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.

Matt Taibi and naked short-selling with Goldman Sachs

Heisted from Matt Taibi's blog, here is an informal look at naked short-selling, another game played by the big boys. It is combined, of course, with setting the rules, which the big boys do via lobbying and regulatory capture. You can smell the dishes they're cooking up in this part of a piece.

An Inside Look at How Goldman Sachs Lobbies the Senate
by Matt Taibi
September 30, 2009

Naked short-selling is a kind of counterfeiting scheme in which short-sellers sell shares of stock they either don’t have or won’t deliver to the buyer. The piece gets into all of this, so I won’t repeat the full description in this space now. But as this week goes on I’m going to be putting up on this site information I had to leave out of the magazine article, as well as some more timely material that I’m only just getting now.

Included in that last category is some of the fallout from this week’s SEC “round table” on the naked short-selling issue.

The real significance of the naked short-selling issue isn’t so much the actual volume of the behavior, i.e. the concrete effect it has on the market and on individual companies — and that has been significant, don’t get me wrong — but the fact that the practice is absurdly widespread and takes place right under the noses of the regulators, and really nothing is ever done about it.

It’s the conspicuousness of the crime that is the issue here, and the degree to which the SEC and the other financial regulators have proven themselves completely incapable of addressing the issue seriously, constantly giving in to the demands of the major banks to pare back (or shelf altogether) planned regulatory actions. There probably isn’t a better example of “regulatory capture,” i.e. the phenomenon of regulators being captives of the industry they ostensibly regulate, than this issue.

In that vein, starting tomorrow, the SEC is holding a public “round table” on the naked short-selling issue. What’s interesting about this round table is that virtually none of the invited speakers represent shareholders or companies that might be targets of naked short-selling, or indeed any activists of any kind in favor of tougher rules against the practice. Instead, all of the invitees are either banks, financial firms, or companies that sell stuff to the first two groups.

In particular, there are very few panelists — in fact only one, from what I understand — who are in favor of a simple reform called “pre-borrowing.” Pre-borrowing is what it sounds like; it forces short-sellers to actually possess shares before they sell them.

It’s been proven to work, as last summer the SEC, concerned about predatory naked short-selling of big companies in the wake of the Bear Stearns wipeout, instituted a temporary pre-borrow requirement for the shares of 19 fat cat companies (no other companies were worth protecting, apparently). Naked shorting of those firms dropped off almost completely during that time.

The lack of pre-borrow voices invited to this panel is analogous to the Max Baucus health care round table last spring, when no single-payer advocates were invited. So who will get to speak? Two guys from Goldman Sachs, plus reps from Citigroup, Citadel (a hedge fund that has done the occasional short sale, to put it gently), Credit Suisse, NYSE Euronext, and so on.

In advance of this panel and in advance of proposed changes to the financial regulatory system, these players have been stepping up their lobbying efforts of late. Goldman Sachs in particular has been making its presence felt.

Last Friday I got a call from a Senate staffer who said that Goldman had just been in his boss’s office, lobbying against restrictions on naked short-selling. The aide said Goldman had passed out a fact sheet about the issue that was so ridiculous that one of the other staffers immediately thought to send it to me. When I went to actually get the document, though, the aide had had a change of heart.

Which was weird, and I thought the matter had ended there. But the exact same situation then repeated itself with another congressional staffer, who then actually passed me Goldman’s fact sheet.

Now, the mere fact that two different congressional aides were so disgusted by Goldman’s performance that they both called me on the same day — and I don’t have a relationship with either of these people — tells you how nauseated they were.

I would later hear that Senate aides between themselves had discussed Goldman’s lobbying efforts and concluded that it was one of the most shameless performances they’d ever seen from any group of lobbyists, and that the “fact sheet” the company had had the balls to hand to sitting U.S. Senators was, to quote one person familiar with the situation, “disgraceful” and “hilarious.”

I’m including the Goldman fact sheets here. They will not make a whole lot of sense to people outside of the finance world, but if you can fight through them, what you’ll find is the statistical equivalent of a non-sequitur. Goldman here is lobbying against restrictions to naked short-selling, and in arguing that point they include a graph showing the levels of “short interest” during two time periods, September-October 2008 (when there was a temporary ban on all short-selling, naked or otherwise) and January-March 2009.

Goldman’s point seems to be that short-selling declined during a period when the market fell sharply, and short-selling went up when the market rallied. I guess on some planet, perhaps not on earth but some other spherical space-boulder, this is supposed to indicate that short-selling is good for the market overall.

