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Tuesday, February 12, 2008

The Banking Sector: Culpable, Insolvent, Desperate --- Podcast Transcript

Direct look at the banking sector

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and we finish with a parable. I misspoke on Monday. This parable of Jesus is from Matthew 18, not Luke.

First let’s begin with some context, courtesy of New Deal Democrat. NDD blogging at Daily Kos. From his Dark Clouds, Silver Lining piece. This is last week’s data, but if you’re looking for the start of the recession, you should be looking in the rearview mirror.

Like a cascade from Imelda Marcos' closet, within the last week, the last shoes have dropped among the indicators used to forecast recession.

Retail sales, which had been holding up decently, tanked in January. Jobless claims have increased, layoffs have increased, payrolls have decreased. While manufacturing, which is now only 10% of the economy grew ever so slightly, the 90% of the economy representing services suddenly and dramatically contracted. And housing continues to sink into the depths like the Titanic.


This morning we found out that it wasn't just Wal-Mart customers who've been tightening their belts recently. The affluent middle class (the 80th-90th percentile of consumers), have also cut back, and stores like Macy's and Nordstrom felt the pinch:

Feb. 7 (Bloomberg) -- Limited Brands, Macy's and Nordstrom Inc said January sales declined while Wal-Mart’s gain trailed analysts' estimates as consumers facing the worst housing market in a quarter century avoided clearance sales and saved gift cards for future purchases.


Department stores and mall-based shops slashed prices on clothing and bedding to attract customers following the slowest holiday season since 2002. Consumers refrained from spending as median home values probably fell for the first time since the Great Depression and employers cut back on hiring.

Also February 7: first-time jobless claims for the second week in a row were over 350,000. Once there is an established trend of weekly new jobless claims over 350,000, almost certainly we are in a recession:

In the same report,

Private placement firm Challenger, Gray & Christmas Inc. said Feb. 4 that job cuts announced by U.S. employers jumped 19 percent in January to 74,986 from a year earlier.

And while the manufacturing sector, which is now so atrophied that it accounts for only 10% of employment in the US, grew ever so slightly as of the last report, on Tuesday we found out that the ISM services index suddenly and dramatically contracted:

The ISM's non-manufacturing index, which assesses banks, retailers and construction companies, slumped to 41.9 from 54.4 the prior month. A reading of 50 is the dividing line between growth and contraction.

Worse still, the ISM index is closely correlated with layoffs, meaning that in January 2008 it is likely that nationwide payrolls contracted substantially.

All of this is added to last week's report that in December nonfarm payrolls not only did not grow, but actually shrank by 18,000 jobs.

That from NDD, to whom we extend our appreciation.

Now let’s turn to the banking sector. A primary purpose of the Fed’s interest rate cuts has been to stabilize this sector. Bernanke has at times been explicit about it. Only secondary, in our opinion, has been the aim to promote economic activity. Stabilization is not working.

Banks and the shadow banking system are culpable for this economic crisis. They are insolvent as a result of their own mistakes and misdeeds. And they are desperate to find a way out. The Fed is helping them as much as it can, though Bernanke and colleagues cannot be pleased that at the same time rates TO banks are being cut, the banks themselves are turning around and jacking up the rates on their own customers, particularly credit card customers. This gives lie to the whole purpose of cutting Fed rates, as it will inevitably contract spending and further cut the legs out from under the retail economy.

The banks and hedge funds and others engaged in ludicrous — at least in retrospect — financial engineering, creating securities which got triple A ratings because they had the word mortgage in them. Then further engineered them into other securities to create total leverage of sometimes forty or fifty to one. So-called off balance sheet vehicles were created so banks did not need to follow prudent capital reserve requirements, but could own in a fashion the higher yield securities. Turns out they were still in house, they were just hidden in a closet.


As these securities and lending practices came home, the banks capital reserves disappeared. The Fed with a wink and a nod has suffered accounting standards to be flexed. In addition, it has set up a special auction facility which takes any paper as collateral for low-interest loans, thus giving value to the valueless and putting the taxpayer on the hook in the event of default. But we already knew they were too big to fail.

In a minute I will speculate on some possible ways of bailing them out. Necessarily imaginative.


Losses according to Nouriel Roubini for the financial sector are $250 to $300 billion. If a ten percent reserve requirement is in place, this contracts lending capacity by $2.5 to $3.0 trillion. The banks have already been around the world once with their tin cups out to the sovereign wealth funds. As above, they’ve tapped into the sovereign wealth of the U.S. Treasury. And now where possible they are squeezing their borrowers – as with the recent round of credit card rate increases.

Credit cards and equity loans have blurred the meaning of money. While I do not understand all the measures — M1 through M6 — I do know that practically speaking credit cards are the money of the retail economy. Look for a drastic cut-back in retail sales and a sharper dive into recession.

Financial markets do not regulate themselves. When they’re allowed to try, the result is a mess. The boom-bust has led to the worst housing recession in U.S. history.

Credit card, student loan, and auto loan defaults are on the way.

The so-called monoline insurers are not long for this world, as they are exposed to the toxic paper and have no standing once their triple A ratings dissolve. Which they are sure to do.

The bankruptcy of a large bank is if not inevitable, at least likely. Already Countrywide has been bailed out with a 55 billion dollar loan from the Federal Home Loan Bank.

So. Culpable. Insolvent. Desperate.

Which brings us to tonight’s parable, from Matthew Chapter 18. At the risk of sounding apocalyptic I’ll just read from the New English translation.

Verse 23

There was once a king who decided to settle accounts with the men who served him. At the outset there appeared before him a man whose debt ran into millions. Since he had no means of paying, his master ordered him to be sold to meet the debt, with his wife, his children, and everything he had.

The man fell prostrate at his master’s feet. “Be patient with me,” he said, “and I will pay in full;” and the master was so moved with pity that he let the man go and remitted the debt. But no sooner had the man gone out that he met a fellow-servant who owed him 100 denarii, and catching hold of him he gripped him by the throat and said, “Pay me what you owe.”

The man fell at his fellow-servant’s feet, and begged him, “Be patient with me, and I will pay you;” but he refused and had him jailed until he should pay the debt. The other servants were deeply distressed when they saw what had happened and they went to their master and told him the whole story. He accordingly sent for the man. “You scoundrel!” he said to him; “I remitted the whole of your debt when you appealed to me; were you not bound to show your fellow-servant the same pity as I showed to you?”

And so angry was the master that he condemned the man to torture until he should pay the debt in full. And that is how it will be with you, unless you each forgive your brother from your hearts.

Are these banks not doing the same thing as this hypocrite. The Fed is risking real debasement of the currency to attempt to heal them. Heavy inflation is virtually guaranteed. Yet the beneficiaries – the banks — are not joining in the attempt to get the economy going, but are turning on their own borrowers with no pity.




This is Alan Harvey from the Demand Side.

Monday, February 11, 2008

The Home Owners Loan Corporation
and other real answers to the impending crisis

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Today we have audio from Robert Kuttner, then I’ll give you some details on the Home Owners Loan Corporation, a New Deal model we could use today to clear the housing market. Kuttner will be back with observations on the political dangers to Democrats.

Remember to change your subscription on iTunes to demandside reborn one word lowercase. That link offers you the serialized version of Demand Side, the book, all at no cost or obligation. We’re moving through the history chapter and should be into economic performance by president, Chapter 4, by the first of next week. Look forward to consistent high marks for Democrats across the range of economic measures — growth, employment, investment AND profitability, all while borrowing trillions less.

Now Robert Kuttner, excerpted from an interview with Amy Goodman at Democracy Now on January 23.
ROBERT KUTTNER: ... the place to start is to recognize why this recession is different from all other recessions. This began and is continuing with a collapse in credit markets, and the collapse in credit markets is, in turn, the result of deregulation gone nuts. And it’s a repeat of a lot of things that happened in the 1920s, where there was too much speculation with too much borrowed money and a complete lack of transparency. The regulators, the public had no idea of what these bonds that had been created out of subprime mortgages really contained, what they were worth. The people who packaged them were not subject to any kind of regulatory scrutiny.

And when it turned out that a lot of these loans were never going to be paid back, the layer upon layer upon layer of bonds and then securities based on the bonds—you know, if you can picture the World Trade Center collapsing floor by floor or you can picture the collapse of the Ponzi schemes of the 1920s, that’s a good—or horrible—analogy. And when you have a credit contraction, it means that banks have less capital against which to make loans, and lowering interest rates doesn’t fix that.

There are two other things that lowering interest rates and an ordinary stimulus package won’t fix. One, you alluded to in your opening comments, Amy, and that’s the collapse in housing prices. At the current rate of decline in housing values, American homeowners—and that’s about 70 percent of Americans—are going to lose $2.2 trillion of net worth this year alone. Well, when you lose $2.2 trillion of savings, you’re not inclined to rush out and do home improvements, you’re not inclined to rush out and buy durable goods. And again, compared to that kind of a loss, a stimulus—and they’re talking about $140–$145 billion, that’s one percent of GDP—that’s a drop in the bucket.

