demandside

The Forecast edition for March, plus idiot of the week:  Arthur Laffer as poster boy for Reaganomics

After some context from Robert Reich and Adam Posen, we get directly into what will happen next.  What will happen to the economy, not so much the stock market.  The markets continue itheir decline — toward six thousand on the Dow and six hundred on the S&P.

Another context for the forecast is those economists who are predicting the ultimate depression.  This is actually a hopeful sign.  Why hopeful?  These same economists predicted until the middle of last year that the U.S. and the world would avoid recession entirely, or that one or another decoupling scenario would prevent the decline from becoming worldwide.  That is, the current crop of financial prognosticators, with a few exceptions, is always wrong.

Discouraging signs:  Some of them, including the Fed’s open market committee, are seeing recovery in 2010.  The FOMC is even more wrong than the mainstream economists.

The Demand Side observation.  The worse the better.  Bad news in the short run will do wonders to stimulate the dramatic and bold action needed for recovery.  Also, we are lucky to have the president we have.

Robert Reich encapsulated the bad news last week

All told, according to the new Commerce Department data, the nation’s economy shrank at an annual rate of 6.2 percent. Last month, the government’s preliminary estimate was only 3.8 percent. Roughly half the revision was due to a sharper drop in business spending than had been anticipated. As a result, business inventories — the amount of stuff they they have on hand to sell — have dropped. That’s good news because eventually businesses will have to replace their inventories, in anticipation of at least some consumer buying, and such replacement spending will spur the economy. But here’s the bad news: Inventories still aren’t dropping as fast as sales are dropping, suggesting even less business spending and investing coming up.

Keep your eyes on the gap between what the economy could produce at full employment and the paltry level of aggregate demand (consumers plus businesses plus exports). That’s why the stimulus is too small — and why Reich is betting the President will be back for more stimulus.

There’s no reason to suppose the 1st quarter of 2009 will be any better, and lots of reason to think it will be worse. Government is spender of last resort. We’re at the last resort now. $787 billion over two years, and only two-thirds of it real spending, is way below what will be needed to get the economy moving back toward full capacity. Do Republicans know this? Is this why they’re continuing to bet that the economy won’t be recovering by November, 2010, and why they’re going to continue to say no?

And from Adam Posen, whom Paul Krugman describes as the go-to guy for understanding Japan’s lost decade, some perspective on the monetary side.  From testimony for a Joint Economic Committee hearing on the 26th.

http://krugman.blogs.nytimes.com/2009/02/25/turning-japanese/

On February 24, the Conference Board reported that its consumer confidence index plummuted further in February.  The Index now stands at 25.0 (1985=100), down from 37.4 in January. The Present Situation Index declined to 21.2 from 29.7 last month. The Expectations Index decreased to 27.5 from 42.5 in January.

Consumers’ appraisal of overall current conditions, which was already bleak, worsened further. Consumers’ short-term outlook turned significantly more negative this month. The employment outlook was also much grimmer.

Meanwhile the American Recovery and Reinvestment Act began moving federal money into infrastructure, help for states, education, unemployment extensions and other avenues.

Now let’s stick our toe in the forecast water with Paul Kasriel at Northern Trust, one of the few very good forecasters.  His assessment released last week, quote

We would like to buttress our credentials by pointing out that Demand Side has a record of accuracy.  Irrespective of orthodox approval, in earlier forms we correctly predicted the fall of the quote New Economy unquote of the Clinton years.  The Three Amigos of the time (perhaps even of Time Magazine) were Alan Greenspan, Robert Rubin and Larry Summers.  Fed Chair, Treasury and Assistant Treasury Secretary.  Neglected in the congratulatory analysis of Rubinomics was acknowledgment of fifteen dollar oil.

Demand Side was one of a very small number, maybe two, who saw the New Economy falling under the old economy weight of higher interest rates and higher energy prices.  Most have put the cause of the downturn in 2001 as the delayed effects of the dot.com crash.  Others, primarily Bush’s group have put it down as some sort of reaction to 9-11, which happened five months after the start of the recession.

