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

Friday, March 20, 2009

Dark Ages of Academic Economics - Part 3

When asked if what Buiter says is true, Brad DeLong says:
Yes, it is true. That is all.

Well, actually, that is not all. Buiter is a little bit too mean to us "new Keynesians", who were trying to solve the problem of why it is that markets seem to work very well as social planning, incentivizing, and coordination mechanisms across a range of activities and yet appear to do relatively badly in the things we put under the label of "business cycle."

I, at least, always regarded Shiller, Akerlof, and Stiglitz as being fellow "New Keynesians." As Larry Summers put it to a bunch of us graduate students l around the end of 1983, Milton Friedman's prediction in 1966 that the post-WWII economic policy order would break down in inflation had come true and that that had given the Chicago School an enormous boost,
Preposterous. Friedman predicted an inflation based on monetary stresses. We got an inflation based on oil prices. Somehow this validated the conceptually vapid Monetarist booshwah.

DeLong continues
but that now they had gone too far and were vulnerable, and that our collective intellectual task if we wanted to add to knowledge, do good for the world, and have productive and prominent academic careers was to "math up the General Theory": to take the conclusions reached by John Maynard Keynes in his General Theory of Employment, Interest and Money, and explain how or demonstrate to what degree they survived the genuine insights into expectations formation and asset pricing that the Chicago School had produced.

In fact, Buiter's column I read as a commentary on General Theory chapter 12: "The State of Long-Term Expectation." Collectively, I think we made a compelling intellectual case--but we were completely ignored and dismissed by Chicago.

But, yes, on the big things Buiter is right.

Brad DeLong
return to Thoma quoting an email [from Paul Krugman],
economists who
"have spent their entire careers on equilibrium business cycle theory are now discovering that, in effect, they invested their savings with Bernie Madoff."
I think that's right, and as they come to this realization, we can expect these economists to flail about defending the indefensible, they will be quite vicious at times, and in their panic to defend the work they have spent their lives on, they may not be very careful about the arguments they make. I don't know if the defenders of the classical faith have come to this realization yet, at least beyond the subconscious level, and the profession will most likely move in the same old direction for awhile due to research inertia if nothing else. But I think what has happened will have a much bigger impact on the profession and the models it uses to describe the world than most economists currently realize:
The end of it all is that economics is a pathetic failure in the current situation. The most prominent economists did not predict the current market failure. It has left the market fundamentalists and monetarists with only one defense. "The government did it." These academically prominent but conceptually irrelevant academics did it by ascribing to the market an efficiency and sophistication it simply does not have.

The policy think tanks such as the American Enterprise Institute, the Heritage Foundation and the Cato Institute are left floating in a Bermuda Triangle of their own making. Their compasses and maps are useless, and unfortunately they are still trying to tell the rest of us where to go.

Demand Side

Thursday, March 19, 2009

The Dark Ages of Academic Economics - Part 2

Mark Thoma reacting to Willem Buiter, see yesterday's post.
I think this is right, but I'd put it differently.

Models are built to answer questions, and the models economists have been using do, in fact, help us find answers to some important questions. But the models were not very good (at all) at answering the questions that are important right now. They have been largely stripped of their usefulness for actual policy in a world where markets simply break down.

The reason is that in order to get to mathematical forms that can be solved, the models had to be simplified. And when they are simplified, something must be sacrificed. So what do you sacrifice?


The models we built were very useful for asking whether the federal funds rate should go up or down a quarter point when the economy was hovering in the neighborhood of full employment, or when we found ourselves in mild, "normal" recessions. The models could tell us what type of monetary policy rule is best for stabilizing the economy. But the models had almost nothing to say about a world where markets melt down, where prices depart from fundamentals, or when markets are incomplete.

Actually, this condition occurs most of the time. At a minimum, the condition of asymmetry of information -- as Joseph Stiglitz has pointed out -- occurs virtually all of the time.
Further, the models did not predict the breakdown of the markets, which Thoma now turns to.

When this crisis hit, I looked into our tool bag of models and policy recommendations and came up empty for the most part. It was disappointing. There was really no choice but to go back to older Keynesian style models for insight.

The reason the Keynesian model is finding new life is that it specifically built to answer the questions that are important at the moment. The theorists who built modern macro models, those largely in control of where the profession has spent its effort in recent decades, did not even envision that this could happen, let alone build it into their models. Markets work, they don't break down, so why waste time thinking about those possibilities?

So it's not the math, the modeling choices that were made and the inevitable sacrifices to reality that entails reflected the importance those making the choices gave to various questions. We weren't forced to this end by the mathematics, we asked the wrong questions and built the wrong models.
But it IS the math.

Mathematics doesn't work on economics. Calculus, the second derivative. Value at Risk. As John Maynard Keynes said, "It is better to be approximately right than precisely wrong." Yet a great deal of economics is math-based efforts to be precise. Statistical models are built with far too few observations, and assume for example, a reversion to a mean as if it were the natural movement of the tides.

It is human behavior, for God's sake. While similar episodes may behave similarly, we have wars and radically varying regulatory frameworks, demographics, and variables that are not internally consistent.

Let's take this last point. The interest rate is not a molecule that will behave consistently, much less have a consistent effect on other similar variables. Economic variables like the interest rate are aggregates of different parts at different times. The interest rate, for example, combines central bank action, competition for money, availability of savings, risk aversion, perceptions of currency strength, perceptions of the future, and so on. The interest rate can be high because the supply of money is low or high because there is too much money and inflation threatens returns. If each of the internal parts of the interest rate could be given its own vector, it might be possible to form a useful variable out of the interest rate. But even this is impossible.

