bank reform

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Meanness, Mediocrity, and Bank Reform

It takes a particularly virulent form of mean spiritedness for a nation to walk away from its most vulnerable citizens at a time of their greatest need. Yet that is what the US, and by implication you and I, has just done. The Senate was unable to muster enough votes to continue the extension of long term unemployment benefits. So they lapsed. The cost would have ben small in the context of our overall deficit. The impact would have been enormous for the thousands of families whose lives have been turned upside down by the corrosive effects of long term unemployment.

Do we care?

No.

We have become a nation so narcissistic and incapable of community action that we simply don’t care.

I fear for the children of those families.

And I fear for the future of any country so implacably opposed to generosity during difficult times.

This was a supremely mean action. It will have practically no impact on the trajectory of our debt. It panders to the puritanism of the right wing who are relentless in their Victorian era desire to impose punishment on the poor, as if being poor or unemployed was driven only by moral incapacity. That horrible and nonsensical attitude still rears its ugly head in Anglo Saxon economies, and is embedded in the roots of modern economics as well. Orthodox economists believe – or at least they teach – that being unemployed is a choice. To them anyone without a job has chosen not to work. So providing benefits to the unemployed to mitigate the effects of unemployment is a distortion of the workings of the ‘free market’. Naturally the puritans love this nonsense and have latched onto it in order to provide themselves with an intellectual legitimacy for their mean spiritedness.

This nasty attitude reminds me of St Augustine who, as ever the fatalist, told the slaves of his era that they must have sinned badly in the eyes of god for him to have made them slaves. His advice was to grin and bear it. And to try to pray a lot.

When historically significant preachers set this kind of example for the elite to trample on the poor, it comes as no surprise to read of the Senate’s nasty attitude.

Moving on:

Today’s report that GDP grew only 2.7% in the first quarter has been treated both as a surprise and a disappointment by the financial markets who imagined things were going better than that. I say ‘imagined’ because the evidence has been accumulating for weeks now that we are experiencing an entirely mediocre upturn. One that continues to be very vulnerable to weakness. Much of the disappointment seems to stem form the fact that every time the government has issued a first quarter GDP report the numbers have been worse. Today’s release is the third and final estimate. The first estimate was for 3.2% growth. That was trimmed in the second estimate to 3.0%. We finally settled at the 2.7% announced today.

That is not a very good growth rate for only the second quarter of recovery. Typically the US economy goes through two or three quarters of rapid growth – well over 4.0% – before settling back down at its historic 3.0% level. That we haven’t had such an experience this time merely reinforces my opinion that the economy was much more damaged by the banking follies of earlier this decade than many others give it credit for. Allow me to repeat: recoveries following financially rooted crises are always – always – more difficult and prone to setbacks. This is an empirically supported observation. Unfortunately it is not well known in academic economic circles because it is the outcome of research by non-traditional economists. Since my more orthodox brethren don’t read heretical works, like those of Keynes or Minsky, they are blissfully unaware of the dangers we still are facing.

Having said that, even the orthodox folks at the Fed are now beginning to become concerned that growth is not what they imagined it would be. That’s a relief since it removes the prospect of a Fed tightening from the immediate agenda. Any rise in interest rates now would send us downward quite quickly. We are lucky that the gloom in today’s report is sufficient to knock some sense into even the thickest of fiscal hawks heads. Or at least I hope so.

Just to complete the survey of mediocrity I should give you the actual numbers from the GDP report:

Consumption was positive, adding 2.1% to GDP

Private investment was also positive, adding 1.8%.

Net exports [exports less imports] was negative, deducting 0.8% from the total.

Government spending was also negative, deducting 0.4% .

These numbers hide a few important points.

First: the consumption figure is decent, but not great. Usually as the economy bounces back consumption is a major driver as consumers spend more than normal in order to make up for the spending they didn’t do during the downturn.

Second: the private investment figure is misleading. All of the growth came form inventory changes and not from actual investment in things like construction or machinery. Those two sectors were flat, and construction looks to be mired in a long term slump.

Third, and final: the government spending number is very worrying. I have warned of this before. The positive impact of the Federal level deficit is being more than offset by the draconian austerity plans that the States are implementing. While these local actions may appear to make sense to local politicians and voters, they are making the economy much weaker. They are draining spending power from the national economy. In effect the States are hoping that someone else will get the economy moving. The irony is that many of those same politicians and voters then express opposition to Federal deficit spending which remains our best hope for stimulating recovery and allowing those local budgets to recover.

Overall I have to admit that the economy is moving along a track that I see as both very predictable and susceptible to risk. We should expect more mediocrity for the rest of this year.

Let me add my voice to those calling for more support to the economy. I have railed against austerity enough. I believe it to be blindly stupid. Those who want to shift the focus to the long term issues, and in particular our budget problems, are missing the point entirely. Without fixing the short term the long term is irrelevant. This was the driver behind Keynes famous dictum that ‘in the long term we are all dead’. His main point being that dealing with long term, far away, issues is always easier than dealing with immediate and more intractable issues. In his view this ease draws the attention of policy makers and economists away from the difficult and often messy problems of today, while allowing them to present a virtuous facade to the public.

