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, August 24, 2010

Transcript: Mainstream economics is blowing through the guardrails of common sense

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Today on the podcast, with a vengeance, idiot of the week with John Taylor, and an examination of a better counterfactual to the Blinder-Zandi paper we critiqued last week, provided by Barry Ritholz.

If the economy recovers to a pre-crisis level by way of the measures advocated by the mainstream of economists, look out for pigs in jet intakes. If it continues to bounce along the bottom, a bottom sloped downward, susceptible to further crises and failing to meet the immense challenges of this century, it will be confirmation of our forecast, but hollow comfort. But we think it time to begin to treat our colleagues in the mainstream with appropriate respect. And we begin today, with John Taylor, idiot of the week!



The shift of attention from the economic and financial collapse of the past three years to entitlement spending is, of course, convenient to the authors of that collapse, but entirely beyond relevance. The incentives and tax structure and deregulated zone described by Taylor existed, in part from his encouragement, for the first part of this decade. It is an empty assertion that the Bush tax cuts and that regulatory capitulation led to anything other than stagnation and financial fragility. There was no meaningful investment. That is established in data. Virtually all investment occurred in residential real estate and its accessory activities.

As to most business people being made timid by uncertain regulation and tax outlook. Phooey. Most business people are hoarding cash against the weak demand outlook. The landscape we are faced with is a result of a housing bust and financial sector collapse. The Fed has propped up the big banks with front and back door bailouts. None of these can be seen from Taylor's window. Only government and international factors. We suspect it is not his window that is without perspective, but his intellecuaal glasses that have been fitted with blinders. And it is really odd, don't you think, that the blip of bailouts of states and localities appeared on Taylor's radar, but the bombs of AIG and the banks do not? And his perspicacity is displayed in its full glory as he denies the new downturn already in progress.


Of course Taylor must disparage the established economics of multipliers because, well, the taxes on dividends and cap gains, for example, have been demonstrated to have no value in producing investment or recovery. Ten years ago there was a clear public policy favoring the Taylor prescription. It worked?! Somehow we got off track? He missed the Great Financial Crisis? But even prior to the housing bust employment growth was dismal. Unemployment rates were kept down by revisions to statistical methodology. All in spite of a doubling of debt levels. Taylor is repeating a catechism that has been shown to have no power.

John Taylor, the George P. Shultz Senior Fellow at Standord's Hoover Institutions, has use this and other endowed posts to unstintingly promote Hooveristic economics. His contributions to rebuilding macroeconomics using mathematical methods and rational expectations assumptions qualilfy him as a key member of the demoliition team dismantling the economics that worked. He served in the Treasury under George W. Bush, on the Council of Economic Advisers under George H.W. Bush, and as a staffer for the Council during the Ford Administration, thus notably assisting in the three worst presidencies in the post-war period in terms of economic outcomes.

Taylor is famous for the Taylor Rule, a prescription to change the nominal interest rate to balance inflation and GDP which introduces mathematic precision into aggregated effects like inflation and GDP as if these were as discrete and intrinsically consistent as molecules in thermodynamics. Its application to current conditions is limited by the fact that it would be negative, by some calculations as much as minus five.

One senses from Mr. Taylor's biography some of reasons for the momentum that is carrying mainstream economics through the guardrails of actual experience. Having invested a carreer in theories that are now proven unworkable, it is still easier and more comfortable to maintain those theories than to reconsider.

John Taylor, Idiot of the Week.


In the audio from Bloomberg, Taylor was responding to the Alan Blinder and Mark Zandi paper, "How the Great Recession Was Brought to an End." We criticized it ourselves last week, but from the other side of Taylor's intellectual wall, so we could actually see what they were saying. Here, to cleanse our palates, are some excerpts from a post on The Big Picture by Barry Ritholz, more or less parallel to our critique, although two levels up in detail.

Big Picture

Blinder and Zandi opined:

“The combined actions since the fall of 2007 of the Federal Reserve, the White House and Congress helped save 8.5 million jobs and increased gross domestic product by 6.5 percent relative to what would have happened had we done nothing.”

Ritholz says, "I did not have cause to disagree with the Blinder/Zandi numbers; they are best guesses using Moody’s econometric modeling. However, I did criticize their overall approach, saying: “That is now our standard — what was done versus doing nothing? That is truly the wrong counter-factual…”


My disagreement with the Zandi-Blinder report is not its theoretical underpinnings — it is by definition a hypothetical counter-factual. Rather, it is the counter-factual Blinder/Zandi chose to use: “What would the economy look like now if we had done nothing?”

Instead, I propose a better counter-factual: “What if we had done the right thing, instead of nothing — or the wrong thing?”

A quick definition first: The term “counter-factual” is a term of art often misunderstood. The definition of counter-factual is a “what-if” — counter-factuals explore historical incidents by extrapolating an alternative time line:...

We don’t have alternative universe laboratories to run control bailout experiments, but we can imagine the alternative outcomes if different actions were taken.

So let’s do just that. Imagine a nation in the midst of an economic crisis, circa September-December 2008. Only this time, there are key differences: 1) A President who understood Capitalism requires insolvent firms to suffer failure (as opposed to a lame duck running out the clock); 2) A Treasury Secretary who was not a former Goldman Sachs CEO, with a misguided sympathy for Wall Street firms at risk of failure (as opposed to overseeing the greatest wealth transfer in human history); 3) A Federal Reserve Chairman who understood the limits of the Federal Reserve (versus a massive expansion of its power and balance sheet).

In my counter factual, the bailouts did not occur. Instead of the Japanese model, the US government went the Swedish route of banking crises: They stepped in with temporary nationalizations, prepackaged bankruptcies, and financial reorganizations; banks write down all of their bad debt, they sell off the paper. Int he end, the goal is to spin out clean, well financed, toxic-asset-free banks into the public markets.

Thus, Bear Stearns is not bailed out by the Fed. Instead, the FOMC chair tells JP Morgan’s CEO “You have 9 trillion dollars in exposure to Bear derivatives. Instead of guaranteeing you $29 billion for a risk free takeover, we will start preparing a liquidation plan for Bear. And given your exposure to them, we best plan one for JPM too. (and if you don’t like that, you can kiss our ass).”

Tough talk, but the outcome would have been much better: JPM would likely have bought Bear anyway, if for no other reason than to prevent someone else from buying them, and forcing JPM into bankruptcy, to pick up their assets for pennies on the dollar. That would have set a much better tone for future bailout expectations, versus the massive moral hazard the Fed created with the Bear bailout.

Lehman? Prepackaged bankruptcy, less disruptive.

AIG ? There never was an implicit government guarantee that all counter-parties dealing with AIG-Financial Products — a giant leveraged structured finance hedge fund hiding under the skirt of the regulated insurer — would be made whole. But the Bush/Paulson/Bernanke bailout created one. Instead, AIG-FP should have been carved out for dissolution/wind down, while the insurer could have continued to exist on its own. AIG would have had the liability for the government’s costs, but the counter parties? They would have gotten zero. If you go to Vegas and shoot craps in the alley way behind the casino, don’t expect the gaming commission to collect your winnings. But that is what we did with AIG.

Fannie & Freddie: Two more crappy banks that should have been wound down. These were publicly traded companies that were guaranteed lower interest rates — not an infinite backing from taxpayers. They should have been wound down like any insolvent bank. Today, they serve as the mechanism for backdoor bailouts of the rest of the wounded banking sector.

The same approach should have occurred with the rest of the crowd of irresponsible banks, investment houses, monoline insurers, etc. One by one, we should have put each insolvent bank into receivership, cleaned up the balance sheer, sold off the bad debts for 15-50 cents on the dollar, fired the management, wiped out the shareholders, and spun out the proceeds, with the bondholders taking the haircut, and the taxpayers on the hook for precisely zero dollars. Citi, Bank of America, Wamu, Wachovia, Countrywide, Lehman, Merrill, Morgan, etc. all of them should have been handled this way.

