Category Archives: Financial Times

France Joins Germany Ganging Up on Bondholders

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It does look like they are trying to cause markets to discount a very high probability of restructuring.

Any restructuring losses are reductions in financial assets and ultimately deflationary, as former bond holders
have less spending power. Unless the restructuring somehow results in more govt spending on goods and services, which, in this case, it clearly won’t. In fact, it will most likely be followed with additional austerity.

So looks like another whipsaw for the euro- down as people flee the currency over fears of losses due to restructuring
as well as fears of officials willing to restructure doing some other unknown thing that could cause losses, followed by a strong currency once it’s sorted out and considered ‘safe’ from default risk.

France Joins Germany Ganging Up on Bondholders to Share Pain

By Mark Deen and Francine Lacqua

November 11 (Bloomberg) — French Finance Minister Christine Lagarde said investors must share the cost of sovereign debt restructurings, backing a German call that helped send yields on Irish and Portuguese bonds to record highs.

“All stakeholders must participate in the gains and losses of any particular situation,” Lagarde said during an interview yesterday in Paris for Bloomberg Television’s “On the Move” with Francine Lacqua. “There are many, many ways to address this point of principle.”

Irish 10-year bonds dropped for a 13th day, driving the yield up 19 basis points to 8.95 percent and the risk premium over benchmark German 10-year bunds to a record 652 basis points. Ten-year Portuguese yields rose 9 basis points to 7.27 percent, while Greek and Spanish bond yields also climbed.

Lagarde’s comments mark France’s most explicit backing of German proposals to make bondholders contribute in bailouts, which deepened the slump in bonds of the so-called euro peripherals. Risk premiums that investors demand to buy their debt have risen since an Oct. 29 European Union summit when German Chancellor Angela Merkel sparred with European Central Bank President Jean-Claude Trichet over forcing bondholders to take losses in restructurings, so-called haircuts.

“We do have differing approaches,” Merkel told reporters after the summit.

The clash continued during the past two weeks, pummeling European bond markets.

‘Nail in the Coffin’

“Lagarde’s comments mentioned restructuring, and that’s another nail in the coffin” for peripheral debt, said Steven Major, global head of fixed-income research at HSBC Holdings Plc in London. “There’s still a big constituency of investors and traders who have not recognized until now that restructuring could happen.”

The spread between yields of Irish 10-year bonds and German bunds has widened more than 200 basis points since Merkel began her push for burden sharing.

German officials are sticking to their guns amid the bond market rout.

“We do also need creditors to be involved in the costs of restructuring,” Merkel said today in Seoul, where she’s attending a summit of the Group of 20 leaders. “There may be a conflict here between the interests of the financial world and the interests of politicians. We can’t constantly explain to our voters that taxpayers have to be on the hook for certain risks, rather than those who make a lot of money taking those risks. I ask the markets sometimes to bear politicians in mind, too.”

Trichet’s Stance

Trichet says such talk risks exacerbating the situation for indebted nations as they struggle to cut their budget deficits.

“The more you talk about restructuring debt, the harder it is to obtain debt,” Irish Finance Minister Brian Lenihan said Nov. 2. “That is the reality.”

“They are making it more likely that countries like Ireland and Portugal will be forced to restructure their debt,” said John Stopford, head of fixed income at London-based Investec Asset Management Ltd., which oversees $65 billion. “There should potentially be some conditionalities, otherwise it will become a self-fulfilling prophecy.”

The cost of insuring Irish debt gained 20 basis points to a record 617 basis points, according to data provider CMA. Credit default swaps for Portugal added 17 basis points to 494. Fallout from the slump in Ireland and Portugal pushed up the default risk on Spanish debt 12 basis points to 289.

Irish and Portuguese debt has suffered the biggest declines this month among the world’s government bonds. Ireland has dropped 8.6 percent since the Oct. 29 EU summit and Portuguese bonds have shed 5.9 percent.

Portugal Bid

Portuguese Finance Minister Fernando Teixeira dos Santos urged the EU yesterday to clarify how the so-called crisis mechanism will operate.

EU leaders plan to map out by December how a permanent bailout facility might work, and also study how to treat private bondholders and whether to involve the International Monetary Fund. The new system would kick in when temporary measures, set up this year to rescue Greece and protect the euro, expire in 2013.

“We have to make an appeal at the European level for the European institutions to rapidly, with the greatest possible urgency, clarify the terms in which this mechanism will function,” Teixeira dos Santos told reporters in Lisbon.

Lagarde cited several ways in which investors would share the losses in a bond scheduling with taxpayers.

“I’m not specially focused on haircuts,” she said. “We can insist on having in any issuance and in any agreements a collective action clause under which any lender agrees that if something goes wrong, the lender will actually participate in the plan that will solve the difficulty, in the same way that you can have rescheduling over time.”

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What Policies for Global Prosperity?

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Antonio Foglia and Andrea Terzi interview Warren Mosler, Distinguished Research Associate of the Center for Full Employment and Price Stability, University of Missouri, Kansas City (participating via videoconferencing)

April 20, 2010

*Antonio Foglia* (AF): I have known Warren from his previous life as an investor, where he definitely proved his skills. Now, he is an economist and, as all economists, he thinks he has a recipe to fix the world. He is also becoming a politician, so he now has another reason for having a recipe to fix the world, and we are definitely most interested in learning what his recipes are today, at a very special conjuncture in the world.

Warren, thanks for being connected with us this evening. I know you are in Connecticut now. We are in Switzerland, so I think a more general point of view of the world is probably more of interest to all of us although I understand that you might be more current on how to fix the U.S., as that is where you hope to have an impact soon.

*Andrea Terzi* (AT): Hello from the Franklin Auditorium, Warren. The floor is yours.

*Warren Mosler* (WM): Thank you. Well, the most obvious observation is that unemployment is evidence of a lack of aggregate demand, so what the world is lacking is sufficient aggregate demand.

In the United States, my prescription includes 1) what we call a payroll tax holiday, i.e., a tax reduction, 2) a revenue distribution to the states by the federal government and 3) a federally funded $8.00-per-hour job for anyone willing and able to work. *

For the euro zone, I propose a distribution from the European Central Bank to the national governments of perhaps as much as 20 percent of GDP to be done on a per capita basis so it will be fair to all the member nations*. The interesting thing is that it would not increase spending, or demand, or inflation, because spending is already constrained by the Stability and Growth Pact (SGP), and so nations would still be required to keep spending down to whatever the EU requires, but what it does do is to eliminate the debt and financing issues, and it takes away the credit risk from the euro zone. The other thing it does is it gives the EU a far more powerful tool for enforcing its requirements. What happens is that anyone who does not comply with the EU’s requirements would risk losing this annual payment. Right now, anyone who does not comply gets fined, but, as we know, fines are not easy to enforce.

*AF*: I think that after three hours of Keynesian presentations today I didn’t expect anything else than an extra vote for more aggregate demand stimulation, on one side, and the irrelevance of printing more money, on the other side. Somehow, though, I do personally remain concerned, and don’t fully understand how, in the long run, this will not have side effects as people begin to actually expect the fact that more money is going to be printed, more demand is going to be stimulated in less and less productive ways (because it is basically government spending rather than private spending). If I look at history there is little evidence of how you get out from the sort of Keynesian policy that you are proposing, that is certainly very effective in stopping a depression from developing (and we are grateful that policy makers did that), but I don’t understand how you then stop those policies, and how the exit from those policies can happen in the medium and long term.

*WM*: Okay, so you put up a lot of things there. So I’ll start from the beginning. First of all, for the U.S., I’m talking about restoring income for people working for a living which will raise the sales in the private sector right now, so it’s not a question of government. You talk about stimulus, but I’m not talking about adding stimulus. I’m talking about removing drag. You can’t get something for nothing. If you have somebody running and a plastic bag falls over his head that slows him down you can remove that plastic bag. We are still limited by our productive potential, and what we have now are restrictive policies that are keeping us from achieving it. Restrictive policies are demand leakages. In the U.S., there is a powerful incentive not to spend your income as this goes into a pension fund, and in Europe you have the same types of things that reduce aggregate demand. The only way any sector can successfully “net save” is if another sector goes into deficit, so what the government is doing when it lowers taxes or increases spending, depending on what the case may be, is filling the hole in demand created by the demand leakages.

My proposal for the EU doesn’t increase anyone’s spending. All it does is this: As long as countries are in compliance with spending limits set by the EU, they receive the allocation. As soon as they are not in compliance, they risk losing this payment, in which case the market will severely punish them and cut them off. So, to address your questions, I am not advocating any excess spending stimulus beyond just making up for the drags created by what I call “saving desires” and “demand leakages” which are largely a function of the institutional structure.

