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

Wednesday, June 23, 2010

And they'll all look back and point to their early calls

The analysts now trying to predict a renewed recession remind me of my wife changing clothes in the front seat of the car. By some Houdini-like manipulations she is able to get her swimming suit on under her clothes. Likewise these guys want to be ready to show the world that they are ready for the water, but just in case, want to keep the lid on.

Demand Side, of course, has the economy still in the last recession. We don't see that the business cycle has come out of its fall because we don't see any investment. Our projection is bouncing along the bottom until the government begins big new investment in public goods and facilitates the write-down of debt on a wholesale basis.

But here is an example of changing your suit under your clothes.

The following is an excerpt from John Hussman’s latest Weekly Market Commentary.

I noted last week that we are closing in on a syndrome of indications that has always and only appeared during or immediately prior to recessions. At present, however, we still do not have that evidence in hand. A recession forecast would be jumping the gun.

The latest data from the Economic Cycle Research Institute (ECRI) draws the same conclusion. The ECRI weekly leading index deteriorated last week to a -5.7% annual growth rate. ECRI head Lakshman Achuthan noted "We’re definitely rolling over, let’s not sugar coat it," but properly reluctant to take that evidence to a recession forecast, he noted, "Unfortunately, it’s not that simple. We’re not brushing this off, but it’s premature. It has not persisted long enough." From my perspective, that’s exactly the right interpretation of the data – of notable concern, but not yet conclusive. Interestingly, the main indication required to trigger our own recession warning composite would be a deterioration in the Purchasing Managers Index to 54 or less, and fluctuations in the PMI have been well correlated with the ECRI’s Weekly Leading Index. Still, we’ll wait for the evidence to emerge in its own right.

Achuthan also added the following comment, which is consistent with our views – "We expect this decade to provide more recessions than anyone is used to."

While it would undoubtedly be more satisfying for the data to provide a specific point forecast of where the market is headed and when, the fact is that we deal with probability distributions, not specific forecasts. The prevailing evidence suggests that the outcome from similar conditions has historically been unfavorable on average, and also suggests that there is a "fat left tail" to the bell curve (that is, a small but larger-than-normal probability of a significantly negative outcome). Still, we can also find instances where similar conditions of valuation and market action were followed by positive returns, so it is impossible to rule out a more benign resolution to our situation.

Given that the primary source of economic growth over the past year can be traced to massive fiscal deficits, and given that credit strains are emerging at the same time this fiscal stimulus is trailing off, it’s tempting to decide in advance which way this situation will play out. We’ll leave that to speculators. We don’t take bearish net positions – but we are fully hedged. For us, that stance adequately reflects the elevated risks we observe here.

Monday, June 21, 2010

Cantwell-Collins promotional material

We recorded Tuesday's podcast before receiving this video from Maria Cantwell on behalf of the CLEAR Act.  Since it combines checks to individuals with a price on carbon, it may have legs.

Here is Cantwell's introduction of the Act back in January.

My Fellow Washingtonian,

Last week, my Democratic colleagues in the United States Senate gathered to discuss a way forward on comprehensive energy and climate legislation. Senate Majority Leader Harry Reid asked me to brief the caucus on my bipartisan legislation, the Carbon Limits and Energy for America's Renewal -- or CLEAR -- Act. Co-sponsored by Senator Susan Collins (R-ME), the CLEAR Act is the only climate bill pending in the Senate with Republican support. As part of my presentation, I showed this video, which explains how our cap-and-dividend proposal is a simple, transparent, and consumer friendly way to reduce carbon pollution, jumpstart our nation's urgently needed transition to a clean energy economy, and reduce our dangerous overdependence on fossil fuels. I would very much appreciate your feedback on the CLEAR Act and encourage you to also share this video colleagues, friends, and family. Also, check out the CLEAR Act page of my website for more information on the legislation, as well as this Washington Post editorial that Senator Collins and I authored last week.

Senator Collins and I introduced the CLEAR Act last December. CLEAR limits carbon pollution by requiring fossil fuel producers and importers to bid at an auction for "carbon shares," which are permits needed to sell fossil carbon into the U.S. economy. Of the resulting revenue, 75 percent would go back to the American people in monthly checks, keeping all low and middle-income families whole for any resulting energy price increases. The remaining 25 percent would go toward clean energy investments and other climate related needs like adaptation needs and funding projects that reduce other greenhouse gases. Majority Leader Reid has identified the CLEAR Act as one of three proposals worthy of serious consideration as the Senate moves forward with climate legislation. Senators John Kerry (D-MA) and Jeff Bingaman (D-NM) were also invited to present at last week's meeting.

Again, the video is available here. Please take a look and let me know what you think. And as always, feel free to e-mail me any concerns, or call one of my offices.

Sunday, June 20, 2010

Germany's policy has the wrong sign, says Siimon Johnson

G-20 Rules; Time for Germany-Bashing
Simon Johnson
Baseline Scenario
June 20, 2010

Yesterday’s announcement by China to introduce greater exchange rate flexibility is unambiguously good news. Greater currency flexibility will help China with its domestic overheating problem. But China deserves a lot of credit for its act of responsible international citizenship, for making its contribution to global re-balancing. Two implications follow.

First, the G-20 deserves a lot of credit for the change in China’s policy. True, Secretary Geithner played his cards skillfully, balancing private chiding with public encouragement. It is also true that recent sabre-rattling by the US Congress to impose trade measures against Chinese exports may have played a role in persuading China. But it is the fact of the G-20 that allowed Secretary Geithner to convert the China currency issue from a bilateral US-China matter (on which little progress had been made for many years) to one in which a broader set of countries had a stake.

The public pronouncements by Brazil and India earlier this year re-inforced this “multilateralization” of China’s currency undervaluation. This multilateralization had two positive effects. It forced China to take more seriously the international consequences of its currency policy. And it also made the politics of changing policy easier because China is seen not as caving to bilateral pressure but as responding to the wider international community. Regardless of what happens at the G-20 Summit in Toronto over this week-end, the G-20 can already count the change in China’s currency policy as its victory.

The second implication is this: with China having made its contribution to global re-balancing, it is time to demand the same of Germany, which is the other large surplus country in the world economy, and which has just received a steroidal boost of competitiveness with the decline of the euro. Where China was an intentional mercantilist, Germany has become an accidental mercantilist, which will further increase its current account surplus.

But Germany has responded by announcing fiscal consolidation. Some have excused this action on the grounds that the tightening involved would be small and back-loaded. But this misses the key point: Germany’s action has the wrong sign: it should be expanding demand, not just for the sake of global re-balancing but to provide some growth impetus to its dire Southern European neighbors. But in fact it is now reducing demand. If this continues, the spotlight will have to be on Germany. China-bashing is now likely to cede to Germany-bashing.

Saturday, June 19, 2010

Will the big banks make us pay after death? Jennifer Taub answers

"The bottom line is, when a behemoth bank burns the candle at both ends and then goes belly up, it’s polite to pay our respects, but it’s ridiculous to pay the bill," says Jennifer S. Taub. Here's her take on the so-called bailout fund.
It's not a bailout, it's a funeral
Jennifer S. Taub
Baseline Scenario
June 17, 2010

In poetry and politics, metaphor matters. Expect some fighting figures of speech on Thursday, when the conference committee takes up the topic of the Orderly Liquidation Fund or “OLF.” Under the proposed financial reform legislation, the OLF is the facility that would hold the money needed by the FDIC to shut down a systemically important, insolvent financial institution before its failure can contaminate other firms and the broader economy. In other words, one purpose of the resolution authority and OLF is to avoid repeating the disorder and disruption of either the Lehman bankruptcy or the AIG bailout.

To be clear, many question whether regulators will have the courage to invoke this provision and pull the plug on a dying bank. Accordingly, the “prevention” measures under discussion in the legislation are critical — these included the swaps desk spinoff, hard leverage caps on financial firms, regulatory oversight over shadow banks and inclusion of off-balance sheet transactions in capital standards, among others.

One of the hottest debates concerning funding the OLF is over who should pay into the fund and when should they pay. On the question of “who,” the choices have been framed as either industry or taxpayers. And the “when” options are described as in advance of or after a failure. Many, including the House majority in its bill and FDIC Chairman Sheila Bair, support an up-front assessment on industry. Those who oppose an industry pre-fund have tried to damn the OLF as a “bailout fund” and at times the financial reform legislation as a “bailout bill.”

It’s laughable that big-bank-boosters only characterize it as a “bailout fund” when the banks pay in advance, but not when taxpayers front the money. It’s tragic, though, when we fall for this propaganda, disseminated by some truth-twisting Republican political strategists. But that’s exactly what happened when that fiction effectively killed the industry pre-fund in the Senate bill. As Paul Krugman noted, politicians continue to repeat these twisted talking points because they hope that if they slap the “bailout” label on any provision of the bill that gets tough on big banks, we will be fooled into backing down.