This first Bush Recession did allow Republicans to move their tax cuts through Congress, neatly changing the message of surplus — “After all, it’s your money,” to one adapted to the need for economic stimulus.  At the time it was assumed all tax cuts have stimulative value.  Meanwhile Alan Greenspan changed high interest rates to rates of one percent, to stave off a newly feared deflation.  Never mind he had stalled the economy with his fears of inflation only twelve months earlier.

No matter how hard we jumped up and down, our miniscule soapbox did not allow us the elevation to get onto the radar.

Demand Side correctly anticipated that tax cuts for the wealthy would be ineffectual.  What ensued was the jobless recovery.  We also made an early call that Greenspan’s one percent rates were not restarting the New Economy, as he may have hoped, but shoveling debt into residential construction, a remarkably passive and unproductive form of capital investment.  We were slackjawed in amazement that Congress came back for a second helping of the Bush tax cut poison.  Clearly jobs and incomes were lagging and a speculative fever was inflating a bubble.

This was made most clear in Dean Baker’s historical trend analysis of rents versus ownership.  A rapidly growing divergence demonstrated, as he had with similar analysis of the dot.com experience, that the housing boom was a bubble.  We repeatedly highlighted the fact that housing had become not just a place to live, but a financial asset.  It was the asset price explosion that was sucking debt into housing, housing which was clearly unaffordable absent the imagined jump in equity.

We called the collapse of the housng bubble eighteen months before its time.  We missed that call, but learned.  The bubble was extended from a basic herd event by the corruption of the housing market in its late stages with fraud and abuse, widely cloaked by the perceived inevitability of prisings rising forever.  That is, the fever of the buyers slash borrowers to participate was enabled by machinations of sellers slash lenders to provide ever more capital.  Extra leverage, financially engineered triple A securities, liars loans, and even criminal conspiracies exploited the boom.

The corruption of the markets had occurred also in the S&L crisis and in the stock market bubble.  We had actully done some work with Baker at the end of the dot.com bubble where he preferred the primacy of the insider trading dynamic and we preferred the rudimentary herd theory.  Of course, both exist.  The bubble creates conditions for fraud and corruption — and delays the natural boom and bust.

By missing the corruption of the housing markets we also missed the devastating impacts on the financial sector of that corruption.  The allocation of capital, the management of risk and the mobilization of savings — the core functions of a working financial system — were completely broken by the practices of the big banks, the mortgage companies, the investment houses, and the other members of the shadow banking system.  We quickly picked up on the work of Nouriel Roubini and Joseph Stiglitz in 2007 to come in far ahead of the curve on the crash.

And you may remember our first editions of the podcast calling the beginning of the recession in the last week of October 2007, statistically for November.  We witnessed months of denial by others, lasting well into May, 2008.  Subsequently the National Bureau of Economic Research identified the recession as beginning in December, 2007.  Their call came after the November elections, our call came contemporaneously, fully a year earlier.

Parenthetically, while the NBER garners plenty of respect for its probity in making this calculation, at Demand Side we do not see the value for policy of a determination made so long after the fact.  It only adds to the confusion.  Decisions that need to be made in real time cannot wait until the committee gets consensus, particularly when the committee is stacked with boneheads.

One event we did not miss at Demand Side that others have — even the most notable — was the commodities bubble.  Following the work of analyst Charles Peabody we called the oil and commodities bubble as it emerged in November 2007.  Our correct stagflation forecast for the first half of 2008 was based on the premise that liquidity was chasing the rising asset price — commodities — and rising asset prices were creating cost-push inflation and subtracting another fraction of effective demand.  We tracked the commodities bubble upward and called its peak virtually the week it happened.  We made lots of virtual money in our fantasy portfolio as oil, metals, grains and energy dropped like a stone.  Oil from $147 to $40.

On the way up we cautioned about the euphoria in alternative energy.  On the way down we warned about the devastating impacts on commodity producers and made mention of the collateral damage on the auto industry.  Both the income shock of $4.50 per gallon gas and the micro shock to the companies, as they lacked the hybrid technology so much in demand.  Hybrids and alternative energy have floated to the back of the collective consciousness today, as the collapse of the banks have replaced every other economic news.

