Economic Dreams - Economic Nightmares

What About the Deficit?

Here in the US, the libertarian right tells us that we are doomed by a federal debt that will soon wreak havoc on the world's financial system, with much pain to be felt here at home. Perhaps they are correct, but I doubt it. If anything a debt problem will be chronic, not acute and near-term calamity is not likely. Their argument gains traction each year as budget deficits add to the debt, and no new jobs (net) seem to be an ongoing tragedy. Even if you don't buy their arguments, there may be other reasons to at least shift spending, if not both shift spending and reduce deficits. So it is at least time to begin to parse various proposals to cut into deficits and debt.

This week President Obama unveiled his budget. There wasn't much to cheer about, for those who hope to trim back a bit on our public debt. Obama and Co. trotted out the same old "let's whittle away at that small percent of government that has served for years as the politically correct set of "touchables," leaving Defense and Entitlements at minimum in the "untouchable" category. Nobody is buying Obama's offering as much more than political posturing w/r/t deficit reduction. So we'll have to look elsewhere for substantive suggestions.

Recently, Mother Jones' David Corn talked with David Stockman (Ronald Reagan's Budget Director) to get his ideas on tackling the problem, a problem Stockman dealt with, unsuccessfully, way back when. Stockman offered up a few ideas: First, cut military spending by $100 to $150 billion a year. Second, apply a means test to Medicare and Social Security. Third, massively raise taxes. On the third, Stockman suggested a Tobin Tax on financial transactions, adding that it might generate $100 billion annually. He also suggested a value-added tax on consumption.

I would add in a few others. Why not try to get another $100 billion/year from the Medical Industrial Complex? I suspect that if we were to seriously look at "end of life" excessive health care we might find that much there. But if not, we might look at excessive profits in the "Complex", and or excessive insurance costs, etc.

Why not get another big number by beginning to phase-in a gas tax? That way we would be hitting the Energy Industrial Complex, to compliment the hits already proposed to the Military, Finance, and Medical Industrial Complexes.

And we might get a bit by raising the tax, progressively, on America's top 5%.

What else might we tag on? We might as well begin developing lists, while we wait and wait for our politicians to do anything beyond "tax and spend" or "borrow and spend."

Note that Stockman also advocated for a "means test" on Social Security. I have thought this a good idea in times past, but now suspect that it wouldn't be worth the fight. Just raise taxes on the rich, and let them collect their pittance from Social Security.

Financial "Rock, Paper, Scissors"

Let the rock be gold, the paper be money, and the scissors, a shredder. We have a stage set for "financial rock, paper, scissors". From a historical perspective, we can easily trace the most recent path from gold to paper money (or fiat currency) as it has played out on the world stage—officially beginning in 1971 when President Richard Nixon officially declared the US to be off the gold standard. Numerous books have been written on the matter. Here is a very short history that begins in 1913 titled "Privatize the Gains, Socialize the Losses", by Peter Treadway. Paper covers rock! {Note: Treadway's paper isn't the best short history around, and may replace it with something else, but I do like the title.}

What is just now playing out is the predicted credit bust that predates the shredding of the paper money when market cycles turn ugly. Or maybe it doesn't precede shredding (partial shredding via inflation really), but someone will have to explain to me just how we get out of this mess otherwise. Oh, I almost forgot Mosler's Law: "There is no financial crisis so deep that a sufficiently large increase in public spending cannot deal with it." I'll post more on the "Chartalist fix" soon.

Numerous blogs are now tracking the debt bubble that is still building (and shifting from "private" to "public") in the wake of the credit bubble. Few are offering acceptable resolutions to the debt problem. At least I'm not finding them—or accepting them. Here are a few places that track the problem: Doug Noland's Credit Bubble Bulletin, Steve Keen's Oz Debtwatch, Edward Harrison's Credit Writedowns.

Paul Krugman, among other Keynesian economists, advocates higher inflation to create more space for interest rate cuts in times of stress. Of course "higher inflation" for awhile would help the government out from under some of the debt burden too. But at the expense of those on fixed incomes, unless tax policy or other means were used to make "fixed incomes" types whole again.

Many on the "right" seem to want to blast Krugman for advocating that we inflate our way out of the crisis, as if that were (1) true, and (2) the only tool Krugman advocates for. Yet the Feb 12 IMF paper, "Rethinking Macroeconomic Policy" (pdf) Krugman points to in a recent post, talks through various tools to try to find a path forward, including

• Raising the Inflation Target
• Combining Monetary and Regulatory Policy
• Higher Inflation Targeting and Foreign Exchange Intervention
• Providing Liquidity More Broadly
• Creating More Fiscal Space in Good Times
• Designing Better Automatic Fiscal Stabilizers

Neo-chartalists, at least some of them, advocate what I'll call an "modern-day alchemy fix" to the debt problem, remember: "There is no financial crisis so deep that a sufficiently large increase in public spending cannot deal with it."

In any supposed "fix" there will be winners and losers, with the government in the middle of the mess. Scary times ahead! Both the Keynesian and the Chartalist approach suggests inflation. But how much? Scissors cut paper! Out come the shredders, figuratively, to cut up the paper. Inflation to counter deflation? Or runaway inflation? What other ideas are worth looking at? Maybe it is as simple as re-regulation — as if that were simple — but I doubt it.