You only have to look at how the Federal Reserve treats all inflation as demand-pull inflation to be remedied with higher interest rates to see how much they are operating in a hypothetical universe. Mathematically precise. Practically useless.

Thoma continues:
New Keynesians have been trying to answer: Can we, using equilibrium models with rational agents and complete markets, add frictions to the model - e.g. sluggish wage and price adjustment - you'll see this called "Calvo pricing" - in a way that allows us to approximate the actual movements in key macroeconomic variables of the last 40 or 50 years.

Real Business Cycle theorists also use equilibrium models with rational agents and complete markets, and they look at whether supply-side shocks such as shocks to productivity or labor supply can, by themselves, explain movements in the economy. They largely reject demand-side explanations for movements in macro variables.

The fight - and main question in academics - has been about what drives macroeconomic variables in normal times, demand-side shocks (monetary policy, fiscal policy, investment, net exports) or supply-side shocks (productivity, labor supply). And it's been a fairly brutal fight at times - you've seen some of that come out during the current policy debate. That debate within the profession has dictated the research agenda.

What happens in non-normal times, i.e. when markets break down, or when markets are not complete, agents are not rational, etc., was far down the agenda of important questions, partly because those in control of the journals, those who largely dictated the direction of research, did not think those questions were very important. Some don't even believe that policy can help the economy, so why put effort into studying it?

I think that the current crisis has dealt a bigger blow to macroeconomic theory and modeling than many of us realize.

Mark Thoma
I hope so.

Wednesday, March 18, 2009

Dark Ages of Academic Economics - Part 1

Paul Krugman commenting on Ben Bernanke:
Friedman and Schwartz were wrong
It’s one of Ben Bernanke’s most memorable quotes: at a conference honoring Milton Friedman on his 90th birthday,
Let me end my talk by abusing slightly my status as an official representative of the Federal Reserve. I would like to say to Milton and Anna: Regarding the Great Depression. You’re right, we did it. We’re very sorry. But thanks to you, we won’t do it again.
He was referring to the Friedman-Schwartz argument that the Fed could have prevented the Great Depression if only it has been more aggressive in countering the fall in the money supply. This argument later mutated into the claim that the Fed caused the Depression, but its original version still packed a strong punch. Basically, it implied that no fundamental reforms of the economy were necessary; all it takes to avoid depressions is for central banks to do their job. But can we say that recent events appear to disprove that claim? (So did Japan’s experience in the 1990s, but that lesson failed to sink in.) What we have now is a Fed that is determined not to “do it again.” It has been very aggressive about monetary expansion. Here’s one measure of that aggressiveness, banks’ excess reserves: And yet the world economy is still falling off a cliff. Preventing depressions, it turns out, is a lot harder than we were taught.
In the postwar period, among the sources of distress that would appear in the good times of the later 1940s and the 1950s was the revival of faith in the magic of monetary policy. In 1951 the Treasury Accord, a conspiracy, in our opinion, set up the Federal Reserve as the fourth branch of government.

Galbraith's trenchant summary of the postwar use of monetary policy is worth repeating.
Monetary policy would again be used as a weapon against inflation and recession. Not to be relied upon in the serious exigency of war, it would again have a role in the less pressing problems of peace. No course of public action would be so successful in surviving disappointment about its efficacy and even its forthright failure.
Krugman and Brad DeLong are concerned with the Chicago School's witless advocacy of the crowding out theory, which postulates that even in the worst of times, if government spends, it merely substitutes for private spending.If, for example, government contracts for the building of a road, and the private contractors hire a bunch of folks to build it, and these people buy food, cars and houses, and nobody else is competing for their labor, or investing in anything, it is still a wash. No increase in economic activity will be seen.

It is not oversimplifying the position, except to omit that the Chicago School imagines somebody will be investing. They see the ghosts of earth movers cast up by their simple models.

Let's enter the discussion by way of Mark Thoma and Willem Buiter
"The Unfortunate Uselessness of Most 'State of the Art' Academic Monetary Economics" Willem Buiter (via Economist's View by Mark Thoma)

Most mainstream macroeconomic theoretical innovations since the 1970s (the New Classical rational expectations revolution associated with such names as Robert E. Lucas Jr., Edward Prescott, Thomas Sargent, Robert Barro etc, and the New Keynesian theorizing of Michael Woodford and many others) have turned out to be self-referential, inward-looking distractions at best.;

Research tended to be motivated by the internal logic, intellectual sunk capital and esthetic puzzles of established research programmes; rather than by a powerful desire to understand how the economy works - let alone how the economy works during times of stress and financial instability.; So the economics profession was caught unprepared when the crisis struck.

Both the New Classical and New Keynesian complete markets macroeconomic theories not only did not allow questions about insolvency and illiquidity to be answered.; They did not allow such questions to be asked. ...

[M]arkets are inherently and hopelessly incomplete.; Live with it and start from that fact. ... Perhaps we shall get somewhere this time.

The most influential New Classical and New Keynesian theorists all worked in what economists call a ‘complete markets paradigm’. In a world where there are markets for contingent claims trading that span all possible states of nature (all possible contingencies and outcomes), and in which intertemporal budget constraints are always satisfied by assumption, default, bankruptcy and insolvency are impossible. ...

The Auctioneer at the end of time

In both the New Classical and New Keynesian approaches to monetary theory (and to aggregative macroeconomics in general), the strongest version of the efficient markets hypothesis (EMH) was maintained.; This is the hypothesis that asset prices aggregate and fully reflect all relevant fundamental information, and thus provide the proper signals for resource allocation.

How stupid is this? The efficient market hypothesis is unraveled several times over just in the two or three decades since it won its promoters the Nobel Prize. The absurd contention that all economic actors have perspicacity beyond measure and all come to the same conclusions, which are right.