We should make mention before we leave the commodity bubble story that the brevity of the bubble and the fact that oil did not reach $200 per barrel as called for by Goldman Sachs was in part due to prompt and aggressive oversight in Congress.  Fraud and market manipulation in commodities no doubt occurred, but on a scale far below that of the other bubbles.

Demand Side’s forecasts have beaten the consensus and the blue chips and would have placed in the top five of the Wall Street Journal’s competition.  The weight assigned to interest rates and the collapse of inflation with the collapse of the financial sector kept us down.

More remarkable, however, than our success is the failure of the Federal Reserve’s open market committee. Upon ascending to the post of Chairman of the Federal Reserve Board, one of Ben Bernanke’s first initiatives was to institute the publication of forecasts of the Fed’s open market committee.  It was and still is a thinly disguised inflation targeting exercise.  But it has proven to be more an exercise in embarrassment, as the bankers repeatedly and consistently miss and miss widely not only inflation, but GDP and employment numbers.  It is as amusing as a chart can be to see the latest quarter’s numbers have migrated out entirely from under the dotted lines that mark the previous quarter’s estimates.

To be fair this has not occurred in January’s GDP for 2009, but only because there are twelve months of 2009 left.  A more representative example would be the October figures.  With only three months left in 2008, the esteemed economists were still radically downsizing their estimates.  It is our observation that the markets are no longer leading indicators of economic events, but coincident.  The Fed’s estimates of the economy are no longer coincident, but lagging.

FOMC unemployment estimates for 2009 jumped a point and a half in the three months between its October and January meetings, with the minimum expected now at 8.0.  Inflation projections are dropping, we suspect, from the evidence of no inflation, rather than from any inference regarding the commodities bubble or financial system crash.

The bottom line is that they have no idea.  The Fed expected their monetary policy moves to do something and they have not.  At this hour Battling Ben is applying bandages to wounds that need a tournequet and splint.  It is a big part of our prediction of a snap back in late 2009 that the situation will get so bad there will be no room for these alternatives to the proper treatments.

On inflation, the Fed has no clue about cost-push inflation and so missed entirely the effects of the commodity bubble on prices.  On growth, they have been laggards in realizing the severity of the housing collapse, but most troubling, they have been unable to comprehend the financial sector collapse.  This began in August 2007.  We arrive in March 2009 with the markets experiencing another jump condition, the financial firms requiring ever more transfusions, and the Fed’s and Treasury’s remedies having little more effect than waving their arms.

It is not necessary to accept the Demand Side prescriptions to see that the orthodox remedies have not worked, are not working and by extension will not work no matter how many times they are applied.  Initially, in the fall of 2007, the markets were confident the Fed could ride to the rescue and were encouraged by every rate cut and new liquidity mechanism.  Not only has there been no rescue, there has been no slowing of the train.

The monetary policy excursions were defeated time and time again.  Bear Stearns, Lehman Brothers, IndyMac, AIG …. you can mark the collapse from any one of these events, but that misses the clearly systemic nature of the collapse.  The Fed is responsible for keeping the banking system stable.  It has not only failed, it has failed spectacularly.  Yet it shows little willingness to alter course.  And there is woefully little demand that it do better.

A year ago it was Captain Ben to the rescue.  Today it is a tired and defeated Dr. Bernanke who knows nothing more to do than push more borrowed chips into the center of the table and hope for a better hand on the next draw.

Let’s be clear.  Demand Side’s forecasting success arose not because of statistical models or any real econometric expertise.  Were were clear about our method at the time.  We correctly observed the conditions of stagnating wages and incomes that underlay the housing bubble and that would be revealed when the tide went out.  The huge increase in debt under Bush was papering over a very weak underlying economy.  The current decrepit economy is the economy of 2001 minus ten trillion dollars of debt.

But recovery has now begixn.  This recovery depends on policy choices and bold action.  Any future recovery depends on their being instituted, and so our forecast depends not on the imagined quote natural economic forces unquote, but on the political will of the nation and its leaders.  As soon as policies are changed, the economy will improve.  Until they are made, the economy will be frustrated.

