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Tuesday, August 25, 2009

Roubini on recession, Minsky on instability

On today's podcast, we have Nouriel Roubini writing in the Phinancial Times and we have Hyman Minsky writing two decades ago about what has happened in the past year. And we apologize for dropping Saturday's podcast. It fell on the floor and rolled under the credenza and we haven't been able to get it out. We'll make it up with an extra long version today.

Before we get to Roubini and Minsky, however, we did get some feedback on our proposition about unemployment and productivity. This from the great economist James K. Galbraith. You will remember our chart showing that productivity and the unemployment rate mirror each other when mapped over a polynomial trend. We suggested the Rule of Eight. Eight minus the unemployment rate equals productivity.

Professor Galbraith wrote, quote:

Thank you. I make a very similar argument in the chapter on standards in The Predator State. It reflects the longstanding Rehn-Meidner (Swedish model) approach to combining wage compression, high employment, and rapid productivity growth.

Regards, James

Our interpretation, and that's what all good economists must expect, is that the chart is a clear picture of what is not completely original and may have a more complete theoretical discussion elsewhere. Nevertheless, our Rule of Eight stands.

So we are very appreciative of Professor Galbraith's comment, not only for the attention, but for the leads on exploration of this very little known -- and some say, though I do not find it to be so -- counter-intuitive relationship between labor and productivity.

Now on to Nouriel Roubini, writing in the Financial Times August 23 2009. Roubini, of course, deserves to be listened to because he was a voice in the wilderness prior to the housing collapse and financial sector crash. Being right is certainly not a necessary condition for being listened to in today's world, but on Demand Side, we treat it so.

The risk of a double-dip recession is rising

By Nouriel Roubini
Financial Times

... it looks like the global economy will bottom out in the second half of 2009. In many advanced economies (the US, UK, Spain, Italy and other euro zone members) and some emerging market economies (mostly in Europe) the recession will not be formally over before the end of the year, as green shoots are still mixed with weeds. In some other advanced economies (Australia, Germany, France and Japan) and most emerging markets (China, India, Brazil and other parts of Asia and Latin America) the recovery has already started.


... the debate is between those – most of the economic consensus – who expect a V-shaped recovery with a rapid return to growth and those – like myself – who believe it will be U-shaped, anaemic and below trend for at least a couple of years, after a couple of quarters of rapid growth driven by the restocking of inventories and a recovery of production from near Depression levels.

This is not explicit here, but I believe Roubini is making this call for the global recession, including those nations he identifies as already in recovery.

There are several arguments for a weak U-shaped recovery.

    • Employment is still falling sharply in the US and elsewhere – in advanced economies, unemployment will be above 10 per cent by 2010. This is bad news for demand and bank losses, but also for workers’ skills, a key factor behind long-term labour productivity growth.
  • Second, this is a crisis of solvency, not just liquidity, but true deleveraging has not begun yet because the losses of financial institutions have been socialised and put on government balance sheets. This limits the ability of banks to lend, households to spend and companies to invest.

departing from Roubini, and as Minsky points out below, the deleveraging as an exercise of cleaning the books is one thing, but a huge implicit guarantee is now in place for institutions and instruments like credit default swaps that makes the entire system not only sluggish now but tremendously more vulnerable to speculation in the future.

back to Roubini

  • Third, in countries running current account deficits, consumers need to cut spending and save much more, yet debt-burdened consumers face a wealth shock from falling home prices and stock markets and shrinking incomes and employment.
  • Fourth, the financial system – despite the policy support – is still severely damaged. Most of the shadow banking system has disappeared, and traditional banks are saddled with trillions of dollars in expected losses on loans and securities while still being seriously undercapitalised.
  • Fifth, weak profitability – owing to high debts and default risks, low growth and persistent deflationary pressures on corporate margins – will constrain companies’ willingness to produce, hire workers and invest.
  • Sixth, the releveraging of the public sector through its build-up of large fiscal deficits risks crowding out a recovery in private sector spending. The effects of the policy stimulus, moreover, will fizzle out by early next year, requiring greater private demand to support continued growth.
  • Seventh, the reduction of global imbalances implies that the current account deficits of profligate economies, such as the US, will narrow the surpluses of countries that over-save (China and other emerging markets, Germany and Japan). But if domestic demand does not grow fast enough in surplus countries, this will lead to a weaker recovery in global growth.

There are also now two reasons why there is a rising risk of a double-dip W-shaped recession. For a start, there are risks associated with exit strategies from the massive monetary and fiscal easing: policymakers are damned if they do and damned if they don’t. If they take large fiscal deficits seriously and raise taxes, cut spending and mop up excess liquidity soon, they would undermine recovery and tip the economy back into stag-deflation (recession and deflation).