(Which, incidentally, it might be. But we’re not talking about short-selling here. We’re talking about naked short-selling).

The thing is, you can’t deduce anything at all about naked short-selling by looking at a graph showing levels of normal short selling. This is like trying to draw conclusions about the frequency of date rape by looking at the number of weddings held. The two things have absolutely nothing to do with one another.

I was so sure that I was missing something that I started asking around. “If you are confused, you are not alone,” one economist wrote back to me. “I have no idea why they are conflating short selling and naked short selling. Members of Congress are probably confused as well.”

The thing is, the only way to draw conclusions about whether or not naked short-selling is a problem is to look at individual cases of individual declines in the share prices of specific companies, and then check to see if there have been large numbers of failed trades in those stocks.

Goldman is not only not doing that here, they’re taking two statistics with no relation to naked short-selling (short interest and stock prices), stats cherry-picked during two seemingly random time-periods, and then slapping them underneath a cover sheet full of platitudes like “The US equities market is increasingly efficient and broadly regarded as the best in the world.” It’s not so much that this is a bad argument, it’s just… not really an argument at all. It’s lazy, really. It makes you wonder what’s going on at that company

Marshall Auerback says financial reform is headed in the wrong direction

The Financial Products Safety Commission is the key to regulation by Demand Side's opinion. Why? The market is nothing more or less than the products, terms and conditions at the moment of purchase-sale. (It is for this reason it is so critical to internalize the externalities so the market can work for the benefit of environment and other societal needs.) Participants in the market, by these lights, are not the market itself. If participants are small enough not to control the market, a great deal of discipline will be introduced, as the "too big to fail" insurance will be eliminated. At the same time, the intrusive oversight being proposed on many sides will be less necessary.

Here is Marshall Auerback's take on the recent Obama speech.

Obama’s finance reform speech fizzles; big banks set to reinflate bubble
Marshall Auerback
New Deal 2.0
September 16, 2009

The President has marked the anniversary of the demise of Lehman Brothers with a new speech designed to breathe new life into his financial reform proposals. But the Obama administration already forfeited its best chance to reform the banking system when the crisis was at its height.

For all of the lofty talk about establishing “the most ambitious overhaul of the financial system since the Great Depression”, Obama’s reforms amount to nothing more than a reshuffling of the deckchairs on the Titanic.

Why? Because Too big to fail (TBTF) banks have grown even more bloated in the past 2 years. And because leverage has increased across the board. Bank of America, the biggest of the “TBTF” institutions, now holds 12% of all US deposits. The top four (Bank of America, JPMorgan Chase, Citigroup and Wells Fargo) now have 46% of the assets of all FDIC-insured banks, up from 37.7% a year ago. Goldman Sachs, the biggest securities firm before it was handed a bank charter, has plunged into even riskier business and upped its trading and investment profits by two-thirds over the past year.

Systemic banks benefit from implicit and explicit government backstops. But a resolution regime for all systemically large and complex institutions like Fannie and Freddie — arguably one of the most important measures– is stalling in Congress amid waning political support. And — surprise! - lobbyist are gearing up to fight the Consumer Financial Protection Agency, whose fate is unclear as the bill works its way through Congress.

We haven’t yet even determined who will be the systemic risk regulator. Could be the Fed. Or it could be the Systemic Risk Council (a new body proposed to keep an eye of financial markets ). Given the Federal Reserve’s dismal record in anticipating this crisis and promoting the wrong-headed economic models that blew up the bubble, it is extraordinary that we are even discussing the notion of providing the central bank with yet more power. But is a Systemic Risk Council really the answer? Why reinvent the wheel, when the obvious alternative is the Federal Insurance Deposit Corporation (FDIC)?

Professor James Galbraith warns that the key ingredients in systemic risk regulation are accountability and supervision”

“It would be all too easy for the Federal Reserve Board to open an internal Office of Systemic Risk Assessment, to staff it with mathematical risk modelers, and to let the matter rest there. Then, when the next crisis hits, the Fed would say that it was something ‘no one could have foreseen’ - just because their internal model-builders failed to foresee it. This is probably not the outcome Congress seeks…

….Essentially, the job is to recognize emerging patterns of dangerous behavior. This function is best taken on by an agency with experience, expertise, and focus on these functions, an agency with no record of regulatory capture or institutional identification with the interests of the regulated sector.”

