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Wednesday, September 30, 2009

Matt Taibi and naked short-selling with Goldman Sachs

Heisted from Matt Taibi's blog, here is an informal look at naked short-selling, another game played by the big boys. It is combined, of course, with setting the rules, which the big boys do via lobbying and regulatory capture. You can smell the dishes they're cooking up in this part of a piece.

An Inside Look at How Goldman Sachs Lobbies the Senate
by Matt Taibi
September 30, 2009

Naked short-selling is a kind of counterfeiting scheme in which short-sellers sell shares of stock they either don’t have or won’t deliver to the buyer. The piece gets into all of this, so I won’t repeat the full description in this space now. But as this week goes on I’m going to be putting up on this site information I had to leave out of the magazine article, as well as some more timely material that I’m only just getting now.

Included in that last category is some of the fallout from this week’s SEC “round table” on the naked short-selling issue.

The real significance of the naked short-selling issue isn’t so much the actual volume of the behavior, i.e. the concrete effect it has on the market and on individual companies — and that has been significant, don’t get me wrong — but the fact that the practice is absurdly widespread and takes place right under the noses of the regulators, and really nothing is ever done about it.

It’s the conspicuousness of the crime that is the issue here, and the degree to which the SEC and the other financial regulators have proven themselves completely incapable of addressing the issue seriously, constantly giving in to the demands of the major banks to pare back (or shelf altogether) planned regulatory actions. There probably isn’t a better example of “regulatory capture,” i.e. the phenomenon of regulators being captives of the industry they ostensibly regulate, than this issue.

In that vein, starting tomorrow, the SEC is holding a public “round table” on the naked short-selling issue. What’s interesting about this round table is that virtually none of the invited speakers represent shareholders or companies that might be targets of naked short-selling, or indeed any activists of any kind in favor of tougher rules against the practice. Instead, all of the invitees are either banks, financial firms, or companies that sell stuff to the first two groups.

In particular, there are very few panelists — in fact only one, from what I understand — who are in favor of a simple reform called “pre-borrowing.” Pre-borrowing is what it sounds like; it forces short-sellers to actually possess shares before they sell them.

It’s been proven to work, as last summer the SEC, concerned about predatory naked short-selling of big companies in the wake of the Bear Stearns wipeout, instituted a temporary pre-borrow requirement for the shares of 19 fat cat companies (no other companies were worth protecting, apparently). Naked shorting of those firms dropped off almost completely during that time.

The lack of pre-borrow voices invited to this panel is analogous to the Max Baucus health care round table last spring, when no single-payer advocates were invited. So who will get to speak? Two guys from Goldman Sachs, plus reps from Citigroup, Citadel (a hedge fund that has done the occasional short sale, to put it gently), Credit Suisse, NYSE Euronext, and so on.

In advance of this panel and in advance of proposed changes to the financial regulatory system, these players have been stepping up their lobbying efforts of late. Goldman Sachs in particular has been making its presence felt.

Last Friday I got a call from a Senate staffer who said that Goldman had just been in his boss’s office, lobbying against restrictions on naked short-selling. The aide said Goldman had passed out a fact sheet about the issue that was so ridiculous that one of the other staffers immediately thought to send it to me. When I went to actually get the document, though, the aide had had a change of heart.

Which was weird, and I thought the matter had ended there. But the exact same situation then repeated itself with another congressional staffer, who then actually passed me Goldman’s fact sheet.

Now, the mere fact that two different congressional aides were so disgusted by Goldman’s performance that they both called me on the same day — and I don’t have a relationship with either of these people — tells you how nauseated they were.

I would later hear that Senate aides between themselves had discussed Goldman’s lobbying efforts and concluded that it was one of the most shameless performances they’d ever seen from any group of lobbyists, and that the “fact sheet” the company had had the balls to hand to sitting U.S. Senators was, to quote one person familiar with the situation, “disgraceful” and “hilarious.”

I’m including the Goldman fact sheets here. They will not make a whole lot of sense to people outside of the finance world, but if you can fight through them, what you’ll find is the statistical equivalent of a non-sequitur. Goldman here is lobbying against restrictions to naked short-selling, and in arguing that point they include a graph showing the levels of “short interest” during two time periods, September-October 2008 (when there was a temporary ban on all short-selling, naked or otherwise) and January-March 2009.

Goldman’s point seems to be that short-selling declined during a period when the market fell sharply, and short-selling went up when the market rallied. I guess on some planet, perhaps not on earth but some other spherical space-boulder, this is supposed to indicate that short-selling is good for the market overall.

(Which, incidentally, it might be. But we’re not talking about short-selling here. We’re talking about naked short-selling).

The thing is, you can’t deduce anything at all about naked short-selling by looking at a graph showing levels of normal short selling. This is like trying to draw conclusions about the frequency of date rape by looking at the number of weddings held. The two things have absolutely nothing to do with one another.

I was so sure that I was missing something that I started asking around. “If you are confused, you are not alone,” one economist wrote back to me. “I have no idea why they are conflating short selling and naked short selling. Members of Congress are probably confused as well.”

The thing is, the only way to draw conclusions about whether or not naked short-selling is a problem is to look at individual cases of individual declines in the share prices of specific companies, and then check to see if there have been large numbers of failed trades in those stocks.

Goldman is not only not doing that here, they’re taking two statistics with no relation to naked short-selling (short interest and stock prices), stats cherry-picked during two seemingly random time-periods, and then slapping them underneath a cover sheet full of platitudes like “The US equities market is increasingly efficient and broadly regarded as the best in the world.” It’s not so much that this is a bad argument, it’s just… not really an argument at all. It’s lazy, really. It makes you wonder what’s going on at that company

Monday, September 28, 2009

Marshall Auerback says financial reform is headed in the wrong direction

The Financial Products Safety Commission is the key to regulation by Demand Side's opinion. Why? The market is nothing more or less than the products, terms and conditions at the moment of purchase-sale. (It is for this reason it is so critical to internalize the externalities so the market can work for the benefit of environment and other societal needs.) Participants in the market, by these lights, are not the market itself. If participants are small enough not to control the market, a great deal of discipline will be introduced, as the "too big to fail" insurance will be eliminated. At the same time, the intrusive oversight being proposed on many sides will be less necessary.

Here is Marshall Auerback's take on the recent Obama speech.

Obama’s finance reform speech fizzles; big banks set to reinflate bubble
Marshall Auerback
New Deal 2.0
September 16, 2009

The President has marked the anniversary of the demise of Lehman Brothers with a new speech designed to breathe new life into his financial reform proposals. But the Obama administration already forfeited its best chance to reform the banking system when the crisis was at its height.

For all of the lofty talk about establishing “the most ambitious overhaul of the financial system since the Great Depression”, Obama’s reforms amount to nothing more than a reshuffling of the deckchairs on the Titanic.

Why? Because Too big to fail (TBTF) banks have grown even more bloated in the past 2 years. And because leverage has increased across the board. Bank of America, the biggest of the “TBTF” institutions, now holds 12% of all US deposits. The top four (Bank of America, JPMorgan Chase, Citigroup and Wells Fargo) now have 46% of the assets of all FDIC-insured banks, up from 37.7% a year ago. Goldman Sachs, the biggest securities firm before it was handed a bank charter, has plunged into even riskier business and upped its trading and investment profits by two-thirds over the past year.

Systemic banks benefit from implicit and explicit government backstops. But a resolution regime for all systemically large and complex institutions like Fannie and Freddie — arguably one of the most important measures– is stalling in Congress amid waning political support. And — surprise! - lobbyist are gearing up to fight the Consumer Financial Protection Agency, whose fate is unclear as the bill works its way through Congress.

We haven’t yet even determined who will be the systemic risk regulator. Could be the Fed. Or it could be the Systemic Risk Council (a new body proposed to keep an eye of financial markets ). Given the Federal Reserve’s dismal record in anticipating this crisis and promoting the wrong-headed economic models that blew up the bubble, it is extraordinary that we are even discussing the notion of providing the central bank with yet more power. But is a Systemic Risk Council really the answer? Why reinvent the wheel, when the obvious alternative is the Federal Insurance Deposit Corporation (FDIC)?

Professor James Galbraith warns that the key ingredients in systemic risk regulation are accountability and supervision”

“It would be all too easy for the Federal Reserve Board to open an internal Office of Systemic Risk Assessment, to staff it with mathematical risk modelers, and to let the matter rest there. Then, when the next crisis hits, the Fed would say that it was something ‘no one could have foreseen’ - just because their internal model-builders failed to foresee it. This is probably not the outcome Congress seeks…

….Essentially, the job is to recognize emerging patterns of dangerous behavior. This function is best taken on by an agency with experience, expertise, and focus on these functions, an agency with no record of regulatory capture or institutional identification with the interests of the regulated sector.”

In Gailbraith’s view, the FDIC fits the bill. And he is right. The FDIC is the logical home for systemic regulation. Yet as far as we can see, Obama is not considering it in his proposals. Perhaps part of this reluctance reflects animus toward Sheila Bair, who is definitely not part of the “old boys’ network”. It also likely reflects the comfort level of Wall Street, given its incestuous relationship with the Fed, and the concomitant embrace by both groups of a like-minded market fundamentalist ideology.

