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

Saturday, October 31, 2009

319 Relay Stiglitz-Suruweicki


Listen to this episode

Doug Noland lays out the likely course of unwinding and reflation

The consensus view holds that the unprecedented – and ongoing – intervention is fundamental to crisis resolution and sustainable recovery.  Noland counters here that such massive market intrusions always create the backdrop for excesses and the next crisis.  The Fed is fighting the last war.  Instability still looms, as well as orthodox myopia.
Mortgage Madness:
by Doug Noland
Prudent Bear
October 24

October 22 – MarketNews International (Steven K. Beckner):  “Federal Reserve Vice Chairman Donald Kohn said Thursday that prices of mortgage-backed securities are likely to fall when the Fed eventually begins selling MBS from its portfolio.  He gave no indication when that might be. But Kohn, echoing earlier comments by New York Federal Reserve Bank President William Dudley, said the Fed may well avoid any losses on its asset holdings, as well as on its liquidity facilities.  ‘These programs may be unwound without loss,’ Kohn said, commenting from the audience at a Boston Federal Reserve Bank conference. He said the Fed entered the market ‘when prices were depressed by high premiums’ and so ‘the Fed could finance without risk.’ That in turn will mean they can be ‘unwound without loss.’”

Federal Reserve holdings of mortgage-backed securities (MBS) this week exceeded those of Treasuries for the first time ($777bn vs. $774bn).  The Fed is now well past half way through its program to purchase $1.25 TN of MBS – which is slated to be completed in March.  Federal Reserve Credit jumped to $2.172 TN, up from less than $900bn to begin September 2008.

Mr. Kohn is too optimistic.  My view is that the Fed is paying too dearly for these mortgage securities and large losses are inevitable.  And while Fed-induced price distortions are not having a big impact on U.S. housing, they exert enormous influence on finance and markets globally. I don’t expect the Federal Reserve’s MBS portfolio to be unwound anytime soon.  Instead, the Fed will live with this exposure for years to come – and will likely expand the scope of mortgage exposure in future crisis periods.  And I expect Washington’s conglomeration of mortgage risk will at some point make or break the dollar.

In the five years preceding the Lehman collapse, benchmark Fannie Mae MBS yields averaged 5.60%.  A very strong case can be made that Fannie, Freddie and the entire mortgage Bubble pushed mortgage borrowing costs artificially low.  Over the past year, as the Fed has been building its Trillion dollar MBS holding, benchmark yields averaged 4.30%.  Fed officials have been talking confidently of their success in unwinding various liquidity facilities that were implemented during the crisis.  Yet the most meaningful government intervention runs unabated throughout the mortgage marketplace.  Between the Fed, Fannie, Freddie, Ginnie Mae, and the FHA – it’s full speed ahead into the uncharted waters of mortgage market nationalization.  It is not easy to envisage a viable exit strategy.  Few contemplate the costs.

The consensus view holds that this unprecedented – and ongoing – intervention is fundamental to crisis resolution and sustainable recovery.  I counter that such massive market intrusions always create the backdrop for excesses and the next crisis.  Most believe inflation does not these days pose a risk and that loose monetary policies no longer foster financial leveraging and other dangerous excess.  Indeed, most see this as an atypical backdrop with little risk to fiscal and monetary looseness.  Many argue that sticking with unprecedented policy responses for an extended period is the appropriate course to combat deflation.  I contend that each government-induced reflationary period comes with its own set of inflationary biases, market responses, excesses, and risks.  But they’re not going to jump up and down and make themselves obvious.

Yet some aspects of policy risk are becoming more apparent.  This week, China reported 8.9% third quarter GDP growth.  The Chinese economy has bounced back convincingly, and Bubble dynamics have returned in full force.  Increasingly, there is a case for a surprisingly strong recovery throughout Asia and the emerging markets.  Crude oil this week traded to $82.  The Goldman Sachs Commodities index jumped 2.2%, increasing y-t-d gains to 48.8%.  Global reflation has attained a head of steam - and the Bernanke Fed is falling only further behind the curve.

Of course, the counter-argument is that U.S. unemployment is 9.7% and the recovery is fragile.  The Fed’s dual mandate – price stability and full employment – certainly provides good cover for sticking with ultra-loose monetary policy. Besides, few see meaningful risk inherent with Fed policymaking anyway.  Nonetheless, the bottom line remains that U.S. monetary policy and the weak dollar are the dominant forces powering inflationary forces globally.  

It is a fundamental tenet to my thesis that the unfolding reflation will be altogether different than previous reflations.  The old were primarily driven by Fed-induced expansions of U.S. mortgage finance and Wall Street Credit.  Our mortgage industry, housing and securitization markets, and Bubble economy were at the epicenter of global reflationary dynamics.  The new reflation is fueled by synchronized fiscal and monetary stimulus across the globe.  China, Asia and the emerging markets/economies have supplanted the U.S. at the epicenter.  U.S. housing is completely out of the mix.  

Those fixated on old reflationary dynamics look today at tepid U.S. housing markets, mortgage loan growth, consumer spending, and employment trends and see ongoing deflationary pressures.  The Fed is wedded to the old and is positioned poorly to respond to new reflationary dynamics.  A stable dollar used to work to restrain global finance – hence global inflationary forces.  The breakdown in the dollar’s stabilizing role has unleashed altered inflationary dynamics – forces that the Federal Reserve disregards.

Two open questions come to mind.  First, when will the new global reflationary dynamics meaningfully impact the U.S. inflation outlook?  Second, what impact will the prospect of foreign central bank tightenings have on U.S. market yields?

U.S. market yields are not priced for a global reflationary backdrop.  Notions of a “new normal” and a central bank content with an extended hiatus tug U.S. and global yields artificially down.  Fragile U.S. underpinnings have global markets convinced both that the Fed will err on the side of ultra-loose monetary policy and that dollar weakness will constrain global policy tightening.  The brunt of global reflationary forces may have shifted overseas, but the U.S. remains firmly at the epicenter of market distortions.

And nowhere do price distortions have more impact than in the mortgage arena.  While Washington and the media focus on Wall Street compensation and regulatory reform, an incredible amount of mortgage risk quietly shifts to the American taxpayer.  Beyond the Fed’s $1.25 TN of MBS, Fannie’s and Freddie’s “books of business” continue to expand, while the FHA and Ginnie Mae balloon their exposure to risky mortgages.  In the short-run, this process reduces systemic stress and boosts market liquidity.  The markets remain quite happy with this dynamic – for now.

The secular bear thesis and the next round of financial crisis don’t require a wild imagination:  The U.S. economy underperforms in the new global reflationary backdrop.  The Fed stays ultra-loose for too long – along with timid Chinese and other central bankers around the globe.  The U.S. fixed income marketplace – especially MBS – becomes too predisposed to artificially low Fed funds and market yields.  Historically low U.S. yields – in the face of booming Asia/emerging markets – continue to weigh on the dollar.  Dollar devaluation and global dynamics set the stage for an inflationary surprise.  And any jump in inflation fears would find U.S. bond and mortgage markets especially poorly positioned, with the U.S. economy extraordinarily vulnerable to any spike in yields.  A crisis in a rising rate environment would be especially problematic for a Fed and Treasury confronting Trillions in mortgage Credit and interest-rate risk.  Foreign holders of our mortgage paper could lose big if market prices and the dollar move against them simultaneously.  And it’s safe to say that the Federal Reserve wouldn’t be profitably unwinding its MBS portfolio.

Friday, October 30, 2009

Atlanta Fed sees some record lows in the labor markets

The unemployment rate as officially measured will soon be getting some reduction from the fact that those whose unemployment runs out will be classed as discouraged workers and not included in the denominator. The Atlanta Fed has been coming up with some data that describe the labor markets (and hence the prospective consumer demand). Here is an especially cogent piece.
A look at another job market number
As we've written in this blog recently, U.S. labor markets are weak at present and are likely to remain that way for some time. Last week's U.S. Bureau of Labor Statistics' August JOLTS (Job Opening and Labor Turnover Survey) report provided further evidence of labor market weakness (see here and here), with both the vacancy and quit rates at record lows (the JOLTS survey has comparable data back to December 2000).
At the end of August there were estimated to be fewer than 2.4 million job openings, equal to only 1.8 percent of the total filled and unfilled positions—a new record low. This is an especially significant issue given the large number of people who are looking for work. The ratio of the number of unemployed to the number of job openings was greater than 6 in August. In contrast, that ratio was under 1.5 in 2007 and previously peaked at 2.8 in mid-2003, suggesting that finding a job right now is extremely difficult (see the chart).

The quit rate moved back down to its record low of 1.3 percent, as relatively few people want to leave a job voluntarily in the face of such a weak labor market. At the same time, the rate of involuntary separations moved up from 1.6 percent to 1.8 percent, not far below the peak of 1.9 percent in April.

The low probability of finding a job has also caused the average amount of time spent unemployed to rise substantially. The average duration of unemployment is up from around 20 weeks in 2004 (the previous peak) to 26 weeks now, with those unemployed more than 26 weeks now accounting for 36 percent of all unemployed versus 22 percent in 2004. Congress is considering an extension of unemployment insurance benefits (currently due to expire December 31) as the mismatch between job openings and the number of people looking for jobs grows.

By John Robertson, a vice president in the Atlanta Fed's research department

Thursday, October 29, 2009

Lucian Bebchuk believes Bondholders need to take a hit BEFORE taxpayers

Bondholders in financial firms get special terms that reflect their risks.  Risk means something is not certain.  If government moves in and makes bondholders whole, Why are they getting special terms?  Indeed, as Lucian Bebchuk points out, making them whole removes another leg of market discipline.
Should Bondholders be Bailed Out?
Lucian Bebchuk
Project Syndicate
October 19, 2009

CAMBRIDGE – A year after the United States government allowed the investment bank Lehman Brothers to fail but then bailed out AIG, and after governments around the world bailed out many other banks, key question remains: when and how should authorities rescue financial institutions?

