Podcast transcript 07.21.09 Housekeeping: GDP, VAR, CPI, ETC.

Call this the slick page edition.

First,

I think we've finally settled on a useful format for the blog. On each of the off days from putting up the transcript of the Demand Side podcast, we've been putting up a single useful piece from the demand side perspective. We don't have time to read as much as we want to, much less translate it back to our readers. Besides which, Calculated Risk, the Economist's View, and others like Brad DeLong do it better than we could.

Our one-piece-per-day service on the blog will hopefully be useful for those who want to get meat without picking through a lot of bones. Five pieces per week plus what you're listening to now in more or less transcript form. DEMANDSIDEBLOG.BLOGSPOT.COM

This week, for example, on the blog we see a couple of pieces connected to print magazines. One from Newsweek asking why Joseph Stiglitz is not at the key adviser's table at the White House. Another from Brad DeLong looks at this week's Economist newspaper's examination of economists, an exercise in the pot calling the kettle black.

We relay a piece from Project Syndicate by the great man himself, Joseph Stiglitz, entitled "The UN Takes Charge." Previous to that are selections from Dr. James Hansen, Paul Krugman, Jeffrey Sachs and others. We hope it is useful.

If you want a list of the economists who did badly, go to the link in the transcript which identifies those signing an open letter or petition for Fed independence. As we've reported before, the fear that the Fed will lose its independence ignores the fact that the Fed is captive to the financial industry. So when we hear "independence," we mean independent from the representative government that must back up its actions.

Historically, since it achieved independence in the middle of the night in 1951, with the so-called Treasury Accord, the Fed has operated for the benefit of what Keynes would call the rentiers, keeping interest rates on the plus side and pulling out all the stops to hammer inflation whenever it could. In fact, a huge premium on debt service has been paid by the taxpayer over what would have been paid with the prior regime. This is one reason the current massive deficits will be much more difficult to pay off than the massive deficits of World War II.

Continuing this theme on the next podcast we will have Robert Eisebeis, formerly of the Atlanta Fed and elsewhere in mainstream economics, continuing to pound the table for his orthodoxy after everybody has left the room. That's on the next idiot of the week. A two-fer this week.

because we have our first repeat winner.

A couple of weeks ago I commented that I had not followed the charts very well in my forecast update piece. Aha! I didn't even get them up on the web site . I win! The coveted first repeater on idiot of the week. Those charts are halfway up now. Thanks to one of our listeners, Greg F, for pointing that out. And one of our more energetic listeners took me up on the challenge to research productivity and the hypothesis that much of the change comes from the price of oil and some of it comes from tight labor markets. Thank you, Alex.

In six months we will have the definitive statement, or we will have had a good time trying to get it.


On health care reform:

Faiz Shakir reminds us that this is the explicit strategy of some in the GOP:

A strategy memo authored by GOP consultant Alex Castellanos suggests that “it is crucial for Republicans to slow down what it calls ‘the Obama experiment with our health.’” The memo concludes, “If we slow this sausage-making process down, we can defeat it, and advance real reform that will actually help.”

Peter Orzag on CNBC said it this way.

ORZAG

It should be a line in the sand, from point A: the public option -- to point B -- done deal by September. We cannot afford to carry inefficient corporate health care into the future. It is a public good and should be treated that way.

Now

Industrial Production Declines, Capacity Utilization at Record Low in June
from Calculated Risk

The Federal Reserve reported:

Industrial production decreased 0.4 percent in June after having fallen 1.2 percent in May. For the second quarter as a whole, output fell at an annual rate of 11.6 percent, a more moderate contraction than in the first quarter, when output fell 19.1 percent. Manufacturing output moved down 0.6 percent in June, with declines at both durable and nondurable goods producers. ... The rate of capacity utilization for total industry declined in June to 68.0 percent, a level 12.9 percentage points below its average for 1972-2008. Prior to the current recession, the low over the history of this series, which begins in 1967, was 70.9 percent in December 1982.

From the Census Bureau:

On a seasonally adjusted basis, the CPI-U increased 0.7 percent in June after rising 0.1 percent in May. The acceleration was largely caused by the gasoline index, which rose 17.3 percent in June and accounted for over 80 percent of the increase in the all items index.
...
The index for all items less food and energy rose 0.2 percent in June following a 0.1 percent increase in May.
...
The index for shelter rose 0.1 percent for the second straight month, as did the indexes of two of its major components, rent and owners' equivalent rent.

CPI is now off 1.2% year-over-year (YoY) - the largest YoY decline since the 1950s, but core CPI is up 1.7%.

Meanwhile owners' equivalent rent (OER) is up 1.9% year-over-year, although only up 0.1% in June. I expect OER to decline soon.

From Reuters

July 16th, 2009
Goldman, liquidity and VAR
Posted by: John Kemp

Goldman Sachs’ second-quarter earnings release showed a continued increase in the amount of market risk held on the firm’s trading book. Its risk appetite has continued to expand at a time when extreme turbulence has forced others to scale back.

True, Goldman’s publicly reported figures may overstate its actual positions. But the Wall Street bank also appears to be taking advantage of its access to liquidity from the Federal Reserve to increase risk.

Total value-at-risk (VAR) averaged $344 million, on a gross basis before diversification effects, up from $303 million in the second quarter of 2008 and $226 million in the second quarter of 2007.

(VAR is a crude measure of the worst loss the firm would expect to report on 19 days out of 20, given prevailing volatility in the market.)

We have the whole Reuters piece in the blog's transcript.

This is confirmation of our characterization of the Fed's actions as providing more chips to the players, nothing for the real economy.

Beyond this, VAR should have been buried along with the financial collapse, because it failed so well. No wonder Nassim Taleb is crazy.

[Reuter's story continues after the podcast transcript for those wishing to read it]


Why doesn't the real economy get any of the cheap money.

Here from the New Republic

The real problem is that borrowing is down. According to the Fed, during the first quarter of 2009, private borrowing by households declined by 1.1 percent and by nonfinancial businesses by 0.3 percent. Net borrowing--the funds borrowed minus those repaid--was down $151.8 billion for households and $28.3 billion for businesses. If individuals are spending part of their earnings paying off credit-card debts or student loans rather than buying a home or car on credit, and if businesses are using their profits to pay off debts rather than to invest, then the economy is going to shrink. The question is what accounts for this decline in borrowing.

The usual answer is that the banks don't have the money to loan, or the capital to absorb losses on existing or new loans. But much of the money they loan is not from deposits (which, incidentally, have been rising), or from interest made on loans, but rather money they themselves have borrowed at lower interest rates than they plan to charge. With federal interest rates near zero, banks are able to borrow money cheaply and lend it to individuals and businesses at very attractive rates. Even with old loans weighing them down, the banks' risk of losing money on new loans has been substantially reduced.

Could the problem, then, be with the borrowers rather than the lenders? That's the answer given by Richard C. Koo, the chief economist of the Tokyo-based consulting firm Nomura Research Institute, in a new book, The Holy Grail of Macro-Economics: Lessons from Japan's Great Recession. Koo argues that the Great Depression of the 1930s, Japan's 15-year recession beginning in the 1990s, and our current downturn are examples of "balance-sheet recessions."

During balance-sheet recessions, individuals are reluctant to spend, and businesses are more worried about paying down their debts than maximizing their profits, wary of expanding their output at a time when there's little demand for their products. So individuals save money and businesses stop borrowing it even when interest rates, which normally spur such activity, approach zero. And this is pretty much what happened in the 1930s and more recently in Japan.

During the Great Depression, Franklin Roosevelt's initial reforms stemmed the financial crisis, but they by no means revived the overall economy. The private debt of non-financial businesses and individuals fell from $129.6 billion in 1929 to $100.6 billion in 1939. The reason that the rate of unemployment fell at all during this period and that economic growth picked up was because the increase in public debt--from $20 billion in 1930 to $108.7 billion in 1939--compensated for the decline in private lending.

And this brings us back to the Demand Side point. Businesses will not borrow when there is gross overcapacity, as we led with today. There are no productive investments to make in any event, with no strong demand in the offing. Individuals will not borrow when they are saving for retirement or against an uncertain future. Only government can borrow with the object of increasing value in the society.

They should. They will have to.