Lastly, this occurs on top of thirty years of increasing insecurity on a whole bunch of fronts: the greater risk of losing your job, the greater risk of having your paycheck not keep pace with inflation, rising energy costs, rising tuition costs, rising health insurance costs. All of the things that make you middle class have become more difficult to attain in the past thirty years. So you’ve got a three-layer cake here. You’ve got this thirty-year history of flat or declining living standards for most Americans, you’ve got this terrible weakness in financial markets, and you’ve got this housing collapse.


the great experiment in deregulation really started under Carter in the late 1970s. It was Carter who started the deregulation of trucking and natural gas and broadcasting. And the whole ideology of deregulation and the practice of deregulation was unfortunately bipartisan.
That’s Robert Kuttner, co-founder of the American Prospect, once an investigator for the Senate Banking Committee, and as good an economist as exists in Washington.

Let’s take the mortgage crisis. What is a way to clear the markets and keep people in their homes?

Kuttner suggests a resurrection of the Home Owners Loan Corporation of the New Deal era.

Information from Answers dot com was provided under the sponsor:

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During the 1920s a typical down-payment was 35 percent for mortgage loans lasting up to only ten years at interest of 8 percent. At the end of that period, borrowers had to hope they could refinance or somehow in some other way come up with the remaining cost of the property. The lending institutions did not offer loan mortgage insurance and were often dangerously under-funded.

The number of mortgages issued nationwide dropped from 5,778 in 1928 to a mere 864 in 1933, and many banks went under, dragging homeowners down with them.

There were three choices:

Marrner Eccles at the Fed urged the policies of the great John Maynard Keynes, public programs operating directly, shoring up the lagging building trades and producing the badly needed housing.

Herbert Hoover preferred to support the banks, the lenders in the private market. In 1932 he created the Federal Home Loan Bank. The number of mortgages let was nationwide under Hoover’s programs was fewer than ten. Total.

Franklin Roosevelt, in his New Deal, in the summer of July 1933, created the Home Owners Loan Corporation, which was authorized to issue new loans to replace the existing liens of homeowners in default.

Of the almost two million applicants, half were accepted, those who could demonstrate a determination to meet their financial obligations and a history of doing so. Existing lenders had to accept losses from lower appraisals, and they were happy to do it. A government guarantee of four percent interest was worth far more than the zero percent they were getting, even if the zero percent applied to a higher valuation.

The HOLC was short-term. It actively issued loans for only three years, between 1933 and 1936. It was liquidated in 1951 at a small profit.

The situation is starkly similar to adjustable rate mortgages of today, which like the short-term loans of the 1920s, are tenable only when refinancing is available on favorable terms.

The HOLC offered full amortization, meaning when the last payment was made the house was owned free and clear. This was built into most future mortgage instruments, until recently. It offered below market interest rates and close counseling and assistance for borrowers. The result was extremely low default rates for what were the subprime borrowers of the day.

As envisioned by Kuttner, the 2008 HOLC would purchase at a deep discount, perhaps 30 to 40 cents on the dollar, the securities that hold the mortgages. At present many of these securities m are valued at zero, since there is no other market for them. There may be tens of billions at the Fed, however, which has taken the shakiest paper as collateral in its special auction facility.

The HOLC program would repopulate homes by offering below market terms. It seems to us that these terms ought to include adjustments should market prices fall further. One very understandable reason for softness in the current market is that would-be buyers are on the sidelines. If these buyers could be insulated from the risk of falling prices, they would come into the market. If they came into the market sufficiently, prices would cease to fall.

We should be clear, falling equity values in the presence of a federal program to rescue the housing market is going to create stresses among those who behaved responsibly over the past half dozen years.

We should also be clear that this just clears up part of the mess. Regulation of the financial sector is likewise essential, as is a forward-looking recovery program — built on infrastructure, green technology and jobs — not one-time, short-term stimulus.



.. let’s bring this back to politics. There’s a big risk that the Democrats, trying to be realists, trying to help out in a crisis, enact something that President Bush can sign, and then their fingerprints are on a piece of legislation that is obviously not going to solve the problem. There’s a time for bipartisanship, and there’s a time for a partisan difference. It seems to me the duty of an opposition party is to oppose, and this is one of those moments when the Democrats would be well-advised to really clarify the differences between themselves and President Bush.

But I want to bring it back to politics in a broader sense. This did not just happen. This was not an accident. This was the agenda of business, particularly Wall Street, going back thirty years. And if you look at the history of this, the Great Depression discredited free-market ideology, because it was such a colossal practical failure. Nobody in the 1930s could argue with a straight face that free markets worked. And so, we had a whole mixed economy, a regulatory structure invented during the New Deal, that really lasted thirty or forty years. By the ’70s, for a variety of reasons, big business had recovered a lot of the political power that it had lost in the Depression. And both parties, beginning with Carter, continuing with Clinton, became enablers of the kind of deregulation that finally has come home to roost in this crisis.

So now we’re learning, painfully, for a second time a lesson that we never should have had to learn twice, that markets don’t regulate themselves. Markets, left to their own devices, create grotesque inequality, ruin the environment and ruin the economy. And we’re seeing that unfold.
Robert Kuttner, American Prospect, author of The Squandering of America, once a chief assistant to Senator William Proxmire.

The political dangers are real. It will be a sad day for Democrats if they underestimate the potential of current slowing to become a real and deep recession. Stagflation. Or if they overestimate the effectiveness of the Fed and its interest rates or their own economists and the stimulus package.

We will need the crisis to unfold, of course, in order to offer the conditions needed to mobilize public support, but a crisis will not provide other necessary elements — like competent political leadership and workable strategies. We’re hoping Democrats spend their political capital to put in place the reconstruction of the middle class economy, to spend it on success, rather than watching it erode through failure.

Tomorrow is five minutes with Bush One in the next section of Demand Side, the book, and we’re back on Wednesday, with a parable from Luke chapter 18, about a man whose debt ran into millions and who was on his way to being sold into slavery when his master relented. The same man went to a person who owed him only a few denarii, and the man would not relent, but had him put into prison until he should pay. It reminds me of certain banks, Bank of America, for example, who have been getting below zero real interest rates from the Fed and have now turned on their cash-strapped borrowers with new and steeply higher rates. In the Bible and the parable, when the master finds out about this, there is hell to pay for the hypocrite. We’ll discuss the terms on Wednesday.

Until then, this is Alan Harvey, from the Demand Side.

The full interview with Kuttner by Amy Goodman

More is available below

AMY GOODMAN: And what could the Democrats do right now as an opposition party?

ROBERT KUTTNER: Well, I think there are three things they ought to be doing. First of all, there’s the housing mess. We need something like the Home Owners’ Loan Corporation of the 1930s, where a government agency, financed by government bonds, would buy these bonds back from Citigroup and Merrill and whoever at a steep discount, maybe thirty or forty cents on the dollar—they’ve already been written down to zero, because nobody wants to buy them—and turn them back into affordable mortgages, turn them into mortgages that would have a rate below market instead of the kind of predatory rate that subprime mortgages had. And you could then repopulate these houses. People on the brink of foreclosure would be able to keep their houses. Other people could become homeowners. So you need a much bolder approach to the housing crisis.

Secondly, I don’t even think “stimulus” is a good word. You need a recovery program. And a recovery program means not just a quick shot in the arm, it means reversing all of the things that make it harder to be middle class in this country. It means everything from a massive program of infrastructure repair to energy independence to good jobs in the service sector, reversing the whole thirty-year trajectory of ordinary people finding that their personal economic situation is insecure, they can’t keep up with the cost of living. And a “stimulus” implies a kind of a quick jolt to get us out of a temporary problem. This is not a temporary problem, this is a long-term problem. It’s going to require long-term solutions. And that doesn’t even get at some of the harder stuff, like the dependency on foreign borrowing that was caused by chronic trade deficits that in turn were the result of bad trade policies.

Thursday, February 7, 2008

How bad can it get -- podcast transcript for Friday, February 8

How bad can it get?

That is the main question I began my interview with. E.B. — E.B. Workman — is a very effusive fellow most of the time, but this time he answered in one word, “Bad.”

In listening to these podcasts, you have probably thought me a somewhat pompous fellow, always using the imperial “we.” It wasn’t the imperial “we,” it was the collective “we.”

I am an inveterate student. I have become a person of questions and the podcast has been a medium of the answers. Many of the answers and more that a few of the better questions have come from E.B. Today I’m going to just do questions and answers.

Why? Because things could get bad and I want to be clear. And also because any of you who have questions can forward to them to Demand Side at podcast@demandside.net.

Remember, also, to change your subscription to the new demandside by way of the website or just at iTunes. The new broadcast locus is demandside one word lower cast. Next time the original site eats up its bandwidth, which it is doing at a heartening rate, it will be the last time we are available through that location.

Question. Why is it going to get bad?

Because the problem is deep and broad, the policy-makers have no intention of facing up to it, and this is because neither they nor the broader population they need to back them up know the dimensions or the dynamics.

What, precisely, is the problem?