The net result of this would have been more turmoil, lower stock prices, and a sharper, but much shorter economic contraction. It would have been painful and disruptive — like emergency surgery is — but its better than an exploded appendix.

And today, we would have a much healthier economy:

• Functioning Banking System: Clean banks not laden with bad paper would be actually making loans to qualified borrowers;

• Healthier Housing Sector: An unsubsidized real estate sector — no tax credits to first time buyers, no ultra low interest rates — would have had much lower prices, with far less bad mortgages floating around. We would be much further along in the foreclosure process. More of the folks who bought more house than they could afford would have moved into homes they can afford;

• Much Smaller Federal Deficits: The trillions of dollars of bailout costs on the books of Uncle Sam would not exist. Not he Tarp, not the government guarantees, not the GSEs, none of it.

• Right-sized Finance Sector: Instead of an outsized banking sector, finance in the US would be more proportional relative to the overall economy. Resources and assets (including programmers, quants, and engineers) would go to more appropriate firms.

• Bond holders Lose: Here is an insane idea: If you lend money to a firm that goes out of business, you lose most of that money (You do get a high priority in the liquidation). The US Taxpayer does not step in to guarantee the loss. Crazy, I know, but it is crazy enough that it just might work!

• Counter-parties Lose: See above

• Managements Lose: It seems that for the most part, most of the upper level bankers who helped bring about the crisis are still working for the same banks. A study found that “92% of the management and directors of the top 17 recipients of TARP funds” are still working for the same banks. Reorg would have caused these people to be fired; perhaps the bankruptcy judges would have clawed back some of the execs ill gotten gains.

• Moral Hazard: Bankers expectations that they can behave recklessly because Uncle Sam will bail them out, is dramatically reduced.

While we certainly can compare what was done with doing nothing, the proper counter-factual is to compare what was done with what should have been done.

Throwing trillions of dollars at the crisis, and hoping for the best will provide a short term improvement over doing nothing; trillions of dollars have that sort of power.

The proper comparison, however, should be versus what should have been done. Performing that analysis leads one to a very different set of conclusions . . .

Monday, August 16, 2010

Transcript: 400 Rogoff and Reinhart trip over the 90% debt line

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The Double Dip has hit the windshield across the mainstream media now, making it very difficult to ignore. The faithful 39 here at Demand Side have heard about this for months, well, since the so-called recovery supposedly began in June 2009. Once again, overwhelming consensus is not a good leading indicator for the economy. So we are heartened by the fact that many respected economists still expect good news just beyond the current fog bank. Unfortunately, it is not fog -- that gray is a cement wall. No investment and no government action on the spending side mean we're back in the soup.

It looks like an army of Michael Jacksons out there in the August heat, as economists and Wall Street forecasters moonwalk back their predictions of robust recovery.

In a moment we take a long and critical look at THIS TIME IT'S DIFFERENT, the book that connects government debt levels to economic malaise. We see the connection, but the causal arrow is pointing in the opposite direction from that suggested by authors Ken Rogoff and Carmen Reinhart.

First, the austerity sponsored by the IMF has begun to bear fruit in Europe. The Wall Street Journal reports that the Greek economy contracted sharply in the second quarter ... The national statistics service Ellsta said that second-quarter gross domestic product fell 1.5% on a quarterly basis, accelerating from 0.8% in the first quarter and weaker than forecasts. GDP is reported on a quarterly basis (not annualized). In the U.S. that would be reported as a 6% decline. Jobs data revealed persistently high unemployment, which ticked higher to 12% from 11.9% in April.



The big problem is, "How to recapitalize the household sector? How to restore the security and prosperity they’ve lost? How to build the productive economy for the next generation? Is there anything today that we might do that can compare with the transformation of World War II? Almost surely, there is not: World War II doubled production in five years.

Today the largest problems we face are energy security and climate change—massive issues because energy underpins everything we do, and because climate change threatens the survival of civilization. And here, obviously, we need a comprehensive national effort. Such a thing, if done right, combining planning and markets, could add 5 or even 10 percent of GDP to net investment. That’s not the scale of wartime mobilization. But it probably could return the country to full employment and keep it there, for years.

Moreover, the work does resemble wartime mobilization in important financial respects. Weatherization, conservation, mass transit, renewable power, and the smart grid are public investments. As with the armaments in World War II, work on them would generate incomes not matched by the new production of consumer goods. If handled carefully—say, with a new program of deferred claims to future purchasing power like war bonds—the incomes earned by dealing with oil security and climate change have the potential to become a foundation of restored financial wealth for the middle class.

This cannot be made to happen over just three years, as we did in 1942–44. But we could manage it over, say, twenty years or a bit longer. What is required are careful, sustained planning, consistent policy, and the recognition now that there are no quick fixes, no easy return to "normal," no going back to a world run by bankers—and no alternative to taking the long view.

A paradox of the long view is that the time to embrace it is right now. We need to start down that path before disastrous policy errors, including fatal banker bailouts and cuts in Social Security and Medicare, are put into effect. It is therefore especially important that thought and learning move quickly. Does the Geithner team, forged and trained in normal times, have the range and the flexibility required? If not, everything finally will depend, as it did with Roosevelt, on the imagination and character of President Obama.


Ken Rogoff and Carmen Reinhardt have taken their careers to a new level on their best-selling quasi economic analysis THIS TIME IT'S DIFFERENT: A PANORAMIC VIEW OF EIGHT CENTURIES OF FINANCIAL CRISES. As the title suggests, the authors have engaged in a massive mapping of data, call it the Google maps of financial crises,

They do the mapping quite comprehensively, in fact, but their conclusions and the lessons people seem to be learning from the book are just wrong. Hence, it stands ready to contribute significantly to the next series of policy debacles.

First of all, we have to establish as self-evident -- though not covered in this book -- that default on government debt cannot occur (except voluntarily) when that debt is denominated in the sovereign fiat currency of the debtor. It must be apparent that the government can make the appropriate entries in the appropriate accounts. If this is a question in anybody's mind, they need to reflect.

Secondly, this time IS different with respect to exchange rates. Prior to 1971, currencies were fixed for the most part, to the dollar or to gold. Many nations today have explicit or implicit pegs to the currencies of other countries, but others do not. Nations with sovereign currencies and floating exchange rates do not default. This includes the U.S., Britain, Japan and Australia. This group does not include the members of the EU, which is an extremely bad deal for the periphery, as we are seeing played out. Germany booms with a weakened euro, setting records for growth. While those nations who would benefit cannot to any meaningful degree.

So, as a practical and operational matter, any concern raised by Rogoff and Reinhart in terms of the United States defaulting on its debt.... Well, it is misplaced. Patently ... misplaced.

The simplistic connection between government debt and economic and financial collapse is not in the direction implied by these two economists. That is, there is a connection, but it runs in the opposite direction they suggest. That is, it is not government profligacy that creates economic weakness, but economic weakness that creates public deficits. Of course, we overstate this in the opposite direction. But only because we have had the benefit of a once in a lifetime economic experiment in the current financial debacle and yet it goes unseen and unappreciated.

The housing sector collapsed, the financial sector collapsed, the economy stumbled, and public deficits arrived from lower revenues and from automatic and discretionary stabilizers. It's hard to see how this could be more clear.

Federal debt held by the public went from 37% of GDP in 2007 to 67% in 2010. Does anyone really doubt which was the cart and which the horse? We will see Rogoff and Reinhart's answer to this question in a moment. But we insist that public debt levels are high now primarily because of the financial collapse and economic failure. Policy response included one of the most massive transfers of wealth from the public to the private sector, rivaled only by the looting of Russian industry in the chaos of IMF-sponsored shock therapy in the 1990s. The Bush tax cuts also contributed, we've argued, both by reducing revenues and by failing to provide economic foundations for growth. But that point is somewhat less obvious.

