naked capitalism

By George Washington of Washington’s Blog .

Daniel Gross points out that part of the reason that the American stock markets are going up even though unemployment is rising and the real economy suffering is because multinational corporations headquartered in the U.S. are experiencing strong sales abroad:

Here’s a puzzle: The stock markets are doing very well, yet the performance of the underlying economy doesn’t seem to justify optimism. The buoyant S&P 500 has risen 53 percent since the March bottom. And while the economy expanded at a 3.5 percent rate in the third quarter, unemployment is high, incomes are stagnant, and consumers are shaky…

It could be that the notion the stock market is an accurate gauge of the domestic economy’s temperature is outdated.

The Dow, the S&P 500, and the NASDAQ are primarily indices of large U.S.-based companies, not main street businesses: more Davos than Chamber of Commerce. These increasingly cosmopolitan firms have been busy globalizing and expanding their operations overseas. In 2006, according to Standard & Poor’s, 238 members of the S&P 500 broke out revenues between U.S. and non-U.S. sales. These companies notched about 43.6 percent of sales outside the United States. For large companies that had already saturated the U.S. market, the home market was something of an afterthought. In the second quarter of 2007, 66 percent of Coca-Cola’s beverage business came from outside North America.

And thanks to the long recession, demand for products and services of all types in the United States has shrunk even since 2006. Yes, the global economy in 2008 experienced its first year of shrinkage since World War II. But growth has resumed, and in some places—Peru, China, India—it never stopped. As a result, the globe’s economic geography has continued to change, with the United States accounting for a smaller chunk of global output and demand each year. For much of the past two years, virtually all growth in economic activity has taken place outside America’s borders. As a result, U.S.-based companies are becoming even more reliant on non-U.S. customers and operations for sales… in two years, big companies’ proportion of sales coming from outside the United States rose 9.8 percent. It’s likely the 2009 figure will be something very close to 50 percent.

Don’t American Workers Win?

The fact that companies based in America are raking in profits from sales abroad is good for American workers, right?

No.

Gross points out that American workers don’t benefit because a lot of the goods sold abroad by American multinationals are made abroad:

If companies participated in foreign markets primarily by exporting U.S.-made goods, this shift would be good news for the U.S. economy and workers. But that’s not how it works. In fact, in the months after the global credit meltdown, U.S. exports plummeted. They bottomed in April, at $120.6 billion, and though they have been rising, the August 2009 total is still 20 percent below the August 2008 total. Globalization is changing the way we do business. It’s not a matter of U.S. companies exporting goods—burgers, soda, cars, software—made in the United States to Beijing but rather, making goods overseas and selling them overseas…

“Based on a Russian fairy tale and produced in Russia using local talent, the film is the latest step in Disney’s broad push into local language production,” the FT reports. As Disney CEO Robert Iger put it: “We would not be able to grow the Disney brand … if we just created product in the US and exported it to the rest of the world.” If Book of Masters succeeds, it will be good for Disney’s American shareholders but won’t do a whole lot of good for its U.S.-based employees. Or consider American icon General Motors. GM’s sales in China are rocking. In the first nine months, the company sold 1.3 million cars in China, including more than 181,000 in September. By contrast, GM in the United States in the first nine months sold 1.5 million cars in the United States, down 36.4 percent from the year before. And in September, GM sold just 156,673 cars in the United States. That growth in China is good for GM’s shareholders and for some of its executives. But since most of the cars sold in China are produced there, with parts produced by suppliers in China, rising sales in the Middle Kingdom won’t translate into jobs for unionized workers in the Middle West.

The rising U.S. stock market and a weak, slow-growing U.S. consumer sector aren’t really in contradiction. Given the large-scale trends transforming the global economy—and the role of large U.S. companies in it—it may be possible to have a sustainable rally in American stocks without a sustainable rally by American consumers.

Don’t Multinationals Pay A Lot in Taxes?

Well, at least the multinationals are paying a good chunk of taxes into the American economy, right?

Not exactly.

The Washington Post notes:

About two-thirds of corporations operating in the United States did not pay taxes annually from 1998 to 2005, according to a new report scheduled to be made public today from the U.S. Government Accountability Office…

In 2005, about 28 percent of large corporations paid no taxes…

Dorgan and Sen. Carl M. Levin (D-Mich.) requested the report out of concern that some corporations were using “transfer pricing” to reduce their tax bills. The practice allows multi-national companies to transfer goods and assets between internal divisions so they can record income in a jurisdiction with low tax rates…

[Senator] Levin said: “This report makes clear that too many corporations are using tax trickery to send their profits overseas and avoid paying their fair share in the United States.”

Indeed, as Pulitzer prize winning journalist David Cay Johnston documents, American multinationals pay much less in taxes than they should through a variety of widespread schemes, including:

• Selling valuable assets of the American companies to foreign subsidiaries based in tax havens for next to nothing, so that those valuable assets can be taxed at much lower foreign rates

• Pretending that costs were spent in the United States, so that the companies can count them as costs or deductions in the U.S. and pay less taxes to the American government

• Booking profits as if they occurred in the subsidiary’s tax haven countries, so that taxes paid on profits are at the much lower safe haven rate

• Working out sweetheart deals with certain foreign governments, so that the companies can pretend they paid more in foreign taxes than they actually did, to obtain higher U.S. tax credits than are warranted

• Pretending they are headquartered in tax havens like Bermuda, the Cayman Islands or Panama, so that they can enjoy all of the benefits of actually being based in America (including the use of American law and the court system, listing on the Dow, etc.), with the tax benefits associated with having a principal address in a sunny tax haven.

• And myriad other scams

As Johnston documents, the American economy is hurt by the massive underpayment of taxes by the huge multinationals.

From Veneroso Associates’ US Economy October Employment Report, ” Huge Discrepancy Between the Payroll and Household Surveys:

Executive Summary

1. According to BLS, payrolls fell at a 188,000 a month rate over the last three months. But their own household survey says employment fell at a 589,000 a month rate.

2. Why the discrepancy?

3. Chris Manning of the BLS told us last month that payrolls were overestimated in the twelve months ending March by 824,000. The source of this error was the birth/death model. BLS used “plug” numbers for the number of births and deaths. These “plug” numbers were wrong. They led to estimated positive contributions to employment that were too high. Most of the error (675,000 out of a total 824,000 jobs) occurred in the first quarter of this year. The birth/death model was adding significantly to payrolls when all other payrolls were falling. In reality the contribution from net births and deaths was in fact negative.

