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

Tuesday, May 25, 2010

Transcript: 386 Real world, fantasy solutions, are making a mess

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Today on the podcast, the results of the Revere Award for the economists who best predicted the collapse. That and the two-step plan that can create an economy able to deal with real challenges: debt writedown and government investment financed on the books. But first, we step out of our fantasies and into the real world, which is a mess, reviving an earlier feature of Demand Side podcasts, Idiot of the Week. We honor Tyler Cowen of the New York Times


Cowen is channeling the Washington Consensus, which is barely more rational than tea party economics, insufficient even for the mildest of examination. We'll put up a sequence of basic Keynesian pieces this week, just to remind you that economics does not have to be so obtuse. The fact that Cowen's opinion is widely held -- and held by many in positions of policy influence -- is only sad.

Which country or corporation is going to pay off all its debts? None, of course. All are going to roll them over and pay interest. It is not the debt, but the debt service that threatens companies, countries and individuals.

It's not that Cowen is alone, it's that it is so wrong. Peter Boone and Simon Johnson offer this view:

With the European Central Bank announcing that it has bought more than $20 billion of mostly high-risk euro zone government debt in one week, its new strategy is crystal clear -- Take the risk from bank balance sheets and give it to the central bank, and let or expect Portugal-Ireland-Italy-Greece-Spain to cut fiscal spending sharply and pull themselves out of this mess through austerity.

The model for this "pull themselves out of this mess through auserity?" Well. With flagging global demand? There are no examples. You could say the Asians of 1997-2007 did it, but they had the export markets. Johnson and Boone cite Latin America in the 1980's. Hardly a success. This save the banks scheme is not going to work. The banks have failed. Johnson and Boone agree, saying

The European Central Bank's head, Jean-Claude Trichet, faces a potential major issue: the task assigned to the profligate nations could be impossible. Some of these nations may be stuck in a downward debt spiral that makes greater economic decline ever more likely.

Prime Minister George Papandreou said this week that Greece needs to see strong investment in order for the austerity program to work. While the government cuts fiscal spending, he said, it needs new private business to employ the dismissed workers so that they are productive, can pay taxes and do not need unemployment benefits.

If that is the plan, it is the equivalent of a military plan that begins by marching the army into the swamp. [See the full article on the blog later in the week.]

And the U.S. is not protected by the Atlantic. These markets were global by design, the design of the big banks and financial interests. Asset quality will rise and fall together. Since we have not fixed anything, we ought not to expect it to work any better than last time.

It is becoming ever more clear that saving the euro has come to mean saving the big banks and the big banks are so fragile that they cannot accept the risk they took on in any sphere. But there is an additional problem. The financial sector is in full casino mode. Since there are no real economy borrowers with prospects, the way to make money is to speculate on failure.

When the housing bust began in late 2007 and the stock market peaked, Demand Side watched as the money moved into commodities. We predicted the oil and commodities bubble, watched it rise, called its peak and collapse -- all on the basis of the simple idea that quote investment quote capital was moving into a new arena and would bid up the prices in that arena. The boom in commodities prices wreaked havoc on those in the world who used oil and gasoline, metals or ate food.

Now we see the money moving into these derivatives, credit default swaps, bidding up their prices.

Here, from earlier in the Weekend Business podcast out of which we found our idiot.


Let's see. Six hundred trillion dollars. Who has six hundred trillion dollars? It's Monopoly money, obviously. Warren Buffet doesn't even want to post a margin on his purchases. Yet action in this monopoly money market is supposed to indicate something about the real economy. The only thing it indicates is that this is the table to which the casino players have moved. High prices for protection against default are being created at this table because there is so much money there.

Consider what is averred here, that this is a kind of insurance.

As a friend of mine in insurance pointed out to me, it is not insurance, which is a pool of money from people facing similar risks, so that if your house burns, you can collect from the pool. In credit default swaps, the insurance policies are written for any body who wants them, not just those with houses to burn, or Greek bonds to default. So when the house burns, it is not just one person who collects, but many. But it is not insurance, it is a wager.

Now consider if Greece or another country actually defaults -- restructures its debt. Something we have advocated here if done in a methodical way. Or actually will advocate in the second half of today's podcast.

Somebody has to pay. We don't know how many credit default swaps have been written on the tiny Greek debt, because -- as Weekend Business' discussion of the financial reform legislation points out -- there is no exchange or oversight of these instruments. It is all done in the back rooms at the bar. But we do know that people like Warren Buffet have big positions without any margin. Zero margin. Of course that's how you can create a fictitious sum like six hundred trillion, which is many multiples of total gross world product.

This makes AIG look like a schoolyard game of marbles.

There is not enough government money to backstop the banks on this one.

Will this market crash? Will credit default swaps writers be discovered to have written them -- like AIG -- without the wherewithal to pay them off? Yes.

The same process is going on now that went on in the S&L debacle of the 1980s and 1990s. S&L's suffered when interest rates went up as a result of the inflation of the 1970's and the response to it by the Fed. They had written long-term mortgages at low rates and financed them with short-term borrowing. Their spreads went negative. The preferred answer? Deregulate the S&L's and allow them into the more lucrative activities that would yield higher interest and maybe they could earn their way out. More lucrative meant higher risk. Fraud. They didn't earn their way out. They created a bigger problem.