A third, and perhaps its major fatal flaw is the gross simplicity. By simply mapping defaults and debt levels against years, distinguishing only between advanced and developing countries, the two authors have not only ignored the questions of sovereign currency and floating exchange rates, but wars, famines, natural disasters, predatory rule, neocolonial exploitation and so on.

And finally, the immense private debt, both household and in some parts of the corporate sector, is totally outside consideration. Last week we talked about the multiplier for various tax cuts And government spending. We are experiencing a decline in the multiplier over time that is explained by these debt levels. Debt payments are virtual subtractions from spending on goods and services. Plus, those goods and services that were bought by debt were purchased in the past. Thus the dreadful decay in the multiplier, but also a good explanation of growth that may have been inculcated by rising debt levels before they were transferred to the public sector.

Now that we've expressed our disapproval, let's let Rogoff and Reinhart have a word.

In a recent Vox piece, they say

The main findings of that study are:

•First, the relationship between government debt and real GDP growth is weak for debt/GDP ratios below 90% of GDP. Above the threshold of 90%, median growth rates fall by 1%, and average growth falls considerably more. The threshold for public debt is similar in advanced and emerging economies and applies for both the post World War II period and as far back as the data permit (often well into the 1800s).

•Second, emerging markets face lower thresholds for total external debt (public and private) – which is usually denominated in a foreign currency. When total external debt reaches 60% of GDP, annual growth declines about 2%; for higher levels, growth rates are roughly cut in half.

•Third, there is no apparent contemporaneous link between inflation and public debt levels for the advanced countries as a group (some countries, such as the US, have experienced higher inflation when debt/GDP is high). The story is entirely different for emerging markets, where inflation rises sharply as debt increases.

Debt and growth causality

As discussed, we examine average and median growth and inflation rates contemporaneously with debt. Temporal causality tests are not part of the analysis. The application of many of the standard methods for establishing temporal precedence is complicated by the nonlinear relationship between growth and debt (more of this to follow) that we have alluded to.

But where do we place the evidence on causality? For low-to-moderate levels of debt there may or may not be one; the issue is an empirical one, which merits study. For high levels of debt the evidence points to bi-directional causality.


Growth-to-debt: Our analysis of the aftermath of financial crisis in 2008 presents compelling evidence for both advanced and emerging markets over 1800-2008 on the fiscal impacts (revenue, deficits, debts, and sovereign credit ratings) of the recessions associated with banking crises.

As we sum up,

“Banking crises weaken fiscal positions, with government revenues invariably contracting. Three years after a crisis central government debt increases by about 86%. The fiscal burden of banking crisis extends beyond the cost of the bailouts.” Reinhart and Rogoff (2008).

There is little room to doubt that severe economic downturns, irrespective whether their origins was a financial crisis or not, will, in most instances, lead to higher debt/GDP levels contemporaneously and or with a lag. There is, of course, a vast literature on cyclically-adjusted fiscal deficits making exactly this point.

Debt-to-growth: A unilateral causal pattern from growth to debt, however, does not accord with the evidence. Public debt surges are associated with a higher incidence of debt crises. [We have analyzed this temporal pattern previously.] ... In the current context, even a cursory reading of the recent turmoil in Greece and other European countries can be importantly traced to the adverse impacts of high levels of government debt (or potentially guaranteed debt) on county risk and economic outcomes. At a very basic level, a high public debt burden implies higher future taxes (inflation is also a tax) or lower future government spending, if the government is expected to repay its debts.

So the observant will see that the authors do not make the points I attribute to them as forcefully as I attribute. But I do not apologize. Their explicit purpose was to create stylized facts, and the stylized facts they have taught and which have been learned are precisely those I suggest.

Here, from Paul Krugman, confirmation.

August 11, 2010

under the title

Reinhart And Rogoff Are Confusing Me

So R-R have a new article in Vox that, they say, aims to “clarify matters”. I don’t feel clarified.

The original paper on debt and growth presented a stark correlation between high debt and low growth, and seemed to say that this was a causal relationship. In practice, the article has been widely used to claim that there’s a red line of 90 percent in the public debt to GDP ratio that one crosses at one’s peril.

Skeptics like me quickly questioned the causal interpretation of the correlation.


We pointed out that in the case of the United States, highlighted in the original paper, the debt-growth correlation came entirely from the immediate postwar years, when growth was low thanks to postwar demobilization. We pointed out that other episodes of high debt and low growth, like Japan since the late 1990s, were arguably cases in which causation ran from collapsing growth to debt rather than the other way around.

So surely the question is how much of the correlation survives once we restrict ourselves to cases in which the causation is plausibly from debt to poor growth, rather than likely being spurious or reversed.

But R-R don’t offer any response to that question. They do give us a list of peacetime high-debt episodes:

the 1920s and 1980s to the present in Belgium,
the 1920s in France,
Greece in the 1920s,
1930s and 1990s to the present,
Ireland in the 1980s,
Italy in the 1990s,
Spain at the turn of the last century,
the UK in the interwar period and prior to the 1860s and, of course,
Japan in the past decade.

If I’m reading this right, then the postwar cases other than Japan — which I’ve argued looks like reverse causation — are Belgium, Ireland, and Italy. Are these cases enough to bear the weight now being placed on that supposed 90 percent red line?

Friday, August 13, 2010

Q: What is the purpose of investment banking? Answer from L. Randall Wray

Investment Banking by Blood Sucking Vampire Squids
New Economic Perspectives
By L. Randall Wray
Tuesday, August 10, 2010

While investment banking today is often compared to a casino, that is not really fair. A casino is heavily regulated and while probabilities favor the house, gamblers can win abut 48% of the time. Casinos are regulated—by the state and presumably by the mob. Top executives who steal funds end up wearing very heavy shoes at the bottom of the ocean.

By contrast, the investment bank always wins, and its customers always lose. Investment banks are “self-regulated” (meaning, of course, they do whatever they want—sort of like leaving your 15 year old at home alone all summer with the admonition to “behave yourself” and keys to the liquor cabinet and the Porsche). Top management rakes off all the funds it wants with impunity. And then the CEOs go run the Treasury to bailout the investment banks should anything go wrong.

This summer I was lunching with a trader who works for one of these investment banks (hint: there are not many left, and he was not with Goldman). Speaking of Goldman he said “those guys are good”. Indeed they are so good, he said, “I don’t know why anyone would do business with them.”

He explained: When a firm approaches an investment bank to arrange for finance, the modern investment bank immediately puts together two teams. The first team arranges finance on the most favorable terms for the bank that they can manage to push onto their client—maximizing fees and penalties. The second team puts together bets that the client will not be able to service its debt. Since the debt cannot be serviced, it will not be serviced. Heads and tails, the investment bank wins.

Note that this is also true of hedge funds and the half dozen biggest banks that are bank holding companies providing a full range of financial “services”.

In the latest revelations, JPMorgan Chase suckered the Denver public school system into an exotic $750 million transaction that has gone horribly bad. In the spring of 2008, struggling with an underfunded pension system and the need to refinance some loans, it issued floating rate debt with a complicated derivative. Effectively, when rates rose, that derivative locked the school system into a high fixed rate. Morgan had put a huge “greenmail” clause into the deal—the school district is locked into a 30 year contract with a termination fee of $81 million. That, of course, is on top of the high fees Morgan had charged up-front because of the complexity of the deal.

