Commentary

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Unemployment: The End in Sight?

This morning’s unemployment released from the Bureau of Labor Statistics makes for grim reading: businesses shed another 563,000 jobs bringing the total of people out of work to 13.7 million, and pushing the unemployment rate up to 8.9%, its highest in about 26 years. Overall in the past twelve months the unemployment rate has risen 3.9% with the number of jobless going up 6 million in the same period.

So why is everyone treating this news with optimism?

The economy seems to reached the bottom in terms of the rate of decline. Things are still getting worse, but now the pace of change has moderated. The employment figures, while awful at any other time represent a step in the right direction: losses are piling up more slowly than in the last few months.

The key point, as I always remind you, is not to get too carried away with this one data point. We can feel much better in the early summer when this month’s apparent change in direction has been confirmed by two or three more months.

Meanwhile, clearly the tone of the economy is shifting. Those green shoots Bernanke referred to a few weeks ago are now looking a lot more robust. So there’s hope the worst is over.

But.

No one should get too excited. Buried in the same report is the news that wages are virtually stagnant. This is supported by local and anecdotal information that indicates wages may even be falling. This is really bad news for the recovery.

Getting the economy to stop falling was the first task. That goal is now within sight. Our next task is to develop the shape or nature of the recovery. My view is that we have to acccomplish a few things in order to establish strong growth over the next few years.

  1. We need to reduce debt loads: both for families and for companies. This will be hard to do if wages and profits remain weak. It will be impossible if wages or profits actually fall. I have written about the problems of deflation before,and at the moment I don’t think it is a significant issue because of the enormous amount of monetary stimulus the Federal Reserve Boards has used to stave off depression. Nonetheless while we may avoid deflation proper we must also be careful to avoid stagnation. My preference would be a return to a healthy 2% – 3% annual inflation rate that helps lift wages and erodes the value of debt without undermining it [as would be the case at a higher inflation rate.]
  2. We need to establish a more robust savings culture. Savings have jumped recently from practically zero to about 4.5%. But I imagine that is a result of a temporary hoarding of cash rather than a permanent shift. Savings will allow investment to flourish since the financial system funnels savings into business via lending. The US has been the end point for much of the world’s ‘surplus’ savings for decades: the flood of foreign money into America provided the grist for the sub-prime mill. We need to wean ourselves off of foreign capital … why?
  3. Because we also need to reduce our trade deficit. A trade deficit has to be financed. The way this is done is by sucking in money from abroad. If we end up buying more foreign goods than we sell abroad we inevitably end up financing it by selling more assets – bonds, stocks, buildings, businesses – to foreigners. We then recycle the cash we receive for those assets in order to pay for the excess goods we buy from them. This closely linked cycle is why the US and China are inextricably linked in trade: we need each other at the moment. The trade balance needs to be reduced … why?
  4. Because we have to ensure the dollar doesn’t fall too fast in value. We have huge government deficits to finance for the next few years as we crawl out of the hole we built for ourselves in the years of indulgence. Much, though not all by a long shot, of that debt will have to sold abroad. In order to attract investors we will need to maintain a stable currency and attractive interest rates. If our savings rate is sufficiently high we can channel some of those savings into government debt to avoid reliance on foreign investment. But that might reduce the amount available for business to use to build new factories and so on. So we simultaneously need to …
  5. Run a tight fiscal policy. That’s code for raising taxes. I am an avid supporter of fiscal stimulus as a short term expediency. If we have a great credit rating for our debt we should use it to acquire funds to spend our way from the edge of depression. But, we also need to ensure we get our books back in balance quickly so that the deficits don’t become permanent. Cyclical deficits are OK. Structural deficits are not. Our government’s books were in dire straits before the crisis because of decades of failed economic thinking and partisan bickering. That has to stop. Of course we can avoid heavy taxation by …
  6. Making sure growth is both steady and strong. One of the failures of the Reagan era was that fiscal policy focused exclusively on reducing taxes. Unfortunately there was no ‘trickle down’ effect and the lower tax regime failed to ignite growth sufficiently to ‘pay for themselves’. That whole policy regime, along with the economic theories that underly it, is now thoroughly discredited. So in order to mitigate the negative effects of higher taxation wages have to grow strongly so as to allow consumers to buy things, save, and still afford the taxes. So wages have to return to their more normal share of GDP at the expense of profits. Remember: profits were the only major factor in the economy to show above normal growth during the past eight years. Wages have been virtually flat.
  7. Finally: we need a financial system that focuses on the careful expansion of credit – loans to families and businesses – rather than on the yahoo wild west nonsense that we have seen since the early 1980’s. This implies heavy re-regulation and possibly the use of anti-trust laws to carve down the size of the ‘too big to fail’ banks that ruined our economy and started this crisis off. Remember the mantra: ‘too big to fail’ means ‘too big to exist’.

