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

Sunday, February 28, 2010

Yeva Nersisyan points to the solution for unemployment: Hiring

On the podcast Friday, we blew off the President's jobs bill on the grounds that it was a supply side solution that would do very little for increasing market dynamics toward investment, nor for increasing aggregated demand for labor.

Here, Yeva Nersisyan comes to the same conclusion about the jobs bill, but offers another way out: a real jobs bill. A guaranteed job. No doubt this would increase aggregate demand and reduce the ongoing and increasing damage to the fabric of the society. It would not, in our view, change the course or produce the investment we need. Changing the course toward the public goods and protection of the Commons (i.e., the planet). Producing the investment because a jobs bill would simply increase demand for current consumer goods and there is plenty of idle capacity in this country and China to avoid having to invest anything. That said, Nersisyan's is a real world analysis that would get us back on the road.

It is worth a historical note here. There is a compelling explanation of the prosperity of the U.S. as issuing from its foundation on soil that was rich, but without the exploitable plantations or mineral wealth of Latin America. The latter, and to a great extent the American South, developed plantation-style, elite-slave relationships that dogged their development. The U.S. North and West, however, had simply the ample opportunity to move West if one didn't like the conditions where one was. A good job was waiting for the one who wanted it. This not only reduced the supply of labor for the remaining farms and industries, but offered a competitive price for labor that had to be matched.

One can only imagine, today, the effect of a choice between a government job in conservation or day care versus a private job flipping hamburgers at night or doing repetitive factory work.

I know the alarm bells are going off for inflation fetishists, but price increases that are directly translated to wages and product at the bottom are not subtractions from demand, nor dangerous to the society. Such inflation would reduce the real value of contracted credit and might even begin to push up asset prices. The last is something Bernanke & Co. have been trying to do with trillions of dollars more than would be involved in a jobs bill of this kind.

But we wander. Here is the quick and easy from Nersisyan:

A Progressive and Tested Policy for Job Creation

By Yeva Nersisyan
Economic Perspectives from Kansas City
February 28, 2010

On February 24, the Senate approved a $15 billion Jobs Bill deemed to be a legislative victory. While it might be the first truly bipartisan measure we have seen for a long time, the important question is whether it will solve the unemployment problem. The centerpiece of the bill (worth $13 billion) is a payroll tax cut to businesses for hiring new workers. It seems that the bill is based on the good old neoclassical reasoning that the unemployment problem will be solved by lowering wages. Tax credits will supposedly lower the labor costs for businesses thus spurring hiring. Unemployment, however, is not due to high wages but is rather caused by insufficient aggregate demand. When the aggregate demand is low, businesses can’t sell what they produce, therefore they cut back on production and fire workers. Lowering wages won’t help, because if the businessmen don’t expect to sell their products, they won’t hire new workers, regardless of how low wages are.

So while unemployment rate is about 10% with alternative measures of unemployment reaching 18% in January 2010, the government hopes that a measly $15 billion bill centered on payroll tax credits will help alleviate the problem. Well, it won’t. The graph below shows the narrowest and most comprehensive measures of labor underutilization for the period 1994 to 2010.

The U6 measure of unemployment unfortunately only goes back to 1994, so we can’t really know what the historical lows are. However, the current number of 18% looks pretty high. During the previous recession of 2001 the U6 measure went up from its all time low of 6.3% to 10.9%, only a 4.6% increase. This time the increase from trough to peak has been over than 10%, more than twice the previous increase of 4.6%. The annual unemployment rate for 2009 was 9.3%. That was much larger than the Post-WWII historical average of 5.6% (1948-2008). People who have been unemployed 27 weeks and longer were 41.2% of the unemployed, double of the January 2009 number of 22.4%.

A small tax credit based policy similar to the current proposal will not work; it never has. On the other hand, we know what works from past experiences. Direct job creation by the government, similar to the Works Progress Administration (WPA) of the New Deal, will have immediate and direct effects on incomes and jobs. Instead of paying unemployment benefits and tax credits, the federal government should offer to hire anyone who wants to work at the federal minimum wage. A universal jobs program will get the economy going.

The benefit of a government jobs program is that the government doesn’t need to be profitable, unlike businesses. Profitability is the criteria for judging the success of a private firm; an unprofitable business cannot last long. The Federal government, however, doesn’t need to make profit off of its employment projects. This doesn’t mean to say that it should be wasteful. Rather, government programs should be evaluated under different standards and criteria, not profitability. One of the purposes of a democratic government is to supply public services to its citizens, and if a job guarantee program can succeed in doing that, then we could rightly argue that it is effective and “profitable”.

So what services could the government provide? The most obvious one that comes to mind is to improve the infrastructure. A study done by the American Society of Civil Engineers, gave the American Infrastructure a D grade point average. None of the 15 infrastructure categories evaluated had a grade above C+. We will need to make 2.2 Trillions of Investment over five years to improve the conditions of our bridges, dams, roads, schools, drinking water, etc. So why not start from there? Why not hire everyone who wants to work to improve the American infrastructure? This will give people earned income (not handouts by the government that have a shelf life of a banana), will help stop foreclosures and bankruptcies and will get the economy going. Without a direct job creation program, it looks like the economy will continue in this recessionary environment for a long period of time. Even most optimistic commentators predict to see another jobless recovery.

I would go even further and argue that the U.S. economy needs such a Job Guarantee program during the “good” times as well. You might say that usually the economy fares pretty well in providing employment; the US has one of the lowest unemployment rates among developed countries, even reaching lows of 3.7% once in a while. But if you look at the U6 measure of unemployment which is by far a more accurate measure of labor underutilization, the lowest it has been since 1994 (the period of the so-called Great Moderation) was 6.3% at the peak of the NASDAQ boom. Hence even in booms, the private sector doesn’t produce enough jobs to employ everyone who wants to work (and I’m not even talking about the quality of jobs).

We won’t see another bubble of the same magnitude as the housing bubble, the US won’t become a major exporter, consumers are deleveraging, people’s incomes aren’t growing to support income induced consumption. So what will take the U.S. economy out of this recession? Construction, banking and manufacturing, traditional job creating industries don’t offer much hope this time. If we want to have a fast recovery that will also provide jobs, why not start with a federal Job Guarantee program?

President Obama said in an interview that he was hoping that the American people would understand him if he just focused on the right policies. Well, if he really did, maybe Americans would understand him, especially those who would finally be able to get jobs and a source of income. Let’s try a Job Guarantee Program and see what all the jobless Americans have to say.

Saturday, February 27, 2010

Relay: 361 The Joseph Stiglitz Book Tour

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at the London School of Economics, promoting FREEFALL: America, Free Markets, and the Sinking of the World Economy

Friday, February 26, 2010

Transcript: 360 Where jobs come from, an object lesson

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Today, Idiot of the Week


We want to point out quickly that you don't hear us debate on idiot the nonsense from the Right about how well free markets can get us out of here and the rest of the bunkum. You can't even have a debate on the color of the sky if your opponent is pointing down. This is not economics, it is some sort of religion cultivated by messing with people's minds.

There is a group of people we might have a constructive conversation with, and in that group I would put our president. Later, we are going to hear from business interpreters, who are less coherent, and then we will lay out why economic policy from the demand side makes markets work, and why the supply side nonsense, like creating jobs in the quantities we need through tax incentives, does not work.

First, though, the winners are in at the Dynamite Prize. We told you about that last week.

First place, Alan Greenspan, Maestro Magoo. Certainly a turnover for the esteemed chairman from one short decade ago, when as a co-author of the New Economy, he was acclaimed as the man who brought us the end of the business cycle.

Second place, Milton Friedman, the P.T. Barnum of economics.

