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Monday, April 19, 2010

Transcript: 376 Christina Romer, Goldman Sachs, William Black, Hyman Minsky, L. Randall Wray

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Today, we're going to look at a recent speech from Christina Romer, the President's chief economist, then listen to the recent turn in the fortunes of Goldman Sachs, and from this hearken back to Hyman Minsky and his view that while the ethical dimension is first and foremost in the current discussion, the causes and conditions of such behavior are endogenous, that is, built in, to market capitalism.

On April 17 -- last Saturday -- the chair of the President's Council of Economic Advisers Christina Romer spoke to a session at Princeton's Woodrow Wilson School.  She offered the current formula for the president's representatives -- describe the hole from which the administration began, outline evidence of a turning point, and then play down expectations.

A taste of it comes through in the following excerpt.


By the second quarter of 2009, GDP had nearly stopped declining.  It actually grew in the third quarter, and surged in the fourth as inventory liquidation finally slowed to a trickle.  Real GDP appears to be continuing to grow solidly.  Job losses gradually slowed over 2009, and in the first quarter of 2010 we averaged job gains of 54,000 per month.  By almost every indicator, the U.S. economy is finally on the road to recovery.

Demand Side, of course, finds plenty of indicators that indicate not recovery, but stagnation and should government deficit spending abate, further economic decline.

Romer continues, however,

It is against this backdrop that many are beginning to talk about what the world will be like when we come through this ordeal.  Indeed, the discussion of “the new normal” has become the new norm.  This is, of course, something the President and his advisers discuss frequently.  I thought I would take time this morning to give my perspective on unemployment and economic growth as we come out of the Great Recession.

My first and most fundamental point is that when it comes to the economy we are very far from normal.  The unemployment rate is currently 9.7 percent.  I find it distressing that some observers talk about unemployment remaining high for an extended period with resignation, rather than with a sense of urgency to find ways to address the problem.  Behind this fatalism, there seems to be a view that perhaps the high unemployment reflects structural changes or other factors not easily amenable to correction.  High unemployment in this view is simply “the new normal.”  I disagree.

Deficient Aggregate Demand Is Key.  The high unemployment that the United States is experiencing reflects a severe shortfall of aggregate demand.  Despite three quarters of growth, real GDP is approximately 6 percent below its trend path.   Unemployment is high fundamentally because the economy is producing dramatically below its capacity.  That is, far from being "the new normal," it is “the old cyclical."

In this regard, I am reminded of a frustration I have felt many times when people write books and organize conferences about the unemployment problem in the Great Depression -- as if the high unemployment were somehow separate or distinct from the rest of the Depression.  Then, as now, the economy had been through a wrenching crisis that had caused demand and production to plummet.  Unemployment was a consequence of the collapse of demand, not a separate, coincident problem.

Now, to be fair, the unemployment rate has risen somewhat more during this recession than conventional estimates of the relationship between GDP and unemployment would lead one to expect. In this year’s Economic Report of the President, we presented estimates that suggest that the unemployment rate in the fourth quarter of 2009 was perhaps 1.7 percentage points higher than the behavior of GDP would lead one to expect.   Some of that unexpected rise goes away when one takes a more sophisticated view of GDP behavior.  The Bureau of Economic Analysis estimates GDP in two ways -- one by adding up everything that is produced in the economy and the other by adding up all of the income received.  These two measures should be identical.  But in this recession, the income-side estimates have fallen substantially more than the product-side ones.  Therefore some, but not all, of the anomalous rise in unemployment may be due to the fact that the true decline in GDP may have been deeper than the conventional estimates suggest.

And the speech continues.  It is very useful to read.  Where we are going today, however, is to the point that many act as if the financial system and its practices are somehow victims of an unexpected shock or the collapse of aggregate demand when the structure and dynamics of the financial system created the shock and the collapse.  Any effort to treat the current stagnation with simple demand stimulus is like treating a broken bone with a bandaid.  If you're lucky, you might hide the blood.

But I want to come at this discussion from the angle of the investigation announced Saturday by the SEC into the business practices of Goldman Sachs.

Here, from Bloomberg, a short interview with William Black,


Black is on top of the corruption and malfeasance of the banking sector and repeatedly warned about problems beginning more than a decade ago.