But we cannot be fooled. The proposed legislation is not a bailout. It is a funeral. A bailout involves using money to revive a failing business so that it can continue operations. In contrast, under both the House and Senate versions of the legislation, the FDIC is given the power to dismantle, shut down and liquidate failing firms. Liquidation means the end of the enterprise. Liquidation requires the valuation and sale of eligible assets, including healthy subsidiaries. It’s a funeral.

That’s good. But, unfortunately, under the Senate version of bill, the taxpayers front the funeral expenses. Let me repeat. The taxpayers front the funeral expenses of the failed firm. The FDIC can borrow from Treasury who can then issue debt. It’s true. And it’s very important. The reason is that funding is needed to process a liquidation. Depending upon the number of firms collapsing, this could be in the hundreds of billions of dollars.

The money is needed to avoid a sudden halt of business that causes the financial firm’s viable assets (such as the remaining enterprise value of a healthy subsidiary) to plummet in value. Funds would allow the firm to keep functioning so that an orderly liquidation can occur. The money would be used to put the failing firm into a bridge entity, then manage it and wind it down. The proceeds of the sale of eligible assets and functioning subsidiaries would be used first to replenish the OLF. With the Senate version, any proceeds would be used first toward paying back the loan from Treasury. Of course, not all assets are eligible to be sold. Creditors with security interests (and otherwise given special protection) can pull their assets away from the receivership. To protect against this, the House version allows the FDIC to require these secured creditors to leave behind 10 percent of their collateral. Known as the “secured creditor haircut,” this mechanism does not exist in the Senate version; it should, particularly given that it would be a good resource to pay back the taxpayers.

While the debate has been framed as either a pre-fund or a post-fund, this is a false dichotomy. There will have to be money available when the failing firm is taken into receivership. There will be pre-funding, period. So, the true story is that if the banks do not pay in advance, we will, and then the only questions becomes who will pay us back and when.

Now is the time to address this issue. While taxpayers should support the House industry-pays-in-advance-for-its-own-funerals, version, given the strange power of doublethink, we are in danger that the Senate taxpayer-fronted-funeral process will survive conference committee and make it into the final law.

The House model requires financial institutions to pay $150 billion in advance into the OLF (called the Systemic Dissolution fund in the House version). An industry pre-funded facility has precedent. The FDIC relies upon bank assessments to fill the deposit insurance fund (the “DIF”). The DIF is most well known for insuring the money bank account holders have on deposit. It also, however, is used to pay the various expenses associated with the liquidation of covered banks. Another precedent is the Pension Benefit Guarantee Corporation. Pension plan sponsors provide funding through an assessment. The resulting fund is used to pay certain employee pension benefits in the event the employer firm goes into bankruptcy.

The Senate bill requires taxpayers to front the costs of liquidating failing firms. The amount FDIC can borrow from treasury is capped by a “Maximum Obligation Limit” calculation. This is in two parts. In the first 30 days of receivership, the FDIC can borrow from Treasury up to 10% of the “total consolidated assets” of the failing firm based upon the most recent financial statement available. So, for a bank with about $800 billion in assets, the FDIC could borrow from Treasury $80 billion in that 30 day window.

Then, in part two, after examining the firm and better determining the value of its assets (and what funding will be needed for orderly liquidation), the FDIC can borrow from Treasury up to 90% of the fair market value of total consolidated assets “available for repayment.” It’s important to note that there may be very few assets if any available for repayment — if, as noted above, secured creditors pull their collateral — so these will not be eligible.

The FDIC is required to pay back the Treasury within 60 months (five years), using the proceeds of the sale of assets, if there are enough. If the firm is so broke that the assets are not sufficient to pay back the FDIC, then the FDIC is supposed to claw back extra amounts paid to certain creditors, and if that doesn’t work out, an ex-post industry assessment on “eligible financial institutions” is permitted.

Thus the taxpayers may be “out-of-pocket” for up to five years or beyond. Given that one of the greatest objections to the Bush Bailout of 2008 was the burden on taxpayers, how did this happen? Opponents of the bank pre-fund claim that the existence of a fund would encourage banks to take high risks because they know that they will be bailed out. This ignores the fact that both the House and Senate bills would impose stricter standards on these institutions, requiring them to have more capital cushions in the event that the assets they own decline in value (a common part of the business cycle). Thus, the risk-taking will be monitored and minimized. In addition, given that firms will be liquidated not rescued, this argument is silly.

Perhaps there’s a third option, an industry paid “Just-in-Time” mechanism. Just-in-Time mean would mean assessing “eligible financial institutions” at the moment of FDIC receivership. And, instead of leaving the allocation formula as a mystery until some future date, the legislation could require the new council of regulators (the Financial Stability Oversight Council) to come up with a methodology that would be transparent to each firm.

Of course, there are plenty of arguments against this approach. One argument is that it is unworkable because the assessments come too late. I agree that it is better to collect “rainy day” resources on a sunny day. And, I support the House’s $150 billion pre-fund approach. Representative Luis Gutierrez, from Illinois’s 4th District, is going to lead this charge on the House side during conference on Thursday. If we can convince the Congress to do that, terrific. But, that is not the message some conference committee members are signaling.

Some might also worry that such a Just-in-Time assessment on industry would be difficult to collect if there were a massive failure a la September 2008. Implicit in this argument is that the liquidation of one firm means a full blown financial crisis has hit. This is not necessarily the case. An FDIC-run liquidation could be a Bear Stearns (March 2008) moment, not a Lehman (September 2008) moment, or even a single, stand alone troubled firm. And, even if it is the Lehman moment, recall that the weekend before Lehman filed for bankruptcy, industry rivals were assembled together ready to buy up its bad assets so that Barclays might buy the good ones. While this transaction fell apart when the UK regulators reasonably insisted that shareholders at Barclays get to vote on the deal, the point is that the top financial institutions were prepared to help.

However, the Just-in-Time language could be drafted in such a way that a firm’s condition could be considered before deciding upon the amount of the up-front assessment. If a firm is too unhealthy to pay in, it could be granted a deferred assessment. In the case of a “one-off” failure, with a fairly isolated insolvency and many healthy firms, it would be a good time to avoid moral hazard and show industry that they, instead of the taxpayers must front the costs of the liquidation. In other words, suggesting the firms won’t have the money when a firm goes into receivership is only a hypothesis. Another hypothesis is that many will. Congress should prepare for both so that passing the hat around to industry happens before we are asked to pinch our pennies and pitch in.

Friday, June 18, 2010

Do we OWE or do we OWN government debt? Edward Harrison answers

Money the government owes us
Edward Harrison
June 17, 2010
Credit Writedowns

Just as a point of fact, it bears noting that government debt is a government liability in much the same way that bank notes are.
What is the functional difference for the federal government between Treasury securities and bank notes? Both are liabilities of the federal government. But liabilities of what? The only obligation they enforce on the government is the promise to repay with more paper (or electronic bank credits, if you will). For all intents and purposes, bank notes, reserve deposits, and Treasury securities are fungible: they are obligations to be repaid in the same fiat currency.
My point is that there is zero difference between currency, notes and bonds except the higher interest rate one receives on longer-dated government liabilities. What this means is that these coins, notes, and bonds are all liabilities of the federal government and assets of individuals who hold them.

What then is the national debt? Answers.com correctly describes it as "[t]he total financial obligations of a national government" i.e. it is an obligation or liability of the national government. For that reason, the terminology often used to describe the national debt is misleading. For example, you might hear someone say "The U.S. owes X US dollars for every American man, woman and child" or "We are leaving our children with a massive debt that will rise to X pounds per person by 2030."

I understand the reasoning behind this – namely the belief that this debt should be repaid and can only be repaid via future taxes (something which isn’t actually true since taxes actually don’t fund government spending – remember it is fiat currency). But, as I just demonstrated, the national debt is not money we owe (a liability). More accurately, it is money we own (an asset).

Paul Segal makes this point in this morning’s Guardian newspaper:
[British Prime Minister] Cameron argues that within five years the national debt will rise to "some £22,000 for every man, woman and child in the country". This may be true, but what he doesn’t tell us is that it is money the government owes to us – not money that we owe to anyone else. That’s right: 80% of our government debt is owed to the British people. What is called "national debt" is our own savings, looked at from the other side of the balance sheet.
A better analogy then is to think of your country as being like any organization that invests your capital. Think of it like a bank, if you will. You have lent it long-term capital (currency is like a demand deposit). As a bondholder, you expect to receive your capital and interest back in full.

Segal goes on to make the valid point that the financial sectors must balance i.e. government deficits are offset exactly by private and trade sector surpluses. And right now, the deficit is driven largely by a drop in consumption demand and an increase in savings as the financial crisis has exposed households to the stress associated with enormous debt burdens that was hidden by rising asset prices. Deficit reduction will not have a positive short-term effect on growth, and to the degree it makes a double dip possible could lead to a debt deflationary spiral of the Irving Fisher variety.

The point deficit hawks make, however, is that as a citizen you are also an owner. You are interested in your equity return, which means pursuing economic policies which maximise national productivity and social well-being while creating a sense of social equity and shared benefit and sacrifice. To the degree that money is spent in ways that later require massive bailouts of specific economic sectors and increase government debt-to-GDP ratios, government has not invested well. Deficit hawks should concentrate on how government policy changes the allocation of real resources in the economy rather than specific deficit targets as Rogoff and Reinhart do because that’s what drives productivity and GDP growth.