Third place, and co-winner, Lawrence Summers. Another co-author of the end of the business cycle, the rise of the self-regulating financial markets, and principal proponent of the too little, too late style of economic stimulus.

But really, all the nominees were deserving of this prize. Now up is the Revere Prize at RWER.wordpress.com. Many fine economists, including the odds-on winner Hyman Minsky, have been nominated. We were, oddly, first to get in Joseph Stiglitz name. While Stiglitz came at the financial collapse not from the Minsky-Keen point of view of overwhelming debt, but from an analysis of perverse incentives, he was there looking at the outcome years before it manifested sufficiently for the orthodox mainstream. By manifested sufficiently, I guess we mean, before it hit them in the back of the head with a two by four.

Now back to idiot of the week.

Here is part of an interview between Bloomberg Business Week's Jim Ellis and that magazine's editor in chief Josh Terangel on the latter's exclusive interview with the commander in chief.


Note, we intended to get the venture capitalists in on this by way of a Brookings-Lazard California conference, but that is too much nuance for one podcast. We hope to get them in soon.

Fundamental to demand side analysis is the proposition that business needs nothing so much as customers -- a healthy market, strong -- yes -- demand.

What is wrong with President Obama's portrayal? And why is his prescription shared by others -- like Joe Stiglitz, for example -- who we normally agree with?

First of all, let's admit that when anybody talks about small business, they are talking about big business, just not humongous business. We're dealing with hundred million dollar corporations in small business.

Second, when we say small business creates the jobs, what we are saying is that a good or service produced by a company finds a market demand that motivates it to hire workers and designers and marketers. What we are not saying is that a small business hires somebody and this then creates some sort of economic dynamic that ratifies the hiring. In the best case for subsidized hiring, jobs are pulled forward from next year and if done in sufficient number these people begin to buy.

But it is fundamentally anti-market. The process requires bureaucratic hoops and a projection, one would assume, not of currently visible demand, but of something beyond the veil. Otherwise the business would be hiring anyway. And in fact, the majority of hiring under such a program would be of people who would have been hired anyway. It only makes business sense. If we are asking businesses to operate in a philanthropic way, we are asking them to corrupt what is the basic dynamic of the market. If we want to act philanthropically, we can just hire the people directly to do things like teach our kids.

And because it will be taken advantage of mostly by the big small businesses and those who get in on the crafting of the legislation, it will leave out the real small businesses.

We have already salted the tax code with enough subsidies for business. What they need are customers, not back-door bailouts. With more customers, more demand, the companies can sort themselves out according to the market value of their product. Insofar as markets are not corrupted by the dominance of huge companies and other distortions.

Let's compare this with a demand side approach, say the carbon tax.

First of all, it is in the right scale. Big. It is not a cost to government, but a revenue. In the case of the Cantwell-Collins CLEAR Act, our favorite, the revenue is 75% rebated to citizens on a per-capita basis, but that does not hurt its economic value.

If the tax is phased in over ten years or so, there is ample opportunity to avoid it by citizens and businesses in the form of being more carbon efficient. But how do they do that? They invest in alternatives.

If you look at the experience of the oil dominated energy market, you see that the problem only begins with its high price. When the price is high, yes, businesses and citizens are hurt. Particularly when the price spikes and people are stuck with their current technology. They cannot easily avoid it in the short term. But they begin to and new energy technology is developed, new and better sources begin to be tapped. Then the price goes down, and the alternatives are no longer economically competitive.

So it is really not -- from the economy's point of view -- the high price of oil that is the problem, it is the fluctuations that make the market erratic and at the control of the oil producers. A stable market price is best for everybody. We don't have that. In our view, however, this is the reason OPEC declines to go after the highest price possible. They know it will only create demand for alternatives, and the longer these alternatives are delayed, the better for them.

But a carbon tax is a floor on the price. A phased-in carbon tax is a rising floor that innovators can count on as the minimum price for their own products. Plus, businesses and citizens can make rational, long-term decisions on equipment and retrofitting and insulation.

This is harnessing the market for the benefit of everybody, except, of course, the purveyors of climate altering substances. Another way would be to require these purveyors to buy climate change insurance. If it proves out that their product does not kill the planet, then they can get the money back. If in fact, the overwhelming consensus of legitimate scientists is correct and the climate changes, we can use the money to evacuate the low-lying areas and rebuild cities and the rest. But in the short term, the insurance premiums would likely bid up the price of oil and we would have the benefits of a healthy market for alternatives. Which market change would in and of itself, even if totally meaningless for long-term survival of the planet, create the investment we absolutely must have for economic survival.

In the Cantwell-Collins proposal, 75% of the revenue is rebated to citizens on a per-capita basis, as we said, which offers the demand potential for alternatives or a good impetus for beating the tax by walking and thus an increase to household income.

This is a healthy market, connected to reality, targeted to encouraging real investment, creating the demand without which businesses have no being. They can do without tax cuts and targeted hiring subsidies, but they cannot do without customers.

In order of importance to businesses, at least based on their decisions on where to site new facilities.

  1. Markets
  2. Transportation, land, air, sea
  3. Workforce -- appropriate and available
  4. Educational facilities, primary, secondary and colleges and universities,
  5. and near statistical irrelevance: Tax Structure

Yet the prinicpal plea you hear in legislatureson behalf of business is for tax breaks and regulatory relief. Why is that? What possible explanation is there for the discrepancy?

A cottage industry of lobbyists and business organizations has grown up whose only product is mining the government for tax and regulatory preferences. These professional courtiers grow constituences among legislators with their access to ample campaign cash. They punish the opposition with sophisticated media. But they need a tangible, useful product. This they have at the micro level with the tax and regulatory preferences. At the macro level, these are destructive of open and free markets, but at the micro level there is a cost-benefit calculation. Hence all acting together produce income for lobbyists and business organizations, but undermine healthy markets and vigorous development of human and physical infrastructure. Unfortunately for the businesses who sponsor these groups and individuals, it is the latter that are the basis for prosperity and incidentally business profits.

Again, this cottage industry is fundamentally anti-free market, because it seeks to sekw rules in favor of its clients and capture regulators for its own designs. Of course, in some sense, the more perfect the market, the more competition and information, and the more profits are competed down. Only market distortions create deadweight profits. Monopolies, oligopolies, cartels, and the shifting of costs of producing and consuming to those outside the specific market.

This last is the so-called externality. Disposal, pollution and so forth. These costs are external only in the instance that they escape the moment of purchase and sale. The price is not only the market signal, it is in a very real sense the market.

Which is why the cost of carbon needs to be in the price of carbon. Bringing it in, no matter what dominating corporations may say, improves the market.

The purchase-sale limitation also displays why markets don't produce public goods efficiently. They can only handle goods which convey directly to the buyer the majority of benefits. They cannot handle the free rider problem. Roads, education, health care, public safety, national defense, are far beyond their ability to produce efficiently.

And we should also note that businesses are compulsively self-serving, motivated by individuals whose concept of sanity is of a world with billions of entirely self-interested people. So it is natural for them to be captured in the micro market of lobbyists and business organizations.

But we've gone a long way from our goal, a list of demand side dynamic processes. Rather than squeeze it in at the end, we'll push that out to next week.

Didn't get very far in the idiot category either. These are well-meaning people, just deluded. Like Alan Greenspan, Milton Friedman and Larry Summers. Congratulations.

Since it's Friday, we'll leave you with a reminder of our forecast. Yes. We still claim the U.S. is in recession. The President may claim for his stimulus an avoidance of the Depression, but that is still in the cards, since we've done nothing substantive to remedy the mess in banking or to restart investment. And insofar as we have done better, much is due to the automatic stabilizers of Social Security and unemployment insurance and Medicare, the New Deal and New Deal style social safety net. The stimulus package has given us a bump in the numbers, but nothing like recovery. And we still have the downward sloping floor from contracting state and municipal governments.