In this case the mediocrity is of leadership and intellect. We suffer from a bureaucratic mindset that frames everything in terms of checklists and rules. So all the solutions on offer are tweaks to existing rules or the addition of new rules. As someone once said: if the only tool at hand is a hammer, all problems look like nails.

Maybe we need new tools.

Finally today, and to add to the mediocrity, we must mention bank reform.

After all the fuss and hand wringing Congress has managed to cobble together a reconciled financial reform bill. Presumably it will get to Obama’s desk before long. The timing of agreement was driven more by political considerations than by the need for reform: Obama is off to attend the latest G20 meeting and wanted to have legislation in hand so the US can dictate the nature of worldwide reform.

The simplest question to ask about the reform is: does it prevent future crises?

No.

What is does is to paper over a lot of the medium sized holes in the system and close down some of the more egregious consumer oriented activities of the banks. It doesn’t have enough strength to stop future melt downs. And it doesn’t prevent the need for future bail outs.

The better parts of the reform focus on the consumer. A new consumer protection agency is created but buried at the Fed. This is a typically lame response to the exploitation of consumers that has characterized banking for years. Remember though that the Fed had oversight for mortgage pricing regulation before the bubble. It did nothing to stop the activities of the worst offenders. Since the Fed remains staffed to the rafters with mathematically inclined economists rather than socially minded attorneys, I doubt this new agency will have the bite that some think it may.

Meanwhile the reform does tighten up the derivatives market somewhat although I suspect that the banks and their armies of overpriced lawyers will gut the intent of the new law within weeks. The ‘Volcker’ rule survived in muted form to reduce bank speculation, and the ‘Lincoln’ initiative also made it through to force banks to offload their speculative book of derivatives into non-Federally insured subsidiaries. Quite what this achieves I am not sure. The simple question we need to ask is: will the regulators allow Citibank to go belly up because its non-insured book of derivatives goes bust and threatens the mother ship? No I don’t think so. Thus the Lincoln plan is window dressing. The Volcker rule has more merit because it simply bans certain activities, specifically the use of low cost Federally insured deposits as a funding source for non-client based speculation. The problem is that the ban is not tight or comprehensive enough. The boys still have plenty of matches to play with.

Other aspects of reform are also humdrum. The big banks will have to cough up some cash to create a bail out fund, so that future bail outs will not come from the taxpayers. This raises the interesting question: why do we need this provision if the reform ‘stabilizes’ the financial system, which is Geithner’s claim? The obvious answer is that no one really thinks we will avoid future bail outs. Nor is the amount anywhere near enough in the context of the behemoth banks that now populate our system.

Finally the much ballyhooed liquidation process for big banks, while it sounds great, will immediately run afoul of international complications. Unless there is a uniform world wide and coordinated approach to bank bankruptcy procedure no amount of huffing and puffing here in the US means much. It certainly does nothing to end too big to fail.

And that is, in my mind, the really big issue. This reform does not eliminate banks that are too big to fail. All it does is to provide some nice rules for future bankruptcy procedures and to mitigate some, but not all, the causes of the past crisis. Our legislators are intent on, and content with, planning to fight the last war. That makes them feel good, but does not solve our central financial problem. While the dinosaurs still roam and dominate finance we are destined to endure more crises and suffer through an oligopolistic market where competition is stifled by the lumbering bureaucracies we call the big banks.

Oh well. I suppose some other president can solve that problem. The current incumbent wants to punt.

Mediocrity indeed.

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Double Dip?

It’s extraordinary how quickly we can go from over-estimating the recovery to near panic over fears of a double dip recession. This volatility of the markets should kill off once and for all the ludicrous notion that markets are somehow ‘efficient’ or ‘rational’. Those two concepts are pillars of text book economics which has now ben exposed as rubbish. Unfortunately it is rubbish held dear by most of the key players in banking, and so I doubt that we can expect any improvement in the tone or quality of their reactions to events any time soon.

But what of this double dip threat?

For those of you who read my comments here regularly, the fact that the recovery will be a long slow and very hard slog should be no surprise.

Let me repeat: recoveries following a financial crisis are always – always – difficult and slow. This is because a key mechanism fueling recovery, notably the banking system, is preoccupied with healing itself rather than in performing it role of being a credit supplier. Without this flow of credit a recovery is likely to stall at the slightest hiccup. And we have hiccups aplenty.

Last week’s report on employment was the most immediate source of panic in the markets. On the surface it looked good: well over 400,000 jobs produced in one month. That’s the number we generated in the entire Bush presidency! However the devil was in the details. Only 20,000 of those jobs came from the private sector. The rest were directly attributable to the government hiring of census workers.

This was not so good.

In fact it was very bad.

The result was a massive sell-off on Wall Street [which remains overvalued in my opinion anyway],and the sudden burst of dire predictions about a double dip recession.

My view is a little different.