A financial sector collapse carrying down with it thousands of billions in debt and net worth. Or to put the clothes on it from before November 2007, the problem is the huge build-up of debt over the past decade, and particularly since the year 2000. This leverage inflated a housing bubble, but also inflated values of commercial real estate and other financial assets and created a second round of problems which has so far been kept behind the curtain.

There was more about that, but I want to get on to the questions on the stimulus plan. E.B. says the plan won’t work.


Because it cannot do what it is supposed to do — reflate the value of those collapsing financial assets. It is not a matter of the interest rate on the debt. It is a matter of collapsing prices. If you borrow $200,000 to buy a home that is going to be worth $150,000 in two or three years, it doesn’t matter how low the interest rate is, the effective cost of financing is going to be astronomical. Similarly, business is not going to invest — put money out up front — in an environment which will not produce profit. The cost of financing failure is enormous, no matter how low the interest rate.

Instead that new liquidity will flow to the rising assets, commodities, currencies and debt in other countries — creating inflation and instability worldwide.

But I was talking about the bi-partisan $600 chicken in every pot. What effect will that have?

Let’s talk NEGATIVE STIMULUS from the government over the past two weeks, according to E.B.’s thinking.

First, dispense with the tax breaks for business. As above, business is not going to do anything other than what makes business sense, but they will be happy to deduct more of what they were going to do anyway from their business taxes.

Second, E.B. sees it as a small stimulus to unaffected sectors. Most people will pay down debt, put it way against a looming storm, or buy food and gasoline. None of this creates new jobs. Even those who do what is asked them, which is apparently to buy consumer discretionaries will stimulate China as much as the U.S.

So what SHOULD we do?

Wait, says E.B., there is the second half of the stimulus plan. The budget bill Bush sent down this past week. Meaning the proposed big cuts in Medicare, Medicaid and other domestic programs. Those are a shot directly into the breadbasket of the economy. If they pass. If they don’t pass, we have over a half trillion dollar deficit for one year.

Okay, so what should we do?

We should have bailed out the states and cities. This is the real negative stimulus. Cuts are being front-loaded to address declining revenues caused by slumping consumer demand and by real estate foreclosures. These are police, teachers, civil servants of all kinds with middle incomes. They are also the thousands of contractors. The federal level had the opportunity to mitigate these cutbacks and the loss of public goods and services that are going to multiply the downward effect. Instead they instituted the Incumbent Rescue Plan.

They are not going to change it. So what should we do going forward?

Robert Kuttner of the book The Squandering of America has as close to the right prescription as there is, according to E.B. But before that, we are going to have to see that the current medicine is not working and resist more of the same medicine before it kills us completely. We do not need a stimulus plan, we need a recovery plan. And we need to do it on budget.

That is not possible, I said for everybody else. Everyone says we need deficit spending stimulus.

Everyone is wrong. Deficit spending would be fine if we hadn’t been doing it for most of the past thrity years. What is going to happen if the cost of private capital begins to rise? This huge federal debt is not all thirty-year fixed. If debt service goes up, as it is going to, the stresses are going to be enormous.

The economic mess was engineered by specific policies that have to be reversed: Non-regulation and control and supervision of the financial sector, from mortgages to hedge funds to private equity and the top gun banking style. Tax cuts for the rich have only exacerbated the problem. Reverse them and more for revenue.

And he had some pretty radical answers for the financial sector. He called them inevitable, but ....

Maybe we’ll get back to this next Friday. E.B. likes reforming health care, investing in education – as a means of improving the workforce, but also as an export commodity – importing the people, educating them and sending them home. But more than that, he likes mass transportation infrastructure – rail — and green technology and infrastructure. We need to grow tradable goods and services. Combining economic recovery with planetary survival looks like a demand side play.

That’s enough for today. I like this format. I am a student, not a teacher. I like the questions and debate and investigation. And I really like the answers. They’ve held up so far. Check the forecast for that, and for how bad E.B. thinks its going to get. Go to demandside.net and click on the forecast pane.

Tomorrow is another episode in the reading of Demand Side, the book, the eight minutes on Ronald Reagan. Monday we’ll be back with some audio of Robert Kuttner and consideration of the dangers for Democrats of being behind the curve.

Until then, this is Alan Harvey from the Demand Side.

Monday, February 4, 2008

Savings v. Investment v. Income -- Podcast Transcript

click on chart for larger image
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It becomes tedious at times to hear people, often well-dressed and well-respected people, discourse on the savings rate and tsk-tsk about the declining financial morality that has overcome our nation since the virtuous Fifties, Sixties and Seventies. Then, as benediction, these people will throw in an alarming factoid on the current precise level of non-saving.

And in fact, I have been one of these people.

Then I began to reflect. The huge volume of 401(k)s and pension funds must not be included. Likewise government debt – which has to be held by at least a few Americans — has been rising by hundreds of billions per year since 1981, except for a brief respite in the last part of the 1990s. Then again, there was five and a half trillion dollars in interest-bearing accounts not too long ago.

Still, as you can see in a chart on the web site, the official savings rate has been trending down since the common turning point of broad economic well-being — 1980 — and the rise of Reaganomics. Prior to that time and consistently since the historic series began in 1959, the rate was nearer ten percent than zero, where it hovers today. More thoughts on that later.

But still.

The first problem is the definition. The Bureau of Economic Analysis, BEA, identifies personal savings as “disposable personal income less personal outlays.”

When you and I think of savings we think of what we have stored away for safekeeping in a bank or investment account or stock of canned tuna. This is characterized by the BEA as “wealth,” not “savings.”

Net worth is what we identify as our savings, with some instinctual alignment to account for the more illiquid assets, such as housing and real estate. Over the past decade as we were spending more and borrowing more our net worth was rising. The figures I have before me here are from Bankrate dot com May 2006. $53.8 trillion in net worth. Compare this to $39.1 trillion in 2002.

We could well give back that $13 trillion while the personal savings rate rises and I doubt whether any one of us would think himself or herself richer. Likely we would experience a queasiness as if we had been told our savings account had been embezzled.

Which brings us to the stimulus package. I repeat that in spite of the tsk-tsk of the well-attired, our instructions are to spend the five or six hundred dollars coming to us in the mail.

Now that I think about it, our current President seems to have cut the cord of inevitability of taxes, at least to the rich. I understand he has an in with the big bearded guy. Do you think he might be persuaded to move the inevitability of death a little as well.

But the point. Our instructions are to spend the checks in the mail. This in the face of crumbling home values and an apparent recession on the way. I don’t know about you, but I’m going to pay down my debts with vigor. That is called “saving” or at least reducing the “dissaving.” But saving will not help the economic downturn.

Any saving by me, of course, will be provided by the government’s borrowing. Fortunately their borrowing rates are low. Or unfortunately. That brings us to the next part. Low interest rates do not entice people into savings, they promote purchase of assets which may have a higher return. The Greenspan housing bubble was to some degree sponsored by this calculation. “I can save at two percent or invest in housing at an annual rate of ten percent. Even if the market softens, at least I have the house.”

If you look at the chart on the blog, and remember when interest rates were high, the downward trend was ameliorated. When they were lower, people looked for other assets with a better return.

Parenthetically, the main thing lower interest rates do is increase the attractiveness of borrowing. Fine if you don’t think we are overextended already. For you and me it means refinancing at a lower, maybe a fixed rate. For the financial sector it means a million dollars today costs only $35,000 when a couple of weeks ago it was forty-two five. In another month it will be even cheaper. Maybe we can start another bubble — oh yes, there is one already. In commodities. Look out Oil Thirty-Six Thousand.

But let us consider the fundamental point of the tsk-tsk-ers. That is that a high savings rate means good things for investment. Everybody is familiar with the national income accounting identity between savings and investment. That identity — that savings equals investment — has almost universally been taken to mean that savings CAUSES investment. This is not correct. Believe it or not.

High personal savings rates under Reagan and Bush I did not produce big investment. Lower savings rates under Clinton did not keep investment from happening. And as we’ve seen the huge investment in passive housing over the past half dozen years came as savings rates were near zero.

We can discuss the source of funds if we want to bore each other, but we’ll lose track of the issue.

What causes investment? The prospect of profit causes investment. The savings rate does not cause investment. A strong economy means a strong demand for investment capital. Companies will go looking for it. Perhaps this would be more intuitive in the old days when individuals saved for the down-payments on their homes.

So how do they equilibrate in a closed economy, which ours is not? How does savings become to equal investment and investment become to equal savings?

A clue is offered inadvertently by the Right Wing apologists for the tax cuts for the rich. The rich save more, they say, and then go into the fallacy above of savings causing investment.

What is REVEALED in this feeble argument is a commonly acknowledged reality. As income goes up, the savings rate goes up. As income goes down, the savings rate goes down. Yes, it is the level of income that determines both investment and savings. My favorite analogy is a hot air balloon. The balloon rises or falls to the level that the air pressure inside is equivalent to the air pressure outside. The pressure inside does not cause the pressure outside to be the same. The pressure inside causes the balloon — income — to rise to an altitude where both are the same.

Income goes up. Better prospects for profit. Better opportunities for savers. Income goes down, not so much investment, not so much savings.

