Savings Equals Investment ... So?

Today on the podcast, the savings rate, savings equals investment, and a look at the leaders in savings -- Japan -- with Richard Koo

Savings Rate

One can get an idea of the confused state of primitive economics when we look at the treatment of the savings rate.

A higher savings rate is a good thing, it is said, long overdue, a necessity for an advanced economy.

Meanwhile Japan with one of the higher savings rates in the world slumps along decade after decade.

The full premise of the savings rate proponents is unspoken and incomplete these days, but is easy to remember. That premise arises from the accounting identity of savings and investment. In a closed economy, savings must equal investment. Algebraically.

The obvious fact is that the American economy is not closed, and it has for many years, decades, been drawing investment quote unquote from the rest of the world, most notably and ironically from the developing world. For a good portion of those many years this flow of capital from developing to highly developed was excused with the explanation, "We should be happy they see the opportunity to invest." I kid you not. Of course, that is on the other side of a housing bubble which distorted the value of those investments. We threaten from time to time to go back and recalculate net U.S. investment in the light of current housing prices.

But the savings rate proponents base their fervor on this truism, because they have carried it on to the fallacy that savings CAUSES investment. This is the fundamental error of the premise, that savings causes investment. If only we had savings, investment would follow.

Looking out the window now as the savings rate skyrockets while investment plummets, it is hard to imagine how profoundly this causal connection has been featured in the minds of primitive economics. It is this superstition of a causal effect that lies at the base of the advocacy of high savings.

We propose, and other demand-siders propose, that the causal arrow actually points in the opposite direction. As in the old days, when you wanted to buy a house, the impetus for savings arose to get the down payment. Expanding this, with the prospect of profit, businesses went out and found the financing. We have only to look into the various bubbles to see that with the prospect, or illusion, of big profits, there is no absence of savings to tap.

Next, let's point out the paradox of thrift. When one person saves, it is a prudential and sober thing. When everybody saves, incomes go down. Since savings are the opposite of spending, and one person's spending is another person's income, the opposite of one person's spending is a reduction in another person's income. A reduction in incomes means a reduction in demand which means a reduction in the prospect of profit for those producing for consumers.

Further, as we pointed out earlier in the year in our discussion of the multiplier, that multiplier also works in the negative direction. A reduction in spending is multiplied to more than the initial amount by its follow-on reductions in incomes to others.

Ultimately an increase in savings absent the investment that will be absent without the prospect of profits leads not to an increase in the absolute level of savings, but to a decrease in incomes and eventual use of those savings to meet expenses.

It can have escaped nobody's notice that just as the savings rate has expanded, so the growth rate has fallen.

It is the role of government to match savings with investment in times like these -- so that incomes don't fall and the paradox of thrift does not enter the liquidity trap of deflation, where buying something tomorrow is less expensive than buying something today and producing something today is more expensive than producing something tomorrow. Thus the cash itself, the liquid securities, become the trap for the economy.

Government can invest, which it is doing. It does not need the prospect of profit. This investment can increase private incomes and keep spending higher, which is happening. And government can reduce the savings of the wealthy by taxation, which it is not doing, funneling them into its investment. Accessing the wealth of the wealthy by borrowing it is not so much more efficient than by taxing. Certainly the claims that the wealthy must be wealthy so the rest can have jobs must weaken a trifle when the rest do not have jobs.

But the word taxes has been given such a stigma by the Right Wing that a proposal that they could be a route out of the current trap sounds almost absurd to most ears.

The bottom line is that there must be investment to ratify savings or incomes will fall. As incomes fall, savings in absolute terms fall, even if the savings rate rises. This is in aggregate. It is analogous to a hot air balloon. The pressure inside and outside the balloon is equalized. Savings equals investment. But it is the height of the balloon -- incomes -- that does the equalizing.

Not understanding this point -- that higher savings in the absence of investment means lower incomes and lower incomes mean lower production and employment in a downward feedback loop -- not understanding this is not understanding economics as it actually manifests. You can have all the stock market recovery in the world, but without incomes beginning to rise again, there will be no recovery in the real economy.

We have a great deal of talk now about the end of the recession and things turning up with a kind of tacit understanding that there is a gyroscope that is automatically re-stabilizing the economy. Things are naturally reverting to the mean, and so on. This is bull. Any stabilization has to come from stabilizing demand, which has not yet happened and which will not happen by simply believing it will. The government is producing a sturdy base with its basic services, some infrastructure spending, the social insurance programs soon to be augmented by -- God willing -- universal health insurance. This is stable enough, but as a base it is too low.

Any bounce off this low is technically a "Recovery," since the growth line is not falling, but is it an economy that will support us?

Now imagine that the savings rate increase is not composed of savings as such, not as the accumulation of liquid assets, but as payments to banks for debt. There is no cash value being built up in the household sector. It is all paying down debt. And it is not as if there is value under even the mortgage payment, since equity has eroded by up to half, leaving a huge debt overhang unsupported by equity value. Banks have continually resisted a New Deal style Home Owners Loan Corporation which would share the pain and give homeowners the needed incentives to stay in their homes. This is a mistake they will come to regret.

The savings rate is an extremely good segue into the experience of Japan.


Japan

The lost decade in Japan is the cautionary example of the times. "We can't do this or we'll end up like Japan..." "That's what Japan did and it led to the lost decade." And so on. In a moment we'll check in with Richard Koo, Chief Economist at the Nomura Research Institute in Tokyo, but first let's interject our view that by ratifying the bad bets the banks and shadow banks made, and taking them on the public shoulders, we have set ourselves up for something at least as bad. And it could be worse. Will the U.S. really expand the federal debt as much as Japan has?

But let's continue our digression. Unless we break up the big banks into entities that are not too big to fail and set them on firm financial footing, we are going to have to carry them forward as we try to get out of the collapse they engineered.

Very discouraging is the administration's regulatory scheme being floated on Capitol Hill. A super regulator is proposed to handle so-called Tier One institutions. Tier One is code for too big to fail. Those who present systemic problems should they fail. JP Morgan Chase, Citibank, Goldman Sachs, Morgan Stanley, American Express, Bank of America. These are the Goliaths who are exempt from market discipline because by virtue of their size they get free too big to fail insurance from the American taxpayer. Meanwhile the rest of us need to run around and clear the road so they don't step on us, or heaven forbid, fall down again. They might crush us.

The Demand Side view is that they are more dangerous walking around and looming over us than they would be on the ground. At a minimum, if they are going to exist, they need to be paying too big to fail insurance premiums to take the weight off the taxpayer.

Ironic and really laughable are the free marketeers who say, "Let the market work, stay out of the way..." until they fail. Then it is a sad duty, but a duty nonetheless, for the rest of us to bail them out. This kind of Capitalism is really rule by the powerful, not any kind of logical or internally consistent system.

The breakup of the banks that is necessary for a successful market follows logically from their failure as business enterprises. That is, there should be no excuses or rationale for not breaking them up. They proved they were not up to the task, and continue to prove they are outside the stream of the real economy. It is not a hypothetical to say the banks are too big.

All right. That was only bullet point one on the how to avoid Japan list. We'll dispense with the rest for the moment and get to Mr. Koo and his discussion of the Japanese experience.

KOO

So what you heard here, I believe, is that Japan's experience is not necessarily such a complete failure. They did not go into depression, but simply stagnated. This with dramatic increases in public borrowing.

This is what we have to look forward to, if we're lucky.

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Podcast Transcript 07.25.09 Audio perspective -- Martin Wolf, Eliot Spitzer, Dylan Ratigan

Plus Idiot of the Week with Robert Eisenbeis.

Today a little bit of audio and some perspective

Eliot Spitzer and Dylan Ratigan explain the garbage on the Fed's balance sheet and why we paid real money for it. Or maybe they just point out that we paid real money for garbage and take the Fed to task. Stay tuned.

Before that we have Idiot of the week with Robert Eisenbeis. We have Martin Wolf speaking directly to the bad economics of the past thirty years.

First this note, following our podcast relay of a House subcommittee's hearing on High Speed Rail, we hear from The Transport Politic website:

The House Okays Additional $4 Billion for High-Speed Rail

24 July 2009

This Budget provision, if approved by Senate, will increase federal allocations for rail to $12 billion in this year alone.

Yesterday, the U.S. House passed its housing and transportation bill, which will provide funds for fiscal year 2010. Approved mostly by members of the majority Democratic party, the bill would allocate $4 billion to high-speed rail programs — if the Senate’s version, likely to be considered after the August recess, includes the same provision.

...

.. The President’s Budget released earlier this year asked the Congress to devote $1 billion for the next five years for high-speed rail, in addition to the $8 billion already marked for the program under the stimulus bill. The House’s decision to increase that number to $4 billion is a direct reaction to the huge response from states and the private sphere for stimulus-based federal rail grants. The FRA revealed that forty states had applied for more than $103 billion.

