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

Wednesday, May 27, 2009

Atlas Dumped

The premise of the Ayne Rand fantasy novel Atlas Shrugged is that certain members of society are far more productive than others and so are underpaid for their services. If they went on strike, all would suffer.

from enotes

the mysterious John Galt begins a revolution against the existing order, believing that the parasitic society would destroy itself if its competent and hardworking members would simply stop working. But first, the protagonists must learn how to let go of the ties of obligation, responsibility, and guilt connecting them to the abusive community in all aspects of their lives.

the political and industrial parasites support each other and live off of the creative and productive "giants" who remain and must support them on their shoulders. The apathy of the people is summed up in a new slang expression, "Who is John Galt?" which conveys hopelessness, fear, and a sense of futility, as well as everything unachievable and imagined.
from Wikipedia

Rand stated that the idea for Atlas Shrugged came to her after a 1943 telephone conversation with a friend who asserted that Rand owed it to her readers to write a nonfiction book about her philosophy. Rand replied, "What if I went on strike? What if all the creative minds of the world went on strike?"

Rand then set out to create a work of fiction that explored the role of the mind in man's life and the morality of rational self-interest, by exploring the consequences when the "men of the mind" go on strike, refusing to allow their inventions, art, business leadership, scientific research, or new ideas to be taken from them by the government or by the rest of the world. Leonard Peikoff noted that "Atlas Shrugged did not become the novel's title until Rand's husband Frank O'Connor made the suggestion in 1956." The working title throughout her writing was The Strike.

According to Barbara Branden, the change was made for dramatic reasons––Rand believed that titling the novel “The Strike” would have revealed the mystery element of the novel prematurely.


In the final section of the novel, Taggart discovers the truth about John Galt, who is leading an organized "strike" against those who use the force of law and moral guilt to confiscate the accomplishments of society's productive members. With the collapse of the nation and its rapacious government all but certain, Galt emerges to reconstruct a society that will celebrate individual achievement and enlightened self-interest, delivering a long speech (fifty-six pages in one paperback edition) serving to explain the novel's theme and Rand's philosophy of Objectivism, in the book's longest single chapter.

Anyone with a sense of reality can get through only about three pages of this nonsense. The society of collapse it begins with bears resemblance to nothing so much as the Great Depression, caused by unbridled free markets.

Rand was unfortunate in her choice of steel and railroads as industrial vehicles for her heroes. Steel rose on the back of the War. Railroads on the back of a gargantuan land give-away. Neither rose from its own.

It is the fact that the benefits of the society flow to the powerful. The barons of industry collect income far beyond their contribution. Of course, these folks bear no resemblance to the Atlases of Rand's imagination. They are organization men who control corporations titularly owned by stockholders, but run primarily for the benefit of their executive teams.

It is no accident that the dicta of Rand when allowed to work into the society, say through the auspices of disciple Alan Greenspan or through the Reagan Revolution, have resulted not in prosperity, but in collapse. Those who have end run the law and ignored moral imperatives have simultaneously run the society over the cliff.

Mighty scarce these days are advocates of the free market who ascribe no role for the government today. Much more common are those who say we must rescue the prodigal financial institutions from the enormous mess they made so they can again operate in their former styles. We have transitioned into an unsteady corporate welfarism, which allows the private sector the profits and assigns the losses to the public sector.

How are we going to pay for this mess? This is often the segue into how irresponsible the government is to run deficits. Today I would like you to consider how can we asssign the costs to those who incurred them.

I would like to suggest we tax the wealthy. It is no stretch to say that those who retain wealth today are those who benefitted from the out-of-control market fundamentalism and financial sector excesses of the past decade. By taxing the wealthy we will be taxing the beneficiaries, if not the culprits, of this massive error.

The Atlases of the world exist only as convenient folk figures to justify the coddling of the wealthy. Economic actors, from the minimum wage worker to the CEO, all act from incentives. To think that those at the top deserve outsized incentives while those at the bottom can be content with the incentive of subsistence is contorting the idea of incentive.