If you look again at the chart and see the downward trend beginning as so many do in 1980, reflect that the peak of the trend line in postwar growth was just a few years earlier, and that wages and income for the bottom half of American workers began to stagnate in this same period. This is the income that is missing. It is not a failing of financial morality, or at least not those at the lower end. It is a reduction in the means of middle- and lower-income Americans. If wages had trended up with productivity, as they should have, the savings rate would have remained stable. Instead, that productivity gain was transferred to the upper strata, and the savings rate stagnated.

Progressive policies to return middle class incomes to the middle class would reorient the savings rate and resurrect opportunity for tens of millions, not to mention reveal investment opportunity for the well-heeled.

Unfortunately, this income explanation means that as incomes go down in the current environment our attempts to pay down our debts or save will be frustrated. Saving in the aggregate will not be realized. Either I or another, perhaps a newly unemployed, will have to withdraw it to cover current expenses, or at these prices borrow again. Or look on the bright side, all those people losing their homes? At least the mortgage debt is off the books. Big new savings! Hooray!

Saturday, January 26, 2008

Podcast Service Back on Track

Podcast Service Back on Track

By popular demand we have moved our podcast to a new site. The switch was not seamless. You will need to re-subscribe to the new feed. The iTunes and feed buttons are on the column to the right or on the web site.

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Wednesday, January 23, 2008

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Friday, January 18, 2008

Inflation and Recession III - Podcast Transcript

As we said in October, it’s not inflation OR recession, it’s inflation AND recession. Since then, Joseph Stiglitz has confirmed “Stagflation Cometh.” See his commentary on Project Syndicate.

Every once in a while I listen past the adds on APM’s Marketplace.

Put it together, high inflation and a slowing economy, and it could equal stagflation. Marketplace’s Jill Barchet looks into whether that scourge of the Seventies might be coming back.


When the economy wobbles, it’s usually inflation OR recession that’s doing the shaking. Inflation usually hits when the economy is booming. High demand for goods pushes prices up. When recession bites, the opposite happens. Demand drops and companies lower prices to move product out the door.

But when high prices and a recession coincide, that’s stagflation. Central bankers haven’t got much in the way of weaponry. They can adjust interest rates or pump money into the economy.
As my son would say, “This is wrong in so many ways.”

We do not have to go back to the 1970s to find recession and inflation occurring together. We can stop at every recession between now and then, with the possible exception of the 2001-03 recession. And you would have to pick on the Guns and Butter era of the 1960s to find a place where a booming economy caused inflation.

What is the Fed to do? Fight inflation or stimulate the economy? This is causing a lot of angst on the FOMC, and elsewhere. At least consider the possibility that it can do neither. Monetary policy is exhausted by decades of liquidity.

Higher rates counter demand-pull inflations, overheating economies. The inflations we have experienced since the 1960s and Johnson’s Great Society and Vietnam War have been cost-push, often driven by higher energy prices. The one we have now adds the falling dollar. Higher interest rates will just add to costs, both for business and consumers. This effect offsets the reduction in demand, particularly since demand for services and goods is already contracting due to higher energy and higher food prices.

And lower rates will not stimulate the economy. The contraction of lending due to loss of capital — the credit crunch — will overwhelm any rescue except the “fiscal option.” Further, consider this, and we’ll spend an entire — if ten minutes can be an entire anything — podcast on this.... Anyway, consider this, that liquidity will find the rising asset prices. This comes from banking expert Charles Peabody whom I heard on one of those excellent NABE conference calls.

Parethetically, it also gives me the reason I may be wrong on the stock market. And a tip of the hat may be due to Nouriel Roubini and his “suckers’ rally” explanation. We’ll take that on with the next Forecast Friday, providing stocks don’t recover.

In Peabody’s view, the liquidity from action by the Fed is not mitigating housing, but is migrating to commodities – see gold and oil — and to currencies. Bidding up the prices of these is leading inflation higher, though now we have left Peabody’s thesis.

So it is not the Monetarist mechanism of more dollars chasing the same number of goods. It is instead an exacerbation of the costs of cost-push.

But the point of fallacy, the basic point of fallacy, in the current situation is that inflation and recession are somehow two sides of the same teeter totter. Further, the argument goes, since the Fed has only one tool — the interest rate — the Fed is in a pickle. This is the common perception. And it is not so.

The inability to distinguish cost-push from demand-pull means the Fed will apply high interest rates as soon as it can to stem inflation. The inadequacy of cheap money to do more than fuel higher costs means the lower interest rates have no economic purpose.

The Marketplace reporters should be forgiven, of course, for the myth of stagflation being confined to the 1970s and the rest. It is part of unchallenged economic lore.

Monday, January 14, 2008

What is the Fed’s cutting of rates supposed to do? -- podcast transcript

The fervor and fever of the current economic debate is all about whether the Fed will cut rates or by how much or if it is going to be too little, too late? The Fed’s decisions are gamed, er, priced in the options and futures markets.
  • Are we in a recession?
  • Are we going into a recession?
  • Will the Fed cut interest rates in time to keep us out of a recession?
  • Has the Fed done the right thing so far, or have they been quote too concerned unquote about inflation?
  • Will the federal government produce a stimulus package to keep us out of recession?
A little critical thinking.... Remember.

Interest rate cuts by the Fed have a lag of 12 to 18 months before they get into the general economy. Today we are under the influence of the high rates at the end of 2006.

Oil prices are moving in the opposite direction and have a similar lag and similar macroeconomic effect.

Whether the Fed cuts tomorrow or at the end of the month is critical for the market, because the market is not rational. It is critical for “confidence.” It reminds one of the cowed Fed during the absurd explosion of stock prices in 1927, ‘28 and 29. The market is telling the Fed to say what the market wants to hear.

More critical thinking.

What do we expect lower rates to do?

Greenspan had to lower rates to one percent in order to create a housing bubble. If we are trying to recreate that, we should think again. We got three years of tepid growth at the cost of trillions in both public and private debt. Now we have a financial sector in dysfunction and acres of houses abandoned. Those in their houses have the sickening experience of watching their retirement nest egg deflating as they approach the need for it.

Speculators, er, investors could use lower rates to make leveraged plays pay off. Leverage is a key component of all bubbles. But you need rising asset prices. An asset bubble in commodities is already forming. Oil is trading at 50 percent above fundamentals. Grain and other futures are getting pumped up. Gold is tickling $900 to the ounce. But speculation in commodities is very destabilizing. Inflation on the front end and big risks at the back end for people who set up to produce commodities only to have the bottom drop out of prices when they come to market.

Do we expect business investment to take off with lower rates?

Significant business investment in the last so-called recovery was absent. It is a mistake to think that businesses invest because money is cheap or tax incentives are available. They invest when they see opportunity for profit. Once a project is decided upon, they may make forays to government offices to seek tax concessions or cheap money, but without the prospect of profit, no form of easy financing will promote business investment. A sagging economy is not a happy place for those looking for potential profit.

Reflect on the cash on the books and the corporations instituting buy-backs, and ask, “Why are they not investing?”

But back to the question.

What do we expect interest rate cuts to do?

We don’t want a commodities bubble. We might inflate stocks for awhile, and that would be good, but it is not the real economy. We are just not going to reflate the housing bubble.

What we want is investment. We nwant to temper the downturn and create some sort of investment. Neither housing nor business investment is a huge part of the economy by itself, but they are the catalysts of growth. Another target could be public infrastructure. Bonds for sewers, water mains, roads, and so on.

Simple borrowing and spending that does not generate investment is simply borrowing and spending.

What do we expect Fed rate cuts to do? Twelve to eighteen months down the road?

Many, the Fed chairman himself included, suggested rate cuts somehow addressed the financial sector collapse. But this is a solvency problem, not a liquidity problem. They may come together if one of these banks goes belly up while holding capital from the special auctions, I suppose.

Here is what Fed action will do. And this is the reason for the fever around it.

The financial sector ran its unregulated games behind closed doors and they came up craps. Mortgaged-backed securities, leveraged instruments in themselves, were used to leverage more. Now it is all unwinding. The game is still behind closed doors, but every once in awhile somebody goes in with a big bag and comes out with an empty one.

By moving the public eye to the Fed, it creates the illusion that whatever happens to the economy will be because the Fed did or did not do something with interest rates. If the economy tanks, Bernanke will be on the cover of Time. If the economy recovers — how could it? — Bernanke will be on the cover of Time. If the economy muddles along — Bernanke will be on the cover of Time.

But it is too late to demystify mortgages for millions of subprime borrowers or vet preposterous innovative securities before they get eaten by the ferocious demand of .... investors looking for fifty beeps more return.

But what is the interest rate supposed to do?


Congress and the president are getting together, it sounds like, on a stimulus plan. And we have to ask, yes

What is stimulus supposed to do?

The Timely, Targeted and Temporary mantra is a quaint formulation of the hypothetical best, but it is being pushed into an arena that is teeming with large and growing deficits already in progress. Yes, deficit spending is already in the hundreds of billions of dollars per year. We’re talking about more hundreds of billions, not moving the hundreds of billions from the tax cuts for the rich to legitimate stimulus targets.