I have always argued that the recovery would be very difficult, and that job generation would be extremely slow. By any measure this was an awful recession and the damage has been huge. We should not fall prey to the news media’s need to move onto to a new story: the economy is still very fragile and will remain that way for months if not years. Yes, years.

Having said that a mere 20,000 new jobs is very worrying. Clearly private business is in no mood to lead the way. I have to assume that businesses everywhere have difficulty planning for a surge in sales and have hunkered down to weather the presumed storm. This, of course, simply ensures the arrival of a storm since the process of hunkering down sets in play a self-fulfilling spiral downwards. At least the planners look good. Every one else suffers the consequence.

The fear that seems still to grip business is only partly justified. The recovery is well established, we have now had three quarters of growth, two of which have seen good growth. As with all recoveries the early stages have been unbalanced with some sectors getting going sooner than others, but the encouraging news from the recent GDP report was that all sectors are now showing signs of life. We seem set for continued growth.

But that growth will not be as strong as the prevailing wisdom suggested. The Fed has fallen prey to the hoopla and has raised its forecast for GDP to above 3.0% for the year. I don’t agree. But if you are an optimist and have moved your forecast upward, that jobs report must come as a nasty shock. Hence the sudden backpedaling.

Just what are the chances of a double dip?

Oddly I think the primary cause of renewed recession would be more a failure of policy than a feature of the economy itself.

Given my premise that the recovery will be slow, and will only eke out growth rather than boom ahead, any tampering with the stimulus or with interest rates will, in my view, cause a downturn. The economy is simply too weak for us to take any pressure off stimulus. The jobs report supports that view. This week’s retail sales report – due Friday – is being heralded as confirmation of a renewed weakening. Rumors are that consumers cut back last month from the relatively lively pace of the month before.

But.

This does not mean we are doomed to fall into recession.

If you hold my view, it was inevitable that the economy would drop away from its fourth quarter 2009 and first quarter 2010 pace. Both those periods were heavily distorted by the effects of the stimulus. Anything more than a cursory review of the numbers would have shown that the underlying rate of growth – with the training wheels kicked off – was much slower. All that is going on at the moment is that we are regressing to that underlying rate, which is much lower than the 3.0% to 3.5% that had become the norm being kicked around in the media.

Within a weak growth scenario such as mine any efforts to cut back on the Federal deficit or to raise interest rates to head off inflation would be a massive mistake and would produce a more pronounced slow down, and, maybe, even a renewed recession. Without any changes in policy, however, I think we can look forward to weak, possibly very weak, growth, but growth nonetheless.

What of those calls for budget cuts and higher rates?

They are foolish and premature.

The will always be people advocating a tighter federal budget or higher rates. These ‘hawks’ are usually politically rather than economically motivated. Right now there is no evidence of an impending surge in inflation. So raising rates is not necessary. On the contrary, inflation has all but disappeared, and the bigger risk is of deflation rather than of inflation. Nor are international money markets clamoring for a tightening of policy. US Treasury interest rates are lower now than they have been for a while. Were the markets calling for budget cuts or anti-inflation moves rates would have started to climb. They have not. The so-called market sentiment is a figment of the imagination of people who are predisposed to such policies. There is no pressure at the moment for change.

But there are risks, and they are increasing.

The credit markets are jittery due to the backwash from the Euro mess. It is an over simplification to extrapolate from the Greek debacle to the US – or the UK for that matter. The circumstances are very different and so the policy options are also very different. Bank risk measures are moving back towards post-Lehman spreads largely because of the potential losses that the Greeks could impose on European banks. Plus there is a growing swell of commercial construction credit losses here in the US. That puts the banks back at the center of things over the next few months.

But we have fixed that problem … no?

No.

The so-called bank reform making its turgid way through Congress at the moment includes a few nifty things like better controls over derivatives and better consumer product regulation, but it fails – totally – to deal with the root causes of the bank implosion of 2007/2008. The banks remain too big and too complex. They remain impossible to regulate. They remain too powerful. Too interconnected. Too prone to swings in asset values. Too able to game the system. And way too concentrated. This last point being the most important. Our banking system has become more risky, not less risky. The share of total assets held by the big six is now much larger than it was before the crisis. They are more, not less vulnerable. And, since they are all much larger, we have become more enmeshed in ‘too-big-to-fail’, rather than less. The fact that the reform includes procedures to wind up a massive behemoth like Citibank doesn’t mean that the regulators will have the courage to call for such an action. More likely is another bail out. In Citi’s case bail outs are a frequent event. This last one was not the first and will not be the last.

So.

If we add the chance that policy makers will go off the deep end and tighten prematurely, which is unfortunately looking probable, to the edginess in the credit markets, and to the continued fragility of our banking system, it is easy to get downcast.

The common theme to all those problems is that they are entirely contrived. They are not outcomes of the economy. They are outcomes of weak leadership, poor analysis, or irrational fear mongering. In other words they are within our ability to avoid.

The fact that we botched bank reform doesn’t bode well for the others.

If we get a double dip recession it will be our own fault.

In this crisis we have, as someone once said, ‘fear itself’, but we also have weakness and incompetence. That’s a toxic brew.