In fact, the wealth of a market society automatically flows to the talented. They have a monopoly, as it were, and can benefit just as any monopolist can benefit. Corporations often think they can corner the market of talent in a particular area just to ride on this monopoly. Of course, all too often, the talented develop better in a garage than on floor three of module A-6.

But take for example sports. The top twenty stars get millions. The next five hundred get some lesser millions. Below that, even if only a small gradation in talent different, the reward is a particle of the others. We could go on.

The point is that it is a distortion and an illusion that Atlases exist in today's society. Rewards are cornered by the powerful, often the monopoly power associated with talent, but more often simple political or institutional power. However they are cornered, the role of the government is to access them for the benefit of the society upon which these gains have been made.

Wednesday, May 20, 2009

Why the Fed is in the dark: The shadow money stock

The shadow money stock: (from the podcast)

It can be argued that the Fed and Ben Bernanke have been engaged in a massive effort to inflate a way out of the current economic contraction. So far, no inflation. Demand Side has not been shy about pointing out the impotence of the Fed's policy. But what are the nuts and bolts?

Two economists from Credit Suisse, James Sweeney and Carl Lantz went on Bloomberg and presented the concept of the shadow money stock. There's a more academic treatment out just this last weekend on the Zero Hedge blog, link on the web site.


It's a concept which after one hears it seems almost too obvious.

During times of strong demand and liquid asset markets, those assets are held in lieu of money and serve the purpose of money. For example, during the housing boom, housing was extremely liquid as a financial asset. Not only could you sell it almost by accident if you answered the door wrong, you could also tap its market value easily and immediately via a home equity loan.

Let me start again with a straightforward rendition of the premise.

The shadow money stock is money the market itself creates in order to finance a boom. Money in the sense of a medium of exchange. In a boom there is not enough cash to go around, so collateral will be used as near money or shadow money.

Many assets can be converted into cash easily in a boom. Take the example of the house we led off with. Homeowners held less cash in checking accounts and other forms because they knew that virtually overnight they could get low interest money out of their homes.

Similarly, government bonds can be taken to the Repo desk and for a one percent haircut converted to cash. During the boom, private bonds and asset-backed securities of less than perfect ratings could easily be converted to cash, with say a five percent haircut.

People used their cash to buy things and these other assets as the rainy day fund. When the downturn came, the value of the assets went down, yes, but also the terms for borrowing against them, including the haircut became more onerous.

For example, a bank once willing to loan on 90 percent of the value of your house became willing to loan only on 70 percent. The value of trillions of dollars of securities became useless as collateral as their markets became illiquid.

Friedrich Hayek, quoted on Zero Hedge, put it this way. (abbreviated)

"There can be no doubt that besides the regular types of the circulating medium, such as coin, notes and bank deposits, which are generally recognized to be money or currency, and the quantity of which is regulated by some central authority or can at least be imagined to be so regulated, there exist still other forms of media of exchange which occasionally or permanently do the service of money.


it is clear that, other things equal, any increase or decrease of these money substitutes will have exactly the same effects as an increase or decrease of the quantity of money proper, and should therefore, for the purposes of theoretical analysis, be counted as money.

In particular, it is necessary to take account of certain forms of credit not connected with banks which help, as is commonly said, to economize money, or to do the work for which, if they did not exist, money in the narrower sense of the word would be required.


The characteristic peculiarity of these forms of credit is that they spring up without being subject to any central control, but once they have come into existence their convertibility into other forms of money must be possible if a collapse of credit is to be avoided."

Lantz and Sweeney calculated that at the peak of the boom there was six trillion dollars in the traditionally defined money stock. The private shadow stock accounted for $9.5 trillion, and government-based shadow money a whopping $11 trillion. Thus the shadow money stock dwarfed the traditionally defined M2.

Remember the shadow money stock is a boom time phenomenon, and creates a lower demand for real money than one would expect. It contributes to the experience of stable or even falling interest rates during times of expansion. Not what one would expect.

Lantz reading of recent statistics indicates that today every one dollar increase in the base money increases M2 by one dollar. In more normal times each dollar of base money will increase M2 by 8.5.

