Keynes

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Warring Economists and The Great Sleep

I sincerely hope that all of you are now busy exploring your economics textbooks. Really. Well at least I hope you are paying close attention the the war being fought within the economics profession. As arcane as it sounds, that war will affect your lifestyle for years to come. We all have a vested interest in the war’s outcome. If the wrong side wins we may well plunge into depression. The stakes are that high.

So while it sounds like a nasty bout of internecine academic sniping, the war between economists is crucial to our welfare.

Nowhere is that war more manifest than at the Federal Reserve Board. And nowhere will the verdict be more important.

If you follow the financial news carefully you will have noted that the big Fed annual shindig took place in Wyoming last week. Bernanke’s speech there was given a ton of coverage as being indicative of how the Fed saw the state of the economy. More to the point his speech was supposed to give us insight into what the Fed was prepared to do if the economy failed to break free of its current becalmed and weak state.

The quick answer is the he said nothing of note.

This failure to make profound announcements has befuddled many. It shouldn’t. The problem is the war between economists.

The simple matter of fact is that the Fed is horribly and, perhaps, irretrievably, divided between neoclassical and Keynesian policy advocates. The division has spilled over into a very public fight, and has embroiled all the usual suspects.

The central question seems to be: do we need more support for the economy? or do we now prepare to undo the work we have done so far? Bernanke himself appears to be stuck between the two.

Looking at the economy from a Keynesian perspective one thing screams out: the unemployment level is too high and we have the tools to make the correction. So why aren’t we?

From the neoclassical perspective the answers are totally different. The actions taken so far have destabilized the economy and we are about to plunge into an inflationary and bad money crisis of our own making.

Essentially the difference boils down to the diagnosis. Do we have a demand deficiency, which is the Keynesian answer; or a supply deficiency, which is the neoclassical answer. Policy responses are radically different depending upon the side you take in the argument.

What is especially disappointing to me is that this debate was resolved a long time ago. My own education typifies that resolution. Anyone who learned economics in the aftermath of the Depression, and relied on Samuelson’s text or a text in the same genre, would look at today’s crisis and know immediately that the response is to prime demand. That means government spending and deficits etc. But all that was expunged after the monetarist debates led by Friedman and the “new classical” approach of Lucas. Their victory meant that anyone educated after the 1980’s would never respond in a Keynesian manner. They would never have read any Keynes. He was eliminated from the curriculum.

So the debate that has resurfaced has already been had. And was already won. That we are wasting time on it is both an indictment of economics, and a truly awful indictment of the post 1980’s years of illusion. The so-called great moderation of the thirty years since Volcker squeezed away inflation was not a function of the victory of the theories of Friedman and Lucas, but was an aberration caused by the coincidence of global and domestic trends that are now being undone.

We are back to the 1930’s.

Let’s hope that Keynes wins again. Otherwise the Great Sleep will continue, possibly for a decade or more.

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An Answer To Carl: All Cash and Nowhere to Invest

My longtime friend Carl wrote this:

“If business is making profits then the market should reflect that and invite participation‰Û? But where is one to join in (invest) in order to share in those profits. Banks pay nothing for the use of private cash deposits‰Û? the stock market is no longer trusted‰Û? Where is it? Is there some new ‰ÛÏCapitalism‰Û? we should be looking to discover an understand?”

As usual he takes us to the heart of a very important question: All that cash and nowhere to invest, why?

Because the economy has been utterly trashed by the banks; because it is bereft of good investment opportunities; and because, even though rates are incredibly low, fear prevents people and businesses committing to risky activities.

One at a time.

Businesses are sitting on piles of cash right now. They obviously are not committing to anything long, or even medium, term at the moment. They feel safer with a buffer of cash rather than building new factories, increasing production rapidly, developing new products, or hiring more workers. The reason is clear: their expectations – as expressed in their internal market forecasts – are weak. They do not see sufficient demand out there to justify any large investment outlays. Absent a change in that outlook I doubt that the recovery will gather momentum much above its current anemic level.