Clearly a regulator should not be chummy with the entities it is charged with regulating. The FDIC is charged with taking over any bank it deems insolvent, and then either selling that bank, selling the bank’s assets, reorganizing the bank, or any other similar action that serves the public. This largely explains why the FDIC is not particularly beloved by Wall Street or Wall Street’s main benefactors in Washington DC.

Indeed, the TARP program was at least partially established to allow the US Treasury to subvert the role of the FDIC. By injecting equity in specific banks, the Treasury managed to keep them from being declared insolvent by the FDIC, and ostensibly allow them to continue to have sufficient capital to continue to lend. The end result? TARP entrenched the dominance of the largest financial institutions, preserving many which were de facto insolvent, at the expense of the better run local, community banks (which are in effect being penalized for the sins of Citi and Bank of America). The big bank problem is one of insolvency; further big banks cannot be and should not be saved. They do not hold the key to recovery; if anything, they are a barrier to sustainable recovery. Given a chance, they will try (in fact, ARE trying) to re-inflate the bubble conditions that led to this crisis. There is nothing in the proposed new regulatory framework which will prevent this.

Additionally, the history of banking crises suggest that the regulatory focus on the liability side of the banks’ balance sheets is faulty. There is much discussion of counter-cyclical capital requirements, but the reality is that capital standards and leverage ratios for financial institutions almost never work. They are always set so low that they allow leverage that would have been viewed as extreme as recently as 30 years ago. They are easy to scam through accounting fraud. When times get tough, the financial services industry demands (and usually receives) regulatory dispensation on flaky accounting, legalizing what would otherwise be blatant securities fraud.

U. S. banks are public/private partnerships, established for the public purpose of providing loans based on credit analysis. Supporting this type of lending on an ongoing, stable basis demands a source of funding that is not market dependent. All regulation, then, should proceed from a ‘public purpose’ standpoint and the regulatory focus should be on the asset side of the balance sheet. Banks should only be allowed to lend directly to borrowers, and then service and keep those loans on their own balance sheets. There is no further public purpose served by selling loans or other financial assets to third parties, but there are substantial real costs to government regarding the regulation and supervision of those activities. And there are severe consequences for failure to adequately regulate and supervise those secondary market activities as well.

Our key recommendations:

• Banks should not be allowed to have subsidiaries of any kind. No public purpose is served by allowing bank to hold any assets ‘off balance sheet.’ Banks should not be allowed to accept financial assets as collateral for loans. Forget about leverage ratios: no public purpose is ever served by financial leverage of any kind.

• Banks should not be allowed to buy (or sell) credit default insurance. The public purpose of banking as a public/private partnership is to allow the private sector to price risk, rather than have the public sector pricing risk through publicly owned banks.

If a bank instead relies on credit default insurance, it is transferring that pricing of risk to a third party, which is counter to the public purpose of the current public/private banking system. CDSs lead investors to be indifferent to a bankruptcy, and in many cases to push for it. Since they own a CDS, they will get their payoff, while negotiating a restructuring takes time and money. Why bother if you can collect immediately via the profits proceeds of a credit default swap? These “Frankenstein” products by all rights ought to be banned outright, but the most the Obama/Geithner reforms dare to propose is a clearinghouse system to reduce potential knock-on effects (systemic risk) from the failure of a large player. But the riskiest products are not standardized enough for a clearinghouse and therefore remain exposed to bilateral counterparty risk which regulators want to mitigate by imposing higher capital charges and disclosure of aggregate position holdings. Naturally, Wall Street opposes this.

The FDIC should be directed to examine the books of the largest insured banks to uncover all CDS contracts held. The gross positions should be netted out amongst these financial behemoths, canceling CDS contracts held on one another. CDS contracts with foreign banks should be unwound; the American taxpayer should not be in the business of bailing out non-US banks. In its examination, the FDIC will have to determine which of these banks are insolvent based on current market values-after netting positions. Those that are insolvent will be resolved. The ultimate objective must be to minimize the cost to FDIC and minimize impacts on the rest of the banking system. It will be necessary to cover some uninsured losses to other financial institutions as well as to equity holders (such as pension funds) arising due to the resolution. And finally, the Treasury and Fed will be directed to work to reduce concentration of the financial sector by avoiding resolution methods that favor large institutions. There will be a bias toward rescue of smaller institutions, and use of the resolution process to break-up the larger institutions.

The past few months have provided ample demonstration that Wall Street intends to recreate the conditions that existed in 2005. And make no mistake, the current situation is worse than it was in 2007 before the collapse, particularly in relation to large, systemically-significant financial institutions. President Obama, Fed Chairman Bernanke and Treasury Secretary Geithner have made many bold claims about their new financial reforms, but these reforms in no way represent a radical shift in its framework of analysis and policy implementation. The reality all three of them continue to turn a blind eye to the underlying problems in the hope that these will not return and blow up again on their watch. This is precisely the recipe for disaster followed by Alan Greenspan, Robert Rubin, and Henry Paulson.

Roosevelt Institute Braintruster Marshall Auerback is a market analyst and commentator.

Saturday, September 26, 2009

The Minsky Hour, or maybe just ten minutes

Plus Marc Faber and Steven Roach

Yes, we've been teasing too much, but there is too much to Minsky. We'll lead off with the insights of this obscure, but much less so today than last year, economist. A bit later we'll get more of Marc Faber and some Steven Roach on China.

First a discouraging word from Joseph Stiglitz, dropped in conversation at the Roosevelt Institute's Four Freedoms dinner recently. Stiglitz suggested to Lynn Parramore that still more than 60 percent of economists are holding on to the Chicago School mentality. Wow. When economics becomes not a science, but a religion.

But let's start out today with our minds clear and our focus simple.

And we go back to the algebra derived from Michal Kelecki's most simple assumption -- that workers consume all their income -- and see how Minsky develops it. Of course the assumption is not completely true, but it is not fatal to the analysis when it deviates the way, for example, the assumption of Neoclassical economics that all firms are price takers or the assumptions of rational expectations that market participants, indeed all economic actors, are imbued with economic omniscience.

Kalecki showed that when his assumption was allowed and in an economy with small government and little trade, investment equals profits, or profits equal investment.

By nothing more controversial than simple algebra, Minsky then demonstrated first that price is positively related to the wage rate and to the ratio of investment goods to consumption goods production, and negatively related to labor productivity. We went over that a couple of weeks ago, when we then digressed on the inappropriately prominent place the quantity theory of money has in the primitive orthodoxy that rules economics today.

But let's consider what Minsky's relationships mean. It's a no-brainer that prices vary in the opposite direction as productivity, because, productivity simply means producing more with the same labor. We at Demand Side recently demonstrated that productivity also goes up when the unemployment rate goes down. (I was so excited.) And since wages and unemployment also vary inversely, there is some amelioration of the labor cost impact on price, that is, on inflation. Put simply, prices do not rise in proportion to wages in periods of falling unemployment. This is, of course, opposite to the information derived from the famous Phillips Curve.

But the second part of this finding is very instructive. The algebra shows what we might also derive from common sense. As investment goods are emphasized over consumer goods, the price of consumer goods tends to rise, because, basically, workers in both sectors are bidding for the output of the consumer goods sector. So when the ratio favors investment goods more, demand for consumer goods is higher and output is lower.

But the implications are not all so common-sensical. The Kalecki demonstration that profits equal investment combines with this revelation that as new investment goes up, so do prices, to produce a condition in which higher prices, higher investment and higher profits coexist. Since investment also connects positively with output and income, we can expect these two -- output and income -- to be in the same virtuous soup.

This indeed was a somewhat surprising empirical finding of our research on economic performance by president. We found that in the postwar period employment is higher, unemployment lower, investment higher, corporate profits higher and GDP growth better when a Democrat is in the White House. It surprised us somewhat that with all the effort by Republicans to push companies into profitability, some would say at the expense of others, that is, the whole supply side idea, that they were not able to accomplish profits better than Democrats. The Kalecki-Minsky analysis demonstrates why it has to be. You can find it on pages 140 and following in Stabilizing an Unstable Economy.

Prices, Minsky says, carry profits, the raison d'etre for investment. In my micro courses we had fixed costs and variable costs and average costs. Prices were determined by marginal costs and where the marginal cost curve intersected the demand curve. This may be true, Minsky says, for price takers. But a whole great swath of the economy, by far its major part, is composed of firms which more or less set prices and vary output according to demand.

These firms operate on the basis of a set of nesting average cost curves, the highest of which includes capital asset validation cost, or profits in the normal use of the word. Such firms keep prices at the requisite level when demand falls by their market power, pricing power. Without this ability to constrain price movements, they may not be able to employ expensive and highly specialized capital assets and large-scale debt financing, Minsky observes.

We include that mention here not because we expect you to get it, the nesting average cost curves and so on, but just to let you know it is there in Minsky, as it is in the real world, and it informs what follows.

