Tag Archives: Deficit Spending

EU Daily | Europe Economic Confidence Rises as Exports Improve

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It’s off to the races for a while in the euro zone as the adjustment that began when the ECB started buying member nation debt continues, and the still large budget deficits support incomes and growth while the still low euro supports exports.

Fears of solvency risks for govts and the banking system are fading fast.

The euro meanwhile will continue to adjust/appreciate with a small lag in response to rising net exports and ultimately keep a lid on them.

If US jobless claims are up it’s good for US stocks, as unemployment is perceived to keep labor costs and interest rates down.
If claims are down it’s good for stocks as it’s evidence of a bit more top line growth, which trumps any fears of damage from interest rate hikes.

China weakness serves to keep a lid on resource costs which is good for stocks.

Earnings season has confirmed that business has figured out how to make money in the current environment, supported by 8%+ federal deficits that is also supporting 4% personal income growth as well as nominal and real GDP growth.

Unemployment working its way lower in tiny increments unfortunately causes politicians and mainstream economists to think their measures are ‘working,’ including revised down deficit projections from the automatic stabilizers, and that it all just need lots of time due to the severity of the downturn.

This is very good for stocks which further supports the political desire to prove themselves right. And it is very bad for people forced to wait years before their lives can begin to recover, as with modest improvement in GDP a fiscal adjustment that could drastically accelerate the move back to full employment is highly unlikely.

At age 60, it’s not looking like I’ll get to experience how good this economy could be for everyone if we understood monetary operations and reserve accounting.

EU Headlines

Europe Economic Confidence Rises as Exports Improve

ECB Puts Bigger Discounts on Low-Quality Collateral

German Unemployment Fell for 13th as Exports Boom

Lagarde Predicts Significant Pickup in World Growth

Berlusconi Survives Confidence Vote to Pass Deficit Reductions

Italian Business Confidence Rises to Two-Year High on Exports

Inflation in Spain at highest point in 18 months

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State tax revenue increasing

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This is another sign of growth creeping in.

The States will be fine with a bit more GDP growth, and if they maintain their equity allocations their pension funds will all recover when equity prices double over the next few years.

With strong productivity growth throughout the recession, there is a lot of catch up down the road as the ongoing 8%+ deficits fill the spending gaps and restore the financial equity that will also support a subsequent credit boom that begins with the ‘get a job buy a car’ accelerator.

Unfortunately we still haven’t addressed our energy consumption issues, and we remain highly vulnerable to arbitrary Saudi price hiking.

Nor have we taken sufficient measures to be able to grow GDP without a substantial corresponding increase in energy consumption in general.

But that’s another story, at least for the near term.


Tax Revenue Creeps Up, but Can’t Fill State Budget Gaps

July 27 (Reuters) – State tax revenue is improving, but only slightly, and may not be enough to end steep spending cuts or replace the loss of assistance from the federal stimulus plan that expires in December, according to a report Tuesday.

The National Conference of State Legislatures said states faced a collective budget gap of $83.9 billion when creating their budgets for fiscal 2011, which for most began on July 1.

Officials surveyed by the group, which represents state lawmakers, said revenue was beginning to pick up or at least slow its rate of decline. Nearly every state expects tax collections this fiscal year to surpass last year’s.

“For the first time in a long time we’re seeing some slight improvement in the state revenue situation,” Corina Eckl, the NCSL’s fiscal program director, said in a statement accompanying the report. “But glimmers of improvement are tarnished by looming problems.”

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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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response to deficit dove letter

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The right level of deficit spending, long term or otherwise, is the one that coincides with full employment.

Any nation with a non convertible currency and floating exchange rate policy is necessarily not in any case operationally revenue constrained.

A statement from Professors Paul Davidson, James Galbraith and Lord Skidelsky.