Iowa Congressman Tom Latham (R) attempted to block the inclusion of so much money for rail, arguing that the government shouldn’t embark on what he argued would be a $100 billion endeavor. Yet his amendment was put down by a vote of 136-284, with 40 Republicans voting against his measure — compared to the only 16 members of the GOP voting for the bill as a whole. This indicates strong bipartisan support in Congress for high-speed rail investment and bodes well for similar action in the more conservative Senate.

...

Demand Side is cheering. The sooner and more aggressive the construction of high speed rail, the cheaper and more productive will be the investment.

Now, On to

Idiot of the Week,

With Robert Eisenbeis, former research director at the Atlanta Fed, talking on the idea of stimulus.

EISENBEIS

Clearly, once again, proximity to money does not mean competence in economics. We've already had the tax cuts fail twice, not to mention the huge debt hole they drilled in the one time surplus. The consumption function is much more substantial when you add stimulus in the form of a new job than in the form of an additional hundred dollars of discretionary income. The discrete these days save. We'll take up the savings rate in the next podcast.

Elsewhere in this interview with Tom Keene, Eisenbeis quotes the P.T. Barnum of economics, Milton Friedman, as saying, "Monetary policy acts with long and variable lags." Which, I think, speaks to the vagaries of monetary policy. The truth is it is far easier to stall an economy with monetary policy than it is to get one going again. We think you are witnessing that in the current experiment of history.

But, Robert Eisenbeis, Idiot of the Week.

Many of our idiots are fairly competent if they don't stray too far from their base of competence. Here is, for example, Eisenbeis in a clip earlier in that Bloomberg interview.

EISENBEIS.

Let's use this comment on the Fed's balance sheet as a segue into Eliot Spitzer and Dylan Ratigan taking on the blather of the Fed with regard to what they've taken on. I hope the schtick translates to audio. It appeared on Ratigan's MSNBC "Morning Meeting" this week.

SPITZER

Enough of that.

Now to finish the podcast, Financial Times chief economist Martin Wolf gave the best interview of the past week, again on Bloomberg on the Economy with Tom Keene. Wouldn't it be nice to have an audio link capacity? Be that as it may, here is what he had to say with regard to the economic paradigm of the past thirty years.

WOLF:

I never bought it. I never believed in the so-called New Classical Economics, which essentially says "Demand is not a problem. The Market always clears. We're always at full employment. And we don't need to worry at all about the sorts of problems that worried John Maynard Keynes in the Thirties and, indded, worried Milton Friedman. I would argue that that sort of view in economics, which was the dominant paradigm for thirty years, that essentially the economy is in equilibrium all the time. The financial system is always in equilibrium. That seems to me to have been a mistake. A mistake made by brilliant people, but a mistake.

And we're going to ahve to go back to the sort of thinking about macroeconomics there was in the middle of the 20th Century. Yes. There's a big job of intellectual reconstruction to be done.

I must say I'm a bit pessimistic about this. What has struck me most forceably in this crisis is how everybody pretty well, with a few exceptions, have gone back to economic thinkers of the middle of the 20th century. Not new thinkers. Certainly not new, new thinkers. Maybe it's because this crisis has come as a terrible shock. It was not something very many people expected, and so there hasn't been the time for economists to think about what it means

But the truth is .... that we are going to have to go back to the drawing board, and ask ourselves "Is the model of the economy of enlighted rational individuals maximizing their wealth as they see it, one which is consistent with equilibrium, full employment all the time. And it seems to me pretty clear that it isn't, because people make absolutely fundamental and systematic errors. If we have the right macroeconomic environment, or the wrong one, which is what we have been discussing...

So yes, I think this is a matter of starting afresh, and I think that starting afresh has hardly started.

Martin Wolf

One thing, this should cause despair among those who toiled in the field of rational expectations. You grew only thorns. On the other hand, young economists should feel some encouragement. You didn't have to learn the wrong stuff and now with a good, direct view, you can be far more competent -- notice I did not say employable, only competent -- than peers with much more experience.

That brings up the thought. Why not a reading list? Yes. Robert Lekachman's The Age of Keynes, maybe forty years old, is very good as a start. I'll pick some others for the next edition of the podcast.

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Forecast Redux -- podcast transcript

Repeating the forecast

As tedious as it may be, today we are reiterating our forecasts, primarily because there has been a full-tilt shuffling of folding chairs over the past few days. The assembled consensus seems to have moved in unison, like a flock of birds into the recession winds. We wanted to remind you we’ve been holding to our call. It seems that the great preponderance of economists were blindsided by last week’s unemployment rate increase and now admit the possibility of recession. It is a bit like admitting it might rain after the water starts pouring in over your boots.

We asserted that the recession was already in progress two months ago. That makes us aggressive. Over the intervening period we’ve moved from being an extreme outlier into being within a couple of standard deviations of the mean.

As far as the unemployment numbers, you may remember we’ve been complaining that the official numbers out of Washington have not been plausible for some time.

I told you this was going to be tedious.

In the last week of September, we made a call of economic weakness, but at the same time strength in stocks, commodity and bond markets. I have yet to see that replicated anywhere. To be clear, by strength in stock markets, I mean the absence of a thirty percent retreat in stocks typical of a recession. By strength in bonds, I mean the strength in bond prices typical in a recession, and a new powering up of commodity markets. The sell-off in stocks after the turn of the year may spook the herd, but we are holding onto the conviction that it will not be for long. We’re sticking with a flat to slightly upward movement in all broad market indexes.

And it was October when we said, it’s not inflation OR recession, it’s inflation AND recession.

The differences between us and the preponderance of economists lies primarily in whether you are Ptolmaic or Copernican, geocentric or heliocentric. That is, supply side or demand side.

Those who believe the supply side drives the economy are reduced to poring over arcane statistics in hopes of detecting a new trend or weakness. Attempting to produce models that are effective statistical trampolines so they can jump high enough to see over the horizon.

Parenthetically, another difference is that the preponderance of economists seem to use equivocation instead of bald assertion. We prefer the latter. If we are wrong, we want to have to explain why. Most prefer to appear not to be wrong, and so they couch their statements in terms of increasing chances, percentage probabilities or slowing economy rather than recession.

The statistical models are less a prediction and more early signs of activity, the smoke of a fire already in progress. This is why you have the ignominious spectacle of forecasters being hit in the back of the head with evidence that doesn’t appear on their charts.

Instead we can simply look at the shape of the economy from the demand side.

The past six years have seen an economy benefitting from interest rates at the bottom of the historic range, a government producing enormous deficits, and a job market that was still pathetic.

The unemployment rate peeked above six percent in 2003 before falling back to near 4.3 in 2006-07. But during that period employment growth stayed below two percent in all quarters except one. In contrast, Bill Clinton inherited an unemployment rate of nearly eight percent from Bush’s father. Growth in employment was above the two percent mark in seven of the next eight years. Net jobs went negative under Bush II in the middle of 2001 and stayed there until the end of 2003. Ten quarters. Longer than any other period of negative growth in jobs in post-war history.

It was this economy that was the scene of the Greenspan housing bubble and the Bush tax cuts for the wealthy. These two forces were the motive force of the last go-round of the so-called business cycle. Wealth, income and employment were all housing- or finance-related. No business investment. No meaningful job growth. The bubble was extended by extremely questionable lending to benefit a voracious appetite for mortgage-backed securities.

So we don’t need to know anything about the future except that it is connected to this past, but without the low interest rates, with a dysfunctional financial sector and in the presence of deflation in housing, the primary component of consumer wealth.

Contrast this with the predominant view among today’s economist that the problem BEGAN in August 2007, and that the previous years were healthy expansion. We were just beset by the, yes, perfect storm.

Our view is that questionable economics from the Fed and White House papered over underlying weakness and now we have the worst of many worlds: inflation, falling dollar, financial sector dysfunction, consumer overextension.

The most talked up prospects for recovery include, improbably, the idea that the Fed will come through with interest rate cuts good enough for housing to recover. This is not going to happen. The Fed cannot go down the Greenspan path because the dollar is on the block and inflation is certain. Even if interest rates could get that low, the housing bubble is over, and housing would not recover in any event because investor appetite is no longer there.

The drop in manufacturing has at least temporarily quieted the notion that export strength from the falling dollar is going to ride to the rescue.

High oil and commodity prices will strangle developed and developing countries alike. If the Fed – as we’ve predicted they will – attempts to keep a tight lid on inflation, then real incomes will be lost to the higher food and fuel prices.

Climate Change from the Demand Side - podcast transcript

We have argued elsewhere the primacy of demand, there about keeping total output and employment at optimal levels. But nowhere is the effectiveness and utility of the demand side more evident than in an economic approach to reducing the causes of climate change.

I struggle with the best way to differentiate supply side solutions from demand side. Today we will try with examples: The deforestation of Indonesia, the development of new transportation technology, and the elimination of wasteful prison mattresses.

Indonesia

Illegal logging and deforestation around the globe is creating about twenty percent of the greenhouse gas problem. In Indonesia Chinese and Chinese-sponsored illegal logging accounts for a tragic loss of this valuable resource. The logs are taken illegally, shipped to China, manufactured into flooring and other wood products, and then sold on into the markets of Europe and America.