Let me just say it in one more way. A government like the U.S. has to determine what the right size of government is. For example: what is the right size for the legal system? You don’t want to have to wait two years to get a court date, but you don’t want to have people calling you up asking you come to court because there are a lot of vacancies, so maybe the right waiting period is, say, 60 days. So you then size your legal system and your legal employees for that kind of public service.

Equally, you have to size the military for what the mission is. You have to size the whole government. *Once you’ve sized your government properly, you then have to determine the correct level of taxes that is needed to sustain the level of private-sector activity that you want, and invariably those taxes are going to be less than the size of the government.* So, even if you want a smaller government, which is fine, you then have to have taxes that are even lower. Why? Because that’s the only way you are going to accommodate your private sector on its savings desires.

*AT*: I know where you are coming from, Warren, and I’m sure you realize that your proposal that the ECB distribute money to European governments makes many people here in Europe jump on their seats for two reasons. One: the ECB is prevented by statute from financing national governments; and two: people fear that this is further additional printing money, creating inflation. Would you mind going back to your proposal and explaining to me and the audience, step by step, what this distribution really means, where this money comes from, and where it is going, in this score-keeping exercise that is the true character of a monetary economy?

*WM*: Right, exactly. So, yes, it would require unanimous approval of EU governments. What I’m saying is that European governments have accounts at the ECB. Under my proposal, the ECB would put a credit balance into government accounts. So what will happen is that the balance in their accounts will go up. *Just because a balance on a national bank account goes up, it does not mean there is any additional spending. It is spending that causes inflation, not just the existence of a credit balance on a central bank computer.* But what would then happen is that in the normal course of spending, borrowing and debt management, this balance would be worked down. Not by an increased volume of spending and not by a change in anything else, but it would just be worked down because, for example, when the Greek bonds would mature, the government would be able to continue its normal spending (this would be limited by compliance with the SGP and other international agencies) without having to refinance its bonds. But once the credit balance is used up, then Greece would continue its normal refinancing, but with a level of debt reduced by about 20 percent GDP the first year.

So again this has no effect on the real economy, no effect on real spending. The only effect is that there would be fewer Greek securities outstanding, and that Greek debt levels would be lower and coming down, which would facilitate their continued funding once the credit balance is used up. So it’s purely, as you stated, an operational consideration and not a real economic consideration, and yes, *people would be afraid of things that they don’t understand*. But anyone who understood central banking from the inside at the operational level would realize that this would have absolutely no effect on inflation, employment, and income in a real economy, other than to facilitate the normal funding of national governments.

*AT*: Are you saying that the effect of such annual distribution would be like the effect of the discovery of a new gold mine every year in a country under the gold standard?

*WM*: Well, no, it’s different, because on a gold standard what we call the money supply is constrained in any case, whereas when you get to a currency it’s the opposite: the currency itself is never constrained. So you have a whole different dynamic.

Let me just expose my point from a slightly different point of view. The reason the EU can’t simply guarantee all the nations, and the ECB can’t simply guarantee all the national governments is because if they did, whoever “deficit spends” the most, wins. You would get a race to the bottom of extreme moral hazard that quickly winds up in impossible inflation. So there has to be some kind of mechanism to control government deficit spending for the member nations*. They did it through the SGP, that sets the 3 percent limit, and there’s no way around that dilemma. It can’t be done through market forces. It has to be done through the SGP. What they did is to leave the national government on a stand-alone basis, so there would be market discipline, but we’ve seen that that does not work either. They’ve got to get back to a situation where they are not subject to the mercy of market forces but at the same time they don’t want the moral hazard of some unlimited fiscal expansion where anybody can run a 5, 10, 20 percent deficit with inflationary effects.

My proposal eliminates the credit risk at the national government level, so they are no longer restrained by the markets in their ability to borrow, but it makes them dependent on annual distributions from the ECB in order to maintain this freedom to fund themselves*.

And because they are dependent on the ECB’s annual check, the ECB has a policy to then be able to remove that check to impose discipline on these countries. *By having this policy tool to withhold payments, rather than implement fines, the EU would be in a much stronger position to enforce the deficit limits they need to prevent the race to the bottom of nations*.

*AT*: Your proposed ECB distribution would have the immediate effect of reducing the interest rate spread between German and Greek bonds. However, if the 3-percent deficit constraint remains in place, there is not much hope of prosperity in Europe. Do you agree?

*WM*: Right. The demand management would be based on the SGP: if they decide a 3-percent deficit is not adequate for the level of aggregate demand they may go up to 4, 5, or 6 percent or whatever level they choose. It’s always a political decision for them, and it’s always going to be a political decision. If they choose something too low, then they’re going to have higher unemployment. If they choose something too high, they’re going to have inflation.

And so it’s going to be a political choice, no matter how you look at. But the thing is, how do you enforce the political choice? Right now they can’t enforce it. Right now, they’ve been enforcing it through the fining of member nations. But it doesn’t work. So they’ve lost their enforcement tool.

The other problem they have is this: because of the credit sensitivity of the national governments, when countercyclical deficits go up like now, which are needed to restore aggregate demand, output and employment, what happens is that the deficits challenge the creditworthiness of the national governments. *This is an impossible situation with national governments risking default because of the insolvency risk. They are in a completely impossible position to accomplish any of their goals. *

Whereas, reversing the situation, i.e., going from “fines as discipline” to “withholding payments as discipline” puts them in a position that is manageable. It still then requires wise management for the correct level of deficits, for the correct level of aggregate demand, but at least it’s possible. Right now, it’s unstable equilibrium, and what I am proposing switches it to a stable equilibrium, as they used to say in engineering class.

*AF*: If I understand correctly, the essence of the policies that you are suggesting, both in the U.S. and in Europe, involve a certain level of deficit spending and debt accumulation. Then one could expect the dollar/euro exchange rate not to move much because people would probably tend to dislike both currencies the same way. How would you see the interaction of these two areas with emerging markets that are in a totally different economic environment and cycle, and whose currencies are actually currently on the rise?

*WM*: Right, if you look at nations like India and even Brazil, they all have high interest rates and high deficits that help them get through. China, as well, maintains an extremely high deficit offsetting its internal savings desires. China may have overdone it, and it has to face an inflation problem, but this is a different story. *I think that the U.S. is in a far better situation than the euro zone right now, because our budget deficits do not represent the sustainability issues or credit issues*.

The EU has put its member nations in the same position as the U.S. states, as if Germany, or Greece, were like Connecticut, or California. They put all their member nations in the same position as state governments but without the federal government spending that the U.S. uses to help them out. This puts the whole burden of sustaining aggregate demand on European member nations. To get an analogy in the U.S., *if the U.S. had to run a trillion and a half million dollar deficit last year at the federal level, and if the only way that could have happened was at the state level, the U.S. would have been in much the same position as the EU, with all our states right on the edge of default.* So because we have our deficit at the federal level, instead of state level, we are in a much stronger position than the EU right now.

You may have already reviewed the mechanics of how nations like the U.S. or the U.K. do their public spending in the conference, but let me do it very quickly. When the United States spends money that it doesn’t tax, it credits the reserve account of whoever gets that money. Now, a reserve account at the central bank is nothing more than a checking account.

Let me now use the example of China so I can combine the problem of external debt with deficit spending at the same time. China gets its dollars by selling goods and services in the United States. When China gets paid, the dollars go into its checking account at the Federal Reserve Bank, and when China buys Treasury securities, all that happens is that the Federal Reserve transfers the funds from their checking account at the Federal Reserve to their securities accounts at the Federal Reserve. U.S. Treasury securities are accounted much like savings accounts at a normal commercial bank. When they do that, it’s called “increasing the national debt”, although when it’s in their checking account it doesn’t count as national debt. The whole point is that the spending of dollars by the federal government is nothing more than the Federal Reserve Bank changing numbers off in someone’s reserve account. The person doing this at the Treasury doesn’t care if funds are in the reserve account at the central bank; it makes no difference at all, operationally. *There is no operational connection between spending, taxing, and debt management.* Operationally, they are completely distinct. And the way any government like the United States or the U.K. or Japan pays off its debt is the same: just transfer funds from someone’s security accounts back to the reserve accounts at your own central bank, that’s it. And this happens every week with hundreds of billions of dollars. None of this acts as an operational constraint on government spending. There is no solvency issue. There is no default condition in the central banks’ computer.

Now, when you get to the EU, it all changes because all this has been moved down to the national government level, and it’s not at some kind of federal level the way it is in the United States. There is no default risk for the U.S., for the U.K., or for Japan where the debt is triple that of the U.S. and double that of Greece. It is all just a matter of transferring funds from one account to another in your own central bank.

