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

Thursday, April 29, 2010

Transcript: 377 How to measure financial fragility

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Ten years ago Alan Greenspan was in the middle of ratcheting up the interest rates to historic real highs. His tea leaves told him inflation was on the way. Instead of inflation, it was the dot.com crash. Within a year he was well on his way to ratcheting them down. The nominal federal funds rate had been fairly steady through the latter half of the 1990s at between five and a half and six percent. It dipped then rose at the behest of the Maestro to six and a half percent.

The inflation was in the oil price rise. The interest rate hike only exacerbated the demand shock. By 2001 the quarter point steps were heading to the basement. Below two percent by the end of the year. At one percent in 2003. Enter housing boom. By mid 2004 they were on their way back up, getting to five and a half percent shortly after the onset of 2006. Then the crash. Then they came back down.

1990s. Stable interest rates investors and entrepreneurs could count on. 2000s, bouncing interest rates that produced, well, nothing good. A chart of the nominal rates is in the transcript. Notice that the huge spikes in the 1970s and 1980s should be reduced by the rate of inflation. The historically highest real rates were in the Greenspan push of the early 2000s.

It is our view that rising oil prices and a slowing economy that corresponded to this cost Al Gore the election and put George W. Bush in office. That and the Florida vote. But that's another story.

The Demand Side view is historical. Historically speaking, we are in a period of muddling through, or trying to muddle through. Trying to get banks to do what we think they should. While the damage to the economy continues, and conservative estimates have it operating around six percent below capacity. Our estimate is closer to 20 percent. This is analogous to not watering the future and expecting that somehow the plants will grow up and give us a crop anyway.

We have recently reviewed Goldman Sachs from the perspective of Hyman Minsky. The real point was that the increased leverage and reduced regulation that led us into the current economic collapse was built in. In order to compete, as a result of apparent stability, and with bonus results for many years. In popular history, the idiots of the early aughts are the insightful prognosticators of today. The geniuses of Greenspan, Rubin, Summers and the arrayed big banks are now the criminally negligent.

In Demand Side history, the low interest rates and massive tax cuts, along with the huge deficits which began in the 2000's with Greenspan and Bush, DID NOT PRODUCE PROSPERITY OR STABILITY, BUT THE OPPOSITE. The decade of the aughts produced zero new jobs for 30 million new people. It continued the massive accumulation of debt until private debt reached levels above that of pre-crash 1929. We say this not to point the finger at George W. Bush or Alan Greenspan as culpable individuals, but to point out that these policies did not work and to some extent the individuals involved were place-holders, produced by the institutional interests abetted by a vapid academic economics and willing political functionaries.

The markets are behaving as if there is a recovery, but they are also behaving as if there is immense liquidity looking for a home and competing with desperate investors slash savers. We are in the midst of witnessing yet another example of the ineffectiveness of monetary policy.

But also the absence of a comprehensive coherent explanation of what went wrong and how to fix it. Maybe it makes emotional sense to attack and defend, but ... Well, in as few words as possible, and borrowing from Gary Dymski and Robert Pollin, an economy not positioned at full employment can be brought there through several possible channels.

Relying exclusively on the market mechanism, Market Fundamentalism suggest the existing unemployment will generate declines in wages which will lead firms to both lower prices and hire more workers. The increases in employment and lower prices will then promote increases in aggregate demand.

Seeing the sad inadequacy of this excuse for economics, interventionist approaches can take the form monetary interventions to lower interest rates, leading firms to borrow more for investment and beginning the upward recovery segment of the business cycle. Therefore we have zero interest rates and all manner of so-called quantitative easing. To no apparent effect on investment or demand

or intervention can take the form of fiscal stimulus, spurring aggregate demand directly. This is being tried right now, to some effect. This is, in fact, what we at Demand Side proposed a couple of years ago, believing that demand would then instigate investment. And it is what Christina Romer advocated in the speech we highlighted on last week's podcast.

But two years older and wiser and having dipped our toes in the analysis of Hyman Minsky, Demand Side today does not believe fiscal stimulus and deficit spending will lead to anything more than the current stagnation.

These schemes depend on the consensus analysis that at their base markets are efficient and stable. And absent from them is an appreciation of financial relations.

This is not lacking in the analysis of Hyman Minsky, what might be called post-Keynesian analysis, although I'm not sure that's what he would call it. The more we look into it, the more we are convinced that this line of reasoning and investigation is the direct lineage of John Maynard Keynes.

Minsky identified the financial structures as key to the surge and ebb of market capitalism. Hedge, speculative and Ponzi financing. The first is what we normally think of a company doing, borrowing in a form that will be paid back with the expected cash flow from the investment that is being financed. The second -- speculative financing -- is very common. Most companies have a web of financial structures for their operations, many of them short-term, with the expectation of rolling over the debt as it comes due. You can imagine the turmoil that might occur if interest rates spiked or roll-over financing suddenly dried up. The third -- Ponzi financing -- abandons pretense of using cash flows from the investment either directly or in steps, and stakes its hopes on appreciation of the asset value. Bubbles are made of this. The current meltdown is probably the world's largest known version.

"Identifying which category any firm falls into provides a measure of its individual financial fragility; classifying all firms in an economy according to these categories provides a means of assessing the level of economywide financial fragility at any point in time. Clearly, fragility is heightened when the proportion of speculativve and Ponzi units is high. Both speculative and Ponzi units have an inelastic demand for borrowed funds, and rely on the money market to maintain solvency. These units' economic viability is thus threatened by rising interest rates. ... The alternative path for such firms to raise funds is to draw down liquid reserves or sell other assets. But when assets are sold concurrently by many firms ... the price of the assets sold falls as well. In addition, speculative units selling their income-generating assets could transform themselves into Ponzi units.

In short, the higher the proportion of speculative and Ponzi financial units, the greater the fragility of the economy. Fragility in the Minskian sense has two components. First, the economy becomes less capable of absorbing shocks, so shocks are more likely to induce a financial crisis and incipient debt deflation. But in addition, the degree of borrowers' and lenders' risk also rises, and this should inhibit the growth of debt-financed invesment activity."

Now to be clear about two terms we let drop. Borrowers' risk arises to the extent that purchasers of capital assets must debt-finance their investment projects and hence increase their exposure to default risk, the chance a return on investment will be below tghe expected return. Lenders' risk arises from moral hazard and uncertainty. Minsky uses these to get at the price of assets.

And now to our own learning curve. Demand Side is based on hedge financing of investments that produce, at least on average, a net gain. It is from the prospect of profit, which is based on the strength of demand, that businesses invest. From this angle, it is the enormous leverage and overhanging debt produced by the unregulated boom that kills the economy by killing demand. In Minsky's finance-centric view, it is the financial crisis that kills the economy unless the government is willing and able to bail out the banks.

