Transcript: 417 Does the ransom for the tax deal amount to a return of Bush II economics?

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Recovery in the midst of recession. Or is it recession in the midst of recovery? Plus will the Democrats shoot themselves in the political foot if they don't pay the king's ransom of tax cuts for the rich? And we look in on the continuing crisis in Europe, where defense of the banking sector is being cast as defense of the euro as a currency, and some folks don't like the euro. So will the banks fall with it?


First a short post from Calculated Risk in its entirety:

Ylan Mui at the WaPo captures the economic bifurcation of America: Economic recovery leaving some behind this Christmas

At Tiffany's, executives report that sales of their most expensive merchandise have grown by double digits. At Wal-Mart, executives point to shoppers flooding the stores at midnight every two weeks to buy baby formula the minute their unemployment checks hit their accounts. Neiman Marcus brought back $1.5 million fantasy gifts in its annual Christmas Wish Book. Family Dollar is making more room on its shelves for staples like groceries, the one category its customers reliably shop.

"When you start to line up all the pieces, you see a story that starts to emerge," said James Russo, vice president of global consumer insights for The Nielsen Co. "You kind of see this polarized Christmas."

Some people are doing fine. Others are barely getting by and still trapped in a deep recession. A 9.8% unemployment rate is unacceptable ... something to remember this time of year. Best to all.

BREAK

I see somebody commented on those sound effects we use for Idiot of the Week. They make the podcast seem juvenile. Sorry, Mr. Meltzer. But if we could somehow take less seriously the promises, premises and positions of the august architects of economic calamity, we would all be better off. When you hear Ben Bernanke on 60 Minutes

BERNANKE

When you hear Ben Bernanke tell America something like this, the appropriate response is to laugh out loud.

BREAK

The recovery is in full swing in the financial sector, but it is absent from the real economy.

As late as March 2008, Bernanke was telling the nation we would escape recession. We already had one foot in it. Now he says if he hadn't acted on such a massive scale, there would have been 25 percent unemployment.

Of course, he is talking about the collapse of the banking sector under the weight of bad mortgages and securitization. His massive response essentially held the banks harmless from their profligate practices. The bailout, the guaranteeing of their loans and the making explict free coverage under too big to fail insurance, none of this has touched the real economy recession.
Credit is not flowing. Cheap money is moving overseas. Bubbles in commodities and in foreign markets are threatening new instability.

At least in hindsight, we can see a restructuring of the banks while holding depositors harmless and allowing the owners and creditors to take a hit might have made more sense. At least it would have begun to reduce the massive debt that to this day prevents any real private sector recovery.

We know that saving the banks did not revive the economy, but simply moved the debt problem onto the government's accounts. Where the taxpayer can foot the bill. The taxpayers who are still waiting for recovery.

We don't hear so much any more the assurances that saving the banks was a necessary precursor to a revived economy. That seems to have been replaced by a sober shaking of the head and a sage recognition that we are in for a long slog. Nor do we hear so much how it is that profitable corporations will revive the labor markets. Instead corporations are generating profits for Wall Street to whistle at by firing people and downsizing.

It looks very much like the lag in the effect of monetary policy has been extended, too. It used to be said that nine to eightteen months after Fed action, we would see action in the real economy. That lag is now up to who knows how long.

So, Ben,

BREAK

Absent these days is the promise of pragmatism from the president. When he came into office, pragmatic was a watchword. We hoped that meant that looking at what works and what doesn't. We were imagining an economic pragmatism. Instead we got political appeasement.

We did get a stimulus that was one-third stimulus and two-thirds bribery. Perhaps that is pragmatism. And having talked to enough people, I understand that most Joes don't think the stimulus worked even one-third. Well, we are about to see what happens without it. If the compromise with the Republicans passes, we have the old Bush policies back in place. Here is a bit from one of the revolutionaries in the House Democratic caucus.

INSLEE

That is Jay Inslee from the great state of Washington.

The point here is well taken. We have not educated one child, built one mile of road, prevented the layoff of one police officer or fireman. Even the extension of unemployment benefits which has the highest multiplier into the real economy suffers from the fact that it is spending without producing anything. Were we to require an hour's litter patrol from unemployment recipients, the economic effect of the dole would be the same -- or actually more by the value of less litter for a day or so.

If we are going to spend federal money to fix the unemployment problem, why don't we use it to hire people? There is plenty to be done. There is plenty of spare capacity to do it. By allowing long-term unemployment, we are degrading our economy, not making it more fit.

We have, say, eight million unemployed. With $30 billion, you can employ a million people a year at low wages, but with benefits. For two hundred billion per year out of this tax cut stuff, you could completely solve the unemployment problem. No, Ben, I am not contemplating a massive gang of litter picker-uppers stretched across the horizon. I am talking about directly employing people, some at lower wages, others at higher wages, all of whom pay taxes and generate a robust multiplier for the rest of the economy. We know people with jobs are going to buy cars or bicycles and clothes and food and we know they are going to pay taxes. At all levels. They are going to buy a wide range of goods and services.

So you have the real economic stimulus plus taxes being paid plus the potentially immeasurable advantage of the work being produced, be it environmental remediation, energy retrofitting, infrastructure construction, educating our kids, protecting the streets, social work, health care. There are jobs in place awaiting funding at all levels of state and local government. It should not tire your brain to envision a substantial workforce, the substantial knock-on benefits to society, the multiples of economic activity. This is pragmatic. This is one of the pragmatic answers that the last president in a depression came to.

BREAK

Now some of you, maybe Ben Bernanke, will say government is a poor allocator of resources, and we need to rely on the market or we will have a nation burdened with white elephants. I won't mention the acres of MacMansions lying vacant, nor the absence of meaningful markets to produce environmental salvation, nor at the opposite end the well-being of the financial fat cats in the midst of the current predicament for the rest of us. That I assume is background to everyone's understanding. So I won't mention it. I'll just say that the markets we have haven't worked very well for most of us.


Now to the Euro.

It was with some amusement that I saw recently reports of a revolt among the German population against the Euro currency. A return of the Deutschmark.

BUSINESS DAILY SEQUENCE

In Europe the bailouts of the various nations, particularly Ireland, is apparently being cast as a defense of the common currency, the Euro. As we have been saying for some time, it is in reality a bailout of the German banks. One effect of big trade surpluses is big capital flows out of the country. One is a mirror of the other. The same mechanism that gives China a trade surplus with the U.S. gives the U.S. capital from China.

Amusement, I say, because the demand for a return to the Deutschmark from inside the country is not very well thought through, regardless of the responsible positions of some of our commenters. In the case of Germany, capital export was not very well managed. Bill Black, you may recall from a couple of weeks ago, compared the German banks to girls gone wild who would put up anything for the promise of a slightly higher bond yield. Granting that the large and hidden derivative exposures of the banks is also a major problem, What would happen if the Eurozone split into two currency areas?

Let's leave aside the German preference that they bring the strong economies in with them, and imagine a Eurozone composed of everybody but Germany. And a Deutschmark zone composed of Germany. One thing is, the bonds Germans hold in non-Deutschmark countries would lose value to the same extent as the currency. This would be a very effective and appropriate tax on the root causes of the crisis.

Having Germany leave the Euro zone is in fact a plausible answer to the problem. Not that it would do what the Germans of our sample seem to think, but it would allow trade to be normalized in the absence of a willingness to stand together with all Europeans. We leave you with a segment from an interview with James K. Galbraith, not last month, but last spring, in the furor of the Greek crisis.

GALBRAITH

James K. Galbraith.

And it is playing out just as he suggested.

The Euro will survive until the breakdown of the social framework. The social framework could be strengthened by the Eurobond suggestions now under consideration, but Germany will not allow that. According to the FT, Angela Merkel, Germany’s chancellor, has publicly rejected the two most high-profile proposals for changes to the EU’s system of responding to the debt crisis – increasing the size of the EFSF or creating a Europe-wide bond.

Look forward to a mess.

Transcript: 416 Answer to the Queen

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Links

Econ Intersect, John Lounsbury


"No One Saw This Coming," Dirk Bezemer, Gronigen Univesity

"Why Credit Money Fails," Steve Keen (with access to video and audio)


Professor Luis Garicano, director of research at the LSE's management department, said: 'The Queen asked me, "If these things were so large, how come everyone missed them?".'

Today the answer to the Queen

The macro model that is used by policy planners in the Fed and in government goes by the name of the Washington University Macro Model. In a research paper entitled “No One Saw this Crisis Coming”, published in June 2009 by Dirk J. Bezemer, Groningen University, Mr. Bezemer describes that model thusly:

The “WUMM” is a quarterly econometric system of roughly 600 variables, 410 equations, and 165 exogenous variables. ... the important observation is that all are real-sector variables except the money supply and interest rates, the values of which are in turn fully determined by real-sector variables. In contrast to accounting models, the financial sector is thus absent (not explicitly modelled) in the model.

In other words, the elements in the economy that are at the root cause of the current crisis are absent from the models of economic activity that are used to guide economic policy. The entire financial sector is absent. The very elements that have siphoned the life blood out of the economy have been completely off the radar screen. The FIRE was hidden behind a shield of invisibility, just pumping money into their coffers until the real economy bled out.

...