If the "scissor act" is too flagrant, as it may well be given the size of the debt we are dealing with, we will see a substantial loss of faith in US currency. Such could trigger wide-spread panic and subsequent worldwide Depression. At minimum we would see at least some countries try to mimic the US move, which might set a stage for hyperinflation. What China and the Arab states might do in response is an open question, particularly if we repudiate the debt outright apply Mosler's Law as some Neo-Chartalists advocate.

The point of this little note is to suggest that in the wake of inflationary actions to deal with the debt bubble, we will likely see — already are seeing, e.g."We are All Austrians Now" — calls for a return to what might be called 21^st century gold standard. If that were to become a political necessity, we will have come full circle: Rock crushes scissors!

I hope that we can stay with fiat currency and find means to deal with the mess at hand. But I am outclassed by most of the economists and finance experts I follow. So I watch and read, and occasionally comment. The "mess" is once-again center stage as the PIIGS threaten default. And California and other messes closer to home will prove interesting to watch as this year unfolds. This is a Wicked Problem of global proportions. But that is a story for another day.

Eric Tymoigne on Three Important Questions

I have been recently trying to better understand where I stand on financial economics and have been quiet for some months. Time to begin blogging again. After spending my youth as a Friedman libertarian then moving on to Hayek (whom I still admire in part, while disagreeing with most contemporary "Austrian economists"), I'm now working to better understand Keynesian philosophies, particularly as practiced by those most label post-Keynesian. In particular I spend a bit of time these days reading Economic Perspectives from Kansas City and Bill Mitchell's Blog, along with Steve Keen's Debtwatch along with other favorites.

Over at Economic Perspectives from Kansas City, Eric Tymoigne recently asked  Can we spend our way out of recession? Is the fiscal deficit unsustainable? Is it time to cut government spending?.  His answers, in short: Yes. No. No, not yet. I'm in agreement, but add that we dare do it — in the face of a mountain of debt — only if we are also going to re-regulate the banking and finance (and insurance) industries. And if we are going to claw-back some of the excess profiteering that went on. And if we are going to seriously investigate the fraud that was no-doubt part of the problem. And if we are going to begin to reign-in the medical industrial complex (and related so-called insurance), and reign-in the energy industrial complex, and reign-in the military industrial complex. What else?

Here is a bit of Tymoigne's reasoning:

So can we spend our way out of a recession? Yes we can; provided that spending is high enough. Will a sovereign government go bankrupt by doing so? No, it will not. Does government spending lead to inflation? No, it does not. Does bigger government spending mean that the government will take over the economy? No, it does not. Does it mean that all types of spending are equally beneficial? Definitely not. Government spending can be wasteful if there is no improvement in the welfare of society through infrastructure spending, better social programs, and other government spending, preferably employment-enhancing, that improve the standard of living of the population. …

In the early 1930s, President Roosevelt first criticized President Hoover for engaging in deficit spending and driving the country down the road to ruin, and then proceeded to implement policies that further increased the fiscal deficit of the federal government to about 5% of GDP (a historical record at that time). These policies greatly helped the economy to get out of the Great Depression, but were the subject of ferocious attacks on the ground that the "massive" deficits would lead to the insolvency of the country, uncontrollable inflation, wasteful spending, the taking over of the economy by the government, and, ultimately, the rise of Communism. …

Did any of those problems actually materialize? As the saying goes "the proof is in the pudding." There was no government takeover, no rise of Communism, and no insolvency. In fact, Roosevelt proceeded to increase government deficit over 20% of GDP during WWII without any of those problems arising. …

The overall cost of running [US depression era] programs was extremely small, less than 1% of GDP. Despite their limited scope, they helped millions of people to make a living, helped to avoid waste of resources (if they had been left idle), and promoted the growth of U.S. infrastructures. In addition, the large deficit spending flooded the private sector with cash; thereby, restoring profitability and willingness to employ. War deficit spending reinforced this trend by flushing banks and private businesses with money and by creating a long period of financial stability. All this without any sign of insolvency of the federal government.

A final complaint is usually that government deficit always creates huge inflation and even hyperinflation. There is here a ton of data going against this argument. One just needs to look at Japan over the past 20 years: massive debt, very low interest rate, deflation or stable prices. But we do not have to go that far. Here is the United States, the "massive" deficits of the 1930s and 1940s did not generate high inflation. …

Obama's Big Gambles

Last week's financial news was once-again grim. The Dow sits at 12-year lows, having fallen nearly 2500 points since the beginning of the year. Worse, the index has fallen over 50% in one year, making its worst performance since the Great Depression. Obama and Co. are just beginning the biggest Keynesian stimulus ever seen, that many believe will ultimately run in the three to five trillion dollar range. One BIG gamble! Another gamble will be to see if this and subsequent Administrations and the US Congress can then claw back enough money — new taxes — to cover the near-term push.

