.) Finally, despite all the warnings about moral hazard, Western banks have been partly bailed out of their bad investments.

Following the 1997 crisis, there was a consensus that fundamental reform of the global financial architecture were needed. But, while the current system may lead to unnecessary instability, and impose huge costs on developing countries, it serves some interests well. It is not surprising, then, that ten years later, there has been no fundamental reform. Nor, therefore, is it surprising that the world is once again facing a period of global financial instability, with uncertain outcomes for the world’s economies.

...

There's more. Read it and weep.

Inflation: Cost push, demand pull, Fed pratfall

Yesterday we looked at what is in the inflation basket, both in core inflation and headline inflation. We saw that the depression of wages over the past 30 years has been the chief inflation-fighting strategy by the Fed.

Today we follow that up with a look at the two dynamics of inflation, cost-push and demand-pull. We’ll give you our conclusion and forecast up front. The Fed will apply the interest rate brakes in error because it does not distinguish between the two dynamics, or if it does, it finds no problem in continuing to call on the middle class to shoulder the inflation-fighting burden for everyone.

First let’s listen to some of the conceptual context. Here’s Fed Chair Ben Bernanke responding to a question from Joint Economic Committee vice-chair Carolyn Maloney on November 8.

“... In all but the shortest of terms the Federal Reserve’s policy determines how much inflation there is, and we’re going to make sure that the inflationary impact that may come from the weakening dollar is not passed into broader prices and become part of the underlying inflation rate.”

Chairman Bernanke is adamant that the Fed not only can control, but can determine inflation in all but the shortest of terms.

Bernanke is not encumbered by concern for the real world. A practicing economist who spoke to the point was Carl Weinberg, chief economist at High Frequency Economics (November 20, Bloomberg’s “On the Economy with Tom Keene).

“... The Fed is out to control the things it can control. When it comes to goods and services, things that are controlled by labor costs, the Fed is in there keeping an eye on it. It doesn’t mean headline inflation isn’t important, but it means that in terms of the Fed monitoring things in terms of what it can do, I think core inflation is probably the place to look.

“Something else to think about is when you see food prices go up, or you see energy prices go up, that’s not inflation. That’s a relative price change. And in fact, the analysis is very different when you see the price of food go up relative to the price of everything else, because it squeezes out consumption of other things and is actually a depressing impact on the economy as long as we don’t have wage increases to offset those food price increases. So generally speaking a rise in food prices brakes the economy by itself. A rise in energy prices brakes the economy as long as other prices are under control.”

To round it off, here is Marvin Goodfriend, former Fed staffer, now a professor at Carnegie Mellon University and a Bernanke disciple (November 15, Bloomberg):

“...Insofar as inflation forecasts go, as you lengthen the horizon the Fed ought to be able to manage inflation. That is, you can target inflation over the long run. That’s the nature of what Monetary Economics teaches us, that Central Banks determine the rate of inflation over the longer run. So the longer the horizons are, the more these forecasts turn into targets for the Federal Reserve to aim at.

“On the other hand, the longer the forecast horizons are, the more difficult it is to forecast the real GDP numbers and the unemployment, over which the Federal Reserve has less control over the longer run.”

So the clear message is that the Fed under Bernanke feels it has an iron lock on inflation in all but the shortest of terms, and the only part it can really affect is wage growth by sponsoring ongoing slack in the labor economy. (Parenthetically, this is a big reason for the support of free trade in many financial quartes – it ships out wage growth).

But back to cost push vs. demand pull.

There are two reasons prices might go up. One is the price of inputs goes up – commodities like oil, metal, grain, etc. The second is that the supply of the product is insufficient for the demand, and the price is bid up. This second is the market’s very effective means of rationing scarce products.