We three were each asked to sign the letter organized by Sir Harold
Evans and now co-signed by many of our friends, including Joseph
Stiglitz, Robert Reich, Laura Tyson, Derek Shearer, Alan Blinder and
Richard Parker. We support the central objective of the letter — a
full employment policy now, based on sharply expanded public effort.
Yet we each, separately, declined to sign it.

Our reservations centered on one sentence, namely, “We recognize the
necessity of a program to cut the mid-and long-term federal deficit..”
Since we do not agree with this statement, we could not sign the
letter.

Why do we disagree with this statement? The answer is that apart from
the effects of unemployment itself the United States does not in fact
face a serious deficit problem over the next generation, and for this
reason there is no “necessity [for] a program to cut the mid-and long-
term deficit.”

On the contrary: If unemployment can be cured, the deficits we
presently face will necessarily shrink This is the universal
experience of rapid economic growth: tax revenues rise, public welfare
spending falls, and the budget moves toward balance. There is indeed
no other experience in modern peacetime American history, most
recently in the late 1990s when the budget went into surplus as full
employment was reached.

We agree that health care costs are an important issue. But health
care is a burden faced by both the public and private sectors, and
cost control is a job for health policy, not budget policy. Cutting
the public element in health care – Medicare, especially – in response
to the health care cost problem is just a way of invidiously targeting
the elderly who are covered by that program. We oppose this.

The long-term deficit scare story plays into the hands of those who
will argue, very soon, for cuts in Social Security as though these
were necessary for economic reasons. In fact, Social Security is a
highly successful program which (along with Medicare) maintains our
entire elderly population out of poverty and helps to stabilize the
macroeconomy. It is a transfer program and indefinitely sustainable as
it is.

We call on fellow economists to reconsider their casual willingness to
concede to an unfounded hysteria over supposed long-term deficits, and
to concentrate instead on solving the vast problems we presently
face. It would be tragic if the Evans letter and similar efforts –
whose basic purpose we strongly support – led to acquiescence in
Social Security and Medicare cuts that impoverish America’s elderly
just a few years from now.

Paul Davidson James K. Galbraith Lord
Robert Skidelsky

Paul Davidson is the Editor of the Journal of Post Keynesian Economics
and author of “The Keynes Solution.”

James K. Galbraith is a Professor at The University of Texas at Austin
and author of “The Predator State.”

Lord Robert Skidelsky is the author, most recently, of “Keynes: The
Return of the Master.”

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NYFed

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Good find!

I recommended this years ago when Karim first introduced me to his Treasury contacts.
It moved forward and was passed around for discussion, but the dealers quashed it.

An unlimited lending program could replace much of the generic libor swap market.

Wish they would revisit it.

Why Is the U.S. Treasury Contemplating Becoming a Lender of Last Resort for Treasury Securities?

“A backstop lending facility turns this understanding on its head: the Treasury would be issuing securities not because it needs cash, but because market participants need securities.”

They don’t notice a difference between gold standard and “modern money”, actually they draw a parallel:

“… the markets for borrowing and lending Treasury securities in the 21st century are broadly analogous to the 19th century market for borrowing and lending money. Dealers and other market participants today have short-term liabilities denominated in Treasury notes; 19th century banks had deposit liabilities. Additionally, there is limited elasticity in the supply of individual Treasury securities today, just as there was limited elasticity in the supply of base money in the 19th century. A backstop securities lending facility would enhance the elasticity of supply of Treasury securities in the same way that the Federal Reserve Banks enhanced the elasticity of currency a century ago. It would mitigate chronic settlement fails, just as the Federal Reserve System mitigated suspensions of convertibility of bank deposits.”

They don’t discuss interest on reserves (and they should, these being functionally equivalent to Tsy securities).

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George Soros Speech

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>   
>   (email exchange)
>   
>   On Mon, Jun 21, 2010 at 6:31 AM, wrote:
>   
>   Soros’s recipe, FYI
>   much about bubbles,
>   also about how bad can be deficit reductions at this time
>   

I usually don’t read or comment on Soros, but comments below this one time only for you.