Two other gambles are in play. First, US President Barack Obama seeks to do what has proven impossible for many other Administrations: to reform the US health care system, and simultaneously to reform and green-up US energy policy. Second, Obama seeks to end Bush's Iraq war, which Tomas Ricks believes history will record as "the biggest mistake in the history of American foreign policy". Obama also seeks to do something positive relative to the rest of the Middle East, especially focused on Afghanistan and Pakistan. We will leave the latter two gambles for later posts and will today focus on the stimulus gamble. Some stage-setting:

Borrow and Spend

Not many years ago Republicans railed against a Democrat-dominated US Congress for what they believed to be highly wasteful and dangerous Tax and Spend Liberalism. That day is gone. Now we fear Borrow and Spend tactics from both sides of the political aisle. This borrow and spend era began in earnest with Ronald Reagan. It was revisited, mimicked really, with George W. Bush's three trillion adventure into Iraq (See, e.g. Stiglitz and Bilmes, Washington Post, Mar 9, 2008) and the beginning salvos of a bailout in the wake of our recent financial meltdown. (For more see Wikipedia, Public Debt).

Now Barrack Obama intends to lead us further down the Borrow and Spend road into a massive Keynesian Fiscal Stimulus that could cost up to to 5 trillion dollars. (Wikipedia, Keynesian Economics).

The end of capitalism or just the end of Laissez-faire capitalism?

The Obama Administration claims they are doing only what is needed. Maybe. I don't know. My biggest fear is that no matter what "stimulus" is thrown at the problem, we simply can't create enough high paying jobs fast enough to innovate our way out of this crisis. When you listen to pundits telling us how we are going to grow our way out of this crisis — more jobs, more wealth — remember what is happening around us with computerized robotics and networked information systems. And the threat isn't just "manufacturing", but "professional practices" in medicine, law, accounting, and so on. Remember too, that the latest-greatest fad, new jobs in financial engineering just failed too.

The winds of Joseph Schumpeter's creative destruction (Wiki link) might this time blow away capitalism as we've known it. You tell me where the jobs are going to come from. I know that prediction is always flawed, and that historically we've "creatively" come up with jobs whenever our capitalist systems were threatened. But I keep hearing echoes from all the great economists, fearing an end to capitalism. Is it near? In any case I just can't see what these new jobs are going to be shaped from. Likely I'm just being short-sighted and frightened. Amidst it all, the Republican right howls about Obama and socialism (put those two word into Google and see what pops up).

If indeed the end of capitalism is not near then I side with the majority of economists that this rediscovered Keynesian is the way forward. If capitalism is indeed dead, we will have given a gift to the banking community that is largely resposible for getting us once again into this mess. And, maybe set a stage for hyperinflation. Scary thought! In either case, I remain angry about the fact that we really didn't have to get into this mess again. The lessons from the 1920s and 1930s should have kept us from allowing the massive bubbles to form this time around. But prevailing Friedmanite economic ideology (Wiki Link) that has only recently been debunked — for how long? — pretty much silenced dissenting voices and reasoning that might have prevented all. That is, prevented politicians, CEOs, brokers, "quants", lenders, borrowers, from drinking the Kool Aid this time around. Serious students of Keynes know that not only do you have to stimulate big economies sometimes, but you also have to "stabilize" by cooling over-heated economies. On that front, we all need to read more Minsky as Financial Times' Martin Wolf recently noted.

This transition, no matter where it takes us will be difficult and many people are going to be hurt, distressed, disgusted, and so on. Doug Noland says

… Today's Post-Bubble Facts of Life [Feb 12] create a serious policymaking dilemma. Unimaginable wealth was shifted to "Wall Street" and their client base during the boom, while millions of regular folk were saddled with unmanageable debt and, now, negative net worth. Those on the right side of the inflationary boom accumulated historic wealth, while millions on the wrong side destroyed their financial health. The runaway boom inflated expectations — and now comes the depressing phase of disappointment and growing despair. Of course the populace is ticked off, spurring politicians to vilify and seek amends and wealth redistribution. In this regard, there are no surprises today to those of us that have studied the post-1929 landscape. …

At minimum, historians are going to have a field day with this moment. For the rest of us, we have to hope that somehow we can find a reasonable path forward.

None Dare Call it Fascism: Moyers and Galbraith

Last Friday, Bill Moyers sat down with Jamie Galbraith to talk about The Predator State and our current mess relative to 1929-. Galbraith says that like 1929-,

The situation today is very similar to the moment of panic and collapse that we saw in 1929. And for very similar reasons. An abandonment of the supervisory responsibility that should have been applied to keep the speculation and the fraud and the abuse from getting out of control. So there's going to be a major period of correction. And dad, [John Kenneth Galbraith, The Great Crash 1929 writing] in 1955, talks about how memory fades and how eventually, although so long as people remembered '29 it wouldn't be repeated, eventually it would be forgotten and the underlying speculative impulse would come back.

Galbraith differs from many who blame our current mess on"the deficit", on the US Government living beyond its means:

BILL MOYERS: But even Barack Obama's website calls the deficit America's "Domestic Enemy." Even he's aware of the fact that the deficit's beyond sight.