Here from the outstanding piece on the excellent blog Global Economic Intersection, we continue with John Lounsbury's account of the Bezemer paper

... macro equilibrium theory dominates academia and has become institutionalized in governments. Bezemer defines the objective of his paper to encourage the merging of accounting and economic theory. He [notes that most of the analysts who got it right] reject rational equilibrium on the basis of arguments related to economic psychology and to the Keynesian notion of ‘radical uncertainty’ (as opposed to calculable risks). Keen, in a 1995 article titled ‘Finance and Economic Breakdown’ explained that “Keynes argued that uncertainty cannot be reduced to ‘the same calculable states as that of certainty itself’ whereas the kind of uncertainty that matters in investment is that about which “there is no scientific basis on which to form any calculable probability whatever. We simply do not know” Keynes argued that in the midst of this incalculable uncertainty, investors form fragile expectations about the future, which are crystallized in the prices they place upon capital sets, and that these prices are therefore subject to sudden and violent change.

Bezemer points out that the critical elements of human behavior and confidence are not reflected in the snapshots of the macro equilibrium models, but are amenable to modeling in a flow-of-cash model [, but] He is not proposing that the macro models be discarded; he feels they should be supplemented and expanded to include flow-of-cash factors.

...

Bezemer says that those who foresaw the coming crisis share the general characteristic that they viewed the economy through an accounting models lens. He wrote,

They are ‘accounting’ models in the sense that they represent households’, firms’ and governments’ balance sheets and their interrelations. [A] society’s wealth and debt levels reflected in balance sheets are among the determinants of its growth sustainability and its financial stability, [so] such models are likely to [provide] timely signals [of] threats [to financial stability].

Models that do not – such as the general equilibrium models widely used in academic and CentralBank analysis – are prone to ‘Type II errors’ of false negatives – rejecting the possibility of crisis when in reality it is just months ahead. Moreover, if balance sheets matter to the economy’s macroperformance, then the development of micro-level accounting rules and practices are integral to understanding broader economic development.

...

The finance, insurance and real estate (FIRE) sector includes all sorts of wealth-managing non-bank firms (pension funds, insurers, money managers, merchant banks, real estate agents etc.), as well as deposit-taking banks, which generate credit flows. It is conceptually separate from the real sector which comprises government, firms and households.

Liquidity from the FIRE sector flows to firms, households and the government as they borrow. It facilitates fixed-capital investment, production and consumption, the value of which – by accounting necessity – is jointly equal to real-sector income in the form of profit, wages and taxes plus financial investment and obligations (principally, interest payments).

...

Problems arise when the funds that originate in the banking part of the FIRE sector return to the FIRE sector in the form of investments or payment of debt service to the exclusion of circulation in the real economy. These problems can lead to recessionary economic collapse (although soft landings are possible), and, in the most severe dislocations, depressions.

...

Bezemer describes the details of how the accounting model displays the unfolding of the economic cycle:

An accounting (or balance sheet) view of the economy makes clear that this dynamic – a bubble – is unsustainable in the sense that it is constrained by the real economy’s ability to service debt. Yet without policy intervention, it can last for many years or even decades if starting from low levels of indebtedness. A bust occurs as investors realize this constraint is approaching or has been reached. The severity of the impact of a bust will be the larger as real-economy consumption (and thereby production) have grown more dependent on capital gains rather than on wages and profit.

This ‘financialisation’ scenario is a self-sustained dynamic separate from real-sector fundamentals (in other words, a bubble) increasing debt burdens but not bolstering the real economy’s potential to create value added from which to repay its growing debt. It is typically driven by the psychological and political economy factors .... In terms of financial incentives, its impetus is that it brings increased asset price gains for a time, but this is unsustainable in the long term as a source of debt servicing. Borio (2004:5) writes that “contrary to conventional wisdom, the growth of markets for tradable instruments …[read securitization] need not have reduced the likelihood of funding (liquidity) crises”. On the contrary, applying an accounting lens demonstrates that because of the debt growing in parallel with tradable instruments, inevitably a bad loan problem (or debt crisis) develops, credit flows dry up ...

That summary had a lot of help from World Economic Intersection, probably the best blog now up for forecasters. Link online.

As we continue to follow the pipers of Wall Street and the IMF, it is probably time to list those who actually saw the crisis coming.

Dean Baker
Wynne Godley
Fred Harrison
Michael Hudson
Eric Janszen
Stephen Keen
Jakob Brochner Madsen and Jens Kjaer Sorensen
Kurt Richebacher
Nouriel Roubini
Peter Schiff
Robert Shiller

Now we turn to audio -- pungent audio -- from Stephen Keen, whose explanation is even more clear.

KEEN 1


This talk from Keen is available with all its graphics online. Find our link at the blog. We excise the presentation of his dynamic model at this point and pick up at the end of his talk, with a summary of his conclusions.

KEEN 2

Transcript: 415 The Greenspan put expires with the economy out on a limb

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We were somewhat taken aback this week when Calculated Risk, one of the people we rely on most for data and analysis -- find him at CalculatedRisk.com -- opined that things were getting better. Our view at Demand Side, as you know, is and has been that things are bouncing along the bottom with significant downside risks for another crisis.

We'll look today at what CR sees, and then we'll offer a little pushback from an important piece from an another anonymous but very influential analyst. We'll also get to the economic models that worked, from a paper by Dirk J. Bezemer, Groningen University, and get some audio from the always pungent and perspicatious Steve Keen, whose accounting framework modeling is the cutting edge.

Sunday, November 28, 2010
The recent improvement in economic news
by CalculatedRisk


It is worth noting the recent improvement in economic news:

• The October employment report showed a gain of 151,000 nonfarm payroll jobs, the most since April ex-Census. Expectations are for a similar gain in November, although probably not enough jobs added to push down the unemployment rate.

• The BEA estimated real GDP grew at a 2.5% annual rate in Q3. This is still sluggish, but an improvement from the 1.7% growth rate in Q2.

• The Personal Income and Outlays report for October indicated incomes grew at a 0.5% rate (month-to-month), and it appears PCE has grown at about a 3% annualized rate over the last three months. The personal saving rate was 5.7% in October, and although I expect the rate to increase a little more - it appears a majority of the adjustment is behind us (a rising saving rate is a drag on personal consumption).

• The 4-week average of initial weekly unemployment claims has declined to 436,000 last week from over 480,000 at the end of August. The weekly reading was 407,000 last week; the lowest since July 2008.

• Most regional manufacturing surveys, with the exception of the NY Fed survey (empire state), has shown a pickup in manufacturing. This suggests the manufacturing sector is still improving (the ISM manufacturing index for November will be released on Wednesday).

• Trucking and rail traffic improved in October, although the Ceridian diesel fuel index was weak.

• The Architecture Billings Index (a leading indicator for commercial real estate) is near flat - suggesting investment in commercial structures such as hotels, offices and malls will stop contracting next year. (addition by subtraction!)

• Even small business optimism has improved slightly.

Most of the reasons for the recent slowdown are still with us - less stimulus spending, the end of the inventory adjustment, problems in Europe and a slowdown in China, and cutbacks at the state and local level - but it appears Residential investment (RI) has bottomed and will most likely add to GDP growth in 2011. I believe the RI drag is now behind us, and RI is usually the best leading indicator for the economy.

The data is still mixed and fits with my general view of a sluggish and choppy recovery (my view since the spring of 2009). Although I don't see a sharp increase in growth, I think the pace of recovery will probably pick up a little bit in 2011, and I'll take the over on the consensus view of 2.5% GDP growth in 2011. My guess is 3%+ GDP growth in 2011 - still not a strong recovery given the amount of slack in the economy, but an improvement over 2010.

Unfortunately there probably will not be enough growth to significantly reduce the unemployment rate in 2011.

Note: I'll add more before the end of the year, but I've been sharing my thoughts with a few analysts and economic commentators and I try to post my views whenever they change - even a little. Right now it looks like the "slowdown, but no double dip call" was correct (it is still early), and now I'm becoming a little more optimistic and taking the "over" on 2011 GDP growth (still no v-shape recovery though).

That from the mysterious Calculated Risk. Not so different from our bouncing along the bottom with downside risks, except CR seems very willing to extrapolate the bump in good news. We are not. And for some of the reasons why, we yield to another anonymous voice:

Ananomen Analyst is a wealth manager associated with a major Wall Street investment bank who uses a pseudonym to avoid any incorrect implication that his views might reflect those of his firm.

Writing under the head "The Greenspan Put Expires Worthless in the Eye of the Hurricane" courtesy of EconIntersect.com

The Fed Used to be Important: The Greenspan Put

For many years our writing has been focused on the Federal Reserve, since monetary policy easily has the largest influence on the economy and financial markets. Since World War II, every recession was preceded by a tightening of monetary policy and higher interest rates, and every recovery spurred by lower rates and an easing of monetary policy. Every cyclical bear market and bull market was also strongly influenced by changes in monetary policy. Since the stock market crash in 1987 and the 1998 collapse of Long Term Capital Management, investors have believed the Federal Reserve also possessed the capacity to manage every crisis. Since those two crises occurred when Alan Greenspan was Chairman and Maestro of the Federal Reserve, it became known as the ‘Greenspan Put’. This reference to the value of a put option during a market decline, increased investors bravado that they needn’t worry about a negative Macro event, since the Fed would simply exercise ‘Greenspan’s Put’ and restore order.

The current financial crisis has exposed numerous fissures in the U.S. economic foundation, which will be addressed later. More importantly, it has shown that the Federal Reserve no longer possesses the capacity to manipulate economic activity, as they did during the last 60 years. The balance of power has shifted from the Federal Reserve being proactive and exerting a strong controlling influence on the economy, to one of being reactive. The Fed can now only indirectly affect the numerous drags on economic growth, despite an unprecedented level of monetary accommodation. This change in the balance of power, from the Federal Reserve being proactive to reactive is significant, since it means ‘Greenspan’s Put’ has expired.