David Cay Johnston has a column at the Nation

look at it. He is up first with how Dems have created more jobs

not fair to start with 1940, since the war was a different time.

Also up on the blog later this week will be Robert Kuttner's latest piece, Smoking the Green Shoots, which begins with the question: Where is the economic recovery going to come from?

Now we leave you a clip from the other great man himself, John Maynard Keynes.

KEYNES

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[Continuation of the Reuter's piece on VAR and Goldman Sachs]

Like other banks, Goldman reports VAR on a net basis after taking account of a “diversification effect”. The diversification effect reflects the fact that risks in different parts of Goldman’s book are not perfectly correlated.

The bank would not expect to lose the maximum amount on all its positions at the same time. So net VAR for the book as a whole is less than the sum of the VARs for the individual components (which Goldman reports as currencies, interest rates, equities, and commodities). Goldman’s net VAR in the second quarter averaged $245 million, up from $184 million in the second quarter of 2008 and $133 million in the second quarter of 2007.

How Much Risk?

Banks understandably prefer to focus on the smaller net figure, but when looking at the amount of market risk on a bank’s book, gross VAR is arguably more useful. The whole point of a crisis is that when it hits, contagion ensures that previously uncorrelated asset classes move in the same direction, and the diversification effect disappears. So it is dangerous to rely too much on the diversification effect to reduce overall risk.

Interestingly, Goldman has been forced to reduce its reported diversification effect from $119 million to $99 million over the last twelve months as correlations have increased, reducing the benefit it receives from diversifying its portfolio, even though the overall trading book appears to have grown.

But whether we use net or gross VAR, Goldman’s risk taking has risen by 50-80 percent over the last two years. Even during the last 12 months, as the financial system has suffered its worst crisis since the 1930s, net VAR is up by 33 percent while the gross figure has risen 14 percent.

Adding Risk in Rates

The additional risk has been added very selectively. All the additional VAR is reported in the firm’s interest rate sector, where the average daily VAR has risen $61 million (42 percent) from $144 million to $205 million. For other components (currencies, equities and commodities) average daily VAR is mostly flat or lower over the last year.

The question is why Goldman has continued to grow its risk-taking even as others have found it prudent to reduce market risk, and why all the extra risk has been added in the fixed income area, when the firm has held the line on risk-taking in other asset classes?

Answers must remain speculative because the firm reports only the minimum detail on average daily VAR by categories required by the Securities and Exchange Commission in its earnings statements and quarterly 10-Q filings.

In the past, though, most changes in Goldman’s VAR have appeared at least partly endogenous. In other words, when the underlying volatility in an asset class has increased, Goldman has preferred to “accommodate” it by allowing traders to continue running positions of roughly the same size, even if total risk is higher, rather than forcing them to cut back positions to keep the VAR level the same.

There is some evidence that the increase in rates VAR was at least partly endogenous in this case. Volatility was especially high in the rate sector during the first two quarters of 2009, as the market struggled to balance hopes of recovery and additional stimulus against fears for continuing recession or an early tightening of monetary policy.

Volatility was far higher than in other asset classes. Goldman may have followed past practice and decided to “accommodate” it rather than push back — especially if the firm concluded its activity in the rates segment was profitable, and that forcing position cuts would weaken its ability to provide liquidity to its customers.

Risk - but Over What Horizon?

That still leaves the question why Goldman felt comfortable allowing VAR to rise so much. One explanation is that the firm is comfortable it can rely on the Greenspan/Bernanke put, now enhanced by its access to the Fed’s discount window as a member of the Federal Reserve System, to limit downside risks in the event of a crisis.

In effect, the put allows the firm to ignore the worst “tail risks”. The firm can ramp up risk-taking confident in the knowledge it will be shielded from the very worst outcomes by the government.

The other explanation has to do the limitations of VAR, and particularly what time horizon to use when measuring volatility.

Like its peers, Goldman publishes VAR on a one-day basis, reflecting price changes from one evening’s close to the next.

But there is nothing special about a one-day horizon (and in some ways it is a very unrealistic measure of risk since a large financial institution would find it impossible to exit all its positions over such a short period).

In practice, banks calculate a whole series of VARs for different time horizons, though only the one-day figures are currently disclosed. VARs for longer horizons (one week, 10 days, one month etc) may paint a very different picture of risk in a trading book. When markets exhibit strong trending behaviour, with many small daily changes cumulating in a consistent direction, VAR will be higher when evaluated over longer horizons. But when markets are choppy and directionless, with large one-day changes frequently reversed the following session, VAR will be higher over a shorter horizon.

The first quarter saw precisely these choppy trading conditions in the interest rate sector. The volatility in asset price changes was much smaller when measured over a five-day
period than over the course of single trading session.

Benefit of Unlimited Liquidity

In the circumstances, Goldman’s risk-managers may have decided that the one-day VAR overstated the true risk of loss in the firm’s book and decided to focus on VAR levels evaluated over longer periods, which showed less build-up of risk.

That approach would be sensible for assets the firm intended to hold for more than a single day. The only reason to evaluate VAR over very short periods (daily, hourly) is if liquidity becomes an issue and the firm was not sure it could absorb large one-day profit and loss (P&L) swings and meet margin calls.

But once the firm was sure of unlimited liquidity from the central bank, it could afford to “look through” the one-day P&L swings, holding loss-making positions and waiting for the market to reverse them in coming days.

In one sense, Goldman’s access to unlimited Fed liquidity increased its capacity to absorb short term volatility and conferred a competitive advantage over other institutions, such as hedge funds, that do not have the same access to central bank funding. Armed with a Fed credit line, Goldman understood the risks in its book were smaller than the crude one-day VAR indicated, and could increase apparent risk-taking on this measure without any increase in the real danger to the firm.

The moral is that the basic one-day VAR figures being disclosed by Goldman Sachs and other financial firms in their SEC filings provide a very limited — and potentially misleading — indication of the true amount of risk they are running.

In a world of limited liquidity, VAR measures may substantially understate the true risk. But once central banks step in as market-makers of last resort and guarantee firms against failure arising from liquidity rather than solvency, the one-day VAR measure probably overstates the degree of risk and banks are comfortable ramping it up.

Brad DeLong on the sad state of economics and the Economist

In its July 18 print edition, the Economist magazine goes after the economics profession, in What Went Wrong with Economics.

While this has been a theme of ours at Demand Side for some time, we suspect the Economist is attempting to cover its own incompetence itself in predicting anything further out than last month.

Brad DeLong takes the trouble to read the magazine and offers the following. He bogs down at the quantity theory of money, but the summary is useful.

But the Economics Profession Right Now *Is* Useless...

The Economist gives us economists too much credit. It writes:

In... the idea that economics as a whole is discredited... backlash has gone far too far.... Economics is less a slavish creed than a prism through which to understand the world...

I would like to draw a distinction between economics as a way of thinking--the way good economists think, at least--and academic economics as a profession. Economics as a way of thinking is, I believe, still very valuable. But academic economics as a profession has proven itself to be not valuable at all in this financial crisis. As the Economist writes later on:

the financial crisis has blown apart the fragile consensus... [about] monetary policy... [because] in a banking crisis monetary policy works less well. With their compromise tool useless, both sides have retreated to their roots, ignoring the other camp’s ideas. Keynesians, such as Mr Krugman, have become uncritical supporters of fiscal stimulus. Purists are vocal opponents. To outsiders, the cacophony underlines the profession’s uselessness...

In my view, when you have Nobel Memorial Prize-caliber economists like Arizona State's Edward Prescott, Chicago's Robert Lucas and Eugene Fama, and Harvard's Robert Barro claiming that there are valid theoretical arguments proving that fiscal stimulus simply cannot work, not even in a deep depression--even though they cannot enunciate such theoretical arguments coherently--it is entirely fair for outsiders to conclude that academic economics as a profession is useless.

And I for the life of me cannot see what the arguments of the "purists" are. The basic quantity theory of money:

(M/P) * V(i) = Y

tells us that output depends on (a) the real money stock M/P, and (b) the velocity of money V, which (c) is an increasing function of the short-term nominal interest rate on government securities i. Fiscal policy--government deficits--change the quantity supplied of government bonds, and by supply-and-demand things that change the quantity of something change its price, and the price of government bonds is this interest rate i. It is true that Robert Barro has an argument that deficits caused by tax-law changes create offsetting changes in desired savings that neutralize the effect of increasing the supply of government bonds, but I know of no argument that claims the same for deficits caused by government-spending changes unless the goods the government buys and distributes with its spending are perfect substitutes for private consumption expenditures.

