demandside

Plus Monday’s Backcast with the G-20, Keynes in Review, and stimulus in the rearview mirror.   Our special surprise guest………

Podcast transcript:

11.17.08

MORGENSEN CLIP

That was Gretchen Morgensen on Fresh Air with Terri Gross offering the crux of the question on stabilizing housing and financial markets

Following a response offering the crux of an answer, again courtesy of Morgenson, this time from the pages of Sunday’s New York Times, we present Monday’s backcast.  First a look back at the quick and meaningless G-20 meeting in Washington this past weekend, then another issue of Keynes in Review, and finally some self-serving audio from February, leading into — time permitting — a grim prognosis for recovery should Republican obstruction in the lame duck Congress stall an absolutely essential stimulus bill.  We absolutely need a beginning point to recovery.  Even the mother of all earmark bills would be welcome.

But back to Morgensen.  Stabilizing the financial sector and the housing market is not a remedy for recovery, but it IS essential to stabilize the patient before recovery can begin.  Damage is continuing to be inflicted day by day, ever more severe damage.

Writing in Sunday’s New York Times, Morgensen explores a possible mechanism under the head,

A Rescue Plan without Taxpayer Money

… now that the original TARP design has been toe-tagged, and because there’s still another $350 billion left for Mr. Paulson to deploy, perhaps it’s time to consider actually attacking the root of the problem: falling home prices and rising delinquencies and defaults.

Since the $700 billion TARP was funded, it has been used solely to shore up banks and other financial institutions.

…

To be sure, private efforts to modify mortgages have increased recently; Citigroup, JPMorgan Chase and Bank of America have all announced plans to restructure troubled borrowers’ loans. So have Fannie Mae and Freddie Mac.

But these efforts are limited to loans that these institutions hold. They don’t address the millions of loans sitting in securitization pools, those profitable instruments cobbled together by Wall Street that are collapsing en masse.

… restructuring loans bundled into pools of securities is much thornier than simply changing the terms of individual loans residing inside individual banks.

Not only do such changes require the approval of hard-to-identify investors who essentially control the mortgages, but also many pools were designed with rules that limit the numbers of loans that can be modified.

Securitization trusts hold $1.5 trillion of subprime and alt-A loans. As of late August, according to figures from the Securities Industry and Financial Markets Association, roughly $400 billion of the loans were delinquent and $1.1 trillion were current on interest and principal payments.

…

A new report from Demos, a public policy research group in New York, points out that [more] millions of mortgages are ticking toward a possible explosion.

Still, there are many smart ideas floating around about how to solve the twin problems posed by securitizations and resetting mortgages.

One interesting idea was conceived by two veteran investment managers, Thomas H. Patrick, co-founder of New Vernon Capital, and Mac Taylor, a principal of the Verum Capital Group.

They propose refinancing all $1.1 trillion of the loans in securitization pools that are still performing but that may soon face punishing interest rate resets. Homeowners whose loans are in these pools would receive newly issued loans with fixed interest rates, currently 6.14 percent, and 30-year terms. Under this plan, Fannie Mae and Freddie Mac would issue debt to pay off the outstanding principal on the loans and then guarantee the new ones.

Voilà: Investors who own the underlying interests in the mortgages would be fully repaid and the securitizations would be closed out.

“Our proposal is based upon the fundamental principle that the only way to ameliorate the problem is to somehow improve the underlying collateral,” says Mr. Patrick. “It rewards those homeowners who have paid their mortgages and have demonstrated financial responsibility.”

Currently, with everyone worried about more losses, the securitizations are trading at rock-bottom levels.

Because big banks and other financial institutions hold most of the securities, refinancing the $1.1 trillion in securitized loans would provide big capital infusions to many of the entities the Treasury is trying to help with TARP, Mr. Patrick said.

But while TARP involves direct payment of taxpayer money to banks, the Patrick-Taylor plan would create losses for taxpayers only if the refinanced loans took a hit later on.

There’s another benefit. Remember all those complicated products like collateralized debt obligations and credit default swaps that have been scaring the pants off people and causing some financial giants to look into the abyss?

Well, the Patrick-Taylor plan would reinflate the value of C.D.O.’s made out of bundled mortgages. And firms that sold C.D.S.’s as insurance against mortgage defaults would also get a boost (the biggest bailout recipient, the American International Group, for example, has been struggling to pay billions of dollars in collateral on weakening C.D.S.’s).

The investment managers reckon that their plan would give the financial system an immediate capital infusion of about $385 billion. That’s their estimate of the difference between the value at which depressed mortgage securities are now valued — 65 cents on the dollar — and par value.

If the assigned value of those assets drops even lower than 65 cents, then the financial benefit to the banks of the Patrick-Taylor plan would be greater.

In return for all of this financial aid tied to the $1.1 trillion of securitized mortgage loans that are still current, the Patrick-Taylor plan would require banks to buy the $400 billion in delinquent securitized loans at full value.

The banks would have to absorb any losses they incur when selling the underlying mortgages. But that’s a small price to pay for getting out from under this albatross.

It is impossible to predict how much financial institutions might lose on that $400 billion. But it is likely to be less than the losses they will suffer if they sit idly by while defaults and delinquencies accelerate.

Because the program would provide such a boost to the banks … these institutions should be required to absorb a portion of possible losses on the $1.1 trillion in healthy loans guaranteed by Fannie and Freddie. …

“This set of securities is what started the fire: it’s what brought down Merrill Lynch, Lehman Brothers and Bear Stearns,” Mr. Patrick said. “You can’t deal with the securities in their current framework, and you can’t solve the problem one mortgage at a time. If we eliminate these securities, strip away the complex structure, we can fix the banking system.”

Under the Patrick-Taylor plan, homeowners would also be helped. Future delinquencies might be reduced, and the downward spiral of home prices could be curbed. ***

Now, continuing a capella, Monday’s Backcast on the recent six-hour G20 meeting.  The score here is from Douglas A. McIntyre of 24/7 Wall Street

It begins with four lines from Elvis Presley A little less conversation a little more action please All this aggravation ain’t satisfactioning me A little more bite and a little less bark A little less fight and a little more spark.