It is now widely expected that, when a financial institution is deemed “too big to fail,” governments will intervene if it gets into trouble. But how far should such interventions go? In contrast to the recent rash of bailouts, future government bailouts should protect only some creditors of a bailed-out institution. In particular, the government’s safety net should never be extended to include the bondholders of such institutions.

In the past, government bailouts have typically protected all contributors of capital of a rescued bank other than shareholders. Shareholders were often required to suffer losses or were even wiped out, but bondholders were generally saved by the government’s infusion of cash.

For example, bondholders were fully covered in the bailouts of AIG, Bank of America, Citigroup, and Fannie Mae, while these firms’ shareholders had to bear large losses. The same was true in government bailouts in the United Kingdom, Continental Europe, and elsewhere. Bondholders were saved because governments generally chose to infuse cash in exchange for common or preferred shares – which are subordinate to bondholders’ claims – or to improve balance sheets by buying or guaranteeing the value of assets.

A government may wish to bail out a financial institution and provide protection to its creditors for two reasons. First, with respect to depositors or other creditors that are free to withdraw their capital on short notice, a protective government umbrella might be necessary to prevent inefficient “runs” on the institution’s assets that could trigger similar runs at other institutions.

Second, most small creditors are “non-adjusting,” in the sense that they are unable to monitor and study the financial institution’s situation when agreeing to do business with it. To enable small creditors to use the financial system, it might be efficient for the government to guarantee (explicitly or implicitly) their claims.

But, while these considerations provide a basis for providing full protection to depositors and other depositor-like creditors when a financial institution is bailed out, they do not justify extending such protection to bondholders.

Unlike depositors, bondholders generally are not free to withdraw their capital on short notice. They are paid at a contractually specified time, which may be years away. Thus, if a financial firm appears to have difficulties, its bondholders cannot stage a run on its assets and how these bondholders fare cannot be expected to trigger runs by bondholders in other companies.

Moreover, when providing their capital to a financial firm, bondholders can generally be expected to obtain contractual terms that reflect the risks they face. Indeed, the need to compensate bondholders for risks could provide market discipline: when financial firms operate in ways that can be expected to produce increased risks down the road, they should expect to “pay” with, say, higher interest rates or tighter conditions.

But this source of market discipline would cease to work if the government’s protective umbrella were perceived to extend to bondholders. If bondholders knew that the government would protect them, they would not insist on getting stricter contractual terms when they face greater risks. The problem of “moral hazard” – which posits that actors will take excessive risks if they do not expect to bear fully the consequences of their actions – is commonly cited as a reason not to protect shareholders of bailed-out firms. But it also counsels against protecting firms’ bondholders.

Thus, when a large financial firm runs into problems that require a government bailout, the government should be prepared to provide a safety net to depositors and depositor-like creditors, but not to bondholders. In particular, if the firm’s equity capital erodes, the government should not provide funds (directly or indirectly) to increase the cushion available to bondholders. Rather, bonds should be at least partly converted into equity capital, and any infusion of new capital by the government should be in exchange for securities that are senior to those of existing bondholders.

Governments should not only avoid protecting bondholders after the fact, when the details of a bailout are worked out; but should also make their commitment to this approach clear in advance. Some of the benefits of a government policy that induces bondholders to insist on stricter terms when financial firms take larger risks would not be fully realized if bondholders believed that the government might protect their interests in the event of a bailout.

In other words, governments should establish bailout policies before the need to intervene arises, rather than make ad hoc decisions when financial firms get into trouble. The best policy should categorically exclude bondholders from the set of potential beneficiaries of government bailouts. This would not only eliminate some of the unnecessary costs of government bailouts, but would also reduce their incidence.

Wednesday, October 28, 2009

Robert Reich adds his voice to "Break up the big banks"

The Obama economic brain trust has come through on consumer protection for financial products, but they have bungled the opportunity of a good crisis when it comes to the big banks.  A return to Glass-Steagall is a return to stability.  A financial sector topheavy with too big to fail firms is not a stable system. Still, the receivership process Reich pans here could well be a route to breaking up the zombies.  It is not the same as the systemic risk merry-go-round first proposed by Geithner (as I understand it).  It is likely a super-bankruptcy mechanism designed to do exactly what Reich wants done -- break up the big banks.
Too Big to Fail: Why The Big Banks Should Be Broken Up, But Why The White House and Congress Don't Want To
by Robert Reich
October 25, 2009

And now there are five -- five Wall Street behemoths, bigger than they were before the Great Meltdown, paying fatter salaries and bonuses to retain their so-called"talent," and raking in huge profits. The biggest difference between now and last October is these biggies didn't know then that they were too big to fail and the government would bail them out if they got into trouble. Now they do. And like a giant, gawking adolescent who's just discovered he can crash the Lexus convertible his rich dad gave him and the next morning have a new one waiting in his driveway courtesy of a dad who can't say no, the biggies will drive even faster now, taking even bigger risks.

What to do? Two ideas are floating around Washington, but only one is supported by the Treasury and the White House. Unfortunately, it's the wrong one.

The right idea is to break up the giant banks. I don't often agree with Alan Greenspan but he was right when he said last week that "[i]f they're too big to fail, they're too big." Greenspan noted that the government broke up Standard Oil in 1911, and what happened? "The individual parts became more valuable than the whole. Maybe that's what we need to do." (Historic footnote: Had Greenspan not supported in 1999 Congress's repeal of the Glass Steagall Act, which separated investment from commercial banking, we wouldn't be in the soup we're in to begin with.)

Former Fed Chair Paul Volcker, whose only problem is he's much too tall, last week told the New York Times he'd like to see the restoration of the Glass-Steagall Act provisions that would separate the financial giants' deposit-taking activities from their investment and trading businesses. If this separation went into effect, JPMorgan Chase would have to give up the trading operations acquired from Bear Stearns. Bank of America and Merrill Lynch would go back to being separate companies. And Goldman Sachs could no longer be a bank holding company.

But the Obama Administration doesn't agree with either Greenspan or Volcker. While it says it doesn't want another bank bailout, its solution to the "too big to fail" problem doesn't go nearly far enough. In fact, it doesn't really go anywhere. The Administration would wait until a giant bank was in danger of failing and then put it into a process akin to bankruptcy. The bank's assets would be sold off to pay its creditors, and its shareholders would likely walk off with nothing. The Treasury would determine when such a "resolution" process was needed, and appoint a receiver, such as the FDIC, to wind down the bank's operations.

There should be an orderly process for putting big failing banks out of business. But this isn't nearly enough. By the time a truly big bank gets into trouble -- one that poses a "systemic risk" to the entire economy -- it's too late. Other banks, competing like mad for the same talent and profits, will already have adopted many of the excessively-risky banks techniques. And the pending failure will already have rocked the entire financial sector.

Worse yet, the Administration's plan gives the big failing bank an escape hatch: The receiver might decide that the bank doesn't need to go out of business after all -- that all it needs is some government money to tide it over until the crisis passes. So the Treasury would also have the authority to provide the bank with financial assistance in the form of loans or guarantees. In other words, back to bailout. (Historical footnote: Summers and Geithner, along with Bob Rubin, while at Treasury in 1999, joined Greenspan in urging Congress to repeal Glass-Steagall. The four of them -- Greenspan, Summers, Rubin and Geithner also refused to regulate derivatives, and pushed Congress to stop the Commodity Futures Trading Corporation from doing so.)

Congress is cooking up a variation on the "resolution" idea that would give the Federal Deposit Insurance Corporation authority to trigger and handle the winding-down of big banks in trouble, without Treasury involvement, and without an escape hatch.

Needless to say, Wall Street favors the Administration's approach -- which is why the Administration chose it to begin with. If I were less charitable I'd say Geithner and Summers continue to bend over bankwards to make Wall Street happy, and in doing so continue to risk the credibility of the President, as well as the long-term financial stability of the system.

Wall Street could live with the slightly less delectable variation that Congress is coming up with. But Congress won't go as far as to unleash the antitrust laws on the big banks or resurrect the Glass-Steagall Act. After all, the Street is a major benefactor of Congress and the Street's lobbyists and lackeys are all over Capitol Hill.

The Street obviously detests the notion that its behemoths should be broken up. That's why the idea isn't even on the table. But it should be. No important public interest is served by allowing giant banks to grow too big to fail. Winding them down after they get into trouble is no answer. By then the damage will already have been done.

Whether it's using the antitrust laws or enacting a new Glass-Steagall Act, the Wall Street giants should be split up -- and soon.

Tuesday, October 27, 2009

Edward Harrison reviews Bill Gross - Both find inflated asset prices

Bubbles in assets have produced a tremendous problem.  The answer according to too many, including Bill Gross, is to keep money cheap and thereby keep asset values artificially high.  This makes sense on one level, but it cannot last, as people on that level seem to think.  Here is Credit Writedowns' Edward Harrison reviewing Gross piece.
Bill Gross: “almost all assets appear to be overvalued on a long-term basis”

