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Monday, December 13, 2010

Transcript: 417 Does the ransom for the tax deal amount to a return of Bush II economics?

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Recovery in the midst of recession. Or is it recession in the midst of recovery? Plus will the Democrats shoot themselves in the political foot if they don't pay the king's ransom of tax cuts for the rich? And we look in on the continuing crisis in Europe, where defense of the banking sector is being cast as defense of the euro as a currency, and some folks don't like the euro. So will the banks fall with it?

First a short post from Calculated Risk in its entirety:

Ylan Mui at the WaPo captures the economic bifurcation of America: Economic recovery leaving some behind this Christmas

At Tiffany's, executives report that sales of their most expensive merchandise have grown by double digits. At Wal-Mart, executives point to shoppers flooding the stores at midnight every two weeks to buy baby formula the minute their unemployment checks hit their accounts. Neiman Marcus brought back $1.5 million fantasy gifts in its annual Christmas Wish Book. Family Dollar is making more room on its shelves for staples like groceries, the one category its customers reliably shop.

"When you start to line up all the pieces, you see a story that starts to emerge," said James Russo, vice president of global consumer insights for The Nielsen Co. "You kind of see this polarized Christmas."

Some people are doing fine. Others are barely getting by and still trapped in a deep recession. A 9.8% unemployment rate is unacceptable ... something to remember this time of year. Best to all.


I see somebody commented on those sound effects we use for Idiot of the Week. They make the podcast seem juvenile. Sorry, Mr. Meltzer. But if we could somehow take less seriously the promises, premises and positions of the august architects of economic calamity, we would all be better off. When you hear Ben Bernanke on 60 Minutes


When you hear Ben Bernanke tell America something like this, the appropriate response is to laugh out loud.


The recovery is in full swing in the financial sector, but it is absent from the real economy.

As late as March 2008, Bernanke was telling the nation we would escape recession. We already had one foot in it. Now he says if he hadn't acted on such a massive scale, there would have been 25 percent unemployment.

Of course, he is talking about the collapse of the banking sector under the weight of bad mortgages and securitization. His massive response essentially held the banks harmless from their profligate practices. The bailout, the guaranteeing of their loans and the making explict free coverage under too big to fail insurance, none of this has touched the real economy recession.
Credit is not flowing. Cheap money is moving overseas. Bubbles in commodities and in foreign markets are threatening new instability.

At least in hindsight, we can see a restructuring of the banks while holding depositors harmless and allowing the owners and creditors to take a hit might have made more sense. At least it would have begun to reduce the massive debt that to this day prevents any real private sector recovery.

We know that saving the banks did not revive the economy, but simply moved the debt problem onto the government's accounts. Where the taxpayer can foot the bill. The taxpayers who are still waiting for recovery.

We don't hear so much any more the assurances that saving the banks was a necessary precursor to a revived economy. That seems to have been replaced by a sober shaking of the head and a sage recognition that we are in for a long slog. Nor do we hear so much how it is that profitable corporations will revive the labor markets. Instead corporations are generating profits for Wall Street to whistle at by firing people and downsizing.

It looks very much like the lag in the effect of monetary policy has been extended, too. It used to be said that nine to eightteen months after Fed action, we would see action in the real economy. That lag is now up to who knows how long.

So, Ben,


Absent these days is the promise of pragmatism from the president. When he came into office, pragmatic was a watchword. We hoped that meant that looking at what works and what doesn't. We were imagining an economic pragmatism. Instead we got political appeasement.

We did get a stimulus that was one-third stimulus and two-thirds bribery. Perhaps that is pragmatism. And having talked to enough people, I understand that most Joes don't think the stimulus worked even one-third. Well, we are about to see what happens without it. If the compromise with the Republicans passes, we have the old Bush policies back in place. Here is a bit from one of the revolutionaries in the House Democratic caucus.


That is Jay Inslee from the great state of Washington.

The point here is well taken. We have not educated one child, built one mile of road, prevented the layoff of one police officer or fireman. Even the extension of unemployment benefits which has the highest multiplier into the real economy suffers from the fact that it is spending without producing anything. Were we to require an hour's litter patrol from unemployment recipients, the economic effect of the dole would be the same -- or actually more by the value of less litter for a day or so.