The majority of mutual fund managers, market strategists, economists, and investors have not yet realized that this shift in control and power has occurred. Their continued faith in ‘Greenspan’s Put’ may cost them dearly in the next few years, as the Federal Reserve struggles to keep the credit bubble from deflating.

The Eye of the Hurricane

The financial crisis that kicked off in August 2007 has never really ended. Much like a Category 5 hurricane, the global economy was battered by the outer wall as it came ashore in 2008 and early 2009. The eye was created, as every central bank adopted an extraordinary level of monetary accommodation. Governments around the world launched massive fiscal stimulus programs that resulted in historic budget deficits in almost all of the developed countries. In the United States, the eye of the hurricane allowed GDP to grow, but at a sub-par pace. Compared to the recession of 1973-1974, the first five quarters of GDP growth since the summer of 2009 have averaged 2.8, half as fast as the first five quarters after the 1973-1974 recession. The first five quarters after the deep 1981-1982 recession averaged GDP growth of 8.4%, three times the strength of this recovery.

There are a number of indications that suggest we will be moving out of the hurricane’s eye sometime in the next six months. Most of the Federal fiscal stimulus has been spent, without launching a self-sustaining recovery. Job growth has been exceptionally weak when compared to other post World War II recoveries. Without a healthy increase in disposable income, consumer spending will not elevate GDP growth above 3% on a sustainable basis. The only way that will occur is if solid job growth of 300,000 jobs per month kicks in, and that’s not likely anytime soon. Spending may marginally pick up during the holidays. Keeping a rein on spending gets old after a while and the holidays are a good reason to loosen up a bit. Unfortunately, millions of unemployed workers will see their unemployment benefits expire, unless Congress extends them, which we expect. However, that will only make cutting the Federal budget deficit more of a challenge.



State legislators do have to balance their budgets and they will be raising taxes and fees, and laying off more state workers. Housing prices are set to fall further, as more than 70% of homes in foreclosure have yet to hit the market.

In Europe, the eye of the hurricane resulted in a very uneven pick-up in economic growth. Although Germany has done well, actually recovering all of the ground lost during 2008, many other countries have not fared well. Ireland and Greece are still contracting, while unemployment in Spain is almost 20%. European banks are in worse shape than their U.S. counterparts. Although we expect the European Union to bail out Ireland’s banks, the credit crisis is likely to eventually engulf Spain. This will prove significant since Ireland and Greece combined represents just 5% of total E.U. GDP, while Spain represents 10%.

In response to the global slowdown in 2008, China initiated a $570 billion stimulus package, and ordered state run banks to lend aggressively. In 2009, Chinese banks increased lending by $1 trillion, an enormous amount given the size of China’s economy, $4.5 trillion. The combination of fiscal and monetary stimulus had the desired effect of boosting China’s economy, but has also resulted in a burst of inflation in 2010. In October, official consumer prices were up 4.4% from year ago levels. The real inflation rate in China could be at least twice as high. China has not revised its CPI since 1993, and the weighting of many food components are not realistic. According to official government data, food prices have risen just 19% over the last three years, but over that period, rice was up 38%, wheat up 35%, and beef and milk prices rose 44%. In contrast, two major supermarkets reported that rice prices had soared by 132% and 190% over the last three years.

In response, China’s central bank has raised its lending rate and bank reserve requirements. Rising inflation isn’t just limited to China, but to most of the Asian countries, which have been enjoying solid growth. South Korea had increased rates once, but Australia has boosted its bank cash-rate seven times from its 2009 low of 3.0% to 4.75%. India has hiked its repo rate six times to 6.25% from 4.75% in early 2010. Inflationary pressures are likely to intensify, since the output gap between capacity and production have disappeared in India, South Korea, China and Indonesia, according to the Royal Bank of Scotland. This makes it easier for companies to raise their prices. These are the countries with the strongest growth, but the gradual tightening of monetary policy will likely result in a slow down during 2011.

As the back wall of the hurricane approaches the global economy with its Category 5 winds, investors will realize that most of the problems that emerged in 2008 were not solved or fully addressed. The macro tides which lifted the global economy for decades have shifted. Investors will have to focus on preservation of capital in 2011, and batten down the hatches.

Components of the Macro Tides

The following is a list of individual headwinds. Each will weigh on growth in the U.S., keep GDP growth from reaching a self-sustaining level, and cause GDP growth to average under +2.0% in coming quarters. This list will provide a worksheet that will allow us to monitor which headwinds are deteriorating or improving. At some point in the future, the majority of these headwinds will begin to improve and help identify when another eye in this extended hurricane is approaching. Many are interconnected and there is some overlap. The most important common denominator is that solid economic growth will address most of these issues. Adopting policies that will strengthen economic growth is imperative. However, there are no easy choices since there are potential negative outcomes associated with every option. We’re in quite a fix. One, even Houdini would struggle with:

¦ The ratio of total debt to total GDP in the U.S.
¦Monetary policy impotence
¦Finding a short and long term solution for the federal budget deficit
¦Recapitalizing the US banking system, so lending broadly resumes
¦Weak job and disposable income growth
¦The change in middle class spending psychology toward less is more
¦Stabilizing housing despite the large overhang of foreclosed homes
¦Commercial property rents and values
¦Dealing with state budget deficits
¦The demographic shift of baby boomers into retirement
¦Social security
¦Addressing the income inequality gap between the top 1% and average worker’s pay
¦The lack of true leadership from either political party
¦The cost of health care rising faster than personal income
¦Medicare
¦The unintended fallout from financial regulatory reform
¦Deflation
¦Inflation
¦Protectionism
¦The European sovereign debt problems
¦Recapitalizing European banks
¦The global economic drag from closing fiscal budget deficits in developed countries
¦Keeping Israel and other middle eastern countries from starting another war
¦China and its currency and trade policies
¦China’s potential bank loan defaults from excess export capacity
¦The Basil increased requirements for international bank capital by 2020
¦The unanticipated

We can add our own:

Deteriorating infrastructure
Failing educational system
Climate change


Well, that was so much fun we didn't get to the important analysis on why the mainstream economists missed the biggest economic event in half a century. The Queen had the right question, "If this was so big, why did nobody see it coming?" We'll answer that question on our next podcast.

Transcript: 414 The Irish bailout of the German banks

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The Celtic Chimera

By William K. Black

November 17, 2010

Ireland was known as the “Celtic Tiger.” It shot to economic fame. From the poor man of Northern Europe, it was transformed into a nation with a reported per capita GDP equivalent to that of the United States. The old, true, and painful joke: “What's Ireland leading export? (Answer: “the Irish”) was reversed as people began to move to Ireland.

Black does not note that Ireland rode to the top by attracting multinationals with radical tax incentives. For many years it was held up as the model for what the U.S. should do. Black continues:

Unfortunately, the Celtic Tiger was ultimately revealed to be a Celtic Chimera. Irish bank supervision was so weak and Ireland's banks so wild and crazy that the New York Times called Ireland the new “Wild West.” Ireland's largest banks hyper-inflated twin bubbles in commercial and residential real estate. They grew massively. Fortunately, Lehman failed and the Irish banks' ability to grow collapsed – which meant that the bubbles imploded in late 2008. Had [they] not done so, the Irish banks would have continued their staggering growth and caused almost incomprehensible losses (relative to the size of the Irish economy) when the (vastly larger) bubbles finally collapsed.

Anglo Irish Bank was merely the worst an awful collection of large Irish banks. The Irish entity disposing of the Irish banks' bad assets is now estimating 70% losses on Anglo's (copious) bad assets. That percentage loss estimate is ... as of a year ago. Property values have fallen significantly since that date and are expected to continue to decline next year. ... The size of Irish bank losses that the Irish government claims its taxpayers should bear is contested, but has a lower bound of roughly 60 billion Euros. Had Dick Fuld's avaricious heart not led to Lehman's collapse, or had Treasury bailed out Lehman and prevented ([read] delayed) its failure, Ireland (and Iceland) would have collapsed as nations. If their banks had continued their growth for even two more years, Ireland and Iceland's per capita debts would have been so staggering (in the range of $50,000) that they would have sparked massive emigration, which would have pushed the per capita debt even higher. Both nations would now be occupied almost entirely by pensioners and non-nationals.

Indeed, upticks in Irish emigration have been reported.

The economists and finance practitioners that presented at the Kilkenomics Festival came from diverse streams of economic and political views. They, nevertheless, agreed on three points about the Irish crisis: (1) it was insane for the Irish government to provide and extend unlimited financial guarantees [to] virtually all debts of the failed Irish banks, (2) the Irish government [has] transformed a private banking crisis into a sovereign debt and budgetary crisis that imperiled Ireland's recovery from the economic crisis and gravely stressed the EU and the Euro, and (3) that [the situation is now that ] either the EU or IMF [will] bail out Ireland or Ireland [will] default.

...

One of the key analytical issues has long been which flashpoint would spark the next stage in the ongoing, global financial crises. The leading candidates have been the EU periphery and the collapse of the still-growing Chinese bubbles. (Of course, they may occur simultaneously or the first crisis may quickly trigger the second.) Europe now looks like it will win the “next crisis” race. (I believe that the European Union (EU) is rich enough to paper over the crisis for several years, but European politics could scuttle that effort.)

... the EU is set up in a fashion that creates strong, perverse incentives for future financial crises. [Add to this the fact that] the EU is set up in a fashion that is periodically strongly criminogenic in particular nations. These criminogenic environments will feed future epidemics of “accounting control fraud” – the leading cause of severe financial crises. Massive amounts of European money will move to fund these frauds, which will cause financial bubbles to hyper-inflate and produce catastrophic banking losses and severe recessions.