It is true, if we are going to borrow to spend, we need to make certain it is potent spending. Tax cuts for the very lowest and spending increases on unemployment compensation or food stamp increases.

Otherwise it needs to be triage for state and local governments. States and municipalities are getting hammered by the housing bust, both in increased costs and in reduced property tax revenues. There is no sense in giving tax cuts to people so they can buy more Chinese lawn mowers or Japanese cars when we could be buying American teachers and policemen. These people will be happy to spend their paychecks, and maybe if we make them, they’ll buy a Chinese lawn mower.

To be completely clear.

The federal government, principally the Fed, screwed up by not policing the mortgage markets nor vetting the silly CDOs and SIVs. Now the locals are suffering. The best stimulus would be federal support to fill in for falling tax revenue and, further, to keep road, sewer, water and other local projects from being shelved.

Timely, temporary, and very well targeted.

Saturday, January 12, 2008

Inflation Fighting - podcast transcript

“In all but the shortest of terms, it is the Federal Reserve’s policy that 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.”
Ben Bernanke, December 8, 2007
testimony before the Joint Economic Committee
We begin with a footnote.

The Federal Reserve Board began the post-war period with a very limited role in fighting inflation. Prior to 1951 and the so-called Treasury Accord, the Fed was semi-independent, perhaps more independent than other agencies, such as the FDA or FCC, but not so much as today. That is, the Fed was not attached to any specific cabinet department, but it made policy in close consultation with the Administration. This was a legacy of both the Depression era and the War years. The Truman administration used its influence over interest rates very effectively to keep debt service on war bonds down. But that changed in 1951. Between 1951 and the late 1970s Federal Reserve action was limited. During long periods, such as during the expansion of the Kennedy-Johnson years, interest rates stayed low and stable. That changed with the activism of Paul Volcker in the late 1970s and continued under Chairman Alan Greenspan who took over in 1987.

Today we are going to look back and touch on a few anecdotes that illustrate who actually did fight inflation during those years. But first the current context.

Inflation pressures today arise from higher commodity prices, prices which have accelerated coincident with the fall of the dollar and the collapse of mortgage lending. Oil, metals and food prices, particularly, will hit consumers hard in the upcoming months. Food inflation worldwide is a potential humanitarian debacle. We’ll go into that issue more deeply in a future podcast.

Inflation has been subdued over the past fifteen years. The Clinton era benefitted from very low oil and energy prices, but all years since 1980 have benefitted from – if benefit is the correct term – stagnant wages. Productivity has increased seventy percent. Wages have not.

Headline inflation, which includes fuel and food, has been followed less closely in recent years than core inflation, which does not include these two categories. What does core inflation consist of? Breaking it down past the sectors, it consists of wages, other manufacturing inputs and imported goods. If imports, fuel and food increase in price, we have the recipe for a classic cost-push inflation. If inflation is kept down, it will be at the expense of wages.

Wages are sticky. That means payrolls are not cut by reducing the wage rate, they are cut by letting people go. It is a trademark of the American economic ship since 1980 that when we need to keep afloat, we don’t bail the water out, nor even throw over some of the heavier goodies from the A deck. Instead we start tossing in the marginalized and even the crew.

But the cost-push, demand-pull distinction is lost on the Fed, which treats all inflation price rises as incipient spirals. How was it done before Volcker-Greenspan?

After World War II, Truman kept the war-time price controls on as long as Congress would allow. He supplemented this by reducing the size of government as fast as possible. He did this in the face of seven million men under arms returning to the work force. The domestic economy was scrambling with pent-up demand meeting industries frantically retooling from the war. World-wide need caused enormous demand for American products, particularly food, and commodity prices rose dramatically.

Truman steadfastly refused to shut down the economy with higher interest rates, and instead encouraged elimination of bottlenecks and mitigation of higher wage demands from workers in many industries who felt they had foregone a share of the booming war years for the good of the country, and now that the war was won, it was their turn. Truman also famously broke a railway strike by threatening to call in the Army to run the rails. But if inflation is too many dollars chasing too few goods, the Truman plan was to increase the number of goods, not reduce the number of dollars.

When the Korean War arrived, a coordinated cutback in domestic industry kept the economy from overheating. Let’s say it came at the cost of a ‘52 Chev.

Kennedy employed wage-price “guideposts,” explicit targets for wage settlements and price increases. Kennedy and his advisors consulted directly with industry and unions – and it was the heyday of unions – during negotiations. His showdown with Steel is notable. The steel unions agreed to a contract within the targets, and virtually the next day all but one of the top steel companies announced price hikes well above the targets. Kennedy is reported to have said, “My father told me that businessmen were sons of bitches, but I didn’t believe it until now.” The coordinated response from his administration was equally volcanic. Investigations were launched by several departments. Contracts were withdrawn and given to Republic Steel, the lone dissenter from the price rise. Every other mechanism was employed. Steel backed down.

Lyndon Johnson during the guns and butter inflation of the late 1960s imposed a ten percent income tax surcharge to take spending power out of the economy. He was the last president to make a tax hike a central point of his economic policy.

Richard Nixon’s was probably the most dramatic. The wage-price freeze. At the same Camp David retreat that produced the decision to go off the gold standard and let the dollar float, the Nixon brain trust came up with a freeze on wages and prices to dampen inflation. Evasion of the controls, including simple cheating, caused them eventually to be abandoned. Their removal witnessed an unexpectedly sharp increase in prices and some time later Nixon, against the advice of his advisers this time, reimposed them. They were even less effective the second time.

Gerald Ford and his chief economist Alan Greenspan tried out the WIN button – Whip Inflation Now – a call for citizen action that never came.

Jimmy Carter put the brakes on gasoline consumption with the 55 mile per hour speed limit and employed Alfred Kahn’s deregulation theories in an effort to reduce business costs. It had some success, but also some notable failures. The 55 mile per hour speed limit may have been the last sacrifice asked of the American consumer, so unpopular did it prove to be.

Then came Ronald Reagan. Reagonomics borrowed deregulation from Carter, but it was for deregulation’s sake. His approach to inflation was to walk away from it and let the Fed handle it, first Paul Volcker, then Alan Greenspan.

The Reagan-Volcker Recession of 1981 was fomented by double-digit interest rates. At that time, it was the supply of money that was restricted, and interest rates were allowed to find their own level. The major inflation fighters during those years were the long lines of unemployed workers and the manufacturing industries that lost out to the high interest high deficit high dollar.

Since then, only the contraction of growth in government under Clinton can be seen as anything approaching a fiscal remedy for inflation. In Clinton’s final year in office, the strategic petroleum reserves were tapped to keep oil prices down, but it was more a favor to Al Gore’s campaign for president than anything else.

So there are non-monetary remedies for inflation that have been tried. Some have been successful.

A couple of notes. In our forecast recap Monday, we missed repeating our call that the Fed will overreact to inflation pressure. We’ve put up some charts on the blog: Demand Side Blog or demandsideblog one word dot blogspot dot com to show you what we think the Fed is looking at and why they might get spooked.

We have called for a cost-push inflation from the rising prices of imports, commodities and the bidding up of domestic products with export markets.

The charts, if you look closely, core consumer inflation simply lags the headline inflation, as higher prices are embedded in costs. Notice the trend of both follows oil prices. Oil isn’t as big per unit of GDP as it used to be, but neither is anything else, including an hour of labor.

We chart producer prices and consumer prices. The PPI, producer price index, has recently risen above the consumer price line, which might cause consternation. Particularly if you look at 1999, when it also happened. Shortly afterward Alan Greenspan began ratcheting up interest rates, right into the rising oil prices that caused the spike to begin with. The result – in our view – contributed to the so-called dot.com bust. It happened again briefly at the beginning of 2005, and we suspect encouraged the last rate hikes.

The third chart takes at look at headline PPI v. core PPI. The latest readings – November – in headline producer prices are the highest in twenty-five years.

The final chart is headline versus core personal consumption expenditures. Just again to note that one leads the other, and a caution to officials not to panic. Or to get too grandiose.
“In all but the shortest of terms, it is the Federal Reserve’s policy that 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.”

Friday, January 11, 2008

Stagflation Cometh -- Joseph Stiglitz

Stiglitz repeats his call for economic slowdown coupled with inflation.

But the good times may be ending. There have been worries for years about the global imbalances caused by America’s huge overseas borrowing. America, in turn, said that the world should be thankful: by living beyond its means, it helped keep the global economy going, especially given high savings rates in Asia, which accumulated hundreds of billions of dollars in reserves. But it was always recognized that America’s growth under President George W. Bush was not sustainable. Now the day of reckoning looms.

America’s ill-conceived war in Iraq helped fuel a quadrupling of oil prices since 2003. In the 1970’s, oil shocks led to inflation in some countries, and to recession elsewhere, as governments raised interest rates to combat rising prices. And some economies faced the worst of both worlds: stagflation.

