Economic Dreams - Economic Nightmares

Minsky on 'Flawed Capitalism', 'Flawed Economics'

I am a fan of Hyman Minsky's work, but have not read — until now — any of his books. I am currently reading Stabilizing an Unstable Economy. Here is a timely quote, from Chapter 12, "Introduction to Policy", emphasizing our current plight both as to our political economy and misguided economic ideology/methodology. It could have been written yesterday but was first published in 1986:

… We need to embark on a program os serious change even as we need to be aware that a once-and-for-all resolution of the flaws in capitalism cannot be achieved. Even if a program of reform is successful, the success will be transitory. Innovations, particularly in finance, assure that problems of instability will continue to crop up; the result will be equivalent but not identical bouts of instability to those that are so eviedent in history.

Political leaders and the economists who advise them are to blame for promising more than they or the economy can deliver. The established advisers have failed to make the political leadership and the public aware of the limitations that economics processes and the the ability to administer impose on what policy can achieve. … [O]ur economic leadership does not seem to be aware that the normal functioning of our economy leads to financial trauma and crises, inflation, currency depreciations, unemployment, and poverty in the midst of what could be virtually universal affluence—in short, that financially complex capitalism is inherently flawed.

Economic advisors, whether liberal or conservative, believe in the fundamental "soundness" of the economy. Finding fault with one thing or another, they may advocate policies such as changing Federal Reserve operating techniques, tax reforms, national health insurance, and wars on poverty, but all in all they are satisfied with the basic institutions of modern capitalism. According to today's gospel [extant faults] are due to secondary, not to fundamental, characteristics.

[T]he economists of the policy-advising establishment differ about details: some propose to fine-tune the economy by fiscal tinkering, others want to achieve a natural rate of employment through steady monetary growth. Neither, however, sees anything basically wrong with capitalism as such. The credit crunch of 1966, the liquidity squeeze of 1970, the banking crises of 1974-75, the inflationary spiral of 1979-80 and the distress, national and international, of 1981-82 are, in their view, aberrations, due to either "shocks" or "errors." Since nothing is basically wrong, they also hold that incisive corrective measures are not needed.

The truth of the matter is that something is fundamentally wrong with our economy. As we have shown, a capitalist economy is inherently flawed because its investment and financing processes introduce endogenous destabilizing forces. The markets of a capitalist economy are not well suited to accommodate specialized, long-lived, expensive capital assets. In fact, the underlying economic theory of the policy establishment does not allow for capital assets and financial relations such as exist. The activities of Wall Street and the inputs of bankers to production and investment are not integrated into, but are added onto, the basic allocation-oriented theory.

Economic policy discussions in recent years have centered on how much more (or less) on the one—fiscal policy—and how much less (or more) of the other—monetary policy—is necessary for economic stability and growth. If we are to do better in the future, we must launch a serious debate that looks beyond the level and the techniques of fiscal and monetary policy. Such a debate will acknowledge the instability of our economy and inquire whether this inherent instability is amplified or attenuated by our system of institutions and policy interventions. ….

Today's economic crisis is as profound … as that of the 1930s. … There is no consensus as to what we should do. Conservatives call for freeing up the markets even as their corporate clients lobby for legislation [to] institutionalize and legitimize their market power…. [C]orporate America pays lip service to Adam Smith, while striving to sustain and legitimize the very thing that Smith abhorred—state-mandated market power.

Liberals, instead of articulating and incisive critique of our capitalism as such and pioneering innovative experimentation and change, are wedded to the past. They support minimum-wage increases without questioning whether these laws have served any real purpose since the Great Depression, when reflation was the policy objective. Liberals are unwilling to face up to the shortcomings of policies inherited from the past and are, fundamentally, timid about setting forth in new directions.

As a consequence, instead of analysis and ideas, we get slogans: free markets, economic growth, national planning, supply-side, industrial policy—imprecise phrases that face up to neither the what nor the how of policy objectives. The various programs for change are based on misconceptions of both the strengths and the weaknesses of market processes. One of the reasons for the intellectual poverty of policy proposals is that they continue to be based on ideas drawn from neoclassical theory. Although economic theory is relevant to policy (without an understanding of how our economy works we cannot find cures), for an economic theory to be relevant what happens in the world must be a possible even in the theory. On that score alone, standard economic theory is a failure; the instability so evident in our system cannot happen if the core of standard theory is to be believed.

Today's economic policy is a patchwork. Every change designed to correct some shortcoming has side effects that adversely affect some other aspect of economic and social life. Every ad hoc intervention breeds further intervention. If we wish to improve upon what we now have, we must embark upon an age of institutional and structural reforms that will check the tendencies toward instability and inflation. Standard theory, however, offers us no guidance on that score; for the problems are outside the domain of relevance of the theory. A new era of reform cannot be simply a series of piecemeal changes. Rather, a thorough, integrated approach to our economics problems must be developed; policy must range over the entire economic landscape and fit the pieces together in a consistent, workable way: Piecemeal approaches and patchwork changes will only make a bad situation worse.

Poverty in the midst of plenty and joyless affluence are but symptoms of a profound disorder [Tibor Scitovsky, The Joyless Economy (New York: Oxford University Press, 1976)]. As we have pointed out, persistent financial and economic instability is normal in our capitalist economy. The commitment to growth through private investment—combined with government transfer payments and exploding defense spending—amplifies financial instability and chronic inflation. Indeed, our problems are in part the result of how we have chosen, inadvertently and in ignorance of the consequences, to run the economy. An alternative policy strategy is needed now. We have to go back to square one — 1933 — and build a structure of policy that is based upon a modem [modern?] understanding of how our type of economy generates financial fragility, unemployment, and inflation. [pp. 319-23]

Note: whereas in Minsky's day inflation tended to be more self-grown, today's inflation tends to wander the globe accompanying unfettered capital mobility. Note further that Minsky was careful to introduce his policy 'remedies' with this caution: "Even as I warn against the handwaving that passes for much policy prescription I must warn the reader that I feel much more comfortable with my diagnosis of what ails our economy and analysis of the causes of our discontents than I do with the remedies I propose."

Gas Prices Not 'Outrageous'

On mainstream news this morning I heard our Utah Governor declare US gas prices "outrageous". Memorial Day national news coverage labeled them "sky high." Wrong! Gas prices only seem outrageous to we Americans who George W. Bush correctly noted are "addicted to oil".

Europeans, by contrast, have lived with high gas prices for years, using proceeds to fund social programs, re-build infrastructure, etc. In addition, as noted in a May 21 Senate-side Congressional hearing Exploring the Skyrocketing Price of Oil (3 hrs), Europeans used gas tax differentials to correctly steer transportation systems toward diesel and away from gasoline, which proves ever-more important now that clean diesel is available. And to steer transportation system toward mass transit and away from single-vehicle transportation. Meanwhile we Americans sat around watching TV and partying until world market forces pushed prices upward, allowing most of the recent 'surplus' to be captured as record profits, record CEO compensation, etc. by what I'll call the Petrochemical Industrial Complex. Finally, Europeans are now beginning to look toward a future free of dependence on petrochemicals and their commingled carbon-loading propensities.

Even though we Americans are just now beginning to face the reality of high gas prices, the prices themselves are not the problem. In fact "sky high" prices are finally getting us to pay attention, however feebly, to alternative sources of energy that are compatible with global climate systems and human survival. As noted in the Congressional hearing, planet Earth is not in jeopardy, rather it is we humans (along with myriad other species) who are at risk. The Earth has worked its way through five Great Extinctions in the past and arguable done remarkably well. But it is in no way clear that we humans will survive the Sixth Great Extinction. Tragically, we humans may be contributing to our collective demise by clamoring for lower gas prices.

This is not to say that all is well in petrochemical industrial complex, medical industrial complex, financial industrial complex, military industrial complex America. But that is a story for another post (or several hundred posts). In the meantime 3 hours are well-spent viewing the hearing. If you want a sneak peak, go to 2:15 in the videocast and watch Senator Charles Schumer (D-NY) in action, followed by others as the hearing winds up.

Note: cross posted at Ecological Economics

Soros: Financial Crisis Stems from Super Bubble

Like me, George Soros is no believer in "equilibrium economics". Rather he believes that sometimes we will see an equilibrium, but that it will be short-lived. Like Hyman Minsky, Soros argues that stability will itself sow the seeds of the next instability. Soros says we are in a unique place with our current crisis, experiencing both inflation and a recession at the same time. Hear/read more from Soros on today's NPR Morning Edition, Financial Crisis Stems from Super Bubble:

… Soros blames what he calls a "super-bubble" that started about 25 years ago. That's when a less-is-more philosophy became popular with economic regulators. That allowed Wall Street to invest increasing amounts of money in credit.

"The idea was that regulators always make mistakes, state interference in the markets just messes things up," Soros says. "And that was a false idea .... Regulators are human and bound to make mistakes, but markets are also human and they are also bound to make mistakes. Instead of markets always being right, they're actually always groping at trying to find out what the facts are. But they never get it right." …

Soros says there's a "super-bubble" in the economy that's bigger than just the recent housing crises, and he blames exotic financial instruments for helping cause it.

