Economic Dreams - Economic Nightmares

Time to rethink 'Smoot-Hawley Myths'?

Today I found this from Ambrose-Evans Prichard, Telegraph:

The long-simmering clash between the world's two great powers is coming to a head, with dangerous implications for the international system. China has succumbed to hubris. It has mistaken the soft diplomacy of Barack Obama for weakness, mistaken the US credit crisis for decline, and mistaken its own mercantilist bubble for ascendancy. There are echoes of Anglo-German spats before the First World War, when Wilhelmine Berlin so badly misjudged the strategic balance of power and over-played its hand.

Within a month the US Treasury must rule whether China is a "currency manipulator", triggering sanctions under US law. This has been finessed before, but we are in a new world now with America's U6 unemployment at 16.8pc.

"It's going to be really hard for them yet again to fudge on the obvious fact that China is manipulating. Without a credible threat, we're not going to get anywhere," said Paul Krugman, this year's Nobel economist. …

I let others discuss the rights and wrongs of this, itself a response to the US report card on China. Clearly, Beijing is in denial about is own part in the global imbalances behind the credit crisis, specifically by running structural trade surpluses, and driving down long rates through dollar and euro bond purchases. No doubt the West has made a hash of things, but the Chinese view of events is twisted to the point of delusional. …

We have talked ourselves into believing that China is already a hyper-power. It may become one: it is not one yet. China is ringed by states - Japan, Korea, Vietnam, India - that are American allies when push comes to shove. It faces a prickly Russia on its 4,000km border, where Chinese migrants are itching for Lebensraum across the Amur. Emerging Asia, Brazil, Egypt and Europe are all irked by China's yuan-rigged export dumping.

Michael Pettis from Beijing University argues that China's reserves of $2.4 trillion - arguably $3 trillion - are a sign of weakness, not strength. Only twice before in modern history has a country amassed such a stash equal to 5pc-6pc of global GDP: the US in the 1920s, and Japan in the 1980s. Each time preceeded depression. …

Contrary to myth, the slide to protectionism after the 1930 Smoot-Hawley Tariff Act did not cause the Depression. Trade contracted more slowly in the 1930s than this time. The Smoot-Hawley lesson is that tariffs have asymmetrical effects. They devastate surplus countries: then America. Deficit Britain did well by retreating into Imperial Preference. …

I have recently thought that both the irony and the tragedy of The Smoot-Hawley Tarriff Act of 1930 (Wikipedia) was that the US imposed the tariff at precisely the wrong moment in history—the US then being a "surplus country". Perhaps now is the right time. Or perhaps some diplomacy in advance of a trade war will prove a better approach going forward. That way world leaders can talk through all the tough economic issues, including trade flow, capital controls, and finance channeling (i.e. whether or not to reinstate some sort of 21st Century Glass-Steagall (Wikipedia), country by country or worldwide). It will prove interesting to see what the blogosphere makes of Prichard's thesis.

Related (Smoot-Hawley):
Is Smoot-Hawley Coming Back? Michael Pettis, Seeking Alpha, Nov. 2008
China's Smoot-Hawley, Yves Smith, Naked Capitalism, Nov. 2008
Smoot-Hawley Fiction, Bob Powell, Feb. 2009
US-China Trade Relations—The Next Dispute?, Michael Pettis, Feb. 2010
Greg Mankiw says NO!, March 2010, and points to a NY Times column from a year ago: It's No Time for Protectionsim, February, 2009. Mankiw's point is, in part, that China's currency had already appreciated 21% by early 2009.
{Update}:Joesph Stiglitz says No! in It's No Time for a Trade War, Project Syndicate, April, 6, 2010

Related (Capital Controls):
The End of an Era in Finance, Dani Rodrik, Project Syndicate, March 2010

Chartalist Sense and Nonsense

I have been struggling with economics and economists for many years—I'm a slow learner. Recently I have been trying to figure out neo-chartalists and neo-monetarists, and watching their interchanges on the blogs. [Note: I need to quit using "neo"]

Today I want to focus on the Chartalists (Wikipedia). I want to lay out what I believe to be sense from their writings and what I believe to be nonsense. The nonsense, if it is indeed nonsense, stems from where Chartalist reasoning departs from Garrett Hardin's first law of ecology, paraphrasing: "You can never do just one thing." Hardin's law ought to have guided the US Federal Reserve's failed attempts to control the money supply and later interest rates. But it didn't, as we are painfully learning, living through the worst contraction since the Great Depression.