But if we manage to dodge those self-inflicted wounds we will muddle through without a double dip recession. And that’s good news.

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The Story So Far

I will be going away for the summer at the end of this week which leaves little time for further commentary until later this year. So I want to give my view of where we are in this recovery, and what I think are the remaining issues to be faced.

First, let’s all recall that the crisis began a long time ago. Depending on your perspective the onset of the malaise was either in the latter part of the Bush administration, or it was much earlier, during the Reagan years when deregulation set in motion the slide towards today’s volatility.

My preferred narrative is that what we are going through now is the inevitable end result of the shift America introduced during the 1980’s. That shift saw the then existing dominant view, which was largely post-war Keynesian, replaced by a re-introduction of pre-war laissez faire. The notion at the time appeared to make sense: the stagflation of the late 1970’s was to be explained by the stifling hand of government and the resultant drop in innovation. Only with the release of free enterprise from the dead hand of government would we be able to restore strong growth.

My issue with that standard story has always been rooted in the facts: economic growth, by any measure, was at its peak during the immediate post-war era, precisely when government intervention was both frequent and fashionable, and, moreover, when trade unions were at the zenith of their influence. This does not mean that those factors caused that growth. But it does mean that the right wing argument that they impede growth is factually wrong.

In truth the stagflation was more a result of a series of one time shocks, and the steady catch up by America’s rivals, than to the failure of the then existing economic policies. Plus, the institution of a right wing free market set of ideas was not associated with a burst of growth. Since the 1980’s America has followed its historical trend for growth rather than exceeding it, and during the past decade we have significantly underperformed. Setting the markets free has not produced a burst of anything. There is no evidence at all that free market policies are any better than the old post-war policies. In fact all the evidence is that they are worse.

This is why we find ourselves in our current predicament. The reduction in regulation has failed to produce any increase in growth, but it has produced enormous costs. So adjusting those mediocre benefits by the above average costs produces a very large net loss for society. Wages have stagnated. We have been buffeted by two successive asset bubbles. We have had to pay enormous amounts to keep our banking system afloat. And we have had to run up huge federal deficits in order to avoid a depression. From this vantage point the entire Reagan/Bush economic project has been an unmitigated disaster.

It is facile to place the blame on anything other than those policy choices. Yes we are now facing more intense competition from abroad, but trade is still a small part of our economy so that competition is not a sufficient explanation for the anemic Bush era economy. Now does it explain the lunacy of the real state bubble which was a purely ‘made in America’ moment.

No, this was, and still is, a self inflicted wound.

As we lumbered into the morass the Bush administration attempted a variety of unprecedented triage treatments. The bank bail outs, and the Fed’s extraordinary monetary policies are the two biggest highlights from those months. That anyone can accuse Obama of spending a fortune to bail out the banks is misdirection of the most cynical kind: it was a Bush policy he inherited. And it was something we had to do given the mess created by deregulation.

The Fed is, of course, not beholden to the administration of the day, so its actions have to be evaluated in a slightly different light, but they, too, seem to me to have been unavoidable.

I think it is far too easy for people to forget just how close we came to outright collapse. There were days when any reading of the numbers was grim to say the least. And on many we were looking at data suggesting a more dramatic collapse than that of the Great Depression itself. At which point Obama arrived amidst a burst of optimism, born more from hope than any sensible take on the circumstances.

The first step towards saving the economy, after the change in power, was the stimulus. This was, for me, a watershed event. The resistance to a surge in government spending – the shift towards fiscal policy to augment monetary policy – was ill informed, vindictive, and just plain wrong headed.

At that moment we had precisely one positive policy choice: go deep into debt to stave off disaster. All other choices were either already in use, or would have led to depression. Doing nothing would have been the worst of all and would have condemned us to an economic freefall of epic proportions.

A recession, or a depression, is simply a dramatic loss of demand in an economy. People stop buying. That causes businesses to cut costs. It causes cash to stop flowing. Banks face loan losses. Families face lost incomes and even worse: they face the loss of their homes. The textbook tells us that to fight off this malaise we should lower interest rates in order to make borrowing cheap. This leads to a recovery in activity and the recession is limited and then ended. But we had a unique problem back in 2007/2008: we had interest rates so low that they could not be lowered any more. We had used up our anti-recession policies in order to fend of the Bush stagnation. So we had one card to play. Keynesian stimulus.

That this was anathema to the right wing is an understatement. That’s why the opposition was so shrill. The very idea that we had to shrug off the Reagan era ideas in order to save ourselves was a huge defeat for the right wing world view. The bitter fighting goes on still. Every opportunity to lump the disaster into Obama’s lap is taken with glee, and the deficit is used to stir up voter antipathy.

As if we had a choice.

Yet here we are alive and getting better.

Criticism that the stimulus failed is just nonsense. It worked exactly as predicted. We avoided depression. It was never going to stave off recession and it was never going to bolster employment because its opponents had succeeded in gutting it and thus watering down its impact. As I look around the economy today, I see plenty of evidence that we need more stimulus, not less. We need to increase demand, not dampen it. But the political will is not there, so we are condemned to a long slow struggle.