"The markets have introduced financial instruments with fancy names — CDOs and CLOs and all these strange instruments that are traded in very large volumes. And they were all constructed on the belief deviations are random.

Soros also has a new book out. Here is a snip from the introducion:

A New Paradigm for Financial Markets, Introduction, George Soros: We are in the midst of the worst financial crisis since the 1930s. In some ways it resembles other crises that have occurred in the last twenty-five years, but there is a profound difference: the current crisis marks the end of an era of credit expansion based on the dollar as the international reserve currency. The periodic crises were part of a larger boom-bust process; the current crisis is the culmination of a super-boom that has lasted for more than twenty-five years.

To understand what is going on we need a new paradigm. The currently prevailing paradigm, namely that financial markets tend towards equilibrium, is both false and misleading; our current troubles can be largely attributed to the fact that the international financial system has been developed on the basis of that paradigm.

The new paradigm I am proposing is not confined to the financial markets. It deals with the relationship between thinking and reality, and it claims that misconceptions and misinterpretations play a major role in shaping the course of history. …

Let me explain briefly how the theory of reflexivity applies to the [current] crisis. Contrary to classical economic theory, which assumes perfect knowledge, neither market participants nor the monetary and fiscal authorities can base their decisions purely on knowledge. Their misjudgments and misconceptions affect market prices, and, more importantly, market prices affect the so-called fundamentals that they are supposed to reflect. Market prices do not deviate from a theoretical equilibrium in a random manner, as the current paradigm holds. Participants' and regulators' views never correspond to the actual state of affairs; that is to say, markets never reach the equilibrium postulated by economic theory. There is a two-way reflexive connection between perception and reality which can give rise to initially self-reinforcing but eventually self-defeating boom-bust processes, or bubbles. Every bubble consists of a trend and a misconception that interact in a reflexive manner. There has been a bubble in the U.S. housing market, but the current crisis is not merely the bursting of the housing bubble. It is bigger than the periodic financial crises we have experienced in our lifetime. All those crises are part of what I call a super-bubble—a long-term reflexive process which has evolved over the last twenty-five years or so. It consists of a prevailing trend, credit expansion, and a prevailing misconception, market fundamentalism (aka laissez-faire in the nineteenth century), which holds that markets should be given free rein. The previous crises served as successful tests which reinforced the prevailing trend and the prevailing misconception. The current crisis constitutes the turning point when both the trend and the misconception have become unsustainable. …

Martin Feldstein: 'Severe Recession' Dead Ahead

US Faces Severe Recession, Yahoo News, March 14: The United States is in a recession that could be "substantially more severe" than recent ones, National Bureau of Economic Research President Martin Feldstein said on Friday.

"The situation is very bad, the situation is getting worse, and the risks are that it could get very bad," Feldstein said in a speech at the Futures Industry Association meeting in Boca Raton, Florida.

"There's no doubt that this year and next year are going to be very difficult years." …

Don't Trust 'The Press'

Dean Baker tells us that we ought not trust the media. In this case it's because they seem to have bought into the 'economy is sound' story for too long, missing the housing and stock bubbles and instead cheering on the ongoing American-led consumption party. On that latter note, Robert Reich tells us that the party is over—the American consumer is tapped out. Worse, the power brokers (including the media) don't yet see it:

The US economy, Pravda style, Dean Baker, The Guardian, Jan 28: … Just as the Soviet press [in the bad old 'cold war' days] wanted the public to trust the wisdom of the party bosses, … pillars of the [American] elite media want the public to believe that the experts who are the insiders on the decision-making process in Washington are uniquely qualified to craft policy. …

Misunderstanding the economy's weakness earlier this month is trivial compared to the much more grandiose mistake of failing to recognize the $8 trillion housing bubble, or before that, a $10 trillion stock bubble. If performance mattered, then the experts who got things so hugely wrong would no longer be the ones shaping public policy. Instead, with the Washington Post style beautification process, experts can jump from policy disaster to policy disaster and never have their failures affect their standing.

If we are ever to have an open debate on economics, or any other area of public policy, we will need media that honestly discuss policy failures and that hold those in charge accountable. In the current situation, the economic disaster facing the economy was entirely preventable, but the Federal Reserve and the rest of the inside crew were either too incompetent to recognize the housing bubble or felt the short-term benefits outweighed the costs that the country would inevitably face when the bubble burst. … [Most] major news outlets chose to hide any serious debate on the problems posed by the bubble on the way up, and they would like to prevent any discussion of this massive policy failure even in retrospect.


The Real Recession Problem: Consumers Are at the End of Their Ropes, Robert Reich, Jan. 28: … [Business tax breaks exemplify] the illogic of what’s called supply-side economics. If you reduce the cost of investing, so the thinking goes, you’ll get more investment. What’s left out is the demand side of the equation. Without consumers who want to buy a product, there's no point in making it, regardless of how many tax breaks go into it.

Which gets us to the real problem. Most consumers are at the end of their ropes and can't buy more. Real incomes are no higher than they were in 2000, while food and energy and health care costs are all rising faster than inflation. And home values are dropping, which means an end to home equity loans and refinancing.

Most of what's being earned in America is going to the richest 5 percent, but the rich devote a smaller percent of their earnings to buying things than the rest of us because, after all, they’re rich — which means they already have most of what they want. Instead of buying, the rich invest most of their earnings wherever around the world they can get the highest return.

Add all this together and there's just not enough consumer demand out there to keep the American economy going. We're finally reaping the whirlwind of widening inequality and ever more concentrated wealth. Supply-siders who want to cut taxes on corporations and the rich just don’t get it. Neither does most of official Washington.

Politics of an Economic Nightmare

I have to pass along:

The Politics of an Economic Nightmare, Robert Reich, Jan. 22: A possible economic meltdown is worrisome enough, but a possible meltdown in an election year is downright frightening. For months now, Republicans have been pushing the White House to take some action that looked and sounded big enough to give them some cover if and when things got worse. President Bush has now responded with a stimulus package more than twice as large as the one Bill Clinton briefly entertained at the start of 1993 but couldn't get passed.

Not to be outdone, Democrats want to appear at least as bold, which means they'll suspend pay-go rules and throw fiscal responsibility out the window. In other words, hold your noses, because the "bipartisan" stimulus package that's about to be introduced could be a real stinker, including tax cuts for everyone and everything under the sun -- except, perhaps, for the key group of lower-income Americans. …

Meanwhile, Fed chairman Ben Bernanke and Co. have surprised everyone with a rate cut larger and sooner than expected. The three-quarters of a percentage point ("75 basis points" in biz-speak) cut announced Tuesday morning may not sound like much, but it's bigger than any rate cut in decades. The politics here are more subtle because Bernanke and his Federal Reserve governors are supposed to be independent of politics. … Expect lots and lots more Washington activity -- enough seemingly bold strokes to convince voters that our nation's capital is doing whatever is necessary to stop whatever seems to be going wrong with the economy.

The problem is, people have different views about what's going wrong. Wall Street sees it as a credit crisis -- a mess that seems never to reach bottom because nobody on Wall Street has any idea how many bad loans are out there. Therefore, nobody knows how big the losses are likely to be when the bottom is finally reached. And precisely because nobody knows, nobody wants to lend any more money. A rate cut won't change this. It's like offering a 10-pound lobster to someone so constipated he can't take in another mouthful.

Main Street sees it as a housing crisis. As I've noted, homes are the biggest assets Americans own -- their golden geese for retirement and their piggy banks for home equity loans and refinancing. But home prices have been dropping quickly. It's the first time this has happened in many decades -- beyond the memories of most Americans, which is why they never expected it to happen, why they bought houses so readily when credit was so easily available, and why so many people bought two or more of them, speculating and fixing up and then flipping. But now several million Americans may lose their homes, and tens of millions more have only their credit cards to live on and are reaching the outer limits of what they can spend. As consumer spending shrinks, companies will reduce production and cut payrolls. That has already begun to happen. It's called recession.

How much worse can it get? As I said before, the housing bubble drove home prices up 20 to 40 percent above historic averages relative to earnings and rents. So now that the bubble is bursting, you can expect prices to drop by roughly the same amount, and new home construction to contract. The latter plunged last month to its lowest point in more than 16 years. A managing partner of a large Wall Street financial house told me a few days ago the scenario could get much worse. He gave a 20 percent chance of a depression.

Even if a stimulus package were precisely targeted to consumers most likely to spend any money they received, the housing slump could overwhelm it. …

In reality, the crisis is both a credit crunch and the bursting of the housing bubble. Wall Street is in terrible shape and Main Street is about to be in terrible shape. And there's not a whole lot that can be done about either of these problems -- because they are the results of years of lax credit standards, get-rich-quick schemes, wild speculation on Wall Street and in the housing market, and gross irresponsibility by the Fed, the Treasury and the Comptroller of the Currency.