Returning to the propositions derived from the insights of Kelecki. Minsky expanded these by introducing big government and trade and workers who save. Elegant and simple algebra yields some remarkable insights.

Note here and we'll explain more in a minute that Minsky's profit is not the same profit with which we are familiar, nor that which we measured in our comparisons of economic performance by president.

Nevertheless, when government and taxes and deficits are introduced, something remarkable appears. It can be shown that after-tax profits equal investment plus the government deficit. When there is no investment, profits equal the deficit. See the details on page 148.

What are the implications of this? One implication is certainly that the big business types who encouraged the tax cuts to promote business should not now be bellyaching about the deficits. They are supporting profits. Now let's look at exactly what profits they are supporting.

Minsky's profits he also terms the "surplus," and it is not only the return on capital we normally think of as profit, but all the returns which are not technologically determined costs of production. These include advertising and professional services, executive salaries and overhead costs, costs of financing and the aforementioned costs to validate capital assets.

Two things jump out at me. One is that the profit or surplus feeds the white collars and presumably the big salaries as opposed to the blue collars on the production side. The other is that price-taking firms are disciplined into being more lean and less top heavy. It appeals to me as justification for taxing incomes progressively.

But let's go back to the price takers versus the price makers. What happens when demand falls? In the case of price takers, demand is reflected by a price that runs back along the marginal cost curve. In the case of price makers, who set the price and prevent its falling by market power, something else happens.

If output drops below the first critical average cost curve, capital asset prices are no longer validated and investment in new capital assets stops -- with implications across the economy for incomes and output. If output drops below the second critical curve, fixed debt payments can no longer be supported, and the various financing instruments come under pressure. Of course, the overhead and executive costs are compressed to some extent, but these may be resistant. For example, firms may increase advertising in attempts to gin up demand.

And when overall demand affects many firms, the same kinds of financial instruments come under pressure and we walk into the kind of crisis we have today.

See that the deflation is resisted by such firms on their products, because they have individual pricing power, but that the drop in output affects incomes and investments and financial arrangements dramatically -- without affecting price.

So my take here is that we ought not to be too ecstatic that deflation is not spiraling. The cost-cutting and absence of investment and the pressure on the financial sector, all too evident in the current stagnation and apparent in declining payrolls may likely mean more bad jujus.

AND of course, business cash flow is being supported mightily by government deficits.

I hope this is semi-clear. It is new to us in this form, and it is a lot to digest. But here at the micro level, you can see what about modern capital-intensive corporate capitalism Minsky found so unstable.

Now, moving on.

Here is Marc Faber, continued from last week. He begins by taking some shots at Paul Krugman, which I purposely leave in here, though I may have to turn in my progressive economics club card. Faber says a kind word about the Austrian School as well. To that I reply with the anecdote in James K. Galbraith's piece we put up on the blog recently. When James K.'s father John Kenneth addressed a conference in Austria, two of the leading lights ... well, here it is verbatim.

...when the Vienna Economics Institute celebrated its centennial, many years ago, they invited, as their keynote speaker, my father [John Kenneth Galbraith]. The leading economists of the Austrian school—including von Hayek and von Haberler—returned for the occasion. And so my father took a moment to reflect on the economic triumphs of the Austrian Republic since the war, which, he said, “would not have been possible without the contribution of these men.” They nodded—briefly—until it dawned on them what he meant. They’d all left the country in the 1930s.

unquote from James K. Galbraith

Now, Marc Faber


Mark Faber

Now just a word from Steven Roach head of Morgan Stanley Asia, in support of our contention that the Chinese miracle may be a mirage unless they establish some sort of basis for homegrown demand, by which I mean social insurances for health care, old age and unemployment. Absent this, they may spend their dollars in pushing infrastructure and see the GDP number respond without establishing anything fundamental. The same sort of infrastructure spending in the U.S. would do great things, but because we have the basis for demand to respond rather than grab the loose dollars and stuff them under the mattress.

Steven Roach with Leslie Cohen of the BBC's Business Daily.


Steven Roach

Dean Baker says an accountable banking system must be composed of smaller banks

The health of any market depends on market discipline. Which substance is totally absent when huge implicit subsidies exist, such as too-big-to-fail insurance. We -- and Dean Baker here -- hope that we return to the Glass-Steagall system which worked rather than creating a new massive bureaucracy subject to the same flaws and fallacies of the current system.

Break up America's banks
Dean Baker
The Guardian, UK
September 21, 2009

The populist anger about Obama's bank bailouts transcends politics. We need a banking system accountable to the public

The large number of people who protested against Barack Obama's healthcare plan in Washington last week drew an enormous amount of media attention. Clearly some of the leaders are certifiably crazy, questioning whether Obama is an American and likening him to Hitler. But many of the protesters had reasonable concerns about how the plan would affect the quality of care that they and their loved ones receive.

It was also striking how often the protesters complained about a government that was out of control and not responsive to ordinary people. One of the items that often came up in the interviews reported in the media was the bank bailout. Clearly this is an enduring and deeply felt cause of resentment.

It would be very hard to tell these people that their concerns on this topic are misplaced. At a time when tens of millions of people are facing unemployment or underemployment, when millions are at immediate risk of losing their homes, the banks seem to be doing better than ever. Goldman Sachs used its government-guaranteed loans to make risky bets that paid off big time. It now plans to distribute $9bn in bonuses to its executives and top traders at the end of the year. Why shouldn't the protesters be absolutely furious about an administration that used taxpayer dollars to make some of the richest people in the country even richer?

It would be great if the anger of these protesters could be turned in a productive direction. Instead of trying to prevent the government from extending healthcare coverage, how about going after the banks that pillaged the country?

The obvious place to start in this effort is the break-up of the "too big to fail" behemoths. It is now pretty much official policy that financial giants like Citigroup, Bank of America and Goldman Sachs will not be allowed to fail. If their bad investment decisions again bring them to the edge of bankruptcy, the federal government will again rush to the rescue, handing out whatever cash and loans are needed to keep the banks afloat.

This status gives these banks a clear edge in credit markets against their smaller competitors. If everyone knows that the government can be counted on to come to the rescue of these banks, then there is less risk in lending them money. Therefore, they pay lower interest rates than if they had to borrow in a free market.

The Obama administration has proposed to correct this inequity by having higher capital requirements and tighter restrictions on risk-taking that will make it undesirable for banks to be too big to fail. In principle, the government could impose restrictions that are sufficiently onerous to offset the advantages of the government safety net, but no one outside of the Obama administration believes this will happen.

The simpler course is to just break them up. We don't have to turn Citigroup and Bank of America into hundreds of small community banks, just large regional banks that can be safely put through a bankruptcy/resolution process if they mismanage their assets. My guess is that most of people protesting healthcare reform last weekend would support this idea.

A second issue likely to draw the support of the protesters is the democratisation of the Federal Reserve. There is already a left-right coalition in the House of Representatives behind a bill calling for an audit of the Fed.

This is a case where the centrist elites have shown complete contempt for the American public. In fact, Federal Reserve Board chairman Ben Bernanke had the gall to argue against an audit of the Fed, warning that it would lead to increased instability.

Did Bernanke forget that less than a year ago he told Congress that the policies pursued by him and his predecessor had brought the economy to the brink of a complete collapse? How do you get less stable than that? This is the sort of nonsense that shows the contempt that the elites have for the masses on both the left and right.

This suggests a great opportunity for a joint effort by the left and right to democratise the Fed. It is absurd that the US has a central bank that is more accountable to the financial industry than to the public.

A joint effort has enormous potential. It will be hard for the elites to even understand such a joint effort of the left and right against the centre. As an example, the New York Times actually asserted that the bill to audit the Fed has "250 Republican" co-sponsors in the House, ignoring the fact that the Republicans are a minority in the 435 seat chamber.

But the ignorance of the elite only increases the probability of success. And, if there is one thing this economic crisis demonstrates, the elite can be very very ignorant.

Friday, September 25, 2009

The Chicago School, Teaching Error without Apology

The Chicago School has garnered more Nobels than any other institution, which says more about the Nobel Prize in Economics than it does about the quality of economics coming down from Chicago. In fact, no greater disservice has been done our society by any school of thought than this one. Milton Friedman, Robert Lucas, John Cochrane, Eugene Fama are completely wrong because what they teach applies to a world that does not exist, yet they insist on applying it to the lives of millions.

Here, Brad DeLong captures some of the tone of the error. Note the double set of comments to each at the end.

Shichinin no Economusutai--NOT!!
from Grasping Reality with Both Hands
by Brad DeLong
September 20, 2009

David K. Levine of Washington University in St. Louis:

"It is a daunting task to bring you [Paul Krugman] up to date on the developments in economics in the last quarter century. I know that John Cochrane has tried to educate you about what we've learned about fiscal stimulae [sic][1] in that period..." and "But the stimulus plan? How can you be arguing for more? Since we are recovering before most of the stimulus money has entered the economy--isn't that evidence it isn't needed? How can you write as if you are proven right in supporting it?"