We are also exposed to more negative risks than positive risks. That is to say, there is more chance of a decline on growth than there is a chance of a strong burst.

High among those risk factors is the overhang of our defunct banking system, which was the primary cause of the collapse, and is now a major inhibitor of strong recovery.

Our banks have become leeches that bleed the economy of wealth. They channel capital into their own pockets rather than allocating into the ‘real’ economy. This is one of the primary – it may be the primary – causes of the failure of the free market era. This is, or course, ironic. That the great deregulatory impulse should have been the factor preventing free market economic policies from unleashing above average growth is an astonishing indictment of that entire set of ideas. yet it is the truth. The unfettering of the banks allowed them to syphon capital away from more productive uses and into their own pockets. It facilitated a surge in earnings for bankers, at the cost of much lower growth in wages for everyone else. Banking crippled us. Banking robbed us of our future.

And that is where we find ourselves today.

The bitterness of the banks opposition to financial reform only proves my point: they are very well aware of the personal losses they will sustain as a result of reform. And this is from what I consider to be fairly weak reform. It is a testimony to the subversion of our politics by the banks, that we were not able to effect a stronger set of reforms. I am in the camp that argues that last week’s legislation is a beginning and not an end. We will be faced by new financial crises sooner rather than later, and only then will we grapple with the big issues that were avoided last week.

Meanwhile the economy is improving slowly and will likely grown around 2.5% this year. Perhaps even a little more. This is an upgrade of my prior forecasted growth, but is still well below that of the Fed and many other forecasters who are now looking for growth of around 3.5%.

My skepticism is based on the damage that the banks have done. They still deploy far too much capital into proprietary trading and not into making old fashioned loans. Without those loans business expansion will be more difficult. Traditional forecasters tend to downplay the importance of the banks in their predictions. This is because free market economic theory has no place for banks. Since banks are intermediaries, free market theory ignores them and focuses only on the end uses of capital. The idea that capital can be under-employed, or even wrongly employed, never affects traditional theorists. They are wrong. And this crisis is a perfect example of why they are wrong. Banking is a central economic activity. Economic theories that ignore this will underestimate the damage a failed banking system will do. More to the point they will ignore the negative drag that a bad banking system will have on a recovery.

So, unfortunately, fixing the banks remains an issue on our agenda.

And so does the federal deficit.

At some point we will have to reverse the incredible laxity of the Reagan/Bush era. As I have said before: they are the only two presidents in our history to have grown federal deficits by choice. All the other deficits were of necessity – caused by things such as war or recession. This legacy is the challenge we face in fiscal policy, and not the unwinding of the stimulus which is small by comparison, and which will fade away as the economy recovers. No, our big challenge is now the correction of the revenue losses caused by the Bush tax cuts, and the control of entitlement and defense spending.

Getting the deficit under control is more a medium term issue than a near tern issue. The recovery is still too fragile for us to entertain serious cost cutting or to indulge in too many tax increases. But both are definitely part of the future – perhaps in 2011 or 2012. Of course the political calendar will play its part in just how successful we are in getting sensible long term policies. America remains addicted to its military sector and so cutting spending will be very difficult even after we are extricated from the Iraqi disaster. Meanwhile social opposition to fixing soaring entitlement costs makes getting that part of the budget under control just as difficult. We are destined to re-debate health care sooner rather than later as medical costs continue to eat up a far too large a portion of our wealth. Fixing social security is a much more easy task from a financial perspective, but it does entail changes in retirement age, payroll taxes, and caps on those taxes, none of which will be popular.

So in many senses we are still having the same discussion, even after all the arguments of the last two years.

If there is a single theme I notice, it is that our leadership has been too weak to tackle our problems with force. We are crippled by deep divisions that stop us from coalescing around a solid consensus. The rise of the tea party in politics shows how disconnected many voters are from the realities of policy implementation. Instead there is a visceral anger against all policy. There is a self-destructive tenor to the tea party that scares me. It is a movement taunted by extremism. It is a rebellion against all legislation. And it is a desperate attempt to reinstate something that never existed.

As I said earlier, our very best years came during a period of heavy government intervention in the economy. Our worst years came after we eliminated that intervention. Whether there is cause and effect in those facts I will not argue here, but they refute the tea party line of reasoning totally.

Our recovery is not simply a function of our getting the economic policies right. It is also a function of our political system and its ability to stay on an even keel. Never in the post war era have we faced such an uncertain political climate. That uncertainty will be the single largest determinant of whether we get the economics right. We cannot afford a deeper plunge into political extremism.

That’s the story to watch over the summer.

The story so far is one of action against disaster by both Bush and Obama, followed by a reaction against the repudiation of the right wing dominance of policy thinking implied by those actions. That reaction has limited our ability to fight the crisis. But despite the reaction the new era policies have taken hold sufficiently to keep us afloat. If, and only if, we can maintain the ascendancy of the new policies we will stave off depression and heal the economy. The elections this fall will play a key role in determining that outcome.