Until now, three critical factors helped the world weather soaring oil prices. First, China, with its enormous productivity increases – based on resting on high levels of investment, including investments in education and technology ­– exported its deflation. Second, the United States took advantage of this by lowering interest rates to unprecedented levels, inducing a housing bubble, with mortgages available to anyone not on a life-support system. Finally, workers all over the world took it on the chin, accepting lower real wages and a smaller share of GDP.

That game is up. China is now facing inflationary pressures. What’s more, if the US convinces China to let its currency appreciate, the cost of living in the US and elsewhere will rise. And, with the rise of biofuels, the food and energy markets have become integrated. Combined with increasing demand from those with higher incomes and lower supplies due to weather-related problems associated with climate change, this means high food prices – a lethal threat to developing countries.

The rest is at Project Syndicate

Thursday, January 10, 2008

Inflation charts for Friday, January 11 podcast

CPI-U All Items (Headline Inflation) v. CPI-U less Food and Energy (Core Inflation)

If you look closely, core simply lags headline inflation, as fuel is incorporated into costs. Notice the great moderation of both and rise of both as it corresponds to oil price declines in the 1990s and rises again after 1999. Oil may not be as big a percentage of GDP as it used to be, but neither is any other single item, even an hour of labor.

CPI-U Core v. PPI Core
Producer prices are nearing the consumer price line, and have crossed a couple of times. One might imagine consternation at the Fed, particularly if you look at 1999 when something similar occurred and the beginning of 2005. Both instances were followed by Fed interest rate increases. Greenspan's right into the teeth of a big rise in oil prices, contributing to the so-called dot.com bust.

PPI Headline v. PPI Core
Take a look at the spike in PPI in the latest readings. Its highest level in 25 years.

Personal Consumption Expenditures (PCE) Headline v. Core
Just again to note that one leads the other. Yes, one is more volatile, but taking out food and energy does not leave a neutral track, it leaves the lagging trend. One wishes officials would not panic.

Market Failure VI: Global Poverty -- podcast transcript

The failure of dozens of countries and their inhabitants in Africa, Asia and Latin America is hardly news.

Much of the Third World was better off forty years ago than it is today. Growth collapses, as the World Bank now refers to them occurred in many areas. Per capita income plunged. Today, nearly fifty percent of the world’s population lives on less than two dollars per day. The UN’s millennium development goals are not so much development targets as targets for survival.

And this understates the problem as hundreds of millions of people are forced off the farm and into cities where more of life is monetized and less well-being is available in the non-monetized economy.

Why is Global Poverty a market failure? The free market apologists are already calling. It is the ABSENCE of free markets, they say, not their presence which is the root of global poverty. Often they mention corruption in the governments of those countries in the next breath. Government functionaries are interfering with the free market actors.

This situation has occurred in the presence of globalization. Globalization was supposed to move capital from the richer countries to the poorer. It has done the opposite. Open markets were supposed to bring a rising tide that would lift all boats. Income disparity in all countries, rich and poor has increased. Free flow of capital was supposed to bring stability, it has brought crisis.

The benefit in well-being of a tiny investment in poor nations puts to shame many of the mega-million capitalist shrines. Who can argue for a market that has missed the mark by such a margin?

Half the world — nearly three billion people — live on less than two dollars a day.

The GDP (Gross Domestic Product) of the poorest 48 nations (i.e. a quarter of the world’s countries) is less than the wealth of the world’s three richest people combined.

Nearly a billion people entered the 21st century unable to read a book or sign their names.

Less than one per cent of what the world spent every year on weapons was needed to put every child into school.

But it is the imprimatur of free market fundamentalism as espoused and enforced by the International Monetary Fund on behalf of the developed nations that is the mark of the free market here , and the cause of so much failure and poverty.

Over the past three decades the international institutions such as the IMF and World Bank have aggressively promoted the Washington Consensus, an informal designation for a program of opening markets to the free movement of capital, promoting privatization and facilitating export-based industry.

The results were a calamity in Russia, as we noted in Market Failure V. They were no less ineffective in Africa, where schools and water supplies have been privatized and draconian budget balancing has deprived whole populations of the education and infrastructure they need to be effective.

From Joseph Stiglitz: The Promise of Global Institutions, Chapter 1 of Globalization and its Discontents

The IMF and the World Bank both originated in World War II as a result of the UN Monetary and Financial Conference at Bretton Woods, New Hampshire, in July 1944, part of a concerted effort to finance the rebuilding of Europe after the devastation of World War II and to save the world from future economic depressions. The proper name of the World Bank -- the International Bank for Reconstruction and Development - reflects its original mission; the last part, "Development," was added almost as an afterthought. At the time, most of the countries in the developing world were still colonies , and what meager economic development efforts could or would be undertaken were considered the responsibility of their European masters.

The more difficult task of ensuring global economic stability was assigned to the IMF. Those who convened at Bretton Woods had the global depression of the 1930s very much on their minds. Almost three quarters of a century ago, capitalism faced its most severe crisis to date. The Great Depression enveloped the whole world and led to unprecedented increases in unemployment. At the worst point, a quarter of America's workforce was unemployed. The British economist John Maynard Keynes, who would later be a key participant at Bretton Woods, put forward a simple explanation, and a correspondingly simple set of prescriptions: lack of sufficient aggregate demand explained economic downturns,; government policies could help stimulate aggregate demand. In cases where monetary policy is ineffective, governments could rely on fiscal policies, either by increasing expenditures or cutting taxes. While the models underlying Keynes's analysis have subsequently been criticized and refined, bringing a deeper understanding of why market forces do not work quickly to adjust the economy to full employment, the basic lessons remain valid.

The IMF was charged with preventing another global depression. It would do this by putting international pressure on countries that were not doing their fair share to maintain global aggregate demand, by allowing their own economies to fall into a slump. When necessary it would also provide liquidity in the form of loans to those countries facing an economic downturn and unable to stimulate aggregate demand with their own resources.
The passage goes on to describe how the IMF’s original mission has been turned on its head. It now espouses a program of free market fundamentalism – open capital markets, privatization and budget austerity. It intimidates and cajoles nations in crisis to adopt wholly inappropriate policies in order to obtain the loans they need to overcome the crisis.

Larger, advanced nations such as the United States have no qualms about ignoring IMF advice. Smaller, more vulnerable economies are caught by their need for crisis funding.

A single example from Ethiopia, one of the poorest countries in Africa. The banking sector of that nation was about the size of a single regional bank in suburban America. IMF conditions pried open the banking sector for multinationals and liberalized banking laws. Within three years fourteen new banks had grown up and failed. Meanwhile, the multinational banks had moved in, attracted the capital, but focused their lending not on the small to medium-sized domestic companies, but to the larger operations. The result was not pretty. This illustrates that while the IMF preaches a free market fundamentalism, the application is hardly market-friendly.

To be brief, there are several elements hidden here:
  1. The free market policies have not been applied on the basis of evidence they work, but from political bias. That realization is sinking in. Those countries which resist the IMF are those which prosper.

  2. Successful development in the West proceeded from demand side policies, not the radical opening of capital markets and enforcement of monetary and budget austerities.

  3. The free market experienced by these nations has come in the form of large corporations building large-scale projects or siting big factories. This is as appropriate as playing baseball with a shot put. It has also produced enormous debt. This top-down development contradicts the bottom-up development of all successful market economies.

  4. Third world nations are not necessarily blessed if they have abundant resources. Without the basic democratic institutions, too often an oppressive elite rules in combination with the resource extraction corporations.

  5. Corruption in government is not a function of government, but often a function of military or corporate power. The United States has often provided aid in the form of military hardware. Many countries are saddled with debt that ought to be considered illegitimate from this practice, as military dictatorships signed up for big arms deals to subjugate their populations. When they were thrown out by popular uprising, the debt remains, and those formerly oppressed are now on the hook for the cost of the weapons once used against them. Some debt relief has occurred, but not enough, and not without conditionality that may be even more burdensome than the debt itself.

  6. In the context of trade treaties, Western developed nations have pursued a colonial-style agenda, using their huge economies to pry open the smaller, more delicate economies for exploitation by multinationals.
A final note, one region of Zambia, I believe the Northwest region, was cut off from assistance by the IMF and world bank for a complex of reasons. Over the period between 1960 and today, it has produced schools, miles of roadway, a thriving trucking industry, and successful and stable small-scale industries. Much of the rest of Africa has produced debt.

Tuesday, January 8, 2008

Forecast Redux -- podcast transcript

Repeating the forecast

As tedious as it may be, today we are reiterating our forecasts, primarily because there has been a full-tilt shuffling of folding chairs over the past few days. The assembled consensus seems to have moved in unison, like a flock of birds into the recession winds. We wanted to remind you we’ve been holding to our call. It seems that the great preponderance of economists were blindsided by last week’s unemployment rate increase and now admit the possibility of recession. It is a bit like admitting it might rain after the water starts pouring in over your boots.

We asserted that the recession was already in progress two months ago. That makes us aggressive. Over the intervening period we’ve moved from being an extreme outlier into being within a couple of standard deviations of the mean.

As far as the unemployment numbers, you may remember we’ve been complaining that the official numbers out of Washington have not been plausible for some time.

I told you this was going to be tedious.