John Cochrane of the University of Chicago:

"[That spending can spur the economy] is not part of what anybody has taught graduate students since the 1960s. They are fairy tales that have been proved false. It is very comforting in times of stress to go back to the fairy tales we heard as children but it doesn’t make them less false..." and "Paul [Krugman's]’s Keynesian economics requires that people make logically inconsistent plans to consume more, invest more, and pay more taxes with the same income..."

Robert Lucas of the University of Chicago:

"Christina Romer--here's what I think happened. It's her first day on the job and somebody says, you've got to come up with a solution to this--in defense of this fiscal stimulus, which no one told her what it was going to be, and have it by Monday morning.... [I]t's a very naked rationalization for policies that were already, you know, decided on for other reasons..." and "If we do build the bridge by taking tax money away from somebody else, and using that to pay the bridge builder--the guys who work on the bridge -- then it's just a wash... there's nothing to apply a multiplier to. (Laughs.) You apply a multiplier to the bridge builders, then you've got to apply the same multiplier with a minus sign to the people you taxed to build the bridge. And then taxing them later isn't going to help, we know that..."

Edward Prescott of Arizona State University:

"I don't know why Obama said all economists agree on [the need for a stimulus bill]. They don't. If you go down to the third-tier schools, yes, but they're not the people advancing the science..." and "the period of the '20s was one of healthy growth, until Hoover's anti-market, anti-globalization, anti-immigration, pro- cartelization policies were instituted, brought this expansion to an end, and created a great depression..."

Eugene Fama of the University of Chicago:

"Sorry, but I’m not familiar with [Hyman] Minsky’s work" and "Haven't seen it [Paul Krugman's article]. I pay no attention to him..." and "Government bailouts and stimulus plans seem attractive when there are idle resources - unemployment. Unfortunately, bailouts and stimulus plans are not a cure. The problem is simple: bailouts and stimulus plans are funded by issuing more government debt. (The money must come from somewhere!) The added debt absorbs savings that would otherwise go to private investment. In the end, despite the existence of idle resources, bailouts and stimulus plans do not add to current resources in use. They just move resources from one use to another..."

Luigi Zingales of the University of Chicago:

"Keynesianism has conquered the hearts and minds of politicians and ordinary people alike because it provides a theoretical justification for irresponsible behaviour. Medical science has established that one or two glasses of wine per day are good for your long-term health, but no doctor would recommend a recovering alcoholic to follow this prescription. Unfortunately, Keynesian economists do exactly this. They tell politicians, who are addicted to spending our money, that government expenditures are good. And they tell consumers, who are affected by severe spending problems, that consuming is good, while saving is bad. In medicine, such behaviour would get you expelled from the medical profession; in economics, it gives you a job in Washington..." and "Among the 37 Economics Nobel prize winners in the last 20 years, four received the prize for their contributions to macroeconomics. None of these could be considered Keynesian. In fact, it is hard to find academic papers supporting the idea of a fiscal stimulus..."

Michele Boldrin of Washington University in St. Louis:

"It is a fantasy that the economic profession at large finds the "stimulus" and the "bank bailout" plans sensible and adequate. Most economists we know oppose them.... Outside the administration, the convinced supporters of the plans are a small minority among academic economists working in those fields. Both plans contradict four decades of research and are designed to please special interest groups..." and "Is there a case for borrowing now to finance a stimulus package? People are worried about the future and are sensibly reducing their spending. Does this imply the government should step in and do the spending for them? Put that way, the idea seems like a non-starter..."

In case there is any doubt:

1. Paul Krugman is reasonably up-to-date on research in macroeconomics over the past quarter century (Levine);

2. that spending can spur the economy is part of what everyone who teaches their graduate students about the dot-com boom of the 1990s ora obout the housing-led expansion of the 2009s says, and the government's spending is as good as anyone else's as far as this is concerned (Cochrane);

3. Christina Romer played a significant role in the design of the ARRA (Lucas);

4. there is certainly debate over whether "advancing the science" means what Ed Prescott thinks it means (Prescott);

5. Eugene Fama really ought to have paid a little attention to Minsky-Kindleberger at some point in his career (and really ought to be paying attention to Krugman now) (Fama);

6. Luigi Zingales needs really, really badly to read John Maynard Keynes's "How to Pay for the War" before he embarrasses himself further (Zingales); and

7. I don't think "working in those fields" means what Michele Boldrin thinks that it means (Boldrin).

And in case there is any doubt:

1. the fact that macroeconomic market failures are no longer getting rapidly worse is not a reason for immediately abandoning all of the policies to deal with thsoe failures (Levine);

2. there is nothing logically inconsistent with models in which aggregate planned expenditure is different from income, and indeed Milton Friedman's, Knut Wicksell's, and David Hume's economic models are all of this type (Cochrane);

3. even full Ricardian equivalence does not keep changes in government purchases from affecting total spending (unless government purchases are perfect substitutes for private consumption) (Lucas);

4. Herbert Hoover was on the right wing of the American political spectrum and tried as best he could to follow pro-market, pro-globalization, pro-competition economic policies (Prescott);

5. the savings-investment identity is an equilibrium condition and not a behavioral relationship, and so it says nothing about how and whether changes in one form of spending will or will not call forth changes in the flow of spending as a whole (Fama);

6. it is in fact rather easy to find academic papers supporting the idea of fiscal stimulus under appropriate conditions, if you look (Zingales); and

7. when the prices of private bonds collapse and the prices of government bonds soar, that is a very powerful market signal that private businesses should borrow (and spend) less and the government should borrow (and spend) more (Boldrin).

The scary thing is not that Levine, Cochrane, Lucas, Prescott, Fama, Zingales, and Boldrin are wrong--people are wrong all the time. The scary thing is the level at which they are wrong: these are all freshman (ok, sophomore) mistakes--yet the seven include two past (and a year ago I would have said three future Nobel laureates in Economics).

If this doesn't frighten you, you aren't paying attention...

Thursday, September 24, 2009

Marshall Auerback and no holds barred for the FCIC

It is our opinion that the financial crisis will have rebounded on us by the time the Financial Crisis Inquiry Commission issues its report. But it is a step forward. Marshall Auerback is resoundingly right in his call for no limits on the investigation.

Financial Crisis Inquiry Commission must examine core financial practices and ideas
from New Deal 2.0
by Marshall Auerback
September 17, 2009

FCIC Chairman Phil Angelides got it right in his remarks at the Commission’s first public meeting:

“We have been called upon to conduct a full and fair investigation in the best interests of the nation –pursuing the truth, uncovering the facts, and providing an unbiased, historical accounting of what brought our financial system and our economy to its knees. This is what the American people deserve and this is what we are obliged to do. In this critical instance, if we do not learn from history, we are unlikely to fully recover from it.”

Ultimately, if Chairman Angelides and the rest of the FCIC are to succeed in their mission, they must start from first principles and explain that the financial system is a means, not an end. It is not justified by its own existence. Banks are not common property, whose growth and profitability are per se matters of national honor or pride. They are public/private partnerships, established for the public purpose of providing loans based on credit analysis. It is therefore particularly important to put a stop to the anti-social, perverse and, in many cases, fraudulent practices of the major financial players which brought on the credit crisis.

If the FCIC (aka “Pecora Commission 2.0?) is to have any long-lasting relevance, it must establish the larger purposes that economic policy in general, and financial policy in particular, should address. A difficulty of regulatory reform lies in the underlying desire, sometimes unstated, to return to the previous status quo ante, without asking whether that system actually met society’s needs or was coincident with broader public purpose. The challenge of the Commission is to align the financial sector’s interests with the broader purposes of public policy via a sensible new regulatory framework.

This principle has been conspicuously lacking in Obama’s “reforms” thus far. Extraordinarily, the moves by governments to provide deficit-stimulus and taxpayer support to their ailing economies have been hitherto hijacked by the financial sector to fill their own coffers. At the same time, their “spokepersons” (media, economists etc) are mounting an increasingly strident attack on the deficits themselves, pleading for a return to fiscal orthodoxy, whist decrying the “draconian” financial reforms designed to reign in the banks so that their objectives begin to align more broadly with public purpose.

These attacks have started to resonate politically. The casino is back in business, trading and speculating on the financial markets are on their way to reach pre-crisis levels. Reform is losing momentum. Banks are again posting profits and managers are again receiving large bonuses, the bankers themselves oblivious to the fact that these bonuses constitute a huge taxpayer subsidy and extremely regressive and anti-social wealth transfer. Meanwhile, the productive economy remains mired in severe recession, yet the financial markets have yet again managed to close the shutters to the real world. Such are the makings of populist revolts.

If governments start cutting back, as the received financial wisdom now dictates, the banks alone will have pocketed billions in public welfare, whilst the rest of us will be left with a huge residual of unemployment and poverty at the other end of the socio-economic scale. Equally significantly, we will be no further along toward understanding the problems that created the crisis in the first place.