I’ll jump straight into a discussion of why in a New Normal economy (1) almost all assets appear to be overvalued on a long-term basis, and, therefore, (2) policymakers need to maintain artificially low interest rates and supportive easing measures in order to keep economies on the “right side of the grass.”
Let me start out by summarizing a long-standing PIMCO thesis: The U.S. and most other G-7 economies have been significantly and artificially influenced by asset price appreciation for decades. Stock and home prices went up – then consumers liquefied and spent the capital gains either by borrowing against them or selling outright. Growth, in other words, was influenced on the upside by leverage, securitization, and the belief that wealth creation was a function of asset appreciation as opposed to the production of goods and services.
American and other similarly addicted global citizens long ago learned to focus on markets as opposed to the economic foundation behind them. How many TV shots have you seen of people on the Times Square Jumbotron applauding the announcement of the latest GDP growth numbers or job creation? None, of course, but we see daily opening and closing market crescendos of jubilant capitalists on the NYSE and NASDAQ cheering the movement of markets – either up or down. My point: Asset prices are embedded not only in our psyche, but the actual growth rate of our economy. If they don’t go up – economies don’t do well, and when they go down, the economy can be horrid.
This, my friends, is the dreaded asset-based economy. It is the same financial model which has led us to mountains of debt and repeated bubbles and extreme financial instability.  I have said in the past that aggregate debt levels as measured by ratios like debt to nominal GDP should remain constant to the degree that the capital used to generate that growth is efficiently allocated. However, we have seen a ballooning in debt, which suggests that we need far more capital to generate a unit of growth than we did a generation ago.  Gross makes similar arguments, focusing instead on assets instead of debt (liabilities).
First of all, assets didn’t always appreciate faster than GDP. For the first several decades of this history, economic growth, not paper wealth, was king. We were getting richer by making things, not paper. Beginning in the 1980s, however, the cult of the markets, which included the development of financial derivatives and the increasing use of leverage, began to dominate. A long history marred only by negative givebacks during recessions in the early 1990s, 2001–2002, and 2008–2009, produced a persistent increase in asset prices vs. nominal GDP that led to an average overall 50-year appreciation advantage of 1.3% annually. That’s another way of saying you would have been far better off investing in paper than factories or machinery or the requisite components of an educated workforce. We, in effect, were hollowing out our productive future at the expense of worthless paper such as subprimes, dotcoms, or in part, blue chip stocks and investment grade/government bonds.
Again, these themes echo something i recently posted on, namely the hollowing out of America’s middle class from downsizing and outsourcing. See my post “A conversation with Stephen Roach on Charlie Rose “ in which the juxtaposition between a Stephen Roach interview circa 1996 and one from this past week makes plain the long-term problem.
Gross comes to a very different conclusion to all of this than I come to.  He says, faced with a potential collapse in nominal GDP growth, the answer is to feed the patient more of the asset price elixir to wean him off his drugs. Cold turkey would lead to depression (i.e. death – that makes the tie to his lead in plain).
This is where it gets tricky, however, because policymakers, (The Fed, the Treasury, the FDIC) recognize the predicament, maybe not with the same model or in the same magnitude, but they recognize that asset prices must be supported in order to generate positive future nominal GDP growth somewhere close to historical norms. The virus has infected far too many parts of the economy’s body, for far too long, to go cold turkey. The Japanese example over the past 15 years is an excellent historical reference point. Their quantitative easing and near-0% short-term interest rates eventually arrested equity and property market deflation but at much greater percentage losses, which produced an economy barely above the grass as opposed to buried six feet under. The current objective of global policymakers is to do likewise – keep the capitalistic patient alive through asset price support, but at an “old normal” pace if possible, six feet or 6% in U.S. nominal GDP terms above the grass.
My conclusion is different. I have said before that I also think cold turkey would lead to disaster (see my post “Confessions of an Austrian economist), but I am under no illusion that we need to keep supporting the asset-based economy indefinitely.  Our goal should be to use government stimulus as cover to eliminate malinvestments and downsize bloated sectors of the economy like financial services. This is one reason I am in favor of introducing a comprehensive too-big-to-fail (TBTF) resolution process to allow big banks to fail and breaking up TBTF financial institutions.
Going back to Gross, he concludes that his policy preference for maintaining is supportive of asset prices in the medium-term but not so supportive that we are going back to the gold rush of yesteryear.
If policy rates are artificially low then bond investors should recognize that artificial buyers of notes and bonds (quantitative easing programs and Chinese currency fixing) have compressed almost all interest rates. But while this may support asset prices – including Treasury paper across the front end and belly of the curve, at the same time it provides little reward in terms of future income. Investors, of course, notice this inevitable conclusion by referencing Treasury Bills at .15%, two-year Notes at less than 1%, and 10-year maturities at a paltry 3.40%. Absent deflationary momentum, this is all a Treasury investor can expect. What you see in the bond market is often what you get. Broadening the concept to the U.S. bond market as a whole (mortgages + investment grade corporates), the total bond market yields only 3.5%. To get more than that, high yield, distressed mortgages, and stocks beckon the investor increasingly beguiled by hopes of a V-shaped recovery and “old normal” market standards. Not likely, and the risks outweigh the rewards at this point.
While I disagree with Gross, his is a very good piece if you want to know which way the wind is blowing. I have linked to it below.
Midnight Candles – Bill Gross, Pimco

Monday, October 26, 2009

Transcript: Demand Side 318 - Forecast:: Is there a soft landing for the dollar?

In a moment we'll get to a new element of the forecast, the fate of the dollar.

Before that, let's hit some points on this economy.

Courtesy of Gerald Minack of Morgan Stanley we hear that Debt to GDP is at an all-time high and effective tax rates are at an all-time low.  This is not the nominal rates, but the effective rates.

David Rosenberg says buy bonds or seek dividends, because this isn’t a normal recovery. 

Rosenberg, the chief economist and strategist for Toronto- based Gluskin Sheff + Associates Inc., was among the first to warn of impending recession in 2006.
“Right now the economy is being held together by very strong tape and glue provided by the Fed, Treasury and Congress,” he says. Rosenberg sees gross domestic product stalling in the current quarter, growing at an annual rate of no more than 1 percent in the first three months of 2010 and no more than 2 percent for all of 2010.

Glenn Rudebusch of the SF Fed:
Gap He also notes the poor outlook for jobs:
Although growth has returned, the economy will remain in a deep hole with high unemployment and underutilized productive resources for some time. So, even though the recession is over, production, income, sales, and employment will persist at subpar levels. A large amount of unemployed or underutilized labor and capital remains in the economy, and it will take a sustained period of growth for the economy to return to its normal or potential level.
In the week ending Oct. 17, the advance figure for seasonally adjusted initial claims was 531,000, an increase of 11,000 from the previous week's revised figure of 520,000. The 4-week moving average was 532,250, a decrease of 750 from the previous week's revised average of 533,000.

And here,
Geoffrey Garin, President, Hart Reasearch Associates, pollsters,

is talking about his polling research on estimations of the economy by real people.  We should listen to real people.  They have proven more accurate than economic forecasters.

That was Jeff Garin.
speaking at the same recent EPI that produced our special presentation of Rosa DeLauro on Saturday.  This coming Saturday we will relay the New Yorker interview of Joseph Stiglitz by James Suruweiki. 


Joseph Stiglitz is featured in on our new website Demand Side Minds at demandsideminds.blogspot.com, along with John Maynard Keynes, Leon Keyserling, John Kenneth Galbraith, Hyman Minsky, James K. Galbraith and George Soros.  The website is primarily to organize our own work, but there is room for expansion and comment.



Against a backdrop where some are saying the dollar must collapse because of all the money the Fed is printing, others are saying dollars will be in high demand to pay debts, others are saying, "Don't worry, dollars will be destroyed when debts are written off as unpayable," Demand Side predicts ... drumroll, please ...  

Dollar Demise

The stress in the world's economy has not abated, only the points of weakness have been shored up.  More correctly, the ship has hit the rocks but has been refloated by a wave of liquidity sent in by the Fed.  This has apparently avoided Armageddon, but in fact has only postponed it.  The next leg down will be the decline of the dollar.

No need for reserve currency that doesn't hold its value.

Investors are again moving into commodities as stores of value.  This puts downward pressure on the dollar and could easily lead to a self-reinforcing downward trend.

Instead of repairing the ship, discarding the broken parts, and resetting the course, the financial sector's excesses have been covered over with another layer of greenbacks.  No change in course.  Repeat, No change in course.  What SHOULD we expect?  Two things.  One:  Another severe shock.  Two: A misunderstanding of the shock, its causes and its remedies. 

In fact (make a note), nobody has said, "I told you so," at this point.  That will come when the duct tape comes off the hull and the water starts rushing in again.  Most of the "I told you so's will be "We should have used more duct tape."

What they have told us is that Armageddon has been avoided and it may be a long, hard slog for you working taxpayers, but we will finally get to the point we were at the start of the millenium.  What they have said is that there will be good growth with bad employment.  To me, that is a sick cow with a pretty bow, a bad job set to music.  Growth is not the measure of economic health.  Employment and incomes are the measure.  Growth may be a harbinger of a return to health, or it may be noise.  "Recovery is just around the corner," is a Hooverism, nothing more.

Are profits being seen in the financial sector examples of health in the financial sector?


But I am getting off point.

The Fed has made valuable things that are not valuable.  It has ratified and validated the basic mistakes of the financial sector.  It has eliminated market discipline in a very one-sided way -- benefiting the banks by shifting the burden to the worker and the taxpayer and stifling the real economy.  It has done this because it can print dollars, distribute money to those it favors with or without collateral, and do so without any restriction from representative government.

The Fed has made valuable things that are not valuable, hence the measure of value must fall.  This is in the interests of nobody, except short dollar traders, so it will likely not be overnight, but neither will it take five years.  And considering the Market's tendency to reflexive behavior, it could well overshoot.

Had a controlled unwinding of the bad investments been undertaken, rather than a ratification of them, debt and its immense burden would have been reduced by writing it off.  Now it is carried forward to be paid from the output of a severely undertooled real economy.  This means the inevitable bankruptcies and writedowns in a much more disorganized way.

Will this lead to inflation?

Not the too much money chasing too few goods inflation, No.  People do not have too much money.  There is no boom in aggregate demand on the horizon.  Inflation could well occur from price increases of commodities and imported goods.  Food, Energy.  If so, expect the Fed to contribute to further economic ruin by starving the real economy further.  The Fed is poised, or in internal conflict about, when to raise rates to combat inflation.  As we've noted ad nauseum, slamming on the brakes when the car is in park will not help.  There is no, zero, prospect of demand-pull inflation.  Only cost-push.  Yet the Fed, astute astronomers of Ptolemy, are all in a tither about such a decision.  Sigh.

The second major outcome I mentioned is confusion among economists, politicians and the public.  Ron Paul will rant that the dollar was trashed because it is a fiat currency.   This is like saying the ship broke because it was made of steel.  True, a boat made of wood would never have carried so many so hard into the rocks.  But it was not the fault of the steel.

