Crowding in or crowding out?

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

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

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

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

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

Another debate continues around the multiplier.


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

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

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

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


Compare recessions by percentage of job loss

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

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

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

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

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

Link to Calculated Risk


Economists still hiding out in crumbling efficient market theory

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

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

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

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

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


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

ANDERSON

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

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

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

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

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

James K. Galbraith

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

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

One, and quoting:

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

Two, and continuing to quote:

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

And three, with a final quote:

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

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

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

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

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

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

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

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

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

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

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

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

[and]

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

...

[continuing]

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

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

p. 179-180

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

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

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

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

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

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

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

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

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

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

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

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

Well worth reading.

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

John Maynard Keynes said in one of his more famous quotes: Better to be approximately right than precisely wrong. New Classical economics and its mathematical precision has directed the wagon over the cliff, yet academic institutions prefer the precise to the correct. Another example here from Lynn Parramore.

Shame on the Dame! Notre Dame embraces wrong-headed neo-classical economists, gives others the boot
Lynn Parramore
New Deal 2.0
September 30, 2009

Here’s a story we wish we didn’t have to bring you. It goes like this: In 2003, the conomics department at Notre Dame was split into two separate entities: (1) The Economics and Econometrics department and 2) the Economics and Policy Studies department.

The mainstream neo-classicist folks went over to the Economics and Econometrics department, which emphasized quantitative tools and gave short shrift to the social context of economics. The Econometrics department was about science. A realm of beautiful models and fancy equations. They didn’t really fit reality, but so what? Adopting them could land you a cushy spot in an Ivy League doctoral program and maybe later a job at the Fed. Buy the nonsense; get paid.
The other poor suckers, Post-Keynesians, Marxists, economic historians, and other civic-minded economists interested in labor, poverty, development, critical analysis of flawed economic theory, and other nefarious agendas, became the Economics and Economic Policy deparment.

Then we had a major economic meltdown, an admission from Greenspan himself that his neo-classical economic model was flawed, and a huge number of Americans suffering because of just the kind of thinking the Econometrics department at Notre Dame has been pushing.

Now the university, which has long ago decided that the split was a bad idea, is getting rid of one of the departments. Guess which one? The one filled with economists whose wrong-headed ideas helped create the climate that led to the Great Recession? Nope! The department to be shut down, its faculty scattered to the wind, is the Economics and Policy Studies department.

From the Chronicle of Higher Education:

They [the' heterodox' economists] say that the dissolution would represent an intellectual loss for the university. While Notre Dame once had an economics program that was distinctively shaped by currents in Roman Catholic social thought, they say, it will now be left with a neoclassical department much like the ones at almost every other major university.

“In light of the crash of the economy, you would think there would be some humility among economists, some openness to new approaches,” says Charles K. Wilber, a professor emeritus of economics at Notre Dame. “There’s not a lot.”

Academia is supposed to be place where the best ideas rise to the top. But in the discredited, Alice-in-Wonderland field of economics, things are upside down. There has been little theoretical competition, and much blind-subscription to dangerous ideas that have cost the country enormously.

Appeals are planned to Notre Dame’s president, Rev. John I. Jenkins, but it looks like the dissolution of the Economics and Policy Studies dept. is pretty much a done deal.

Even stranger: Notre Dame makes this move while that the Pope himself has been blasting American-style capitalism for its lack of ethical focus and affronts to human dignity in and at the G-8 meeting in July
Shame on the Dame. Way to be on the wrong side of history.

Nouriel Roubini weighs in on the exit strategy, a topic of high interest. Demand Side does not see an exit into a world we recognize. We came into the theater by the front door, past the neon and polished surfaces. We exit into a dark alley of financial sector institutions who more than ever control their regulators and are guaranteed by the U.S. government, no matter what they do. These are zombies who demand, not companies who serve.

As we've written before, unwinding the toxic assets on the Fed's balance sheet is basically an impossible task. The economy going forward is sapped of vitality by the very projects that kept Great Depression II from arriving. In fact, it is Great Depression II on prozac. No fundamental reform has occurred. Only the mood of the patient has been altered.