As a practical matter, our only real hope for avoiding a deep recession or worse depends on loans and investments from abroad -- some major U.S. financial firms have already gotten key cash infusions from foreign governments buying stakes in them -- combined with export earnings as the dollar continues to weaken. But this is something no politician wants to admit, especially in an election year. …

Meanwhile Paul Krugman opines that the recession is likely to be deep and long. And, the Fed may not have enough ammunition to properly play out its role. He hints that a Japan-style Liquidity Trap may await us. Finally, Krugman remembers Greenspan's 2001 surprise inter-meeting rate cut:

On January 3, 2001 the Greenspan Fed announced a surprise, inter-meeting rate cut (50 basis points, compared with 75 yesterday.)

The markets went wild with joy. The Nasdaq rose 14 percent that day.

It didn’t last.

Jim Cramer's Rant: 'Fiction in Financials'

Normally I'm not one to recommend financial madman Jim Cramer's rants. But I'll make an exception today for: Cramer Rages on Banks: 'Where's the SEC?!'. The video feed (embedded in the CNBC post) is well-worth a few minutes of your time, even to endure a short ad at the beginning. The CNBC post begins, "Why isn't the Securities and Exchange Commission getting more involved in the whole banking sector writedown situation? Especially since the numbers are likely to get worse, not better? That's what Jim Cramer, CNBC's resident stock guru, wants to know." Then continues:

… "It's all fiction!" [Cramer] declared during a forceful exchange ….

"How can we have these levels of fiction in financials after Sarbanes-Oxley? How do people get away with this? How do they live with themselves?"

Cramer made his comments while reviewing results from Merrill. But his real consternation surrounded the insurers who cover banking investments. Some of those insurers haven't come clean about their liabilities, Cramer speculated. Eventually they will, and then the "fiction" will disappear, he said.

The banking sector and its related industries are all too chummy, Cramer accused. That led the numbers related to mortgage investments -- investments that are currently souring -- to break from reality.

"I think the financial guys all belong to the same club and they got to protect each other," he said.

Worse, those executives behind the current credit crunch are unlikely to get any punishment for their mistakes and disingenuousness about their numbers, Cramer opined.

"I'm fed up with it. The American people should be fed up with it. And the SEC should be fed up with it," Cramer said.

"This is what the SEC is supposed to protect us from," he added. …

P.S. Cramer takes aim too at so-called "mortgage insurers".

Hat Tip: Paul Kedrosky, Infectious Greed.

Banking Gone Bad: 'Privatizing gains and Socializing Losses'

Yves Smith at Naked Capitalism is one of the very best economic bloggers. He keeps the rest of us up to date on a daily basis. Today, I'm impressed with this particular find/commentary (snipped, in part):

Why banking is an accident waiting to happen", Nov28: Martin Wolf, the well respected lead economics editor of the Financial Times, turns to a favorite topic: why banks regularly get themselves in trouble. His answer: it's "a risk-loving industry guaranteed as a public utility." Privatizing gains and socializing losses, particularly if the employees share in that arrangement, is a formula for reckless behavior.

Wolf takes note of the persistent high profitability of the banking industry, in return on equity terms, and attributes it to formal and informal public guarantees (they allow banks to borrow more cheaply than otherwise) and undercapitalization relative to the risks assumed. But there is another way to look at bankings' relative profitability. Remember, ultimately, the banking industry provides services to the productive economy and individuals and extracts fees for those services. Its high profits represent a wealth transfer from the productive sector to what ought to be a support function.

Wolf briefly reviews some possible remedies …

Banks are wards of the state. The sooner the powers that be recognize that and treat them accordingly, the better off the rest of us will be.

From the Financial Times:

Why does banking generate such turmoil, with the crisis over securitised lending the latest example? Why is the industry so profitable? Why are the people it employs so well paid? The answer to these three questions is the same: banking takes high risks. But the public sector subsidises this risk-taking. It does so because banks provide a utility. What the banks give in return, however, is gung-ho speculation. …

Governments are not totally stupid. They guarantee banks because the latter provide a social utility: a safe haven for money, and a payment system. But governments also realise that they are providing incentives for banks to economise on capital and take on risk. So governments impose capital-adequacy ratios, rules on risk management and (if they are sensible) liquidity requirements, as well. Unfortunately, these institutions are not only complex, but are staffed by single-minded and talented people. They go round regulations, just as water flows round an obstruction.

The result of this ingenuity includes “special purpose vehicles”, hedge funds and even, in some respects, private equity funds. These are all, in varying ways, off-balance-sheet banks: ways to exploit the exceptionally profitable opportunities (and corresponding risks) created by high leverage and maturity transformation. Securitisation, to take a salient example, is a clever way to shift what would once have been bank loans on to the books of these quasi-banks, with the consequences we all now see. …

So what we have is a risk-loving industry guaranteed as a public utility. One result has been insufficient capital. That permits splendid returns in good times. But the capital may well prove inadequate in bad ones. The loss of capital could well lead to a tightening of credit in the years ahead.

If so, the structure and regulation of banking might have to be reconsidered, again. One possibility would be higher capital requirements. This would lower peak returns and so reduce the chances of subsequent negative returns. Mr Smithers and Prof Wood suggest a 40 per cent increase in capital for the UK. Other possibilities are measures to make regulation easier: narrow banking is an old favourite, although hard to make work. Henry Kaufman, a highly experienced observer of credit markets, suggests intense scrutiny of banks deemed “too big to fail”.

What seems increasingly clear is that the combination of generous government guarantees with rampant profit-making in inadequately capitalised institutions is an accident waiting to happen – again and again and again. Either the banking industry should be treated as a utility, with regulated returns, or it should be viewed as a profit-seeking industry that operates in accordance with the laws of the market, including, if necessary, mass bankruptcies. Since we cannot accept the latter, I suspect we will be forced to move towards the former. Little can be done now. But when the recovery begins, we must impose higher capital requirements.

A way out of the Mess? Martin Wolf opines

It's nice to see Financial Times columnist Martin Wolf championing works from the Levy Institute, i.e. Wynne Godley and others, The US Economy: Is There a Way Out of the Woods? Nov 2007, [PDF] . I'm a big fan of the Levy Institue's work, and have frequently pitched their policy briefs, reports, and working papers here. Wolf:

Who will pick up the thread after the great unwinding?, Martin Wolf, FT.com, Nov 20: … A plausible view of the future, then, is that the US will experience a lengthy period of sluggish growth in domestic private demand, partially offset by fiscal expansion and an improvement in net exports. It is via the latter effect, moreover, that monetary policy should have its principal impact, since households are unlikely to borrow much more while their houses decline in value.

This is the great unwinding. So what does it mean for the rest of the world? It means that the rest of the world will adjust either by increasing demand, relative to potential supply, or by reducing its supply relative to demand. The former adjustment is clearly the more desirable.

Will it happen? The good news is that the build-up of foreign currency reserves and accompanying desire to prevent currency appreciation, by keeping interest rates down, are themselves expansionary. The resulting “overheating” is part of the solution, not part of the problem. If this overheating becomes bad enough, governments may allow still faster currency appreciations: perhaps even the Chinese will finally realise the error of their interventionist ways.

The great unwinding is a turning-point for the world economy. The rest of the world — and the emerging markets in particular — must now become the demand engines of the world economy. Will they do so? This is the big macroeconomic question to be answered over the next few years. …

Who Gets It: Charles Hugh Smith Edition

Charles Hugh Smith seems to be someone who "gets it". At least his recent expose of The Rot Within tells me that he, like Jim Kunstler, does indeed understand the plight of our US-lead, consumption-at-all-costs, nature-be-damned so-called economy. Here is Smith:

The Rot Within, Charles Hugh Smith, Sept. 17: … We as a society and as an economy are the frog in the pot, [never] noticing the bubbles of near-boiling water forming beneath our feet [until it is too late].

In no particular order, here is my short listing of The Rot Within, systemic sources of rot which have eroded the entire structure of our society and economy to the point of structural failure. I will be exploring these issues in upcoming entries.

1. Infrastructure: broken. Air traffic control system: broken. 160,000 bridges: obsolete, defective, or worse. …

2. Legal system: broken. Big homebuilders hide defects galore behind "binding arbitration" clauses, bankruptcy favors the banks which continue offering credit to the uncreditworthy, consumer protection is under assault, public health and safety agencies are grossly underfunded, ….

Yes, we live in a legal system based on advocacy and contention. But with one million lawyers and counting, how much of the horrendously costly advocacy ends up becoming a hidden and essentially unproductive tax on productive resources? How much is spent protecting the 300 million citizens and safeguarding the 145 million taxpayers from fraud and waste? Put simply: how much is a huge waste of money? Answer: Most of it. The system is broken.

3. Lobbyists own Washington. An old story, blah blah blah, money is the mother's milk of politics, etc. But how about the fact that there were 11,000 lobbyists in 1997, and now there are 33,000? How about the fact that corporations can "earn" $344 in Federal "earmarks" (i.e. pork-barrel spending) for every $1 "invested" in a lobbyist? Democracy: broken.