[At the same time] the EU is set up in a manner that makes it extremely difficult (and expensive) to attempt to respond to the severe recessions and debt crises that these perverse incentives generate. The EU “channels” IMF's “let's turn a financial crisis into a crisis of the real economy” strategy.

... the Irish government's response to their epidemic of fraudulent lending ... demonstrates the catastrophic costs of deregulation, desupervision, and deifying finance. [It] allows one to illustrate why it is essential to combine good analytics, skepticism, courage, and integrity in responding to such epidemics."

Black then cites a report co-authored by Professor Karl Whelan of University College Dublin. One of his key conclusions is that sovereign defaults by EU nations are likely and that the EU must prepare now to deal with them.

[Nevertheless] Whelan's briefing paper makes clear why there will be an EU bailout of the Irish banks. ...

“While the public discussion of this decision has largely focused on the idea that the agreement was aimed at preserving the Euro as the common currency, the truth was more prosaic: The European banking system was already in a fragile state and would not have coped with a series of sovereign defaults. The need to maintain financial stability, specifically banking sector stability, was what prompted the unprecedented announcement of the bailout funds.”

“The health of the European banking system remains in question. The most likely trigger for sovereign defaults in the next few years is a prolonged period of slow growth or perhaps a double-dip recession.”

Whelan is trying to make clear the great underreported [foundation] of the Irish banking crisis – the broader EU banking crisis. (And, while Whelan does not emphasize this point, his discussion inherently means that there was a horrific failure of EU banking regulation.) He explains that the European “stress tests” were farcical because they assumed no sovereign defaults could occur and ignored all market value losses on the banks' “held for investment” exposures to sovereign risk. ...

“Large cross-border exposures (defined as an exposure above 5% of Tier 1 capital) to Greece are present for Germany, France, Belgium (all with systemically important banks), Cyprus and Portugal. Large exposures to Portugal are present in Germany and Belgium; to Spain in Germany and Belgium; to Italy in Germany, France, Netherlands, Belgium, Luxembourg, Austria and Portugal; and to Ireland in Germany and Cyprus.”

The alert reader will have noted the nation whose banks have large, unrecognized losses on debt [in] all of the PIIGS – Germany. German banks acted like drunken “Girls Gone Wild” as soon as they were approached by a foreign borrower. Germany's Bank Gone Wild were hooked on yield – for a trivial increase in yield, without any meaningful due diligence, they made massive unsecured loans to many of the most fraudulent borrowers throughout Europe. Borrowers engaged in control fraud have two great attractions for bankers gone wild – they typically report extreme profitability (which makes them appear to be creditworthy to the credulous) and they are willing to promise to pay higher interest rates). ...

Where were the German banking regulators? They seem to have believed that “What happens in Vegas (Dublin) stays in Vegas (Dublin).” Instead, their German banks came back from their riotous holidays in the PIIGS with BTDs (bank transmitted diseases). The German banks' regulators continue to let them hide the embarrassing losses they picked up on holiday, but that cover up will collapse if any of the PIIGS default. The PIIGS will default if the EU does not bail them out, so there will be a bail out even though the German taxpayers hate to fund bailouts.

All of this should put a very different interpretation on Chancellor Merkel's insistence on unsecured creditors suffering losses when they lend to banks that fail. She has argued that it is essential that they suffer losses so that they will have the proper incentives to provide effective “private market discipline” and that it is fair that they suffer losses given the premium yields they received and their lack of due diligence. German banks would be the primary losers under her proposal, so her position is remarkable. She is apparently disgusted with the German “banks gone wild.”

[And well she should be. German banks] ... were the largest funders of the accounting control frauds that [were at the epicenter] of the European financial crises and helped push Europe into the Great Recession.
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Transcript: 413 The rule of free trade: money flows to power

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413

Trade, an angle on the German position in the current drama in Europe, forecasts, Robert Kuttner on the deficit reduction commision, taxes and oil prices, and more.

First Trade.

Money flows to power. This is a principle suggested forty-five years ago by John Kenneth Galbraith and a prime cause for the failure of free trade to make people better off.

Money is power, it is said. But more to the point, power is money. It works everywhere from the military dictatorships of the Third World, to the monopolies and oligopolies of multinational corporations, right into the U.S. Capitol.

Yes, free trade CAN make everybody better off. This theoretical condition is well described in every economics text. But as Yoram Baumann says when he lampoons Greg Mankiw, CAN is not WILL. And if you can't say free trade WILL make everybody better off, or DOES make everybody better of, then it won't and it doesn't.

Who does it make better off? The gatekeepers. The power of controlling the transactions and dominating the exchange makes Wal-Mart, shippers and multi-nationals extremely profitable. The diminished power of labor in each country means that -- according to our principle -- money is going to flow away from them. And this is what we observe.

There is often talk of making the losers in trade whole through retraining workers and remedial help to communties. It rarely happens. It comes with a cost. Is that cost going to be paid by the winners? No. The winners point to the government.
Cheaper prices of goods to consumers is another purported benefit. Indeed, costs ARE lower at Sam's Club and Wal-Mart. But taken as a class, the half of those consumers who are workers see their incomes fall in greater proportion. Another big chunk, the social security and welfare recipients, depend on those workers. The government -- including its social insurances -- is a net loser, because YES the gains from trade are not taxed like the gains from working.

We proposed a thought experiment a couple of weeks ago. What if every country were encouraged to impose a tariff of 15 percent? The details could be arranged to allow for fair treatment of intermediate goods. Two main things would happen.

One, as your price theory says, there would be rents accruing to domestic producers with foreign competition. Domestic firms would be advantaged over multi-nationals. The rents would be collected as increased profits and labor incomes. Domestic investment would be encouraged. And yes, everybody pays taxes.

And two, an enormous revenue benefit would accrue to the governments imposing the tariff. You may not recall, but the federal government subsisted entirely on tariffs during the Nineteenth Century. These revenues. Guess what? They derive from the people who are gaining from trade and are available to make the losers whole. These revenues derive both from foreign producers taking a lower profit and from domestic consumers paying a higher price. But they also derive from lower transportation costs. Ah. An environmental benefit.

Remember, every country institutes a tariff of identical size. This is a fair trade arrangement, Is it not. Nations which depend on imports may be allowed, but not requried, to lower their tariffs for goods that have no domestic competition. On the other hand, they may be allowed to keep them up to garner revenue from producers outside their borders. One abiding mark of good tax policy is it minimizes the burdens on one's own citizens.

Wait! Wait! Wait! Are we really suggesting the end of free trade? The erection of protectionist barriers? The return of Smoot-Hawley?

I have questions for you. What other form of economic activity is conducted without taxes? Where better to get the resources needed to make the losers from free trade whole. And how exactly is free trade free when it costs jobs, communities and national independence? Is trade today a matter of comparative advantage or capitalist power over labor?

BREAK

Coming down from our thought experiment, let's go back to the complexity of the real world. Or the confusion of the world of financial globalization, at least. From Econoblog101, produced by Dirk Ehnts, a keen observer of the European situation from his post at the University of Oldenberg in Northwest Germany, we excerpt the following:

The integration of global financial markets leads to a competition for global capital. This competition, which Germany wins day by day, must be taken seriously. Only when institutional investors (Krugman’s bond vigilantes!) which invest the billions of the people trust a government, do they invest in its bonds.

This is the view of Germany, both politicians and economists. There are exceptions, of course, but they are few.

...

The problem with this view, besides being wrong, is that it degrades government. According to [the establishment] view, politics should dress up for international bond investors. It should bow to the wishes of these investors, not to those of the people who got it elected. This is hardly the idea of democracy as it is normally perceived. Either the political power lies with the people, or with the bond investors. You have to pick a side.

Turning his attention to the financial crisis in which Germany is the epicenter, Dr. Ehnts continues:

The crisis started because of capital misallocation by the private sector. German banks, among others, invested money in the European periphery real estate markets directly and indirectly without understanding the consequences. The ensuing real estate bubble almost destroyed the European financial system and made government intervention necessary. Note that government budgets did not cause the crises. (Ireland’s debt/GDP ratio was 25 percent in 2006 and 2007, that of Spain 40 and 36. It was 66 and 64 for Germany.)

If you export more than import, you must accept IOUs as payment. That means that if you are a net exporter you will send more capital abroad than you will get from abroad.

...

The idea that [reducing] wages in the deficit countries [is] the right way to come out of this crisis [has been] discredited since the publication of the General Theory.... The real economy and the monetary economy are two sides of the same coin. ... Falling nominal wages in Ireland and Spain will depress incomes. That means that debts, which do not come down with wages, will be harder to pay back. This will cause the financial crisis to reappear with a vengance and hurt existing German loans to those countries.

What is an alternative adjustment? Well, you could always raise wages in the surplus countries, which is, well, mostly Germany. That would not cause a problem on the monetary/financial side, since it makes debt repayments in Germany easier and households are not indebted anyway. If you insist on falling wages in the deficit countries, falling tax income will probably lead to lower government spending. This might lead to demand falling in a downward spiral of falling incomes, falling taxes, falling government spending, falling demand, and so on. (The UK seems poised to go down that road.)

...

If competitiveness has to come through lower wages only, this will be a deflationary force which might push the whole euro zone into deflation. Paying back debt will become ever harder, and entrepreneurs will not like to see their margins evaporate and react by pushing input prices lower, leading to a potential deflationary trap.

And there's more, Econoblog101, link in the transcript

Dr. Ehnts concludes.