Some more context:

Economics: What went wrong with economics: OF ALL the economic bubbles that have been pricked, few have burst more spectacularly than the reputation of economics itself. A few years ago, the dismal science was being acclaimed as a way of explaining ever more forms of human behaviour, from drug-dealing to sumo-wrestling. Wall Street ransacked the best universities for game theorists and options modellers. And on the public stage, economists were seen as far more trustworthy than politicians. John McCain joked that Alan Greenspan, then chairman of the Federal Reserve, was so indispensable that if he died, the president should “prop him up and put a pair of dark glasses on him.”

In the wake of the biggest economic calamity in 80 years that reputation has taken a beating.... [T]heir pronouncements are viewed with more scepticism than before. The profession itself is suffering from guilt and rancour. In a recent lecture, Paul Krugman, winner of the Nobel prize in economics in 2008, argued that much of the past 30 years of macroeconomics was “spectacularly useless at best, and positively harmful at worst.” Barry Eichengreen, a prominent American economic historian, says the crisis has “cast into doubt much of what we thought we knew about economics.”...

[T]wo central parts of the discipline—macroeconomics and financial economics—are now, rightly, being severely re-examined.... There are three main critiques: that macro and financial economists helped cause the crisis, that they failed to spot it, and that they have no idea how to fix it. The first charge is half right. Macroeconomists, especially within central banks, were too fixated on taming inflation and too cavalier about asset bubbles. Financial economists, meanwhile, formalised theories of the efficiency of markets, fuelling the notion that markets would regulate themselves and financial innovation was always beneficial. Wall Street’s most esoteric instruments were built on these ideas.

But economists were hardly naive believers in market efficiency. Financial academics have spent much of the past 30 years poking holes in the “efficient market hypothesis”. A recent ranking of academic economists was topped by Joseph Stiglitz and Andrei Shleifer, two prominent hole-pokers. A newly prominent field, behavioural economics, concentrates on the consequences of irrational actions.... But as insights from academia arrived in the rough and tumble of Wall Street, such delicacies were put aside. And absurd assumptions were added.... The charge that most economists failed to see the crisis coming also has merit. To be sure, some warned of trouble. The likes of Robert Shiller of Yale, Nouriel Roubini of New York University and the team at the Bank for International Settlements are now famous for their prescience. But most were blindsided. And even worrywarts who felt something was amiss had no idea of how bad the consequences would be....

Macroeconomists also had a blindspot.... Their framework reflected an uneasy truce between the intellectual heirs of Keynes, who accept that economies can fall short of their potential, and purists who hold that supply must always equal demand. The models that epitomise this synthesis--the sort used in many central banks--incorporate imperfections in labour markets (“sticky” wages, for instance, which allow unemployment to rise), but make no room for such blemishes in finance. By assuming that capital markets worked perfectly, macroeconomists were largely able to ignore the economy’s financial plumbing. But models that ignored finance had little chance of spotting a calamity that stemmed from it.

What about trying to fix it? Here the financial crisis has blown apart the fragile consensus between purists and Keynesians that monetary policy was the best way to smooth the business cycle. In many countries short-term interest rates are near zero and in a banking crisis monetary policy works less well. With their compromise tool useless, both sides have retreated to their roots, ignoring the other camp’s ideas. Keynesians, such as Mr Krugman, have become uncritical supporters of fiscal stimulus. Purists are vocal opponents. To outsiders, the cacophony underlines the profession’s uselessness....

[T]here is a clear case for reinvention, especially in macroeconomics.... [A] broader change in mindset is still needed. Economists need to reach out from their specialised silos: macroeconomists must understand finance, and finance professors need to think harder about the context within which markets work. And everybody needs to work harder on understanding asset bubbles and what happens when they burst. For in the end economists are social scientists, trying to understand the real world. And the financial crisis has changed that world.

The other-worldly philosophers: [M]acroeconomists were not wholly complacent. Many of them thought the housing bubble would pop or the dollar would fall. But they did not expect the financial system to break. Even after the seizure in interbank markets in August 2007, macroeconomists misread the danger. Most were quite sanguine about the prospect of Lehman Brothers going bust in September 2008.

Nor can economists now agree on the best way to resolve the crisis. They mostly overestimated the power of routine monetary policy (ie, central-bank purchases of government bills) to restore prosperity. Some now dismiss the power of fiscal policy (ie, government sales of its securities) to do the same. Others advocate it with passionate intensity.... For Mr Krugman, we are living through a “Dark Age of macroeconomics”, in which the wisdom of the ancients has been lost.

What was this wisdom, and how was it forgotten? The history of macroeconomics begins in intellectual struggle. Keynes wrote the “General Theory of Employment, Interest and Money.”... [The] classical mode of thought held that full employment would prevail, because supply created its own demand... whatever people earn is either spent or saved; and whatever is saved is invested in capital projects. Nothing is hoarded, nothing lies idle. Keynes... [thought] investment was governed by the animal spirits of entrepreneurs, facing an imponderable future. The same uncertainty gave savers a reason to hoard their wealth in liquid assets, like money, rather than committing it to new capital projects. This liquidity-preference, as Keynes called it, governed the price of financial securities and hence the rate of interest. If animal spirits flagged or liquidity-preference surged, the pace of investment would falter, with no obvious market force to restore it. Demand would fall short of supply.... The Keynesian task of “demand management” outlived the Depression, becoming a routine duty of governments... aided by economic advisers.... [T]heir credibility did not survive the oil-price shocks of the 1970s. These condemned Western economies to “stagflation”, a baffling combination of unemployment and inflation, which the Keynesian consensus grasped poorly and failed to prevent.

The Federal Reserve, led by Paul Volcker, eventually defeated American inflation in the early 1980s, albeit at a grievous cost to employment. But victory did not restore the intellectual peace. Macroeconomists split into two camps.... The purists... blamed stagflation on restless central bankers trying to do too much. They started from the classical assumption that markets cleared, leaving no unsold goods or unemployed workers. Efforts by policymakers to smooth the economy’s natural ups and downs did more harm than good.... [P]ragmatists... [saw] the double-digit unemployment that accompanied Mr Volcker’s assault on inflation was proof enough that markets could malfunction. Wages might fail to adjust, and prices might stick. This grit in the economic machine justified some meddling by policymakers. Mr Volcker’s recession bottomed out in 1982. Nothing like it was seen again until last year. In the intervening quarter-century of tranquillity, macroeconomics also recovered its composure. The opposing schools of thought converged.... For about a decade before the crisis, macroeconomists once again appeared to know what they were doing....

[Willem] Buiter... believes the latest academic theories had a profound influence.... He now thinks this influence was baleful... a training in modern macroeconomics was a “severe handicap” at the onset of the financial crisis, when the central bank had to “switch gears” from preserving price stability to safeguarding financial stability. Modern macroeconomists worried about the prices of goods and services, but neglected the prices of assets. This was partly because they had too much faith in financial markets....

Before the crisis, many banks and shadow banks... believed they could always roll over their short-term debts or sell their mortgage-backed securities, if the need arose. The financial crisis made a mockery of both assumptions. Funds dried up, and markets thinned out. In his anatomy of the crisis Mr Brunnermeier shows how both of these constraints fed on each other, producing a “liquidity spiral”. What followed was a furious dash for cash, as investment banks sold whatever they could, commercial banks hoarded reserves and firms drew on lines of credit. Keynes would have interpreted this as an extreme outbreak of liquidity-preference.... But contemporary economics had all but forgotten the term....

In the first months of the crisis, macroeconomists reposed great faith in the powers of the Fed and other central banks.... Frederic Mishkin... presented the results of simulations from the Fed’s FRB/US model. Even if house prices fell by a fifth in the next two years, the slump would knock only 0.25% off GDP, according to his benchmark model... [because] the Fed would respond “aggressively”, by which he meant a cut in the federal funds rate of just one percentage point. He concluded that the central bank had the tools to contain the damage at a “manageable level”. Since his presentation, the Fed has cut its key rate by five percentage points to a mere 0-0.25%. Its conventional weapons have proved insufficient to the task. This has shaken economists’ faith in monetary policy. Unfortunately, they are also horribly divided about what comes next.