In the last week of September, we made a call of economic weakness, but at the same time strength in stocks, commodity and bond markets. I have yet to see that replicated anywhere. To be clear, by strength in stock markets, I mean the absence of a thirty percent retreat in stocks typical of a recession. By strength in bonds, I mean the strength in bond prices typical in a recession, and a new powering up of commodity markets. The sell-off in stocks after the turn of the year may spook the herd, but we are holding onto the conviction that it will not be for long. We’re sticking with a flat to slightly upward movement in all broad market indexes.

And it was October when we said, it’s not inflation OR recession, it’s inflation AND recession.

The differences between us and the preponderance of economists lies primarily in whether you are Ptolmaic or Copernican, geocentric or heliocentric. That is, supply side or demand side.

Those who believe the supply side drives the economy are reduced to poring over arcane statistics in hopes of detecting a new trend or weakness. Attempting to produce models that are effective statistical trampolines so they can jump high enough to see over the horizon.

Parenthetically, another difference is that the preponderance of economists seem to use equivocation instead of bald assertion. We prefer the latter. If we are wrong, we want to have to explain why. Most prefer to appear not to be wrong, and so they couch their statements in terms of increasing chances, percentage probabilities or slowing economy rather than recession.

The statistical models are less a prediction and more early signs of activity, the smoke of a fire already in progress. This is why you have the ignominious spectacle of forecasters being hit in the back of the head with evidence that doesn’t appear on their charts.

Instead we can simply look at the shape of the economy from the demand side.

The past six years have seen an economy benefitting from interest rates at the bottom of the historic range, a government producing enormous deficits, and a job market that was still pathetic.

The unemployment rate peeked above six percent in 2003 before falling back to near 4.3 in 2006-07. But during that period employment growth stayed below two percent in all quarters except one. In contrast, Bill Clinton inherited an unemployment rate of nearly eight percent from Bush’s father. Growth in employment was above the two percent mark in seven of the next eight years. Net jobs went negative under Bush II in the middle of 2001 and stayed there until the end of 2003. Ten quarters. Longer than any other period of negative growth in jobs in post-war history.

It was this economy that was the scene of the Greenspan housing bubble and the Bush tax cuts for the wealthy. These two forces were the motive force of the last go-round of the so-called business cycle. Wealth, income and employment were all housing- or finance-related. No business investment. No meaningful job growth. The bubble was extended by extremely questionable lending to benefit a voracious appetite for mortgage-backed securities.

So we don’t need to know anything about the future except that it is connected to this past, but without the low interest rates, with a dysfunctional financial sector and in the presence of deflation in housing, the primary component of consumer wealth.

Contrast this with the predominant view among today’s economist that the problem BEGAN in August 2007, and that the previous years were healthy expansion. We were just beset by the, yes, perfect storm.

Our view is that questionable economics from the Fed and White House papered over underlying weakness and now we have the worst of many worlds: inflation, falling dollar, financial sector dysfunction, consumer overextension.

The most talked up prospects for recovery include, improbably, the idea that the Fed will come through with interest rate cuts good enough for housing to recover. This is not going to happen. The Fed cannot go down the Greenspan path because the dollar is on the block and inflation is certain. Even if interest rates could get that low, the housing bubble is over, and housing would not recover in any event because investor appetite is no longer there.

The drop in manufacturing has at least temporarily quieted the notion that export strength from the falling dollar is going to ride to the rescue.

High oil and commodity prices will strangle developed and developing countries alike. If the Fed – as we’ve predicted they will – attempts to keep a tight lid on inflation, then real incomes will be lost to the higher food and fuel prices.

Monday, January 7, 2008

Climate Change from the Demand Side - podcast transcript

We have argued elsewhere the primacy of demand, there about keeping total output and employment at optimal levels. But nowhere is the effectiveness and utility of the demand side more evident than in an economic approach to reducing the causes of climate change.

I struggle with the best way to differentiate supply side solutions from demand side. Today we will try with examples: The deforestation of Indonesia, the development of new transportation technology, and the elimination of wasteful prison mattresses.


Illegal logging and deforestation around the globe is creating about twenty percent of the greenhouse gas problem. In Indonesia Chinese and Chinese-sponsored illegal logging accounts for a tragic loss of this valuable resource. The logs are taken illegally, shipped to China, manufactured into flooring and other wood products, and then sold on into the markets of Europe and America.

International pressure has come to bear on China for this practice, since its companies are obtaining and processing the illegal logs for profit. China counterclaims that the host country should be responsible for the crime on its own shores. Indonesia, however, is a weak state, and even if it were not, the incentives are all in the wrong direction. The logs would no doubt be brought out by bribery or bullying or other tactics even if government were much stronger in Indonesia.

The Demand Side answer is to ban the sale in the American and European market, coupling the ban with a tax on all imported finished wood products – a tariff, if you will. As soon as the possibility of final sale dries up, the entire market dries up. The wealthy countries have the wherewithal to monitor such things. A tariff or tax provides revenue for the monitoring, plus a convenient and easily proven crime with which to prosecute smugglers. That is, tax evasion is far easier to prove than the derivation of any particular product, or the complicity of the retailer in obtaining that product.

Reducing carbon emissions

The current favored mechanism for reducing carbon emissions is the Kyoto binding caps on emissions by country. The US is being dragged into the process kicking and screaming. China and India are opting out. So-called cap and trade schemes are the market-based solution preferred in the developed countries. These provide a value which can be bought and sold, and so pollution is allocated to the most inefficient. Carbon taxes are another idea along this line, attempting to bring the costs of so-called externalities into the price. This is a useful and noble exercise, but it is not enough to produce the needed technological revolution.

Be clear. The only way to internalize externalities is to bring the cost of a product’s use and disposal into the market, the purchase-sale event. But this is not sufficient.

This is not to say bring as many of the costs of a products use and disposal into the market, the purchase-sale event, is the only way to internalize the externalities of the market. But it has many problems.

For one thing, the ultimate costs can never be known until after the fact. If the cost of nonaction is the destruction of the planet, then there is no price too high. Another obstacle is the political bickering about what costs ought or ought not to be assigned to the purchase-sale event. This could produce arguments and litigation which would extend far beyond the deadline for action.

Finally, nudging the costs up, particularly if done in a half-hearted or inconsistent way, will never provide the impetus for the widespread innovation needed to reduce carbon production to one-fifth its current levels. Such an approach will tend to produce graduated adjustments to current technology, not new technology. Remember, we need to get to one-fifth our current carbon output by 2050, little more than forty years.

A better model for action was produced by the state of California. The Californian skies in the 1970s were a soup of pollutants: carbon monoxide, particulates, nitrous oxide. California chose not to provide incentives to suppliers to do the right thing or to generate public information campaigns to coax consumers. It simply issued the mandate that automobiles bought or used as of a certain date needed to have a highly reduced emission level. A simple regulation.

But a huge market for those who could innovate the solution and the loss of a huge market for those who could not. First, the state listened to a cacophony of complaints and dire predictions. Cutting emissions to the target could not be done, and even if it could be done, the cost would be prohibitive.

Thirty years later, as a result of that law and subsequent amendments, emissions have been reduced to one one-thousandth of their former level. Yes. Zero point zero zero one. We have the catalytic converter and a separate reduction reaction in the converter box (as I understand it) and a result that any chemist or engineer in 1980 would have ruled out of the question.

This is the magic of demand side. In terms of reducing carbon, we describe the resultant products in terms of their carbon footprints and let the market innovate to that result.

Jonathan Frost, director of Britain’s Johnson-Matthey fuel cells has argued persuasively that if there is a guaranteed market for a product with clear specifications, that is, a guaranteed sale if the product is produced, the private sector will generate the investment and energy to get there. In the case of California, there were millions of cars to sell. The investment by the state in the technology was zip.

Government procurement

This leads into a process that is familiar to defense contractors who are given specifications and asked to produce. The most outlandish weapons or surveillance or battlefield technology has been developed by this method. See at night, get a three ton missile to home in on a four foot square target. Spy from a thousand miles up.

If government guaranteed it would purchase ex number of no carbon buses, they would be produced within five years.

Frost gives the example of zero waste prison mattresses. British prisons dispose of hundreds of thousands of mattresses that cannot be burned or used as weapons, etc. The specs for these were twenty six years old when, as part of a demonstration project, Frost and his colleagues altered them to include the stipulation of zero waste. No waste prison mattresses. They put it out to bid.

The first thing they got was what California got. “Can’t be done,” “If it could be done, it would be exorbitantly expensive.” Next they received thirty-three proposals. Multi-nationals down to inventors in garages came up with innovations on how it could be done. Ultimately the zero waste prison mattress was produced at a net savings over previous costs when disposal is considered.

Oh that’s right. In California. The catalytic converter and subsequent technology reduced emissions by one hundred thousand percent on an adjusted cost here, too, of — zero.

So it can be done. The first step may be the hardest, to think about and describe exactly what the result is that you want. Resist the temptation to describe the processes to get to the result. The current ethanol situation substituting fuel for food comes to mind. Previously it was liquified natural gas. Just concentrate on the low-carbon, high-performance product and let the private sector do its own innovation. That’s what they do best.