:)

George Soros Speech

Institute of International Finance, Vienna, Austria
June 10, 2010

In the week following the bankruptcy of Lehman Brothers on September 15, 2008 – global financial markets actually broke down and by the end of the week they had to be put on artificial life support. The life support consisted of substituting sovereign credit for the credit of financial institutions which ceased to be acceptable to counter parties.

As Mervyn King of the Bank of England brilliantly explained, the authorities had to do in the short-term the exact opposite of what was needed in the long-term: they had to pump in a lot of credit to make up for the credit that disappeared and thereby reinforce the excess credit and leverage that had caused the crisis in the first place. Only in the longer term, when the crisis had subsided, could they drain the credit and reestablish macro-economic balance.

Not bad, but he doesn’t seem to understand there is no ‘macro balance’ per se in that regard. He should recognize that what he means by ‘macro balance’ should be the desired level of aggregate demand, which is altered by the public sector’s fiscal balance. So in the longer term, the public sector should tighten fiscal policy (what he calls ‘drain the credit’) only if aggregate demand is deemed to be ‘too high’ and not to pay for anything per se.

This required a delicate two phase maneuver just as when a car is skidding, first you have to turn the car into the direction of the skid and only when you have regained control can you correct course.

It’s more like when you come to an up hill stretch you need to press harder on the gas to maintain a steady speed and if you get going too fast on a down hill section you need to apply the brakes to maintain a steady speed. And for me, the ‘right’ speed is ‘full employment’ with desired price stability.

The first phase of the maneuver has been successfully accomplished – a collapse has been averted.

But full employment has not been restored. I agree this is not the time to hit the fiscal brakes. In fact, I’d cut VAT until output and employment is restored, and offer a govt funded minimum wage transition job to anyone willing and able to work.

In retrospect, the temporary breakdown of the financial system seems like a bad dream. There are people in the financial institutions that survived who would like nothing better than to forget it and carry on with business as usual. This was evident in their massive lobbying effort to protect their interests in the Financial Reform Act that just came out of Congress. But the collapse of the financial system as we know it is real and the crisis is far from over.

Indeed, we have just entered Act II of the drama, when financial markets started losing confidence in the credibility of sovereign debt. Greece and the euro have taken center stage but the effects are liable to be felt worldwide. Doubts about sovereign credit are forcing reductions in budget deficits at a time when the banks and the economy may not be strong enough to permit the pursuit of fiscal rectitude. We find ourselves in a situation eerily reminiscent of the 1930’s. Keynes has taught us that budget deficits are essential for counter cyclical policies yet many governments have to reduce them under pressure from financial markets. This is liable to push the global economy into a double dip.

Yes, and this is an issue specific to govts that are not the issuers of their currency- the US States, the euro zone members, and govts with fixed exchange rates.

It is important to realize that the crisis in which we find ourselves is not just a market failure but also a regulatory failure and even more importantly a failure of the prevailing dogma about financial markets. I have in mind the Efficient Market Hypothesis and Rational Expectation Theory. These economic theories guided, or more exactly misguided, both the regulators and the financial engineers who designed the derivatives and other synthetic financial instruments and quantitative risk management systems which have played such an important part in the collapse. To gain a proper understanding of the current situation and how we got to where we are, we need to go back to basics and reexamine the foundation of economic theory.

I agree, see my proposals here.

I have developed an alternative theory about financial markets which asserts that financial markets do not necessarily tend towards equilibrium; they can just as easily produce asset bubbles. Nor are markets capable of correcting their own excesses. Keeping asset bubbles within bounds have to be an objective of public policy. I propounded this theory in my first book, The Alchemy of Finance, in 1987. It was generally dismissed at the time but the current financial crisis has proven, not necessarily its validity, but certainly its superiority to the prevailing dogma.