4. Deficit spending: broken. As this administration has added trillions in debt onto the backs of future generations, they have the unmitigated gall to trumpet a Federal budget deficit of "only" $$177 billion, down from $413 billion a few years ago. But this is based on bubblicious profits (and therefore taxes) flowing from the real estate and stock market bubbles, and includes the slight-of-hand accounting which applies the Social Security surplus to the entire Federal Budget.

Social Security is supposedly a Trust Fund which retains surpluses to be used in years when outlays exceed FICA tax collections. But instead, these massive surpluses are used to offset non-Social Security Federal spending. If you look closely at the budget and projections for Medicare and Social Security entitlements due to rise in the near future, there is only one conclusion: Federal borrowing and spending: broken.

5. Public pensions: broken. As public pension managers flocked to the higher returns offered by hedge funds, CDOs and other "exotic" investments based on derivatives and leverage, they have dug their own graves. Most public pension funds are set to suffer stupendous losses in capital when the entire derivatives/easy-credit/no-risk speculative bubble pops.

6. Government as savior: broken. From the billions wasted on post-Katrina aid (pixture hundreds of empty mobile homes sitting in an empty field), to the bail-outs being proposed for housing bubble gamblers/speculators, it's all about Uncle Sam borrowing hundreds of billions of dollars to bail out private parties.

7. Foreign policy: broken. Fill in the blanks, folks.

8. Energy Policy: broken. We don't have one, except "drill Alaska--that'll give us another month of oil, dammit!" This simple math leads to astounding totals: the U..S. uses 23 million barrels of oil a day. That's 8.4 billion barrels a year. A two-billion barrel oil find is perhaps 50% recoverable, meaning about 1 billion barrels can be extracted. That 1 billion barrels will cover about 6 weeks of America's oil consumption--but it will take at least a decade to drill, extract, refine and deliver to consumers.

9. Accounting: broken. This week we will witness the big investment banking houses release their earnings reports, and virtually everyone who knows anything knows the reports will be filled with what are essentially self-serving lies: assets which are not fairly priced because they are not required to be marked-to-market by third parties. This is modern-day accounting in the U.S. of A.: off-balance sheet assets, marked-to-model, and various other accounting tricks and prevarications.

10. Bureaucracies: broken. Medicare: $9,000 CAT scans, a week of "care" costs $100,000, and your elderly parent exits without even being healed. Welcome to Medicare and our "best of the best" medical system. The Pentagon, FEMA, your local school district, your state housing office, your local building department, the list is (in too many places) nearly endless. Yes, there are a few bright spots, but in general: bloated, inefficient, unresponsive, broken.

11. The Media: mostly broken. Celebrity-focused, backward-looking, advertising-dependent, largely in thrall to powerful interests whose chief concern is maintaining the status-quo (i.e. their power).

12. Technology: oversold. Beneath the razz-matazz press releases and the hype, most of the new, wonderfully-marketed technology (iPods, smart phones, Web2.0, social networks, etc.) is either unproductive time-sinks (a.k.a. "entertainment"), unreliable, or fundamentally a toy for kids with too much time on their hands.

13. Our "health"-care system (in actuality our sick-care system): broken. Unaffordable now, inevitably metastasizing into an unaffordability which bankrupts the nation.

14.Government statistics: broken. Unemployment stats: lies. Inflation numbers; Lies. Budget numbers: lies. Call them misleading or manipulated if you prefer, but I'll stick to the raw simplicity of calling them knowing lies, carefully engineered to pull the wool over the eyes of a fatuous, want-to-believe-fantasy public and mainstream media.

15. Our health and food consumption: nearly broken. Over a hundred million prescriptions written for psychotropic drugs--hmm, if we're so happy and well-adjusted and spiritually whole, then why are we driven to buy billions of dollars of illegal drugs and pop hundreds of millions of "feel good/fix me" pills? If our healthcare system is so great, and our food so wonderful, why are 2/3 of us obese to point of dangerous consequences, and so many of us unable to sleep well or run around the block even once? If we're so healthy, why do we look like Heck warmed over?

16. The culture: completely broken. Greed, self-absorption, self-as-what-do-I wear-consume-drive, mega-churches promoting wealth, bakeries for dogs, victimhood as saintliness, I-want-my-15 seconds-of-fame-now-on-national-TV, entitlements, working 20 years on the public payroll in order to nail down 40 years of fat retirement checks, violence glorified 24/7, hype and marketing-as-reality, Fox and CNBC cheerleading shameless propaganda, "reality" TV--in sum, a culture so twisted, dysfunctional and ill that self-parody has been rendered impossible.

How Capitalism is Killing Democracy

Robert Riech reminds us of our responsibilities as citizens in a democracy relative to our roles as participants in a market economy. We seem to have forgotten (aided by Madison Ave. spinmeisters) that we have responsibilities to keep democratic traditions strong and to keep market (and political) mechanisms from running amok. Here is an excerpt (Hat Tip: Mark Thoma):

How Capitalism Is Killing Democracy, by Robert B. Reich, Foreign Policy (free w/reg.): Free markets were supposed to lead to free societies. Instead, today's supercharged global economy is eroding the power of the people in democracies around the globe. Welcome to a world where … government takes a back seat to big business. …

Conventional wisdom holds that where either capitalism or democracy flourishes, the other must soon follow. Yet today, their fortunes are beginning to diverge. Capitalism … is thriving, while democracy is struggling to keep up. China … has embraced market freedom, but not political freedom. Many economically successful nations-from Russia to Mexico-are democracies in name only. They are encumbered by the same problems that have hobbled American democracy in recent years, allowing corporations and elites … to undermine the government's capacity to respond to citizens' concerns. …

[T]hough free markets have brought unprecedented prosperity to many, they have been accompanied by widening inequalities…, heightened job insecurity, and environmental hazards such as global warming. Democracy is designed to allow citizens to address these very issues in constructive ways. And yet a sense of political powerlessness is on the rise among citizens in Europe, Japan, and the United States…. In short, no democratic nation is effectively coping with capitalism's negative side effects.

This fact is not, however, a failing of capitalism. … Capitalism's role is to increase the economic pie, nothing more. … Democracy, at its best, enables citizens to debate collectively how the slices of the pie should be divided and to determine which rules apply to private goods and which to public goods. Today, those tasks are increasingly being left to the market. What is desperately needed is a clear delineation of the boundary between global capitalism and democracy-between the economic game, on the one hand, and how its rules are set, on the other. If the purpose of capitalism is to allow corporations to play the market as aggressively as possible, the challenge for citizens is to stop these economic entities from being the authors of the rules by which we live. …

[C]itizens living in democratic … have the ability to alter the rules of the game so that the cost to society need not be so great. And yet, we've increasingly left those responsibilities to the private sector-to the companies themselves and their squadrons of lobbyists and public-relations experts-pretending as if some inherent morality or corporate good citizenship will compel them to look out for the greater good. … We forget that they are simply duty bound to protect the bottom line. …

Why has capitalism succeeded while democracy has steadily weakened? Democracy has become enfeebled largely because companies, in intensifying competition for global consumers and investors, have invested ever greater sums in lobbying, public relations, and even bribes and kickbacks, seeking laws that give them a competitive advantage over their rivals. The result is an arms race for political influence that is drowning out the voices of average citizens. … The only way for the citizens in us to trump the consumers in us is through laws and rules that make our purchases and investments social choices as well as personal ones. …

Let us be clear: The purpose of democracy is to accomplish ends we cannot achieve as individuals. But democracy cannot fulfill this role when companies use politics to advance or maintain their competitive standing, or when they appear to take on social responsibilities that they have no real capacity or authority to fulfill. That leaves societies unable to address the tradeoffs between economic growth and social problems such as job insecurity, widening inequality, and climate change. As a result, consumer and investor interests almost invariably trump common concerns. …

[F]or those of us living in democracies, it is imperative to remember that we are also citizens who have it in our power to reduce these social costs, making the true price of the goods and services we purchase as low as possible. We can accomplish this larger feat only if we take our roles as citizens seriously. The first step, which is often the hardest, is to get our thinking straight.

Financial Fundamentalism: Fifteen Fatal Fallacies

Today, as a last volley (maybe?) in the Neoclassical Economics Mafia debate, Max Sawicky points us to William Vickrey's Fifteen Fatal Fallacies of Financial Fundamentalism, 10/5/96. Sawicky notes that

Vickrey was thoroughly 'neo-classical', as mathed-up as anybody else for his time, acclaimed all around for his work. Nobel prize winner, president of the American Economic Association. He asserted that a basic theory in macroeconomics going to a fundamental public issue was not merely wrong, but "vicious."

Here are Vickrey's 'fifteen' in short form. As you read through them, ask youself: Which do you agree (disagree) with? Then read Vickrey's note. Then voice any dissent or confirmation, and we can talk about it

To Vickrey's Fifteen Financial Fallacies:

Much of the conventional economic wisdom prevailing in financial circles, largely subscribed to as a basis for governmental policy, and widely accepted by the media and the public, is based on incomplete analysis, contrafactual assumptions, and false analogy. …

Some of the fallacies that result from such modes of thought are as follows. … And should the implied policies be fully carried out in terms of a "balanced budget," we could well be in for a serious depression.