The last event of demand-pull inflation in the US economy was in the 1960s under Lyndon Johnson, with the Great Society competing with the Vietnam War for labor and capital. It was called “Guns and Butter” inflation. American consumers, flush with cash, pulled prices up. Johnson responded with an income tax surcharge of 10 percent to cool off demand. He was the last president to make a tax increase the central point of economic policy. Since that time taxes have been equated with the vilest of sins, the US has run immense budget deficits, and the economy has generally performed at one-third the Johnson era level.

Also since that time – even in the “New Economy” Dot.Com boom of the 1990s, we have not had demand pull inflation (noting that inflation is a generalized rise in prices).

But we have had cost-push inflation. Beginning under Nixon with the first OPEC oil crisis: Oil supplies were reduced by the OPEC oil cartel for the precise purpose of pushing up the price. The market began to ration the supplies by way of the price mechanism. “Stagflation” began, and plagued the 1970s.

Yes, I said “ration.” Here, too, the supplies are insufficient for the demand, but because the supply is constrained. One is too many dollars chasing goods. The other is too few goods being chased. It’s all the same, you say? Upon reflection, you will see there is the possibility of balance without inflation that lies between the two extremes. But more importantly the events on the ground look different.

In demand-pull inflation, there is a boom. Producers are motivated to generate product in the earlier, lower cost years, further stimulating demand. In cost-push inflation, there is not a boom, because the costs of the commodities are already, as Weinberg says, braking the economy.

In terms of economic policy, stagflation was an important turning point. It was here that the country, under Richard Nixon and Ronald Reagan, took a hard right away from the Keynesian Demand Side policies that had accompanied the great growth of America after the Second World War. The proposition that supposedly refuted the Keynesian conceptual framework was the supposed contention by Keynesians that unemployment and inflation could not co-exist. This connection between inflation and employment began with the so-called Phillips curve, an invention outside Keynesian theory. But that made little difference to ideologues looking for a return to Supply Side dominance.

The inflation-employment connection continues today at the Fed (hardly a Keynesian institution) in the form of NAIRU – the non-accelerating inflation rate of unemployment. NAIRU as a proposition was blown up by Nobelist Robert Eisner, but adhered to anyway by the Fed, who may have realized that tighter employment markets might not accelerate inflation, but slack markets certainly dampened it.

And since the 1960s, in spite of the confusion of pundits, all recessions have been accompanied by inflation.

The Why of this is not difficult to see. Weinberg put his finger on it. If the product of an economy is composed of labor and commodity inputs, and the price of commodities goes up, in order to keep the overall price level constant, the price of labor must go down.

Now as we approach an inflation fueled by higher oil prices, higher commodity prices of all kinds – including food, metals and energy, and higher input prices from a falling dollar, we basically have two options. We can allow inflation; that is allow these pressures to be reflected in the overall price level. Or we can attempt to reduce demand further, put a lid on prices, by raising the interest rate. No matter that demand, as Weinberg says, is already dampened.

The risk is that the Fed will choose the low volatility in the short run, by increasing the downward pressure on the middle class, rather than allow the short-term price volatility that will release the pressure. Complicating the problem is that the asset investor bubble that moved from the Dot.Com boom to Housing has now migrated into commodities. This source of inflation pressure ought to be addressed by an increase in margin requirements.

The Fed has already released its inflation targets, although it refers to them as “forecasts.” And as you heard, the Fed considers itself duty bound to address only inflation, never mind regulating the Wild West of mortgage originators or the Wild West of unregulated securities and investment trusts. Never mind the collapsing dollar or incipient recession. The Fed will raise rates when prices begin to rise. Why raise rates instead of, say, increasing reserve requirements or some other demand-dampening tactic? Because as we’ve seen the Fed knows only one tool – the easy button of interest rates.

Two additional points.

One: Attempts to keep oil prices out of even core inflation are hopeless. Oil leads all energy prices – including coal, electricity and natural gas – as a component or as a substitute. These energy prices must contribute to transportation, power and heating components of other goods and services. A simple example, air travel.