4. Manning told us that the faulty birth/death model was still being used for the months after March of this year. The implication was that the faulty birth/death model would continue to overstate payrolls and understate the payroll job losses in the months since March.

5. And, in fact, the BLS is doing just that. For the last three months they are assuming net birth/deaths have added 18,000 jobs a week. Last year over the same period they assumed it added 17,000 a week, the year before 18,000 a week, and the year before smack in the middle of the economic boom 18,000 a week.

6. It is obvious what BLS is doing. They are simply plugging in an extrapolated figure with zero adjustment for the most severe labor market contraction in three generations. And, worse yet, they know the birth/death number they are using is pure baloney.

7. NUTS!

8. Therefore, reality probably lies somewhere between the payroll survey monthly rate of job loss of 188,000 and the noisy household survey rate of job loss of almost 589,000. A best guess would be that jobs continue to be lost at a rate of 300,000 a month or more.

Payrolls were down 190,000. A slightly larger decline than the consensus. But prior payrolls were revised to show a lesser decline in August and September combined of 91,000. Payrolls with revisions declined only 99,000.

From a payroll survey perspective employment conditions are improving significantly. Not so from a household survey perspective.

The unemployment rate rose by .4%. I expected a rise, but only because I expected the sharp drop in the labor force in recent months to be partly reversed. In fact the labor force fell further by 31,000. The increase in the unemployment rate came entirely from another huge decline in the household measure of employment of 589,000. This followed declines of 785,000 in September and 292,000 in August. That is an average monthly rate of decline in employment of 589,000. That is as bad as it has been for the entire recession adjusted for population discontinuities.

The household survey of employment is a very noisy series. I was absolutely certain that, after the huge declines of August and September, we would see a much lesser decline in household survey employment in October. I thought that a decline of 200,000-300,000 would still signal serious employment weakness because of the huge declines in the prior two months.

No matter how noisy we think the household survey is, we have to take these household survey employment declines seriously. The three month decline may not be close to 1.8 million; it may be half that. It does not matter. A 300,000 a month rate of employment decline is very serious.

How can there be such a huge divergence between the household survey which now shows almost 600,000 job losses a month and the payroll survey which now shows average job losses of under 200,000 a month? Part of it, of course, is data noise. But part of it must be a continued overestimation of net positive job creation arising from the notorious birth/death model….

Therefore, reality probably lies somewhere between the payroll survey monthly rate of job loss of 188,000 and the noisy household survey rate of job loss of almost 589,000. A best guess would be that jobs continue to be lost at a rate of 300,000 a month or more.

Is this consistent with anything else? Yes. Though the manufacturing ISM showed a huge increased in its employment index, the non-manufacturing ISM showed a significant decrease to a low level. The vast majority of employment is in the non-manufacturing sector.

Also, if the rate of job loss was seriously contracting the work week should be rising. A move to a longer work week is often the first move by employers when labor conditions start to improve. The payroll survey shows a decline in the work week over the last three months and no improvement in the last month.

The latest initial and continuing claims suggest that there is some recent abatement in job losses. But they have probably continued at a significant rate and income destruction probably continues at a rapid pace….

As for the markets, they are so clueless at reading the fundamentals I have no idea how they will react to this data.

By George Washington of Washington’s Blog.

Investors are basically rational, right?

In fact, as many studies have demonstrated, the answer is no.

But instead of wading through all of the investment psychology research, let’s look at research into people’s basic reasoning abilities. Bear with me for a minute. A study in an area unrelated to investing sheds light on people’s basic thinking processes.

Sociologists from four major research institutions investigated why so many Americans believed that Saddam Hussein was behind 9/11, years after it became obvious that Iraq had nothing to do with 9/11.

The researchers found, as described in an article in the journal Sociological Inquiry (and re-printed by Newsweek):

• Many Americans felt an urgent need to seek justification for a war already in progress

• Rather than search rationally for information that either confirms or disconfirms a particular belief, people actually seek out information that confirms what they already believe.

• “For the most part people completely ignore contrary information.”

• “The study demonstrates voters’ ability to develop elaborate rationalizations based on faulty information”

• People get deeply attached to their beliefs, and form emotional attachments that get wrapped up in their personal identity and sense of morality, irrespective of the facts of the matter.

• “We refer to this as ‘inferred justification, because for these voters, the sheer fact that we were engaged in war led to a post-hoc search for a justification for that war.

• “People were basically making up justifications for the fact that we were at war”

• “They wanted to believe in the link [between 9/11 and Iraq] because it helped them make sense of a current reality. So voters’ ability to develop elaborate rationalizations based on faulty information, whether we think that is good or bad for democratic practice, does at least demonstrate an impressive form of creativity.

An article yesterday in Alternet discussing the Sociological Inquiry article helps us to understand that the key to people’s active participation in searching for excuses for actions by the big boys is fear:

Subjects were presented during one-on-one interviews with a newspaper clip of this Bush quote: “This administration never said that the 9/11 attacks were orchestrated between Saddam and al-Qaeda.”The Sept. 11 Commission, too, found no such link, the subjects were told.

“Well, I bet they say that the commission didn’t have any proof of it,” one subject responded, “but I guess we still can have our opinions and feel that way even though they say that.”

Reasoned another: “Saddam, I can’t judge if he did what he’s being accused of, but if Bush thinks he did it, then he did it.”

Others declined to engage the information at all. Most curious to the researchers were the respondents who reasoned that Saddam must have been connected to Sept. 11, because why else would the Bush Administration have gone to war in Iraq?

The desire to believe this was more powerful, according to the researchers, than any active campaign to plant the idea.

Such a campaign did exist in the run-up to the war…

He won’t credit [politicians spouting misinformation] alone for the phenomenon, though.

“That kind of puts the idea out there, but what people then do with the idea … ” he said. “Our argument is that people aren’t just empty vessels. You don’t just sort of open up their brains and dump false information in and they regurgitate it. They’re actually active processing cognitive agents”…

The alternate explanation raises queasy questions for the rest of society.

