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

Saturday, January 29, 2011

William K. Black answers the question, "Why is 'Wall Street' not in the Financial Crisis Inquirity Report?"

"Why are we suffering recurrent, intensifying crises? To answer this question we must find not only the causes of the crises, but also (and even more importantly) why we fail to learn the correct lessons ... and keep making even worse policy mistakes. The answer to the second part is dogma. The definition of dogma is that it cannot be examined or changed – except to become even purer."
Friday, January 28, 2011
How can the Architects of the Crisis Investigate it?

By William K. Black

The Financial Crisis Inquiry Commission (FCIC) issued its report today on the causes of the crisis. The Commissioners were chosen along partisan lines and the Republicans, one-upping the Republicans’ dual responses to President Obama’s State of the Union address, have issued three rebuttals. The rebuttals follow a failed preemptive effort by the Republicans to censor the report – they insisted on banning the use of the terms “shadow banking system” (the virtually unregulated financial sector that conducts most financial transactions), “Wall Street,” and “deregulation.” The Republicans then issued their first rebuttal last month, their “primer.” The primer, following the lead of the censorship effort, ignored the contributions that the shadow banking system, Wall Street, and deregulation made to the crisis. The combination of the demand that the report be censored and the primer’s crude apologia critical role that the unmentionable Wall Street, particularly its back alleys (the unmentionable “shadow banking system”), and the unmentionable deregulators played in causing the crisis was derided by neutrals. The failure of their preemptive primer has now led the Republican commissioners to release two additional rebuttals to the Commission report. Again, they issued their rebuttals before the Commission issued its report in an attempt to discredit it.

The primary Republican rebuttal was issued by Bill Thomas, a former congressman from California and the vice chairman of the commission; Keith Hennessey, who was President George W. Bush’s senior economic advisor, and Douglas Holtz-Eakin, who was an economic advisor to President Bush on the regulation of Fannie and Freddie and principal policy advisor to the Republican nominee for the President, Senator McCain.

Republican Commissioner Peter Wallison felt his Republican colleagues’ dissent was insufficient, so he drafted a separate, far longer dissent. Wallison is an attorney who was one of the leaders of the Reagan administration’s efforts to deregulate financial institutions and later became the leader of the American Enterprise Institute’s (AEI) deregulation initiatives. His bio emphasizes his passion for financial deregulation.

From June 1981 to January 1985, he was general counsel of the United States Treasury Department, where he had a significant role in the development of the Reagan administration’s proposals for deregulation in the financial services industry….

[He] is co-director of American Enterprise Institute's ("AEI") program on financial market deregulation.
Each of the Republicans commissioners was a proponent of financial deregulation and was appointed to the Commission by the Republican Congressional leadership to champion that view. Three of the Republican commissioners were architects of financial deregulation. For example, the Republican congressional leadership appointed Wallison to the commission because they knew that he was the originator and leading proponent of the claim that Fannie and Freddie were the Great Satans that had caused the current crisis. The fourth member, Representative Thomas, voted for the key deregulatory legislation when he was in Congress and was a strong proponent of deregulation.

The Republican commissioners’ desire to ban the use of the word “deregulation” in the Commission’s report is understandable. There was no chance that they would support a report that explained the decisive role that deregulation and desupervison played in making the crisis possible. Wallison was a major architect of three successful anti-regulatory pogroms (primarily, but not exclusively, led by Republicans) that created the criminogenic environments that led to our three most recent fraud epidemics and financial crises (the S&L debacle, the Enron era frauds, and the current crisis). The Republican congressional leadership appointed Wallison to the Commission in order to place the nation’s leading apologist for deregulation in a position where he could defend it. President Bush appointed Harvey Pitt to be SEC Chairman because he was the leading opponent in America of the SEC Chairman Levitt’s efforts to make the SEC a more effective regulator. In each case, “mission accomplished.”

Each of the Republican commissioners was in the impossible position of having to investigate and judge their own culpability for the crisis. The Republican politicians who selected them for appointment to the Commission knew that they were placing them in an impossible position and ensuring that the Commission would either give deregulation a pass or split along partisan lines and lose some of its credibility. The proverbial bottom line is that the Commission would fail to identify the real causes of the crisis and the control frauds that drove it would continue to be able to loot with impunity.

In contrast, only one of the six Democratic commissioners was involved in financial institution regulation or deregulation. None of the Democrats was known as a strong proponent of any particular view about the causes of the crisis prior to their appointment. Brooksley Born was head of the Commodities Futures Trading Commission (CFTC) under President Clinton. She famously warned of the systemic risks that credit default swaps (CDS) posed. Her efforts to protect the nation were squashed by the Commodities Futures Modernization Act of 2000, which deliberately created regulatory “black holes” by removing the CFTC’s authority to regulate many trades in financial derivatives. Enron exploited one of these black holes to create the California energy crisis of 2001. The largest banks and AIG exploited the black hole to trade CDS. While the squashing of Brooksley Born was a bipartisan effort (Senator Gramm and Alan Greenspan were the most prominent Republicans in the effort), it was led by the Clinton administration – Messrs. Rubin and Summers at their arrogant, anti-regulatory worst.

By appointing Born to the Commission, the Democrats were admitting their error and ensuring that one of the Democratic Party’s great embarrassments – passage of the Commodities Futures Modernization Act – would be exposed. The Democrats were fostering rather than seeking to forbid discussion of their dirty laundry by appointing someone with a proven track record of taking on her own party.

In 1999, Born resigned as CFTC Chair. She retired from her law firm in 2002. She did not influence or seek to influence regulatory policy role during the crisis. She was not active in making comments about the causes of this crisis prior to her appointment to the Commission.

The next, nastier stage in the Republican apologia for Wall Street and the anti-regulators has already begun. Bloomberg reports that House Oversight Committee Chairman Issa claims to be:

“looking into allegations of partisanship, mismanagement and conflict of interest at the commission. The California Republican and two other lawmakers sent a letter yesterday renewing a demand for documents on the panel’s spending, its use of media consultants and its staff turnover.”
Issa is a deeply committed anti-regulator. He will not be investigating the allegations of partisanship and conflicts of interest by the Republican commissioners who have exemplified partisanship and who are in the impossible position of having to examine their own culpability for the crisis. He will seek to discredit any report and any expert who explains why financial deregulation and desupervision are criminogenic.

The most important question we must answer about our financial crises is actually a two-part question: why are we suffering recurrent, intensifying crises? To answer it we must find not only the causes of the crises, but also (and even more importantly) why we fail to learn the correct lessons from the crises and keep making even worse policy mistakes. The answer to the second question is dogma. The definition of dogma is that it cannot be examined or changed – except to become even purer. The ever purer anti-regulatory dogma creates the ever more intensely criminogenic environments that produce intensifying crises. The Commission’s report makes that clear. For example, Alan Greenspan claimed that markets automatically exclude fraud. He did so after the most notorious “accounting control fraud” of the S&L debacle (Charles Keating) used him to praise his fraudulent S&L, leading to the most expensive failure in the entire debacle. Greenspan learned nothing useful from the S&L debacle. He concluded that there was no reason for the Fed to use its unique authority under HOEPA to stop the pervasively fraudulent “liar’s” loans that were hyper-inflating the real estate bubble and leading us to a crisis. Greenspan ignored the FBI’s September 2004 warning that mortgage fraud was becoming “epidemic” and would cause an “economic crisis.” This anti-regulatory dogma that Greenspan exemplified spread through much of the Western world, and the resultant crises have done the same.