• Fallacy 1: Deficits are considered to represent sinful profligate spending at the expense of future generations who will be left with a smaller endowment of invested capital. This fallacy seems to stem from a false analogy to borrowing by individuals. …
• Fallacy 2: Urging or providing incentives for individuals to try to save more is said to stimulate investment and economic growth. This seems to derive from an assumption of an unchanged aggregate output so that what is not used for consumption will necessarily and automatically be devoted to capital formation. …
• Fallacy 3: Government borrowing … "crowd[s] out" private investment. …
• Fallacy 4: Inflation is … the "cruelest tax." The perception seems to be that if only prices would stop rising, one's income would go further, disregarding the consequences for income. …
• Fallacy 5: "A chronic trend towards inflation is a reflection of living beyond our means." …
• Fallacy 6: It is … to keep unemployment at a "non-inflation-accelerating" level ("NIARU") in the range of 4% to 6% if inflation is to be kept from increasing unacceptably. …
• Fallacy 7: …[I]f only governments would stop meddling, and balance their budgets, free capital markets would in their own good time bring about prosperity, possibly with the aid of "sound" monetary policy. It is assumed that there is a market mechanism by which interest rates adjust promptly and automatically to equate planned saving and investment in a manner analogous to the market by which the price of potatoes balances supply and demand. In reality no such market mechanism exists; if a prosperous equilibrium is to be achieved it will require deliberate intervention on the part of monetary authorities…
• Fallacy 8: If deficits continue, the debt service would eventually swamp the fisc. [That is,] … debt service would absorb the entire income tax revenue, or confidence is lost in the ability or willingness of the government to levy the required taxes so that bonds cannot be marketed on reasonable terms ….
• Fallacy 9: The negative effect of considering the overhanging burden of the increased debt would … cancel the stimulative effect of the deficit. …
• Fallacy 10: The value of the national currency in terms of foreign exchange (or gold) is held to be a measure of economic health, and steps to maintain that value are thought to contribute to this health. …
• Fallacy 11: …[E]xemption of capital gains from income tax will promote investment and growth. …
• Fallacy 12: Debt … [will] eventually reach levels that cause lenders to balk with taxpayers threatening rebellion and default. …
• Fallacy 13: Authorizing income-generating budget deficits results in larger and possibly more extravagant, wasteful and oppressive government expenditures. …
• Fallacy 14: Government debt is … a burden handed on from one generation to its children and grandchildren. …
• Fallacy 15: Unemployment is not due to lack of effective demand, reducible by demand-increasing deficits, but is either "structural," resulting from a mismatch between the skills of the unemployed and the requirements of jobs, or "regulatory", resulting from minimum wage laws, restrictions on the employment of classes of individuals in certain occupations, requirements for medical coverage, or burdensome dismissal constraints, or is "voluntary," in part the result of excessively generous and poorly designed social insurance and relief provisions. …

Marx and Engels' Insights into Globalization

Today while looking for scraps of evidence to finish my income taxes, I stumbled into a copy of Marx and Engels' The Communist Manifesto, written in 1848. Some time back I must have dropped the little book into a basket in a corner. As I will do just about anything to avoid dealing with taxes, I re-read it. What amazed me was the parallels Marx and Engels (and others?) drew between the mid 1800s and today's globalization.

To illustrate, let's condense a bit of Chapter I, "Bourgeois and Proletarians". In addition to condensing, I will embed a few notes to highlight particular points of similarity that I find noteworthy. For those who don't know, I'm drawn to post-Keynsian thought. Still, I find the Marx and Engels' circumstantial descriptions of mid-century 1800s too compellingly similar to what we are seeing today to not share their view with you. At the end I point to some books that may help others see why "free market" capitialsim isn't the end-all, be-all some make it out to be. Marx and Engels:

[Bourgeois and Proletarians:] The history of all hitherto existing society is the history of class struggles. … Our epoch [and continuing until today], the epoch of the bourgeoisie, possesses … this distinctive feature: It has simplified the class antagonisms. Society as a whole is more and more splitting up into two great hostile camps, directly facing each other—bourgeoise [ruling classes under capitalism] and proletariat [the working classes]. …

Modern industry has established the world market, for which the discovery of America [and most recently the opening of China and India] paved the way. This market has given an immense development to commerce, to navigation, to communication [or has been aided an abetted by such immense developments,. Which comes first, chicken or egg?]. … [I]n proportion as industry [and] commerce extended, in the same proportion the bourgeoisie developed, increased its capital, and pushed in the background every class handed down form the Middle Ages. …

Each step in the development of the bourgeoisie was accompanied by a corresponding political advantage of that class. [Remember Warren Buffet's 2004 remark, "If class warfare is being waged in America, my class is winning."] [T]he bourgeoisie has at last … conqured for itself … exclusive political sway. …

The bourgeoisie, wherever it has got the upper hand, has put an end to all feudal, patriarchal, idyllic relations. It has pitilessly torn asunder the motley feudal ties that bound men to his "natural superiors." and has left no other bond between man and man than naked self interest, than callous "cash payment." It has drowned the most heavenly ecstasies of religious fervor, of chivalrous enthusiasm, of philistine sentimentalism, in the icy water of egotistical calculation. It has resolved personal worth into exchange value. And in place of the numberless indefeasible chartered freedoms, has set up that single, unconscionable freedom—Free Trade. In one word, for exploitation, veiled by religious and political illusions, it has substituted naked, shameless, direct, brutal exploitation.

The bourgeoisie has stripped of its halo every occupation hitherto honored and looked up to with reverent awe. It has converted the physician, the lawyer, the priest, the poet, the man of science, into its paid wage-laborers.

The bourgeoisie has torn away from the family its sentimental veil, and has reduced the family relation to a mere money relation. [For a modern-day version see, e.g. Gary Becker's "household production function" and related literature. For a contemporary view similar to that of Marx and Engel's see, e.g. economic imperialism] …

Constant revolutionizing of production, uninterrupted disturbance of all social conditions, everlasting uncertainty and agitation distinguish the bourgeois epoch from all earlier ones. All fixed, fast-frozen relations, with their train of ancient and venerable prejudices and opinions, are swept away, all new-formed ones become antiquated before they can ossify. All that is solid melts into air, all the is holy is profaned, and man is at last compelled to face with sober senses his real conditions of life and his relations with his kind [now when all is reified into "commodity"].

The need of a constantly expanding market for its products chases the bourgeoisie over the whole surface of the globe. It must nestle everywhere, settle everywhere, establishes connections everywhere.

The bourgeoisie has through its exploitation of the world markets given a cosmopolitan character to production and consumption in every country. To the great chagrin of Reactionists, it has drawn from under the feet of industry the national ground on which it stood. All old-established national industries have been destroyed or are daily being destroyed. They are dislodged by new industries, whose introduction becomes a life and death question for all civilised nations, by industries that no longer work up indigenous raw material, but raw material drawn from the remotest zones; industries whose products are consumed, not only at home, but in every quarter of the globe. In place of the old wants, satisfied by the production of the country, we find new wants, requiring for their satisfaction the products of distant lands and climes. In place of the old local and national seclusion and self-sufficiency, we have intercourse in every direction, universal inter-dependence of nations. And as in material, so also in intellectual production. The intellectual creations of individual nations become common property. National one-sidedness and narrow-mindedness become more and more impossible, and from the numerous national and local literatures, there arises a world literature.

The bourgeoisie, by the rapid improvement of all instruments of production, by the immensely facilitated means of communication, draws all, even the most barbarian, nations into civilisation. The cheap prices of commodities are the heavy artillery with which it batters down all Chinese walls, with which it forces the barbarians’ intensely obstinate hatred of foreigners to capitulate. It compels all nations, on pain of extinction, to adopt the bourgeois mode of production; it compels them to introduce what it calls civilisation into their midst, i.e., to become bourgeois themselves. In one word, it creates a world after its own image.

The bourgeoisie has subjected the country to the rule of the towns. It has created enormous cities, has greatly increased the urban population as compared with the rural….

The bourgeoisie keeps more and more doing away with the scattered state of the population, of the means of production, and of property. It has agglomerated population, centralised the means of production, and has concentrated property in a few hands. The necessary consequence of this was political centralisation. Independent, or but loosely connected provinces, with separate interests, laws, governments, and systems of taxation, became lumped together into one nation, with one government, one code of laws, one national class-interest, one frontier, and one customs-tariff. ….

… Modern bourgeois society, with its relations of production, of exchange and of property, a society that has conjured up such gigantic means of production and of exchange, is like the sorcerer who is no longer able to control the powers of the nether world whom he has called up by his spells. … [Rendering an] epidemic of over-production. … The conditions of bourgeois society are too narrow to comprise the wealth created by them. And how does the bourgeoisie get over these crises? On the one hand by enforced destruction of a mass of productive forces; on the other, by the conquest of new markets, and by the more thorough exploitation of the old ones. That is to say, by paving the way for more extensive and more destructive crises, and by diminishing the means whereby crises are prevented. …

Why was The Communist Manifesto kicking around my house? Years ago, my good friend and then co-worker Hank was finishing his PhD in Economics at the University of Utah, curiously then and now a hot-bed of Marxian thought. [Note: It proves curious the the U of U Econ Department leans left, since Utah is a bright red Republican stronghold.]