“I think we’d all like to believe that when people come across disconfirming evidence, what they tend to do is to update their opinions,” said Andrew Perrin, an associate professor at UNC and another author of the study…

“The implications for how democracy works are quite profound, there’s no question in my mind about that,” Perrin said. “What it means is that we have to think about the emotional states in which citizens find themselves that then lead them to reason and deliberate in particular ways.”

Evidence suggests people are more likely to pay attention to facts within certain emotional states and social situations. Some may never change their minds. For others, policy-makers could better identify those states, for example minimizing the fear that often clouds a person’s ability to assess facts …

The Alternet article links to a must-read interview with psychology professor Sheldon Solomon, who explains:

A large body of evidence shows that momentarily [raising fear of death], typically by asking people to think about themselves dying, intensifies people’s strivings to protect and bolster aspects of their worldviews, and to bolster their self-esteem. The most common finding is that [fear of death] increases positive reactions to those who share cherished aspects of one’s cultural worldview, and negative reactions toward those who violate cherished cultural values or are merely different.

Fear in the Economic and Financial Arenas

Has something similar happened in the economic/financial arenas?

Congressmen Brad Sherman and Paul Kanjorski and Senator James Inhofe all say that the government warned of martial law if Tarp wasn’t passed. And Rahm Emanuel famously said:

Never let a serious crisis go to waste. What I mean by that is it’s an opportunity to do things you couldn’t do before.

Last year:

• Senator Leahy said “If we learned anything from 9/11, the biggest mistake is to pass anything they ask for just because it’s an emergency”

• The New York Times wrote:
  

  “The rescue is being sold as a must-have emergency measure by an administration with a controversial record when it comes to asking Congress for special authority in time of duress.”
  ***

  Mr. Paulson has argued that the powers he seeks are necessary to chase away the wolf howling at the door: a potentially swift shredding of the American financial system. That would be catastrophic for everyone, he argues, not only banks, but also ordinary Americans who depend on their finances to buy homes and cars, and to pay for college.

  Some are suspicious of Mr. Paulson’s characterizations, finding in his warnings and demands for extraordinary powers a parallel with the way the Bush administration gained authority for the war in Iraq. Then, the White House suggested that mushroom clouds could accompany Congress’s failure to act. This time, it is financial Armageddon supposedly on the doorstep.

  “This is scare tactics to try to do something that’s in the private but not the public interest,” said Allan Meltzer, a former economic adviser to President Reagan, and an expert on monetary policy at the Carnegie Mellon Tepper School of Business. “It’s terrible.”

Not Just Government

But it’s not just government . . .

If the too big to fails say that the world economy will crash and there will be martial law unless they are bailed out, politicians – most of whom don’t understand finance or economics – will believe them, and sound the alarm themselves.

As Karl Denninger wrote yesterday:

[AIG's CEO] left Geithner with two documents. One was a fact sheet that listed all the attributes of AIG FP [the division run by Joe Cassano that blew the company up] and argued why it should be given status as a primary dealer. The other–a bombshell that Willumstad was confident would draw Geithner’s attention–was a report on AIG’s counterparty exposure around the world, which included “2.7 trillion of notional derivative exposures, with 12,000 individual contracts.” About halfway down the page, in bold, was the detail that Willumstad hoped would strike Geithner as startling: “$1 trillion of exposures concentrated with 12 major financial institutions.”

Was that a threat?

And isn’t threatening the United States (whether directly or otherwise) something you’re not supposed to do?

Sounds like “Bail me out or I will crash everything.”

Isn’t that analagous to walking into a bank, opening one’s coat to reveal an explosives-laced belt, and saying “gimme all the money or everyone dies!”

Yves Smith has previously used a similar analogy.

Fear Among Individual Investors

Investors – as with politicians or Americans in general – believe that “when [they] come across disconfirming evidence . . . . they tend to … update their opinions”, but in reality, they cling to the beliefs they formed during certain heightened emotional states, such as fear.

Fear turns people into sheep. Once they are sheep, they will strive mightily to justify the actions of their “leaders” – whether those leaders gave trillions of dollars in bailouts or got us into war, and even if the leaders’ justifications were false.

I believe this dynamic is also playing out in the fact that many Americans assume that the government has a real plan for fixing the economy, is working as hard as it can to do so, and that – eventually – things will improve.

Just as most Americans believe “since we’re at war in Iraq, and since the government previously claimed that Saddam was behind 9/11, he must have been”, they are probably thinking “since the government gave trillions to the giant banks and said that economists have figure out how to fix things, they must have done what was needed, and things will turn around in a v-shape recovery”.

The lengths people go to rationalize a false link between Saddam and 9/11 is a great example, because it may reveal by analogy how far people will go to justify their trust in our economic leaders and in their own investment decisions.

Of course, the yearning for high returns is the other half of what drives investor psychology. But this essay focuses on fear.

It was curious to see the immediate complacent stock market reaction to the FOMC remarks that the Fed is going to keep rates low for an extended period (although it did crumble right before the close of trading). Yes, the central bank will have a tricky balancing act when it has to mop up liquidity, so there is a lot of hand-wringing about inflation down the road. But the subtext is that the big risk is deflation. And Japan has never had to worry about mopping up liquidity, it had and still has to worry about creating demand.

Some new sightings on the “where have all the consumers gone” front. The Financial Times reports that Americans are cutting back at the grocery store, even on pet food. That tells me that despite the effect of cash for clunkers and a pick-up in luxury spending, the average consumer is belt-tightening, literally and figuratively:

Tights, sunglasses and boneless chickens have joined the list of casualties of America’s economic crisis, as the era of impulse shopping gives way to more wary behaviour in the nation’s grocery aisles.

Americans unwilling to pay extra for their food to be prepared bought $65m more whole frozen chickens in the third quarter than a year earlier, and $50m fewer boneless birds…

“Instant gratification” categories such as sunglasses and tights registered some of the steepest declines…

Men, keen to look sharp in the office as the country faces its highest unemployment rates for a generation but unwilling to spend on the salons that had enjoyed a male grooming mini-boom, bought 28 per cent more hair-care products at grocery and pharmacy chains.

“The old world was about instant gratification, but in the new world consumers are making a shopping list . . . They’re less impulsive,” Ms Thompson said. “Changes in shopping behaviour suggest some new habits may be emerging.”