We are witnessing in the multiple Republican apologias for their anti-regulatory policies an example of why we fail to learn the correct lessons from the crises. The groups most in the thrall of the dogma appoint true believers in theoclassical economics to the body that is supposed to find the truth. These anti-regulatory architects of the crisis then purport to be impartial judges of the causes of the crisis that they helped create. The Republican House leadership now openly threatens to use aggressively its subpoena authority to bash anyone who dares to oppose the dogma and the Republican effort to censor the decisive role the anti-regulators play in causing our recurrent, intensifying crises.

The Commission is correct. Absent the crisis was avoidable. The scandal of the Republican commissioners’ apologia for their failed anti-regulatory policies was also avoidable. The Republican Congressional leadership should have ensured that it did not appoint individuals who would be in the impossible position of judging themselves. Even if the leadership failed to do so and proposed such appointments, the appointees to the Commission should have recognized the inherent conflict of interest and displayed the integrity to decline appointment. There were many Republicans available with expertise in, for example, investigating elite white-collar criminals regardless of party affiliation. That was the most relevant expertise needed on the Commission. Few commissioners had any investigative expertise and none appears to have had any experience in investigating elite white-collar crimes. These Republicans, former Assistant U.S. Attorneys (AUSAs) and FBI agents would have played no role in the financial regulation or deregulation policies in the lead up to the crisis. They would not have had to judge their own policies and they would have brought the most useful expertise and experience to the Commission – knowledge of financial fraud schemes and experience in leading complex investigative and analytical skills.

Thursday, January 27, 2011

Minsky's elegant algebra

As promised, here is the elegant algebra from Hyman Minsky which demonstrates the root of profits, the root of inflation, and where the fruit of government deficits goes.

Tuesday, January 25, 2011

421: Forecast: Stagnant Inflation and Investment, featuring Hyman Minsky and Jeffrey Sachs

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Today on the podcast, the Demand Side Forecast moves into inflation and investment, with able assistance from Hyman Minsky. We also take a listen to Jeffrey Sachs on economics, policy and governing.


Jeffrey Sachs, speaking to the Economist. More of Sachs remarks at the end of today's podcast.

Now, Inflation and Investment. Forecast: Stagnation in both. Not surprising, because the two are connected.

Inflation used to mean a general rise in prices, and that is the primary focus of our analysis. This is easily confused with a rise in the CPI or other measures, which may be caused by specific, not general prices (often oil prices). Currently there is a rise in many commodity prices that is not part of any general surge in inflation, but stems directly from the financial markets. As we've said, it is parallel to the experience of late 2007 and the first half of 2008, when a commodity bubble blew up from a similar rush from speculators. Such events are not unprecedented by any means. Directly after World War II, one of the greatest so-called inflationary shocks occurred when American farmers were favored by the destruction of Europe and the release of pent-up demand from years of wartime restrictions. Food commodities began to be held back, speculating on continuing rises in price. Price controls had been turned off with the advent of peace. Why would you sell today, when by holding the grain your silo for a month, you could get ten percent more next month.

We cherry pick this episode, because the Truman Administration under the able direction of Leon Keyserling successfully deflected and resisted calls for restrictions on monetary policy. Truman essentially refused to shut down the economy to shut down the inflation. A short, sharp recession occurred as general demand was choked back by this commodity price extraction, but the economy righted itself and food prices broke and all just in time to help Truman come back against all odds in the 1948 election.

We're getting a bit off track here, but there are a couple of other things to note about this post-war inflation. First, it took guts to hold the line on the reactionary call for economic slowdown. A similar inflation after the First World War had led directly into a serious recession. The nation only too well remembered the Depression years which had been, it seemed, only interrupted by the War and would now likely return, particularly considering the tremendous federal debt. But Keynesian and New Deal economics had brought the best minds of the generation to economics, and thanks to the political will of Harry Truman, they proved out.

Second, the monetary policy was still in control of the elected government at that time. So the president had the option of not turning up the interest rate. That is not the case today. In 1951 with the so-called Treasury Accord, the Fed won its independence as the fourth branch of government. What would they do in a similar situation? It has not been difficult to see. Most famously, during the oil price shock and subsequent price rise of the late 1970s, Paul Volcker executed the Monetarist experiment. Following the notion of Milton Friedman, Volcker restricted the supply of money. But instead of prices normalizing quickly and painlessly, as Friedman promised, interest rates shot through the roof and the recession of 1980 and then a much deeper recession in 1981-82 followed. The money supply was soon abandoned as a policy lever, to be replaced by the interest rate. But later, for example in 1999, when oil prices began to rise off their $15 a barrel floor, Alan Greenspan tightened the monetary screws against inflation -- an inflation invisible to nearly everyone else -- and precipitated the dot.com bust.

Well, that was a little bit out of the way. Back to the point and to Hyman Minsky. To say that Hyman Minsky anticipated the Great Financial Crash and the experience since 2007 is both accurate and not. Accurate because his analysis of the importance of financing structures and banks precisely described the causes and conditions and outcomes we have seen. "Not" because Minsky did not believe debt-deflation would occur in the era of Big Government. In the same sequence of elegant algebra we are about to visit for its relevance to inflation, Minsky demonstrated that profits are equal to investment plus government deficits. In a downturn, he said, quote

"In effect, Big Government rigs the economic game, so that profits are sustained; by sustaining profits, government deficits can prevent the burden of business debt from increasing during a recession."

In this process, however, inflation was to be expected. Quoting again,

"Inflation may be the price we pay for depression-proofing our economy."

Such inflation had the advantage of reducing the real value of debts and allowing the economy to escape its burdens.

Unfortunately, we have expanded private debt to a level unprecedented in human history and probably unanticipated by Minsky. At the same time we have eschewed the more aggressive Keynesian remedies in favor of holding the big banks harmless.

Moving quickly,

Inflation, in our general sense, needs to be seen primarily as a function of investment. Returning to Minsky's algebra, and eventually we'll get that up on the website -- Demandsideeconomics dot net,

With the not too radical assumption that workers consume all their income, we can show that if all workers produce is consumption goods, then there is no inflation, because their income is matched perfectly by the supply of consumption goods. If some workers, however, produce investment goods, then the quantity of consumption goods is being bid on by both those who produce them and those who do not, hence the price goes up, mitigated only be any rise in productivity of workers.

That is the ultra short form.

Of course, the economy is not composed only of workers producing consumption or capital goods. There is a whole stratum of nonproductive labor in management, marketing, and so on. There is government. And there are resources, such as oil and mineral commodities whose price may be run up not by demand or utility in the real economy, but by financial speculation.

That this financial event will be confused as a real economy event is almost a foregone conclusion. So as we forecast no inflation, no investment, and stagnation, we also forecast continued buffoonery in policy, as the Fed and inflation hawks first scream about the commodity bubble and then, probably successfully, choke off recovery if or when investment begins again.

That's the Demand Side forecast on inflation and investment.

Does Jeff Sachs have anything more uplifting. Let's see.


That's Jeffrey Sachs

Wednesday, January 19, 2011

Transcript: 420 Forecast 1: Recession of 2011

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That was Wall Street's favorite bear, David Rosenberg. More from him later in the podcast.

As an economic recovery denier, Demand Side can hardly be expected to have the optimistic view of the world going forward that most economic forecasters are demonstrating. Even Rosenberg's "getting better in dribs and drabs" to us is bouncing along the bottom, with as much bad news as good. The blue chip forecasters are in the stratosphere compared to our assessment of the probable experience of the economy in 2011 and beyond.

Over the next three weeks, we will be updating our bi-annual, once every two years, view of GDP, net real GDP, employment, inflation and investment. Subsequently we hope to begin looking back at our calls and how they worked out, compared to our rivals.