But it seems to us that profit, sound finance and growth all depend on productive investment, which itself is a producer of demand and jobs. And this investment does not exist only in the private sphere. In fact, we question whether the technological advancement so favored by private investors is really so productive. Smart phones replace regular cell phones and in one fell swoop Apple booms and the laggard technologies bust. Huge investment. But productive.

Shumpeter's creative destruction, in one view, can be the replacement of one adequate technology by another more adequate technology at the same time people are starving in Africa and struggling in Latin America. Technology needs not only new ideas, but a customer base.

The simplest example of productive investment is a tool which improves the productivity of labor. The cash flow from increased output pays off the financing of the tool. It is fairly simple to see infrastructure, education and health care in these terms, but what about the favored investments of the private sector? What about technological gadgets and housing?

Housing is not an asset which produces a positive cash flow. Its value is appropriately the rental value. In earlier times the purchase of a house was actually less than the comparable rent, reflecting the financial commitment of the homeowner. Subsequently it became much greater, entirely as a result of the anticipated capital gain. This financial asset aspect of housing is what spawned a nation of Ponzi investors.

At Demand Side we are fond of straying far ahead of the popular debate. And you will not find too many others, though they do exist, who advocate such broad public investment as we do. We have some roots, however. In John Maynard Keynes General Theory, 1936, page 378, you will find.


"A somewhat comprehensive socialization of investment will provide the only means of securiing an approximation of full employment."


Elsewhere, we notice the NBER

Business Cycle Dating Committee statement:
The Business Cycle Dating Committee of the National Bureau of Economic Research met at the organization’s headquarters in Cambridge, Massachusetts, on April 8, 2010. The committee reviewed the most recent data for all indicators relevant to the determination of a possible date of the trough in economic activity marking the end of the recession that began in December 2007. The trough date would identify the end of contraction and the beginning of expansion. Although most indicators have turned up, the committee decided that the determination of the trough date on the basis of current data would be premature. Many indicators are quite preliminary at this time and will be revised in coming months. The committee acts only on the basis of actual indicators and does not rely on forecasts in making its determination of the dates of peaks and troughs in economic activity. The committee did review data relating to the date of the peak, previously determined to have occurred in December 2007, marking the onset of the recent recession. The committee reaffirmed that peak date.
NBER always waits some time before declaring a recession over.

It took the National Bureau of Economic Research (NBER) Business Cycle Dating Committee over a year and half after the 2001 recession ended to call the trough of the cycle. And it took 21 months after the 1990-1991 recession ended for NBER to date the end of the recession.

The previous NBER announcements make it clear that NBER will not date the trough of the recession until certain economic indicators - like real GDP - are above the pre-recession levels. Any downturn before economic activity reaches pre-recession levels will probably be considered a continuation of the recession that started in December 2007.

All of which recalls our suggestion that the question of whether the economy is in recovery has yet to be decided and will be decided by what happens in the future, not the past. Our second suggestion is that the business cycle is broken. Sitinig a trough absent a strong improvement in investment is meaningless.


Monday, April 19, 2010

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

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

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

A taste of it comes through in the following excerpt.


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

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

Romer continues, however,

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

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

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

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

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

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

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

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


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

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

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

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

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

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

What is that view?

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

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

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

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

Remember, Fazzari is writing in 1992.

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

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

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

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


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

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

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

Speaking of jail time,

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


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

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

The rest of that and the link is online.

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

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

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

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

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

And Goldman may soon have company.

The Wall Street Journal published Monday the following,

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

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

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

Tuesday, April 13, 2010

373 Crisis in Europe, Oil Prices and the hard slog

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Today we are going to dip our toe in the current crisis in Europe with some audio from James K. Galbraith and Joseph Stiglitz,  take just a minute on oil prices, and finish with another vignette from the Sarkozy Report.

Caught by Bloomberg in Cambridge, England, at the inaugural conference for INET -- the Institute for New Economic Thinking -- James K. Galbraith continued his annoying practice of applying perspective to the current Greek crisis.


James K. Galbraith

Also caught for a few words was Joseph Stiglitz


Joseph Stiglitz

Quickly on to oil prices.

A year ago, oil was in the $45 per barrel range.  Now it is around $85.  True, most of that rise occurred in the first two months, but the trend has been up.
Demand Side makes a special point of oil prices.  In particular, oil prices and interest rates have been shown by Andrew Oswald and others to predict recessions.  The demand side effect is not difficult to describe.  Oil prices subtract from both consumers and producers bottom lines.  Oil prices generally lead other energy prices higher.  This is a demand side shock.
Over the weekend, James Hamilton of Econobrowser took up the question, beginning

Do rising oil prices threaten the economic recovery?

Ten of the 11 recessions in the United States since World War II have been preceded by a sharp increase in the price of crude petroleum. Oil had been holding around $80/barrel over the last month, but traded as high as $87 last week, leading the Financial Times to ask whether oil could give the "kiss of death to recovery."
and he produces some interesting charts before answering his question:
Americans buy a little less than 12 billion gallons of gasoline in a typical month. With gas prices now about a dollar per gallon higher than they were a year ago, that leaves consumers with $12 billion less to spend each month on other things than they had in January of 2009. On the other hand, the U.S. average gas price is still more than a dollar below its peak in July of 2008. Changes of this size can certainly provide a measurable drag or boost to consumer spending, but are not enough by themselves to cause a recession.

Average U.S. retail price of gasoline (dollars per gallon). Source: NewJerseyGasPrices.com.

My view is that it is not just the level of consumer spending but also a sudden change in its composition that sometimes contributes to an economic recession. When oil price increases are sufficiently sudden and dramatic, we see abrupt drops in consumer sentiment, postponement of purchases of consumer durables, and important changes in the kinds of vehicles consumers buy. Because labor and capital can not costlessly shift out of the affected industries, the result is unemployment in those sectors which is an important additional factor bringing the economy down.

Demand Side breaks in here to note that indeed the volatility of oil prices is a major problem.  It prevents alternative technologies from knowing whether they will pencil out financially.  Businesses that would be viable competing with $100 per barrel oil may have no customers at $90.  Since the investment in these projects is necessarily long-term, the volatility and uncertainty of prices is often a deal breaker.
The downturn was more severe than could be attributed solely to the oil shock of 2007-2008, but that shock appears to have been an important contributing factor, and the overall path followed by GDP up to this point is very similar to the 2-year-ahead prediction.