The complex interchange of financial and emotional impulses is being felt even by the nation’s cats and dogs as consumers traded down from “wet” pet food, but then supplemented their animals’ more basic diets with snacks “so they still feel good about it for their animals”, Ms Thompson said…

A trend away from eating out led to a 70 per cent jump in the number of ice cream cakes sold, as more children’s birthday parties took place at home. Ready-to-eat popcorn purchases were up 55 per cent and sausage dinners up 27 per cent as more evenings were spent in front of the television.

Popcorn and sausage dinners notwithstanding, some Americans remain willing to pay up for a healthier diet. So-called performance drinks, such as protein smoothies and vitamin-enhanced water, were up 67 per cent, or $7m, at the expense of cola sales.

My own data point is I stopped at Whole Foods last night on the way back from visiting a buddy in the hospital, and the lines were long at 9:30 PM. But New York is afloat on TARP funds, and Whole Foods is still cheaper than ordering in.

Another factoid courtesy DoctoRx is that 63% of Americans expect to spend less on holiday presents this year than last year. And remember, last year people had just witnessed the meltdown. More findings:

The Discover U.S. Spending Monitor fell 3.2 points in October to 85.8 (based out of 100). The decline was primarily due to a rising number of consumers concerned about the state of the economy. Overall, 56 percent of consumers rated the economy as poor, a 4-point increase from September. Forty-six percent of consumers felt economic conditions were getting worse, a 3-point rise from September and the first increase reported since July.

Concern over personal finances also rose in October, as 27 percent rated their finances as poor, a 4-point increase from September. Forty-nine percent felt their finances were getting worse, a 1-point increase from September.

The decline in economic and financial confidence was greatest among women, which may be a concern for retailers heading into the holiday shopping season. The Monitor has shown that spending intentions are tied to economic and financial confidence, and so far, numbers suggest consumers, especially women, are anticipating cutting as much if not more of their holiday spending as they did last year . . .

For the seventh straight month, less than a majority of consumers have money left over after paying monthly bills. In October, a Monitor-low 44 percent planned on having money left over, a 3-point drop from September. Furthermore, 41 percent were expecting an added expense or income shortfall in the month ahead, a 3-point rise from last month and the highest since December 2008.

This is a pretty new survey, but the results are far from encouraging.

By George Washington of Washington’s Blog.

The Wall Street Journal admits this week that economists blew it:

The pain of the financial crisis has economists striving to understand precisely why it happened and how to prevent a repeat…

The crisis exposed the inadequacy of economists’ traditional tool kit, forcing them to revisit questions many had long thought answered, such as how to tame disruptive boom-and-bust cycles…
“We could be looking at a paradigm shift,” says Frederic Mishkin, a former Federal Reserve governor now at Columbia University.

That shift could change the way central bankers do their job, possibly leading them to wade more deeply into markets. They could, for example, place greater emphasis on the amount of borrowing in the economy, rather than just the interest rates at which borrowing is done. In boom times, that could lead them to restrict how much money various players, ranging from hedge funds to home buyers, can borrow

I have repeatedly pointed out the flaws in mainstream economics. See this, this, this, this and this.

But the Journal makes it sound like the policy-makers and economists who deployed faulty models were innocently ignorant of any larger truths:

The models “were not able to draw up the red flags,” says Tim Besley, a professor at the London School of Economics who served on the Bank of England’s policy-making committee until recently.

Barry Ritholtz has an excellent criticism of the article, pointing out:

There are many areas I would have liked to see the [journal's] article explore: The lack of Scientific Method, the mostly awful performance of economists, its misunderstanding of the value of modeling, the bias inherent in Wall Street variant of economics, and lastly, the corruption of economics by politics...

Let’s start with the basics. Hard “science” — Physics, Biology, Chemistry, and all variants thereto — begins humbly. They try to describe the universe around us by creating theories, and then testing them. These theorems are always preliminary. Even when testing validates them, Science is always prepared — even eager — to replace them with newer theories that are proven to be even more valid.

The humility of science begins with an admission: We know nothing. We seek to learn through experiment and logic, and constantly evolve more and more accurate explanations. Scientific belief evolves gradually over time. Nothing is assumed, presumed, or hypothesized as true. Indeed, research is a presumption that current theories are inadequate or incomplete. The practice of science is a an ongoing search for better explanations, more proof, further verification — for Truth.

Science is the ultimate “show me” state.

Economics has a somewhat, shall we call it, less rigorous approach. Indeed, the arrogance of economics is that it is the polar opposite of Science. It begins with a few basic assumptions, many of which are obviously untrue; some are demonstrably false.

No, Mankind is not a rational, profit maximizing actor. No, markets are not perfectly, or even nearly, efficient. No, prices do not reflect the sum total of all that is known about a given market, sector or stock. Those of you who pretend otherwise are fools who deserve to have your 401ks cut in half. That is called just desserts. The problem is that your foolishness helped cut nearly everyone else’s 401ks in half. That is called criminal incompetence.

Where was I? Ahhh, our sad tale of the practitioners of the dismal arts.

Starting from a false premise that fails to understand the most basic behaviors of the Human animal, economics proceeds to build an edifice of cards on a foundation of sand. (How could that possibly go astray?) Like a moonshot off by a few inches at launch, by the time the we reach further into time and space, the trajectory is off by millions of miles . . .

Economics … creates an illusion of precision where none exists. The belief in their models led to all manner of mischief, from subprime to derivatives to risk management…

The Behaviorists have been fighting the mainstream for decades now, trying to correct the errors of the basic building blocks of the dismal science.

But I would go further in my criticism of the economic profession by arguing that the decisions to use faulty models was an economic and political choice, because it benefited the economists and those who hired them.

For example, the elites get wealthy during booms and they get wealthy during busts. Therefore, the boom-and-bust cycle benefits them enormously, as they can trade both ways.

Specifically, as Simon Johnson, William K. Black and others point out, the big boys make bucketloads of money during the booms using fraudulent schemes and knowing that many borrowers will default. Then, during the bust, they know the government will bail them out, and they will be able to buy up competitors for cheap and consolidate power. They may also bet against the same products they are selling during the boom (more here), knowing that they’ll make a killing when it busts.