To compliment Hardin's First Law we need to add two more from Barry Commoner: First, "Everything depends on everything." It comes with a corollary, "Every thing comes from something." Second, "There is no such thing as a free lunch." Again with a corollary, "Everything must go somewhere." Now we need to see how things work in our world.

I suspect that Chartalists will correct me on my allegations of nonsense, and tell me that they are not guilty of falling into the narrow-focus trap that other economists fall into—that they don't violate laws of ecology. But I remain puzzled. Sometimes, at least, they sound like they do. First let's note what the Chartalists get right.

Chartalist Sense

Chartalists provide an accurate picture of how money and credit operate in banking. As such they can — and we can too, following their accounting — easily point out silliness, even danger in trying to "balance the budget" by, say, cutting government spending. All that single move will do is to drive private saving further into the red. Again, "You can never do just one thing." Now, let's see what Chartalists get wrong.

Chartalist Nonsense (or not?)

I have been trying to wrap my mind around government "deficits" and "debt" for some time, (e.g., here). I remember my anger when Dick Cheney said "deficits don't matter. Now it seems there are more and more economists who at least pretend that deficits are a positive good. See posts from, e.g. Jamie Galbraith, Marshall Auerback, Randall Wray, among others. These are economists who I follow, so I'm struggling to better understand how they could come to conclusions that seem untenable.

My guess is that most Chartalists agree with me (maybe they don't?) that there is only so much "papering over problems" that is acceptable in a society, and to other societies that any society is indebted to. Internally, people will only accept so much inflation; externally, too much debt and/or too much debt evasion via inflation (or devaluation) will also be met with hostility. But Chartalist writings — particularly their popular writings — lead to the opposite conclusion that "deficits are always good." This certainly can't be the case, as Heilbroner and Bernstein so aptly demonstrate in The Debt and the Deficit.

As I understand it, if a government seeks to expand its monetary base under what is commonly called Modern Monetary Theory (MMT) (via Bill Mitchell,YouTube video) there is a likelihood of expanding future job production. I get that. But we must pay attention to the word "likelihood." Assuming that new jobs actually happen and are beyond "subsistence level", expanding future job production provides a bigger base from which to extract taxes to pay for government services and government debt. Such is the nature of growth economics for countries that have their own currency. But problems arise when jobs are being destroyed in epoch numbers via Schumpeter's Creative Destruction (Wikipedia) and are not being replaced with similar quality jobs, and when jobs are sent to other countries too rapidly.

There are also problems when finance gets too far out in front of the so-called real economy. George Ackerlof and Paul Romer call it looting. As does Joseph Stiglitz. So does Michael Hudson, and so do the Chartalists.

Financialization-of-Everything

The US has recently played hegemon on the world financial stage and has presided over a world of financial bubbles. US-led financialization-of-everything allowed money to flow to wherever speculators felt they could inflate the next bubble make a quick buck. All in the name of efficiency. There were no, or at least not enough productive distribution channels for the liquidity that the US was providing (as a base) to the world's money markets. So being good bad "capitalists," CEOs and top traders kited markets and took the booty. Many economists and politicians were cheer-leading this as a new era of globalization, a new-found economic miracle. As we are now learning, however, it was neither. And now we are in the middle of a credit bust, with a major-league private debt hangover.

A big problem was that the "new world order" was achieved by destroying high paying jobs in the developed world. This may have been inevitable. But a question lingers as to whether or not it might have happened rather slowly, rather than all at once. I'm inclined to believe that given world and US psychology/politics it had to happen as a crisis. The question that lingers is,"What next?"