We see stagnant GDP, double digit unemployment, with the all-in U-6 measure reaching 20 percent. We also see a 50-50 chance for another financial crisis, possibly related to credit default swaps or the impending insolvency of second tier, not too big to fail banks.

We'll send you out with Martin Wolf, describing why.


That is Martin Wolf, the eminent columnist for the Financial Times.

Wednesday, February 24, 2010

Steve Keen reports Greenspan as Winner of Dynamite Prize, Friedman second

We don't see it on the rwer website, but Steve Keen is reporting Alan Greenspan, Milton Friedman and Larry Summers as winners of the first and only (hopefully) Dynamite Prize. Notice Keen is up for a Revere Prize from the same folks

Greenspan wins Dynamite Prize in Economics
Published in February 23rd, 2010

Greenspan has been judged the economist most responsible for causing the Global Financial Crisis. He, and 2ndand 3rd place finishers Milton Friedman and Larry Summers, have won the first–and hopefully last—Dynamite Prize in Economics.

In awarding the Prize, Edward Fullbrook, editor of the Real World Economics Review, noted that “They have been judged to be the three economists most responsible for the Global Financial Crisis. More figuratively, they are the three economists most responsible for blowing up the global economy.”

The prize was developed by the Real World Economics Review Blog in response to attempts by economists to evade responsibility for the crisis by calling it an unpredictable, “Black Swan” event. In reality, the public perception that economic theories and policies helped cause the crisis is correct.

The prize winners were determined by a poll in which over 7,500 people voted—most of whom were economists themselves from the 11,000 subscribers to the real-world economics review . Each voter could vote for a maximum of three economists. In total 18,531 votes were cast.

Fullbrook cautioned that not all economics and economists were bad. “Only ‘neoclassical’ economists caused the GFC. There are other approaches to economics that are more realistic—or at least less delusional—but these have been suppressed in universities and excluded from government policy making.”

“Some of these rebels also did what neoclassical economists falsely claimed was impossible: they foresaw the Global Financial Crisis and warned the public of its approach. In their honour, I now call for nominations for the inaugural Revere Award in Economics, named in honour of Paul Revere and his famous ride. It will be awarded to the 3 economists who saw the GFC coming, and whose work is most likely to prevent another GFC in the future.”

Dynamite Prize Citations

Alan Greenspan (5,061 votes): As Chairman of the Federal Reserve System from 1987 to 2006, Alan Greenspan both led the over expansion of money and credit that created the bubble that burst and aggressively promoted the view that financial markets are naturally efficient and in no need of regulation.

Milton Friedman (3,349 votes): Friedman propagated the delusion, through his misunderstanding of the scientific method, that an economy can be accurately modeled using counterfactual propositions about its nature. This, together with his simplistic model of money, encouraged the development of fantasy-based theories of economics and finance that facilitated the Global Financial Collapse.

Larry Summers (3,023 votes): As US Secretary of the Treasury (formerly an economist at Harvard and the World Bank), Summers worked successfully for the repeal of the Glass-Steagall Act, which since the Great Crash of 1929 had kept deposit banking separate from casino banking. He also helped Greenspan and Wall Street torpedo efforts to regulate derivatives.
In total 18,531 votes were cast. The vote totals for the other finalists were:
Fischer Black and Myron Scholes 2016

Eugene Fama 1668

Paul Samuelson 1291

Robert Lucas 912

Richard Portes 433

Edward Prescott and Finn E. Kydland 403

Assar Lindbeck 375
The poll was conducted by PollDaddy. Cookies were used to prevent repeat voting.

For further information and interviews email: pae_news@btinternet.com

L. Randal Wray: Is this the worst scandal in US history? To ask the question is to answer it.

Worst Revelation Yet in the On-going Goldman-AIG-NYFed Scandal
By L. Randall Wray
Tuesday, February 23, 2010
Economic Perspectives from Kansas City

Richard Teitelbaum reported today (here) that Timothy Geitner's New York Fed hid the smoking gun that proves Goldman played the key role in bringing down AIG. The only plausible explanation for hiding the document is that Geithner et.al. were protecting Goldman. Is this the worst scandal in US history? To ask the question is to answer it.

In brief, here is the story. Recall that securitization of mortgages was supposed to be a risk-reducing innovation that would move mortgages off the books of banks and into well-diversified portfolios of those better able to absorb risks. Mortgage originators would do the underwriting (verify credit-worthiness), securitizers would do the packaging, credit raters would do the rating, and investors would buy the securities and take the risks. Ah, but Wall Street was too clever for all that. So here is how it really worked. Banks owned mortgage lenders who made NINJA loans (no income, no job, no assets), then worked with credit raters to get the ratings desired. The raters did not actually examine any of the loans because the banks bought Credit Default Swap (CDS) "insurance" from AIG to guarantee safety of the Collateralized Debt Obligation (CDO) issued against the mortgages. Goldman and other banks would then either sell the CDO while using a CDS to bet on default; or they would hold the CDO and use the CDS bet against it to hedge risk. Of course, since Goldman had securitized toxic waste, the bet was not a gamble at all. It knew the CDOs would fail. But meanwhile, it got to book all sorts of fees and income so that it could reward its management with outsized bonuses.

As the subprime market began to crater—due to "unexpected" delinquencies and defaults on mortgages—AIG's own financial situation was down-graded. This led Goldman and other banks to demand collateral from AIG against their CDS bets. Goldman, in particular, played hardball with AIG—ensuring it would fail.

Here is how bad those CDOs were: losses are running as high as 78% on the toxic waste underwritten by Goldman. No wonder the firm bet against it! Yet, when Geithner's NYFed intervened to rescue AIG, it demanded that AIG pay Goldman 100 cents on the dollar—for the "insurance" AIG provided on the toxic waste created by—you betcha—Goldman. Timmy's office then ordered AIG to engage in a cover-up—telling it in November and in December 2008 to keep bank names out of documents filed. As late as January 27 2010 "the New York Fed was still arguing that the contents of Schedule A shouldn't be fully disclosed", Teitelbaum reports. Schedule A is the damning document that not only names names but also details the CDO deals.

It shows that Goldman underwrote $17.2 billion of the $62.1 billion in CDOs that AIG "insured"—the most of any bank. Goldman, in turn, received $14 billion from AIG as its share of the settlement (second only to Societe Generale, which got $16.5 billion). If you do the math, Goldman was paid over 80 cents for every dollar of CDO it wrote that got AIG insurance ($14B/$17.2B). The government has poured $182 billion into the rescue to date and now holds much of the toxic waste created by Goldman and others.

Why did Timmy do it? Why does the NY Fed still insist on secrecy? "They must have been trying to shield Goldman" says Professor James Cox of Duke.

And here is the most outrageous part of the story. As Marshall Auerback and I wrote (here) Goldman's top management was not only betting against the toxic waste they created, they also bet against Goldman:

top management unloaded their Goldman stocks in March 2008 when Bear crashed, and again when Lehman collapsed in September 2008. Why? Quite simple: they knew the firm was full of toxic waste that it would not be able to continue to unload on suckers—and the only protection it had came from AIG, which it knew to be a bad counterparty. Hence on March 19, Jack Levy (co-chair of M&As) sold over $5 million of Goldman's stock and bet against 60,000 more shares; Gerald Corrigan (former head of the NY Fed who was rewarded for that tenure with a position as managing director of Goldman) sold 15,000 shares in March; Jon Winkelried (Goldman's co-president) sold 20,000 shares. After the Lehman fiasco, Levy sold over $6 million of Goldman shares and Masanori Mochida (head of Goldman in Japan) sold $56 million worth. The bloodletting by top management only stopped when Goldman got Geithner's NYFed to produce a bail-out for AIG, which of course turned around and funneled government money to Goldman. With the government rescue, the control frauds decided it was safe to stop betting against their firm.
Goldman appears to be the classic case of what my colleague Bill Black calls a "control fraud". But the NY Fed and by implication the US Treasury (which is also captured by Goldman) is involved in the cover-up of the frauds perpetrated by Goldman's top executives—those "savvy businessmen" President Obama has praised. And that, dear reader, is what makes this rank among the worst scandals in US history.