But economists have pretended there is no such thing as a bubble. Indeed, BIS slammed the Fed and other central banks for blowing bubbles and then using “gimmicks and palliatives” afterwards.

It is not like economists weren’t warning about booms and busts. Nobel prize winner Hayek and others were, but were ignored because it was “inconvenient” to discuss this “impolite” issue.

Likewise, the entire Federal Reserve model is faulty, benefiting the banks themselves but not the public.

However, as Huffington Post notes:

The Federal Reserve, through its extensive network of consultants, visiting scholars, alumni and staff economists, so thoroughly dominates the field of economics that real criticism of the central bank has become a career liability for members of the profession, an investigation by the Huffington Post has found.

This dominance helps explain how, even after the Fed failed to foresee the greatest economic collapse since the Great Depression, the central bank has largely escaped criticism from academic economists. In the Fed’s thrall, the economists missed it, too.

“The Fed has a lock on the economics world,” says Joshua Rosner, a Wall Street analyst who correctly called the meltdown. “There is no room for other views, which I guess is why economists got it so wrong.”

The problems of a massive debt overhang were also thoroughly documented by Minsky, but mainstream economists pretended that debt doesn’t matter.

And – even now – mainstream economists are STILL willfully ignoring things like massive leverage, hoping that the economy can be pumped back up to super-leveraged house-of-cards levels.

As the Wall Street Journal article notes:

As they did in the two revolutions in economic thought of the past century, economists are rediscovering relevant work.

It is only “rediscovered” because it was out of favor, and it was only out of favor because it was seen as unnecessarily crimping profits by, for example, arguing for more moderation during boom times.

The powers-that-be do not like economists who say “Boys, if you don’t slow down, that bubble is going to get too big and pop right in your face”. They don’t want to hear that they can’t make endless money using crazy levels of leverage and 30-to-1 levels of fractional reserve banking, and credit derivatives. And of course, they don’t want to hear that the Federal Reserve is a big part of the problem.

Indeed, the Journal and the economists it quotes seem to be in no hurry whatsoever to change things:

The quest is bringing financial economists — long viewed by some as a curiosity mostly relevant to Wall Street — together with macroeconomists. Some believe a viable solution will emerge within a couple of years; others say it could take decades.

Note: I am not necessarily saying that mainstream economists were intentionally wrong, or that they lied because it led to promotions or pleased their Wall Street, Fed or academic bosses.

But it is harder to fight the current and swim upstream then to go with the flow, and with so many rewards for doing so, there is a strong unconscious bias towards believing the prevailing myths. Just like regulators who are too close to their wards often come to adopt their views, many economists suffered “intellectual capture” by being too closely allied with Wall Street and the Fed.

As Upton Sinclair said:

It is difficult to get a man to understand something, when his salary depends upon his not understanding it.

Submitted by Edward Harrison of Credit Writedowns

I am posting this in the interest of widening the discussion at Naked Capitalism to include some topics in Europe.

Fitch, the credit rating agency, has just downgraded the sovereign debt ratings for the Republic of Ireland from AA+ to AA-.  That is two notches and is proof-positive that the ratings agencies are worried about the hole in Dublin’s finances.

If you read the Irish press this morning, it is all doom and gloom and has a lot to do with the banks and budget deficit.  It is not just about the ratings downgrades.

The EU has just released figures putting in doubt Ireland’s rosy scenario for cutting budget deficits.

The Irish Independent says:

Next month’s Budget may set the economy back further, but without it the country’s national debt could reach 100pc of output (GDP) by 2011, the EU Commission has said in a new analysis.

The Commission is forecasting a decline of 1.4pc in Irish GDP next year. But Brussels is not taking the impact of next month’s Budget into account, because the details are not yet known.

“Depending on the specific measures that are eventually implemented, a dampening effect on consumer demand cannot be excluded,” the Commission says in its autumn economic forecast.

Correction

On the other hand, it says that faster correction of the economy’s problems might give more support to consumption and investment by helping confidence.

The Government’s plans include a correction of 4.3pc of GDP — around €8bn — in the Budgets for 2010 and 2011.

Unless there is a compensating boost from confidence, this could also reduce the modest 2.6pc growth forecast for 2011.

These forecasts are higher than those in the Commission’s estimates last May, but it warns of the struggle facing the Irish economy in trying to return to strong growth.

Another top headline in the Irish Independent has the OECD warning that the Irish government should not rule out nationalising banks in addition to its bad bank programme, NAMA.

The Government shouldn’t rule out temporarily nationalising the country’s banks as they may require more capital to cushion against surging bad debts, the Organisation for Economic Cooperation and Development said.

The Government is setting up the so-called bad bank that will buy €77bn of property loans from banks at a discount of 30pc. Losses on those assets may leave the lenders needing extra capital.

“Further recapitalisation may be necessary as assets are being purchased below book value,” the Paris-based OECD said in a report today. “Temporary nationalisation would have a number of drawbacks, but it should not be ruled out altogether.”

The Government has already guaranteed all deposits at banks and some of their debts, pumped €7bn into Allied Irish Banks and Bank of Ireland and seized Anglo Irish Bank.

“Substantial” banking losses are likely to be met by the taxpayer and nationalisation should only be undertaken with the “utmost reluctance,” the OECD said.

The FT’s Stacy-Marie Ishmael has a piece out doubting the maths used in NAMA, which bolsters the OECD view that the bad bank may not be enough.

So you have a trifecta of bad news coming out of Ireland: a two-notch downgrade by a major ratings agency, a warning from the EU that the economy will be weak for sometime to come and that deficits targets will not be met, and another warning from the OECD that the banking situation in Ireland is still very grave.

Quite frankly, it is not looking good for an Irish recovery at this time without the help of the IMF. This all brings me back to my question one year ago: Is Ireland the next Iceland? They will be if the EU, IMF and Irish government do not take today’s bad news seriously and take drastic action to bolster the Irish banks, economy, and government finances.

Who said the financial crisis was over? It is not.

By Edward Harrison of Credit Writedowns

Christopher Wood, the well-noted market strategist at CLSA and writer of the classic Japan crash warning book “The Bubble Economy,” is now warning of a market correction in the West.  According to CNBC India, Wood believes that the markets’ extreme upward move is increasing the chances of a major correction.