Here are six key actions:

1. Reduce the principle in mortgage debt.
2. Reconstruct the financial sector by dealing directly with insolvent zombie banks
3. Stop the contraction of state and local governments with grants to replace collapsing revenues.
4. Step up infrastructure, green energy and jobs spending.
5. Institute improvements to the social insurance system by instituting national health care and improving social security retirement.
6. Coordinate similar policies with other nations.  Use the power of the dollar to create physical and human capital around the world.  Inevitably this will create wealth and markets for the U.S. to sell its products into.  More importantly it will mobilize cooperation that we need to meet the incredible challenges ahead, economic, environmental and social.

There are primary obstacles to recovery.  Five on top are:

1. The consumer economy.
2. Reaganomics
3. The obtuseness of orthodox economics
4. The institutional power of the Fed
5. The burden of debt

For the first three we employ our features the History Note and Idiot of the Week.  Let’s begin with this week’s idiot, that emblem of Reaganomics, whose well-named Laffer Curve had no intellectual basis, never worked, yet continues today as the centerpiece of the Radical Right Republican economic understanding.  We mean none other than Arthur Laffer.

LAFFER

The Laffer Curve was originated by this man and purported to show that government tax revenue increases in times when tax rates are cut.  This depends on an unleashing of largely imaginary creative and productive impulses which previously have been restrained by the marginal tax rate.  It requires that total output — in say a 33% tax world — increase by tremendous amounts so that the lost revenue from the rates is recaptured by the volume.

Never happened, yet it has never been renounced, or even explained.  This is similar to the entire Supply Side rationale, which was supposed to generate big new investment and creativity by favoring the private sector.  Business investment languished under Reagan and Bush II.  And as we’ve said many times here on Demand Side, economic growth under Republicans since Reagan took office in 1980, when netted for government borrowing, equals zero.  All growth under Republican presidents in the last thirty years has been borrowed.

The clip here displays Mr. Laffer not engaged in economics, but in marketing.  His supply Side brand has been badly damaged by its obvious deficiencies.  It would have been recalled long ago but for a few highly monetarily endowed sponsors.  Mr. Laffer is protecting his brand.  It should be mentioned that he was among the economic advisors to Mr. McCain during the last election.

History Note:

Back to the Depression.  It is no exaggeration to say that the economics purveyed by the Right, the Cato Institute, the Heritage Foundation, the American Enterprise Institute, could not survive in the free market it champions.  In a competitive market the many and varied shortcomings would have seen it withdrawn long ago.  But these institutions and their economics are subsidized by the corporate moneyed interests that benefit from a free hand in the markets they control.

It is also no exaggeration to say that the economics currently purveyed by the right and these institutions is the same economics that led into the Great Depression and failed so well to address any of the collapse.

Following John Kenneth Galbraith, we observe that economics in normal times is lacking in drama.  After the stock market crash of 1929 and the financial sector crash of this era, however, have come marked and dramatic downturns.  The theater now present reveals, as it did in the 1930s, actors of no enormous talent.  The kingpins of Wall Street, the Mozillos, Madoffs, Thanes, and even Greenspans and Rubins, are unprepossessing and even dull readers of dull texts when the genius of the boom is bust.

Currently, as then, the stock market is assumed to be anticipating or reflecting underlying forces and financial analysts tend to look to it for answers.  “The market is telling us this or that about policy.”  In fact, as George Soros suggests, the Market is reacting to itself.  The current collapse of business, commodity prices and imports is completely parallel to that coming at the end of 1929.  For a time it was, and in some circles still is, assumed that the crash was a superficial phenomenon, a signal, rather than part of the deflationary mechanism.

As Galbraith insists, the crash and the causative speculation were not passive reflections of deeper trends in the economy.  And they will have solid consequences in the years ahead.  In the 1930s the consequence was a decade of idle plant capacity and persisting unemployment, until World War II, not economic wisdom, brought it to an end.  As we’ve argued elsewhere, the New Deal mitigated the most brutal aspects of this flaw in capitalism.  And here, Keynesianism did not arrive in sufficient scale until the War.

To repeat, the so-called natural forces of the economy, to which we heard Arthur Laffer refer, do not tend to the optimal outcome, but can as easily find their equiliburim in depression or recession.  The economics of the so-called free market are the same as they were in the 1930s.   The government should get out of the way.  Tax cuts, of course, are needed, and never mind the huge subsidies being extracted by the failure of the markets at the same time.