*AT*: I’m glad you touched upon the question of China accumulating credits with the U.S., because this is poorly understood. Money that Chinese earn by sending merchandise to the United States are credits in the U.S., and these credit units are nonredeemable, so Chinese owners can do nothing with these things unless they use them to buy American products, and if they do, those units become profits for American firms. But there is also another possibility, which sometimes raises concerns in the larger public, and this is what happens if China should choose to get rid of these dollars by selling the U.S. securities they own. While the amount of dollars owned by foreigners doesn’t change, the price of the dollar would in fact decline. If China sells off American debt, dollar depreciation may be substantial.

*WM*: Operationally, it’s not a problem because if they bought euros from the Deutsche Bank, we would move their dollars from their account at the Fed to the Deutsche Bank account at the Fed. The problem might be that the value of the dollar would go down. Well, one thing you’ve got to take note of is that the U.S. administration is trying to get China to revaluate currency upward, and this is no different from selling off dollars, right? So, what you are talking about (selling off dollars) is something the U.S. is trying to force to happen, would you agree with that?

*AT*: Yes!

*WM*: Okay, so we’re saying that we’re trying to force this disastrous scenario—that we must avoid at all costs—to happen. This is a very confused policy. *What would actually happen if China were to sell off dollars? Well, first of all, the real wealth of the U.S. would not change: the real wealth of any country is everything you can produce domestically at full employment plus whatever the rest of the world sends you minus what you have to send them, which we call real terms of trade.* This is something that used to be important in economics and has really gone by the wayside. And the other thing is what happens to distribution. While it doesn’t directly impact the wealth of the U.S., *the falling dollar affects distribution within U.S., distribution between those who profits from exports and those who benefit from imports.* And that can only be adjusted with domestic policy. So, number one, we are trying to make this thing happen that we are afraid of, and number two, if it does happen, it is a demand-distribution problem, and there are domestic policies to just make sure this happens the way we want it to be.

*AT*: Would you like to elaborate on another theme of today’s symposium? How do you see the income distribution effects of the U.S. fiscal package? Is it going in the right direction in your opinion?

*WM*: Well, we had 5 percent growth on the average maybe for the last 2 quarters while unemployment has continued to go up. If GDP is rising and people in the world are getting hurt, and real wages are continuing to fall, then who is getting the real growth? Well, everybody else. And so what we’ve seen from a Democratic administration is perhaps the largest transfer of real wealth from low income to high income groups in the history of the world. Now, I don’t think that was the intention of their policies but it has certainly been a result, and it comes from a government that does not understand monetary operations and a monetary system and how it works.

*AT*: Warren, what would be your first priority, the one action that you would enforce immediately to improve the current situation?

*WM*: The United States has a punishing regressive tax which we call payroll taxes. These take out a fixed percent of our income, 15 percent (7.5 percent paid by employees and 7.5 percent by employers), so it starts from the very first dollar you earn, and the cap is $108,000 a year. *I would immediately declare a payroll tax holiday, suspend the collection of these taxes. This would fix the economy immediately from the bottom up. A person making $50,000 a year would see an extra $325 a month in his pay check, simply by having the government stop subtracting these funds from his or her pay.

Our economy has always worked best if people working for a living have enough take-home pay to be able to buy the goods and services that they produce. Right now, in the United States, people working for a living are so squeezed they can pay for gasoline and for food and that’s about it, maybe a little bit of their insurance payments, and so we’ve had an economic and social disaster. *The cause of the financial crisis has been people unable to make their payments.* The only difference between a Triple-A loan and “toxic assets” is whether people are making their payments or not. And you can fund the banks and restore their capital and do everything else, but it doesn’t help anyone making their payments. We’re two years into this and we’re still seeing delinquencies moving up, although they levelled off a little bit, at unthinkably high levels. Hundreds of thousands of people getting thrown out of their homes—that’s the wrong way for a Democratic administration to address a financial crisis.

To fund a bank, simply stop taking the money away from people working for a living so they can make their payments and fix the financial crisis from the bottom up. *All that businesses and banks need and want at the end of the day is a market for their products; they want people who can afford to make their payments and buy their products.* So my first policy would deliver exactly that, which is what I think we need to take the first big step to reverse what’s going on.

*AT*: The action you proposed, the payroll tax holiday, entails some form of discretionary fiscal policy and this raises two questions. First, discretionary fiscal policy has been discredited. Economists like to model politicians’ behavior in a way that we cannot trust their decisions as they just aim at winning the next elections. So how do we make sure that discretionary fiscal policy would be used correctly to achieve full employment and avoid inflation?

*WM*: My proposal is not talking about discretionary spending. It’s about cutting taxes and restoring incomes for people who are actually working for a living, who are the people that at the end of the day we all depend on for our lifestyle, so it is not an increase in government spending, it is a tax cut on people working for a living. The only reason this hasn’t happened is because of what I call “the innocent fraud” (from my book, *The seven deadly innocent frauds*, available on my website), that the government has run out of money, the government is broke, the federal government has to get funding, has to get revenues from those who pay tax, or it has to borrow from China and leave it to our children to pay back. This is complete myth, and it is the only barrier between us and prosperity. Now, in terms of using excess capacity and create inflation, the theory says yes, it can happen, though I’ve never seen it in my forty years in the financial markets.

As they say, in order to get out of a hole, first you have to stop digging, right? Right now, we’ve got an enormous amount of excess capacity in the United States. Unemployment is at 10% only because they changed the way they define it. Using the old method, we have up to 22% unemployment.

The payroll tax holiday will both increase spending power and lower costs, so we get a little bit of deflationary effect as spending starts. Should there be a time when we see demand starts threatening the price level, then it can come a point where it makes sense to raise taxes, but not to pay for China, not to pay for social security, not to pay for Afghanistan (we just need to change the numbers up in bank accounts) but to cool down demand. We have to understand that taxes function to regulate aggregate demand and not to fund expenditures.

*AT*: Discretionary fiscal policy also includes discretionary changes in taxes, not only discretionary changes in spending, so how do we make sure that the political ruling class will raise taxes when needed?

*WM*: Well, right now they’re raising taxes, so they don’t seem to have much of a reluctance to do that, and they also understand that voters have an intense dislike for inflation. It’s not justified by the economic analysis, it’s just an emotional dislike for inflation. They believe it’s the government robbing people of their savings and they believe it’s morally wrong. And so they are always under intense pressure to make sure that inflation does not get out of control or they are going to lose their jobs. But that’s the checks and balances in a democracy. It’s what the population votes for. And the American population has shown itself to vote against inflation time and time again. The population decides they want more or less inflation, it boils down to whether you believe in democracy or you don’t. And I’m on the side to believe in democracy.

*AT*: In terms of democracy, this choice is not available to Europeans right now. The ECB has been given an institutional mandate of price stability, and the decision of what’s more evil, inflation or unemployment, has been removed from voters’ preferences on the ground that price stability is the premise to growth and full employment!

But I’m afraid our time is over. Warren, thank you very much. Although the volcano in Iceland prevented you from attending today, at least we had this opportunity to discuss via teleconference.

*WM*: Was the volcano a result of the financial crisis over there?

*AF*: It was a way for Iceland to take revenge on the Brits!

Warren, we thank you very much for making this conference possible and thank you for your time. I encourage anybody who is interested to go to your website to get a view of your most recent ideas, and all the best from this side of the Atlantic on your campaign.

*WM*: Thank you. If anyone has more questions just write to my email address warren.mosler@gmail.com and I’ll be happy to correspond with anyone looking for more information.

*AT*: Thank you Warren.

*WM*: Okay, thank you all!

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1938 in 2010

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1938 in 2010

By Paul Krugman

September 5 (Bloomberg) — Here’s the situation: The U.S. economy has been crippled by a financial crisis. The president’s policies have limited the damage, but they were too cautious, and unemployment remains disastrously high. More action is clearly needed. Yet the public has soured on government activism, and seems poised to deal Democrats a severe defeat in the midterm elections.

The president in question is Franklin Delano Roosevelt; the year is 1938. Within a few years, of course, the Great Depression was over. But it’s both instructive and discouraging to look at the state of America circa 1938 — instructive because the nature of the recovery that followed refutes the arguments dominating today’s public debate, discouraging because it’s hard to see anything like the miracle of the 1940s happening again.

Now, we weren’t supposed to find ourselves replaying the late 1930s. President Obama’s economists promised not to repeat the mistakes of 1937, when F.D.R. pulled back fiscal stimulus too soon. But by making his program too small and too short-lived, Mr. Obama did just that: the stimulus raised growth while it lasted, but it made only a small dent in unemployment — and now it’s fading out.