Mr Krugman and others advocate a bold fiscal expansion... stimulating resources that might otherwise have lain idle.... Mr Barro thinks the estimates of Barack Obama’s Council of Economic Advisors are absurdly large. Mr Lucas calls them “schlock economics”, contrived to justify Mr Obama’s projections for the budget deficit....

Economists were deprived of earthquakes for a quarter of a century. The Great Moderation, as this period was called, was not conducive to great macroeconomics. Thanks to the seismic events of the past two years, the prestige of macroeconomists is low, but the potential of their subject is much greater. The furious rows that divide them are a blow to their credibility, but may prove to be a spur to creativity.

Financial economics: Efficiency and beyond: IN 1978 Michael Jensen, an American economist, boldly declared that “there is no other proposition in economics which has more solid empirical evidence supporting it than the efficient-markets hypothesis” (EMH). That was quite a claim. The theory’s origins went back to the beginning of the century, but it had come to prominence only a decade or so before. Eugene Fama, of the University of Chicago, defined its essence: that the price of a financial asset reflects all available information that is relevant to its value.

From that idea powerful conclusions were drawn, not least on Wall Street. If the EMH held, then markets would price financial assets broadly correctly. Deviations from equilibrium values could not last for long. If the price of a share, say, was too low, well-informed investors would buy it and make a killing. If it looked too dear, they could sell or short it and make money that way. It also followed that bubbles could not form—or, at any rate, could not last: some wise investor would spot them and pop them. And trying to beat the market was a fool’s errand for almost everyone. If the information was out there, it was already in the price.

On such ideas, and on the complex mathematics that described them, was founded the Wall Street profession of financial engineering. The engineers designed derivatives and securitisations, from simple interest-rate options to ever more intricate credit-default swaps and collateralised debt obligations. All the while, confident in the theoretical underpinnings of their inventions, they reassured any doubters that all this activity was not just making bankers rich. It was making the financial system safer and the economy healthier.

That is why many people view the financial crisis that began in 2007 as a devastating blow to the credibility not only of banks but also of the entire academic discipline of financial economics. That verdict is too simple. Granted, financial economists helped to start the bankers’ party, and some joined in with gusto. But even when the EMH still seemed fresh, economists were picking holes in it.... Academia thus moved on, even if Wall Street did not.... The EMH, to be sure, has loyal defenders. “There are models, and there are those who use the models,” says Myron Scholes, who in 1997 won the Nobel prize in economics for his part in creating the most widely used model in the finance industry—the Black-Scholes formula for pricing options. Mr Scholes thinks much of the blame for the recent woe should be pinned not on economists’ theories and models but on those on Wall Street and in the City who pushed them too far in practice.

Financial firms plugged in data that reflected a “view of the world that was far more benign than it was reasonable to take, emphasising recent inputs over more historic numbers,” says Mr Scholes. “Apparently, a lot of the models used for structured products were pretty good, but the inputs were awful.” Indeed, the vast majority of derivative contracts and securitisations have performed exactly as their models said they would. It was the exceptions that proved disastrous.... Even as financial engineers were designing all sorts of clever products on the assumption that markets were efficient, academic economists were focusing more on how markets fall short....

Behavioural economists were among the first to sound the alarm about trouble in the markets. Notably, Robert Shiller of Yale gave an early warning that America’s housing market was dangerously overvalued. This was his second prescient call. In the 1990s his concerns about the bubbliness of the stockmarket had prompted Alan Greenspan, then chairman of the Federal Reserve, to wonder if the heady share prices of the day were the result of investors’ “irrational exuberance”. The title of Mr Shiller’s latest book, “Animal Spirits” (written with George Akerlof, of the University of California, Berkeley), is taken from John Maynard Keynes’s description of the quirky psychological forces shaping markets. It argues that macroeconomics, too, should draw lessons from psychology. “In some ways, we behavioural economists have won by default, because we have been less arrogant,” says Richard Thaler of the University of Chicago, one of the pioneers of behavioural finance. Those who denied that prices could get out of line, or ever have bubbles, “look foolish”. Mr Scholes, however, insists that the efficient-market paradigm is not dead: “To say something has failed you have to have something to replace it, and so far we don’t have a new paradigm to replace efficient markets.” The trouble with behavioural economics, he adds, is that “it really hasn’t shown in aggregate how it affects prices.”...

One task, also of interest to macroeconomists, is to work out what central bankers should do about bubbles—now that it is plain that they do occur and can cause great damage when they burst. Not even behaviouralists such as Mr Thaler would want to see, say, the Fed trying to set prices in financial markets. He does see an opportunity, however, for governments to “lean into the wind a little more” to reduce the volatility of bubbles and crashes. For instance, when guaranteeing home loans, Freddie Mac and Fannie Mae, America’s giant mortgage companies, could be required to demand higher down-payments as a proportion of the purchase price, the higher house prices are relative to rents. Another priority is to get a better understanding of systemic risk, which Messrs Scholes and Thaler agree has been seriously underestimated. A lot of risk-managers in financial firms believed their risk was perfectly controlled, says Mr Scholes, “but they needed to know what everyone else was doing, to see the aggregate picture.” It turned out that everyone was doing very similar things. So when their VAR models started telling them to sell, they all did—driving prices down further and triggering further model-driven selling...

If Obama is not listening to Joe, he is not getting the best advice

Krugman calls him "an insanely great economist." His critics call him arrogant. Joseph Stiglitz is simply right. End of story.

The Most Misunderstood Man in America

Joseph Stiglitz predicted the global financial meltdown. So why can't he get any respect here at home?

Newsweek

Anya Stiglitz was in the middle of a Pilates class in Central Park on an April morning when her cell phone rang. Glancing down, she saw "202" pop up—no number attached—and knew it was the White House. An aide to Larry Summers was on the line, looking for her husband, the Nobel Prize–winning economist Joseph Stiglitz. Anya said she'd pass on the message to Joe—then went back to work on her abs. No big deal, she thought. People often call her when they want to talk to Joe, because even though he's spent four decades figuring out how the global economy works, he hasn't quite gotten the hang of voice mail. "He doesn't listen to his messages, so if you want to talk to him, keep calling," Anya says on his cell-phone recording.

Anya figured Summers, Obama's chief economic adviser, was probably just calling to gripe about Joe's latest op-ed in The New York Times. Joe Stiglitz and Larry Summers, two towering intellects with egos to match, are not each other's favorite economist. "They respect each other, but they hate each other like poison," says Bruce Greenwald, Stiglitz's friend and academic collaborator at Columbia. ("I've got huge admiration for Joe as an economic thinker," Summers told NEWSWEEK.) Stiglitz had been hammering at Obama's economic team for its handling of the financial crisis. He wrote that the stimulus program was too small to be effective—a criticism that has since swelled into a chorus, though Obama says he's not adding more money. Stiglitz also had called the administration's bailout plan a giveaway to Wall Street, an "ersatz capitalism" that would save the banks' investors and creditors and screw the taxpayers. "I thought, Larry—he's just going to yell at Joe," Anya recalls.

But Summers's aide soon called back, and this time he said it was urgent: could Professor Stiglitz come to Washington for a dinner hosted by the president—that same night? Anya patched him through to Joe's office at Columbia University; Stiglitz accepted, and jumped on an early train. He was a little miffed: the other eminent economists attending the dinner, like Princeton's Alan Blinder and Harvard's Kenneth Rogoff, had been invited the week before. Stiglitz, a former chairman of Bill Clinton's Council of Economic Advisers, had supported Barack Obama as a candidate as early as 2007. But until that day, four months into the administration, he had heard barely a word from the White House. Even now, when the president was making an effort to hear a range of economic voices, Stiglitz seemed to be an afterthought. (A White House spokesman said only that the president wished to include Stiglitz.)