…

The G20 financial summit did not yield much of significance if it was meant to help staunch the bleeding brought on by the worldwide economic crisis.

Among the modest and and ill-defined suggestions from the meeting, members “urged governments to implement “appropriate” fiscal and monetary policies to shore up sagging economic, according to The Wall Street Journal.

The meeting lasted less than six hours.

The document issued by the members suggested more oversight of hedge funds, more transparency for trading in the global default swaps mareket, and greater supervision of credit rating agencies. All of these steps have been urged by central banks and economists for months. In other words, there was nothing new here and the proposals were given no teeth.

The document also called for a “colleges of supervisors” will be set up to monitor the world’s biggest financial institutions.

The G20 plans another meeting for April 2009. The world ought to be in the grips of the worst recession in seven decades by then, and it will be too late for goverments to do much about it.

Douglas A. McIntyre

Now Keynes in Review

a periodic feature which attempts to help John Maynard Keynes and his economics

leap over sixty years of distortion and misrepresention and land in the present day to help us understand our situation, what is working and what cannot work.

Keynes Economic Principles

“Keynesian” means many things to many people.  We will put them in context in story form as we continue here, but to lay out a skeleton:

Output is determined by aggregate demand. “Aggregate” means “total, combining all elements.”  This was contrary to the most basic tenet of classical economics, that the process of supply created the demand to purchase that supply (known as “Say’s Law).   Prior to Keynes, it was virtually a precondition to be considered a serious economist to advocate Say’s Law, and the belief that by the process of manufacturing, one creates the wages, payments to suppliers and the profits that are needed to purchase that supply.  This is still the supply side proposition. Markets are not inherently self-correcting, they are fundamentally flawed. By their own internal dynamics, markets create instability and break down.  This arises from the “entrepreneurial animal spirits” which translate into effective demand for investment that creates runaway expansion (investment booms) which are inevitably brought to a halt by accumulated financial changes’ making the system fragile.  This is diametrically opposite to the Invisible Hand paradigm, which posits not only self-correction, but best outcomes in a capitalist economy.  While Keynes personally preferred and worked toward a managed capitalist system and is rightly seen as one of those who saved capitalism from itself, the fundamental nature of this flaw should not be ignored.  Keynes ultimate answer to this problem was to expand the size of the public sector of the economy so as to minimize the impact when the private, market side broke down.  Thus one could salvage the dynamism, vigor and vitality of the animal spirits without periodically sacrificing the structure of the society.

Investment has a multiplier effect on output and employment. Keynes borrowed and promoted R.F. Kahn and his development of the investment multiplier.  This is the base of the so-called “Keynesian stimulus.”  Its nut is that an investment from outside the system will increase activity to a degree greater than the simple dollar value of that investment BECAUSE the money paid to create the investment was passed from worker to grocer to baker to farmer and so on creating multiples.  In theory this multiplier should be reduced only by the savings of each actor at each step.  In the real world, we see multipliers much reduced.  A savings rate of five percent, for example, should create a multiplier of 20.  In practice, we see best multipliers are in the range of 2.  This multiplier effect is the root of the Keynesian stimulus which later manifested itself in government spending to “jump-start” the economy.  It should be noted here that tax cuts have the lowest multiplier of all government spending, particularly in conditions of uncertainty, which is precisely the time that calls for the highest multiplier.

Liquidity Trap.  When there is little prospect of profit, investors will not invest.  This is often said in a kind of reverse form, referring to an interest rate falling to a very low point, but still not stimulating investment because of dim prospects.  The phenomenon is best illustrated and understood from the more dynamic statement:  It doesn’t matter how low interest rates are, if there is no prospect of profit, entrepreneurs and investors will stay home.

So, Demand Side in its first year as a podcast has recorded some good scores, but it is not so much on account of our brilliance as it is that the Keynesian principles thumbnailed above reflect the way things really work.

Here, from February 26, 2008, a younger and slower Alan Harvey

DEMAND SIDE

That from February.  Too bad we didn’t do infrastructure in February.  “It takes too long,” is the main critique.  You still here it.  At least it works.  More tax cuts didn’t work.  And won’t work.

What will work?  We’ll put that off until Wednesday.

Plus George Soros on the “cardiac arrest” of the financial sector following the Lehman Bros. bankruptcy, the Demand Side flaws to the China stimulus, and Jeffrey Sachs on how to avoid a global recession…..

Today is the Forecast Friday Employment, after which we have some notes in honor of this weekend’s G-20 meetings, including a comment in our characteristically contrarian style on China’s recent announcement of a huge $584 billion stimulus, a modest suggestion on the organizational framework for Bretton Woods two point one, and a few observations on international economics cribbed from Nobelist Jeffrey Sachs.

Forecast Friday

Continuing ineptitude by the Fed and the Treasury and negligence by the Administration on all sides causes us to revise downward our already pessimistic forecast for the short term.  Unemployment and employment are the two most important measures of economic health, and today we suggest that this downturn as exacerbated by the financial crash will eventually see unemployment at 10 percent by the official measure, an effective 15 percent.

We along with the rest of the nation hope the new Obama administration will be able to move quickly to turn things around.  Unfortunately, by the time Obama is in the White House, the economy may be well under water.  The current Administration seems almost malicious in enforcing their ideological bias, but it

Forecast Friday

Today, the employment and unemployment portion of our forecast.  We agree with Soros both above and elsewhere in his testimony where he suggested a deep recession is now inevitable and the possibility of a depression cannot be ruled out.