International pressure has come to bear on China for this practice, since its companies are obtaining and processing the illegal logs for profit. China counterclaims that the host country should be responsible for the crime on its own shores. Indonesia, however, is a weak state, and even if it were not, the incentives are all in the wrong direction. The logs would no doubt be brought out by bribery or bullying or other tactics even if government were much stronger in Indonesia.

The Demand Side answer is to ban the sale in the American and European market, coupling the ban with a tax on all imported finished wood products – a tariff, if you will. As soon as the possibility of final sale dries up, the entire market dries up. The wealthy countries have the wherewithal to monitor such things. A tariff or tax provides revenue for the monitoring, plus a convenient and easily proven crime with which to prosecute smugglers. That is, tax evasion is far easier to prove than the derivation of any particular product, or the complicity of the retailer in obtaining that product.

Reducing carbon emissions

The current favored mechanism for reducing carbon emissions is the Kyoto binding caps on emissions by country. The US is being dragged into the process kicking and screaming. China and India are opting out. So-called cap and trade schemes are the market-based solution preferred in the developed countries. These provide a value which can be bought and sold, and so pollution is allocated to the most inefficient. Carbon taxes are another idea along this line, attempting to bring the costs of so-called externalities into the price. This is a useful and noble exercise, but it is not enough to produce the needed technological revolution.

Be clear. The only way to internalize externalities is to bring the cost of a product’s use and disposal into the market, the purchase-sale event. But this is not sufficient.

This is not to say bring as many of the costs of a products use and disposal into the market, the purchase-sale event, is the only way to internalize the externalities of the market. But it has many problems.

For one thing, the ultimate costs can never be known until after the fact. If the cost of nonaction is the destruction of the planet, then there is no price too high. Another obstacle is the political bickering about what costs ought or ought not to be assigned to the purchase-sale event. This could produce arguments and litigation which would extend far beyond the deadline for action.

Finally, nudging the costs up, particularly if done in a half-hearted or inconsistent way, will never provide the impetus for the widespread innovation needed to reduce carbon production to one-fifth its current levels. Such an approach will tend to produce graduated adjustments to current technology, not new technology. Remember, we need to get to one-fifth our current carbon output by 2050, little more than forty years.

A better model for action was produced by the state of California. The Californian skies in the 1970s were a soup of pollutants: carbon monoxide, particulates, nitrous oxide. California chose not to provide incentives to suppliers to do the right thing or to generate public information campaigns to coax consumers. It simply issued the mandate that automobiles bought or used as of a certain date needed to have a highly reduced emission level. A simple regulation.

But a huge market for those who could innovate the solution and the loss of a huge market for those who could not. First, the state listened to a cacophony of complaints and dire predictions. Cutting emissions to the target could not be done, and even if it could be done, the cost would be prohibitive.

Thirty years later, as a result of that law and subsequent amendments, emissions have been reduced to one one-thousandth of their former level. Yes. Zero point zero zero one. We have the catalytic converter and a separate reduction reaction in the converter box (as I understand it) and a result that any chemist or engineer in 1980 would have ruled out of the question.

This is the magic of demand side. In terms of reducing carbon, we describe the resultant products in terms of their carbon footprints and let the market innovate to that result.

Jonathan Frost, director of Britain’s Johnson-Matthey fuel cells has argued persuasively that if there is a guaranteed market for a product with clear specifications, that is, a guaranteed sale if the product is produced, the private sector will generate the investment and energy to get there. In the case of California, there were millions of cars to sell. The investment by the state in the technology was zip.

Government procurement

This leads into a process that is familiar to defense contractors who are given specifications and asked to produce. The most outlandish weapons or surveillance or battlefield technology has been developed by this method. See at night, get a three ton missile to home in on a four foot square target. Spy from a thousand miles up.

If government guaranteed it would purchase ex number of no carbon buses, they would be produced within five years.

Frost gives the example of zero waste prison mattresses. British prisons dispose of hundreds of thousands of mattresses that cannot be burned or used as weapons, etc. The specs for these were twenty six years old when, as part of a demonstration project, Frost and his colleagues altered them to include the stipulation of zero waste. No waste prison mattresses. They put it out to bid.

The first thing they got was what California got. “Can’t be done,” “If it could be done, it would be exorbitantly expensive.” Next they received thirty-three proposals. Multi-nationals down to inventors in garages came up with innovations on how it could be done. Ultimately the zero waste prison mattress was produced at a net savings over previous costs when disposal is considered.

Oh that’s right. In California. The catalytic converter and subsequent technology reduced emissions by one hundred thousand percent on an adjusted cost here, too, of — zero.

So it can be done. The first step may be the hardest, to think about and describe exactly what the result is that you want. Resist the temptation to describe the processes to get to the result. The current ethanol situation substituting fuel for food comes to mind. Previously it was liquified natural gas. Just concentrate on the low-carbon, high-performance product and let the private sector do its own innovation. That’s what they do best.

It is simple and effective. It engages corporations in what they do best – innovation, production, technological advancement – and urges them away from what they do worst – manipulate demand and manipulate the political and regulatory processes.

Minimum Wage and other non-stories of 2007: Podcast transcript

Today we look back at some of the non-stories that were widely reported in 2007.

That is, things that did not happen that were widely reported as having happened or were certain to happen.

Among the non-stories covered in this podcast:

• The minimum wage hike causes unemployment to rise
  


• A weaker economy sends the stock markets tumbling
  


• Banks and the shadow banking sector face up to their problems with write-downs


• Housing slump nears its bottom
  


• Federal Reserve Bank liquidity puts confidence back in lending, or rescues credit markets
  


• Falling dollar does not mean higher inflation.



• Market stability will follow from newly sobered investors

All right, so the last hasn’t been reported yet.

First: Unemployment

If you’ve listened to us very long, you will remember our distrust of the official employment figures coming out of Washington in the past year, in particular the strength of the so-called birth-death assumption which has propped up payroll numbers.

BUT one thing about a strong employment record is its reflection on the great non-event of the rise in the minimum wage. The compassionate free marketeers were telling us that a hike in the minimum wage was going to adversely affect those it was intended to help. The lowest paid would lose their jobs as a result of the extra, what, five dollars a day in wage costs. Didn’t happen.

Where I live here in Washington state, we have the highest minimum wage in the nation at $7.22, and the only reason there’s any slack in the labor market is people keep moving here. Ours is, by the way, indexed to inflation. This is the right thing to do to start with, since it doesn’t require grandstanding to keep up.

That was my favorite non-story, but there were bigger ones.

The stock market collapse.

In full view of the biggest housing recession in postwar history and the current and continuing crisis in credit markets, the stock market has not tanked. In spite of many reports to the contrary. The Dow and the S&P 500 are actually up for the year. So is the NASDAQ, and by ten percent, its biggest calendar year rise since 2003.

Volatile? Yes. Down substantially? No. This non-event was actually announced several times by over-eager journalists who pronounced the inevitable as already having happened. Now it is just ignored, pushed under the table with the minimum wage.

Also under the table are the early reports that banks were facing up to their losses and taking write-downs that would clear their balance sheets, return transparency to their operations, and allow us to get on with business. No. They are holding onto as much of the toxic paper as they can as long as they can and being as opaque as possible. Occasionally they sell five or ten billion dollar chunks of themselves to foreign countries and announce writedowns of five or ten billion dollars the next day. Sometimes the same day.

We are going to see the so-called “fiscal option” in 2008. We only hope Americans get the same equity as the other sovereign wealth funds for their bailouts. Likely we’ll just get more debt, as in the bailout of the Savings and Loan banks in the Reagan-Bush I era.

HOUSING SLUMP NEARS ITS BOTTOM.

Perhaps only realtors are clinging to this. But the variant that the mortgage meltdown would not affect the broader economy is still getting substantial play after the data is in. Again, the so-called mortgage meltdown should really be called the financial sector collapse. We can’t call it the banking sector collapse unless we acknowledge that these shadow banking institutions and the hedge funds are also included. We’ve yet to see the sickening results of so-called innovation in commercial real estate and corporate debt markets.

CENTRAL BANK PRODUCES LIQUIDITY AND RESTORES CONFIDENCE.

The liquidity happened. Money is getting easier and cheaper for these guys to get. It bought about three weeks of very timid confidence.

MANUFACTURING EXPORTS WILL OFFSET CONSTRUCTION SECTOR JOB LOSSES

No. Exports need to offset imports before they start offsetting any other sectors.

FALLING DOLLAR DOES NOT MEAN HIGHER INFLATION

Usually this claim is followed by, “After all, imports are a relatively small part of consumption.” Yes. But the flip side of higher exports is higher priced domestic goods with export markets. Like food. Food inflation may not show up on the Fed’s preferred list of prices – core inflation. Higher food prices may not even be a completely bad thing. But it is inflation.