Others will say it was government deficits.  But the real economy depends on the government spending, social insurance and the public goods like education, health care, transportation, courts and police, and so on.  Even the financial sector depends on the cash flow from these deficits.  There is certainly room to lower deficits with taxes focused on financial transactions, fossil fuels, and the higher incomes.  Revenue would likely come right off the top of financial sector profits.  Certainly such taxes would be in the direction of economic efficiency.  But government bashing is an occupation like circuses meant to keep the populace amused.  Fortunately in a society that allows information to flow, those so distracted are dwindling in number.  Whether they have become a minority, I don't know.

And Wall Street, of course, will not blame itself.  There will be some ineptness elsewhere they will conjure up.  Providing no value for its trillions in bailouts and cheap chips does not seem pertinent.  Its most pressing duty is to keep itself up as a going concern and its executives well paid.  For the benefit of all, of course.  Currently they are consumed with new bubbles.  Fed alert:  here is Jim Bianco of Bianco Research on Bloomberg Surveillance last week.


But the idea that a rescued financial sector would lead a robust recovery is now, sadly, a distant refrain sung off-key.  A favorite still of Fed Chair Ben Bernanke.  But no robust recovery is in the offing in anybody's estimation.  So Wall Street will find others to blame.  In the process of dollar decline, some of its own may fold, and then it will be the government's failure to rescue that will be the proximate cause of subsequent problems, not the systemic rot.

The most accurate lens to see this through is the idea that the requisite change in course was not made, the requisite repair and reconstruction was put off in favor of a superficial, if costly, papering over, and that the dollar collapse is simply this tape job breaking through.

There are those who point out that there is no substitute for the dollar as a reserve currency.  But what use is a reserve currency if it is falling in value?  It is a reserve currency because it holds its value.  It may be another cue for the Fed to put the screws on the real economy, to bid up the price of the dollar.  This would add to inflation, but subtract from economic health.

Monetary policy has been tried repeatedly and enthusiastically over many years to very little effect but great acclamation.

Bruce Judson suggests we try what works, Glass-Steagall

Market discipline in the financial sector was a fact prior to the dismantling of the New Deal's Glass-Steagall Act.  Can we really afford to take a flier on new rules and give them to the same old captive regulators?  This is a major misstep by the Obama administration.  It needs to be reconsidered.
Glass-Steagall 2.0: The American People Deserve An Explanation
by Bruce Judson
New Deal 2.0
Oct 4, 2009

As a candidate, President Obama decried the removal of Glass-Steagall without an adequate regulatory replacement. In March 2008, speaking at Cooper Union in New York City, he said:

“..we have deregulated the financial sector and we face another crisis. A regulatory structure set up for banks in the 1930s needed to change, because the nature of business had changed. But by the time the Glass-Steagall Act was repealed in 1999, the $300 million lobbying effort that drove deregulation was more about facilitating mergers than creating an efficient regulatory framework.”

Now, Secretary Geithner has proposed a revised regulatory structure, that relies on a super-regulator to oversee entities that are “too big to fail.” Last week, in testimony before the House Financial services Committee Paul Volcker, the former Chairman of the Federal Reserve, expressed skepticism about the concept of adequately regulating banks that were “too big to fail” and suggested a system that separated high risk activities from commercial banking. He effectively advocated an updated version of the Glass-Steagall Act, although Volcker avoided using this term. As discussed below, I agree.

The decisions we make in our current effort have the potential to influence the nation’s prosperity for at least a generation. The principal job of the financial system is to allocate capital appropriately. When it does its job well, the economy has the greatest chance of thriving. When it performs poorly, productive activities are unable to acquire the capital they need. Today, we are experiencing the results of an extreme failure on the part of the financial system to direct capital appropriately.

With so much at stake, the American people deserve a full explanation for why one vision of the financial system is superior to another. As a consequence, this post is linked to a petition asking the Financial Crisis Inquiry Commission and the Treasury Secretary to explain in detail their reasons for recommending, or not, a system that relies on a highly concentrated, limited number of interlinked financial entities who are clearly “too big to fail,” and who mix activities that are vital to the health of the nation with high risk activities that are frequently described as a casino.

To date, I have been shocked to discover that I cannot discover any coherent statement by the Executive Branch which explains the rationale for its current proposal as opposed to the type of system advocated by Paul Volcker and others.

This petition does not advocate a specific position. Rather, it is a request that the Financial Crisis Inquiry Commission fully meet its mandate to inquire, and that the Executive Branch fully explain its reasoning.

In our democracy, this request for a full explanation should be unnecessary. However, I am promoting this extra level of public engagement to ensure our process of full public debate works.

Before reading the rest of this post, click here to sign the petition.

My conclusions, as described below, may change once I see the detailed explanations requested in this petition. However, at this moment, here is why I believe we will be a far healthier society with smaller, less-integrated financial institutions.

I subscribe to the view that we need an updated version of the Glass-Steagall Act that ultimately restricts the activities of financial institutions into one of four types of entities: commercial banks, insurers, investment banks (including underwriting, brokerage activities, and securities related advice), and speculative trading. In this updated vision of a Glass-Steagall 2.0, investment banks would not be permitted to issue securities and operate hedge-fund like trading operations.

The definition of freedom, going all the way back to Athens, is the ability to do whatever you want provided you don’t hurt anyone else. Since the financial system has now caused misery for millions of people and received special subsidies from the federal government, the notion that financial institutions have an inherent right to operate in any and all lines of business is simply wrong. The central question must be what’s best for the nation.

There are five principal questions that should guide the development of financial system reform.

* First, how do we restore trust and confidence in both our financial institutions and in the self-correcting nature of our democracy?

Right now, millions of Americans are suffering economically. Millions of additional people will suffer before this Great Recession ends. This is a cruel reality. Americans who thought they would have comfortable lives are waking up to diminished circumstances. They are also increasingly concluding (right or wrong) that rather than increase the total income of our society the financial sector engineered a huge transfer of income from the middle to the top. People are increasingly angry, cynical and mistrustful.

All of this means that whatever financial reform is undertaken, the government must demonstrate that our nation is not, as MIT economist Simon Johnson asserts, run by financial oligarchs.

The public perceived the financial bail-outs as favoring Wall Street, at the expense of Main Street. In addition, millions of suffering people feel like they are suffering, while those at the top — who caused the crisis — are not sharing the pain. We are at a moment when cynicism, mistrust and anger could grow to even higher levels in our society. As I wrote in It Could Happen Here, such a reaction moves us down the dangerous path to political instability.

The parallel to the era of the New Deal is real. By breaking up the financial conglomerates, the Glass-Steagall Banking Act of 1933 demonstrated that America was run for the benefit of the general population, and not an elite group. The same symbolism would hold true today. A Glass-Steagall 2.0 would send a strong, and much-needed, message to the American people that we remain a vibrant, self-correcting democracy.

* Second, what does experience tell us about regulatory policy?

The creation of a super-regulator, charged with monitoring entities deemed “too big to fail,” will necessarily lead to an enormous regulatory structure. Imagine both the complexity and lack of certainty that will be involved in such a regulatory effort.

In his testimony before the House Committee, Volcker similarly expressed concerns on this issue:

…However, the clear implication of such designation, whether officially acknowledged or not, will be that such institutions, in whole or in part, will be sheltered by access to a Federal safety net in time of crisis; they will be broadly understood to be “too big to fail.”

Think of the practical difficulties of such designation. Can we really anticipate which institutions will be systemically significant amid the uncertainties in future crises and the complex inter-relationships of markets? Was Long Term Capital Management, a hedge fund, systemically significant in 1998? Was Bear Stearns, but not Lehman? How about General Electric’s huge financial affiliate, or the large affiliates of other substantial commercial firms? What about foreign institutions operating in the United States?

Regulated markets function best when we are able to establish a few Bright Lines, with clear rules that are known by all the players and, to the maximum extent possible, limited uncertainty. One of the virtues of breaking up firms by function is it establishes bright lines, and as a nation we know how to run the resulting competitive markets effectively.

In Freedom from Fear, the Pulitzer Prize winning New Deal historian David Kennedy, describes these bright lines as one of the virtues of the original Glass-Steagall Act. He also notes that the Roosevelt Administration faced very questions about regulating large financial institutions that are remarkably similar to what we face today:

…the New Deal confronted a choice… it could accede to the long-standing requests of the major money-center banks-especially those headquartered around Wall Street-to relax restrictions on branch and interstate banking, allow mergers and consolidation, and thereby facilitate the emergence of a highly concentrated private banking industry, with just a few dozen powerful institutions to carry on the nation’s banking business…But the New deal did neither…[it separated commercial and investment banks and established what would be the FDIC]

…These two simple measures did not impose an oppressively elaborate new regulatory apparatus on American banking, nor did they levy appreciable costs on either taxpayers or member banks. But they did inject unprecedented stability into the American banking system.”

With “These two simple measures” FDR and his Administration made the hard choice that ensured a stable system for over half a century. Rather than accept the status quo, they created a new system that operated effectively, and with far less regulatory oversight than would otherwise have been required. Our contemporary government must now act with a similar resolve.

* Third, what solution will minimize risk while ensuring that our financial system fulfills its responsibility to appropriately allocate capital?

This question has two parts. First, the absolute failure of the existing financial system suggests there is no reason to believe larger institutions allocate capital more efficiently than smaller, focused entities. In fact, recent events suggest that larger horizontally integrated institutions may do the reverse. It’s possible that financial entities in multiple lines of business are systematically allocating capital away from the patient investments that most benefit our society and channeling capital into short-term high-risk activities involving trading and speculation.

So, the answer to this question revolves around what types of entities create the greatest risk for the society, sine greater size does not seem to lead to more efficient allocation of capital. The answer is straightforward. As many observers have repeatedly noted, institutions that are too big to fail pose a clear risk to the financial system.