As you saw last week, one of the November surprises was the most gloomy employment report since these statistical series came into being.  Not only did the economy shed

Well, here’s the Bureau of Labor Statistics lead verbatim

“Nonfarm payroll employment fell by 240,000 in October, and the unemployment rate rose from 6.1 to 6.5 percent, the Bureau of Labor Statistics of the U.S. Department of Labor reported today. October’s drop in payroll employment followed declines of 127,000 in August and 284,000 in September, as revised. Employment has fallen by 1.2 million in the first 10 months of 2008; over half of the decrease has occurred in the past 3 months. In October, job losses continued in manufacturing, construction, and several service-providing industries. Health care and mining continued to add jobs.”

Will George W. Bush be the first American President in the post-war period to produce a negative job number?  It is possible.  He is certain to produce fewer jobs in his entire eight-year term than Bill Clinton averaged in each of his eight years.

The 6.5 percent unemployment rate cited is two points above that of a year ago.  The U-6 effective unemployment rate is now at 11.8 percent, almost four points above one year earlier.

The continued ineptness at the Treasury and in the Administration suggest a much sharper short-term fall for the economy.  Job numbers should look for 8.5 or even ten percent before they turn around in the third quarter of a new Obama administration.

Absence of adequate policy over the next two months could greatly aggravate an already bad situation, and makes accurate forecasting difficult.  We notice that the Philadelphia Fed’s Survey of Professional Forecasters has been delayed, perhaps indicating problems across the board.  They are now due out next week.  We’ll entertain you with a comparison of ours versus theirs and the next output forecast next Friday.

We do expect the popularity and program of the incoming president, once they can be implemented, to make real changes to the economic outlook.  Until then.  Let’s hope we don’t drown.

**

Another stimulus that will not work:  China

Much has been made of China’s aggressive new stimulus program — nearly $600 billion in infrastructure spending.  Our view is contrary to that of the congratulatory majority.  Some reports have suggested that a good part of the so-called “stimulus” consisted of projects already in the pipeline.  But the point from the Demand Side is that infrastructure spending in China will likely not provide the needed boost to domestic demand.

First a report on the Chinese plan, the day after it was announced:

“Bullishness in Asia on Monday was tempered by questions about how much of China’s plan is actually new — or is simply a repackaging of past commitments, such as the rebuilding effort following the Sichuan earthquake. Investors appeared to question estimates that Beijing would spend another 6% to 7% of its gross domestic product in each year of the plan, as the raw numbers of the plan would suggest. . .

Beijing may be prepared to add extra stimulus. A Beijing think tank, the China Academy of Social Sciences, said Monday it has submitted a report to economic policy makers outlining ways for the government to offset stock-market panic. One suggestion is to deploy as much as $115 billion to buy shares in the stock market’s 50 biggest companies if the Shanghai Composite Index slips to 1500. The market remains 64% below last year’s close.

The package didn’t address one big question about China’s economic-policy plans: whether it will stoke its own domestic demand by letting the yuan rise, or act defensively to let the currency fall to relieve pressure on its own exporters.”

Another observer was Douglas A. McIntyre at 24/7

Six hundred billion dollars may be a lot of money, even by national bailout standards, but it won’t save China from a recession. Based on data release overnight, China reported the slowest export growth in four months. Imports suffered as the Chinese consumer felt a bit more impoverished. With real estate prices falling and the Shanghai stock market off nearly 70% from its high, the average citizen in the world’s largest country by headcount has to worry about his job.

In China, according to Bloomberg, “Manufacturing contracted by a record last month, industrial output grew by the least in six years in September, and the halving of inflation from a 12-year high in February may be another sign that the economy is losing steam.”

Economists want to cling to the fiction that China’s GDP growth will only drop to 8% or so next year. It ran 9% last month. The fact of the matter is that keeping up that kind of pace is not improbable. It is impossible.

It now appears that GDP could contract by 4% to 6% in the US during the first quarter of 2009. EU countries and Japan are not likely to do much better. That leaves China with nowhere to send its goods. Only so much inventory can be piled up at the nation’s ports and on outbound ships.

There is absolutely no reason to believe if the economies of the West seize up like old engines that China can keep its export growth in plus territory year-over-year. GDP growth in China could easily drop to the 3% to 4% range. In China, where the economy has moved up by 10% for five years, that is a recession.

Douglas A. McIntyre Let’s look at this from the Demand Side.

At the same time we argue for infrastructure in the United States, we question its efficacy in China.  If the problem is to stimulate demand, internal demand, it would appear that a

more effective and productive means of stimulus would be institution of a social security system for retirement and disability.

This is because the Chinese save an enormous part of their income.  I believe the figure is near forty percent.  Unlocking this demand is essential to creating sustainable, robust domestic dynamics. Something like the Social Security system, a part-pay-as-you-go and a partly funded system could cut the savings rate in half very quickly, as people relaxed from hoarding against old age and want. As it is, the contractors will continue to get rich, the workers will save whatever they can, and internal demand will stagnate.  The only route to healthy domestic demand in China is through the masses.  Absent this domestic demand, there is no security in hoarding.

Of course, this is exactly the opposite remedy we prescribed for the U.S. economy, but these are virtually polar opposite economies.  The U.S. ought to concentrate on infrastructure, technology, and limit its social security stimulus to extending unemployment and rationalizing the impossibly expensive and inefficient health care system.

China would also do better to concentrate on reducing its environmental deficit.  That country’s rise in economic power has come at the cost of its air and water and land.  This deficit in well-being will, we’ve argued in the past, make of China the first environmentally failed state.

*

Now, in anticipation of the G-20 coming to Washington, we offer this context from Nobelist Jeffrey Sachs, abbreviated from a recent piece

director of the Earth Institute at Columbia University and special adviser to Ban Ki-Moon, UN secretary-general

*

Sachs

The best recipe for avoiding a global recession

By Jeffrey Sachs

Before our political leaders get too fancy remaking capitalism … at the Bretton Woods II summit in Washington, they should attend to urgent business. Since the closure of Lehman Brothers triggered a global banking panic, political leaders in the US and Europe have successfully thrown a cordon round their banks to prevent financial meltdown. What they have not done yet is to co-ordinate macroeconomic policies to stop a steep global downturn. …

A US downturn will not be avoided. …Some other economies will also suffer home-grown recessions because they too allowed a housing bubble … Australia, the UK, Ireland and perhaps Spain. …

Yet even a steep recession in the US and in a few other countries need not throw the world into recession. The world economy is about $60,000bn, so a first-round demand decline of as much as $1,800bn would be about 3 per cent of world output. If there were no offsetting macroeconomic policy changes, the demand decline could be multiplied further to as much as 6 per cent, relative to 4 per cent trend growth, meaning a global decline of about 2 per cent.