If you look at the last quarter-century of government policy in the US or the UK, it has been pro-business by reducing anti-trust, regulation, and regulatory oversight. The result has been an increase in corporate risk-taking – especially in but not limited to the financial sector – that has resulted in an extraordinary financial crisis and massive bailouts. I would argue this is a waste for two reasons.

First, the crisis and bailouts demonstrate ex-post that government has failed in setting and enforcing adequate ground rules for the safe and efficient long-term operation of business. Government’s anti-regulatory zeal has favoured large organizations over small, corporations over individuals and has fostered excessive risk-taking by corporate insiders who leave bond- and shareholders – or eventually government – holding the bag.

Second, the crisis, bailouts and easy money demonstrate ex-ante that the government is still at it. Government is creating numerous moral hazards that tell corporate insiders there are few penalties for individuals for the kind of behaviour which created financial sector stresses. This knowledge engenders a contempt for government which makes people resistant to supplying more stimulus. And this knowledge amongst corporate insiders favours risk-taking to the exclusion of prudence, making another crisis all but inevitable if we don’t succumb to this one still ongoing.

I have long come to the conclusion that the only thing which will cause government to change course is an even more severe depression and economic collapse. If we don’t have leaders who get it after so much hardship, what will it take?

Wednesday, June 16, 2010

Will BP's gusher and ocean acidification accomplish marine extinction? Brendan Smith answers

As big as the BP oil disaster is, it is the "concentration" in the Gulf that makes its damage so apparent. A larger dead zone is growing around the world in the form of acidified ocean caused by greenhouse gases. Both derive from the addiction to fossil fuels.

BP: No Friend of the Oysterman
Brendan Smith
June 10, 2010

With gallows humor, my fellow oystermen around the country have been passing around a Youtube clip of a 1960 educational film produced by the oil industry entitled "Lifeline to an Oyster."

This reel explains how in the late 1950's Louisiana oystermen began sounding the alarm that oil production in the Gulf was killing their oysters. The American Petroleum Institute came to the rescue, donating $2 million to researchers at Texas A&M University to "figure out the problem" by studying the effects of oil on oysters. Any guesses on the results?

Turns out oysters love oil.

According to the narrator, after six months of living in a simulated oil spill "The test oysters showed no ill effects from oil. As a matter of fact the test oysters were so happy they brought forth new generations to share their lot. They never had it so good!" Scientists are shown explaining to eager oystermen why oil is a friend not foe of the oyster industry.

Fast forward 50 years and oil companies like BP remain dedicated to "helping" oystermen. Within days after the initial spill BP, set up employment centers where oystermen and other fishermen had the opportunity to wait in line for temporary jobs "cleaning" the Gulf. Tony Hayward, BP's CEO soothed fears by explaining amount of oil in the Gulf is "tiny" compared with all that seawater and that the environmental impact will be "very, very modest." BP even donated $2 million to the Louisiana Seafood Council to figure out how to respond to worried customers asking: "Are these oysters from the Gulf?"

Gallows humor masks our pain and fury.

BP's reckless and insatiable pursuit of ever-deeper underwater oil wells has turned the Gulf into a poisonous swamp forcing the shutdown of 1000's of acres of oyster grounds. NOAA has set up an oil "damage assessment" program to use Gulf oysters to signal where and when oil contaminants are entering the food chain. As one scientist explained, "Because oysters have to sit there and take it and they can't run away, they're a very good canary in the coal mine."

One oyster filters up to 50 gallons of water a day -- with nowhere to hide they are left to choke on BPs toxic sludge. And whatever oysters do survive will poison the entire ocean food chain as both oil and dispersant contaminants concentrate in their tissues and are passed onto larger marine species.

As the oyster goes, so goes the oysterman. Before the disaster, the Gulf provided 40% of the nation's oysters, generating $318 million annually for the region. It's brutal to watch the evening news, night after night, as Gulf oystermen and other fishermen choke back tears and fury, clinging to legacies of self-reliance and fortitude. "We'll bounce back; we always do" is the refrain. But as the disaster continues to unfold, they know, in words of one captain, that "We're watching our livelihood and even an entire culture being washed away by crude oil and chemicals."

BP has now hired Anne Womack Kolton, an aide to former Vice President Dick Cheney, to run it's $50 million new media campaign to promote the company's efforts to "restore the livelihoods" of Gulf Coast fishermen. As of June 1st, BP had paid out an average of $1,200 per person to 25,000 people in six states. People whose livelihoods BP has wiped out for their lifetime and perhaps their children's lifetimes are being offered less than they might make from a single day's catch. Reports are now pouring in of BP's claims adjusters rejecting fishermen's applications left and right.

At the same time, BP appears to be laying the groundwork to limit its future liabilities in court. Listen closely to BP's CEO and every mention of covering fishermen's losses is couched as paying only "legitimate claims." This is legalese for "We'll tie up your claims in court until you either die off or we convince a judge to reduce damage awards". Exxon did it in Alaska, appealing for more than 20 years and finally convincing the courts to reduce damages by 90%. Based on his experience as the lawyer representing Alaskan fishermen against Exxon, Brian O'Neill recently told Huffington Post, "if you were affected in Louisiana, to use a legal term, you are just f--ked."

BP has no intention to make anyone "whole" again. But this is only a small piece of the picture of how BP and other oil corporations are "f--cking" oystermen and everyone else along the way.

Supposing Obama and the courts really required BP to pay for the damage it has done: all bills get paid; all the oil is cleaned up; fishing grounds are miraculously restored.

Oystermen would still be doomed.

Why? Because within 40-50 years scientists anticipate a die-off of oysters worldwide. The greenhouse gases released from burning oil and other fossil fuels are quickly turning oceans too acidic for oysters and other shellfish to survive. This ocean acidification is taking place at ten times the rate that preceded the mass marine extinction 55 million years ago. Scientists recently studied the unexpected die-off of several billion oyster, clam and mussel larvae at the Oregon Whiskey Creek Shellfish Hatchery in 2008 and concluded that acidic water was the likely candidate for the destruction. Another 2009 report estimates that 85 percent of oyster reefs worldwide have already been destroyed.

As the old salts say in Newfoundland, 'tis a bad outlook, my son. On our current course, all of us oysterman will be left to stand in the unemployment lines.

Of course BP is not the only one responsible -- our whole society runs on fossil fuels. But the oil industry has pumped millions into campaigns to ensure the twin evils of greenhouse gases -- climate change and ocean acidification -- are not addressed.

If BP, Obama and the rest of the country are more than rhetorically committed to saving the oyster and rest of the seafood industry, it's going to require a major commitment -- and funding -- to wean ourselves off of fossil fuels and repower our society with renewable energy sources. It's going to mean thousands of wind and solar farms, just transition and green jobs programs for oil, coal and other workers impacted by a switch to renewable energy.

There is already an on-going struggle to make BP pay for the damage it has done to fishing communities and everyone else in the Gulf. But that can't mean putting things back to the same doomed condition they were in before. We should require BP to compensate those whose livelihoods it has destroyed by paying for hundreds of wind and solar farms -- providing its victims green jobs restoring the region's economy based on clean, safe, and renewable energy. Let's take BP's motto "Beyond Petroleum" to heart and make the region BP destroyed the poster child for the transition to a green energy economy.

Out of disaster this could be the beginning of saving our oceans and the livelihoods of all that work the sea.
Demand Side has repeatedly called for taxing the wealthy and taxing profits as an economically relatively painless way to reduce deficits and fund what must be the engine of real recovery -- the production of public goods. We've also taken some heat from the followers of the MMT (Modern Monetary Theory) on the basis that government is not restrained by revenue and does not need to tax. Here Marshall Auerback responds to the same set of concerns..

By Marshall Auerback
Economic Perspectives from Kansas City
Wednesday, June 16, 2010

Deficit spending by the government is merely the counterpart of private sector saving. What government deficit spending does is to permit the private sector to achieve its level of desired saving. When the latter changes, government spending ought to be adjusting in the opposite direction to offset it (unless the current account balance happens to do the job).

But consider the implications of what happens if one the economy's three major sectors – in this case, the corporate sector – retains savings above and beyond that required to reinvest and establish growth in the productive economy.

If one examines recent cases in which the corporate sector remained a net saver, both the Japanese and Canadian experiences spring to mind. Even today, Japan's corporate sector remains the largest repository of non-government savings, yet employment growth is virtually non-existent. Similarly, during the 1990s, the Canadian household sector was a net lender in the 1980s and 1990s and the corporate sector was a net borrower. So the biggest adjustment that came via Canada's export boom was a huge increase in corporate savings during the years of Paul Martin's fiscal austerity drive. But these savings were not really deployed aggressively for reinvestment in the productive economy and, hence, job creation.

