naked capitalism

By Richard Alford, a former economist at the New York Fed. Since them, he has worked in the financial industry as a trading floor economist and strategist on both the sell side and the buy side.

A number of economists, economic policymakers, regulators, and central bankers have attempted to explain away their failure to both foresee and mitigate the current financial crisis by asserting that no one saw it coming. The inference is that they cannot be held accountable for something so unusual, so extraordinary, and so unforecastable that that no one saw it coming. Robert Shiller, in a November 1, 2008 NYT OP-ED, noted the following example:

Alan Greenspan, the former Federal Reserve chairman, acknowledged in a Congressional hearing last month that he had made an “error” in assuming that the markets would properly regulate themselves, and added that he had no idea a financial disaster was in the making. What’s more, he said the Fed’s own computer models and economic experts simply “did not forecast” the current financial crisis.

However, the Fed and other policymaking agencies cannot honestly claim that no one saw it coming. There is ample evidence that:

• Economist and commentators “saw it coming”; and

• Economists and others repeatedly brought their observations to the attention of the authorities including the Fed, but were ignored.

In fact, the Fed increasingly exhibited a willingness ignoring critics and criticism. The existence of this pattern at the Fed can be illustrated by looking at two presentations by Kohn. The first is from 2003 and the second is from 2005. But first, a return to Shiller’s OP-ED piece:

Mr. Greenspan’s comments may have left the impression that no one in the world could have predicted the crisis. Yet it is clear that well before home prices started falling in 2006, lots of people were worried about the housing boom and its potential for creating economic disaster. It’s just that the Fed did not take them very seriously.

Schiller blamed self-censorship and group think. Shiller reports that while he was a member of the economic advisory panel of FRBNY, he felt the need to use self-restraint and stated that he only gently warned about bubbles in the housing markets.

It is one thing for someone to practice self-censorship. It is another thing all together for an institution charged with a public responsibility to allow and foster an atmosphere in which someone well respected enough to be asked to sit on an advisory board feels as though he or she must temper their statements or pull punches. What was the role of the advisory board, if the members did not feel free to raise and discuss competing views or alternative policy paths? In the context of the dynamics of globalization and financial innovation, why was conformity to a static consensus tolerated and even encouraged?

Furthermore, while the Fed had a responsibility to promote economic and financial stability, Shiller did not. Once well respected economists and analysts highlighted the possible risks the Fed had an obligation to assess those risks. Shiller also reported that the group-think that ignored signs of the impending financial crisis extended well beyond the halls of the Fed:

I gave talks in 2005 at both the Office the Comptroller of the Currency and at the Federal Deposit Insurance Corporation. I argued that we were in the middle of a dangerous housing bubble. I urged these mortgage regulators to impose suitability requirements on mortgage lenders, to assure that the loans were appropriate for the people taking them.

The reaction to this suggestion was roughly this: yes, some staff members had expressed such concerns, and yes, officials knew about the possibility that there was a bubble, but they weren’t taking any of us seriously.

Returning to the Fed, a speech by Kohn in February 2003 indicates that while Shiller was self-censoring, other commentators had been pointed enough in expressing their concerns to merit a response:

In particular, a number of commentators have raised the specter that imbalances are being created in the markets for consumer durable goods and houses–unsustainably high prices or activity–that will produce macroeconomic strains when, inevitably, they correct. These concerns obviously echo those expressed by some observers that monetary policy allowed run-ups in equity prices and capital spending in the 1990s that ultimately proved to be destabilizing.

In a footnote, Kohn went on to say:

Another possibility is that the buildup of debt associated with the strength in household investment will feedback adversely on financial conditions, especially as the boom unwinds. Such consequences could occur even in the absence of a “bubble” in housing prices if households were overextended and lenders had not taken adequate precautions against even a measured drop in collateral values… Moreover, loan-to-value ratios on mortgages have been about flat, leaving ample cushion for moderate housing price declines, should they occur. These observations suggest that widespread credit difficulties with important macroeconomic effects are unlikely when interest rates rise.

Kohn not only acknowledged the existence of the commentators and their concerns and took them seriously enough to present evidence that he thought should lay to rest those concerns to rest. He also suggests that the likely short-lived nature of the interest rate -driven increases in housing prices and real estate investment implied that any resulting macroeconomic or financial problem would be of a manageable scale:

Judging from this analysis, and bearing in mind its inherently tentative–if not speculative–character, it seems likely that as the economy strengthens and interest rates rise in response, household investment and prices are likely to soften some relative to recent trends, but not to break precipitously. Houses and cars would not be providing the impetus to economic activity they often have in past recoveries…

At the Jackson Hole Conference of 2005, a speech by Rajan, the then Chief Economist at the International Monetary Fund, “Has Financial Development Made the World Riskier?” and a response by Kohn allows us to get a read on Fed policymakers reactions to warnings about possible economic or financial dislocations two years later. In the opening paragraphs, Rajan argued that the transformation of the financial sector had made it more efficient, but at the expense of increased risk:

The expansion in a variety of intermediates and financial transactions has major benefits,…However, it has potential downsides, which I will explore ..

… the incentive structures of investment mangers today differs from the incentive structures of bank managers in the past in two important ways. First,… managers have a greater incentive to take risk. Second, their performance relative to other managers matters.

