Reader Sanity Check: Interest Rate Policy, Leverage and the Financial Crisis

There are some interesting things one learns in putting together a book. Blogging is a lot like working in watercolors, speed and confidence in execution are key, versus the oil-painting medium of a book. And you learn how many times you wind up scraping the canvas and reworking. I’m up to the sixth revision of one chapter, and I guarantee it isn’t the last for that one either.

Another thing is dealing with comments. Input from informed sources is critical. Better to have friendly people tell you where you are full of it when you can do something about it than learn of glaring omissions or errors after it’s in print.

But the flip side is that comments also reflect people’s personal perspectives, which means you need to watch whether your are rejecting an argument because you think it reflects a reader’s idee fixe, or whether, even if that is true, they still have a point.

The object lesson today is a chapter that discusses liquidity and leverage. I will say it’s well written, which at this stage is dangerous; I may be unduly taken with the fact that the the sentences, on the whole, are good and it moves forward. That is a far cry short of it necessarily being persuasive to someone how knows the terrain.

I’m getting pushback from one reader, an economist, who is of the view that interest rate policy played a role in the crisis (a role, mind you; it certainly was not the sole factor). His argument is a full employmemt; anything less than full employment, the US has labor slack which means rates should be lower.

I am taken with the view of Richard Alford (Tim Duy and Axel Leijonhufvud, who argue that interest rate policy was too loose since the mid-late 1990s because the Fed didn’t allow for the role of imports:

One of the interesting aspects of economic policy in the US is a belief that we exist independent of the rest of the world. In the minds of many policy makers, the US is the focus and the rest of world economy is just a stable background. To open the model up to external factors, market imperfections, and quasi-floating exchange rates would increase the complexity of the model and limit the number of policy prescriptions that could be made, so most US economists pretend that the rest of the world does not exist, is stable, or that the dollar will quickly adjust so as to maintain US external balances. It has only been in the past few years that the trade deficit has moved to a level that is clearly unsustainable….

If you look at the difference between gross domestic purchases and potential output, by US consumers, businesses, and government — all are above potential output. The only time in recent memory when the difference between these two measures started to narrow was in 2001 when we were in a recession. One of the things we need to consider is that that US may need to see consumption drop significantly before we can achieve a sustainable position, for example vis a vis the dollar…

[T]he demand side is fine. Remember, US domestic purchases are still running around 105-106% of potential domestic output. The problem is not the level of demand but rather the composition of demand. Americans are buying too many imported goods and the world is not buying enough of our exports. So we have a growing wedge growing between gross domestic purchases, which is what the Fed really controls, and net aggregate demand, which is defined as gross domestic purchases less the trade deficit. Given the inability or unwillingness of the US to correct the trade imbalance, the Fed has run expansionary monetary policy almost continuously, generating higher levels of domestic purchases so as to keep net aggregate demand near potential output. The Fed did this using low interest rates, which generated asset bubbles, large increases in consumer debt and sharp declines in savings, and also a larger trade deficit. What has been totally missing is any policy aimed correcting the external imbalance. We are relying on the tools of counter-cyclical domestic demand management to address problems caused by a structural external supply shift..

A second bone of contention is the argument that Greenspan kept rates too low too long 2002-2004. The Fed was clearly worried about deflation; recall the famous Helicopter Ben speech of 2002. But this strikes me as a mistake analogy to Japan post-bubble. The Japanese had undergone a real estate bubble of catastrophic proportions (remember the stories how a parcel of land in central Tokyo was worth more than all of California?) Banks would lend 100% against land in central Tokyo, Osaka, and Nagoya. This was a classic case of debt feeding an asset bubble, and the financial system piling on lots of loans that turned out to be bad,

By contrast, margin lending even at the peak of the tech mania was not large relative to total market cap. And unlike real estate loans, when equity values decline, either the borrower puts up more margin or the position is liquidation. The potential for losses is limited. Yes, you could have a crash, and the gap down might lead to losses, but I don’t have the impression that losses on broker loans was a major issue in the dot-com bust.