But if they maintain large budget deficits, bond market vigilantes will punish policymakers. Then, inflationary expectations will increase, long-term government bond yields would rise and borrowing rates will go up sharply, leading to stagflation.

Another reason to fear a double-dip recession is that oil, energy and food prices are now rising faster than economic fundamentals warrant, and could be driven higher by excessive liquidity chasing assets and by speculative demand. Last year, oil at $145 a barrel was a tipping point for the global economy, as it created negative terms of trade and a disposable income shock for oil importing economies. The global economy could not withstand another contractionary shock if similar speculation drives oil rapidly towards $100 a barrel.

In summary, the recovery is likely to be anemic and below trend in advanced economies and there is a big risk of a double-dip recession.

So we must interject again that the technical designation of a recovery is upward movement, the patient being able to raise his hand. It is not return to the previous state, which is what normal folks think of as recovery. In terms of recovering to a previous state of health. That is a long way off.

Now to Hyman Minsky, a long-time scholar and teacher at Brown University, UC Berkeley and Washington University in St Louis. At the time of his death he was a Senior Scholar at the Levy Economics Institute of Bard College.

Minsky would say, or I will say after reading a bit of Minsky, that the risks have been amplified by Fed and Treasury action to rescue the economy. Yes, the institutions and some of the securities and facilities have been saved, but the implicit guarantee now in place dwarfs all the implicit guarantees of previous cycles.

Commercial paper, real estate investment trusts, strategically placed hedge funds have all benefited from the backstopping of the Federal Reserve or a Fed-inspired consortium of private institutions. Now we have such animals as credit default swaps plus the entirety of big banking institutions now under the protection of the Fed. This means that the Fed and the integrity of the system are backstopping whatever innovations quote unquote the financial sector cowboys can come up with.

Not only are the risks of a return to speculative financing on an even grander scale more certainty than risk, but the rest of the economy must labor along under the weight of the past fiascoes being socialized and placed on the backs of the rest of us.

Rather than speak for Minsky, I would like to offer an introduction through a few passages from his book "Stabilizing an Unstable Economy," 1986. This book offers some of the best economic thinking, but the Twentieth Century Fund, which published it, should have hired a more competent editor.

Being a theory guy, let's start here, page 102.

The Current Standard Theory: The Pre-Keynesian Legacy

During the 1970s American economists engaged in what might have been taken to be a serious controversy between Keynesians and Monetarists.

Reading the footnote

The literature is immense, and any full citations (sic) would be book-length. The key names for monetarism are Milton Friedman and the joint and separate products of Karl Brunner and Alan Meltzer. Paul Samuelson, Franco Modigliani and James Tobin are names in the neoclassical Keynesian camp, although from time to time Tobin shows signs of being a Keynesian rather than a neoclassical Keynesian.

Returning to the main body of the text

The participants and the press made it appear that a deep debate was taking place. In truth, the differences were minor -- as the competing camps used the same economic theory. Furthermore, the public policy prescriptions do not really differ. The debate was largely academic nitpicking, and the public controversy was largely created by the press and by politicians. In this debate, Monetarists emphasized that changes in the money supply destabilize the economy, and Keynesians argued that fiscal variables can be used to stabilize the economy. Until late in the 1970s, and even into the first years of the Reagan administration, both believed that with correct (that is, their) policy the economy could be fine-tuned so that full employment without inflation would be achieved and sustained. Both schools hold that the business cycle can be banished from the capitalist world; and neither school allows for any within-the-system disequilibrating forces that lead to business cycles. Neither Keynesians nor monetarists of the policy establishment are critical of capitalism as such; at most they are critical of some institutional or policy details.

Both Monetarists and Keynesians are conservative in that they accept the validity and viability of capitalism. Neither are troubled by the possibility that there are serious flaws in a market economy that has private property and sophisticated financial usages. The view that the dynamics of capitalism lead to business cycles that may be thoroughly destructive is foreign to their economic theory.

The economic theory that is common to the Keynesians and the Monetarists is the Neoclassical Synthesis. Keynes held that his new theory of 1936 marked a sharp contrast with the economic theory that then ruled. The Neoclassical Synthesis, however, integrates strands of thought derived from Leon Walras -- a nineteenth-century economist -- with insights and apparatus derived from Keynes. The dominant view among contemporary economists was expressed by Gardner Ackley -- a member and then chairman of the Council of Economic Advisers in the Kennedy-Johnson era -- when he said "that Keynes' work represents more an extension than a revolution of 'Classical' ideas."