As Professor Mario Seccareccia of the University of Ottawa has noted in a recent paper, in Canada during the latter half of the 1990s and during the subsequent decade, the corporate sector began to act like Keynes's economic rentiers ("The Role of Public Investment in a Coordinated "Exit Strategy" to Promote Long-Term Growth: The Keynes Legacy"). An implication to be drawn from this analysis is that even when corporations build up massive savings, as they are now doing in Japan (and as they did in Canada in the mid-1990s), one ought to pose the question: if those profits are not being reinvested to create further job growth, shouldn't the government tax them, so that it can use the fiscal resources itself to move policy in that direction?

As Seccareccia notes in the Canadian context, massive build ups of cash flow can and did facilitate all sorts of mischief - zaitech (i.e. financial engineering), accounting frauds, control fraud:

"[T]his reversal of the net lending/borrowing position of the business and household sectors is of critical importance in understanding the evolution of financial capitalism over the last decade, with much of the speculative drive having been fueled by the growing savings of the corporate sector. It was the rentier behaviour of the corporate sector, with the latter finding it ever more lucrative to engage in financial acquisitions, which largely led to an abandoning of productive investment since the 1990s."

In this context, the entire economy becomes financialised and therefore far less productive and more prone to fraud and higher rates of unemployment. But it serves the interests of the economic rentiers. This is exactly what happened in Canada and has happened all over the world in the past decade.

It is true that taxing the savings of the corporate rentiers in itself will not necessarily lead to more spending in the economy. And from a Modern Monetary Theory (MMT) perspective, it is also the case that the government does not "need" the so-called fiscal resources to spend. The government is never revenue constrained per se and could easily do more regardless of its take on corporate tax receipts.

In making this concession, my point was not that corporate tax receipts are required for the government to spend, but more that the threat of taxation might induce the corporate sector to do some of the government's "heavy lifting" on the job creation front. There's some political advantage here because, as we are witnessing today, there are profoundly strong forces currently mobilizing against government spending on the spurious grounds of "fiscal sustainability."

So let's call their bluff.

There are additional social benefits to be derived from this proposal. If the government taxes excess corporate savings, it means there are fewer corresponding opportunities for corporate financial engineering, control frauds, etc., and therefore greater financial stability as you have an economy less prone to financialisation. That's an unalloyed social good.

In effect, this becomes a tax aimed explicitly at the corporate rentiers who are not reinvesting their super profits in tangible capital equipment, except in tech/telecom bubbles, or in Chinese malinvestment schemes, etc. And it serves an ideological purpose of a) forcing nonfinancial capitalists to, well, be capitalists, not speculators, and b) ties the deficit reduction initiatives, which, as we have argued many times in the past, are insane and suicidal, but are nonetheless being carried out, to making the rentiers pay their "fair share."

The deficit hawks have gained significant policy traction, but we need to perform whatever jiu jitsu we can to point the finger at the real source of the so called "savings glut", which is lack of corporate reinvestment in anything but zaitech, payouts, financial engineering, and other delights of casino capitalism. We have to demystify what it means to have the whole system geared to serve "shareholder value," and we have to demonstrate that capitalists are failing to serve their role before a large consensus behind public and public/private investment initiatives can be rebuilt from the ashes of Austeria.

It appears that massive build ups of cash flow facilitate all sorts of mischief - zaitech (i.e. financial engineering), accounting frauds, control fraud, etc. And this would be about the time modern compensation systems began to change, tying, more and more, management bonuses to share price. So you see firms "investing" their earnings in massive buybacks of their own stocks.

In Canada, the reversal of the net lending/borrowing position of the business and household sectors is of critical importance in understanding the evolution of financial capitalism over the last decade, with much of the speculative drive having been fueled by the growing savings of the corporate sector. It was the rentier behaviour of the corporate sector, with the latter finding it ever more lucrative to engage in financial acquisitions, which largely led to an abandoning of productive investment since the 1990s.

When an economy becomes financialised and therefore far less productive, it becomes more prone to fraud, greater financial instability, and higher rates of unemployment. But it serves the interests of the economic rentiers. Minsky was right: you need a "big government" to act as a stabilising bulwark against the financialisation of the economy. Taxing retained corporate earnings is clearly another aspect of dealing with the ravages of money market capitalism.

Tuesday, June 15, 2010

Transcript: 391 David Levy on the Forecast, Peter Boockvar on the Treasury View

Listen to this episode


Today on the podcast, the Forecast with David Levy standing in; Idiot of the Week with Peter Boockvar; an exercise in sorting Keynesians -- New Keynesians, Neo Keynesians, Post Keynesians -- we'll give it a try. First, Our reading of the various analysts is that the good ones are getting leverage to the downside.

Calculated Risk is out today with numbers that show the economy would have to grow at three percent real GDI just to keep the unemployment rate in the high nines. If we got six percent real growth over one year, the unemployment rate would come down to barely under eight. This is recovery? I mean, we're coming up on twelve full months of this so-called recovery and we can't do better than this?

No, we can't. The economy is still smothered by huge private debt.

Expanding on that on the Forecast today, David Levy of the Levy Forecast Center.



This excerpt is taken from Tech Ticker at Yahoo. When Levy mentions profits here, however, be aware he is not talking about the simple financial profits we first think of, but of everthing above the technologically determined costs of production.


But what about the G-20? Even the policy heads of major governments say government is not the solution, but the problem going forward, and will have to consolidate.


The bouncing along the bottom data included recently a very disappointing jobs report. Private sector jobs increased a miniscule 41,000 last month. Were we to average that level over the next year, according to Calculated Risk's chart with which we led off the podcast, the unemployment rate would be around ten and a half.

But here is our Idiot of the Week, Peter Boockvar, responding to those employment numbers with the unlikely diagnosis that government should get out of the way.


The economy is falling and the best thing is for it to hit the ground hard. If we survive, we'll be in good shape to go on. At least that's what I hear him saying. Peter Boockvar: IDIOT OF THE WEEK. Thank you, Marketwatch.

Let's agree that three Years ago Keynesian was not the thing to be. Having been reviled in the 1970s by Monetarism and pushed aside in the 1980s in favor of Market Fundamentalism, by the 1990s and 2000s, even the pronunciation had been lost, and we were Keensians.

With the advent of the crisis, pundits and others leapfrogged back over the decades to resurrect the Keynes of the 1930s. Not a bad idea, but it missed and continues to miss the productive development of his thought in Hyman Minsky, Steve Keen and others. But Keynes did not ride back in triumph. He had already done that, in the 1960s, although the horse was not his own.

To be less glib, "We are all Keynesians now," is a famous quote ascribed sometimes to TIME magazine, sometimes to Richard Nixon, and sometimes even to Milton Friedman. It referred to a period in the 1960s when it appeared that by fiscal policy alone, the economy could be fine=tuned to produce prosperity without the devastating busts of the pre-war years.

The stagflation of the 1970s and the rise of pro-business chairs in leading universities created the conditions where the orthodoxy had to be rewritten. And the orthodoxy of the times was Keynesianism. Or was it? Joan Robinson -- a collaborator and associate of John Maynard -- called the triumphal strain of economic thought "Bastard Keynesianism." This less than enthusiastic endorsement indicated the belief by her and others that the grafting of some of Keynes ideas onto the classical assumptions of competitive markets and tendency toward equilibrium were not entirely legitimate.

The financial side of Keynes was largely rejected in the climate, in favor of fine-tuning output or enlightened stabilization policies.

In the so-called Neo-Keynesian school, Keynes predictions of wide swings in aggregate demand were converted to fine-tuning. His colorful concepts like animal spirits fell under enlightened stabilization policies.

In the most direct line of transmission of Keynes's insights, the so-called Post Keynesian school, retained the emphasis in the original. Financial relations could cause volatility in investment and in the macro economy.

In the 1980s, a school with the unfortunate name New Keynesian arose. It retained the marriage, however illegitimate to Joan Robinson, to the classical principles, and sought to solve the bad match to empirical evidence by examining so-called "Market imperfections." An example is Joseph Stiglitz [so beloved of Demand Side] whose work on information asymmetries exposes a deep market imperfection. One so deep as to be lethal. In fact, the term "market imperfections," indicates the potential of more or less mild remedies to an otherwise smooth-functioning machine. The term market failures is better, but market fatal flaws is perhaps best.

Other New Keynesians might include Paul Krugman, whose fascination with the zero bound on interest rates suggests that a technical problem limits monetary policy, when post-Keynesians, or at least Demand Side, suggests monetary policy is swamped by enormous debt and only when debt levels come down to about half their current level can traditional monetary policy have an effect again.

Hyman Minsky is one line of direct transmission of Keynesianism. It should be called financial Keynesianism, and we saw in David Levy's comments in today's podcast some absurdities of orthodoxies which basically ignore profit, debt, balance sheets, asset prices, and so on. Minsky saw apparent stability and prosperity as the condition which produces excess leverage and ever more fragile financing structures. The two powers of the central bank and big government can right a listing ship with bail outs and deficits, but do so at ever greater costs in ballast. That ballast eventually finds its way above deck. Sooner or later it has to be removed.

The effect of finance on demand has been illustrated by Steve Keen. Keen points out simply that delta demand equals delta income plus delta debt. The change in demand is composed of the change in income plus the change in debt. The demand side of booms is fueled by increasing leverage. The demand side of busts reflects declining or even simply stagnant changes in debt.

