Transcript: Demand Side 322 - The one-eyed forecast on Net GDP -- Depression era numbers

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In the land of the blind, the one-eyed man is king.

Not so.

In the land of the blind, the one-eyed man is an outcast.  If they could catch him, they would put him in prison.

Two years ago, the blind central banker was leading the blind investor or the other way around in the Fed stood ready to do quote "whatever is necessary" unquote to keep the economy from falling into recession.  Unfortunately when your only tool is a fire hose, it is hard to hammer a nail or keep dry in the rain.

Twenty-four months later we have ended the piper's parade in a land of zombie bankers taking ghostly trips to the back windows of the central bank.  There they obtain chips to take to meaningless marketplaces to blow up more bubbles.  Or they take their borrowings from the back windows to the front doors to trade for interest-bearing Treasuries.

The promised land of healthy banks leading healthy economic recovery does not exist.  The promise of renewed credit flows is a mirage.

One might have thought that a one-eyed man would be useful.  And he would be to the people who want to go somewhere.  But to those sitting in the seats that satisfy,  it only means somebody knows they've made an unholy mess of things.

And in fact, it is not so much that there are so few one-eyed men, it is that there are so many blind kings.  In the land of blind kings, one-eyed men are paupers.

With that, the forecast, a pot-shot at Paul Krugman, and some words in praise of taxes.


FORECAST

Net Real GDP Reveals Economy's Weakness and the Deficit's Bite

3rd Quarter 2009 GDP hit 3.5 percent by preliminary calculations, and more than one economist has made a career call that the economy is out of recession into recovery. At the same time the federal budget deficit backed out of complete free-fall, though it is still in serious trouble, with revenues being choked off by falling incomes and expenditures ballooning to fund stimulus, social insurance and bank bailouts. (Notably the pass-through of payroll taxes into the General Fund which has been going on for decades finally reversed earlier this year, with the social insurance trust funds actually showing a net outflow.)

We've argued elsewhere that positive GDP does not mean growth. Demand equals supply. So when the government buys stuff or makes payments, GDP goes up. This has little to do with the business cycle, except to mitigate its brutal bottom. The term "recovery" has come to refer to this very modest artificial monetized activity.

In fact, it is our view that the business cycle is broken.  "Recovery" in the context of a broken business cycle is meaningless. There is no recovery. The inventory action pointed to as evidence of investment is just restocking the shelves. It is not investment in the sense of business cycle recovery.

It was to disentangle this kind of government spending from real economic health that Demand Side developed the metric Net Real GDP. This is simply GDP minus the deficit. Again, demand equals supply, so when the government spends, product is produced.

Let's say Real GDP grew at 3.5 percent in the 3rd quarter. Figures are not yet out for federal borrowing, but it is likely that such borrowing was around Q2's 8 percent of GDP.  3.5 percent minus 8 percent gives us a net of minus 4.5 percent growth. In Q1, Net Real GDP hit 11.9 percent on an annualized basis.

Many observers will admit that these numbers capture the flavor of the economic situation better than simple GDP.  They certainly track unemployment better.  It ought also to give pause to those who say deficits will produce better growth.  In fact, it seems that the large deficits of the Reagan and Bush years actually masked weak growth and that balancing the budget Clinton and in pre-Reagan times seems to go better with sturdy economic output.

Our forecast for GDP and Net GDP is up on the Forecast site along with  charts, prospective and retrospective, going back to the Depression and focusing in on the past decade. 

The forecast is not a pretty picture.  Real GDP below Depression levels at about one percent.  Net Real GDP is solidly negative and again below Depression levels at minus 6.5 percent.  This is if nothing more is done.  Obviously, something will be done.  Politically these numbers are not tenable. 

On the other hand, there is an increasing likelihood of another financial crisis, either in the dollar as we have predicted, or back in the financial institutions themselves, who are again playing casino games with the blessing of the Fed.  Goldman Sachs is stocked with ex-Enron traders.  Why we should expect good things, I do not know.

As Keynes said about capitalism, "[It] is the astounding belief that the most wickedest of men will do the most wickedest of things for the greatest good of everyone."


Now Paul Krugman and the monolith of the zero bound

Krugman blogged on his ever-popular New York Times site last week:

It’s the stupidity economy

OK, maybe a more polite way to say it is this: bad ideas are acting as serious constraints on policy.

We’re in a liquidity trap, with interest rates up against the zero bound. This means that conventional monetary policy isn’t sufficient. What should we do?

The first-best answer — that is, the answer that economic models, like my old Japan’s trap analysis, suggest would be optimal — would be to credibly commit to higher inflation, so as to reduce real interest rates.

But the key thing to recognize about this answer is that it’s all about expectations — the central bank only has traction over expected inflation to the extent that it can convince people that it will deliver that inflation after the liquidity trap is over. So to make this policy work you have to (i) convince current policymakers that it’s the right answer (ii) Make that argument persuasive enough that it will guide the actions of future policymakers (iii) Convince investors, consumers, and firms that you have in fact achieved (i) and (ii).

In reality, we haven’t even gotten anywhere near (i): the conventional wisdom is still that any rise in expected inflation above 2 percent is a bad thing, when it’s actually good.