SPECULATORS ARE OUT OF THE MARKETS

The subprime meltdown was an isolated phenomenon. No. This story was a complete non-story. It wasn’t reported wrongly. It was just not reported. Speculation moved from the stock market to real estate after the dot.com bust of the late 1990s. Now we have the housing bust. Speculation has moved to commodities and currencies. While the individual market experts identify speculation as a likely culprit for ninety-six dollar oil instead of sixty dollar oil, the mainstream media reports the higher price as a function of supply worries or demand pressure. Maybe the day-to-day variations have something to do with storms or wars, but the baseline is determined by the money in the market.

This is bad news for inflation. Speculation in wheat, corn, soybeans, food of all kinds, metals, natural gas, and so on, is bad news at the front end for inflation and at the back end for farmers and others who invest in expectation of high prices and will have to go sit in line with the subprime mortgagees when the bubble bursts.

Forecast Friday comes on a Monday this month: Podcast transcript

Monday December 31, 2007

The Demand Side forecast is far too recent for us to bail on it already. We’ve put it up on the website at Demand.net again. It is the doom and gloom forecast, possibly just shy of John Williams prediction for hyperinflation and depression. We also refer you there to a few of the causal elements, most proposed by Nouriel Roubini of NYU’s Stern School. There’s a link to Roubini’s more detailed versions.

Since there has been no great rush from other economists to this side of the bell curve, we wondered what the hell they were looking at and wandered over. It is a bit intoxicating, as they pass around the bong of confidence in Fed interest rate cuts to apparently monetize us out of peril of every type. But we didn’t inhale.

Many were looking at the Conference Board’s (registered trade mark) U.S. Business Cycle Indicators (service mark) which were released on December (copyright – just kidding) twentieth. The leading index, the press release says, “decreased sharply for the second consecutive month in November, and it has been down four of the past six months.”

It was down 0.6 points in November after being off 0.7 points in October. But really, if you look at past charts, that is not so sharp. Also, yes down four of the past six months, but also three of the past four and the only exception being a tiny rise in September which followed a big drop in August.

Leading economic indicators as trademarked, service marked, but not yet copyrighted by the Conference Board. How good are they? What’s up with them?

First of all, they are not and they do not pretend to be causal. They are either forward seismic sensors on the supply side, such as new orders and building permits, indicators of demand to come like unemployment claims, or assessments of economic actors, like stock prices, interest rate spreads and consumer confidence.

Specifically, the leading indicators are ten:

1. average workweek for manufacturing production workers
2. average weekly initial unemployment claims,
3. manufacturers new orders for consumer goods,
4. vendor performance,
5. manufacturers new orders for nondefense capital goods,
6. building permits
7. stock prices,
8. M2 money supply,
9. the spread between Treasury bonds and federal funds,
10. and the index of consumer expectations

Let me repeat that .... No?

These seem to be the talking points for most of the economists I’ve heard. The first thing I did was to reach over their shoulders and toss into the drink the money supply M2. With credit cards, Fed willingness to print, and the seizing up of credit markets, it is hard to see what relevance this rather narrow version of money has going forward, or even since the 1980s.

The workweek doesn’t change in manufacturing, they just fire people. Those who are left continue to work the same schedule. There may be three instead of thirteen, but they’re still working a 40-hour week. Or actually a 41.1-hour week.

I grabbed the whole manufacturing sheaf, including the two manufacturers new orders and the vendor performance. Manufacturing used to be one-fifth of the economy. You could argue in the late seventies that it generated another two-fifths in support services. Now it is a tenth of the economy and maybe up to a total of three tenths including support. But it is half the Conference Board’s list of leading indicators. Now it is confusing matters. Manufacturing is up, yes, for the export market, but that will be mitigated if the dollar rebounds, or it will translate into higher prices if it doesn’t, since it is not only imports that will increase in price with a lower dollar, but products where export markets bid up domestic prices – like food.

Then I slipped the stock prices out of the deck. Stocks are strong not on the economic outlook, but on the demand for inflation proofing and their cheapness as a hedge against a rebound in the dollar. So we’re left with consumer expectations, interest rate spreads, building permits, and average weekly initial unemployment claims.

The aggregate of these four were:

• Down 0.31 in November.
• Down 1.56 since July.

With only two positive numbers among the sixteen: a microscopic 0.01 rise in consumer expectations in September (following August’s 0.22 drop) and a bump in the index for unemployment claims, also in September. (Notice these are index numbers, not percentages.)

Looking over at the graph of the indicators since 1960. The leading indicators, and really all the indicators, were much more emphatic predictors prior to 1980. The strength of movement has declined steadily since then. The jagged teeth of the line graph have been rounded off and softened. Yes, E.B., I realize it is a log scale. If it weren’t a log scale they would all look like a ski jump or a J curve.

This softening is no doubt related to the declining importance of manufacturing in the real economy not reflected in the trademarked leading indicators. BUT the turns are pretty close to the mark, and the turn has occurred. This is referencing the Conference Board’s full list of ten. There was one spot in the 1966-67 Guns and Butter era when a false signal was given, but that was back in the days of a strong middle class.

Other than that, no. Flattening and decline have always meant recession, as defined by the official arbiters, the Conference – trademark not for redistribution or public posting without express permission – Board.

[Thank you, E.B.]

Economic Stimulus with Public Works: Podcast Transcript

What to do when deficits are too big already

Wednesday, yesterday, we went over the varieties of possible stimulus and how efficient they were likely to be. These included Fed rate cuts – parenthetically, cuts by the Fed to this point in 2007 have been widely reported as a response to the flagging economy. In fact they were explicitly intended to remedy “turbulence” and the threat to the economy from credit markets, not from falling demand; that is bail out the bankers. Not stimulate the economy.

Okay – no more detours – Stimulus options we mentioned included those Fed rate cuts, more tax cuts for the rich, across-the-board tax cuts, tax incentives for business investment, and government spending on public works. Oh yes, when we found none of these particularly inviting, we proposed direct support to state and local governments to stabilize them in a period of falling revenues. Without such support, federal expansion will be more than offset by state and local contraction. Further, spending on consumer discretionaries will substitute for spending on schools, police and other state and municipal services.

Now.

We have a problem. The federal government under George W. Bush has been running deficits and big ones ever since the tax cuts for the rich. They are rising again. If we borrow further to stimulate the economy, there will be additional upward pressure on interest rates. Higher interest rates could undo any stimulus with increased credit costs.

That’s a bit more than I said yesterday. A week ago Wednesday Senator and chair of the Joint Economic Committee Charles Schumer said this in response to a question following a talk at the Brookings Institute.

We have huge infrastructure needs over the next twenty-five to thirty years. Most of our fundamental infrastructure – roads, sewer, water – was done fifty to a hundred years ago and has to be redone.

When I go around New York State, the number one – in suburban, smaller cities and rural areas – number one, two or three on the list of the local governments is, “How are you going to help us with our need, not for roads, which is more federally oriented and state oriented, but for water and sewer.

So this is a serious problem. School buildings. I greatly worry that overall since 1980 that the federal government has a much more restricted role and the next twenty-five years we’re going to pay a price. We’d better figure out a way to adapt to that in terms of infrastructure and in terms of education.

We have a great system. And we energize people, no matter what their background and what their economic level, the way China doesn’t, Europe doesn’t, Europe doesn’t. Its great. So we have all of this going for us. And the anxiety I have is, as somebody who loves this country, I think we have let things lag, rather significantly, over the last twenty-five years, but particularly over the last six or seven. And we better figure out ways to deal with it.

The substance of the Senator’s talk – as I’ve mentioned before – was the housing and credit market mess and it will be up on the podcast this Saturday. Schumer knows the way out of this mess. He can explain it. And we should be following him, not the scarecrows at the Fed or the ostriches in the White House.

So, the set-up is nearly complete. One more piece. Public Goods v. Private Goods.

Public Goods

Demand Side makes a special point of Public Goods. Public Goods account for an immense portion of the well-being of our citizenry, and at the same time generate immense wealth to private economic actors.

A brief definition: Private goods – those which our society creates and consumes in such abundance – are marked by two primary characteristics. They are excludable and they are depletable.

Excludable means that to a greater or lesser degree the use or enjoyment can be limited to a person, household, or group. This is important. My use excludes your use of the item. Autos, houses, durable goods, food, electronics, air travel, and on and on.

Depletable means the benefit of the product can be limited, focused, monopolized. The entire economic benefit is consumed, or can be consumed by the buyer, wearer, user, and so on.

Public Goods, by contrast, are to a greater or lesser degree not depletable and not excludable. For example, a road is not depletable: No matter how many cars use a road today (and recognizing that there are limits to everything) cars will be using it tomorrow as well. It is not excludable. Who will be able to collect a toll for every road, or collect the cost of the service if the road is plowed free of snow?

Not being depletable means in their own way Public Goods are the goose that lays the golden egg. Not being excludable means the private market is unable to isolate the benefit sufficiently to be an efficient producer of Public Goods. The private market requires payment in an amount approximating value. Such a payment will not be forthcoming if one party does not monopolize the benefit and enjoy the predominant value of the good.