Energy expenditures as a fraction of consumer spending. Calculated as 100 times nominal monthly consumption expenditures on energy goods and services divided by total personal consumption expenditures. Data source: BEA Table 2.3.5U, "Personal Consumption Expenditures by Major Type of Product and Expenditure," obtained from Econstats. Dashed line is drawn at 6.0%.

So to return to the question posed at the beginning: $87 oil is certainly not helping the recovery. But I would be very surprised if it proves to be the kiss of death.
This is good evidence of economists tendency to view things as if in petri dish, when they occur in real life.  Of course, the levels of oil prices we have seen are not helping.  A rise in prices will not help.  And this is particularly true in the context of financial weakness.  A price rise today will have a serious effect on demand.  It is our view, contrary to Professor Hamilton, that the drop in gasoline prices after July 2008 did have its follow-on effect, typically lagged by several quarters.  But it was modest, because the drop in prices was modest and short-term.
The recovery

Before we get into the next section of the Sarkozy Report, let's reflect on our recent history.  One thing you notice when you compare the GDP numbers for the postwar recessions is that they have become less defined, particularly in their recovery.  As we've talked recently, GDP measures activity, not well-being or economic health.  Not prosperity.  But the charts are for GDP are instructive, in that they illustrate what Hyman Minsky observed thirty years ago, that the process of bailing out the financial innovation loaded the economy with debt that subsequently slowed recoveries.
The observation is more striking with employment.  The bowl of employment loss was deeper and narrower in the early recessions.  Until the most recent one, the bowl had grown wide, but more shallow.  Some of this has to do with the recalibrating of what is unemployed.  Some has to do with the increased emphasis on GDP and lesser emphasis on jobs.  But some also has to do with the quality of the economy.  A jobless recovery is an oxymoron.  Now we have deep and wide.

The famous statistic is that we did not add one job in the aughts, but we added 30 million people.

We were instructed by the Sarkozy Commission that median income is the measure of well-being that best filters out the noise of GDP and elminates the error of averaging.  I would love to be able to put my finger on that number, but the best I could do for anything current was total personal income.  Flat in February.  I will bet that median income is still falling, because I will bet that incomes in the lower half are falling and those at the top are rising.

This is not a hard slog out.  This is a hard slog going nowhere.

Monday, April 12, 2010

Relay: Michael Greenberger on Derivatives

Michael Greenberger on Over-the-Counter Derivatives (MMBM) from Roosevelt Institute on Vimeo.

Michael Greenberger is a professor at the University of Maryland School of Law, where he teaches a course entitled "Futures, Options and Derivatives."  In 1997, Professor Greenberger left private practice after more than 20 years to become the Director of the Division of Trading and Markets at the Commodity Futures Trading Commission.  He currently serves as the Technical Advisor to the United Nations Commission of Experts of the President of the UN General Assembly on Reforms of the International Monetary and Financial System.  He has also been named to the International Energy Forum's Independent Expert Group.

Sunday, April 11, 2010

Relay: Michael Konczal on a 21st Century Glass-Steagall

from the "Make Markets Be Markets" symposium sponsored by the Roosevelt Institute

Michael Konczal on a 21st Century Glass-Steagall (MMBM) from Roosevelt Institute on Vimeo.

Raj Date is Chairman and Executive Director of the Cambridge Winter Center for Financial Institutions Policy.  He is a former Wall Street managing director, bank senior executive, and McKinsey consultant.
Michael Konczal, a former financial engineer, is a fellow with the Roosevelt Institute.  His work has appeared at The Atlantic Monthly's Business Channel, NPR's Planet Money, The Baseline Scenario, Seeking Alpha, Huffington Post, and The Nation.

Saturday, April 10, 2010

Relay: Josh Rosner on Securitization

Joshua Rosner on Securitization from Roosevelt Institute on Vimeo.

Joshua Rosner is a Partner at the independent research consultancy Graham Fisher & Co and advises regulators and institutional investors on housing and mortgage finance issues.  Previously he was the Managing Director of financial services research for Medley Global Advisors and was an Executive Vice President at CIBC World Markets.  Mr. Rosner was among the first analysts to identify operational and accounting problems at the Government Sponsored Enterprises and one of the earliest in identifying the peak in the housing market, the likelihood of contagion in credit markets, and the weaknesses in the credit rating agencies' CDO assumptions.

Friday, April 9, 2010

Transcript: 369 Inflation? We should be so lucky... But there is a problem

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Today we continue with a look at the Sarkozy report on economic metrics, and we get a bit from Michael Greenberger on regulating derivatives, but first, we want to bring up a problem with inflation.

The dynamics of recovery from the Demand Side point of view involve inflation, because they involve investment. First, in the private sector, investment requires a financing structure built into the price. That is, people invest with the expectation of a return. The process is not so much different in the public sector, when investment spending has to be paid back. Both need to come from the stream of payments generated by the investment. That is, a new road must generate well-being sufficient to make it worthwhile. Cost-benefit.

But second, investment spending creates jobs in the production of non-consumer goods. When everyone is employed in the production of consumer goods, there is less demand pressure, and it becomes a simple trade of one for the other through the medium of money. When a portion of the population is employed in producing investment goods, they bid against the producers of consumer goods and may bid up the price. This is a danger in a fully employed economy, which is far from where we are today in our global economy.

Inflation is a messy thing, but it has the advantage, and we have benefited from this advantage in every post-war recovery up until now, that it reduces the real value of fixed debt contracts. It is a way of getting out from under onerous debt and getting the flow going again.

We note here that typically workers in the investment goods industries earn more than those in the consumer goods industries. Perhaps too general, but important if we want to again create living wage jobs.

We have introduced here at Demand Side the idea that government can invest. The infrastructure, education, technology changes that begin with government we think is exactly equivalent to the investment of the private sector. The only difference is that government produces public goods, and the private sector produces private goods. The difference, you will remember, is that private goods are excludable and depletable. One person or household's use of a private good by and large excludes another person or household from the use of that good. And to a greater or lesser extent, the food, clothing, technology, housing, etc., is depleted over time. Public goods, on the other hand, as described by a road, are not so excludable or depletable. The not being excludable gives rise to the free rider problem. The not being depletable means public goods are a very good deal. And the last point in this brief refresher. Taxes are the means of financing public goods. Nothing else. Taxes are not the siphoning off of the great energy of the private sector by a vampire government. Taxes are the means of creating the investment that underlies the economy's basic human and physical capital stock.

The fact that education and infrastructure, public safety and social security, underlie the rest of the economy is missed by the myopic. The leaves and branches do not grow and flourish without these roots. But let's leave that aside for today.