JAMES GALBRAITH: Well, the deficit isn't beyond sight. The deficits in the Bush administration in relation to the size of the economy were never all that large. They were certainly larger than they were under Clinton, but that was in part necessary because of the changed economic situation, the collapse of the dot-com bubble in 2000.

The United States government's credit is good. The deficit is a financial number that people are going to have to get used to because there is no way in these circumstances of avoiding an increase in the deficit. One of two things can happen. The government can take action and help stabilize the economy in which case we will have more spending but also more employment.

Or the government cannot take action and let the economy collapse in which case we will have much less tax revenue. The deficit is going to be larger either way. There is no way of avoiding that. The only question is do you work to have a good economy or do you accept a terrible economy?

BILL MOYERS: What are the negative effects of a soaring deficit?

JAMES GALBRAITH: Well, the one thing I would have worried about is that we might not find lenders who are willing to provide funds to the U.S. government, that the Chinese or the Japanese might decide that they would rather be in some other currency and that we'd then have trouble with inflation. But that's not going to happen. It's not going to happen because, as it turns out, the major alternative, the euro, simply isn't viable as a reserve asset for the rest of the world. It's the dollar or nothing. So the United States basically can finance itself to the extent necessary to deal with this crisis. And I'm right now quite sanguine about that, quite confident that we won't face a problem.

At the end of the interview, Moyers gets to Galbraith's new book, The Predator State, and how some like Steve Forbes are already beginning to blame the mess on reformers like Galbraith. Here's a snip

BILL MOYERS: [T]here are capitalists like Steve Forbes, … of "Forbes Magazine," who argue that people like you are going to go too far and that it was actually the government's excesses and failures in the '80s and '90s that contributed to what began to happen in 2007 with the meltdown. And that if you have your way, people like you have your way, you will criminalize business. You will raise taxes and dry up the economy. You will take government unchecked into the same kind of catastrophe that unchecked Wall Street has carried us. How do you answer a Steve Forbes?

JAMES GALBRAITH: Well, first of all, I very much agree with him, that it was failures of government that were responsible for this. It was the actual failure, the abandonment, the neglect of the supervisory regulatory responsibility. That's at the root of this.

Just as you cannot prosper without a private economy, you cannot prosper without an effective autonomous government capable of thinking for itself, capable of balancing things out, of standing for other interests, of standing for labor and consumers and for the public interest as a whole. If you don't have that, you're going to get these pyramids, these bubbles, these epidemics of fraud and abuse, and ultimately the collapse of trust and the collapse of the economy itself. That's what's happened in the predator state.

I agree with Galbraith on much, including the fact that both private (e.g. so-called "rating agencies") and public regulators (e.g. government agencies, the US Congress, and US Adminsitrations dating back to Ronald Reagan) were asleep at the wheel. I hope Galbraith is right about the US dollar's non-endangered "reserve currency" status for the near term. I also hope he and other reformers are able in the next few years to restructure the world's financial systems to set a stage for thoughtful investment rather than unbridled speculative excess.

Note: My title might better have been written "None Dare Call it Corporatism." Here is a Wikipedia link to Corporatism. See also Wikipedia on The Economics of Fascism.

Minsky Wake-up Call

For several years I've been using this blog to bring attention to the work of American economist Hyman Minsky — and watching to see who might be warming up to the work he began and others continue at the Levy Economics Institute at Bard College. In brief, the work is Post Keynesian and tracks money and credit flows with an eye toward instability — stability breeds instability and fragility trumps resilience at times. Bubbles need to be dealt with as they emerge, not by papering over them in the aftermath. Now Financial Times' Martin Wolf, building on a paper from Carmen Reinhart and Kenneth Rogoff deliveris a wake-up call to American bankers: Pay Attention to Minsky!

I will be watching around the blogosphere to see who else, particularly among American economists seems to be warming up to the real causes of great contractions, and who begins to show signs of learning lessons not-yet-learned. I will update this post and add others as I see evidence of economists waking up. Economists have lead the decent to the edge of the Abyss, and are rightfully blamed for their part in the mess. To Wolf:

Asia's revenge, Martin Wolf, October 8, Financial Times: What confronts the world can be seen as the latest in a succession of financial crises that have struck periodically over the last 30 years. The current financial turmoil in the US and Europe affects economies that account for at least half of world output, making this upheaval more significant than all the others. Yet it is also depressingly similar, both in its origins and its results, to earlier shocks. …

Carmen Reinhart of the University of Maryland and Kenneth Rogoff of Harvard University identify the similarities in a paper published earlier this year.* They focus on previous crises in high-income countries. But they also note characteristics that are shared with financial crises that have occurred in emerging economies.

This time, most emerging economies have been running huge current account surpluses. So a "large chunk of money has effectively been recycled to a developing economy that exists within the United States' own borders", they point out. "Over a trillion dollars was channelled into the subprime mortgage market, which is comprised of the poorest and least creditworthy borrowers within the US. The final claimaint is different, but in many ways the mechanism is the same." …

[L]inks between the financial fragility in the US and previous emerging market crises mean that the current banking and economic traumas should not be seen as just the product of risky monetary policy, lax regulation and irresponsible finance, important though these were. They have roots in the way the global economy has worked in the era of financial deregulation. Any country that receives a huge and sustained inflow of foreign lending runs the risk of a subsequent financial crisis, because external and domestic financial fragility will grow. Precisely such a crisis is now happening to the US and a number of other high-income countries including the UK.