First we can always act to sustain aggregate demand and employment at desired levels across any asset price cycle with fiscal policy. No one would have cared much about the financial crisis if we’d kept employment and output high in the real sectors. Note that because output and employment remained high (for whatever reason) through the crash of 1987, the crash of 1998, and the Enron event, they were of less concern than the most recent crisis where unemployment jumped to over 10%.

Let me briefly recapitulate my theory for those who are not familiar with it. It can be summed up in two propositions. First, financial markets, far from accurately reflecting all the available knowledge, always provide a distorted view of reality. This is the principle of fallibility. The degree of distortion may vary from time to time. Sometimes it’s quite insignificant, at other times it is quite pronounced. When there is a significant divergence between market prices and the underlying reality I speak of far from equilibrium conditions. That is where we are now.

I’d say ‘equilibrium’ conditions are necessarily transitory at best under current institutional arrangements, including how policy is determined in Washington and around the world, and continually changing fundamentals of supply and demand.

Second, financial markets do not play a purely passive role; they can also affect the so called fundamentals they are supposed to reflect. These two functions that financial markets perform work in opposite directions. In the passive or cognitive function the fundamentals are supposed to determine market prices. In the active or manipulative function market prices find ways of influencing the fundamentals. When both functions operate at the same time they interfere with each other. The supposedly independent variable of one function is the dependent variable of the other so that neither function has a truly independent variable. As a result neither market prices nor the underlying reality is fully determined. Both suffer from an element of uncertainty that cannot be quantified.

Goes without saying.

I call the interaction between the two functions reflexivity. Frank Knight recognized and explicated this element of unquantifiable uncertainty in a book published in 1921 but the Efficient Market Hypothesis and Rational Expectation Theory have deliberately ignored it. That is what made them so misleading.

Reflexivity sets up a feedback loop between market valuations and the so-called fundamentals which are being valued. The feedback can be either positive or negative. Negative feedback brings market prices and the underlying reality closer together. In other words, negative feedback is self-correcting. It can go on forever and if the underlying reality remains unchanged it may eventually lead to an equilibrium in which market prices accurately reflect the fundamentals. By contrast, a positive feedback is self-reinforcing. It cannot go on forever because eventually market prices would become so far removed from reality that market participants would have to recognize them as unrealistic. When that tipping point is reached, the process becomes self-reinforcing in the opposite direction. That is how financial markets produce boom-bust phenomena or bubbles. Bubbles are not the only manifestations of reflexivity but they are the most spectacular.

Ok, also seems obvious? Now he need to add that the currency itself is a public monopoly, as the introduction of taxation, a coercive force, introduces ‘imperfect competition’ with ‘supply’ of that needed to pay taxes under govt. control. This puts govt in the position of ‘price setter’ when it spends (and/or demands collateral when it lends). And a prime ‘pass through’ channel he needs to add is indexation of public sector wages and benefits.

In my interpretation equilibrium, which is the central case in economic theory, turns out to be a limiting case where negative feedback is carried to its ultimate limit. Positive feedback has been largely assumed away by the prevailing dogma and it deserves a lot more attention.

Even his positive feedback will ‘run its course’ (not to say there aren’t consequences) for the most part if it wasn’t for the fact that the currency itself is a case of monopoly and the govt. paying more for the same thing, for example, is redefining the currency downward.

I have developed a rudimentary theory of bubbles along these lines. Every bubble has two components: an underlying trend that prevails in reality and a misconception relating to that trend. When a positive feedback develops between the trend and the misconception a boom-bust process is set in motion. The process is liable to be tested by negative feedback along the way and if it is strong enough to survive these tests, both the trend and the misconception will be reinforced.

Makes sense.

Eventually, market expectations become so far removed from reality that people are forced to recognize that a misconception is involved.