When one party does not monopolize the benefit, it is difficult for the private market to exist. Remember, the market itself consists of nothing more or less than the moment of purchase and sale. This leads into the cul-de-sac for the market known by the technical term “the free rider problem.” The classic example is national defense. If the nation is defended from attack, I am defended, even if I do not choose to pay for the service. I am defended because my neighbor is defended. This is the downside of not being excludable, and it is the major reason that we have a universal coercive means of financing – taxation. There ought to be no free riders on Public Goods. The cost of the road, national defense and education ought to be shared by all, since their benefits are shared by all.

Public Goods as exemplified by roads are obviously a good deal for private actors. MacDonald’s founder Ray Kroc once asked his protégé, “What business am I in?” The unsurprising answer was, “The restaurant business.” “No. The Real estate business.” The success of his fast-food outlets depended on their locations. The value of a location depended on the access from streets and roads. A new highway or bridge may increase property values immensely. In rare instances part of the gain may be captured for public use. Most often it becomes wealth to private landowners.

The same sort of benefit attends all public goods, education, national defense, etc., etc. The total return is far greater than the cost or than the benefit returned to the individual, but it is impossible to isolate and capture that larger return in a transaction. The market requires a relatively simple transaction to operate efficiently. It cannot deal well with multiple beneficiaries or variable benefits or extended or uncertain periods of time. A good which returns enormous benefits over costs will not be produced by the market unless the purchaser commands enough of the benefit to match the seller’s price.

Taxes are simply the means of purchasing or financing Public Goods, in the same way mortgages finance houses. The great success of the anti-government Right Wing in the United States has arisen from their ability to separate taxes from the goods they purchase in the minds of the electorate. In fact, taxes are the source of funding for Public Goods. Public Goods which have a high multiplier at the front end, being expenditures of government, and so stimulate economic activity. They often produce immense value over their cost. And they create wealth for many private economic actors.

Now, for those of you – approximately three of the faithful thirty-nine – who like sports metaphors – we’ve driven the ball down the field. Time is running out. We can’t afford to risk another run, so we’re going to pass for the score.

Wednesday we established that Public Works would be by fr the best stimulus if it could only be implemented more quickly. Here we establish that public works create growth in and of themselves over time.

Let’s just admit that the Bush tax cuts for the rich have been a bust, recapture that money for the operating budget, and use the debt space for bonds for the public works this country needs. This is a sustainable growth path.

Again, thank you E.B. for this transcript of the podcast for Thursday, December 27

Stimulus Options: Podcast transcript

We thank E.B. for producing the following transcript of the podcast for Wednesday, December 26, 2007.


Last Wednesday at the Brookings Institute, former Treasury Secretary Larry Summers proposed fiscal stimulus for what he saw as a dangerously slowing economy. This in addition to continued Fed interest rate reductions.

Note: E.B. has done a great deal of work in editing that talk, and by eliminating Summers repetitive measured pauses, his liberal use of caveats and some secondary points, the speech has been reduced from over forty-five minutes to sixteen.

We’ll put that up on the Saturday Special in two weeks. This week remember is Chuck Schumer speaking at the same Brookings event.

Here, let’s listen to the pith of Summers, then I’ll come back with some description of the mechanics of stimulus and at least one good idea I haven’t heard so far.

Now here is Lawrence Summers:

If economic data come in as I fear they will, with increasing signs of recession, policy response should include fiscal as well as monetary measures. Fiscal policy can work more rapidly than monetary policy, which has a lag of about a year between a change in the Federal Funds rate and its maximum impact.

Moreover, the efficacy of monetary policy may well be diminished by capital constraints that limit the ability of banks to lend, or creditworthiness constraints that limit the ability of businesses to borrow. As important, the extent to which monetary policy can prudently be used in the current environment is limited by concerns about the dollar as well as about the bubble-creating effect of very low interest rates.

Certain problems, such as the impact of mass foreclosures on affected communities, are not easily amenable to monetary policy.

Fiscal stimulus is therefore potentially critical. But it can be counterproductive if it is not timely, targeted, and temporary. Gene Sperling’s Bloomberg column this week makes these points strongly.

Fiscal policy has to have its impacts in a timely manner.

It has to be targeted to assure that increased government borrowing translates directly into increased spending and demand.

And critically, it has to be temporary, so that its effects are not offset by higher long-term interest rates.

From the point of view of stimulus, the optimal package is one that raises spending and the deficit in the short run while reducing the deficit in the long run, therefore bringing down long-term interest rates.

Stimulus approaching fifty to seventy-five billion dollars, roughly in the range of one-half of one percent of GNP is likely to be appropriate.

Summers specifically supported stimulus in the amount of one-half of one percent of GDP that was quote timely, targeted and temporary unquote and composed of tax cuts, food stamps and unemployment benefit extension.

Republicans are circling any talk of tax cuts for a flagging economy, ready to enlist recession fears in their continuing demands to bring tax rates to zero. Tax cuts are their favorite remedy for all ills.

George W. Bush recommended tax cuts during his first campaign as the correct response to a healthy economy and a surplus in the budget. “After all, it’s your money,” was the campaign slogan. Bush later promoted tax cuts as the necessary medicine for economic weakness. To admit the obvious, the long campaign against taxes has borne fruit. Today taxes are not considered the necessary means of financing public goods, but the teeth of a vampire government. This is a subject for another day, perhaps one day soon. To continue, when the tax cuts of 2001 did not work Bush – along with the compliant Congress – asserted it was because there were not enough of them, and another round came down in 2003. The slogan was not, I should note, “After all, it’s your children’s money.”

...

All valid stimulus theory follows from the theory of the multiplier, developed by R.F. Kahn in the 1930s and developed and promoted by John Maynard Keynes. The multiplier is at the heart of Keynesian demand side stimulus.

The idea of the multiplier is that an exogenous (outside) spending stimulus will generate much more economic activity than the simple dollar value of the stimulus, because it will echo through the economy. The laborer will buy bread from the baker who will use the money to buy wheat from the farmer who will use the money to buy machinery from the tractor dealer who will use the money to buy meat from the butcher and so on. There is leakage into savings and out of the economy at each step, so the multiplier is not infinite, and may be between two and five, depending on the situation.

Keynes himself proposed public works financed by government deficits as the preferred way of stimulating demand and starting the cycle of jobs and investment. Some time later, Keynesians under John Kennedy proposed a very modest tax cut for the middle class to stimulate the economy of the 1960s. That is, they kept the deficit, but passed the spending along to private households, who bought things and produced some activity. Kennedy’s has been the model for all stimulus programs since.

The multiplier, then, suggests that an exogenous infusion of spending will multiply through the economy and get the providers of goods and services back into forward gear.

Let’s look at five possible stimulus methods.

One

Reduction of interest rates. This is the monetary version of stimulus The Fed can make money, at least in the short term, cheaper. This encourages investment and spending in theory, which would engage the multiplier, but the idea that it creates strong business investment action is not well supported by evidence. The last time it was tried we got a housing bubble. Business did not invest. Now we have a huge inventory of energy-inefficient houses, millions of people in financial distress, a credit market dysfunction and a huge debt overhang. This suggests that now, even if money were free, the tendency would be to hold onto it rather than invest.

Two

Tax cuts for the rich.

This has been tried a couple of times. Once under Ronald Reagan and more recently, of course, under George W. Bush. In both instances the economy was not stimulated, as the wealthy simply added the bonus cuts to their wealth and continued to spend as before. This suggests the second of Larry Summers trinity TARGETED, where the tax cuts go to those who will spend, and thus at least start the multiplier.

Three

Tax cuts for the poor or across the board.

The lower the income, the higher the tendency to spend. So if tax cuts are stimulus policy, the lower on the income ladder, the more effective at least for the first round. An interesting parallel exists with inflation. Just as the multiplier differs for different income classes and goes up as you go down the income scale, the same is true of recent inflation. Food and fuel comprise a higher proportion of purchases at the lower end. When you throw in the double digit rises in health care you find that in times such as ours, the effective inflation rate is much higher at the bottom.

Four

Tax cuts for targeted business investment

A way to leverage a higher exogenous stimulus would be to offer tax cuts to business investment. If business moved investment forward or made a yes rather than a no decision on an investment decision as a result of tax incentives, a greater initial boost would follow creating a greater total stimulus. There is, please note, no essential difference between government deficit spending and business investment whether financed by investment or debt. They are both exogenous and stimulative.

The major problem with this scheme is it doesn’t work very well. Businesses may move around investment decisions, but their basic calculus is not changed. They invest when they see an opportunity for profit, not because money is cheap or costs are less. In a flagging economy, profit opportunities may not be very clear.

Five

Public spending on public works.

This was the method preferred by Keynes. Producing public works means you hire somebody up front. His or her paycheck is the means of getting the spending into the private economy. One big advantage is that there is no leakage in the first round, thus the multiplier is greater for the same spending. That is, one hundred percent of the initial spending goes to employment, whereas in tax cuts the recipients may save some portion and will very likely spend at least a little of the rest on goods that generate overseas employment rather than American.