Meanwhile I am off to Vermont to write a book.

I will post infrequently as the news dictates.

Enjoy the summer.

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What Difference?

There have been a number of good books written about the crisis we are embroiled in. Depending on what you want to learn and what perspective you want to take the shelves are groaning with tomes each presenting a credible view. From what I can tell they all triangulate on one simple fact: that our elites, the media, the politicians, business leaders, and academics, failed us horribly. They failed to realize the consequences of their social engineering – the extraordinary emphasis on home ownership as opposed to home renting – and their unabashed commitment to free market ideology. They genuinely thought that markets resolve problems. They never considered that markets may also cause problems.

Group think permeated the US from the late 1970’s through until 2008. Every aspect of our lives was exposed to the rawness of unfettered market power. Regulations were stripped away because “government was the problem”. That meant protections were also stripped away, a fact that voters less committed to the ideology failed to grasp.

So when Katrina roared through we watched as our government was helpless – rendered that way by the deliberate reduction in its capacity. It was government, so it was bad. Likewise when tainted products arrived from China we were exposed to their dangers because the “bad government” had been reduced and could not cover the vast territory of inspection we still expected it to. And finally we all were forced to watch as our government caved in meekly to the banking industry as it imploded and asked peremptorily for our help. This after having been deregulated and allowed to pile up the disaster from which it sought relief.

Our elites failed us.

So the question we should ask, naturally, is: will that failure continue?

Sadly yes.

Getting back to those books.

What most stands out for me is the extraordinary analysis in “This Time Is Different” by Reinhart and Rogoff.

The one message that they hammer home is that it is never different. Crises have time worn similarities. Symptoms do exist. It is possible to tell whether an asset bubble is brewing. We are quite capable of seeing the problems arise and before they reach catastrophic levels of urgency.

Our one problem is that we keep convincing ourselves that ‘this time is different’.

We heard that endlessly about the rise of the internet and that somehow the internet had changed, irrevocably, the basics of economics. We heard it about the rise of the insanity in the financial markets, where ‘risk management’ techniques had eliminated, forever, the chance that risk would destroy a bank.

The point is that while the innovation of the internet may alter the way in which business is done – and that is something I am completely convinced of – those changes do not alter the more basic relationships of profit and loss. Profits my be sourced in different ways, and losses may crop up in different guises, but the economy, in aggregate, is still subject to the same forces that have always buffeted it.

The insanity of the ‘dot com’ era was that profit was not as important as revenue growth. So money poured into speculative projects that had no reason for being. Most of that money was lost. Yes, many great companies emerged from the debris, but only after they embraced the fundamentals of finance and economics. Old fashioned fundamentals allowed them to survive and flourish. As for the rest: they disappeared and took a ton of very valuable capital with them. Capital that could have been employed rebuilding our infrastructure, or our manufacturing industries.

The insanity of the financial boom and bust was that people came to believe in magic. They believed risk could be neutralized – eliminated rather than simply managed – by deploying endless layers of increasingly opaque rigamarole and legal hocus-pocus. It was a profitable illusion for a while and the main players all made personal fortunes. But they robbed the economy at large of its vibrancy and debilitated one of our great assets: our healthy banking system.

In retrospect, which is the perspective of all the books now flooding us with their 20/20 hindsight, the staggering fact is the we did this to ourselves. We allowed ourselves to suspend our better judgement because the dreamy ‘city on a hill’ was sufficiently gaudy that we took our focus off reality.

We fell for saccharin, old wives tales, and ‘this time is different’.

Why am I repeating this?

Because, already, the next bubble is growing. The financial media, for which my contempt is unbounded, is already touting our recovery and is breathlessly talking of new highs in the Dow just a few months from now.

And the energy, determination, and simple brute fortitude needed to fix the structural mess that underlay the crisis is fading from our legislators daily.

The case in point is bank reform.

We will witness the passage of bank reform. My guess sooner rather than later. The new law will have a glossy edge to it and will be filled with well meaning and tough sounding jargon. But it will not fix the big problems.

Our biggest banks will remain too-big-to-fail. They will thrive off our subsidy. They will pay egregious bonuses. They will continue to ‘innovate’. They will syphon capital into their paychecks rather than channel into our businesses. And they will assuredly fail again.

We all have a tendency to avoid the big decisions. Politicians more so than the rest of us because they are so exposed to our vanities. Now is not a time to fail by such avoidance. The pall cast across the world by the Euro crisis should warn us not to postpone action. The failure of the Euro was predictable. It was a matter of time. It was a classic case of ‘this time is different’. The failure is now obvious: without a full integration at the political level, and the fiscal integration that would have implied, each Euro member has only limited choices in policy. Europe’s problem can be boiled down to this: wages are too high in some parts when compared to the wages of the other parts. This means that Greek and Spanish workers need to deflate their incomes – by about 30% – in order to compete with Germany. Other ways to accomplish a re-balancing of purchasing power – local inflation or local currency devaluation – do not exist. So the original weakness to seek the bold solution, political integration, has left a legacy for which today’s workers will pay a terrible price.