The process of assimilating Keynes' "General Theory into the previous tradition began with the early reviews and academic interpretations. In this process, important aspects of Keynes' theoretical structure, which lead to revolutionary insights into the functioning of capitalism and to a serious critique, were ignored. This is why Joan Robinson called standard Keynesianism "bastard Keynesianism." As far as an understanding of Keynes by policy-advising economists and their political patrons is concerned, the Keynesian revolution is still to come.

The elements of Keynes that are ignored in the Neoclassical Synthesis deal with the pricing of capital assets and the special properties of economies with capitalist financial institutions. These elements can serve as the foundation for an alternative economic theory that is a better guide to interpreting events and is more relevant for policy-making than current standard theory. Indeed these forgotten parts lead to a theory that makes instability, which has been of increasing importance since the mid-1960s, a normal consequence of relations that reflect essential attributes of a capitalist economy.

The view that instability is the result of the internal process of a capitalist economy stands in sharp contrast to neoclassical theory, whether Keynesian or monetarist, which holds that instability is due to events that are outside the workings of the economy. The Neoclassical Synthesis and the Keynesian theories are different because the focus of the Neoclassical Synthesis is on how a decentralized market economy achieves coherence and coordination in production and distribution, whereas the focus of the Keynesian theory is upon the capital development of an economy. The Neoclassical Synthesis emphasizes equilibrium and equilibrating tendencies, whereas Keynes' theory revolves around bankers and businessmen making deals on Wall Street. The Neoclassical Synthesis ignores the capitalist nature of the economy, a fact of which Keynes' theory is always aware.

The Walrasian input to the Neoclassical Synthesis starts with a discussion of an abstract exchange (barter) economy. The analogue may be a village fair. Results are obtained by analyzing a model that does not allow for capital-intensive production, capital assets as we know them, and capitalist finance. Using an artificial construction of trading relations, the theory demonstrates that a decentralized market economy achieves a coherent result.

decentralized and free market are synonyms.

Standard economic theory then goes on to show that the property of coherence also carries through for an economy that produces, but only under heroic assumptions about the nature of capital and time. In further extensions, the analytical apparatus of the Neoclassical Synthesis is applied to problems of aggregate income, money prices, and economic growth. In particular, supply and demand relations for labor are derived, and it is assumed that a price-level-deflated wage will adjust so that labor supply and demand are equal. The theory is set up in such a way that any deviation from the labor supply-labor demand equality will be removed by market interactions. That is, the theory holds that full employment is achieved by means of the internal operations of the economy. The theory does not explain, however, how any initial deviation is brought about. Unemployment as the result of economic processes is unexplained. The emphasis is upon the interactions that make for equilibrium and not upon endogenous disequilibrating processes.

...capital accumulation and the rate of growth of the labor force determine the rate of output growth. The savings ratio yields the proportion of income that is accumulated. The neoclassical theory treats household savings propensities as the tune-caller, determining investment and, in turn, investment is the determinant of growth. The theory has no room whatsoever for institutions that finance investment and, in so doing, force saving.

paragraphs suffers from not seeing the subsequent decades of immense investment and dropping household savings

Neoclassical theorists do short-run analysis -- where inflation and unemployment exist -- on the basis of a theory that does not allow for inflation or unemployment except as the result of outside forces. The Monetarists identify an outside force -- inept changes in the money supply -- as the cause of unemployment and inflation. Neoclassical Keynesians do not have a consistent explanation of how unemployment and inflation are brought about. Their short-run theory is a muddle. They believe that the economy will not sustain full employment, but they do not identify the mechanisms that lead to unemployment and inflation.

In addition to demonstrating that decentralized market processes lead to coherent results, the tools and techniques of the neoclassical Synthesis are used to demonstrate that a decentralized competitive market mechanism achieves an optimal result. The optimum that is derived is of a very special character: It rules out interpersonal comparisons of well-being and ignores the equity of the initial distribution of resources (and thus of income).



Current theory makes an economy a lifeless arena in which depersonalized agents play abstract auctioning or re-contracting games. In our world of imperfect knowledge and imprecise actions, standard theoretical analyses posit either perfect knowledge or a fantastic capacity to compute.

here anticipating the rise of rational expectations which odd theory won many a Nobel Prize in the decades subsequent to this writing.

Nevertheless these models (which are now highly mathematical) are interesting because they show that coherence is possible. But what practical people need to know is the extent to which market processes can be used to achieve desired results. The practical problem of economic policy is to identify the sources of instability and to determine policy interventions that constrain the emergence of incoherence, even as policy abstains from intervening in those markets whose internal operations tend to yield coherent results.

There is much more to Minsky. Forthcoming. But let's conclude with something from the beginning.

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.

Yes. That is, manage the markets. Where there are the conditions for decentralized markets that are not conducive to instability, let them go. Where markets promote instability and collapse, structure them and organize them. If necessary take them out of the market framework as pure public goods.

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