Tuesday, February 23, 2010

Transcript: 359 Savings, Taxes, Deficits, Credit Crunches, Demand

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I've been having a spirited discussion with Marshall Auerback and Edward Harrison at their "Credit Writedowns" blog on the savings rate, which finally led to this comment.

There does seem to be a qualitative difference between the current savings and that of more prosperous times. Backing up: Beginning in the 1980s "savers" were split off into those who saved by putting money in debt instruments and those who went after equities. Those who bought equities were subtractions from the savings rate. The purchase of assets is not savings, even though it is your nest egg, your retirement stash.  For a time, a long time, these guys who went after stocks were the smart ones, prudent in their diversification, much smarter than the grannies who held their wealth in 2% passbook accounts. Just as with the big guys, the little guys became more and more aggressive, but well within the bounds.  "Stocks have never fallen in any seven-year period" became proof they would never fall again.  When stocks did fall, equity positions were wiped out and people went for safety -- housing.  "Housing never goes down." 

The 2000s was an enormous collapse.  No job growth.  In spite of huge increases in household debt.  As we look back now, we see a series of bubbles, each one larger than the previous.  And we see each has been ratified by the central bank.

But the "saver," one can argue, was never different in her belief that she was behaving responsibly and wisely. It is likely, even, that savings and investment of households increased over the period, as boomers neared retirement.  

Now the savers are back to basics. Their saving is a straightforward subtraction from spending.  Combined with the pullback in borrowing, it is a crushing blow to economic activity.  As Steve Keen points out, spending plus borrowing is the full definition of effective demand. The federal government's discretionary and automatic stabilizers may provide a bottom, but are not in any sense a way out of the mess.

In a minute we'll get to another crimp in effective demand that has the regulators near panic, which is the lapse in lending to small businesses.

On Friday, we'll bring back "idiot of the week," and feature venture capitalists and business advocates who continue to be, well, idiots about obstructing efforts to get effective demand back on the road.  You'll get the full list of why full-scale demand resurrection is preferable -- in the way water is preferable to sand when you're thirsty -- to tax preferences.

Also on the blog transcript I put up the CBPP -- Center on Budget and Policy Priorities -- chart describing the source of the projected federal deficits through 2019.


You'll see the major contributor is the Bush-era tax cuts, which source comprises well more than half of the projected $1.35 trillion deficit by 2019.  The economic collapse is second in magnitude as a cause.  The Stimulus and TARP spending initially are comparable together to these first two sources, but shrink quickly to very modest scales -- assuming there are not more.  The wars in Iraq and Afghanistan roll along as the base to it all, costing $200 billion per year as far as the eye can see.  Absent these sources, the deficit is effectively zero.  Yet where are we going to look for a solution?  Likely not in these root causes.

You can draw your own conclusions.  Mine is that the tax cuts have to be reversed with carbon taxes, financial transaction taxes, high roller taxes.  Say, maybe now that corporations have full First Amendment rights and are virtual people, maybe they could start paying people tax rates.  What a concept.  From ten percent of tax revenues, maybe they could be twenty-five.  Hey.  They were fifty percent in the 1950s.  Seems to have been a pretty good decade.

Maybe we'll get back to the proof of this soon, that taxes do not decrease, but increase demand.  It's not only historically true in the U.S., but compare high-tax to low-tax countries around the world.  Or just compare the magnitude and promises of the Bush tax cuts with the prosperity we find ourselves in today.

Be careful, don't rescind them, we might jeopardize our economy.  Humbug.

Also at Credit Writedowns, we get news of a press release from the complete list of federal government regulators of the financial industry.  It -- this press release -- demands banks start lending to small businesses. 

The regulators supporting the press release were the following: The Board of Governors of the Federal Reserve System, the Federal Deposit Insurance Corporation, the National Credit Union Administration, Office of the Comptroller of the Currency, Office of Thrift Supervision, and the Conference of State Bank Supervisors.

Some small businesses are experiencing difficulty in obtaining or renewing credit to support their operationsBetween June 30, 2008, and June 30, 2009, loans outstanding to small businesses and farms, as defined in the Consolidated Report of Condition (Call Report), declined 1.8 percent, by almost $14 billion. Although this category of lending increased slightly at institutions with total assets of less than $1 billion, it declined over 4 percent at institutions with total assets greater than $100 billion during this timeframe. (These are the big banks.)  This decline is attributable to a number of factors, including weakness in the broader economy, decreasing loan demand, and higher levels of credit risk and delinquency. These factors have prompted institutions to review their lending practices, tighten their underwriting standards, and review their capacity to meet current and future credit demands. In addition, some financial institutions may have reduced lending due to a need to strengthen their own capital positions and balance sheets.

Supervisory Expectations

While the regulators believe that many of these responses by financial institutions are prudent in light of current economic conditions and the position of specific financial institutionsexperience suggests that financial institutions may at times react to a significant economic downturn by becoming overly cautious with respect to small business lending. Regulators are mindful of the harmful economic effects of an excessive tightening of credit availability in a downturn and are working through outreach and communication with the industry and supervisory staff to ensure that supervisory policies and actions do not inadvertently curtail the availability of credit to sound small business borrowers. Financial institutions that engage in prudent small business lending after performing a comprehensive review of a borrower’s financial condition will not be subject to criticism for loans made on that basis.
On next Saturday's relay, we'll have the Joe Stiglitz book tour at the London School of Economics.  Stiglitz remarks in that talk that the real estate collapse has hurt small businesses which formerly borrowed on the base of their real estate collateral.

Here you have every single regulator coming down on the lenders.

As Ed Harrison says at Credit Writedowns, This is official confirmation that the credit crisis is not over and that regulators are worried.

my comment

Banks have no incentive to look for small businesses when they can borrow at 0 and go get 3 or 4 in the Treasury market. Why not squeeze that margin so they are motivated to lend to real customers? I do not see that zero has created any investment. It seems to help those who have loans tied to the prime rate, identified now, I guess, as 3 percent above the federal funds rate, and more importantly, it helps the banks via backdoor bailouts. 

A 2 percent federal funds rate would squeeze them back into the real economy looking for good credit risks. It seemed to work in the early 1990s.

Finally, a comment we have resisted making on the Greek crisis.  It is our view that Greece has become the target for speculative attack.  The EU ought to get it together to backstop the Greeks and make the speculators pay as much as possible.  We would not be surprised that the author of the deceptive derivatives that aided Greece in its escape of EU fiscal restraints -- Goldman Sachs -- has a lot of trades on the short side here.  

On the other hand, we could see the Greek debt default and watch as to whether the credit default swaps that are traded over the counter -- that is, the counter in the back room -- are honored in their entirety.  Could the central banks really want the decision of whether or not to bail out another AIG?

Ed Harrison again, says 

The takeaway here is that we are still in a credit crisis. What is happening in the sovereign debt markets is going to force policy makers to unwind stimulus and accommodation sooner than later. However, doing so risks disaster because signs of recovery are still quite incomplete at this juncture. The evidence comes in both the Fed’s assessment of low credit demand and the ECB’s assessment of outright monetary contraction.  You don’t get sustainable GDP growth in a world of contracting monetary aggregates and sluggish credit demand.

