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Friday, September 18, 2009

Bernanke, Stiglitz, Minsky -- Who was right?

Today on the podcast, continuing with our series on listening to those who were right with Hyman Minsky, who perhaps predicted better than anybody because he described the capitalism in which we live and identified the sources of instability.

I just listened to the Brookings conference on Lehman Brothers one year later and the remarks of Fed Chairman Ben Bernanke, whom regular listeners will remember I often call Baffled Ben. Mr. Bernanke's remarks were essentially a litany of all the dominoes in the financial sector's collapse and the special and extraordinary measures he and others have taken to prop them up again.

My impulse during it all was to say out loud again and again, "And you didn't see it coming."

This was indeed a collapse of epic dimensions. The imposing facade of Wall Street was made of glass. And they were bowling inside. One of the balls got loose, as they tend to do when constraints are minimal, it hit the glass and the entire thing cracked and began to chip out.

The Fed has spent trillions on duct tape, so a good chunk of the facade is still standing. It doesn't look very good. In the places where clear glass has replaced the opaque variety, we can see that those who work behind the walls are more clowns or grifters than titans or geniuses, but they still rake in the big bucks. Unfortunately the stability of the wall of glass, even taped up as it is, does not help the real economy. It ratifies a lot of bad decisions, keeps the authors of the debacle from reaping their just desserts and keeps up pretenses.

It reminds me of Bernanke's predecessor, Maestro Magoo Greenspan, who spent most of his career at the Fed as the acknowledged genius of economics and only when the philosophy of nonregulation and the tactic of ever more liquidity blew up the economy was he relegated to his rightful place. Still, there are plenty of voices advocating going slow on regulation, and heavens, don't do anything fundamental, and let's try to find a new bubble to blow up. Greenspan was as close as anybody to the man who knows all. Now we see him as the befuddled Wizard of Oz. Yet Oz itself, Wall Street, is considered the heart of the economy, and now that it is seemingly rescued, it is assumed that the rest will follow. No.

Beneath it all is a fever to keep asset prices from further collapse. This is working to some extent in the stock markets, where more easy money is buoying up the S&P. When financial assets are valued on the basis of casino markets and the ability to find buyers, we are in deep do-do. Assets need to be valued on the basis of the stream of value one obtains by owning them.

In any event, I would have played Mr. Bernanke's rendition of all that went wrong, except that it was his entire speech. To some extent he is the fireman who saved Oz from burning to the ground and his heroic deeds are oft repeated. One only wishes he had not provided the arsonists with the gasoline. Ah, well.

As to forecasting, Mr. Bernanke admits to not being very good, and properly includes the majority of academic and Wall Street forecasters with him in not being very good, before announcing that the Great Recession is over and although the next period will be the Great Stagnation, some day things will get back to normal. Of course, he does not mention those who did predict the calamity, nor the fact that many of these are not satisfied either with the remedies in place, those in prospect, nor with the outlook going forward.

We'll get to Hyman Minsky in a moment, but let's get to another who is writing contemporaneously. Joseph Stigltiz. In our view the greatest living economist. We'll introduce his latest piece this way.

Recession and Recovery. It may surprise the listener that one can have higher employment, GDP and other economic activity in a recession than in a recovery, even if they are separated only by a year or so. That is no doubt what we will have this time around. Recession and Recovery are designations of the direction of economic activity, most often represented by the statistic GDP. As we said, Ben Bernanke and others predict the period going forward will be the Great Stagnation, with very weak and probably falling employment, very weak, but likely rising growth, and a very weak investment climate.

This is a flat line, particularly if you take into consideration that the population is rising and the projected growth is likely not to even match the growth in population. Yet because it is up, it is recovery. We will not be recovered in the sense of returning to any form of health, but the economic designation by the sages at the NBER will be quote recovery unquote.

By these lights it is obviously time to introduce new designators, and we at Demand Side, never shy, are stepping up to the challenge. We hereby offer the following designations for economic health: Strong Economy, Weak Economy, Failing Economy. We are in a Failing Economy, on account of the critically deficient employment of labor and capital and the failed and essentially insolvent financial system.