It is simple and effective. It engages corporations in what they do best – innovation, production, technological advancement – and urges them away from what they do worst – manipulate demand and manipulate the political and regulatory processes.

Wednesday, January 2, 2008

Inflation and Recession, seconded by Joseph Stiglitz

Joseph Stiglitz is the preeminent economist of our day. It was an evil delight this observer (to use a Nouriel Roubini construction) took reading Stiglitz piece today at Project Syndicate. Evil because the prediction entails the misery the misery of billions in a downturn whose dimensions cannot be known. You may, or may not remember one of the first posts here after transferring in from Northwest Progressive Institute was just such a call.

Stagflation cometh, by Joseph Stiglitz, Project Syndicate:
The world economy has had several good years. Global growth has been strong, and the divide between the developing and developed world has narrowed... Even Africa has been doing well, with growth in excess of 5% in 2006 and 2007.
But the good times may be ending. There have been worries for years about the global imbalances caused by America's huge overseas borrowing. America, in turn, said that the world should be thankful: by living beyond its means, it helped keep the global economy going, especially given high savings rates in Asia... But it was always recognised that America's growth under President Bush was not sustainable. Now the day of reckoning looms.
Comment: Bill Clinton left office with one earnest plea: Maintain fiscal responsibility. Bush II used the excuse of 9-11 to throw all responsibility out the window.
America's ill-conceived war in Iraq helped fuel a quadrupling of oil prices since 2003. ... Until now, three critical factors helped the world weather soaring oil prices.
Comment: It is often stated that oil prices don't matter as much as they used to, since oil is a much smaller percentage of GDP than it used to be. The same could be said of all inputs, including labor, where a 70% rise in manufacturing output over the past 40 years has been performed by five million fewer workers. In addition, we import the energy component of products with those products, but we don't import directly the oil itself. Oil prices lead all energy prices, including natural gas and electricity. The price of oil matters, and it matters more than a little.
First, China, with its enormous productivity increases ... exported its deflation. Second, the US took advantage of this by lowering interest rates to unprecedented levels, inducing a housing bubble... Finally, workers all over the world took it on the chin, accepting lower real wages and a smaller share of GDP.

That game is up. China is now facing inflationary pressures. What's more, if the US convinces China to let its currency appreciate, the cost of living in the US and elsewhere will rise. And, with the rise of biofuels, the food and energy markets have become integrated. Combined with increasing demand from those with higher incomes and lower supplies due to weather-related problems associated with climate change, this means high food prices - a lethal threat to developing countries.
Comment: The Chinese have hocked their environment for the economic growth they have seen over the past two decades. Now fully two hundred million of its citizens depend on agriculture that is not sustainable due to ground water mining.
Prospects for America's consumption binge continuing are also bleak. Even if the US Federal Reserve continues to lower interest rates, lenders will not rush to make more bad mortgages. With house prices declining, fewer Americans will be willing and able to continue their profligacy.

The Bush administration is hoping, somehow, to forestall a wave of foreclosures - thereby passing the economy's problems on to the next president, just as it is doing with the Iraq quagmire. Its chances of succeeding are slim. For America today, the real question is only whether there will be a short, sharp downturn, or a more prolonged, but shallower, slowdown.

Moreover, America has been exporting its problems abroad, not just by selling toxic mortgages and bad financial practices, but through the ever-weakening dollar... Europe, for instance, will find it increasingly difficult to export. ...

At the same time, there has been a massive global redistribution of income from oil importers to oil exporters - a disproportionate number of which are undemocratic states - and from workers everywhere to the very rich. It is not clear whether workers will continue to accept declines in their living standards... In America, one can feel the backlash mounting.

For those who think that a well-managed globalisation has the potential to benefit both developed and developing countries, and who believe in global social justice and the importance of democracy (and the vibrant middle class that supports it), all of this is bad news. ...

Indeed, the ... world [is] facing depressed aggregate demand. For the past seven years, America's unbridled spending filled the gap. Now both US household and government spending is likely to be curbed, as both parties' presidential candidates promise a return to fiscal responsibility. After seven years in which America has seen its national debt rise from $5.6tn to $9tn, this should be welcome news - but the timing couldn't be worse.

There is one positive note in this dismal picture: the sources of global growth today are more diverse than they were a decade ago. The real engines of global growth in recent years have been developing countries.

Nevertheless, slower growth - or possibly a recession - in the world's largest economy inevitably has global consequences. There will be a global slowdown. If monetary authorities respond appropriately to growing inflationary pressure - recognising that much of it is imported, and not a result of excess domestic demand - we may be able to manage our way through it. But if they raise interest rates relentlessly to meet inflation targets, we should prepare for the worst: another episode of stagflation.

If central banks go down this path, they will no doubt eventually succeed in wringing inflation out of the system. But the cost - in lost jobs, lost wages, and lost homes - will be enormous.

- Joseph Stiglitz

Minimum Wage and other non-stories of 2007: Podcast transcript

Today we look back at some of the non-stories that were widely reported in 2007.

That is, things that did not happen that were widely reported as having happened or were certain to happen.

Among the non-stories covered in this podcast:
  • The minimum wage hike causes unemployment to rise

  • A weaker economy sends the stock markets tumbling

  • Banks and the shadow banking sector face up to their problems with write-downs

  • Housing slump nears its bottom

  • Federal Reserve Bank liquidity puts confidence back in lending, or rescues credit markets

  • Falling dollar does not mean higher inflation.

  • Market stability will follow from newly sobered investors

All right, so the last hasn’t been reported yet.

First: Unemployment
If you’ve listened to us very long, you will remember our distrust of the official employment figures coming out of Washington in the past year, in particular the strength of the so-called birth-death assumption which has propped up payroll numbers.

BUT one thing about a strong employment record is its reflection on the great non-event of the rise in the minimum wage. The compassionate free marketeers were telling us that a hike in the minimum wage was going to adversely affect those it was intended to help. The lowest paid would lose their jobs as a result of the extra, what, five dollars a day in wage costs. Didn’t happen.

Where I live here in Washington state, we have the highest minimum wage in the nation at $7.22, and the only reason there’s any slack in the labor market is people keep moving here. Ours is, by the way, indexed to inflation. This is the right thing to do to start with, since it doesn’t require grandstanding to keep up.

That was my favorite non-story, but there were bigger ones.
The stock market collapse.
In full view of the biggest housing recession in postwar history and the current and continuing crisis in credit markets, the stock market has not tanked. In spite of many reports to the contrary. The Dow and the S&P 500 are actually up for the year. So is the NASDAQ, and by ten percent, its biggest calendar year rise since 2003.

Volatile? Yes. Down substantially? No. This non-event was actually announced several times by over-eager journalists who pronounced the inevitable as already having happened. Now it is just ignored, pushed under the table with the minimum wage.

Also under the table are the early reports that banks were facing up to their losses and taking write-downs that would clear their balance sheets, return transparency to their operations, and allow us to get on with business. No. They are holding onto as much of the toxic paper as they can as long as they can and being as opaque as possible. Occasionally they sell five or ten billion dollar chunks of themselves to foreign countries and announce writedowns of five or ten billion dollars the next day. Sometimes the same day.

We are going to see the so-called “fiscal option” in 2008. We only hope Americans get the same equity as the other sovereign wealth funds for their bailouts. Likely we’ll just get more debt, as in the bailout of the Savings and Loan banks in the Reagan-Bush I era.
Perhaps only realtors are clinging to this. But the variant that the mortgage meltdown would not affect the broader economy is still getting substantial play after the data is in. Again, the so-called mortgage meltdown should really be called the financial sector collapse. We can’t call it the banking sector collapse unless we acknowledge that these shadow banking institutions and the hedge funds are also included. We’ve yet to see the sickening results of so-called innovation in commercial real estate and corporate debt markets.
The liquidity happened. Money is getting easier and cheaper for these guys to get. It bought about three weeks of very timid confidence.
No. Exports need to offset imports before they start offsetting any other sectors.
Usually this claim is followed by, “After all, imports are a relatively small part of consumption.” Yes. But the flip side of higher exports is higher priced domestic goods with export markets. Like food. Food inflation may not show up on the Fed’s preferred list of prices – core inflation. Higher food prices may not even be a completely bad thing. But it is inflation.
The subprime meltdown was an isolated phenomenon. No. This story was a complete non-story. It wasn’t reported wrongly. It was just not reported. Speculation moved from the stock market to real estate after the dot.com bust of the late 1990s. Now we have the housing bust. Speculation has moved to commodities and currencies. While the individual market experts identify speculation as a likely culprit for ninety-six dollar oil instead of sixty dollar oil, the mainstream media reports the higher price as a function of supply worries or demand pressure. Maybe the day-to-day variations have something to do with storms or wars, but the baseline is determined by the money in the market.

This is bad news for inflation. Speculation in wheat, corn, soybeans, food of all kinds, metals, natural gas, and so on, is bad news at the front end for inflation and at the back end for farmers and others who invest in expectation of high prices and will have to go sit in line with the subprime mortgagees when the bubble bursts.