Two: Raising interest rates to fight cost push inflation is similar to the medical practice of bleeding the patient practiced in the pre-scientific era. Higher interest rates contribute to higher costs, not what you want to do with cost-push inflation.

In the end, I suppose, the patient either recovers in spite of the treatment or dies. In either case, the disease is resolved and the Fed can point with pride at its interest rate remedy.

Conference Board Indicators Point to Weakening Economy

Our call that the economy was in recession as of the last week of October has still not found takers among the statistical model crowd, but here's a look at the Conference Board's latest thinking, Notice that all the indicators are negative except the stock markets and the supply of money. Both are explained by the financial sector crisis and bailout. The Fed's easing created the money. The flight from all sorts of alternative investment vehicles back into the mainline assets explains the stock market.

As we've said, and will repeat this weekend, Look for a strong stock market and rapidly weakening economy.

Fed target on inflation is painted on the backs of the middle class

Ben Bernanke told the Senator Chuck Schumer and the Joint Economic Committee on November 8, quote.

“... In all but the shortest of terms the Federal Reserve’s policy determines how much inflation there is, and we’re going to make sure that the inflationary impact that may come from the weakening dollar is not passed into broader prices and become part of the underlying inflation rate.”

The hubris is chilling.

What is inflation? It is a generalized rise in prices. A basket of consumer goods is priced from one period to the next and the rise in the sum of its prices is the rise in inflation.

Sometimes food and fuel are taken out of the basket purportedly to remove volatility, because their prices bounce around. The slightly emptier basket is called core inflation.

Bernanke is not encumbered by concern for the real world. A practicing economist who spoke to the point was Carl Weinberg, chief economist at High Frequency Economics (November 20, Bloomberg’s “On the Economy with Tom Keene).

“... The Fed is out to control the things it can control. When it comes to goods and services, things that are controlled by labor costs, the Fed is in there keeping an eye on it. It doesn’t mean headline inflation isn’t important, but it means that in terms of the Fed monitoring things in terms of what it can do, I think core inflation is probably the place to look.

“Something else to think about is when you see food prices go up, or you see energy prices go up, that’s not inflation. That’s a relative price change. And in fact, the analysis is very different when you see the price of food go up relative to the price of everything else, because it squeezes out consumption of other things and is actually a depressing impact on the economy as long as we don’t have wage increases to offset those food price increases. So generally speaking a rise in food prices brakes the economy by itself. A rise in energy prices brakes the economy as long as other prices are under control.”

We'll take up food and energy below, but the key point here is a primary component of prices -- up, down, or sideways -- is the wage rate, or remuneration to workers. Not, of course, as a separate item in the basket, but as an element of all the items, all the goods and services. This is particularly true of the core inflation basket. And this is the secret the Fed has found to keeping inflation down, keeping enough slack in the labor market.

Real wage rates have stagnated since the 1970s. “Real” means adjusted for inflation. Productivity has gone up by 50 percent. Wage rates could have adjusted upward by 50 percent. Imagine the economic dynamo. This is particularly true since the turn of the century (see chart). Productivity gains have not been realized by workers, but have been transferred to the upper classes (the rentiers, as Keynes called them) and to the producers of commodities and services, notably health care.

If we look at “core” inflation as a proxy for the price of labor, we begin to get a different take on inflation. The evil of rising labor prices is not so easy to fathom. If labor prices rise, demand rises, and presuming there is capacity in business, all boats rise. Labor prices can rise at the rate of productivity improvement without increasing inflation. Instead, labor prices have risen only at the lethargic rate of core inflation, thus real incomes have stagnated, as mentioned.

Combine this with the fact that food and fuel consume a great deal of the American budget, so removing them removes much of what is important to lower and middle class Americans. This "headline" inflation affects different economic levels differently. Food, fuel and health care make up a larger portion of the costs at the lower end. The rate of inflation has been greater for the bottom ranks of the population than for the top. In fact, the inflation rate goes up as you go down the income scale. This means the balance is made up at the upper end with lower inflation.