The knowledge that managers are being evaluated against other managers can induce superior performance, but also perverse behavior.

One is the incentive to take risk that is concealed from investors—since risk and return are related , the manger then looks as if he outperforms peers,,, typically the kind risks that can be concealed most easily… are known as tail risks.

Both behaviors can reinforce each other during an asset price boom…An environment of low interest rates flowing a period of high rates is particularly problematic, for not only does the incentive of some participants to “search for yield” go up, but asst prices are given the initial impetus which can lead to an upward spiral, creating conditions for a sharp messy realignment…..

…the most important concern is whether banks will be able to provide liquidity to financial markets so that if tail risk does materialize, financial positions can be unwound and….the real consequences to the real economy minimized.”

The balance of the Rajan paper was a development of these ideas along with the presentation of considerable amount of supporting evidence. He referenced over 50 plus scholarly papers. Rajan never forecasted or predicted the crises which were to follow relatively quickly. However, he concluded:

a risk management approach to financial regulation will be important to attempt to stave off such states through the judicious operation of monetary policy and through macro-prudential measures. I argue some thought also should be given to attempting to influence incentives of financial institutions mangers lightly, but directly.

Kohn was a Discussant, but his response was not so much a discussion or rebuttal of the Rajan theses as it was simply a restatement of his and presumably the Fed’s belief that the greater dispersion of financial risk away from banks necessarily implied lower levels of systemic risk. There was no discussion of the implication of the changes in incentive structures or herding behavior. Kohn dismissed concerns about tail risk citing reduced volatility of output and inflation over the previous twenty years. However, who believes that tail risk has to either manifest itself in a twenty year period, or be non-existent. Furthermore, the factors cited by Rajan had come to dominate the financial sector only during the prior ten years.

No mention was made of LTCM or the Tech bubble. Concerns that low interest rates may contribute to increased risk in the financial system were dismissed on the grounds that those policies contributed to greater stability in output and inflation. Kohn never addressed the point that the shift away from bank-center finance might leave the system short of liquidity should risks materialize.

In short, Kohn’s response to Rajan’s theses was nothing more than a curt dismissal when compared to his detailed response to the specter of imbalanced -induced concerns voiced by the unnamed commentators in 2003. It appears that the perceived need to respond, even if only in words, to well researched warnings by prominent economists had disappeared.

Furthermore, Kohn on this occasion and presumably others, never publicly revisited (to my knowledge) the contingencies which were in part the basis of his rejection of the warnings in 2003. Interest rates had risen very slowly amidst a jobless recovery and a failure of investment spending to propel the economy. Ten year Treasury yields were only about 25 bps higher and monetary policy remained accommodative. Loan to value ratios had started to erode as had lending standards. If Kohn had re-checked the reasons he cited in his in 2003 rejection of warnings he would have found that the conditions he had cited for being sanguine no longer obtained.

In summary, numerous people, including well respected economists and officials saw the grounds for economic and financial crises being laid. Furthermore, these warnings were brought to the attention of US policymakers. Assuming the two presentations cites above are representative, the warnings were at first treated as worthy of a serious response. However, even as evidence of serious imbalances and bubbles grew, the responses to warnings became perfunctory and devoid of serious analysis.

Houston, we have a problem.

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.

By DoctoRx, who writes at EconBlog Review:Introduction

A few days ago, Naked Capitalism kicked off a series of posts on government deficits with a first-of-two posts by me. My Debate on Deficits, was followed by posts by Marshall Auerback, Rob Parenteau and Dr. Edward Harrison. My initial post was itself a response to Dr. Harrison’s comprehensive essay from a few weeks earlier on broad economic matters; in it, he recommended that the government increase its borrowing in response to his belief that: “The real problem is the debt – specifically an overly indebted private sector”. He pointed prominently to the financial sector balances model to explain his call for more government debt.

IA.

In Dr. Harrison’s essay, the concept of a financial sector balances model was described, per his quote from Mr. Auerback, was that: “the domestic private sector cannot increase savings unless and until foreign or government sectors increase deficits.” (From here on, for simplicity we will exclude foreign flows.)

Being a fan of William of Ockham’s logical razor, I suggested in response that an alternative path was for the private sector to settle its debts within itself. My specific point was in fact simply that there were alternatives that were not covered by the model. Specifically, this model deals with financial dealings between the private and public sector. Ergo, by definition it excluded financial dealings within the private sector.

As there was no attempt to refute that point of mine by any of the three responders, I’m moving on. The model he used was a flow of funds between; mine was debt simplification without any inter-sector flows (earning one’s way out of debt of course being superior to default or principal reduction).

IB.

In trying to understand the apparent illogic of the idea that the government needs to go more in debt for the private sector to go more in surplus, I had an aha! moment. This came when I realized that for obscure reasons, Federal Reserve notes are technically debt obligations of the Treasury. However, their only practical use is transactional. As I have no expertise in this matter, comments are solicited on how this fact may or may not affect the financial sector balances model.

A commenter to one of the above posts pointed out that Canada’s paper money is transactional only and not a governmental debt obligation. In most people’s minds, greater wealth in the private sector can be reflected in more money in circulation to reflect that wealth and productivity. If, however, economists must count that cash as Federal debt, that could explain some of the points of disagreement. Once again, expert commentary would be appreciated.