That’s a heady agenda. But as you can see it is all intertwined. Wages must be growing well for us to accomplish our goal of strong GDP growth. We need a better balance between thrift and consumption. We need a more conservative fiscal policy – and yes I mean conservative. And we need to eliminate the excesses and excessive behaviors that caved the roof in the last time.

Which brings me back to today’s release: that wage data tells me that a strong recovery is far off still. We may be growing slightly by year end, but the pace of that growth will be very poor.

Our efforts should all now be on acceleration. There are huge policy debates ahead that will determine our success. Most importantly re-shaping banking, and getting a better sense of fairness into our economy should top the agenda.

Wages over profits for the near term. And make banking dull.

They’re the two thrusts needed to get this place humming again. This morning’s data shows we have a long way to go.

But at least we have started.

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Bank Stress Tests

The administration has announced that it will release the results of those infamous stress tests next Thursday. That’s a little later than originally planned. But the more interesting news is that they will now release more than summary findings. Instead we will be treated to a much more detailed set of results. That presents a problem for some, but is unequivocally in the best interests of the public.

Naturally the weaker banks will spend much of the next week protesting that the tests radically underestimate their strength. The Federal Reserve Board published the test methodology last week, and having read through it, I would argue that the tests are fairly modest. The toughest scenario puts s great deal of emphasis on the effects of unemployment rising beyond roughly 8% which the Fed assumes will trigger a burst of credit card losses. I was disappointed not to see a parallel emphasis on a potential melt down in commercial real estate, since in my opinion that has already begun, and will certainly end up causing the big banks heavy losses over and above those in their credit card portfolios.

It is this next wave of losses that represents a more normal credit cycle. Banks always suffer loan losses during recessions and those losses tend to lag behind the onset of the downturn. The reason is obvious: businesses and individuals are still able to pay their loans on time early in a recession, it is only as the downturn continues that cash gets tighter and the defaults start to pile up.

By now you’re all bored with my constant harping on the unusual nature of this cycle: it started as a banking crisis, so we are now entering the ‘normal’ phase of the credit cycle with already severely weakened banks. That’s why we are nowhere near done with potential bank failures. In fact I think this next wave of losses will probably be too much for at least one, if not two, of our biggest banks – neither Citibank nor Bank of America has sufficient capital, either at the Tangible Common Equity [‘TCE’] or Tier 1 levels, to weather much of a credit storm over the next few months.

It is this information I expect to emerge from the stress test release next week.

Then what?

There are a couple of things to bear in mind as this starts to unfold:

  • The weaker banks will see their stock drop quite quickly. Or at least they should. No one will want to hold the equity of a failing bank and so the rush to sell will start as soon as we hear leaks of the test details. And creditors may start to unload their holdings as well. The value of Citi’s debt has already tumbles ahead of the release. I expect that trend to continue.
  • The probability of a bank failure will rise. Not due to the actual loan losses I just mentioned as being on the way, but in reaction to the loss of market confidence. Some of these banks have been dead on their feet for months now, and have been struggling to raise equity back to anything approaching sensible levels. Their impending status as ‘weak’ will hamper these capital raising efforts even more, which will force them to start a fire sale of their businesses and assets. Citi has already managed to raise about $8 billion by dumping some of its Japanese operations. We will most likely see more of this kind of capital raising.
  • Even so, I doubt that the weaker banks will have sufficient time to fix their capital levels before a combination of lost market confidence and reduced capital raising opportunities force them into the arms of the government. I think we are at the beginning of an inexorable slide towards some form of government control and forced reorganization for both Citibank and B. of A.
  • Which raises an interesting point: by releasing the results of the tests the government is actually restricting its own policy options. As long as the results are vague there is always leeway for various interpretations, consequences, and therefore courses of action. Once the situation is clear, and the market reacts, the set of policy choices starts to narrow quickly. The weak banks will be tied ever tighter to the purse strings of the Treasury Department as alternative sources of cash dry up.