So when the Fed chairman insists he has the answer to the inflation problem, that the Fed controls inflation, the middle class of America should watch out. The interest rate button, the Fed’s tool of choice, is connected to a trap door under their jobs.

Toxic paper comes to State funds

State pension funds and general operating funds nationwide have apparently invested in the toxic paper produced by the unregulated financial markets, according to Joseph Mason, associate professor of finance at Drexel University.

On Bloomberg, Mason made some bone-jarring revelations.

• The CDOs and structured debt for corporations that have similar weaknesses could plague the economy into 2012 and beyond.


• Subprime mortgages are not the only debt with resets to be packaged and sliced (tranched) for the investing animal. Corporate debt, too, has resets coming due.
  


• Why was the contagion in credit markets not confined to subprime? Corporate borrowers are on the hook for the same sorts of problems. This is not invisible to those on the inside. (That is three bullets on the same point. But it begins to reveal why credit markets are seizing up when the problem is advertised to reside only in CDO's holding subprime loans.)
  


• $40 billion has been written down so far, out of at least $400 billion. These resets will be cleared by the end of 2009.
  


• Not only is it your pension fund, it is in your state's general fund. State's run their own money market funds, and have been buyers of the toxic paper.
  


• State money market funds do not have a parent bank to bail them out. They have only the taxpayer. It is the taxpayer's money that is in these money market funds. (Note: The federal government is restricted from this type of activity by the Treasury's tax and loan account program, which places federal taxes in commercial banks, but only in safe, liquid accounts. States are not following this model.)
  


• The bind on state budgets is a direct line into the middle and lower income levels, where recessions are made. Demand Side perspective gives state budgets a full pass-through in the multiplier. That means a hit to the state government is a body blow compared to a hit on the financial sector, which is a jab.
  

The problem is not a liquidity problem. A liquidity problem is where an instrument has a price, but there is no money to buy it. These "credit market innovations" are opaque, so potential buyers guess at what they're worth and then discount the value for the risk of not knowing. Potential sellers don't like the prices. No market. But not because of liquidity.

While everybody who owns this toxic paper is blowing smoke to disguise their irresponsibility, it is coming clear that many states are in significant jeopardy. A short look at one example will also show how big $400 billion is, or $900 billion, or even $1,500 billion -- all figures that have been offered as costs for this debacle -- and what sort of fix they're in.

Florida has an annual budget of $50 billion, according to Mason. Its annual revenues are about $36 billion. (Notice, a large state's annual budget is small compared to the impending problem.) Imagine that Florida has invested in structured debt with tax money in a kind of self-sponsored money market accout. Maybe 4.37% of this debt is in instruments already downgraded to near zero, and maybe another 7.33% is in portfolio credit watch negative. That could be $2.2 billion in the first account, and $3.6 billion in the second account. Maybe this is 12% of the fund.

Consider further that, as Florida, your sales tax revenues are plummeting from the recession and you have no income tax. This is 12% of your annual revenue for 2006. The outlook for 2007 is worse. You have no big brother to bail you out, as the bank's money market funds do, or as the entire financial sector does with the Fed. You have mandated programs like food stamps, health and social services, etc.

Remember that in the Depression, some state's went bankrupt, closed universities and other operations, and paid remaining employees with IOUs.

Be glad you are not Montana, with possibly 20% of its fund in jeopardy.

The economic fallacy of "free trade"

The economist's definition of the benefits of trade is based on the concept of comparative advantage:

There will be a net gain to both countries with trade because it allows each country to produce from its comparative advantage, which is that good or goods where it is least inefficient.

A classic example of comparative advantage: Scotland can produce five bales of wool per acre and only a gallon of bad wine per acre. France can produce ten bales of wool per acre or twenty gallons of good wine. France has the absolute advantage in both products, but it still makes sense for both countries for Scotland to trade wool for French wine. Both will end up with a better total product.