The size of the shadow money stock was estimated by multiplying the haircut percentage against the asset base. For example, the value ofthe housing stock times the level of potential borrowing against it. Say during the boom, a homeowner could borrow against 90 percent LTV -- loan to value -- and now it is 80 percent. Plus -- or minus in this case -- the reduction in actual value. Lantz and Sweeney estimate that the total drop was $3.5 trillion.

They also suggest this was offset completely by an increase in the government shadow money stock, following the huge new borrowing needed to finance the deficit as well as the aggressive liquidity measures of the Fed, and presumably including the expansion of the Fed's balance sheet in the conversion of dodgy private securities into full faith and credit. This huge increase in liquidity has been the source of muchhand wringing about potential inflation. Bernanke issued notice that the Fed is "focused like a laser on the exit strategy."

In fact, according to Lantz and Sweeney, this explosion of liquidity was necessary simply to accommodate the demand for cash occasioned by the crisis. Absent this money growth, the collapse of the private shadow money stock would have led to severe, or more severe deflation.

Lantz suggests concern over inflation is ridiculously premature, and predicts much of the unwind of the liquidity measures from the government will occur naturally, as government programs get paid back and rescuemeasures for the banks wind down.

Our observation at Demand Side is that monetarists who can so clearly describe the monsters hiding under the bed will become ever more hysterical as things begin to turn around. We suspect that the adults will choose to calm them, rather than follow the more effective policy measures. The efforts to calm them will be counter-productive to the real economy.

At the risk of dislocating an elbow, we'd like to make the note that we've made a couple of comments that look good from this new perspective. Deleveraging we have said is a process of money contraction. This was an insight that arose from instinct, not instruction. Here is the instruction.

Another self administered pat on the back follows from our observation in early 2008 that credit cards as near money enabled spending from the stimulus to be smoothed, in a downward slope, to reflect the restrictions on this form of money.

In fact, the actions of banks and credit card companies demonstrate clearly the error of the Fed-Treasury plan to allow zombie banks to continue among the living. These insolvent institutions have no choice but to maximize revenues from the spread. That is, they may borrow cheaply, but this will not be passed on to their credit card clients, who will get only the maximum rate laws allow.

This note from the New York Times

From the NY Times: Overhaul Likely for Credit Cards

Banks are expected to look at reviving annual fees, curtailing cash-back and other rewards programs and charging interest immediately on a purchase instead of allowing a grace period of weeks, according to bank officials and trade groups.

“It will be a different business,” said Edward L. Yingling, the chief executive of the American Bankers Association, which has been lobbying Congress for more lenient legislation on behalf of the nation’s biggest banks. “Those that manage their credit well will in some degree subsidize those that have credit problems.”

The larger point is that money is a much broader phenomenon than we have been used to thinking. At the same time, the Fed's control of money is much narrower. In a boom, with confidence in asset values, the effective money supply will expand as collateral becomes near-money. In a bust the effective money supply will convulsively contract, as assets become less liquid, banks lend less and keep more in reserve, and all parties hold traditional, not shadow cash against a rainy day.

The threat of inflation is much lower than widely assumed, since as things pick up, the government shadow money stock will tend to be reduced. Programs end. Loans are paid back. Et cetera.

Another blow to the quantity theory of money.

Monday, May 18, 2009

History Note: The Rise and Fall of Keynesianism

From the 05.14.09 podcast:

The history note:

In the mid - 1960's, it is no exaggeration to say, and Lord Eric Roll in his definitive History of Economic Thought did say, "... the New Economics enjoyed an acclaim unprecedented in its speed and intensity."

Economics and economists had penetrated the policy-making framework as never before. in the Depression, the New Deal Brain Trust around FDR drew some economists in, but by the 1950s and 1960s there was a systemic and institutional presence of economists in countries around the globe.

And as Lord Roll puts it ...

"for at least over thirty years after the appearance of Keynes' General Theory, the status of economics, largely with the kind associated with his name and general approach, increased steadily until it reached a position of authority, both as a branch of social science and as a perceived tool for the better ordering of human affairs, unparalleled in its history and unequalled by any of the other of the non-physical sciences."