On the other hand, even a 3 per cent global demand decline can be substantially offset by expansionary policies, undertaken by the surplus economies of Asia and the Middle East. Ironically, until recently China had been pursuing monetary and fiscal tightening to fight inflation. Now China must make a policy U-turn, to boost its internal demand and support a coordinated expansion throughout east Asia.

Any coordinated expansion should include the following actions. First, the US Federal Reserve, the European Central Bank and the Bank of Japan should extend swap lines to all main emerging markets, including Brazil, Hungary, Poland and Turkey, to prevent a drain of reserves.

Second, the International Monetary Fund should extend low-conditionality loans to all countries that request it, starting with Pakistan.

Third, the US and European central banks and bank regulators should work with their big banks to discourage them from abruptly withdrawing credit lines from overseas operations. Spain has a role to play with its banks in Latin America.

Fourth, China, Japan and South Korea should undertake a coordinated macroeconomic expansion. In China, this would mean raising spending on public housing and infrastructure. In Japan, this would mean a boost in infrastructure but also in loans to developing nations in Asia and Africa to finance projects built by Japanese and local companies. Development financing can be a powerful macroeconomic stabilizer. China, Japan and South Korea should work with other regional central banks to bolster expansionary policies backed by government-to-government loans.

Fifth, the Middle East, flush with cash, should fund investment projects in emerging markets and low-income countries. Moreover, it should keep up domestic spending despite a fall in oil prices. Indeed, the faster a global macroeconomic expansion is in place the sooner oil prices will recover.

Sixth, the US and Europe should expand export credits for low and ­middle-income developing countries, not only to meet their unfulfilled aid promises but also as a counter-cyclical stimulus. It would be a tragedy for big infrastructure companies to suffer when the developing world is crying out for infrastructure investment.

Finally, there is scope for expansionary fiscal policy in the US and Europe, despite large budget deficits. The US expansion should focus on infrastructure and transfers to cash-strapped state governments, not tax cuts. This package will not stop a recession in the US and parts of Europe, but could stop a recession in Asia and the developing countries. At the least it would put a floor on the global contraction that is rapidly gaining strength.

**

The first three legs to a new economic order must be:

• A stable currency exchange regime.
• An end to the Washington Consensus’ tenet of free-flowing capital.
• A functioning international institution that benefits all nations.

We recently suggested that the financial transactions tax known as the Tobin Tax could serve very well as the catalyst for this order.  It can serve to make capital markets more efficient and at the same time the institution needed for its implementation would be legitimate, independent and a step into reality from the superfluous committees of nations that do nothing but convene and speechify.

One huge flaw in markets is that they do not take all costs into account in the transaction price.  The moment of exchange is the only venue for accounting.  Costs which are not captured in this moment become so-called “externalities,” that is, problems for other people to deal with, and not the market players.

A tax, such as the Tobin Tax, brings the costs of the movement of capital into the transactions of financial actors.  These costs are immense in terms of stability and in currency, the externalities are often borne by those whose domestic currency is not the dollar or the euro.

So once again, we recommend the tobin tax, because it would

1. Slow the destabilizing free wash of capital (and to some degree the radical variances in exchange rates)
2. Create hundreds of billions in new revenues from an extremely broad base and an extremely low rate levied on financial actors.
3. Necessitate a forum for international economic cooperation that will have new legitimacy and an independent budget.

Now, as promised, the opening statement by George Soros to the House Government Oversight Committee yesterday, Thursday, November 13.

Plus a challenge to the cave man metaphor and “Idiots of the Week,” Kevin Hassett and Dennis Gartman

Continuing Stiglitz, from Washington Post, Sunday, November 9

The U.S. financial sector, once the emblem of our economic success, has failed us. Financial markets are supposed to allocate capital and manage risk; instead, they squandered capital and created risk. Even more galling, the banks’ chiefs raked in private rewards totally out of whack with what scant good they were doing for the wider society.

So Obama will have to push for major changes, in both regulations and the overall systems of carrots and sticks, to restore confidence, spur lending and ensure that our financial markets do what they are supposed to do. This may require, for instance, restricting some of the special benefits (such as easy-to-get Federal Reserve loans) granted to the banks in recent months only to well-behaved institutions that actually lend more and use publicly provided funds responsibly. And it means that the financial sector should not only fully repay the bailout funds it has received but also give taxpayers a return commensurate with the risks the country has undertaken. If that means taxing the banks, so be it. Wall Street would demand no less if it were doling out its own money.

Obama will also need to deal with some vast inefficiencies in our economy if we are to prevent further erosions in our standard of living. Some U.S. sectors are global leaders, such as our world-beating universities and the high-tech firms that thrive on the ideas hatched in our ivory towers. Others are embarrassing, such as health care, where Americans spend far more than citizens in many other industrialized countries and get underwhelming results. We need a bold approach here, reforming not just the way we provide medicine but also thinking more broadly about health. That means doing more about diseases associated with alcohol, drugs, tobacco and obesity, which have increasingly come to symbolize American over-consumption.

Similarly, we should think more broadly about the bang we get for our buck in international affairs. Our current military expenditures are a serious drain; we could get more security for far less money if we didn’t waste so much on weapons systems that don’t work or are designed to fight enemies that don’t exist. (Think the Air Force’s multibillion-dollar program for a new deep-strike bomber that would be completely useless against terrorists.) Moreover, we might be the richest country in the world, but we have been among the stingiest of the advanced industrial countries when it comes to fighting global poverty and disease. We devote only 0.16 percent of our world-leading GDP to foreign aid, among the lowest rates in the developed world. If we make the World Bank and the International Monetary Fund more democratic, we will lose some voting power, but we will gain tremendously in “soft power,” or global influence.