From this concept, economists take a great deal of pleasure. It is simple, obvious, and illustrates that economists are enlightened and the public are Luddites. (See Alan Blinder's treatment.)

In fact, there will be a net gain, but there is a big hole in the "net" when the gain is not shared. The hole in this net is big enough to drive one-third of American manufacturing through, and tens of millions of Latinos back the other way.

The experience of trade is different than this economist's dream of stylized facts and frictionless perfection. To say trade is a net benefit, is similar to saying there is enough food on the planet to feed everyone and enough money to provide clean water and health care and then walking away as if everything is fine. The market does not distribute according to need, but according to the power of its participants. And those who bear a great deal of the costs of free trade are often not among the powerful.

We've put up the whole story at the web site.

Rebalancing the global economy

This graph from the UN Dept. of Economic and Social Affairs displays, among other things, the pressure on the dollar. As a so-called "reserve currency," the dollar has become a commodity in itself, and not simply a medium of exchange. As we've written elsewhere, a correction has long been called for by all standard economic theory.

A collapse in the value of the dollar, however, is not the best way to resolve the imbalance, believe it or not. It leaves the rest of the world -- notably China, Japan and other developing nations -- holding the dollar bag. They lent us the money to buy their products. Now we are saying we'll pay them back in cheaper dollars.

The flip side is they depend on our markets for their economic activity. The slide of the dollar means a rise in their currency (unless China continues to starve itself in its obstinance). The UN DESA puts it this way:

A global contraction, triggered by a tight reining in of domestic spending in the United States is one way out, but this is neither what the United States or the rest of the world would hope for. Equally disruptive would be a large and rapid devaluation of the dollar. The alternative is a long- term strategy of re-switching the impetus of global demand growth to surplus economies, mixed with a rebalancing in the United States, from household consumption to business and infrastructural investment.

They correctly suggest free marketeers and their nannies in the central banks have a different notion, a short-term fix of cheap money:

Some commentators still argue that the best chance of the United States economy, and with it the world economy, regaining a degree of balance is to allow the market mechanism to re-price risk, adjust exchange rates and weed out irresponsible investors. Th e decisiveness with which central bankers reacted to the crisis is a clear sign that financial markets cannot be left to their own device and that some form of intervention is necessary. But to spare the world economy from a succession of similar crises, equally decisive action is needed by policy makers to correct the global imbalances.

Business and infrastructure investment is productive and forward-looking. Equally forward-looking would be a wholesale shift to producing new energy technology and equipment as merchandise for trade with the rest of the world. Better and more stable, at least, than producing small green pictures of men in powdered wigs.

This is the rational, cooperative and stable approach. We think it has as much chance as another proposal of similarly broad and coherent view, proposed last year for the calamity in Iraq. That would be the proposal from George McGovern and William R. Polk to rebuild that country from the inside. The tough answers then and the hard-headed answers now will likely take another road. Then into the slough of hell, here into a further feeding of the financial sector. Both result not in stability and a way forward, but in a ratcheting up of the dangers and going further down the wrong road.

Economic Performance by President Charts Up

Long promised charts displaying the economic performance in the post-war years by president are up at the DemandSide.net

No wonder they chose the color red.
Borrowing is higher, employment and investment lower under Republicans. Or if you prefer the more positive, Democrats have been good for employment, investment and fiscal responsibility.

There are the charts by president for borrowing, employment, unemployment, net real GDP, real GDP, investment and corporate profits. Charts by year (not included this month) show the consistent improvement of the economy under Democrats and the volatile nature of the measures under Republicans. That's for next year, or the book.

Stiglitz: The economic consequences of Mr. Bush

John Maynard Keynes wrote "The Economic Consequences of the Peace" shortly after resigning from the British team negotiating the Treaty of Versailles. That treaty set the reparations requirements from the losers of World War I. In that short book, he correctly identified the consequences of the economic vise imposed by the allied victors on Germany. The consequences? Impossible economic contradictions, social unrest and a fertile field for the kind of desperation that fueled the Third Reich.