Finding the Policy Exit
Nouriel Roubini
Project Syndicate
September 22, 2009

NEW YORK – There is a general consensus that the
massive monetary easing, fiscal stimulus, and support of the financial system
undertaken by governments and central banks around the world prevented the deep
recession of 2008-2009 from devolving into Great Depression II. Policymakers
were able to avoid a depression because they had learned from the policy
mistakes made during the Great Depression of the 1930’s and Japan’s near
depression of the 1990’s.

As a result, policy debates have shifted to arguments about what the
recovery will look like: V-shaped (rapid return to potential growth), U-shaped
(slow and anemic growth), or even W-shaped (a double-dip). During the global
economic free fall between the fall of 2008 and the spring of 2009, an L-shaped
economic and financial Armageddon was still firmly in the mix of plausible
scenarios.

The crucial policy issue ahead, however, is how to time and sequence
the exit strategy from this massive monetary and fiscal easing. Clearly, the
current fiscal path being pursued in most advanced economies – the reliance of
the United States, the euro zone, the United Kingdom, Japan, and others on very
large budget deficits and rapid accumulation of public debt – is unsustainable.

These large fiscal deficits have been partly monetized by central
banks, which in many countries have pushed their interest rates down to 0% (in
the case of Sweden to even below zero), and sharply increased the monetary base
through unconventional quantitative and credit easing. In the US, for example,
the monetary base more than doubled in a year.

If not reversed, this combination of very loose fiscal and monetary
policy will at some point lead to a fiscal crisis and runaway inflation,
together with another dangerous asset and credit bubble. So the key emerging
issue for policymakers is to decide when to mop up the excess liquidity and
normalize policy rates – and when to raise taxes and cut government spending
(and in which combination).

The biggest policy risk is that the exit strategy from monetary and
fiscal easing is somehow botched, because policymakers are damned if they do and
damned if they don’t. If they have built up large, monetized fiscal deficits,
they should raise taxes, reduce spending, and mop up excess liquidity sooner
rather than later.

The problem is that most economies are now barely bottoming out, so
reversing the fiscal and monetary stimulus too soon – before private demand has
recovered more robustly – could tip these economies back into deflation and
recession. Japan made that mistake in 1998-2000, just as the US did in
1937-1939.

But, if governments maintain large budget deficits and continue to
monetize them as they have been doing, at some point – after the current
deflationary forces become more subdued – bond markets will revolt. When that
happens, inflationary expectations will mount, long-term government bond yields
will rise, mortgage rates and private market rates will increase, and one would
end up with stagflation (inflation and recession).

So how should we square the policy circle?

First, different countries have different capacities to sustain public
debt, depending on their initial deficit levels, existing debt burden, payment
history, and policy credibility. Smaller economies – like some in Europe – that
have large deficits, growing public debt, and banks that are too big to fail and
too big to be saved may need fiscal adjustment sooner to avoid failed auctions,
rating downgrades, and the risk of a public-finance crisis.

Second, if policymakers credibly commit – soon – to raise taxes and
reduce public spending (especially entitlement spending), say, in 2011 and
beyond, when the economic recovery is more resilient, the gain in markets’
confidence would allow a looser fiscal policy to support recovery in the short
run.

Third, monetary policy authorities should specify the criteria that
they will use to decide when to reverse quantitative easing, and when and how
fast to normalize policy rates. Even if monetary easing is phased out later
rather than sooner – when the economic recovery is more robust – markets and
investors need clarity in advance on the parameters that will determine the
timing and speed of the exit. Avoiding another asset and credit bubble from
arising by including the price of assets like housing in the determination of
monetary policy is also important.

Getting the exit strategy right is crucial: serious policy mistakes
would significantly heighten the threat of a double-dip recession. Moreover, the
risk of such a policy mistake is high, because the political economy of
countries like the US may lead officials to postpone tough choices about
unsustainable fiscal deficits.