This is not the situation today. A recent edition of Business Week lampooned economists as people who could not agree on what had happened, on what to do, on what would happen, and would be wrong anyway.

In a moment we will look at what happened to change the situation from a condition in which economics and economists were held in high regard to one in which they are ... not. But first, let me emphasize that the high standing and respect accorded to economists int he postwar years prior to 1970 is not my invention. The clear perception among politicians and the public was that Keynesian economics, demand side economics, had been refined and perfected and was responsible for that period of growth, prosperity, low unemployment and modest inflation.

What happened?

Two things: The stagflation of the 1970s and early 1980s and a counter-revolution.

Much could be said about the stagflation. It occasioned Richard Nixon's wage-price freezes, initially well-received, and later experienced as disruptive and counter-productive. Still ill-appreciated is the role of oil prices, energy prices, not just as demand shocks, but as directly eroding wages and incomes. Whatever might be said, the stagflation exploded the illusion of precision which economists had gathered around themselves, and offered the opening for a politically led counter revolution that unseated the orthodoxy of the New Economics.

I choose the words "politically led" very carefully. The Monetarist laissez faire supply side scheme that replaced the Keynesian conventional wisdom was by no means generally accepted among economists or among nations, though it has achieved sway among bankers. The revolution against Keynesianism was decidedly not a revolution led by economists. At most there was a civil war during which time the elections of Thatcher and Reagan put the new dogma into the seats of power in some influential countries.

Supply Side has never really been a branch of economics. More a parasitic vine. No serious academic lineage has followed it. Its advocates are not housed primarily in universities, but are centered in corporate-sponsored Right Wing think tanks like the American Enterprise Institute and the Heritage Foundation.

Monetarism, laissez fair, New Classical math-based, and Rational Expectations schools have enjoyed far less consensus among economists than the Demand Side schools that preceded them, although they too have been the beneficiaries of significant corporate sponsorship, in the form of endowed chairs and business school boosterism. However that may be, none of these schools carries any pretense of precision into the second year of this current recession.

The hybrid Monetarism and laissez faire philosophy that controls the Fed and Treasury can claim no precision now after so many years of false promises and predictions. To have the financial potentates still at the helm after so many protests that they had not seen it coming is one of the great ironies of the current year. The Rational Expectations and the mathematical strains of the New Classical school are clearly wrong or irrelevant. Libertarian bias sometimes masquerades as a market efficiency theme, but both are as completely out of place looking forward as they were in describing the corporate oligarchy that rose up behind the smokescreen of Reaganism.

The current crisis and its depth are impossibilities from the points of views espoused by these folks only a couple of years ago.

That said, until this recession, the collapse of this housing market and this financial sector, and for the twenty years prior, for an economists to be Keynesian or Demand Side in approach was to be hopelessly naive and stuck in the past, and to look for employment at the Post Office.

Keynesianism may have been defeated by a motley coalition of political opportunists, corporate connivers and academic hacks, but it WAS defeated.

I took my degree from a large state university in 1995. The name Keynes appeared about twice -- literally during my undergraduate education. It was not until after graduation I even learned how to pronounce the name of the greatest economist of the Twentieth Century. Only subsequent to the 2007 housing collapse and financial debacle did KEENES become Keynes again to the policy maker and the media talking head.

Paul Krugman's blog the other day said something about this period. Where is it?

Brad DeLong catches a footnote in a decade-old paper by Olivier Blanchard:

Paul Krugman recently wondered how many macroeconomists still believe in the IS-LM model. The answer is probably that most do, but many of them probably do not know it well enough to tell.

I actually have no memory of saying that. But I was worrying about the state of macro a decade ago. Here’s a short piece I wrote back then. Even then, it was obvious that the Great Forgetting was underway; only economists of a certain age knew how to think about what remain the essential insights of macro.

So in a way it should be no surprise to find, 10 years later, that we have entered a Dark Age of macroeconomics.