If we are going to spend federal money to fix the unemployment problem, why don't we use it to hire people? There is plenty to be done. There is plenty of spare capacity to do it. By allowing long-term unemployment, we are degrading our economy, not making it more fit.

We have, say, eight million unemployed. With $30 billion, you can employ a million people a year at low wages, but with benefits. For two hundred billion per year out of this tax cut stuff, you could completely solve the unemployment problem. No, Ben, I am not contemplating a massive gang of litter picker-uppers stretched across the horizon. I am talking about directly employing people, some at lower wages, others at higher wages, all of whom pay taxes and generate a robust multiplier for the rest of the economy. We know people with jobs are going to buy cars or bicycles and clothes and food and we know they are going to pay taxes. At all levels. They are going to buy a wide range of goods and services.

So you have the real economic stimulus plus taxes being paid plus the potentially immeasurable advantage of the work being produced, be it environmental remediation, energy retrofitting, infrastructure construction, educating our kids, protecting the streets, social work, health care. There are jobs in place awaiting funding at all levels of state and local government. It should not tire your brain to envision a substantial workforce, the substantial knock-on benefits to society, the multiples of economic activity. This is pragmatic. This is one of the pragmatic answers that the last president in a depression came to.


Now some of you, maybe Ben Bernanke, will say government is a poor allocator of resources, and we need to rely on the market or we will have a nation burdened with white elephants. I won't mention the acres of MacMansions lying vacant, nor the absence of meaningful markets to produce environmental salvation, nor at the opposite end the well-being of the financial fat cats in the midst of the current predicament for the rest of us. That I assume is background to everyone's understanding. So I won't mention it. I'll just say that the markets we have haven't worked very well for most of us.

Now to the Euro.

It was with some amusement that I saw recently reports of a revolt among the German population against the Euro currency. A return of the Deutschmark.


In Europe the bailouts of the various nations, particularly Ireland, is apparently being cast as a defense of the common currency, the Euro. As we have been saying for some time, it is in reality a bailout of the German banks. One effect of big trade surpluses is big capital flows out of the country. One is a mirror of the other. The same mechanism that gives China a trade surplus with the U.S. gives the U.S. capital from China.

Amusement, I say, because the demand for a return to the Deutschmark from inside the country is not very well thought through, regardless of the responsible positions of some of our commenters. In the case of Germany, capital export was not very well managed. Bill Black, you may recall from a couple of weeks ago, compared the German banks to girls gone wild who would put up anything for the promise of a slightly higher bond yield. Granting that the large and hidden derivative exposures of the banks is also a major problem, What would happen if the Eurozone split into two currency areas?

Let's leave aside the German preference that they bring the strong economies in with them, and imagine a Eurozone composed of everybody but Germany. And a Deutschmark zone composed of Germany. One thing is, the bonds Germans hold in non-Deutschmark countries would lose value to the same extent as the currency. This would be a very effective and appropriate tax on the root causes of the crisis.

Having Germany leave the Euro zone is in fact a plausible answer to the problem. Not that it would do what the Germans of our sample seem to think, but it would allow trade to be normalized in the absence of a willingness to stand together with all Europeans. We leave you with a segment from an interview with James K. Galbraith, not last month, but last spring, in the furor of the Greek crisis.


James K. Galbraith.

And it is playing out just as he suggested.

The Euro will survive until the breakdown of the social framework. The social framework could be strengthened by the Eurobond suggestions now under consideration, but Germany will not allow that. According to the FT, Angela Merkel, Germany’s chancellor, has publicly rejected the two most high-profile proposals for changes to the EU’s system of responding to the debt crisis – increasing the size of the EFSF or creating a Europe-wide bond.

Look forward to a mess.

Tuesday, December 7, 2010

Transcript: 416 Answer to the Queen

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Econ Intersect, John Lounsbury

"No One Saw This Coming," Dirk Bezemer, Gronigen Univesity

"Why Credit Money Fails," Steve Keen (with access to video and audio)

Professor Luis Garicano, director of research at the LSE's management department, said: 'The Queen asked me, "If these things were so large, how come everyone missed them?".'