I'm going to give second-to-last words to Heilbroner, as a challenge to Chartalists in terms of better "framing" (Wikipedia) for their arguments that I call nonsense above:

Public investment creates public debt, exactly as private investment normally creates private debt. One hears much these days about the "burden" this public debt will impose on our children. We hear less about the consequence of removing that burden by retiring our debt. Retiring debt means that there will exist fewer and fewer government bonds, which are our debt. When there is no longer any debt, there will no longer exist any securities backed by the full financial capability of government. In what bonds will our children then invest the Social Security retirement trust? What will their banks, or businesses, or they themselves use as giltedged securities? Zero public debt would not be a blessing; it would be an unmitigated catastrophe

I get the last words, and they are simply these: I am trying to learn what I can from economists, ecologists and more—in recent days particularly from Chartalists. I apologize in advance for errors I make in the process of "writing to learn."

Can Chartalism Get a Fair Hearing?

L. Randall Wray has been a long-time critic of orthodox monetary economics and US economic policy. Recently he continued his crusade in a paper titled Alternative Approaches to Money [pdf], Theoretical Inquires into Law (11:1), January 2010. Wray is among many Chartalists (Wikipedia) who are active both in published forums and blogs.

Given the state of the world's finances, it seems to me that Chartalist thinking needs to be given a fair hearing — at least an open-forum rebuttal — by "orthodox" economists in academia and government. To date, as Wray notes in the paper, Chartalist thinking has not been given such a hearing.

A fair appraisal of orthodox v. Chartalist thought is especially important since we are into three decades of failed economic policy in the US. A first mistake, according to Wray and others was to base economic reasoning on notions of efficiency and equilibrium, when in fact our financial systems are complex, adaptive systems that are better thought of as "far from equilibruim", at least at some important phase shifts. A second mistake, was to attempt to control complex financial systems via US monetary policy. When money supply control via "monetary targets" failed, the US Fed switched to interest rate targeting. That too failed, Wray claims. Now we are faced with PIIGS that don't fly — at least their currencies don't — and at least five US states that are threatening default. What better time for orthodox economists, along with government policy-makers to think outside the box?

To Wray:

By the end of the 1980s, orthodox policy was also in disarray, as central banks were unable to control the money supply, while money was not closely linked to nominal GDP or to inflation. Furthermore, to many observers it seemed that money matters, in the sense that monetary policy affects unemployment and growth in predictable — even if moderate — ways. Without monetary rules to guide them, central banks cast about for alternatives, including gold prices, real or nominal interest rates, inflation rates, or exchange rates. The overriding belief was that monetary policy somehow is responsible for maintaining the value of money. The trick was to find the right policy rule to maintain a stable value for money.

During the 1990s, orthodoxy developed a "New Monetary Consensus" (NMC) in regard to theory and policy. There are several versions, but all reject monetary targets in favor of interest rate targets. Policy consists of adjusting the overnight interest rate in response to deviations of inflation and output growth from desired performance. Unlike 1960s Keynesianism, fiscal policy plays a small role, while monetary policy controls demand and hence growth. When the economy grows too fast, fueling inflation, the central bank dampens demand by raising interest rates; when it grows too slowly (causing unemployment and deflation), the central bank lowers rates to stimulate demand.

Private banks and financial markets accommodate, following the central bank's lead. The NMC encourages central bank transparency because effective monetary policy requires the cooperation of financial markets; this, in turn, requires consistency of expectations so that central bank intentions can be quickly incorporated in expectations and thus in market behavior, making policy more effective. Further, policy changes are implemented gradually to avoid disruptive surprises that generate instability. In this way, the central bank slows growth and inflation through a limited series of small interest rate hikes — avoiding the problems created in the early 1980s when the Fed raised rates above twenty percent to fight inflation, precipitating the U.S. thrift crisis and developing country debt crises.

The combination of the NMC and the Efficient Markets Hypothesis had a synergistic effect from the mid-1990s until the current global financial crisis. Greenspan was acclaimed as the world's greatest central banker ever. After discovering the NMC as a pragmatic response to the demise of Friedmanian monetarism, he sought to manage expectations to control real world outcomes by building credibility as an inflation-fighting free market proponent. With inflation expectations checked, robust growth became possible without a Phillips Curve tradeoff; growth in turn was promoted through deregulation and reduced government oversight. When self-interested pursuit of profits threatened financial and economic stability, the Fed quickly intervened with the "Greenspan put" — lowering interest rates and arranging a resolution. His replacement, Ben Bernanke, proclaimed the era of "the great moderation": economic stability and better economic policy (at the hands of the central bankers) lowered risks. Innovators further reduced risks by creating financial instruments to hedge and diversify, and to allocate risk to those best able to bear it. Highly complex quantitative models assessed risk so that opaque instruments could be rated. These models, in turn, relied on theoretical advances derived from the efficient markets hypothesis.

