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

Well worth reading.

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Stiglitz: Wall Street Hypocrisy, Business as Usual

In a note available at Project Syndicate, Joseph Stiglitz reminds us of the ineptness, sometimes tragic ineptness, of Wall Street and the IMF. This account bears strikingly synchronous tones to our recent "The Economic Fallacy of Free Trade" in the PolicyIndex.

Ten years after the Asian Currency Crisis ...

.... Looking back at the crisis a decade later, we can see more clearly how wrong the diagnosis, prescription, and prognosis of the IMF and United States Treasury were. The fundamental problem was premature capital market liberalization. It is therefore ironic to see the US Treasury Secretary once again pushing for capital market liberalization in India – one of the two major developing countries (along with China) to emerge unscathed from the 1997 crisis.

It is no accident that these countries that had not fully liberalized their capital markets have done so well. Subsequent research by the IMF has confirmed what every serious study had shown: capital market liberalization brings instability, but not necessarily growth. (India and China have, by the same token, been the fastest-growing economies.) Of course, Wall Street (whose interests the US Treasury represents) profits from capital market liberalization: they make money as capital flows in, as it flows out, and in the restructuring that occurs in the resulting havoc. In South Korea, the IMF urged the sale of the country’s banks to American investors, even though Koreans had managed their own economy impressively for four decades, with higher growth, more stability, and without the systemic scandals that have marked US financial markets with such frequency. ....

The contrast between the IMF/US Treasury advice to East Asia and what has happened in the current sub-prime debacle is glaring. East Asian countries were told to raise their interest rates, in some cases to 25%, 40%, or higher, causing a rash of defaults. In the current crisis, the US Federal Reserve and the European Central Bank cut interest rates.

Similarly, the countries caught up in the East Asia crisis were lectured on the need for greater transparency and better regulation. But lack of transparency played a central role in this past summer’s credit crunch; toxic mortgages were sliced and diced, spread around the world, packaged with better products, and hidden away as collateral, so no one could be sure who was holding what. And there is now a chorus of caution about new regulations, which supposedly might hamper financial markets (including their exploitation of uninformed borrowers, which lay at the root of the problem.) Finally, despite all the warnings about moral hazard, Western banks have been partly bailed out of their bad investments.

Following the 1997 crisis, there was a consensus that fundamental reform of the global financial architecture were needed. But, while the current system may lead to unnecessary instability, and impose huge costs on developing countries, it serves some interests well. It is not surprising, then, that ten years later, there has been no fundamental reform. Nor, therefore, is it surprising that the world is once again facing a period of global financial instability, with uncertain outcomes for the world’s economies.

...

There's more. Read it and weep.

The economic fallacy of "free trade"

The economist's definition of the benefits of trade is based on the concept of comparative advantage:

There will be a net gain to both countries with trade because it allows each country to produce from its comparative advantage, which is that good or goods where it is least inefficient.

A classic example of comparative advantage: Scotland can produce five bales of wool per acre and only a gallon of bad wine per acre. France can produce ten bales of wool per acre or twenty gallons of good wine. France has the absolute advantage in both products, but it still makes sense for both countries for Scotland to trade wool for French wine. Both will end up with a better total product.

From this concept, economists take a great deal of pleasure. It is simple, obvious, and illustrates that economists are enlightened and the public are Luddites. (See Alan Blinder's treatment.)

In fact, there will be a net gain, but there is a big hole in the "net" when the gain is not shared. The hole in this net is big enough to drive one-third of American manufacturing through, and tens of millions of Latinos back the other way.

The experience of trade is different than this economist's dream of stylized facts and frictionless perfection. To say trade is a net benefit, is similar to saying there is enough food on the planet to feed everyone and enough money to provide clean water and health care and then walking away as if everything is fine. The market does not distribute according to need, but according to the power of its participants. And those who bear a great deal of the costs of free trade are often not among the powerful.

We've put up the whole story at the web site.

Rebalancing the global economy

This graph from the UN Dept. of Economic and Social Affairs displays, among other things, the pressure on the dollar. As a so-called "reserve currency," the dollar has become a commodity in itself, and not simply a medium of exchange. As we've written elsewhere, a correction has long been called for by all standard economic theory.

A collapse in the value of the dollar, however, is not the best way to resolve the imbalance, believe it or not. It leaves the rest of the world -- notably China, Japan and other developing nations -- holding the dollar bag. They lent us the money to buy their products. Now we are saying we'll pay them back in cheaper dollars.

The flip side is they depend on our markets for their economic activity. The slide of the dollar means a rise in their currency (unless China continues to starve itself in its obstinance). The UN DESA puts it this way:

A global contraction, triggered by a tight reining in of domestic spending in the United States is one way out, but this is neither what the United States or the rest of the world would hope for. Equally disruptive would be a large and rapid devaluation of the dollar. The alternative is a long- term strategy of re-switching the impetus of global demand growth to surplus economies, mixed with a rebalancing in the United States, from household consumption to business and infrastructural investment.

They correctly suggest free marketeers and their nannies in the central banks have a different notion, a short-term fix of cheap money:

Some commentators still argue that the best chance of the United States economy, and with it the world economy, regaining a degree of balance is to allow the market mechanism to re-price risk, adjust exchange rates and weed out irresponsible investors. Th e decisiveness with which central bankers reacted to the crisis is a clear sign that financial markets cannot be left to their own device and that some form of intervention is necessary. But to spare the world economy from a succession of similar crises, equally decisive action is needed by policy makers to correct the global imbalances.

Business and infrastructure investment is productive and forward-looking. Equally forward-looking would be a wholesale shift to producing new energy technology and equipment as merchandise for trade with the rest of the world. Better and more stable, at least, than producing small green pictures of men in powdered wigs.

This is the rational, cooperative and stable approach. We think it has as much chance as another proposal of similarly broad and coherent view, proposed last year for the calamity in Iraq. That would be the proposal from George McGovern and William R. Polk to rebuild that country from the inside. The tough answers then and the hard-headed answers now will likely take another road. Then into the slough of hell, here into a further feeding of the financial sector. Both result not in stability and a way forward, but in a ratcheting up of the dangers and going further down the wrong road.

GM's shutdowns abetted by Bush budgets

GM's announced shutdown of a dozen plants and layoff of tens of thousands of workers has set off intense handwringing and even more vilification of the corporate giant. Some of it is justified. Some of it is national policy. Universal health insurance would reduce stress on businesses by reducing the cost of benefit for workers, for example. More important is the value of the dollar.

"The de-industrialization of America" is a tag on the Reagan era, when half the auto industry was exported to Japan. It was not a happy time. Fingers were pointed in every direction. Councils on competitiveness were convened. Trade protection was demanded. Then, as now, the cost of the dollar was ignored because it was not understood.

When trade goods are translated through a high dollar, imports are cheaper and exports more expensive. Wal-Mart booms and Hundais rule. The dollar gets higher when the federal government does not balance its budget and has to offer a higher interest rate (price) for debt financing. It is higher, too, when other countries purposely maintain a weak currency.

Dubya's outlandish deficits are even bigger than Reagan's. Balance the budget by returning taxation to the rich. Then let's go to work on a sensible exchange rate system.

PS: Don't be surprised when the Chinese come in and buy up the neighborhood. What else are they going to do with dollars? The greenback doesn't spend good in China. We should be happy our debt isn't denominated in yuans. And notice that Boeing will continue to do well because its competition is in Europe. The dollar is weak against the euro.