In particular, the temptation for governments to use inflation to
reduce the real value of public and private debts may become overwhelming. In
countries where asking a legislature for tax increases and spending cuts is
politically difficult, monetization of deficits and eventual inflation may
become the path of least resistance.

The Consumer Protection Agency for financial products is a non-intrusive way of getting fairness and transparency into the market, of making the market work. This is, of course, not what the big boys want. Much more can be made if they control the information, create products only they understand, and market in opaque venues. So they are fighting it. Much more, it seems, than they are fighting the intrusive big brother Fed approach. Here are Simon Johnson and James Kwak.

It's Crunch Time: The Fight to Fix the Financial System Comes Down to This:
by Simon Johnson and James Kwak
September 29, 2009
Washington Post
The next couple of months will be crucial in determining the shape of the financial system for decades to come. And so far, the signs are not encouraging.

The Obama administration is trying to refocus our attention on regulation, beginning with the president's speech in New York two weeks ago. ... Barney Frank, chairman of the House Financial Services Committee, says that he still plans to pass a regulatory reform bill before the end of the year.

But in a clear indication of trouble ahead, Frank signaled his intention last week to scale back the proposed Consumer Financial Protection Agency, one of the pillars of the administration's reform proposals. ...

We have criticized the administration's reform proposals, in particular for not going far enough to address the problem of financial institutions that are "too big to fail." But we support much of what was in the original package... The question now is how hard Obama and Geithner will fight for it.

Financial regulation, like health care reform, has entered the phase where speeches and proposals matter less than arm-twisting and horse-trading on Capitol Hill. With health care, President Obama attempted to go over the heads of Congress, directly to the American people. With financial regulation, that is no longer an option, given the extent to which it has faded from public consciousness. Instead, the administration is playing on the home turf of the banking industry and its lobbyists. ... Is Obama up for this fight? ...

Elections have consequences, people used to say. This election brought in a popular Democratic president with reasonably large majorities in both houses of Congress. The financial crisis exposed the worst side of the financial services industry to the bright light of day. If we cannot get meaningful financial regulatory reform this year, we can't blame it all on the banking lobby.

Bruce Judson points out continuing income inequality

Income inequality according to Hyman Minsky is a source of instability in the system. Demand Side has been among those expecting a decrease in income inequality as a result of the destruction of asset values. We may have been premature. Here Bruce Judson lines up the evidence that inequality is a continuing concern.

New Income Inequality Data: Surprising and Frightening
by Bruce Judson
September 29th, 2009

The newest economic inequality numbers, which ran counter to the expectations of almost all experts, are frightening. Yesterday, the Associated Press released an article titled, US income gap widens as poor take hit in recession. The opening paragraph of the article, based on recent census data, reads:

The recession has hit middle-income and poor families hardest, widening the
economic gap between the richest and poorest Americans as rippling job layoffs
ravaged household budgets.

The article, which then discussed the Census statistics that led to this conclusion, failed to mention that the Census Bureau considered the differences between 2007 and 2008, with regard to economic inequality, statistically insignificant.

But, whether the Census Data shows a meaningful increase, or not. is irrelevant. The Census Data reports that, contrary to the almost universal expectations of economists, economic inequality most likely did not decrease in 2008. Experts had anticipated that the declines in income of the rich would lead to a reversal in this groups ever–widening share of our national income. Instead, the Census reported that the 2008 income losses by the top 10% of Americans were offset by larger losses among middle class and poorer Americans.

Let’s review what we know about the measurement of income inequality before discussing the disturbing implications of this newest government report.

