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

Tuesday, September 8, 2009

What if we were to listen to those who were right?

Beginning this week and for the next four weeks, we'll examine the alternatives to hoocouldanode economics.
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The economics which failed -- that of Greenspan, Bernanke and Ken Pruitt, along with the majority of academic economists and the great majority on Wall Street -- continues as the most influential among policy-makers only because of its political positioning. Ensconced at the Federal Reserve, beloved of Wall Street and occupying the high chairs (pun intended) of sponsored seats in Academia, the economics which pointed the way into this blind alley continues as the trusted pilot.

The second biggest indictment of the primitive orthodoxy is that it did not see the downturn and crisis coming. The biggest is that its practitioners now offer the defense that they didn't see it coming. Of course, they couch it in the phrase, "Nobody saw it coming," or "You can't tell you're in a bubble until it's over," but as we'll review today, these two claims are demonstrably false.

Perhaps the third biggest indictment of this primitive orthodoxy is that it now offers more of the same remedies that blew up the previous bubbles and created the current crisis. So far as these have been applied, they have shown no restorative effect, we might add. The absence of forecasting accuracy, in the context of its fevered precision to two decimal points, has been covered here before. In the next four episodes we will look at the alternative economics that did describe events contemporaneously and did point to likely outcomes ahead.

These four explanations overlap, because events overlap, and within this they focus to some degree on the breakdown of the financial system.

  • The basic demand side framework you have been listening to on this podcast lays out the weakness of the economy as a long-term road taken in the early 1970s and followed with few deviations since then. We have explored the weakness of the economy prior to the bubble, the dynamics of the bubble itself, and the problematic outlook going forward. We'll review that today.

We'll incorporate Nouriel Roubini here as one who has simply looked directly at the economy and analyzed it correctly, without being influenced by the primitive orthodoxy or the media that magnifies it.

  • Hyman Minsky's view that the financial system has become ever more fragile with succeeding bailouts, beginning in the late 1960's with the backstopping of the commercial paper market and continuing forward to this day we will look at on next week's podcast. Minsky suggested that the economy becomes more sluggish as it incorporates failed financial experiments and at the same time becomes more unstable as the implicit guarantees create another stratum of speculative finance.

  • James K. Galbraith's view -- we'll call it an institutional view -- that the behavior that created the crisis arose from the rise of corporate oligarchs and their capturing the national government and its regulatory apparatus. Galbraith sees the orthodoxy as little more than an official religion of free markets and free trade serving to screen off the malevolent exploitation of the public welfare for the private gain of an elite. We will look at that in three week's time and maybe incorporate the view of Robert Kuttner.

  • Finally, four weeks out, we'll look at George Soros' version of market instability. Not dissimilar to Keynes, Soros sees an internal financial market dynamic which creates fundamentals and carries them off in the wrong direction. We'll leave it until that point to describe in a bit more detail the massive breakdown of market discipline that led to this latest calamity.

The Demand Side View

The view we have espoused is that decreasing returns to labor manifested in stagnating median wages and higher trend unemployment. These along with higher energy prices and interest rates have led to widening income and wealth disparities have served to diminish aggregate demand over time by reducing the multiplier. As the middle class has stagnated, so has growth. The political solution has been to maintain a functioning middle class by pushing people off into poverty on the lower end. Now that many of the middle class themselves are walking the plank, this is no longer a solution.

This deterioration in the economy began in the 1970s, with a double whammy of higher energy prices and then interest rates, combined with a break in the trade regime under Richard Nixon. It was exacerbated by the Reagan recessions and the assault on organized labor. High federal deficits under Reagan and overt policies at the Fed began the deindustrialization of America. The preference to corporate interests begun under Reagan were amplified under the second George Bush, making the economy brittle as well as unstable.

In addition, the damage to and decay of public goods -- infrastructure, education, public health -- reduced general welfare and productivity. From the demand side angle, the real economy was allowed to decay and eventually was not able to support a financial economy that was allowed to run wild after it was deregulated. The New Deal bargain to support labor and productive, real economy business by restraining and managing financial services was broken. The result was inevitable. The dot.com and housing bubbles were circuses in which real work and real production was replaced by easy credit and asset inflations.