Our short form for 2010 was the economy would continue to bounce along the bottom, with significant downside risks from European debt and banking problems and from domestic weakness in commercial real estate. We saw only modest manifistation of those risks in 2010.

The short form for our 2011 outlook is that those risks will be put in play in 2011, triggered by the traditional trigger, rising oil and commodity prices. 2011 will witness significant new disruption to the American and global economies, likely within the first eight months of the year. The potential for bubbles in emerging economies to burst is growing. And since the structural dilapidation of mega-banks and investment houses has not been repaired, only papered over, and the paper has all been used up, a new and severe crisis in the financial sector is a non-trivial possibility.

The key to the call is the trigger, rising oil prices.

In our view, we have returned to 2008, when political constraints and economic ignorance resulted in over-reliance on the Fed and a very poorly designed stimulus package under George W. Bush. The stimulus design had its advocates in the Democratic camp too, and might be most correctly laid at the feet of Larry Summers, who descended from Harvard with a mantra: Timely, Targeted and Temporary. Public infrastructure spending was deemed too slow a mechanism. The tax cut package cobbled together was weighted toward business, and although everyone appreciated the $400 or $800 bonus from the government, the economy did not respond.

Meanwhile a huge commodity bubble rose out of the ashes of the housing bust, as investors scrambled for returns and a hedge against the inflation that was assumed to be inevitable from aggressive Fed action. This commodity bubble has largely been ignored to this day. Yes, everyone remembers the $147 dollar oil, but do they associate it with a financial bubble? Mostly not.

Rising oil prices, combined with higher interest rates, have been the surest early warnings of impending recessions. This same trigger was operative in 2000. Oil prices and interest rates rose together in 1999, when then Maestro, now buffoon, Alan Greenspan raised short-term rates right into the explosion of oil prices. Demand Side listened to Warwick University's Andrew Oswald, and joined him in predicting the recession of 2000. This was the collapse of the New Economy.

And the same two factors triggered the 2007 recession.

Interest rates are low in the current environment, but credit terms are tight and dropping real estate values means collateral is not as handy as it is in normal times.

Oil and broader commodity prices are the match that will start a new conflagration in 2011. In our view, the American economy is fundamentally weak and burdened with debt, public policy has chosen the madness of austerity, and the corruption of the financial sector is structural. That is, the economy will not be able to bear the shock. This is not your father's economy.

Oil prices are the trigger for two reasons. One, a rise in oil and gasoline acts as a tax on consumers, constraining their purchases of other goods and services and weakening their confidence. Two, resource extraction industries, particularly oil production and distribution, are by far the worst producers of jobs. A dollar spent on gasoline or heating oil employs fewer workers than a dollar spent on any other activity. Thus, returns to oil up, returns to labor down, and labor produces demand when oil does not.

A new research paper is just out from James Hamilton describing the connection between oil shocks and recessions. Link online.

Now what is cause of the commodity bubble now unfolding? Many have pointed to new demand from emerging markets or supply disruptions. But commodities prices are rising together, and the surge in demand is not confirmed by the Baltic Dry Index. The BDI, as Wikipedia informs us, measures the demand for shipping capacity versus the supply of dry bulk carriers. The demand for shipping varies with the amount of cargo that is being traded or moved in various markets (supply and demand).

The supply of cargo ships is generally both tight and inelastic — it takes two years to build a new ship, and ships are too expensive to take out of circulation ... So marginal increases in demand can push the index higher quickly, and marginal demand decreases can cause the index to fall rapidly.

Well, the index is not collapsing as it did post July 2008, but it is in a slump and has been for some time. Hard to connect to booming commodity prices. In fact, as we've said, commodities have been bid up by the Fed's printing of money.

We'll see if we can get the chart up on the transcript.

There is no doubt that commodity prices are making new highs. The CRB Index which incorporates both spot and near-term futures prices is in new territory. And as David Rosenberg said in his most recent note


Food price inflation is starting to bind in emerging economies, as it did in 2008. Food riots in Africa and soaring prices in India and China.

Quoting Rosenberg:

... movements in oil prices still exert a statistically significant impact on the economy and earnings with a 12-24 month lag. In other words, growth was still receiving a tailwind from the sharp downdraft in crude prices experienced from mid-2008 to early 2009 right through last year. But the gig is up and the economy is going to feel the effects of the near-120% surge in oil prices for the balance of 2011 and into 2012 barring a reversal. Only once in the past did the U.S. economy fail to sputter or head into outright recession after such a two-year surge in oil prices (food will only make matters worse in terms of depressing real wages) and that was in 2006 when the economy generated over two million jobs, the unemployment rate was 4.5%, wages were rising at a 6% annual rate, home prices rose an average of 8%, and bank credit expanded 10%. Those offsets are not in play this year.

Rosenberg goes on to the point of commodity price inflation:

And the question is whether the Fed would dare embark on QE3 with headline inflation in acceleration mode (even if core is still well contained). It’s one thing to bring on QE1 when oil prices are at $45/bbl and the CRB spot index is sitting at 325 (futures at 215) as was the case in March 2009. And then to announce QE2 nearly 18 months later when oil is sitting at $75/bbl and the CRB is sitting at 380 (futures were at 270). But can the Fed really be serious about yet another round of balance sheet expansion to please the stock market when oil is now above $90/bbl and the CRB is at a record high of over 530 (futures now north of 330)? Talk about rolling the dice with the bond market vigilantes.

Also, have a look at The Latest American Export: Inflation in the op-ed pages (A17 to be precise) of the WSJ. Indeed, not only has the Fed managed to create an illusion of prosperity by stepping up the print press and swinging the stock market around with QE2 chatter last summer, but now it is actually helping the government cause a de facto real appreciation of the yuan by pursuing a back-door policy of boosting inflation in China. Bernanke is a true magician, no question about it.

David Rosenberg. We note that the lag has not been very long in the most recent recessions.

So there is a trigger. Dramatically lower state and local government spending -- meaning employment -- will provide further downdrafts. States have already raided their reserve funds and pulled every accounting gimmick they can find. They have cut deeply into schools, parks and public transit systems. They have had to put away the rosy scenarios and are now cutting into the bone.

In California, once and now again governor Jerry Brown has proposed cuts to Medi-Cal, in-home services for the elderly and higher education with a five-year extension of income, sales and vehicle taxes. In New York Gov. Andrew Cuomo proposed eliminating 20 percent of state agencies by combining duties, as part of "radical reform" to pull that state out of its fiscal crisis. Gov. Chris Christie in New Jersey skipped a $3.1 billion payment to the state's pension system in a push to cut benefits for public workers, while proposing higher employee contributions and a boost in the retirement age from 62 to 65.

In Illinois, lawmakers voted for a dramatic 66 percent hike in personal income tax, from 3 percent to 5 percent, in a bid to resolve a $15 billion deficit, which amounts to more than half of the state's entire general fund. The tax increase will be coupled with strict 2 percent limits on spending growth.

Note: This account relies heavily on a Huffington Post survey.

In Texas, where education and social service spending is relatively low and Republican Gov. Rick Perry has railed against government spending, the shortfall is projected to be between $15 billion and $27 billion over the coming two-year budget cycle.

In South Carolina, outgoing Gov. Mark Sanford has proposed a spending plan that would end funding for museum and arts programs, slash college funding and give many state employees a 5 percent pay cut.

In Georgia, deep cuts appear to await the state's popular HOPE scholarship program that provides public college tuition to students who earn good grades. States are expected to collect 6.5 percent less than they did in 2008.

Meanwhile, support from the federal government is about to fall off the table. No new assistance is likely, Republicans in Congress say they will try to provide states with relief by reducing mandated programs, not by giving them more money.