About two weeks ago, I critiqued a Sept 10, 2009 front page story in the Wall Street Journal titled, Income Gap Shrinks in Slump at the Expense of the Wealthy. My critique had three central points:

First, economists have, with few exceptions, agreed that Census Data is inappropriate for measuring income inequality because it consistently understates the income of the wealthiest families. To protect the privacy of reporting individuals, the Census “top-codes” income, which means that no one is ever recorded as making more than about $1.1 million in a single year. So, oil traders, hedge fund executives and anyone else at the super-high end of the income strata who might earn $100, $50 or $5 million in a single year, always earn $1.1 million or less in this Census Data. In addition, the Census Data does not include capital gains income, which is typically a large source of income for the wealthiest Americans.

Two economists, Professors Emmanuel Saez and Thomas Piketty, developed a method for measuring income inequality using IRS data, which avoided the problems inherent in using Census Data. This data was recently updated in response to the IRS release of 2007 information, and found that: Economic inequality in 2006 was, by some measures at the highest levels, ever found in the data available for the past 95 years. In 2007, these same measure showed a further jump further bringing America to it it’s highest levels of economic inequality in recorded history.

As a consequence of Census top-coding and the lack of capital gains data, the Saez-Piketty methodology has consistently shown that the Census substantially understates the extent of economic inequality in the nation. This means that, there is a real possibility that the the new Census Data understated the extent to which income inequality grew in 2008, and that the relative losses of the wealthiest families, versus less fortunate Americans, will be more than statistically insignificant.

It is possible that losses in reported capital income by the wealthiest Americans, if captured by the Saez-Piketty methodology, will be larger than the the incomes above $1.1 million that were not reported and offset the Census findings, leading as economists anticipated to a decline in the share of income going to the rich. However, I view this as unlikely. In considering this possibility, its important to remember that the IRS works on reported income gains, not gains which were never captured as taxable income. For income reporting purposes, the question is not whether the market value of capital assets declined but whether they were sold at an actual loss from their purchase price.

We will not know the answer to this question until July or August 2010, but in weighing the available evidence my working hypothesis is that as demonstrated by this new Census Report, income inequality did not decrease from 2008 to 2007.

Second, the original Journal article expressed a strong expectation that, as a result of the Great Recession, the ongoing growth of income inequality would decline substantially through 201o. My critique indicated that this was “far from clear.” The conventional economic wisdom, based on historical data, is that income inequality decreases, at least temporarily, as the richest Americans lose income faster than less-well-off Americans during a downturn. In contrast, this new data suggests that the dangerous cycle toward increasing income at the top of America has become even more self-reinforcing than previously recognized. We are now at the point where the pure market forces, which many economists told us would eliminate this issue, are no longer effective.

Third, the Journal article implied that the decrease in economic inequality it incorrectly predicted might be the start of a long-term trend. Instead, I demonstrated that, even if income inequality did decline in 2008 and 2009, it would almost certainly be “temporary.” The historical evidence shows that economic inequality frequently declines in a downturn, in the absence of strong government action, but that it will almost inevitably rebound and continue its march forward.

Now, let’s return to our main point:

Early next week, my new book It Could Happen Here will be released by HarperCollins. The book is an in-depth look , based on a historical analysis, of the implications of our historically high levels of economic inequality for the nation’s ultimate, long-term political stability. As economic inequality grows, nations invariably become increasingly politically unstable: Should we complacently believe that America will be different?

A central conclusion of the book is that once economic inequality reaches a self-reinforcing cycle it is halted only by inevitably controversial, hard-fought, bitterly opposed government action. Senator Jim Webb encapsulated this idea, when he wrote in his book, A Time to Fight: Reclaiming A Fair and Just America:

“No aristocracy in history has decided to give up any portion of its power
willingly.”

In 1928, economic inequality was near today’s levels. Franklin Roosevelt succeeded in reversing the trend toward the continuing concentration of wealth, but it was a turbulent battle. In 1936, while campaigning for his second term and speaking at Madison Square Garden, FDR told the crowd:

“Never before in all our history have these forces [Organized Money] been so united against one candidate as they stand today. They are unanimous in their hate for me and I welcome their hatred.

I should like to have it said of my first Administration that in it the forces of selfishness and of lust for power met their match. I should like to have it said, wait a minute, I should like to have it said of my second Administration that in it these forces met their master.”