IIA.

Yours truly is a medical doctor, with a specialty in internal medicine, a subspecialty in cardiovascular diseases, and an overriding interest in disease prevention. I also have extensive experience in the pharmaceutical and financial fields, have filed over 60 U. S. patent applications, and have had 6 books published. I began posting on the Net late last year largely from outrage that the incoming Obama administration was signaling continuity with the Big Finance bailout policies of the Bush team.

Because treating real people has the potential to kill them in more ways than you can imagine, the doctor is admonished thusly: primum non nocere. First, do no harm. In other words, God, fate or nature (take your pick) has given the person a health problem. The physician’s first responsibility is to not make it worse and to not create a new problem. I believe that government needs to be as thoughtful on behalf of its citizens as physicians are supposed to be on behalf of their patients. I also believe that finance has lost its moorings regarding professional standards of prudence, and that it is its responsibility to make its failings up to society by rationalizing the debts it created with borrowers who borrowed not wisely but too well. I and other investors have suffered enough collateral damage from the fallout of the global financial crisis. More debt to be incurred by the people? No way. Let the stock- and bond-holders of the financial companies take all the hits first, till they hit zero if it comes to that (which I doubt will happen on the bond side).

The ramifications of the financial insanity of the past decade and more (it is almost 13 years since Chairman Greenspan’s “irrational exuberance” statement) will not be solved by government pushing a “Send” button to create more “money”. Creation of real wealth- the tangible and human kinds- has little to do with the quantity of money. After all, money has a velocity, and that velocity can very markedly.

In a sense, there is no “economy”. There are only human needs and desires that are satisfied by mutual consent via commercial means when self-help and private, non-commercial means do not suffice. The elevation of GDP as the measure of the nation’s well being is bizarre. When a country has achieved as much material wealth as America and has, in the current Great Recession-ary state, disposable personal income of about $30,000 per capita, then other factors beyond accumulation of material goods are indeed important. Yet the powers that be continue to support in a very large way industries that make the quintessential debt-financed products- homes and autos. All for finance.

IIB, Prescriptions for a healthy American economy

a. The Merchants of Debt and the Merchants of (mostly empty) Calories have had a parallel rise. Debt and junk food are both addictive but are easily marketed to addicts or prospects. Just as America would be better off breaking the addiction the Merchants of Debt have caused, so would it be better off eating less. Less debt would mean smaller houses that could actually be paid for, and fewer cars that harm the atmosphere and deplete natural resources. Less food production would mean less obesity, and less processing of food would mean less of the modern toxins of salt and refined sugar in our diets. This would then mean vastly less cardiovascular disease, fewer medical expenditures, and a smaller economy. And more walking in general, and more bike-riding to work where practical, would also mean a “smaller” economy. But we’d all be better off. Quelle paradox!

We must not equate a higher GDP with improvement in anything important. What is made, how it is made, for whom it is made, how it is paid for, what the effect on the environment is, and the like are some of the factors that matter.

b. Back to finance.

My blog’s motto is “In equity, veritas”. (The term “equity” relates both to ownership rather than debt; and to fairness rather than, for example, crony capitalism.) Thus, I sympathize with Dr. Harrison’s and Mr. Parenteau’s arguments that private debt is core to our current financial and economic problems.

Yet I disagree strenuously with that viewpoint.

I believe that this country has become “over-financialized”, and that debt is just part of the inappropriate recent primacy of finance over the production of useful, real goods and services. This primacy manifests itself in such ways as:

i. Wasteful merger and acquisition effort, given that the average deal does not meet its stated goals;
ii. The cult of the publicly-owned stock even though the companies are run for the benefit of insiders;
iii. The existence of interest rate swaps reportedly in the hundreds of trillions of dollars of notional value;
iv. The whole credit default swaps mess;
v. The overtrading of vital commodities such as oil, a barrel of which reportedly changes hands over 20 times before anything useful is done to it; and
vi. The entire concept that corporations and government can really promise important retirement benefits, given that the future is unknowable. All new pension obligations should be variable.
vii. Most importantly, strategists should consider that the quantity of new government debt was consciously decided upon to outweigh retiring private debt. Thus the debt-GDP ratio continues to rise, into cloud-cuckoo land. If you liked the last debt cycle, you will love the next one!

My medical-financial view is that global growth became manic this decade due to excessive use of stimulants provided by central banks and Big Finance. Now that the seemingly inevitable crash occurred, the patient has become partially resistant to the same stimulants. If the patient had been allowed to go through withdrawal, the addiction could be prevented from returning. In other words, too much frantic economic and financial activity occured that did not arise from real human needs. People, and therefore the economy, need to rest. That’s a rough medical analogy. Plus, Dr. Bernanke was the doctor in charge well before the crisis. He was guilty of malpractice due to failure to diagnose. Initially he failed to treat with a statin and high blood pressure medicine (continuing the patient’s former doctor’s negligence). Then when the patient had chest pains in 2008, he failed to perform an angiogram. Finally a messive myocardial infarction ensured. Only then, he brought in specialists and all the big guns when the patient was on a respirator, but the patient lived but has suffered permanent harm. In medicine, this us actionable malpractice.