As Buiter says
Even during the seventies, eighties, nineties and noughties before 2007, the manifest failure of the EMH in many key asset markets was obvious to virtually all those whose cognitive abilities had not been warped by a modern Anglo-American Ph.D. education ... But most of the profession continued to swallow the EMH hook, line and sinker, although there were influential advocates of reason throughout, including James Tobin, Robert Shiller, George Akerlof, Hyman Minsky, and Joseph Stiglitz ...

In financial markets, and in asset markets, real and financial, in general, today’s asset price depends on the view market participants take of the likely future behaviour of asset prices.


But in a decentralised market economy there is no mathematical programmer imposing the terminal boundary conditions to make sure everything will be all right. ... The friendly auctioneer at the end of time,


No wonder modern macroeconomics is in such bad shape. ...; Confusing the equilibrium of a decentralised market economy, competitive or otherwise, with the outcome of a mathematical programming exercise should no longer be acceptable.

Linearize and trivialize

If one were to hold one’s nose and agree to play with the New Classical or New Keynesian complete markets toolkit, it would soon become clear that any potentially policy-relevant model would be highly non-linear


Macroeconomists are brave, but not that brave; So they took these non-linear stochastic dynamic general equilibrium models into the basement and beat them with a rubber hose until they behaved.; This was achieved by completely stripping the model of its non-linearities and by ... mappings into well-behaved additive stochastic disturbances.

Those of us who have marvelled at the non-linear feedback loops between asset prices in illiquid markets and the funding illiquidity of financial institutions exposed to these asset prices through mark-to-market accounting, margin requirements, calls for additional collateral etc.; will appreciate what is lost: Threshold effects, non-linear accelerators - they are all out of the window. Those of us who worry about endogenous uncertainty arising from the interactions of boundedly rational market participants cannot but scratch our heads at the insistence of the mainline models that all uncertainty is exogenous and additive.


The practice of removing all non-linearities and most of the interesting aspects of uncertainty from the models ... was a major step backwards.; I trust it has been relegated to the dustbin of history by now in those central banks that matter.

Thursday, March 12, 2009


People - notably the Reactionary Right -- Complain about government borrowing and the stimulus spending in the trillions of dollars, leaving aside the indisputable fact that fully one trillion of the deficit is directly inherited from the last Bush year. Also, as we noted, those who are lending the money do not seem to be persuaded that the government is a bad risk, since the interest rates seem to be as low as one could imagine. That is, the market price of Treasuries is remarkably low.

But let's take another tack and compare the Obama stimulus with the Bush stimulus.

Over eight years, the national debt under George W. Bush rose from about five and three-quarter trillion to over ten trillion dollars. That nearly five trillion was incurred by way of a combination of tax cuts, whose biggest beneficiaries were the wealthy, and spending increases, much on an unpopular and ill-advised invasion of Iraq. The first time tax cuts have been paired with a war in American history.

The Bush economic stimulus had the advantage of expansionary Fed policy. The blame for the housing bubble has been allocated roughly equally between the Administration's antipathy to regulation and ineptness in policy and the Federal Reserve's holding interest rates too low for too long. Thus you have expansion of the money supply, high spending from the government and huge borrowing very much along the lines of the program today. Except in the cowboy capitalism the monetary policy actually generated expanded borrowing. That is debt.

The investment was not in infrastructure and public goods, but passive housing and financial engineering. Forty percent of profits in the period came in the financial sector.

Housing is now in freefall with regard to price. The amounts entered in the National Income and Product Accounts for residential investment during the middle and later Bush years are made a lie by the fall in price.

In reality, during the past four years, the federal government was in a deficit far greater than the official numbers indicated, because the bubble economy was creating tax revenues. The Laffer curve failed to materialize, but economic activity was spurred by the debt bubble and huge private borrowing and financial "leverage" involved in hedge funds, leveraged buyouts, collateralized debt obligations, uncovered swaps, and so on. It created the illusion of wealth among those wealthy enough to play the game. This is the only reason the economy of the Bush years had any life in it.

Absent that juice, the economy would have been stagnant and aimless. With it, we have the toxicity of today's economy, and the crashing revenues. New York, for example, is experiencing immense budget pressures caused by the withdrawal of the illusory gains. These budget gaps are directly caused by the Bush/Greenspan stimulus.

Compare this to the Obama stimulus.

Well, you can't. The deficits, as above, are in place from the Bush years but on the accounts of Obama. Further, there is no market pricing mechanism for public goods, which is the investment of choice in the current Administration. There is no market in roads, no education exchange, no police or fire protection clearing house. You will hear in a moment, on Idiot of the Week, David Frum expressing the market fundamentalist view that the private sector is much more productive. Much of this perception is due to this pricing problem. For example, health care that the private sector produces more money, but is this more efficient. Much of the problem of comparison is right here. Private goods have a market price. The value of public goods is assumed at cost.

The great absurdity that only the private sector creates wealth, which is literally the position of the Right Wing market fundamentalists, is given lie by the simple observation of an automobile. What is the wealth inherent in an automobile without the public road, the traffic organization, the policing, the consumer protection of product? What is the wealth involved in computers absent the intellectual capital developed by those who build and use them? That the contracts between two parties may have enormous inherent value absent the legal structure to enforce those contracts is a proposition that is simply ludicrous.

People who hold to the idea that the private sector creates all wealth ought to examine the difference between wealthy and poor societies. Certainly plenty of companies have moved production to poorer societies and any individual or group is more than welcome to relocate itself to take advantage of the absence of government interference.

There is a reason the wealthier societies have the larger, more stable governments. There is a reason that stability and prosperity in the years of big government after World War II were substantially greater than in the small government years before the War.