Demand Side as we practice it uses the multiplier to show that growing leverage means shrinking demand dynamics.

All of which impacts investment. The capital goods sector is the original stimulus sector. When liquidity preference, shrinking capital goods prices, or projected flagging demand for output appear, they appear in the investment goods sector.

Now the Keynesian views of all stripes have to accept that it is not just the level, but the composition of investment that matters. The economy has failed as much by creating MacMansions when we needed climate survival as it has for its misallocation to the wrong line of accounts.

Consumer capitalism which favors private goods has run its course. No Keynesianism will succeed which does not recognize that current failures originated in the pilot's house. Short-term-ism is blindness. And the short-term rules in our current corporate oligarchy. The time is right not for more taxpayer ballast, but for jettisoning a good chunk of dead weight, and rebalancing in lines that are forward-looking and sustainable.

Monday, June 14, 2010

Did would-be homeowners overreach and cause the crash? Robert Kuttner's answer

Don't Blame the Dream of Home Ownership
Robert Kuttner
June 13, 2010

Here is a fable that is making the rounds. It is a collection of half-truths and outright lies:

The financial meltdown was the result of too many people pursuing the American Dream of home ownership. People who couldn't really afford to be homeowners became speculators. Government added to the damage with cheap mortgages, misguided laws such as the Community Reinvestment Act, and overgrown government-sponsored agencies like Fannie Mae and Freddie Mac.

This stuff is a staple of rightwing talk shows. In a moment, I will rebut each element of this storyline, but first I want to single out a wildly misleading piece by the New York Times financial columnist Joe Nocera. The piece, which ran in Saturday's business section, was titled "Wake-Up Time for a Dream."

The dream -- surprise -- is home ownership. It is depressing that a rightwing theme has invaded the mainstream Times.

Nocera writes, "The financial crisis might well have been avoided if we as a culture hadn't invested so much political and psychological capital in the idea of owning a home. After all, the subprime mortgage business's supposed raison d'etre was making homeownership possible for people who lacked the means -- or the credit scores -- to get a traditional mortgage."

Now this is just malarkey. And the Nocera piece is worth reading in its entirety to appreciate just how an influential financial columnist can get a critically important story so utterly wrong.

For starters, the homeownership rate was already 64 percent in the mid 1960s. It peaked at about 69 percent just before the bubble burst -- but was nearly 68 percent in 2001 before subprime lending took off. Back in the 19th century, thanks to the Homestead Acts of the Lincoln era, homeownership (mainly family farms) was well over 70 percent in much of the west.

Ordinary working people can become homeowners and accumulate property wealth when two elements are present. Government programs have to be competently run and prevent private-industry sharks from abusing them. And working people need a degree of financial predictability in their job security.

In the period between, Franklin Roosevelt and LBJ, both factors prevailed. The Federal National Mortgage Association, later privatized as Fannie Mae, was part of the government. If mortgages met its standards, FNMA bought them from local banks and replenished bank working capital. Just as importantly, wages of working people steadily rose, so that more and more ordinary Americans could afford mortgage payments. Not surprisingly, homeownership rates rose. After Congress passed fair housing legislation in 1968, so that minorities could get a fair shot, black homeownership took off, too.

But beginning in the 1970s, wages stopped increasing with productivity growth. And the financial sharks got hold of programs intended to promote homeownership.

A newly privatized FNMA increasingly thought more about using its implicit government guarantee to increase market share and enrich its executives and shareholders. Not until Bush II, however, in 2004 and 2005 just before the housing collapse, was Fannie directed by the political masters in the White House to lower its standards and purchase pools of dubious mortgages so that Bush's "Ownership Society" could claim credit for increasing homeownership rates.

Fannie Mae, a corrupted agency, has become a handy all purpose scapegoat. The lack of a provision in the financial reform legislation to resolve the mess at Fannie has become the main alibi that Republican senators give for voting against the whole reform package.

Nocera contends that the subprime industry's "raison d'etre" was to promote homeownership "for people who lacked the means -- or the credit scores -- to get a traditional mortgage." Sorry, Joe. The industry's reason for being was so that financial wise guys could make a bundle at the expense of suckers. Low income prospective homeowners were merely useful props. They were the poster children, but not the real purpose.

(In 1994, the same Nocera was celebrating prosperity-for-all in a wildly over-optimistic book titled "A Piece of the Action: How the Middle Class Joined the Moneyed Class." If his latest debunking is Nocera's way of doing penance for his own earlier misplaced euphoria, it is just not helpful.)

The pity is that carefully run government programs, from the Homestead Acts to Neighborhood Housing Services, to the good work of community development financial institutions such as Chicago's ShoreBank, have indeed increased the rate of homeownership among working people, and have done so by avoiding bait-and-switch products like subprime loans, not promoting them. The culprit is not the dream of owning your own home, but the utter cynicism of the financial sharks who took advantage of people innocently pursuing the dream.

Large numbers of subprime loans were in fact marketed to elderly people who had low mortgage debts, who could not live on fixed incomes and who needed to refinance their homes to take out equity. This was not about promoting homeownership but destroying it. Many of these victims are now losing their homes. The stripping of home equity is partly a story of a collapsing pension system in the face of rising costs for America's seniors.

The 1977 Community Reinvestment Act, which encouraged banks to keep credit flowing to less affluent neighborhoods "consistent with sound lending standards" is not part of this fiasco at all. Had CRA been enforced, subprime loans that waived underwriting standards would have been illegal. Most of the mortgage brokers who retailed subprime loans were not even covered by CRA.

It's certainly true (and no serious person claims otherwise) that 100 percent of Americans will never own their own homes. Some people are too transient or just too poor. Some would prefer to rent. But, maddeningly, one element of the story that the debunkers of the American Dream invariably leave out is the near-collapse of programs for affordable rental housing. Among moderate income Americans who rent, the fraction of income spent on housing rose steadily for three decades.

Ironically, many low income people turned to homeownership as a last resort because they couldn't find an affordable rental -- and the same Bush Administration that gutted subsidies for affordable rental housing refused to enforce laws on the books specifying standards for responsible lending to aspiring homeowners.

A sound housing policy would combine assistance for homeownership with affordable rental housing. A homeownership rate of 70 percent, which is common in several affluent European nations, is perfectly reasonable -- if our political system keeps sharks like the subprime gang from wrecking the system and agencies such as FNMA from being corrupted.

Fannie Mae, which over-reached and went broke as a private company with a government guarantee, is now a ward of the federal government. It should be restored to its original form under Roosevelt, as a public corporation with high principles and high standards.

In the aftermath of the subprime collapse, many hard working lower income people, including a great many African Americans, have seen their dreams wiped out. The home ownership rate in black communities, which were targeted for subprime loans, is in free fall. Brandeis University's Institute on Assets and Social Policy reports a devastating increase in the black-white wealth gap.

The same New York Times recently published a fine piece by reporter Michael Powell on what is happening to the black middle class in Memphis, "Blacks in Memphis Lose Decades of Economic Gains."

The same story could be told about hundreds of predominantly African American neighborhoods.

The villain of the piece is the mortgage meltdown coupled with rising unemployment rates that are the collateral damage of the same financial collapse. The villain is not moderate income homeowners.

These people paid their mortgages on time, and there was nothing wrong with their dream. What was wrong was the failure of their government to keep the private financial industry from stealing the dream.

Saturday, June 12, 2010

Why is Section 716 the indispensable reform? Jane D'Arista

Why Section 716 is the Indispensable Reform
By Jane D’Arista
Baseline Scenario
June 11, 2010

Dominated by the world’s largest banks, the over-the-counter (OTC) derivatives market has been expanding since the break-down of the Bretton Woods Agreement in the early 1970s privatized the international monetary system by shifting the payments process from central banks to commercial banks. The proliferation of foreign exchange forwards and swaps that followed set in motion an ever-expanding menu of exotic instruments that reached a nominal value of over $600 trillion by the middle of the current decade. Central banks and financial regulators ignored the implications of the growth of this market and ignored warnings from the Bank for International Settlements (BIS) and the International Monetary Fund (IMF) from 2002 forward that OTC derivatives were at the center of what had become a global casino in which the largest international institutions were the biggest speculators.

The large, international institutions that created the OTC market for foreign exchange forwards and swaps were commercial banks. Following established banking practice, they conducted their derivatives business like portfolio lenders rather than broker/dealers, buying and selling forwards and swaps outside of established markets. But OTC derivatives contracts can’t be classified as assets or liabilities until they are settled and can’t be held on banks’ balance sheets the way loans and deposits are held. Instead, they were booked off balance sheet as contingent liabilities. The market structure that emerged in what came to be the largest market in the global economy was one in which non-tradable contracts were bought by and sold to customers without real time information on volume or pricing or the aggregate positions of the dealers themselves. Moreover, the fact that the contracts were illiquid required constant hedging by dealers that expanded their positions and inflated the size of the market relative to all other national and international financial markets. Meanwhile, the commercial bank dealers’ derivatives business was operating with all the implicit guarantees and subsidies that governments put in place to protect this core financial sector. In 2008, those guarantees became explicit and were exercised.