In fact, Neal Barofsky, the Tarp Inspector, recently expressed sentiments that our level of risk has increased during the past year. Since the start of the financial crisis, the size of the remaining banks has increased, making the system more concentrated and more dependent on the few remaining players. As a consequence, Barofosky believes the financial system “may now be a far more dangerous place“.

Second, the potential problems associated with large financial institutions is not simply their size, but the extent to which they inevitably become interconnected.

Third, if there is one thing we learned in this crisis it’s that regulators must be willing to regulate. The Federal Reserve, which the Geithner plan proposes as the super-regulator, failed utterly in preventing the sub-prime mortgage debacle. Do we really believe that any entity will be able to effectively regulate, or even understand, the risks associated with the activities of our existing financial conglomerates? In contrast, smaller focused institutions will pose less risk to the system if one fails and be easier for regulators to understand.

Fourth, the bright lines provided by clear legislation create market guidelines that are far less likely to be arbitrarily weakened with changes in the philosophy of the Executive Branch.

Finally, a system composed of smaller focused financial institutions will be more resilient as different types of institutions will be following different business models. Today, our limited number of financial institutions seem to gravitate to toward the newest, profitable financial innovation. If the innovation goes south-such as securitized mortgages-all of the institutions, and the entire system are endangered. Smaller, focused entities must necessarily pursue a plethora of business models, which provides some immunity from this type of contagion.

* Fourth, what impact will the policy have on competition and accountability?

As many others have said, institutions that are too big to fail are ultimately not accountable. Period.

It is this lack of accountability which has severely undermined the faith of the American people. In the absence of the possibility of the downside, discipline disappears, high risk is the obvious course of action, and the rest of the society wonders why entities that never pay the price for failure warrant high compensation if they succeed. In a capitalist economy, risk and reward are meant to be intimately linked.

There is another important factor at work here as well. The original Glass-Steagal Act effectively served as an antitrust constraint in the financial sector as well. Since the beginning of the crisis, concentration in the financial services industry has risen. By correctly shaping a Glass-Steagall 2.0, we can restore higher competition to this arena.

* Fifth, should the plan give special deference to the status quo?

The answer must be no. First, shareholders remain whole. They receive stock in each of the individual entities created from a larger whole. Second, none of the benefits associated with financial supermarkets that were articulated at the time the original Glass Steagall act was repealed actually materialized.

In his April 2009, Joseph Stiglitz testified before the Joint Economic Committee of Congress and eloquently addressed this question:

“The only justification for allowing these huge institutions to continue is that there are significant economies of scope or scale that otherwise would be lost. I have seen no evidence to that effect. Indeed, as I have suggested, these big banks are not responsible for whatever dynamism there is in the American economy. The touted synergies of bringing together various parts of the financial industry have been a phantasm; more apparent are the conflicts of interest-evidenced so clearly in the Worldcom and Enron scandals earlier this decade. In short, we have little to lose, and much to gain, by breaking up these behemoths, which are not just too big to fail but also too big to save and too big to manage.”

This discussion is not a statement that,as some have asserted, repealing the original Glass-Steagall Act was the cause of the current financial crisis. Rather, a Glass-Steagall 2.0 would address new realities, and would benefit from what we have learned in this crisis. It is, however, a statement that the fundamental approach of simplicity embodied in the original Glass-Steagall Act is how we should now orient our policies.

Whether or not you agree with this proposal, please sign this petition. The essence of a democracy is a full, often messy, generally contentuous debate. What’s most important now is that this happen, and that everyone be as informed as possible.

Roosevelt Institute Braintruster Bruce Judson is a Senior Faculty Fellow at the Yale School of Management, and the author of the forthcoming book, It Could Happen Here, which will be released by HarperCollins on October 6.

*This post appeared originally on Judson’s blog, itcouldhappenhere.com.

Sunday, October 25, 2009

Congressmen want Bernanke's confirmation tabled

In a letter from Ron Paul and Alan Grayson, admittedly not Demand Side's favorite Congressmen, they offer something Demand Side very much favors -- a demand to postpone Ben Bernanke's confirmation until the scope of his activities can be brought into the light.
Congress of the United States
Washington, DC 20515

Chairman Chris Dodd
U.S. Senate Committee on Banking, Housing, and Urban Affairs
534 Dirksen Senate Office Building
Washington, DC 20551

Dear Chairman Dodd and members of the Banking Committee,

We are writing to ask you to postpone the confirmation of Ben Bernanke until the Federal Reserve releases documentation that will allow the public and the Senate to have a full understanding of the commitments that the Federal Reserve has made on our behalf. Without such an understanding, it is impossible to know whether Chairman Bernanke is fit to serve another term and fulfill the Federal Reserve’s dual mandate to ensure price stability and full employment. A list of said documentation is enumerated below.

Since 2007, the Federal Reserve has expanded its balance sheet by $1.2 trillion and taken on substantial credit, interest-rate, and foreign exchange risk. It has lent immense sums to some financial institutions against overvalued collateral, while refusing to lend to others with no clear standards as to who was rescued and who was not. It has set up holding companies using no-bid contracts, and guaranteed substantial liabilities of Citigroup, all the while keeping information about its actions secret from the public and Congress. This is in stark contrast to the analogous period in the 1930s, when the Reconstruction Finance Corporation fully disclosed loans and collateral to Congress.

Today, big banks are being bailed out and have a substantially lower cost of capital through an implicit government backstop even as Americans themselves are seeing their pay cut. This lower cost of capital – at government expense – coupled with increased scarcity of credit is resulting in the banks recapitalizing by charging American consumers higher credit costs, including record overdraft fees and much higher credit card rates.

As you know, the Federal Reserve has a chartered mandate of both price stability and “full” employment. Since 2002, the year Bernanke joined the Federal Reserve board and aligned himself with Alan Greenspan’s activities, the incomes of Americans have actually declined in absolute terms, with incomes projected to decline a further 5% in 2009. One quarter of all mortgage holders owe more than they own, with that number projected to rise to nearly 50% by 2010. Consumer asset prices, most importantly housing, continue to fall, and unemployment continues to rise. This raises real questions about Bernanke’s tenure as Federal Reserve chairman, and about where those trillions of dollars have gone.

Federal Reserve secrecy must be understood in the context of an intellectual dogma which Alan Greenspan inculcated into the fabric of the Federal Reserve and the economics profession, and which has severely harmed ordinary Americans. Bernanke’s ‘Great Moderation’ speech in 2004 didn’t even consider the idea that the economy was becoming more unstable, even as risks were being built into the system by the policies he encouraged. He ignored evidence of a crisis, saying in 2007 that the turmoil was contained to subprime mortgages, ignoring the bankruptcy of over 100 mortgage originators, and the clear evidence the crisis would spread. Now, even as the crisis is said to be subsiding, we still do not have credit markets that are able to function without substantial government support, we have not addressed institutions that are ‘too big to fail’ which the Fed oversees, bank credit availability is again shrinking (posing risk of further increasing already high unemployment), and toxic assets in the system on the books of both private banks and the Federal Reserve have still not seen price discovery.

Chairman Bernanke’s policy-making errors might be chalked up to errors of judgment, and it’s possible to argue that he has been chastened by the last few years of turmoil. What is more disturbing is how the Federal Reserve has refused to disclose the details of its commitments to the bankers who came close to destroying our economy. The Bernanke Fed’s execution of its dual mandate cannot be judged without consideration of those commitments, which would require the Fed to disclose documents which it still contends the public has no right to see.

Specifically, I ask that you postpone the confirmation of the Chairman until after the Federal Reserve discloses:

(1) Information that Bloomberg reporter Mark Pittman has requested via a Freedom of Information Act Request on the Bear Steams rescue and that the Federal Reserve is contesting in the courts,i and which Manhattan Chief U.S. District Judge Loretta Preska has ordered by turned over by the Federal Reserve.

(2) Information that Rep. Grayson requested in February at a hearing and by follow-up letter on which institutions received the $1.2 trillion added to the Federal Reserve’s balance sheet, how much reach institution received, and what was promised in return.

(3) All Federal Reserve documents that went to Attorney General Andrew Cuomo’s office relating to the Bank of America/Merrill Lynch merger in which potentially illegal and coercive activity might have occurred, as well all Federal Reserve documents relating to the lawsuit pursued by Merrill Lynch shareholders in the US District court for the Southern District of New York.

(4) Transcripts of all Open Market Meeting Minutes up to and including that of June, 2009, transcripts which are normally withheld from the public for five years.

(5) Full disclosure of all terms and conditions of all off-balance sheet Fed transactions in the past three years.

The Federal Reserve must become transparent and open with Congress and the public about its behavior during the financial crisis. Thank you for your consideration of this matter.


Alan Grayson
Member of Congress

Ron Paul
Member of Congress

Saturday, October 24, 2009

Sony Kapoor thinks the time has arrived for the Tobin Tax

Taxes are economically efficient if they substitute for costs not incorporated in the market, the so-called "externalities." Massive costs have been incurred by financial sector freedom, and these are external, it seems, to nobody but the financial cowboys who make the big profits. The Tobin Tax is long overdue. Here's some hope it may be on the way.

Time for Polluters to Pay Up?  Tobin or Not Tobin ...
Sony Kapoor
New Deal 2.0
October 13, 2009

*This piece is based on an Op-Ed in SuedDeutsche Zeitung, Germany’s leading daily newspaper.

Proponents of Tobin Tax(es) or, more technically, Financial Transaction Taxes, are happy that these have been in the news a lot lately. The so-called “Tobin Tax” on capital flows was originally proposed in 1971 by Nobel laureate James Tobin as a way to address speculation in global markets. Today, everyone from Sarkozy and Merkel to the head of the UK Financial Regulator has been positive about levying such a tax. Even the former Senator Obama had voiced support on the campaign trail. Does it mean that we will get some form of a Tobin Tax, finally? Or are the proponents set for yet another disappointment? Signs are that that they are likely to get their way…well sort of.

The financial crisis, the biggest in living memory, has massively titled the political and financial landscape in a direction that makes such taxes not just more desirable also much easier to implement.