But with corporate balance sheets so strong, why hasn’t the stock market taken off?

Because the stock market has a prospective, not retrospective, view. Stock prices reflect what the market thinks will happen, not what has happened. So there is nothing incompatible between modest stock prices and piles of cash sitting on company balance sheets. At least in the short term. Indeed, I would be very surprised if the stock market view of the economy and the aggregated views of business were very far apart. Both seem to be saying the same thing: demand is weak and likely to stay that way for a while.

As for the banks: the rates they offer on deposits are so closely tied to general market rates that it is no shock their rates are historically low. They are focused on rebuilding their capital at the moment so they want to stay liquid and avoid risk. That means attracting and keeping low cost deposits and working down their toxic asset portfolios.

So the problem Carl is facing as he looks for places to invest is common to everyone: the fear of risk is so paramount, and the outlook so uncertain that cash is sitting idle, under deployed, and accumulating. Despite the low interest rates that the Fed hopes act as an incentive to invest – the cost of borrowing is so low, the reasoning goes, that practically any investment project returns a profit.

This is exactly the conundrum that Keynes identified and solved in his “General Theory”. It is a liquidity trap. The economy is awash with cash, but there seems to be nowhere to invest it where the risk and return is proportionate. So everyone hoards the cash. And get progressively more frustrated with the lack of return.

In broad terms this situation can be characterized as the private sector seizing up. If you look at the trend for private sector investment it collapsed back in 2007 and has only marginally recovered. The only thing that prevented a wholesale depression breaking out as a result was the massive increase in government spending that filled the gap left by that collapse.

This upcoming week, on Friday, we will be getting the next revision to the GDP figures for the second quarter. Many analysts are looking for a big downward revision to about 1.4%. That’s awful. But it justifies the weak outlook of business: with demand faltering there is no reason to ramp up investment. But weak investment is a major contributor to that faltering demand. The private sector has fallen into a self fulfilling trap. Under those circumstances the stock market is correct in placing modest values on stocks, and holding cash will exert a greater appeal.

Keynes realized that capitalist economies can get into this bind both easily and frequently. Economic history is full of major swings in capitalist economies. There have been a number of depressions. Most often those depressions were associated with major social unrest. In some instances the result was the emergence of alternative economic ideas and systems- socialism and both fascism and communism took hold or were invented during depressed economic periods. So Keynes set out to ‘save capitalism from itself’. He saw that the great need was to fill the void created by the huge and irrational cycles the private sector is prone to. Which is why he advocated massive government spending programs when such crises occurred – but not when there was no crisis. In effect the only way capitalism can be saved is by adding a large and steady government sector to provide a flow of demand even in down cycles. This is why things like Social Security, Medicare, and Unemployment assistance are so valuable: they act as stabilizers, and ensure a basic level of demand in an economy. In extreme cases, such as the 2007/2008 recession, we also need to add in one time stimulus to top up demand and save the private sector from total implosion.

So we do not need to search for a new capitalism. We simply need to modify our existing system by returning it to the more balanced ways of the immediate post war years, when profits were more shared – wages grew more rapidly – and productivity flowed into general wealth and not simply into the coffers of a limited number of citizens.

Having said all that, I have no doubt that the basic shape of our version of capitalism will indeed change. Perhaps that’s where Carl should look to invest.

The current crisis will abate. As you know I am skeptical of the policies in place at the moment to force us into a better growth path, but let’s assume we get back to normal sometime in the next few years.

That still leaves us with a major problem: the impact of globalization.

The central problem is that capitalism is not geographically constrained, at least not yet. So it will act as usual and seek to maximize profit by moving production to the low cost locations and by substituting cheap capital whenever labor gets expensive. This presents the US with a problem: it has a relatively high cost labor force, so it will be in constant danger of bouts of very high unemployment as its traditional jobs are moved elsewhere. There are two ways to combat this effect: one is to shut the door to trade and suffer the consequent loss in wealth that implies – consumers end up paying much higher prices for goods that are available abroad much more cheaply. Or it is to seek new ways to earn a living. This latter is the better course in the long run, but involves dislocation in the short run. We can build an economy more focused on services – which tend to be less prone to outsourcing. We can develop new industries built around skills and knowledge only available here. And we can alter the way in which our traditional industries do business in order to lower their costs. All three of these courses involve a big investment in education, infrastructure, and technology. More to the point they imply a rethinking of management.