But this is getting beyond the comparison. We suspect that the Obama approach will produce something other than a market crash and the Great Recession. We expect recovery, as we've noted before, at a rate determined by the willingness to make the major policy moves in housing, finance and conversion to a public goods economy.

Wednesday, March 11, 2009

The medium of exchange has been compromised

Three years ago the world was happily booming, everyone had a job, miners and merchants, factory workers and farmers, all gainfully employed helping each other out.

Today, job losses mean idleness has replaced industry. Need replaces plenty. Insecurity replaces confidence. People are not able to obtain the goods and services they need. Artists and artisans go wanting. The higher aspects of our culture are discretionary purposes.

What is the difference between then and now? Are there fewer industrious people, less commodities, a cut in plant and equipment? No. The difference between then and now is that the financial sector has screwed up the medium of exchange.

It is not that there is not enough money, it is that the money itself is compromised. The way we transfer value from the future to the present, from one person to another, from producer to consumer. The object of any economy, market, socialist, or Martian, should be to keep its members employed in productive enterprises and provision them as well as sustainably possible.

Where is the money going to come from? Well, Where did it go? Who has it? Money is not magical stuff that morphs into whatever you need, so you need to hoard it. Money is the medium of exchange. It allows my work to be traded for your work without barter. It allows me to accumulate credits to use in my retirement, exchanging work then for resources now. It allows the future benefit of a good, say a car or house, to be tapped to pay for it today.

Unfortunately, the credit aspect has been ultimately compromised by those we have allowed to be in charge of it, and in turn has compromised the system. Much of the activity was for the purpose of getting rich, rather than producing value, and in consequence has done neither. Now the unwinding of all that leverage is eating the money up.

To compensate, the Federal Reserve is producing as much money in as many different ways as it can think of, under the assumption that more money will produce more activity. In normal times, such a frantic effort by the Fed would have created hyperinflation. But it is not the amount of money, but the amount of exchange. This amount of exchange is called by economists, the "velocity" of money.

Never well understood by Monetarists, it has always frustrated their math.

The private sector has never been responsible enough to have the authority we have given them by abdication. The province of greed is no place for discipline in this most sensitive mechanism of exchange.

The dollar may still be strong, but the currencies of other countries have been compromised by the free flow of capital. The credit these economies need is flowing into the perceived safety of the strongest money. The dollar. The strength of the dollar comes from the weakness of the system. Not a good sign.

But by returning to basics, the activities, the productive activities of the societies, we can return value and stability to the medium of exchange.

Monday, March 9, 2009


History Note

In 1929 federal spending totaled $3.1 billion, revenues were $3.9 billion. In 1933, spending was 4.6 billion, revenues $2.0 billion.

The hidden truth of these numbers is that they do not reflect a push by the new Roosevelt administration to deficit spending, but the minimal deficit of a conservative government mitigated by compassion.

The budget constraint was felt sharply by everyone, economists and politicians alike, universally. Programs were made necessary by need, not any sort of economic strategy. Direct relief of the impoverished. Farmers in crashing commodities markets. Jobs for the jobless.

Galbraith the Elder, a neophyte in the Department of Agriculture at the time, says, quote, "That recovery might come from increased public spending, an increased public deficit, was well beyond the range of responsible thought. A deficit reflected, at best, harsh necessity. Certainly it had no positive value. Or so it was until what came to be called the Age of Keynes." unquote.

The shock of Keynes' prescription of deficit spending can hardly be exaggerated. Had he not written presciently on the disastrous treaty of Versailles and had his criticisms of Churchill's return to the gold standard not proven prophetic, it is likely he would have been ignored. As it was, even in the circumstances of the Depression, though among the most preeminent economists, there was more than a little doubt about his advice.

We have read here from Keynes open letter to President Roosevelt, published in the New York Times on the last day of 1933, which advocated

"... overwhelming emphasis on the increase of national purchasing power resulting from governmental expenditure financed by loans."

This and subsequent visits to Roosevelt, plus the publication of Keynes' General Theory in 1936 made far less impact that is imagined today. But it did give room in policy for the programs of help that took the edge off the collapse of the cowboy capitalism of the 1920s.

Saturday, March 7, 2009

Forecast: Recovery contingent on policy actions, Fed improvement

This Week

Listen to this episode

Another context for the forecast is those economists who are predicting the ultimate depression. This is actually a hopeful sign. Why hopeful? These same economists predicted until the middle of last year that the U.S. and the world would avoid recession entirely, or that one or another decoupling scenario would prevent the decline from becoming worldwide. That is, the current crop of financial prognosticators, with a few exceptions, is always wrong.

Discouraging signs: Some of them, including the Fed's open market committee, are seeing recovery in 2010. The FOMC is even more wrong than the mainstream economists.

The Demand Side observation. The worse the better. Bad news in the short run will do wonders to stimulate the dramatic and bold action needed for recovery. Also, we are lucky to have the president we have.

Paul Kasriel, Northern Trust

Now let's stick our toe in the forecast water with Paul Kasriel at Northern Trust, one of the few very good forecasters. His assessment released last week, quote

The current economic environment is indeed bleak and there are precious few signs of a recovery. But we believe that if the massive fiscal stimulus package being worked up in Congress is financed largely by the banking system and the Federal Reserve, there is a good chance the economy will begin to grow by the fourth quarter of this year and continue to do so throughout 2010. And if we are correct on this, we also believe there is a good chance that the consumer price index will be advancing at a fast enough pace by the second half of 2010 to induce the Federal Reserve to become more aggressive in draining credit from the financial system. This could set the stage for another recession commencing in 2012, or perhaps some time in 2011. So, the shape of the path of economic activity we see over the next few years is not a “V”, a “U”, or an “L”, but a “W” – down, up, down, up, all within four or five years.