Such is the lot of Joe Stiglitz. Even in the contentious world of economics, he is considered somewhat prickly. And while he may be a Nobel laureate, in Washington he's seen as just another economic critic—and not always a welcome one. Few Americans recognize his name, and fewer still would recognize the man, who is short and stocky and bears a faint resemblance to Mel Brooks. Yet Stiglitz's work is cited by more economists than anyone else's in the world, according to data compiled by the University of Connecticut. And when he goes abroad—to Europe, Asia, and Latin America—he is received like a superstar, a modern-day oracle. "In Asia they treat him like a god," says Robert Johnson, a former chief economist for the Senate banking committee who has traveled with him. "People walk up to him on the streets."

Stiglitz has won fans in China and other emerging G20 nations by arguing that the global economic system is stacked against poor nations, and by standing up to the World Bank and International Monetary Fund. He is also the most prominent American economist to propose a long-term solution to the imbalances in capital flows that have wreaked havoc, from the Asian contagion of the late '90s to the subprime-investment craze. Beijing has more or less endorsed Stiglitz's idea for a new global reserve system to replace the U.S. dollar as the world currency. Chinese Prime Minister Wen Jiabao has been influenced by Stiglitz's work, especially when "he talks about the economics of poor people," says Fang Xinghai, the head of Shanghai's financial-services office. But his stature is huge in Europe as well: French President Nicolas Sarkozy recently featured him at a conference on rethinking globalization. And earlier this month, while traveling to Europe and South Africa, Stiglitz received a call from British Prime Minister Gordon Brown's office: could he return through London and help the P.M. get ready for the G20 meeting in Pittsburgh?

Stiglitz is perhaps best known for his unrelenting assault on an idea that has dominated the global landscape since Ronald Reagan: that markets work well on their own and governments should stay out of the way. Since the days of Adam Smith, classical economic theory has held that free markets are always efficient, with rare exceptions. Stiglitz is the leader of a school of economics that, for the past 30 years, has developed complex mathematical models to disprove that idea. The subprime-mortgage disaster was almost tailor-made evidence that financial markets often fail without rigorous government supervision, Stiglitz and his allies say. The work that won Stiglitz the Nobel in 2001 showed how "imperfect" information that is unequally shared by participants in a transaction can make markets go haywire, giving unfair advantage to one party. The subprime scandal was all about people who knew a lot—like mortgage lenders and Wall Street derivatives traders—exploiting people who had less information, like global investors who bought up subprime- mortgage-backed securities. As Stiglitz puts it: "Globalization opened up opportunities to find new people to exploit their ignorance. And we found them."

Stiglitz's empathy for the little guy—and economically backward nations—comes to him naturally. The son of a schoolteacher and an insurance salesman, he grew up in one of America's grittiest industrial cities—Gary, Ind.—and was shaped by the social inequalities and labor strife he observed there. Stiglitz remembers realizing as a small boy that something was wrong with our system. The Stiglitzes, like many middle-class families, had an African-American maid. She was from the South and had little education. "I remember thinking, why do we still have people in America who have a sixth-grade education?" he says.

Those early experiences in Gary gave Stiglitz a social conscience—as a college student, he attended Martin Luther King's "I Have a Dream" speech—and led him to probe the reasons why markets failed. While studying at MIT, he says he realized that if Smith's "invisible hand" always guided behavior correctly, the kind of unemployment and poverty he had witnessed in Gary shouldn't exist. "I was struck by the incongruity between the models that I was taught and the world that I had seen growing up," Stiglitz said in his Nobel Prize lecture in 2001. In the same speech he declared that the invisible hand "might not exist at all." The solution, Stiglitz says, is to move beyond ideology and to develop a balance between market-driven economies—which he favors—and government oversight.

Stiglitz has warned for years that pro-market zeal would cause a global financial meltdown very much like the one that gripped the world last year. In the early '90s, as a member of Clinton's Council of Economic Advisers, Stiglitz argued (unsuccessfully) against opening up capital flows too rapidly to developing countries, saying those markets weren't ready to handle "hot money" from Wall Street. Later in the decade, he spoke out (without results) against repealing the Glass-Steagall Act, which regulated financial institutions and separated commercial from investment banking. Since at least 1990, Stiglitz has talked about the risks of securitizing mortgages, questioning whether markets and authorities would grow careless "about the importance of screening loan applicants." Malaysian economist Andrew Sheng says, "I think Stiglitz is the nearest thing there is to Keynes in this crisis."

That would be John Maynard Keynes, the great 20th-century economist who rocketed to international renown in late 1919 when he published The Economic Consequences of the Peace. In his book, Keynes warned that the draconian penalties imposed on Germany after World War I would lead to political disaster. No one listened. The disaster he predicted turned out to be World War II. Like Stiglitz, Keynes was not a favorite at the White House. Keynes also believed that markets were imperfect: he invented modern macroeconomics—which calls for major government intervention to help ailing economies—in response to the Great Depression. But after meeting Keynes for the first time in 1934, FDR dismissed him as too abstract and intellectual, according to Robert Skidelsky, Keynes's biographer. Keynes himself fretted that Roosevelt was not spending enough.

To his critics—and there are many—Stiglitz is a self-aggrandizing rock-thrower. Even some of his intellectual allies note that while Stiglitz is often right on the substance of issues, he tends to leap to the conclusion that government can make things better. Harvard economist Rogoff has called him intolerably arrogant—though he added that Stiglitz is a "towering genius." In a letter to -Stiglitz published in 2002, Rogoff recalled a moment when the two of them were teaching at Princeton and former Fed chairman Paul Volcker's name came up for tenure. "You turned to me and said, 'Ken, you used to work for Volcker at the Fed. Tell me, is he really smart?' I responded something to the effect of 'Well, he was arguably the greatest Federal Reserve chairman of the 20th century.' To which you replied, 'But is he smart like us?'" (Stiglitz says he can't remember the comment, but adds that he might have been referring to whether Volcker was an abstract thinker.)

Stiglitz's defenders say one possible explanation for his outsider status in Washington is his ongoing rivalry with Summers. While they are both devotees of Keynes, Summers often has supported deregulation of financial markets—or at least he did before last year—while Stiglitz has made a career of mistrusting markets. Since the early '90s, when Summers was a senior Treasury official and Stiglitz was on the Council of Economic Advisers, the two have engaged in fierce policy debates. The first fight was over the Clinton administration's efforts to pry open emerging financial markets, such as South Korea's. Stiglitz argued there wasn't good evidence that liberalizing poorly regulated Third World markets would make anyone more prosperous; Summers wanted them open to U.S. firms.

The differences between them grew bitter in the late 1990s, when Stiglitz was chief economist for the World Bank and took issue with the way Treasury Secretary Robert Rubin, and Summers, who was then deputy secretary, were handling the Asian "contagion" financial collapse. After World Bank president James Wolfensohn declined to reappoint him in 1999, Stiglitz became convinced that Summers was behind the slight. Summers denies this, and maintains that no rivalry exists between them. Summers's deputy Jason Furman says that Summers now "talks to [Stiglitz] a lot." "A lot" is an exaggeration, Stiglitz responds. "We've talked one or two times," he says.

Despite the Obama team's occasional efforts to reach out to him, Stiglitz remains deeply unhappy about the administration's approach to the financial crisis. Rather than breaking up or restructuring the big banks that failed, "the Obama administration has actually expanded the notion of 'too big to fail,' " he says. In a veiled poke at his dubious standing in Washington, Stiglitz adds: "In Britain there is a more open discussion of these issues." A senior White House official, responding to this critique, says that the Obama administration is most often criticized these days for intervening too much in the economy, not too little.

In other respects, Obama is embracing some of Stiglitz's views, suggests Peter Orszag, director of the Office of Management and Budget—and a former Stiglitz protégé (he worked for Stiglitz during the Clinton administration). One example: Obama's new idea for reforming health care by creating a government-run program to compete with private-sector insurers. "There is an intellectual paradigm in health care that says you should move to purely private markets," says Orszag. "Joe's perspective would suggest major difficulties [with that]. That led to the thought that we need a mix: there is an important government role."

Today, settled as a professor at Columbia, Stiglitz occasionally finds himself welcomed in the nation's capital, though usually at the other end of Pennsylvania Avenue, to testify before Congress. While he had no great desire to go back into government, friends say he was deeply disappointed when an offer didn't come from Obama last fall. Not surprisingly, Stiglitz believes his old rival was behind it, though Summers denies this. As for the invitation to dinner at the White House, there were a few theories kicked around the spacious Stiglitz household on Manhattan's Upper West Side as to why it came at the last minute: one was that Obama, in an interview posted online that week by The New York Times, had cited Stiglitz as one of the critics he listens to, so it would have seemed strange if he hadn't been invited to the dinner.