I gave a speech many years ago to the board of the holding company who owned the bank where I worked. One of the features of that presentation was my focus on the American weakness in energy efficiency: the US is the worst of the large industrial economies in converting a BTU of energy into a dollar of wealth. This is a result of its historic energy abundance: it could be wasteful and not worry. Those years have long gone, and yet the US still lags well behind in efficiency. I use this as an example of the way in which our version of capitalism has to change: we need better technology at a basic level, and we need to deploy the fancy technologies more imaginatively.

We need to reinvent our capitalism, or, rather, update for the next century. We are now competing with nations deep in low cost labor. We need to abandon our wasteful ways and shepherd our resources to maximum advantage.

But that’s the opportunity for longer term investment.

Short term, we need to break out of our liquidity trap: more stimulus and more government debt to stoke that demand. Only then will the cash get invested and business start to thrive again.

Sorry Carl, there is no easy answer.

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It’s The Demand, Stupid

Things are not looking very good. When we have luminaries such as Greenspan and Rubin agreeing that the economy is weak, but that it will get through this minor lull in good shape, we have to worry. Neither of them has much credibility any more, so I take their unanimity on the positive outlook as a bad sign: the economy must be getting weaker.

In any case the data seems to suggest we have hit a tough patch. How tough is all we are debating.

The problem is that I don’t think there’s any way to tell exactly where this slide will end up. It is easy to make the case that GDP could continue to drop back into negative territory. It is also easy to argue that we will pull put of the dive before we hit the ground. My own view is that the evidence suggests a rocky second half with very low growth, but growth nonetheless. This is small comfort to the unemployed: it would be no surprise at all were unemployment to creep up as the swoon continues.

It is remarkable how quickly the discussion has turned to towards trying to size up the decline. Only a few months ago those of us who warned of a tough road ahead were being called unduly pessimistic. After all profits were rebounding, manufacturing was on the up, productivity was rising, and even housing had a semblance of life. Only profits remain healthy. Everything else has hit the proverbial bump in the road.

If you recall my view of 2010 was conditioned by the oddity or imbalance of the spurt in activity that generated all that hope. There was a genuine rebound from the depths of 2007/2008, especially later last and early this year. My issue was with the froth over and above that base rebound. A big inventory cycle reversal and the benefits of the stimulus, neither of which were permanent features of the ongoing economy, made it very difficult to determine just how robust the recovery was.

We are now finding out.

Which brings us to the question of what policy should be going forward.

The main line of attack should be supportive. Of that there is no doubt. Now is far too early to start any tightening. In fact, while I have argued against tightening throughout the past few months, that position is even more important now.

The Fed acknowledged as much yesterday with its begrudging approach to the money supply. As I predicted, the Fed basically avoided making any move in either direction, it stayed pat. It accomplished this by announcing that it would reinvest the proceeds of any maturities in its portfolio back into more investments. This means that it is not reducing its level of support for the economy. Nor is it adding anything.

Meanwhile the war amongst various policy camps rages on.

There are those who argue we should reduce or simply get rid of the stimulus since it has not achieved a total reversal of the crisis. This is, of course, nonsense. I agree that the stimulus failed to turn the unemployment situation around. But that was entirely predictable. It was too small to begin with. What the stimulus achieved was a far more limited goal: it stopped us falling into depression. So far anyway. The notion that we should look to investment activity and business to lead the way is totally without credibility. Yet this is the alternative being pressed by those who opposed the stimulus. Their line of attack is that we should reduce regulation and other ‘encumbrances’ on business. We should reduce the uncertainty in the business environment. We should subsidize investment. We should throw tax breaks to businesses. And, most of all, we should get rid of any silly notions of government interference in the ‘natural’ workings of the economy. Once this is all done, the sun will rise again, the birds will sing and we will emerge into a re-run of the good old days. Oh and there will be plenty of jobs in this rediscovered capitalist nirvana.