Today the answer to the Queen

The macro model that is used by policy planners in the Fed and in government goes by the name of the Washington University Macro Model. In a research paper entitled “No One Saw this Crisis Coming”, published in June 2009 by Dirk J. Bezemer, Groningen University, Mr. Bezemer describes that model thusly:

The “WUMM” is a quarterly econometric system of roughly 600 variables, 410 equations, and 165 exogenous variables. ... the important observation is that all are real-sector variables except the money supply and interest rates, the values of which are in turn fully determined by real-sector variables. In contrast to accounting models, the financial sector is thus absent (not explicitly modelled) in the model.

In other words, the elements in the economy that are at the root cause of the current crisis are absent from the models of economic activity that are used to guide economic policy. The entire financial sector is absent. The very elements that have siphoned the life blood out of the economy have been completely off the radar screen. The FIRE was hidden behind a shield of invisibility, just pumping money into their coffers until the real economy bled out.


Here from the outstanding piece on the excellent blog Global Economic Intersection, we continue with John Lounsbury's account of the Bezemer paper

... macro equilibrium theory dominates academia and has become institutionalized in governments. Bezemer defines the objective of his paper to encourage the merging of accounting and economic theory. He [notes that most of the analysts who got it right] reject rational equilibrium on the basis of arguments related to economic psychology and to the Keynesian notion of ‘radical uncertainty’ (as opposed to calculable risks). Keen, in a 1995 article titled ‘Finance and Economic Breakdown’ explained that “Keynes argued that uncertainty cannot be reduced to ‘the same calculable states as that of certainty itself’ whereas the kind of uncertainty that matters in investment is that about which “there is no scientific basis on which to form any calculable probability whatever. We simply do not know” Keynes argued that in the midst of this incalculable uncertainty, investors form fragile expectations about the future, which are crystallized in the prices they place upon capital sets, and that these prices are therefore subject to sudden and violent change.

Bezemer points out that the critical elements of human behavior and confidence are not reflected in the snapshots of the macro equilibrium models, but are amenable to modeling in a flow-of-cash model [, but] He is not proposing that the macro models be discarded; he feels they should be supplemented and expanded to include flow-of-cash factors.


Bezemer says that those who foresaw the coming crisis share the general characteristic that they viewed the economy through an accounting models lens. He wrote,

They are ‘accounting’ models in the sense that they represent households’, firms’ and governments’ balance sheets and their interrelations. [A] society’s wealth and debt levels reflected in balance sheets are among the determinants of its growth sustainability and its financial stability, [so] such models are likely to [provide] timely signals [of] threats [to financial stability].

Models that do not – such as the general equilibrium models widely used in academic and CentralBank analysis – are prone to ‘Type II errors’ of false negatives – rejecting the possibility of crisis when in reality it is just months ahead. Moreover, if balance sheets matter to the economy’s macroperformance, then the development of micro-level accounting rules and practices are integral to understanding broader economic development.


The finance, insurance and real estate (FIRE) sector includes all sorts of wealth-managing non-bank firms (pension funds, insurers, money managers, merchant banks, real estate agents etc.), as well as deposit-taking banks, which generate credit flows. It is conceptually separate from the real sector which comprises government, firms and households.

Liquidity from the FIRE sector flows to firms, households and the government as they borrow. It facilitates fixed-capital investment, production and consumption, the value of which – by accounting necessity – is jointly equal to real-sector income in the form of profit, wages and taxes plus financial investment and obligations (principally, interest payments).


Problems arise when the funds that originate in the banking part of the FIRE sector return to the FIRE sector in the form of investments or payment of debt service to the exclusion of circulation in the real economy. These problems can lead to recessionary economic collapse (although soft landings are possible), and, in the most severe dislocations, depressions.


Bezemer describes the details of how the accounting model displays the unfolding of the economic cycle:

An accounting (or balance sheet) view of the economy makes clear that this dynamic – a bubble – is unsustainable in the sense that it is constrained by the real economy’s ability to service debt. Yet without policy intervention, it can last for many years or even decades if starting from low levels of indebtedness. A bust occurs as investors realize this constraint is approaching or has been reached. The severity of the impact of a bust will be the larger as real-economy consumption (and thereby production) have grown more dependent on capital gains rather than on wages and profit.