Monday, February 22, 2010

Auerback and Wray advise Greece to go after Goldman Sachs

By Marshall Auerback And L. Randall Wray
Economic Perspectives from Kansas City
February 21, 2010

In recent weeks there has been much discussion about what to do about Greece. These questions become all the more relevant as the country attempts to float a multibillion-euro bond issue later this week. The Financial Times has called this fund-raising a critical test of Greece's credibility in financial markets as it battles with a spiraling debt crisis and strikes. (see here) The "credibility" of the financial markets is an important consideration in a country which has functionally ceded its sovereign ability to create currency, and thus remains dependent on the vagaries of the very banking institutions which helped create the mess in the first place.

Maybe Greece should secede from the European Union and default on its euro debt? Or go hat-in-hand to the International Monetary Fund (IMF) to beg for loans while promising to clean up its act? Or to the stronger Euro nations, hoping for charitable acts of forgiveness? Unfortunately, all of these options are going to mean a lot of pain and suffering for an economy that is already sinking rapidly.

And it is questionable whether any of them provide long term viable answers. Polls show that given the perception of fiscal excesses of Greece and the other countries on the periphery, the public in Germany opposes a bailout of these countries at its expense by a significant margin. Periphery countries such as Ireland that have already undertaken harsh austerity measures also oppose the notion of a bailout, despite—nay, because of--the tremendous pain already inflicted on their own respective economies (in Ireland's case, the banks are probably insolvent as well). The IMF route is also problematic, given that Greece probably doesn't qualify under normal IMF standards, and many euro zone nations would find this unpalatable from an ideological standpoint, as it would mean ceding control of EU macro policy to an external international institution with strong US influence.

The Wall Street Journal recently highlighted an article by Simon Johnson and Peter Boone, lamenting that the demands being foisted on Greece and other struggling Euronations would "massively curtail demand, lower wages and reduce the public sector workforce. The last time we saw this kind of precipitate fiscal austerity—when nations were tied to the gold standard—it contributed to the onset of the Great Depression in the 1930s" (see here). Where we disagree with Johnson and Boone is the suggestion that the IMF be brought in to craft a solution. Any help from this organization will come with tight strings attached—indeed, with a noose around Greece's neck. Germany and France would be crazy to commit their scarce euros to a bail-out of Greece since they face both internal threats from their own taxpayers and external threats from financial vampires who are looking for yet another nation to attack.

Here's a more appropriate action: declare war on Goldman Sachs and other global financial firms that created this mess. Send the troops, the planes, the tanks, and the ships. Attack every outpost of the saboteurs on European soil. Blockade the airports and ports. Make Wall Street traders and CEOs fear for their lives, or at least for their freedom to travel. Build some Guantanamo-like facility to hold these enemy financial combatants until they can be tried, convicted, and properly punished.

Ok, if a literal armed attack on Goldman is too far-fetched, then go after the firm using the full force of the regulatory and legal systems. Close the offices and go through the files with a fine-tooth comb. Issue subpoenas to all non-clerical staff for court appearances. Make the internal emails public. Post the names of all managers and traders on Interpol. Arrest anyone who tries to board a plane, train, or boat; confiscate their passports; revoke their visas and work permits; and put a hold on their bank accounts until culpability can be assessed. Make life at least as miserable for them as it now is for Europe's tens of millions of unemployed workers.

We know that the Obama administration will not go after the banksters that created this global financial calamity. It has been thoroughly co-opted by Wall Street's fifth column—who hold most of the important posts in the administration. Europe has even more at stake and has shown somewhat more willingness to take action. Perhaps our only hope for retribution lies there.

Some might believe the term "banksters" is too mean. Surely Wall Street was just doing its job—providing the financial services wanted by the world. Yes, it all turned out a tad unfortunate but no one could have foreseen that so many of the financial innovations would turn into black swans. And hasn't Wall Street learned its lesson and changed its practices? Fat chance. We know from internal emails that everyone on Wall Street saw this coming—indeed, they sold trash assets and placed bets that the trash would crater. The crisis was not a mistake—it was the foregone conclusion. The FBI warned of an epidemic of fraud back in 2004—with 80% of the fraud on the part of lenders. As Bill Black has been warning since the days of the Saving and Loan crisis, the most devastating kind of fraud is the "control fraud", perpetrated by the financial institution's management. Wall Street is, and was, run by control frauds. Not only were they busy defrauding the borrowers, like Greece, but they were simultaneously defrauding the owners of the firms they ran. Now add to that list the taxpayers that bailed out the firms. And Goldman is front and center when it comes to bad apples.

Lest anyone believe that Goldman's executives were somehow unaware of bad deals done by rogue traders, William Cohan (see here) reports that top management unloaded their Goldman stocks in March 2008 when Bear crashed, and again when Lehman collapsed in September 2008. Why? Quite simple: they knew the firm was full of toxic waste that it would not be able to continue to unload on suckers—and the only protection it had came from AIG, which it knew to be a bad counterparty. Hence on March 19, Jack Levy (co-chair of M&As) sold over $5 million of Goldman's stock and bet against 60,000 more shares; Gerald Corrigan (former head of the NY Fed who was rewarded for that tenure with a position as managing director of Goldman) sold 15,000 shares in March; Jon Winkelried (Goldman's co-president) sold 20,000 shares. After the Lehman fiasco, Levy sold over $6 million of Goldman shares and Masanori Mochida (head of Goldman in Japan) sold $56 million worth. The bloodletting by top management only stopped when Goldman got Geithner's NYFed to produce a bail-out for AIG, which of course turned around and funneled government money to Goldman. With the government rescue, the control frauds decided it was safe to stop betting against their firm. So much for the "savvy businessmen" that President Obama believes to be in charge of Wall Street firms like Goldman.

From 2001 through November 2009 (note the date—a full year after Lehman) Goldman created financial instruments to hide European government debt, for example through currency trades or by pushing debt into the future. But not only did Goldman and other financial firms help and encourage Greece to take on more debt, they also brokered credit default swaps on Greece's debt—making income on bets that Greece would default. No doubt they also took positions as the financial conditions deteriorated—betting on default and driving up CDS spreads.

But it gets even worse: An article by the German newspaper, Handelsblatt, ("Die Fieberkurve der griechischen Schuldenkrise", Feb. 20, 2010) strongly indicates that AIG, everybody's favorite poster boy for financial deviancy, may have been the party which sold the credit default swaps on Greece (English translation - here).

Generally, speaking, these CDSs lead to credit downgrades by ratings agencies, which drive spreads higher. In other words, Wall Street, led here by Goldman and AIG, helped to create the debt, then helped to create the hysteria about possible defaults. As CDS prices rise and Greece's credit rating collapses, the interest rate it must pay on bonds rises—fueling a death spiral because it cannot cut spending or raise taxes sufficiently to reduce its deficit.

Having been bailed out by the Obama Administration, Wall Street firms are already eyeing other victims (and for allowing these kinds of activities to continue, the US Treasury remains indirectly complicit, another good reason why one shouldn't expect any action coming out of Washington). Since the economic collapse is causing all Euronations to run larger budget deficits and at the same time is raising CDS prices and interest rates, it is easy to pick off nation after nation. This will not stop with Greece, so it is in the interest of Euroland to stop the vampires now.