It is difficult to convey how much doubt has been thrown on the entire corpus of orthodox theory by the current global crisis. Events rated by models as 25 standard deviation possibilities (once in 100,000 years) have become common. It seems that debt does matter, after all — it is not a good substitute for equity or income — as do leverage and liquidity ratios.

Monetary (interest rate) policy is impotent, although money does appear to be important in the sense that the whole crisis began with deflating nominal values of assets and debts — which generated a run into the most liquid assets. In short, it is hard to see the crisis as an "equilibrium" outcome (Real Business Cycle), as a suboptimal position that resulted from sticky wages or prices (New Keynesian), or as a result of excessive government regulation. Markets never took seriously attempts by Treasury Secretary Paulson or Chairman Bernanke to downplay problems — each new policy announced to deal with the crisis only led to another round of catastrophic collapses. Those outside the discipline legitimately wonder whether economic "science" has advanced at all since the 1930s.

Perhaps it has not. It could be argued that the direction taken by orthodoxy with respect to money was entirely wrong. There was already a viable alternative (with an already long tradition) that was virtually ignored by postwar economists. … [footnotes omitted here]

So is it time yet to get a full airing of Chartalist thinking? And while we are at it, ought we not shed more daylight on the fact that our economic systems, especially our money/credit systems are complex, adaptive systems and ought to be modeled as such.

For those not familiar with Chartalist thinking, I recommend that readers begin with Rogue Economist's Questions About Chartalism and/or Responses to my questions About Chartalism. Decline and Fall of Western Civilization's The Tail Risk to the United States in the GFC is worth a look too.

For even more, see New Economic Perspectives from Kansas City … and beyond.

Necessary Evils: Government, Markets

Around 1980 I went to work for the US federal government, the US Forest Service to be specific. I was then a libertarian economist (Austrian School). Many people I knew were puzzled as to why I chose the Forest Service over private industry. The answer was simple and personal: I believed then that the financial collapse that happened in 2007 (or 2001 depending on perspective) was imminent. I also believed that the government might be a better safe-haven than private industry during a financial hurricane. And I loved the public lands, which was a chink in my libertarian armor.

During my early years in the Forest Service I adjusted my ideology, drifting left. I was never a fan of government bureaucracy, but I came to view government as a necessary evil. Despite being embedded within bureaucracy I continued (and continue now in retirement) to rail against bureaucratic bungling (e.g. here, here, here).

After thirty years studying markets and market mechanisms, I believe that capitalism (Wiki link) too is a necessary evil, at least for the foreseeable future. Capitalism is necessary because it is the best way to deliver the type and amount of "goods" people desire. It is evil because it is "cruel, unjust, and turbulent", as noted long ago by Joan Robinson. My dream is that someday (distant "Star Treck" future) we will be able to transcend capitalism, but that is only a dream. We would at minimum, have to find a means (read "incentives") to unleash the creative innovations that market mechanisms now unleash, and to transfer effective "price signals" and other signals that market mechanism now transfer when markets function effectively.

I also believe both government and markets to be necessary and good. That is, when functioning well they both serve necessary functions in society.

But both government and capitalism tend toward abuses of power, sometimes intertwined, that lead to evil. This is particularly true when we fail to recognize this tendency. Crony capitalism (Wiki link) is only one of these. Our challenge is to find means to thwart evil tendencies in both government and capitalism, and to find means to enhance the good in each — in both. Our challenge it to quit thinking "either, or" and start to face the reality of "both, and".

Capitalism's Fatal Flaws

In The Worldly Philosophers, Robert Heilbroner tells us that all the great economists foresaw a time when capitalism would come to an end. In Stabilizing an Unstable Economy (1986), Hyman Minsky outlines an agenda for ending capitalism as we've know it (what Heilbroner called "Capitalism as a Regime" in Behind the Veil of Economics). Minsky suggests that we replace laissez-faire capitalism (Wiki link) with a less-flawed version of Capitalism that allows for much better automatic stabilizers than found in our current system.