And just as some of us feared, the inadequacy of the administration’s initial economic plan has landed it — and the nation — in a political trap. More stimulus is desperately needed, but in the public’s eyes the failure of the initial program to deliver a convincing recovery has discredited government action to create jobs.

In short, welcome to 1938.

The story of 1937, of F.D.R.’s disastrous decision to heed those who said that it was time to slash the deficit, is well known. What’s less well known is the extent to which the public drew the wrong conclusions from the recession that followed: far from calling for a resumption of New Deal programs, voters lost faith in fiscal expansion.

Consider Gallup polling from March 1938. Asked whether government spending should be increased to fight the slump, 63 percent of those polled said no. Asked whether it would be better to increase spending or to cut business taxes, only 15 percent favored spending; 63 percent favored tax cuts. And the 1938 election was a disaster for the Democrats, who lost 70 seats in the House and seven in the Senate.

Most interesting!

Then came the war.

From an economic point of view World War II was, above all, a burst of deficit-financed government spending, on a scale that would never have been approved otherwise. Over the course of the war the federal government borrowed an amount equal to roughly twice the value of G.D.P. in 1940 — the equivalent of roughly $30 trillion today.

Had anyone proposed spending even a fraction that much before the war, people would have said the same things they’re saying today. They would have warned about crushing debt and runaway inflation. They would also have said, rightly, that the Depression was in large part caused by excess debt — and then have declared that it was impossible to fix this problem by issuing even more debt.

Agreed! The deficit per se was of no consequence. The risks were and remain inflation from excess demand, which is not an easy channel to use to generate what we call inflation in today’s world. Our CPI problems have tended to come in through the cost channel and propagated by govt indexation of one form or another.

But guess what? Deficit spending created an economic boom — and the boom laid the foundation for long-run prosperity.

Agreed. Though the way I say it, for a given size govt. and given set of credit conditions there is a level of taxes that coincides with full employment, and that level is generally well below the level of govt spending.

Overall debt in the economy — public plus private — actually fell as a percentage of G.D.P., thanks to economic growth and, yes, some inflation, which reduced the real value of outstanding debts. And after the war, thanks to the improved financial position of the private sector, the economy was able to thrive without continuing deficits.

What??? Here, sadly, Paul’s implication that the actual level of the govt debt per se matters, and that his bent that lower deficits are somehow ‘better’ shines through, keeping him in the camp of being part of the problem rather than part of the answer.

(Good article for MMT’s to earn some hearts!)

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Audit the Fed!!!

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The Fed should offer full transparency. These are the reasons the Fed gives for secrecy:

“The Fed argued that allowing disclosure could stigmatize banks, causing a loss of confidence that could lead to deposit runs, bank failures and damage to the economy.”

The fact that the Fed fears a liquidity crisis is evidence that it doesn’t understand banking.
With the FDIC offering deposit insurance for up to 100% of any bank’s liabilities, it should be clear to the Fed the liability side of banking is not the place for market discipline. Liquidity should not be an issue and it should be provided in unlimited quantities at all times, much like most of the rest of the world’s central banks have been doing for a long time.

All the Fed has to do is simply trade in the fed funds market and offer any bank unlimited funding at the Fed’s target interest rate, and turn all of their focus on regulating the asset side of banking where it belongs.

The Fed should be audited NOW, and get this issue behind them as soon as possible.

See this and the rest of my proposals, thanks.

Fed in emergency bid to put bailout ruling on hold

Aug 25 (Reuters) — The Federal Reserve asked a U.S. appeals court to delay implementing a ruling that would force the central bank to disclose details of its emergency lending programs to banks during the financial crisis.

Wednesday’s emergency request for a 90-day delay came after the U.S. Second Circuit Court of Appeals on August 20 denied a motion by the Fed to rehear the case, which had been brought by Bloomberg LP, the parent of Bloomberg News, and News Corp’s Fox News Network.

A stay would give the Fed and the Clearing House Association, a group of major U.S. and European banks, until November 18 to appeal the ruling to the U.S. Supreme Court.

The Fed programs were designed to shore up the financial markets, and more than doubled the central bank’s balance sheet to well over $2 trillion, especially after the September 2008 collapse of Lehman Brothers Holdings Inc.

In March, the Second Circuit ordered the Fed to disclose information, including the names of bailout recipients and amounts received, that the news media had requested under the federal Freedom of Information Act.

The Fed argued that allowing disclosure could stigmatize banks, causing a loss of confidence that could lead to deposit runs, bank failures and damage to the economy.

In its Wednesday filing, the Fed said denial of a stay would “force the government to let the cat out of the bag, without any effective way of recapturing it” if the Second Circuit ruling were later reversed.

“The public policy interest identified by the government will be irreversibly lost,” it added.

Fed spokesman David Skidmore said “the stay is necessary to permit the board to consult with the Department of Justice regarding an appeal to the Supreme Court.”

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Bernanke Must Raise Benchmark Rate 2 Points, Rajan Says – Bloomberg

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If they actually understood how it all works they’d be calling for tax cuts rather than interest rate increases.

>   
>   (email exchange)
>   
>   On Mon, Aug 23, 2010 at 12:18 PM, wrote:
>   
>   Yes, Krugman criticised this today and I put in a kind word
>   for Mr Rajan in the comments section.
>   

I suspect Rajan is looking in part at the deflationary impact of the “fiscal channel” via the current 0% interest rate. Your NY Times colleague, Gretchen Morgenson, had a very good piece on this in the Sunday NY Times. Of course, the impact of this policy would, as you suggest, be ruinous for borrowers and highlights the comparatively diffuse impact of monetary policy, vs fiscal policy in terms of solving the problem of aggregate demand. Overall, this uncertainty points to the problems involved in using monetary policy to stimulate (or contract) the economy. It is a blunt policy instrument with ambiguous impacts.

The major problem facing the economy at present is that there is not a willingness to spend by the private sector and the resulting spending gap, has to, initially, be filled by the government using its fiscal policy capacity. I prefer direct public sector job creation to be the principle fiscal vehicle. But fiscal policy it has to be. Then when the negative sentiment is turned around, private borrowing will recommence and investment spending will grow again. Then the economy moves forward some more and the budget deficit falls.

Bernanke Must Raise Benchmark Rate 2 Points, Rajan Says

By Scott Lanman and Simon Kennedy

Aug. 22 (Bloomberg) — Raghuram Rajan accurately warned central bankers in 2005 of a potential financial crisis if banks lost confidence in each other. Now the International Monetary Fund’s former chief economist says the Federal Reserve should consider raising rates, even as almost 10 percent of the U.S. workforce remains unemployed.

Interest rates near zero risk fanning asset bubbles or propping up inefficient companies, say Rajan and William White, former head of the Bank for International Settlements’ monetary and economic department. After Europe’s debt crisis recedes, Fed Chairman Ben S. Bernanke should start increasing his benchmark rate by as much as 2 percentage points so it’s no longer negative in real terms, Rajan says.

“Low rates are not a free lunch, but people are acting as though they are,” said White, 67, who retired in 2008 from the Basel, Switzerland-based BIS and now chairs the Economic Development and Review Committee at the Paris-based Organization for Economic Cooperation and Development. “There will be pressure on central banks to follow an expansionary monetary policy, and I worry that one can see the benefits, but what people inadequately appreciate are the downsides.”

He and Rajan will have the chance to make their case at the Fed’s annual symposium in Jackson Hole, Wyoming, this week. In 2003, White told attendees central banks might need to raise rates to combat asset-price bubbles. In 2005, Rajan, 47, said risks in the banking system had increased. They were met with skepticism from then-Fed Chairman Alan Greenspan, 84, and Governor Donald Kohn, 67.

Losing Confidence

While the Fed did boost its target rate for overnight loans among banks in quarter-point steps to 5.25 percent by 2006 from 1 percent in 2004, that didn’t prevent a housing bubble, which began to pop in 2006. Banks began losing confidence in August of the same year and started charging other financial institutions higher interest on loans.

A minority of policy makers are increasingly echoing Rajan and White’s current worries, including Kansas City Fed President Thomas Hoenig, who is hosting the Aug. 26-28 symposium, and Andrew Sentance, one of nine members on the Bank of England’s monetary-policy committee.

Hoenig has dissented from all five Fed policy decisions this year, preferring to jettison a pledge to keep rates low for an “extended period.” Sentance was defeated for a third month in August in his bid to withdraw emergency stimulus by increasing the benchmark interest rate.