With Washington unlikely to do anything to constrain Goldman, it looks like the European Union, which is launching a major audit, just might banish the bank from dealing in government debt. The problem is that CDS markets are essentially unregulated so such a ban will not prevent Wall Street from bringing down more countries—because they do not have to hold debt in order to bet against it using CDSs. These kinds of derivatives have already brought down an entire continent – Asia – in the late 1990s (see here), and yet authorities are still standing by and basically doing nothing when CDSs are being used again to speculatively attack Euroland. The absence of sanctions last year, when we had a chance to deal with this problem once and for all, has simply induced even more outrageous and fundamentally anti-social behavior. It has pitted neighbor against neighbor—with, for example, Germany and Greece lobbing insults at one another (Greece has requested reparations for WWII damages; Germany has complained about subsidizing what it perceives to be excessive social spending in Greece).

Of course, as far as Greece goes, the claim now is that these types of off balance sheet transactions in which Goldman and others engaged were not strictly "illegal" under EU law. But these are precisely the kinds of "shadow banking transactions" that almost brought down the global financial system 18 months ago. Literally a year after the Lehman bankruptcy - MONTHS after Goldman itself was saved from total ruin, it was again engaging in these kinds of deals.

And it wasn't exactly a low-level functionary or "rogue trader" who was carrying out these transactions on behalf of Goldman. Gary Cohn is Lloyd "We're doing God's work" Blankfein's number 2 man. So it's hard to believe that St. Lloyd did not sanction the activities as well in advance of collecting his "modest" $9m bonus for last year's work.

If these are examples of Obama's "savvy businessmen" (see here), then heaven help the global economy. The transaction highlighted, if reported that way in the private sector, would be accounting fraud. Fraud - "Go to jail, do not pass Go" fraud. That senior bankers had no problem in structuring/recommending/selling such deals to cash-strapped governments should probably not surprise us at this point. However, it would be interesting to know if the prop trading desks of those same investment banks, purely by coincidence of course, then took long CDS (short the credit) positions in the credit of the countries doing the hidden swaps. A proper legal investigation by the EU could reveal this and certainly help to uncover much of the financial chicanery which has done so much destruction to the global economy over the past several years.

In this country, we have had a "war on terror" and a "war on drugs" and yet we refuse to declare war on these financial weapons of mass destruction. We all remember Jimmy Carter's "MEOW"—the attempt to attack creeping inflation that was said to sap the strength of the US economy in the late 1970s. But Europe—and indeed the entire globe—faces a much more dangerous and immediate threat from Wall Street's banksters. They created this mess and are not only profiting from it, but are actively preventing recovery. They are causing unemployment, starvation, destruction of lives, and even violence and terrorism across the world. They are certainly more dangerous than the inflation of the 1970s, and arguably have disrupted more lives than Osama bin Laden—whose actions led the US to undertake military actions in at least three countries. That should provide ample justification for Greece's declaration of figurative war on Manhattan.

However, in an ironic twist of fate, it was just announced that Petros Christodoulou will take over as the head of Greece's national debt management agency. He worked as the head of derivatives at JP Morgan, and also previously worked at Goldman—the firm that got Greece into all this trouble!

Dimitri Papadimitriou has recently made what we consider to be an important plea for moderation of the hysteria about Greece's debt. Writing in the Financial Times, he complained that "The plethora of articles in your pages and others, some arguing in favour and other against a bail-out, contribute to market confusion and drive the country's financing costs to record levels. It is not yet clear that a bail-out is even needed, but this market confusion is rendering the government's ability to achieve its deficit goals ever more difficult." Indeed, we suspect that the same financial firms that helped to get Greece into its predicament are profiting from—and stoking the fires of—the hysteria. He goes on, "what Greece really needs now is a holiday from further market confusion being created by contradictory, alarmist public commentary" (see here).

Greece, Euroland in general, and the rest of the world all need a holiday from the manipulation and destruction of our economies by Wall Street firms that profit from speculative bubbles, from burying firms, households, and governments under mountains and debt, and even from the crises that they create. Governments all over the globe should use all legal means at their disposal to ferret out the bad faith and even fraudulent deals that global financial behemoths are foisting on us.

Saturday, February 20, 2010

Relay: 358 Jim Chanos on the Chinese property bubble

Listen to this episode

This noted short-seller talks and takes questions

Week links and paragraphs

Calculated Risk's digest of the special inspector's report....
To the extent that the crisis was fueled by a “bubble” in the housing market, the Federal Government’s concerted efforts to support home prices risk re-inflating that bubble in light of the Government’s effective takeover of the housing market through purchases and guarantees, either direct or implicit, of nearly all of the residential mortgage market.  .... (continues at link)

Questions for Joseph Stiglitz from the NY Times....
As you make the rounds of television talk shows to promote your new book, “Freefall: America, Free Markets and the Sinking of the World Economy,” many of us are wondering why you aren’t talking to the members of the Obama administration instead. Were you offered a job by the president? .....
The Economist Backs Cantwell-Collins
Which attentive readers know, is the climate change bill that auctions almost all emission allocations starting on day one, and refunds most of the proceeds to households. Here’s the Economist story. (Technically, it’s just the columnist “Lexington,” but the Economist has a consistency voice and position unlike any other news publication.) Here’s an excerpt: (courtesy James Kwak from The Baseline Scenario)
“Of all the bills that would put a price on carbon, cap-and-dividend seems the most promising. . . . The most attractive thing about the bill is that it is honest. To discourage the use of dirty energy, it says, it has to be more expensive. To make up for that, here’s a thousand bucks.
“This challenges the conventional wisdom in Washington, DC, that the only way to pass a global-warming bill is to disguise what’s in it. Leading Democrats try to sell cap-and-trade as a way to create jobs and wean America from its addiction to foreign oil.”
Atlantic interview with Paul Samuelson, very pungent.
Atlantic Part II with Paul Samuelson

Friday, February 19, 2010

Transcript: 357 Forecast and Mortgage Interest Rates

Listen to this episode


Today on the podcast, Mortgages and Debt, what went wrong and what is going to go wrong, focusing on the upcoming exit of the Fed from the MBS market, its effect on interest rates, and what that is likely to do to prices.  Then we look at the right way to do things, featuring the writings of two-time Nobelist Joseph Stiglitz (once for economics, once as part of the IPCC for peace).

And speaking of the Nobel, we see Assar Lindbeck made it to the short list of the Dynamite prize.  The Dynamite Prize, you may be aware, was originally called the Ignoble Prize in Economics.  It will be awarded to the three economists who contributed most to enabling the Global Financial Collapse (GFC), or more figuratively, to the three economists who contributed most to blowing up the global economy.  

By working to make the Riksbank Prize in Economic Sciences (“Nobel Prize in Economics”) almost exclusively a prize for neoclassical economists, this Swedish economist has contributed significantly to the conversion of the economics profession and of world public opinion to market fundamentalism. 

There are other, more notable economists up for the prize, which you yourself can vote on at rwer.wordpress.com.  I voted for only one.  The P.T. Barnum of economics, Milton Friedman, whose hash of history melded neatly with a theory that never worked and was promoted tirelessly by the man to the detriment of real economics.  

The blog has it right in their dossier:

"Milton Friedman propagated the delusion, through his misunderstanding of the scientific method, that an economy can be accurately modeled using counterfactual propositions about its nature.  This, together with his simplistic model of money, encouraged the development of the financial theories with unrealistic assumptions that facilitated the GFC.  In short, he opened the door for everyone subsequently to theorize without fear of having to be attached to reality."

But there are others, and you don't need to limit yourself to one.  You get three votes.

But now to mortgages and debt.

Our view of Alan Greenspan was not the mainstream's view, even in 2000.  Greenspan is also on the short list at the Dynamite Prize.  We referred to him as Maestro Magoo, since whatever he did, no matter how obtuse or dangerous, since the economy landed on its feet and he was still smiling, he got credit for doing something right.  Hopefully some of you will remember Mister Magoo, the myopic cartoon character voiced by Jim Backus who escaped calamity time and time again, and because he escaped, or more rightly because he never knew he was in danger, his confidence in himself never wavered.  "Oh, Magoo, you've done it again."