This time is never different.

Boldness, clarity, and direct action will always be preferable to limp explanations that, somehow, we have discovered the magic that enables us to ignore reality.

So beware the financial media’s triumphal headlines about the next big thing.

Ask: what difference?

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Update: Jobs, Debt, Bank Reform

This has been a dull week for economic reporting with only dribs and drabs of news being released, and the Senate ploughing on through what seems like an endless pile of amendments to the basic Dodd bank reform bill. Nonetheless there are some small items to discus:

Jobs:

The weekly report on first time claims for unemployment assistance edged down once again, repeating the pattern of recent weeks. The decline was minimal at 4,000, and so does not signal a breakthrough in the jobs market. The weekly total of 444,000 is still way too high for us to relax and imagine that unemployment will come down quickly. Instead it marks another small step forward in what has become a war of attrition. We have to look over longer time spans to comprehend the improvement: this time last year the weekly claims were in the 600,000+ range, which means that we have improved about 30% over the last twelve months. That’s good progress, but insufficient, and the weekly gains have all but vanished: we have gained only 2.2% in the first third of 2010, which implies that the market has flattened out at an unacceptably high level. My own estimate is that we need the first time claims number to be somewhere in the mid 300,000 range before we will see dramatic changes in the unemployment rate. Until then we have to make do with these tiny weekly advances.

The more worrisome figure is the huge build up in long term unemployment. 4.63 million workers are now collecting long term unemployment benefits and more drop out weekly as they exhaust even the full 99 months now available. As I have mentioned before the existence of this huge number of long term unemployed has sparked a spirited debate in economics. The question being whether these workers represent ‘structural’ or ‘cyclical’ unemployment. This is an important distinction. If they are cyclically unemployed the implication is that they are still well skilled and that when jobs re-appear they will quickly find work. If, on the other hand, they are structurally unemployed, they are unlikely to find work quickly at all. This is either because their skills have atrophied due to prolonged unemployment, or that their skills do not match the requirements of the new jobs being generated. Clearly the policies put in place to fend off cyclical unemployment are very different from those needed to cure structural unemployment. In the case of cyclical job losses the focus should be on bolstering demand sufficiently to restore business activity to its pre-recessionary levels. Structural job losses are intractable to simple demand management: they need a longer term perspective and respond only to things such as retraining and relocation.

The resolution to this debate will have very large consequences for government policy during the upcoming year. Right now I think the answer seems to be that we have shed a great number of jobs that will never return. Which implies the need for aggressive retraining and career development support rather than simple demand management.

Debt:

The background chatter about our national debt continues. David Leonhardt in the New York Times did us all a disfavor this week by writing a long article comparing the US and Greek debt situations. Everywhere, it seems, commentators are asking whether we will go down the same road as the Greeks, and the big question has become: will the US default?

The short answer is no.

This, of course, seems like an evasion, especially when the Congressional Budget Office issued its assessment of the monthly budget deficit. On the surface the CBO report makes for ugly reading: the first seven months of the US fiscal year show an accumulated deficit of $800 billion, with April being much worse than the equivalent month last year. It was April’s poor figures that sparked quite a flurry of doomsaying: April 2010 saw a monthly deficit of $85 billion compared with April 2009’s $21 billion. The significance of April, of course, is that it tax month, and usually shows a net inflow of revenue for the government from all those tax receipts. In neither of the last two years did April show such an inflow, which means that the government has now suffered its longest ever run of deficit moths – the record run now stands at 19 consecutive loss making months. That’s awful. But entirely explicable. The big drop in this April’s revenue, when compared with last year’s, results simply from the massive drop in personal incomes being taxed. The biggest inflow each April comes from taxes on income that is not subject to withholding. Those taxes tend to be bunched up and paid at tax time. The problem this year is that the tax non-withholding incomes earned in 2009 dropped substantially over those of 2008. So, naturally, the amount of tax revenue dropped also. To get a better look at the trend in government revenues we need to look at the taxes being collected on incomes subject to withholding. Those are the incomes that are more immediately affected by the economy and the recovery. At that level of detail we find a significant improvement in tax revenues inflows. This supports the notion that the deficit will start to drop quickly as the economy generates more incomes on which taxes can be collected.

The outlook for the deficit is, in other words, improving, despite the flood of red ink.

But.

We still have an enormous budget problem that will not go away even when the economy is back to strong growth.

Not only are we burdened by the cost of the Bush tax cuts that contributed over half of the current deficit – the stimulus and the bailouts combined represent less than a third of the problem – but the long term trajectory of our costs is wrong: we are heading into an era of high costs. This is especially the case in health care, which is why I have been beating the drum of health care reform as a budget saving device. Even with the modest reform passed this spring we still have a long term gap in the budget that needs to be filled.

But the gap is nowhere near that of Greece. So the two situations cannot be compared. The American budget problem is far less difficult to deal with than the Greek problem. To deal with its crisis Greece will have to endure depression like reductions in aggregate demand, and an austerity program that will have to last for years. In contrast, the US has to lower its spending – increase its federal revenues – by about 6% of GDP. That’s still a big hole to fill, but it is not a crisis.