The IS-LM model was an invention of John Hicks, later Sir John Hicks. He won the Nobel Prize for it, which did not prevent him from later recanting, or more accurately, ascribing its relevance only to a narrow part of reality. But it was mathematical, and Keynesian. I'm not sure by this whether Krugman, DeLong or any others actually advocate this scheme. A paper Krugman wrote at that time makes this note:

Afficionados know that much of what we now think of as Keynesian economics actually comes from John Hicks, whose 1937 article "Mr. Keynes and the classics" introduced the IS-LM model, a concise statement of an argument that may or may not have been what Keynes meant to say, but has certainly ended up defining what the world thinks he said. But how did Hicks come up with that concise statement? To answer that question we need only look at the book he himself was writing at the time, Value and Capital, which has in a low-key way been as influential as Keynes' General Theory.

Hicks and the IS-LM were searching for precision and found it in irrelevance. But the formulation remained the central Macro formulation, event absent Keynes' name. It is best ignored for the present.

The Keynesian policies in play today are the federal infrastructure spending, the aid to states and local governments and assistance to health and education systems. You might also add the New Deal programs of social security and unemployment insurance as base supports of demand, but which are not strictly Keynesian. I combine the two in the definition of Demand Side.

These are the measures of which JMK would have approved.

Compare the "Timely Targeted and Temporary" tax cuts of early 2008, which was plainly a bust from the beginning from a Demand Side perspective. If you've been with us, you heard us among the voices discounting the efficacy of these checks to individuals, no matter their political popularity. The primary sponsor of Timely Targeted and Temporary was, of course, Larry Summers. As we predicted from before the beginning here on the podcast, that triple T stimulus was a non-starter in the real economy. Republicans and Conservative economists who continue to insist on tax cuts as being effective are ignoring this evidence.

Those who expect big things from loan guarantees and making nice with the banks so they will lend are destined for disappointment from the same cause. The consumer is not going to be the engine it once was. The why's go beyond the fact that his/her net worth is going negative fast and his/her income is dropping on average, but we won't go into them here.

Getting back to Timely Targeted and Temporary. Didn't work any better than tax cuts for the rich.

The entire Monetarist scheme to refloat the banks is from the Demand Side perspective a Monetarist scheme to refloat the banks. To us there is no clear reason why it should work as a remedy for the economy, since there is no clear motivation to invest or borrow or lend absent demand strength. It's great to have a good ferry, but if nobody wants to go across the river, nobody will benefit, even the ferry.

The idea that the financing function of the economy will be saved by salvaging the companies that screwed it up is dubious on its face. Or that ratifying their bad decisions by having the government cover them with taxpayer money? It does not stand the test of common sense, let alone the Demand Side theory. In fact, it's hard to see whose theory it does test out in. Perhaps the theory that those who control the government set the policy.

But this IS the history note. And the note is simply the contrast. First between the economic consultants of the New Deal and the economic establishment that grew out of Keynesianism to such prominence in the third quarter of the Twentieth Century, and second the contrast between that and the current Tower of Babel. The rise of Keyneisanism and Demand Side, its successful revolution against classical laissez fair and broad acceptance, to the unseating of that consensus by a commercial-political-economic gang that had no coherent or widely accepted replacement philosophy, sharing only the common trait of being contrary.

Anyway, that's the abbreviation of the Cliff Notes version of the Keynesian Revolution, the establishment of the first coherent policy framework, and the subsequent fall into intellectual chaos.

Monday, May 4, 2009

Captured regulator premise gets more backers


Mark Thoma is coming close to the captured regulator position with regard to the Fed's handling of the financial crisis.



In a couple of posts linked on the web site, including his post entitled "The Professionals are not being Held Accountable" on Economist's View, Thoma addresses this point. In one he cites Michael Pomerleano


Viral V. Acharya and Rangarajan Sundaram. The latter two point out: “The US recapitalization scheme ... is ... generous to the banks in that it imposes little direct discipline in the form of replacement of top management or curbs on executive pay, and secures no voting rights for the government“.