Reining in the big banks is, of course, not the course chosen by their chosen regulator Ben Bernanke. The Fed Chairman's academic career is based on the hypothesis that the Great Depression could have been avoided by avoiding the collapse of the banking institutions.  It is from this point of view that he has committed trillions in Fed funds and guarantees and bailouts to ratify too big to fail.  In our view the stagnation is ample evidence that the hypothesis and the treatment are wrong and wrong-headed.

But is that what Hyman Minsky would say?  You can read in the 1992 compilation of essays in honor of Hyman Minsky, entitled Financial Conditions and Macroeconomic Performance, that in the words of Steven Fazzari, "The twin pillars of Minsky's recommended policy structure are "big government" (a fiscal authority that engages in large spending and taxing programs) and a "big bank" (a lender of last resort)."

Let's get a little deeper into Fazzari's summary to separate the real understanding of Minsky from the delusion of Bernanke and in the process give a little perspective to Goldman Sachs.

"In day-to-day conversations," Fazzari writes, "It is clear that Minsky has little patience with interpretations of his cyclical perspective that tie predictions of endogenous instability to 'irrational' behavior on the part of investing firms or financing agents.  The behavior at the micro level may be quite rational, even essential, to maintaining their position in the competitive struggle.  They may be quite awqare of increasing systemic fragility, but this problem is a financial externality over which individual agents have no control."

And we ask you, Is this not exactly what we have seen in the current crisis?  Chuck Prince's famous statement that "as long as the music is playing, you have to get up and dance," is exactly this point.  Perhaps the ethics of the situation are questionable, but the success of the firm is such that if one agent's moral compass points in another direction, the firm will get another agent.  Thus, it is built in to Minsky's cyclical view.

What is that view?

In brief, stability is destabilizing.  "The longer a boom continues, the more the liabilities of firms must be increased to finance investment, i.e., the greater the demands on current cash flows to finance debt payments.  This increased "financial fragility" sows the seeds of the next downturn, placing financial instability in an inherently dynamic and cyclical context."

When debt service becomes a large part of corporate income, the system is in danger of catastrophic collapse in the event of a downturn.  When corporations cannot service their debt through revenue, there begins the debt deflation cycle which we have discussed before, and pass on now for reasons of time.

The Fed can engage in lender of last resort activities and put a floor on debt deflation.  But to the extent that intervention has prevented financial crisis, the disciplining mechanisms that discourage high leverage are weakened, higher indebtedness is encouraged, and the frequency and magnitude of intervention will increase, possibly, Fazzari says, "to the point where crisis can no longer be contained."

"If intervention is successful at constraining instability, researchers may be misled to conclude that the system is endogenously stable and that policy intervention is not required to maintain macro coherence.  With the macro problems apparently suppressed, policy may strive for micro efficieny gains from financial deregulation.  The latter may weaken the mechanisms essential to thrwarting excessive booms, however, and set the stage for the system's explosive dynamics to cause a financial collapse." 

Remember, Fazzari is writing in 1992.

At that time, corporate debt service to income was about 60%.  A high number.  Since that period -- and I have not found the parallel statistic for today -- but since that period, the ratio of corporate debt to corporate profit has tripled.  Interest rates were higher in 1992, but the evidence is clear.  Profits have come as a function of leverage.  The forces that created this leverage are endogenous -- built in.

The twin pillars of government spending and the Fed's lender of last resort action are described in this way, quoting

"The key role of big government operates through the "Kalecki mechanism," which Minsky adopted as a cornerstone of his analysis of fiscal policy: economic downturns cause reduced profit flows.  Reduced profits weaken the ability of firms to service existing debt commitments.  Consequently, asset quality deteriorates and the price of capital assets declines relative to the prive of current output.  This, in turn, reduces investment and magnifies the downturn.  Such a process has the potential to be unstable.  But according to Kelecki, goernment deficits support business profits.  If the fiscal impact of the government is large enough to attenuate falling profits, the price of capital assets will be supported, and the dowside potential of this channel can be contained.  The Reagan fiscal policy of running large deficits as the U.S. economy recovered from the deep recession of the early 1980s could have been recommended on the basis of Kalecki/Minsky logic.

"Big deficits, however, affect profits and the economy over a period of months or yhears.  This policyh cannot contain the speculative instability in asset markets that can arise in financial panics and that causes the price of capital assets to crash.  The best medicine for panic conditions is intervention by the "big bank."  ... the lender of last resort can support capital asset prices, maintain order in financial markets, and thwart debt deflation."