Obama is also inheriting a climate crisis. The United States and China have been racing to see which nation will contribute most to the greenhouse gases that cause global warming. It looks as though China will win in absolute terms, but on a per capita basis, America takes the smoggy cake. We cannot save the planet without a global agreement, and we cannot get such an agreement without massive reductions in U.S. emissions. This transition could have upsides beyond the environmental ones. A carbon tax — or the auctioning of emissions permits — could generate huge revenues; some of those could be used to help Americans adjust to the new “green economy,” while the rest could be used to reduce the deficit or lower taxes on workers. But we really have little choice here: Europe and other global players are likely to slap a carbon tax on U.S. goods if we don’t deal with the issue at home. Their firms will not tolerate giving U.S. firms a competitive advantage simply because we refuse to bear our responsibility for the global environment.

We may be witnessing the birth of a new economic model. We have been treating two of the world’s scarcest resources, air and water, as if they were actually free. No wonder we have paid so little attention to resource-saving innovations. Perversely, the U.S. tax code has actually been subsidizing the production of the very fossil fuels that contribute to global warming. We have been pursuing a policy that amounts to “Drain America first.” It has made us even more dependent on oil imports — a stunningly short-sighted plan.

And in the rare cases when we have turned to renewable sources of fuel, we have done so in a manner driven by special interests, not by common sense. Subsidies to corn-based ethanol, for instance, offer little if any benefit to the environment; such handouts have been justified in the name of helping out an infant industry that will stand on its own feet if given a good start. But ethanol is an infant that has refused to grow up.

The new economic model will require changes in the ways and places where we live and work. There will be some losers (including the oil industry, which has done jarringly well in recent years), but there will be even more winners.

In so many ways, the United States has reached a low point. Picking ourselves up off the ground is itself no mean achievement. But I hope that our new president will do even more for us than that.

Joseph Stiglitz, a professor at Columbia University, won the Nobel Prize in economics in 2001. His latest book, with Linda J. Bilmes, is “The Three Trillion Dollar War.” **

** Changing the metaphor

One of the most lethal arguments against the Demand Side is the metaphor of the family.  Societies or governments should emulate a responsible family.

It goes something like:

I work hard and pay my bills and live within my means and take care of my family.  Why can’t the government?  The other guy?  The other country?  Let them tighten their belts and work harder and leave me to my steady income.

In fact, unless you eat money or live in money or clothe yourself in money, this metaphor falls apart quickly.  It actually falls apart before that — because if, for example, you are buying a home, you are far more in debt than the government at any level.

That aside, for the family metaphor to work, there has to be this “out there” which provides the place to go and get the stuff.  There is no “out there” for the government.  For the society at large, there is only “in here.”

It IS possible to create a metaphor without magical money or an “out there.”  That is the family farm.  One can imagine growing one’s own food, using timber to create housing, and even finding a source for clothing.

In this metaphor, grandfather created the farm and built the tools and the basic structures.  Grandmother stored away the commodities needed in winter and hard times.  The grown children work the farm, and the children grow up to continue the cycle, particularly taking care of their parents.

What happens if there is too much rain in the spring and the ground is too wet to plant?  On a farm do the grown children lie around and wait for the ground to dry?  No.  During this time and other times when crops do not need tending, they build and repair the barn, improve the roadways, perhaps install a pump or improve the drainage.  All of which will pay off later in efficiency or improved living standards.

What they absolutely do not do is lie around.  It is ever apparent that their own security and that of their family improves when they are productively employed.

What if the whole season is lost, though?

For this we need to go back to the family, which after several generations has branched out and moved into several farms.  Grandfather rents his plow and sells his barn in exchange for a chit that is good for part of the crop and a place to live in his old age.  Those who are better at farming exchange markers with those who are better at building.  Those who do not want to work so hard get fewer chits but more time in the sun.

When the season comes to be lost, grandfather receives no chits for the rent of his plow, the farmers create no markers to trade to the builders, and except that grandmother has saved enough and is willing to take these chits and markers, they all starve.  Unless, for a promise to pay in the future, it is agreed that some chits can be produced without a substance behind them.  Then there is no starvation.  So long as people are willing to take the markers.  But there are still idle farmers

What if the farmers who are idle go to work improving irrigation or roadways during the down time?  For this, it is agreed that they may be paid in chits that will have future value when and if the crops come in.  And the irrigation and roadways improve the prospects for those crops.

Now you have not only an internal consistent metaphor, but monetary and fiscal policy.  And we see that fiscal policy, spending on stuff the society needs, is a better way than monetary policy.  You can also see that with the enlargement and separation of the family, it becomes less apparent that everybody is in it together, and that the greatest prosperity occurs when all are gainfully employed.  You can also see that this is very do-able with an enlightened control over the means of exchange.

What may be less distinct is that it is necessary for the activity to be truly productive in order to be most effective.  In a situation where all are given chits as a means of simply increasing their consumption and stimulating activity on a random basis, it will not work so well.  In a situation where the chits are given to those who can most convince the bankers, er, chit-makers, that they will get them back, a few will benefit and the product may or may not be what the society needs.

In a situation where the chit-makers exchange them for productive employment and are then given the purview to recover them later in a universal levy on all the society, all of whom will benefit from the improvements, the system works well.

It is a longer metaphor, but longer only because it takes into account all the elements.  There are no magical realms in which the householder can slay dragons for the magical money which can be turned into anything back in the cave.  It explains why this cave-dweller might spend his youth learning one art and the cave-dweller in the next valley may — and likely would — choose another.

To me, it is simpler.  I have trouble with magic money.

*

* Idiot

Shutting down talk shows?  Igniting trade wars?  Hasset is reaching for the apocolyptic vision.  Unfortunately the bad stuff has already happened.  But that’s not what he wants to talk about.