The second major advantage of public works spending is you have the public work when you are done. A road or sewer will yield benefits far into the future for the society that the purchase of a lawn mower will not.

Now

How do these rate on efficacy? And how do Summers Timely, Targeted and Temporary criteria apply?

But first, notice that the multiplier works with negative numbers, too. If for some reason spending is subtracted from the economy, the effect is far more dire than the simple dollar value of the initial subtraction. Ask any community faced with the closure of a plant or military base.

But second, Let us see what goods comprise the initial round of spending. With tax cuts, many people get a relatively small bonus to spend, and that which is not saved goes for consumer goods, discretionaries or necessities at the margin, depending on the income level. With tax cuts for business investment, providing new investment is leveraged, it goes for the range of plant and equipment or R&D and this includes many payroll jobs. Public works is a similar mix.

But third, just be aware that any stimulus, by definition, must be deficit financed. If we rob Peter to pay Paul, the community which includes them both is no better off. So with stimulus we are indeed intending to add to the deficit, all other things equal.

So efficacy?

Interest rate reductions?

Are we really going to restart a housing boom? Is business going to invest in this economy, particularly considering the seizing up of the credit markets we are currently witnessing? Low rates are better than high rates, but the financial markets have a lot of self-repair to do before there is any help from that direction.

Timely? Even aside from the problematic nature of the financial sector, interest rate reductions take twelve to eighteen months to be effective. Knowing how much is enough is very difficult when the results are that far out.

Targeted? As mentioned, last time interest rates were used as the primary stimulus method, housing boomed. It is hard to think that this was the intention, since business investment is always on the front of every policy presentation.

Temporary? Who knows? Interest rates also double as the main inflation-fighting mechanism. That promotes ... well, volatility.

Tax Cuts

Timely

Tax cuts can be instituted very quickly by reducing withholding rates. So something, perhaps not a great amount, could be done almost immediately.

Targeted

Across the board cuts as would likely be used disproportionately benefit the wealthier. According to the Congressional Budget Office, roughly 85 percent of income from all sources goes to the top half of Americans. This is the wrong target. A cut in payroll taxes is not appreciably less biased, with about 80 percent in the upper half. Tax cuts would thus produce more spending on consumer discretionaries after an initial round of leakage (which would be significant, since savings are encouraged in the present consideration).

Temporary

As Summers has noted, the tax cuts of 2001 and 2003 have been very sticky.

Business Tax Cuts to Stimulate Investment

Timely

New business investment does not respond very quickly or directly to tax cuts. As before, prospects of profit far outweigh tax considerations. Evidence is strong that investment decisions already made can be moved forward, but this may not bode well for later time periods, even if the cuts are NOT temporary.

Targeted

The target is clear. The question is whether tax cuts for business ever reach that clear target. Evidence is not good except in extreme cases, such as some of the Reagan tax incentives of the early 1980s which at times actually made investment cost less than nothing. Note that this tended to promote investments into the favored types, decisions that may have been out of step with overall strategy and so less useful to the business and to the economy.

In the first round, the composition would be more or less productive investments and jobs. This is significantly different than consumer discretionaries. Jobs provide more income to less people than individual tax breaks, but the next round of spending is not focused on discretionaries or at the margin, but across the board, to housing, utilities and the rest of personal consumption.

Temporary

These sorts of tax cuts have also been somewhat sticky, tending to outlast their original intention, and drawing businesses to depend on them.

Public Works

Timely

New public works projects would likely not start until after the need for stimulus was past, considering the need for design and site preparation and so on. Public works already underway could be accelerated, perhaps, or those on the shelf implemented somewhat more quickly. When Keynes developed the theory, the recession in question was a matter of years, not a few quarters.

Targeted

Again, as with business investment, in addition to the actual public work and materials for it, the target would be the range of personal consumption expenditures, as it would produce jobs, not bonuses to existing workers.

Temporary

Public works, once completed, provide ongoing public benefit with no ongoing cost. Any particular project, however, could extend into years before completion.


This discussion shows that none of the alternatives is very efficient, but the context of recession on the ground suggests another course. Tax receipts for state and local governments fall during recession, often because they are dependent on sales taxes, but in the current case also because property values are falling.

Since these levels of government do not have the luxury of deficit spending, reducing their revenue reduces their expenditure, and the situation of negative numbers referenced above occurs. That is, the multiplier is employed in reverse. A federal stimulus program might simply offset this contraction.

An alternative would be for the federal level to provide stability to the economy by supporting the state and local levels, mitigating their contraction. Further, this is a direct conduit to public works, since most public works are managed by these lower levels. Support through this channel has a better chance of finding useful projects that can be accelerated, implemented quickly, or just not shelved.

Timely

This would be immediate

Targeted

Public services, public works. These are jobs, thus the range of personal consumption expenditures is wide. Notably the number of employees in the upper quintile would be fairly small.

Temporary

As property tax and other revenue recovers, the need for federal assistance would be reduced. This would be relatively easy to see and document.

We apologize for the length of this podcast. Providing stimulus in the context of an ongoing and deepening federal deficit has its own dangers we did not mention. Thursday we’ll take a more direct look at this question and possibly another benefit for public works.

The curse of growth

It’s time to examine the benefits of Growth.

First a couple of notes. I see that many of the faithful thirty-nine have been forwarding the piece on income-based farm support for farmers as an alternative to the current price-based supports for farm commodities. That was a particularly esoteric (although well-timed, considering the Farm Bill was up) issue. We were surprised at the interest. So we’re going to put together an extended treatment of that. It originally aired on December 5 as Market Failure III right after Market Failure II: Immigration. The two are corollaries. If you have specific questions or points of view, you can e-mail us at blog@demandside.net. Be nice.

Also, on the last Saturday Special of the year we will hear from Chuck Schumer – Senator Charles Schumer of New York, speaking at the same Brookings event as Larry Summers, noted later in this podcast.

Schumer is right on top of the subprime meltdown and banking and financial sector mess. If we could plug in his ideas today, we’d eliminate a lot of suffering and error over the next several years. Schumer will be ticking off the problems and the real solutions available as well as revealing in a straightforward manner the dangerous incompetence currently running the show in the Administration and at the Fed.

And we’ll have an extra podcast this week. The fourth Friday of the month is Forecast Friday. Well see how we’re doing and whether we need to make any adjustments to our calls, such as introduce the ambiguity and equivocation we’ve heard from the cattle who comprise the consensus. The answer is No.

Now. The Curse of Growth

It is entirely appropriate to blame Alan Greenspan for the housing bubble. His fiercely low interest rates and complete absence from the scene in terms of structuring and regulating the mortgage market make him the proximate cause of untenable housing price increases. His total disinterest in overseeing or even knowing anything about the Enron-style off balance sheet SIVs or the peculiar securities called collateralized debt obligations and exponential leveraging schemes make him the chief enabler of the binge that has left most banks badly overextended.

But if you’re going to blame him for the bust, you’ve got to credit him for the boom. It was the boom that remade Greenspan’s reputation after his mishandling of the dot.com bust. Not that it was much of a boom. But it was growth and we love our growth.

Similarly, the immense growth of China that is the toast of the free market world has come at an enormous cost. The economies of competitors have suffered and trading partners have been at a disadvantage with the exchange rate manipulation, but far more worrisome than any economic impact on competitors or partners is the environmental impact on the common environment.

The massive use of coal and the employment of worst practices mining and extraction at home and abroad have exported pollution and environmental degradation along with the cheap manufactured goods. Inside the borders of China, the situation is even worse. We have called China the first environmentally failed state because its own tipping points have been passed and the wholesale degradation of its water, its atmosphere and its arable land are now assured.

Growth and slavish adoration of growth as measured by GDP in these two instances have been the sugar for poisonous events. GDP, you will remember, is no measure of well-being, but a measure of monetized activity. GDP-wise, wars are better than peace, prisons the equal of Ivy League campuses, and the depletion or destruction of resources are invisible.

What we need is a good recession.

Seriously.

At least in the great avalanche of consumer goods.

We need a recession that reduces frivolous discretionaries, forces us to tightly structure financial institutions and markets, and compels investment in public works and public goods such as energy-saving infrastructure and health care.

I was listening to Tom Keene interviewing a retail analyst the other day. It was with some shock and awe that I heard her repeat over and over again redundantly that the keys to retail success with respect to fashion was awareness and exclusivity. Awareness and exclusivity. Perhaps it could be said awareness of exclusivity. But awareness of a product seems to me to be somewhat exclusive of exclusivity.

But no! By the magic of marketing, Chan4el hangs its handbag on an actress in a magazine and tens of thousands of target-aged women make the purchase for $185, or probably more, for all I know. Manipulation of consumer demand by the supplier is one of the most egregious sins in the co-called free market.

Enough said about that.

To achieve planetary survival, consumption has to be reduced. That means growth has to be negative. Yes?

No. Of course, we can grow rail transport, green energy, education, health care, third world survival, and so on. Just not SUVs, ATVs or RIPs.