The point I want to make involves recovery. The dynamics of recovery involve inflation, as we said. We run a great risk when we finance the recovery spending of government by deficits, for one reason. A great part of the federal debt is short-term bonds. These will reset -- absent a coherent Federal Reserve -- at higher levels with inflation, and thus the debt service will increase. Our incoherent Fed is peopled with individuals who actually want the interest rate to rise as soon as possible to choke off inflation. We can leave that for future idiots of the week. Unfortunately the general ignorance is so loud, that when debt service increases as it will, there will be a cacophony of "I told you so's" and "Profligate government led us on the road to ruin."

Now remember, I am not talking about the current noise in the economic numbers. Many see these as a recovery, albeit a weak recovery. We see the business cycle as broken and any real recovery being delayed until we get off our butts and start investing in what we need. Then the inflation starts. Then the nonsense begins.

So, what if we were to magically be graced with an enlightened public policy? We would tax to finance the recovery. Now many, most, nearly all Keynesian voices will be heard to object. Taxation will reduce demand. I can hear it now. But this is not the case. Why? Because Keynesian stimulus relies on the multiplier. The general idea of the multiplier is that it operates on deficits and that tax cuts are as good as spending increases when it comes to stimulus.

This is not true. Government spending and investment by the private sector both involve creating jobs which create a full spectrum of spending.

Back up. The multiplier works by the logic that one person's spending is another person's income. The multiplier gets bigger when the second person spends his income. This is why we target the lower income levels. They will spend their income. This why we want to create jobs with spending. The workers will spend most of their income. Even if they save five percent it is a lot less than will be saved if there is a tax cut. That is marginal income that people will tend to save as much as possible.

The second and third steps in the pass-through of the stimulus spending are critical. Our society is so burdened with debt and so unequal in income, that before many steps go along the spending is drained off into debt payments or saved in some way by the wealthy and advantaged. Public sector spending has a very high multiplier because it is very much concentrated on jobs.

But, unfortunately, we are not graced with an enlightened public policy. Most recovery spending will come out of deficits, borrowing, and the prospect that any recovery will be choked off by hysterical responses to inflation is almost a sure thing.

We went on longer than we meant to. But we did not want to continue to advocate for inflation as an essential part of any recovery process without bringing out this very serious drawback. It's effect on the short-term debt of the federal government and on subsequent debt service payments.


Of course, the preceding discussion treats inflation in its demand-pull form, a form we haven't seen since the 1960s. Recent bouts have had to do mostly with oil prices and commodity speculation, cost-push. You'll remember the great commodity bubble of 2007-2008 culminating in $147 per barrel oil before it collapsed. That created heavy inflation. Right in the middle of the housing bust. And such is likely to be any future inflations.

When you have oil spiking, you have a siphoning away of demand as it goes to filling up the tank. At the same time, you have a Fed which cannot see inflation as anything other than demand pull, and a bias from the nabobs to raise interest rates. This is exactly what Alan Greenspan did in late 1999. He saw inflation. he ratcheted up interest rates. We had historically high rates and then the dot.com crash and historically low rates. In an earlier form, we at Demand Side predicted the end of the so-called New Economy based on that action from the Fed. That myopia.

To some extent, higher interest rates would help. It would reduce the backdoor bailout to the banks and force them into real lending. It would assist those who are trying to save and prevent some of the stock market enthusiasm.

But let's move on. Here is today's audio, again from the Roosevelt Institutes's Making Markets Be Markets symposium, which we are putting up over the next week or two on the blog. Today is a clip from Michael Greenberger's presentation on derivatives. All of these are up on the main feed at demandside one word. On the blog we have embedded the video in the post, in case you want to see the visuals. Since we have some extra bandwidth this month, we'll put some of them up on the two word demand side feed.

Michael Greenberger.

Now, to continue the discussion of the Sarkozy Report, and some resonance with what we were talking about earlier. We've taken up the shortcomings of GDP as a measure, since it is production, not income, and measures bads as well as goods. The averaging of income is not so good, we saw, in economies with high discrepancies in income. Today, what about the changes in price. Let's quote:

from the Commission on the Measurement of Economic Performance and Social Progress, chaired by Joseph Stiglitz, advised by Amartia Sen,

In all the measures we have calculated, we have taken into account changes in prices over time. We do not just measure money income. Statistical agencies calculate the increase in prices by looking at what it costs to purchase an average bundle of goods. The problem is that different people buy different bundles of goods. Poor people spend more on food, rich on entertainment. When all prices move together, different indices for different people my not make much difference. But recently, with soaring oil and food prices, these differences have become marked. Those at the bottom may have seen real incomes fall by 50% or more, while those at the top may have seen real incomes hardly affected. A price index for actual private consumption for major groups in society, differentiated by age, income, rural or urban, for example -- is necessary if we are to appraise their economic situation. Such indices are not readily available in most countries, but could be made available at moderate costs. Their development should constitute a medium-term research objective.

While the problems that are involved in constructing good indices are well understood, the rapid changes in relative prices and economic structures have meant that conventionally constructed price indices may be seriously flawed.

And it continues, noting the difficulties with assessing health care costs, the changes in quality of goods, and the problems arising when an increasing fraction of sales are done over the Internet or at discount stores.

A little dry today, but thank you for listening.

Thursday, April 8, 2010

Relay: Frank Portnoy on Off Balance Sheet Accounting

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From "Making Markets Be Markets" via the Roosevelt Institute

Frank Partnoy on Off-Balance Sheet Transactions (MMBM) from Roosevelt Institute on Vimeo.

Frank Partnoy is the George E. Barnett Professor of Law and Finance and is the director of the Center on Coporate and Securities Law at the University of San Diego.  He worked as a derivatives structurer at Morgan Stanley and CS First Boston during the mid-1990s and wrote F.I.A.S.C.O.: Blood in the Water on Wall Street, a best-selling book about his experiences there.  His other books include Infectious Greed: How Deceit and Risk Corrupted the Financial Markets and The Match King: Ivar Kreuger, The Financial Genius Behind a Century of Wall Street Scandals.

Wednesday, April 7, 2010

Transcript: 367 We're back up with Roubini, Sarkozy and more

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We are back up and running after a somewhat unexpected few weeks off.  We took advantage of the hiatus to finish some other work which hopefully we will be announcing soon.  Thanks for listening.

Today we have notes from and comments on Nouriel Roubini's recent Project Syndicate post, some audio from the Roosevelt Institute's Make Markets be Markets symposium and a continuation of our series on the Sarkozy report.

you will be happy to know that we return as incorrigible as ever.  The recovery has been accepted by acclamation, but the vote only counts at the National Bureau of Economic Research, and they won't be announcing it until after the fact.  Otherwise it depends on economic data, not popular opinion.  Demand Side still sees us bouncing along the bottom.  The business cycle is broken without investment, and there is only a government stimulus program substituting for investment.  The bottom may be higher than in the previous Depression by virtue of the automatic and discretionary stabilizers, but it is still a bottom.  The bad news is they went about fixing things in the first Depression, and we haven't fixed anything this time around.  In particular, we have not dealt with insolvent banks or the mountain of privately held debt.