So whether by accident, or by design, next week’s news should start the next phase of bank bailout. And this time the opportunity for the government to avoid direct control will be restricted by the lack of privately available options.

I don’t know whether this was the plan all along, but direct control will accelerate the cleaning up process. Since that’s what I’ve been advocating from the beginning I have to admit that I am looking forward to next week.

As for Citi and B. of A..

Well they probably have a very different perspective.

Tough.

Addendum:

The Financial Times reports that the cause of the delayed release of the stress tests is the ongoing tussle between some of the banks and the administration. Apparently the weaker banks are arguing that they don’t need extra capital. I hope the Treasury Department holds the line on this argument. The last thing we ned is a bunch of crippled, and therefore useless, banks cluttering up the economy just as we need an infusion of credit from our banking system. As we are all aware by now, these so-called ‘zombie’ banks are worse than failed banks because they live on but serve no economic purpose.

Still, the release alone should cause the weaker banks to crumble quickly. Already the market is humming with rumors. Can a takeover be far away? I hope not.

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Capitalism and Democracy: An Expansion on My Rant

Having already been bashed, unfairly, for being ‘anti-capitalist’ I feel I should expand on my previous post.

Before I begin, here’s a post at Simon Johnson’s blog to demonstrate that I am far from alone:
The Economy and Popular Democracy – The Baseline Scenario

So here’s the way I look at this:

First, I happen to think that democracy and capitalism are antithetical systems. They are mutually destructive. I know this seems to fly in the face of received wisdom so I owe an explanation.

I see capitalism as a greed based, individual-centric and innovative system designed to generate wealth through the incentive of huge financial rewards unimpeded by any socially ethical considerations. It is intensely centered on individual brilliance and accomplishment as embodied in the iconic ‘entrepreneur’. It has both positive and negative consequences among which are the massive concentration of wealth within a capital owning class; and the acceleration of technical innovation, and subsequent economic growth, through open competition.

Democracy, on the other hand, I see as a more social-centric system designed to encourage a broad distribution of power and consequently a more egalitarian distribution of wealth. Because of its more consensual tenor and lower emphasis on competition, democracy can inhibit innovation but has the benefit of involving a broader segment of society in major economic activities and so makes better broad-scale use of a society’s intellectual resources. It tends to be bureaucratic and less incisive, but more inclusive.

Both systems can fall into extreme conditions: capitalism can produce oligarchy and democracy can produce rabid populism.

We have experienced both extremes recently.

During the just ended Reagan era the economy rapidly and clearly concentrated wealth in the hands of a small elite: highly educated, well connected, and predominantly in the financial world – including the various hangers on such as corporate lawyers, accountants and even academics who invented financial theories to support the development of the derivatives business. This group exerted sufficient power through lobbying and intellectual framing of public policy that it was able to secure an almost unprecedented share of the national wealth. It was able to influence policy on a grand scale – bank deregulation; the stifling of derivatives regulation; Federal Reserve Bank policy; and finally the Bush tax cuts which disproportionately shifted Federal revenues back into a very small number of hands.

The result of this concentration of power was the embedding of ‘market economics’ as the predominant worldview of policy makers and the gradual stripping away of the middle classes ability to retain wealth for itself: while the Reagan era was not totally a zero-sum game for wealth distribution, it was, by any standards, a massive shift of wealth from the lower and middle classes to the top income tier.

This ability to suborn an unequal share of the nation’s wealth resulted from the destruction of the post-war balance between capitalism and democracy. Reagan’s famous charge that government ‘was the problem’ undermined popular faith in a democratically elected government’s ability to rectify imbalances created by capitalism. The subsequent three decades saw a steady shift rightward in politics and consistent faith in market forces as the premier organizing force for wealth allocation.

Democracy was diminished.

Money flowed into politics and enabled the elites to consolidate power.

However, and inevitably, the elites overreached. The inherent instability within the financial system – finance has far fewer of the negative feedback loops that provide stability in the labor and goods sectors of an economy – led to two successive and ultimately destructive asset price bubbles. The economy fell into steep recession and increasingly populist reaction grew rapidly in response to the need to bail out the very financiers who had created the problem.

In other words we are now running the very real danger of an overly populist assertion of democratic ideas – wealth redistribution for instance – that could impair the innovative power of capitalism for decades to come.