So the big effect on falling stock prices was wealth effect, and that would (did) produce a downturn. Yes, the recession might have been moderate rather than mild in the absence of (overly) aggressive Fed policy, but I don’t buy the defenses of the Fed on this one.

One bit that I think gets missed, but is hard to prove, is that we had a big structural change in the 1990s. Workers had nada bargaining power. bargaining power unless you had gambled correctly and developed very narrow skills in high demand. But lose your perch, and next best, if you don’t have a buddy who will give you a chief administrative officer job at a private company (hopefully not too small) is Home Depot or “consulting”. And if people high in the food chain don’t, imagine what it is like at the bottom. The version there was ridiculously overspecified hiring requirements.

This was due to opening of markets, and companies going hog wild (well beyond what was economically defensible) for offshoring and outsourcing. The successful outsourcing was with foreign co’s. The research is pretty unambiguous here. But companies continued to outsource and offshore even in the face of mediocre to bad success rates. Why? Wall Street expected it. It was something analysts liked hearing. And if you didn’t do it, you were a Luddite. But this was the most visible symptom of an ongoing fixation with cost reduction to boost bottom lines. I heard about this across the board, particularly companies “dis investing” as in cutting spending on stuff necessary to maintain the viability of their business long term, like advertising. And this was when the economy was good. Even though everyone is familiar with short-termism, we’ve become desensitized to what exactly it means and how it operates.

Big companies were in savage cost cutting mode from at least 1995 through now. I’m not certain I can prove what happened at medium sized companies. Suppliers were clearly squeezed, and one might assume at least ones that competed with public companies would be under pressure to match their cost-cutting efforts to stay competitive.

The proof is in the complete failure in the post 2002 expansion for workers to get ANYTHING. Prior expansions had them getting in the low 60% of GDP gains. They got only 29% this time. Prior low was 55%.

So we had the great sucking sound of jobs going to China, India, Korea, Mexico, you name it, but a fair bit of it was in excess of what was necessary to maintain competitiveness due to companies’ obsession with short term profits and cutting costs. Interest rate policy is not a great way to beat that (although we went a long way that way anyhow). Using interest rates v. unemployment as a metric against a fundamental shift like that is going to lead to bad decisions. But there are no economic models that can deal with a change like that in progress (or are there?).

The only job engine in the post 2002 period was small companies, or at least that’s conventional wisdom and I’ve seen some data releases supporting that. I need to do some checking here as to how solid that factoid is and when that pattern took hold, But assuming it is accurate, what are lower rates going to do much for them? Given big co job shedding, and medium co’s being squeezed (some as suppliers to Big Cos and subject to more cost pressures due to intense focus on cost reduction) an economy-wide interest rate cut is a VERY inefficient way to get the only type of company predisposed to create jobs to make them. Reductions in borrowing costs don’t help them directly; the vast majority have access only to credit cards, which are not too sensitive to short term rate reductions. And other loans to small business are based on prime, again a pretty sticky rate. So in the new world of anorexic companies, you have to stimulate the entire economy to get job creation by small establishments, which by the way are not stable employers.

Now I’d need to look at the right data series to see when the pattern took hold (do either of you know which series breaks out job gain/losses by establishment size//type? There is one that has only three sizes, that’s the one I have in mind), but when you start seeing job creation in a period of say 2% or greater GDP growth ONLY in the small establishment cohort, that is when interest rate policy as a way to create employment is likely to have been blunted by structural factors.

Another issue is that I think some culprits in the crisis have been overdone. My current hunch is that the reason for the explosion in debt was the use of leverage on leverage: hedge fund of funds adding another layer of borrowing to often levered hedge funds, credit market investment strategies that used leverage to meet target returns, and vehicles that were highly geared (CDOs in particular, perhaps also CMOs and CLOs).