I’d say it’s more like the price gets high enough for the funding to run dry at that price for any reason? Unless funding is coming from/supported by govt (and/or it’s designated agents, etc), the issuer of the currency, that funding will always be limited.

A twilight period ensues during which doubts grow and more and more people lose faith but the prevailing trend is sustained by inertia.

‘Inertia’? It’s available spending power that’s needed to sustain prices of anything. The price of housing sales won’t go up without someone paying the higher price.

As Chuck Prince former head of Citigroup said, “As long as the music is playing you’ve got to get up and dance. We are still dancing.”

This describes the pro cyclical nature of the non govt sectors, which are necessarily pro cyclical. Only the currency issuer can be counter cyclical. Seems to me Minsky has the fuller explanation of all this.

Eventually a tipping point is reached when the trend is reversed; it then becomes self-reinforcing in the opposite direction.

The spending power- or the desire to use it- fades.

Typically bubbles have an asymmetric shape. The boom is long and slow to start. It accelerates gradually until it flattens out again during the twilight period. The bust is short and steep because it involves the forced liquidation of unsound positions. Disillusionment turns into panic, reaching its climax in a financial crisis.

The simplest case of a purely financial bubble can be found in real estate. The trend that precipitates it is the availability of credit; the misconception that continues to recur in various forms is that the value of the collateral is independent of the availability of credit. As a matter of fact, the relationship is reflexive. When credit becomes cheaper activity picks up and real estate values rise. There are fewer defaults, credit performance improves, and lending standards are relaxed. So at the height of the boom, the amount of credit outstanding is at its peak and a reversal precipitates false liquidation, depressing real estate values.

It all needs to be sustained by incomes. the Fed’s financial burdens ratios indicate when incomes are being stretched to their limits. The last cycle went beyond actual incomes as mortgage originators were sending borrowers to accountants who falsified income statements, and some lenders were willing to lend beyond income capabilities. But that didn’t last long and the bust followed by months.

The bubble that led to the current financial crisis is much more complicated. The collapse of the sub-prime bubble in 2007 set off a chain reaction, much as an ordinary bomb sets off a nuclear explosion. I call it a super-bubble. It has developed over a longer period of time and it is composed of a number of simpler bubbles. What makes the super-bubble so interesting is the role that the smaller bubbles have played in its development.

Fraud was a major, exaggerating element in the latest go round, conspicuously absent from this analysis.

The prevailing trend in the super-bubble was the ever increasing use of credit and leverage. The prevailing misconception was the believe that financial markets are self-correcting and should be left to their own devices. President Reagan called it the “magic of the marketplace” and I call it market fundamentalism. It became the dominant creed in the 1980s. Since market fundamentalism was based on false premises its adoption led to a series of financial crises.

Again, a financial crisis doesn’t need to ‘spread’ to the real economy. Fiscal policy can sustain full employment regardless of the state of the financial sector. Losses in the financial sector need not affect the real economy any more than losses in Las Vegas casinos.

Each time, the authorities intervened, merged away, or otherwise took care of the failing financial institutions, and applied monetary and fiscal stimuli to protect the economy. These measures reinforced the prevailing trend of ever increasing credit and leverage and as long as they worked they also reinforced the prevailing misconception that markets can be safely left to their own devices. The intervention of the authorities is generally recognized as creating amoral hazard; more accurately it served as a successful test of a false belief, thereby inflating the super-bubble even further.

‘Monetary policy’ did nothing and probably works in reverse, as I’ve discussed elsewhere. Fiscal policy does not have to introduce moral hazard issues. It can be used to sustain incomes from the bottom up at desired levels, and not for top down bailouts of failed businesses. Sustaining incomes will not keep an overbought market from crashing, but it will sustain sales and employment in the real economy, with business competing successfully for consumer dollars surviving, and those that don’t failing. That’s all that’s fundamentally needed for prosperity, along with a govt that understands its role in supporting the public infrastructure.