On the other hand, parts of the world such as India that did not get whipped by artificial stimulants are, one notes, normal economically.

c. Depository banks probably should not be publicly traded. (Nassim Taleb believes they should be nationalized.) In any case, they should never have runs due to a falling stock price, but their loans and capital assets should be very plain vanilla. Clearly, depository banks fulfill such a critically important function that FDR’s war against bank holding companies should be revived. Separate them from investment banks. Then, divide investment banks into separate companies. One company would engage in principal trading. The other would service clients. The inherent conflicts inside a Goldman Sachs that engages in both these functions cannot be reliably overcome without that separation.

d. FDIC insurance should be reduced ASAP to limits that protect only the financially needy. There is no societal interest in guaranteeing the loans millionaires make to financial companies (i. e. savings deposits). Perhaps $10,000 per family is an appropriate total amongst all banks, not per bank. If anyone wants more government-provided coverage, that person or entity can simply buy a Treasury. Until a year ago, Australian banks had no deposit insurance– and no bank failures. I would also suggest that if ordinary citizens can rule on life and death matters in trials, they can work along with, or oversee, bank regulators. It’s our capital. We should know how it is being handled.

e. Depository institutions should not hold “Level 3″ assets. Even Level 2 assets are dicey.

g. If lenders want to obtain insurance on a big loan, then let CDS’s be regulated as standard insurance products with reserves, etc. And make it as illegal for the insurer to resell them as it is for them to resell any insurance product. No holder of a CDS should ever be in a position to profit from the failure of the debt.

h. Most interest rate swaps are little more than line extensions as well, take advantage of the borrower, and serve no business need that is worth the cost of purchasing the swap and the ongoing attention it requires.

i. The “G30″ that is so influential in financial and governmental circles has (had) Jacob Frenkel, an AIG VP, as its CEO. I pay no attention to anything it says. Everything it says is for the greater good of Big Finance.

j. Problems with Dr. Harrison’s and Mr. Auerback’s calls for more government debt include:

i. Just as we should be cautious about taking on debt as individuals and on the corporate level, government should if anything be our better angels and be even more cautious. Borrowing more and more from hard-working Chinese et. al for routine expenditures such as those on the elderly is, to put it mildly, a bad idea. Either raise taxes or cut expenditures. I’m not arguing for one path or the other, rather to just be honest about it. Government can print money but should be restrained in doing so.

ii. No matter how many people try to define Federal debt strictly as current obligations, here is Wikipedia on the subject: “The U.S. government is committed under current law to mandatory payments for programs such as Medicare, Medicaid and Social Security. . . The present value of these deficits or unfunded obligations is an estimated $41 trillion. This is the amount that would have to be set aside during 2008 such that the principal and interest would pay for the unfunded commitments through 2082.” What’s enshrined in the law is, indeed, the law. Where is the gold in the vault to meet these commitments?

Dr. Harrison, in his response to my post, wrote: “The governments unfunded liabilities for social security and healthcare are akin to General Motors’ unfunded pension liabilities. GM’s unfunded liabilities are germane to a credit crisis only to the degree they flow through the income statement and, thus, require credit financing in real time.”

But . . . GM had to pay a higher price than Toyota when purchasing credit in part because every lender to GM raised the price of said credit in part because of said unfunded liabilities. GM might not have gone bankrupt had it not been for those unfunded obligations. As I read it, Dr. Harrison is supporting my point.

The same Wikipedia entry has a nice summary of the government’s obligations regarding Fannie and Freddie and the other bailout costs. I would expect that the surging low quality FHA debt should then be added to that amount.

The truth is that the net Federal obligations are extremely high, and all-in debt obligations relative to GDP are at all-time record levels for this country. The Ockham’s razor solution involves simplification of our obligations to one another and to foreigners at as many levels as possible. This solution is therefore opposite to one involving creation of more government debt obligations. If my favored solution entails 1% economic growth instead of 2% is irrelevant. Things are now getting like the emperor who had another set of “clothes” made that were just as see-through as the first set. Let’s get this mess cleaned up and move on. Government’s been “stimulating” this recession using debt financing since Q2 2008, when it was only a mild recession.

k. In contrast to all the environmentally unfriendly economic activities that count as good things in the sanctified GDP print, and all the corporate-friendly, person-unfriendly efforts that go on in this economy, there are insufficient efforts on truly useful activities. These include the fields of medical technology, public health, pro-environment activity and research, education at all levels, specific literacy efforts, vocational retraining, urban renewal, food production close to where people live, etc. If America made more of an effort to press its advantage in biotech and medical devices (etc.), and made a “First to the Moon” type race on alternative energy (more intensive than what has been enacted to date), it could regain world leadership in economic sectors of the future and develop an export economy with good jobs at home. In turn, this economy could lead the world toward a healthier and cleaner tomorrow while leading to an intrinsically strong dollar.

Conclusion:

In the waning months of the Clinton Presidency, I lunched with a friend and his friend (call the friend of a friend “DC”). The two of them were discussing a business venture they controlled that tied into some governmental telecoms license arrangement. DC, as it happens, was the 3rd generation scion of a very tied-in Washington family. His daughter sat next to Chelsea at Sidwell Friends at the time. With sadness in his voice and demeanor, he mentioned that he and his family had never seen Washington so “for sale” as then, with the true bipartisan spirit having taken hold in that respect. Worse than the Watergate era? Yes, for sure.