We seem to forget one of the successful lessons from the late 1980s savings and loan crisis in structuring positive and negative incentives: holding accountable the directors and officers, lawyers, accountants of the banks, investment banks and the rating agencies. ... The Office of Thrift Supervision, which regulates the US’s thrifts, and its sister agency, the Resolution Trust Corp which was in charge of disposing of the assets of failed S&Ls, embarked on a deliberate deterrence strategy targeting lawyers, accountants, directors and officers of failed thrifts that aided and abetted the excesses leading to the S&L crisis. The intent was to discourage future abuses and recover some of the lost taxpayer funds. ...

In the US, we are told that there are no culprits in the crisis. The attitude of the policy makers, regulators, bankers and traders involved in the crisis is virtually fatalistic, treating the crisis as an inevitable “force majeure”.

(Demand Side point: According to Wikipedia, force majeure, literally superior force, refers often to a common clause in contracts which essentially frees both parties from liability or obligation when an extraordinary event or circumstance beyond the control of the parties, such as a war, strike, riot, crime, or an event described by the legal term "act of God" (e.g., flooding, earthquake, volcano), prevents one or both parties from fulfilling their obligations under the contract. However, force majeure is not intended to excuse negligence or other malfeasance of a party, as where non-performance is caused by the usual and natural consequences of external forces (e.g., predicted rain stops an outdoor event), or where the intervening circumstances are specifically contemplated.

Returning to Thoma, Pomerleano, Acharya and Sundaram.

All of them were observers and “no one saw it coming”. In short, the crisis is a Lemony Snicket’s “Series of Unfortunate Events”.

In reality the regulators that should have kept a close eye on the rapid growth of the shadow banking system were complacent, and the boards did not have the background in the industry and didn’t understand the risks. It is clear that the policy makers and regulators lack the moral authority to lead us out of the crisis. ...

The US Treasury plans to rely on the same firms and people that were involved in leading to the crisis to get us out of it. ... Clearly, nothing learned, nothing gained from the S&L crisis or the Swedish experience. Maybe this will change.

Saying it's not your fault you crashed the ship into the rock because the rock was underwater and hidden - nobody could have seen it coming - loses its force when you are navigating in waters that are known to be rocky. Even if you have the latest sonar based upon fancy, innovative math that is supposed to detect the rock before you hit it, and even if regulators were supposed to clearly map and mark all danger, if you hit it anyway, there's a reason why captains are expected to go down with - or at best be the last ones off - the ship. It ensures they'll do all they can to avoid hitting it in the first place.


This is getting very close to the Demand Side position that the Fed and other financial regulators are no different than examples throughout government where oversight bodies have become captives to the industries they are supposed to regulate. The Fed's continued insistence on rescuing the financial institutions rather than stabilizing the banking functions in new, smaller, credible institutions is the ultimate proof.

Sunday, May 3, 2009

Stimulus from the market

Demand side stimulus, Keynesian stimulus, traditionally is seen as deriving from government spending or tax cuts. It is hard to find an economist or politician today who argues for no use of these. Even the sacred tax cuts for the rich, established under the supply side prediction that they would lead to ever greater output, are now defended from the demand side. That is, reversing these tax cuts will reduce much needed demand for products and services.

But demand side stimulus can come from the market as well, if the appropriate incentives are in place.

The supply side market stimulus is most often seen in state tax breaks to businesses to encourage them to site a factory or other facility in the neighborhood. The theory goes that the new private facilities will produce jobs which will make the economy better. But as Yogi Berra said, "In theory there is no difference between practice and theory. In practice there is."

All too often the new facilities undershoot their targets. Some local businesses may be pleased, but rarely will it stop their complaining about the taxes which necessarily shift away from the newcomers and onto the current rate base. And at bottom, studies have shown, there is a tendency for businesses to site according to more salient factors, then just game the local jurisdictions to cut their tax exposure. More primary to business siting decisions, for example, are -- one, two and three -- market access, four, workforce availability, five transportation in and out, six educational facilities, and among the category of "also may be important" comes tax considerations.

And even here, the supply side stimulus is a zero sum game. When one jurisdiction is chosen, the others are neglected. If one community scores a Wal-Mart, businesses in all affected communities suffer.