The German position is the result of a misperception of the working of the economy. Real and monetary side of the economy should not be seen as isolated parts, since they belong together inherently. Those dealing with [the hardliners in Germany] should realize that there is no way to make them understand. There seems to be no competition of ideas at the top. Ideology rules. Are you surprised that China agrees with the German position regarding global imbalances?

BREAK

Okay, that's trade.

Let's talk fat bureaucrats and paper shuffling bureaucracies costing thirty percent of every health care dollar. Ooops. Not taxes. That's the market insurance solution to health care. How about extra charges on every gallon of gasoline, extracting billions of extra dollars from households who are struggling. Oh. Not carbon taxes. It's oil price speculation.



Forecasts

Our bouncing along the bottom sloped downward forecast has been in place for at least a year. As has our call for continued weakness in housing and potential crises from speculation on sovereign debt by European banks and or from collapsing commercial real estate in the United States. These crises are in the wings because we did not fix the banking situation, nor did we repair household balance sheets through mortgage writedowns. The only effective counter to the downside pressures was the ARRA, the stimulus plan passed in the first months of the Obama administration. That stimulus spending is now petering out.

Recently we added a commodity bubble watch, as the Fed's easy money for the financial sector pushes the dollar down even as it moves into commodity speculation. Commodity prices are increasing. This is not inflation. Inflation means businesses or labor has pricing power and somebody's incomes are going up. Or if you want to call it inflation, call it cost-push inflation. It means additional erosion of stagnant household incomes.

By comparison, the Philly Fed released its survey of forecasters. The history of the consensus of the 43 forecasters indicates extreme accuracy in predicting the present. Not so much the future. They ARE better than the Fed and its governors, however. Early in the year the predictions rose with the surge in the economy from the stimulus spending. Now the predictions are settling in at around 2.2 percent GDP growth, 9.6 unemployment and 86,000 per month in employment growth. The trend is lower.

Demand Side's numbers are marginally lower. We haven't changed them. Although we showed the bounce, we did it prior to its occurance and prior to its showing up in other forecasts.

The consensus of forecasters expects a righting of the ship by the invisible hand that we do not see. Nor do we hear a convincing narrative of why it should happen. Business confidence will grow with political gridlock and hiring will resume is what we hear. To a Keynesian, this is preposterous.

Government-sponsored investment in public goods, attacking unemployment by directly hiring people, rebuilding America by rebuilding America, these are the strategies that will drain the liquidity trap and work for the real economy, the economy people live in. Cheap chips for the financial sector and its reciprocal, starving households, will not work any better in the future than they have in the past.

BREAK

Now to a review of Erskine Bowles' and Alan Simpson's deficit reduction plan, here from Robert Kuttner.

KUTTNER

The following is a complete reproduction of Kuttner's comments to Juan Gonzalez of Democracy Now, November 11, 2010.

The only thing worse than the economics is the politics. The economics are totally perverse. Bowles talks about being on a path to an economic crisis. Of course, we’re in an economic crisis. We’re in a prolonged recession that bears more resemblance really to a depression. And you cannot get out of a depression by austerity. The idea that you should have an arbitrary set of cuts in the deficit at a time when you need more public spending is totally perverse. It’s the economics of Herbert Hoover. It’s the politics of the Republican right. And it’s one more indication of the capture of the Obama administration by Wall Street.

I mean, Erskine Bowles gets over $300,000 a year for attending a few meetings of Morgan Stanley, the investment bank, on whose board he sits, so he gets more money in board fees than 99 percent of Americans earn. And you’ve got three privately funded commissions by the Peterson Foundation, Pete Peterson, proposing the same stuff. It’s intended to create a drumbeat to carry out a wish list that has long been the goal of fiscal conservatives, that has nothing to do with this crisis. Social Security is in surplus for the next 27 years. So, the idea that you can somehow get the budget closer to balance by cutting Social Security is perverse. It’s politically insane.

And if the President had the kind of spine that we hoped he had when we elected him, he would be saying, "No way are we going to balance the budget on the backs of working people." Instead, I think the risk is that the President is going to embrace some version of this. And the hope is that the four progressives on the commission, three of whom have already said "no way," plus Max Baucus, the chair of the Senate Finance Committee who’s on the commission, will view this as a threat to his prerogatives as a Senate committee chairman. The best thing about this commission is that maybe it will deadlock.

JUAN GONZALEZ: And when you say the four progressives, who are the other progressives that you are expecting to stand up on these issues?

ROBERT KUTTNER: Well, Jan Schakowsky, who’s a member of the Democratic House leadership, she’s a very progressive member of Congress from Chicago; Xavier Becerra, also a progressive; and Dick Durbin, the senator from Illinois. They have said "no way." Andy Stern, the former head of the Service Employees International Union, is on the commission. Andy is a bit of a free spirit. Andy loves to see if there can be some kind of a deal. But I think this particular deal will even stick in Stern’s craw. So, I think the hope is that the Republicans, some of them, will say, "Well, nothing that reduces defense spending or reduces tax loopholes are we going to support," and the liberals on the commission will hang tough and say, "No way are we going to cut Social Security and Medicare."

I think the problem is that the editorialists of this country—if you read this morning’s New York Times editorial—are saying, "Well, gee, anything that the left and the right don’t like must be pretty good." And that’s exactly wrong. I mean, this is a case where the so-called center just completely has it wrong. You cannot get out of a depression by having deeper cuts in spending. And I think if you look at the criticism of the Federal Reserve policy of buying treasuries because it doesn’t know what else to do, in the hope that that will lower interest rates and somehow stimulate recovery, the Fed is doing that as a last resort because Congress is opposed to increasing social investment. The only way you can really get out of a prolonged slump like this is to increase social investment in job creation, in the infrastructure, in the clean energy that the country needs. And yet that path seems to be blocked. And instead of fighting for some degree of public investment, Obama, who, after all, appointed this commission, is at risk of embracing at least some of its proposals.

So I think the only thing that’s going to block this—and we heard some of this from Rich Trumka—the progressive movement needs to put forward its own version of a budget that would cut defense spending, cut tax loopholes, insist on suspending the Bush tax cuts for the wealthy, and dramatically increase social investment, and explain to the American people why that’s a better route out of the real crisis that we’re in. There’s one resource I want to commend to all of your viewers and listeners. It’s a new website, ourfiscalfuture.org, which proposes a counter-strategy for getting the economy out of this mess. That’s a coalition of progressive think tanks—Demos, where I’m a fellow, Economic Policy Institute, Century Foundation. And we have a huge fight on our hands, because the other side is investing tens of millions, if not hundreds of millions, of dollars in a propaganda effort on behalf of austerity. It’s backed by Wall Street. And all we can do is try and argue that this whole set of proposals is bad economics and bad politics for the Obama administration and the Democrats.

...

The Alice in Wonderland character of this whole exercise is demonstrated by the fact that, on the one hand, they’re talking about some kind of a tax deal where you cut loopholes and you raise rates—or lower rates. And by the way, one of the so-called loopholes that they want to close is the child tax credit. Hundreds of millions of dollars of relief for working poor people, where you get a refundable tax credit to help you raise your kids, that’s one of the supposed loopholes that the commission wants to get rid of. That’s crazy. Also, the idea that you cut loopholes and then cut rates, that produces no net increase in revenue. It simply reshuffles the deck.

And the other thing that’s deceptive is that at the same moment that the Republicans on the panel are proposing this deal, they’re also demanding that the Bush tax cuts from 2001, which expire at the end of this year, be extended not just for the 98 percent of Americans who make less than $250,000 a year, as President Obama proposes, but for very, very rich people. Now, continuing those tax cuts for very rich people would add almost a trillion dollars to the deficit over the next ten years, and yet the commission is treating that as absolutely untouchable, because there’s no way the Republicans would buy into that. So, you’re absolutely right. I mean, if we want to do something about the deficit in the long run—and we should not be doing anything about it in the short run. In the short run, with the economy in the condition that it’s in, we need more deficit spending, not less. But if we want to deal with the deficit in the long run, restore higher tax rates on the people who got us into this mess, who are still making an absolute killing and, unlike working people, who can afford to pay higher taxes.

...

And again, here’s Erskine Bowles. He’s on the board of directors on one of the top five banks that would actually be taxed if you taxed financial speculation. And he’s the chair of this, appointed by President Obama. And that proposal is nowhere to the seen. I would call that a conflict of interest. I mean, if Obama had put, you know, Rich Trumka as one of the two co-chairs, the right would be screaming bloody murder, and so would Wall Street. And yet, Wall Street got one of its people, not as the Republican co-chair, but as the Democrat co-chair.

BREAK

That's Robert Kuttner

And we end today's podcast with an apology. We do have some minimal quality control here at Demand Side, but something slipped through last week. That was the stat for the benefit of the Bush tax cuts to the top stratum of income. You may have heard "point three." The five was clipped off. That is, versus the two point two for the middle income households, the richest benefit to the tune of five point three percent. Low economic stimulus value, high cost in deficits, but hey! We need to extend them. Right?

Also in the way of apology, we are afraid that sometimes our keen insight on the most critical issues of the day approaches tedious diatribe. We are trying to shorten it up. If you object, e-mail us at demandside@live.com Also, feel free to write a review on iTunes. We find it is one of the main ways potential listeners learn how to become actual listeners. And thank YOU for listening.