While Stiglitz was flattered by the discussion over a dinner of roast beef and Michelle Obama's homegrown lettuce, he can't stop himself from complaining that an occasional meal with dissidents is not the best way for the president to formulate policy. "Some of the most difficult debates and judgments can't really be hammered out in an hour-and-a-half meeting covering lots of topics," he says. Stiglitz may a prophet without much honor in Washington, but he seems to be determined to keep the prophecies coming.

© 2009 Newsweek

Podcast Transcript 07.18.09 Bad News: Borrowing is not earning

Net Real GDP

If you want to see the hole into which the prosperity of the American people has been shoveled, take a look at the chart up on the blog and web site on Net Real GDP

This is a Demand Side exclusive statistic as far as I know. It is simply Real GDP minus federal borrowing from all sources, including the Socoial Security Trust Fund and other social insurance trust funds. Real GDP is monetized activity adjusted for inflation, nothing more. It goes up when we go out for a meal rather than cook at home. The wife going into the workforce makes a lot of monetized activity like this. GDP measures bads and goods above the line. Alcohol counts as much as nutrition. Prisons as much as schools. Mayhem as much as -- or more -- than harmony.

Net Real GDP subtracts from this monetized activity the federal deficits. After all, deficits are run in theory to increase activity in bad times and jump start growth. Otherwise they are simply the American blue plate special of borrowing to consume. There is some discussion about the appropriate size of deficits as a percentage of GDP. But the idea that government borrowing is in itself economic growth does not stand up to even a cursory examination. It is like counting the water used to prime the pump as a product of the well.

But the federal government borrows not only from China and Uncle Fred and XYZ Fund, but also from the social insurance trust funds -- Social Security and Medicare being the biggest. This is the source of confusion both about the real size of the deficit and about the integrity of Social Security retirement and disability.

Social Security is on very firm financial footing for decades outward, IF the government bonds that fill it up are any good. It is a model program, and the rest of us should be so lucky as to have our portfolio in government bonds. But when they come due, they will need to be paid. That will mean higher taxes.

This borrowing from the trust funds has masked the size of the deficit, because of the fiction of the so-called unified budget. Rather than explicitly say the operating slash capital side is raiding the retirement and disability funds, the budget process reduces the official deficit by the amount of these borrowings without a word.

Aside: This is not the great "unfunded liabilities" debate, wherein some would have us set aside capital that could earn the needed payouts. The pay-as-you-go scheme was appropriate for the 1930s when it was instituted as part of the New Deal, and it has worked well so far, and why not?

In the early 1980s, Alan Greenspan led a commission to fix social security, because even then they could see that the baby boomers would retire someday. They fixed it by raising payroll taxes, taxes which would never have passed to fund anything other than social security. These regressive payroll taxes were almost immediately passed out of the trust funds into the operating budget. The entire Greenspan exercise turned out to be a Trojan Horse for more regressive taxation.

Perhaps it would be different if the retirement and disability trust funds were the ONLY place from which the federal government borrowed. But they are not. The big spenders have also been the big borrowers from the public at large.

And it's not as if these are productive assets we're borrowing to build. Education, infrastructure, R&D. No. The vast majority of debt built up since Ronald Reagan made deficits acceptable in polite company have gone for war, war machines, and tax cuts.

All of which is a long way of saying there is no silver lining to the deficits. They are borrowing from the future, and because half of that borrowiing is hidden inside the unified budget, they are much less benign than many have said. They do matter, Mr. Cheney. This is simple borrowing, not earning.

For this combination of reasons, to get an accurate view of the earnings of the economy, we subtract federal borrowing from all sources from gross Real GDP and obtain Net Real GDP, a measure which describes the health and vitality of the economy clean of the artificial animation of borrowing.

Gross Real GDP favors a Democrat in the White House by an average of 1.3 percentage points per year. Net Real GDP favors Democrats by 2.7 percent. Gross Real GDP has been 2.7 percent per year under Republicans, 4.0 under Democrats. When federal borrowing is subtracted, Republicans net only 0.8 percent average annual growth. Democrats 3.5 percentage points.

More startling, the net real GDP number since Gerald Ford is negative for all presidents of the Republican persuasion. More than one hundred percent of growth has been borrowed.

Specifically, Eisenhower led Republicans with 3.5 percent net real GDP growth. Nixon came second with 1.5 percent. Ford -0.1, Reagan -0.1, Bush I -2.0, Bush II -0.2. To be fair, you'd have to shift some of the red from Bush II back into the Reagan policies that he inherited.

Among Democrats, Truman 4.5, Kennedy 5.2, Johnson 4.6, Carter 2.2, Clinton 2.1.

Two things about this. The period of Keynesian influence, before 1970, is at a level above that since. And the Democrats Carter and Clinton may have suffered from following Republicans. Clinton, in particular, as is evident from the chart by year, climbed out of a deep hole. That era of "fiscal responsibility" ended abruptly with the arrival of Bush II. The Net Real GDP of Clinton's second term was 4.1, back in the pre-1970 range.

It is the Demand Side suggestion that Democrats do not have the inside dope on the economy.

As one of our listeners Jack Stewart put up on his USvotersite, link on the blog,
Jack Stewart's USvotersite

https://sites.google.com/site/usvotersite/Home/

Much like Alice's Cheshire cat in the Disney cartoon Alice in Wonderland - political parties have disappeared, leaving behind nothing but the many similar smiles of very independent, entrepreneur politicians.

Instead, they have the constituency which, when served, leads the economy higher. The Republicans on the other hand, are the party of tax give-aways, which policy has shown little positive benefit for the economy as a whole.


There it is. Charts on demandsideblog.blogspot.com.

Net Real GDP

President	Democrat	Republican
Truman	4.5
Eisenhower		3.5
Kennedy	5.2
Johnson	4.6
Nixon		1.5
Ford		-0.1
Carter	2.2
Reagan		-0.1
Bush I		-2.0
Clinton	2.1
Bush II		-0.2

Casting back to previous podcasts' discussion of Bernanke and the banks, David Goldman of the Inner Workings blog, defines zombie more precisely for us. Goldman writes:

As I predicted last March, American banks are hoarding rather than divesting the so-called toxic assets. The volume of trading in non-agency mortgage backed securities is considerably lower than many traders might have expected. Financial institutions That makes the stabilization of asset prices along with the stabilization of bank equity prices a self-referential argument: asset prices are doing well because banks (and other financial institutions) are buying them, and that reassures the equity market.

Rather than relying on distressed investors to bail them out, banks ARE the main distressed investors. After the suspension of FAS 157 banks have an incentive to hold rather than sell securities trading at low dollar prices.

The toxic waste never came out. The zombies are living quite happily on it. The banks will continue to tip back and forth between credit losses and elevated income from their distressed portfolios.

And I forgot James K. Galbraith's response when I criticized his giving Bernanke a "C" in the handling of the economy. I said, C? When the pilot crashes the plane, he shouldn't get a passing grade just because nobody died. Galbraith e-mailed me in what is still one of the nicest things this podcast has produced. He said, "I was grading on the curve."

From Brad DeLong on the stimulus package:

Jared Bernstein and Christy Romer constructed extremely crude estimates of the delta-effect of the stimulus package on the economy by taking when they thought the different components of the $787 billion would be spent and how long it would then take for the government spending to have an impact on the economy. Their estimate is that we saw the effect of $0 (zero) (none) (nada) dollars of the stimulus package on the economy in the first quarter, that we saw the effects of only $14.5 billion in the second quarter, and that we are about to see the effects of $38.6 billion now in the third quarter as the effects of the package ramp up to their peak in the fall of 2010, when we will see $82.1 billion of stimulus spending hit the economy.

To say that what happened in the second quarter means that "the last few hundred billion dollars have had virtually no effect" is like sticking your toe into the ocean and pointing out that your hair is still dry...