To add insult to injury, the whole fiasco began because the pension fund was short $400 million, and subsequent losses due to bad performance of its portfolio since 2008 wiped out almost $800 million—so even with the financing arranged by Morgan the pension fund is back in the hole where it began but the school district is levered with costly debt that it cannot afford but probably cannot afford to refinance on better terms because of the termination penalties. This experience is repeated all across America—the Service Employees International Union estimates that over the past two years state and local governments have paid $28 billion in termination fees to get out of bad deals sold to them by Wall Street. (See Morgenson www.nytimes.com/2010/08/06/business/06denver.html)

Repeat that story thousands of times. Only the names of the cities and counties need to be changed. Analysts say that deals like that pushed onto Denver would never be accepted by for-profit firms. Investment banks preserve such shenanigans to screw the public. Michael Bennet, who was the head of the school district pushing for the deal had worked for the Anschutz Investment Company—so he knew what he was doing. He was rewarded for his efforts—he is now a US senator from Colorado.

Magnetar, a hedge fund, actually sought the very worst tranches of mortgage-backed securities, almost single-handedly propping up the market for toxic waste that it could put into CDOs sold on to “investors” (I use that term loosely because these were suckers to the “nth” degree). It then bought credit default insurance (from, of course, AIG) to bet on failure. By 1998, 96% of the CDO deals arranged by Magnetar were in default—as close to a sure bet as financial markets will ever find. In other words, the financial institution bets against households, firms, and governments—and loads the dice against them—with the bank winning when its customers fail.

In a case recently prosecuted by the SEC, Goldman created synthetic CDOs that placed bets on toxic waste MBSs. Goldman agreed to pay a fine of $550 million, without admitting guilt, although it did admit to a “mistake”. The deal was proposed by John Paulson, who approached Goldman to create toxic synthetic CDOs that he could bet against. Of course, that would require that Goldman could find clients willing to buy junk CDOs. According to the SEC, Goldman let Paulson suggest particularly risky securities to include in the CDOs. Goldman arranged 25 such deals, named Abacus, totaling about $11 billion. Out of 500 CDOs analyzed by UBS, only two did worse than Goldman's Abacus. Just how toxic were these CDOs? Only 5 months after creating one of these Abacus CDOs, the ratings of 84% of the underlying mortgages had been downgraded. By betting against them, Goldman and Paulson won—Paulson pocketed $1 billion on the Abacus deals; he made a total of $5.7 billion shorting mortgage-based instruments in a span of two years. This is not genius work—an extraordinarily high percent of CDOs that are designed to fail will fail.

Previously, Goldman helped Greece to hide its government debt, then bet against the debt—another fairly certain bet since debt ratings would likely fall if the hidden debt was discovered. Goldman took on US states as clients (including California and New Jersey and 9 other states), earning fees for placing their debts, and then encouraged other clients to bet against state debt—using its knowledge of the precariousness of state finances to market the instruments that facilitated the shorts.

To be fair, Goldman is not alone — all of this appears to be common business procedure.

There is a theory that an invisible hand will guide unfettered markets to perform the public interest. In truth, unregulated Wall Street bets against the public and operates to ensure the public loses. Investment banks are now all corporations (and all have bank charters). Corporations and banks are chartered to further the public purpose. Why do we allow them the screw the public?

Tuesday, August 10, 2010

Transcript: 399 On the brink with European CDS's and US commercial real estate?

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One of the elements of the current economy, according to the Demand Side assessment, is the continuing fragility of the banking sector. We suggested in our forecast last January that new financial crises could be triggered by breakdowns in Europe's handling of its sovereign debt or in the non-too-big banks and their exposure to dropping commercial real estate values. Last week we even devoted a good part of the podcast to the possibility of a new Greek debt crisis starting the fall of a trail of dominoes through credit default swaps and ending in the fall of banks worldwide.

Today, we review and retrench on that. Also a critical review of the new paper by Alan Blinder and Mark Zandi and its hopeful title "How the Great Recession Was Brought to an End."

Since the first of the year, Demand Side has been concerned about a new financial crisis emanating from either the European sovereign debt mess or U.S. commercial real estate as it affects the not-too-big-too-fail banks.

On point one, we made a big deal last week of how the banking system is poised for defeat should it be required to digest the credit default swaps written on Greek bonds. We suspected, along with Carl Weinberg, that the IMF would come into Athens with its green eyeshades and find the Greek response wanting and trigger a restructuring, which is a default event.

Instead the IMF took only a few days to give Greece a high five on the “strong start” they’ve made in cutting their deficit and in reward for this “great progress” they will get the next tranche as scheduled in September.

Quoting a news account:

Greece makes 'strong start' on reforms
By Kerin Hope in Athens

Greece has won praise from the International Monetary Fund for making a “strong start” to implementing a three-year programme of fiscal and structural reforms aimed at overcoming its debt crisis.

Oh, wait, that was from July. Here's the one from after their visit.

Greece in "strong start" implementing austerity measures: IMF
Aug 5, 2010, 11:20 GMT

Athens/Brussels - Greece has made a 'strong start' in implementing austerity measures and structural reforms to cut its massive deficit but still faces many challenges, European and International Monetary Fund inspectors said Thursday.

The group of EU/IMF officials wrapped up a two-week review of Greece's austerity programme to determined whether it should qualify for a 9-billion euros installment of emergency loans.

The 'performance criteria have all been met, led by a vigorous implementation of the fiscal programme and important reforms are ahead of schedule,' the EU, IMF and European Central Bank officials said in a joint statement.

'Our overall assessment is that the programme has made a strong start.'

IMF official Poul Thomsen told journalists that he was confident Greece would receive the next installment of a three-year, 110 billion euro rescue package.

Athens hopes to receive the 9 billion euro installment by September 13. In exchange, Athens has been implementing a set of austerity measures that range from pension and pay cuts to increases in taxes.

The delegation applauded Greece's progress, saying the government was ahead if its targets in many areas but also warned that the country still faced 'important challenges and risks.'

In their review, the EU/IMF said that while Greek authorities have kept spending significantly below budget limits at the state level they still need to control expenditures at the sub-national level, namely local governments, hospitals and social security funds.

And so on with the austerity bleeding and leeches prescribed by these economic physicians


The commercial real estate market’s pricing has been a tale of two worlds with the largest metro markets attracting significant institutional capital and forcing prices upward over the first two quarters of 2010, while the broader market has continued to soften. This divergence of the two worlds may soon change as we are now witnessing a pause and softening even within the investment or institutional grade primary markets, says Calculated Risk.

The collapse of commercial real estate prices is real and will continue, but it may not trigger the kind of meltdown that residential property did, because there is more ability of the smaller banks to renegotiate the terms and write down the loans to keep those properties working. Commercial Mortgage Backed Securities may also be more amenable to unpacking and dealing with rationally.

We'll see. CR also notes, though we have lost the link:

Distress is becoming a bigger factor in the mix of properties being traded. Since 2007, the ratio of distressed sales to overall sales has gone from around 1% to above 23% currently. Hospitality properties are seeing the highest ratio, with 35% of all sales occurring being distressed. Multifamily properties are seeing the next highest level of distress at 28%, followed by office properties at 21%, retail properties at 18%, and industrial properties at 17%.


On the forecast segment this week, we take note of a hopeful title from the redoubtable duo of Mark Zandi and Alan Blinder. "How the Great Recession Was Brought to an End."

To our mind the Great Recession is not at an end, but is continuing and worsening. Zandi and Blinder may achieve a place in history alongside Irving Fisher and his "permanent high plateau." That said, and noting that Fisher contributed a great deal, including the concept of debt-deflation, there is much in the new paper to like and dislike.

It offers strong evidence that the economy was significantly helped by the ARRA.

Evidence for help from the financial sector bailout regime indicates it had a much stronger impact than the fiscal policy response. Here we object. A legitimate counterfactual is not included. The baseline is compared with a condition of "No policy response." The possibility of no policy response did not exist. The chief alternative was a nationalization of the banks.