I’m not sure one commonly-cited culprit, the SEC liberalizing capital requirements for the big five broker dealers in 2004 is as big a deal as many make it out to be. Yes, it most certainly did mean that when things got bad, they were fragile. So in the unwind their leverage played a role as a point of breakdown, But I am not certain their gearing played much of a role in creating the mess. The bigger impact no doubt was their assets were drecky and thus were more sensitive to the repricing that started when credit spreads started to blow out.

This chart shows leverage ratios, and there is no obvious smoking gun (click to enlarge). The issue seems to have been composition of the balance sheet, and (for some banks) off balance sheet commitments.

I am also not certain that SIVs played a major role. They were geared 14x. That’s higher than a bank would gear, but not hugely so. The unwind was more orderly than many expected. My impression is that the big issue here was that Citi was heavily exposed (they were far and away the biggest SIV player). But the losses on SIVs weren’t all that large relative to other culprits. This was a $400 billion product at its peak. Last data I saw was NAVs just below 70%, which means losses of under 3% ish. Even if you got to 5% losses, that’s $20 billion on the product. Am I missing something here? Now having said that, Cheyne did liquidate for 44 cents on the dollar, but I didn’t see any other reports of that ilk.

Reader comments encouraged, Pointers to relevant data and research particularly appreciated. Feel free to write me at

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  1. GreeneTimes

    In simplest terms the problem is the strong dollar at a time of massive current account deficits.

    1. Under a floating exchange regime the yuan should have increased and the dollar dropped, but because China was pegging it did not. Therefore the best way for the US to counteract the China peg would have been to raise rates and choke off consumption of imports from China (and oil imports as well). For political reasons this did not happen. Now the hole is much deeper.

    2. The only real way out of the current economic mess is for a dollar devaluation, but this is made especially difficult by the dollar's reserve status … each time the economy looks to be shrinking (bad economic data) the dollar rises on safe haven flows. It looks like it will take an unending tsunami of new government issuance to finally push the dollar down…but how long will it take?

  2. David Kaiser

    This has nothing to do with this particular post but I thought your site would be intersted in this information.
    For many years I have had a US Air Visa from Bank of America. A couple of months ago they announced the visas would be closed out and we would be receiving Mastercards. The new card arrived last week–it was from Barclay's Bank.
    What was interesting was this: I attempted to log on to the B of A site for the last time to pay off my balance. It turned out it was no longer accessible–and that I had to pay Barclay's the balance that I had run up on the old card. In other words, apparently they made a deal under which Barclay's bought all the balances, in cash, presumably with a discount.
    I would guess that Bank of America was trying to build its cash reserves in order to get out from under TARP. I hope some one from your site looks into this.


  3. Yves Smith


    That is something I discuss, but frankly, it isn't sufficient as a cause, If you look at the amount of securities issued versus global savings, and make a reasonable assumption as to how much went into financial markets, it isn't even close, The paper sold WAY outstripped savings. The math does not work, The growth in leverage was a major factor.

  4. moslof

    In the seventies my econ classes were full of guys who couldn't calculate the slope of a curve. If you could you studied engineering because Chemistry and physics were too weird with quantum mechanics thrown in. Robert Prechter didn't fall for any of it and went from psychology to contrarian investing to the works of R.N. Elliott and now his own theories of Socionomics which have fully explained the current situation in terms of basic human behaviors starting in 1995.

  5. reason

    I agree with Greene Times, and to be honest Yves, I don't understand your answer. I think we have a real versus financial parallelism here. The USD is too high, you can tell because American's are importing WAY more than they export. The financial flows are ephemeral fluff to me. Yes, the catastrophe that has happened is primarily financial, but the underlying cause was misaligned prices in the real economy – specifically exchange rates.

  6. Yves Smith

    Greene, reason….

    Sorry if the response was clipped, but I don't want to recap the entire book, or a long chapter here. I do discuss the imbalances, but frankly, even that story is more complicated than you think. The Plaza accord led to doubling in the value of the yen and Japanese did not buy more US goods. It wasn't just FX. It was a bigger constellation, longer in the making.

    But it was NOT the sole cause. You cannot get to the magnitude of the bubble here from the imbalances.

    I'd like to focus comments on my question, which is that Keynesians would disagree with my characterization of interest rate policies. They'd say the policies were on balance sound, that if anything rates should have been lower.

    I don't buy that, given that the effect wound up driving financial asset speculation rather than real economy activity. With all due respect to Keynes, who I do think has a lot of valid ideas that were incorrectly marginalized, you have a 1930s methodology applied to an economy 70 years later that is pretty different.

    So I am looking for feedback on the Keynes/interest rate angle. I am strongly of the view that structural changes in the economy altered the usual transmission mechanisms for policy actions, but am not certain how to argue that, or whether that hangs together. But the behavior of public companies in the 1990s became frankly bizarre thanks to the rise of options based pay. You suddenly has analysts hectoring companies for sticking to their guns with long-term strategies because they gave up a point or two of margin to do so. They were effectively dis-investing in their businesses. That's the reverse of what you expect someone with a viable enterprise to do.

    Now that may not be the right culprit, and I could be wrong ad the Keynesians are right. But the stock market started behaving very oddly in 1996, as Greenspan's irrational exuberance remark attests. The trade deficit in 1996 was bigger than in 1995, but not by all that much, so it appears insufficient as an explanation . You can make a stronger argument in 1998, when the deficit really got much larger, but the timing of the onset suggests other factors were in play.

    Yes, we were not going after Japan, since its economy was a basket case. But the trade deficit with Japan fell from 1995 to 1996, so that doesn't appear to be an immediate cause.

    So again, my big question is the interest rate policy, both post 2002 and in the 1990s.

  7. Dan Duncan

    Damn…employment rates, the role of imports, overvalued dollar (from comment #1), interest rate policy, leverage and liquidity…that's a lot of moving parts.

    Here's another one for you: If you're talking about liquidity and debt, then at some point you're going to talk about Balance Sheets…as the health (or lack thereof) of the balance sheet has to be factored in when addressing these things.

    It seems, then, that any chapter on leverage and liquidity also needs to mention Marked to Market…as "marked to market" tells the liquidity and leverage providers that a balance sheet comprised of fat unrealized gains is just as healthy as a balance sheet fat realized gains.

    As a result, unrealized gains justify more "cash-out" debts…which is invested, and like clockwork yields more even unrealized gains.

    "Health" begets more "health" until it doesn't.

    Balance Sheets that are continuously marked to market during the good times lead to an obscene obesity…like the fat guy in Monty Pythons' "Meaning of Life"…

    Maitre D: And finally, monsieur, a wafer-thin mint.

    Mr Creosote: No.

    Maitre D: Oh sir! It's only a tiny little thin one.

    Mr Creosote: No. Fuck off – I'm full… [Belches]

    Maitre D: Oh sir… it's only wafer thin.

    Mr Creosote: Look – I couldn't eat another thing. I'm absolutely stuffed. Bugger off.

    Maitre D: Oh sir, just… just one…

    Mr Creosote: Oh all right. Just one.

    Maitre D: Just the one, sir… voila… bon appetit…

    [Mr Creosote somehow manages to stuff the wafer-thin mint into his mouth and then swallows. The Maitre D takes a flying leap and cowers behind some potted plants. There is an ominous splitting sound. Mr Creosote looks rather helpless and then he explodes, covering waiters, diners, and technicians in a truly horrendous mix of half digested food, entrails and parts of his body. People start vomiting.]

    Maitre D: [returns to Mr Creosote's table] Thank you, sir, and now the check.

    [Yves, you might consider illustrating the above exchange and selling this book as a "graphic economics book".]

    But seriously, you asked for research: Consider this paper done in Sept of '07

    Our findings also shed light on the concept of "liquidity" as used in common discourse about financial market conditions. In the financial press and other market commentary, asset price booms are sometimes attributed to "excess liquidity" in the financial system. Financial commentators are fond of using the associated metaphors, such as the nancial markets being "awash with liquidity", or liquidity
    "sloshing around". However, the precise sense in which "liquidity" is being used in such contexts is often left unspecified. Our empirical findings suggest that funding liquidity can be understood as the rate of growth of aggregate balance sheets. When financial intermediaries’ balance
    sheets are generally strong, their leverage is too low. The financial intermediaries hold surplus capital, and they will attempt to find ways in which they can employ
    their surplus capital. In a loose analogy with manufacturing firms, we may see the financial system as having "surplus capacity". For such surplus capacity to be
    utilized, the intermediaries must expand their balance sheets. On the liabilities side, they take on more short-term debt. On the asset side, they search for potential borrowers that they can lend to. Funding liquidity is intimately tied to how hard the financial intermediaries search for borrowers."

  8. Gunther

    Hello Yves,
    A view from Germany to the interest rate argument:
    In a closed economic system it makes sense to stimulate the economy to achieve full employment. If outsourcing to cheap-labour-countries is possible, the low interest rate means low cost of capital, it is cheap to build a new factory in the low-wage country and job export gets subsidized by low interest rates. The result of low rates is more debt and less manufacturing jobs in the US. This describes in short a mechanism why low interest rates do not have the desired effect. The Peg of the Yuan to the Dollar prevents any balancing via the exchange rate.
    Cost cutting sounds very familiar to me. In Germany the employers were proud that wages did not go up in any meaningful way for years and at the same time complained that people were not consuming enough. Nobody was able to see a connection there. In Germany was almost no housing boom lately and houses are bought usually for the long term and taking out home equity did not happen either. I did not hear that any economist connected the dots that without increase in real wages people do not spend more.

  9. yoganmahew

    For how small and medium sized companies were squeezed, there's a book on Walmart that goes into how they squeeze their suppliers to outsource or die ( This one, I think, ).

    Factor that up across other companies (even if not to the same degree) and there is a huge level of squeeze and cost cutting going on at what should be a time of expansion of the economy.

    In terms of outsourcing, many companies are tempted by the Flat World model (a la Friedman) without looking at the costs – I work in IT and have yet to see a successfully outsourced project (measured by the initial parameters of the project rather than the final revision of them!) with a company two streets away, never mind with a company two continents and twelve timezones away (apart from the ones I run :-) ).

    I would add revenue recognition to the mix of the problem. By selling assets to themselves (via SIVs), companies were able to recognise revenue streams from the future allowing for expected losses. This boosted short-term profits (unrealised revenue), but the loss estimates were hopelessly inadequate, so losses are now being taken way in excess of expertations. As the income (that hasn't arrived) has already been spent either in the form of extra leverage or in the form of dividends and bonuses, the losses have to come out of real money (reserves, cash flow, or raised funds). By selling to themselves, the real leverage was greatly increased as it allowed capital to be raised in two places – on the parent company balance sheet and in the supposedly independent SPV. Double your money, but you can only bet on black. Let's hope we don't see any red numbers… No?

  10. GreeneTimes

    Just another quick thought.

    It is interesting to compare the Canadian experience to the US one. Over the time period under consideration Canada put its house in order while the US went in the opposite direction. As Canadian rates typically track US ones (and have actually fallen further) one would have thought that the outcomes would be similar, but they definitely were not.

    Reuters had a good series this week on the Canadian banking system
    In addition, Canadian banks hold mortgages on their balance sheets rather than selling them off as most U.S. lenders did during the housing boom. Holding the mortgages gives the Canadians good reason to ensure the quality of the loans.

    "We felt an obligation to make sure the Canadian housing market didn't go nutso and we didn't do stupid things in the mortgage market, but also we had an earnings solidity of a huge mortgage base because we didn't sell them off," Clark said.

    Regulation, too, ensured strong Canadian balance sheets.

    Canadian banks must have a Tier 1 capital ratio — the percentage of a bank's capital to its risk-weighted assets — of at least 7 percent. They also cannot be leveraged by more than 20 to 1. Conservative corporate culture and market pressure has typically meant the banks have Tier 1 capital closer to 10 percent, and are leveraged just 16 or 17 to 1.

    U.S. banks, by contrast, had Tier 1 closer to 4 percent, while European banks were leveraged 40 or 50 to 1.

    TD's Clark puts it this way: "We've always been liquidity freaks. What I've always said is 'You will be the last bank in the world ever to have to call the Bank of Canada or Federal Reserve,' even though that will cost us earnings."


  11. emca

    I can't give opinion on technicals, but your comparison of watercolors as oppose to oils, although I haven't heard it placed in terms of writing, is apt. Being of the oil painting camp, I painfully engage in repeated revisions a paragraph before comprising on a finished script (comprise is the key here). I do admire those who can commit with one stroke of the pen, a complete and intelligible sentence coordinated to the larger idea of theme, but I'm not one of them.

    That aside, GreeneTimes has touch on a point, that is even if you are to arrive at the correct economic diagnosis and propose a solution most likely to effect a cure, the politics of such a strategy make rendering it an impossibility… except all for the most courageous.
    Economic reform is what is the short-term palatability to a voting public, not a solution dictated by a hard-nosed assessment of remedies.

  12. Yves Smith


    Good point. Canada was a trade surplus country, so the interest rate effect is different. Recall Japan super low rate and big trade surpluses (until recently). One can argue the two are related, keeping rates low in non-reserve currency leads to undervauation, which leads to exports, which leads to underconsumption….if you choose to buy the "underconsumption" bit. I'm still noodling whether the use of language that has evolved from international accounting requirements is the best way to characterize the problem,


    Yes, very good points…outsourcing from everything I can tell was WAY oversold, yet continued to be popular.

    Do you have anything you can point me to re SIV accounting? That sort of thing goes in another part of the book, but it is VERY important, on the various ways accounting simply did not represent cash flows,

    A very big part is what you talk about, how revenues/profits were accelerated. Can you tell me of point me to something that describes from sponsor bank perspective what happened from an accounting standpoint when an SIV was established, particularly the revenue/profit impact? Thanks!

  13. yoganmahew


    Over-egged revenue recognition is what I suspect was happening based on what happened at a company I worked for (the oppositie of the Walmart model reduced!) – the company delivered many year IT projects with ongoing payments and balloon payments at the end. The financial whiz-kids came in and told management that revenue recognition was the next-big-thing. So, they could recognise most of the revenue from the project in the current year since the contract was complete and the rest of the project was just implementation. So 1996's figures looked great. 1997 had a huge loss as costs escalated and the customer refused the final balloon payment… (or rather, nobody asked them for it, but that's a different story!).

    I know it is a bit tenuous, but I've seen supporting hints on blogs and financial fora. Part of the problem with it, I believe, is that it started small in the 1990s and has built up into a monster. The authorities seem to belated realise this:
    (in non-financial companies anyway).

    Anyway, this seems to have some useful pointers (for all it's gramattical and spelling errors)?

    Can't wait to finally understand this from the book!

  14. OSR

    Your causes aren't causes, they are merely symptoms. Ritholtz's book had the same problem, ironically leaving him in dire need of a Bigger Picture.

  15. Hugh

    Re the full employment argument, Bill Clinton created 22.7 million jobs during his two terms. Bush by contrast created 5.6 million before the recession hit in December 2007. This fell far short of even covering natural population growth. Then most of those were lost before he left office, leaving him with a net job creation over 8 years of just 2.1 million.

    You can go here and create your own table and see:

    Now since interest rates were loose under both Presidents, I'm not really sure how they play in to anything.

    Re Keynes or really any of these arguments, I think they overlook how distorted, and corrupted, the economy had become. So a given input under a traditional scenario was not going to have an expected output because it was going to get sucked into the paper economy where as long as that form of Ponzi economics was still bubbling along profits were higher. Debt in this view from whatever source was just more fuel to keep the contraption bubbling along for that much longer.

  16. yoganmahew

    And addition consideration may be the lack of new inventions in the last ten years. If new industries are supposed to replace old as a result of innovation on new inventions, we've seen the move from products to the rather more nebulous services.

    The life-sciences were supposed to be the new paradigm at one stage, as was IT, but neither of these things have an impact with consumers – we are stuck buying ever-shinier versions of the same stuff – iPods for cassette walkmans, plasma/LCD TVs for cathode ray ones, Blu-ray for VHS, smart drugs for antibiotics.

    Instead, investment has shifted to financial and real-estate products. Financial innovation has replaced technical and engineering innovation. Without an industrial step-change to soak up risk capital, it has gone into bubbles, so this cause is as a result of inventive stagnation…

  17. John J. Xenakis


    Many people claim to have an explanation of the real estate / credit
    bubbles that led to the current crisis. Some blame Greenspan, some
    blame Bush, some blame Barney Frank, for example.

    But history didn't start in 2003. None of these people ever seem to
    have an explanation for the dot-com bubble of the late 1990s. Why
    did it occur? Why did it begin in 1995 (instead of, say, 1985 or
    2005)? How did it lead to the real estate / credit bubbles?

    In my opinion, anyone who can't answer those three questions has any
    right whatsoever to claim that he has a credible explanation for the
    real estate and credit bubbles.

    John J. Xenakis

  18. John J. Xenakis


    Technology was exploding in the mid-1980s. The IBM PC/XT and Apple
    Macintosh (microcomputers) had just come out, as had powerful new
    midrange computers from IBM, DEC, Data General, and others. Local
    area networking was exploding. There were huge cottage industries in
    developing everything from clones to peripherals to software. As it
    was, there were massive changes in corporate governance, as word
    processors, spreadsheets, accounting software, critical path method
    software, etc., flattened management charts, eliminating layers of
    middle management. And yet, there was no technology bubble. Why


  19. john bougearel

    The proof is in the complete failure in the post 2002 expansion for workers to get ANYTHING. Prior expansions had them getting in the low 60% of GDP gains. They got only 29% this time. Prior low was 55%.

    A new feature to this post 2002 expansion was the jobless recovery. Mfg began its recovery in May-June 2003, but jobs did not show up until March-April 2004, and then were only strong for two consecutive months, before falling into subpar job growth again through the balance of 2004. Hence, part of the reason for getting only 29% of GDP gains was a function of the lack of domestic job growth in the brave new world.

    Initial indications are as job growth slows in developed countries, and accelerates in emerging countries, wage gaps will narrow in subsequent cycles.

  20. Hugh

    John Xenakis, if you want one take on the dot com bubble, you might check out Matt Taibbi's most recent article in Rolling Stone.

  21. andrewg

    Yves, your view re Keynesians and interest rates is correct. Have confidence in it. Essentially, I’m just going to simplifying what you already wrote:

    Printing money is indeed likely to lead to higher employment (though it has serious deleterious effects on the economy). And indeed loose monetary policy by the Fed (and Japan and others) over the last 25 years did result in enormous job creation. That job creation just happened to take place in China (and elsewhere), not primarily in the U.S. In other words, Keynes is essentially correct on this point (more money = more jobs). Except that his policy prescriptions only work in a closed economy. So, the link between US monetary policy and US employment was weak, (as was the link to the CPI – which is why the Fed was completely blind). The market couldn’t correct itself, yes, partially due the Chinese peg but also because unskilled and marginally skilled wages in the US weren’t allowed to decline (due to minimum wage laws, unions, immigration restrictions, etc) anywhere near as much as they economically should have. To say there are no models to describe this is silly since this is all just macro 101. Why 99% of economists don’t understand macro 101 is another question. Now, Keynes’s General Theory was wrong in other ways, but that’s beyond the scope of your question.

  22. Hugh

    andrewg, how do you account for the 22.7 million jobs that Clinton created? I should point out that under Clinton there was even a small increase in manufacturing jobs a little over 300,000. Under Bush on the other hand, there was a loss of 4.4 million jobs in manufacturing or a quarter of the total such jobs. You can check this data out in the b-1 tables at the Bureau of Labor Statistics.

  23. juan

    Robert P. Brenner, Jeong Seong-jin, “Overproduction not Financial Collapse is the Heart of the Crisis: the US, East Asia, and the World” The Asia-Pacific Journal, Vol. 6-1-09, February 7, 2009.


  24. andrewg

    Hugh, I never said that jobs weren't created in the US due to loose monetary policy. I just said that the bulk of the job creation occurred overseas.

  25. andrewg

    also, that job growth was much weaker during the bush years, when monetary policy was at its loosest, further indicates the weak link between domestic monetary policy and domestic employment

  26. reason

    I think the USD being the reserve currency blinds people. Think about NZ running a 5-6% trade deficit and then think things through again. Without massive credit creation the economy collapses, 5-6% is a leakage from the circular flow of income. And it explains a lot more. I like the argument that consumption financed by consumer credit increases corporate income but not corporate costs (people are taking credit because they aren't getting the wages) and so pushes up profits. You can blow a financial asset bubble and deflate it with relatively minor effects on the real economy, but people living consistantly beyond their means will come a cropper one day!

    Call this a "Keynesian" analysis if you like, labels don't mean much to me, I just think it is common sense.

  27. reason

    Oh and what OSR said! (Although he could have expanded his story a bit)!

    P.S. By the way I don't think your story is all wrong, I just think the relative emphasis is wrong. If there weren't massive cross-border financial flows the problem would be much more manageable.

  28. reason

    "The market couldn’t correct itself, yes, partially due the Chinese peg but also because unskilled and marginally skilled wages in the US weren’t allowed to decline (due to minimum wage laws, unions, immigration restrictions, etc) anywhere near as much as they economically should have."

    Come on that is just silly (- you are talking about Bush's America where these things are irrelevant). If real exchange were allowed to adjust (either by reallignment or relative inflation) then US manufacturing would be competitive in something. The fact that it has all but disappeared in all but the most protected of sectors (weapons manufacture) is a sign that the major reason that the market couldn't adjust is neo-Mercantilism (not just Chinese).

  29. reason

    Basically, an misaligned currencies means that there were no profitable productive investments to be made in the US, and this encouraged leverage (to push up rates of return) and speculation – rather than the other way around.

  30. andrewg

    Reason, the US is not competitive in manufacturing because US wages haven't adjusted in response to the shock of a billion people entering the global workforce in the past 25 years. Now yes, of course, neo-Mercantilism plays a role but to say it is the major reason the US is not competitive is the same thing as blaming the current mess on the Asian savings glut, is it not? It's only half the story. The money has to come from somewhere and someone has to buy what the neo-mercantilists are selling.

  31. reason

    I don't think you believe in marginalism. Remember that a fall in the USD means a rise in the cost of oil (and hence transport). Any change in relative costs will affect some marginal producer. Wage costs are not anywhere the largest costs in manufacturing (and definitely not in manufacturing currently employing minimum wage labour).
    (Given that the US currently EXPORTS foodstuffs even at current exchange rates.) A big fall in nominal low wage incomes means people will starve (absent food stamps), a big change in exchange rates and they probably won't.

  32. reason

    perhaps it is best to think about it another way. A devaluation of the US currency is equivalent to domestic deflation (as you point out for wages alone). However, given that many people in the US are substantially in debt, deflation makes that debt burden much worse and there will be (even) more bankrupcies. Is that what you want? No I think devaluation is the right anser BECAUSE it is the inflationary equivalent.

  33. reason

    P.S. For those who bring out PPP comparisons, I would like to point out that coutries raising much of their revenue from VAT tax imports but not exports (and income does the reverse), and this distorts PPP comparisons.

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