Are there reasons to protect derivatives dealers?

Because the largest U.S. commercial banks were dominant players in the OTC derivatives markets, Federal Reserve lending, FDIC guarantees and taxpayer bailouts during the 2008 crisis gave explicit protection to both bank and non-bank swap dealers and major swap participants. Those protections are not grounded in the traditions and practices of U.S. financial law and regulation. They are no more appropriate than would be an extension of federal protection to financial entities (including bank affiliates) that market and trade corporate stocks and bonds. Recognizing how far the government’s response in 2008 deviated from the existing rational framework for government intervention, Section 716 of the Senate bill makes clear that such protections are not to be given statutory approval; that allowing banks to continue to deal and trade in derivatives would be to accept this egregious violation of prudential standards in legislation intended to reform and strengthen a fragile financial system.

The movement of the largest banks into the business of marketing and trading OTC derivatives occurred during a period when the process of deregulation was sweeping away traditional regulatory barriers and was not challenged. That fact should not, however, lead to the assumption that this is a “normal” banking activity. There is no economic or systemic reason why derivatives should be sold by banks. As the entry of large investment banks into the business in the 1980s suggests, it is not tied to the traditional deposit-taking and lending activities of banks or to the payments system. It is, in fact, so esoteric an activity that, currently, only five institutions account for 90 percent of the market. The remaining 8,000 or so U.S. banks do not sell derivatives or trade them for their own account.

Equally questionable is the assertion that dealing in derivatives is part of banks’ role as intermediaries; that they are helping to meet the hedging needs of their customers. As CFTC Chairman Gary Gensler recently pointed out, BIS data show that sales and trades with commercial end-users account for only eight to nine percent of the OTC market. Over 90 percent of contracts involve transactions between dealers or with other financial institutions. Meanwhile, the events of 2008 have made a mockery of the frequently voiced assertion that derivatives were invaluable in shifting risk to those most able to bear it – unless, of course, the assumption was that those most able to bear it were taxpayers.

Risk and fiduciary responsibility

Housing the business of marketing and trading derivatives in banks intensifies systemic risk and undermines fiduciary responsibility. Buying and selling OTC derivatives contracts is a zero sum game. Unlike portfolio lending that links the fortunes of borrowers and lenders, one party to a derivatives transaction wins while the counterparty loses. Given the nature of the game, dealers must constantly hedge their positions but, unable to do so by trading their side of the contract, their exposures grow higher and higher and include a number of contracts with long maturities. Systemic risk is embedded in this type of market structure – the more so since the buildup in these positions over the decade preceding the crisis depended on short-term borrowing and rising leverage. Touted as a way to defuse risk, the expansion of banks’ derivatives business actually intensified it

The buildup in derivatives positions among the large dealers also created a new and dramatically intense form of systemic risk: interconnectedness. The share of total transactions accounted for by contracts between a relatively small group of dealers resulted in an increasingly symbiotic web of interdependence among the largest institutions in the global market. The size of individual dealers’ positions contributed to systemic risk but interconnectedness was at the epicenter of the problem.

What section 716 does to alleviate the problem

The most important element in section 716 is the structure it provides – one that makes a clear separation between the business of banking and that of marketing and trading derivatives. This structure makes it possible to protect the core financial functions of banks without extending those protections to cover highly risky derivatives transactions.

By requiring that dealing and trading derivatives move to separately capitalized affiliates that do not have access to Fed lending facilities or FDIC guarantees, section 716 will also contribute to shrinking the size of individual institutions’ positions and the market itself. The huge capital reserves of the five institutions that dominate the U.S. market will no longer be available to support their outsized positions. The capital of derivatives affiliates – even if within the same holding company – will necessarily be much smaller and will limit their aggregate positions. This will create opportunities for non-bank firms to enter the market with capital positions equivalent to those of the affiliates of major institutions.

By shifting the activity to affiliates, section 716 eliminates the burgeoning counterparty risk the largest banks incur through marketing and trading OTC derivatives. Encouraging an expansion in the number of dealers will help reduce the risk to the system as a whole. The intent in both the House and Senate bills to require clearing and trading on exchanges using a central counterparty structure is another critical element for alleviating interconnectedness but only if the pressure to create loopholes is resisted.

Are there other provisions that mitigate these risks if banks are allowed to continue selling and trading derivatives?

There are other provisions in the House and Senate bills that address some aspects of bank exposure to risks involving derivatives but none of them remove the government guarantee backing their marketing and trading by banks. For example, the Volcker Rule in section 619 of the Senate bill deals with the equally important problem of proprietary trading by proposing to bar trading in any financial instrument, including derivatives, for a bank’s own account. The Merkley-Levin amendment strengthens this provision by making the reform a statutory ban rather than leaving it to the discretion of regulators. In addition, it would crack down on trades that conflict with customers’ interests.

But Merkley-Levin is not a substitute for section 716. It would still allow banks to deal and trade on behalf of their clients. Their derivatives business would still be backed and subsidized by Federal Reserve lending and FDIC guarantees and, in the event of another crisis, might require taxpayer bailouts to protect the banking functions of these huge enterprises.

Other sections of the Senate bill – sections 608–611 – address the systemic risk posed by interconnectedness. Section 610 limits a bank’s credit exposure (including derivatives) to another bank or financial institution as a percentage of its capital. This provision will tend to shrink the OTC derivatives market since, as noted, over 90 percent of aggregate transactions involves trades between dealers or with other financial institutions. Another section (608) complements section 716 by limiting a bank’s credit exposure (including derivatives) to affiliates. But, again, banks would still be able to conduct their derivatives business within the bank and the government backing for the bank that constitutes a guarantee and subsidy for selling and trading derivatives would remain.

Both the House and Senate bills authorize regulators to impose aggregate position limits on traded contracts and swaps. These provisions complement both sections 610 and 716 in the Senate bill by allowing regulators to address excesses and imbalances in the derivatives positions of individual institutions and the aggregate market as well. They are a very important tool for strengthening the regulation of derivatives markets but – once more – they do not remove the anticompetitive government support uniquely enjoyed by the derivatives operations of the five largest U.S. financial institutions.

In summary, there are no substitutes for section 716 – no provisions that will accomplish what it does in terms of removing the subsidy enjoyed by (literally) a handful of institutions and ending the ongoing threat to the taxpayer that the guarantee of their derivatives business poses. Ignoring that threat would undermine all the other contributions to reform that the House and Senate bills provide.

Thursday, June 10, 2010

L. Randall Wray and Yeva Nersisyan on What is more absurd than cutting government deficits in a downturn?

Full employment is the only context for a balanced budget that makes sense. We offer the following simple examination of the error and possibility of enlightened budgeting. Sadly, the error is from the CBO. This is too simplistic in some ways. For example, a deficit in the private sector (the enormous growth of private debt) was the necessary condition for the bubble and collapse. That said, whether from deficits, taxes, debt write-downs and restructurings, or whatever, the financial archetecture has to be modified to fit the real economy's imperitive to operate at capacity.

It is no accident that the fiscal troubles of states and nations has followed the economic collapse engineered by an out-of-control financial sector. What is more absurd than than governments cutting back in slack conditions? Answer: the pretense that somehow the troubles of government are precipitating an economic downturn. You have to reverse the arrow of time to make it happen (as well as revise the laws of logic).
Letter to a Seventh Grader (and also to the Director of the Congressional Budget Office)
By Randall Wray and Yeva Nersisyan
Economic Perspectives from Kansas City
June 9, 2010

A few of days ago a Letter to a Seventh Grader written by the Director of the Congressional Budget Office appeared on the CBO's blog. It is nice to have a responsive public official. Unfortunately, the CBO's Director does not understand federal budgeting. He seems to believe the US still operates on a gold standard. At best, his letter should be taken as a history of thought lesson, something that a CBO Director might have written to a seventh grader in 1931. There is nothing in the letter that would help anyone to understand government finance in the US today, in the post-Bretton Woods era with a floating exchange rate, non-convertible—sovereign – currency.

So we have decided to correct the CBO's errors and to provide a letter to a seventh grader that actually addresses the current situation. Here are the questions of the 7th grader, the CBO Director's responses (in italics) and, then, our (correct) response to the questions.

1. What are the primary causes of the current federal budget deficits?
The current large deficits are the result of a combination of factors. These include an imbalance between tax revenues and the government's spending that began before the recent economic recession and turmoil in the financial markets, sharply lower revenues and higher spending related to current economic conditions, and the budgetary costs of policies put in place by the government to respond to those conditions.