And in fact, that is what we are seeing today.  Except that debt deflation has not been thwarted, leverage continues to climb, and the magnitude of big government spending is certainly going to fall short of what is necessary.  Or likely to, anyway.

Perhaps too brief a treatment, but let's get back to Goldman Sachs with a cautionary analogy from Minsky.  The Federal Reserve, as it tries to contain financial instability, is in an ever-changing situation -- even when it applies itself, which it has not recently.  Financial institutions will devise innovations to evade limits on leverage.  The Federal Reserve will look around like Judy Garland in the Wizard of Oz and say, "Toto, we're not in Kansas any more."  Just so, Minsky intimated, the Federal Reserve is placed in new surroundings by the financial actors whose success depends on leverage.  And as he elsewhere stated, it is not a fair game.  The rewards to the evaders are far above those of the regulators.  So, then, was the reward for the evaders to capture the regulators, as they most certainly did in the current circumstance.

So in our view, although discipline of the Goldman Sachs, Citigroups, JP Morgan Chase, Bank of America and other behemoths bloated with debt is necessary and may proceed more swiftly with outrage, we are going to miss the boat if we do not see that the so-called irrationality was in some sense essential to their survival and we need firm systemic discipline in the form of structure and regulation, not just jail time for the miscreants.

Speaking of jail time,

Let's take a view from L. Randall Wray, also from this weekend.  [Demand Side aside, Wray was the author of one of the essays in the 1992 book we quoted from above.]


In a startling turn of events, the SEC announced a civil fraud lawsuit against Goldman Sachs. I use the word startling because a) the SEC has done virtually nothing in the way of enforcement for years, managing to sleep through every bubble and bust in recent memory, and b) Government Sachs has been presumed to be above the law since it took over Washington during the Clinton years. Of course, there is nothing startling about bad behavior at Goldman—that is its business model. The only thing that separates Goldman on that score from all other Wall Street financial institutions is its audacity to claim that it channels God as it screws its customers. But when the government is your handmaiden, why not be audacious?

The details of the SEC's case will be familiar to anyone who knows about Magnetar. This hedge fund sought the very worst subprime mortgage backed securities (MBS) to package as collateralized debt obligations (CDO). The firm nearly single-handedly kept the subprime market afloat after investors started to worry about Liar and NINJA loans, since Magnetar was offering to take the very worst tranches—making it possible to sell the higher-rated tranches to other more skittish buyers. And Magnetar was quite good at identifying trash: According to an analysis commissioned by ProPublica, 96% of the CDO deals arranged by Magnetar were in default by the end of 2008 (versus "only" 68% of comparable CDOs). The CDOs were then sold-on to investors, who ultimately lost big time. Meanwhile, Magnetar used credit default swaps (CDS) to bet that the garbage CDOs they were selling would go bad. Actually, that is not a bet. If you can manage to put together deals that go bad 96% of the time, betting on bad is as close to a sure thing as a financial market will ever find. So, in reality, it was just pick pocketing customers—in other words, a looting.

The rest of that and the link is online.

Elsewhere, the SEC's probe into Goldman attracted the following from Great Britain's Gordon Brown

"I want a special investigation done into the entanglement of Goldman Sachs and the companies there with other banks and what happened," Brown told BBC television.

"There are hundreds of millions of pounds have been traded here and it looks as if people were misled about what happened. I want the Financial Services Authority (FSA) to investigate it immediately," he said.

"I know that the banks themselves will be considering legal action," Brown said, apparently referring to European banks that lost money ...

And a German government spokesman said that country may pile on as well.

And Goldman may soon have company.

The Wall Street Journal published Monday the following,

The Securities and Exchange Commission, after having hit Goldman Sachs Group Inc. with a civil fraud charge, is investigating whether other mortgage deals arranged by some of Wall Street's biggest firms may have crossed the line into misleading investors.

The SEC's case against Goldman Friday has exposed an open secret on Wall Street: As the housing market began to wobble a few years back, some big financial firms designed products aimed at allowing key clients, such as hedge funds, to bet on a sharp housing downturn.

We suspect that, as in all previous situations, as Hyman Minsky pointed out for us, the financial institutions will be discovered to have been flying in formation. 

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