When the issue is jobs and services, allowing states to reduce services does not help.

The states with the greatest concerns about their fiscal health are those with costly public employee pensions that are underfunded. Many public pension systems use overly optimistic rates of return and do not provide a true, long-term cost to taxpayers. A recent study by the Pew Center on the States found states face a $1 trillion funding shortfall in public-sector retirement benefits, but said that likely underestimates the problem.

And weakness in cities and counties is likely to increase the damage to states, as municipalities look to the state for bailouts.

The new decline in demand and jobs at the state and local level is on top of the stagnation in the household sector as a result of huge mortgage debt and other forms of consumer debt. At the same time, large corporations are sitting on what is said to be trillions of dollars in ready cash. This is an object lesson in which comes first, the demand or the investment and hiring by the private sector.

Nevertheless, there is no shortage of commentators who predict if not good times, at least less bad times. We'll get to some of them in a moment. First, let's finish off Mr. Rosenberg's comments.


David Rosenberg

As we said, there are plenty of folks who think the economy is going to do well. The front page of the December 31 edition of the Seattle Times featured the banner headline "Happy days may be near again." With growth projections from Macroeconomic Advisers, Moody's Analytics, and IHS Global Insight fetured in colored boxes. That's the first time I've seen such a thing. Parenthetically, Macroeconomic Advisers predicts 4.4 percent growth in 2011, Moody's 3.9 percent and Global Insight 3.0 percent.

We predict negative growth in Q3 and Q4 and just 1.0 overall, after a so-so start. Our view is shared not so much by other forecasters, as by American consumers. The University of Michigan consumer sentiment survey remains in recession territory. It has been bouncing along between 65 and 75 since the so-called end of the recession in June 2010. Such a protracted low reading is unprecedented in the history of the survey. Except for the turn of the year 1992, readings such as these have occurred only within or leading directly to recessions. And it took another dip during December.

Consumers have been much better at predicting economic reality than professional economists, being fully six months ahead of the majority of economists in calling the last recession.

Others on the positive side include our favorite whipping boys, the Fed. Notoriously wrong and late to change their calls, the Fed has been tightening up the act in the last eighteen months. Not to last. Typical of their bias is Dennis Lockhart, President of the Atlanta Fed. In a recent paper
Lockhart predicted: "Sustainable Growth despite Headwinds" for 2011. According to Lockhart, the economy seems to have gained durable momentum. Growth in gross domestic product, personal income, and jobs should be better this year compared with 2010. Lockhart thinks that although the growth pace is likely to remain relatively modest, economic performance could surprise on the upside.

This is also the view of Calculated Risk, from whom we borrow the following:

In Lockhart's view, the recovery continues to be constrained by ... the interplay among the housing market, household finances and consumer spending, ongoing credit market repair, and lingering uncertainty restraining business and consumer spending. Lockhart believes these headwinds to a significant degree reflect structural adjustments that in the longer term will place the U.S. economy on a stronger footing.

CR's Note: I think the key headwinds are 1) housing market issues, 2) State and local government cutbacks and debt, and 3) European financial issues.

Ah, we hope so. But when you paint the positive predictions with such dark colors, it makes us doubt. In fact, however, we see the failure to correct housing and debt burdens, to restructure large banks, to reduce joblessness by hiring people, and to help states and localities is about to sink us. The ship is weak, and the shock of higher oil and commodity prices will start the chain reaction.

This is

Thursday, January 13, 2011

Transcript: 419B Non-Events of 2010, Part II

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or alternatively


It is virtually a theme of the Demand Side podcast to demand that the Fed show some results for its extraordinary interest rates, its unprecedented purchases of toxic securities, and its so-called Quantitative Easing, essentially pushing money into the financial sector in hopes something will happen. We draw the contrast with the problems of Democrats, who tried and failed to sell the line, "It would have been a lot worse without the stimulus."

The Fed, on the other hand, has ready believers when it says lowering rates to zero made a difference. No investment spending, but without it, who knows what would have happened?

Before we go on, we do admit the financial system is still standing because of Fed and Treasury action. A couple of trillion dollars plus several more in implicit guarantees will do that. The operation amounted to widening the lanes and pulling traffic off the roads to prevent the car from crashing, rather than replacing the drunk driver. We have tanked the economy to benefit the people who caused the problem.

In any event, a great deal of credibility accrues to those close to the money, in spite of their not seeing the problem coming. Ben Bernanke, a prime promoter of the Great Moderation, failed to see the largest credit bubble in human history, and still -- to this day -- prefers to deal with the problem by piling on debt.

One of the chief causes of the Fed's impotence is their misunderstanding of money. As we said, this is a point made eloquently and pungently by Australian economist Steve Keen. It was confirmed last week by none other than Federal Reserve Board Governor Elizabeth A Duke in a speech to the Maryland Bankers Association.



........the linkage between the level of reserve balances and the monetary aggregates in the current environment is quite weak. You were probably taught, as I was, that the broad monetary aggregates increase when reserve balances increase because the larger volume of reserves supports increased lending, which in turn leads to a larger volume of reservable deposits. While that argument might hold in normal circumstances, in the current environment excess reserves are many multiples of required reserves, and adding reserves is unlikely to spark a further increase in the volume of deposits. As a result, the textbook linkage between reserve balances, bank loans, and transaction deposits just is not operative at present. Fundamentally, the levels of M1 and M2 are determined by the strength of the economy and the preferences of businesses and consumers for money, which depend on the yields on monetary instruments and competing assets.

Recent experience has again illustrated the difficulty in identifying a reliable relationship between reserve balances and the monetary aggregates. Even though Federal Reserve actions to fight the financial crisis and support the economic recovery added roughly $1 trillion to ... aggregate bank reserves, M1 and M2 rose at relatively moderate rates over the same period.


This is somewhat more bureaucratese than Steve Keen's remark that when the economy is booming, banks make loans and record the deposits, creating money, and go looking for the reserves later. In a downturn, the banks don't make loans, so money is not created.

But we are avoiding the most controversial one, or maybe we're just saving it ....


A distant memory now is the phalanx of V-shapers that descended on the economics media during the first part of the year. Particularly after the stock market rebound, there was little doubt in the minds of the bulls that the economy was back on track. 'V' is not the shape of the recovery.

Eighteen months after the National Bureau of Economic Research, the official arbiter of recession calls, proclaimed the end of the longest recession in postwar history, Demand Side clings to the contention that there is no recovery. Part of the issue is definition. But it is not splitting hairs.

A recovery in the business cycle is not necessarily a return to previous levels of growth and output. It is, instead, the period after the trough. If the economy drops from 100 to 90, and then improves to 91 and continues to improve, the economy is said to be in recovery. Recession is the mirror of this -- when the economy begins to fall from a peak, and continue to fall.

One issue of definition revolves around the measurement of economic activity. For all intents and purposes, the official call is content to rely on GDP growth as the first and last metric of importance. If gross domestic product increases -- GDP grows -- consistently for three quarters, the economy is technically out of recession according to many. The NBER is a bit more sophisticated, but not much.

In the system of national accounts, GDP equals GDI, Gross Domestic Product must equal Gross Domestic Income. Here you begin to see that flaw. If the well-being of an economy has anything to do with the well-being of its citizens, incomes must be rising for at least a significant portion. You cannot have economic recovery except in the Orwellian sense when one percent of the population receives huge increases in income and ninety-nine percent see their incomes decline. Yet that is, in a sense, what we have.

Even median income would be more useful.