The government's budget is an accounting record of the government's spending and revenues (mostly taxes). When spending exceeds revenues, the budget is in deficit. To a large degree, the government's budget balance is non-discretionary and simply mirrors what is going on in the rest of the economy. During a recession private sector spending falls and unemployment rises. As the private sector spends less, the government automatically spends more—especially on unemployment benefits and other forms of social assistance. But most importantly, as economic activity declines, tax revenues fall. Falling tax revenues combined with rising social spending – called automatic stabilizers- create a gap between revenues and expenses resulting in a budget deficit. Economic recovery will automatically reduce the government's deficit. If growth were so robust as to produce a government surplus, this would mean that the nongovernment sector would be running a deficit. By accounting identity, the sum of the government's balance plus the non-government's balance is zero. In other words, today's government budget deficit is equal to the nongovernment sector's surplus (also called net financial saving).

2. How will budget deficits affect people under the age of 18?
The government runs a budget deficit when it spends more on its programs and activities than it collects in taxes and other revenues. The government needs to borrow to make up the difference. When the federal government borrows large amounts of money, it pushes interest rates higher, and people and businesses generally need to pay more to borrow money for themselves. As a result, they invest less in factories, office buildings, and equipment, and people in the future—including your generation—will have less income than they otherwise would.

Also, the government needs to pay interest on the money it borrows, which means there will be less money available for other things that the government will spend money on in the future. Squeezing other spending affects different people in different ways, depending on their individual situations. For example, many young people benefit from government programs that provide money to families in need of food or medical care or to people who have lost their job, or from the financial support the federal government provides to local schools, or from the grants or loans the government offers to help pay for college education.

The Federal government (Federal Reserve and the Treasury) is the monopoly issuer of U.S. dollars. The dollars that we all use come from the federal government. This means that the government never has or doesn't have dollars, nor can it run out of dollars. It just creates them at will whenever it needs to spend.

When the government uses its currency issuing capacity in a meaningful way it can do a lot of good for the private sector. It can hire people who are currently unemployed to build bridges, highways, repair the streets, to care for the elderly and so on. It can provide healthcare to people who need it. It can provide education to those who want to get one. Federal budget deficits create a surplus for the nongovernment sector and federal budget debt is a financial asset and net financial wealth for the nongovernment sector. So budget deficits today mean more income, more roads, schools and hospitals (tangible assets), healthier and more highly educated population and more financial assets for the private sector than it would otherwise have.
Today's young people look forward to jobs, growing labor productivity and higher living standards in the future. The government has an important role to play to ensure that outcome. By itself, a government deficit is neither good nor bad. What really matters is the consequence: if a budget deficit is too small (spending is too low and/or taxes are too high), then the economy operates below capacity and grows too slowly; if the budget deficit is too large then inflation can result as the government takes too many resources away from private use and prices and wages are bid up. A deficit of the proper size allows the economy to operate at full employment of its resources.

3. How is the U.S. government working to reduce budget deficits?

The President created a National Commission on Fiscal Responsibility and Reform to draw up plans to address the deficit problem. Most of the people on the commission are Members of Congress.The commission will consider ways to reduce the budget deficit by 2015 as well as ways to improve the long-term budget outlook. Under current government policies, the gap between the government's spending and revenues in coming years will be large. Therefore, balancing the budget would require significant changes in spending, taxes, or both. On CBO's Web site, you can find information about the budget outlook during the next 10 years and over the long term.

More information about the commission can be found on its Web site: Fiscal Commission
Congress also has enacted a new law (called "Pay-As-You-Go") that typically requires legislation that increases spending or lowers tax revenues to include other measures to offset the costs of those changes.

Targeting deficit reduction is not an appropriate goal for the federal government. Rather, the budget should be the tool used to achieve the public purpose – better education, infrastructure, healthcare – anything that the public decides it wants/needs. At the macro level, if the government reduces its deficits, the nongovernment sector will have less income and less saving. The National Commission on Fiscal Responsibility and Reform created by the President is misguided because it is trying to reduce the budget deficit in a time of massive quantities of unused and underutilized resources. Those on the Commission don't understand how our modern monetary regime works and if we followed their advice we would probably cause a "double dip" as the economy fell back into deep recession. Note also that their deficit-cutting proposals most likely would not reduce deficits in any case because a slowing economy sets off the automatic stabilizers—tax revenue would fall and social spending would rise.

4. What can people, and especially school-aged children, do to help curb budget deficits?
The most important thing that school-aged children can do to help reduce future deficits is to study hard and acquire the best possible education. This will help you and your classmates get better jobs when you grow up, which will help the economy grow. In turn, a stronger economy will produce higher tax receipts for the government, which will lower the deficit.When young people get jobs, they should be sure to save some of the money they earn.Through a fun and important bit of math called compounding, savings of small amounts can grow over time into significant amounts. For the economy as a whole, the more people save, the more money is available for businesses to invest in factories, office buildings, and equipment. For individuals and families, more savings provide a financial cushion in times of economic difficulty. In particular, more savings can help people pay large medical expenses or save their home in case they lose their job or become ill, thus helping them avoid needing government assistance.

People of all ages can also help to reduce the deficit by learning how the government spends money and from whom the government collects money. Understanding the current budget is essential for choosing intelligently among different ways to change programs and policies in order to reduce deficits.

Again, cutting the budget deficit is not a legitimate goal—for government or for people. The best thing that a young person can do is to study hard, do well in school, and prepare herself for a long, healthy, and productive life. The best thing for the government to do is to support young people in those pursuits. Unfortunately, those who are trying to reduce the budget deficit will rely mostly on spending cuts that especially hurt young people. Since health, education, and social welfare spending (including Social Security) account for a very large part of government spending (at all levels), those are usually the first programs to be cut by those trying to "balance the budget". Not only does that mean trouble today, but it has long-term impacts for generations to come. Some projections show that the current generation of school-age children will be the first one that will actually be less educated than their parent's generation. Rather than cutting back on education, the federal government should be increasing its support for those in school.

5. If I am to convey one key message to my school regarding the federal budget deficit, what would it be?
The prospect of budget deficits for many years in the future is a serious problem for our country. Ultimately, people in the United States will have to bring into balance the amount of services they expect the government to provide, particularly in the form of benefits for older Americans, and the amount of taxes they are willing to send to the government to finance those services. Because it takes a long time to implement major policy changes, deciding what those changes will be is an urgent task for our citizens and for our policymakers.

Do not listen to all the nonsense about the ill effects of budget deficits coming out of Washington. The federal government cannot "run out of money" because it is the issuer of our currency. It can make all payments as they come due. It can never go bankrupt in its own currency. It can afford to spend on the necessary scale to end this recession and to put the economy on track to robust growth. It can afford to create as many jobs as necessary to ensure that anyone who wants to work will be able to make a positive contribution to our economy. It can afford to support programs to protect and restore our natural environment. And it can and must spend more to support our schools.

Wednesday, June 9, 2010

What can we do to fix Washington State revenues?

Pardon an interruption in the normal style of Demand Side. We're promoting a solution to Washington State's dreadful tax structure and got caught without a good resource link, so -- thinking slowly -- we gave out this one.

A relatively simple adjustment to the B&O tax can turn it into a tax on value added.

This has virtues of its own in terms of equity and sturdiness, as well as relieving the burden on small business, but it also would allow the tax to be extended to the government sector, and is the least painful way to completely fill the budget hole.

The B&O is now a very low rate tax levied on gross receipts (gross sales). It is considered by many to be as regressive as the retail sales tax. By allowing the deduction of purchased inputs, and thus changing the base from gross receipts to value added, the many current rates could be reduced to one, and this one rate could be extended to government payrolls - a proxy for value added.
If, say, that rate turned out to be 2% (probably a low number), applying it to the public sector would yield between $600 and $800 million and by itself cover nearly half the essential deficit.

(Similarly, the revised tax could be extended to other currently exempt areas.)

It cannot be an option for state government to fail. The budget proposed by the governor amounts to a failure. If it or anything like it is enacted, it amounts also to a failure of leadership. Aside from simplifying and making the B&O more fair to small business, such a change would have one other, perhaps greater advantage - it would fill the budget hole.

There are no other good options. The sales tax is effectively maxed out. The property tax is off the table. Sin taxes, and special-purpose taxes and fees are nickels and dimes when we need tens and twenties.

Following is a detailed paper produced in 2005 describing the first half -- the transformation of the B&O from a gross receipts tax to an "enterprise tax" (name chosen to avoid confusion regarding value added).

B&O Reform 032105 rev 0610

Tuesday, June 8, 2010

Transcript: 390 With the ship sinking, G20 advocates drilling holes in the hull to let the water out

Listen to this episode

Today on the podcast, Notes, the dynamics of expectations from John Maynard Keynes, markets, some politically incorrect environmentalism from Stewart Brand, and Steve Keen debunking a mainstay of orthodox microeconomics -- the marginal cost curve.

By way of Calculated Risk, we find

First, from the Financial Times: G20 drops support for fiscal stimulus

Finance ministers from the world’s leading economies ripped up their support for fiscal stimulus on Saturday ...

The communiqué of the meeting made it clear that the G20 no longer thinks that expansionary fiscal policy is sustainable or effective in fostering an economic recovery because investors are no longer confident about some countries’ public finances.

from the G20 communiqué:

The recent events highlight the importance of sustainable public finances and the need for our countries to put in place credible, growth-friendly measures, to deliver fiscal sustainability, differentiated for and tailored to national circumstances. Those countries with serious fiscal challenges need to accelerate the pace of consolidation.