Blinder and Zandi begin:
The U.S. government’s response to the financial crisis and ensuing Great Recession included some of the most aggressive fiscal and monetary policies in history. The response was multifaceted and bipartisan, involving the Federal Reserve, Congress, and two administrations. Yet almost every one of these policy initiatives remain controversial to this day, with critics calling them misguided, ineffective or both. The debate over these policies is crucial because, with the economy still weak, more government support may be needed, as seen recently in both the extension of unemployment benefits and the Fed’s consideration of further easing.

Absent from this treatment and any other we have seen is an appreciation of the stability provided by the policy regime surviving from the New Deal. That is, demand has a floor from social security and unemployment insurance, and the bit of financial regulation that survived deregulation, most notably the FDIC, has been a major tool of financial sector stability. Absent these programs, Great Depression 2.0 might be much closer.

That said, the ultimate cost and the worst case downside described by Blinder and Zandi assumes, we believe incorrectly, a natural force toward equilibrium. Absent ANY policy response, they suggest, output and employment would return to an upward slope. Irving Fisher would not agree. Nor do we. Absent policy action, even in the current situation, there will be no return to a positive economic trajectory.

Let's leave it to you to analyze the paper for yourself, link on line, while we pick out some of the more interesting of the findings:

"The effort to end the recession and jump-start the recovery was built around a series of fiscal stimulus measures," they say. "Tax rebate checks were mailed to lower- and middle-income households in the spring of 2008; the American Redevelopment and Recovery Act (ARRA) was passed in early 2009; and several smaller stimulus measures became law in late 2009 and early 2010. In all, close to $1 trillion, roughly 7 percent of GDP, will be spent on fiscal stimulus. The stimulus has done what it was supposed to do: end the Great Recession and spur recovery. We do not believe it a coincidence that the turnaround from recession to recovery occurred last summer, just as the ARRA was providing its maximum economic benefit."

This is a good point. We have said that stimulus spending is had its maximum effect in Q2 2010. Blinder and Zandi say summer of 2009. We might compromise with the biggest bang for the buck occurred in 2010, while the biggest number of bucks flew out in 2009.

Absent a policy response, Blinder and Zandi describe a GDP that would have been negative through 2010. In fact, GDP returned to positive territory in Q3 of 2009. Absent a policy response, they say, more than eight million more jobs would have been lost by the end of 2010, roughly twice the actual loss, and the unemployment rate would peak at 16.3 percent in 2011, compared to their projection of 9.8 percent. Plus deflation would have continued into 2011.

More than half of the positive effect is attributed by Zandi and Blinder to the financial policy response. This suffers, as we said, from the supposition that there would have been no response absent the full-scale bailout of banks, when in fact, the likely alternative was a more effective policy. But that said, it is not the scale of its effect, but its costs -- both past and going forward -- that we most disagree with. In particular, we question whether the Federal Reserve's massive purchases of securities and its guarantees of credit, its zero interest rate and a too big to fail insurance policy that remains for the biggest banks that is neither efficient nor costless. Blinder and Zandi estimate total cost at $15 billion.

We look forward to the audit of the Fed, mandated in the recent Financial Regulation Bill, to come up with a more sensible estimate.

To us, some of the most intersting stuff comes buried here at the end. An estimate of the multipliers for various programs and functions. Sometimes referred to as "the bang for the buck," we use it to gauge the outcomes of all kinds of economic events. Blinder and Zandi look at two categories -- tax cuts and direct government spending.

With regard to tax cuts, estimates of the multiplier range from 1.30 to 0.32. Best was judged to be a job Tax Credit at 1.30, followed closely by the payroll tax holiday and refundable lump-sum tax rebates. Coming in at or below 1.0, that is, you could buy hamburgers and do as well, are across the board tax cuts and the housing tax credit. Way down there, below 0.50, that is, benefitting the recipient at a net cost to the economy, are the tax cuts for the rich and the business subsidies. These include extention to the alternative minimum tax patch, making the Bush tax cuts permanent, making dividend and capital gains tax cuts permanent, cuts in the corporate tax rate and -- at 0.22 and 0.25 respectively -- the business friendly tax cuts of loss carryback and accelereated depreciation.

Bottom line: All tax cuts are not equal

Contrast the bang for the buck from actual spending. Work share programs, unemployment insurance extensions, infrastrucutre spending and food stamps all contribute above 1.57 per one dollar. General aid to state governments is estimated at only 1.41. We assume this has to do with states gaming the system, because this ought to be at the top if all aid were passed through without reducing anticipated spending from other sources.

This demonstrates, to us, at least, the effective way out, because the multipliers work in reverse as well. Curtailing costly tax benefits to the rich and to business and transferring the revenue to spending and to middle class tax benefits is a revenue neutral way of generating more economic activity. Specifically, creating jobs directly, building infrastructure, supporting states and municipalities, and strengthening the social safety net work. Middle income tax benefits kind of work. High end and business tax cuts do not work.

Next week, the light of common sense comes to Rogoff and Reinhardt's popular, superficial and alarmist analysis in "This Time It's Different," the book that brought you a straight line from government debt to economic collapse and default. The straight line may be there, but the head of the arrow is on the opposite end.

Saturday, August 7, 2010

Finally, a clear critique of "This Time It's Different" -- Yeva Nersisyan

"This time it's not simplistic," or similar saarcasm ought to be applied to the Rogoff and Reinhart bestseller that is polluting the minds of the public against public deficits. Here is a very good critique

More Reasons to Doubt Rogoff and Reinhart

By Yeva Nersisyan
New Economic Perspectives
August 6, 2010

With unemployment expected to remain high in the U.S. and Europe and the possibility of a double-dip recession growing stronger, some sensible voices are calling for another round of fiscal stimulus. And then there are others who not only argue that we don't need more stimulus, but make a case for starting to cut spending today, notwithstanding a very fragile "recovery." Ken Rogoff (see here), who has become the de-facto authority on the issue of sovereign deficits and debt (together with his co-author, Carmen Reinhart), in a recent FT article is trying to make the case for the redundancy of further economic stimulus. Subpar economic performance and unemployment are the usual companions of post-financial crisis recovery, he argues, hence there is no need for a "panicked fiscal response" (even Secretary Geithner has cited their research to demonstrate that the current slow pace of recovery is normal). Rogoff goes on to argue that the long-term effects of government debt accumulation on growth shouldn't be ignored. The theoretical and empirical bases for his arguments are found in his recent book with Reinhart, This Time is Different, as well as an NBER paper, "Growth in Time of Debt". This paper, similar to the book, has been very popular, especially among those needing empirical justification for their anti-fiscal policy stance. While the RR book focuses on the short-run, immediate impacts of sovereign debt (i.e. financial and economic crises), the focus of the paper is the impact of sovereign debt on long-term growth. In this blog I want to give a quick, critical evaluation of the paper (a longer version can be found here).

When orthodox economists start their empirical research regarding the long-term impact of deficits and sovereign debt, they do not ask whether deficits contribute to or inhibit long-term economic growth. They do not ask, because they already "know" the answer, as the ECB put it: "Although fiscal consolidation may imply costs in terms of lower economic growth in the short run, the longer-run beneficial effects of fiscal consolidation are undisputed." (ECB, Monthly Bulletin, June, 2010). What they want to find is some threshold for deficit-to-GDP and debt-to-GDP ratios beyond which debt becomes detrimental to growth. With this goal in mind, Rogoff and Reinhart embark on a "scientific" journey through time and space.

Their method is actually quite simple: they construct some arbitrary ranges for debt-to-GDP ratios (0-30, 30-60, 60-90, >90) and take the average of growth rates for each range. They then take the average of these averages for a large number of countries and conclude that when the government debt-to-GDP ratio crosses the threshold of 90% (again, an arbitrary number), median growth rates fall by one percentage point and the average falls even more. This limit is the same for developed and developing countries, however, when it comes to external debt (which is defined in their book as both public and private debt issued in a foreign jurisdiction, and usually, but not always, denominated in foreign currency), the threshold is much lower, just 60% of GDP. Once a country crosses this lower external debt threshold, annual growth declines by about 2 percentage points and at very high levels, the growth rate is cut almost in half.