Minsky, following his reading of Keynes, tells us that modern financial institutions (with inherent tendencies toward monopoly) inevitably will turn into predators on other economic subsystems. Minsky also tells us that most economic theories, with emphasis on "equilibrium" while allowing only for occasional shocks to the system, are ill-equipped to deal with the systemic problems stemming from stability that breeds instability. Minsky (p.280):

In a world with capitalistic finance it is simply not true that the pursuit by each unit of its own self-interest will lead an economy to equilibrium. The self-interest of bankers, levered investors, and investment producers can lead the economy to inflationary expansions [including asset inflation] and unemployment-creating contractions. Supply and demand analysis—in which market processes lead to an equilibrium—does not explain the behavior of a capitalist economy, for capitalist financial processes mean that the economy has endogenous destabilizing forces. Financial fragility, which is a prerequisite for financial instability is, fundamentally, a result of internal market processes. …

Institutions such as the Federal Reserve, which were introduced in an effort to control and contain disorderly conditions in banking and financial markets, are now slaves of an economic theory that denies the existence of such conditions.

The "stability breeds instability" process is now well-know to complex systems theorists. As systems age, newly emergent systems first gain, then lose redundancy and therefore resilience—they become fragile, brittle, or tightly-coupled. At some point a shock to the system will cause catastrophic failure (if the system just doesn't get stuck in a "poverty trap"), setting the stage for rebirth of that system or newly emergent systems that arise in the wake of the old. (See, e.g. adaptive cycle, or more generally: Resilience Alliance.)

Minksy's dream is a hard sell in the American culture, with our new-found American values. Minsky's agenda is to relegate market mechanisms to relatively minor roles. Minsky's "solutions" which he offered up humbly, are for bigger government, smaller banking institutions, and an elimination of "welfare" via a government-sponsored "employment strategy". It is an agenda that is still being pitched by some of Minsky's disciples, although there is dissension among the disciples as is always the case with economists. Minsky also advocated for a "balanced budget" — balanced not every year, but over a reasonable time-frame so as to avoid hyper-inflationary possibilities.

Time will tell whether Capitalism will survive (and if it does, In what form?). In the meantime we all watch and wait, cuss and discuss.

For more on Minsky and more on the bankster crisis, see:
Economic Perspectives from Kansas City.
For more on monetary complex systems thought, see:
Macroeconomic Resilience

Rediscovering Values

On Doug Fabrizio's "Radio West" this morning (Podcast here), Jim Wallis talked us through his new book, Rediscovering Values. The book and the podcast is about what is wrong with our American value system and how to begin to "find a way out". Seems we have, once again, bowed down to a god of our own making. This time it is 'The Market', run by unbridled selfishness and greed.

Wallis (Wikipedia link), a theologian and activist, asks this important question, "What do you do when the invisible hand lets go of the common good?"

Referring to our recession/depression Wallis points out that most people ask "When will the crisis be over?" Wallis notes that this is the wrong question. Instead we ought to be asking "How will the crisis change us?"

Wallis says that we now act on these values: "Greed is good. It's all about me. I want it now."  Wallis notes that "Wealth doesn't trickle down, but bad values do." Instead of the values that seem to drive our society/economy, Wallis argues that we ought to be acting on "new old virtues": "Enough is enough. We are in this together.  … [And the] Native American indigenous peoples' ethic that you evaluate decisions today by their impact on the seventh generation out."

Instead of "keeping up with the Joneses", Wallis suggests why not "Let's check with the Joneses, and see if they are OK." Wallis is no anti-market zealot, rather he wants to see markets relegated to their proper place in society.

Pointing to one indicator of our values crisis Wallis asks rhetorically, Does anyone think it is a good idea when CEO pay goes from 30 times average workers' salary to 415 times? This happened in just 30 years. How does this single notion erode the values of a culture? Wallis has much more.

Wallis ends with something I too pitched long ago, Gandhi's Seven Deadly Sins:

• Wealth without work.
• Pleasure without conscience.
• Knowledge without character.
• Commerce without morality.
• Science without humanity.
• Worship without sacrifice.
• Politics without principles.

We are there! Where do we go from here? One more book to add to my long list of yet-to-read: Rediscovering Values: On Wall Street, Main Street, and Your Street, by Jim Wallis.