It should be emphasized that my theories of bubbles cannot predict whether a test will be successful or not. This holds for ordinary bubbles as well as the super-bubble. For instance I thought the emerging market crisis of 1997-1998 would constitute the tipping point for the super-bubble, but I was wrong. The authorities managed to save the system and the super-bubble continued growing. That made the bust that eventually came in 2007-2008 all the more devastating.

No mention that the govt surpluses of the late 90’s drained net dollar financial assets from the non govt sectors, with growth coming from unsustainable growth in private sector credit fueling impossible dot com business plans, that far exceeded income growth. When it all came apart after y2k the immediate fiscal adjustment that could have sustained the real economy wasn’t even a consideration.

What are the implications of my theory for the regulation of the financial system?

First and foremost, since markets are bubble-prone, the financial authorities have to accept responsibility for preventing bubbles from growing too big. Alan Greenspan and other regulators have expressly refused to accept that responsibility. If markets can’t recognize bubbles, Greenspan argued, neither can regulators–and he was right. Nevertheless, the financial authorities have to accept the assignment, knowing full well that they will not be able to meet it without making mistakes. They will, however, have the benefit of receiving feedback from the markets, which will tell them whether they have done too much or too little. They can then correct their mistakes.

Second, in order to control asset bubbles it is not enough to control the money supply; you must also control the availability of credit.

Since the causation is ‘loans create deposits’ ‘controlling credit’ is the only way to alter total bank deposits.

This cannot be done by using only monetary tools;

Agreed, interest rates are not all that useful, and probably work in the opposite direction most believe.

you must also use credit controls. The best-known tools are margin requirements

Changing margin requirements can have immediate effects. But if the boom is coming for the likes of pension fund allocations to ‘passive commodity strategies’ driving up commodities prices, which has been a major, driving force for many years now, margin increases won’t stop the trend.

and minimum capital requirements.

I assume that means bank capital. If so, that alters the price of credit but not the quantity, as it alters spreads needed to provide market demanded risk adjusted returns for bank capital.

Currently they are fixed irrespective of the market’s mood, because markets are not supposed to have moods. Yet they do, and the financial authorities need to vary margin and minimum capital requirements in order to control asset bubbles.

Yes, man is naturally a gambler. you can’t stop him. and attempts at control have always been problematic at best.

One thing overlooked is the use of long term contracts vs relying on spot markets. Historically govts have used long term contracts, but for business to do so requires long term contracts on the sales side, which competitive markets don’t allow.

You can’t safely enter into a 20 year contract for plastic for cell phone manufacturing if you don’t know that the price and quantity of cell phones is locked in for 20 years as well, for example. And locking in building materials for housing for 20 years to stabilize prices means less flexibility to alter building methods, etc. But all this goes beyond this critique apart from indicating there’s a lot more to be considered.

Regulators may also have to invent new tools or revive others that have fallen into disuse. For instance, in my early days in finance, many years ago, central banks used to instruct commercial banks to limit their lending to a particular sector of the economy, such as real estate or consumer loans, because they felt that the sector was overheating. Market fundamentalists consider that kind of intervention unacceptable but they are wrong. When our central banks used to do it we had no financial crises to speak of.

True. What the govt creates it can regulate and/or take away. Public infrastructure is to serve further public purpose.

But both dynamic change and static patterns have value and trade offs.

The Chinese authorities do it today, and they have much better control over their banking system. The deposits that Chinese commercial banks have to maintain at the People’s Bank of China were increased seventeen times during the boom, and when the authorities reversed course the banks obeyed them with alacrity.

Yes, and always with something gained and something lost when lending is politicized.