And from Paul Krugman: Lost Decade, Here We Come

It’s basically incredible that this is happening with unemployment in the euro area still rising, and only slight labor market progress in the US.


The right thing, overwhelmingly, is to do things that will reduce spending and/or raise revenue after the economy has recovered — specifically, wait until after the economy is strong enough that monetary policy can offset the contractionary effects of fiscal austerity. But no: the deficit hawks want their cuts while unemployment rates are still at near-record highs and monetary policy is still hard up against the zero bound.


Utter folly posing as wisdom. Incredible.

The G20 has been reading from The Economist magazine/newspaper's most recent issue: "Fear Returns -- How to Avoid a Double Dip Recession." that confirms it. The Economist was encouraging us to avoid the onset of the last one, or the first part of this one, well into 2008.

The Economist cheerleads the sinking, with quote "America contemplates yet more fiscal stimulus and leaves the pain for later."

This "bring it on" bravado for the benefit of the real economy and governments is substantially absent in the Economist when it has to do with the financial sector. It's as if shrinking economies are going to find treasure in the mud.

Exports are going to save the economy, the Economist says, every economy. How is that going to work. Oh, Here. The forthcoming issue: Mars just phoned in with a massive order for MacMansions.

The Economist's slogan should be, "We didn't see it coming, We don't know hwere it's going, but we'll tell you what to think and besides our graphics are good.


Stocks Down

Oil Down

Dollar Up (Is it oil down or dollar up?)

Bonds higher (don't forget the backdoor bailout of the banks means they can borrow from the Fed at zero, take it over to the treasury and lend, and collect the difference. This is a form of monetizing the debt, but paying for the privilege.)

The very weak jobs report was in line with Demand Side predictions. The second quarter was the peak of the federal stimulus, which provided the only positive noise in an otherwise deep and continuing recession. It should be observed that even with the federal stimulus, because of tightening at the state and local levels, the net contribution from government was slightly negative.

The help to states goes away in September and next January, although there is a probability that support for Medicaid will be continued. From the Demand Side point of view, there are only a few fibers holding us from another serious leg down. Perhaps it will not be as dramatic as the fall into the pit. But we're drilling below every other postwar recession now.

Another note from John Maynard Keynes on expectations. From Steve Keen's seminal article in 1995 entitled "Finance and economic breakdown: modeling Minsky's 'financial instability hypothesis.'

Keynes' (as in John Maynard's) explanation for the formation of expectations under uncertainty has three components:

  • a presumption that 'the present is a much more serviceable guide to the future than a candid examination of past experience would show it to have been hitherto;"
  • the belief that 'the existing state of opinion as expressed in prices and the character of existing output is based on a correct summing up of future prospects;' and
  • a reliance on mass sentiment: 'we endeavor to fall back on the judgment of the rest of the world which is perhaps better informed."

As Keen points out, "the fundamental effect of shifts in expectations is to change the importance attributed to liquidity, thus shifting the apportionment of funds between assets embodying varying degrees of liquidity, with volatile consequences for the level and composition of investment."

Points one and two are the pillars of Rational Expectations theory and the efficient markets hypothesis favored by the Chicago School

According to Wikipedia:

There are three major versions of the hypothesis: "weak", "semi-strong", and "strong". Weak EMH claims that prices on traded assets (e.g., stocks, bonds, or property) already reflect all past publicly available information. Semi-strong EMH claims both that prices reflect all publicly available information and that prices instantly change to reflect new public information. Strong EMH additionally claims that prices instantly reflect even hidden or "insider" information. There is evidence for and against the weak and semi-strong EMHs, while there is powerful evidence against strong EMH.

In other words, in 1936, Keynes identified the fallacy of expectations in conditions of fundamental uncertainty. In the 1980s, the fallacy was developed into a Nobel Prize winning theory.

The final component in Keynes triad, reliance on mass sentiment, is all the more powerful today. It did Stiglitz, Keen, Baker, Roubini, Krugman, Galbraith, et al, no good in terms of influence to be right in their analysis and predictions. As we saw, policy-makers are in thrall to the thousand-voiced financial sector, which dutifully amplifies the traditional sentiment to a frightening pitch. The fiscal tightening policy has no chance of success, even in producing the returns for the bond vigilantes themselves.

Now for something new. It seems like we've been saying the same thing for so long.

Stewart Brand is a long-time environmetalist. We excerpt aggressively from a TED lecture called four environmental heresies, bringing you a couple of them: nuclear power is environmentally friendly, genetically engineered crops are a moral imperitive, and geoengineering will have to be tried to reverse the environmental degradation of the Anthropocene, the geological successor to the Holocene.


How broken is orthodox economics?

Last week we watched in horror as Steve Keen dismembered the standard curves used to describe prices in classical market curriculum. The curves? Fixed costs. Variable costs. The combination produces marginal cost -- the cost of producing one additional unit. Price set at the point where marginal costs equal morginal revenue.

Nice on paper. A feature of every textbook. Not accurate. Keen says, in part,
What “state of the art” means in economics, sadly, is applying a textbook model that is empirically and theoretically false to a real industry. Only by luck will it actually have the intended impact.


Neoclassical economists draw their “average cost curve” by combining two other hypothetical curves: one for fixed costs that don’t depend on the level of output (machines in a factory, or the cost of prospecting), and the other for variable costs that do depend on the output level ( labour, raw materials, energy, fuel).

Average fixed cost necessarily falls as output rises—a constant cost level is divided by an increasing output. For variable costs, economists make two assumptions:

  • that the cost of inputs remains constant: inputs like labour and raw materials (of a set quality) are assumed to be readily available at a set price, regardless of how many units the firm purchases; and
  • that the productivity of these inputs falls as output rises. Economists call this assumption “the Law of Diminishing Marginal Productivity“. Since each worker costs the same amount, but produces a lesser amount than the one before, the marginal cost of production rises.
Average cost per unit falls as the decline in “average fixed costs” dominates, but then rises as “marginal costs” increase. The average cost of production is therefore U-shaped.

It’s a simple, intuitively appealing model that is believed by all neoclassical economists. And it’s also empirically false. Over 150 academic studies of manufacturing firms have found that most firms have cost structures that look nothing like these drawings.

The most recent such research—Asking About Prices, by Alan Blinder, a past Vice-President of the American Economic Association—found that 89% of firms reported either constant or falling marginal costs (Blinder (1998)), while previous studies had put the figure as high as 95% (Eiteman and Guthrie (1952)).

It appears that the “Law” of Diminishing Marginal Productivity doesn’t apply in the real world. The reason is simple, and best illustrated with a farming example where the fixed input is land and the variable input is fertiliser.

Economists imagine that a farmer with a 100 hectare farm and 1 bag of fertilizer would spread the entire bag of fertilizer over the entire farm—using all of both his fixed and variable inputs.

But what a farmer does instead is leave most of the land unfertilized, and spread the bag at the recommended ratio per hectare—since this gives him the highest productivity. As each new bag of fertilizer is added, more land is fertilized, and so on, so that productivity remains constant right out to the 100 hectare limit.

A similar story applies for factories: they are designed by engineers so that they reach maximum efficiency at very close to maximum capacity. When a factory is first commissioned, it will have oodles of spare capacity—since it is built with the expectation that demand will grow over time. Therefore unit costs will fall as output rises because the factory becomes more efficient—not less, as economists fantasise.

Economists cling to the counter-factual fantasy they teach in their textbooks because without that fantasy, their model of a perfectly competitive market falls apart. As Blinder noted:

“The overwhelmingly bad news here (for economic theory) is that, apparently, only 11 percent of GDP is produced under conditions of rising marginal cost.” (Alan Blinder, Asking About Prices, p. 102)


Blinder’s “discovery” of this phenomenon casts an interesting light on the nature of scholarship in neoclassical economics. He undertook the research to provide a “microfoundation” for his position as a “New Keynesian” macroeconomist, where that particular Neoclassical sub-school explains unemployment (and other real world macro-phenomena) by the proposition that prices are “sticky”, and therefore don’t instantly adjust to eliminate involuntary unemployment as unreconstructed Neoclassical theory argues should happen (the rival “New Classical” school argues instead that prices do in fact adjust rapidly, and that all unemployment is voluntary—including that which occurred during the Great Depression).

But though he expected to find a reason for prices not to behave as the textbook said they should—to rapidly bring all markets into equilibrium—he was obviously surprised by what he found. His summary of findings included statements like the following (in addition to the “overwhelmingly bad news” comment above; I’ve added the emphases below):

“in a fair number of cases—and this was the big surprise—we found that the ‘fixed’ versus ‘variable’ distinction was just not a natural one for the firm to make.” (p. 101)

“Firms report having very high fixed costs-roughly 40 percent of total costs on average. And many more companies state that they have falling, rather than rising, marginal cost curves. While there are reasons to wonder whether respondents interpreted these questions about costs correctly, their answers paint an image of the cost structure of the typical firm that is very different from the one immortalized in textbooks.” (p. 105)

See much more at Keen's Debtwatch site, link online