Hank and I used to spend many an hour debating economics, me from my Milton Friedman-influenced libertarian perspective, and Hank from a Marx/Engels' leftest perspective. Hank has since moved, as he says, "from Marx to Mastercard", and is now comfortably running a growing business. I, on the other hand, and in large part due to Hank's insights, have moved considerably in the direction of what might be called the "new left" despite the political incorrectness of the label.

Here are some of my favorite books — that some argue lean "left of center" as well. They have proved their worth to me in helping figure out where we might go from here, faced with similar conditions to those Marx and Engels saw long ago. Coincidentally these books help debunk today's round of "free market fundamentalism" that seems too pervasive these days.

Deborah Stone. 2002. Policy Paradox: The Art of Political Decision Making (revised edition).
Margaret Jane Radin. 1996. Contested Commodities
Thomas Prugh. 1995. Natural Capital and Human Economic Survival
James G. March. 1994. A Primer on Decision Making: How Decisions Happen
Elizabeth Anderson. 1993. Value in Ethics and Economics
Andrew Bard Schmookler. 1993. The Illusion of Choice: How the Market Economy Shapes Our Destiny
Herman E. Daly and John B. Cobb. 1989. For the Common Good
Robert L. Heilbroner. 1988. Behind the Veil of Economics
Mark Sagoff. 1988. The Economy of the Earth: Philosophy, Law and the Environment
Andrew Sayer. 1984. Method in Social Science: A Realist Approach
E.F. Schumacher. 1977. A Guide for the Perplexed
E.F. Schumacher. 1973. Small is Beautiful: Economics as if People Mattered

If these books don't shed light on where we might go next, maybe I'll once again have to retreat to the desperation of Kurt Vonnegut Jr.'s Player Piano saga. I found Vonnegut's books helpful, long ago, to counteract the propaganda I was getting from business school when studying or my MBA. But that is a story for another time/place.

Financial Armageddon: The Blog

Late last year Michael Panzner unveiled Financial Armageddon as a blog to compliment his latest book. Here are a few highlights:

Prepare for Repricing, [1/29/2007]: In "Prepare for Asset Repricing, Warns Trichet," the Financial Times' Gillian Tett describes what seems to be a quickening sense of alarm among some policymakers.

Current conditions in global financial markets look potentially "unstable", suggesting that investors need to prepare themselves for a significant "repricing" of some assets, Jean-Claude Trichet, president of the European Central Bank, warned at the weekend in Davos.

The recent explosion of structured financial products and derivatives had made it more difficult for regulators and investors to judge the current risks in the financial system, Mr Trichet said.

"We are currently seeing elements in global financial markets which are not necessarily stable," he said, pointing to the "low level of rates, spreads and risk premiums" as factors that could trigger a repricing.

"There is now such creativity of new and very sophisticated financial instruments … that we don't know fully where the risks are located," he added. "We are trying to understand what is going on — but it is a big, big challenge."…

Malcolm Knight, managing director of the Bank for International Settlements, said: "Financial innovation has produced vehicles for leverage which are very hard to measure … liquidity is increasing very rapidly and this is affecting asset prices."

Central banks were scrambling to address the problem by intensifying their joint discussions via forums linked to the BIS, he said, but he warned that international co-operation and data gathering efforts "need to be deepened".

A few have even started voicing once unthinkable concerns about who will clean up the mess if and when policymakers' worst fears are realized. …

Unknowable and Uncontrollable, [1/15/2007]: Proponents argue that the benefits of derivatives far outweigh the dangers. In particular, these synthetic securities allow risks to be transferred from those who don't want them to those who do. In their view, such activity makes the financial system healthier and more resistant to shocks.

However, this perspective fails to take account of at least some current realities. Turnover and open interest outstanding have expanded at a mind-boggling rate, making it difficult for anyone, let alone regulators and policymakers, to gain a solid handle on what is going on. Moreover, much of the activity is centered in lightly regulated over-the-counter markets, and increasingly involves instruments that are breath-taking in their complexity. …

"The Stability of the World Financial System May Be More Apparent than Real", [12/26/2006]: Nowadays, optimists pooh-pooh the notion that the failure of a major global financial operator could easily trigger a far-reaching systemic crisis because those in charge have plans in place to deal with such an event. They argue that when circumstances call for level-headed leadership, clarity of purpose, and seamless cooperation between regulators and policymakers, someone will quickly grab the baton and step in resolve the situation — just as the New York Fed President did when he orchestrated a bailout of failed hedge fund LTCM back in 1998.

Perhaps.

Then again, when it comes to the realities of modern global finance, maybe things are different this time …

… Roche's conclusion is that this essentially leaves central bankers increasingly powerless to control liquidity — meaning that not only are they unable to prick the current credit bubble, but will be equally impotent to combat its future collapse.

Financial Armageddon looks to be "one more blog" to watch closely.

As soon as I finish reading the latest edition of Charles Kindelberger's classic Manias, Panics and Crashes: A History of Financial Crises, and take one more look at Peter Bernstein's Against the Gods: The Remarkable Story of Risk, I'll tackle Panzner's book Financial Armageddon. More on all three, later.

PS. Don't expect too much blogging from me in the the next couple of weeks. I'm going on the road (for work) and will be spending evenings with books.

Love the Deficit or Fear the Deficit?

In his latest Credit Bubble Bulletin, Doug Noland counters Bear Stearns' David MalPass's recent, optimistic Wall Street Journal article "Embrace the Deficit." Here's a sampler:

Credit Bubble Bulletin, Doug Noland 122706: …Financial historians will reflect back on this period’s prevailing complacency, especially with respect to the massive U.S. Trade and Current Account Deficits, with astonishment and disbelief. Yet for now years of Credit and asset inflation — parceling out unimaginable financial rewards along the way — have Wall Street reassured that There's Simply Not an Imbalance Not to Love. The Street now appreciates that massive and intractable Trade Deficits provide the fountainhead of global liquidity overabundance. Moreover, the markets keenly recognize that the Bernanke Fed (like Greenspan's) is content to acquiesce to deficit and liquidity excesses. There is today no constituency for reining in the Bubble(s).

This week's release of a record quarterly Current Account Deficit ($225.6bn in Q3) garnered little attention from the media and even less in the markets. This despite the Deficit having now reached $900 billion annualized, or 6.8% of GDP. For perspective, the deficit for all of 1998 was $229 billion. At $877 billion, the Current Account Deficit over the previous four quarters compares to 2005's $812 billion, 2004's $664 billion, 2003's $537 billion, and 2002's $506 billion. And it is worth noting that the third quarter's deficit was up 36% from Q2 2004's $166 billion, back when the Fed commenced its fateful "tightening" cycle.

Bear Stearns' chief economist David Malpass provided commentary this week to The Wall Street Journal — "Embrace the Deficit." Mr. Malpass did a commendable job articulating Wall Street's dangerously flawed analysis of Credit Bubble-induced imbalances. …

Mr. Malpass: "For decades, the trade deficit has been a political and journalistic lightning rod, inspiring countless predictions of America’s imminent economic collapse. The reality is different. Our imports grow with our economy and population while our exports grow with foreign economies, especially those of industrialized countries. Though widely criticized as an imbalance, the trade deficit and related capital inflow reflect U.S. growth, not weakness — they link the younger, faster-growing U.S. with aging, slower-growing economies abroad. Since the 2001 recession, the U.S. economy has created 9.3 million new jobs, compared with 360,000 in Japan and 1.1 million in the euro zone excluding Spain. …"

…This protracted Credit Bubble would be much less perilous if our nation was expanding debt to finance sound investment. Or, if our mounting foreign borrowings were funding wealth-creating capacity — providing the ability at some point to satisfy our debt obligations with valued goods or services, or at least significantly reduce the scope of future deficits through the exchange of goods for goods — our current standard of living would not be so susceptible to the whims and fragilities of finance and global financial markets. Instead, we are the subprime borrower living beyond our means, yet for now luxuriating in our competitive advantage in issuing AAA securities in exchange for endless imports. These days, the vast majority of new debt liabilities issued to our foreign creditors are collateralized by inflated asset market prices (chiefly real estate and securities). This creates a Ponzi Bubble Dynamic where the perceived soundness of the underlying debt issued is dependent upon unrelenting Credit and Speculative excess (and resulting asset inflation). …

…U.S. household net worth has been expanding rapidly owing to Credit-induced home price and securities markets (price and volume) inflation. … $2.7 Trillion of debt instruments … created to pay for imports …$27 Trillion of debt held by households…. Our economy consumes more than it produces, financing this deficit through the endless inflation of additional debt instruments. Wall Street can stick with the fanciful tale that our Trade Deficits are instigated by "capital" inflows. It is, however, clearly a case of Credit excesses fostering over-consumption and mal-investment, creating progressively unwieldy dollar liquidity outflows to the world (that, by their nature, must be recycled back to U.S. debt instruments). …

…The U.S. Bubble economy has been sustained in 2006 only through the massive expansion of Credit (certainly including securities finance/leveraging!) — more than last year but less than next. But in no way is the Trade Deficit the "mechanism allowing consumption and investment in the U.S. to grow faster…" Instead, the deficit has evolved to become one of the prevailing unavoidable consequences of the Credit Inflation required to hold the downside of the Credit Cycle at bay. Of course, Wall Street, politicians, and the Bernanke Fed will work in earnest to avoid the downside of Credit excess. And, the way these Credit booms work, things tend to run amuck on the upside when they are turning most susceptible to faltering to the downside.