Keynes was an early proponent of FTTs, and the idea got a new lease on life when James Tobin extended it to currency markets. The Asian crisis helped revive the discussion, and after falling off the agenda again, the idea was brought back once more as a potential source of revenue for funding poor country development. Each time it died a slow death. The opponents of FTTs won those battles, but they are about to lose the war. Here is why.

Even before the crisis hit, the ‘markets always work efficiently and know best’ school of thought was losing the battle of evidence. Those that believed that while financial markets mostly worked well, they were often prone to excesses and sometimes failed with bad social consequences were clear frontrunners. The crisis has picked the winning side in a dramatic way. It’s time for those who opposed FTTs with the argument that any interference with what they regarded to be well-functioning markets to shut up. Many have done so already.

Everyone agrees that even a small tax would penalize short term transactions and favour longer investment horizons. At a 0.01% rate, those trading 100 times a day will end up with a tax rate of 240%/year, and those that hold onto their stocks for 5 years will pay 0.002%. Automated computer trading based on mechanistic rules which sometimes buys and sells the same security hundreds of times a day would become untenable. Given the risk such trading poses to the financial system as highlighted by its total breakdown in August 2007, that would be no bad thing. Such High Frequency Trading is also dubious because the fact that it allows large actors access to markets a fraction of second before others and raises serious questions of fairness at a time where the little people are getting screwed all around. A reduction in trading patterns which threaten financial stability and skew the playing field without delivering much in the form of social benefits would reduce the likelihood of financial crisis. This appeals both to regulators and politicians.

It is good policy to tax polluting activities which have a negative footprint on society. An increasing number of financial transactions served no underlying social purpose and in the case of trades in complex derivatives and credit default swaps significantly increased systemic risk. Ever higher volumes of financial trades (churning) have been driven by the prospect of increasing fee based incomes. Ever increasing complexity was driven by the prospect of juicier profit margins. While privately profitable to the financial sector, both trends have imposed costs on the wider economy. It is good public policy then to impose a sin tax that penalizes churning and complexity. Financial Stability regulators are taking serious note.

This systemic risk which has crystallized in the shape of the ongoing crisis necessitated the allocation of trillions of dollars of scarce taxpayer funds to bail out the financial sector. Recovering the costs of these bailouts from the financial sector is not only fair but is also the only sensible policy option in line with the ‘polluter pays’ principle. The many existing transaction taxes raise substantial amounts of tax revenue. Extending these taxes to recover bailout funds from the financial sector is an idea that has snowballing political support behind it.

The crisis depressed tax revenues and necessitated stimulus spending. Governments are now saddled with the highest debt and deficit levels seen in a generation. These debts need to be repaid and the money will need to come from higher taxation. While no tax is perfect, the FTT stands heads and shoulders above other feasible options such as increasing Sales Tax, Value Added Tax or social security contributions. In contrast to these taxes, a FTT will have a highly progressive incidence and will tax activities that at best offer little social utility and at worst pose serious systemic risk. Increasing the tax burden on ‘the little people’ while ignoring the role of the under-taxed financial sector in facilitating tax avoidance by rich individuals and corporations would be political suicide. Politicians have already taken note.

For those sceptical about the dual revenue and stability goals of the tax, it might be instructive to look at sin taxes on smoking or pollution which marry substantial revenues while at the same time depressing harmful activities. To address the concerns of those who think the tax may harm markets, tax rates could start out very low and ratchet up annually once it is clear that the markets can bear the load. The regulatory response to the crisis has settled any remaining doubts about feasibility for good. The G-20 response of driving derivative transactions on to exchanges, making centralized clearing compulsory, introducing enhanced registration and reporting requirements and expanding the regulatory boundary to include hedge funds as well as off shore jurisdictions has all made it cheaper and easier to collect financial transaction taxes and will make it impossible to avoid them.

While international co-ordination is desirable, the success of existing taxes such as the UK Stamp Duty, a 0.5% tax on share transactions in the London Stock Exchange indicates that it is not necessary. This Stamp Duty nets the UK more than $8 billion every year. The US imposes a much smaller section 31 fee on stock transactions which funds the operations of the Security Exchange Commission. Increasingly electronic audit trails, greater cross-border regulatory co-ordination, action against tax havens and greater oversight of derivatives has only made implementation much easier both at a unilateral and multilateral level.

Under pressure from the French and Germans, the G-20 has finally asked the IMF to look into various options to get the financial sector to put in a greater contribution - the Tobin tax was on the top of their minds. There are also strong suggestions that some of the revenue could also be put to use savings lives in poor countries. Even then, expect the financial sector to cry bloody murder and send their lobbyists out in full force - surely one cannot expect the big banks to take a new tax lying down!

Proponents take heart…while it remains unlikely that the G-20 will agree to a ‘global tax’; the world will nonetheless still see a mushrooming of new unilateral transaction taxes in several financial markets and countries around the world. Little Tobin Taxes will bloom all around - and that would be a good thing!

Sony Kapoor is an ex-investment banker and Managing Director of Re-Define (Re-thinking Development Finance & Environment), an international Think Tank dedicated to improving the footprint of the financial system.

Thursday, October 22, 2009

Marshall Auerback on downsizing the financial sector

Market discipline does not work when the products are opaque and the deals are done in the back room. Marshall Auerback offers some stunningly coherent steps to get to square one in the financial sector
Financial Reform Victory? You can’t reform vampires and zombies.
Marshall Auerback
October 16, 2009
New Deal 2.0

The victory on financial reform claimed by the Obama Administration is not only unjustified, but delusional. Marshall Auerback argues that the monster-sized financial system must be downsized, and offers guidelines on how to do it.

If nothing else, the Obama Administration has learned the virtues of Clintonian spin. The so-called “financial reform victory” claimed today over approved new rules for over-the-counter derivatives is, in reality, akin to using a band-aid to treat gangrene.

Any kind of bill which (in the words of the Reuters report), “strives to balance a desire to curb speculative market excess with preserving the market’s useful role in helping corporations hedge against operational risks” ignores the fact that it is not the market playing a “useful role in helping corporations hedge against operational risks”, but the product of a big financial subsidy to Wall Street. Lack of transparency is a hallmark of these instruments and this gives huge pricing power to the banks. More importantly, it makes them tougher to regulate. There is no public, continuous record of Credit Default Swap trades that is comparable to the data available to investors and regulators from the major cash and derivatives exchanges, and the “reforms” introduced by the House of Representatives Financial Services Committee do nothing to address this reality for Credit Default Swaps.

This is in sharp contrast to the available pricing for other OTC derivatives, which is generally good and tracks the highly visible cash basis that underlie many other derivatives markets, OTC and exchange-based. Whether you are talking about currency swaps or a commodities related product, the world of OTC derivatives excluding CDSs is largely standardized in line with the exchange-traded products. Hence, they do not generate the same volumes of profits for Wall Street, which explains why the latter have fought to retain the status quo in spite of almost blowing up the entire financial system last year.

Obama clearly believes the BS fed to him by Jamie Dimon. I guess we should not be surprised; the President taught at the University of Chicago, after all, and clearly seems to have imbibed some of the Chicago School’s free market ideology, and the unspoken assumption that free, unfettered markets are the optimal state. Anything else is a distortion or a rigidity. That of course fails to address the problem of fraud, which my colleague, Bill Black, has tirelessly sought to highlight.

Dealing with fraud is not only an important moral issue, but also crucial on basic economic grounds.

If we don’t know what’s really going on, we can’t gauge whether the government’s economic policies are working or not. The advantages of living in a society governed by the rule of law require both the right laws that, with common agreement, public purpose, as well as enforcement sufficient to deter non-compliance in the first place. Laws that most agree are okay to break, and a lack of enforcement, break down the core morality of the system, and result in a dangerous degeneration into lawlessness.

Leaving aside political agendas, the truest test of any reform is: will it have any kind of positive effect? As far as the current financial regulatory reforms go, the answer is probably yes in a very LIMITED fashion, but that is more a function of the impairment of the capital markets themselves, which is precluding additional proliferation of these horrible Frankenstein financial products. If you don’t deal with a cancer fully, it comes back and spreads, even if you conduct surgery to remove some of the tumor the first time around. And, as any oncologist can tell you, it’s the secondary recurrence which usually kills.

Reform of the current US financial sector is neither possible nor would it ever be sufficient. It’s a bit like saying, “Well, this slavery thing has a few problems, but we can ‘reform’ it and make it better”. As any student of horror films knows, you cannot reform vampires or zombies. They must be killed (stakes through the hearts of Wall Street’s vampires, bullets to the heads of zombie banks). In other words, the financial system must be downsized.

Downsizing can begin with the following set of actions:
  • All bank assets and liabilities must be brought onto balance sheets, and made subject to reserve and capital requirements and, more importantly, to normal oversight by appropriate regulatory agencies. Any assets and liabilities that are left off balance sheet will be declared null and void, unenforceable by US courts. 
  • All CDSs must be bought and sold on regulated exchanges; otherwise they will be declared unenforceable by US courts.
  • Unless specifically approved by Congress, securitization of financial products such as life insurance policies will be prohibited and thus unenforceable by US courts.

  • The FDIC will be directed to examine the books of the largest 25 insured banks to uncover all CDS contracts held. These will then be netted among these 25 banks, canceling CDS contracts held on one another. CDS contracts with foreign banks will be unwound. The FDIC will also examine derivative positions with a view to determine whether unwinding these would be in the public interest. 
  • In its examination, the FDIC will determine which of these banks is insolvent based on current market values-after netting positions. Those that are insolvent will be resolved. Resolution will be accomplished with a goal of i) minimizing cost to FDIC and ii) minimizing impacts on the rest of the banking system. It will be necessary to cover some uninsured losses to other financial institutions as well as to equity holders (such as pension funds) arising due to the resolution.
These actions should substantially reduce the size of the financial sector, and would eliminate some of the riskiest assets, including assets that serve no useful public purpose. The financial system would emerge with healthier institutions and with much less market concentration.