*

Keep bad things from happening.  Hassett and his American Enterprise Institute ran the economic paradigm for the past eight years.  Bad things happened.  We did not avoid the worst things because the free marketeers steered directly into them.  Their blithe confidence has now morphed into a denial of the disaster.  Perhaps this will work, though I am by no means certain.

*

A double on todays idiot, Dennis Gartman of the Gartman Letter and a South Virginia reactionary.

*

It is gone only if Obama or his advisors listen to this newly minted Keynesian.  The idea that low taxes on the rich are good for the economy has been the backbone of Bush Economics.  Once again, it didn’t work.  As Joseph Stiglitz pointed out on Monday, Obama’s tax policies are not bad for the economy and you could throw in an increase in capital gains to the level of ordinary, earned income without hurting recovery and in the long run preventing the budget from melting through into another calamity.

*

Card check is open petition with a scary name.  The trade war problem will be less a concern for unions after there are no more union jobs because of the demolition of American industry.  Hasset needs to practice economics rather than pandering to his political ideologues to ever be taken seriously again.

Obama sticks to his guns, Stiglitz: “One hell of a way to win,” Keynes points out there is no guarantee of a “reversion to the mean,” Inslee:  Perhaps we can spend as much to save the planet as we did to get to the moon, or maybe one-quarter of the amount we spend on R&D for weapons could go to R&D on energy.

You don’t know how happy I was to hear Obama not backing off his commitment to his campaign positions on middle class tax cuts, job creation and infrastructure.  Those who cynically ascribe promises in the campaign to political convenience were not paying attention.

Speaking of cynical, I am waiting for the bad news this week, on the issues and secrets the Bush-Cheney administration pushed past the election.  There may not always be an October surprise, but there is always a November surprise.

In a similar cynical vein, I expect the NBER, the official arbiters of recession timing, to make their way forward now, perhaps six months late.  Calling a recession in the middle of a political campaign would have shown political independence.  Not calling one shows the opposite.  We expect — as we’ve said since that time — that the recession began in the fourth quarter of 2007, specifically in the last week of October.

Getting stimulus in a bill that can be signed on the day after inauguration that includes help for states and municipalities is absolutely essential.  We are already ankle deep in the mud, waiting until we are knee-deep until we try to get out is not going to be useful.  States and municipalities can, with enlightened credit facilities, manage their business in spite of obstruction by the current administration.

Another prediction we made — you can look it up on Daily Kos or in your archives of Demand Side the podcast — the Democrats were going to have to begin to govern before Inauguration Day.  So it seems.  Could there be a bigger challenge?  War, financial crash, recession, tremendous budget deficits, and the least competent administration in a hundred years lying in the road.

Oy.

You can look it up, Monday February 18, 2008,

Democrats may have to lead BEFORE inauguration. A banking crisis is looming, and what has worked in the past is not going to work this time.  The scale is global.  The cost is enormous.  There is no capacity to pay for it. In Mr. Obama’s current comments, he is careful to point out that he is not the president, and that we have only one president at a time.  It is easy to forget there is somebody else with pretenses to being the leader of the nation.

Audio

We introduce today a hopefully recurring feature we’ll call Keynes Review, for want of a better name.  What happened to the thought of John Maynard Keynes between then and now.  We’re going back to the source.  Beginning with:

Aggregate demand determines supply and activity, the public and private sectors are complements not substitutions in a condition of low employment, and of course, markets are not self-correcting.  They will drown if the authorities don’t save them.

It causes us no end of heartburn when we are forced to watch, for example, CNBC and the anchors who were brought up on the miracle of the free market now holding on as the market goes down.  Apparently they don’t have any skin in the game.  The market players see that the invisible hand has them around the ankles and is dragging them under.

Today on Keynes, we’re going to jump right into the middle, following H.P. Minsky and his book John Maynard Keynes.

In the mid 1960’s the economic house was in order, economists were held in high regard for the prosperity of the time, and economic thought had coalesced around the so-called Neoclassical Synthesis.  By the mid-1970’s this had all fallen apart.  The intellectual situation had returned to the condition Keynes found in 1936, when he published his General Theory of Employment, Interest and Money.

“At the present moment,” he wrote in the concluding words to that seminal work of Demand Side, “people are unusually expectant of a more fundamental diagnosis; more particularly ready to receive it, and eager to try it out, if it should be even plausible.”

In fact, that is even more so the condition today.

But in the 1970’s it was not the Keynesianism of Keynes that was unsatisfactory, but the Keynesianism of the Neoclassical Synthesis, bastard Keynesianism, as Joan Robinson called it.

This was a cross of the previous classical economics that Keynes had so profoundly rejected and some of the principles Keynes expounded in their stead.  During and following his life, the ideas that were incorporated into conventional economic thought from Keynes where those which were (1) most easily assimilated into the fold of conventional economics, and (2) those most applicable to the situation of the Depression and then to World War II and the Bretton Woods Accords.

What has been lost, according to Hyman Minsky, is a major part of the General Theory and that part which is most relevant to the economic problems of the present.  Neglected have been Keynes thinking on decision-making under uncertainty, the cyclical character of the classical process, and the financial relations in advanced capitalist economies.

Completely ignored is Keynes insistance on the disequilibrium of all economics, that is, that we are always in transition from one state to another, and there is no steady state.  Perhaps most important to this time is that the classical quantity theory of money has come back in a revised form and is guiding the hand of hte monetary authorities.  The most dangerous assumption of this theory is that a decentralized economy is stable.  The fact is — as Keynes and the Great Depression demonstrated — there is no inherent “reversion to the mean” in a capitalist economy.  Markets are unstable without explicit structure.  A market economy can amplify imbalances and focus them and create huge detours and disasters.

Next week, I hope, we will look at the other errors of this old classical monetarism and how they have come back to life in the current orthodox doctrine.

** ** More Pain to Come Even if He’s Perfect

By Joseph Stiglitz Sunday, November 9, 2008; B03

This is one hell of a way to win.