The heroes of the free market, the unregulated banking sector, only a few years ago, are now the goats.  The free marketeers may take credit for what meager success there was, but they need not take blame for the collapse, but only sentence the offenders to failure and move on.  It is a hypocrisy and irresponsibility that makes the sub-prime borrower look like a saint.

I am not expressing very well how similar the economics of the orthodoxy in 1932 was to that of the Republican Right today.  Let me just add the anecdote of the Hoover tax cut.  Once he slackened in his assurances that the economy was fundamentally sound, Hoover instituted a step in resonance with today.  He reduced income taxes.  A taxpayer with an income of $5,000, very comfortable in those days, saw a reduction of two-thirds, from $16.88 to $5.63.  Someone with $10,000 in income, roughtly the equivalent of $175,000 today, saw his tax go from $120 to $65.

As Galbraith noted, Nothing is more constant in depression or recession than the belief that more money for the affluent, not excluding oneself, will work wonders as to recovery.  In that event, as in the current one, the depression will continue as before.

Enough of that.

There is no greater obstacle to recovery today than the institutional power and economic bias of the Fed.

As we’ve observed, it was Fed interest rate policy under Alan Greenspan that fueled the housng bubble and the grand increases in leverage and indebtedness across the society — household, business, government.  It was Fed oversight and regulation missing from the field that allowed — enabled — the misallocation of capital, mismanagement of risk, and explosion of hidden obligations.  It is the inadequacy of the Fed’s economic understanding that has kept the current calamity growing long after it could have been dealt with rationally.

The Fed is independent as no other agency of federal government is independent.  it reports to Congress.  Its chairman and other board members are appointed by the President.  It is owned by its member private banks.  And since the notorious Treasury Accord of 1951 it has exercised ever more complete control over one-half of economic policy — monetary policy.  The Fed takes direction from nobody.  Up until its attention was diverted by an economic collapse of historic proportions, the Fed was obsessed primarily with inflation.

The philosophy under which it operates is shared across the banking community.  Today it is a hybrid of Monetarist pap and the aforementioned anti-inflationary bias.  This is combined with an ever more aggressively violated trust in the bankers themselves.  It is nothing other than the picture of a regulatory agency which has become captive to the industry it was supposed to regulate.

Ben Bernanke himself has made his academic place with the proposition that the Great Depression could have been prevented with radically more expansive monetary policy and a commitment to save the banks.  The first — the monetary policy — is indeed the primary premise of the Monetarist school led by Milton Friedman.  The second, the primacy of the banking institutions, is an unproven hypothesis Mr. Bernanke is testing with trillions of real money.

The size of these megabank zombies is testament to the deregulation which dismantled New Deal protections.  Bernanke has turned the Fed’s own b alance sheet into a replaca of those of the zombies in an effort to save them — transfusing the full faith and credit into basically corrupt institutions.

It is our speculation  here at Demand Side that the inability to institute the receivership operation on these zombie banks that is routinely undertaken by the FDIC — nationalization — is largely because of opposition by the Fed and Bernanke’s interest in keeping them alive.  Likely there is sympathy for this position by amigo Larry Summers in the White House and Timothy Geithner at Treasury.  But hte central obstacle is the Fed.  The Fed is beholden to nobody.  And without the Fed no coordinated triage can take place.

No doubt Bernanke will be a one-term chairman, but right now he holds the levers of banking regulation.  The good start on fiscal policy made by the Obama administration will be frustrated if there is not some real improvement on this front.

One does not need to accept the Demand Side remedies to admit that the Fed has not provided any relief in the arena of its responsibility.  It is our contention that it is the Dark Agest economic philosophy, the institional decay and the intellectual biases of its chairman that colesce into the single biggest obstacle to recovery.

Next week we’ll look at the debt.  Much has been made of the federal deficit, but a great deal more borrowing has been done by the private sector.  Reducing this debt burden is essential to recovery.  Part one of reducing this debt, rather than simply transferring it to the taxpayer, needs the Fed to act radically different than it now is.