The same thing is happening here. Can't make money the old fashioned way? Invent something new, more lucrative, more risky, and watch it blow up. After all, the government is there to ... wait, we're betting the government will fail. As soon as insurance is written for somebody without an insurable interest, it ceases to be insurance.

Our answer is to immediately end the ability of anybody to buy a swap without owning the bond that swap is written against. Add one percent margin required for writers every month for the next one hundred months on current swaps without insurable interests. Such a process would deflate the value of these swaps, move them from Monopoly money into real money, and perhaps allow an orderly decline in the values in question without a crisis that brings down the system. At least it would make investment in the real economy more attractive. As long as you're playing with real money, you might as well do real things.

Would this scheme work? Probably not. Debt will be written down. Indeed we argue, it has to be. Another name for writing down debt is default.

Isolating the players in this game and letting them take the fall for their behavior is the least worst way of resolving it.

This is the idiocy of the Bernanke strategy of saving the big banks. We are saving whatever games they want to play. Let's instead identify the games and activities that are the real purpose of banking, structure those markets rationally, and let the institutions rise or fall according to their own merits.

And we remind you, we called for new crises several months ago in European debt and also in small and regional banks in the U.S. as a result of the commercial real estate crash.

Look out below!


Some -- among them Paul Krugman -- have made a point of the tiny deflation in consumer and producer prices. As Minsky told us, this was to be expected, as the work force moves into producing strictly consumer goods. Price rises are to be expected when the work force is divided between producing investment goods and consumer goods, since both groups are bidding for the output of the consumer goods sector.

To get focused on this tiny drop, or really stability in prices in the CPI and PPI is to miss the enormous and continuing drops in the prices of assets. Asset price deflation -- when untreated -- is the cause of depressions. No investment means asset prices are deflating.

One feature of successful recoveries from recession in the postwar period is inflation. The Fed has typically eased monetary policy, and the authorities have traditionally backstopped and bailed out financial innovation creating easy money for investors, which has created inflation.

But let's do the Revere Award first

This has just been posted on the Real World Economics Review

Revere Award for Economics for the 3 economists who warned the world


For Immediate Release

13 May 2010

Keen, Roubini and Baker win Revere Award for Economics

Steve Keen (University of Western Sydney), receiving more than twice as many votes as his nearest rival, has been judged the economist who first and most cogently warned the world of the coming Global Financial Crisis. He and 2nd and 3rd place finishers Nouriel Roubini (New York University) and Dean Baker (Center for Economic and Policy Research) have won the Revere Award for Economics. The award, sponsored by the Real World Economics Review Blog is named in honor of Paul Revere and his famous ride through the night to warn Americans of the approaching British army.

In announcing the winners, Edward Fullbrook, editor of the Real World Economics Review, said:

Keen, Roubini and Baker have been judged in a poll by their peers, over 2,500 of them, to be the three economists who first and most cogently warned of the approaching Global Financial Collapse.

If the powers of the world had listened to these guys or any of the other finalists, instead of Greenspan, Summers and that lot, the collapse and all the human misery and lost opportunity it caused and is still causing would have been avoided.

More than 2,500 people voted — most of whom were economists themselves from the 11,000 subscribers to the real-world economics review. With a maximum of three votes per voter, a total of 5,062 votes were cast. The voters were asked to vote for:

•the three economists who first and most clearly anticipated and gave public warning of the Global Financial Collapse
•and whose work is most likely to prevent another GFC in the future.
The poll was conducted by PollDaddy. Cookies were used to prevent repeat voting.

Commenting on the results, Fullbrook said:

The general failure to warn of the approaching Global Financial Collapse showed that in the economics profession today the general level of competence at real-world economics is grievously less than what society requires.

Worse, some people in the economics establishment have attempted to evade all responsibility for the Collapse by calling it an unpredictable, “Black Swan” event.

Such statements are plainly untruthful. Some economists did–and on the basis of deep analysis–foresee the crisis and warn the public of its approach. At the time they were widely ridiculed for doing so.

Hopefully the Revere Award will give these economists some of the professional and public recognition they deserve, and encourage others to utilize their methods, and increase the likelihood that, for the benefit of humankind, empirically responsible economists, instead of faith-based ones, will be listened to in the future.

I must emphasize that it is not just for the winners’ sake but for everyone’s that Keen, Roubini and Baker should be given public credit for their competence and courage.

Revere Award Citations

Steve Keen (1,152 votes)

Keen’s 1995 paper “Finance and economic breakdown” concluded as follows:

The chaotic dynamics explored in this paper should warn us against accepting a period of relative tranquillity in a capitalist economy as anything other than a lull before the storm.