But the issue is deeper than this. It is hidden behind the current formulation, "We have recovery, but we do not have self-sustaining recovery." What does this mean? It means housing, employment, and investment may still be in recession, but overall spending, stock markets and corporate profits are recovering. If housing, employment and investment are not the core of an economy, what is? The business cycle has no meaning if these principle elements of the real economy are outside the measurement of its health.

But the listener may ask, How is it possible that real elements are stagnating and financial elements are recovering. It is precisely because of the government's deficit. The great Polish economist Michal Kalecki demonstrated by nothing more than simple, if elegant, algebra that in our situation -- that is, absent real investment, corporate profits equal government deficits. And this unlocks the truth behind the term "self-sustaining recovery." The economy's recovery is not self-sustained, because the huge government deficits are floating it along. The business cycle is now subsidized by government borrowing.

As an aside, it is a thorny political problem for corporate apologists in Congress to at once decry the federal deficit as an example of how business is better than government and at the same time rely on the deficit to drive profits for the corporate sector. The spin problem, as are many, is made simpler by ignorance.

But to us the lie of recovery is exposed by the stagnation of employment. In spite of enormous deficits and stimulus, the unemployment rate has remained month after month in depression territory. Here the spin doctors still trot out the nostrum that unemployment is a lagging indicator. What used to be meant by that was a lag of a quarter or so. Now it apparently means a lag of indefinite duration.

Which brings us to the final event widely reported, didn't really happen


At 9.4 percent official unemployment and 16-plus in the U-6 measure we have an economic crisis. The large number of long-term unemployed, laid off older workers, and college graduates working as barristas is threatening to hollow out the human and capital infrastructure of the nation. Instead of putting people to work by hiring them to do things that need to be done, we are relying on a circuitous and expensive subsidy to banks, corporations and private spending to create consumer demand. This will generate jobs in China or in hair salons, but not the jobs that will bring robust recovery.

That said, the official announcements of private sector job gains which the president hangs his hat on are not only pathetically small compared to the need, but are usually smaller than growth in the number of potential workers.

Even in the recent drop to 9.4 percent, the change was driven more by people leaving the workforce than in the highwater mark in post crash job gains.

Calculated Risk reports from the recent government surveys,


on the declining participation rate.

Only 103,000 jobs were added in December, short of the estimated 150,000 necessary to hold the unemployment rate steady against population increases. The population of potential workers 16 and over increased 174,000, but the labor force decreased 260,000.
Meaning there were more than 300,000 fewer people in the labor force than might have been expected by demographics.

Thus even this unexpected improvement in the unemployment rate resulted more from the decay of the labor force than from any improvement in the economy. At present,

As Calculated Risk concludes, if the participation rate had held steady at 64.5%, then the unemployment rate would have only declined to 9.64%. Almost two-thirds of the decline in the unemployment rate was related to the decline in the participation rate. Some of the decline might be from workers going back to school, but some is probably due to people just giving up, CR says.

Very troubling is that a large portion of the decline in the participation rate was for people in the 16 to 24 age group. According to the BLS, the 16 to 24 civilian labor force declined by 244 thousand. Most of these people will probably return to the labor force as the economy improves - and that will put upward pressure on the unemployment rate. The participation rate has fallen sharply from 66% at the start of the recession to 64.3% in December. That is almost 4 million workers who are no longer in the labor force and not counted as unemployed in U-3, although most are included as "discouraged workers" or "Marginally Attached to Labor Force" in U-6.

So there you have it, the Demand Side annual list of events that were widely reported, but didn't really happen:



I know it's another long podcast, but there was a lot of non-news. We have to acknowledge the main source for today's presentation -- Econ Intersect. Look it up. And we'll add a bonus item largely taken from that very valuable blog, one that may or may not prove to be true.


As we've noted, the housing crisis rivals the great depression's. During the Great Depression, home prices fell 25.9 percent in five years. The U.S. housing market is now down around 25 percent from its peak in 2006. As housing price expert Robert Shiller pointed out in September 2008: Throughout the 1930s, they plunged 30%. That is right where we are now, and with the housing industry a greater part of the economy.

Housing bubbles are now bursting in China, France, Spain, Ireland, the United Kingdom, Eastern Europe, and many other regions.

And the bubble in commercial real estate is also bursting world-wide.

States and Cities In Worst Shape Since the Great Depression, and they, too, are a greater part of the economy than then. Many may default in 2011. California is issuing IOUs for only the second time since the Great Depression.

Loan Loss Rate Higher than During the Great Depression

Indeed, top economists such as Anna Schwartz, James Galbraith, Nouriel Roubini and others have pointed out that while banks faced a liquidity crisis during the Great Depression, today they are wholly insolvent. Insolvency is much more severe than a shortage of liquidity.

Unemployment at or Near Depression Levels when you calculate the rate with the same methodology as they did then. If you look up the unemployment chart at Calculated Risk, you will see a huge bowl for the current employment collapse, one much deeper and wider than any other recession. The bottom of the bowl is flattening, but ... I guess we have to assume it's a bowl. All the others came back up.

1 out of every 7 Americans now rely on food stamps.

Inequality Worse than During the Great Depression

The War Isn’t Working. Ongoing wars have not stimulated the economy out of recession, although they have continued far longer than World War II.

The New Deal had a price tag of only $500 billion in 2008 dollars. The Marshall Plan that enabled the reconstruction of Europe following WWII comes out to approximately $125 billion in 2008 dollars. World War II, when 16.3 million U.S. troops fought in a campaign lasting four years, cost a bit more than five trillion. Here we are in only the third year from the beginning of the recession. Our cost cannot be calculated precisely, but it is in the trillions at least, and there is no end in sight.

Wednesday, January 12, 2011

L. Randall Wray asks “How long until the fall of orthodox macro?”

Monday, January 10, 2011

Pressures on the Paradigm: The Fall of the New Monetary Consensus

By L. Randall Wray
The following is a paper given at the ASSA conference in Denver this past week for a panel organized by James Galbraith, titled Pressures on the Paradigm, sponsored by Economists for Peace & Security.

The Queen famously asked her economists why none had seen the global crisis coming. Obviously the answer is complex, but it must include the evolution of economic theory over the postwar period—from the “Age of Keynes”, through the Friedmanian era and the return of virulent Neoclassical economics, and finally on to the New Monetary Consensus with a New anti-Keynesian version of fine-tuning by an unaccountable (“independent”) central bank.

We cannot leave out the parallel developments in finance theory—with its efficient markets hypothesis—and the subsequent deregulation and de-supervision that led to the financialization of everything.

But to make a long story short: if your theory says that a global collapse is impossible, you won’t see one coming. In truth, as Jamie has argued in his great book, the Predator State, no one outside Chicago and other institutes of the higher learning ever took the free market mantra seriously—outside the ivory towers it was nothing but a slogan, a justification for enrichment of the powerful few.

Like Jamie, I believe orthodox macroeconomics is finished—although not all the zombie practitioners of that dismal religion recognize they are dead. After the crisis hit, Jamie, Duncan Foley and I were invited to appear on panels at the University of Chicago along with a dozen or so of the Chicago boys.

Not surprisingly, none of them was budging from his dogma of free and efficient markets: the crisis was caused by too much government interference; the solution is more deregulation. Three years into this crisis those who never saw it coming proclaim signs of recovery everywhere they look.

And, still, it is only academia that is clueless. Everyone in financial markets saw it coming—indeed, they planned on it and worked fastidiously to create it. They would profit on the way up, and then profit more in the collapse whilst collecting on their credit default swap bets and stealing all the homes.

It is Bush’s ownership society and the goal all along was to transfer all ownership to the top through the creation of serial bubbles—what Michael Hudson calls Bubbleonia. The biggest land grab since the enclosure movement.