[W]hat is our rationale for a late-2009 economic recovery and a subsequent 2011 or 2012 slowdown/downturn? Massive federal spending funded by the Federal Reserve and the banking system. The Obama administration and Congress are in the process of developing a two-year fiscal stimulus package that at last, but likely not the final, count totals $825 billion. This fiscal stimulus program will include all things to all people – traditional and non-traditional infrastructure spending, aid to state and local governments, expansion of food stamp and unemployment insurance programs, and tax cuts for households and businesses. This massive federal spending and tax cut program will be financed by issuing additional federal debt. Who is likely to purchase this debt? The Federal Reserve and the banking system.

The implication of the banking system and the Federal Reserve monetizing large proportions of nonfinancial sector borrowing – government or private sector – is that the borrowers are able to increase their spending without any other entity cutting back on its spending. Thus, in terms of the GDP accounts, total spending in the economy increases. This is why we expect a recovery in real GDP by the fourth quarter of this year.

If monetizing nonfinancial debt were costless, economically speaking, the Zimbabwean economy would be the envy of the world. But, of course, there are economic costs. Monetizing debt means printing money. And printing money ultimately leads to accelerating prices – prices of goods, services and assets. ... If we are correct that a real GDP recovery commences by the fourth quarter of this year, then we believe the Federal Reserve will cautiously begin slowing its credit creation in the first half of 2010 – that is, the Fed will begin to slowly increase the federal funds rate. We then see inflationary pressures intensifying in the second half of 2010 and the Fed reacting to this with more aggressive hikes in the federal funds rate. This is what we believe will trigger the next official recession, or at least, growth recession.

In conclusion, over much of 2009, the year-over-year change in the CPI is likely to be negative. We advise investors not to extrapolate this “deflation” into 2010 and 2011. With the massive monetization of debt that is likely to occur, increases in the CPI are expected to resume.

Demand Side Forecast

The Demand Side forecast is unchanged from November not entirely because we are too lazy to update the web site demandside dot net, but also because it is as accurate as anything contemporaneous. It sees a U-shaped recession that is severe enough in the short term to stimulate the needed policy measures. We anticipate the Fed's fever about inflation will be sufficiently chastened by its ineptness in the current crisis to prevent the aggressive intervention predicted by Kasriel.

History of Accuracy

We would like to buttress our credentials by pointing out that Demand Side has a record of accuracy. Irrespective of orthodox approval, in earlier forms we correctly predicted the fall of the quote New Economy unquote of the Clinton years. The Three Amigos of the time (perhaps even of Time Magazine) were Alan Greenspan, Robert Rubin and Larry Summers. Fed Chair, Treasury and Assistant Treasury Secretary. Neglected in the congratulatory analysis of Rubinomics was acknowledgment of fifteen dollar oil.

Demand Side was one of a very small number, maybe two, who saw the New Economy falling under the old economy weight of higher interest rates and higher energy prices. Most have put the cause of the downturn in 2001 as the delayed effects of the dot.com crash. Others, primarily Bush's group have put it down as some sort of reaction to 9-11, which happened five months after the start of the recession.

This first Bush Recession did allow Republicans to move their tax cuts through Congress, neatly changing the message of surplus -- "After all, it's your money," to one adapted to the need for economic stimulus. At the time it was assumed all tax cuts have stimulative value. Meanwhile Alan Greenspan changed high interest rates to rates of one percent, to stave off a newly feared deflation. Never mind he had stalled the economy with his fears of inflation only twelve months earlier.

No matter how hard we jumped up and down, our miniscule soapbox did not allow us the elevation to get onto the radar.

Demand Side correctly anticipated that tax cuts for the wealthy would be ineffectual. What ensued was the jobless recovery. We also made an early call that Greenspan's one percent rates were not restarting the New Economy, as he may have hoped, but shoveling debt into residential construction, a remarkably passive and unproductive form of capital investment. We were slackjawed in amazement that Congress came back for a second helping of the Bush tax cut poison. Clearly jobs and incomes were lagging and a speculative fever was inflating a bubble.

This was made most clear in Dean Baker's historical trend analysis of rents versus ownership. A rapidly growing divergence demonstrated, as he had with similar analysis of the dot.com experience, that the housing boom was a bubble. We repeatedly highlighted the fact that housing had become not just a place to live, but a financial asset. It was the asset price explosion that was sucking debt into housing, housing which was clearly unaffordable absent the imagined jump in equity.

We called the collapse of the housing bubble eighteen months before its time. We missed that call, but learned. The bubble was extended from a basic herd event by the corruption of the housing market in its late stages with fraud and abuse, widely cloaked by the perceived inevitability of prices rising forever. That is, the fever of the buyers slash borrowers to participate was enabled by machinations of sellers slash lenders to provide ever more capital. Extra leverage, financially engineered triple A securities, liars loans, and even criminal conspiracies exploited the boom.

The corruption of the markets had occurred also in the S&L crisis and in the stock market bubble. We had actully done some work with Baker at the end of the dot.com bubble where he preferred the primacy of the insider trading dynamic and we preferred the rudimentary herd theory. Of course, both exist. The bubble creates conditions for fraud and corruption -- and delays the natural boom and bust.

By missing the corruption of the housing markets we also missed the devastating impacts on the financial sector of that corruption. The allocation of capital, the management of risk and the mobilization of savings -- the core functions of a working financial system -- were completely broken by the practices of the big banks, the mortgage companies, the investment houses, and the other members of the shadow banking system. We quickly picked up on the work of Nouriel Roubini and Joseph Stiglitz in 2007 to come in far ahead of the curve on the crash.