This sort of reasoning is the time honored approach adopted by all right of center thinkers. It can be summed up as: ‘get government out of the way and we’ll be fine’.

The problem I have with this is that all the evidence contradicts it.

Profits are strong. Companies have cash to spend. Interest rates are very low, which means that borrowing is cheap, and that even marginal investments will make a profit. Project hurdle rates are minimal. The economy is awash with cash – if it isn’t why are people concerned about the inflationary impact of the money supply?

Yet despite all this, business is still retrenching or standing still. The investment environment is strong. Why aren’t we seeing a surge of construction, development or expansion?

It’s the demand stupid!

Demand is weak.

That reduces the prospect for sales and so offsets the low cost of capital. This weak sales outlook cripples business expectations. And as any Keynesian will tell you: the most volatile component of the economy is business investment based upon those expectations. Until demand picks up even ridiculously low interest rates and the total elimination of regulation will not be sufficient to spur investment.

Which also undermines the parallel argument we hear from the same analysts that all that government debt implied by the stimulus soaks up the available savings and so ‘crowds out’ private investors from the credit markets. This is specious for the same reasoning. We are suffering from excess savings not insufficient savings. There has been a remarkable collapse in business investment. So there is no demand for capital coming from that quarter. In any case profits have recovered, so businesses are generating capital from internal cash flows. They don’t need, necessarily, to borrow. That represents a problem for the capital markets: where does the cash all go, if not into private investment? Into government. All that is happening at the moment is that the government is borrowing instead of the private sector, and spending, instead of the private sector, because the private sector has no intention of doing so.

Were the government deficits crowding out the private sector we should be seeing interest rates rising in response to the capital squeeze. But they are falling, not rising. If the prospect of government debt inundating the market was as awful as the deficit hawks tell us it is, those fears would be translated into higher rates, not lower rates.

The point is simple: all the signs are that the credit market fears continued decline more than it fears the bloating of government debt. This makes perfect sense when we look at the cost of lost wealth from recession/depression versus the cost of debt accumulation. The cost of carrying debt is far less than the cost of all that lost wealth from our failure to reignite the economy. The tradeoff is simple and the credit market is voting with its feet for more stimulus and more debt. Despite all the bleak words flowing from the denizens of the market. Plus, once we get GDP rising at reasonable rates we can run deficits for long periods and still lighten the debt load. This is because of basic math: as long as the increase in GDP outpaces the increase in debt, the debt load and its cost as a percentage of GDP goes down.

The goal has to be getting GDP going at decent rates. Not managing the debt downwards.

To put this in perspective: the rate on inflation proofed government five year bonds fell below zero this week. Think about that. There are sufficient investors, with enough cash, who are so concerned about the economy’s prospects that they will pay the government to keep their cash safe rather than look for an opportunity to invest it at higher rates. That’s what a negative rate implies.In other words business expectations are so bleak that the government could borrow almost endlessly at almost zero cost and still not absorb all the money looking for a safe home.

There is a savings glut.

We are in a liquidity trap.

The only exit is through more expansive government activity.

There is only one target for policy:

It’s the demand stupid!

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The Fed And Deflation: Are We There Yet?

Who knows?

Most likely nothing but issue a statement designed to let us know that they are still vigilant.

The problem is that the Fed is now highly divided between the fiscal hawks, and the newly energized deflation worriers. Under normal circumstances the Fed airs its differences around the table and not in public, but as the economy stalls – and there is no doubt it has turned down – a much more open argument has broken out.

And the stakes are extraordinarily high.