So, no, there is no recovery. The banks are more massively insolvent than they were 2 years ago. They are cooking their books so they can pay executive bonuses and reward the traders and the foreclosers who are successfully transferring all wealth to the elite.

But Jamie asked me to address the state of theory—not the economy. I want to focus on one particular Zombie that needs a stake through its heart or a bullet through its head: the New Monetary Consensus. This is an updated New Keynesian version of the old Bastard ISLM model. The idea is that inflation slows growth so it must be diligently fought. The Fed will keep inflation expectations low, inflation will be low, and growth will be robust.

Every link in that sentence is a delicious illusion.

The Fed supposedly manages expectations by convincing markets that it controls inflation, and so long as it controls expectations it can control inflation.

But if it cannot control expectations it cannot manage inflation and all bets are off. What a flimsy reed upon which to hang public policy! And in any case, why should low inflation generate robust growth? Because—well, because the Fed says it will, contrary to all evidence.

Out in the real world, expectations alone cannot govern any economic phenomena: inflation expectations will determine actual inflation only if those with ability to influence prices act on those expectations. And inflation below the high double digits has never proven to be a barrier to economic growth.

Let us take the current experience as an example. We have moved on to QE2, an application of the NMC.

Helicopter Ben is supposedly injecting trillions of dollars of money into the economy to create expectations of inflation—to counter the deflationary real world forces. And many wingnuts actually ARE expecting inflation—running around like Chicken-Littles, buying gold and screaming about hyperinflation and collapse of the dollar. And, yet, no inflation. Why?

Because those who might have pricing power—corporations and organized labor—cannot create inflation. Workers cannot increase their wages given massive global unemployment, and firms cannot increase prices in the face of competitive pressures. So no matter how strong is the will to believe, it has no purchase against the facts.

The wingnuts will be proven wrong. The Fed cannot create inflation. It is within the power of the central bank to lower the price of reserves—the overnight rate--as close to zero as it wants. It can also lower longer term rates on assets it is willing to buy, but there is a nonzero practical limit to that based on what Keynes called the square rule.

Quantitative easing supposedly pumps money into the economy to generate spending in order to create expectations of inflation. But all it really amounts to is substituting reserves for treasuries on bank balance sheets—lowering their interest earnings. QE won’t work because:

  1. additional bank reserves do not enable or encourage greater bank lending;
  2. the interest rate effects are small at best, and are swamped by private sector attempts to deleverage -– The best estimate based on NYFed work: 18 basis points
  3. purchases of Treasuries are simply an asset swap that reduce the maturity of private sector assets, but do not raise private sector incomes; and
  4. given the reduced maturity of private sector portfolios, reduced interest income could actually be deflationary.

But we knew all that—Japan has been doing QE for 20 years, trying to create expectations of inflation in the face of deflationary headwinds, thus, it is interesting to compare Japanese and US experience (so far) by looking at a series of three graphs.

As they say, history doesn’t repeat itself but in this case it rhymes nicely. Only insanity would lead us to follow Japan’s path while expecting different results.

Let me finish my critique of the NMC with an observation of a Galbraith—John Kenneth this time:
To limit unemployment and recession in the US and the risk of inflation, the remedial entity is the Fed… For many years (with more to come) this has been under the direction from Washington of a greatly respected chairman… The institution and its leader are the ordained answer to both boom and inflation and recession or depression… Quiet measures enforced by the Fed are thought to be the best approved, best accepted of economic actions. They are also manifestly ineffective. They do not accomplish what they are presumed to accomplish. Recession and unemployment or boom and inflation continue. Here is our most cherished and, on examination, most evident form of fraud.

Even if the early postwar “Keynesian” economics had little to do with Keynes at least it had some connection to the real world. What passed for macroeconomics on the precipice of the global collapse had nothing to do with reality—it is as relevant to our economy as flat earth theory is to natural science.

In short, expecting the Queen’s economists to foresee the crisis would be like putting flat- earthers in charge of navigation for NASA and expecting them to accurately predict points of re-entry and landing of the space shuttle. Of course, the economic advisors to Presidents Bush and Obama could do no better.

Referring to the work of the best known economists over the past thirty years, Lord Robert Skidelsky argues “Rarely in history can such powerful minds have devoted themselves to such strange ideas.” Not only were they strange, but the ideas of the Larry Summers’, Bob Rubins, Mankiws, Marty Feldsteins, Bernankes and John Taylors of the world were, predictably, dangerous.

But one economist got it right, and did see it coming. And that is Hyman Minsky. His theory said it can happen again: market forces are destabilizing.

The economy emerged from WWII with a robust financial system—hardly any private debt and lots of safe and liquid government debt. Various New Deal and postwar reforms also made the economy stable: a safety net that stabilized consumption; strict financial regulation; minimum wage laws and support of unions; low cost mortgages and student loans, and so on. And memories of the Great Depression discouraged risky behavior.

Gradually all that changed—memories faded, self-regulation replaced financial regulations, unions lost power and government support, globalization brought low-wage competition, and the safety net was shredded. Further, profit-seeking firms and financial institutions took on greater risks with ever more precarious finance. Thus, fragility grew on trend. This made “it” possible again.

While most who invoke Minsky focus on the crash, he believed that the main instability is a tendency toward explosive euphoria. High aggregate demand and profits associated with high employment raise expectations and encourage increasingly risky ventures based on commitments of future revenues that will not be realized.

A snowball of defaults then leads to a debt deflation and high unemployment unless there are “circuit breakers” that intervene to stop the market forces. The main circuit breakers, are the Big Bank (central bank as lender of last resort) and Big Government (countercyclical budget deficits).

And, boy-oh-boy have we got a Big Bank and a Big Government! Together, the Benny and Timmy tag team have spent, lent, or guaranteed $25 trillion in the name of Uncle Sam. And that still is not enough. “It” is still happening.

The problem is that most of this was done by the Big Bank Fed, aimed at helping financial institutions—trying to prop up their worthless assets. In short, it was based on the theory that we need Money Manager capitalism and that the only hope is to generate another bubble.

It won’t work. Financialization is the problem, not a sustainable economic strategy. We need to turn instead to an updated Keynesian-Minskian New Deal based on jobs, growing wages, consumption—especially public consumption, constrained and downsized finance, and greater equality. Monetary policy also has to be downsized, while fiscal policy has to play a bigger role. Not fine-tuning but a positive and permanent presence to counter and guide and supplement the private purpose.

More importantly we’ve got to formulate theory applicable to the world in which we actually live—not one in which imaginary representative agents allocate resources along an optimal consumption path.

To that end, we stand on the shoulders of the giants like Minsky in the heterodox tradition.

Tuesday, January 11, 2011

Transcript 419A: Non-Events of 2010, Part I

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This is the Annual Demand Side account of news widely reported in the economics media that didn't really happen. Our list today is familiar from last year:

Housing prices have bottomed out
Problems with the banks have been resolved and banks have stabilized
Its corrolary, the bailout of banks has ended,
Demand is returning
The unemployment rate has topped out, employment is rebounding
The Federal Reserve is doing whatever it takes and preventing further damage to the economy
A robust recovery is underway

So let's begin with the oft-reported item that the EUROPEANS HAVE A HANDLE ON THEIR SO-CALLED SOVEREIGN DEBT CRISIS

The headlines of the day refute this claim. The Greek bailout turned into the Irish bailout. Seldom noted is the complete divergence of the two economies. The Greeks brought it on themselves, it is argued, and the Irish, well ... mmm. In fact, the two economies are not similar. The Greeks were widely castigated for profligacy. The Irish were the poster-child of corporate welfare, having offered the lowest corporate tax rates in Europe and boomed on a housing bubble.