And you may remember our first editions of the podcast calling the beginning of the recession in the last week of October 2007, statistically for November. We witnessed months of denial by others, lasting well into May, 2008. Subsequently the National Bureau of Economic Research identified the recession as beginning in December, 2007. Their call came after the November elections, our call came contemporaneously, fully a year earlier.

Parenthetically, while the NBER garners plenty of respect for its probity in making this calculation, at Demand Side we do not see the value for policy of a determination made so long after the fact. It only adds to the confusion. Decisions that need to be made in real time cannot wait until the committee gets consensus, particularly when the committee is stacked with boneheads.

One event we did not miss at Demand Side that others have -- even the most notable -- was the commodities bubble. Following the work of analyst Charles Peabody we called the oil and commodities bubble as it emerged in November 2007. Our correct stagflation forecast for the first half of 2008 was based on the premise that liquidity was chasing the rising asset price -- commodities -- and rising asset prices were creating cost-push inflation and subtracting another fraction of effective demand. We tracked the commodities bubble upward and called its peak virtually the week it happened. We made lots of virtual money in our fantasy portfolio as oil, metals, grains and energy dropped like a stone. Oil from $147 to $40.

On the way up we cautioned about the euphoria in alternative energy. On the way down we warned about the devastating impacts on commodity producers and made mention of the collateral damage on the auto industry. Both the income shock of $4.50 per gallon gas and the micro shock to the companies, as they lacked the hybrid technology so much in demand. Hybrids and alternative energy have floated to the back of the collective consciousness today, as the collapse of the banks have replaced every other economic news.

We should make mention before we leave the commodity bubble story that the brevity of the bubble and the fact that oil did not reach $200 per barrel as called for by Goldman Sachs was in part due to prompt and aggressive oversight in Congress. Fraud and market manipulation in commodities no doubt occurred, but on a scale far below that of the other bubbles.


Let's be clear. Demand Side's forecasting success arose not because of statistical models or any real econometric expertise. Were were clear about our method at the time. We correctly observed the conditions of stagnating wages and incomes that underlay the housing bubble and that would be revealed when the tide went out. The huge increase in debt under Bush was papering over a very weak underlying economy. The current decrepit economy is the economy of 2001 minus ten trillion dollars of debt.

This recovery depends on policy choices and bold action. Any future recovery depends on their being instituted, and so our forecast depends not on the imagined quote natural economic forces unquote, but on the political will of the nation and its leaders. As soon as policies are changed, the economy will improve. Until they are made, the economy will be frustrated.

Here are six key actions:

  1. Reduce the principle in mortgage debt.
  2. Reconstruct the financial sector by dealing directly with insolvent zombie banks
  3. Stop the contraction of state and local governments with grants to replace collapsing revenues.
  4. Step up infrastructure, green energy and jobs spending.
  5. Institute improvements to the social insurance system by instituting national health care and improving social security retirement.
  6. Coordinate similar policies with other nations. Use the power of the dollar to create physical and human capital around the world. Inevitably this will create wealth and markets for the U.S. to sell its products into. More importantly it will mobilize cooperation that we need to meet the incredible challenges ahead, economic, environmental and social.

There are primary obstacles to recovery. Five on top are:

  1. The consumer economy.
  2. Reaganomics
  3. The obtuseness of orthodox economics
  4. The institutional power of the Fed
  5. The burden of debt
Next Week

Next week we'll look at the debt. Much has been made of the federal deficit, but a great deal more borrowing has been done by the private sector. Reducing this debt burden is essential to recovery. Part one of reducing this debt, rather than simply transferring it to the taxpayer, needs the Fed to act radically different than it now is.

Friday, March 6, 2009

Fed biased toward obtuseness

There is no greater obstacle to recovery today than the institutional power and economic bias of the Fed.

As we've observed, it was Fed interest rate policy under Alan Greenspan that fueled the housng bubble and the grand increases in leverage and indebtedness across the society -- household, business, government. It was Fed oversight and regulation missing from the field that allowed -- enabled -- the misallocation of capital, mismanagement of risk, and explosion of hidden obligations. It is the inadequacy of the Fed's economic understanding that has kept the current calamity growing long after it could have been dealt with rationally.

The Fed is independent as no other agency of federal government is independent. it reports to Congress. Its chairman and other board members are appointed by the President. It is owned by its member private banks. And since the notorious Treasury Accord of 1951 it has exercised ever more complete control over one-half of economic policy -- monetary policy. The Fed takes direction from nobody. Up until its attention was diverted by an economic collapse of historic proportions, the Fed was obsessed primarily with inflation.

The philosophy under which it operates is shared across the banking community. Today it is a hybrid of Monetarist pap and the aforementioned anti-inflationary bias. This is combined with an ever more aggressively violated trust in the bankers themselves. It is nothing other than the picture of a regulatory agency which has become captive to the industry it was supposed to regulate.

Ben Bernanke himself has made his academic place with the proposition that the Great Depression could have been prevented with radically more expansive monetary policy and a commitment to save the banks. The first -- the monetary policy -- is indeed the primary premise of the Monetarist school led by Milton Friedman. The second, the primacy of the banking institutions, is an unproven hypothesis Mr. Bernanke is testing with trillions of real money.

The size of these megabank zombies is testament to the deregulation which dismantled New Deal protections. Bernanke has turned the Fed's own balance sheet into a replica of those of the zombies in an effort to save them -- transfusing the full faith and credit into basically corrupt institutions.