Transcript: 412 Deficit reduction, taxes, and how not to crash the economy

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The question of fully funding government has come back to the top of the legislative agenda on Capitol Hill. Up until this week, the question was connected to the extension of the Bush tax cuts for the rich. Now, Alan Simpson and Erskine B. Bowles, co-chairmen of President Obama’s panel on reducing the national debt, released a report that surprised many people. They outlined what the New York Times called "a politically provocative and economically ambitious package of spending cuts and tax increases" and ignited a debate that is likely to grip the country for years, or for the next couple of weeks anyway.

The plan calls for deep cuts in domestic and military spending, a gradual 15-cents-a-gallon increase in the federal gasoline tax, limiting or eliminating popular tax breaks in return for lower rates, and benefit cuts and an increased retirement age for Social Security.

Today's podcast begins with extended excerpts from Donald Marron, director of the Tax Policy Center, exerpted from a recent presentation to the National Economists Club. These few comments from Mr. Marron are worth the entire report from the Bowles-Simpson panel.

MARRON

Donald Marron. We improved the audio as much as we could. You can get the whole presentation with bad audio and Q&A off the National Economists Club feed. We fully support Mr. Marron's analysis of the tax expenditures. The controversy over rolling back the mortgage interest deduction could be addressed by cutting the overall tax rate for the middle class.

So. How to generate taxes in a productive manner? You have heard our advocacy for a Tobin tax on financial transactions and a driect tax on gasoline or the cap-and-dividend plan of Maria Cantwell and Susan Collins. That is taxing the bads of speculation and greenhouse gases.

As a bit of an aside, another way of eliminating the distortion for the mortgage interest deduction was proposed in 1992 by then candidate for the Democratic nomination for president and now once and future governor of California Jerry Brown. Brown proposed as part of a reconstruction of the tax code, allowing everybody, renters and owners, a housing allowance deduction. It replaced other forms of deduction and exemption. Brown's two tax program is still the standard for simplification with fairness. Maybe we'll remember that in an upcoming podcast in more detail.

In any event, up until Bowles and Simpson made their splash, the tax question was revolving around the extension of the Bush tax cuts for the rich.

Republicans in the person of new House majority leader John Boehner say, "Yes. Now is not the time to raise taxes on anybody. Instead it is time to cut services and roll back infrastructure, health care and education."

On the Democratic side, the position is more equivocal. The president is clearly in the pocket of Wall Street, even as it comes clear that hedge funds and other Wall Street financiers were behind the Carl Rove attack ad gangs. Yet it is the president who is most forcefully talking up letting the rich take a hit on taxes. Everyone is for extending the cuts for the middle class, and maybe include an extension of the larger middle class Obama tax cuts from the stimulus package. But Democrats begin to mumble when the issue gets to the top of the income scale. Either "No, we cannot afford to extend those cuts," or "No, but raise the definition of who is rich to beyond Suleiman." Or "Yes, extend them, but only for a year or so." Or, "Let's go along with the Republicans in the name of bi-partisanship and besides we're rich too."

The economic impact of tax cuts is not rocket science. Clearing away the political smoke may be beyond current technology, but there is a clear number, an index number, if you like, that displays the economic efficiency of tax cuts. Above 1.0, the tax cuts stimuate the economy. Below 1.0, no stimulation, higher cost than benefit. This index number is the multiplier. We can also use it to gauge the relative effectiveness of tax cuts vs. government spending as economic medicine. And we will. With Wall Street in control in DC, abetted by the corporate insiders of the National Chamber and the pseudo-populist tea partiers, we have to acknowledge that the political air has little chance of clearing, but we insist there is no doubt about the economics.

A special report to Congress from the Congressional Research Service, authored by Thomas L. Hungerford, issued on October 27, gives us some early information on the effect of the Bush tax cuts. First of all, it is entirely appropriate to call them the Bush Tax Cuts for the Rich.

Reduced capital gains, reduced dividends taxes, a repeal of what is called PEP/Pease, basically affect only the rich. The reduction of the top rate from 39.5 percent to 35 percent and the 36 percent rate to 33 also affect predominantly the rich. In the end, the richest one percent those with incomes averaging $1,071,100, saw their incomes boosted 5.3%. Those in the middle, not so much, 2.2%. So it is obvious that the tax cuts were massively regressive. This is borne out by their Suits index numbers. The Suits index is a straightforward gauge of regressivity. With zero as perfectly proportional, neither regressive nor progressive, and minus 1.0 as perfectly regressive, the four major boons to the rich earned minus .80, minus .73, minus .58, and minus .66.

But these are not our index numbers for economic stimulus value. Those are the multiplier. Still, it is instructive to note that the more progressive a tax, the higher the value of its multiplier. And again, the multiplier is the measure of the economic bang for the buck.

A somewhat conservative, but widely accepted estimate of the value of various multipliers was released earlier in the year by Mark Zandi and Alan Blinder, mostly Zandi at Moody's. Dividend and capital gains tax cuts earned a .37 rating. But wait! The multiplier has a different neutral value than the Suits index. The neutral number is 1.0. That is, any value below 1.0 is less than a dollar of value for a dollar of cost. That above 1.0 creates more than a dollar in economic bang for the dollar cost. So the .37 rating means the benefit of a capital gains tax cut is 63 percent below its cost.

Largely as a feature of its canting to the upper income brackets, the multiplier for the income tax portion of the Bush tax cuts for the rich earned a multiplier of 0.32. That is, a benefit on a dollar's cost of 32 cents.

Backing up a bit, there are disputes as to the size of the multiplier, with some contending the multiplier is zero. This is the contention of noted knothead Robert Barro, who in spite of all evidence to the contrary, continues to promote the Ricardian equivalence theory that tax cuts or spending increase decisions by the government will be perfectly estimated by private actors who will reduce their spending by precisely the amount of those decisions.

I kid you not. Barro’s notion of a zero multiplier depends on perfect foresight by households and businesses and financial markets that are perfectly functioning. They not only know precisely what their future tax liability will be, but move immediately to save for that event.

Yes, even after the Wall Street debacle and the spectacle of millions of households under water.

On the other end, very few economists posit a multiplier greater than 2.0. This is a bit surprising to the newcomer, because algebraically, in an economy in which everyone spends what they don't save and the recipients of that spending do likewise in exactly the same proportion. That is, in which a savings rate for all actors is the same, say 5 percent, the multiplier would be twenty. Twenty is a lot different than two.

Oddly the advocates of the zero multiplier are closely allied with the free market extend all tax cuts group. But as we said, in order for the multiplier to be zero, we would have to either repeal the laws of arithmetic or imagine a one hundred percent savings rate. The multiplier is simply the mathematical acknowledgement that for any specific spending event, a number of purchases are generated, each of which is an income to somebody and the source of further purchases. The dollar given to the butcher produces a purchase from the baker, whose new revenue allows a buy from the miller and the farmer and a few truckers and maybe a barrista.

But if tax cuts for the rich are not only regressive, but economically inefficient, What about tax cuts for the middle class? It turns out they are modestly productive as stimulus. An across-the-board tax cut of any particular amount is estimated by Zandi to have a multiplier of 1.02. A payroll tax holiday, which would be progressive, since the payroll tax is regressive on account of its not applying to unearned income and being capped at roughly 100,000 -- a payroll tax holiday would have a multipllier of 1.24, according to Zandi. Unemployment benefits have a multiplier of 1.61. Food stamps increases 1.74.

Now we come to the phenomenon with regard to fiscal policy that nearly cost Dwight Eisenhower his place in the Republican Party. That is, government spending has a higher multiplier than tax cuts.

Yes, They have it exactly backward when Tea partiers say that we cannot afford to raise taxes and we need to cut spending to get government off the backs of the economy. The contadiction to this does not rely on the obvious distributional effects which in all rational economics allows that a dollar to a lower income person is more valuable than a dollar to an upper income person. Neither does it include the calculation of the undeniable benefits of public goods created with government spending. The superior economic impact of government spending versus tax cuts comes simply from the size of the multiplier. Public spending has more bang for the buck than tax cuts.

In Zandi's list, this is displayed in the size of the multipliers for general aid to state governments, for increased infrastructure spending, as well as for food stamps and unemployment. General aid to state governments has a multiplier estimated at 1.41. Infrastructure spending 1.57. Just as a function of the stream of payments. Before benefits received.

Why are the multipliers for spending higher than those for tax cuts? Because government spending begins at one point oh. Government hiring and procurement produces economic activity with the first cent. A tax cut will be divided between savings and spending. For every dollar of cuts, five cents may be saved, another ten cents go to debt service, maybe a quarter to rents, and so on. There will be some follow-on spending from rents and debt payments, but certainly not to the level of groceries or professional services. In fact, since a new tax cut is a marginal addition to a broad range of incomes, the stimulus benefit is limited.

Every cent of a marginal increase may be spent at the lowest income, but this is not where tax cuts are concentrated. Tax cuts by definition accrue to those who pay taxes, and the more taxes you pay, the more marginal income you get from a tax cut. The biggest beneficiaries will be those whose propensity to consume out of marginal income is the lowest.

The Bush tax cuts, for example, as we said, benefited a top income to the tune of fifty or sixty thousand. Those in the middle, two or three thousand. Those at the bottom make out in the low three figures. Leaving aside all arguments about fairness, in terms of the ecoomic impact of the multiplier, that kind of distribution is immasculating.

The argument we have been making is that marginal additions to incomes are in general not as stimulative and tax cuts are disproportionately weighted to those who have the least propensity to spend. A similar, but distinct argument says that the spending out of marginal income is likely to be lower than out of average income. Public spending tends to create jobs which create average spending profiles. Hiring a teacher produces new demand for goods and services across the spectrum at the level of middle income cohorts rather than the very wealthy. And all this is in addition to the services of teaching, a productive activity that is not really challenged in the private sector for its value.