So what is needed by the FCIC is a major examination of the practices and ideas that created the underpinnings for this crisis. We need a no-holds barred commission, one that ruthlessly investigates all financial institutions, even those that are not under the jurisdiction of the federal government. We need a profound restructuring of our financial system, so that it doesn’t unduly foster reckless bubbles (where transitory gains in employment and income are wiped out in the subsequent crash), but is redirected to growth along lines that meet a range of important physical and social objectives. Banking can play a role in the transformation and reform of our economy, but only if the regulation to which they should be subject is directed toward public purpose, not private enrichment. It is, as Chairman Angelides suggests, a daunting and complex task, but at it’s core a simple one: “To rebuild and sustain a system of capital that helps us create enterprises of value, that puts Americans to work so they can support their families and fulfill their dreams, and that provides the foundation for a new era of broadly shared prosperity.” Good luck to him and the other members of the Commission!

Wednesday, September 23, 2009

James K. Galbraith on the causes and conditions of crisis and for recovery

In a teabag party debate, James K. Galbraith succinctly captured the causes of the crisis and by direct implication the route back to true stability. Galbraith wears well.

Causes of the Crisis
James K. Galbraith
The Texas Observer
May 01, 2009

Editor’s note: These remarks were delivered to a meeting of the Texas Lyceum in Austin on April 3, at a debate between University of Texas professor James Galbraith and former Majority Leader Richard Armey, chief instigator of the recent Astroturf “tea party" protests. Armey had begun his remarks by noting that his rule in life was “never trust anyone from Austin or Boston,” and proceeded to declare his allegiance to the “Austrian School” of economics, a libertarian view that regards public intervention in private markets as socialism.

It is of course a pleasure to be with you today. I was born in Boston, and I am proud of it. And I have lived 24 years in Austin—and I’m proud of that.

Leader Armey spoke to you of his admiration for Austrian economics. I can’t resist telling you that when the Vienna Economics Institute celebrated its centennial, many years ago, they invited, as their keynote speaker, my father [John Kenneth Galbraith]. The leading economists of the Austrian school—including von Hayek and von Haberler—returned for the occasion. And so my father took a moment to reflect on the economic triumphs of the Austrian Republic since the war, which, he said, “would not have been possible without the contribution of these men.” They nodded—briefly—until it dawned on them what he meant. They’d all left the country in the 1930s.

My own economics is American: genus Institutionalist; species: Galbraithian.

This is a panel on the crisis. Mr. Moderator, you ask what is the root cause? My reply is in three parts.

First, an idea. The idea that capitalism, for all its considerable virtues, is inherently self-stabilizing, that government and private business are adversaries rather than partners; the idea that freedom without responsibility is a viable business principle; the idea that regulation, in financial matters especially, can be dispensed with.

We tried it, and we see the result.

Second, a person. It would not be right to blame any single person for these events, but if I had to choose one to name it would be a Texan, our own distinguished former Senator Phil Gramm. I’d cite specifically the repeal of the Glass-Steagall Act — the Gramm-Leach-Bliley Act — in 1999, after which it took less than a decade to reproduce all the pathologies that Glass-Steagall had been enacted to deal with in 1933. I’d also cite the Commodity Futures Modernization Act, slipped into an 11,000-page appropriations bill in December 2000 as Congress was adjourning following Bush v. Gore. This measure deregulated energy futures trading, enabling Enron and legitimating credit-default swaps, and creating a massive vector for the transmission of financial risk throughout the global system. When the Washington Post caught up with me at an airport in Parkersburg, West Virginia, a year ago to ask for a comment on Gramm’s role, I said very quickly that he was “the sorcerer’s apprentice of financial instability and disaster.” They put that on the front page. I do have to give Gramm some credit: When the Post called him up and read that to him, he said, “I deny it.”

Third, a policy. This was the abandonment of state responsibility for financial regulation: the regulation of mortgage originations, of underwriting, and of securitization. This abandonment was not subtle: The first head of the Office of Thrift Supervision in the George W. Bush administration came to a press conference on one occasion with a stack of copies of the Federal Register and a chainsaw. A chainsaw. The message was clear. And it led to the explosion of liars’ loans, neutron loans (which destroy people but leave buildings intact), and toxic waste. That these were terms of art in finance tells you what you need to know.

Subprime securities are inherently unsafe and should never have been permitted. They are based on loans to borrowers who cannot document their income and who may have bad credit histories, and they are collateralized by houses with fraudulently inflated appraisals, rated by agencies that did not examine the loan files. Writing in The Washington Post, Richard Cohen described one case, of Marvene Halterman of Avondale, Arizona:

At age 61, after 13 years of uninterrupted unemployment and at least as many of living on welfare, she got a mortgage. She got it even though at one time she had 23 people living in the house (576 square feet, one bath) and some ramshackle outbuildings. She got it for $103,000, an amount that far exceeded the value of the house. The place has since been condemned. ... Halterman’s house was never exactly a showcase—the city had once cited her for all the junk (clothes, tires, etc.) on her lawn. Nevertheless, a local financial institution with the cover-your-wallet name of Integrity Funding LLC gave her a mortgage, valuing the house at about twice what a nearby and comparable property sold for. ... Integrity Funding then sold the loan to Wells Fargo & Co., which sold it to HSBC Holdings PLC, which then packaged it with thousands of other risky mortgages and offered the indigestible porridge to investors. Standard & Poor’s and Moody’s Investors Service took a look at it all, as they are supposed to do, and pronounced it ‘triple-A.’”

The consequence of tolerating this and like behavior is a collapse of trust, a collapse of asset values, and a collapse of the financial system. That is what has happened, and what we have to deal with now.

Can “stimulus” get us out?

As a matter of economics, public spending substitutes for private spending. It provides jobs, motivates useful activity, staves off despair. But it is not self-sustaining in the absence of a viable private credit system. The idea that we will be on the road to full recovery and returning to high employment in a year or so therefore seems to me to be an illusion. And for this reason, the emphasis on short-term, “shovel-ready” projects in the expansion package, while understandable, was a mistake. As in the New Deal, we need both the Works Progress Administration, headed by Harry Hopkins, to provide employment, and the Public Works Administration, headed by Harold Ickes, to rebuild the country.

The desire for a return to normal is very powerful. It motivates both the ritual confidence of public officials and the dry numerical optimism of business economists, who always see prosperity just around the corner. The forecasts of these people, like those of official agencies such as the Congressional Budget Office, always see a turnaround within a year and a return to high employment within four or five years. In a strict sense, the belief is without foundation. Liquidation of excessive debt is now, and will remain for a time, the highest priority of American households. That is in part because for the moment they want to hold on to cash, and therefore they do not wish to borrow, and in part because with the collapse of house values, they no longer have collateral to borrow against. And so long as that is the case, there can be no strong recovery of private spending or business investment.

The risk we run, in public policy, is not inflation. It is lack of persistence, a premature reversal of direction, and of course the fear of large numbers. If deficits in the trillions and public debt in the tens of trillions scare you, this is not a line of work you should be in.

The ultimate goals of policy are not measured by deficits or debt. They are measured by the performance of the economy itself. Here Leader Armey and I agree. He spoke with approval, in his remarks, of the goals of 3 percent unemployment and 4 percent inflation embodied in the Humphrey-Hawkins Full Employment and Balanced Growth Act of 1978. Which, as a 24-year-old member of the staff of the House Banking Committee in 1976, I drafted.

Tuesday, September 22, 2009

Economy on the bottom, Dow on the rise, Question Mark

Plus a continuation of our look at Hyman Minsky.

In chess match analysis, whenever a move is followed by an exclamation point, it means "good move." When it is followed by a question mark, it means "blunder." The Fed's aggressiveness in taking over the bad securities of the zombie banks and keeping the money taps open for financial speculators has resulted in Dow ten thousand and strong commodity markets. Exclamation point or question mark?

Question mark. And the technical chess term "Blunder."

This is Alan Greenspan's one percent interest rates only on a grander scale. The Fed hoped that saving the banks and giving them lots of money would encourage them to restart credit flows. It is not working. It hasn't worked. It won't work. No market works from the supply side, not even the financial markets.

Where is the money going? Here are three quick perspectives off of Bloomberg, the first from Marc Faber, the well-respected investor.


We may play more of Marc Faber in an upcoming podcast, as he weighs in on Paul Krugman and economics.

But here, also from Bloomberg September 15, Liam Dalton, chief executive officer of Axiom Capital Management, saw this:


Liam Dalton

and here, George Magnus, senior economic adviser at UBS,


George Magnus

"Exit strategy" is often equated with unprinting money. As we've noted before, the Fed cannot print money fast enough to counteract the destruction of money caused by deleveraging. The real exit strategy is how to get the garbage off the Fed's balance sheet when it is not worth anything and the institutions who created it cannot repatriate it. They barely have the strength to stand even with the massive assistance they're getting.

At one point the Fed floated the idea of having the Treasury buy it, making explicit the taxpayer's responsibility for the recklessness of Wall Street. That didn't fly. Still, the implicit guarantee to anything and everything Wall Street wants to do is hardly hidden. And that guarantee, along with the wall of money, make things not better, but worse, as we go forward.

Robert Reich has another idea of why the Dow is rising.