These latest crises are also related to those that preceded them – particularly the Asian crisis of 1997-98. …

The big global macroeconomic story of this decade was, then, the offsetting emergence of the US and a number of other high-income countries as spenders and borrowers of last resort. Debt-fuelled US households went on an unparalleled spending binge – by dipping into their housing "piggy banks".

In explaining what had happened, Ben Bernanke, when still a governor of the Federal Reserve rather than chairman, referred to the emergence of a "savings glut". The description was accurate. After the turn of the millennium, one of the striking features became the low level of long-term nominal and real interest rates at a time of rapid global economic growth. Cheap money encouraged an orgy of financial innovation, borrowing and spending.

That was also one of the initial causes of the surge in house prices across a large part of the high-income world, particularly in the US, the UK and Spain. …

The savings glut had another dimension, related to a second financial shock – the bursting of the dotcom bubble in 2000. One consequence was the move of the corporate sectors of most high-income countries into financial surplus. In other words, their retained earnings came to exceed their investments. Instead of borrowing from banks and other suppliers of capital, non-financial corporations became providers of finance.

In this world of massive savings surpluses in a range of important countries and weak demand for capital from non-financial corporations, central banks ran easy monetary policies. They did so because they feared the possibility of a shift into deflation. The Fed, in particular, found itself having to offset the contractionary effects of the vast flow of private and, above all, public capital into the US.

A simple way of thinking about what has happened to the global economy in the 2000s is that high-income countries with elastic credit systems and households willing to take on rising debt levels offset the massive surplus savings in the rest of the world. The lax monetary policies facilitated this excess spending, while the housing bubble was the vehicle through which it worked. …

[L]inked dangers between external and internal imbalances, domestic debt accumulations and financial fragility were foretold by a number of analysts. Foremost among them was Wynne Godley of Cambridge university in his prescient work for the Levy Economics Institute of Bard College, which has laid particular stress on the work of the late Hyman Minsky.**

So what might – and should – happen now? The big danger, evidently, is of a financial collapse. The principal offset, in the short run, to the inevitable cuts in spending in the private sector of the crisis-afflicted economies will also be vastly bigger fiscal deficits.

Fortunately, the US and the other afflicted high-income countries have one advantage over the emerging economies: they borrow in their own currencies and have creditworthy governments. Unlike emerging economies, they can therefore slash interest rates and increase fiscal deficits.

Yet the huge fiscal boosts and associated government recapitalisation of shattered financial systems are only a temporary solution. There can be no return to business as usual. It is, above all, neither desirable nor sustainable for global macroeconomic balance to be achieved by recycling huge savings surpluses into the excess consumption of the world’s richest consumers. The former point is self-evident, while the latter has been demonstrated by the recent financial collapse.

So among the most important tasks ahead is to create a system of global finance that allows a more balanced world economy, with excess savings being turned into either high-return investment or consumption by the world’s poor, including in capital- exporting countries such as China. A part of the answer will be the development of local-currency finance in emerging economies, which would make it easier for them to run current account deficits than proved to be the case in the past three decades.

It is essential in any case for countries in a position to do so to expand domestic demand vigorously. Only in this way can the recessionary impulse coming from the corrections in the debt-laden countries be offset.

Yet there is a still bigger challenge ahead. The crisis demonstrates that the world has been unable to combine liberalised capital markets with a reasonable degree of financial stability. A particular problem has been the tendency for large net capital flows and associated current account and domestic financial balances to generate huge crises. This is the biggest of them all.

Lessons must be learnt. But those should not just be about the regulation of the financial sector. Nor should they be only about monetary policy. They must be about how liberalised finance can be made to support the global economy rather than destabilise it.

This is no little local difficulty. It raises the deepest questions about the way forward for our integrated world economy. The learning must start now.

*Is the 2007 US subprime financial crisis so different? An international historical comparison. Working paper 13761, www.nber.org

**The US economy: Is there a way out of the woods? November 2008, www.levy.org [concluding hyperlinks empowered by Iverson]

For more from the Levy Economics Institute see, e.g., Macroeconomics Meets Hyman P. Minsky: The Financial Theory of Investment, L. Randall Wray and Éric Tymoigne, September, 2008:

Expanding on an approach developed by financial economist Hyman Minsky, the authors present an alternative to the standard "efficient markets hypothesis—the relevance of which Minsky vehemently denied. Minsky recognized that, in a modern capitalist economy with complex, expensive, and long-lived assets, the method used to finance asset positions is of critical importance, both for theory and for real-world outcomes—one reason his alternate approach has been embraced by Post Keynesian economists and Wall Street practitioners alike.