Does anyone think things are cleaner lately?

A government that is “for sale” will want to expand its power. That is ultimately why in real time I oppose that phenomenon.

In gargantuan America, smaller and simpler is, for me, today and tomorrow, beautiful.

Copyright (C) Long Lake LLC 2009

By Edward Harrison of Credit Writedowns.

DoctoRx, Rob Parenteau and Marshall Auerback have each written articles here to bring clarity to some issues I first raised at the beginning of the month in my post, “The recession is over but the depression has just begun.”

As I see it, the issue we are debating has to do with how the government responds when large debts in the private sector constrain demand for credit in the face of a severe economic shock and fall in aggregate demand. In short, if private sector debt levels are so high that a recession precipitates private sector credit revulsion, how should government respond?

Frankly, this question is as much philosophical and political as it is economic.  So I want to wait to answer it and first frame the monetary system in a way which reveals the political nature of the question. Afterwards, I hope it is apparent that there is no one answer to this question and that any society’s answer depends on and reveals its priorities as a people. I will try to make some concluding marks about government debts and taxes in a fiat currency system given the analysis Marshall’s post.

Money and the sectors of the economy

Money is a tool, a medium of exchange, which derives its value from its utility in allowing individuals in an economy to trade goods and services. It eliminates the need to barter and make direct exchanges of goods and services in order to trade. Think of any economy as a collection of individuals or groups which trade goods and services with each other and with the outside world in exchange for a money-value of those goods and services. Each transaction is an exchange of a good or service for a equivalent value amount of money.

So, in any country, the flow of goods and services should be a one for one mirror image of the money flows. Now, if you break an economy down into sectors like the government sector, the private sector, and the foreign sector, the same is also true. Two accounting identities flow from this.

• In any particular time period, the changes in both money value of goods and the changes in the financial balances must sum to zero.  As Rob, illustrated: Household FB + Business FB + Government FB + Foreign FB = 0
• One sector’s deficit is another sector’s surplus. Think of it this way, if you and I are the only ones in the economy. If I spend more than I earn in, say, one particular month to buy your goods and services, you must have spent less than you earned in that same month to buy my goods and services.

If you take Rob’s formula and combine the two sectors of households and businesses into one sector, the private sector, you are left with Private FB + Government FB + Foreign FB = 0. What this means is that in any given time period, the private sector financial balance is offset by the government and foreign sectors’ balance such that they all sum to zero.

Private sector debts and credit revulsion

Given the framework above, it should be clear that when the private sector has a net surplus, the government and foreign sectors must have a combined net deficit.

So what happens when the economy lapses into recession because of a financial crisis caused in large part by excessive leverage and debt?

The answer is credit revulsion, also known as deleveraging. And this is what we have just seen in the U.S. economy.  Credit revulsion means that the private sector (businesses and households) reduce or are forced to reduce their debt burdens. This change in behavior induces a net surplus in the private sector; the private sector increases savings.

I’m sure you know where this is going. If the private sector moves to a net surplus, the combined government/foreign sectors must axiomatically move to a deficit.

A foreign sector deficit means that we are net exporting i.e. foreigners are buying more stuff from us than we are from them. We are talking money flows here not goods and service: more money coming in than going out (FB deficit) means fewer goods coming in than going out (current account surplus). Since the U.S. is not going to run a current account surplus, I am going to leave this out of the discussion to focus on the real issue: Government.

We can try and reduce private sector savings

So, the result for the U.S. of a private sector which is net saving is government deficits – this what naturally flows from a credit-revulsion induced private sector deleveraging. By saying this, I am stating fact, I am not making a political argument for or against deficit spending.

However, this is where the political/philosophical discussion starts. Two questions come to mind.

• Do we want the private sector to net save at this point in time?
• If so, do we want this savings to occur in an environment of more aggregate demand or less?

Policymakers today have answered no to the first question. They have said, “we do not like credit revulsion and our preferred policy choice is to work against it by reducing private-sector savings.” How do they do this? They lower interest rates in such a way that there is less incentive to save. Policymakers are in effect voting to continue the asset-based economic model.

But, there are several problems with this policy decision: it rewards debtors over savers, it prevents deleveraging from occurring, it creates asset bubbles, it keeps zombie companies and overcapacity alive, and it misallocates resources by artificially lengthening time preferences for money. In short, it is poor policy and it will end poorly as well.

Or we can maintain it and decide to either increase or decrease aggregate demand?

If you reject this policy path, you then have two options. In one, aggregate demand is reduced. In the other aggregate demand is increased.  Which option we choose, again, depends on politics.

In a July post, I outlined the choices. (Note the labels ‘surplus’ and ‘deficit’ should really be labeled ‘financial balance.’ For simplification the foreign sector isn’t depicted but one could assume it is aggregated with the government sector.):

In the Minsky world, the increase in net savings in the private sector and reduction of the current account deficit is axiomatic when the government is increasing deficits.  The point is that the private sector net saving and current account deficit must equal the government deficit.  So, when the combined private savings and current account deficit increases, the government’s financial balance must become more negative.