It is our speculation here at Demand Side that the inability to institute the receivership operation on these zombie banks that is routinely undertaken by the FDIC -- nationalization -- is largely because of opposition by the Fed and Bernanke's interest in keeping them alive. Likely there is sympathy for this position by amigo Larry Summers in the White House and Timothy Geithner at Treasury. But hte central obstacle is the Fed. The Fed is beholden to nobody. And without the Fed no coordinated triage can take place.

No doubt Bernanke will be a one-term chairman, but right now he holds the levers of banking regulation. The good start on fiscal policy made by the Obama administration will be frustrated if there is not some real improvement on this front.

One does not need to accept the Demand Side remedies to admit that the Fed has not provided any relief in the arena of its responsibility. It is our contention that it is the Dark Ages economic philosophy, the institutional decay and the intellectual biases of its chairman that coalesce into the single biggest obstacle to recovery.

Thursday, March 5, 2009

Fed Forecasts in the Dark

Demand Side's forecasts have beaten the consensus and the blue chips and would have placed in the top five of the Wall Street Journal's competition. The weight assigned to interest rates and the collapse of inflation with the collapse of the financial sector kept us down.

Fed Forecasts in the Dark

More remarkable, however, than our success is the failure of the Federal Reserve's open market committee. Upon ascending to the post of Chairman of the Federal Reserve Board, one of Ben Bernanke's first initiatives was to institute the publication of forecasts of the Fed's open market committee. It was and still is a thinly disguised inflation targeting exercise. But it has proven to be more an exercise in embarrassment, as the bankers repeatedly and consistently miss and miss widely not only inflation, but GDP and employment numbers. It is as amusing as a chart can be to see the latest quarter's numbers have migrated out entirely from under the dotted lines that mark the previous quarter's estimates.

To be fair this has not occurred in January's GDP for 2009, but only because there are twelve months of 2009 left. A more representative example would be the October figures. With only three months left in 2008, the esteemed economists were still radically downsizing their estimates. It is our observation that the markets are no longer leading indicators of economic events, but coincident. The Fed's estimates of the economy are no longer coincident, but lagging.

FOMC unemployment estimates for 2009 jumped a point and a half in the three months between its October and January meetings, with the minimum expected now at 8.0. Inflation projections are dropping, we suspect, from the evidence of no inflation, rather than from any inference regarding the commodities bubble or financial system crash.

The bottom line is that they have no idea. The Fed expected their monetary policy moves to do something and they have not. At this hour Battling Ben is applying bandages to wounds that need a tournequet and splint. It is a big part of our prediction of a snap back in late 2009 that the situation will get so bad there will be no room for these alternatives to the proper treatments.

On inflation, the Fed has no clue about cost-push inflation and so missed entirely the effects of the commodity bubble on prices. On growth, they have been laggards in realizing the severity of the housing collapse, but most troubling, they have been unable to comprehend the financial sector collapse. This began in August 2007. We arrive in March 2009 with the markets experiencing another jump condition, the financial firms requiring ever more transfusions, and the Fed's and Treasury's remedies having little more effect than waving their arms.

It is not necessary to accept the Demand Side prescriptions to see that the orthodox remedies have not worked, are not working and by extension will not work no matter how many times they are applied. Initially, in the fall of 2007, the markets were confident the Fed could ride to the rescue and were encouraged by every rate cut and new liquidity mechanism. Not only has there been no rescue, there has been no slowing of the train.

Fed Policy a Loser

The monetary policy excursions were defeated time and time again. Bear Stearns, Lehman Brothers, IndyMac, AIG .... you can mark the collapse from any one of these events, but that misses the clearly systemic nature of the collapse. The Fed is responsible for keeping the banking system stable. It has not only failed, it has failed spectacularly. Yet it shows little willingness to alter course. And there is woefully little demand that it do better.

A year ago it was Captain Ben to the rescue. Today it is a tired and defeated Dr. Bernanke who knows nothing more to do than push more borrowed chips into the center of the table and hope for a better hand on the next draw.

Wednesday, March 4, 2009

After some context from Robert Reich and Adam Posen, we get directly into what will happen next. What will happen to the economy, not so much the stock market. The markets continue their decline -- toward six thousand on the Dow and six hundred on the S&P.
Robert Reich encapsulated the bad news last week

All told, according to the new Commerce Department data, the nation's economy shrank at an annual rate of 6.2 percent. Last month, the government's preliminary estimate was only 3.8 percent. Roughly half the revision was due to a sharper drop in business spending than had been anticipated. As a result, business inventories -- the amount of stuff they they have on hand to sell -- have dropped. That's good news because eventually businesses will have to replace their inventories, in anticipation of at least some consumer buying, and such replacement spending will spur the economy. But here's the bad news: Inventories still aren't dropping as fast as sales are dropping, suggesting even less business spending and investing coming up.
Keep your eyes on the gap between what the economy could produce at full employment and the paltry level of aggregate demand (consumers plus businesses plus exports). That's why the stimulus is too small -- and why Reich is betting the President will be back for more stimulus.
There's no reason to suppose the 1st quarter of 2009 will be any better, and lots of reason to think it will be worse. Government is spender of last resort. We're at the last resort now. $787 billion over two years, and only two-thirds of it real spending, is way below what will be needed to get the economy moving back toward full capacity. Do Republicans know this? Is this why they're continuing to bet that the economy won't be recovering by November, 2010, and why they're going to continue to say no?
And from Adam Posen, whom Paul Krugman describes as the go-to guy for understanding Japan's lost decade, some perspective on the monetary side. From testimony for a Joint Economic Committee hearing on the 26th.
The guarantees that the US government has already extended to the banks in the last year, and the insufficient (though large) capital injections without government control or adequate conditionality also already given under TARP, closely mimic those given by the Japanese government in the mid-1990s to keep their major banks open without having to recognize specific failures and losses.
The result then, and the emerging result now, is that the banks’ top management simply burns through that cash, socializing the losses for the taxpayer, grabbing any rare gains for management payouts or shareholder dividends, and ending up still undercapitalized. Pretending that distressed assets are worth more than they actually are today for regulatory purposes persuades no one besides the regulators, and just gives the banks more taxpayer money to spend down, and more time to impose a credit crunch.
These kind of half-measures to keep banks open rather than disciplined are precisely what the Japanese Ministry of Finance engaged in from their bubble’s burst in 1992 through to 1998 …
On February 24, the Conference Board reported that its consumer confidence index plummuted further in February. The Index now stands at 25.0 (1985=100), down from 37.4 in January. The Present Situation Index declined to 21.2 from 29.7 last month. The Expectations Index decreased to 27.5 from 42.5 in January.
Consumers' appraisal of overall current conditions, which was already bleak, worsened further. Consumers' short-term outlook turned significantly more negative this month. The employment outlook was also much grimmer.
Meanwhile the American Recovery and Reinvestment Act began moving federal money into infrastructure, help for states, education, unemployment extensions and other avenues.