One last point. Double the impact. Yes, when we trade government services for tax cuts as we do under the Mad Hatter plan, we employ the multiplier in a negative direction. The reduction in government spending operates downward with the same velocity as increases in spending go upward. So when we trade a 1.41 multiplier for a .32 multiplier, well, you can do the math. We are going in reverse.

So it is literally upside down to say small government and low taxes are good for the economy. Do I hear a groundswell of support for big government? No? Just gas? Ah well, welcome to the Great Stagnation.

Following is a summary of Donald Marron's remarks to the NEC:

Raising more revenue: The best methods
Summary of remarks by
Donald Marron,
Director
Tax Policy Center, Urban Institute
October 7, 2010

The shared vision of the long-term federal budget is scary, with debts and deficits poised to rise precipitously in the years and decades to come. In the short-term, whenever a nation recovers from recession, governments will spend more than they collect in taxes. In the long-term, the government will have to make changes both in spending and in revenue.

One challenge in forecasting is that there is disagreement about the baseline scenario, as it is uncertain whether Congress will extend the tax cuts that are supposed to expire at the end of the year. The Congressional Budget Office assumes the tax cuts will expire in their projections. But even if the tax cuts are extended, tax burdens will rise at a faster rate than the economy due to bracket creep.

Whatever the baseline, given our debt and deficits, it is unlikely we will have the same tax burdens in two decades that we have now. We have the lowest level of tax revenues relative to the economy in our lifetime, about 15 percent of GDP compared to a historical average of a bit more than 18 percent. As the economy recovers, revenues will naturally revert to 18 to 19 percent of GDP and are scheduled to go a bit higher with the introduction of additional Medicare taxes in 2013 and the so-called “Cadillac tax” on high-cost health insurance in 2018. At the same time, however, policymakers will confront increasing pressures to make some tax cuts, for example to patch the alternative minimum tax and to reduce corporate taxes.

Stronger economic growth is one way to increase tax revenue. CBO estimates that a one percent increase in economic growth would increase tax revenues by two and a half trillion dollars over the next ten years. Productive members of society need to be encouraged to work longer, and immigration of high skilled workers should be encouraged.

Reducing tax expenditures is another way to increase tax revenue. Tax expenditures are effectively spending programs operated through the tax system. Not all tax expenditures are created equal. A particularly egregious expenditure is the mortgage interest deduction, which studies have shown has no effect on homeownership rates. In addition, this deduction encourages more debt, bigger homes, and higher interest rates. Furthermore, it is skewed towards those who itemize and who probably can afford homes without help from the deduction. It costs the federal government $150 billion annually.

We could also generate more revenue if we taxed employer-sponsored health insurance. Not taxing health insurance plans leads to over-coverage.

In the spirit of using taxes to guide behavior, a carbon tax would also be an appropriate way to generate more revenue. Some argue we need more research and development before we impose such a tax. Marron disagrees: The carbon tax would drive R&D. It is the ideal Pigouvian tax.

If all of these taxes have not raised sufficient revenue to meet expenses, then the government needs to consider value added taxes. Bigger governments tend to have VATs; the tradeoff in simplicity is that it is less progressive than other taxes might be.

After Marron’s prepared remarks, he fielded questions.
Q: What about state and local tax receipts?
A: State and local governments have their own challenges, with balanced budget requirements and volatile revenues. Also these governments must deal with underfunded pensions.
Q: What about taxing (and making legal) certain currently illegal activities as a way of generating more revenue?
A: Senators Wyden and Gregg have a step in that direction – raising revenue from gambling – in their tax reform proposal.
Q: What role does the monumental defense budget have in the current fiscal crisis?
A: The defense budget should certainly be reconsidered.
Q: Other nations use the green technology that we create here. How do we make sure we capture the return on investment?
A: There is certainly this challenge with intellectual property.
Q: We are falling behind on infrastructure investments – how do we make this a priority?
A: We have to convince the decision makers that infrastructure and economic growth are related.
Q: What role does tax evasion play in our current fiscal situation?
A: An estimated $300 to $400b in owed taxes is not paid every year. Small businesses are particular scofflaws, and it is difficult to pursue them.
Q: What is the outlook for the fiscal commission?
A: The commission is doing good work, but faces significant political hurdles in reaching agreement. The Bipartisan Policy Center is also delivering a report about debt reduction.

Donald Marron is the Director of the Tax Policy Center at the Urban Institute. Marron previously served as a member of the President’s Council of Economic Advisers, as acting director of the Congressional Budget Office, and as executive director of Congress’s Joint Economic Committee. Before his government service, he taught economics and finance at the University of Chicago Graduate School of Business and served as chief financial officer of a health care software start-up. Marron is also a visiting professor at the Georgetown Public Policy Institute.

Transcript: 411 Austerity, Idiots and Potential Mistakes, with Allan Meltzer and Robert Pollin

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The clash of headlines has been remarkable since the election.

Stocks closed Thursday at their highest level since the collapse of Lehman Brothers

On news of an unexpected surge in unemployment appllications -- up to 467,000

No, probably on the long-anticipated acquiescence of the Fed to the Market's demand for more money.

Dollar down, oil prices up.

Bloomberg reports: The dollar fell against all of its major peers as the European Central Bank signaled it will likely stick with its stimulus-exit strategy even as the Federal Reserve buys $600 billion of bonds to boost the U.S. economy.

The greenback reached a nine-month low versus the euro as the ECB said it will decide on further exit steps next month. The pound rose as the Bank of England refrained from adding to its asset purchases. The New Zealand dollar climbed against all of its counterparts as commodities surged.

“The lack of policy adjustment from the ECB, from the Bank of England and the aggressive action by the Fed gives traders no reason that there’s not going to be a steady depreciation of the dollar,” said Jessica Hoversen, a Chicago-based analyst at the futures broker MF Global Holdings Ltd.

While

Oil prices hit $86.25. It's not supply and demand. It is all dollar weakness and speculation.

BERNANKE

This approach eased financial conditions in the past and, so far, looks to be effective again. Stock prices rose and long-term interest rates fell when investors began to anticipate the most recent action. Easier financial conditions will promote economic growth. For example, lower mortgage rates will make housing more affordable and allow more homeowners to refinance. Lower corporate bond rates will encourage investment. And higher stock prices will boost consumer wealth and help increase confidence, which can also spur spending. Increased spending will lead to higher incomes and profits that, in a virtuous circle, will further support economic expansion.


Contrat this with Jeremy Grantham's blistering critique in his latest letter, entitled "Night of the Living Fed."

Evidence for increased debt increasing growth is nonexistent in the long term. Stable, low debt levels prior to the 1970s produced higher growth than the ballooning debt levels since then. And what is the point of lower interest rates except to generate more debt. But the level of debt is not on the Fed's radar. This is the great blind spot of people who are supposed to know what they are doing. That increasing debt decreases current flexibility and spending power is almost too obvious to have to say out loud. But the Fed assumes that there is a borrower Fred and a lender Henry and when Fred pays his loan Henry buys at just the same rate as Fred. So it doesn't matter, basically. I kid you not. The logic is exactly this. Ignore the fractional banking system. Ignore the evidence. Ignore the debt.

We found an amusing, well-produced animation online which described this process. The Fed from its elevated vantage point sees unemployment. It buys bonds from banks. That gives them extra reserves and they lower their interest rates. The factory owner is enticed by lower interest to expand his plant. Employment increases, wages go up, demand is spurred, a virtuous cycle begins.

Unfortunately, it is fantasy, an animated fantasy. Capitalists do not invest in plant and equipment on the basis of the cost of money, they do it based on the strength of demand. Large projects are typically financed in steps and nobody can predict the interest rate they will face at the next step. The certainty of demand and thus the prospect of profit is by far the largest consideration. Of course, the government can make investment literally free through the tax code, as it did under Reagan in the early 1980s. People will invest if it costs them nothing. But that investment is typically badly targeted.

But let's get back to the episode we interrupted on Wednesday

BREAK

Allan Meltzer

MELTZER SEVEN

Here we protest. The great fable of monetarists and Fed apologists is that the Fed is independent by way of a legal framework. This is not the case. 1951 was not the year in which a statute or Constitutional amendment elevated the Fed to the fourth branch of government. 1951 was the year in which the so-called Treasury Accord was negotiated in a back room in the dark of night with the sitting president -- Truman -- at the nadir of his popularity on account of recalling Douglas MacArthur from Korea and the Treasury Secretary in the hospital. It extracted essentially for the banking sector control of the Fed and from that point to this, though to a far greater extent in more recent times, the Fed has exercised control of one-half of economic policy, that is monetary policy, largely outside control from the elected branches of government. It has done so primarily for the benefit of its constituent private banks, who control its board and hold its stock. To say this has any legal legitimacy is a stretch, however accepted it may be.

Excess interest payments by the federal government alone in years subsequent to 1951 are in the trillions of dollars. We may be alone among modern economists in supporting the position of Leon Keyserling, Truman's chair of the council of economic advisers and arguably the most influential person ever to hold that position, but we do. Keyserling never tired of castigating then Treasury Deputy William McChesney Martin for his role in the backroom deal. Martin very soon became Chairman of the Federal Reserve.

Arguably Fed independence could be a good thing. It probably is in the parallel universe where they do not operate for the benefit of the big banks and have some more coherent economic understanding than the Supply Side Monetarism that has fueled bubbles and restrained prudential oversight. On this planet, it is a bad thing.

I suppose we should just be grateful that no other of the quasi-independent governmental organizations like the FCC or FDA have gone rogue.