In many ways we have had an oddly asymmetric recession and pseudo recovery. We are now suffering from an all time record number of long term unemployed. As a percentage of all unemployed, those out of work for 26 weeks or longer is now almost twice its previous post-war record. That’s an astonishing level, and one that explains the enormous cost of the unemployment relief programs throughout the crisis. Any attempt to understand the Federal budget deficit must include an acknowledgement that much of the swing deeper into the red has been directly a result of unemployment relief payments. Normally this far into a recovery those payments would be shrinking rapidly and thus reducing the deficit. This time any reduction is more due to workers falling off the unemployment rolls because they have exhausted their support rather than having found work.

This stubborn refusal of unemployment to drop has re-opened a lively debate about the nature of the labor market. There are those who argue that the problem remains lack of final demand – I am in that camp – and there are those who suggest that we are experiencing an unusual level of ‘structural’ inflexibility in the market. The structuralists argue that we have a very large number of workers whose skills are inappropriate for what jobs the economy is generating, and thus they are unemployable rather than simply unemployed. I have pointed out in the past that this structural argument should be supported in the data by sectoral lumpiness: there should be some industries with very high rates of unemployment and others with little unemployment. The lumpiness results from the oversupply in the declining industries and the undersupply in the newer or emerging industries. Obviously, so this argument goes, not all skills in the declining industries are transferrable, so some workers find themselves unsuited to the kinds of jobs that are available. And with abundant labor supplies there is no or very little incentive for firms to hire unsuitable workers and then train them. Hence the long term unemployment problem.

While the structural argument may have some truth to it, in my mind it fails to explain the enormous level of long term unemployment we now have. Besides the sectoral data doesn’t have the kind of lumpiness in it that I think should be there to validate the argument.

A far better explanation for our ills is that final demand is just too weak. Yes it has perked up somewhat, but we are still suffering from a lack of demand sufficient to get us moving again.

And it seems to be getting worse again.

Plus, as I have argued here before, there are worrying signs that we are slipping into a Japan style deflation. That can only make matters worse. Much worse.

It is in this context that the Fed is now riven through. Long gone is any semblance of unanimity with respect to policy. Behind the scenes the staff is now more worried about deflation than inflation, but at the top of the house there are still hard line deficit hawks peddling the bond market crunch and imminent inflation threat theories. Bernanke himself seems to be in the deflation fears camp, or at least he ought to be based upon his academic research, but he has to balance the two factions.

Policy freeze is a likely outcome, pending more data.

I suspect one thing is certain though: there will be no tightening any time soon.

The war inside the Fed mirrors the war being played out in economics generally. And that war is eerily reminiscent of the 1930’s, when almost exactly the same arguments were being made.

Lest you think that the 1930’s were simply a case of Keynes versus the rest, let me draw your attention to a paper written by Irving Fisher, a giant of early 1900’s economic theorizing, in 1933. Entitled “The Debt-Deflation Theory of Great Depressions” its policy analysis is strikingly relevant to today’s problems and is very Keynesian at the same time.

The most notable part of the Fisher paper is his suggestion that it is the combination of a debt driven collapse, as in the case of an asset price bubble driven by borrowing, along with a subsequent bout of deflation that inevitably causes depressions. Unless the government steps in to bolster demand. Looking at Fisher’s paper today I am struck by how prescient it seems. It also fits well with Minsky’s analysis of financial instability being the root cause of crises. There can be no more vicious threat to our wellbeing than the combination of a banking/debt crisis followed by a steady downward spiral into deflation: debtors can never catch up with their debts and are thus driven to keep on liquidating assets to pay off creditors. This drives asset prices even lower, which means that the next round of asset liquidation yields less. And so on. In Fisher’s phrase: “The more debtors pay, the more they owe”. Since deflation means that cash gains in value in real terms, and since steady liquidation of assets reduces the value of assets with respect to cash, debtors can never catch up. They are doomed to end up in default, which undermines the banks and causes further panic.

While we are not yet in the cold grip of such a deflationary cycle, its potential presence should be enough to cause the Fed to act to head off the problem.