By cutting rates, Greenspan let people reach for more house.  As rates went down, house prices began to go up.  The same monthly payment could afford a more expensive house.  House prices rising brought in people running from the dot.com bust, then it brought in the archetypical Ponzi investors, who were not looking for a productive asset, but for an increase in its price.  These combined with the simple savers, who bought and paid for as much house as they could buy because, hey, the increase in every year is doing a lot better than anybody's stocks or savings accounts.  

So that is what is needed for a bubble, the only necessary and sufficient conditions, easy money and rising asset prices.  Other elements of bubbles, such as the corruption that inevitably preys on the phenomenon -- and which we should say is often blamed for the process -- are not sufficient to cause one.  Of course, much of the professional and intellectual corruption sponsored innovations that brought money down to free.  Now, of course, we have the reverse playing out
The Fed is winding down its MBS purchase program, specifically designed to keep interest rates low.  For the past year, the Fed has been virtually the only purchaser of these securities.  Most predictions are for 5.5 to 7 percent mortgages, up 50 to 150 basis points.  See a list on the blog transcript.
    •  Guy Cecala, publisher of Inside Mortgage Finance. "My opinion is that rates will go up a full percentage point initially," meaning that 30-year fixed conforming loans, now hovering around 5 percent, would hit 6 percent.

    •  Keith Gumbinger, vice president of HSH Associates, which compiles mortgage loan data, thinks that rates will slowly rise to about 5.75 percent after the Fed withdraws. 

    •  Julian Hebron, branch manager at RPM Mortgage's San Francisco office, anticipates a bump up to around 5.5 percent by summer ...

    •  Christopher Thornberg, principal at Beacon Economics in Los Angeles [said] "Clearly, when they stop printing all that money, it's going to be a shock to the system. I have to assume that when they pull back on it, it will cause a 100- to 200-basis-points rise" to rates of 6 percent or 7 percent ...
And a couple earlier predictions:

  •  Eric S. Rosengren, president and chief executive of the Boston Fed, expects a 50 to 75 bps increase.
  •  Pimco's Bill Gross expects about a 50 bps increase. He also thinks the Fed will restart the program later in 2010.

    Calculated Risk's estimate is based on the 10 Year Treasury -- an increase in the spread of about 35 bps (maybe 50 bps).

It is worthwhile to reflect on another episode when interest rates went up.  In the early 1980s when Paul Volcker tried to crush inflation with high interest rates.  Back up.  No.  He was applying Milton Friedman's prescription and restricting the money supply.  In any event, interest rates went up and the Savings & Loan business model was crushed.

Inflation came down, but it was not the painless exercise Friedman had promised.  Instead it was the deepest recession between the Great Depression and now.  The value of the S&L held mortgages collapsed.  The S&L's quickly became essentially bankrupt.  Accounting rules allowed them to forestall the day of reckoning.  They didn't have to write down the mortgages to reflect reality.  Some tried to solve the problem by continuing to grow -- a kind of Ponzi scheme, as Stigltiz says.  Ronald Reagan helped them along by softening accounting standards.  The S&L's were zombies -- dead banks that remained among the living.  They began a gamble on resurrection.  The result was a much bigger hole than the original one and in the process of gambling, a lot of corruption and scandal was birthed.

So will interest rates go up with the end of the Fed's MBS purchases and the sunsetting of these other programs?  Well, house prices will fall.  If interest rates don't go up, it will be for lack of demand.  Terms will also get much tighter and prices will go lower on the downslope of the interest rate bell curve.  One thing for sure, zero financing to the banks will not increase the number of mortgages they are writing.  Another reason to raise the rate and squeeze them toward productive, real economy loans.

Lower prices mean more people under water.  What is the opposite of a bubble?  A black hole?

And consider Stiglitz' point, a mortgage for one hundred percent of the value of a house in a non-recourse environment -- where the borrower can just send the keys back to the lender with no recourse open to the lender, this type of contract is also known as an option.

On Wall Street, if you had this deal, you would look at the price and the cost and make a calculation.  It is absurd to see bankers trying to bully people with moral intimidation when they have done much worse and given themselves bonuses for it.  But we're not going there.  Sorry.

We are not going to deal with the corruption today, nor the toxic derivatives, nor the many and manifold asymmetries between social purposes and banking incentives.  And we're going to take as given the fact that the huge privately held debt, household and business, is the mountain that must be removed before the economy can recover.

Following Stiglitz, securitzation made it more difficult to renegotiate mortgages.  They were packed and sliced.  The mortgage servicers have little incentive to renegotiate, particularly when the securities contain specific restrictions making such action more difficult.

Add to this that a typical highly indebted homeowner has a first mortgage for, say, 80 percent of the value of the house, and a second mortgage for, say, 15 percent.  If the home falls 20 percent in value, we have a problem.  A single mortgage of 95% would be easier to write down because both borrower and lender would be interested in a -- theoretically both would be interested in getting the financial incentives right to stay in the home.  But the second mortgage holder has no reason, since he will be wiped out in foreclosure.  A dim chance of recovery in the housing market is the only light he sees in terms of getting any of his money back.  The interests of the first and second mortgage holders are thus diametrically opposed.  

Add to this the fact that the holder of the second mortgage was often, who else?  the mortgage servicer who has responsibility for renegotiation.

And beneath it all, there is the trepidation of the banks themselves, or the mortgage holders, who would be required to recognize losses that bad accounting allows them to ignore at present.

So what is the answer?

The economy needs to reduce this debt.  Stiglitz suggests the best of all options.  Homeowners Chapter 11.

One in seven mortgages is delinquent.  The proportion of those 90 days or more and in the foreclosure process continues to expand.  Check the blog for Calculated Risk's chart.

MBA Prime Delinquency and Foreclosure RateClick on graph for larger image in new window.

Homeowners Chapter 11 is modeled on the corporate bankruptcy process, which he discusses in his must-read book FREEFALL.  This would be a speedy restructuring of liabilities of poorer homeowners.  In a corporate Chapter 11, the stock holders, those who own the equity, are wiped out, and the bondholders become the new equity owners.  In a home, it is the homeowner who holds the equity, so to speak, and the bank is the bondholder.  Here, along with writing down the value of what the homeowner owes, the bank receives equity, and when the house is eventually sold, a large fraction of the capital gain on the house would go to the lender.  Obviously those who bought mainly to speculate would not find such a deal attractive.

With Homeowners' Chapter 11, people would not have to go through the full bankruptcy process, discharging all of their debts.  The home would be treated as if it were a separate corporation.  The house would be appraised and the individual's debt would be written down to, say, 90 percent of the appraisal.  The bank avoids foreclosure losses and gets upside potential.  The foofaraw around renegotiation is greatly diminished.  Debt disappears.

Another idea Stiglitz presents in his book, which you have heard here, is using the very low borrowing costs of the federal government to directly benefit citizens, rather than going a long way around through the banks and maybe getting someday back to something to do with what could be a real economy.

The government not only has low borrowing costs, but it is in a much better situation to ensure payment.  If the government lends to the homeowner at 2 percent rather than 6 percent, for example, the interest payments on a $300,000 mortgage drop to $1,500 a month from $6,000.  Quoting now, rather than paraphrasing.  

"For someone struggling to get along at twice the poverty rate, around $30,000 a year, that cuts house payments from 60 percent of the before-tax income to 20 percent.  Where 60 percent is not manageable, 20 percent is.  And apart from the cost of sending out the notices, the government makes a nice $6,000 profit per year on the deal.  