The Demand Side observation is that a broader stimulus is needed, a recovery program, involving ongoing spending, and this will do much better because private contractors will begin to invest more deeply themselves, the jobs will come with more security and hence higher consumption functions, and the transition away from the consumer society will be accelerated.

from Krugman

Jan Hatzius of Goldman Sachs has a new note (no link) responding to claims that government support for the economy is postponing the necessary adjustment. He doesn’t think much of that argument; neither do I. But one passage in particular caught my eye:

The private sector financial balance—defined as the difference between private saving and private investment, or equivalently between private income and private spending—has risen from -3.6% of GDP in the 2006Q3 to +5.6% in 2009Q1. This 8.2% of GDP adjustment is already by far the biggest in postwar history and is in fact bigger than the increase seen in the early 1930s.

That’s an interesting way to think about what has happened — and it also suggests a startling conclusion: namely, government deficits, mainly the result of automatic stabilizers rather than discretionary policy, are the only thing that has saved us from a second Great Depression.

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Robert Reich: Goldman Sachs is still gaming the system

One of the biggest beneficiaries of the AIG bailout was Goldman Sachs. They have learned their lesson. Take the money and run.

Goldman's Back, and Why We Should Be Worried
by Robert Reich

Should we breath a sigh of relief that Goldman Sachs has posted record earnings as revenue from trading and stock underwriting reached all-time highs (second quarter net income was $3.44 billion) -- less than a year after the firm took $10 billion directly from taxpayers and $13 billion indirectly through AIG?
In some ways, yes. That Goldman is back signals that the worst of Wall Street's recent meltdown is over. And at least New York City's economy will again benefit from the trickle-down effects of the multi-million dollar bonuses of Goldman's executives and traders.

But in another respect, Goldman's resurgence should send shivers down the backs of every hardworking American who has lost a large chunk of retirement savings in this economic debacle, as well as the millions who have lost their jobs. Why? Because Goldman's high-risk business model hasn't changed one bit from what it was before the implosion of Wall Street. Goldman is still wagering its capital and fueling giant bets with lots of borrowed money. While its rivals have pared back risks, Goldman has increased them. And its renewed success at this old game will only encourage other big banks to go back into it.

“Our model really never changed, we’ve said very consistently that our business model remained the same,” Goldman's chief financial officer tells Bloomberg News. Value-at-risk -- a statistical measure of how much the firm’s trading operations could lose in a day -- rose to an average of $245 million in the second quarter from $240 million in the first quarter. In the second quarter of 2008, VaR averaged $184 million.

Meanwhile, Goldman is still depending on $28 billion in outstanding debt issued cheaply with the backing of the Federal Deposit Insurance Corporation. Which means you and I are still indirectly funding Goldman's high-risk operations.

Goldman is skillful at playing the market. Now that most of its major competitors are out of the action or still under the strict control of the Treasury and the Fed, it has the market mostly to itself. Expect the others to jump back in to high-risk deals as soon as they can. But Goldman is also skillful at playing politics -- something its rivals aren't nearly as good at. Recall that last fall, at a closed meeting between Treasury Secretary Hank Paulson (formerly Goldman's CEO), Tim Geithner (then at the New York Fed), and a handful of others to decide on the fate of giant insurer AIG, Goldman's cheif executive, Lloyd Blankfein, was at the table. The decision to bail out AIG resulted in a $13 billion giveaway to Goldman because Goldman was an AIG counterparty. Indeed, Goldman executives and alumni have played crucial roles in guiding the Wall Street bailout from the start.

So the fact that Goldman has reverted to its old ways in the market suggests it has every reason to believe it can revert to its old ways in politics, should its market strategies backfire once again -- leaving the rest of us once again to pick up the pieces.

Podcast Transcript 07.15.09 The Alternative to Stimulus is What?

The naive are punished

Our forecast and understanding of what lies ahead is based on the idea that policy-makers will alter a course that does not go in the appropriate direction. This is apparently a naive opinion. Neither policy-makers, pundits, nor the public has adapted in the sense we assumed. Instead, the adaptation has been an acceptance of the status quo, a shifting of the load of blame to others, and an entrenchment along ideological lines. Trying everything until it works, the pragmatism of FDR, is what we counted on with Obama. By this process of elimination, we expected demand side remedies to get a fair shake. Once their effectiveness became apparent, we expected them to be reinforected. This process is not yet in evidence.

Particularly instructive has been the response to the stimulus package, the Recovery Act. The airwaves have been saturated with critiques and analysis of what effect the stimulus is having. Where are the jobs? Where is the much-ballyhooed recovery? Krugman said, What didn't the vice president know and when didn't he know it?

But some of us did predict the double digit unemployment rate. It was, after all, baked in, we said. Absent a massive stimulus, it was going to be a lot worse.

Here, again, from Krugman, shortly after his "What didn't the vice president know, and when did he not know it?" comment.

Seriously, the economy isn’t doing all that much worse than a number of people warned was probable. And the whole political economy thing was, sadly, predictable:

I wrote during the political skirmishing leading up to the stimulus

This really does look like a plan that falls well short of what advocates of strong stimulus were hoping for — and it seems as if that was done in order to win Republican votes. Yet even if the plan gets the hoped-for 80 votes in the Senate, which seems doubtful, responsibility for the plan’s perceived failure, if it’s spun that way, will be placed on Democrats.

I see the following scenario: a weak stimulus plan, perhaps even weaker than what we’re talking about now, is crafted to win those extra GOP votes. The plan limits the rise in unemployment, but things are still pretty bad, with the rate peaking at something like 9 percent and coming down only slowly. And then Mitch McConnell says “See, government spending doesn’t work.”

Let’s hope I’ve got this wrong.

Apparently I didn’t.

No, he didn't have it wrong. The package got three Republican votes in the Senate, one of whom, Arlen Specter subsequently skipped to the D side, and two of whom remain to constitute the entirety of the Moderate Wing of the Republican Party.

The Demand Side framework has been this: The economy was weak in 2001 when the Fed began its one percent interest rate policy and the Bush Administration instituted the tax cuts for the rich. For the next five years it floated on the paper of residential housing financing. When that huge debt bubble collapsed, the weak economy beneath was exposed. It had no way of supporting the collapse and the entire financial system broke through. Now we're scrambling around in the rubble trying to find our way out.

We have the weak economy of 2001, along with credit markets that do not even function, let alone pump out debt for consumers. State and local government revenues have shrunk, taking down more demand. From the demand side, the only game in town is federal spending. But the Recovery Act is barely replacing the loss of state and local spending, much less filling the hole left by the housing bubble and systemic collapse of the financial system.

The process is made all the more difficult for the blow to consumer confidence, which shrinks the multiplier by shrinking the consumption function.

It is all about demand. Household demand has plummeted along with household wealth. State and local demand has dropped because their revenues have dropped. Business investment demand is nonexistent because there is overcapacity in every area and no prospects for profit on any front.

Yes, the infrastructure is crumbling. We could spend two hundred billion a year for the next twenty years and barely get back to adequate. Yes, global warming requires a complete reformation of transportation and energy and support for developing countries to do the same. These are needs and challenges, but they are not being translated into effective economic demand. Only the government can do that.

Our prescription has been to rebuild the American economy by rebuilding America.

The counter is what? First, do as little as possible. The second .... I'm not clear on what the second is. Just don't do whatever Obama is doing.

A great deal of the problem with government spending is the idea that it will pump up inflation. First we have to ignore the historical fact that there has been no demand-pull inflation for more than forty years, so a modest increase in government spending in the worst economic downturn since the great depression is not going to cause a fever of buying that would bid up the prices of ... what? ... food, clothing, gasoline, houses, what is going to be bid up?

Oh, and just because I have to do it every time inflation is mentioned, look at oil prices. Look at inflation. Notice that oil prices have not responded to demand-supply. Notice that oil prices have led every inflation since 1970. This is called cost-push inflation in our terminology. It would be different if asset prices were included. Then you would have housing or stocks pushing inflation. But it would always be a financial bubble, not demand, pushing up prices. End of Demand Side aside.

What about just trusting monetary policy. Let's not mention that the nay-sayers conflate the Fed's policy with stimulus building infrastructure, bailing out states and extending unemployment. Let's just take the zero interest rate part first.

Yes, monetary policy acts with a lag. Maybe up to 18 months. Eighteen months after the Fed began aggressive action on interest rates, the U.S. had the worst quarter for GDP and employment in a quarter century. Low interest rates gave the players more chips to play with, but it gave nothing to the real economy. Zilch. Zero. Nada.