Keynes also wrote a shorter piece later, "The Economic Consequences of Mr. Churchill," pointing out the dreadful consequences of the latter's insistence on a macho currency regime.

Now we have Joseph Stiglitz and "The Economic Consequences of Mr. Bush," in Vanity Fair. This is a well-deserved excoriation of the performance of the president since taking office. The consequences are grim. Stiglitz is the best economist practicing today. Read it.

Stagcession and Inflation, Bernanke's not on board, but he's on the tarmac with his suitcase

Now I'm worried. Ben Bernanke seems to agree with me. Inflation AND recession. (Blog or better, check out the two podcasts on the subject via the link to the right). Not that he would speak so clearly, particularly when he has lots of covering of his backside to attend to, but the tone changed in testimony before the Joint Economic Committee and Chuck Schumer today.

Particularly note that further rate cuts are not indicated by either his long-term imagination that economic fundamentals will eventually come around, nor by his concerns for short- and long-term inflation. In spite of this, you don't need to be a Fed watcher to know that further interest rate cuts are coming to benefit the financial sector and credit markets.

Bernanke's testimony, in part:

"[The FOMC does} not see the recent growth performance as likely to be sustained in the near term .... the contraction in housing-related activity seem[s] likely to intensify. Indicators of overall consumer sentiment suggested that household spending [will] grow more slowly, a reading consistent with the expected effects of higher energy prices, tighter credit, and continuing weakness in housing.

....

" [H]eightened uncertainty about economic prospects could lead business spending to
decelerate as well. Overall, the Committee expect[s] that the growth of economic activity [will] slow noticeably in the fourth quarter from its third-quarter rate.

"Growth [is] seen as remaining sluggish during the first part of next year, then strengthening as the effects of tighter credit and the housing correction began to wane.

....

"The Committee also [sees] downside risks to this projection: One such risk was that
financial market conditions would fail to improve or even worsen, causing credit conditions to become even more restrictive than expected. Another risk [is] that, in light of the problems in mortgage markets and the large inventories of unsold homes, house prices might weaken more than expected, which could further reduce consumers’ willingness to spend and increase investors’ concerns about mortgage credit.

....

"[The] inflation outlook was also seen as subject to important upside risks. In particular, prices of crude oil and other commodities had increased sharply in recent weeks, and the foreign exchange value of the dollar had weakened. These factors were likely to increase overall inflation in the short run and, should inflation expectations become unmoored, had the potential to boost inflation in the longer run as well."

His recommendations for policy changes and his belated oversight efforts come long after the horse is out of the barn. His analysis of the problems comes fully two years after they would have been useful.

Net Real GDP by President, for Podcast

Here's the chart relating to the Net Real GDP podcast, 11/05/07.

Prediction holds: Strong Stock Market, Weak Economy

Here is our Sept. 29 forecast, with updated text in CAPS.

The economy slips toward recession and stocks ignore it. Why? Courage from the average investor perhaps? Confidence in the underlying strength of the economy? Hardly.

Investors are in full flight, trampling each other to get out from under the collapse of the housing industry, just as they rushed out of stocks and into housing after the so-called dot.com bust. Now they are fleeing housing after creating a similar fiasco in that market. But the money has nowhere to go.

The Fed’s solution to every crisis since 1987 has been to pump low-cost money into the financial markets. That’s one reason Wall Street thinks IT SEES strength over the past four decades while Main Street has turned into a row of double-wides.