The similarity, of course, is the banks. In the case of the Greeks. The rational restructuring of their debt was put off limits to avoid the chaos of triggering credit default swaps, which would have shuffled the financial paper in unknown ways and rewarded the speculative attacks. The Greek double-play, for example, involved bidding up the spread on Greek bonds and insuring oneself with credit default swaps. The Irish situation was much more obviously a failure of the banks. The Irish government had in the first days of the banking crisis explicitly guaranteed the debts of the banks. When the value of the loans held came up craps, the Irish people were on the hook. ARE on the hook.

The banks and their continued weakness promise to put every man, woman and child in the Eurozone in hock for decades to come.

But in light of the Greek double play and contemporary speculative attacks moving to Portugal and Belgium, we offer a preview from next week's forecast edition with audio from the Economist's Zani Minton-Beddoes


Yes, I know we ragged on the Economist last week. Maybe they do have one or two good staffers.

What next?

How about with one of the most widely reported items, one that had a significant effect on the 2010 mid-term elections.


Construction spending is down

The American Recovery and Redevelopment Act -- also known as the Obama stimulus plan -- was widely reported to have been a waste of money, doing nothing for the economy and costing north of seven hundred billion dollars. In fact, the stimulus was poorly designed, being one-third useless give-aways to business, one-third low impact tax cuts and one-third high impact public spending, much of it on construction of infrastructure, and some of it in pass-throughs to state and local government.

As we've argued at demand side since the beginning, rebuilding the American economy by rebuilding America and addressing climate change is the best model for stimulus. At a minimum it was necessary to bail out state and local government as tax revenues fell and budgets were slashed. Instead, you have the ridiculous contrast of billions in cash balances on corporate balance sheets and slashing of needed public goods and services. Those goods and services come with jobs. The cash balances and the speculation still rampant on Wall Street do not.

The efficacy of ARRA was attested to in a mid-year report from Alan Blinder and Mark Zandi, which demonstrated the higher growth and lower unemployment rate directly related to the Act. We are now on the cusp of its expiration. There is nothing left of the tax cuts and candy for business, and the aid to states and localities is about to fall off a cliff. As for construction spending: Public construction had grown into the vacuum created by collapsing residential construction. No investment by business has arrived from its tax cuts and low interest rates. Now the rational construction of infrastructure and public goods are being scaled back.

According to US Census, construction spending increased in November 2010 by 0.4% month-over-month (MoM) – and is still down approximately 6% year-over-year. In 2005 the government accounted for 20% of construction spending – in 2010 it was 40%. The public sector cutbacks will at least be $12 billion per month. Currently private sector non-residential construction is running at 2005 levels. The collapse in construction spending is all in private sector residential construction.

We are about to see whether the ARRA really had no effect. The tax cut package passed in the lame duck session will not provide stimulus of any magnitude. It is, as we've argued, a repeat of the 2008 experience. With states and localities now feeling the full brunt of the financial meltdown and the Great Recession, and no counterweight from the federal government, we expect stagnation and decline.



Consumption expenditures have been pointed to as evidence that demand is returning. These expenditures are being inflated by rising commodity -- including oil -- prices. Median incomes are shrinking, and remember, effective demand is composed of increases in incomes and the change in debt. Consumer credit is still contracting. We'll get to that in a moment. Just a bit of evidence first.

Manufacturing New Orders Remain Flat in November 2010, according to Global Economic Intersections analysis of private surveys. Also from Econ Intersect, a caution on Christmas sales. People, they say, are inundated with many different variants of December 2010 retail sales numbers depending on the sample. For example, on-line sales have been reported up from 12% to 18% – but on-line sales are not yet a significant part of Christmas retail sales. A Bank of Tokyo Mitsubishi sample of major retailers' same store sales demonstrated that December’s year-over-year increase was similar to any other month in 2010 – and that is very disappointing for the bulls who believed consumers would spend with reckless abandon during this holiday season.

The Consumer Metric Institute (CMI) Contraction Watch started flashing warning signs of a leveling off in consumer spending in late December.

As for consumer credit,

on January 7, Steven Hansen at Econ Intersect, noted that the Federal Reserve released the November 2010 G.19 compilation of consumer credit outstanding showing that revolving credit decreased at an annual rate of 6-1/4 percent, and nonrevolving credit increased at an annual rate of 4-1/4 percent. The majority of revolving credit is from credit cards, while nonrevolving credit includes automobile loans and all other loans not included in revolving credit, such as loans for mobile homes, education, boats, trailers, or vacations. Whither the increase? The Federal government continues to build its portfolio in nonrevolving credit adding over $30 billion in the last month alone. The Federal government has no revolving credit holdings.

This year the Federal government has increased its credit portfolio by $129 billion. Although not broken out, it is assumed this growth is due to student loans. This month's annualized increase is 13.8% – and without the government’s purchases, non-revolving credit would have declined.

Ignoring the government’s involvement in non-revolving credit, consumer credit contracted $197 billion this year- and contracted $68 billion including their portfolio.

As Steve Keen has pointed out, demand growth throughout the 1990s and 2000s was driven by an increase in debt. When debt contracts, or even flat-lines, effective demand is significantly reduced. As I remember, Keen pointed to 23 percent of private demand in the run-up to the collapse was fueled directly by increases in debt. This is 23 percent above the best-case for current debt-driven demand.

And Now, another event widely reported that is not matched by phenomena in the real world,


If by fully operational, we mean they are providing credit to the real economy, we can dismiss the reported events as emanating from Area 51. Banks are not lending, they are speculating on one hand and taking their various back-door bailouts on the other. Internal incentives are still skewed toward short-termism and risk.

But even there we are talking about only the mega-banks. Smaller and regional banks continue to be closed methodically by the FDIC, as quickly as the examiners can get to the next town.

As to the bailouts, at Demand Side we have talked about banks borrowing at zero from the Fed and carrying their cash a few keystrokes down to the Treasury where they lend at two or three or four percent and pocket the spread. But others have written about bailouts in other areas. In May, 2010, John R. Talbott wrote at Salon.com about the transfer of $1.2 trillion in assets from banks onto the Fed balance sheet, about $1 trillion of this in mortgage backed securities. The actual value of these securities is unknown because there is no accounting surveillance.

On January 3, 2011, Econ Intersect reported that Bank of America has reached a settlement with Fannie Mae and Freddie Mac to pay them $2.8 billion compensation for the bank having sold the GSEs bad mortgages. The actual eventual losses on these bad mortgages are unknown and may be many times the $2.8 billion settlement amount. This action may well be the start of a process that will be a backdoor bailout, transferring many billions (or even hundreds of billions) of bank losses to the federal government.

The most recent rate of bank charge offs, which hit $45 billion in the past quarter, and have now reached a total of $116 billion, is at 3.4%, which is same as the peak in the Great Depression, 3.4% in 1934.

The total exposure of the Fed is unknown. Without transparent accounting, there is no way to know if any of these MBS assets are as toxic as the synthetic CDOs that went into the Abacus 2007-AC1 securities offering by Goldman Sachs (GS) that quickly lost all value and are the subject of the civil case SEC vs. Goldman Sachs. William K. Black has testified that, as a class, the so-called “liar loan” sub prime mortgage issuance has resulted in losses between 50% and 85%.

How much of the MBS related securities acquired by the Fed have resulted in (as yet unrecognized) losses of more than 50%? How many toxic assets were acquired at nominal value when they contained large current and future unrealized losses? How many other assets were acquired above true value? You will remember that Demand Side did not need accounting reports to identify these purchases by the Fed as purchases of garbage.