Failing that, we should at least have the government get into the insurance business as credit insurer of last resort. Private firms can’t do it, as they do not have the financial resources to meet the potential claims (see AIG). And private firms have a tendency to mis-price credit risk (again, see AIG), which creates further incentives to bad behavior. As “Credit Insurer of Last Resort” (Professor Perry Mehrling’s term, not mine), the government can charge proper premiums for it, which will have the additional impact of mitigating the worst behavior of Wall Street. The government can put a floor on the value of the best collateral in the system. As Mehrling says (in a variation of the Bagehot rule - i.e. “lend freely but at a high rate during a crisis”)): Insure freely but at a high premium.

We can spend more time blogging about these issues, but now is the time to do something about it. As my friend Dean Baker has already noted, those disgusted by the rapacious and highly destructive behavior of our bankers can go to Chicago on the dates of Oct. 25-27th when the American Bankers Association is having their annual meeting and make yourselves heard. If we stay quiescent, we’ll get the kinds of “reforms” we deserve. To paraphrase Rahm Emanuel, it’s time to ensure that this crisis does not go to waste.

Wednesday, October 21, 2009

Robert Kuttner offers an early warning on the new EU doing business as usual

Political institutions across the globe are echoing the actions of the institutions of higher education in rewarding those who were wrong with tenure. The latest example is the prospect of Tony Blair becoming President of Europe. The navigators put the ship on the rocks. Instead of changing course, they have spent oodles to bring in more water so the ship can continue on -- to higher rocks. Baffling.

The Blair Project
Robert Kuttner
October 21, 2009

Tony Blair, the former British prime minister who turned a once-progressive party into Tory-lite, is now in line to be the first President of Europe. Given Blair's central role in creating the conditions that invited Britain's financial collapse, this idea makes about as much sense as putting proteges of Bob Rubin in charge cleaning up after the mess that Wall Street made (whoops, that happened, too).

The new constitution for the European Union, unlike its current set of basic laws, provides for a strong president. After much delay, the proposed constitution is now likely to take effect because the Irish recently reversed their "no" vote. (In the current crisis, aid from the EU is helping to keep their economy from going the way of Iceland.) The last holdout, Czech President Vaclav Klaus, who doesn't much like the treaty, said Saturday that he would not stand in its way.

Blair is in need of a high-profile job, and President of the EU suits his ambition. But there seems to be remarkable forgiveness for the fact that Blair helped launch the race to the bottom in financial regulation that helped produce the financial collapse. Under Blair, the British Labour Party decided that the best way to fight Thatcherism was to go it one better and cut a deal with the City of London, Britain's Wall Street. Britain would become the global capital of unregulated hedge funds, private equity, and casino products like credit default swaps. In the U.K., this was known as "light-touch regulation." The bankers, in turn, would give New Labour their financial support.

The unit of AIG that helped take down the world economy was based in London, where it could enjoy even more feeble supervision than in George Bush's United States. Early in the present decade, whenever Americans began warning that finance was becoming dangerously speculative, defenders of business as usual solemnly warned that if we began regulating the affair, the show would move offshore to London, finance's new wild west.

Blair's notion was that it didn't much matter if Britain was losing its manufacturing economy. The City of London, as the center of the world's deregulated money market, would carry Britain. Well, it carried Britain to collapse. The aftermath of Britain's bubble economy today is a bigger disaster even than its American counterpart.

Blair also helped wreck what was once a proud left-of-center party. Progressives have been systematically purged from New Labour. Under Blair's successor, the dour Gordon Brown, Labour's popularity is now at a postwar low, setting the stage for a Conservative comeback despite the fact that the Tories offer nothing more in the way of solutions than do the Republicans in the United States.

Much the same thing happened in Germany a few weeks ago, where a Social Democratic Party (SPD), which had abandoned social democracy a decade ago in favor of neo-liberalism, turned in its worst electoral performance in six decades. If you wonder why left parties are not making any gains from the worst crisis of capitalism since the Great Depression, you need only look to the British Labour Party and the German SPD. They have nothing to offer.

Why, then, is Blair likely to be the first President of Europe? Because he is just what Europe's ruling financial elite wants -- nominally a man of the center-left who can be trusted to continue business as usual.

There are alternatives to Blair, but they are long shots. One is Joschka Fishcher, the well-respected leader of Germany's Greens and Germany's former foreign minister in the late SPD-Green coalition government. Another is Poul Nyrup Rasmussen, the former Danish Social Democratic prime minister who is an actual social democrat as well as Europe's leading advocate of real financial reform.

Politically, however, the failure of nominally center-left parties that emulated the center right has undercut the appeal of genuine progressives. The more likely scenario that could spare us Blair is that leaders of several of Europe's smaller member nations are not quite sure that they want such a high-profile figure, and a compromise candidate could be a functionary or a less visible leader from a small country.

Despite the fact that modern Europe is generally friendlier to a managed form of capitalism than the US, the Blair project reminds us that real reform is not likely to originate in Europe any time soon. That puts even more pressure on Barack Obama to get financial reform right.

Tuesday, October 20, 2009

Joseph Stiglitz on the question of incentives:

In this piece, Stiglitz contrasts the career of Norman Borlaug to that of the nameless Wall Street bankers, and wonders whether some noble people are corrupted by the immense money to be made in finance. The question goes beyond this, as must be plain by now. The incentives themselves were corrupting, not only of the people, but they suborned criminal and near criminal unconsciousness of the public's welfare. You don't get rich by doing the right thing on Wall Street. Of course, many have clothed themselves in the invisible hand, a myth to which even Stiglitz gives too much credit.. It is less than a fig leaf. Here is Stiglitz.
Borlaug and the Bankers
Joseph E. Stiglitz
Project Syndicate
October 20, 2009

NEW YORK – The recent death of Norman Borlaug provides an opportune moment to reflect on basic values and on our economic system. Borlaug received the Nobel Peace Prize for his work in bringing about the “green revolution,” which saved hundreds of millions from hunger and changed the global economic landscape.

Before Borlaug, the world faced the threat of a Malthusian nightmare: growing populations in the developing world and insufficient food supplies. Consider the trauma a country like India might have suffered if its population of a half-billion had remained barely fed as it doubled. Before the green revolution, Nobel Prize-winning economist Gunnar Myrdal predicted a bleak future for an Asia mired in poverty. Instead, Asia has become an economic powerhouse.

Likewise, Africa’s welcome new determination to fight the war on hunger should serve as a living testament to Borlaug. The fact that the green revolution never came to the world’s poorest continent, where agricultural productivity is just one-third the level in Asia, suggests that there is ample room for improvement.

The green revolution may, of course, prove to be only a temporary respite. Soaring food prices before the global financial crisis provided a warning, as does the slowing rate of growth of agricultural productivity. India’s agriculture sector, for example, has fallen behind the rest of its dynamic economy, living on borrowed time, as levels of ground water, on which much of the country depends, fall precipitously.

But Borlaug’s death at 95 also is a reminder of how skewed our system of values has become. When Borlaug received news of the award, at four in the morning, he was already toiling in the Mexican fields, in his never-ending quest to improve agricultural productivity. He did it not for some huge financial compensation, but out of conviction and a passion for his work.

What a contrast between Borlaug and the Wall Street financial wizards that brought the world to the brink of ruin. They argued that they had to be richly compensated in order to be motivated. Without any other compass, the incentive structures they adopted did motivate them – not to introduce new products to improve ordinary people’ lives or to help them manage the risks they faced, but to put the global economy at risk by engaging in short-sighted and greedy behavior. Their innovations focused on circumventing accounting and financial regulations designed to ensure transparency, efficiency, and stability, and to prevent the exploitation of the less informed.

There is also a deeper point in this contrast: our societies tolerate inequalities because they are viewed to be socially useful; it is the price we pay for having incentives that motivate people to act in ways that promote societal well-being. Neoclassical economic theory, which has dominated in the West for a century, holds that each individual’s compensation reflects his marginal social contribution – what he adds to society. By doing well, it is argued, people do good.

But Borlaug and our bankers refute that theory. If neoclassical theory were correct, Borlaug would have been among the wealthiest men in the world, while our bankers would have been lining up at soup kitchens.

Of course, there is a grain of truth in neoclassical theory; if there weren’t, it probably wouldn’t have survived as long as it has (though bad ideas often survive in economics remarkably well). Nevertheless, the simplistic economics of the eighteenth and nineteenth centuries, when neoclassical theories arose, are wholly unsuited to twenty-first-century economies. In large corporations, it is often difficult to ascertain the contribution of any individual. Such corporations are rife with “agency” problems: while decision-makers (CEO’s) are supposed to act on behalf of their shareholders, they have enormous discretion to advance their own interests – and they often do.

Bank officers may have walked away with hundreds of millions of dollars, but everyone else in our society – shareholders, bondholders, taxpayers, homeowners, workers – suffered. Their investors are too often pension funds, which also face an agency problem, because their executives make decisions on behalf of others. In such a world, private and social interests often diverge, as we have seen so dramatically in this crisis.

Does anyone really believe that America’s bank officers suddenly became so much more productive, relative to everyone else in society, that they deserve the huge compensation increases they have received in recent years? Does anyone really believe that America’s CEO’s are that much more productive than those in other countries, where compensation is more modest?

Worse, in America stock options became a preferred form of compensation – often worth more than an executive’s base pay. Stock options reward executives generously even when shares rise because of a price bubble – and even when comparable firms’ shares are performing better. Not surprisingly, stock options create strong incentives for short-sighted and excessively risky behavior, as well as for “creative accounting,” which executives throughout the economy perfected with off-balance-sheet shenanigans.

The skewed incentives distorted our economy and our society. We confused means with ends. Our bloated financial sector grew to the point that in the United States it accounted for more than 40% of corporate profits.

But the worst effects were on our human capital, our most precious resource. Absurdly generous compensation in the financial sector induced some of our best minds to go into banking. Who knows how many Borlaugs there might have been among those enticed by the riches of Wall Street and the City of London? If we lost even one, our world was made immeasurably poorer.