This ‘financialisation’ scenario is a self-sustained dynamic separate from real-sector fundamentals (in other words, a bubble) increasing debt burdens but not bolstering the real economy’s potential to create value added from which to repay its growing debt. It is typically driven by the psychological and political economy factors .... In terms of financial incentives, its impetus is that it brings increased asset price gains for a time, but this is unsustainable in the long term as a source of debt servicing. Borio (2004:5) writes that “contrary to conventional wisdom, the growth of markets for tradable instruments …[read securitization] need not have reduced the likelihood of funding (liquidity) crises”. On the contrary, applying an accounting lens demonstrates that because of the debt growing in parallel with tradable instruments, inevitably a bad loan problem (or debt crisis) develops, credit flows dry up ...

That summary had a lot of help from World Economic Intersection, probably the best blog now up for forecasters. Link online.

As we continue to follow the pipers of Wall Street and the IMF, it is probably time to list those who actually saw the crisis coming.

Dean Baker
Wynne Godley
Fred Harrison
Michael Hudson
Eric Janszen
Stephen Keen
Jakob Brochner Madsen and Jens Kjaer Sorensen
Kurt Richebacher
Nouriel Roubini
Peter Schiff
Robert Shiller

Now we turn to audio -- pungent audio -- from Stephen Keen, whose explanation is even more clear.


This talk from Keen is available with all its graphics online. Find our link at the blog. We excise the presentation of his dynamic model at this point and pick up at the end of his talk, with a summary of his conclusions.


Wednesday, December 1, 2010

Transcript: 415 The Greenspan put expires with the economy out on a limb

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We were somewhat taken aback this week when Calculated Risk, one of the people we rely on most for data and analysis -- find him at CalculatedRisk.com -- opined that things were getting better. Our view at Demand Side, as you know, is and has been that things are bouncing along the bottom with significant downside risks for another crisis.

We'll look today at what CR sees, and then we'll offer a little pushback from an important piece from an another anonymous but very influential analyst. We'll also get to the economic models that worked, from a paper by Dirk J. Bezemer, Groningen University, and get some audio from the always pungent and perspicatious Steve Keen, whose accounting framework modeling is the cutting edge.

Sunday, November 28, 2010
The recent improvement in economic news
by CalculatedRisk

It is worth noting the recent improvement in economic news:

• The October employment report showed a gain of 151,000 nonfarm payroll jobs, the most since April ex-Census. Expectations are for a similar gain in November, although probably not enough jobs added to push down the unemployment rate.

• The BEA estimated real GDP grew at a 2.5% annual rate in Q3. This is still sluggish, but an improvement from the 1.7% growth rate in Q2.

• The Personal Income and Outlays report for October indicated incomes grew at a 0.5% rate (month-to-month), and it appears PCE has grown at about a 3% annualized rate over the last three months. The personal saving rate was 5.7% in October, and although I expect the rate to increase a little more - it appears a majority of the adjustment is behind us (a rising saving rate is a drag on personal consumption).

• The 4-week average of initial weekly unemployment claims has declined to 436,000 last week from over 480,000 at the end of August. The weekly reading was 407,000 last week; the lowest since July 2008.

• Most regional manufacturing surveys, with the exception of the NY Fed survey (empire state), has shown a pickup in manufacturing. This suggests the manufacturing sector is still improving (the ISM manufacturing index for November will be released on Wednesday).

• Trucking and rail traffic improved in October, although the Ceridian diesel fuel index was weak.

• The Architecture Billings Index (a leading indicator for commercial real estate) is near flat - suggesting investment in commercial structures such as hotels, offices and malls will stop contracting next year. (addition by subtraction!)

• Even small business optimism has improved slightly.

Most of the reasons for the recent slowdown are still with us - less stimulus spending, the end of the inventory adjustment, problems in Europe and a slowdown in China, and cutbacks at the state and local level - but it appears Residential investment (RI) has bottomed and will most likely add to GDP growth in 2011. I believe the RI drag is now behind us, and RI is usually the best leading indicator for the economy.

The data is still mixed and fits with my general view of a sluggish and choppy recovery (my view since the spring of 2009). Although I don't see a sharp increase in growth, I think the pace of recovery will probably pick up a little bit in 2011, and I'll take the over on the consensus view of 2.5% GDP growth in 2011. My guess is 3%+ GDP growth in 2011 - still not a strong recovery given the amount of slack in the economy, but an improvement over 2010.