Wood is still cautious. He says there is some initial indication of a technical breakdown in the US. “The US market will be vulnerable early next year the US market. If it becomes clear, after this inventory cycle, that consumption, employment is not really recovering, then the market will go down. You will then get renewed stimulus in the US and measures trying to generate growth. The key variable in the West is government policy.” CLSA’s best case scenario is 1,200 on the S&P 500 by year-end, he added.

I agree with Wood that underlying economic demand may indeed be weak and all we may be seeing is an inventory and stimulus induced cyclical upturn (see my July post “ISM: Is this the mother of all inventory corrections?”). Of course, the worry is about the employment cycle not turning up before these measures’ positive effect wears off.  This is the question for 2010. If this happens, we get  a double dip and a huge market-sell off. Even if the employment situation starts to improve slowly while stimulus and the inventory cycle recede, this will lead to a muddle-through scenario, again inducing a correction. This is the heart of Van Hoisington and Lacy Hunt’s call about partial recoveries and stock market weakness.

For those of you who want to believe and want to load up on junk, there’s a clap for that too, via bear turned bull Richard Bernstein:

Richard Bernstein of Richard Bernstein Capital Management is a lot more bullish. “Right now, there is a blurring between the secular issues and the cyclical ones. There are people, including me, who are concerned about the secular issues, but we can’t ignore the fact that the economy is getting better, employment is improving. When that happens you will see a cyclical rebound.”

Just in September, Bernstein was saying America “practically invites another catastrophe.” What happened to that guy? He better be right on his bullish turn or he is going to have a lot of egg all over his face.

Source

Chances of a deeper correction are rising: Chris Wood – CNBC TV18 India

By Edward Harrison of Credit Writedowns

If you have been wondering whether a statistical recovery is at hand, today’s ISM manufacturing report should be the clincher.  The report was definitely bullish with the ISM index rising to 55.7 and sub-components supporting the understanding that the manufacturing sector is expanding. This is quite a contrast to last month’s weak data and demonstrates that last month was a one-month aberration in what should now be seen as a full-blown technical recovery.

I want to talk about this recovery briefly in the context of the signs that came before it, my own forecasting psychology and what the future holds.

The ISM data

The key data points to see as evidence of a fairly broad-based expansion in manufacturing come from new orders, production and inventories.  The production number came in at an incredibly bullish 63.3, marking the fifth consecutive month of increase. New orders slipped slightly, but were also in striking distance of the 60 range. (50 represents the demarcation between expansion and contraction).

But, from my perspective, it is inventories which are the most bullish data points. The inventories data show that inventories in the manufacturing sector were still being purged in October even while production is increasing.  That means that inventories are likely to make a huge contribution to GDP going forward in Q1 and Q2 of 2010. GDP could again surprise to the upside.

My mea culpa on forecast herding

All of this suggests the economy has been growing since the beginning of Summer. In the early Spring, I indicated that jobless claims were peaking (which added to my stock market bullishness at the time). This call turns out to have been accurate. However, at the time, this post produced very negative sentiments, albeit more from readers on Naked Capitalism than Credit Writedowns – in my opinion because most people erroneously extrapolate a current trend into the future (see my reaction to this from a post weeks later, “Through a glass darkly: the economy and confirmation bias in the econoblogosphere”)

Nevertheless, a piece from NBER guru Robert Gordon that I reported demonstrated to me that I was not alone in seeing the trend reversal in jobless claims. Eventually, in May I indicated that the jobless claims data were pointing to an imminent recovery and remarked that the data had usually been fairly accurate in the past.

And for the record, I have said I see a recovery happening probably in Q4 2009 or Q1 2010 (see my post “The Fake Recovery”).

The real question is how robust a recovery are we going to have and this is directly related to why the jobless claims series has been sending a false signal.  Now, initial claims has been sending a recovery signal since January. Yet, continuing claims continued to rise more quickly until last week.  In the past, one had seen these two series as harbingers of imminent recovery.  But, I am talking Q4 here.  Why? Deleveraging.

In the end, consumers are going to be forced to reduce debt and save more in this more cautious financial environment.  Team Obama does seem intent on re-kindling animal spirits but the personal savings rate has gone up nonetheless.  This will be a drag on GDP growth going forward and means that the economy’s rebound will be more tenuous and slower to develop.  In my view, this means recovery will be delayed and once it gets going it will be weak.  The potential for a double dip is very high.

So, to be clear, first derivatives are starting to turn up and since recession is a first derivative event, we are probably going to see an end to this recession soon enough.  But, with structural problems still remaining, the U.S. economy will be weak for a long time to come.

Why do I bring this up?  Because, despite the data pointing to recovery, I decided the start of the recovery process would be delayed until this quarter or Q1 2010 by consumers repairing their balance sheets – and, in retrospect, in part due to a desire to avoid being too far out of step with the consensus.

I must admit to falling prey to forecast herding, something I talked about in June (admittedly without mentioning my own culpability which I should have done). At the time, I said:

No one wants to go out on a limb with a bold call only to see this prediction proved wrong.  If one fails, it is better to fail conventionally.  The necessary corollary of that statement is this: market forecasters and analysts play it safe by making sure their forecasts are not often far from the consensus forecast.  Think of the consensus forecast as an anchor which restricts the outlook of any individual forecaster afraid of failing unconventionally.

In Roubini’s case – and this logic also applies to media darlings like Meredith Whitney – it does NOT pay to up the ante.  What Faber is saying is that they have already benefitted from the bold and unconventional contrarian market call they initially made.  There is little payoff and much risk from continuing on that path.  A bearish analyst who misses the turn gets the stick.  Just ask the original Dr. Doom, Henry Kaufman.

Roubini is not running with the herd

The one thing that makes me think about my error in tweaking my bullishness has to do with Nouriel Roubini. In the quote above, I said he has little incentive to double down on a bearish forecast at this point in time.  Both he and Meredith Whitney, two voices of caution leading into crisis, have been much more upbeat of late. Are they hedging as I did?  Hard to say.

But, with Nouriel Roubini’s recent FT Op-Ed, this is over. Roubini decried the easy money policy he believes is leading to a dollar carry trade and an increase of risk appetite across a wide variety of asset classes. He believes this experiment will not end well. I share his view.