Interestingly, however, average growth rates don't monotonically decline, i.e. the average rate of growth is higher when debt-to-GDP ratio is in the 60-90% range than the lower range of 30-60%. In addition, growth rates don't slow down for all the countries in their sample. For some countries the average growth rate is higher when debt is over 90% of GDP than for lower levels of debt. Reinhart and Rogoff don't point out this "anomaly," nor do they offer any explanations. More importantly, since they take the average of averages of a number of countries, it is possible that countries like the U.S. may drive the results for the whole group. They single out the case of the U.S. in their paper to demonstrate their results. However, a closer look shows that they only have 5 data points for the U.S. when the debt-to-GDP ratio was over 90%. This is only 2.3% of the total of 216 observations. Moreover, 3 out of these 5 observations are for the years 1945, 1946 and 1947, the period after WWII when government debt was high due to war spending. In this period, growth slowed down significantly as the government was withdrawing war spending from the economy. In 1946 alone, GDP contracted at a pace of -10.9%. Rogoff and Reinhart fail to even mention this in their paper. Similar situations might be true for many other countries, where high levels of debt-to-GDP follow extreme economic or political events.

But what is even more important is that what they find in the data is merely a correlation. The causation then is imposed by Reinhart and Rogoff with explanations based on Barro's Ricardian equivalence theory. "The simplest connection between public debt and growth is suggested by Robert Barro (1979). Assuming taxes ultimately need to be raised to achieve debt sustainability, the distortionary impact imply is likely to lower potential output" [sic].

There is no doubt about the correlation between high debt-to-GDP ratios and low economic growth found in the data. However, there is a more sensible explanation for this correlation. As explained in many past posts on this blog, the government budget balance automatically goes into deficit in a recession leading to an accumulation of public debt. Besides, GDP, the denominator of the ratio shrinks making the ratio even larger. It is sufficient to look at what happened during this most recent crisis to see this. The average rate of growth has been -0.23% for the recession years 2007-2009. At the same time, government debt held by the public has increased from 36% of GDP in 2006 to about 52% in 2009. So if you look at the data, the rate of growth was 2.7% in 2006 corresponding to a debt-to-GDP ratio of 36%. In 2009 growth was -2.6% with a corresponding debt-to-GDP ratio of 52%. Hence there is a correlation between slow growth and high levels of debt which is not surprising. But unless you want to argue that the current recession was caused by high levels of government debt, then it is obvious that causation runs from slow growth to high debt and not the other way around as Reinhart and Rogoff claim.

They also find that growth deteriorates significantly at external debt levels of over 60% and that most default on external debt in emerging economies since 1970s has been at 60% or lower debt-to-GDP ratios (which is the Maastricht criteria). While this might be a surprising finding for them, it should be clear why countries are not tolerant to external debt which is almost always denominated in foreign currency. When a government borrows in foreign currency, even low levels of indebtedness can be unsustainable since the government is not able to issue that foreign currency to meet its debt obligations. As countries need to earn foreign exchange from exports, a sudden reversal in export conditions can render the country unable to meet its foreign debt obligations leading to a crisis and slower growth. Sovereign governments, on the other hand, do not face any financial constraints and cannot run out of their own currency as they are the monopoly issuers of that currency. They don't need to increase taxes in the future (a la Barro) to pay off the debt as they make interest payments on their "debt" as well as payments of principal by crediting bank accounts, meaning that operationally they are not constrained on how much they can spend. See here for more on this.

While many experts believe that there is an acute possibility of a double-dip recession in the U.S. (see here) and other developed nations, Ken Rogoff is not one of them. And even if we do face the threat, he argues, monetary policy will suffice (if anything, this crisis has demonstrated the ineffectiveness of monetary policy (interest rate management to be more precise) not to be confused with the massive lender-of-last resort operations that the Fed undertook to stabilize the financial system).

Even if there was no threat of a double-dip recession, one could rightly argue that the current high levels of unemployment and underemployment require more government spending. Rogoff's argument, however, is that sustained high unemployment is the normal consequence of a financial crisis and hence he seems to conclude that fiscal measures to solve the unemployment problem are unnecessary. This is very bad policy advice – we know we have a problem (unemployment), we know how to solve it (public works), but we shouldn't do so for fear of growth slowing or markets disciplining the government at some indefinite time in the future, a fear based on the wobbly research of Reinhart and Rogoff.

To summarize, the Rogoff and Reinhart research is not a scientific quest but merely a journey with a set destination. It is not based on any sensible theory, and the statistical analysis is of questionable quality as well. Government deficits and debt largely mirror what goes on in the private sector. There are no magic numbers for deficit and debt ratios applicable to all countries and all times. Devising such ratios is a useless exercise.

Even in better times, the U.S. economy is operating with considerably high levels of unemployment and underemployment, underscoring the necessity of government intervention in the economy. In a recession as the private sector cuts back its spending and tries to de-leverage, the role of government, as the only entity in the economy that can run persistent deficits without facing solvency issues, becomes especially important. Regardless of whether there is a threat of a double dip recession, the government should act to solve the unemployment problem through direct job creation TODAY. High levels of unemployment are not compatible with a democratic society.

Monday, August 2, 2010

The best place in history for the deficit commission would be no place at all

Attacking the federal budget covered by the smokescreen of the economic downturn is entirely inappropriate, concludes James K. Galbraith.

8. Markets are not calling for Deficit Reduction; Now or Later.

Let me turn next to a larger economic question. Do deficit projections matter? Are they important? Was the President well-advised to frame the mandate of the Commission as he did?

What, in short, are the economic consequences of a high public deficit and a rising debt-to-GDP ratio, and what (if any) benefits are to be expected from creating an expectation that deficits will come down and that the debt-to-GDP ratio will fall?

The idea that US economic policy should aim for a path of reduced deficits in the future, is shared by liberals and conservatives, and it is, from a political standpoint, a very powerful idea. The Commission's charter takes for granted that this goal is desirable. It specifies that your objective is to achieve a balanced "primary budget" -- net of interest payments, by 2015.

Yet your charter does say why this is an appropriate goal. It cites no study to which one might refer. It does not explain why 2015 is the right target date, as opposed to (say) 2025 or even 2050. It does not spell out the economic consequences -- if any -- of failing to meet the stated objective.

Does the requirement make economic sense? I shall tackle that question in two parts. The first accepts the view most people hold of the fiscal and financial world. The second reflects, from an operational standpoint, how that world actually works in practice.

Most informed laymen believe that the Federal government must borrow in order to spend. They believe that the interest rate on Treasury securities is set in a market for government bonds. The markets impose discipline on the government. Thus their idea is that "fiscal responsibility" will produce low long-term interest rates and tolerable borrowing conditions for the federal government, while "irresponsibility" will be punished by higher, and eventually intolerable, debt service costs.

Accepting this view for the moment, what does the present level of long-term interest rates tell us? As I write, thirty year Treasury bonds are yielding just over four percent -- or just a little more than half their yield a decade back. On the argument just given, this must be an extraordinary success of virtuous policy. It seems that Wall Street has made a strong vote of confidence in the fiscal probity of our current policies. This vote is unqualified, backed by money, contingent on nothing. It therefore represents a categorical rejection, by Wall Street itself, of the CBO's doomsday scenarios and all other deficit-scare stories.

On this theory, it follows that the mandate to reduce the primary deficit to zero by 2015 is unnecessary. Such an action can hardly reduce interest rates -- neither short nor long-term -- which are already historically low.

But wait a minute, some may say. Yes interest rates are low at the moment. But bond markets are fickle, they can turn on a dime. And what then?