Few Converts

The naysayers may fail to win many converts any time soon as the recovery slows and U.S. unemployment, at 9.5 percent in July, remains near a 26-year high. The resulting extension of low rates may increase volatility of government bonds, especially in response to any stronger-than-anticipated economic data, said Marc Fovinci, head of fixed income at Ferguson Wellman Capital Management Inc.

Indications that growth will be at least 3 percent “in the coming months” would cause yields on 10-year Treasuries, which were 2.61 percent on Aug. 20, to rise to 3 percent within about a week, said Fovinci, who is based in Portland, Oregon, and helps invest $2.5 billion.

JPMorgan Chase & Co. reduced its forecast last week for growth in this quarter to an annual rate of 1.5 percent from 2.5 percent and in the last three months of 2010 to 2 percent from 3 percent.

“I’m not worried about inflation, because the economy appears to be weak,” Fovinci said. At the same time, the bond market seems to be “tightly coiled up like a spring.”

Rising Yields

Between June 3 and June 8, 2009, yields on 10-year Treasuries rose to 3.88 percent from 3.54 percent after the smallest drop in U.S. payrolls in eight months and European Central Bank President Jean-Claude Trichet’s forecast for economic growth in 2010. Two-year Treasury yields rose to 1.4 percent from 0.91 percent in the same period.

The margin for error is “incredibly thin,” said Derrick Wulf, a portfolio manager at Dwight Asset Management Co. in Burlington, Vermont, which oversees $64.3 billion. “A lot of investors have become complacent about being long” in Treasuries.

Rajan, now a professor at the University of Chicago’s Booth School of Business, says near-zero interest rates are a crisis tool and economists don’t know if the benefits from using them for longer periods outweigh the costs. While inflation isn’t the main threat now, “you can’t be totally comfortable,” he said in an Aug. 18 interview. People think “there is significant unused capacity in the economy” and that assumption may be mistaken.

‘Bad Incentives’

Near-zero rates create “bad incentives” for financial firms, he added.

“Blow the system up, we’ll come back and reward you with very low interest rates that allow you to build up capital, and then you could try it again next time around,” Rajan said.

The Fed also may be “prolonging pain” by propping up the housing market and keeping home prices from falling, he said.

Companies are sending mixed signals.

“Demand is very low across the country” for houses, Richard Dugas, chief executive officer of Bloomfield Hills, Michigan-based Pulte Group Inc., said Aug. 20 on Bloomberg Television’s “In the Loop with Betty Liu.” Meanwhile, Caterpillar Inc., the world’s largest maker of construction equipment, may add as many as 9,000 workers worldwide this year, Doug Oberhelman, chief executive officer of the Peoria, Illinois-based company, said Aug. 19.

Another Bubble

White, a Bank of Canada deputy governor from 1988 to 1994, says the benefits of low rates may already be waning “in a world with so much debt, especially household debt,” which in the U.S. totaled a near-record $11.7 trillion at the end of June. There’s also a danger they might create another bubble, he said.

Another risk is that near-zero rates allow companies to roll over nonviable loans, a practice known as “evergreening” that can create so-called zombie businesses, which happened in Japan, he added.

Rajan and White’s arguments aren’t winning over Keith Hembre, chief economist at U.S. Bancorp’s FAF Advisors Inc. in Minneapolis, where he helps oversee $86 billion.

“There’s little evidence that the very low rates today are inflicting any harm,” said Hembre, a former Fed researcher. While he has “some longer-term sympathy with the argument,” it’s “just off-base today, given the evidence available from both real-time and market indicators.”

Bernanke, 56, and the majority of Fed officials show little inclination to change course. The Fed lowered its benchmark rate to a range of zero to 0.25 percent in December 2008 and said after each policy meeting since March 2009 it will likely stay very low for an “extended period.”

Emergency Measures

The ECB has kept its main refinancing rate at 1 percent since May 2009, and the Bank of England’s key rate has been 0.5 percent since March 2009. Axel Weber, an ECB council member, said in an Aug. 19 Bloomberg Television interview that policy makers should keep emergency liquidity measures in place at least through the end of the year, beyond Trichet’s October guarantee. Bernanke and Trichet will speak at the Fed symposium Aug. 27.

White and Rajan have ruffled central-bank feathers before at Jackson Hole, where policy makers, academics, analysts and money managers from dozens of countries mix hiking and rafting in Grand Teton National Park with debate over monetary policy and bank regulation.

In 2003, White and then-colleague Claudio Borio, who was head of BIS research and policy analysis, told central bankers they might need to raise interest rates to “lean against” asset-price bubbles.

‘Cannot Work’

“The one thing I am sure about is that a mild calibration of monetary policy to address asset-price bubbles does not and cannot work,” Greenspan, who retired in 2006, responded at the conference.

Bernanke, then a Fed governor, told attendees that Japan raised rates in 1989 to prick a bubble, and as a result, “asset prices collapsed and they had a 14-year depression.”

In 2005, Rajan warned that if banks lost confidence in each other, “the interbank market could freeze up, and one could well have a full-blown financial crisis.”

Kohn disagreed in a speech after Rajan’s presentation.

“As a consequence of greater diversification of risks and of sources of funds, problems in the financial sector are less likely to intensify shocks hitting the economy and financial market,” he said.

More Open

Bernanke has since become more open to White’s view. While low interest rates didn’t cause the U.S. housing bubble, he said in a January speech, if the next wave of regulation proves “insufficient to prevent dangerous buildups of financial risks, we must remain open to using monetary policy as a supplementary tool for addressing those risks.”

Kohn, the Fed’s vice chairman from 2006 through June, said in a March speech that “serious deficiencies” with securitization of loans “exposed the banking system to risks that neither participants in financial markets nor regulators fully appreciated.”

Spyros Andreopoulos, a London-based global economist at Morgan Stanley, says he worries about the inflationary implications of extreme monetary accommodation beyond the next two to three years, with policy makers likely to lean toward low rates because of the fear of deflation.

“Imagine a car that’s stuck in the mud,” he said. “When you press on the gas, the car doesn’t emerge smoothly; it jumps up. My fear is when economies pick up after the stimulus, you’ll see inflation faster than was expected.”

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High-Freq Data/Fed/Call Centers

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Karim writes:

  • ABC survey improved by 2pts this week, and 5pts over past 2 weeks; Still in range of past 2yrs.
  • MBA refi index up 17.1% this week


New Purchase index down a tad but remains reasonably flat after correcting when the home buying credit expired.

Yesterday, Minny Fed President Kocherlakota talked about last week’s FOMC:

“The FOMC’s decision has had a larger impact on financial markets than I would have anticipated. My own interpretation is that the FOMC action led investors to believe that the economic situation in the United States was worse than they, the investors, had imagined. In my view, this reaction is unwarranted. I would say that there is no new information about the current state of the economy to be learned from the FOMC’s actions or its statement.”

Agreed. Q2 earnings good with Q2 gdp probably around 1%. Q3 GDP estimates still around 2.5% should be good further support earnings.

Modest growth not enough to bring down unemployment for a while, good for stocks however.

This was my interpretation but nice to hear an FOMC member say so.

And this from page 1 of today’s FT:

Call centre workers are becoming as cheap to hire in the US as they are in India, according to the head of the country’s largest business process outsourcing company.

Link

All above reasonably positive news…..

Yes, for stocks.
But not if you are a call center worker, or anyone else looking for a job…

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China Seen Robbing Consumers With Low Interest Rates

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Looks like someone’s catching on to the interest rate channel. And Bloomberg is reporting it.

(Bloomberg never reported it when I communicated with them.)

China Seen Robbing Consumers With Low Interest Rates

Aug 6 (Bloomberg) — Peking University professor Michael
Pettis was discussing declining bank-deposit returns when a
student interrupted with a story about her aunt that may stymie
China’s plan to boost consumer spending.

“To send her son to university in six years it means she
must replace each yuan in lost income with one from her wages,”
the student said, according to Pettis.

The government’s policy of keeping interest rates low to
reduce the burden of soaring municipal debt is costing savers as
much as 1.6 trillion yuan ($236 billion) a year in lost income
on bank deposits, according to Pettis, former head of emerging
markets at Bear Stearns Cos. To make up the shortfall, savers
have to set aside a larger proportion of wages, undermining
China’s efforts to counter slower export growth with consumer
spending at home.

“Consumption is already at a dangerously low level,” said
Pettis, author of the “The Volatility Machine,” a 2001 book
that examines financial crises in emerging markets. “If it
doesn’t begin to rise very quickly, China has a problem because
household consumption will continue to drop as a share of GDP.”