Barack Obama owes his victory in large measure to the prospect of the longest and deepest economic downturn in a quarter-century and perhaps since the Great Depression. If he performs well, he could become a great president. If he flubs it, he could get the same reception as Jimmy Carter. In the crassest political terms, it was good luck to have the financial crisis hit so close to the election. But Obama’s lucky streak will end in a hurry if he can’t find a way out of this mess. He will also have to manage expectations: Even if he does everything perfectly, we probably won’t turn the corner for 18 months, and the downturn could last far longer than that.

The first task facing President-elect Obama, after eight years of misguided economic policies, will be to begin the recovery — or at least forestall a further decline. It won’t be easy. More than 1.2 million private-sector jobs have already been shed this year, and by the end of the year an estimated 1.15 million people will have exhausted their unemployment-insurance benefits. To make matters worse, when Americans lose their jobs, they typically lose their health insurance, too. Meanwhile, 3.8 million homes are under foreclosure, and states are facing massive revenue shortfalls; without assistance, they will have to cut spending, plunging the economy deeper into recession.

So some steps are obvious: assistance to homeowners and bankruptcy reform; extending unemployment insurance; and making up for the gap in state revenue. The United States also has an infrastructure deficit, not just a fiscal and trade deficit, which means that spending more on infrastructure (such as public transport and technology — especially of the green variety) will stimulate the economy in the short term and help us be more competitive in the long run.

But then matters start to get trickier. The economy obviously needs a direct shot in the arm, but the 44th president needs to be careful about the design of the stimulus he proposes. That’s because President Bush will bequeath him a national debt — $10.5 trillion and rising — that has almost doubled since he took office, even before you factor in the full costs of the financial bailout and the Medicare prescription benefit, as well as the price tag for providing for the hundreds of thousands of returning Iraq war veterans.

To his credit, Obama knows much of this. During the campaign, he argued against cutting taxes on upper-income Americans, who have done so well in recent years. In addition to repealing the 2001-03 tax cuts for the wealthiest, Obama should also consider taxing dividends and capital gains at the same rate as ordinary income: It would reduce the deficit, have few short-term adverse effects on an already reeling economy and make the tax code more fair. After all, why should speculators — whether on oil, food or real estate — be taxed less than those who work long hours to make a living?

Another major problem Obama has to tackle is growing inequality in this country. Some of these trends will take decades to reverse, but ensuring that no Americans are denied a college education because they can’t afford it, providing adequate funding for public primary and secondary schools and so forth would be a good beginning

Obama has also promised to wind down the war in Iraq. Spending a fraction of the war’s cost — my estimate places the total at $3 trillion for our entire economy — on investments within the United States would help reduce the deficit and boost economic growth at home.

While the federal deficit looms over the Obama administration’s economic deliberations, we must be careful not to let it block bold action. Sometimes, we’re wiser to pay now rather than later. Borrowing for high-yielding investments (not just Wall Street bailouts) is common sense. The decisions not to reinforce the levees in New Orleans or upgrade the bridges in Minneapolis were penny-wise, pound-foolish blunders that we lived to regret.

The root of so many of our problems is the reeling financial sector. The plan cooked up by Bush and his Treasury secretary, Henry M. Paulson Jr., isn’t likely to work, or work well enough. So Obama’s team will have to wade in.

Already, the banks have been talking about using taxpayers’ money for dividends, bonuses and acquiring other banks, rather than doing more lending, which was clearly what Congress had in mind for the $700 billion. U.S. taxpayers got a raw deal, compared to the terms won by other governments (such as Great Britain) or by the legendary investor Warren Buffett, who provided capital to the best capitalized investment bank, Paulson’s own Goldman Sachs. Want further proof that Washington got a lousy deal? Look at how the markets reacted. The share prices of the bailed-out banks shot up, showing that investors expected net profits to rise substantially.

We’ll continue on Wednesday,

Here is Jay Inslee

INSLEE

Plus Robert Shiller on forecasting, parallels to the Great Depression in market volatility, and more unsettling stuff…………………………….. Forecast Friday

First, the forecast

The exercise of forecasting during a crash is necessarily imprecise.  If one is expected to predict which way the shards will scatter, forecasting is basically a matter of luck.  If one is expected to describe future aggregate measures in prices, employment and activity, one may do better, but without being very helpful.

Such aggregates may describe either a patched-together wreck propelled by momentum and hope, or it may describe a reformed and retooled economy more appropriate to the tasks at hand and more likely to serve the society.

The difference in the two arises from policy choices.

We need to begin at a place to which many have not yet arrived.  The fact is, the economy will not come back to a functioning equilibrium without significant government redesign and reconstruction.  Financial markets, in particular, have to be put back on a sane footing.  They will not reconstitute themselves, nor will they function any better if we simply prop them up in the same form as before.

So, yes, there will be a period of governmental intervention.  Without this, there will be no healthy outcome.

In the Great Depression model, we are still at point one, during the crash, with the banks still in the hands of the free marketeers whose ambition is to prop them up in a form as close to that they formerly occupied as possible.  On the other side, reformers know something needs to be done, but they have not coalesced around any particular structure, as far as I know.  There are good ones, and at the end of today’s podcast, we’ll look at one.

The point is, during the Depression, there was the stabilization phase, during which time the housing market was stabilized with the Home Owners Loan Corporation, the financial markets were stabilized with Glass Steagall, the FDIC and the SEC came into being and the rest.  It was only a couple of years later that concerted stimulus was applied, and even then the recovery plan was of a scale below that necessary to provide escape velocity.

It is our contention that an effort similar to the Second World War is necessary for the economy to recover.  That effort needs to be organized around planetary survival, green technology and mitigating global suffering, both from poverty and the climate changes.  It needs to include efficiency measures in transportation and health care delivery.

The closer we come to this target, the healthier our economy will be, measurements of GDP notwithstanding.