Why the Dow is Hitting 10,000 Even When Consumers Can't Buy And Business Cries "Socialism"
by Robert Reich
September 22, 2009

So how can the Dow Jones Industrial Average be flirting with 10,000 when consumers, who make up 70 percent of the economy, have had to cut way back on buying because they have no money? Jobs continue to disappear. One out of six Americans is either unemployed or underemployed. Homes can no longer function as piggy banks because they’re worth almost a third less than they were two years ago. And for the first time in more than a decade, Americans are now having to pay down their debts and start to save.

Even more curious, how can the Dow be so far up when every business and Wall Street executive I come across tells me government is crushing the economy with its huge deficits, and its supposed “takeover” of health care, autos, housing, energy, and finance? Their anguished cries of “socialism” are almost drowning out all their cheering over the surging Dow.

The explanation is simple. The great consumer retreat from the market is being offset by government’s advance into the market. Consumer debt is way down from its peak in 2006; government debt is way up. Consumer spending is down, government spending is up. Why have new housing starts begun? Because the Fed is buying up Fannie and Freddie’s paper, and government-owned Fannie and Freddie are now just about the only mortgage games remaining in play.

Why are health care stocks booming? Because the government is about to expand coverage to tens of millions more Americans, and the White House has assured Big Pharma and health insurers that their profits will soar. Why are auto sales up? Because the cash-for-clunkers program has been subsidizing new car sales. Why is the financial sector surging? Because the Fed is keeping interest rates near zero, and the rest of the government is still guaranteeing any bank too big to fail will be bailed out. Why are federal contractors doing so well? Because the stimulus has kicked in.

In other words, the Dow is up despite the biggest consumer retreat from the market since the Great Depression because of the very thing so many executives are complaining about, which is government’s expansion. And regardless of what you call it – Keynesianism, socialism, or just pragmatism – it’s doing wonders for business, especially big business and Wall Street. Consumer spending is falling back to 60 to 65 percent of the economy, as government spending expands to fill the gap.

The problem is, our newly expanded government isn't doing much for average working Americans who continue to lose their jobs and whose belts continue to tighten, and who are getting almost nothing out of the rising Dow because they own few if any shares of stock. Despite the happy Dow and notwithstanding the upbeat corporate earnings, most corporations are still shedding workers and slashing payrolls. And the big banks still aren't lending to Main Street.

Trickle-down economics didn't work when the supply-siders were in charge. And it's not working now, at a time when -- despite all their cries of "socialism" -- big business and Wall Street are more politically potent than ever.

Robert Reich. See the complete piece in today's transcript on the blog. Demandsideblog.blogspot.com.

But Reich is wrong here.

Yes, the government is responsible for every penny of real investment now being done through its support of mortgages and its direct purchase of construction services for infrastructure. But in the stock market we are not talking about real investment, we are talking about financial investment. It is a casino. Buying a share of stock does not produce one penny of investment. They are like baseball cards, whose value depends on the willingness of others to buy. There is no demand to spur investment or produce a flow of dividends. Commodity prices are being floated by speculation in ETF's and futures markets. It is the same house of cards we just came from.


I have queued up here a very interesting short historical take from an EPI -- Economic Policy Institute -- event on too big to fail, featuring Simon Johnson, formerly chief economist at the IMF and now at MIT's Peterson Insitute.

We're not going to get to it today, but next week, look for that.


Hyman Minsky.

So very intersting.

I should make a short note here on a piece we put up on the blog this week from By Stephen Mihm and Boston Globe on Minsky under the title

Why capitalism fails

said the following.

To prevent the Minsky moment from becoming a national calamity, part of his solution (which was shared with other economists) was to have the Federal Reserve - what he liked to call the “Big Bank” - step into the breach and act as a lender of last resort to firms under siege. By throwing lines of liquidity to foundering firms, the Federal Reserve could break the cycle and stabilize the financial system. It failed to do so during the Great Depression, when it stood by and let a banking crisis spiral out of control. This time, under the leadership of Ben Bernanke - like Minsky, a scholar of the Depression - it took a very different approach, becoming a lender of last resort to everything from hedge funds to investment banks to money market funds.

Our reading of Minsky says, yes, the economy is stabilized by lender of last resort backstopping, but it continues forward at a more sluggish pace as the debts weigh on the economy, and the future is no less unstable, but more so, for the implicit guarantees to yet another class of financing instrument.

This lender of last resort function -- whether under the auspices of the FDIC or other agency -- is ultimately the Fed. When it is required, it will be will be immense, because when it is called for, the entire market will be in need. And it is backstopping of debt incurred in a speculative form. For example, as we understand it, simple borrowing for inventory is speculative financing because it is not buying and selling. There is a further speculation, however, when one borrows to set up a business which then depends on borrowing for inventory. And so on, as virtually all business depends on financing much more complex than this.

Absent the lender of last resort, an institution will be forced to sell out its position in financial and real assets to meet its short-term needs, which then leads to sharp declines in asset values. We must ask ourselves today whether the government, the Fed, is actually large enough to be the lender of last resort, or whether the markets have grown out of scale with even the central bank. Our answer, looking at the hundreds of trillions in derivatives, is unfortunately, yes. I'm sorry. It was necessary not to backstop over-the-counter derivatives and to thus drive down their prices and their uses.

You know, let's listen to the Simon Johnson piece and get back to Minsky next week. We'll take half the podcast then, and deal with his insights into the role of prices, profits and investment.

Here, Simon Johnson.


Monday, September 21, 2009

A letter to the Queen


10 August 2009
Her Majesty the Queen
Buckingham Palace
London SW1A 1AA


We are writing both in response to the question you posed at the London School of Economics last November – concerning why few economists had foreseen the credit crunch – and the answer to you from Professors Tim Besley and Peter Hennessy dated 22 July.
We agree with many of the points made by Professors Besley and Hennessy, principally those summarized in the next paragraph, but we regard their overall analysis as inadequate because it fails to acknowledge any deficiency in the training or culture of economists

Their letter rightly mentions that ‘some of the best mathematical minds’ were involved in risk management but ‘they frequently lost sight of the bigger picture’. Many believed that risks had been safely dispersed and ‘virtually removed’ through ‘an array of novel financial instruments ... It is difficult to recall a greater example of wishful thinking combined with hubris. ... And politicians of all types were charmed by the market.’ In summary, they conclude, ‘the failure to foresee the timing, extent and severity of the crisis and to head it off, while it had many causes, was principally a failure of the collective imagination of many bright people, both in this country and internationally, to understand the risks to the system as a whole.’

In addition to the factors mentioned in their letter, we suggest that part of this responsibility lies at the door of leading and influential economists in the United Kingdom and elsewhere. Some leading economists – including Nobel Laureates Ronald Coase, Milton Friedman and Wassily Leontief – have complained that in recent years economics has turned virtually into a branch of applied mathematics, and has been become detached from realworld institutions and events. (We can document these and other complaints fully on request.)

In 1988 the American Economic Association set up a Commission on the state of graduate education in economics in the US. In a crushing indictment published in the Journal of Economic Literature in 1991, the Commission expressed its fear that ‘graduate programs may be turning out a generation with too many idiot savants skilled in technique but innocent of real economic issues.’ Far too little has since been done to rectify this problem. Consequently a preoccupation with a narrow range of formal techniques is now prevalent in most leading departments of economics throughout the world, and notably in the United Kingdom.

The letter by Professors Besley and Hennessy does not consider how the preference for mathematical technique over real-world substance diverted many economists from looking at the vital whole. It fails to reflect upon the drive to specialise in narrow areas of enquiry, to the detriment of any synthetic vision. For example, it does not consider the typical omission of psychology, philosophy or economic history from the current education of economists in prestigious institutions. It mentions neither the highly questionable belief in universal ‘rationality’ nor the ‘efficient markets hypothesis’ – both widely promoted by mainstream economists. It also fails to consider how economists have also been ‘charmed by the market’ and how simplistic and reckless market solutions have been widely and vigorously promoted by many economists.

What has been scarce is a professional wisdom informed by a rich knowledge of psychology, institutional structures and historical precedents. This insufficiency has been apparent among those economists giving advice to governments, banks, businesses and
policy institutes. Non-quantified warnings about the potential instability of the global financial system should have been given much more attention.

We believe that the narrow training of economists – which concentrates on mathematical techniques and the building of empirically uncontrolled formal models – has been a major reason for this failure in our profession. This defect is enhanced by the pursuit of
mathematical technique for its own sake in many leading academic journals and departments of economics.

There is a species of judgment, attainable through immersion in a literature or a history, that cannot be adequately expressed in formal mathematical models. It’s an essential part of a serious education in economics, but has been stripped out of most leading graduate programmes in economics in the world, including in the leading economics departments in
the United Kingdom.

Models and techniques are important. But given the complexity of the global economy, what is needed is a broader range of models and techniques governed by a far greater respect for substance, and much more attention to historical, institutional, psychological and other highly relevant factors.

In summary, the letter by Professors Tim Besley and Peter Hennessy overlooks the part that many leading economists have had in turning economics into a discipline that is detached from the real world, and in promoting unrealistic assumptions that have helped to sustain an uncritical view of how markets operate.