What this implies is this (diagram from Paul Krugman’s post with the unfortunate title “Deficits saved the world”):

To make the graph easier to follow we start with sector balances at zero i.e. where sector surplus/deficit equals zero for both the private sector including the current account deficit and for the government sector. And just to be clear, points above the line show private sector savings or public sector deficit.

1. We start where the red circle is.
2. When an economic shock hits which precipitates a massive deleveraging, the entire demand curve shifts to the left to a new lower GDP level, everything else being equal. Thus, deleveraging equals recession. And we now see the private sector curve hitting the public sector curve where the blue circle is. The private sector is now saving and the public sector is in deficit. That is where we are today.
3. However, to bring things back to neutral i.e. where sector surplus/deficit equals zero for both sectors, one could cut government spending dramatically.  That shifts the entire government curve to the red line on the left, leaving us where the green circle is: in a deep, deep depression. Krugman calls this the Great Depression outcome.

The cult of zero imbalances

In the depression post which kicked off this debate, I said “I must admit to having a preternatural disaffection for large deficits and big government which is what Koo and Minsky advise respectively.” Consider me a card-carrying member of the cult of zero imbalances. My preference is to see a neutral state where the sectors are balanced as the average long-term outcome. We may deviate from a zero imbalance state over the short-term, but we should be working toward it over the longer-term.

However, in the interim, what we want is to get back to that red circle in the chart and higher GDP and stay away from the green circle and lower GDP – also known as depression.  The difference between these two is government deficit spending.

Depressions are downward economic spirals. And when I invoke the term spiral, you should not be thinking of some stable equilibrium like the Great Moderation, Goldilocks economy, Nash equilibrium or some other close facsimile of economic Nirvana. You should be thinking war, famine and pestilence because those are the events which are historically associated with periods of high deflation and depression.

For me, the choice is clear.

The key is liquidation of overcapacity

While the picture I presented above represents a single point in time, what we want to know is how we get back to the green circle over time. In the depressionary example, we contract immediately and violently as aggregate demand is reduced in both the public and private sectors. The result is a liquidation of overcapacity and a depression. In the pro-growth example, aggregate demand is boosted by government spending whilst the private sector deleverages. In this scenario, liquidation of overcapacity also occurs if the government allows it to do so.

And this is the key: to the degree that government deficit spending is used as a vehicle for channeling funds to so-called systemically important businesses to prevent them from failing, we are merely kicking the can down the road. With the deleveraging, malinvestment must be purged for the economy to right itself on a sustainable growth path.

Government’s hidden debt?

That brings me to the last point: government debt. The first issue I want to address is unfunded liabilities.  This is something of great concern to many (including myself).  However, when we are talking about debt and credit, it is not particularly relevant. I mention this because of my statement in the original post:

The government plays a crucial role here because of the huge private sector indebtedness.  In the U.S. and the U.K., the public sector is not nearly as indebted.

A lot of people want to bolt the unfunded liabilities onto government debt to make the government’s debts appear larger than they actually are.  But when talking about the credit system, we have to be careful and distinguish between obligations and actual debt – related but different terms.

In a period of credit revulsion, the key issue is the overall credit in the system. At issue is a debtor’s inability to meet large existing obligations such that the debtor defaults, the obligation is written down, and the overall credit in the system contracts by the amount of capital that has been allocated to that writedown. The issue is credit writedowns and how they suck capital out of the system, reducing credit and leading to a potential deflationary spiral. It has absolutely nothing to do with unfunded obligations.

The governments unfunded liabilities for social security and healthcare are akin to General Motors’ unfunded pension liabilities. GM’s unfunded liabilities are germane to a credit crisis only to the degree they flow through the income statement and, thus, require credit financing in real time.

Government and its money

The difference between GM and the federal government is vast, however. General Motors is a private organization which must fund its obligations by selling products.  To quote Ben Bernanke’s now infamous words:

the U.S. government has a technology, called a printing press (or, today, its electronic equivalent), that allows it to produce as many U.S. dollars as it wishes at essentially no cost.

The U.S. government has monopoly control of the currency and no other entity can print money as a medium of exchange in the United States (see my post “The origin of the U.S. dollar as legal tender and its link to Depression” for how this came to be.)  When anyone else attempts to print money, it is called counterfeiting. In saying this, I am stating fact, I am not making a political argument for or against legal tender laws.

This is a problem for states – which cannot print their own money – and for Eurozone countries – which also cannot print their own money (as I laid out in my post, “Depressionary bust in Ireland is echoed in California”) – but it is not a problem for the U.S. government. If the U.S. government so chooses, it can ‘fund’ any purchase with additional money it prints. It is not constrained in the same way private sector actors or even states and local municipalities are.

It is disingenuous for economic pundits like Marc Faber to suggest the U.S. is going to go bust. The United States will not literally be declared insolvent as long as it issues debt in its own currency. Countries that have gone bust, Russia, Mexico, and Argentina were borrowing in foreign currency because of interest rate differentials. No sovereign nation which prints and issues debt in its own fiat currency can ever involuntarily be made insolvent.

Inflation is another issue altogether.  When the economy is operating at potential, money printing leads to consumer price inflation. But this is not the case right now, there is an enormous output gap that is not going to be closed anytime soon.  So the government can print all the money it wants and buy all the Treasuries it wants; none of this will lead to consumer price inflation in the short run except via dollar depreciation and import prices. Again, I have to remind you that in saying this, I am stating fact, I am not making a political argument for or against quantitative easing.