Roubini, in going public in this way, is officially departing from a more hedged nuanced position he has been using over the last few months as the recovery has taken hold. Yves Smith says:

Nouriel Roubini has officially left the “hedging your bets on the economy” camp.

I applaud him for coming out with this piece and suggest you read it because it may come to be seen as the make or break call in determining his reputation as economic soothsayer.

Recovery is happening, but watch asset prices

For my part, I will look to avoid a repeat of the ‘jobless claims incident.’ Hopefully, I have done by writing my depression post at the beginning of last month, which outlines my view that we are in a cyclical recovery in the middle of a longer-term depression.

I would like to make some amendments to my thinking at the time though. First and foremost, I have come to doubt whether we are seeing a balance sheet recession right now. One reason I am writing this post is because the ISM manufacturing data turned up in May at precisely the same time that the credit revulsion-induced savings rate turned down. Translation: there is no balance sheet recession in the U.S., at least not yet. (see my post “Americans are not increasing savings”). This means the recovery could surprise to the upside. Moreover, the ISM data point to potential upside surprises from inventories, leading to an even more robust outlook.

What I believe is happening has much to do with Nouriel Roubini’s comments. U.S. economic policy is geared toward reproducing the status quo ante via reflation of asset prices (something Bill Gross thinks is the right policy and even Dilbert has made fun of). The policy has been wildly successful so far, with asset prices bubbling over globally. I have called this the fake recovery, but as recently as September I was on the fence about how much uptick we were to get. I never dreamed the recovery process could be so robust given the headwinds we faced.

However, reflation has also given investors a license to take risk. Look at the return of John Meriwether as a telltale sign.  Reflation policies are inflating assets far and wide: European high yield, American high yield, Swedish house prices, London house prices, Chinese property prices, and inducing reckless lending. The list is endless. Even Bill Gross’ piece pointed to inflated prices, a view shared by Jeremy Grantham.

The long and short is we are seeing another asset bubble inflating courtesy of easy money. While Morgan Stanley worries easy money will lead to inflation, former Morgan Stanley economist Andy Xie fears this will end in a double dip. To make matters worse, there is a dollar carry trade now spreading a liquidity seeking return dynamic abroad. This is the additional risk of which Roubini writes, believing it could precipitate another crunch or crash. Ironically, a strong recovery is not necessarily bullish.

Is a double dip or crash a baseline scenario? No, not necessarily – but it is increasingly likely. So, as bullish as I believe the data are, I am more worried about a bad outcome, not less.

By George Washington of Washington’s Blog.

Keynesians argue that we must increase fiscal stimulus to prevent a full-scale depression.

They argue that “deficit hawks” are wrong when they say that we can’t afford any more stimulus, and that worrying about debt in a crisis of this size is penny wise and pound foolish, given the bleak unemployment figures and other fundamentals. They also point out that America’s debt as a percentage of GDP is far less than Japan’s.

On the other hand, those worried about the giant debt overhang argue that massive debt and the failure to write down worthless assets and “purge malinvestments” from the system are the main problems.

Many also argue that the 1930s Keynesian stimulus programs did not work, and that the Depression did not end until World War II. And they also argue that every dollar in additional debt incurred now is another burden added to our childrens’ shoulders.

Who is right?

Before deciding, you might want to look at two pieces of data.

Different Bangs for the Buck

Initially, many Keynesian academics argue that it doesn’t matter where the stimulus money is spent, just as long as it is spent on something. However, this is untrue. For example, it should be obvious that spending in some areas will have more and quicker turnover (increasing money velocity) as compared to others. And, in fact, economists have documented that some types of stimulus spending have more bang for the buck than others.

So it is idiotic to talk about “fiscal spending” in the abstract. Without a cost-benefit analysis as to each category of proposed spending, any analysis is hollow.

Aggressive Fiscal Stimulus Only Buys Two Quarters

Moreover, as former chief IMF economist and MIT professor Simon Johnson points out:

Perhaps the best analysis regarding the impact of fiscal policy on recessions was done by the IMF. In their retrospective study of financial crises across countries, they found that nations with “aggressive fiscal stimulus” policies tended to get out of recessions 2 quarters earlier than those without aggressive policies. This is a striking conclusion – should we (or anyone) really increase our deficit further and build up more debt (domestic and foreign) in order to avoid 2 extra quarters of contraction?

Indeed, many experts say that continuing to cover-up the fraud which led to the financial crisis will extend the crisis for many years. In other words, failure to investigate and prosecute those responsible for bringing about the crisis may extend the crisis longer than any failure to spend more on stimulus.

(And investigations and prosecutions for fraud – unlike stimulus spending – would not increase America’s debt or tax burden.)

A real debate about whether we should spend more on stimulus – and if so, what types of stimulus – cannot even begin unless and until the aforementioned data is considered.

Note: Others have calculated bang for the buck from stimulus packages. For example, here are the Congressional Budget Office’s estimates (look for “Estimated Policy Multiplier”):

Nouriel Roubini has officially left the “hedging your bets on the economy” camp. He has declared the markets to be frothy because super low dollar borrowing rates have turned the greenback into the funding currency for the carry trade.

Far more important than the peppy rally in the stock market is the resumption of early 2007 style risk taking in the credit markets. As Gillian Tett of the Financial Times noted last week:

Earlier this month, I received a sobering e-mail from a senior, recently-retired banker. This particular man, a veteran of the credit world, had just chatted with ex-colleagues who are still in the markets – and was feeling deeply shocked.

“Forget about the events of the past 12 months … the punters are back punting as aggressively as ever,” he wrote. “Highly leveraged short-term trades are back in vogue as players … jostle to load up on everything from Reits [real estate investment trusts] and commercial property, commodities, emerging markets and regular stocks and bonds.

“Oh, I am sure the banks’ public relations people will talk about the subdued atmosphere in banking, but don’t you believe it,” he continued bitterly, noting that when money is virtually free – or, at least, at 0.5 per cent – traders feel stupid if they don’t leverage up.

“Any sense of control is being chucked out of the window. After the dotcom boom and bust it took a good few years for the market to get its collective mojo back [but] this time it has taken just a few months,” he added. He finished with a despairing question: “Was October 2008 just a dress rehearsal for the crash when this latest bubble bursts?”