The money pump rattled into action again on September 18, when Bernanke and the Fed cut rates by half a point. There was only one excuse: To give the financial markets "confidence" so they can “run smoothly.” Bailing out financial institutions is a central bank theme. IT KEPT CHUGGING ALONG ON OCTOBER 31, WITH ANOTHER QUARTER POINT. AGAIN,THE AVOWED PURPOSE WAS TO:

"forestall some of the adverse effects on the broader economy that might otherwise arise from the disruptions in financial markets and promote moderate growth over time." (Fed statement, 10/31)

"GROWTH OVER TIME" MEANS THEY KNOW INTEREST RATES DON'T SIFT INTO THE REAL ECONOMY FOR 18 MONTHS. THIS IS NOT ABOUT ECONOMIC HEALTH, IT'S ABOUT BAILING OUT THE BANKS.

IN THE OLD DAYS, "LIQUIDITY" USED TO MEAN CASH AND LIQUID ASSETS, NOW IT MEANS ACCESS TO CREDIT. THE RATE-CUTTING ACTION OF THE FED IS EQUIVALENT TO PRINTING MONEY FOR THE FINANCIAL SECTOR.

So we have plenty of money sloshing around at the top. But where to put it? Housing is deflating. (Pity the poor homeowner who was counting on that to finance his retirement.) Stocks? It IS rumored some companies have foreign presence. Bonds? Sure, but you’re going to lose real value if inflation kicks up. COMMODITIES, OF COURSE, ARE TOPS AS AN INFLATION HEDGE AND AS A FIRST BET ON THE NEXT BUBBLE.

BOTH PRINTING MONEY AND BIDDING UP COMMODITIES MEAN WE ARE IN FOR INFLATION. INFLATION AND RECESSION IS THE RULE NOWADAYS, AND UNFORTUNATELY THE MILLIONS OF INFLATION FIGHTERS IN THE FORM OF THE UNEMPLOYED CAN'T TOUCH A COST-PUSH INFLATION THEY DIDN'T START.

The smart money is buying foreign securities. Even if they don’t appreciate in value, you can ride up with the underlying currency. Or at least avoid sliding down with the dollar.

WEAKNESS IN THE STOCK PRICE OF THE FINANCIALS IS NOT WARRANTED. THE FED IS PROVING "TOO BIG TO FAIL" IS STILL IN OPERATION. WHAT COULD BE BETTER FOR A BANK THAN ACCESS TO THE MINT? A MASSIVE TRANSFER OF WEALTH FROM THE REAL TO THE FINANCIAL ECONOMY IS UNDER WAY. GET THOSE FINANCIALS WHILE THEY'RE DOWN.

The economy? No. Fed action is to benefit the financial sector

If Fed action is supposed to forestall a downturn in the economy, there is a small problem. Interest rate cuts work into economic results only after a lag of about 18 months.

The Fed action is really about bailing out the financial sector. Banks are in big trouble, with their off-balance sheet vehicles threatening to come onto the balance sheet when more CDOs turn bad. The so-called Super Conduit, or whatever its current name is, will only push the problem out six months. When the borrow short, lend long SIVs come back home to live, the sheet will hit the fan.

At least $400 billion is likely tied up in this mess.

And to be fair, the Fed didn't pretend that this was an attempt to improve things on Main Street. Their statement began:

The Federal Open Market Committee decided today to lower its target for the federal funds rate 25 basis points to 4-1/2 percent.

Economic growth was solid in the third quarter, and strains in financial markets have eased somewhat on balance. However, the pace of economic expansion will likely slow in the near term, partly reflecting the intensification of the housing correction. Today’s action, combined with the policy action taken in September, should help forestall some of the adverse effects on the broader economy that might otherwise arise from the disruptions in financial markets and promote moderate growth over time.

(emphasis added)

There is panic in the big banks.

The problem is too big for the only tool the Fed ever uses, the interest rate, to solve. Rate cuts are no doubt the wish of everybody on the FOMC's cocktail circuit and these banks and bankers will call the tune for the Fed, but this is not a moral hazard we're driving a golf ball into. This moral hazard is a sinkhole swallowing the dollar.