I should point out that the output gap is why money printing is leading to an asset price bubble both in the U.S. and globally and one reason we should reject QE even in the absence of consumer price inflation (this line was added because the initial comments suggested readers thought I am advocating quantitative easing when I am not).

I hope this post adds to the debate Marshall, Rob, and DoctoRx have taken on.

By Marshall Auerback, an investment strategist and analyst who writes for New Deal 2.0.

A major shortcoming in an otherwise thoughtful post by DoctoRX on deficit spending is a traditional mistake in which analysts seek to analogise the expenditures of government with that of a private household or business. The government is sovereign. This fact gives to government authority that households and firms do not have. In particular, government has the power to tax and to issue money. The power to tax means that government does not need to sell products, and the power to issue currency means that it can make purchases by emitting IOUs. No private firm can require that markets buy its products or its debt. Indeed taxation creates a demand for public spending, in order to make available the currency required to pay the taxes. No private firm can generate demand for its output in this way. Neither of these statements is controversial; both are matters of fact. Nor should they be construed to imply that government should raise taxes or spend without limit. However, they do imply that federal budgeting is different from private budgeting, and should be considered in its proper, public context.

It simply means that the government does not “need” money to “fund” its operations. It seems counter-intuitive, but the public actually needs the government’s money to pay its taxes rather than the government needing taxes to pay for highways, bridge repairs, schools, national defense, etc. For the household, paying back debt means they have to sacrifice current consumption (spending). For the government, no such financial constraint is imposed. Its ability to spend now is independent of how much debt it holds and what is spending was yesterday. That situation can never apply to a household or business firm.

Because the government is the only entity that gets to create money, it can “buy” whatever is for sale in terms of its money merely by providing that money to the public, which opens up a huge range of policy options. Putting this in concrete terms, the government–‘buys’ a new highway or a new aircraft carrier, as long as the construction materials and workers’ wages can be paid for in its own currency.

Where does the government get the money? The government creates this money by crediting bank accounts. It creates money with the stroke of a computer keyboard. New money is an entry on a spreadsheet, nothing more.

To put this in everyday terms, the dollars the government creates function something like tickets to the Super Bowl. As you go into the stadium, you hand the man a ticket worth $1000, and then he tears it up and throws it away. Why? Because the ticket has served its function: it has enabled you to gain entry to the event in question; similarly, a tax is paid to extinguish a state liability, but as soon as the tax is paid, it has no further value to the government. The tax receipt can be sent to the shredder. Tax payments (which discharge a liability to the state) then “drain” the money we call legal tender (otherwise known as “fiat currency”), which can be pictured as a movement of funds away from the private sector and “down the drain” as the money is literally burned, or simply wiped off the liability side of the Federal Reserve’s balance sheet.

How does the government taking your tax money and throwing it in a shredder pay for anything? The answer is that it doesn’t.

Taxes function to reduce aggregate demand, also known as spending power, and not to collect what the government needs to spend on something else.

As a matter of conceptual clarity, it makes no sense to say that a government ever “builds up a store of savings” that allows for higher spending capacity in the future. The government neither has or doesn’t have any dollars; it simply makes computer entries on a bank’s balance sheet, as Federal Reserve Chairman Bernanke described in the “60 Minutes” interview above.

It spends by changing numbers upwards in our bank accounts. Think of this like a football game. Awarding 6 points for a touchdown doesn’t “use up” some stock of points held by the stadium. It is “electronically credited” via the scoreboard. Nobody asks that the 6 points be “repaid” somehow.

You don’t “save” what you have the option of creating or not creating (i.e. fiat currency). Not spending, not “creating currency” via crediting bank accounts, simply means less present day economic output.

We all learned this as the paradox of thrift.

There is nothing to “save”. The government is never revenue constrained.

This is in contradistinction to the way users of the currency, versus the issuer of a currency, such as a household functions.

For them, spending is constrained by income. Their checks will bounce if there is no money in their accounts. And for users of the currency monetary savings can be stored to permit higher consumption in the future. And households don’t have an electronic printing press in their basements which would eliminate that constraint. As Rob Parenteau has already noted, this is called “counterfeiting” and it’s a jailable offence.

True, if a government spends too much after getting us to a state of full employment and higher economic growth, excessive government spending can create inflationary pressures. So to that extent, there is a limit. But acknowledging that unconstrained government spending can create inflation is not the same as arguing that it is in any way operationally constrained. Contrary to conventional “gold standard” thinking, where it is said that every DOLLAR SPENT HAS TO BE ‘FINANCED’ BY AN OUNCE OF GOLD ALREADY IN EXISTENCE, our government can afford anything that it is for sale in its own currency.

The debate therefore should not be focussed on “affordability” but on what our the national priorities of our government? The political process, not a non-existent gold standard, determines that if we want more killing toys then the national government can always meet those expectations in a fiscal sense, unless we run out of real resources. Likewise if we desire universal health care, in a manner where the government provides this as a national right, rather than foisting it on business as a marginal cost of production (remember, businesses are constrained in a way that governments are not).
Further, if there is a problem with excessive private indebtedness and overspending, then the mirror image of that has been the excessive fiscal drag that the national government inflicted on the USA between 1996 and 2007. If you want the economy to grow and produce the saving capacity (via income growth) to allow the private sector to repair their precarious balance sheets then the last thing you would want to do is run “tight Budgets … for a long time into the future”.

