A low volume, high quality source from the demand side perspective.The podcast is produced weekly. A transcript is posted on the day of.

Wednesday, August 12, 2009

Other voices on the Fed and economic instability

with Leon Keyserling, Hyman Minsky, Adam Posen, David Wessel and Willem Buiter



Throughout the recorded history of mankind, there have been periods when certain institutions or other citidels of power became what might be called "sacred cows." Although the damage they did far exceeded the benefits, their strongly positioned defenders prevented effective challenge to their misdeeds, or at least reduced the challenge to an ineffectual whisper. Very few people, unlike the child in the wellknown fable, dared to raise their voices and point out that "the king has no clothes on."

The outstanding example of this in the United States has become the Federal Reserve Board and System ... created in 1913 during the first Administration of Woodrow Wilson. It would be interesting and instructive to trace in detail the many times since 1913 when the Fed has instituted policies so erroneous and impervious to real needs that great hurt has been done to the economy and to the American people. Before and during the Great Depression, the smaller depression of 1920-1922, and the economic stagnations and recessions since 1953, the Fed has been a main contributor to the oncoming of economic and related social disaster or lesser calamity and to their aggravation and protraction.


The opening of Leon Keyserling's "Money, Credit and Interest Rates: Their Gross Mismanagement by the Federal Reserve System," 1980, published by the Conference on Economic Progress.


Treatment of ... technicalities is not necessary to describe and appraise the practical consequences of the two basic things which the Fed is doing or attempting to do, which are to determine or predominantly influence the availability of money and credit and rates of interest. Indeed, the excessive focus upon ... technicalities involves recognition that the general public cannot really be well-informed about them, and all too frequently is based upon awareness that this excessive focus maintains the unchallenged authority of the "sacred cow." This leads the trusting public to believe that it must let those in authority do as they please, because only they and other experts or so-called experts can possibly understand what it is all about.

I thought today on the podcast we would listen to the words of others.

Hyman Minsky, writing in 1985

p. 5

... Fundamental institutional changes similar in scope to the basic reforms of the first six years of the Roosevelt presidency are necessary if we are to recapture such relative tranquility.

For a new era of serious reform to enjoy more than transitory success it should be based on the understanding of why a decentralized market mechanism -- the free market of the conservatives -- is an efficient way of handling the many details of economic life, and how the financial institutions of capitalism, especially in the context of production processes that use capital-intensive techniques, are inherently disruptive. Thus, while admiring the properties of free markets we must accept that the domain of effective and desirable free markets is restricted. We must develop economic institutions that constrain and control liability structures, particularly of financial institutions and of production processes that require massive capital investments. Paradoxically, capitalism is flawed precisely because it cannot readily assimilate production processes that use large-scale capital assets.


p. 6

oscillation between imminent collapse and rampant speculation


The financial fragility that led to the instability so evident since the 1960s was ignored. The deregulation drive and successful effort to bring the inflation rate down by large-scale and protracted monetary constraint and unemployment exacerbated the financial instability that was so evident in 1967, 1970, 1974-75 and 1979-80. Lender-of-last-resort interventions, which had papered over the problems of the fragile financial structure in the intermittent crises of the late 1960s and 1970s, became virtually everyday events in the 1980s.


The protracted unemployment and bankruptcies and near bankruptcies of firms and banks radically transformed the labor force from being income-oriented to being job-security oriented. Job security is no longer being guaranteed by federal macroeconomic policy; the only guarantee that labor now enjoys seems to be the right to make concessionary wage settlements.

These concessions by workers mean that the cost push part of the business cycle is attenuated -- but it also means that consumer demand due to increasing wage income will be less buoyant during an expansion. If anything, the Reagan reforms made prospects for instability worse -- but like many things in the economy and politics the full effects of the reforms will not be felt for some time. Even as a deficit-aided strong recovery leads to an apparent success for Reaganomics, the foundations for another round of inflation, crises, and serious recession are being laid.

p. 7

The major contours of our present institutional setup were put in place during the Roosevelt reform era, particularly in the second New Deal, which was completed by 1936. This structure was a response to the failures of the emergency legislation of 1933 to foster a quick recovery and to the spate of Supreme Court rulings invalidating various portions of the first New Deal that had been enacted during the one hundred days of 1933.

p. 8

footnote: There is a policy ineffectiveness theorem in contemporary economics. (See Thomas J. Sargent and Neil Wallace, "Rational expectations and the Theory of economic Policy," Journal of Monetary Economics, 1976, pp. 169-83.) Such theorems can be maintained only as the in fact institutional structure is ignored.