Yes, it is possible that interest rates could rise. But the problem with this argument is that it takes us away from the premise of rationality. If bond markets are fickle and arbitrary, who is to say what they will do in response to any particular policy? In the face of irrational markets, the sensible policy is to borrow heavily for so long as they are offering a good deal. One may say that all good things end, and perhaps they will. But if markets are irrational, then by construction you cannot prevent this by "good behavior."

The conclusion from this section is that one cannot logically argue that markets insist on deficit reduction. Either the markets are rationally unworried about deficits, or they are acting irrationally right now, in which case they can hardly "insist" on anything.

9. In Reality, the US Government Spends First & Borrows Later; Public Spending Creates a Demand for Treasuries in the Private Sector.

As noted, the above argument is based on the common belief that the government must borrow in order to spend, and thus that the government faces "funding risks" in private markets. Such risks exist, of course, for private individuals, for companies, for state and local governments, and for national governments such as Greece that have ceded monetary sovereignty to a central bank. But the situation of the United States government is quite different.

The U.S. government spends (and the Federal Reserve lends) in a very simple way. It does so by writing checks -- in fact simply by marking up numbers in a computer. Those numbers then appear in the bank accounts of the payees, who may be government employees, private contractors, or the recipients of federal transfer programs.

The effect of government check-writing is to create a deposit in the banking system. This is a "free reserve." Banks of course prefer to earn interest on their reserves. Thus they demand a US Treasury bond, which pays more interest without incurring any form of credit or default risk. (This is like moving a deposit from a checking to a savings account.) The Treasury can meet that demand, or not, at its option -- it can permit, or not permit, the stock of US Treasury bonds in circulation to increase.

So long as U.S. banks are required to accept U.S. government checks -- which is to say so long as the Republic exists -- then the government can and does spend without borrowing, if it chooses to do so. And if it chooses to issue Treasuries to meet the demand, it can do that as well. There is never a shortfall of demand for Treasury bonds; Treasury auctions do not fail.

In the real world, the government creates demand for bonds by spending above the level drained by taxation from the system. The extent to which those bonds are held locally, or abroad (another common source of worry) depends on the US current account deficit. This also has nothing to do with approval or disapproval by foreign bankers, central bankers, or their governments of American deficit policy. A foreign country cannot acquire a US Treasury bond unless someone outside the United States has acquired dollars to pay for them, which is generally done by running a trade surplus with the United States. And when foreigners do acquire those dollars, then like domestic banks they prefer to earn interest, which is why they buy Treasury bonds.

Insolvency, bankruptcy, or even higher real interest rates are not among the actual risks to this system. The actual risks in this system are (to a minor degree) inflation, and to a larger degree, depreciation of the dollar. However at the moment there is wide agreement that a lower dollar would be a good thing -- against the Chinese RMB and now also the euro. So it is difficult to believe that the goal of deficit reduction per se serves any coherent, or presently desirable, economic objective.

We can conclude that there is actually no economic justification for the target of reducing the primary deficit to zero by 2015 or any other date. The right economic objectives are to meet real problems, not those conjured from thin air by economists. Bringing about a rapid end to unemployment, caring properly for an aging population, cleaning up the Gulf of Mexico, coping with our energy insecurity and with climate change are all far more important objectives than reducing a projection of future budget deficits.

10. The Best Place in History (for this Commission) Would be No Place At All.

Most people assume that "bipartisan commissions" are designed to fail: they are given thorny (or even impossible) issues and told to make recommendations which Congress is free to ignore or reject. In many cases -- yours is no exception -- the goal is to defer recognition of the difficulties for as long as possible.

You are plainly not equipped by disposition or resources to take on the true cause of deficits now and in the future: the financial crisis. Recommendations based on CBO's unrealistic budget and economic outlooks are destined to collapse in failure. Specifically, if cuts are proposed and enacted in Social Security and Medicare, they will hurt millions, weaken the economy, and the deficits will not decline. It's a lose-lose proposition, with no gainers except a few predatory funds, insurance companies and such who would profit, for some time, from a chaotic private marketplace.

Thus the interesting twist in your situation is that the Republic would be better served by advancing no proposals at all.

Transcript: 398 Are credit default swaps set to blow up in the pockets of European banks?

Listen to this episode

Today on the podcast a market minute with the earnings reports and our question of whether in fact these higher profits for corporations DO contradict the underlying weakness of the economy, as many analysts seem to assume.
Then some data highlights, followed by a heads up on a potential August crisis in European banks triggered by our old friends unregulated credit default swap,

It is amusing to hear analyists puzzled over the contradiction they se between bad economic data and good earnings reports from corporations. In the absence of top line growth, revenue growth, the two go together.

Earnings are fueled by firings, euphamistically called efficiencies or downsizing. Bad economic data is fueled by unemployment. Cancelling out the identities, earnings are fueled by unemployment or earnings without top line growth are bad for the economy.

To add insult to injury, good earnings data in a continuing recession is a sign that nothing has changed about the short-termism of American corporate CEO's. They have no other way of earning their bonuses than cutting labor and other costs, and in concert reducing effective demand.

One of the flaws in the Blinder-Zandi paper we take a look at in next week's podcast is their assumption that improved earnings and profits will generate more hiring and expansion. Increased demand will do that. But although cash flow to corporate bottom lines is available by way of massive government deficits, these profits will do nothing for investment or hiring. Any recovery must start on the demand side. This is one refutation to the invisible hand, where each actor is pursuing single-minded self-interest, to the detriment of the whole, and eventually, to himself.

In the market minute, today, we are not going to offer investment advice. Our observation is that equity other markets may be corrupted to an extent greater than commonly acknowledged by computers trading with each using other zero-cost positions supplied by the Federal Reserve as their stacks of chips.

It is interesting to note on the bottom of your stock charts. In the entire history of the Dow, for example, the volume before 1995 was below 500 million. Between 1995 and 2000, when the Dow went from 4,000 to 10,000, the volume increased to about 1.3 billion. In the period between 2000 and 2005, when the Dow traded flat, the volume increased hardly at all. In late 2006, it hit 2 billion. In late 2007, it hit 4 billion. In the collapse of 2008, it reached 7.6 billion. (Actually at one point 9.3 billion in September 08.) Since then, the level is down to the high fours and low fives.

What a difference a decade makes. Flat prices, multiples of volume.



Demand side strength is not evident in current data. In fact, it is weakening according to two key indicators:

From the American Trucking Association: ATA Truck Tonnage Index Fell 1.4 Percent in June

From the Association of American Railroads: Rail car loadings decreased for the second consecutive month, down 1.3 percent in June.

Manufacturing had been relatively strong. Not so much now.

hat tip Calculated Risk
  • From the Kansas City Fed: Tenth District manufacturing activity rebounded moderately in July. However, plans for future hiring and capital spending were essentially flat. Price indexes were mostly unchanged.
  • From the July 15th Empire State Manufacturing Survey: "[T]he pace of growth in business activity slowed substantially over the month."
  • From the Philly Fed on July 15th: Firms See Slower Growth Rate
  • From the Dallas Fed on July 26th: Texas Manufacturing Activity Remains Sluggish
  • From the Richmond Fed on July 27th: Manufacturing Activity Moderates in July; Expectations Slip
  • From the Chicago Fed: Index shows economic activity declined in June
  • The Commerce Department said durable goods orders fell 1.0 percent after a revised 0.8 percent drop in May. Analysts polled by Reuters had forecast orders increasing 1.0 percent in June from May's previously reported 0.6 percent fall.