What is needed when the economy has been driven by private spending funded by ever-increasing levels of debt (and a contracting public sector as a proportion of total output) then what is required is a change in the composition of final expenditure – from private to public – unless you want to “scorch the earth” and deliberately contract the economy.

The consequences of overspending might be inflation or a falling currency, but never bounced checks a government creating its own currency can never go broke. Government spending limits ought to be set by our policy makers by considering what we, as a society, want, like universal healthcare, full employment, a well-functioning economy and our ability to accomplish this—not out of some preconceived notion of what is “affordable”.

By Richard Alford, a former economist at the New York Fed. Since them, he has worked in the financial industry as a trading floor economist and strategist on both the sell side and the buy side.

It has been frequently charged that the Fed, under Alan Greenspan and Ben Bernanke, kept interest rates too low for too long, contributing to bubbles in the stock, credit and real estate markets. The Fed has repeatedly denied that this is the case. The arguments, while presented with conviction, remain unsatisfying.

For example in a recent blog posting, an official at one of the Reserve Banks joined the chorus in arguing that monetary policy was not to blame. He presented a chart of the actual Fed funds rate and an estimate path for the Fed funds rates based on measures of inflation, actual output relative to potential output, and the lagged Fed funds rate for the period 1988-2009.

The estimated and actual rates never diverge by very much. (The author explicitly disavows calling his formulation a “Taylor Rule”. Perhaps it is because John Taylor has stated that the Taylor Rule correctly formulated indicates that the Fed funds rate was too low too long.)

The author then draws the following conclusion:

..whatever the underlying structure of policy decisions, after the fact the FOMC appears to have behaved in an extraordinarily consistent way over the period extending from the late 1980s. This observation, in turn, suggests to me that there was nothing all that unusual about monetary policy in 2003 once you account for the state of the economy. Which leads me to my main point…: If you are of the opinion that interest rate policy was good through the late 1980s and 1990s, then there seems to be a good case the FOMC was just sticking with “proven” success as it set interest rates through the dawning of the new millennium.

In its bare bones form, the argument is simply:

1. this policy regime was appropriate in prior years (late 1980s and 1990s);
2. the policy regime was unchanged;
3. therefore the policy regime must have been appropriate during the period in question (2002-2007).

I suggest that the Fed official talk with the fellows from LTCM. They back-tested their models during periods that include the late 1980s and early to mid 1990s and they did well—for a while. I suggest that the policymaker talk to the financial engineers who structured mortgage backed securities and portfolios based on the historically accurate premise that house prices had not fallen on a national basis since the Great Depression (as opposed to just the late 1980s and 1990s). They also did well –for a while. The list goes on.

The author does acknowledge that macroeconomics and policy has not kept pace with changes in financial markets:

…prior to 2007 it was not at all clear that detailed descriptions of how funds moved from lenders to borrowers or how short-term interest rates are transmitted to longer-term interest rates and capital accumulation decisions were crucial to getting monetary policy right. Models without such detail tended to deliver policy decisions not far from the sort depicted above, and, as I noted, they seemed to be working quite well in terms of macroeconomic outcomes.

However, the underlying argument is unchanged. This policy regime was consistent with “getting monetary policy right” in the past. Hence it cannot be responsible for poor outcomes in the present. Given the nature and the pace of recent change in:

1. the US financial sector,
2. the US external position and trade competitiveness,
3. the role of imported disinflationary pressures, and
4. the savings behavior of households

choosing a policy regime because it “got” it right in the late 1980s and 1990s is/was like trying to drive a car by looking through a telescopic rear-view mirror.

Furthermore, by what measure did policy get it right during the period 1988-2002? From 1996 to 2001, we had an economy supported by an unsustainable bubble in stock prices, growing external imbalances and a decline in the household savings rate while measured inflation was held down by imported disinflation. Toss out the Tech bubble years and the author’s base period is down to 1988-1995, which includes one recession. For much of the time in the expanded time horizon (1988-2009), the US economy was either in recession (1990, 2001, 2007), experiencing asset bubbles (1996-2000 and 2002-2007) which eventually burst causing economic dislocation, or enjoying a jobless recovery.

Throughout the discussion of the merits of Fed policy, I get the sense that the Fed wants to be Marked-graded-to-Model (of its own choosing) as opposed to the actual economic outcome. The Fed does appear to have done a credible job when the chosen metric is how closely the actual Fed rates tracks an estimated Fed funds rate (based on one or another variant of the Taylor Rule). However, when the metric is one that includes concerns such as sustainability of growth, external balance, and financial stability, as well as the output gap and inflation, it does not.

The Fed was quick to take credit for the “Great Moderation” and the longest economic expansion in US history, but now the Fed portrays itself as an innocent victim of circumstance. It is almost as if the Fed sees itself as a comic book super hero, endowed with powers that can only be used for good.

Rob Parenteau, CFA, sole proprietor of MacroStrategy Edge, editor of the Richebacher Letter, and a research associate with the Levy Economics Institute, responds to DoctoRx’s post, “Debate on Deficits.”