Our anatomy of a bubble has played out repeatedly in the era of financial market rule.

  1. Asset prices rise
  2. People are drawn in by the opportunity for capital gains
  3. Easy credit fuels further participation
  4. The bubble is extended by hook or crook
  5. Prices cease to rise and immediately fall, since they were rising only because they had been rising. The "crash."

In terms of forecasting the turns, Demand Side has followed the work of Andrew Oswald of Britain's Warwick University, who with his colleagues demonstrated the causal link from rising oil prices and interest rates to economic downturns as described by unemployment. To be candid, we were early on both calls, and both times, we believe, because we did not appreciate point 4, particularly the crook in "extended by hook or crook."

The connection between interest rates and demand is straightforward both on the consumer and business sides, conceptually as well as empirically. Likewise oil and energy prices directly impact consumer and business costs and reduce their activity. It should be noted that oil, in particular, is a low multiplier industry, generating only about one-third the jobs per dollar of other industries. It is for this reason that the current speculative bubbles being generated in the financial sector with regard to commodities and oil is very troubling. We note that all the elements of our anatomy of a bubble were present in the commodities boom which busted in July 2008, and are present and active at this writing, again in the oil markets.

These steps played out in the dot.com boom and bust, with number 4 being the insider trading scandals and the fraudulent mortgage activities. While these were egregious, they were parasites on the boom itself, generated with the necessary assistance of easy credit. The Fed under both Alan Greenspan and Ben Bernanke, operated under the idea that bubbles were difficult to identify and measure. Simply measuring the federal funds rate would have been one clue. These bubbles, again, cannot happen without access to easy money leveraging up the prices.

(Another simple way to identify the elusive bubble would be to simply add asset prices to an index of other prices. The total will go up in a bubble. The Fed responds to incipient inflation as measured by similar indexes with Draconian interest rate hikes. Such hikes would be far more apt and far less harmful if they came in response to asset price inflation.

Demand Side acknowledges the serious and continuing crisis in the financial sector, with zombie banks and credit being very sluggish. We did not see the seriousness of the collapse until were alerted by the likes of Nouriel Roubini, but unlike the nabobs of the primitive economic orthodoxy, we did listen to Roubini and others because we were not busy denying the bubble and recession.

Nouriel Roubini, professor at the Stern School of Business, made his career by accurately predicting the dimensions of the calamity irrespective of the contemporaneous denial. Roubini described the economy in 2006 and early 2007 in terms of "three ugly bears." This was a reference contradicting the so-called Goldilocks economy of the orthodox -- not too hot, not too cold, the Great Moderation. Inflation not too high, growth not too low.

Roubini's three bears were a housing recession, the rise in Fed interest rates, and a credit crunch for subprime mortgages.

Roubini's presentation to the Davos conference of elite economists and financial system bigwigs in 2007 was rebutted by an American International Group (AIG) vice chairman, Jacob A. Frenkel, who said somewhat off the fairy tale script, "A lot of ugly bears grow horns and become bulls." AIG subsequently epitomized the financial sector's systemic rot by requiring hundreds of billions of dollars in bailout money, much of which was passed directly through to the big zombie banks.

With similar predictive accuracy to his call on the housing market and credit crunch Roubini saw the onset and potential scale of the systemic financial meltdown that produced the failures of Bear Stearns and Lehman Brothers and culminated in the no-holds-barred bailout strategy of the Treasury and Federal Reserve.

At this point, Roubini sees an ongoing sluggish economy. Consumers are "tapped out, spending less and debt burdened," he says in one favorite phrase. Households need to deleverage, which will be a drag on consumption for years to come. The financial system is severely damaged and will not produce the credit growth needed for both consumption and business investment. And at the same time the corporate sector faces a glut of capacity, further reducing likely capital spending. Private sector investment and spending may also be crowded out to some extent by the force of the public spending in stimulus and recovery efforts.

Demand Side allows at least hypothetically for a new concerted program of public spending in infrastructure, education and to combat climate change. On a sufficient scale, such an ongoing commitment to public goods could be the engine pulling the economy of the U.S. and hence the world out of a protracted slump.

Roubini, perhaps true to his moniker Doctor Doom, posits no such possibility.

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