We respectfully submit that part of the problem lies in the additional factors that we have outlined above. As trained economists and United Kingdom citizens we have warned of these problems that beset our profession. Unfortunately, at present, we find ourselves in a minority. We would welcome any further observations that Your Majesty may have on these problems and their causes.

We remain your most humble and obedient servants,

Sheila C. Dow
Professor of Economics, University of Stirling and author of Money and the Economic Process and Economic

Peter E. Earl
Associate Professor of Economics, University of Queensland, Australia, and author of Business Economics: A
Contemporary Approach

John Foster
Professor of Economics, University of Queensland, Fellow of the Academy of the Social Sciences in Australia
and President Elect of the International J. A. Schumpeter Society

Geoffrey C. Harcourt
Emeritus Reader, University of Cambridge, Emeritus Professor, University of Adelaide, Academician of the
Academy of Social Sciences, Fellow of the Academy of the Social Sciences in Australia

Geoffrey M. Hodgson
Research Professor of Business Studies, University of Hertfordshire, Academician of the Academy of Social
Sciences and Editor-in-Chief of the Journal of Institutional Economics

J. Stanley Metcalfe
Emeritus Professor of Economics, University of Manchester and former member of the Monopolies and
Mergers Commission

Paul Ormerod
Academician of the Academy of Social Sciences and author of the Death of Economics, Butterfly Economics,
and Why Most Things Fail

Bridget Rosewell
Chairman of Volterra Consulting and Chief Economic Adviser to the Greater London Authority

Malcolm C. Sawyer
Professor of Economics, University of Leeds and Managing Editor of the International Review of Applied

Andrew Tylecote
Professor of the Economics and Management of Technological Change, University of Sheffield

Sunday, September 20, 2009

Minsky rises from obscurity

Hyman Minsky saw it happening. To say "he saw it coming" is not correct, because what was happening washappening right under his nose. Everybody's nose, for that matter. But Minsky's glass saw into the workings. Like seeing a tree coming out of the ground and predicting fruit one day, it's not really a matter of foresight, it's a matter of recognition.

Here from the Boston Globe is an account. composed more of the conclusions than the description of the activity, it is nonetheless instructive. How appropriate and ironic that the non-Nobelists Minsky, Joan Robinson, John Kenneth Galbraith, should be right on the mark, while Nobelists Milton Friedman, Robert Lucas and too many others have been a monumental waste of time. The latter are like the pilots looking for the Northwest Passage before the ice melted, except that they led convoys of ships with the productive capacity of the world. Now forced to retreat, or more often, resisting that and insisting on continuing in futility, these are more self-important sirens than any sort of guide.

Why capitalism fails
The man who saw the meltdown coming had another troubling insight: it will happen again

By Stephen Mihm
Boston Globe
September 13, 2009

Since the global financial system started unraveling in dramatic fashion two years ago, distinguished economists have suffered a crisis of their own. Ivy League professors who had trumpeted the dawn of a new era of stability have scrambled to explain how, exactly, the worst financial crisis since the Great Depression had ambushed their entire profession.

Amid the hand-wringing and the self-flagellation, a few more cerebral commentators started to speak about the arrival of a “Minsky moment,” and a growing number of insiders began to warn of a coming “Minsky meltdown.”

“Minsky” was shorthand for Hyman Minsky, a hitherto obscure macroeconomist who died over a decade ago. Many economists had never heard of him when the crisis struck, and he remains a shadowy figure in the profession. But lately he has begun emerging as perhaps the most prescient big-picture thinker about what, exactly, we are going through. A contrarian amid the conformity of postwar America, an expert in the then-unfashionable subfields of finance and crisis, Minsky was one economist who saw what was coming. He predicted, decades ago, almost exactly the kind of meltdown that recently hammered the global economy.

In recent months Minsky’s star has only risen. Nobel Prize-winning economists talk about incorporating his insights, and copies of his books are back in print and selling well. He’s gone from being a nearly forgotten figure to a key player in the debate over how to fix the financial system.

But if Minsky was as right as he seems to have been, the news is not exactly encouraging. He believed in capitalism, but also believed it had almost a genetic weakness. Modern finance, he argued, was far from the stabilizing force that mainstream economics portrayed: rather, it was a system that created the illusion of stability while simultaneously creating the conditions for an inevitable and dramatic collapse.

In other words, the one person who foresaw the crisis also believed that our whole financial system contains the seeds of its own destruction. “Instability,” he wrote, “is an inherent and inescapable flaw of capitalism.”

Minsky’s vision might have been dark, but he was not a fatalist; he believed it was possible to craft policies that could blunt the collateral damage caused by financial crises. But with a growing number of economists eager to declare the recession over, and the crisis itself apparently behind us, these policies may prove as discomforting as the theories that prompted them in the first place. Indeed, as economists re-embrace Minsky’s prophetic insights, it is far from clear that they’re ready to reckon with the full implications of what he saw.

In an ideal world, a profession dedicated to the study of capitalism would be as freewheeling and innovative as its ostensible subject. But economics has often been subject to powerful orthodoxies, and never more so than when Minsky arrived on the scene.
That orthodoxy, born in the years after World War II, was known as the neoclassical synthesis. The older belief in a self-regulating, self-stabilizing free market had selectively absorbed a few insights from John Maynard Keynes, the great economist of the 1930s who wrote extensively of the ways that capitalism might fail to maintain full employment. Most economists still believed that free-market capitalism was a fundamentally stable basis for an economy, though thanks to Keynes, some now acknowledged that government might under certain circumstances play a role in keeping the economy - and employment - on an even keel.

Economists like Paul Samuelson became the public face of the new establishment; he and others at a handful of top universities became deeply influential in Washington. In theory, Minsky could have been an academic star in this new establishment: Like Samuelson, he earned his doctorate in economics at Harvard University, where he studied with legendary Austrian economist Joseph Schumpeter, as well as future Nobel laureate Wassily Leontief.

But Minsky was cut from different cloth than many of the other big names. The descendent of immigrants from Minsk, in modern-day Belarus, Minsky was a red-diaper baby, the son of Menshevik socialists. While most economists spent the 1950s and 1960s toiling over mathematical models, Minsky pursued research on poverty, hardly the hottest subfield of economics. With long, wild, white hair, Minsky was closer to the counterculture than to mainstream economics. He was, recalls the economist L. Randall Wray, a former student, a “character.”

So while his colleagues from graduate school went on to win Nobel prizes and rise to the top of academia, Minsky languished. He drifted from Brown to Berkeley and eventually to Washington University. Indeed, many economists weren’t even aware of his work. One assessment of Minsky published in 1997 simply noted that his “work has not had a major influence in the macroeconomic discussions of the last thirty years.”

Yet he was busy. In addition to poverty, Minsky began to delve into the field of finance, which despite its seeming importance had no place in the theories formulated by Samuelson and others. He also began to ask a simple, if disturbing question: “Can ‘it’ happen again?” - where “it” was, like Harry Potter’s nemesis Voldemort, the thing that could not be named: the Great Depression.

In his writings, Minsky looked to his intellectual hero, Keynes, arguably the greatest economist of the 20th century. But where most economists drew a single, simplistic lesson from Keynes - that government could step in and micromanage the economy, smooth out the business cycle, and keep things on an even keel - Minsky had no interest in what he and a handful of other dissident economists came to call “bastard Keynesianism.”

Instead, Minsky drew his own, far darker, lessons from Keynes’s landmark writings, which dealt not only with the problem of unemployment, but with money and banking. Although Keynes had never stated this explicitly, Minsky argued that Keynes’s collective work amounted to a powerful argument that capitalism was by its very nature unstable and prone to collapse. Far from trending toward some magical state of equilibrium, capitalism would inevitably do the opposite. It would lurch over a cliff.

This insight bore the stamp of his advisor Joseph Schumpeter, the noted Austrian economist now famous for documenting capitalism’s ceaseless process of “creative destruction.” But Minsky spent more time thinking about destruction than creation. In doing so, he formulated an intriguing theory: not only was capitalism prone to collapse, he argued, it was precisely its periods of economic stability that would set the stage for monumental crises.

Minsky called his idea the “Financial Instability Hypothesis.” In the wake of a depression, he noted, financial institutions are extraordinarily conservative, as are businesses. With the borrowers and the lenders who fuel the economy all steering clear of high-risk deals, things go smoothly: loans are almost always paid on time, businesses generally succeed, and everyone does well. That success, however, inevitably encourages borrowers and lenders to take on more risk in the reasonable hope of making more money. As Minsky observed, “Success breeds a disregard of the possibility of failure.”

As people forget that failure is a possibility, a “euphoric economy” eventually develops, fueled by the rise of far riskier borrowers - what he called speculative borrowers, those whose income would cover interest payments but not the principal; and those he called “Ponzi borrowers,” those whose income could cover neither, and could only pay their bills by borrowing still further. As these latter categories grew, the overall economy would shift from a conservative but profitable environment to a much more freewheeling system dominated by players whose survival depended not on sound business plans, but on borrowed money and freely available credit. Once that kind of economy had developed, any panic could wreck the market. The failure of a single firm, for example, or the revelation of a staggering fraud could trigger fear and a sudden, economy-wide attempt to shed debt. This watershed moment - what was later dubbed the “Minsky moment” - would create an environment deeply inhospitable to all borrowers. The speculators and Ponzi borrowers would collapse first, as they lost access to the credit they needed to survive. Even the more stable players might find themselves unable to pay their debt without selling off assets; their forced sales would send asset prices spiraling downward, and inevitably, the entire rickety financial edifice would start to collapse. Businesses would falter, and the crisis would spill over to the “real” economy that depended on the now-collapsing financial system.