Unfortunately there probably will not be enough growth to significantly reduce the unemployment rate in 2011.

Note: I'll add more before the end of the year, but I've been sharing my thoughts with a few analysts and economic commentators and I try to post my views whenever they change - even a little. Right now it looks like the "slowdown, but no double dip call" was correct (it is still early), and now I'm becoming a little more optimistic and taking the "over" on 2011 GDP growth (still no v-shape recovery though).

That from the mysterious Calculated Risk. Not so different from our bouncing along the bottom with downside risks, except CR seems very willing to extrapolate the bump in good news. We are not. And for some of the reasons why, we yield to another anonymous voice:

Ananomen Analyst is a wealth manager associated with a major Wall Street investment bank who uses a pseudonym to avoid any incorrect implication that his views might reflect those of his firm.

Writing under the head "The Greenspan Put Expires Worthless in the Eye of the Hurricane" courtesy of EconIntersect.com

The Fed Used to be Important: The Greenspan Put

For many years our writing has been focused on the Federal Reserve, since monetary policy easily has the largest influence on the economy and financial markets. Since World War II, every recession was preceded by a tightening of monetary policy and higher interest rates, and every recovery spurred by lower rates and an easing of monetary policy. Every cyclical bear market and bull market was also strongly influenced by changes in monetary policy. Since the stock market crash in 1987 and the 1998 collapse of Long Term Capital Management, investors have believed the Federal Reserve also possessed the capacity to manage every crisis. Since those two crises occurred when Alan Greenspan was Chairman and Maestro of the Federal Reserve, it became known as the ‘Greenspan Put’. This reference to the value of a put option during a market decline, increased investors bravado that they needn’t worry about a negative Macro event, since the Fed would simply exercise ‘Greenspan’s Put’ and restore order.

The current financial crisis has exposed numerous fissures in the U.S. economic foundation, which will be addressed later. More importantly, it has shown that the Federal Reserve no longer possesses the capacity to manipulate economic activity, as they did during the last 60 years. The balance of power has shifted from the Federal Reserve being proactive and exerting a strong controlling influence on the economy, to one of being reactive. The Fed can now only indirectly affect the numerous drags on economic growth, despite an unprecedented level of monetary accommodation. This change in the balance of power, from the Federal Reserve being proactive to reactive is significant, since it means ‘Greenspan’s Put’ has expired.

The majority of mutual fund managers, market strategists, economists, and investors have not yet realized that this shift in control and power has occurred. Their continued faith in ‘Greenspan’s Put’ may cost them dearly in the next few years, as the Federal Reserve struggles to keep the credit bubble from deflating.

The Eye of the Hurricane

The financial crisis that kicked off in August 2007 has never really ended. Much like a Category 5 hurricane, the global economy was battered by the outer wall as it came ashore in 2008 and early 2009. The eye was created, as every central bank adopted an extraordinary level of monetary accommodation. Governments around the world launched massive fiscal stimulus programs that resulted in historic budget deficits in almost all of the developed countries. In the United States, the eye of the hurricane allowed GDP to grow, but at a sub-par pace. Compared to the recession of 1973-1974, the first five quarters of GDP growth since the summer of 2009 have averaged 2.8, half as fast as the first five quarters after the 1973-1974 recession. The first five quarters after the deep 1981-1982 recession averaged GDP growth of 8.4%, three times the strength of this recovery.

There are a number of indications that suggest we will be moving out of the hurricane’s eye sometime in the next six months. Most of the Federal fiscal stimulus has been spent, without launching a self-sustaining recovery. Job growth has been exceptionally weak when compared to other post World War II recoveries. Without a healthy increase in disposable income, consumer spending will not elevate GDP growth above 3% on a sustainable basis. The only way that will occur is if solid job growth of 300,000 jobs per month kicks in, and that’s not likely anytime soon. Spending may marginally pick up during the holidays. Keeping a rein on spending gets old after a while and the holidays are a good reason to loosen up a bit. Unfortunately, millions of unemployed workers will see their unemployment benefits expire, unless Congress extends them, which we expect. However, that will only make cutting the Federal budget deficit more of a challenge.

State legislators do have to balance their budgets and they will be raising taxes and fees, and laying off more state workers. Housing prices are set to fall further, as more than 70% of homes in foreclosure have yet to hit the market.