... when the difficulties encountered by giant corporations ad financial institutions are central to the instability that plagues the economy, the very largest concentrations of private power should, in the interest of efficiency as well as stability, be reduced to more manageable dimensions.

p. 9

The major flaw of our type of economy is that it is unstable. This instability is not due to external stocks (sic) or to the incompetence or ignorance of policy makers. Instability is due to the internal processes of our type of economy. The dynamics of a capitalist economy which has complex, sophisticated, and evolving financial structures leads to the development of conditions conducive to incoherence -- to runaway inflations or to deep depressions. But incoherence need not be fully realized because institutions and policy can contain the thrust to instability. We can, so to speak, stabilize instability.

Minsky's point so far is that the stability of the economy after 1966 was due to two things. First the presence of Big Government whose purchases and programs tended to be counter-cyclical, but whose debt being secure tended to act as ballast to the portfolios of private actors. Second, the Fed acted as backstop to the speculative financing that grew up during the good times. As lender of last resort, it became the de facto alternative financing when the first line of financing faced trouble. Only the Fed was big enough and had the money to stand up when the demand for backstop financing became enormous.

Here, from Chapter 2:

Chapter 2

p. 13

In the first quarter of 1975 (and again in midyear 1982), it seemed as if the American and the world economy was rushing toward a depression that might approach the severity of the Great Depression of the 1930s. Not only was income declining rapidly and the unemployment rate exploding, but virtually each day saw another bank, financial organization, municipality, business corporation, or country admit to financial difficulties.

p. 14-15

What, then, prevented a deep depression in 1975 and 1982? The answer centers on two aspects of the economy. The first is that Big Government stabilizes not only employment and income, but also business cash flows (profits) and as a result asset values. [FN: This is a proposition derived from the work of Kalecki. See Michael (sic) Kalecki, Selected Essays on the Dynamics of the Capitalist Economy (1933-1970) ...] The second aspect is that the Federal Reserve System, in cooperation with other government agencies and private financial institutions, acts as a lender of last resort. It will be argued that the combined behavior of the government and of the central bank, in the face of financial disarray and declining income, not only prevents deep depressions but also sets the stage for a serious and accelerating inflation to follow. The institutions and usages that currently rule have not prevented disequilibrating forces from operating. What has happened is that the shape of the business cycle has been changed; inflation has replaced the deep and wide trough of depressions.

You may say there have been no long periods of inflation since Minsky wrote in 1985. Here I would substitute "bubble" for inflation. Bubble is essentially an inflated asset price. These may not appear in CPI, but they are inflations. This would then lead into some of Soros work.

I do want to clarify here that "speculative financing" is simply that financing which is not a straightforward loan arrangement. I will buy a machine and borrow the money from you and pay you back with the cash flow generated by the machine. Much or most of modern corporate finance entails interim financing arrangements, where some borrowing is done to pay off the capital investment loan. This is speculative and has to have a backup if it is not going to be completely unstable.

But enough of my voice for today.

Let's get some audio from others:

Adam Posen, Deputy Director of the Peterson Institute, but soon to resign to become an external member of the monetary policy committee of the Bank of England.


Here is David Wessel, writer and author of "In Fed We Trust," economics editor of the Wall Street Journal.


Wessel has a slightly different view than Posen, you may have noticed, and as befits his position with the Wall Street Journal, chief apologist for Wall Street. Instead of screwing up, Bernanke was looking for exactly what happened, and moved aggressively to save the banks -- by transferring trillions from the taxpayer and average citizen to the bankers, in the form of making good on some of the worst financial decisions in history. Of course, even the Fed cannot fix the huge hole that has been created. But they could have stopped it. Bernanke was looking out for the banks, it is true. Whether that constitutes doing the job is another question.

Now, here is Willem Buiter (BOUTER). Buiter is now of the London School of Economics and a columnist for the Financial Times. He was an immediate predecessor of Posen as an external member of the Bank of England's monetary policy committee. He is a notable Dutch economist.


Willem Buiter

So, we'll be looking more directly at the instability of top-heavy capitalism in upcoming podcasts. Maybe one of these days we'll give Baffled Ben a break. It is beyond me how he can have as much support as he does.

I think on Saturday, however, we're going for something completely different. We're going to replay Jonathan Frost's presentation on the real dynamics of innovation and specifically dealing with climate change. It's one of the best things we've heard. How to create the products we need and use the budget process to do it.

It is a demand side solution.

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