[Wray and Tymoigne] argue that the current financial crisis, which began with the collapse of the U.S. subprime mortgage market in 2007, provides a compelling reason to show how Minsky’s approach offers us a solid grounding in the workings of financial capitalism. They examine Minsky’s extension to Keynes’s investment theory of the business cycle, which allowed Minsky to analyze the evolution, over time, of the modern capitalist economy toward fragility—what is well known as his financial instability hypothesis. They then update Minsky's approach to finance with a more detailed examination of asset pricing and the evolution of the banking sector, and conclude with a brief review of the insights that such an approach can provide for analysis of the current global financial crisis

Another Frightening Show About the Economy: NPR Edition

If you want to get really scared/mad about our current financial mess, take an hour and listen to last Friday's version of Chicago Public Radio's This American Experience, titled Another Frightening Show About the Economy.

Act One: The Day the Market Died
Act Two: Out of the Hedges and into the Woods
Act Three: Swap Cops
Act Four: What's Next

A few quick notes:

Act One helps us better understand how the very boring arena of Commercial Paper recently caught the attention of high government officials when the arena suddenly dried up, threatening businesses small and large, state governments, and more.

Act two delves deep into Credit Default Swaps and might be subtitled: How 'Insurance' morphed into 'Speculation' on a massive, unprecendented scale. If you want to get a good feel for these arcane instruments, listen closely. A Snip: "If bad mortgages got the financial system sick, [Credit Default Swaps] helped spread the sickness into an epidemic."

Act Three helps us better understand Regulation (or the lack of it). For example, Why were CDSs not regulated, say, way back in 1998 when Michael Greenberger, then with the U.S. Commodities Futures Trading Division, and others tried to get such regulation? Many in the Clinton Administration and Congress argued, according to Greenburger, "These products are entered into by very sophisticated financial institutions … you and I couldn't buy them … and these people are very, very smart and it is a mistake to let government get in the way." In Dec. 2000, Congress passed a law — as a little-discussed 262 page rider to an Omnibus Appropriations Bill — that credit default swaps and things like them could not be regulated. So it went! So it goes… Nobody was even trying to restrain the investors, turned 'speculators.'

Greenburger concludes, "… The idea that you can have $60 Trillion in a financial market which is more than all the stock sold anywhere in the world and not have any oversight whatsoever is self-evidently absurd, and we are seeing the end result of that today."

Act Four give us some insight into the Bailout Bill as it was, and as it transformed into Law.

And if that whets your appetite, listen/read to Michael Greenberger's Sept. 17 Was Adult Supervision Needed on Wall Street?, also from NPR.

HT: Calculated Risk

A Trillion Here, A Trillion There

Rumor has it that former US Congressman Everett Dirksen once quipped "… a billion here, a billion there, and pretty soon you are talking about some real money." In the last few years we've upped the ante. Now it's a trillion here, a trillion there — on the Wall Street Bailout, on the Iraq War, for instance. It looks like the NeoCons have at least insured that the government will be squeezed in times to come. Their dark dream of Starving the Beast, however, is not a short-term outcome though. Looks like the US government is getting ever-more-powerful by the day and by the year, in both military and financial arenas. Or maybe that was their real dream after all. Sad but likely true: Too few NeoCons will go to jail. Too many of the rest of us will suffer.

Here is Gretchen Morgenson's take on the latest phase of the mess in today's NY Times, subtitled Fixing Others' Mistakes:

…Treasury Secretary Henry M. Paulson Jr. [Paulson] has called the fund the "troubled asset relief program." I'll just call it TARP for short (you know, the kind of thing they spread over muddy fields so you don’t soil your Guccis). [Iverson note: Yesterday, Willem Buiter called it a TAD: Toxic Asset Dump ].

And depending on how TARP is operated, and how the assets are valued before taxpayers are forced to buy them, it could bloat our final bill for this mess while benefiting the very institutions that got us into it.
Yes, we need a smart plan and a concerted effort to get the frozen credit markets up and running. But we also have to be certain that the types of conflicts of interest that riddle Wall Street aren't visited upon TARP.

Consider: A bank wants to sell the TARPistas (also known as TAXPAYERS) a pile of stinky mortgage securities that it currently values at 60 cents on the dollar. Let’s assume that the most recent actual trade between market participants for similar assets was struck at 30 cents on the dollar.

So what's a fair price that we TARPistas should pay for the assets?

If we bought at 60 cents, a price that the bank would argue is appropriate, we would most likely face a loss. The bank, however, would be much better off than if it had to dump at 30 cents.

Conversely, if the assets were sold at 30 cents, taxpayers could wind up making a profit on the purchase if the assets performed better than expected over time. But the bank would have to write down the value of the assets as a result of the sale, possibly threatening its financial standing yet again.

Do you think, perchance, that financial services lobbyists might be working their Hill contacts right this very
minute to ensure that the TARP valuations are rigged in their favor?

You know the answer to that.

And you also know that we should steel ourselves for heavy losses as the TARP gets pulled over our eyes. Never mind that it was the banks, with their reckless lending and monumental leverage, that drove us into this ditch.

Such is our lot today: They break it. We own it. …

For background, here is yesterday's NY Times look at Hank Paulson and Ben Bernanke's recent takeover of the US financial system: A Professor and a Banker Bury Old Dogma on Markets .