Emphasis on exports and investments have caused domestic
consumption to fall to 35 percent of gross domestic product, the
lowest of any major economy, from 45 percent a decade ago,
Societe Generale AG says.

Pettis isn’t alone in being skeptical about a consumer boom
in China. Yale University finance professor Chen Zhiwu and Huang
Yasheng at the Massachusetts Institute of Technology also
predict constrained consumer spending.

State Controlled

Chen estimates the state controls 70 percent of the
nation’s assets and says most of its profits don’t flow to
consumers. On an inflation-adjusted basis government income
surged more than tenfold in the past 15 years while disposable
urban income increased less than three times, he said.

Pettis said the drag on consumer spending from depressed
deposit rates may help slash China’s annual economic expansion
to between 5 and 7 percent a year through 2020, from an average
of about 10 percent in the past decade.

The Group of 20 nations has urged China to boost domestic
consumer spending to help offset reduced consumption from debt-
strapped consumers in the U.S. and Europe. If Chinese shoppers
fail to take over that mantle as the government’s 4 trillion
yuan in stimulus wanes, then the nation may have to fall back on
exports for growth. That would revive trade disputes with the
U.S., which is battling 9.5 percent unemployment, said Huang.

Trade Tensions

“I do not see how trade tensions can be avoided,” said
Huang, a professor at MIT’s Sloan School of Management in
Cambridge, Massachusetts, and author of “Capitalism with
Chinese Characteristics: Entrepreneurship and the State.”
“Even in the best-case scenario I do not see household
consumption replacing investment as a driver of growth in the
foreseeable future.”

China’s leaders have vowed to boost consumption’s share of
GDP since at least 2006 — so far to no avail. The ratio of
consumption in China’s economy is about half that of the U.S.,
and about 60 percent of both Europe and Japan, according to
Credit Agricole CIB.

China’s past development has created an “irrational
economic structure” and “uncoordinated and unsustainable
development is increasingly apparent,” said Vice Premier Li
Keqiang in a June article in the government-owned Qiu Shi
magazine. Long-term dependence on investment and exports for
growth “will grow the instability of the economy,” he said.

Low Rates

Pettis computes the 1.6 trillion yuan in lost returns to
savers by comparing the difference between China’s nominal
deposit and growth rates to those in other emerging markets.
That calculation indicates China’s deposit rates should be at
least 4 percentage points higher, he said.

“The government maintains a cap on deposit rates, which
helps prop up bank profits, but only by spreading the cost to
households in the form of artificially low interest returns,”
said Mark Williams, an economist at Capital Economics Ltd. in
London who worked at the U.K. Treasury as an adviser on China
from 2005 to 2007.

China has left interest rates unchanged since December 2008,
even as countries from Malaysia to Taiwan, South Korea and India
raised them. The central bank sees little need for an imminent
increase, the International Monetary Fund said in a staff report
on July 29 after consultation with the Chinese government.

China’s inflation, near a two-year high of 2.9 percent in
June, is also eroding household savings. That may cause people
to spend less and save more to cover rising costs of healthcare,
pensions and children’s education, said Pettis. The one-year
deposit rate is 2.25 percent.

Lost Returns

In June 2009 savers earned a real return on one-year
deposits of 3.95 percent. That slumped to a negative 0.65
percent in June this year, indicating lost returns to savers of
1.8 trillion yuan annually compared with a year earlier. Pettis
estimates China’s household deposits account for 60 percent of
total deposits, or about 40 trillion yuan.

Chinese investors have few appealing options. Capital
controls inhibit citizens from investing overseas. A crackdown
on property speculation may cause property prices to fall as
much as 30 percent in the next 12 months, according to Barclays
Capital. The Shanghai Composite Index, up 0.1 percent as of the
11:30 a.m. local time break in trading, has slumped about 20
percent this year.

Pettis said the 3.06 percentage-point spread between
deposit and lending rates that is set by the central bank will
help banks pay for potential bad loans after an 18-month lending
boom that was almost as big as the U.K.’s gross domestic product.

Bad Loans

“Evidence is mounting that the lending spree not only has
created bad loans but is now constraining monetary policy,”
said Huang.

Concern about potential losses in the financial system may
deepen after China’s banking regulator decided to conduct stress
tests of the nation’s lenders. The tests include a worst-case
scenario of property prices falling as much as 60 percent in
cities where they have risen significantly, a person with
knowledge of the matter said.

Banks could be saddled with bad loans of more than $400
billion, said Jim Walker, chief economist at Hong Kong-based
Asianomics Ltd.

Some economists argue that surging retail-sales figures and
rising wages show China’s shift to greater consumer spending is
on track. Dariusz Kowalczyk at Credit Agricole CIB in Hong Kong
estimates consumption will account for 47 percent of GDP within
10 years.

Retail sales rose 18 percent in the first half of 2010 to
7.3 trillion yuan. Citigroup Inc. says wages in the unskilled
labor market may double over the next five years.

Middle Class

“Disposable income levels are growing, the middle class is
growing and urbanization is alive and strong,” said Andy Mantel,
Hong Kong-based managing director of Pacific Sun Investment
Management Ltd.’s consumer-focused Mantou Fund, which invests
mainly in Greater China equities. “That would be positive for
the next five to 10 years.”

Mantou’s holdings include companies like Fujian-based fruit
and vegetable producer China Green (Holdings) Ltd. whose new
drinks line is “higher quality than has been available on the
market,” said Mantel. “People these days are willing to pay a
bit extra for better products.”

Hong Kong-based Nomura Holdings Inc. analyst Emma Liu
expects China Green’s stock to rise more than 20 percent over
the next year to HK$10.8 ($1.4).

Investor’s Picks

Rising rural incomes prompted Shanghai-based River Fund
Management to buy shares this year in Qingdao-based Qingdao
Haier Co. Ltd. and Zhuhai-based Gree Electric Appliances Inc.,
two of China’s biggest makers of air conditioners.

“People nowadays are not only replacing their old air-
conditioners, but upgrading from low-end to high-end ones,”
said fund manager Zhang Ling. “This will continue over the next
10 years.”

Driven by government subsidies for consumer products
including cars and refrigerators, retail sales rose 16 percent
in 2009 after adjusting for consumer price changes, the most
since 1986.

China supplanted the U.S. as the world’s largest auto
market last year as vehicle sales jumped 46 percent. Households
borrowed 2.5 trillion yuan, almost four times more than a year
earlier.

Even as sales rise, the hope that China was at “a turning
point” for the role of consumer spending in the economy may
have been premature, said Nicholas Lardy, a senior fellow at the
Peterson Institute for International Economics in Washington.

‘More Unbalanced’

The economy is “still becoming slightly more unbalanced”
toward investment, said Glenn Maguire, chief Asia Pacific
economist at Societe Generale in Hong Kong. “Until consumption
grows faster than fixed-asset investment for a sustained period,
the economy will remain unbalanced.”

Urban fixed-asset investment surged 25.5 percent in the
first half to 9.8 trillion yuan. Another 29.6 trillion yuan is
needed to finish outstanding fixed-asset projects, said Sun
Mingchun, an economist with Nomura Holdings Inc. in Hong Kong.

To achieve sustained rebalancing, China should allow a
stronger currency that boosts household purchasing power,
improve pension and healthcare coverage and gradually allow
markets to determine interest rates, the IMF report said.

“I never believed the hype that China was turning the
corner on rebalancing growth toward consumption,” said Huang.
“The main political agenda is not to let GDP growth slip and
that means continued investment growth.”

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Stockman’s ‘Four Deformations of the Apocalypse’

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Four Deformations of the Apocalypse

By David Stockman

July 31 (NYT) — If there were such a thing as Chapter 11 for politicians, the Republican push to extend the unaffordable Bush tax cuts would amount to a bankruptcy filing. The nation’s public debt — if honestly reckoned to include municipal bonds and the $7 trillion of new deficits baked into the cake through 2015 — will soon reach $18 trillion. That’s a Greece-scale 120 percent of gross domestic product, and fairly screams out for austerity and sacrifice. It is therefore unseemly for the Senate minority leader, Mitch McConnell, to insist that the nation’s wealthiest taxpayers be spared even a three-percentage-point rate increase.

Yet another ‘expert’ with fear mongering with ‘the US is the next Greece’ nonsense. So much for whatever positives may be left of his legacy.

More fundamentally, Mr. McConnell’s stand puts the lie to the Republican pretense that its new monetarist and supply-side doctrines are rooted in its traditional financial philosophy. Republicans used to believe that prosperity depended upon the regular balancing of accounts — in government, in international trade, on the ledgers of central banks and in the financial affairs of private households and businesses, too. But the new catechism, as practiced by Republican policymakers for decades now, has amounted to little more than money printing and deficit finance — vulgar Keynesianism robed in the ideological vestments of the prosperous classes.