In Europe, the eye of the hurricane resulted in a very uneven pick-up in economic growth. Although Germany has done well, actually recovering all of the ground lost during 2008, many other countries have not fared well. Ireland and Greece are still contracting, while unemployment in Spain is almost 20%. European banks are in worse shape than their U.S. counterparts. Although we expect the European Union to bail out Ireland’s banks, the credit crisis is likely to eventually engulf Spain. This will prove significant since Ireland and Greece combined represents just 5% of total E.U. GDP, while Spain represents 10%.

In response to the global slowdown in 2008, China initiated a $570 billion stimulus package, and ordered state run banks to lend aggressively. In 2009, Chinese banks increased lending by $1 trillion, an enormous amount given the size of China’s economy, $4.5 trillion. The combination of fiscal and monetary stimulus had the desired effect of boosting China’s economy, but has also resulted in a burst of inflation in 2010. In October, official consumer prices were up 4.4% from year ago levels. The real inflation rate in China could be at least twice as high. China has not revised its CPI since 1993, and the weighting of many food components are not realistic. According to official government data, food prices have risen just 19% over the last three years, but over that period, rice was up 38%, wheat up 35%, and beef and milk prices rose 44%. In contrast, two major supermarkets reported that rice prices had soared by 132% and 190% over the last three years.

In response, China’s central bank has raised its lending rate and bank reserve requirements. Rising inflation isn’t just limited to China, but to most of the Asian countries, which have been enjoying solid growth. South Korea had increased rates once, but Australia has boosted its bank cash-rate seven times from its 2009 low of 3.0% to 4.75%. India has hiked its repo rate six times to 6.25% from 4.75% in early 2010. Inflationary pressures are likely to intensify, since the output gap between capacity and production have disappeared in India, South Korea, China and Indonesia, according to the Royal Bank of Scotland. This makes it easier for companies to raise their prices. These are the countries with the strongest growth, but the gradual tightening of monetary policy will likely result in a slow down during 2011.

As the back wall of the hurricane approaches the global economy with its Category 5 winds, investors will realize that most of the problems that emerged in 2008 were not solved or fully addressed. The macro tides which lifted the global economy for decades have shifted. Investors will have to focus on preservation of capital in 2011, and batten down the hatches.

Components of the Macro Tides

The following is a list of individual headwinds. Each will weigh on growth in the U.S., keep GDP growth from reaching a self-sustaining level, and cause GDP growth to average under +2.0% in coming quarters. This list will provide a worksheet that will allow us to monitor which headwinds are deteriorating or improving. At some point in the future, the majority of these headwinds will begin to improve and help identify when another eye in this extended hurricane is approaching. Many are interconnected and there is some overlap. The most important common denominator is that solid economic growth will address most of these issues. Adopting policies that will strengthen economic growth is imperative. However, there are no easy choices since there are potential negative outcomes associated with every option. We’re in quite a fix. One, even Houdini would struggle with:

¦ The ratio of total debt to total GDP in the U.S.
¦Monetary policy impotence
¦Finding a short and long term solution for the federal budget deficit
¦Recapitalizing the US banking system, so lending broadly resumes
¦Weak job and disposable income growth
¦The change in middle class spending psychology toward less is more
¦Stabilizing housing despite the large overhang of foreclosed homes
¦Commercial property rents and values
¦Dealing with state budget deficits
¦The demographic shift of baby boomers into retirement
¦Social security
¦Addressing the income inequality gap between the top 1% and average worker’s pay
¦The lack of true leadership from either political party
¦The cost of health care rising faster than personal income
¦The unintended fallout from financial regulatory reform
¦The European sovereign debt problems
¦Recapitalizing European banks
¦The global economic drag from closing fiscal budget deficits in developed countries
¦Keeping Israel and other middle eastern countries from starting another war
¦China and its currency and trade policies
¦China’s potential bank loan defaults from excess export capacity
¦The Basil increased requirements for international bank capital by 2020
¦The unanticipated

We can add our own:

Deteriorating infrastructure
Failing educational system
Climate change

Well, that was so much fun we didn't get to the important analysis on why the mainstream economists missed the biggest economic event in half a century. The Queen had the right question, "If this was so big, why did nobody see it coming?" We'll answer that question on our next podcast.