MELTZER EIGHT

Well, this is right. Trying to get the hated politician to take the fall is a bit of a stretch. It is, of course, the Market's control of the Fed and of Congress that instigated the purchase of illiquid assets that are even now decaying in value on the Fed's balance sheet. Since the Fed has refused to disclose to the public and Congress the nature of its purchases, it is problematic to say that Congress pressured them to do the deals. There will be an audit of the Fed coming up that will display exactly the mood of Congress with regard to these.

MELTZER NINE

This fever about inflation without understanding inflation and money is simply wrong, widespread -- and even dominant at the Fed -- but wrong. But here is something with which we agree wholeheartedly.

MELTZER TEN

And here's some more bad analysis, at least from the benefit of hindsight. Remember, this interview was August 2008.

MELTZER ELEVEN

So. That is Allan Meltzer from 2008. History supplies the critique. Let's see what he's up to in 2010. From October 2010, and On Point with Tom Ashbrook, we have Mr. Meltzer speaking in contradiction of Robert Reich, who points out the historically unprecedented disparity of incomes and wealth in America today and the danger, if not the fact, of plutocracy -- rule by the rich.

MELTZER TWELVE

Painfully wrong on many levels. The Tea Party as an objection to the redistribution of income? Hard to see where that comes from.

MELTZER THIRTEEN

First we need to object that the pre-tax distribution may be similar in these countries, but the after-tax distribution is not similar. This fact is convenient for Mr. Meltzer to ignore. Second, the educational performance of all countries is not as bad as that of the United States. And lastly, to say that the income moves up and down and bounces around using the years Mr. Meltzer does is simply disingenuous. It ballooned to 1928 and collapsed to 1950. A great part of the collapse was due to the Depression and World War II. Was that a virtue of capitalism. During the 1950s and 1960s the economy was stable and vibrant. In part this was due to the absence of wealth and income disparity. As it has grown to the present, so has growth decayed and the well-being of the population deteriorated.

MELTZER FOURTEEN

And also wrong. Per capital median income in the United States is less than $40,000. And it has been stagnant in real terms for decades. These are facts Mr. Meltzer as an economist knows, or should know. There is no excuse to say things are good or are getting better. And for this alone, he deserves the title this week.



Now directly to Robert Pollin.

Contrary to Allan Meltzer, Pollin, who is co-director of the PERI -- Political Economy Research Institute -- at UMass Amherst, does not see the Market moving in to straighten things out. Although that may not be fair to Mr. Meltzer, since his view in 2010 may be widely different than that in 2008, when many of his comments were recorded. But here is Robert Pollin courtesy of the Real News Network.

Pollin begins here with a response to the contention that large fiscal deficits will create inflation, high interest rates and large government debts.

POLLIN ONE


Well, what about business confidence?

POLLIN TWO

That's it for this time.

Transcript: 410 The Political Business Cycle

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Today on the podcast, an extended Idiot of the Week with a Fed historian who is celebrating with the tea party today Allan Meltzer. Also the excerpt from Robert Pollin on the error of austerity we promised. But first

This election will mark a significant downturn in the economy. It did not matter who won. This is the way it was planned. The stimulus was enacted in 2009 with a timeline for payouts that precisely matched the electoral cycle. It was thought to be enough to carry the economy through election day. That it was too small was the responsibility, in all likelihood, of Larry Summers, now returned to Harvard.

The political business cycle has been part of politics since it was introduced by Richard Nixon. Only Jimmy Carter failed to implement a pro-electoral cycle economic policy. We are seeing a major miscalculation when we see the stimulus was not enough to do the job. Many say the stimulus did not work. The next two years, absent a lame duck stimulus, will tell the tale. If the economy recovers during gridlock, our explanation will have to be revised. If it falters and stagnates, the arguments of the market fundamentalists will have to be quietly put back in the drawer and new red herrings invented.

The point is that fiscal policy will soon become a significant net drag, as states and localities hit their budget walls while the federal government's major program payouts drop. Corporations are already downsized. Investment capital is fleeing the country. More money from the Fed is not going to alter any of this. QE II is DOA.



To set up our next segment, some commentary on inflation and deflation.

The Great Financial Crisis and the current what I will call depression is evidence enough that money is not created the way it has long been supposed. That is, in spite of the massive production of money via Fed purchases of this and that, no inflation has occurred. Therefore, either the tenet of Milton Friedman that inflation is always and everywhere a monetary phenomenon is wrong, or the tradition that the Fed controls the money supply is wrong. Or both.

It is both. Inflation is not driven by the supply of money, the supply of money is driven by expansion. In some conditions, expansion is accompanied by inflation. So except in the narrow condition that you need money to make transactions, inflaiton is not a monetary phenomenon. And if we've learned nothing else in the current crisis, we should have learned that just because the Fed produces money, it doesn't mean the banking system turns it into credit.

This latter mistake is one that was made across the economics spectrum. Stiglitz, Feldstein, Krugman, and most economists hooted down the first version of TARP in favor of a straightforward recapitalization of the banks. The Troubled Asset Relief Program was seen as a way to move bad assets from the banks into the Treasury. Better capitalize the banks directly, since the value of the assets to be sold had to be lower than the price the Treasury would get them at. Besides, the banks would multiply their new reserves by lending and the economic impact would be a multiple. Well, the new TARP didn't work. Yes, the government got paid back in large measure, but the lending did not occur. The banks stabilized by getting too bigger to fail and by milking the spread between zero rate borrowing at the Fed and the very low, but greater than zero, rates they can get from the Treasury.

In any event, the hoped-for credit creation never occurred. Which should teach us all that the Fed can print money. It can inflate financial assets. But it is not the Fed's printing of money that drives real economy inflation.

Which we will review in our idiot of the week in just a moment. But we need to add some relevant details. With excess productive capacity in recession territory, there could be a lot of purchasing power added to the economy without bidding up prices. And with cheap positions now moving into commodities, it is far more likely that inflation will derive from a weak dollar and booming commodity prices than from any demand spur. Yet it is only demand-pull inflation that the Fed can see. Or rather, any inflation is assumed to be demand-pull and thus to require higher interest rates to dampen.

Ah well

BREAK

Allan Meltzer, noted historian of the Fed and professor of political economy at Carnegie Mellon University. We're going to allow that Mr. Meltzer has some principles, and we're going to spend a good deal of time with him today. These interviews span the past two and one-half years. We want to enlist the flow of history in contradicting this Market First, watch out for inflation, nonsense. First, from an interview on Bloomberg on March 17, 2008.

MELTZER ONE.

OOOPS. Stability of the economy is not the second leg of the dual mandate. It is full employment. The Fed is tasked with price stability and full employment. It is not tasked with making banks profitable. It is well established that Mr. Bernanke's academic career is based on work that hypothesizes that had the Fed saved the banks in the Great Depression, there would have been no Great Depression. But that was a monetarist hypothesis, which he is in the process of disproving. It WAS work that earned him the trust of the banks and no doubt got him the job as head of the Fed, but it is not work that is reliable or useful to price stability or full employment, only to bank profitability.

So Mr. Meltzer slipped on that one. Setting aside the support of Hank Paulson and the health of the U.S. economy, at that point three months into the recession.

MELTZER TWO

Here I would agree with Mr. Meltzer. The Fed went to one percent interest under Alan Greenspan and generated a housing bubble. Now it is at zero interest, and the fact that there is no problem is not that there is no problem, but that it is not occurring in the United States. Of course, here the public was burned on stocks in the 1990s and real estate in the 2000s and there is no other asset as widely held. But emerging markets. Yeah. That's the ticket. Brazil and China can boom like you've never seen before, we'll take our cheap Fed money and carry it to emerging markets. Presto. A bubble. Not one that helps us. It may set other economies on fire, but .... You get the point. Cheap Fed rates are a substitute for effective policy. It is not going to do anything but eventual harm.

MELTZER THREE

And see the preceding discussion and the subsequent two years of history to demonstrate that inflation was and is not the bogeyman Mr. Meltzer sees at the window.

MELTZER FOUR

Hallelujah. This is so very true. Here we have to congratulate Mr. Meltzer on adhering to principle. He may have given back his credibility when he fudges the comparison. It is not six percent today, since over 25 percent of a tremendously larger housing market is in question now versus the era of the Great Depression, which was before 30-year fixed mortgages. So he fudged on his comparison. But more interestingly, Will the population revolt?

Now we move to another Bloomberg interview. This one is in August of 2008, at the time of the financial sector meltdown. He begins on the same note as he ended his March interview. Then, well, here ....

MELTZER FIVE


I'm not sure what to make of this. It is not a recession because it is worse, is what I here him saying. But I think he may be trying to say ... something on the order of the lenders and creditors need to take a hit, not just the households. That would create the conditions for a steeper growth path in recovery. Are we poorer? What has been transferred to the foreigners? In many cases the foreigners are the capitalists. I believe this is a weak cousin of Richard Koo's balance sheet recession. If so, good.


MELTZER SIX

Well, you've heard us make the same point, that commodity prices increasing is not the same as inflation, nor should it be treated like inflation. Here, Meltzer's one-time increase in energy and food was soon reversed, so it is entirely possible to have another commodity bubble, but what is really not clear is how the Fed is supposed to keep the price of oil out of other activities. I assume he wants to use the Volcker prescription, or a modern version, of incrasing the price of money to counteract an increase in the price of energy. Demand Side is one place you will not find congratulations for Paul Volcker, as we see the severe recession of 1981-83 as coming out of this experiment and the unemployment of millions as the way inflation was brought down, not any sterile Freidmanesque painless deflation of the money.