"Moreover, becaue the house is not being forced into foreclosure, real estate prices remain stronger, and the neighborhood is better off.  There are advantages all around -- except for the banks.  The government has an advantage," Stiglitz says again, "both in raising funds and in collecting interest." 

and later,

""If banks can't make the easy money by exploining poor Americans, they might go back to the hard business, what they were supposed to be doing all along -- lending money to help set up new enterprises and expand old ones."
The same type of scheme could be used to help consumer credit holders.  It has its precedent in the student loan programs and in government mortgages.  Here it reduces debt burdens without touching the principle, and makes the economy better off at everybody's benefit except -- again -- the banks.

As we mentioned when we first brought this up, oh, a year ago, however, these sorts of remedies -- which go directly to the heart of the debt problem -- are not even on the table.

The inevitability of a slide absent such measures is complete.  The effect of interest rate rises on housing and housing prices is sure.  The follow-on hit to effective demand for all goods is assured.  Thus the forecast.  The rosy 3 percent plus GDP numbers coming out of the Administration are imaginary.  Our 1 percent is optimistic.  (That is out the stimulus bump we are now enjoying).  One percent.  Demand equals supply.  Contracting credit.

Political weight on top of the required public investment will not go away soon, is our guess.  And there is no other way out than reducing debt and increasing public investment.  We can all be looking through the windows at the predatory casino capitalism, or we can get to work educating and building in a society of solvent citizens.  Only the second option leads to economic vitality.

Thursday, February 18, 2010

Marshall Auerback asks Will we have to blow up a continent (again) before we stop Wall Street?"

If financial markets are melting down, can Wall Street derivatives be far behind?

Will we have to blow up a continent (again) before we stop Wall Street?
by Marshall Auerback
New Deal 2.0
February 15, 2010

Surprise, surprise: Wall Street tactics akin to the ones that fostered subprime mortgages in America have worsened the financial crisis shaking Greece, Spain, Portugal, and undermined the euro by enabling European governments to hide their mounting debts. This has now become front page news in the Sunday New York Times.

According to the Times:

“Even as the crisis was nearing the flashpoint, banks were searching for ways to help Greece forestall the day of reckoning. In early November — three months before Athens became the epicenter of global financial anxiety — a team from Goldman Sachs arrived in the ancient city with a very modern proposition for a government struggling to pay its bills, according to two people who were briefed on the meeting. The bankers, led by Goldman’s president, Gary D. Cohn, held out a financing instrument that would have pushed debt from Greece’s health care system far into the future, much as when strapped homeowners take out second mortgages to pay off their credit cards” (our emphasis).

Sound familiar? This is exactly how AIG built up its credit default swap business, in essence facilitating regulatory arbitrage on behalf of the banks. Basically, banking regulations encouraged companies to buy cheap swaps so that they could treat risk assets as almost risk-free, concealing their toxic nature via the ledger main of financial engineering. This, in turn, allowed them to take money out of their reserves and buy more risky assets, which they then covered up with more credit default swaps. All of this was designed to evade the capital adequacy requirements mandated under the Basel banking accords.

AIG was destroyed, but as the NY Times article illustrates, the practices still persisted. As late as November 2009, Goldman Sachs, its own survival now successfully assured by repeated US government lifelines and guarantees, was seeking to perpetuate a similar kind of ruse over the European Union.

We have railed against the stupidity of the rules underlying the European Monetary Union many times, but poorly thought-out rules do not give a bank the right to destroy an entire continent, even “Government Sachs”. In the words of Simon Johnson,

“These actions are fundamentally destabilizing to the global financial system, as they undermine: the euro zone area; all attempts to bring greater transparency to government accounting; and the most basic principles that underlie well-functioning markets. When the data are all lies, the outcomes are all bad – see the subprime mortgage crisis for further detail.“

But it’s nothing new. Virtually the same thing happened in East Asia during the late 1990s. Most people are now familiar with standard derivative contracts used in hedging risk, such as forwards, futures and options. While foreign-currency forwards remain the province of bank foreign exchange dealers, most basic futures and options contracts are standardized and traded in organized, regulated markets. Banks have also long offered derivative contracts to their clients in what is termed the “over-the-counter” (OTC) market. But, there is no market involved in these contracts, which may involve the stipulation of standard futures and options contracts outside of the organized market on a bilateral basis with individual clients.

The majority of OTC activity involves individually tailored, often highly complex, combinations of standard financial instruments packaged together with derivative contracts designed to meet the particular needs of clients. These kinds of contracts involve very little direct lending by banks to clients, and thus generate little net interest income. But during the 1990s, they had the advantage, given the necessity of meeting the Basel capital adequacy requirements, of requiring little or no capital, or of being classified as off-balance sheet items because they did not represent a direct risk exposure of bank funds. Or so it appeared. And they had the additional benefits to Wall Street of generating substantial fee and commission income.

The volumes of these OTC structured credit notes rose substantially in the mid-1990s. While these derivatives were by no means unique to East Asia (see Orange County in 1993, Mexico in 1994, Long Term Capital Management in 1998), an IMF study from 1998 suggests that most of the initial losses sustained during the initial impact of the Asian crisis were related to derivative-based credit swap contracts. Furthermore, the Bank of Korea reported in March 1998 that trading in financial derivatives by South Korean banks increased by 60.1% in 1997 to $556.5 billion and largely contributed to the virtual nationalization of the entire Korean banking system as these positions blew up. It also helps to explain why heavily exposed banks such as JP Morgan (which had huge exposure via their derivative positions to the Korean banks) were at the forefront of the move to convert Korean banks’ short-term debt into sovereign debt.

Much the same can be said for Thailand, Indonesia, and Malaysia. The crash was even more devastating to people’s living standards and sense of security than the Latin America crash of the 1980s. Indonesia’s real GDP shrank 17 per cent in the first three quarters of 1998, Thailand’s 11 per cent, Malaysia’s 9 per cent, and Korea’s 7.5 per cent. It took nearly two years to reach the bottom. Many millions who were confident of middle class status had their lifetime savings destroyed. Public expenditures of all kinds were forcibly cut as all of the countries fell under the punitive aegis of the IMF. The IMF itself mounted the biggest financial bailout in history — $110bn, almost three times Mexico’s $40bn “rescue” package from the 1994-95 “Tequila crisis”.

Yet the experience of the past 2 years suggests that we have learned nothing and our political leaders seem determined once again to avoid dealing with the problem once and for all. God forbid that Congress should antagonize one of its main funding sources.

Perhaps now that these destructive practices are appearing in Europe’s own backyard, the authorities there may be sufficiently motivated to do something, if one is to judge from the recent comments of French Finance Minister, Christine Lagarde. Of course, cracking down on “currency speculators”, or short sellers, is largely beside the point, when you’ve got clear evidence of a bank deliberately conspiring to hide the true extent of an EU government’s debt. That’s abetting fraud, plain and simple. Jeffrey Skilling, former CEO of Enron, is sitting in jail today for that very offence. By contrast, Gary Cohn’s boss, Lloyd Blankfein, just received a $9m bonus.

It seems more than extraordinary that nothing was done following the economic implosion of East Asia during the 1990s. Eighteen months ago, we experienced the near the near wipe-out of our global banking system, and today we face the threatened destruction of the European Monetary Union. And still all we get is nothing more than the vague threat of action, and feeble efforts at regulatory reform.

Hey, as Jamie Dimon noted at the FCIC hearings a few weeks ago, stuff like this happens every 5 to 7 years, so what’s the big deal? Why bother letting the potential vaporization of a currency stop Wall Street from behaving recklessly and with complete disregard to the basic tenets of international financial stability? Heaven forbid that government should impede something as important as “financial innovation”. Shit happens. That’s no reason to “punish” a growth industry, even one where the main growth component appears to be the perpetuation of financial fraud.