Joseph Stiglitz, writing recently on Project Syndicate looked at it this way, under the title.

GDP Fetishism

NEW YORK – Striving to revive the world economy while simultaneously responding to the global climate crisis has raised a knotty question: are statistics giving us the right “signals” about what to do? In our performance-oriented world, measurement issues have taken on increased importance: what we measure affects what we do.

If we have poor measures, what we strive to do (say, increase GDP) may actually contribute to a worsening of living standards. We may also be confronted with false choices, seeing trade-offs between output and environmental protection that don’t exist. By contrast, a better measure of economic performance might show that steps taken to improve the environment are good for the economy.

Eighteen months ago, French President Nicolas Sarkozy established an international Commission on the Measurement of Economic Performance and Social Progress, owing to his dissatisfaction – and that of many others – with the current state of statistical information about the economy and society. On September 14, the Commission will issue its long-awaited report.

The big question concerns whether GDP provides a good measure of living standards. In many cases, GDP statistics seem to suggest that the economy is doing far better than most citizens’ own perceptions. Moreover, the focus on GDP creates conflicts: political leaders are told to maximize it, but citizens also demand that attention be paid to enhancing security, reducing air, water, and noise pollution, and so forth – all of which might lower GDP growth.

The fact that GDP may be a poor measure of well-being, or even of market activity, has, of course, long been recognized. But changes in society and the economy may have heightened the problems, at the same time that advances in economics and statistical techniques may have provided opportunities to improve our metrics.

For example, while GDP is supposed to measure the value of output of goods and services, in one key sector – government – we typically have no way of doing it, so we often measure the output simply by the inputs. If government spends more – even if inefficiently – output goes up. In the last 60 y ears, the share of government output in GDP has increased from 21.4% to 38.6% in the US, from 27.6% to 52.7% in France, from 34.2% to 47.6% in the United Kingdom, and from 30.4% to 44.0% in Germany. So what was a relatively minor problem has now become a major one.

Likewise, quality improvements – say, better cars rather than just more cars – account for much of the increase in GDP nowadays. But assessing quality improvements is difficult. Health care exemplifies this problem: much of medicine is publicly provided, and much of the advances are in quality.

The same problems in making comparisons over time apply to comparisons across countries. The United States spends more on health care than any other country (both per capita and as a percentage of income), but gets poorer outcomes. Part of the difference between GDP per capita in the US and some European countries may thus be a result of the way we measure things.

Another marked change in most societies is an increase in inequality. This means that there is increasing disparity between average (mean) income and the median income (that of the “typical” person, whose income lies in the middle of the distribution of all incomes). If a few bankers get much richer, average income can go up, even as most individuals’ incomes are declining. So GDP per capita statistics may not reflect what is happening to most citizens.

We use market prices to value goods and services. But now, even those with the most faith in markets question reliance on market prices, as they argue against mark-to-market valuations. The pre-crisis profits of banks – one-third of all corporate profits – appear to have been a mirage.

This realization casts a new light not only on our measures of performance, but also on the inferences we make. Before the crisis, when US growth (using standard GDP measures) seemed so much stronger than that of Europe, many Europeans argued that Europe should adopt US-style capitalism. Of course, anyone who wanted to could have seen American households’ growing indebtedness, which would have gone a long way toward correcting the false impression of success given by the GDP statistic.

Recent methodological advances have enabled us to assess better what contributes to citizens’ sense of well-being, and to gather the data needed to make such assessments on a regular basis. These studies, for instance, verify and quantify what should be obvious: the loss of a job has a greater impact than can be accounted for just by the loss of income. They also demonstrate the importance of social connectedness.

Any good measure of how well we are doing must also take account of sustainability. Just as a firm needs to measure the depreciation of its capital, so, too, our national accounts need to reflect the depletion of natural resources and the degradation of our environment.

Statistical frameworks are intended to summarize what is going on in our complex society in a few easily interpretable numbers. It should have been obvious that one couldn’t reduce everything to a single number, GDP. The report by the Commission on the Measurement of Economic Performance and Social Progress will, one hopes, lead to a better understanding of the uses, and abuses, of that statistic.