Particularly now, when there is no other consumer bubble to blow up. The ex-Enron traders at Goldman Sachs may invent higher oil prices and milk the casino markets for more big profits, but a widespread consumer boom from lower interest rates. It is not going to happen. When will they give it up? Monetary policy simply does not work. It needs to accommodate growth, but it is never going to cause recovery.

Zero rates is distinct from the Fed's policy of bailing out the banks. This is similar to scrounging around in the rubble for broken beams to spend billions of dollars taping back together again and rebuilding the house. No. Throw them out. The government didn't break them, they broke themselves. Use the pieces that are not broken, the smaller banks, and get a new system. Maybe it has to be a smaller financial house, but why the hell was it so big in the first place? Certainly not because it was sheltering the great majority of us. Financial houses made nice digs for the financial players. The rest of us? Not so much.

We could, of course, try more tax cuts. After all, the great Bush tax cuts of the early part of the decade did so well. Oh. And the first stimulus? 2007 tax cuts from Bush? Immediate, but ineffective. They immediately had no effect. Economy-wide, that is. It was nice to have the check and it helped cushion the blow, but jump-starting the economy? No. Nearly everybody agrees with that now, so long as we're talking about the past. Several more voices join in when the discussion of tax cuts in time shifts to the future. Always there is the Heritage Foundation.

But ...

Here's more Krugman

Whenever you encounter “research” from the Heritage Foundation, you always have to bear in mind that Heritage isn’t really a think tank; it’s a propaganda shop. Everything it says is automatically suspect.

Greg Mankiw forgets this rule, and approvingly (yes, it’s obvious he approves -no wiggling out) links to a recent Heritage attempt to explain away Medicare’s low administrative costs...

Well, whaddya know — this is an old argument, and has been thoroughly refuted. ...

You should always remember:

1. Don’t believe anything Heritage says.

2. If you find what Heritage is saying plausible, remember rule 1.

The suggestion that the Recovery is too slow portends bad things when the recovery does not produce robust growth. After all, barely ten percent of it has gone out the door. The vast majority will be spent in 2010 and beyond. And it is not compared with the lagged effects of monetary policy.


More bad news:

The IMF says the world is pulling out of recession.

The famous bastion of Neoliberalism is marking up its growth forecasts for next year and hinting that it might reduce its estimates for bank losses.

The IMF's chief economist, Olivier Blanchard, proclaimed, “The recovery is coming,” But it is likely to be a weak recovery.

Maybe another jobless recovery like the first Bush recession. A jobless recovery is not a recovery. It is simply an obsession with GDP which is monetized activity which in this case was a housing bubble.

Here in the latest Harper's

Unless Obama changes course, he’ll look more like Hoover than FDR

an account from New Deal 2.0 by Lynn Parramore reads

Since his inauguration and even before, Barack Obama has garnered countless comparisons to FDR. In this month’s Harper’s magazine, Kevin Baker says there’s a more apt presidential parallel: Herbert Hoover.

Baker writes:

“The comparison is not meant to be flippant. It has nothing to do with the received image of Hoover, the dour, round-collared, gerbil-cheeked technocrat who looked on with indifference while the country went to pieces. To understand how dire our situation is now it is necessary to remember that when he was elected president in 1928, Herbert Hoover was widely considered the most capable public figure in the country. Hoover—like Obama—was almost certainly someone gifted with more intelligence, a better education, and a greater range of life experience than FDR. And Hoover, through the first three years of the Depression, was also the man who comprehended better than anyone else what was happening and what needed to be done. And yet he failed.”

We're putting up our counter to Obama as Hoover this next week. Or beginning it. That is the historical fact and statistics that show that a Democrat in the White House has meant good things for GDP, employment and investment. First, this week, it will be GDP.

By Bureau of Economic Analysis statistics, since 1948 growth in real GDP has averaged 4.0 percent per year under Democrats. Under Republicans 2.7 percent. No Democrat has seen this number under 3.7 percent. That being Clinton. No Republican has seen growth over 3.4 percent, that being Ronald Reagan. In fact, only Reagan is above 3 percent at all, and the two Bushes are closer to 2 percent.

We'll get into that, and into even more evidence showing Democrats mean good things for economy, even after Roosevelt.

For now, this is Alan Harvey, from the Demand Side

Joseph Stiglitz on the UN in Charge

The UN Takes Charge

Joseph Stiglitz
Project Syndicate

NEW YORK – While discussions about economic “green shoots” continue unabated in the United States, in many countries, and especially in the developing world, matters are getting worse. The downturn in the US began with a failure in the financial system, which quickly was translated into a slowdown in the real economy. But, in the developing world, it is just the opposite: a decline in exports, reduced remittances, lower foreign direct investment, and precipitous falls in capital flows have led to economic weakening. As a result, even countries with good regulatory systems are now confronting problems in their financial sectors.

On June 23, a United Nations conference focusing on the global economic crisis and its impact on developing countries reached a consensus both about the causes of the downturn and why it was affecting developing countries so badly. It outlined some of the measures that should be considered and established a working group to explore the way forward, possibly under the guidance of a newly established expert group.

The agreement was remarkable: in providing what in many ways was a clearer articulation of the crisis and what needs to be done than that offered by the G-20, the UN showed that decision-making needn’t be restricted to a self-selected club, lacking political legitimacy, and largely dominated by those who had considerable responsibility for the crisis in the first place. Indeed, the agreement showed the value of a more inclusive approach – for example, by asking key questions that might be too politically sensitive for some of the larger countries to raise, or by pointing out concerns that resonate with the poorest, even if they are less important for the richest.

One might have thought that the United States would have taken a leadership role, since the crisis was made there. Indeed, the US Treasury (including some officials who are currently members of President Barack Obama’s economic team) pushed capital- and financial-market liberalization, which resulted in the rapid contagion of America’s problems around the world.

While there was less American leadership than one would have hoped, indeed expected under the circumstances, many participants were simply relieved that America did not put up obstacles to reaching a global consensus, as would have been the case if George W. Bush were still president.

One might have hoped that America would be the first to offer large amounts of money to help the many innocent victims of the policies it had championed. But it did not, and Obama had to fight hard to extract even limited amounts for the International Monetary Fund from a reluctant Congress.

But many developing countries have just emerged from being overburdened with debt; they do not want to go through that again. The implication is that they need grants, not loans. The G-20, which turned to the IMF to provide most of the money that the developing countries need to cope with the crisis, did not take sufficient note of this; the UN conference did.

The most sensitive issue touched upon by the UN conference – too sensitive to be discussed at the G-20 – was reform of the global reserve system. The build-up of reserves contributes to global imbalances and insufficient global aggregate demand, as countries put aside hundreds of billions of dollars as a precaution against global volatility. Not surprisingly, America, which benefits by getting trillions of dollars of loans from developing countries – now at almost no interest – was not enthusiastic about the discussion.

But, whether the US likes it or not, the dollar reserve system is fraying; the question is only whether we move from the current system to an alternative in a haphazard way, or in a more careful and structured way. Those with large amounts of reserves know that holding dollars is a bad deal: no or low return and a high risk of inflation or currency depreciation, either of which would diminish their holdings’ real value.

On the last day of the conference, as America was expressing its reservations about even discussing at the UN this issue which affects all countries’ well being, China was once again reiterating that the time had come to begin working on a global reserve currency. Since a country’s currency can be a reserve currency only if others are willing to accept it as such, time may be running out for the dollar.

Emblematic of the difference between the UN and the G-20 conferences was the discussion of bank secrecy: whereas the G-20 focused on tax evasion, the UN Conference addressed corruption, too, which some experts contend gives rise to outflows from some of the poorest countries that are greater than the foreign assistance they receive.

The US and other advanced industrial countries pushed globalization. But this crisis has shown that they have not managed globalization as well as they should have. If globalization is to work for everyone, decisions about how to manage it must be made in a democratic and inclusive manner – with the participation of both the perpetrators and the victims of the mistakes.

The UN, notwithstanding all of its flaws, is the one inclusive international institution. This UN conference, like an earlier one on financing for developing countries, demonstrated the key role that the UN must play in any global discussion about reforming the global financial and economic system.