The number that people like Leonhardt obsess over is the accumulated national debt when compared with annual GDP. Right now the Greek debt stands at about 115% of GDP, and Leonhardt projects the US to hit somewhere around 140% when we reach the peak a couple of decades out.

This is nonsense.

First is is speculative. Second it assumes that tax and spending stays at their current levels. And, third, it fails to take into account the impact of rising inflation.

Speculation is inherent in any forecast, but it is entirely unreasonable to assume that tax policies remain unchanged. There will be tax hikes. There will also be spending cuts. I agree that politicians are notoriously incapable of imposing painful decisions on the voting public, but the current crisis and the global mess highlight the need for restrictive action. I think fiscal restraint will become the watchword, but only as the crisis, and the need for laxity, abates.

The two areas that are crying out for attention are defense and entitlements. The former is bloated by bureaucracy and outmoded thinking – the US military is awash with waste and duplication. I have advocated eliminating the Air Force entirely and handing its role back to the Army and Navy. The cost reduction by that move alone would be enormous. And we would lose no effectiveness. The litany of wasteful weapons programs and duplicative base locations is another perennial nut to crack. As for entitlements: we have to come to terms with the idea that those programs were put in place in an era when life spans were very different. they were never funded for the modern world. The idea that someone can retire at 65 and then live for another couple of decades is preposterous. The burden on the future taxpaying population is simply intolerable. It is this that has made the ‘unfunded’ liability explode. The mismatch between life expectancy and the amounts being set aside to cover the costs of those extended lifetimes is the source of the crippling outlook. So the answer is simple: current workers need to save more since they will have the benefit of longer lives; and we need to raise the age at which benefits can be collected. The notion of early retirement needs to be abolished. In any case, the concept of retirement is a modern post-industrial invention. We need to modify it to take into account medical advances.

Bank Reform:

Speaking of needed modification: the Senate’s slow crawl towards bank reform continues.

This last week we have been treated to a couple of stunning examples of bi-partisan cooperation. Senator Sanders from Vermont managed to get his amendment to create audits of the Federal Reserve Board passed by a 96 – 0 margin. While Senator Boxer’s amendment concerning the rules for winding up large banks and restricting the use of taxpayer money for bail-outs passed by a 96 – 1 margin. That audit of the Fed is highly restricted and does not apply to monetary policy decisions. The libertarians amongst you will be disappointed by that, but I think the maintenance of an independent monetary policy making body is worth a certain amount of obfuscation. I am glad, therefore, that Senator Sanders watered his amendment down even though he incurred, along the way, the wrath of Ron Paul and the more extreme anti-Fed evangelists.

Such is the hubris, willfulness, and incompetence of the banking industry that it has engendered this astonishing moment of cooperation in Congress. No one, it seems, wants to defend the banks too much.

Good.

But, there have been losses as well.

The Brown-Kaufman amendment to reduce the big banks in order to force an end to ‘too-big-to-fail’ was defeated by a healthy margin. Yet I think this aspect of the debate has opened up paths towards other ways of reining the banks in. So the efforts of Senators Brown and Kaufman will not go to waste.

Other issues being voted on concern the elimination of naked credit default swaps, and the introduction of a modicum of transparency into the derivatives market.

A naked CDS is one where a bank buys insurance against the failure of an asset that it doesn’t even own. This is an absurd practice and is akin to pure gambling. It allows Goldman, for instance, to purchase insurance against the failure of an asset owned by AIG. Not only is this a massive disconnect in the financial marketplace, but it encourages anti-social behavior. It decouples risk taking from risk management with the result that risk takers have no interest in limiting the damage on bad credit decisions. On the contrary they have vested interest in encouraging failure. This disincentive to manage risk has become pervasive and, I believe, contributes heavily to the destabilization of the credit market. When we remove the incentive to manage risk, because it is covered by a naked short position, we simultaneously remove the need for sound upfront credit policies and practices. The erosion in basic banking that the development of these pseudo-risk management products has wrought is astonishing and dangerous. So getting rid of the more egregious examples moves us in the right direction.

The Senate is continuing its deliberations. The current trend in the voting on the various amendments seems to be towards a more stringent final legislation than either Dodd or the Administration anticipated. I think this trend is welcome. My initial reaction to the Dodd proposal was that it was weak and meek. Hopefully Dodd’s lack of spine will be offset by the anger that seems to have taken hold of the Senate.

We can only hope.

Meanwhile, politics intrudes at every turn. The Senate is delaying a vote on the inclusion of the derivatives ruling from the Agriculture Committee until after the Arkansas Democratic primary. The reason? Blanche Lincoln is in danger and needs to present a populist success to her electorate. She runs the Agriculture Committee and is responsible for the more draconian rules agreed there. The Senate as a whole is likely to agree to a watered down version of those rules, so it is politic to allow the tough rules to appear dominant until Lincoln has weathered the vote.

And so it goes on.

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