For a perspective on that, we turn to Nouriel Roubini, now operating from an undisclosed location as Roubini dot com.  He was among the first to see the housing bubble and probably the very first to step out and peg the looming meltdown of the financial sector.  It used to be you could get quite a bit of Roubini.  Now -- at least for non-paying clients -- not so much. 

Here, the first and last paragraphs from a Project Syndicate post by Roubini, entitled.

States of Risk
Nouriel Roubini
Project Syndicate
March 15, 2010

"The Great Recession of 2008-2009 was triggered by excessive debt accumulation and leverage on the part of households, financial institutions, and even the corporate sector in many advanced economies. While there is much talk about de-leveraging as the crisis wanes, the reality is that private-sector debt ratios have stabilized at very high levels."

"Unsustainable private-debt problems must be resolved by defaults, debt reductions, and conversion of debt into equity. If, instead, private debts are excessively socialized, the advanced economies will face a grim future: serious sustainability problems with their public, private, and foreign debt, together with crippled prospects for economic growth."

This is the big point.  The problem with demand is it is crushed by debt in the private sector.  Many of these are bad debts.  To be good, they need to be written down.  That is, the lender has to realize risk has two directions.  Absent this, there is no recovery.

In between these two paragraphs, however, Roubini digresses.

"Thus, the recent problems faced by Greece are only the tip of a sovereign-debt iceberg in many advanced economies (and a smaller number of emerging markets). Bond-market vigilantes already have taken aim at Greece, Spain, Portugal, the United Kingdom, Ireland, and Iceland, pushing government bond yields higher. Eventually they may take aim at other countries – even Japan and the United States – where fiscal policy is on an unsustainable path."

"In most advanced economies, aging populations – a serious problem in Europe and Japan –exacerbate the problem of fiscal sustainability, as falling population levels increase the burden of unfunded public-sector liabilities, particularly social-security and health-care systems. Low or negative population growth also implies lower potential economic growth and therefore worse debt-to-GDP dynamics and increasingly grave doubts about the sustainability of public-sector debt."

"The dilemma is that, whereas fiscal consolidation is necessary to prevent an unsustainable increase in the spread on sovereign bonds, the short-run effects of raising taxes and cutting government spending tend to be contractionary. This, too, complicates the public-debt dynamics and impedes the restoration of public-debt sustainability. Indeed, this was the trap faced by Argentina in 1998-2001, when needed fiscal contraction exacerbated recession and eventually led to default."

"In countries like the euro-zone members, a loss of external competitiveness, caused by tight monetary policy and a strong currency, erosion of long-term comparative advantage relative to emerging markets, and wage growth in excess of productivity growth, impose further constraints on the resumption of growth. If growth does not recover, the fiscal problems will worsen while making it more politically difficult to enact the painful reforms needed to restore competitiveness."

Bond market vigilantes are doing nobody any good, not even themselves, except those who win.  These are the casino traders.  They are the masters of the states.  As soon as they are brought to heel, everyone will get back to work.

Side note:  the unfunded liabilities of Social Security do not exist in any meaningful way.  Again, it is the low performance of the economies, which have been run into the ground by the belief that more consumer goods and greater pollution are the route to prosperity, that is the problem.  Reorient economies to bring them into the production of productive goods and the problems disappear.

"... If growth does not recover ..."  Where will growth come from?  Investment.  Where will investment come from?  Not producing more or different types of toothpaste, or even autos and computers, because the demand is being crushed by debt burdens (and plenty of capacity stands idle).  The engines of private investment are blown.  China is willing to create all the industrial capacity the world needs so as to make jobs at $2 per hour. Where, then, is the growth?  It is in the things we need that have been shoved aside for the great free market boom:  infrastructure, climate change technology, education, and so on.

"A vicious circle of public-finance deficits, current-account gaps, worsening external-debt dynamics, and stagnating growth can then set in. Eventually, this can lead to default on euro-zone members’ public and foreign debt, as well as exit from the monetary union by fragile economies unable to adjust and reform fast enough."
Investment, investment, investment.  It does not need to be deficit financed.  Taxing the wealthy, financial transactions, pollution and greenhouse gases.  These bads are being touted as necessary.  With investment in public goods and reductions in private debt, the consumer economy can recover, though not to its previous dominance.  Yes, there will be inflation, perhaps disconcerting spikes of inflation, but we should hope to get there.  The example of Japan is an example of a low-tax, low-social safety net country.  The example of Argentina is an example of doing exactly what Roubini advocates here, following the Washington Consensus.  Avoid Argentina.  Avoid Japan.


Turning to the recent symposium sponsored by the Roosevelt Institute.  We are going to put up a series of relays from this important event over the next week or so as a kind of grand re-opening event for the podcast.  Here is a sample.

Frank Partnoi

from the Making Markets be Markets symposium.  On the relays you will hear Joseph Stiglitz, George Soros, Elizabeth Warren and others. 

Finally, today, our series on the Sarkozy report.

We last visited the International Commission on the Measurement of Economic Performance and Social Progress on the subject of the shortcomings of GDP as a measure of well-being with the points made in the report that it does not, in fact, measure well-being, but production.  Disposable personal income is a better measure.  Note, income is flat in the U.S.  Now we return with a quote from the report.

"Average disposable income per person is helpful, but gives no indication about how available resources are distributed across persons or households.  For example, income per capita can remain unchanged while the distribution of income becomes less equal.  It is therefore necessary to look at disposable income information for different income groups.  A simple way of capturing distribution aspects is to measure median disposable income, the income such that half of all individuals are above that income, half below.  With increasing inequality, there may be increasing differences between median and average income; a focus on average income does not give an accurate picture of the economic well-being of the "typical" member of society.  Evidence for certain countries, e.g., for the United States shows that median household income as a share of average income fell over the past years, signaling a widening of the income distribution.

A second step toward bringing demography and some distributional aspects into income measures is to follow disposable income per consumption unit or per household rather than per person.  Consumption units are households with an adjustment for their size so that account is taken of the fact that there are fixed costs to running a household.  This adjustment is of increasing importance as the size of the household units changes.  For example, in France real disposable income per person rose at 1.6% per year over the period 1974-2006, but real income per consumption unit rose at 1.3%  Work by the OECD has shown that differences can be even more important in other countries."