Today Paul Krugman tells us that he isn't sure that the TARP isn't instead just the perverbial 'wool pulled over our eyes':

Thinking the Bailout Through: … Even without panic asset selling, the financial system would be seriously undercapitalized, causing a credit crunch — and this plan does nothing to address that.

Or I should say, the plan does nothing to address the lack of capital unless the Treasury overpays for assets. And if that's the real plan, Congress has every right to balk.

So what should be done? Well, let's think about how, until Paulson hit the panic button, the private sector was supposed to work this out: financial firms were supposed to recapitalize, bringing in outside investors to bulk up their capital base. That is, the private sector was supposed to cut off the problem at stage 2.

It now appears that isn’t happening, and public intervention is needed. But in that case, shouldn't the public intervention also be at stage 2 — that is, shouldn’t it take the form of public injections of capital, in return for a stake in the upside?

Let's not be railroaded into accepting an enormously expensive plan that doesn’t seem to address the real problem.

Yves Smith hates the Paulson/Bernanke plan too, and tries to help us better understand why:

Why You Should Hate the Treasury Bailout Proposal …First, let's focus on the aspect that should get the proposal dinged (or renegotiated) regardless of any possible merit, namely, that it gives the Treasury imperial power with respect to a simply huge amount of funds. $700 billion is comparable to the hard cost of the Iraq war, bigger than the annual Pentagon budget. And mind you, $700 billion is not the maximum that the Treasury may spend, it's the ceiling on the outstandings at any one time. It's a balance sheet number, not an expenditure limit.

But here is the truly offensive section of an overreaching piece of legislation:

Decisions by the Secretary pursuant to the authority of this Act are non-reviewable and committed to agency discretion, and may not be reviewed by any court of law or any administrative agency.

This puts the Treasury's actions beyond the rule of law. This is a financial coup d'etat, with the only limitation the $700 billion balance sheet figure. The measure already gives the Treasury the authority not simply to buy dud mortgage paper but other assets as it deems fit. There is no accountability beyond a report (contents undefined) to Congress three months into the program and semiannually thereafter. The Treasury could via incompetence or venality grossly overpay for assets and advisory services, and fail to exclude consultants with conflicts of interest, and there would be no recourse. Given the truly appalling track record of this Administration in its outsourcing, this is not an idle worry.

But far worse is the precedent it sets. This Administration has worked hard to escape any constraints on its actions, not to pursue noble causes, but to curtail civil liberties: Guantanamo, rendition, torture, warrantless wiretaps. It has used the threat of unseen terrorists and a seemingly perpetual war on radical Muslim to justify gutting the Constitution. The Supreme Court, which has been supine on many fronts, has finally started to push back, but would it challenge a bill that sweeps aside judicial review? …

And Robert Reich said on Thursday that The Bailout of All Bailouts leaves too much room for future Wall Street shenanigans, for future "moral hazard."

… A better idea would be for the Fed and Treasury to organize a giant workout of Wall Street — essentially, a reorganization under bankruptcy, for whatever firms wanted to join in. Equity would be eliminated, along with most preferred stock, creditors would be paid off to the extent possible. And then the participants would start over with clean balance sheets that reflected new, agreed-upon rules for full disclosure, along with minimum capitalization. Everyone would know where they stood. Bad debts would be eliminated. Taxpayers wouldn't get left holding the bag. And there would be no "moral hazard" incentive for future financial wizards to take giant risks with other taxpayers' money.

Today Reich lays out five conditions that ought to be placed on any Bailout:

What Wall Street Should Be Required to Do, to Get A Blank Check From Taxpayers … 1. The government (i.e. taxpayers) gets an equity stake in every Wall Street financial company proportional to the amount of bad debt that company shoves onto the public. So when and if Wall Street shares rise, taxpayers are rewarded for accepting so much risk.

2. Wall Street executives and directors of Wall Street firms relinquish their current stock options and this year’s other forms of compensation, and agree to future compensation linked to a rolling five-year average of firm profitability. Why should taxpayers feather their already amply-feathered nests?

3. All Wall Street executives immediately cease making campaign contributions to any candidate for public office in this election cycle or next, all Wall Street PACs be closed, and Wall Street lobbyists curtail their activities unless specifically asked for information by policymakers. Why should taxpayers finance Wall Street’s outsized political power – especially when that power is being exercised to get favorable terms from taxpayers?

4. Wall Street firms agree to comply with new regulations over disclosure, capital requirements, conflicts of interest, and market manipulation. The regulations will emerge in ninety days from a bi-partisan working group, to be convened immediately. After all, inadequate regulation and lack of oversight got us into this mess.