In May, Talbott described the motivation of the Fed to engage in such deception -– namely, to avoid the collapse of banks into bankruptcy. Talbott went on to describe how Fannie and Freddie can be used in the future as a mechanism for the Fed (with government complicity) to transfer the bad assets to the taxpayers. Since the GOEs (government owned enterprises) are off balance sheet to the federal debt, the deception can be hidden from less discerning observers.

Bank of America is still far from out of the woods. The $2.8 billion settlement covers only mortgages produced by Countrywide up to 2008 for Freddie Mac and is less specific for Fannie Mae. Other government claims may still be made. And others besides the government may also make claims. One estimate is that MBS insurers may have claims in the $10 – $20 billion range. And of course we have the potential for claims from other banks, pension funds and others. The putback process is just beginning.

At the core of the banks' problem is, of course, the debt bubble around housing. A returning headline from last year's list:


Although in 2009, there were more than a few reports that the house price recovery was underway. No such reports in 2010. But did house prices bottom. No.

Deceleration in growth rates and outright declines in the Case-Shiller Index for November confirmed that a second dip in residential home prices is underway. The 10-City Composite was up only 0.2% and the 20-City Composite fell 0.8% from their levels in October 2009. Home prices decreased in all 20 MSAs. In October, only the 10-City Composite and four MSAs – Los Angeles, San Diego, San Francisco and Washington DC – showed year-over-year gains. While the composite housing prices are still above their spring 2009 lows, six markets – Atlanta, Charlotte, Miami, Portland (OR), Seattle and Tampa – hit their lowest levels since home prices started to fall in 2006 and 2007.

Calculated Risk relays an LA Times description of new declining cities. Some neighborhoods are never going to come back. Potential candidates in a Rockefelleer Institute of Government study include several inland California metropolitan areas that grew rapidly during the boom -- Stockton, Modesto, Fresno, Riverside and San Bernardino. Las Vegas and Miami also made the list.

A city in decline is one that has suffered a sustained population drop, leaving behind empty houses, apartment buildings, offices and storefronts. Cleveland and Detroit, for instance, suffered from the erosion of manufacturing and the loss of residents. Instead of eroding a particular industry, however, study cites the housing bust's leaving behind a glut of homes and foreclosures. Calculated Risk points out that there IS a particular industry in those cities that has disappeared -- construction!

We'll abbreviate our list for the moment, and be back on Friday

Tuesday, January 4, 2011

Transcript: 418 Stiglitz on banks, Galbraith on jobs

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Today on the podcast, Joseph Stiglitz on banks, James K. Galbraith on jobs, and an extended Idiot of the Week, featuring everybody's favorite newspaper, the Economist magazine.

First, Joseph Stiglitz,



"Idiot of the Week"

Today's idiot of the week is a duo. Tweedle Dee and Tweedle Dum, Laurel and Hardy, Lockwood and Ip. If there is a reason the Economist newspaper is always behind the curve, it probably has to do with selling magazines. Peddling conventional wisdom and the standard neoclassical stuff does not offend one's customers. Market fundamentalism may not do very well in practice, but with the right tone of insiderism (th?), it can be convincing at least this week. And consumers of economics media have demostrated their short memories. If we lived backward in time, they wouldn't do so well.

Here we have Chris Lockwood, U.S. Editor, and Greg Ip, U.S. Economics Editor, in a colloquy of dunces. (Idiot of the Week is not kind.) The conversation took place in November 2010.


Whoops. We forgot anti-tax. And we would have added anti fiscal responsibility. It remains to be seen how anti-spending they are. The last two anti-spending Republican Administrations, Reagan and Bush II, ended up spending enormously on national defense. The second of these floating two wars on credit, and in fact, cutting taxes mostly for the rich at the same time -- perhaps the apex of fiscal profligacy in our nation's history.


We are not aware of a concerted effort on the Right against the Fed. There may be some noise, but it is well-muted by the Wall Street financiers who rightly recognize that their bread is being buttered by the Fed's actions. As Ip notes, you could hardly argue there is inflation in the economic data, because there is not. But this is another hallmark of the Right. Stick with the theory long after the facts have disproven it. And then jump on any data point that seems to support you as if it is absolute proof. This selective vision is what we are about to witness with the rise in commodity prices fueling some cost-push inflation. It will be seen as a result of too much money being printed.

Unfortunately, they will be right. Fed pushing money into the financial sector is bidding up commodity prices and fueling bubbles in developing economies that will put definite upward pressure on prices. Not the price of labor, nor the price of manufactures or servcies, but the price of basic commodities. This will at the same time seem to ratify the Right's concern over inflation and reduce effective demand. The combination will push the economy downward -- a point we'll argue in more detail in our upcoming 2011 Forecast edition of Demand Side.


Well, unfortunately, six weeks have passed and the dollar is not declining as this gentleman is predicting, largely on the weakness in Europe. But the more telling point, is that Brazil and Korea are not worked up for fear of competition, but because the QE is flowing out, as we heard Professor Stiglitz describe earlier, and creating pressure where it is not wanted.


"The same thing by another mechanism," demonstrates a fully inadequate level of understanding. Stimulus by way of spending on infrastructure, unemployment -- or even pushing forward the Social Security retirement age as Professor Galbraith suggested -- produces jobs and demand. QE or lower interest rates has only produced large cash balances for banks and other corporations, not the lending which it is supposed to and which the theory says will produce hiring by the private sector. The phrase "A bit more stimulus" dots the 'I' and crosses the 'T' in 'idiot.' What is needed is not "a bit more" government action, but a great deal more action, and not of the poorly designed tax cut variety.


First of all, a correction in the facts of the matter. George W. Bush would not have passed his TARP, nor his early 2008 stimulus, without Democratic support. In fact, as you will remember, it was the Republicans in the House who broke ranks and scuttled TARP on the first vote. Whether or not they were good ideas, they did not get through without Democrats cooperating with the President. Parenthetically, they were not good ideas. TARP did not extract the restructuring of banks that is necessary for recovery, and the Bush 2008 stimulus, primarily a tax cut bill, proved wholly ineffective. Which is one of the reasons Demand Side is confident the latest stimulus, poorly designed for the same reasons, will prove ineffective as well. At the end of the day, however, the American people held W responsible because he WAS responsible. Eight years in office produced the fewest jobs of any president in modern history by far. And those few million jobs were gone within a few months.


If by "irony," you mean contradiction, I suppose. The promises and expectations of monetary policy have been sinced the beginning contradicted by subsequent experience. The question of whether the Fed was going to back down is idle chatter. As to whether the Fed needs independence to do what is necessary in spite of its unpopularity, well, it is not effective, so whether it is necessary is an open question. And it is highly popular with the Fed's true constituency, the big banks and Wall Street. The object, as we will now hear, is to assuage the sensitivities of the what Paul Krugman has called the Confidence Fairy.


So there you have it, Chris Lockwood and Greg Ip and the Economist, Idiots of the Week.


As you saw there, economic indicators were turning up in November, mildly and certainly not enough to help Democrats in the election. It grates me to hear unemployment insurance called a "dole check," irrespective of whether I think Mr. Ip has contributed anything of value in exchange for his check. The economy crashed because of private sector excesses, a housing bubble, and financial sector mismanagement. The discussion of the current condition absent that perspective is like blaming the ground for your hard landing rather than the jump off the cliff.

But the economy is turning up. The recovery of 2010 features prominently next week in our annual list of events that were widely reported in the economics media, but didn't really happen. For now, this is Alan Harvey, from the Demand Side.