The same kind of error is occurring with the savings rate. Obviously in an era of uncertainty, unemployment and excessive debt, people are trying to cut back for personal security's sake.  "Saving for a rainy day," particularly when the storm clouds are so dark.  This is reflected in the savings rate.
But there are many for whom the rainy day has arrived -- the unemployed and financially stressed -- who are drawing down their savings. 
(1) Savings is a function of income; the higher your income, the greater the percentage you save.
(2) A Depression will lower incomes.  The target savings rate will not be the net.  Insofar as incomes continue to decline, or even flatten (total), savings will come under stress.  In a society with wide discrepancies in income, the average savings rate is in some ways meaningless.  The bottom half is struggling to make the rent payment.  The top is cutting back on some discretionaries.

Inevitably in a Depression the savings rate for the majority will have to be lower because they will run out of income.  The top quintile may be saving as never before.

The concern of many is the paradox of thrift.  Of course, this is reflected everywhere, that lower spending reduces economic activity which reduces incomes which then reduces spending further.  It is our view that taxing the upper income brackets will tax savings to some extent and not reduce spending as many imagine.

Tuesday, April 6, 2010

Joseph Stiglitz wants a multilateral solution for the China problem

"Trade war" brings to mind a battle of manufacturing giants, each protecting its own industry. The pegging of the Chines yuan at artificially low rates is a problem more for other developing economies. The collapse in tradable goods is the lesson of the Great Recession, and it was accomplished without a trade war. But we like Joe Stiglitz very much and pass on whatever he wants to say. He's probably right.
No Time for a Trade War
Joseph E. Stiglitz
October 6, 2010
Project Syndicate

The battle with the United States over China’s exchange rate continues. When the Great Recession began, many worried that protectionism would rear its ugly head. True, G-20 leaders promised that they had learned the lessons of the Great Depression. But 17 of the G-20’s members introduced protectionist measures just months after the first summit in November 2008. The “Buy America” provision in the United States’ stimulus bill got the most attention. Still, protectionism was contained, partly due to the World Trade Organization.

Continuing economic weakness in the advanced economies risks a new round of protectionism. In America, for example, more than one in six workers who would like a full-time job can’t find one.

These were among the risks associated with America’s insufficient stimulus, which was designed to placate members of Congress as much as it was to revive the economy. With soaring deficits, a second stimulus appears unlikely, and, with monetary policy at its limits and inflation hawks being barely kept at bay, there is little hope of help from that department, either. So protectionism is taking pride of place.

The US Treasury has been charged by Congress to assess whether China is a “currency manipulator.” Although President Obama has now delayed for some months when Treasury Secretary Timothy Geithner must issue his report, the very concept of “currency manipulation” itself is flawed: all governments take actions that directly or indirectly affect the exchange rate. Reckless budget deficits can lead to a weak currency; so can low interest rates. Until the recent crisis in Greece, the US benefited from a weak dollar/euro exchange rate. Should Europeans have accused the US of “manipulating” the exchange rate to expand exports at its expense?

Although US politicians focus on the bilateral trade deficit with China – which is persistently large – what matters is the multilateral balance. When demands for China to adjust its exchange rate began during George W. Bush’s administration, its multilateral trade surplus was small. More recently, however, China has been running a large multilateral surplus as well.

Saudi Arabia also has a bilateral and multilateral surplus: Americans want its oil, and Saudis want fewer US products. Even in absolute value, Saudi Arabia’s multilateral merchandise surplus of $212 billion in 2008 dwarfs China’s $175 billion surplus; as a percentage of GDP, Saudi Arabia’s current-account surplus, at 11.5% of GDP, is more than twice that of China. Saudi Arabia’s surplus would be far higher were it not for US armaments exports.

In a global economy with deficient aggregate demand, current-account surpluses are a problem. But China’s current-account surplus is actually less than the combined figure for Japan and Germany; as a percentage of GDP, it is 5%, compared to Germany’s 5.2%.

Many factors other than exchange rates affect a country’s trade balance. A key determinant is national savings. America’s multilateral trade deficit will not be significantly narrowed until America saves significantly more; while the Great Recession induced higher household savings (which were near zero), this has been more than offset by the increased government deficits.

Adjustment in the exchange rate is likely simply to shift to where America buys its textiles and apparel – from Bangladesh or Sri Lanka, rather than China. Meanwhile, an increase in the exchange rate is likely to contribute to inequality in China, as its poor farmers face increasing competition from America’s highly subsidized farms. This is the real trade distortion in the global economy – one in which millions of poor people in developing countries are hurt as America helps some of the world’s richest farmers.

During the 1997-1998 Asian financial crisis, the renminbi’s stability played an important role in stabilizing the region. So, too, the renminbi’s stability has helped the region maintain strong growth, from which the world as a whole benefits.

Some argue that China needs to adjust its exchange rate to prevent inflation or bubbles. Inflation remains contained, but, more to the point, China’s government has an arsenal of other weapons (from taxes on capital inflows and capital-gains taxes to a variety of monetary instruments) at its disposal.

But exchange rates do affect the pattern of growth, and it is in China’s own interest to restructure and move away from high dependence on export-led growth. China recognizes that its currency needs to appreciate over the long run, and politicizing the speed at which it does so has been counterproductive. (Since it began revaluing its exchange rate in July 2005, the adjustment has been half or more of what most experts think is required.) Moreover, starting a bilateral confrontation is unwise.

Since China’s multilateral surplus is the economic issue and many countries are concerned about it, the US should seek a multilateral, rules-based solution. Imposing unilateral duties after unilaterally labeling China a “currency manipulator” would undermine the multilateral system, with little payoff. China might respond by imposing duties on those American products effectively directly or indirectly subsidized by America’s massive bailouts of its banks and car companies.

No one wins from a trade war. So America should be wary of igniting one in the midst of an uncertain global recovery – as popular as it might be with politicians whose constituents are justly concerned about high unemployment, and as easy as it is to look for blame elsewhere. Unfortunately, this global crisis was made in America, and America must look inward, not only to revive its economy, but also to prevent a recurrence.

Copyright: Project Syndicate, 2010.

Sunday, April 4, 2010

Simon Johnson and James Kwak want the other Roosevelt

Teddy showed the banks who's boss. Will Obama?
Dragging swaps out of the shadows
By Simon Johnson and James Kwak
Sunday, April 4, 2010

In late February 1902, J.P. Morgan, the leading financier of his day, went to the White House to meet with President Theodore Roosevelt and Attorney General Philander Knox. The government had just announced an antitrust suit -- the first of its kind -- against Morgan's recently formed railroad monopoly, Northern Securities, and this was a tense moment for the stock market. Morgan argued strongly that his industrial trusts were essential to American prosperity and competitiveness.