Let’s look at it from the perspective of the current argument of what to do about impending recession. Former Clinton economic adviser and Treasury Secretary Larry Summers made a presentation at the Brookings Institute on Wednesday calling for strong early action that includes fiscal stimulus, by which he meant across the board tax cuts that were “targeted, timely, and temporary.” He also called on the Fed to move more aggressively on interest rates, while admitting that interest rates at best have a one-year lag to effectiveness.

Underlying both tax cuts and interest rates are more private goods, more discretionary spending that may or may not build American jobs. Better stimulus came from the Congress last week with its spending bill complete with lots of earmarks.

The mechanics of stimulus are not difficult. There is a reason the Bush tax cuts were not useful stimulus. The techniques of lowering short-term rates, fiscal deficits to finance tax cuts, fiscal deficits to finance public works, and fiscal deficits to finance other sorts of strategies will be the subject of tomorrow’s post

But this will come down to a battle between public goods and private goods. On Thursday we will look at public goods directly, why they need to be financed through government, and why they are in themselves stimulative, irrespective of whether they are revenue or deficit financed. We will end that podcast with the absurd suggestion that effective stimulus need not increase deficits, and no, not on account of the well-named Laffer Curve.

Today, however, we are talking about the God of Growth of GDP. GDP measures monetized activity, as we said. Well-being be damned. Perhaps a consumer recession is not such a bad idea.

Market Failure V: The Great Financial Sector Crash of 2007

No time and place and situation in postwar America has fallen more completely under the sway of the free market than the first decade of the Twenty-First Century in the banking and financial sector. We may soon see that no financial crisis will cost America more than that composed and orchestrated and performed by this unregulated, unsupervised, predacious sector.

Of course, the financial sector is not by itself in being outside the pale of even rudimentary structure, although because the central bank was under the control of a self-described Libertarian Republican Alan Greenspan, it could be argued that banks and brokers had special access to government largesse. But with George W. Bush in the White House and his handler Dick Cheney never far away, the corporate oligarchy has written the laws that governed their sectors not only in finance, but in energy, health care, media, and more.

The roots of the financial crash.

In the financial sector during the Greenspan/Bush era, innovation was the word of the day. Special accounts or entities called Structured Investment Vehicles (SIVs) were created by banks off the balance sheet to take advantage of special securities called collateralized debt obligations (CDOs). Imaginative modeling was applied to mortgages to take advantage of a housing expansion built on cheap interest. The extra few beeps from these accounting functions found a ready audience in investor capital. The voracious demand for these securities drove ever more predacious mortgage brokers and ever riskier mortgage loans.

All of it was sanitized by an absent Securities and Exchange Commission, by a diffident Fed and by rating agencies – Standard and Poors and Moodys – in thrall to those they rated. Mortgage-backed securities were stamped Triple A whatever their worth and treated as near money for further leveraging. The demand for it drove the whole sorry circus. Meanwhile, hedge funds operated as usual, in a dark shadow. Mortgage brokers were not licensed, nor were their products examined.

Whatever there is to say about the expansion of the financial sector under Bush/Greenspan, government interference is not part of it. Loud and detailed complaints about government arose only after the collapse. They come from all offices on Wall Street and amount to variations on the theme that government was not, and is not, doing enough to clean up the mess. The banking sector is vital. It needs ever more and ever cheaper money. No time to look at the past.

The common name for this financial sector collapse is the Subprime Mortgage Meltdown, as if it were authored solely by those individuals who obtained inappropriate loans. Lenders, in fact, bear the responsibility and ought to bear the costs. As we see less than six months later, lenders can be very discerning in their choices of mortgage buyers.

Facing the nation and the world today is a solvency problem, no matter what brave face the banks may paint on it. And solvency will be assured by you and me. These banks are – and they realize it – too big to faily. You and I are the deep pockets. Debt leveraged by debt was not a very good idea. Every write-down or equity stake sold to a Mideast potentate is accompanied by assurances, not from the corporate offices, please note, but from analysts and fellow travelers, that banks are facing the music, taking their lumps, clearing their books. Bull. Accounting is opaque. Losses are dribbled out over time as slowly as possible with moves designed only to maintain as long as possible a facade of integrity.

Now, as the Fed moseys into the mortgage corral like a self-conscious Barney Fife to finally close the gate, laughably late, with the fences broken and the tumbleweeds rolling across the scene. The horses are gone. Barney's new, weak subprime lending protections are announced to empty stalls. Deputy Fife retires to his offices, knowing as we all do that even before the charade, the subprime mortgage market was forever a thing of the past.

But the bank examiners have still failed to report for duty. So deep in the pockets of the banks is the Fed that it colludes without a second thought. Its role is not to wonder at causes, but to listen and respond to whispers from the big houses. As much as possible the extent of the damage must be kept from the prying eyes of the public. It was an explicit feature of last week's special auction facility that nobody would know who was using it.

It is still our contention that the overall damage will reach toward one point three trillion dollars, with eight hundred to nine hundred billion resting in the American financial sector and the rest lying mostly in Europe. While write-offs, downgrades and bankruptcies will eliminate some of the overhang, on one hand. On the other the government and taxpayer may be on the hook for the biggest bailout of all time. This in addition to the ever broader gusher of liquidity focused on the sector.

There can be no doubt this is a market failure through and through. The government, particularly the Fed under Greenspan did nothing but abet the private financial sector actors.

It will surprise nobody that we propose some real remedies and responses beyond the, Oh well, it is little more than the normal cycle.

But first, a few notes.

1. One, the authors of this fiasco are the highest paid professionals in the country. These are the brilliant minds of the A list business schools. They are getting millions and hundreds of millions of dollars. This on the premise that they are providing value. Instead they are costing us – hundreds of billions and rocking the foundation of credit for the whole economy. Aside from a few sacrificial lambs who left with nine figure severance packages, nobody has been held accountable.


2. Two, the problem is not the unraveling and collapse. The problem was the growth on false pretenses, the bubble itself promoted by cheap money and no structure. The collapse was simply the final act.


3. Three, the best thing the credit markets can do is every day provision of a reliable supply of capital at the lowest rates possible for the productive industries. Slicing and dicing securities and buying and reorganizing and selling companies is very close to a shell game. At best it spruces up the bottom line and makes the stock more attractive. But the economy is not measured in stock prices, it is measured in jobs, security, continuity and maybe a bit of moral integrity. Whatever incentives make this financial gymnastics activity attractive have to be reversed.

So the remedies.

• Out the securities for the public to examine. These are not so much complicated as they are preposterous.


• Realign the mortgage seller with the mortgage buyer. Do not allow secondary markets in mortgages. If people want to invest in mortgages, let them invest in the mortgage providers.


• Institute a financial transactions tax of five one-hundredths of one percent to recoup the immense costs of these bailouts. A standard, minute tax will generate a great deal of revenue and at the same time discourage the day trading and hyperactivity in what amounts to a casino.


• Establish a marginal income tax rate of at least 50 percent on income above a couple of million per year, all sources. This event is evidence enough that people are paid enormous sums not for value delivered, but for value extracted.


• If there is going to be a bailout, aside from the cheap money, get a stake in the companies. Why should Dubai have a stake in Citigroup and the USA not? Providing there is a similar investment.


• And structure this market. Let's not have financial vehicles or securities that are simply some Wharton grad's senior project. Let's get things vetted. Markets can work, but unstructured markets don't work.

Market Failure IV: Russia

The fall of the Soviet Union was a tremendous opportunity. That was squandered when the advice of free market zealots overrode rational transition schemes. Ronald Reagan's grandstanding aside, most historians will say that the West won on the basis of economic might. The democratic mixed economy of the United States produced enormous prosperity for its citizens, replicated in Western Europe. The Soviet Union and that part of Europe under Soviet-style command economies fell further and further behind. Finally Russia acceded to the inevitable.

As we will see, under Western sponsored "shock therapy" Russia was not transformed or invigorated, but brought to its knees economically. Today, largely on the basis of its oil resource, that nation is rising from decline. But the Russia of Vladimir Putin bears more resemblance to the bureaucratic dictatorship of the Soviet era than it does to a European-style democratic mixed economy.

Now. What happened? Why is this market failure IV? Following we offer a very quick description, a skimming of the events taken largely from Stiglitz excellent book Globalization and Its Discontents, the 2003 version.

The debate between gradualists and the free market fundamentalists in the IMF and US Treasury was won by the latter. Their prescription of wholesale liberalization of the economy was accepted by the Russians.

The first mistakes occurred almost immediately upon the decision to institute the shock therapy. Most prices were freed overnight in 1992. Since many prices had been kept artificially low under the communist regime, freeing them – or liberalizing – set in motion an inflation, a hyperinflation of double digits per month, that wiped out savings and moved price stability to the top of the agenda.

The second round of shock therapy thus began – raising interest rates to stem price increases.

The third round of shock therapy was rapid privatization.

When the smoke cleared, a few dozen oligarchs were in control of former state-owned industries. A more broad-based ownership was frustrated by the inflation, which wiped out the savings of the broad population and prevented them from becoming stakeholders in the new economy.