And, yes, as difficult as it is for me to accept, "they" really have come to Embrace the Trade Deficit. I guess "they" have no choice. As is often said, "people will believe what they have to believe." All the same, it's been stupefying to witness over the course of many years the seed of this spurious notion mature into a full-fledged national self-deception — ripening to the point of achieving ratification from top policymakers (including our Fed chairman), affirmation from the financial markets, and acceptance throughout. Students of economic history are all too familiar with the repeated bouts of turmoil, wreckage and revulsion — the legacies of absolutely ridiculous notions that somehow came to be readily embraced in the heat of intoxicating booms. Reading Mr. Malpass's piece yesterday ... left me again with that uncomfortable feeling that we’re living today in one of those extraordinary periods that will be studied and contemplated for many decades to come.

Main Street America Thinks Economy Stinks

Although still generally optimistic when looking at their own prospects, more and more Americans believe that the middle class is slipping away. Not only do Americans worry a lot about retirement, health care, immigration, globalization, and effective represention in the workplace, they also think they are not being listened to by American politicians. The "new economy" has created "new insecurities," says a report [PDF] from the Economic Policy Institute.

Talking Past Each Other: What Everyday Americans Really Think (and Elites Don't Get) About the Economy: …For most people today, their greatest anxiety is not that they will lose their job and be unable to find another, and their greatest hope is not that they will be able to get and keep a job. Instead, they have more complex concerns: Will their jobs be outsourced to a subcontractor or off-shored to another country? Will a full-time, permanent job be converted into a part-time or temporary job? Will their health insurance be cut back or their premiums or co-payments increased? Will they receive regular raises or earn merit raises? Will they be able to stretch their paychecks to cover their family's expenses? Will their employer continue to provide pensions that offer guaranteed retirement benefits? And can they keep their skills current so that they can hold onto their current job and qualify for a promotion or for a new and better job? These uncertainties are more complicated than what worried their parents and can be summarized as a concern about both regular wages and other aspects of "job quality."

Mogambo Guru's latest: Or Don't We Need Jobs/Money to Buy All the Stuff from 'Productivity Gains'?

Sometimes a few words are worth more than a picture. If you don’t occasionally read Richard Daughty's The Mogambo Guru, you are missing some good, dark humor on the state of the World and particularly the US economy. Here is a snip from his latest:

E-Economic Newsletter 12/06/06, The Mogambo Guru: …All this fits in with a good news/bad news article from MarketWatch.com titled "Fed's Big Worry Gets Revised Away". It reports that "A huge spike in wages and salaries in the second quarter proved to be an illusion, according to the latest data from the Bureau of Labor Statistics and the Bureau of Economic Affairs." The toxic good news/bad news cocktail is that "Slower wage growth means less inflation, but also less growth."

The bad news, which is what I fixate upon because that is the pitifully miserable way I am, is that slower wage growth means that "consumers don't have as much money as everyone thought they did ... $100 billion less on an annual basis." A hundred billion bucks less income than they figured! Whew!

Viewed in another light, "The new data show that, instead of growing at a 7.4% annual rate in the second quarter, employee compensation actually grew just 1.4%." Apparently, those are nominal gains, and are not adjusted for inflation. A sneer of contempt crossed the handsome face of The Mogambo (played by, if you recall, Brad Pitt), and they instantly knew that they had made a mistake! Quickly they added "The new data shows that real disposable incomes fell in the second quarter by 1.5%, rather than rising by 1.7%."

Real, inflation-adjusted incomes fell! Not rose! Fell! By this time I can feel a scream of panic rising in my throat, and I am kind of surprised that "panic" tastes sort of like the leftover burrito I had for breakfast. With a Heroic, Manly Mogambo Effort (HMME), I force myself to keep reading, and I am sorry I did, as "Consumers didn't earn the money they spent in the second quarter, they borrowed it. The personal savings rate dipped to negative 1.4%, the lowest since the Great Depression, except for the negative 1.5% seen in the fourth quarter of last year after Hurricane Katrina." Since the Great Depression of the '30s! Seventy years ago!

In case you are keeping score, and I am sure that you are, the savings rate has now been negative for 19 straight months, which is another world record. To give you an appropriate metaphor as to what this portends, I recall that, as a clever teenager, I discovered the miracles of caffeine and alcohol at the same time, and I was roaring drunk and completely crazy for 19 straight, buzzing hours once, and it ended very, very, very badly, which I think may be very instructive.

Continuing on the theme of income diminution, Bloomberg.com sported the headline "Bernanke Scrutinizes Labor Costs for Inflation Signs (Update5)" It says that "Federal Reserve Chairman Ben S. Bernanke said a new source of inflation may be emerging in rising wages and salaries even as energy prices retreat."

To show you the utter cluelessness of this Bernanke character about how the world works, he says he thinks it is a "worrisome possibility'" that companies will "pass all or part of their higher labor costs through to prices." Hahaha!

I can see it now! CFOs and accountants around the world will slap their foreheads and say "That is where we made our big mistake! We lost money because we set our prices too low! We forgot to add in labor costs when we set prices! Hahaha! The jokes on us!"

And it is not, I am sorry to say, just Bernanke, either. As equally clueless is Amar Mann, an economist at the Bureau of Labor Statistics in San Francisco, who says "It's too early to tell if higher labor costs are being passed on to consumers." Hahahaha! Well, if it ain't being passed on to the consumer, then it is being passed on to the business owners in the form of less profits, because all expenses have to be passed along to the consumer, dork! So is one better than the other? Hahaha!

Well, I don't think we have to worry too much about profits, as the Commerce Department said "Corporate profits from current production rose 31 percent in the year through September, the biggest 12-month gain in 22 years."

But in keeping with the depressing news about incomes, they go on to say that increasing productivity (less labor per unit of output) means that more people do not have jobs producing these units of output. …

Recession Ahead: Krugman and Roach Sound Alarms

December dawns with bad tidings of great foreboding. Both Paul Krugman and Stephen Roach are strident today, reading 'tea leaves' from the bond market and more.

Economic Storm Signals {$], by Paul Krugman, Tough 2007, Commentary, NY Times [12/01/06]:…[T]he bond market, which has a pretty good record of forecasting recessions, is pointing toward a serious economic slowdown next year. …[M]ost forecasters are still telling us not to worry. So whom should you listen to? And how can you avoid believing what you want to believe?

Maybe the best answer is to look at what the financial markets say. Not the stock market, which is a notoriously bad indicator of the economy’s direction, but the bond market. (Paul Samuelson, the Nobel Prize-winning ... economist, famously quipped that the stock market had predicted nine of the last five recessions).

Since last summer, when the housing bust became unmistakable, interest rates on long-term bonds have fallen sharply. They’re now yielding much less than short-term bonds. The fact that investors are willing to buy those long-term bonds anyway tells us that these investors expect interest rates to fall. And that will happen only if the economy weakens, forcing the Federal Reserve to cut rates. So bond buyers are, in effect, betting on a future economic slowdown.

How serious a slump is the bond market predicting? Pretty serious. Right now, statistical models ... give roughly even odds that we’re about to experience a formal recession. And since even a slowdown that doesn’t formally qualify as a recession can lead to a sharp rise in unemployment, the odds are very good — maybe 2 to 1 — that 2007 will be a very tough year. [More (and good commentary) from Mark Thoma's blog, Hat Tip!]

Unprepared in Beijing, by Stephen Roach, Morgan Stanley [12/01/06]: Taking its cue from a powerful liquidity cycle and the frothy financial market conditions it has inspired, the world is not prepared for a meaningful shortfall of US economic growth. …[M]ost remain in denial over the swift and sudden deterioration in the US economy. That's true in China, as well as in the United States and elsewhere around the world. Yet there are now signs of cumulative weakness in the US economy that have all the classic manifestations of a looming cyclical downturn. …

Adding it all up -- housing, consumption, capex, together with an upward revision to 3Q06 inventory building -- and the US economy may be on the brink of its second post-bubble recession in five years. A surging bond market and a weaker dollar appear to be alone among major asset classes in figuring this out. I continue to fear the implications of that realization for other markets -- especially equities and spread products, which remain priced for the veritable absence of any risk.