The banker wanted a deal. "If we have done anything wrong, send your man to my man and they can fix it up," he offered. But the president was blunt: "That can't be done." And Knox succinctly summarized Roosevelt's philosophy. "We don't want to fix it up," he told Morgan, "we want to stop it."

Just over a century later, on March 27, 2009, 13 bankers were summoned to the White House. The global financial system was verging on collapse, in no small measure because of the bankers' concentrated power and their manifest inability to manage the risks of their "financial innovation." Banking had to be rescued -- no modern economy can function without credit, of course -- and only the Obama administration had the power to save the day.

But instead of specific new regulations or changes in the way they operate -- or even any constraints on their power -- what did these 13 bankers find waiting for them? On this day and in the months that followed, the administration provided generous expressions of unconditional financial and moral support, both explicit and implicit, along with gentle and nonbinding admonitions.

The headline quote from President Obama sounded tough: "My administration is the only thing between you and the pitchforks," he told the meeting. But the reality was as mild as it could be: All 13 bankers, no matter how discredited, kept their jobs, their salaries, their bonuses, their pensions, their staff and, most remarkable given the near-complete breakdown of governance, even their boards of directors. Our leading bankers were saved by the generosity and magnanimity of our president.

Since that meeting, the country has seen no discernible changes in the financial management and incentive systems that for 30 years have given Wall Street the benefits of the upside and Main Street the costs of the downside. And politically, our financial titans have bitterly opposed the mild reforms that the Obama administration eventually proposed. Even Citi and Bank of America, which essentially spent 2009 as wards of the state, have engaged in egregious lobbying.

There is no way that Teddy Roosevelt would have stood for this. He saw finance and economics through the lens of political power. In his book, it did not matter how important you were, or claimed to be, to the economy. If you were too powerful, and if your actions were hurting other people in the economy, Roosevelt wanted to take you on -- and he instructed his lawyers accordingly.

Roosevelt did not launch the antitrust movement by gently tugging on some low-hanging fruit. He took on J.P. Morgan, the central figure in the burgeoning American financial system, and he won (though just barely, with the Supreme Court voting 5 to 4 to dissolve Northern Securities). And after many twists and turns, the new consensus regarding acceptable business practices led to the breakup of John D. Rockefeller's Standard Oil -- arguably the most powerful company in U.S. history to that date.

Of course, Roosevelt did have the 1890 Sherman Antitrust Act on his side. But before 1902, that law had never been used against an industrial trust, and precedent suggested that there was no legal basis for reining in Morgan's ventures. Roosevelt's audacious move seemed against the odds, and it was very much against the advice of top figures in his Republican Party.

In the spring of 2009, Obama and his senior advisers did not seem terribly troubled by the dangerous concentration of power, wealth and hubris on Wall Street. The president thought it reasonable to find a way forward through amicable accommodation, assuming that Big Finance really could change. Yet, in memoirs and public statements, the bankers repeatedly submit their defense: The system -- the mechanics and incentives of Wall Street -- made them do it. Unfortunately, Wall Street and its intimate connections to Washington have not become any safer for the American economy since this crisis began.

In fact, the latest boom-bust-bailout cycle probably worsened matters. We can argue whether, before September 2008, the people running huge financial firms really thought they were "too big to fail." Lehman, after all, did go bankrupt; Morgan Stanley and Goldman Sachs were rescued at the eleventh hour. But today, who thinks Goldman could fail?

In the moment of most intense crisis, Goldman became a bank holding company, subject to the supervision of the Federal Reserve and able to borrow from the Fed's official "discount window" -- effectively gaining government support. Yet today the firm is also allowed to carry out essentially the same activities (including securities and foreign-exchange trading, as well as real-estate-related transactions) as it did prior to the meltdown of 2008, when there was supposedly no government backing.

If you were exempt from paying speeding tickets, no matter how fast you drove, what would you do? Perhaps, immediately after observing a horrific crash or having a near-death experience, you would be more careful. But soon you would feel the need to get somewhere quickly. And you might even think that your special legal status merely reflected your advanced skills. How long until the next big accident?

Since Democrats lost the special Senate election in Massachusetts in January, the president has shown some new fire. In a major potential course correction, he proposed the "Volcker Rule," named after former Fed chairman and current Obama adviser Paul Volcker, which would constrain the risk-taking and the size of the largest U.S. banks. The move blind-sided Wall Street. In the sound bite of Jan. 21, Obama sounded just like Teddy: "If these folks want a fight," he said, "it's a fight I'm ready to have."

It is now time for that fight. Senate Democrats have proposed a financial overhaul that includes the Volcker Rule, and White House spokesman Robert Gibbs said Tuesday that passing regulatory reform by late May is realistic. But to make progress in this legislative cycle, the president needs to go all in, as he did with health-care reform. The potential political message here is powerful: If opponents of reform think they are "too big to fail," then we will prove them wrong.

It doesn't help that Wall Street has vast amounts of cash to spend on lobbying and political ads. Yet, if framed correctly, the reform message cuts across the political spectrum. If there is one thing that the left and the right agree upon, it is that a "get out of jail free" card distorts the free market. Massive banks have access to cheaper financing because the credit markets understand that the government stands behind them. This is unfair competition, pure and simple.

Will the administration stand up and fight now, before we have another crisis? Surely this is what Theodore Roosevelt would have done. He liked to act preemptively; when he saw excessive power, he took it on, creating his own moments of political opportunity.

Of course, there is always the other Roosevelt. When FDR took power in March 1933, he took aim at the banks. As historian Arthur Schlesinger wrote in "The Coming of the New Deal" -- "No business was more proud and powerful than the bankers; none was more persuaded of its own rectitude; none more accustomed to respectful consultation by government officials. To be attacked as antisocial was bewildering; to be excluded from the formation of public policy was beyond endurance."

By the mid-1930s, Franklin Roosevelt had become skeptical of powerful financiers, but he was only able to translate those feelings into policy after a major global depression. Obama shouldn't wait for another one before pushing for the changes that matter.

Saturday, April 3, 2010

John Mauldin says, "This is a recovery?"

The top of John Mauldin's weekly letter hits some of the high points on the low economy. Mauldin subsequently, not included here, makes some odd and wrong points about taxes (that a tax increase results in triple damages to the economy), and he is still wading around in the illusion that the economy going forward must be a version of what went on in the past, but the first part here is along the lines we have been promoting.

We are still not calling it a recovery. Absent investment there is no business cycle. Like expecting your garden to grow without sun.

Is This a Recovery?
by John Mauldin
April 2, 2010

Last week I wrote a letter to my kids trying to explain what Greece meant to them. Reader Ken V wrote: "Great letter, John. Now you should write one for the adults who are retired and don't have the long future your kids do. If the US becomes Greece, things won't recover in time for much of the rest of my life to be more than one grim, dreary period. What is your investment advice for those with roughly a 10-year horizon, not 30-40-50 years?"