In other words, everyone seems to be in on this bubble except most borrowers in the real economy. But that wasn’t the main objective…it was to reflate asset prices to save the global banking system…by rerunning the same movie that drove it off the cliff in the first place (well, this is a sequel, so there are some minor plot changes, like the dollar rather than the yen as the basis for the carry trade).

From Roubini in the Financial Times:

Since March there has been a massive rally in all sorts of risky assets… and an even bigger rally in emerging market asset classes (their stocks, bonds and currencies). At the same time, the dollar has weakened sharply, while government bond yields have gently increased but stayed low and stable.

This recovery in risky assets is in part driven by better economic fundamentals…. Whether the recovery is V-shaped, as consensus believes, or U-shaped and anaemic as I have argued, asset prices should be moving gradually higher.

But while the US and global economy have begun a modest recovery, asset prices have gone through the roof since March in a major and synchronised rally….Risky asset prices have risen too much, too soon and too fast compared with macroeconomic fundamentals.

So what is behind this massive rally? Certainly it has been helped by a wave of liquidity from near-zero interest rates and quantitative easing. But a more important factor fuelling this asset bubble is the weakness of the US dollar, driven by the mother of all carry trades. The US dollar has become the major funding currency of carry trades as the Fed has kept interest rates on hold and is expected to do so for a long time. Investors who are shorting the US dollar to buy on a highly leveraged basis higher-yielding assets and other global assets are not just borrowing at zero interest rates in dollar terms; they are borrowing at very negative interest rates – as low as negative 10 or 20 per cent annualised – as the fall in the US dollar leads to massive capital gains on short dollar positions.

Let us sum up: traders are borrowing at negative 20 per cent rates to invest on a highly leveraged basis on a mass of risky global assets that are rising in price due to excess liquidity and a massive carry trade. Every investor who plays this risky game looks like a genius – even if they are just riding a huge bubble financed by a large negative cost of borrowing – as the total returns have been in the 50-70 per cent range since March.

People’s sense of the value at risk (VAR) of their aggregate portfolios ought, instead, to have been increasing due to a rising correlation of the risks between different asset classes, all of which are driven by this common monetary policy and the carry trade. In effect, it has become one big common trade – you short the dollar to buy any global risky assets.

Yet, at the same time, the perceived riskiness of individual asset classes is declining as volatility is diminished due to the Fed’s policy of buying everything in sight – witness its proposed $1,800bn (£1,000bn, €1,200bn) purchase of Treasuries, mortgage- backed securities (bonds guaranteed by a government-sponsored enterprise such as Fannie Mae) and agency debt. By effectively reducing the volatility of individual asset classes, making them behave the same way, there is now little diversification across markets – the VAR again looks low.

So the combined effect of the Fed policy of a zero Fed funds rate, quantitative easing and massive purchase of long-term debt instruments is seemingly making the world safe – for now – for the mother of all carry trades and mother of all highly leveraged global asset bubbles.

While this policy feeds the global asset bubble it is also feeding a new US asset bubble….

The reckless US policy that is feeding these carry trades is forcing other countries to follow its easy monetary policy….This is keeping short-term rates lower than is desirable. Central banks may also be forced to lower interest rates through domestic open market operations. Some central banks, concerned about the hot money driving up their currencies, as in Brazil, are imposing controls on capital inflows. Either way, the carry trade bubble will get worse: if there is no forex intervention and foreign currencies appreciate, the negative borrowing cost of the carry trade becomes more negative. If intervention or open market operations control currency appreciation, the ensuing domestic monetary easing feeds an asset bubble in these economies. So the perfectly correlated bubble across all global asset classes gets bigger by the day.

But one day this bubble will burst, leading to the biggest co-ordinated asset bust ever: if factors lead the dollar to reverse and suddenly appreciate – as was seen in previous reversals, such as the yen-funded carry trade – the leveraged carry trade will have to be suddenly closed as investors cover their dollar shorts. A stampede will occur as closing long leveraged risky asset positions across all asset classes funded by dollar shorts triggers a co-ordinated collapse of all those risky assets – equities, commodities, emerging market asset classes and credit instruments.

Why will these carry trades unravel? First, the dollar cannot fall to zero and at some point it will stabilise; when that happens the cost of borrowing in dollars will suddenly become zero, rather than highly negative, and the riskiness of a reversal of dollar movements would induce many to cover their shorts. Second, the Fed cannot suppress volatility forever – its $1,800bn purchase plan will be over by next spring. Third, if US growth surprises on the upside in the third and fourth quarters, markets may start to expect a Fed tightening to come sooner, not later. Fourth, there could be a flight from risk prompted by fear of a double dip recession or geopolitical risks, such as a military confrontation between the US/Israel and Iran. As in 2008, when such a rise in risk aversion was associated with a sharp appreciation of the dollar, as investors sought the safety of US Treasuries, this renewed risk aversion would trigger a dollar rally at a time when huge short dollar positions will have to be closed.

This unraveling may not occur for a while, as easy money and excessive global liquidity can push asset prices higher for a while. But the longer and bigger the carry trades and the larger the asset bubble, the bigger will be the ensuing asset bubble crash. The Fed and other policymakers seem unaware of the monster bubble they are creating. The longer they remain blind, the harder the markets will fall.

The Journal has a less apocalyptic story on the very same topic: “Dollar Calls the Tune for Stocks, Bonds, Oil“:

A joke making the rounds among stock investors is that they’ve all become currency traders. In recent weeks, the relationship between moves in the dollar and stocks has been incredibly tight; as the dollar rises, stocks fall and vice versa.

And it isn’t just stocks. Links between the dollar, corporate bonds, energy prices and gold have grown closer. Traders and analysts point to one factor as the cause: the Federal Reserve’s efforts to flood the financial markets with dollars. They say the Fed has created an unusual environment where investors essentially have two choices — hold onto dollars or buy something, anything else.

The connections between assets have been growing as investors become more fixated on how and when the Fed will turn off the spigot.

The intensity of the links “tells me there is a lot of nervousness and a lot of fast money,” says Michael O’Rourke, a market strategist at BTIG.

As a result, some believe the markets are in a new bubble, driven by interest rates essentially at zero, which will pop sooner rather than later. That camp includes Pimco’s Bill Gross, who last week wrote that the six-month rally in riskier assets, spurred on by the Fed and U.S. Treasury, “is likely at its pinnacle.”