In Gailbraith’s view, the FDIC fits the bill. And he is right. The FDIC is the logical home for systemic regulation. Yet as far as we can see, Obama is not considering it in his proposals. Perhaps part of this reluctance reflects animus toward Sheila Bair, who is definitely not part of the “old boys’ network”. It also likely reflects the comfort level of Wall Street, given its incestuous relationship with the Fed, and the concomitant embrace by both groups of a like-minded market fundamentalist ideology.

Clearly a regulator should not be chummy with the entities it is charged with regulating. The FDIC is charged with taking over any bank it deems insolvent, and then either selling that bank, selling the bank’s assets, reorganizing the bank, or any other similar action that serves the public. This largely explains why the FDIC is not particularly beloved by Wall Street or Wall Street’s main benefactors in Washington DC.

Indeed, the TARP program was at least partially established to allow the US Treasury to subvert the role of the FDIC. By injecting equity in specific banks, the Treasury managed to keep them from being declared insolvent by the FDIC, and ostensibly allow them to continue to have sufficient capital to continue to lend. The end result? TARP entrenched the dominance of the largest financial institutions, preserving many which were de facto insolvent, at the expense of the better run local, community banks (which are in effect being penalized for the sins of Citi and Bank of America). The big bank problem is one of insolvency; further big banks cannot be and should not be saved. They do not hold the key to recovery; if anything, they are a barrier to sustainable recovery. Given a chance, they will try (in fact, ARE trying) to re-inflate the bubble conditions that led to this crisis. There is nothing in the proposed new regulatory framework which will prevent this.

Additionally, the history of banking crises suggest that the regulatory focus on the liability side of the banks’ balance sheets is faulty. There is much discussion of counter-cyclical capital requirements, but the reality is that capital standards and leverage ratios for financial institutions almost never work. They are always set so low that they allow leverage that would have been viewed as extreme as recently as 30 years ago. They are easy to scam through accounting fraud. When times get tough, the financial services industry demands (and usually receives) regulatory dispensation on flaky accounting, legalizing what would otherwise be blatant securities fraud.

U. S. banks are public/private partnerships, established for the public purpose of providing loans based on credit analysis. Supporting this type of lending on an ongoing, stable basis demands a source of funding that is not market dependent. All regulation, then, should proceed from a ‘public purpose’ standpoint and the regulatory focus should be on the asset side of the balance sheet. Banks should only be allowed to lend directly to borrowers, and then service and keep those loans on their own balance sheets. There is no further public purpose served by selling loans or other financial assets to third parties, but there are substantial real costs to government regarding the regulation and supervision of those activities. And there are severe consequences for failure to adequately regulate and supervise those secondary market activities as well.

Our key recommendations:

• Banks should not be allowed to have subsidiaries of any kind. No public purpose is served by allowing bank to hold any assets ‘off balance sheet.’ Banks should not be allowed to accept financial assets as collateral for loans. Forget about leverage ratios: no public purpose is ever served by financial leverage of any kind.

• Banks should not be allowed to buy (or sell) credit default insurance. The public purpose of banking as a public/private partnership is to allow the private sector to price risk, rather than have the public sector pricing risk through publicly owned banks.

If a bank instead relies on credit default insurance, it is transferring that pricing of risk to a third party, which is counter to the public purpose of the current public/private banking system. CDSs lead investors to be indifferent to a bankruptcy, and in many cases to push for it. Since they own a CDS, they will get their payoff, while negotiating a restructuring takes time and money. Why bother if you can collect immediately via the profits proceeds of a credit default swap? These “Frankenstein” products by all rights ought to be banned outright, but the most the Obama/Geithner reforms dare to propose is a clearinghouse system to reduce potential knock-on effects (systemic risk) from the failure of a large player. But the riskiest products are not standardized enough for a clearinghouse and therefore remain exposed to bilateral counterparty risk which regulators want to mitigate by imposing higher capital charges and disclosure of aggregate position holdings. Naturally, Wall Street opposes this.

The FDIC should be directed to examine the books of the largest insured banks to uncover all CDS contracts held. The gross positions should be netted out amongst these financial behemoths, canceling CDS contracts held on one another. CDS contracts with foreign banks should be unwound; the American taxpayer should not be in the business of bailing out non-US banks. In its examination, the FDIC will have to determine which of these banks are insolvent based on current market values-after netting positions. Those that are insolvent will be resolved. The ultimate objective must be to minimize the cost to FDIC and minimize impacts on the rest of the banking system. It will be necessary to cover some uninsured losses to other financial institutions as well as to equity holders (such as pension funds) arising due to the resolution. And finally, the Treasury and Fed will be directed to work to reduce concentration of the financial sector by avoiding resolution methods that favor large institutions. There will be a bias toward rescue of smaller institutions, and use of the resolution process to break-up the larger institutions.