5. Wall Street agrees to give bankruptcy judges the authority to modify the terms of primary mortgages, so homeowners have a fighting chance to keep their homes. …

I can't wait to see what the next few weeks/months bring. "Interesting Times" indeed! Looks like a good time for me to resume this blog…

Catching up on Financial 'Interesting Times'

Let's begin with Paul Krugman's Dec 14 Authors@Google Series video on how we got into our current financial mess and some "mysteries" on how we might get out of it this side (or the other side) of a 'hard landing.' In this very good hour with Krugman, he covers the previous Long Term Capital Management induced mess, the Nasdaq "tech bubble", the housing bubble, the Fed, "financial innovation", and more. Good insights for we who don't spend 24/7 dealing with matters financial:

Krugman believes that the housing mess is with us for about the next six years, guessing, based on early '90s S. California housing bust, with an average 30% price drop (in "real" dollars) from "bubbleicious" peaks. In a blog post today, Unknown Housing Territory, Dec 19, Krugman gives us more:

… The bubbles in the most bubbleicious areas were bigger than anything we've ever seen — and there's every reason to think that the required fall in prices in those areas will be much bigger than anything we've seen since the Great Depression. …

In the video, Krugman admits being surprised by the enormous impacts of the housing and related credit crunch have on the "financial system". He highlights how the Fed has been 'behind the curve' on dealing with this latest crisis, naïvely believing that the same medicine that 'solved' the LTCM mess years ago would suffice here. Since that medicine didn't work this time, Krugman gives us glimpses of the newer approaches central bankers are trying to put into play.

One Highlight: Glassman's law, as a correlary to Stein's law (also from Bubble Denial, Dec 10 on Krugman's blog):

… [B]ack in 2005, when I started writing about the housing bubble — it didn't take much to see that something was way out of whack.

So how come the housing crisis has come as such a surprise to so many people?
Part of it was the usual bubble psychology. Economists like to cite Stein's Law: "If something cannot go on forever, it will stop." I think it needs to be paired with another law — let's call it Glassman's Law — along the lines of "If something unsustainable goes on for a while, there will be people claiming it can go on forever."

According to Krugman, everybody looks to the 1998 'fix' for the Long Term Capital Management debacle as a model for this episode. Problem is, that strategy doesn't seem to be working this time. The 'fix' as applied last August, seemed to work for awhile, but 'trouble' is now welling up again. So the Fed and other Central Bankers are now trying hard to funnel short- to medium-term liquidity into the system.

Krugman is hoping this latest, belated effort from central bankers will work, although he suggests there are no 'quick fixes' to this mess — adding that we still don't even know the size and extent of the mess. "Steve Cechetti is hopeful but has his doubts", says James Hamilton in his Monetary Policy Using the Asset Side of the Fed's Balance Sheet, Dec 16. Whatever you read from these extended hyperlinks, don't miss Cechetti's The Art of Crisis Management: Auctions and Swaps, Dec 16.

Noruiel Roubini is even less sure that even this latest easing will help , although he has been advising central bank "easing" for some time. See Roubini: First, Central Banks Are Getting Desperate in Dealing with the Liquidity Crunch …, Dec 18, and second, Why Monetary Policy Easing is Warranted Even in the Current Insolvency Crisis, Dec 15

Finally, Michael Shedlock (as an interesting member of the Libertarian Right) is apoplectic, not only at what he considers continuing mis-steps by the Fed, but also since Roubini, whom he admires as a forecaster, doesn't buy Shedlock's particular brand of 'free market fundamentalism': asking for the Fed to be abolished and for a return to the gold standard and private banking. See Shedlock's Missing the Boat on Monetary Easing, Dec 18.

Quite a bunch of interesting stuff out and about! Mostly I just sit back and read from the really good commentators I track on my sidebar (and my Google Reader). I don't pretend to be in the same league as they are on matters of finance and geopolitics. But I do like to try to sort out some of it, second hand. Ocasionally I even help others in their own sorting, and that makes this little hobby of mine worthwhile.

Happy Holidays to those who are celebrating such during this season.

The Debt and the Deficit

I am a big fan of Peter Bernstein. I recently re-read The Debt and the Deficit to refresh my mind as to where we stand relative to both. Bernstein co-authored the book with Robert Heilbroner back in 1989. Heilbroner and Bernstein argue that, by itself, cutting the American budget deficit will not increase private savings, indeed it might help make it worse. In response to the question, "Can we raise the national savings rate by cutting the budget deficit?", they say:

The answer is no if that will result in a further squeeze on household and business income. The answer is yes if at the same time we are committed to measures to improve the productivity and international competitiveness of the American economy. And the achievement of these goals is critically dependent on a high level of public as well as private investment.

I highly recommend this little book to any who struggle with our current and historical debt and deficit problems. Too bad Heilbroner and Bernstein's insights were not followed. Here in the USA, we might have turned around our slide into household sector "dissaving". We might have rethought our using the military-industrial complex for purposes of Military Keynesianism (to whatever extent this very controversial proposition may have been employed (see also Republic or Empire)). We might have imposed a gas tax, as they then advised, in an era long before allegations of corporate wrong-doing and price gouging became fashionable.

All of it might have been done while keeping an eye open to the need to move more slowly into Globalization with some form of nation-to-nation capital flow controls to keep "hot money" from creating ever-bigger bubbles to later burst wreaking havoc afterwards. All of it might have been done with some form of policy to moderate the waves of outsourcing and offshoring that have plagued middle-class workers in the "more developed" countries. Oh well!