Third, since markets are potentially unstable, there are systemic risks in addition to the risks affecting individual market participants. Participants may ignore these systemic risks in the belief that they can always dispose of their positions, but regulators cannot ignore them because if too many participants are on the same side, positions cannot be liquidated without causing a discontinuity or a collapse. They have to monitor the positions of participants in order to detect potential imbalances. That means that the positions of all major market participants, including hedge funds and sovereign wealth funds, need to be monitored. The drafters of the Basel Accords made a mistake when they gave securities held by banks substantially lower risk ratings than regular loans: they ignored the systemic risks attached to concentrated positions in securities. This was an important factor aggravating the crisis. It has to be corrected by raising the risk ratings of securities held by banks. That will probably discourage loans, which is not such a bad thing.

My proposals, here, limit much of that activity at the source, rather than trying to regulate it, leaving a lot less to be regulated making regulation that much more likely to succeed.

Fourth, derivatives and synthetic financial instruments perform many useful functions but they also carry hidden dangers. For instance, the securitization of mortgages was supposed to reduce risk thru geographical diversification. In fact it introduced a new risk by separating the interest of the agents from the interest of the owners. Regulators need to fully understand how these instruments work before they allow them to be used and they ought to impose restrictions guard against those hidden dangers. For instance, agents packaging mortgages into securities ought to be obliged to retain sufficient ownership to guard against the agency problem.

One of my proposals is that banks not be allowed to participate in any secondary markets, for example

Credit default swaps (CDS) are particularly dangerous they allow people to buy insurance on the survival of a company or a country while handing them a license to kill. CDS ought to be available to buyers only to the extent that they have a legitimate insurable interest. Generally speaking, derivatives ought to be registered with a regulatory agency just as regular securities have to be registered with the SEC or its equivalent. Derivatives traded on exchanges would be registered as a class; those traded over-the-counter would have to be registered individually. This would provide a powerful inducement to use exchange traded derivatives whenever possible.

There is no public purpose served by allowing banks to participate in CDS markets and therefore no reason to allow banks to own any CDS.

Finally, we must recognize that financial markets evolve in a one-directional, nonreversible manner. The financial authorities, in carrying out their duty of preventing the system from collapsing, have extended an implicit guarantee to all institutions that are “too big to fail.” Now they cannot credibly withdraw that guarantee. Therefore, they must impose regulations that will ensure that the guarantee will not be invoked. Too-big-to-fail banks must use less leverage and accept various restrictions on how they invest the depositors’ money. Deposits should not be used to finance proprietary trading. But regulators have to go even further. They must regulate the compensation packages of proprietary traders to ensure that risks and rewards are properly aligned. This may push proprietary traders out of banks into hedge funds where they properly belong. Just as oil tankers are compartmentalized in order to keep them stable, there ought to be firewalls between different markets. It is probably impractical to separate investment banking from commercial banking as the Glass-Steagall Act of 1933 did. But there have to be internal compartments keeping proprietary trading in various markets separate from each other. Some banks that have come to occupy quasi-monopolistic positions may have to be broken up.

Banks should be limited to public purpose as per my proposals, here.

While I have a high degree of conviction on these five points, there are many questions to which my theory does not provide an unequivocal answer. For instance, is a high degree of liquidity always desirable? To what extent should securities be marked to market? Many answers that followed automatically from the Efficient Market Hypothesis need to be reexamined.

Also in my proposals, here.

It is clear that the reforms currently under consideration do not fully satisfy the five points I have made but I want to emphasize that these five points apply only in the long run. As Mervyn King explained the authorities had to do in the short run the exact opposite of what was required in the long run. And as I said earlier the financial crisis is far from over. We have just ended Act Two. The euro has taken center stage and Germany has become the lead actor. The European authorities face a daunting task: they must help the countries that have fallen far behind the Maastricht criteria to regain their equilibrium while they must also correct the deficinies of the Maastricht Treaty which have allowed the imbalances to develop. The euro is in what I call a far-from-equilibrium situation. But I prefer to discuss this subject in Germany, which is the lead actor, and I plan to do so at the Humboldt University in Berlin on June 23rd. I hope you will forgive me if I avoid the subject until then.

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