The populist backlash is a natural and inevitable consequence of the Reagan destruction of the post-war social contract. Remember that the only economic indicator to run at above average rates throughout the past eight years was corporate profits. All else, including wage growth and the employment outlook underperformed. An increasing number of middle and lower wage earners found it impossible to maintain the mythic American dream – no matter how hard they worked. A backlash was bound to occur. The recession was simply the opportunity to articulate the unease and for populism to coalesce around the need ‘for change’.

The larger point I am trying to make is that the American genius has not been to unfetter capitalism or to establish democracy – other nations did that. It was to blend the two so that the negative sides of each counter and offset one another. From that blending emerged what we call the American Dream which is a simple and idealized balance of two opposing forces.

It is this balance that was broken by Reagan and which has led to the emergence of what Simon Johnson calls the new oligarchs. It has also created a pernicious and destructive populism that threatens our ability to cure the economy.

And it is only within this balance that I can defend the potential of what Schumpeter referred to as the ‘creative destruction’ of capitalism, or can tolerate the muddled and frustrating nature of democratic government that Churchill once described as the ‘worst form of government except all the rest’.

So am decidedly pro-capitalist. Within reason. And therein lies the rub.

Addendum:

The notion that capitalism is essentially naked greed seems to offend some people. Why? That’s what it is. To try to mask it with homilies to its socially beneficial side effects is simply an attempt to divert attention away from its central premise: capitalism is about making money. Period. The fact that other people may get a lift in life as a consequence of a capitalist’s actions does not imbue those actions with any higher moral purpose. We should look at intentions: was there an immanent moral driver in the action that gives us cause to view the capitalist as socially ethical? If so good. Otherwise let’s just call it what it is. Plain old fashioned greed. Nothing wrong with that, we’re all greedy in our own ways. But when greed spills over into entitlement and entrenched political power society has a problem. Inequity becomes rife and ultimately social stability is threatened. A wise plutocrat is one who throws a little money to others or contributes to public causes as a way to ameliorate the inequity: it helps distract the less fortunate. America is littered with so called charitable redistributions of income as a result of such wisdom, and most are dignified with the names of a plutocratic benefactor. Naturally, since we live in a capitalist society, we call these actions ‘giving back to society’. A less tolerant view would be to call the gifts an effort to numb the rest of us against the rawness of the greed that contributed to the accumulation of the original wealth. Or perhaps, most benignly, the plutocrats themselves realize the venality of their own motivations and their gifts are an attempt to buy social forgiveness: a self administered and self calculated benediction?

The word ‘self’ is the most appropriate to characterize the entire Reagan era. It was an era of ‘selfishness’ par excellence. Poverty reduction and health care, both indicators of communal spirit were cast aside as motivations for personal action. Instead our talents were thrown into creating mountains of bond trades, derivative contracts, and the resultant bonuses.

Paul Krugman hesitates to refer to the talented people who were drawn into finance by the lure of riches as our ‘best and brightest’. Matthew Yglesias comments here on the same theme: The Ethics of Home Economicus .

Bright they certainly are.

Best? Not so much.

Look for a rash of generous donations to galleries and hospitals as the Reagan era tries to cleanse its reputation in preparation for history.

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Open Comment To Simon Johnson

FYI. I posted this comment on Simon Johnson’s blog this afternoon. He had advocated, among many things, a wholesale changing of the guard in bank boardrooms.

“Not to annoy anyone, but:

Where do we get the new and presumably better directors? Who are they? And who are the new managers? Where will they come from?

Simon you are correct to say board oversight was a problem. Let’s dump the boards. But it is far too easy to glide lightly past the practical and obvious questions. We will need more managers in a system with more and smaller banks. We will need qualified regulators. We need better educated legislators. Where is the improved education going to come from? MIT?

Of course I’m biased, being an ex-banker myself, but I think we should focus on the practical as well as the fun of bank bashing.

The expansion of the derivatives business which is the heart of our problem was enabled by years of education at places like your own school Simon. Those ‘quants’ came equipped with economics PhD’s, many from MIT. So as we sweep up the elites and send them packing, do we include the economics profession? Do we need to take a look at the oversight of the curricula at our top universities?

I realize this sounds a tad whining, but when I read some of the comments your blog elicits I feel impelled to point out that there are quite a few Nobel prize winners who’s work enabled the derivative business to be what it became. The yahoo’s at Goldman Sachs etc. thought they were acting on solid theory. Sure they were motivated by huge and wrongheaded incentives, but their managers thought the risks were safe. Why? Because the Nobel prize winners said so.

This is a failure of ideas as well as of ethics. We should all, economists as well, look at ourselves as we try to find solutions.”