But regardless of any of this, there are market-based measures that can stimulate from the demand side.

One is the forward commitment procurement process. You may remember Dr. Jonathan Frost, featured repeatedly here on the podcast, advocating this technique. Government simply commits to purchasing products in the future which meet the desired specifications. Frost used the example of the British prison system's procurement of a zero-waste mattress.

They described the attributes they wanted in a mattress. In this case, not being flamable, usable as a weapon, and so on, and particularly including the attribute of producing no waste for the landfill. The prospect was described by some as impossible. Even if such a product could be produced, it would be prohibitively expensive.

In fact, they received over thirty responses to their proposal, and the one selected produced a mattress that actually -- when disposal costs were included -- was more economical than the previous version.

A more famous example cited by Frost is the mandate by the state of California for a halving of emissions from automobiles. This was issued in the 1970s when the atmosphere of Southern California was nearly viscous with pollutants. The premise was that autos could not be sold into the California market unless they met strict emission requirements.

Of course, the common response was that even if such a product could be produced, it would be prohibitively expensive. The actual outcome, after billions in overwhelmingly private investment activity, was the catalytic converter and skies cleaner by far more than half.

The two salient features are the simplicity of the mandate -- two paragraphs describing the product as to its emission effects -- and the absence of government interference or micromanaging. A great error of the ethanol debacle, for example, was to describe the technology, not the desired result. Let the market do what it does best, innovate to the desired outcome

And here let us extend what is really a long digression. One of Frost's insights was the difference between R&D and innovation. Research and development is always successful, he says, because you always discover something you didn't know. It is essentially an intense study. Innovation is extremely difficult and often not successful. You begin with an idea of the desired result and the process of innovation is essentially a creation of a path from here to there.

It is difficult, expensive, and as said often not successful. The only reason to do it, Frost says, is because there is no other option. That is the situation we have with global climate change. There is no option other than solving the energy and transportation carbon problem.

End of digression.

The point we began with was that by mandating an emission level in order for automobiles to be sold into the California market, that state generated tens of billions of dollars in private investment and economic activity. The same sort of opportunity could generate multiples of that number without a dime of public spending.

For example, if the national government mandated zero emission vehicles within ten years, and the mandate were credible, we would be looking at a complete turnover of the automobile fleet in addition to the investment in technology up front. New plants, facilities, et cetera. This is economic activity. This is stimulus that produces jobs.

Would it be economically efficient? Unless you believe that the destruction of the planet's climate is economically efficient, the answer has to be yes.

And it overcomes a basic dynamic of depression, the collapsing consumption function. We'll go into this more deeply in another podcast, but the basic idea is that people are hoarding and cutting back spending in the face of economic uncertainty. This restriction of spending is exacerbating the downturn. Also discouraging spending from the monetary side is the collapse of credit markets, including pullbacks in credit cards, and you have a downward vector greater by perhaps a factor of three than the sum of the upward vectors of the stimulus and the various ad hoc measures being cobbled together by the Fed and Treasury.

Of course, a ten-year turnover over of the auto fleet is not realistic. A workable plan would involve the mandate -- the carrot of being able to sell cars -- and penalties for gas guzzlers. But this is another point on which Frost and I agree. Taxes cap-and-trade schemes are not sufficient. They will lead simply to expensive use of the same technologies. The mandate, the necessity to innovate, is essential.

That said, you would generate a lot of investment and a substantial turnover of the fleet by higher carbon taxes. Simply higher oil taxes. The runup in oil prices between October 2007 and July 2008 brought to the fore a new generation of energy options and sold a lot of Toyota Priuses. The retreat in oil prices carried many of these survival options out with them.

In this case, you generate new economic activity by making the status quo too expensive.

So those are market-based stimulus techniques that are economically efficient.

These could be combined with publicly sponsored stimulus in the form of infrastructure spending to create real progress, both in the short-term economic situation and in long-term security and stability. Notice the publicly sponsored stimulus overcomes the problem of a declining consumption function by taxation. This is forced consumption of public goods. It is stimulative, but not necessarily a cut in taxes.