Toss in the weaker tone of in the Fed's Beige Book, Calculated Risk notes, and this raises the question: Is Fed Chairman Bernanke and the FOMC behind the curve (again)? In his testimony last week, Bernanke said:
My colleagues on the Federal Open Market Committee (FOMC) and I expect continued moderate growth ... Most FOMC participants expect real GDP growth of 3 to 3-1/2 percent in 2010
"That seems pretty optimistic," sez Calculated Risk. Elsewhere The Bureau of Economic Analysis released revisions to its GDP numbers late last week, displaying a slower economy than previously reported since 2006. Changes to real disposable personal income brought that number up, bringing the two measures into closer harmony, but at a 0.2 percent lower rate of GDP. In particular, GDP for the fourth quarter of 2009 was revised down to an annualized increase of 5.0, from 5.6, and in Q1 2010 up from 2.7 to 3.7. President Obama's near six percent growth has faded. The Bureau of Labor Statistics reported initial weekly claims in the 450,000 range for the eighth straight month. The 4-week average of initial weekly claims has been at about the same level since December 2009 at about 452,500. This is above all but the peak months of the 2001-02 recession. In our recovery. Summary: The Demand Side forecast that we are bouncing along a bottom that is sloped downward is intact. Noise from the Recovery Act was not evidence of recovery, Corporate bottom line growth is not evidence of recovery. Without structural changes in debt levels and real investment in private or public goods, there will be no recovery. BREAK THE LOOMING CRISIS IN EUROPE As we noted last week, austerity policy sweeping Europe is threatening to trigger a severe contraction. The perceived need to restructure some sovereign debt has also triggered a full-scale panic. To that in a minute. We begin with words from L. Randall Wray courtesy of the New Economic Perspectives blog.
As part of the EU/IMF plan to resolve Greece's debt crisis and to make its economy more competitive, the government announced a couple of weeks ago plans to revamp labor relations laws and social security entitlements. The minimum monthly wage for new entrants into the labor market will be decreased from 700 euros to 560 euros, and workers will be required to have 40 years of employment to receive a full pension (which has also been subject to significant reductions). And companies would face far fewer restrictions with regard to layoffs and layofff compensations--which have been cut in half. The strategy is obvious: Greece wants to win the race to the bottom in the Eurozone, that is, to win competitive advantage by having the region's lowest and meanest living standards. That, of course, will now be an even tougher race to win, with the recent entry of Estonia into the Eurozone.

The crisis in government budgets trailed the financial sector meltdown by a full two years, yet the IMF and other advocates of the Washington Consensus insist that governments must lead any recovery. They must lead, not by increasing effective demand, but by shrinking their operations and paying off their debts on time.

A footnote here. We delayed presenting this segment to have the benefit of the series running on Calculated Risk describing derivatives and their potential for causing problems. That series minimized the dangers of credit default swaps by concentrating on the net value. Here, however, Carl Weinberg of High Frequency Economics correctly points out that the triggering event may be a very modest rescheduling of payments, but does not necessarily involve a neat netting of values and can create mountains of liabilities among counerparties that have a checkered history of responsibility. This refers not to the governments, but to the banks.

The focus is still on Greece. Credit default swaps on that country's debt have been the chosen weapon of the markets in recent months. Would a restructuring of Greece's debt be cataclysmic? Would allowing lenders to take a hit for their risk premiums be out of line? If not, Why the resistance?

It may not be the governments of Europe that are fragile, nor is the absolute value of their debt that is the sum in question. It may be the banks and their exposure to credit default swaps. Supposedly designed to hedge risk, these unregulated securities may have created a huge risk We heard a note of panic in Weinberg's comments to Bloomberg a couple of weeks ago.


In these comments, we hear that it is apparently not the exposure of Greeks to capital markets that is the great danger. It is the exposure of banks to credit default swaps. What is Weinberg's solution?


Ah, that's it, extend the terms and pass a law in every nation in Europe and presto! And all by the end of August. What could be simpler? How about flying to the moon? If not that, some economists suggest, the lenders could acknowledge that they were paid higher premiums for taking risk and perhaps they need to take their hit. The continued market fundamentalism imposed by the IMF also troubles many, who say that as long as the IMF is calling the tune, the dancers are going to get hurt and perhaps it's time to get a new orchestra.

Sunday, August 1, 2010

Social Security is outside irrelevant to deficits and outside deficit commission's mandate, says Galbraith

6. Social Security and Medicare "Solvency" is not part of the Commission's Mandate.

I note from Chairman Simpson's conversation with Alex Lawson that the Commission has taken up the questions of the alleged "insolvency" of the Social Security system and of Medicare. If true, this is far outside any mandate of the Commission. Your mandate is strictly limited to matters relating to the deficit, debt-to-GDP ratio and fiscal stability of the U.S. Government as a whole. Social Security and Medicare are part of the government as a whole, so it is within your mandate to discuss those programs -- but only in that context.

To make recommendations about the matching of benefits to payroll taxes -- now or in the future -- would be totally inappropriate. Within your mandate, the levels of payroll taxes and of Social Security benefits are relevant only insofar as they influence the current and future fiscal position of the government as a whole. Their relationship to each other is not relevant. You are not a "Social Security Commission" and there is no provision in your Charter for a separate discussion of the alleged financial condition of either program taken on its own. Such discussions, if they are occurring, should be subjected to a point of order.

The usual "solvency" arguments directed at the Social Security system and at Medicare as separate entities are in any event complete nonsense. These programs are just programs, like any others, in the Federal Budget, and the Social Security and Medicare "systems" are thus fully solvent so long as the Federal Government is. Further, as explained below, under our monetary arrangements there is no "solvency" issue for the federal government as a whole. The federal government is "solvent" so long as U.S. banks are required to accept U.S. Government checks -- which is to say so long as there is a Federal authority in the Republic. This point has been demonstrated repeatedly in times of stress, notably during the Civil War and World War II.

7. As a Transfer Program, Social Security is Also Irrelevant to Deficit Economics.

Political discussions of "long-term fiscal sustainability" -- including in the Charter for this Commission -- make an economic error when they loosely use the word "entitlements" and suggest that supposed economic dangers of federal deficits (for instance, rising real interest rates) can be reduced by "entitlement reform." As a matter of economics, this is not true.

"Government Spending" -- as any textbook will verify -- is a component of GDP only insofar as the spending is directly on purchases of goods and services. That alone is what economists mean by the phrase "government spending." GDP is the final consumption of produced goods and services, and government is one of the major consuming sectors; the others being private business (investment) and households (consumption).

Social Security is a transfer program. It is not a spending program. A dollar "spent" on Social Security does not directly increase GDP. It merely reallocates a dollar from one potential final consumer (a taxpayer) to another (a retiree, a disabled person or a survivor). It also reallocates resources within both communities (taxpayers and beneficiaries). Specifically, benefits flow to the elderly and to survivors who do not have families that might otherwise support them, and costs are imposed on working people and other taxpayers who do not have dependents in their own families. Both types of transfer are fair and effective, greatly increasing security and reducing poverty -- which is why Social Security and Medicare are such successful programs.

Transfers of this kind are also indefinitely sustainable -- in fact there can intrinsically be no problem of sustainability with transfer programs. Apart from their effect on individual security, a true transfer program uses (by definition) no net economic resources. The only potential macroeconomic danger from "excessive" transfers is that the transfer function may be badly managed, leading to excessive total demand and to inflation. But there is no risk of this so long as the financial crisis remains uncured. Under present conditions Social Security and Medicare are bulwarks for stabilizing a total demand that would otherwise be highly deficient.

Similarly, cutting Social Security benefits, in particular, merely transfers real resources away from the elderly and toward taxpayers, and away from the poor toward those less poor. One can favor or oppose such a move on its own merits as social policy - but one cannot argue that it would save real resources that are otherwise being "consumed" by the government sector.

The conclusion to be drawn is that Social Security should in any event be off the agenda of your Commission, as it is a transfer program and not a program of public spending in the economic sense. In particular it does not use capital resources and will not drive up interest rates. This is true whether the "Social Security System" is in internal balance or not.