The past few months have provided ample demonstration that Wall Street intends to recreate the conditions that existed in 2005. And make no mistake, the current situation is worse than it was in 2007 before the collapse, particularly in relation to large, systemically-significant financial institutions. President Obama, Fed Chairman Bernanke and Treasury Secretary Geithner have made many bold claims about their new financial reforms, but these reforms in no way represent a radical shift in its framework of analysis and policy implementation. The reality all three of them continue to turn a blind eye to the underlying problems in the hope that these will not return and blow up again on their watch. This is precisely the recipe for disaster followed by Alan Greenspan, Robert Rubin, and Henry Paulson.

Roosevelt Institute Braintruster Marshall Auerback is a market analyst and commentator.

The Minsky Hour, or maybe just ten minutes

Plus Marc Faber and Steven Roach

Yes, we've been teasing too much, but there is too much to Minsky. We'll lead off with the insights of this obscure, but much less so today than last year, economist. A bit later we'll get more of Marc Faber and some Steven Roach on China.

First a discouraging word from Joseph Stiglitz, dropped in conversation at the Roosevelt Institute's Four Freedoms dinner recently. Stiglitz suggested to Lynn Parramore that still more than 60 percent of economists are holding on to the Chicago School mentality. Wow. When economics becomes not a science, but a religion.

But let's start out today with our minds clear and our focus simple.

And we go back to the algebra derived from Michal Kelecki's most simple assumption -- that workers consume all their income -- and see how Minsky develops it. Of course the assumption is not completely true, but it is not fatal to the analysis when it deviates the way, for example, the assumption of Neoclassical economics that all firms are price takers or the assumptions of rational expectations that market participants, indeed all economic actors, are imbued with economic omniscience.

Kalecki showed that when his assumption was allowed and in an economy with small government and little trade, investment equals profits, or profits equal investment.

By nothing more controversial than simple algebra, Minsky then demonstrated first that price is positively related to the wage rate and to the ratio of investment goods to consumption goods production, and negatively related to labor productivity. We went over that a couple of weeks ago, when we then digressed on the inappropriately prominent place the quantity theory of money has in the primitive orthodoxy that rules economics today.

But let's consider what Minsky's relationships mean. It's a no-brainer that prices vary in the opposite direction as productivity, because, productivity simply means producing more with the same labor. We at Demand Side recently demonstrated that productivity also goes up when the unemployment rate goes down. (I was so excited.) And since wages and unemployment also vary inversely, there is some amelioration of the labor cost impact on price, that is, on inflation. Put simply, prices do not rise in proportion to wages in periods of falling unemployment. This is, of course, opposite to the information derived from the famous Phillips Curve.

But the second part of this finding is very instructive. The algebra shows what we might also derive from common sense. As investment goods are emphasized over consumer goods, the price of consumer goods tends to rise, because, basically, workers in both sectors are bidding for the output of the consumer goods sector. So when the ratio favors investment goods more, demand for consumer goods is higher and output is lower.

But the implications are not all so common-sensical. The Kalecki demonstration that profits equal investment combines with this revelation that as new investment goes up, so do prices, to produce a condition in which higher prices, higher investment and higher profits coexist. Since investment also connects positively with output and income, we can expect these two -- output and income -- to be in the same virtuous soup.

This indeed was a somewhat surprising empirical finding of our research on economic performance by president. We found that in the postwar period employment is higher, unemployment lower, investment higher, corporate profits higher and GDP growth better when a Democrat is in the White House. It surprised us somewhat that with all the effort by Republicans to push companies into profitability, some would say at the expense of others, that is, the whole supply side idea, that they were not able to accomplish profits better than Democrats. The Kalecki-Minsky analysis demonstrates why it has to be. You can find it on pages 140 and following in Stabilizing an Unstable Economy.

Prices, Minsky says, carry profits, the raison d'etre for investment. In my micro courses we had fixed costs and variable costs and average costs. Prices were determined by marginal costs and where the marginal cost curve intersected the demand curve. This may be true, Minsky says, for price takers. But a whole great swath of the economy, by far its major part, is composed of firms which more or less set prices and vary output according to demand.