In FDR’s era and in our own, money brings power: both explicitly and implicitly, in hundreds of different ways, both large and small. Today, the wealthiest Americans, together with a number of financial and corporate interests that act on their behalf, protect their ever-increasing influence through activities that include, among others, lobbying, supplying expertise to the councils of government, casual conversation at dinner parties, the potential for jobs after government service, the power to run media advertisements that influence public opinion. Indeed, MIT economist Simon Johnston, writing in The Atlantic asserted that the U.S. is now run by an oligarchy:

The great wealth that the financial sector created and concentrated [ from 1983 to 2007] gave bankers enormous political weight–a weight not seen in the U.S. since the era of J.P. Morgan (the man) … Of course, the U.S. is unique. And just as we have the world’s most advanced economy, military, and technology, we also have its most advanced oligarchy.

The new inequality data suggests that the potential problems for the nation associated with the concentration of wealth and power are even more severe than previously recognized. Two weeks ago, I wrote that “Once income concentration becomes a reinforcing cycle of the kind we are witnessing, it is never stopped by pure market forces.” This mechanism is now in full swing. The market forces associated with the Great Recession, which many economist had expected to stem the growing, corrosive gap between the rich and the poor, appear to have become ineffective.

The great strength of American democracy has always been its capacity for self-correction. However, Robert Dahl, the eminent political scientist, recognized that political power fueled by wealth may ultimately neutralize this central aspect of our democracy. In his 2006 book, On Political Equality, Dahl wrote:

As numerous studies have shown, inequalities in income and wealth are likely to
produce other inequalities..

The unequal accumulation of political resources points to an ominous possibility: political inequalities may be ratcheted up, so to speak, to a level from which they cannot be ratcheted down.

The cumulative advantages in power, influence, and authority of the more privileged strata may become so great that even if less privileged Americans compose a majority of citizens they are simply unable, and perhaps even unwilling, to make the effort it would require to overcome the forces of inequality arrayed against them.

In the chapter following this quote, Dahl notes “that we should not assume this future is inevitable.” He’s right. But, was clearly concerned. Three years late, we should be even more concerned.

Many current Executive Branch initiatives deserve our support and praise: However, nothing proposed to date will effectively halt growing economic inequality, and its corrosive impact on our economy and the long-term future of the nation. (In a future post, I will explicitly discuss the proposed regulatory reform of the financial sector.)

My analysis in It Could Happen Here concludes that without a vibrant middle class, the the American democracy as we know it, is not sustainable. Before the Great Recession, the middle class was in far worse shape than was generally acknowledged. In an economy with a record number of job seekers for every available job, the potential for nearly one-half of all home mortgages to be underwater, and increasing foreclosures, the collapse of the middle class will accelerate. With each job loss and each foreclosure, another family becomes a member of the former middle class.

America has never been a society sharply divided between have’s and have not’s. Unfortunately, this new data says to me we continue to head in that direction. Economists assumed that the Great Recession would be a circuit breaker that would halt this advance, at least temporarily. It did not.

With no new legislation, it appears we are potentially on course for 13 million foreclosures, almost one in every four mortgages in the nation, from the end of 2008 through 2014. Do we really believe that we can turn such huge numbers of Americans out of their homes with no consequences for the health of our system of governance? Could our democracy survive a transformation into a nation composed principally of a privileged upper class and an underclass which struggles from paycheck to paycheck and lacks basic economic security?

We will only stop the growth of economic inequality if the President and the Congress are ready to fight in the style of Franklin Roosevelt. FDR was a divider not a conciliator. Before World War II, he fought an all-out war at home. Today, “There’s class warfare, all right,” as Warren Buffett said, “but it’s my class, the rich class, that’s making war, and we’re winning.”

I fervently hoped that we have not passed the point of no return, described by Professor Dahl. The recent news shows we are one step further on this road. If we continue down it, our nation may be on the path to becoming a House divided against itself, which ultimately cannot stand.