Tuesday, March 3, 2009

History Note: It's the same orthodoxy as in 1929

Back to the Depression. It is no exaggeration to say that the economics purveyed by the Right, the Cato Institute, the Heritage Foundation, the American Enterprise Institute, could not survive in the free market it champions. In a competitive market the many and varied shortcomings would have seen it withdrawn long ago. But these institutions and their economics are subsidized by the corporate moneyed interests that benefit from a free hand in the markets they control.

It is also no exaggeration to say that the economics currently purveyed by the right and these institutions is the same economics that led into the Great Depression and failed so well to address any of the collapse.

Following John Kenneth Galbraith, we observe that economics in normal times is lacking in drama. After the stock market crash of 1929 and the financial sector crash of this era, however, have come marked and dramatic downturns. The theater now present reveals, as it did in the 1930s, actors of no enormous talent. The kingpins of Wall Street, the Mozillos, Madoffs, Thanes, and even Greenspans and Rubins, are unprepossessing and even dull readers of dull texts when the genius of the boom is bust.

Currently, as then, the stock market is assumed to be anticipating or reflecting underlying forces and financial analysts tend to look to it for answers. "The market is telling us this or that about policy." In fact, as George Soros suggests, the Market is reacting to itself. The current collapse of business, commodity prices and imports is completely parallel to that coming at the end of 1929. For a time it was, and in some circles still is, assumed that the crash was a superficial phenomenon, a signal, rather than part of the deflationary mechanism.

As Galbraith insists, the crash and the causative speculation were not passive reflections of deeper trends in the economy. And they will have solid consequences in the years ahead. In the 1930s the consequence was a decade of idle plant capacity and persisting unemployment, until World War II, not economic wisdom, brought it to an end. As we've argued elsewhere, the New Deal mitigated the most brutal aspects of this flaw in capitalism. And here, Keynesianism did not arrive in sufficient scale until the War.

To repeat, the so-called natural forces of the economy, to which we heard Arthur Laffer refer, do not tend to the optimal outcome, but can as easily find their equilibrium in depression or recession. The economics of the so-called free market are the same as they were in the 1930s. The government should get out of the way. Tax cuts, of course, are needed, and never mind the huge subsidies being extracted by the failure of the markets at the same time.

The heroes of the free market, the unregulated banking sector, only a few years ago, are now the goats. The free marketeers may take credit for what meager success there was, but they need not take blame for the collapse, but only sentence the offenders to failure and move on. It is a hypocrisy and irresponsibility that makes the sub-prime borrower look like a saint.

I am not expressing very well how similar the economics of the orthodoxy in 1932 was to that of the Republican Right today. Let me just add the anecdote of the Hoover tax cut. Once he slackened in his assurances that the economy was fundamentally sound, Hoover instituted a step in resonance with today. He reduced income taxes. A taxpayer with an income of $5,000, very comfortable in those days, saw a reduction of two-thirds, from $16.88 to $5.63. Someone with $10,000 in income, roughly the equivalent of $175,000 today, saw his tax go from $120 to $65.

As Galbraith noted, Nothing is more constant in depression or recession than the belief that more money for the affluent, not excluding oneself, will work wonders as to recovery. In that event, as in the current one, the depression will continue as before.

Arthur Laffer: Idiot of the Week

Idiot of the Week

For the first three we employ our features the History Note and Idiot of the Week. Let's begin with this week's idiot, that emblem of Reaganomics, whose well-named Laffer Curve had no intellectual basis, never worked, yet continues today as the centerpiece of the Radical Right Republican economic understanding. We mean none other than Arthur Laffer.


The Laffer Curve was originated by this man and purported to show that government tax revenue increases in times when tax rates are cut. This depends on an unleashing of largely imaginary creative and productive impulses which previously have been restrained by the marginal tax rate. It requires that total output -- in say a 33% tax world -- increase by tremendous amounts so that the lost revenue from the rates is recaptured by the volume.

Never happened, yet it has never been renounced, or even explained. This is similar to the entire Supply Side rationale, which was supposed to generate big new investment and creativity by favoring the private sector. Business investment languished under Reagan and Bush II. And as we've said many times here on Demand Side, economic growth under Republicans since Reagan took office in 1980, when netted for government borrowing, equals zero. All growth under Republican presidents in the last thirty years has been borrowed.

The clip here displays Mr. Laffer not engaged in economics, but in marketing. His supply Side brand has been badly damaged by its obvious deficiencies. It would have been recalled long ago but for a few highly monetarily endowed sponsors. Mr. Laffer is protecting his brand. It should be mentioned that he was among the economic advisers to Mr. McCain during the last election.