All this is a long way away from the hustle and bustle of Beijing. China's performance has been so impressive for so long that I sense a growing tendency to take the boom for granted. Reflecting this belief, I am starting to detect an important shift in the Chinese mood, with long-entrenched feelings of self-doubt now giving way to a new-found confidence. There's nothing wrong with confidence -- it can be a critical element of any successful economic development strategy. But confidence must be on solid ground to fuel sustainable growth. Lacking in support from internal private consumption, the Chinese confidence factor is increasingly dependent on a powerful export-led growth dynamic and associated gains in fixed investment -- both very much tied to the open-ended expansion of China's outward-looking export production platform. This could turn into a surprisingly precarious situation. What happens if the narrow underpinnings of China's growth strategy are undermined by the twin surprises of Washington-led protectionism and a sudden deterioration in the US economy? Beijing is unprepared for either of those possibilities -- as is, I'm afraid, the rest of the world.

Trapped in the past, creatures of habit miss important trendbreaks

Stephen Roach again warns us against complacency. Once again warns us against focusing too narrowly, becoming too rigidly wedded to our habits of thought or action:

The End is Never the Same [Stephen Roach, 11/27/06]: …Drawing comfort from a benign inflation outlook, financial markets are convinced that central banks pose little risk of a classic interest-rate-led endgame. However, just because cycles of the past have been terminated by interest rate pressures, that need not be the case in the current cycle. …

Three possibilities — none of them driven by interest rates — have the potential to trigger a cyclical endgame: (1) A post-housing-bubble shakeout in the US could derail the American consumer and a still US-centric global economy. (2) The renewed decline in the dollar is a reminder of the possibility that massive global imbalances could lead to a disruptive rebalancing of the world economy. (3) A pro-labor shift in economic policies could occur — reflecting a backlash over growing inequalities of income distribution; a post-election US is especially vulnerable, but there are similar risks in Europe, China, and India. …

In the absence of interest-rate pressures, most believe that financial markets enjoy a Teflon-like immunity from any and all potential sources of adversity. I have my doubts. A number of potentially powerful macro forces are now in play that could challenge this conclusion — namely, a bursting of the US housing bubble, renewed dollar weakness, and a pro-labor swing of the political pendulum. Any one of these developments has the potential to derail a seemingly benign macro climate. A combination of them would be all the more destabilizing. …

Awash in liquidity, financial market participants have no compunction about putting more and more money to work in what they perceive to be benign circumstances. I have my doubts. The risk is that investors are trapped in the past — unprepared for an outcome that could be very different from the inflation- and interest-rate-led endgames of earlier cycles. …

We are all creatures of habit. That's true of economists, investors, policy makers, and politicians — all of whom look to signs from the past as guides to the future. That leaves us captives of history, whether we like it or not. I have great respect for history and spend a lot of my time reading it. But I have long been struck by the flaws of autoregressive thinking — extrapolating on the basis of recent trends and looking for guidance from historical patterns to predict the future. Time and again, we learn that no two cyclical endgames are alike. Yet time and again, we draw the wrong inferences from patterns of earlier periods. This is one of those times. …

The risk is that investors are trapped in the past — aiming their defenses in the wrong direction. Such a possibility reminds me of the legendary Battle of Singapore in 1942. Convinced that the next war would be like the ones of the past, British military strategists positioned their fixed artillery for a classic invasion by sea. The Japanese, of course, invaded by land from the North — leading to what historians have called one of the largest and quickest capitulations in British military history and Winston Churchill's worst disaster. Here's where history may have something to say about increasingly complacent financial markets. No two endgames are alike.

The Bell Tolls Differently for Wall Street Tycoons v. Middle Class

Whether from Chris Matthews or Stephen Roach, we are seeing folks once again talking about the plight of the middle class. When I listened to Matthews last Sunday I thought his commentary apt. There are millions of Americans missing out on the speculative run on Wall Street, and falling further behind economically. As expected, Matthews has been berated by the far right as working a political stunt, e.g. here. So I was glad to Stephen Roach add more detail in a similar commentary on Monday. I wonder whether the problem has any "nice" resolution, given that one way or another the middle class looks more and more like an "endangered species."

What might this mean for America's future as per capitalism and democracy such as they are, such as they have been, and as they may become? Brad Setser is not optimistic for a good outcome, stating in follow-up comments to a 10/23 post, that he thinks "it rather unlikely that the US will retain its financial preeminance; the rules of global finance are not usually set by debtors."

Setser's comments were in response to reader JohnH's comment: "One of the lessons of history, I believe, is that great powers typically see their mature productive sectors decline as the finance industry becomes dominant. As other countries build their productive capacity, they emerge as great powers, accumulate wealth and ultimately supplant the reigning financial power. Genoa, for example, was a great financial power after its other economic sectors withered. Britain through much of the 20th century followed the same pattern. Is there any reason the US shouldn't be following this pattern now? Why wouldn't Japan, China, and the Gulf States learn to dispense with the need for intermediaries and consign New York and London to the dustbin of history?" (See Setser's 10/23 post titled One more sign we live in a new gilded age – Europe is once again the world’s financial center … )

{Update: See too Mark Thoma's The Rise and Fall of the Managerial Class (w/ 62 comments so far) }

Roubini: Fed in Panic Mode, Cannot Prevent Coming Recession

Nouriel Roubini has been bearish for awhile as this blog (and his and Brad Setser's ) have noted. Now he proclaims that do what they will, the US Fed is powerless to forstall a deep recission that is coming soon. His last two posts prove especially worthwile, July 31 here and July 28 here.

Here's an excerpt from Roubini's latest, titled Why a Fed Pause or Even An Easing Will Not Prevent the Coming U.S. Recession: It is now clear that the Fed is in panic mode about the risks of a U.S. recession; they hoped to get a soft landing but, obviously, the Three Ugly Bears that I have been warning about since last fall - high oil prices, a slumping housing and rising inflation leading to higher short and long term interest rates - are now killing the economy. The Fed is particularly scared now about the effects of the housing slump, as John Berry’s [$] (being the most insider of all Fed watchers) latest column clearly suggests and as the speech today by SF Fed President Janet Yellen also signals. …

There is now in the market a wishful hope that a Fed ease, possibly followed by an easing in the fall, will prevent a serious slowdown and allow a soft landing of the economy (something in the 2.5%-3% growth rate in H2 2006 followed by a 3% growth in 2007).

I beg to disagree. The Fed will not be able to avoid coming recession even if it were to pause now and ease in the fall. …

[D]o not expect the Fed to be able … to rescue the U.S. economy from the coming recession. It failed to do so in 2001 and it will fail to do so this time around. In almost every previous episode of serious Fed tightening since the 1950s we ended up with a recession. The only exception was 1994-95. But then conditions were very different from now: a) even then the 300bps tightening in 1994 led to an almost 0% growth by Q1 of 1995; b) then the economy was coming out of a sharp recession and sluggish recovery (1990-93) and had very little of the macro vulnerabilities that we are facing today; c) the economy was then on the verge of the IT technology and internet productivity miracle of the 1990s; d) inflation was – unlike today – very mild; e) it took an aggressive easing in 1995 to prevent the real sharp tightening of 1994 from spinning the economy into a recession in 1995 and even then growth close to 0% in Q1 of 1995 and sluggish through H1 of 1995. This time around, the vulnerabilities are much larger than in 1994 and than in 2000-2001. There will no so soft landing and the recession will be painful. And the Fed will be able to do little to prevent the coming recession. The recession train wreck is having too much of its own unstoppable momentum now – as it did in 1974, 1980, 1990, and 2000 – for the Fed to be able to stop it. Fed pause or easing will not avert the coming recession. We will now pay for living above our means for too long, for making serious fiscal and monetary policy mistakes that allowed only a drugged recover, and for creating unsustainable macroeconomic and financial imbalances that festered for too long. Thus, the coming payback will be unavoidable - whatever the Fed does or does not - and most painful for the U.S. and for the global economy. [emphasis added]

Please Read the rest! Do you Believe it? It sounds likely to me! But time will indeed tell! Expert prediction is sometimes too easy to believe, and too easily rolls off the lips of the expert.

Paul McCulley's "Kind Word for the Austrians," Minsky, and Keynes

PIMCOs Paul McCulley's July words ring true to my ears. McCulley concludes:

I am a Keynesian. But more precisely, I'm a Keynesian wearing Minsky clothing, and doffing Austrian shoes. In the fullness of time, I expect Chairman Bernanke, a brilliant Keynesian, to rediscover that the Austrians were not all wet in their diagnosis of the potential for maldistribution of investment, even though they were soaking wet about what to do about it. The Austrians said let the asset price and credit excesses purge themselves. A much better way, I believe, is to lean against the excesses preemptively, using all available tools, including regulatory tools.

Yes, Inflation targeting is fine. Myopic inflation targeting is not. Asset prices matter, and not just in the context of their influence on aggregate demand relative to aggregate supply and, thus, inflation. Asset prices matter in their own right, because wild swings in asset prices, even in the context of "stable" goods and services inflation, are a source of both volatility and maldistribution in investment.

And, in the long run, a source of deflationary, not inflationary risk.

Let's hope Chairman Bernanke is listening. Below find McCulley's A Kind Word for the Austrian School: