Demand Side Exposed: The Confessions of an Unreconstructed Progressive Economist

One of the questions that appears in my e-mail at Demand Side is, "Who are you?" When this does not send me into a period of morbid introspection, it produces a resistance and defensiveness most often characterized by the response, "I am the person writing this material. If it doesn't make sense, move on."

Today all that is changed. As the introduction to Demand Side, the book, 2nd ed. I have drafted the following characterization of who I am and what I'm about.

Look, I wanted to study economics. But even as an undergraduate I could see that Academic economics, at least at the large state university I attended, was ill-suited to the real world. It seemed to be a place people went to study things nobody else could understand so they would have job security. In four years I heard the name Keynes mentioned only twice in lecture, and then it was mispronounced.

Perhaps I was convinced they were hiding something, so I persevered with good results on the GPA scorecard. But when it came time to make a decision for graduate school, I came up against a personal reality. I was already in my forties with family.

The Neoclassical main line was not difficult to reject. The assumptions of perfectly competitive markets and perfect information plainly did not correspond to even one real world situation. Monopoly and oligopoly ruled. Even restaurants were rewarded more for location and less for quality of food or service. Prices in the real world were not supply and demand, except in limited circumstances, but manipulated by market power or government regulation and subsidy.

The mathematics and statistics I learned were useful in themselvs, but economics I could see even then was a science of human behavior. The mathematics was suited for thermodynamics, but plainly in a system that was not closed and where there were no independent variables unless by assumption, applying math meant results that worked only in a hypothetical world. And for all the precision of the econometric models, the results in terms of forecasting were not good. Perhaps I should say they were very good when applied to the past, but very poor when applied to the future.

The economic lions of the day were at the University of Chicago. Milton Friedman and Robert Lucas and the others. Friedman advocated a policy of increasing the stock of money at a steady pace to control prices. But it was back in Macro 101 we looked at the equation PQ = MV, and Friedman was plainly ignoring the V. The great experiment of Paul Volcker in bringing down inflation in the late 1970s and early 1980s was premised on Friedman's assurances that constraining the quantity of money would certainly move prices quickly and painlessly down. The severe recession of 1981 was not quick and was very painful for people I knew. Plus it was relieved only when oil prices fell and the money stock came out from under the Fed's thumb by way of credit cards.

Robert Lucas described a scheme called Rational Expectations. Here, too, the fallacy was right up front. Rational Expectations requires economic actors who are prescient beyond possibility and certainly beyond any historical evidence.

Efficient Markets and the claims for them by their Chicago School advocates were belied by the results. "Efficiency" needed a very narrow definition to make the theory work. Agriculture, for example, had all the elements of perfect competition -- homogenous products and a multitude of producers, low barriers to entry and the rest -- yet the efficient market impoverished everyone. Admittedly, my "efficiency" was a social outcome, while that of the Chicago School was a price outcome. Still, the assumption that the two converged was implicit and was contradicted every time I looked out the window.

Perhaps it was my experience in the real world, where I had a list of jobs longer than yours, from cabs, to restaurants, to mines, to forestry, to municipal government. I was keenly aware that these theories were flowers appropriate only in hothouses and other controlled environments.

I am not claiming any special insights. It is my firm belief that many if not most of my fellow students found them equally invalid, or at least dreadfully uninteresting. Certainly the Business School and the Economics Department did not cross-pollinate.

So in terms of graduate school I was hard up against the orthodoxy. I had done well in the undergraduate curriculum by granting it the benefit of the doubt. I think I was convinced that once we got through the fundamentals and the weak in spirit were weeded out, the elect would emerge into a realm where the absurd assumptions were removed and the tools became applicable. Never happened.

And as I said, I was personally up against being forty-something with a family. I did not have the time or patience to continue down a road without some more sound assumptions being made explicit. My particular school did not have a parallel course for heretics. There were no other schools in our region. Nothing in economics. Some in business applications, but a cursory look at that showed it to be more than a little contrived. It would be math and facile theory or nothing.

The choice I made was to take my high grades and new degree to work with me on the bus. (To be completely candid, I did have the opportunity to become a budget analyst for the County, but declined in preference for purity of macro purpose, a purpose probably misplaced.)

In any event, in order to study Keynesian or even the successes of the economy during and following World War II, I needed to study on my own.  John Kenneth Galbraith, John Maynard Keynes, an early chair of the Council of Economic Advisers and prominent New Dealer named Leon Keyserling, Joseph Stiglitz, James K. Galbraith, George Soros, and now Hyman Minsky.  There is a lineage of economic thought that has progressed and become more useful.  Fortunately, some of it survived in the U.S. House of Representatives and had some access to policy.  But Demand Side became confused with the success of the New Keynesians such as Paul Samuelson and James Tobin.  (What Joan Robinson referred to as "Bastard Keynesianism."  And it was dominated later by the rise of the Monetarist, Rational Expectations, Supply Side and Efficient Market nonsense.  But it exists.  And it informs very well what is going on now.

My studies quickly began to pay off.  I was able to predict -- following closely the work of others -- the end of the Clinton New Economy.  I was able to identify bubbles when we were inside them -- a feat much less remarkable than those at the Fed would have you believe.  And I came to know what questions to ask, who to listen to, and who to discount.

It is much more surprising to me that the decline of U.S. industry and the stagnation of median incomes, the decline of social infrastructure and the rise of a parasitic financial sector, has been considered a golden period, the Great Moderation, by most economists.  High Academia and the halls of Wall Street seemed to become the repository for self-serving ignorance, not for workable economics.  This was perhaps as surprising to me as my claim of knowledge is to you.

Nevertheless, I recently returned to my alma mater in hopes that the housing bust, financial meltdown, socialization of the financial sector and bleak prospects going forward would have opened a parallel path for at least a few heretics.  In response to a description of my success in forecasting, my work on state tax policy and my interest in the theory of multipliers and productivity (which appear later in this volume), the reply was pointed:

Dear Mr. Harvey,

Thank you for your email, it is always good to hear from former students, especially ones who have retained a deep interest in Economics.

But I regret that the answer to your question about fitting into the Ph.D. program is almost certainly negative.  Like most other Economics departments, our Ph.D. program has become increasingly theoretical and mathematical over time.  As a result, we generally accept only individuals who have taken a heavy dose of calculus, linear algebra, and mathematical statistics in the recent past, because a solid foundation in all three is necessary to master the first-year core courses.

One presumes the theory is not Keynesian.  Certainly the mathematics has been disgraced by the absence of results, and indeed the creation of loss, in the real world.  While I have good skills in all three areas, this response clearly indicated the department, having started down the road of irrelevance, would not be detouring any time soon. 

On one hand, it would be logical to be discouraged and frustrated.  So I am.  On the other hand, How much more to learn and trust these fallacies and then be forced to the choice of either admitting a life spent in error or denying  reality.  At least my forecasts work and my studies build on each other to a more complete understanding.

We see around us the rubble of an intellectual conceit, yet at the highest points still standing the debate is dominated by the architects who built the structure and claimed it would last forever.  Here I hope to offer the views of those not favored by academic elites or corporate subsidies.  I hope to consolidate the views of those who make sense, display the evidence that proves them right, and do it in a way that is accessible and useful to the reader's own understanding.

It is not simply that we must escape the errors of the past, no matter how great.  We must also move aggressively into a productive and sustainable future.  Standing around waiting will only serve the interests of the entrenched interests and increase the damage of the collapse now in progress.

Bill Black suggests that in saving the banks, we have saved the vampires

The inability and unwillingness to correct the corruption and decay in the financial sector led to the current economic decline.  Continued unwillingness and delay will certainly bring a return of the same fruits.  But beyond passive enabling, the Fed and Treasury have actively and substantially enriched the authors of the debacle because of the delusion that these practices are similar to legitimate banking because they are carried out behind the same august facades.

Bill Black here outlines the scope and severity of the ongoing crisis, and points to the ultimate access to levers of power. The ability of the financial sector to block meaningful reform after bringing the world to the brink of a second great depression proves how exceptional its powers are to corrupt nearly every critical sector of American public and economic life. The five largest U.S. banks control roughly half of all bank assets. They use their political and financial power to provide themselves with competitive advantages that allow them to dominate smaller banks.

How the Servant Became a Predator: Finance’s Five Fatal Flaws
by Bill Black
October 13, 2009
New Deal 2.0

What exactly is the function of the financial sector in our society? Simply this: Its sole function is supplying capital efficiently to aid the real economy. The financial sector is a tool to help those that make real tools, not an end in itself. But five fatal flaws in the financial sector’s current structure have created a monster that drains the real economy, promotes fraud and corruption, threatens democracy, and causes recurrent, intensifying crises.

1. The financial sector harms the real economy.

Even when not in crisis, the financial sector harms the real economy. First, it is vastly too large. The finance sector is an intermediary — essentially a “middleman”. Like all middlemen, it should be as small as possible, while still being capable of accomplishing its mission. Otherwise it is inherently parasitical. Unfortunately, it is now vastly larger than necessary, dwarfing the real economy it is supposed to serve. Forty years ago, our real economy grew better with a financial sector that received one-twentieth as large a percentage of total profits (2%) than does the current financial sector (40%). The minimum measure of how much damage the bloated, grossly over-compensated finance sector causes to the real economy is this massive increase in the share of total national income wasted through the finance sector’s parasitism.

Second, the finance sector is worse than parasitic. In the title of his recent book, The Predator State, James Galbraith aptly names the problem. The financial sector functions as the sharp canines that the predator state uses to rend the nation. In addition to siphoning off capital for its own benefit, the finance sector misallocates the remaining capital in ways that harm the real economy in order to reward already-rich financial elites harming the nation. The facts are alarming:

• Corporate stock repurchases and grants of stock to officers have exceeded new capital raised by the U.S. capital markets this decade. That means that the capital markets decapitalize the real economy. Too often, they do so in order to enrich corrupt corporate insiders through accounting fraud or backdated stock options.

• The U.S. real economy suffers from critical shortages of employees with strong mathematical, engineering, and scientific backgrounds. Graduates in these three fields all too frequently choose careers in finance rather than the real economy because the financial sector provides far greater executive compensation. Individuals with these quantitative backgrounds work overwhelmingly in devising the kinds of financial models that were important contributors to the financial crisis. We take people that could be conducting the research & development work essential to the success of our real economy (including its success in becoming sustainable) and put them instead in financial sector activities where, because of that sector’s perverse incentives, they further damage both the financial sector and the real economy. Michael Moore makes this point in his latest film, Capitalism: A Love Story.

• The financial sector’s fixation on accounting earnings leads it to pressure U.S manufacturing and service firms to export jobs abroad, to deny capital to firms that are unionized, and to encourage firms to use foreign tax havens to evade paying U.S. taxes.

• It misallocates capital by creating recurrent financial bubbles. Instead of flowing to the places where it will be most useful to the real economy, capital gets directed to the investments that create the greatest fraudulent accounting gains. The financial sector is particularly prone to providing exceptional amounts of funds to what I call accounting “control frauds“.  Control frauds are seemingly-legitimate entities used by the people that control them as a fraud “weapons.” In the financial sector, accounting frauds are the weapons of choice. Accounting control frauds are so attractive to lenders and investors because they produce record, guaranteed short-term accounting “profits.” They optimize by growing rapidly like other Ponzi schemes, making loans to borrowers unlikely to be able to repay them (once the bubble bursts), and engaging in extreme leverage. Unless there is effective regulation and prosecution, this misallocation creates an epidemic of accounting control fraud that hyper-inflates financial bubbles. The FBI began warning of an “epidemic” of mortgage fraud in its congressional testimony in September 2004. It also reports that 80% of mortgage fraud losses come when lender personnel are involved in the fraud. (The other 20% of the fraud would have been impossible had these fraudulent lenders not suborned their underwriting systems and their internal and external controls in order to maximize their growth of bad loans.)

• Because the financial sector cares almost exclusively about high accounting yields and “profits”, it misallocates capital away from firms and entrepreneurs that could best improve the real economy (e.g., by reducing short-term profits through funding the expensive research & development that can produce innovative goods and superior sustainability) and could best reduce poverty and inequality (e.g., through microcredit finance that would put the “Payday lenders” and predatory mortgage lenders out of business).

• It misallocates capital by securing enormous governmental subsidies for financial firms, particularly those that have the greatest political power and would otherwise fail due to incompetence and fraud.

2. The financial sector produces recurrent, intensifying economic crises here and abroad.

The current crisis is only the latest in a long list of economic crises caused by the financial sector. When it is not regulated and policed effectively, the financial sector produces and hyper-inflates bubbles that cause severe economic crises. The current crisis, absent massive, global governmental bailouts, would have caused the catastrophic failure of the global economy. The financial sector has become far more unstable since this crisis began and its members used their lobbying power to convince Congress to gimmick the accounting rules to hide their massive losses. Secretary Geithner has exacerbated the problem by declaring that the largest financial institutions are exempt from receivership regardless of their insolvency. These factors greatly increase the likelihood that these systemically dangerous institutions (SDIs) will cause a global financial crisis.

3. The financial sector’s predation is so extraordinary that it now drives the upper one percent of our nation’s income distribution and has driven much of the increase in our grotesque income inequality.

4. The financial sector’s predation and its leading role in committing and aiding and abetting accounting control fraud combine to:

• Corrupt financial elites and professionals, and

• Spur a rise in Social Darwinism in an attempt to justify the elites’ power and wealth. Accounting control frauds suborn accountants, attorneys, and appraisers and create what is known as a “Gresham’s dynamic” — a system in which bad money drives out good.  When this dynamic occurs,  honest professionals are pushed out and cheaters are allowed to prosper. Executive compensation has become so massive, so divorced from performance, and so perverse that it, too, creates a Gresham’s dynamic that encourages widespread accounting fraud by both financial firms and firms in the real economy.

As financial sector elites became obscenely wealthy through predation and fraud, their psychological incentives to embrace unhealthy, anti-democratic Social Darwinism surged. While they were, by any objective measure, the worst elements of the public, their sycophants in the media and the recipients of their political and charitable contributions worshiped them as heroic. Finance CEOs adopted and spread the myth that they were smarter, harder working, and more innovative than the rest of us. They repeated the story of how they rose to the top entirely through their own brilliance and willingness to embrace risk. All of their employees weren’t simply above average, they told us, but exceptional. They hated collectivism and adored Ayn Rand.

5. The CEO’s of the largest financial firms are so powerful that they pose a critical risk to the financial sector, the real economy, and our democracy.

The CEOs can directly, through the firm, and by “bundling” contributions of its officers and employees, easily make enormous political contributions and use their PR firms and lobbyists to manipulate the media and public officials. The ability of the financial sector to block meaningful reform after bringing the world to the brink of a second great depression proves how exceptional its powers are to corrupt nearly every critical sector of American public and economic life. The five largest U.S. banks control roughly half of all bank assets. They use their political and financial power to provide themselves with competitive advantages that allow them to dominate smaller banks.

This excessive power was a major contributor to the ongoing crisis. Effective financial and securities regulation was anathema to the CEOs’ ideology (and the greatest danger to their frauds, wealth, and power) and they successfully set out to destroy it. That produced what criminologists refer to as a “criminogenic environment” (an atmosphere that breeds criminal activity) that prompted the epidemic of accounting control fraud that hyper-inflated the housing bubble.

The financial industry’s power and progressive corruption combined to produce the perfect white-collar crimes. They successfully lobbied politicians, for example,  to legalize the obscenity of “dead peasants’ insurance“(in which an employer secretly takes out insurance on an employee and receives a windfall in the event of that person’s untimely death) that Michael Moore exposes in chilling detail. State legislatures changed the law to allow a pure tax scam to subsidize large corporations at the expense of their taxpayers.

Caution: Never Forget the Need to Fix the Real Economy

 Economic reform efforts are focused almost entirely on fixing finance because the finance sector is so badly broken that it produces recurrent, intensifying crises. The latest crisis brought us to the point of global catastrophe, so the focus on finance is obviously rational. But the focus on finance carries a grave risk. Remember, the sole purpose of finance is to aid the real economy. Our ultimate focus needs to be on the real economy, which creates goods and services, our jobs, and our incomes.  The real economy came off the rails at least three decades ago for the great majority of Americans.

We need to commit to fixing the real economy by guaranteeing that everyone willing to work can work and making the real economy sustainable rather than recurrently causing global environmental crises. We must not spend virtually all of our reform efforts on the finance sector and assume that if we solve its defects we will have solved the other fundamental reasons why the real economy has remained so dysfunctional for decades. We need to be work simultaneously to fix finance and the real economy.

William K. Black is an Associate Professor of Economics and Law at the University of Missouri-Kansas City. He is a white-collar criminologist and was a senior financial regulator. He is the author of The Best Way to Rob a Bank is to Own One.

Modern economics is mathematical and theoretical. Too bad it is not more real. But the real world is inconveniently asymetric. It resists modeling.

Here, from Brad DeLong, a request that the real world again enter the cognitive sphere of economists.

The Anti-History Boys
J. Bradford DeLong
Project Syndicate
October 6, 2009

BERKELEY – If you asked a modern economic historian like me why the world is currently in the grips of a financial crisis and a deep economic downturn, I would tell you that this is the latest episode in a long history of similar bubbles, crashes, crises, and recessions that date back at least to the canal-building bubble of the early 1820’s, the 1825-1826 failure of Pole, Thornton & Co, and the subsequent first industrial recession in Britain. We have seen this process at work in many other historical episodes as well – in 1870, 1890, 1929, and 2000.

For some reason, asset prices get way out of whack and rise to unsustainable levels. Sometimes the culprit is lousy internal controls in financial firms that over-reward subordinates for taking risk. Sometimes the cause is government guarantees. And sometimes it is simply a long run of good fortune, which leaves the market dominated by unrealistic optimists.

Then the crash comes. And when it does, risk tolerance collapses: everybody knows that there are immense unrealized losses in financial assets and nobody is sure that they know where they are. The crash is followed by a flight to safety, which is followed by a steep fall in the velocity of money as investors hoard cash. And that fall in monetary velocity brings on a recession.

I will not say that this is the pattern of all recessions; it isn’t. But I will say that this is the pattern of this recession, and that we have been here before.

But if you ask the same question of a modern macroeconomist – for example, the extremely bright Narayana Kocherlakota of the University of Minnesota – you will find that he says that he does not know, and that macroeconomic models attribute economic downturns to various causes. Most, he points out, “rely on some form of large quarterly movements in the technological frontier. Some have collective shocks to the marginal utility of leisure. Other models have large quarterly shocks to the depreciation rate in the capital stock (in order to generate high asset price volatilities)...”

That is, downturns are either the result of a great forgetting of technological and organizational knowledge, a great vacation as workers suddenly develop a taste for extra leisure, or a great rusting as the speed at which oxygen corrodes accelerates, reducing the value of large things made out of metal.

But modern macroeconomists will also say that all these models strike them as implausible stories that are not to be taken seriously. Indeed, according to Kocherlakota, nobody really believes them.: “Macroeconomists use them only as convenient short-cuts to generate the requisite levels of volatility” in their mathematical models.

This leads me to ask two questions:

First, is it really true that nobody believes these stories? Ed Prescott of Arizona State University really does believe that large-scale recessions are caused by economy-wide episodes of forgetting the technological and organizational knowledge that underpin total factor productivity. One exception is the Great Depression, which Prescott says was caused by real wages far exceeding equilibrium values, owing to President Herbert Hoover’s extraordinary pro-labor, pro-union policies.

Likewise, Casey Mulligan of the University of Chicago really does appear to believe that large falls in the employment-to-population ratio are best seen as “great vacations” – and as the side-effect of destructive government policies like those in place today, which lead workers to quit their jobs so they can get higher government subsidies to refinance their mortgages. (I know; I find it incredible, too.)

Second, regardless of whether modern macroeconomists attribute our current difficulties to causes that are “patently unrealistic” or simply confess ignorance, why do they have such a different view than we economic historians do? Regardless of whether they have rejected our interpretations and understandings or simply have built or failed to build their own in ignorance of what we have done, why have they not used our work?

The second question is particularly disturbing. After all, economic theory should be grappling with economic history. Theory is crystallized history – it can be nothing more. Someone observes some instructive case or some anecdotal or empirical regularity, and says, “This is interesting; let’s build a model of this.” After the initial crystallization, theory does, of course, develop according to its own intellectual imperatives and processes, but the seed of history is still there. What happened to the seed?

This is not to say that the macroeconomic model-building of the past generation has been pointless. But I do think that modern macroeconomists need to be rounded up, on pain of loss of tenure, and sent to a year-long boot camp with the assembled monetary historians of the world as their drill sergeants. They need to listen to and learn from Dick Sylla about Alexander Hamilton’s bank rescue of 1825; from Charlie Calomiris about the Overend, Gurney crisis; from Michael Bordo about the first bankruptcy of Baring brothers; and from Barry Eichengreen, Christy Romer, and Ben Bernanke about the Great Depression.

If modern macroeconomists do not reconnect with history – if they do not realize just what their theories are crystallized out of and what the point of the enterprise is – then their profession will wither and die.

Yesterday's podcast carried Barack Obama's full statement on the Financial Products Safety Commission. Here is another take from Richard Wolf

Why is this country so hostile to users of consumer financial products?
from New Deal 2.0
by Richard Wolf
October 11, 2009

This country’s economy is predicated on individual consumerism. Indeed, with America’s 217 million adults and 116 million households, individual consumption represents as much as 70% of this country’s economy. Consumerism creates jobs. Individual households thrive when jobs are aplenty, and the country prospers when households thrive.

Much of that consumption is supported by consumer loans in the form of home mortgages, home equity lines of credit, auto loans, student loans, and of course, ubiquitous credit card loans. There is nothing intrinsically bad or dangerous about credit as long as it is used wisely and prudently. People would not want to return to the ‘good old days’ when one could only purchase a big ticket item like a house or car after saving a satchel full of cash to pay for it. Consumer credit facilitates the modern economy. (In fact, in the past bankers used to even call consumer loans ‘credit facilities’.)


Unfortunately, the market for consumer credit products is broken. It is broken because consumers lack trust and confidence. The system is unnecessarily complex and opaque. Loan agreements now consist of incomprehensible fine print and legalese burying a wide assortment of potential tricks and traps. While lenders offer low teaser rates to win more market share, they hide the numerous fees and practices, their real profit-makers, in the fine print — where the consumer can’t find or understand them. Consumers are unable to easily compare products or choose the ones with the lowest cost or lowest risk. “Financial innovation” now centers around the invention of new incomprehensible fees rather than better serving consumer preferences.

Because the true cost of credit is now so badly distorted, consumers use too much credit. And the government’s approach to oversight is presently unwieldy, complex, costly, and ineffective. This has resulted in a consumer credit market that is broken, dangerous, and, because left unchecked, has greatly contributed to the current economic meltdown.

Fortunately, this situation may be about to change. There is an initiative being debated in Congress to establish a Consumer Financial Protection Agency (CFPA). The CFPA would be a dedicated advocate for users of financial products in this country. Its scope would encompass consumer financial products and services including selling practices, advertising and underwriting. It would establish minimum federal standards by product, so consumers could compare various offerings more easily and have confidence in their decisions. Lenders would all face the same set of guidelines and disclosure rules. They wouldn’t be able to escape regulation by changing their corporate charters, geographic location, or regulatory supervisor as is the case now.

America’s Consumer Product Safety Commission has long been established and has the authority to develop uniform safety standards for physical products, order the recall of unsafe products, and ban products that pose unreasonable risks. This is similar to the FDA’s authority over food and pharmaceuticals. It is long overdue for John Q. Public to have uniform protection and standards for financial products.

A CFPA would concentrate the review of financial products in a single location but would not limit competition among lenders. Lenders would still evaluate risk, set prices, and design marketing campaigns and activities. However, a CFPA would focus primarily on expanding consumer safety rather than corporate profitability.

Unfortunately, there is an oft unstated fact that financial transactions are far riskier for consumers today than even a mere ten years ago. As complexity and opacity have increased with these financial products, with the advent of practices like immediate cross default, penalties with no notice, myriad nuisance fees, and the devilish practices of double-cycle billing, and with the evolution of a much smaller safety net, consumers are much less secure than they once were. Consumers need — and deserve — an advocate and a level playing field.

Our forecast has not changed over the past six months, so we have not drawn too much attention to it. Today we will, along with an explicit description of the current state of the economy and the obstacles to a complete recovery. Forecast: Stagnation. Currrent State: Failing. Obstacles: Continued Fed Obtusess, Unwillingness to pay bills in cash, and the Meanness that arises from a general Me-ness.

We will expand from these brief descriptions in the forecast section of today's podcast.

Later we will dig a bit deeper into the Fed on Idiot of the Week, and we have comment on the Taylor Rule and other nonsense, taking off from Paul Krugman.

First, though, complete and unedited, the statement by Barack Obama on the Financial Products Safety Commission. We view this new regulatory body as essential to moving out of the current case of market domination by big banks and bad practice.

As we've said before, this is a non-intrusive means of regulation. This has nothing to do with audits, pay restrictions, capital requirements, or any of your back rooms. One must ask Why the big banks have marshaled their money and purchased representatives in opposition to such a bill. As I said, it is not intrusive. One is examining products, not producers. Legitimate real economy firms welcome such consumer safety regulation as a way of weeding out the less competent and presumably less well-funded and at the same time increasing confidence among purchasers.

We suspect that it is precisely because such a financial products safety commission would bring order to the market and prevent exploitation by the well-positioned that it is being resisted by those well-positioned. And we are extremely pleased that Obama has invested political capital in this venture. Here he is, beginning with a calling of the roll.

OBAMA

Barack Obama

If nothing else, the current crisis has demonstrated how thoroughly the financial sector has captured its main regulator, the Fed. This new agency is an important escape from that corrupt arrangement.

Now. The Forecast.

First let's line up the opposition.

The consensus of economists suggests recovery proceed before too long into an equilibrium of high unemployment and lower trend growth, what I will a recovery, that is, slight improvement, into stagnation. Not a V-shaped, not a W-shaped, but a square root shaped -- down, up and out at a lower level.

This is mistaken because of the stable tail.

Another camp, primarily at the Fed, predicts a somewhat stronger rebound and posits a danger, even mortal danger, from an inflation arising from the need to unwind the Fed's injections of liquidity with a fire hose.

These guys have long been clueless and serve only as powerfully placed voices standing ready to sabotage any real recovery in the real economy.

The true context for policy is an economy that is highly fragile and posed for another leg down. The financial sector is a millstone, the zombie banks are hardly rowing, and the prospect of further weakness in residential and commercial real estate and continued negative contributions from derivative and commodity speculation are already on the charts.

Specifically, zombie banks are profitable because they are gouging consumer credit users, playing in commodity and futures casinos, and eating the interest payments from the toxic securities which are still on their balance sheets. The financial sector is not enabling productive investment activity because they don't have to. They have the government. Besides, the prospect of profit from new investment in the context of overcapacity and a retreating consumer is very low.

Aside from propping up the zombie banks and other formerly private sector markets, the Fed's policy has done nothing. There are no more bubbles to blow up, even at zero percent, that will generate private investment. No more high tech booms, no more residential housing booms, no more commercial real estate booms. There are only financial market casinos to play in. Fine if you have the zero percent chips and are playing with the house, but for people looking for productivity in the real economy. Not so much.

The only route to real recovery and a return to strong growth is through the Demand Side. Only with a renewed job market and a recovery of incomes can we escape the blunders of the past few decades. As we've said, this demand side recovery does not need a return to the consumer economy. The consumer economy, after all, was premised on borrowing and the idea of selling houses back and forth to each other. Consumer baubles large and small were the end point of this economy.

The public goods of infrastructure, education, public health and climate change mitigation are ample and productive occupations that can support prosperity. As incomes grow, the overcapacity of the private sector will shrink. But more to the point for private investment, a new emphasis on public goods opens new industries where there is currently NO overcapacity and where new investment would not be redundant. (To be clear for the simple, spending on public goods is income to private economic actors, whether employees or contractors.) These types of industries are very much not currently dominated by foreign industry. Health care, education, domestic infrastructure, energy retrofitting, reengineering transportation and energy and information infrastructure. All domestic activities. All productive activities, in that they generate improvements in the productive framework. These are not BMW's or flat screen tvs or perfume in one hundred dollar bottles.

Three main obstacles are likely overwhelming, however.

1. Fed intransigence in its error.
2. Political opposition to paying cash for public goods, and
3. A social psychology which believes the good of the whole is code for taking away from me.


The Demand Side way out is really the only way out. And that's why we've outlined it here in the context section. Insofar as the path diverges from this prescription, and by the same dimension, it will be a reduction from the optimal outcome.

The three main obstacles are likely overwhelming, however.

Demand Side is not revolutionary in the sense it is new or complicated, but only because it is fundamentally separate from these errors.

Oh, and four, such a solution likely means inflation in non-core commodities like energy and food. That is because any investment-led growth would mean inflation, as we read Minsky. No less investment-led growth tied to public goods. In the early stages, such inflation would be very mild. In every stage it could be controlled by tax policy -- by reducing inflationary demand via increases in taxes. (This would make sense in that we have bills to pay, but see below.)

But lets go back to one through three.

One, the Fed stands ready to kill any recovery with monetary policy. We have hammered the Fed elsewhere and we have debunked the effectiveness of monetary policy relentlessly. We will do it again next week, but soon we will begin to leave them alone, not because they are unimportant or are gaining a new comprehension, but because they are hopelessly wedded to their doctrines.

Two, Consumer and mortgage credit inflated the housing bubble. It may take public borrowing to create the public goods that can lead us forward. But not because it is necessary or advisable, only because it has been one of the signal successes of the Rovian or Reagan Right to turn the word "taxes" into a synonym for "incest." Since taxes are the way we pay for public goods in the absence of deficit spending, the prospect of paying outright is diminished. One of the continuing marvels of this age is that the non-results from tax cutting fevers have been ignored. The rhetoric continues that cutting taxes will lead us to water even as we go further into the desert.

Three. The Me culture. To some extent "Don't tax me" is a function of this broader "Me" culture. The focus on consumerism and the consumer is also a function of this "Me." And the resistance, as before, to strengthening the whole is very often an affirmation that what is mine is what is most important.

In previous generations, the influence of and dependence on family was felt strongly. Community was essential. "Me" was impolite, at best. The religeon of primitive economics is 180 degrees divergent. Greed is good. Getting what I can is not only all right, it is of positive benefit to everyone. Beliefe that strong community, stable environments, planning, and public goods produce a positive sum game is viewed as dangerously naive. So we keep digging.


All Right. All right. Forecast.

Yes, if you've noticed, we've drawn back in from DemandSide dot net to get more proprietorial. We've decided if we're going to be right, we should look into getting paid for it. Nevertheless, we'll be dropping those charts back onto another vehicle soon, for those of you who have been cribbing off our work.

Forecast continued recession.

The happy talk on Wall Street of recovery is based on a definition of recovery as two successive quarters of positive GDP growth. This is, of course, not a very sophisticated description of the economy, and it is not the formula used by the NBER when they make their official determination. If it were, they wouldn't need twelve months. It is our belief that even considering the strong political winds now blowing in favor of quote recovery unquote and the flimsy increase in activity that is needed to justify such a determination, the NBER will not be persuaded to declare recovery in the same quarter as rising unemployment and continued industrial stagnation.

Our Demand Side descriptions are not recovery and recession, which have peculiar and not well understood technical definitions, but on the three levels of failing, weak and strong economies. The current situation is failing.

We have the stimulus and recovery potential of the Recovery Act on one hand. On the other, we have the negative stimulus of no private investment and contracting state and local governments.

Specifically, real GDP growth will be somewhat volatile around zero. Nominal GDP volatile around 1.5. Unemployment in the narrow measure will continue to trend upward into 2010. Unemployment in the broad U-6 measure will go up less quickly than it has over the past 18 months, but at a steeper slope than the narrow measure.

We have a idiosyncratic measure called Net Real GDP, which is essentially GDP minus the federal deficit needed to make it happen, that will continue to decline. That will likely be our first chart up on the new site.

Demand Side does not see forecasts as a crap shoot, which is the consensus view, but as the evidence of understanding. Neither do we put stock in precision. Better to be approximately right than precisely wrong, as John Maynard Keynes said. Nor do we see economic outcomes as independent of policy choices. All of which creates a different platform than the typical statistical model based forecasts.

(We notice Ellen Zentner, a chief advocate of "The recovery began in June" camp, reserves the right to tweak forecasts up to the day before the next official data come out. This displays sensitivity to statistical trends, but not really forecasts.)

So, having been right, we will continue to tell you about it until we are wrong. Not a V. Not a W. Not a square root. There is upside, but not until the employment situation has been fully addressed and the drag from the financial sector's systemic meltdown is cut away. There are upturns on the charts, and strong ones, but these depend on policy choices not yet made. Until then, it is the Great Stagnation, with a distinct risk of another leg down.

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From the beginning, the New Deal's Home Owners Loan Corporation (HOLC) was the appropriate model for dealing with teh fall in home values. Share the problem of bubble purchases between borrowers and lenders rather than force borrowers into foreclosure.

Protecting the lenders has been the preferred approach. Of course, the appropriate solution is fouled to some extent by the securitization of mortgages, which constructs legal Rubic cubes out of straightforward mortgages. But returning to the one-on-one coordination that will keep borrowers in their homes, their mortgages close to market prices, and the flow of payments continuing is the only effective way to keep the housing collapse from dragging down the economy for the next decade.

Here from the New York Times is an assessment of the latest attempt to finesse the essential write-down of principle.

Panel Says Obama Plan Won’t Slow Foreclosures
October 10, 2009
New York Times

By PETER S. GOODMAN

A day after the Obama administration proclaimed significant progress in its effort to spare troubled homeowners from foreclosure, an oversight panel on Friday sharply criticized the program and declared it would leave millions of Americans vulnerable to losing their homes.
In a report mild in language but pointed in substance, the Congressional Oversight Panel — a watchdog created last year to keep tabs on taxpayer bailout funds — said the administration’s program would, “in the best case,” prevent “fewer than half of the predicted foreclosures.”
The report rebuked the administration for failing to shape a program that addressed the most significant engines of the foreclosure crisis — soaring joblessness and exotic mortgages with low introductory interest rates that give way to sharply higher payments over the next three years. Many of those mortgages are too large to qualify for modification under the administration’s plan. People who lose their jobs often lack enough income to qualify for relief.
The administration’s plan appears “targeted at the housing crisis as it existed six months ago, rather than as it exists now,” asserted the oversight panel in its report. “The panel urges Treasury to reconsider the scope, scalability and permanence of the programs designed to minimize the economic impact of foreclosures and consider whether new programs or program enhancements could be adopted.”
In a telephone briefing with reporters, the oversight panel’s chairwoman, Elizabeth Warren, said the administration’s housing program was so limited that it was unlikely to keep pace with the growing wave of foreclosures.
“Even when Treasury’s programs are running at full speed, foreclosures are estimated to outpace modifications by about two to one,” Ms. Warren said. “It simply isn’t clear that the programs in place will do enough to tame the crisis and have a significant impact on the broader economy.”
The Treasury acknowledged that its anti-foreclosure program was limited, with the effect of rising unemployment not fully checked. But the department said other relief efforts, like extended jobless benefits and continued health insurance for people who lose work, were better suited to alleviating economic distress than the housing program.
“In developing this program, it was critical that we address challenges that could be solved quickly with the tools available to us to ensure the most effective use of taxpayer money,” said Meg Reilly, a Treasury spokeswoman.
The administration’s decision to limit the cost of its one program aimed at helping homeowners could become more contentious as the foreclosure crisis grinds on. Populist anger has flashed over the rescues of major institutions including Citigroup and the American International Group — the most prominent components of a $700 billion taxpayer-financed bailout — while homeowners struggle.
“These Treasury people are all from Wall Street, and they’re not doing anything but protecting Wall Street,” said Melissa A. Huelsman, a Seattle lawyer who represents homeowners fighting foreclosure. “They don’t care in the least about protecting homeowners.”
When the Obama administration began its $75 billion Making Home Affordable program in March, it said the plan would spare as many as four million households from foreclosure. On Thursday, Treasury announced that 500,000 homeowners had since had their payments lowered on a trial basis, celebrating this as a milestone.
But the report from the oversight panel directly challenged the administration’s characterizations.
Most prominently, the panel had grave uncertainty about whether large numbers of the trial loan modifications — which typically run for three months — would successfully be converted to permanent terms.
As of the beginning of September, only 1.26 percent of trial modifications that had made it through the three-month trial period had become permanent, the report found. Of course, very few of those trial loans had reached their three-month expiration because the program only recently began processing large numbers of applications. As of Sept. 1, the Obama plan had produced 1,711 permanent loan modifications.
Some homeowners complain they have received trial modifications only to have them canceled for what seem dubious reasons — checks sent but supposedly never received, documents once in the file but suddenly missing.
“We’re on the phone arguing with mortgage companies every day,” said Dan Harris, chief executive of Home Retention Group, a company that negotiates with mortgage companies for loan modifications on behalf of homeowners, adding that trial modifications for four of his clients had been canceled over the last month. “It’s incredible.”
Major mortgage companies say they have significantly increased staffing to better manage the flow of paperwork, while notifying customers of the need to send in fresh documents to make their trial modifications permanent. But the companies offer no assurances that a large number of trial modifications will indeed become permanent.
“The process is too new,” said Dan Frahm, a spokesman for Bank of America. “We don’t know the number.” He estimated that 15 percent to half of all trial modifications would fail to become permanent.
The Treasury expressed hopes that a newly streamlined process that allowed borrowers to submit documents to mortgage companies more easily would help make large numbers of trial modifications permanent.
“We are intent on working with servicers to ensure that eligible borrowers receive permanent modifications,” said the department spokesperson, Ms. Reilly.
The oversight panel’s report expressed chagrin that the vast majority of loan modifications did not lower loan balances, leaving many homeowners still “under water,” or owing more than their homes were worth.
This tends to lower all property values, the report noted, because underwater borrowers have less incentive to care for their homes, and greater reason to stop making payments and default.
An Obama administration official who spoke on condition of anonymity, citing a lack of authorization to speak publicly, said the Treasury would have preferred that the program focused more on writing down principal balances but ultimately opted against it because “that would make it significantly more expensive to the taxpayer.”
In Wauwatosa, Wis., Theresa Lutz, 47, has been seeking to lower the payments on her home for several months. She is a graphic designer whose working hours were cut last summer. In September, her employer cut her salary by 6 percent. That has made it difficult for her to pay her monthly mortgage of $1,307.
As Ms. Lutz described it, her mortgage company, Wells Fargo, initially agreed to lower her payments. But then, last week, the bank informed her that she would have to come up with a fresh $3,000 to compensate the investor who owned her loan.
A Wells Fargo spokesman, Kevin Waetke, said that information had been conveyed “in error” and “the customer has been notified that payment does not need to be made.”
As Ms. Lutz struggled to clarify her agreement with Wells Fargo, she expressed dismay at news of the oversight panel’s report, and its finding that not enough help seemed to be on the way.
“It looks to me like Wall Street is too invested in our government,” she said. “Big business is winning out over the average person.”

Economists make themselves almost as ridiculous when they suggest recovery in the middle of the recession as when they fail predict a recession or bubble when it is already in progress. The recession is not abating. As described by standard economics, perhaps it is, since these numbers concentrate on monetized activity, which surely is increased artificially by government spending. But fundamentally, the economy has stabilized in a "failing" stage. Stabilized by the Recovery Act, but not having escaped the gravitational pull of the financial system's collapse.

This piece from EPI demonstrates the current bad state. Until this number is cut in half, the economy has not recovered.

Number of job seekers per available job continues steep climb

By Heidi Shierholz
October 9, 2009
Economic Policy Institute
While the gradual moderating of job loss is a very welcome sign, it is nevertheless getting harder every month for job seekers to find a job as more people continue to become unemployed and openings for new jobs continue to drop.
This morning, the Bureau of Labor Statistics released the August report from the Job Openings and Labor Turnover Survey (JOLTS), which showed that job openings decreased by 21,000 to 2.4 million in August. At the same time, the number of unemployed workers increased by 466,000 to 14.9 million. Thus there were 12.5 million more unemployed workers than job openings in August, or 6.3 job seekers per available job (see Figure). This was up from 6.0 in July. Importantly, the ratio of job seekers to job openings does not include job seekers who are currently employed but looking for work due to a lack of job security in their current position, so the ratio actually understates the number of job seekers who are competing for each job opening.



Between December 2007 and August 2009, the number of job openings declined by 2 million, or 45.5%. However, thanks to the American Recovery and Reinvestment Act, the declines are slowing—from September 2008 to March 2009, the losses averaged 156,000 per month, but from June 2009 to August 2009, the losses averaged less than a third of that, at 45,000 per month.
Although unemployment numbers for September became available last Friday, JOLTS data are released with a one-month lag. However, given last Friday’s announcement that unemployment increased by 214,000 in September, the number of job seekers per job opening was almost certainly at least 6.3 in September. While layoffs are abating, until employers start posting jobs and hiring again, finding employment will continue to be very difficult for the millions of jobless workers in this country.

Jobs and incomes are the source of any real recovery. We won't say the bailout money has been squandered, but we will say all the sacrifice is being extracted from the worker and the taxpayer. To Robert Reich's list below, we would add some more aggressive measures, like the CCC style employment programs envisioned in the Humphrey-Hawkins bill. Watching people suffer and reading the Dow as if it were their vital signs is mismanagement.

Specifically, What Should Be Done For Jobs?
by Robert Reich
October 8, 2009

In his Saturday radio address, President Obama acknowledged the White House is exploring "additional options to promote job creation.” It's about time. This is the worst job market in seventy years -- including the longest duration of steep job losses.

If anyone had any doubt that something far more dramatic must be done, listen to former Federal Reserve Chairman Alan Greenspan. He warned Sunday against further stimulus because “we are in a recovery, and I think it would be a mistake to say the September numbers alter that significantly.” Greenspan has turned into an inverse soothsayer. After his cataclysmic error about where the economy was headed before the meltdown, his views about the future should be carefully noted as being the exact opposite of what's likely to be in store.

The economy may be in a technical recovery but this is not a real recovery and the "green shoots" or "positive signs" that Wall Street cheerleaders love to shout about are phantoms of their ever-optimistic imaginations. The stimulus is working but it is far from adequate. Before the stimulus, we were losing more than 500,000 jobs a month. Now that 40 percent of the stimulus has been spent, we are losing more than 250,000 jobs a month.

What to do? With the debt ceiling approaching and the gravitational pull of the 2010 elections increasing, the White House can't go back to Congress with a formal bill to enlarge the stimulus package. Four simpler moves would be to:

(1) Use existing authority under both the stimulus package enacted earlier this year and the nefarious TARP bailout fund -- extending and combining them into a fund to make up for state and local cuts in public school budgets, childrens' health, public health (we need workers to administer swine flu vaccine) and public transportation. Instead of bailing out banks and giant automakers, we should switch to bailing out public services that average people need.

(2) Propose a one-year payroll tax holiday on the first $20,000 of income. Republicans as well as Blue Dog Dems could go along with this, and it would be a highly progressive tax cut since 80 percent of Americans pay more in payroll taxes than they do in income taxes.

(3) Give small businesses a "new jobs tax credit" for every net new job created over the next year. Granted, under normal circumstances this sort of jobs credit doesn't have much effect, and it's difficult to separate hires that would have happened anyway from net new ones. But we're not in normal circumstances; small businesses, which are responsible for most new jobs, still aren't hiring. They need a boost.

(4) Dramatically expand the Small Business Administration's lending programs and have the Fed buy up the SBA's debt. Big banks are not lending to small businesses. TARP has been an utter failure in this regard. The SBA and the Fed should circumvent them and help small businesses get the capital they need, so they can start hiring again.

The politics of these four steps aren't difficult. It would be hard to get a new stimulus package through Congress, but no member who's up for reelection next year when unemployment is likely to be in double digits wants to be accused by rivals of voting against steps to help small businesses, public schools, childrens' health, and average working people who need a tax cut.

Crowding in or crowding out?

Paul Krugman and others are battling over crowding out and crowding in. Do government deficits steal investment capital or make it more expensive for private borrowers?

Our reading of Minsky suggests that deficits and investment are indeed substitutes for each other, but not competitors. Government deficits keep business cash flow from collapsing altogether. Minsky's equation profits equal investments plus deficits indicates that business, far from suffering from deficits, actually benefits.

Others have suggested that government deficits increase expected inflation and so will help investment, since deflation is death to current investment.

Our reading of Minsky suggests that the drop in demand is the problem. It may lead to deflation among price takers, but even if prices can be supported by market power, pricing power, as demand drops the revenue that would support new investment disappears.

One only needs to reflect on the explosion of investment in a boom. Surely one investor is bidding against another, just as these folks see all investors bidding against the government, yet investment surges in booms.

Another debate continues around the multiplier.


To say the multiplier is a constant number that can be isolated empirically is to ignore the fact that it depends on the savings rate. The higher the savings rate, the lower the multiplier.

To say the propensity to spend a tax rebate is the same as the propensity to spend the income from a new job is also nonsense. Thus the stimulus from the tax cuts of 2008 will be much lower than the stimulus from the job-creating infrastructure spending. The multiplier from the former may well be less than one. The multiplier from the latter is already one when it employs the first person.

And the multiplier works in reverse, as well. So the multiplier effect of the collapse of business investment may well wash away much of that of the stimulus bill.

This is not that difficult for those not entangled in protecting their reputations.


Compare recessions by percentage of job loss

Elsewhere, a comparison of recessions inspired by a chart at Calculated Risk demonstrates that the so-called mild recessions of 2001 and 1990, were not so mild in terms of job losses. True they were not as deep as others, but they were longer and in terms of jobs lost were more severe than the short, sharp recession and recoveries of 1953, 1960, 1969, and 1974. That is percentage terms, so it is not skewed by the size of the workforce. Plus, job growth emerged from the past two recessions at a much flatter angle than earlier, pre-Greenspan recessions. Put bluntly, in terms of jobs, the recessions have not been getting more mild, just longer. No longer V-shaped, these are basin-shaped.

All other recessions pale in comparison to the current one in terms of employment. Each of the others, aside from the 2001 Bush recession and the 1981 Reagan recession reached a trough in job losses by the 13th month. The current recession is still going down sharply in the twenty first month. This is, indeed, the Big One.

And although the employment crisis is continuing to deepen, the original published numbers understate it. As CR says,

Note: The the preliminary benchmark payroll revision is minus 824,000 jobs. (This is the preliminary estimate of the annual revision - this is very large).

Get that link to Calculated Risk in the transcript of today's podcast on the blog at Demandsideblog.blogspot.com.

Link to Calculated Risk


Economists still hiding out in crumbling efficient market theory

One of the principal illusions, or delusions, of the primitive orthodoxy is that markets are efficient. The efficient market hypotheses is, in fact, the core of the Chicago School's error and of -- due to the consequent damage done by those who follow it -- that school's moral liability.

Markets would be efficient, or at least more efficient, if all goods were private goods, or if all costs were included in the price, or (as Joseph Stiglitz has pointed out) if information were symetrical between buyers and sellers, or if market imperfections such as monopoly and monopsony did not exist. Unfortunately, that hypothetical world exists somewhere other than the industrial states in which efficient market zealots preach.

To be fair, the Chicago School concentrated on the efficiency of financial markets, a preposterous proposition to which they still cling despite all evidence to the contrary. Nevertheless the idea of efficient markets has been carried everywhere and so, too, it seems, the perception that somehow markets are working today to maximize benefit.

No better demonstration of the absence of critical thinking in economics exists than the continued deference to the Chicago School and its efficient markets. How absurd, for example, that the outcome now extant in the financial sector might be considered an optimal outcome, or that the proliferation of McMansions and underwater mortgages might be considered the maximum benefit for the whole, or that the degradation and imminent collapse of the environment might be somehow to the advantage of a substantial percentage of the population, or that the shift of wealth to developed countries and native elites in the wake of the opening of Third World markets might be somehow efficient. These are plainly the result of markets let loose to be controlled by the powerful, rather than structured and confined to be efficient.

That may be a lengthy introduction to today's audio clip, but it is just the tip of the iceberg in terms of the vacuous understanding of markets displayed by the primitive orthodoxy and its cathedral the University of Chicago.


Ray Anderson is founder and chairman at InterfaceInc. Anderson sees tax policy as a way of rectifying some of the fatal shortcomings of markets.

ANDERSON

That was Ray Anderson on internalizing externalities. Anderson was interviewed here on Bloomberg. He has led his company InterfaceInc into a dominant place in the supply of carpeting to business and industry. He did this with vision and an appreciation for all the costs of production, not just those traditionally internalized.

There is much more to be said about the role and power of market participants and the structure and scope of markets themselves, and we will say it here sooner or later. In their place and structured rationally, markets are great. When entrenched powers dominate others via market distortions and then resist correction in the name of market efficiency, it is the lingering stench of the Chicago School.

Let us take the most extreme example of the nonworking of markets. Suppose there is a market in household goods and there is no police authority. The market in goods is bustling with the contraband of thieves and robbers. It is an efficient activity to go house to house and extract people's wealth to take to the market. The first activity is an externality to the market. Is such antisocial robbery on a large scale possible without the market, the place to sell? No. It is called an externality only because it exists apart from the point of purchase-sale.

This is not too far a step from the degradation and exploitation of the environment. Large corporations with the correct industrial capacity and small dumpers of toxic material both enjoy a capacity to steal from and harm future generations that is inextricable from the market for the goods in question, yet these are considered outside markets. Externalities.

Is the market efficient? Well, it finds the right price considering the subsidies of future generations -- and current -- and the structure and rules of traffic in the particular goods.

James K. Galbraith

In our series looking for the perspective of those who got it right, we turn to James K. Galbraith, son of the great economist John Kenneth Galbraith and apparently invisible to those who say nobody saw it coming.

We've promoted Galbraith's book the Predator State ad nauseum here on the podcast. Let's review a few of the anti-orthodox principles that organize that book.

One, and quoting:

Because markets cannot and do not think ahead, the United States needs a capacity to plan. To build such a capacity, we must, first of all, overcome our taboo against planning. Planning is inherently imperfect, but in the absence of planning, disaster is certain.

Two, and continuing to quote:

The setting of wages and control of the distribution of pay and incomes is a social, and not a market, decision. It is not the case that technology dictates what people are worth and should be paid. Rather, society decides what the distribution of pay should be, and the technology adjusts to that configuration. Standards -- for pay but also for product and occupational safety and for the environment -- are a device whereby society fashions technology to its needs. And more egalitarian standards -- those that lead to a more just society -- also promote the most rapid and effective forms of technological change, so that there is no trade-off, in a properly designed economic policy, between efficiency and fairness.

And three, with a final quote:

At this juncture in history, the United States needs to come to grips with its position in the global economy and prepare for the day when the unlimited privilege of issuing never-to-be-paid chits to the rest of the world may come to an end. We should not hasten that day. In fact, if possible, we should delay it. We should take reasonable steps to try to keep the current system intact. But given the rot in the system, we should also be prepared for a crisis that could come up very fast. The fate of the country, and indeed the security and prosperity of the entire world, could depend on whether we are able to deal with such a crisis once it starts.

Galbraith traces the fall of conservativism from the Reagan Revolution into the more or less overt plundering of the society by the politically well-positioned oligarchs of Big Oil, Big Pharma, Insurance, Finance, Agriculture and Media.

Galbraith in 1981 as a young director of the Congressional Goint Economic Committee organized what he called "a largely futile frontline resistance to Reaganomics." The vapid combination of Supply Side pap and Milton Friedman Monetarism resulted in immediate large deficits and the beginning of hte deindustrialization of America. (Whatever might be contested about the causes of the events, the timing is not debatable.) Earlier Galbraith drafted the Humphrey-Hawkins bill, which generated the dual mandate for the Fed, and other mechanisms that focused on full employment.

The bill was created by Representative Augustus Hawkins and Senator Hubert Humphrey and signed into law in 1978. Its full title is the Full Employment and Balanced Growth Act. As written it was a worthy successor to the most important piece of economics legislation, the Full Employment Act of 1946. As implemented, it has been a way to get the Fed Chairman before Congress a couple of times a year, but otherwise has been limited to creative footnotes. Lip service is a strong description.

In particular, the Act requires the President to set numerical goals for the economy of the next fiscal year in the Economic Report of the President and to suggest policies that will achieve these goals and requires the Chairman of the Federal Reserve to connect the monetary policy with the Presidential economic policy.

The Act sets specific numerical goals for the President to attain. By 1983, unemployment rates should be not more than 3% for persons aged 20 or over and not more than 4% for persons aged 16 or over, and inflation rates should not be over 4%. The Act allows Congress to revise these goals as time progresses. If private enterprise is lacking in power to achieve these goals, the Act expressly allows the government to create a "reservoir of public employment." These jobs are required to be in the lower ranges of skill and pay so as to not draw the workforce away from the private sector.

Coordination between fiscal policy and economic policy has not occurred, of course, and it was actually one of the accomplishments of the Reagan Revolution to drive them as far apart as they have become. Unemployment rates of 3 and 4 percent are now considered the stuff of fantasy. A public employment program?

The Reagan Revolution, whatever its tenets, resulted not in principled conservativism, but in a corporate takeover of the state, as Galbraith has described in his book. By the way, this digression on Galbraith's early work is not from the book, but our contribution with an assist from Wikipedia.

The American economic model in Galbraith's view, is not the free rein to the markets and public be damned approach of Reagan and Bush, but is the structure created by the New Deal. The institutions, Galbraith writes, "are neither purely private nor wholly public. They are not like the socialist welfare institutions of Europe, but neither are they private enterprise."

Some are supported by state spending -- entitlements, but also bank credit, credit guaranetees, and implicit guarantees, and -- Galbraith is writing prior to the massive bailouts when he says -- quote --- the expectation of rescue in the event of trouble. Mortgages, health, agriculture, and the military are some of the other areas receiving massive public subsidies.

And Galbraith is also adamant about the need for standards, which rises from the delusion that markets will produce a competitive market price. Quoting

"As economic theorists know, the real world is necessarily devoid of any such thing [as a competitive market price]. If there is one administered, or controlled, or monopolistic price in the system -- an oil price or an interest rate -- then even if all the other markets are perfectly competitive, all of them will be "distorted" by the presence of that one monopolistic price ...

[and]

The fact is that monopoly and market power are not only pervasive, they are at the center of economic life. The very purpose of a new technology is, of course, to create a monopoly where none previously existed.

...

[continuing]

That being so, prices and wages would serve a quite different function in the real world than the market model assigns to them. Instead of being set so as to maximize efficiency in production, they are set essentially by social relations between groups of workers and by the pattern of prices that are explicitly controlled. They express, in other words, the preixisting matrix ...

... Seen in this light, deregulation of wages and prices ... is nothing more than a rearrangement of social power relations. And the consequences have little or nothing to do with the efficiency whereby a good or service is produced...

p. 179-180

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All the green shoots on Wall Street won't gain a single seat in the House come next November if something more effective is not done in public policy. Demand Side believes a rebound is likely next year, and will in fact generate a larger majority for Democrats. Despite the current weakness, elections are not decided during the autumn of the previous year.

We suspect Mr. Obama will demonstrate the same election year skill on behalf of Congress and the Republican slide will continue. That said, we note we are not so good at forecasting elections as we are at the economy. Robert Kuttner is better.

It's the Unemployment, Stupid
by Robert Kuttner
Huffington Post
October 4, 2009

If the unemployment numbers keep rising into 2010, the Republicans are primed to pick up dozens of seats in the House, crippling the Obama administration's capacity to recoup in the second half of the president's first term. Obama would lose his very tenuous working majority and would confront a situation very much like the one Bill Clinton faced after the Republican gains of 1994, when he worked even more closely with Republicans in order to save his own skin. If you liked triangulation Clinton-style, wait for Rahm Emanuel's version of it.

The most recent employment numbers were bad enough on their face -- 263,000 job losses in September, and a measured increase in payroll employment to 9.8 percent. But the real numbers are much worse. The nominal rate conceals the fact that the labor force is 615,000 workers smaller than it was a year ago, even though the working age population continues to grow. People who can't find jobs and quit looking are no longer counted as part of the labor force. If normal labor force growth had continued, the unemployment rate would be close to 12 percent. See the analysis of the numbers by the good people at the >Economic Policy Institute and the estimable Dean Baker. The administration's people know this reality, and they are aware of the political risks. So what are they doing? Precious little.

I had a conversation with a senior administration economic official last week and I asked him to suspend disbelief and consider a large increase in public spending to create more jobs. What would he spend the money on? We discussed the pro's and con's of emergency fiscal aid to the states versus a tax credit for job creation in the private sector, subsidized job-sharing, and direct public works employment. But it was clear that the administration considers a Stimulus II a non-starter. The view is shared by Fed Chairman Ben Bernanke, who testified last week that there was not much we could do about rising unemployment except wait it out.

This is economically deplorable and politically self-defeating. When the administration considered its $787 billion stimulus bill last winter, its projection was that unemployment would peak at 8.9 percent. It's clear that joblessness is going to be a lot worse, and nobody has a convincing story about where the new jobs are going to come from once economic growth turns positive. Time magazine recently ran a cover story suggesting that we might just have to get used to a new reality of persistently high joblessness, and compensate with other policies such as more heroic job training (but for non-existent jobs?)

But that view is malarkey. Economists were making the same argument in 1938 and 1939. The economy, supposedly, had reached a level of maturity and technological sophistication that there just weren't enough jobs. Unemployment was just stuck around 15 percent. Then along came World War II. The federal deficit rose to 29 percent of GDP (this year it will be about 11 percent) and unemployment disappeared.

The president should be making the case for increased deficit spending on job-creation in 2010 and 2011, followed by a program of deficit reduction financed by progressive taxation. Public opinion on these issues is not static, and in fact a recent poll done by Hart Research Associates for EPI shows that the public cares a lot more about joblessness than it does about the deficit. 53 percent of respondents said lack of jobs was the most important issue, but only 27 percent said the deficit was. Fully 83 percent sand that unemployment was a big problem, and just two percent said it was not a problem. Presidential leadership could make a huge difference in translating these attitudes into action.

The Blue Dog Democrats in Congress are opposed to larger deficits, but many of them would support a ten-year program of more public outlay now coupled with deficit reduction after recovery comes. Unfortunately, a lot of Washington's centrist savants are skipping directly to the deficit reduction, overlooking the fact that we are still a long way from recovery. As EPI was holding a conference releasing the results of its research, the more moderate Center for American Progress (CAP) was holding a big event on alarm about the national debt. CAP President John Podesta, former director of the Obama transition team, is an enthusiast of value-added taxes as deficit-reduction medicine.

My own view is that VAT's are highly regressive taxes on consumption. I could go along with them if they were part of a deal that included progressive taxes such as a tax on financial transactions and if some of the money went to expanding public services rather than just reducing deficits. But this is only half of the conversation, and the less urgent half. Unless we get a bigger recovery going, and get unemployment down well before the 2010 mid-term elections, all this center-left policy wonkery will be beside the point because the Republicans will be running the country.

As Marshall Auerback says here, "Instead of trying to revive the productive economy, most of the G20’s resources have consisted of mouth-to-mouth resuscitation for a dying financial sector. This has not “worked” to the extent that last weekend’s communiqué advertised. The best analogy to describe the current state of our financial system is that we have placed scaffolding over a decaying building, but done little to repair the underlying structure. What happens when the economic scaffolding is removed via “exit strategies”, as the G20 participants have advocated?"

Well worth reading.

The G20 Summit: Hijacked by Neo-liberalism
10/1/2009
by Marshall Auerback
New Deal 2.0

We’ve said it before and we’ll say it again. As a matter of national accounting, the domestic private sector cannot increase savings unless and until foreign or government sectors increase deficits. Call this the tyranny of double entry bookkeeping: the government’s deficit equals by identity the non-government’s surplus.

So, if the US private sector is to rebuild its balance sheet by spending less than its income, the government will have to spend more than its tax revenue. The only other possibility is that the rest of the world stops saving on a massive scale — letting the US run a current account surplus. But that is highly implausible and socially undesirable, since it means we export our economic output, rather than consume it domestically. And if the government deficit does not grow fast enough to meet the saving needs of the private domestic sector, national income will decline, which, given the size of the private sector’s debt problem, will generate a huge debt deflation.

This is the foundation of modern monetary theory. Would that the IMF and the G20 understood these basic facts. The anodyne communiqué from last weekend’s Pittsburgh summit makes clear that this is not the case. Western policy makers appear determined to consign us to years of additional economic misery because of the continued embrace of a flawed market fundamentalist economic paradigm.

So far, instead of trying to revive the productive economy, most of the G20’s resources have consisted of mouth-to-mouth resuscitation for a dying financial sector. This has not “worked” to the extent that last weekend’s communiqué advertised. The best analogy to describe the current state of our financial system is that we have placed scaffolding over a decaying building, but done little to repair the underlying structure. What happens when the economic scaffolding is removed via “exit strategies”, as the G20 participants have advocated?

For many generations, we didn’t face the unprecedented financial fragility we are experiencing today. But there are good reasons why we avoided this until recently. We have spent the past quarter century eviscerating what was fundamentally a robust structured originally devised during New Deal, a system which basically saved the US capitalist system and served the interests of its citizens very well until it was hijacked by a bunch of corporate predators under the guise of deregulation and neo-liberalism.

To read the communiqué from the Pittsburgh summit is to gain insight into an ideology which views government, not as a stabilizing influence protecting us from private sector rent seeking monopolists. Rather it’s an unwanted stepchild, brought out on display as a necessary evil, and destined to be shoved away as soon as we get back to a “normal” economic state of affairs, where the government minds its own business and lets the magic of the “free market” operate. Hence, the emphasis by the Pittsburgh summiteers on “sustained, strong and balanced growth“, the usual code words designed to encourage budget surpluses, more private sector savings and shift from public to private sources of demand.

There is little understanding that if households and firms try to net save (save more out of income flows than they tangibly invest) incomes collapse, and desired private net saving is thwarted. The private “excess saving” cannot exist without a budget deficit or a trade surplus. Many people make this mistake. At best, we can talk about planned private saving being in excess of planned private investment, but other than that, we are violating double entry book keeping principles.

And consider this: in 1998, 1999 and 2000 (increasing each year), the US government “virtuously” ran budget surpluses. And guess what happened? The private sector became more heavily indebted than before as the fiscal drag squeezed liquidity and destroyed aggregate demand and incomes. Along with our misconceived embrace of financial deregulation, the combined result was sharply rising unemployment and a major recession in 2001-02 with unemployment rising sharply and the automatic stabilizers pushing the budget back into deficit.

Unfortunately, that was the yellow flag for what was to follow, a warning signal blithely ignored by our economically illiterate policy makers. Instead, we perpetuated a massively leveraged financial system via Frankenstein financial products such as collateralized debt obligations, and credit default swaps. We squeezed private sector incomes via constrictive fiscal policy, thereby inducing the debt-fueled consumption that is now regularly decried by our officialdom and the commentariat.

The bottom line is that if we want habitual private sector savings, we need habitual government deficits.

And government deficits are not an aberration; they are the norm. Our first (and possibly greatest) Treasury Secretary, Alexander Hamilton, called the national debt a “national blessing”. Similarly, Paul Krugman and L Randall Wray have argued that it was World War II and the subsequent cold war that ended the depression, which created the foundations for a significant expansion of government debt, which in turn set the stage for the “Golden Age.” The government deficit reached 25 percent of GDP during the war, providing a massive amount of private sector saving in the form of safe financial assets that strengthened balance sheets. From 1960 onward, the baby boom drove rapid growth of state and local government spending, so that even though federal government spending remained relatively constant as a percent of GDP, total government spending grew rapidly until the 1970s. This pulled up aggregate demand and private sector incomes, and thus consumption.

This is unsurprising: The private sector cannot create “net nominal wealth” because every private financial asset is offset by a private financial liability. Over the long term, the maximum that a government can hope to collect in the form of taxes is equal to its purchases of goods of services. There is no hope of running long-term budget surpluses because the government cannot possibly collect more than the income it has created as it paid out dollars. When the government attempts this, as it did during the Clinton Administration, the public finds that its net financial assets would be less than its tax liability, requiring households to dip into its “reserves” of accumulated savings, which gradually become depleted. In the absence of other factors, demand slows and the government almost invariably falls back into deficit.

If an external creditor is added (such as China or Japan) it merely delays or extends the process, since for a time, countries running current account surpluses with the US can use their surplus dollars to accumulate additional US dollar financial claims. But in the absence of any increase in US government spending (which is the only source of NEW NET FINANCIAL ASSETS), the end result is still a massive accumulation of private sector debt, which is what got us into this mess in the first place. By contrast, assuming a non-convertible, freely floating fiat currency, a government can never be insolvent even if its tax revenue declines significantly. Its balance sheet can never become precarious in the same way that a household balance sheet can.

In the abstract, this always sounds controversial to those uncomfortable viewing the world within a financial balances construct. It also helps to explain the intellectual incoherence at the heart of the G20 communiqué and the Obama Administration’s economic policies, which has been dominated by Wall Street interests.

So it’s worthwhile considering some historic examples, which illustrate the point better. During WWII, the US government generated huge deficits and bond issues. The record expansion of government deficits not only facilitated the war effort, but created full employment. (As an aside, it is always interesting to pose the following question to “deficit terrorists “: if government budget deficits are so awful, and so egregious for the long term performance of an economy, then why run them at all during wartime, when presumably we need the economy to be functioning in an optimal manner?) After the war, the Fed was concerned with potential inflationary pressures and raised interest rates. President Truman, a hard money man par excellence, drastically cut defense spending from $90.9bn to $10.3bn and the US accumulated huge fiscal surpluses. Post war surpluses, combined with Fed tightening, contributed to a recession in 1949. Unfortunately, it took the “military Keynesianism” brought on by the Korean War to shift Truman away from his aversion to deficit spending, which was continued by Eisenhower, and sustained via his national highways building program. During that period, unemployment decreased. Similarly benign effects on unemployment were manifested in the wake of the Kennedy tax cuts and those of Reagan in the early 1980s.

Today, budget deficits are the highest as a percentage of GDP, but they are overstated to some degree, because they include the TARP measures to stabilize the financial system which brought the global economy to its knees in 2007/08. Classic Treasury expenditures deal with the purchase of real goods and services; Federal Reserve functions deal with the purchase and sale of financial assets. And yet, the focus of policy makers is quickly reverting to “exit strategies” and a reduction of budget deficits, where the Pittsburgh communiqué pledged to “prepare our exit strategies and, when the time is right, withdraw our extraordinary policy support in a co-operative and co-ordinated way, maintaining our commitment to fiscal responsibility.”

If only that were true. The only way one could politically justify a government running a sustained surplus would be to make the case that unemployment created a more functional way of ensuring high profits (via wage discipline) than full employment. Put in those terms, it’s not a particularly compelling message, but it has the virtue of being consistent with modern monetary theory.

Oddly enough, the G20 communiqué devotes considerable attention to the government’s “exit strategies”, which came in response to the destructive private sector financial practices which created this catastrophe. There has been less attention directed to the underlying causes themselves. Thus the IMF, in its latest “Global Financial Stability Report”, suggests that restarting securitization markets is “critical” to a wider economic recovery, and that current US and European proposals to force banks that originate loans to hold on to the first 5% of losses in all securitizations, were not sufficiently flexible and might backfire. In the words of Credit Lyonnais Asia strategist, Christopher Wood:

“[The IMF] is yet again doing the world a disservice by acting as a lobbying group for the securitised debt peddlers. It is clearly fundamentally correct that the agents of securitisation should be made to retain some ’skin in the game’ after the terrible damage they have inflicted. It is true that the collapse of securitisation represents a massive deflationary risk for the global economy. But that does not mean that the answer is to allow a new free-for-all in securitisation assuming, charitably, there is demand for the securitised product.” (”Greed and Fear”, 24 Sept. 2009, CLSA, Asia Pacific Markets)

The IMF, the G20, indeed virtually all policy makers — including the Obama Administration — will make themselves far more relevant when they emphasize that full employment and prosperity can only be achieved to the extent that governments are prepared to spend up to a level justified by non-government saving. That does not mean unconstrained government spending. But the spending ought to be set with regard to results desired and competencies to execute plans — not out of some pre-conceived notion of what is “affordable”. Our federal government can afford anything that is for sale in terms of its own currency. And if it spends too much after getting us to a state of full output, it can get inflationary. But let’s get to that state of affairs first before we start worrying about perpetuating the flawed model of the past. That got us transitory prosperity and wage gains. And it promises years of economic misery if we do not move beyond neo-liberal economic fairy tales.