A very good question Ken, and one that was asked more than a few times. So today I will touch on that thorny issue, as well as look at the employment numbers for what we see about the potential for an actual recovery.
First, let me say that what I am not doing here is giving you, gentle reader, specific advice. To be able to do that I would need to have specific knowledge of your situation, assets, location, needs, health, etc. But what I will try to do is give you a general assessment of what I see for the economy over the next few years and what the investment climate might look like. I am also going to refer to a lot of previous letters I have written, for those of you who want to do further research.
Is This a Recovery?

First, we are in a nascent recovery from the depths of the Great Recession, but the question is "what kind of recovery?" Many suggest that we will see a typical recovery, like we have seen with every recession since World War II. As regular readers know, I don't think we've gone through a typical, garden-variety recession, and to expect a typical recovery is more faith-based than factual. We had a deleveraging recession and we are still deleveraging. The process, as shown in studies I have written about, takes years to conclude.

When I started talking in 2002 about a Muddle Through Economy for the rest of the decade, I had a lot of people giving me a hard time by 2005-6. But as we closed out the decade, average growth of US GDP for the entire decade was less than 2% annualized, which by my definition is Muddle Through. For the US economic machine, that was pretty anemic growth. It resulted in a lost decade for stocks, except for the NASDAQ, for which it was merely a dismal decade. Traditional 60-40 (stocks to bonds) portfolios did not fare well, coming nowhere close to the projections of standard-issue money managers.

I think we are in for yet another Muddle Through period, at least for 5-7 years and maybe for the decade, depending on a few scenarios I will come to in a minute. As my friend Prieur du Plessis outlined for us in last Monday's Outside the Box, if we measure the stock market by either earnings or dividend yields, valuations are in the top 10% historically. Average (!) returns, going out for ten years, are 2.6% real, with some historical 10-year periods being negative. Below is the range of returns, based on dividend yields. It does not look much different from the chart based on earnings. We are currently at the far right-hand bar.

This does not suggest a happy outcome for those who espouse buy-and-hope portfolios, at least not if you have expectations or needs of 7-8% or more.
This Time is Different

If you are a new reader, I suggest going to the archives at http://www.2000wave.com/archive.asp and searching on the name "Rogoff," to read the letters I have written on his and Carmen Reinhart's must-read book, This Time is Different, which shows us that it is never different this time. They looked at 266 financial crises in over 60 countries across a span of 200 years.

Debt crises have sadly similar conclusions: they always end in pain and tears. And although we have stopped, as private citizens, from accumulating debt (or in some cases, such as mortgages, have just walked away from the debt), our national government has stepped into the breach and is borrowing at mind-boggling levels.

Below is a chart that is a wonderful illustration of an economic truth: if something can't happen then it won't happen. We cannot borrow $15 trillion in the next ten years. Not at anywhere near the low interest rates we enjoy today, and probably not even at nosebleed rates. (Note that the chart was created before the health-care reform bill. Add at least another trillion to the total. Anyone who thinks that bill was revenue neutral is kidding themselves.)

The End Game

Something has to change. We have two paths to choose from. We can either slowly bring the US budget deficit back into balance (or at least to a level less than the growth in nominal GDP) or we can continue on the current path and become Greece or Japan. (Again, go the archives and search for "Japanese Disease".)

The first choice is a bad one, but the latter choice would be disastrous. If we take the first choice, which I call the Glide Path Option, a meaningful reduction would have to be on the order of $200-250 billion a year. That, along with reduced spending by state and local governments could (and probably will) amount to reducing spending by a little more than 2% of GDP.

I have written several letters on the equation GDP = C (consumer and business consumption) + I (investments) + G (government spending) + E (net exports) (again, searchable). The Keynesians point out that when "C" is reduced in a recession, "G" should be increased to offset the effects of reduced consumption. And they are correct that a deficit will help overall GDP in the short run.

But we are coming to the end of the Debt Supercycle. There are limits to what even the US government can borrow, and the sooner we recognize that as a nation the better off we will be in the long run.

But if we start to reduce our deficits (the "G"), it will be a short-term drag on GDP. There is no way around it. That means that if inflation is 2% and we have a reduction in "G" of 2% of GDP, then the nominal growth in GDP will have to be 6% in order to achieve after-inflation growth of 2%. Two percent as in Muddle Through.

But wait, John, didn't we just grow at 5.6% last quarter? Why are you being so gloomy? For several reasons. First, the growth was largely statistical. Part of it came from inventory accounting, as inventories had got as low as they could go. Note that an increase in inventories will increase GDP but possibly result in a lower future GDP as the excess inventory is depleted. And inventories are still rising, but not by as much.

Secondly, a significant portion of the increase in GDP came from the stimulus. As noted above, an increase in "G" will be reflected in current GDP. This stimulus begins to go away in the second half of the year, and I think there is little reason to believe there will be anything other than an extension of unemployment benefits past two years, by way of "stimulus" this year.

I rather think the last half of the year will show a slowing (though still positive) economy. Unemployment will be closer to 10% than 9% at the end of the year, as the large number of temporary census workers will no longer be employed by the government.

Friday, April 2, 2010

Disinflation continues in personal consumption expenditures

Despite the springtime optimism of almost everyone else, Demand Side continues to say we are bouncing along the bottom, and there is no recovery.  Unemployment has stabilized at 9.7 percent, according to latest figures, and house prices are no longer going down, BUT...

Personal income is flat, and investment is nonexistent, except for the government's stimulus spending.  The reason investment is flat is real assets continue to deflate in value.  Two weeks without bad news does not change this.

Here is the deflation data on PCE, personal consumption expenditures.  Not real assets. But indicative of the stagnation, very reminiscent of what Seymour Harris, a Keynesian, expected to result from the end of WW2.  Again, absent a reduction in the private debt, there will be no meaningful recovery.
Disinflation Continues...

Despite all the worries about inflation, the latest release of the Dallas Fed's Trimmed mean PCE inflation calculations (a measure of the core rate of inflation) indicates that inflation is still headed downward:
"The trimmed mean PCE inflation rate is an alternative measure of core inflation in the price index for Personal Consumption Expenditures"
Here are the recent data for the 12-month inflation rate (3/29 release):

Mar-09 2.26
Apr-09 2.24
May-09 2.08
Jun-09 1.94
Jul-09 1.66
Aug-09 1.60
Sep-09 1.45
Oct-09 1.51
Nov-09 1.40
Dec-09 1.37
Jan-10 1.18
Feb-10 1.04