The report should also provide guidance for creating a broader set of indicators that more accurately capture both well-being and sustainability; and it should provide impetus for improving the ability of GDP and related statistics to assess the performance of the economy and society. Such reforms will help us direct our efforts (and resources) in ways that lead to improvement in both.

Now at last, on to Hyman Minsky, another voice who has been right, and I see we are running long, so we will continue some of our look at Minsky next week.

Hyman Minsky wrote in the 1970s and 1980s, and was as close as anybody to being the direct line of succession from Keynes.

[At this point I was googling for a more complete bio, the first signs of instability in my computer appeared, and between now and then has been difficult. Always back up your stuff. Continuing.]

Minsky's work that I have looked at are the two books John Maynard Keynes and Stabilizing an Unstable Economy. Both are profoundly coherent and both are difficult reads.

Postwar financial sector instability began in the 1960s with the backstopping of the commercial paper market, according to Minsky. Prior to that banks dealt primarily in government securities when "making their positions." There was an ample supply of these government securities left as a legacy of World War II. As the years have progressed, the innovation of financing instruments has progressed, and also the periodic backstopping of these instruments by the government or a consortium of banks organized by the government or Fed.

We've looked at that before, and the fact that it continuously adds another stratum to the financial sector, making the system ever more topheavy. Now we've arrived at the point where the government is behind the banking institutions and whatever they do in their entirety. No matter how egregious or massive, they are too big too fail. If this system is not materially altered soon, the outcome is inevitable and catastrophic.

Now let's turn to a line of Minsky's thought which follows from the work of the great Polish economist Michal Kalecki. We brought this up a couple of weeks ago in our observations on the 70-30 historically stable split between labor and capital.

Kalecki observed that with not-too-heroic assumptions, including that workers consume all their income, it followed that, among other things, investment equals profit in a simple economy. I was surprised and delighted to find in my reading of Stabilizing an Unstable Economy, that Minsky has taken this line and developed it fully, or more fully, for economies with a government, a large government, trade and where workers save some of their income and capitalists consume some of theirs.

The simplest useful equation in Minsky, which is derived directly from Kalecki's insights has to do with prices.

Pc = W/Ac (1 + NI/NC)

The formula states that the price level is positively related to the wage rate and the ratio of labor in the investment goods sector to labor in consumption goods sector -- that is, the balance of the economy toward investment. It gets more complicated as government and trade is introduced, but one key connclusion does not change. To quote Minsky:

"Explanations of inflation are usually in terms of either too rapid an increase in money, a budget deficit, or wages rising too fast."

But, he continues,

"The money supply does not appear in the price level equation. The quantity theory is not visible."

Minsky goes on,

"Money appears in teh subsystems that determine realized investment and the financing of government deficits. In particular, money affects total demand and the course of prices through the banking mechanism that finance activity and control over (sic) capital and financial assets."

[Now we begin a long digression.]

The quantity theory of money PQ = MV has been treated as a key to unlocking inflation by many and even most economists. The quantity theory is a fallacy not because it is not true, but because it does not explain anything. V, velocity, varies radically in alignment with other parameters. V is a wild card. Monetarists want PQ = M, and Milton Friedman's famous "Inflation is always and everywhere a monetary phenomenon" is based on PQ = M, not PQ = MV. V can be one or a hundred or one one-hundredth. This being so, it washes away any significance of M.

It is like saying the total height you can jump is based on your strength times the gravitational pull. Well, your mass affects that pull and so does the planet you are on. If you can vary these at your pleasure, your strength is not a determining factor. To make the height you can jump relevant to strength, you need to set the conditions much more explicitly than a simple equation. So it is with velocity, which carries he sum of a dozen other indicators. The interaction of these indicators is expressed in velocity and it is these indicators that determine PQ.

[This digression is not from Minsky. Returning to him now, and his simple elegant algebra... After introducing governments and deficits, he shows that when the dust settles

You know, I'm sorry we didn't get more into this earlier. Next week, we'll go deeper, including the eye-opening discovery that in some very substantial way, government deficits arise in the absence of private investment. That is, it is useful to think of the two as substitutes, and the fact that substantial private investment is not on the table for years to come is a good sign that government deficits are.

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