These firms operate on the basis of a set of nesting average cost curves, the highest of which includes capital asset validation cost, or profits in the normal use of the word. Such firms keep prices at the requisite level when demand falls by their market power, pricing power. Without this ability to constrain price movements, they may not be able to employ expensive and highly specialized capital assets and large-scale debt financing, Minsky observes.

We include that mention here not because we expect you to get it, the nesting average cost curves and so on, but just to let you know it is there in Minsky, as it is in the real world, and it informs what follows.

Returning to the propositions derived from the insights of Kelecki. Minsky expanded these by introducing big government and trade and workers who save. Elegant and simple algebra yields some remarkable insights.

Note here and we'll explain more in a minute that Minsky's profit is not the same profit with which we are familiar, nor that which we measured in our comparisons of economic performance by president.

Nevertheless, when government and taxes and deficits are introduced, something remarkable appears. It can be shown that after-tax profits equal investment plus the government deficit. When there is no investment, profits equal the deficit. See the details on page 148.

What are the implications of this? One implication is certainly that the big business types who encouraged the tax cuts to promote business should not now be bellyaching about the deficits. They are supporting profits. Now let's look at exactly what profits they are supporting.

Minsky's profits he also terms the "surplus," and it is not only the return on capital we normally think of as profit, but all the returns which are not technologically determined costs of production. These include advertising and professional services, executive salaries and overhead costs, costs of financing and the aforementioned costs to validate capital assets.

Two things jump out at me. One is that the profit or surplus feeds the white collars and presumably the big salaries as opposed to the blue collars on the production side. The other is that price-taking firms are disciplined into being more lean and less top heavy. It appeals to me as justification for taxing incomes progressively.

But let's go back to the price takers versus the price makers. What happens when demand falls? In the case of price takers, demand is reflected by a price that runs back along the marginal cost curve. In the case of price makers, who set the price and prevent its falling by market power, something else happens.

If output drops below the first critical average cost curve, capital asset prices are no longer validated and investment in new capital assets stops -- with implications across the economy for incomes and output. If output drops below the second critical curve, fixed debt payments can no longer be supported, and the various financing instruments come under pressure. Of course, the overhead and executive costs are compressed to some extent, but these may be resistant. For example, firms may increase advertising in attempts to gin up demand.

And when overall demand affects many firms, the same kinds of financial instruments come under pressure and we walk into the kind of crisis we have today.

See that the deflation is resisted by such firms on their products, because they have individual pricing power, but that the drop in output affects incomes and investments and financial arrangements dramatically -- without affecting price.

So my take here is that we ought not to be too ecstatic that deflation is not spiraling. The cost-cutting and absence of investment and the pressure on the financial sector, all too evident in the current stagnation and apparent in declining payrolls may likely mean more bad jujus.

AND of course, business cash flow is being supported mightily by government deficits.

I hope this is semi-clear. It is new to us in this form, and it is a lot to digest. But here at the micro level, you can see what about modern capital-intensive corporate capitalism Minsky found so unstable.

Now, moving on.

Here is Marc Faber, continued from last week. He begins by taking some shots at Paul Krugman, which I purposely leave in here, though I may have to turn in my progressive economics club card. Faber says a kind word about the Austrian School as well. To that I reply with the anecdote in James K. Galbraith's piece we put up on the blog recently. When James K.'s father John Kenneth addressed a conference in Austria, two of the leading lights ... well, here it is verbatim.

...when the Vienna Economics Institute celebrated its centennial, many years ago, they invited, as their keynote speaker, my father [John Kenneth Galbraith]. The leading economists of the Austrian school—including von Hayek and von Haberler—returned for the occasion. And so my father took a moment to reflect on the economic triumphs of the Austrian Republic since the war, which, he said, “would not have been possible without the contribution of these men.” They nodded—briefly—until it dawned on them what he meant. They’d all left the country in the 1930s.

unquote from James K. Galbraith

Now, Marc Faber

FABER

Mark Faber

Now just a word from Steven Roach head of Morgan Stanley Asia, in support of our contention that the Chinese miracle may be a mirage unless they establish some sort of basis for homegrown demand, by which I mean social insurances for health care, old age and unemployment. Absent this, they may spend their dollars in pushing infrastructure and see the GDP number respond without establishing anything fundamental. The same sort of infrastructure spending in the U.S. would do great things, but because we have the basis for demand to respond rather than grab the loose dollars and stuff them under the mattress.

Steven Roach with Leslie Cohen of the BBC's Business Daily.

ROACH

Steven Roach

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