In December 2005, drawing heavily on his 1995 theoretical paper and convinced that a financial crisis was fast approaching, Keen went high-profile public with his analysis and predictions. He registered the webpage www.debtdeflation.com dedicated to analyzing the “global debt bubble”, which soon attracted a large international audience. At the same time he began appearing on Australian radio and television with his message of approaching financial collapse and how to avoid it. In November 2006 he began publishing his monthly DebtWatch Reports (33 in total). These were substantial papers (upwards of 20 pages on average) that applied his previously developed analytical framework to large amounts of empirical data. Initially these papers analyzed the Global Financial Collapse that he was predicting and then its realization.

Nouriel Roubini (566 votes)

In summer 2005 Roubini predicted that real home prices in the United States were likely to fall at least 30% over the next 3 years. In 2006 he wrote on August 23:

By itself this [house price] slump is enough to trigger a US recession.

And on August 30 he wrote:

The recent increased financial problems of … sub-prime lending institutions may thus be the proverbial canary in the mine – or tip of the iceberg – and signal the more severe financial distress that many housing lenders will face when the current housing slump turns into a broader and uglier housing bust that will be associated with a broader economic recession. You can then have millions of households with falling wealth, reduced real incomes and lost jobs…”

In November 2006 on his blog he wrote:

[t]he housing recession is now becoming a construction recession; and the construction recession is now turning into a clear auto and manufacturing recession; and the manufacturing recession will soon turn into a retail recession as squeezed households – facing falling home prices and rising mortgage servicing costs – sharply contract their rate of consumption.

Dean Baker (495 votes)

In August 2002 Baker published “The Run-Up in Home Prices: Is It Real or Is It Another Bubble?” in which he concluded that it was the latter. In December 2003 he published in the Los Angles Times “Who to Blame When the Next Bubble Bursts”. This was the first of dozens of columns appearing in US newspapers that Baker wrote on the bubble. In one from May 2004, “Building on the Bubble”, he wrote:

The fact that people are borrowing against their homes at a rapid rate (more than $750 billion in 2003) is more evidence of an unsustainable bubble. The ratio of mortgage debt to home equity is at record highs.

In 2006 he put out repeated warnings of the systemic implications of the housing bubble, and in November published the paper “Recession Looms for the U.S. Economy in 2007” in which he wrote:

The wealth effect created by the housing bubble fuelled an extraordinary surge in consumption over the last five years, as savings actually turned negative. …This home equity fuelled consumption will be sharply curtailed in the near future…. The result will be a downturn in consumption spending, which together with plunging housing investment, will likely push the economy into recession.

The vote totals for the other finalists were:

•Joseph Stiglitz 480
•Ann Pettifor 435
•Robert Shiller 409
•Paul Krugman 399
•Michael Hudson 351
•Wynne Godley 281
•George Soros 262
•Kurt Richebächer 168
•Jakob Brøchner Madsen 64

Next time we'll get into a clear explication of what can be done, writing down debt and financing big new government investment.

This is so far down the road and so far outside the current discussion that any real recovery is far away. Instead tea party economics based on fantasy, ignoring history, whose impetus apparently derives from unprocessed emotional problems, gets the press. Instead of writing down debt, we are going to cling to the schemes that haven't worked, let the banks tell us what to do, and watch the economies and peoples of the world sink.


  1. There are a number of problems with the derivatives market. The first is that at somewhere between $600 and $700 trillion it is substantially larger than the world economy. So there is not enough money to back stop these if there were a problem. While many will cancel out, there will be a substantial number where the seller collapses. Leaving the buyer nursing losses. If there were another major default then the banks who have been the major writer of these deals will find themselves insolvent again, and nursing losses that even the national governments cannot plug. Banks are gambling that governments will do everything possible to avoid default. So can demand higher risk premiums on the idea that they may fail, thinking that is an outside risk.

    One is that they are betting against the lenders of last resort. If they were to start betting that the US Treasury would not be able to clear its debts then interest rates would have to rise to compensate buyers of treasuries for any potential risk, this could might raise incomes for the banks who have access to free money from the fed and can lend to the Treasury at considerably higher rates, at least for the short term. It could also close off the free Fed money, which is keeping them solvent for now.

    If there were a plan by a number of european governments to default and leave the euro, it would devastate a number of other countries banks. The greek bailout is a not so secret bailout of the german banks. If Greece were to default then many of the german banks would probably be close to collapse. The german public are not happy to bail out anyone, even german banks. Though a series of defaults might actually make others consider it as an option. Making credit default losses astronomical. That will wipe out the remaining big money centre banks. Though it will have a huge benefit. Governments will not be able to hold off breaking up the banks and even nationalising them temporarily.

    The options of too many countries imposing austerity measures will have a serious impact on stock markets who are seriously overvalued on the expectation that normality has returned.

  2. Agreed.

    Absent a recovery in demand that is not on the horizon, markets are in trouble.

    I do not think the banks are save-able. Their function is necessary, however.

    As for default and leaving the EU. The only country whose departure would actually improve things is Germany. Then everybody could revalue the currency relative to the Germans and perhaps balance the trade.

    Very depressing that the IMF's regime is still taken seriously. Austerity is not the answer. Reform, yes, but we are not going to shrink our way out.

    I'm starting to think Michael Hudson is right. We're going to become serfs to the debt holders.