So, policy choices are central.  It is far too early to assume policy will attack the problems coherently or aggressively.  As you have heard over the past weeks, our dismay is virtually complete that so many are clinging to the notion that the consumer economy can be the engine of growth, and though fewer, a substantial number — many with powerful voices — still maintain things are fine, and it was governmental intervention in the private markets that caused the meltdown.

Yikes!

Today we’ll look at some of the key dynamics of a new forecast.  Now that the downward trajectory is visible in the mainstream’s rearview mirror, there will be a lot more competition for accuracy.  I say rear view on purpose, because even today I heard several analysts say something not far from, “Third quarter numbers show there is a bleak prospect for the economy.”  This is the fourth quarter.  The past is some indication of the future, but it is not the future, and it is the mainstream’s great weakness that this month’s forecast looks a lot like the extension of the trend.

Among the most guilty are the Fed governors.  A year or more ago, Ben Bernanke rolled out a new report that gave forecasts from each of the FOMC members.  Bad timing.  They have been shown to be very poor predictors.  One of the charts demonstrates the shift from the previous opinion, using dotted lines.  Following these for inflation projections, for example, you see a dance back and forth, obviously depending on the previous experience.  How is this forecasting?

Our organization of the roll out of the new forecast will be inflation today, employment/unemployment next Friday, growth on the third Friday of the month,and the rest — including investment, market performance, et cetera — on the final Friday of November.

1. Credit freeze.  Trade, durable purchases, consumer credit is going to drive activity down.
2. Consumers dead from loss of asset wealth — housing and stocks — and from the loss of jobs.
3. The commodities bubble has expired
4. Farm prices are down and the dollar is up, putting the big squeeze on farmers
5. The financial markets are erratic and volatile, driving money into short-term Treasuries, so-called safety.

Behind these lie the strategic imbalances which affect any discussion of inflation.

One

A huge trade deficit over many years has left the U.S. a net debtor to the rest of the world.  Big time.  A confounding contradiction now presents itself.  In a floating exchange rate system, the dollar ought to be the weakest of currencies.  Because, however, it is the agreed upon store of value, it is the strongest.  Both because people are happy to have their money in dollars and because previously they were happy to exchange goods for dollars.

Two

Markets are not self-correcting.  This Keynesian insight is being re-learned at great cost.  Our many Chinese listeners may not have heard that this basic premise of the free market — that they will correct themselves — is only wishful thinking.  The Invisible Hand operates only in the context of structured, policed markets.  Otherwise it is invisible because it does not exist.

If markets are not self-correcting, what corrects them?  The central authorities have to step in and reconstruct markets.  There is no alternative.

It is widely known that the Great Depression was not resolved by the New Deal policies, however productive those policies were.  Social security, government encouragement of aggregate demand and so on were helpful, but it was the massive effect of World War II that changed things.

What is not clearly understood is that it was not only the stimulus of war demand, but the mobilization and organization of the national economy during the war and the subsequent organized re-entry into peacetime which allowed the American prosperity.  It was very widely expected, even among Keynesians, that the economy would return to the doldrums of the Depression Era once the war wound down.  Instead there was prosperity.

That ought not to be overstated, since probably more important was the fact that the U.S. and its industrial infrastructure was unscathed relative to the wholesale destruction of the plant and equipment in Europe and Japan.  These economies offered ready markets and enlightened reconstruction policies — in stark contrast to the aftermath of the First World War — allowed the world to grow out of the devastation.

Which is a long way of getting back to inflation and the point.  We don’t really know what will happen to inflation here at Demand Side.  Our previous call for higher levels are now off the board.  Those were premised on a weak dollar and a commodity bubble.  Both those conditions have succumbed to the financial panic.

We now have a strong dollar and pressure downward on commodities on account of lower demand.  This means lower prices.  The Fed will no doubt continue to create liquidity by whatever means it can, that is, promote inflation.  Our fear is that at some point they will succeed too well.  Inflation itself is not so bad, but the currency dynamics are not sustainable and may be fragile, depending on the actions of interested parties.

Inflation or deflation is kind of like the wind.  It depends on the circumstances and the strength as to whether it is helpful, insignificant, or disastrous.  An American inflation based on increasing incomes and a strong job market would be very useful to everyone.

Unfortunately this is precisely the type of inflation the Fed is most poised to resist.

An American inflation that is based on rising commodity prices, particularly oil, such as we had over the past year, is not good because of the bubble dynamics.  A big caveat — as we will argue next week on Market Failures 2.0, a high tax on oil and gasoline which is fed back into the system by way of infrastructure spending or development of alternative energy, would be very good.  It is not the price of oil that is the problem, but the fact that it creates no domestic jobs and few international jobs.

Returning to the point, commodity-driven, cost-push inflation is relatively neutral in itself.  It can be simply an adjustment of relative prices that is not a general inflation but is called one because these items appear in inflation measures.  It is the bubble dynamics of the most recent commodities experience that is the problem, not so much the price change.

An American inflation based on the collapse of the dollar is very, very bad.  Such an inflation would mean a lot of things have gone wrong internationally as well as domestically.  It is absolutely vital that the U.S. and to the rest of the world address the trade issues and the imbalances that make this outcome ever more likely.

Again, at Demand Side we take no comfort from the current strength of the dollar.  This means that it is priced high relative to other financial assets.  It IS an opportunity to fund recovery programs, but it is essentially a sign of weakness.  Everybody believes the U.S. government can repay its debts.  The U.S. government CAN repay its debts because they are denominated in dollars.  But………

Stability would come with a balancing of trade and a reduction in U.S. debt.  This will not happen with the dollar at these levels.

So.

We will change the numbers on the web site this weekend to flat, much lower than they currently are.  But remember, they are incidental to the economic outlook.  Their primary effect is on the actions of the monetary authorities.  A strong economy can enjoy the breeze of inflation in its face.  A weak economy may as easily be pushed down by excessive inflation or sucked downward by deflation.  The U.S. needs to work with other nations to stabilize and formalize the currency regime and reverse the imbalances which threaten us all.