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Open Letter To Josh Marshall At TPM Media

OK. I was angry this morning. In fact I have been brewing for a while. The vitriol about the ‘insiders’ and ‘oligarchs’ in banking who are plundering the economy has got to stop. TPM Media is a very well regarded blog site. But the folks there have gone nuts. Reporting is one thing. Instigating populist nonsense is another. This is what I wrote to Josh Marshall TPM’s publisher this morning:

“Josh:

I am surprised you propagate the sensationalism of [Professor] Johnson’s usage of the word oligarchs. It is misleading to say the least. Throwing around such terms is designed presumably to stir up argument so let me dive in:

First: from my personal and lengthy experience in banking there are no oligarchs. None. If Professor Johnson disagrees ask him to name someone.

Second: I do not believe for an instant that there is some small group of elitists plotting to plunder America. The word oligarchs suggests there is. Again name them. Spreading that meme only raises the temperature of the populist voice. It solves nothing and gets in the way of doing something practical.

That’s far too simplistic. The system sprawls across a vast number of firms both public and private sometimes with very little in common.
Fourth: but to continue with your nomenclature, the ‘banks’ screwed up big time. This wasn’t robbery. It was incompetence. Bureaucratic incompetence.

Fifth: the source of this incompetence is clear. The managers and employees of these ‘banks’ were executing strategies based upon a set of ideas. Those ideas were sourced directly from modern financial economic theory. Yes the execution was flawed in some cases. But in most cases the execution was perfect. It was the theory that failed. Bureaucrats execute, the CEO’s we all are currently denigrating are nothing but over sized bureaucrats. To unravel the root cause of our crisis we need to follow the string a little deeper. What did the bureaucrats think they were doing? Where did they get their ideas?

Your interviews with Joe Stiglitz and Johnson betray the root cause of our problem. Neither of them was asked the pertinent series of questions: how come the derivatives market grew so quickly and uncontrollably over the past twenty years? Is it merely coincidence that during that same time financial economic theory developed models of derivatives that allowed ‘proper’ pricing? Is it merely coincidence that every single ‘bank’ ran its portfolio precisely according to those models? Where did all those PhD’s [the ‘quants’ of Wall Street] get their educations? Hint: MIT; Harvard; Columbia: Wharton; Stanford; Chicago etc [I will leave out Princeton as a nod to Paul Krugman]

If Professor Johnson, for whom I have a very high regard, truly wants to root out the ‘oligarchs’ perhaps all he needs to do is pop across the floor at MIT. Most of the financial economic theory that enabled the explosion in the derivatives markets was developed right next door to him! They have the Nobel prizes to prove it.

This is not a failure of a few nefarious money hungry ‘oligarchs’, it is failure of an entire intellectual elite. It may be that Stiglitz and Johnson are not personally involved in the teaching of financial economics; but they surely are aware of the curriculum. If they have problems with it then stop it. Passive ignorance or extending professional courtesy to fellow academics is an evasion of responsibility for the discipline within which they work.

I suppose what angers me most about the commentary on your site and the glib nature of the analysis being put forward by guys like Stiglitz and Johnson is that it elides the wider responsibility. Everyone can see the fractured nature of economic theory: interview Barra at Harvard instead of Stiglitz. Or Fama in Chicago and you will get a totally and diametrically opposed view of what the right policy is from your interviews with Krugman, DeLong, or Baker. But that’s plain old macroeconomic theory. In contrast financial economic theory is a homogenous whole. There is no alternative.

Accusing incompetent bureaucrats of being oligarchs reminds me of Soviet era show trials when the five year plan failed. You trot out the disheveled department heads and blame them. Yes they’re fools. But thinking they’re the root of our problem misses the huge point: our ideas failed us. The entire system needs a makeover. Yes there are a few economists who are giving us leadership. And yes I have no doubt about the integrity of Stiglitz and Johnson. But it is gratuitous for them to disown their share of the problem. While we are all enjoying watching the spectacle of the public humiliation of the ‘bankers’ are we also preparing to question Professors Black, Shcoles, Merton et al also? [I believe Professor Black unfortunately is dead!]. To complete the cleansing that’s what we need to do. I realize attacking intellectuals with vastly impressive resumes is intimidating. But it’s the right place to start. Here’s an opening question: “What did economics learn from the LTCM debacle a decade ago?” Anything?

Regards,

Peter”

I doubt he’ll reply.

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