At least they are practical enough to add to aggregate demand when needed.
Does anyone think there is an excess of demand that calls for a tax hike?
Any call for a tax hike on ‘fairness’ should be ‘paid for’ with at least an offsetting tax cut somewhere.

This approach has not simply made a mockery of traditional party ideals. It has also led to the serial financial bubbles and Wall Street depredations that have crippled our economy. More specifically, the new policy doctrines have caused four great deformations of the national economy, and modern Republicans have turned a blind eye to each one. The first of these started when the Nixon administration defaulted on American obligations under the 1944 Bretton Woods agreement to balance our accounts with the world. Now, since we have lived beyond our means as a nation for nearly 40 years, our cumulative current-account deficit — the combined shortfall on our trade in goods, services and income — has reached nearly $8 trillion. That’s borrowed prosperity on an epic scale.

That’s been adding to our real terms of trade and standard of living on an epic scale, and, ironically, the rest of the world is fighting to continue it while we are pressing to end it. Go figure!

It is also an outcome that Milton Friedman said could never happen when, in 1971, he persuaded President Nixon to unleash on the world paper dollars no longer redeemable in gold or other fixed monetary reserves. Just let the free market set currency exchange rates, he said, and trade deficits will self-correct.

He was right. It continuously self corrects to reflect rest of world savings desires of $US financial assets.

It may be true that governments, because they intervene in foreign exchange markets, have never completely allowed their currencies to float freely. But that does not absolve Friedman’s $8 trillion error. Once relieved of the discipline of defending a fixed value for their currencies, politicians the world over were free to cheapen their money and disregard their neighbors.

Yes, to our advantage!

In fact, since chronic current-account deficits result from a nation spending more than it earns, stringent domestic belt-tightening is the only cure.

Leave it to Dave to promote a cure for prosperity.

When the dollar was tied to fixed exchange rates, politicians were willing to administer the needed castor oil, because the alternative was to make up for the trade shortfall by paying out reserves, and this would cause immediate economic pain — from high interest rates, for example. But now there is no discipline, only global monetary chaos as foreign central banks run their own printing presses at ever faster speeds to sop up the tidal wave of dollars coming from the Federal Reserve.

It’s not from the Fed, Dave, it’s from the Treasury deficit spending and private deficit spending.

The second unhappy change in the American economy has been the extraordinary growth of our public debt. In 1970 it was just 40 percent of gross domestic product, or about $425 billion. When it reaches $18 trillion, it will be 40 times greater than in 1970. This debt explosion has resulted not from big spending by the Democrats, but instead the Republican Party’s embrace, about three decades ago, of the insidious doctrine that deficits don’t matter if they result from tax cuts.

Public sector deficits = non govt savings of those financial assets. And the unemployment rate and inflation rate are telling us federal deficits are too small to provide the savings demanded by the rest of us.

In 1981, traditional Republicans supported tax cuts, matched by spending cuts, to offset the way inflation was pushing many taxpayers into higher brackets and to spur investment. The Reagan administration’s hastily prepared fiscal blueprint, however, was no match for the primordial forces — the welfare state and the warfare state — that drive the federal spending machine. Soon, the neocons were pushing the military budget skyward. And the Republicans on Capitol Hill who were supposed to cut spending exempted from the knife most of the domestic budget — entitlements, farm subsidies, education, water projects. But in the end it was a new cadre of ideological tax-cutters who killed the Republicans’ fiscal religion.

And over the next 10 years inflation came down from over 12% to 3%, even with all the deficit spending because savings desires were even higher, and continue to grow geometrically due to tax advantaged pension contributions, etc.

Through the 1984 election, the old guard earnestly tried to control the deficit, rolling back about 40 percent of the original Reagan tax cuts. But when, in the following years, the Federal Reserve chairman, Paul Volcker, finally crushed inflation,

Volcker did not crush inflation. If anything, his high rates added to business costs and unearned income long after inflation turned down due to positive supply shocks in the energy markets, helped by the dereg of natural gas in 1978 that did the lion’s share of cutting the demand for crude for electricity generation.

enabling a solid economic rebound, the new tax-cutters not only claimed victory for their supply-side strategy but hooked Republicans for good on the delusion that the economy will outgrow the deficit if plied with enough tax cuts. By fiscal year 2009, the tax-cutters had reduced federal revenues to 15 percent of gross domestic product, lower than they had been since the 1940s. Then, after rarely vetoing a budget bill and engaging in two unfinanced foreign military adventures, George W. Bush surrendered on domestic spending cuts, too — signing into law $420 billion in non-defense appropriations, a 65 percent gain from the $260 billion he had inherited eight years earlier. Republicans thus joined the Democrats in a shameless embrace of a free-lunch fiscal policy.

Not my first choice for Federal spending, but certainly did the trick of turning the economy in 2003.

The third ominous change in the American economy has been the vast, unproductive expansion of our financial sector. Here, Republicans have been oblivious to the grave danger of flooding financial markets with freely printed money and, at the same time, removing traditional restrictions on leverage and speculation. As a result, the combined assets of conventional banks and the so-called shadow banking system (including investment banks and finance companies) grew from a mere $500 billion in 1970 to $30 trillion by September 2008.

The real problem with the financial sector is that it preys on the real economy with both a massive brain drain and a drain of other real resources as well.

But the trillion-dollar conglomerates that inhabit this new financial world are not free enterprises. They are rather wards of the state, extracting billions from the economy with a lot of pointless speculation in stocks, bonds, commodities and derivatives. They could never have survived, much less thrived, if their deposits had not been government-guaranteed and if they hadn’t been able to obtain virtually free money from the Fed’s discount window to cover their bad bets.

They didn’t get free money to cover their bad debts. All losses were deducted from shareholder value. Some banks lost all shareholder funds and were liquidated or sold (with the FDIC realizing losses after the shareholders were wiped out)
Functionally, tarp was regulatory forbearance, not a federal expenditure.

The fourth destructive change has been the hollowing out of the larger American economy. Having lived beyond our means for decades by borrowing heavily from abroad, we have steadily sent jobs and production offshore. In the past decade, the number of high-value jobs in goods production and in service categories like trade, transportation, information technology and the professions has shrunk by 12 percent, to 68 million from 77 million. The only reason we have not experienced a severe reduction in nonfarm payrolls since 2000 is that there has been a gain in low-paying, often part-time positions in places like bars, hotels and nursing homes.

Not true. The trade deficit is an enormous benefit. For a given size govt, it allows for lower taxes/higher deficits so Americans can have enough spending power to buy both all we can produce at full employment plus whatever the rest of the world wants to sell us. In 1999/2000, unemployment fell below 3.8%, even as the trade deficit soared to $380 billion.

It is not surprising, then, that during the last bubble (from 2002 to 2006) the top 1 percent of Americans — paid mainly from the Wall Street casino — received two-thirds of the gain in national income, while the bottom 90 percent — mainly dependent on Main Street’s shrinking economy — got only 12 percent. This growing wealth gap is not the market’s fault. It’s the decaying fruit of bad economic policy.

Agreed!!! However this has nothing to do with the rest of what he’s been droning on about. In fact, higher deficits are usually result in stronger economies which are associated with lower income inequality.

The day of national reckoning has arrived. We will not have a conventional business recovery now, but rather a long hangover of debt liquidation and downsizing — as suggested by last week’s news that the national economy grew at an anemic annual rate of 2.4 percent in the second quarter. Under these circumstances, it’s a pity that the modern Republican Party offers the American people an irrelevant platform of recycled Keynesianism when the old approach — balanced budgets, sound money and financial discipline — is needed more than ever.

No, we need a full payroll tax holiday, $500 per capita revenue sharing for the states, and an $8 transition job for anyone willing and able to work.

David Stockman, a director of the Office of Management and Budget under President Ronald Reagan, is working on a book about the financial crisis.

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The Political Genius of Supply-Side Economics

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Where am I wrong, if at all?

I agree with the political analysis.

I know Bruce Bartlett and he’ll be the first to tell you he does NOT understand monetary operations. Even simple statements like ‘China keeps its dollars in its reserve account at the Fed’ seem to cause him to glass over. He can only repeat headline rhetoric and has no interest in drilling down through it.

Krugman’s column a week ago, however, may have been a major breakthrough. He conceded the issue of long term deficits was inflation and not solvency. And while his maths and graphs disqualified him from participating in the inflation debate, it so far seems to have shifted the deficit dove position to much firmer ground.