Monday, October 19, 2009

Transcript: Demand Side 318 - Senator Cantwell, George Soros, on health care reform and the way the world works:

The Fed IS the bad bank;
Then continuing our series on those who got it right, George Soros;
and finally a bubble alert from Demand Side for the benefit of the Fed

First, though, complete and unedited, the statement by Senator Maria Cantwell at the recent Senate Finance Committee hearing on Health Reform


You know, part of George Soros thinking which we are not going to get to today involves the need to hold politicians feet to the fire.  The public option, and indeed, single payer is the only economically sound answer to health care. When alternatives involving insurance companies and employer mandates and so on are introduced, it is an attempt by those in power to create a reality that will ultimately and in the not too distant future disappoint.  Electoral democracy is efficient only when the politicians interest in power corresponds to the public's interest in truth and reality.  We believe Senator Cantwell is in line with the public's interest.

Now, on to

The Fed is the bad bank.

In the casino of financial markets, Ben Bernanke was one of the most confident players.  His hypothesis was that the Great Depression could have been avoided if the banking institutions -- the National City's of the world -- had not been allowed to fail.  He produced a distinguished career on this premise.

And when the financial crisis approached and then overwhelmed the economies of the world, he methodically placed ever larger stacks of chips on this bet.  Now the Fed has $1.25 trillion in mortgage backed securities on its balance sheet. 

The Fed has become the bad bank.

The hypothesis that the Depression could have been avoided by saving the banks and banking institutions has come a cropper.  The banks and the unregulated securities dealers have been bailed out.  The banks are making profits.  Earnings from trading are up.  But there is no recovery.  There is no resumption of lending to the real economy.  Absent the Obama stimulus and recovery money, the cash for clunkers program, the first time home-buyers subsidy, there would be no positive action at all.

Cheap money and other Fed action are focused entirely on the banking sector.  A recovered banking sector was supposed to lead a recovery in the economy.  Hasn't worked.  Won't work.  Even the economists who supported the moves now admit any return to normalcy is years away.  Others are more positive.  We survived the storm.  Things are returning to normal.  Except that the Fed is the bad bank.  The unwinding of the mortgage securities on its books is not a repatriation to those from whom it bought them.  It is not parallel to the special lending facilities.  Unwinding means selling into a market that has no use for mortgage securities because they hide the worst of the nonprime mortgages.  So the unwinding is essentially taking the losses for the worst of the bad practices in the recent housing bust.

This history has yet to be accepted.  But it is a farcical irony that the Monetarists who lampooned the 1930s Fed for causing the Great Depression have blundered into a hole many times the size of that one. 

The Fed could make its tremendous errors without the consent of the representative government we purportedly have in the United States, because the Fed is independent as no other federal agency is.  It takes direction from its own governors and the presidents of its banks, which are all owned by constituent private banks and which serve the interests of the private banks.

On the blog is a link to the testimony of Patricia A. McCoy of the Connecticut School of Law, prepared for a Senate Subcommittee.  This piece is the clearest description of what securitization is and what went wrong with it that I have read.  It explains the incentives that led the worst of mortgages to be placed in these securities.  It does not explain why, rather than attempt to correct bad practices and unwind the securities themselves, the Fed chose to ratify the bad practices by buying them.

George Soros

Today we look at George Soros, the billionaire investor and philanthropist, who has a view of ever expanding bubbles.  Soros is notable for being rich, yet advocating normalization and structure to financial markets.

I am sometimes -- not so much recently -- asked, "If you're so smart, why aren't you rich."  I point to -- or pointed to -- Soros, replying, "He's rich, why don't you listen to him?"

Soros is famous for purportedly breaking the British Pound for his own enrichment, which earned him opprobrium from both sides along the lines of, "If you're so concerned with social welfare, Mr. Soros, Why did you do such a thing?"  Converted to an assertive statement, it might be, "It's all right to profit if you're greedy, but not if you have concern for others."

Let's begin from Soros most recent book, The New Paradigm for Financial Markets:  The Credit Crisis of 2008 and What It Means."


"... The central idea in my conceptual framework [is] that social events have a different structure from natural phenomena.  In natural phenomena there is a causal chain that links one set of facts directly with the next.  In human affairs the course of events is more complicated.  Not only facts are involved, but also the participants views and the interplay between them enter into the causal chain.  There is a two-way connection between the facts and opinions prevailing at any moment in time:  on the one hand participants seek to understand the situation (which includes both facts and opinions); on the other, they seek to influence the situation (which again includes both facts and opinions).  The interplay between the cognitive and manipulative functions intrudes into the causal chain so that the chain does not lead directly from one set of facts to the next, but reflects and affects the participants' views.  Since those views do not correspond to the facts, they introduce an element of uncertainty into the course of events that is absent from natural phenomena.  That element of uncertainty affects both the facts and the participants' views.  Natural phenomena are not necessarily determined by scientific laws of universal validity, but social events are liable to be less so."

It certainly is necessary to address this question of the difference between economics and a natural science.

Robert Skidelsky, Keynes most famous biographer, pointed out that if economics were a natural science it likely would have responded to the mathematical tools employed so enthusiastically on its behalf to produce some significant progress.  Unlike physics or biology, it has not.  Skidelsky notes we are having the same arguments today as were had in the 1930s.  The exact same, down to the level of vitriol between the parties.  He refers to Krugman v. the Chicago School.  Look for that Skidelsky interview on Bloomberg on the Economy with Tom Keene last week.

Here in Soros we see one explanation for the resistance (near complete resistance in the Demand Side view) of economics to the mechanical tools valid for the natural sciences.  Soros calls it reflexivity.

"I explain the element of uncertainty inherent in social events by relying on the correspondence theory of truth and the concept of reflexivity....

Knowledge is represented by true statements.  A statement is true if and only if it corresponds to the facts.  That is what the correspondence theory of truth  tells us.  To establish a correspondence, the facts and the statements which refer to them must be independent of each other.  It is this requirement that cannot be fulfilled when we are part of the world we seek to understand."


Demand Side has repeatedly referred to no independent variables within the mathematics, no closed system, hence no fulcrum from which to lever the hypothetical world.  If all variables in the model are dependent upon each other, and indeed can morph into each other, there is no causal chain that mathematics can produce.  It becomes radically dependent on its assumptions.

Soros is talking in a different sphere, although he describes a similar recognition he had in his early years at the London School of Economics, where assumptions were allowed in economic theory to:

"... produce universally valid generalizations that were comparable to those of Isaac Newton in physics."

As economics was forced to abandon one assumption, it replaced with others until,

"The assumptions became increasingly convoluted and gave rise to an imaginary world that reflected only some aspects of reality, but not others.  That was the world of mathematical models describing a putative market equilibrium.  I was more interested in the real world than in mathematical models, and that is what led me to develop the concept of reflexivity."


"I contend that rational expectations theory totally misinterprets how financial markets operate.  Although rational expectations theory is no longer taken seriously outside academic circles, the idea that financial markets are self-correcting and tend toward equilibrium remains the prevailing paradigm on which the various synthetic instruments and valuation models which have come to play such a dominant role in financial markets are based.  I contend that the prevailing paradigm is false and urgently needs to be replaced.

"The fact is that participants cannot base their decisions on knowledge.  The two-way, reflexive connection between the cognitive and manipulative functions introduces an element of uncertainty or indeterminacy into both functions.  That applies both to market participants and to the financial authorities who are in charge of macroeconomic policy and are supposed to supervise and regulate markets.  The members of both groups act on the basis of an imperfect understanding of the situation in which they participate.  The element of uncertainty inherent in the two-way reflexive connection ... cannot e eliminated, but our understanding, and our ability to cope with the situation, would be greatly improved if we recognized this fact."

Soros by his own admission desperately wants to be taken seriously as a philosopher.  He should be.  His conceptual framework brings forward the problem of understanding the world in which we exist by way of concepts that are necessarily symbols or shortcuts to reducing the mass of phenomena to a manipulable scale.  I would say that the exercise leaves us relating to something that is really our own projection.

Graduating from LSE with grades too poor to gain him entry into Academia, he finally hooked on as an arbitrage trader.  Soros interest in reflexivity and fallibility equipped him to handle the states of nonequilibrium, boom and bust, well enough to make one fortune after another.

And indeed, markets proved to be the perfect application of reflexivity, as market players create boom and bust by their participation, not their comprehension.  Perception created reality, a reality that folded back on non-market participants in often harmful ways.

Thinking about thinking and conceptual frameworks which try to define concepts are inherently subject to contradiction.  So when Soros assumes an objective aspect of reality, it may become more useful, but less accurate, just as his theory predicts.  Everyday events are predictable and reflexive processes are not, he says.  But it would seem that reflexivity can provide momentum in stability as well as instability. 

We'll leave Soros here, well short of full development, with the note that his assessments of markets and economic dynamics when he is making his calls is often simple and often intuitive, but what he does show in his practical looks adheres broadly to demand side functionalities.

We also note for the benefit of those who have complete confidence in their economic schemes, but view forecasts as a crap shoot, that Soros passes on the observation from Popper,

"Predictions and explanations are symmetrical and reversible."

Following Soros is a very good place to put up our bubble alert.  This is for the benefit of the Fed, which cannot seem to see them when they are in progress.

One necessary element of a bubble is, of course, cheap money and easy leverage.  The Fed is providing this currently to the big trading houses.  One must then look for asset prices that are rising in anticipation not of demand or supply parameters, but of further increases in prices. 

We find them today in the commodity markets and in the stock markets.  The bubble in these markets is underway, and is totally belied by the simultaneous upward pressure on bond prices.

Here are a couple of clips, first from Business Daily on the previous commodity bubble, which as far as I know, has yet to be acknowledged at the Fed or across the orthodox economic community.  We never tire of telling you (actually we do, but it's still good promo), Demand Side called the onset of the commodities bubble in late 2007 and the peak and collapse of the bubble as it happened in July 2008.


Now, here from Bloomberg last week, David Schork


Our Friends on Wall Street, indeed.

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