From the 1960s onward, Minsky elaborated on this hypothesis. At the time he believed that this shift was already underway: postwar stability, financial innovation, and the receding memory of the Great Depression were gradually setting the stage for a crisis of epic proportions. Most of what he had to say fell on deaf ears. The 1960s were an era of solid growth, and although the economic stagnation of the 1970s was a blow to mainstream neo-Keynesian economics, it did not send policymakers scurrying to Minsky. Instead, a new free market fundamentalism took root: government was the problem, not the solution.

Moreover, the new dogma coincided with a remarkable era of stability. The period from the late 1980s onward has been dubbed the “Great Moderation,” a time of shallow recessions and great resilience among most major industrial economies. Things had never been more stable. The likelihood that “it” could happen again now seemed laughable.

Yet throughout this period, the financial system - not the economy, but finance as an industry - was growing by leaps and bounds. Minsky spent the last years of his life, in the early 1990s, warning of the dangers of securitization and other forms of financial innovation, but few economists listened. Nor did they pay attention to consumers’ and companies’ growing dependence on debt, and the growing use of leverage within the financial system.

By the end of the 20th century, the financial system that Minsky had warned about had materialized, complete with speculative borrowers, Ponzi borrowers, and precious few of the conservative borrowers who were the bedrock of a truly stable economy. Over decades, we really had forgotten the meaning of risk. When storied financial firms started to fall, sending shockwaves through the “real” economy, his predictions started to look a lot like a road map.

“This wasn’t a Minsky moment,” explains Randall Wray. “It was a Minsky half-century.”

Minsky is now all the rage. A year ago, an influential Financial Times columnist confided to readers that rereading Minsky’s 1986 “masterpiece” - “Stabilizing an Unstable Economy” - “helped clear my mind on this crisis.” Others joined the chorus. Earlier this year, two economic heavyweights - Paul Krugman and Brad DeLong - both tipped their hats to him in public forums. Indeed, the Nobel Prize-winning Krugman titled one of the Robbins lectures at the London School of Economics “The Night They Re-read Minsky.”

Today most economists, it’s safe to say, are probably reading Minsky for the first time, trying to fit his unconventional insights into the theoretical scaffolding of their profession. If Minsky were alive today, he would no doubt applaud this belated acknowledgment, even if it has come at a terrible cost. As he once wryly observed, “There is nothing wrong with macroeconomics that another depression [won’t] cure.”

But does Minsky’s work offer us any practical help? If capitalism is inherently self-destructive and unstable - never mind that it produces inequality and unemployment, as Keynes had observed - now what?

After spending his life warning of the perils of the complacency that comes with stability - and having it fall on deaf ears - Minsky was understandably pessimistic about the ability to short-circuit the tragic cycle of boom and bust. But he did believe that much could be done to ameliorate the damage.

To prevent the Minsky moment from becoming a national calamity, part of his solution (which was shared with other economists) was to have the Federal Reserve - what he liked to call the “Big Bank” - step into the breach and act as a lender of last resort to firms under siege. By throwing lines of liquidity to foundering firms, the Federal Reserve could break the cycle and stabilize the financial system. It failed to do so during the Great Depression, when it stood by and let a banking crisis spiral out of control. This time, under the leadership of Ben Bernanke - like Minsky, a scholar of the Depression - it took a very different approach, becoming a lender of last resort to everything from hedge funds to investment banks to money market funds.

Minsky’s other solution, however, was considerably more radical and less palatable politically. The preferred mainstream tactic for pulling the economy out of a crisis was - and is - based on the Keynesian notion of “priming the pump” by sending money that will employ lots of high-skilled, unionized labor - by building a new high-speed train line, for example.

Minsky, however, argued for a “bubble-up” approach, sending money to the poor and unskilled first. The government - or what he liked to call “Big Government” - should become the “employer of last resort,” he said, offering a job to anyone who wanted one at a set minimum wage. It would be paid to workers who would supply child care, clean streets, and provide services that would give taxpayers a visible return on their dollars. In being available to everyone, it would be even more ambitious than the New Deal, sharply reducing the welfare rolls by guaranteeing a job for anyone who was able to work. Such a program would not only help the poor and unskilled, he believed, but would put a floor beneath everyone else’s wages too, preventing salaries of more skilled workers from falling too precipitously, and sending benefits up the socioeconomic ladder.

While economists may be acknowledging some of Minsky’s points on financial instability, it’s safe to say that even liberal policymakers are still a long way from thinking about such an expanded role for the American government. If nothing else, an expensive full-employment program would veer far too close to socialism for the comfort of politicians. For his part, Wray thinks that the critics are apt to misunderstand Minsky. “He saw these ideas as perfectly consistent with capitalism,” says Wray. “They would make capitalism better.”

But not perfect. Indeed, if there’s anything to be drawn from Minsky’s collected work, it’s that perfection, like stability and equilibrium, are mirages. Minsky did not share his profession’s quaint belief that everything could be reduced to a tidy model, or a pat theory. His was a kind of existential economics: capitalism, like life itself, is difficult, even tragic. “There is no simple answer to the problems of our capitalism,” wrote Minsky. “There is no solution that can be transformed into a catchy phrase and carried on banners.”

It’s a sentiment that may limit the extent to which Minsky becomes part of any new orthodoxy. But that’s probably how he would have preferred it, believes liberal economist James Galbraith. “I think he would resist being domesticated,” says Galbraith. “He spent his career in professional isolation.”

Stephen Mihm is a history professor at the University of Georgia and author of “A Nation of Counterfeiters” (Harvard, 2007).

Saturday, September 19, 2009

Paul Krugman and the Ptolmeic Astronomers of the Chicago School

Paul Krugman writes here about his reaction to becoming the lightening rod for pushback from the primitive orthodoxy that has passed for macroeconomics since the 1980s. In the past thirty years academics has been purged of anything resembling coherence or common sense as the practitioners of economics wander off into hypothetical fields of rational expectations and applying mathematics to human behavior.

Eugene Fama, one of the pillars of the Chicago School was recently asked what he thought about the work of Hyman Minsky. Fama replied, "I'm not familiar with his work." Minsky is the guy who is talking about the real world, Mr. Fama.

Ptolmeic astronomers went to the point of demanding the excommunication or execution of their rivals, all to avoid admitting they had devoted their lives to a fallacy. The same phenomenon is being played out today.

Freshwater rage
Paul Krugman
September 14, 2009

I’m still on the road, with only sporadic internet access. So I’ve missed out on much of the outpouring of rage over my magazine article. I gather, though, that the usual suspects are utterly outraged at my suggestion that freshwater macro has spent several decades heading down the wrong path. They’re smart! They work hard, using hard math! How dare I say such a thing?

And all of this, of course, without a hint of irony.

For when freshwater macro took over a good part of the field, its leaders gleefully dismissed all the work Keynesian economists had done over the previous few decades, often with sneers and sniggers.

And that same adolescent quality was evident in the reactions to the Obama administration’s attempts to deal with the crisis — as Brad DeLong points out, people like Robert Lucas and John Cochrane (not to mention Richard Posner, who isn’t a macroeconomist but gets his take from his colleagues) didn’t say that when serious scholars like Christina Romer based policy recommendations on Keynesian economics, they were wrong; the freshwater crowd declared that anyone with Keynesian views was, by definition, either a fool or intellectually dishonest.

So the freshwater outrage over finding their own point of view criticized is, you might think, a classic case of people who can dish it out but can’t take it.

But it’s actually even worse than that.

When freshwater macro came in, there was an active purge of competing views: students were not exposed, at all, to any alternatives. People like Prescott boasted that Keynes was never mentioned in their graduate programs. And what has become clear in the recent debate — for example, in the assertion that Ricardian equivalence rules out any effect from government spending changes, which is just wrong — is that the freshwater side not only turned Keynes into an unperson, but systematically ignored the work being done in the New Keynesian vein. Nobody who had read, say, Obstfeld and Rogoff would have been as clueless about the logic of temporary fiscal expansion as these guys have been. Freshwater macro became totally insular.

And hence the most surprising thing in the debate over fiscal stimulus: the raw ignorance that has characterized so many of the freshwater comments. Above all, we’ve seen the phenomenon of well-known economists “rediscovering” Say’s Law and the Treasury view (the view that government cannot affect the overall level of demand), not because they’ve transcended the Keynesian refutation of these views, but because they were unaware that there had ever been such a debate.

It’s a sad story. And the even sadder thing is that it’s very unlikely that anything will change: freshwater macro will get even more insular, and its devotees will wonder why nobody in the real world of policy and action pays any attention to what they say.