A Congressman might vote to cut Social Security due to fear of Federal insolvency, with all ‘noted’ economists arguing only how far down the road it may be, along with dependence on foreign creditors.

However, I doubt most Congressman would vote to cut Social Security based on some economists predicting possible inflation in 20 years.

So even though Krugman’s reasoning was simply ‘they can always print the money’ followed by highly suspect graphs and statements about how someday that could cause hyper inflation, hopefully it did shift the discussion from solvency to inflation, where it belongs.

So now the hawk/dove question is, as it should be, whether long term deficits imply long term run away inflation. And while the correct answer is: depends on the offsetting demand leakages/unspent income like pension contributions and other nominal savings desires. Just the fact that the debate shifts away from solvency should be enough for a change of global political attitude.

And, if so, this opens the door to a new era of prosperity as yet unimagined.


The political genius of supply-side economics

By Martin Wolf

July 25 (FT) – The future of fiscal policy was intensely debated in the FT last week. In this Exchange, I want to examine what is going on in the US and, in particular, what is going on inside the Republican party. This matters for the US and, because the US remains the world’s most important economy, it also matters greatly for the world.

My reading of contemporary Republican thinking is that there is no chance of any attempt to arrest adverse long-term fiscal trends should they return to power. Moreover, since the Republicans have no interest in doing anything sensible, the Democrats will gain nothing from trying to do much either. That is the lesson Democrats have to draw from the Clinton era’s successful frugality, which merely gave George W. Bush the opportunity to make massive (irresponsible and unsustainable) tax cuts. In practice, then, nothing will be done.

Indeed, nothing may be done even if a genuine fiscal crisis were to emerge. According to my friend, Bruce Bartlett, a highly informed, if jaundiced, observer, some “conservatives” (in truth, extreme radicals) think a federal default would be an effective way to bring public spending they detest under control. It should be noted, in passing, that a federal default would surely create the biggest financial crisis in world economic history.

To understand modern Republican thinking on fiscal policy, we need to go back to perhaps the most politically brilliant (albeit economically unconvincing) idea in the history of fiscal policy: “supply-side economics”. Supply-side economics liberated conservatives from any need to insist on fiscal rectitude and balanced budgets. Supply-side economics said that one could cut taxes and balance budgets, because incentive effects would generate new activity and so higher revenue.

The political genius of this idea is evident. Supply-side economics transformed Republicans from a minority party into a majority party. It allowed them to promise lower taxes, lower deficits and, in effect, unchanged spending. Why should people not like this combination? Who does not like a free lunch?

How did supply-side economics bring these benefits? First, it allowed conservatives to ignore deficits. They could argue that, whatever the impact of the tax cuts in the short run, they would bring the budget back into balance, in the longer run. Second, the theory gave an economic justification – the argument from incentives – for lowering taxes on politically important supporters. Finally, if deficits did not, in fact, disappear, conservatives could fall back on the “starve the beast” theory: deficits would create a fiscal crisis that would force the government to cut spending and even destroy the hated welfare state.

In this way, the Republicans were transformed from a balanced-budget party to a tax-cutting party. This innovative stance proved highly politically effective, consistently putting the Democrats at a political disadvantage. It also made the Republicans de facto Keynesians in a de facto Keynesian nation. Whatever the rhetoric, I have long considered the US the advanced world’s most Keynesian nation – the one in which government (including the Federal Reserve) is most expected to generate healthy demand at all times, largely because jobs are, in the US, the only safety net for those of working age.

True, the theory that cuts would pay for themselves has proved altogether wrong. That this might well be the case was evident: cutting tax rates from, say, 30 per cent to zero would unambiguously reduce revenue to zero. This is not to argue there were no incentive effects. But they were not large enough to offset the fiscal impact of the cuts (see, on this, Wikipedia and a nice chart from Paul Krugman).

Indeed, Greg Mankiw, no less, chairman of the Council of Economic Advisers under George W. Bush, has responded to the view that broad-based tax cuts would pay for themselves, as follows: “I did not find such a claim credible, based on the available evidence. I never have, and I still don’t.” Indeed, he has referred to those who believe this as “charlatans and cranks”. Those are his words, not mine, though I agree. They apply, in force, to contemporary Republicans, alas,

Since the fiscal theory of supply-side economics did not work, the tax-cutting eras of Ronald Reagan and George H. Bush and again of George W. Bush saw very substantial rises in ratios of federal debt to gross domestic product. Under Reagan and the first Bush, the ratio of public debt to GDP went from 33 per cent to 64 per cent. It fell to 57 per cent under Bill Clinton. It then rose to 69 per cent under the second George Bush. Equally, tax cuts in the era of George W. Bush, wars and the economic crisis account for almost all the dire fiscal outlook for the next ten years (see the Center on Budget and Policy Priorities).

Today’s extremely high deficits are also an inheritance from Bush-era tax-and-spending policies and the financial crisis, also, of course, inherited by the present administration. Thus, according to the International Monetary Fund, the impact of discretionary stimulus on the US fiscal deficit amounts to a cumulative total of 4.7 per cent of GDP in 2009 and 2010, while the cumulative deficit over these years is forecast at 23.5 per cent of GDP. In any case, the stimulus was certainly too small, not too large.

The evidence shows, then, that contemporary conservatives (unlike those of old) simply do not think deficits matter, as former vice-president Richard Cheney isreported to have told former treasury secretary Paul O’Neill. But this is not because the supply-side theory of self-financing tax cuts, on which Reagan era tax cuts were justified, has worked, but despite the fact it has not. The faith has outlived its economic (though not its political) rationale.

So, when Republicans assail the deficits under President Obama, are they to be taken seriously? Yes and no. Yes, they are politically interested in blaming Mr Obama for deficits, since all is viewed fair in love and partisan politics. And yes, they are, indeed, rhetorically opposed to deficits created by extra spending (although that did not prevent them from enacting the unfunded prescription drug benefit, under President Bush). But no, it is not deficits themselves that worry Republicans, but rather how they are caused: deficits caused by tax cuts are fine; but spending increases brought in by Democrats are diabolical, unless on the military.

Indeed, this is precisely what John Kyl (Arizona), a senior Republican senator,has just said:

“[Y]ou should never raise taxes in order to cut taxes. Surely Congress has the authority, and it would be right to — if we decide we want to cut taxes to spur the economy, not to have to raise taxes in order to offset those costs. You do need to offset the cost of increased spending, and that’s what Republicans object to. But you should never have to offset the cost of a deliberate decision to reduce tax rates on Americans”

What conclusions should outsiders draw about the likely future of US fiscal policy?

First, if Republicans win the mid-terms in November, as seems likely, they are surely going to come up with huge tax cut proposals (probably well beyond extending the already unaffordable Bush-era tax cuts).

Second, the White House will probably veto these cuts, making itself even more politically unpopular.

Third, some additional fiscal stimulus is, in fact, what the US needs, in the short term, even though across-the-board tax cuts are an extremely inefficient way of providing it.

Fourth, the Republican proposals would not, alas, be short term, but dangerously long term, in their impact.

Finally, with one party indifferent to deficits, provided they are brought about by tax cuts, and the other party relatively fiscally responsible (well, everything is relative, after all), but opposed to spending cuts on core programmes, US fiscal policy is paralysed. I may think the policies of the UK government dangerously austere, but at least it can act.

This is extraordinarily dangerous. The danger does not arise from the fiscal deficits of today, but the attitudes to fiscal policy, over the long run, of one of the two main parties. Those radical conservatives (a small minority, I hope) who want to destroy the credit of the US federal government may succeed. If so, that would be the end of the US era of global dominance. The destruction of fiscal credibility could be the outcome of the policies of the party that considers itself the most patriotic.

In sum, a great deal of trouble lies ahead, for the US and the world.

Where am I wrong, if at all?

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GE chief gives vent to frustration over China

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GE chief gives vent to frustration over China

June 29 (FT) — General Electric chief executive Jeff Immelt told Italian industrialists at a dinner on Wednesday that he was worried about the way Beijing was treating foreign companies. “I am not sure that in the end they want any of us to win or any of us to be successful,” said the man who runs the largest manufacturing company. “After 30 years of progressive market reforms, many foreign businesses in the country feel as though they have run up against an unexpected and impregnable blockade,” Joerg Wuttke, former head of the European Chamber of Commerce, complained in the Financial Times in April. The American Chamber of Commerce in Beijing has made similar statements, while a new survey of European companies released this week by the European Union Chamber of Commerce in China showed that almost half expect even more problems with regulators during the next two years.

GE has moved production out of China.

FDI (foreign direct investment) alters fx reserves and currency levels, as does domestic inflation.

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