This is the Monetarist answer that Krugman's Princeton colleague Ben Bernanke is trying with all his might.  It suffers from a couple of fatal flaws.  First, it is only in the minds of the economic elite that inflation expectations have anything to do with the activities of people in three-piece suits.  Expectations are not generated by bombastic sermons, but by experience.  Simplistically put, expectations are a function of the past three months.  People extrapolate.  They do not project changes in trends.  When they change, they will change dramatically and will be self-reinforcing.  One avenue to change is if the Fed's current cheap chips to the trading houses bids up the prices of commodities and this cost-push inflation comes back down on the real economy.  This would be good?  It wasn't good last time.  It would, in fact, be another blow to real aggregate demand.  Aggressively trying for inflation instability is wrong.  Creating demand stability by employing people doing useful things is right.

Back to Krugman:

OK, so what’s next? The second-best answer would be a really big fiscal expansion, sufficient to mostly close the output gap. The economic case for doing that is really clear. But Washington is caught up in deficit phobia, and there doesn’t seem to be any chance of getting a big enough push.

Demand Side's view is that the fiscal expansion should be credible and long-term and not designed to restart the factories, that is, fill the output gap of previous consumer-based industries, but to create new lines of industry in energy, infrastructure and elsewhere that will require new investment, thus doubling up the government's stimulus.

It is extremely troubling that everybody realizes what a big mistake the bubble economies of the past fifteen years were, but the remedy seems to be create another bubble to get consumers back to that level of spending.  We don't need private consumer goods, we need public consumer goods.

Krugman again:

That’s why, at this point, I’m turning to what I understand perfectly well to be a third-best solution: subsidizing jobs and promoting work-sharing.

Call it constrained optimization, where the constraint comes from the power of bad ideas.

Subsidizing jobs in the private sector is make-work.  It is make-work doing things that will be useless.  The subsidies will substitute for private sector spending and the jobs will disappear when the subsidies disappear.  Why not invest in the things the public sector is supposed to provide.  Education, infrastructure, and security?  The productive value of this sort of spending is well appreciated.

Elsewhere, Krugman's West Coast brother Brad DeLong is of the same sort of mind, focusing on the efficacy of monetary answers when there is none.  He does offer the following definitions to make the monetary hash more intelligible

DeLong says:

I would prefer to divide the policy universe into four categories:

    * Monetary policy is the purchase or sale of Treasury bills for cash.
    * Fiscal policy is the selling of bonds by the government to cover a deficit.
    * Quantitative easing policy is the altering of market expectations of the long-run path of the money stock.
    * Banking policy is the altering of the quantity, duration, or riskiness of the assets (other than Treasury bills) held by the private sector.

I think this provides the cleanest and closest to orthogonal basis for discussing macroeconomic policy.

Demand Side suggests writing down the bad debts rather than ratifying them.  The Home Owner's Loan Corporation could realize the losses that have occurred in actuality and free the borrowers from some of the burden of paying the banks for those bad loans, thus freeing up spending.  The same thing could be done across the board, if we were not in thrall to the bond holders on every side.

On Saturday we'll have Nouriel Roubini in full voice describing the dangers of the carry trade fully funded by the Fed.  Saturday's relay of Roubini will also have his forecast going forward.  Hint -- it's not a V.


Now to Taxes

Bruce Bartlett

BARTLETT

At Demand Side, we don't think anybody is positioned to our left, but neither do we think that deficits necessarily mean stimulus, nor does stimulus really require massive deficits.  Cutting spending is not the answer.  Raising revenues may be.

Government is THE most efficient spender of its income.  Every dime of tax revenue not going to debt service goes right back out the door in the form of spending.  Increasing the government's revenue will in no way decrease spending, IF it comes from sources that are not spending now.  That is, no rate increases on incomes, either on payroll taxes or increases to marginal rates at the low end.

But, we can, for example:

1.  Uncap the payroll tax.  Right now the most regressive part of the tax code is the cap on the payroll tax, which means that your tax liability starts going down at $100,000.  This is unconscionable and would be a great place to begin if people are serious about helping the social security and medicare trust funds.

2.  Gas taxes.  How absurd is it that the price of a gallon of gasoline can bounce one or two dollars in a year and it is okay, but a five cent per year increase in the gas tax is met with outrage?  Oil products produce the fewest number of jobs per dollar of any sector.  Taxes produce the most.  A credible plan to increase the tax would generate the will and the way to avoid the tax by reducing oil consumption.  It is the source identified by the Blue Ribbon Task Force on Surface Transportation Infrastructure, composed of business, labor and government.  The fact that it has not been enacted is testament to the power of the oil lobby.  Such a stable long-term source for infrastructure spending would, as we said before, begin private investment of a similar magnitude.

3.  Higher marginal rates at the top.  Big tax cuts to the big savers will cause the economy to boom.  Remember that?  Bush II and before him Reagan.  Didn't happen.  No investment, only gutted public revenues.  Only borrowing and in some cases higher payroll taxes for those higher marginal rates.  Extremely high marginal rates for those making in the millions would not only generate a few dollars, but would go a long way to reduce incentives to corruption.  One day we will go back to incentives that were not all pecuniary.  Doing it sooner would be better.

4.  Tobin Tax on financial transactions.  The casino profits of the big trading houses and others on Wall Street are held up as necessary for long-term financial health.  In fact they are corrupt and decadent subtractions from the real economy.  A tiny tax on financial transactions would be invisible to most of us, but to those who engage in the massive games, they would be substantial, and maybe reduce the instability inherent in such activity.

These are not small sources of revenue, they are huge.  But they increase activity and productive investment.  And they reduce debt service down the road.  Most importantly, each is economically efficient in its own regard.

What we want is stability and turnover, not big deficits.

Some day we'll turn the deficit question on its head and ask what sort of strong economy the private market capitalist economy made with its huge deficits.