Between 1990 and 1998, Russian industrial production fell 42.9 percent. GDP fell 45 percent. This was nearly twice the damage experienced by the nation's economy during World War II.

The oligarchs got wealthy not by developing industry, but by buying oil at its still restricted prices and selling it overseas. They exploited the newly opened capital markets – a fourth element of shock therapy – to send a flood of money out of the country, quite the opposite of the intention to draw outside capital in.

The IMF kept promising recovery was just around the corner. In 1997 a combination of high interest rates, a collapse in oil prices and insistent borrowing – at IMF direction – to prop up the ruble, eroded the base of the economy completely, and it collapsed.

As Stiglitz says, page 146

An overvalued exchange rate – combined with the other macroeconmic policies foisted on the country by the IMF – had crushed the economy.

Although unemployment was disguised, it was no less traumatic. Workers were kept on payrolls; there was little production. As Stiglitz says,

While workers only pretended to work, the firms only pretended to pay. Wage payments fell into massive arrears, and when workers were paid it was often with bartered goods rather than rubles.

In July 1997 a "rescue" quote unquote was organized by the IMF with participation by the World Bank and was primarily intended to keep the value of the ruble high. Tens of billions of dollars in loans were organized to support the exchange rate.

The rescue failed. An inevitable devaluation did not lead to the doomsday predictions promised by the IMF. But the debt was in place. The oligarchs and Western bankers took what they could.

This is the history, or the froth of the history. What was the root of the failure?

The shock therapy. While markets work, they only work in the context of strong government institutions and mitigation of excesses by social programs. Western societies have hundreds of years of institutional development. Regulatory agencies, courts to enforce contracts, well-developed supply chains and intermediate markets, controls against monopoly exploitation and patent corruption. Russia did not have these. The Soviet economy, in fact, had relied on back alley arrangements to circumvent the official red tape, and was thus practiced in corruption.

Free market fundamentalists believed that the magic of the market itself would organize the society. No less blind than religious zealots, they pushed an idealized liberalization ahead of institutional development and oversight. Most notably, democracy itself was left to follow the market rather than lead it.

Hire the Third World to develop low carbon sustainable agriculture

What are the two major problems on the globe today? No, Tiffany, it's not finding parking for your Escalade. No, Buzz, it's not getting rid of the coach.

Global warming and global poverty.

The UN climate change conference in Bali ended in acrimony. The world produced a barely adequate so-called road map forward, a process for beginning a process that needed to be in its second decade last year. Obstruction and obfuscation are generated primarily by the United States and its chief supplier China, who refuse to alter their mode of self-interest from greed to simple survival. As we noted in an earlier podcast, it is an enormous market failure when clear information is available to all parties -- that is, the demise of the Earth as an environment suitable for human life -- and the response of the most market-driven economies is to insist on burning more fossil fuels and creating an ever higher tower of cards.

Let us look for a moment at two parts of this issue. First the abstract issue of the motivation of economic actors. The second being the way to connect the undeveloped world to a successful growth path, which by the definition of successful, means a path that is not carbon-intensive.

Motivation.

In economic science, or at least in the primitive form currently in vogue, the world is made up of billions of little units operating on the basis of a kind of primal automatic response to material self-interest. Sometimes economists will introduce institutions as a collective form of this self-interest. The simplistic and oft-repeated magic of the market is then proposed, a catalyst that organizes these billions of self-interested atoms into a perfect crystal of optimal outcome. The invisible hand molds the best destiny, unless of course, government interferes.

Among the many unexamined contradictions and assumptions needed to support this leap of faith are the mass of evidence to the contrary, the patent absence of free markets in the real world, the many anecdotal examples -- say the current financial sector chaos -- where markets that are relatively free produce not optimal outcomes, but crisis and dysfunction. Along with this are the billions who actually act on a basis not exclusively rooted in personal material self-interest. Family, community, nation, race, and many other non-individual, dare we call them social, elements compose the individual's motivation in any particular incident.

To the point relative to Bali and the UN's roadmap. The survival of the planet also entails at least a modicum of self-interest. But this form is not the personal greed of the free market that is supposedly cleansed by the invisible hand. It is a survival where all must survive if one is to survive. The optimal survival of one means the survival of all. This is a powerful shift in motivation and is felt deeply by many of our society. The good of the whole is very much in direct concert with the good of the individual. This creates the opposite perspective on many economic actions, but one still impelled by self-interest. (Leaving aside the Game Theory discussion for the moment.)

I leave that for your reflection with only one additional note. The self-interest of survival ought to engender no less ruthlessness on our parts than that exhibited by the self-interest of those whose world ends at the edge of their skin.

Second point from Bali.

The dispute in Bali seemed to center on equal opportunity to stone our children to death. The U.S. demands its historical rights to foul the common nest. The developing world insists it has not had its full opportunity to pollute.

Pretend for a moment that we need a low carbon replacement for carbon-intensive agriculture and that we need the planting and maintenance of billions of carbon consuming planet regenerator units, aka trees. Suppose we see that we need to replace the current food production method within, say, thirty or forty years with an entirely new method. Not new acreage or sites or substitute fuels for the current method. And entirely new, carbonless method.

If that method were labor-intensive instead of capital intensive, and needed two or three or four decades lead time to come into full production, you would have a compelling rationale for supporting the agrarian economies of the undeveloped world with schools, roads, libraries, intensive R&D in green technology and assistance of all other kinds. A self-interested motive for cooperation.

These conditions exist in exactly this way. Therefore the way to address poverty is exactly the way to support the end of carbon, which is to generate this next agricultural system.

It is a misreading of history to say that the great industrialization of the world drew people from farms to better lives in the city. The great industrialization began on the farms and evicted and continues to evict those working there out over time. The tractors, combines, chemical fertilizers. It was the mechanization and technological alteration of the farm that expelled the population into the cities. If we now find that mechanization, chemicalization and technical complexity is damaging to the planet, then a reversion to technology that is simpler, though more sophisticated in its appreciation of the interrelation of systems, will do nothing but reinvigorate a healthy, prosperous life for billions of people.

Labor market numbers are not credible

It has been a theme of ours that the numbers coming out of the Bush administration do not reflect life on the ground for Americans, particularly the 20% of consumers occupying the bottom half of the population.

The November job numbers came out last week, demonstrating a growth of a much trumpeted 94,000 payroll jobs. This was accompanied by adjectives such as "solid," strong," sometimes "surprisingly strong or solid," and at least "better than expected."

94,000 when the economy needs 150,000 just to tread water is better labeled "tepid" or "weak" and at BEST "better than expected."

But 94,000 jobs were not created.

Dismay has been voiced by, among others, Paul Kasriel, chief economist at the Northern Trust Company of Chicago, who points out that 76 percent of all job growth over the past twelve months has been found in the so-called Birth Death adjustment which attempts to account for 1-5 person businesses going in and out of existence. This corresponds to 36 percent of job growth from these sources in the previous 12-month period.

Similar distrust has been voiced for some time by Michael Shedlock, or Mish, whose blog Mish's Global Economic Trend Analysis is one of the best observers of current economics on the web or anywhere.

For 9 consecutive months the BLS assumed that new unaccounted construction businesses were created in this environment where business spending has been weak, housing has been horrid, and close to 200 lenders have gone out of business or stopped writing loans according to Implode-O-Meter. There is still a lot of catching up to do on those construction assumptions. Eventually we will see higher negative revisions in the months to come. However, I am still struggling with 11 consecutive months of birth death additions to financial services in light of imploded lending. Even though "imploded" does not imply out of business, the number of small 1-5 person shops that have ceased doing mortgage related business has to be staggering. Those numbers are not reflected in Implode-O-Meter stats or in the birth/death model revisions. All things considered, the Birth Death revisions continue to remain in Bizarro World with the model adding 1,239,000 jobs to the economy since February. I do not believe it and neither does the treasury market.

Then we add the commentary. Job growth has been "trending up." Oops, watch the language "Nonfarm payroll employment continued to trend up." If "trend up" means the number got bigger, that is possibly true. As above, possibly not. But if "trend up" means growth is improving, that is demonstrably false.

An EPI report put out on the same day as the BLS numbers demonstrates that growth -- even by official numbers is trending down from over 2 percent in February 06 to 1.4 percent in March 07 and now to approaching 1 percent in November 07. Private payroll growth has trended down even more sharply and is nowless than half its March '06 level.

Underlying this discussion is the question, not of transparency, but of veracity. Clearly the statistical arms of the government are clearing their verbiage with the political arms. The question is whether they are manufacturing the numbers. Private market and public policy analysts have no alternative to official federal numbers. We cannot turn to another provider. Our only choice is to believe or not to believe.

We have seen this administration play fast and loose with national security intelligence to sway public opinion. If the same spin is being applied to the economy, the results could be very bad.

Not being able to believe the data coming out of the BLS and BEA is similar to not being able to believe the accounts of a private corporation. The lost of trust can be an enormous downside risk.