Anyone who is arguing against an anti-deflationary policy is most likely doing so on the basis of an ideological stance rather than an economic theoretical stance. Such a division along ideology rather than economic theory are exactly what Michael Kalecki spoke about in his 1943 paper “Political Aspects of Full Employment”.

Kalecki and others argued that perpetual government deficits are an essential feature of any economy running at full employment, and that any argument to reduce of eliminate such deficits was more driven by ideological than economic factors. Kalecki, unlike Fisher, seems outdated in light of the subsequent history, but there remains a kernel of truth in his position: those who are arguing for deficit reduction are almost always on the right in politics and pro-business rather than pro-worker. Such people do not fear radical crises since it strips workers of bargaining power and opens up opportunities to reduce wages relative to profits.

Lest you all gasp at the implied ‘class’ struggle nature of that argument allow me to point out a simple fact:

Profits are strong. Even in this crisis, firms have been able to protect earnings and avoid widespread bankruptcies. Indeed, despite the headline counter examples like GM, this cycle has been very benign for most businesses. They have stripped down their workforces and maintained payouts to investors. Cost cutting has protected business from the extent of the damage suffered by households. And this is not new. As I have described before, the Bush administration saw the same phenomenon: jobs were hammered, but profits rose.

It is this dichotomy, where some parts of the economy are doing well even in the depths of crisis, while others are being crushed, that gives Kalecki a glimmer of relevance. There is a clear political bent to the economic argument. We have long passed the point where the policies that helped the economy had no political ramifications, and thus little political controversy.

It will be interesting to see how the Fed reacts. My bet is that nothing much will be done. Things will have to be worse before the political gridlock breaks in the face of greater crisis.

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Deflation Express?

“It is hard to see a light at the end of the tunnel for housing. Lower rates are not spurring activity because the light may be from a deflationary train.”

Thus ends an article on the Federal Reserve Board’s holdings of mortgage backed securities in today’s Financial Times.

I hate to keep harping on this topic, but I see far too many articles cluttering up good media space talking about inflation and the impact of the huge government debt now piling up.

Yes the debt is an issue to deal with in the future. No it is not a problem today.

People keep thinking of the debt in all the wrong ways. The best way to keep a perspective is to calculate the cost of carrying that debt, not just its aggregate size. It is the burden of interest payments on future budgets that matter more than the total amount of debt. That burden can be managed only if we have a healthy growing economy. In other words we need to get GDP rising from its current slowdown. And we need to avoid deflation at all costs. If GDP grows at anything like its historic rate the debt burden is automatically reduced both as a percentage of GDP, and as a percentage of the budget. It is basic math. But if we wander around trying to cut and slice the economy in order to reduce the deficit, the chances are that we will shrink the economy by reducing growth rates. So all that hard thrift and blood spilling will actually end up increasing the debt as a percentage of both the economy and the budget. Again: basic math. Thrift is self-defeating. Keynes taught us that in the Great Depression. Evidently much of our supposedly well educated analysts community never read Keynes.

And another canard to avoid: I read in some places that people calculate the debt burden and then argue that the interest payments are equal to a certain dollar amount per person. In one example I saw the figure $30,000. I am not going to dignify that calculation with a direct response, but I want to point out an even more obvious issue: those supposedly crippling debt interest payments go somewhere. Most likely into a US based pension fund or similar creditor account. It’s called double entry bookkeeping. Something the Venetians invented centuries ago. This means that the ‘crippling’ payment is someone else’s, presumably less than crippling, income. This is crucial to bear in mind. Too often we forget that the biggest investors in US bonds are US citizens. Notwithstanding the brouhaha over Chinese investments in the US the vast majority of US debt is held domestically. So one person’s crippling burden is another person’s safe retirement fund. Yes the cash is re-allocated from one set of folks to another, but basic accounting tells us that it has to go somewhere, and that somewhere is predominantly right here.

Now back to the FT article.

The big point is that for all the cash sloshing about the US economy, investment is still weak.

Why?

Classic Keynes: business expectations are very negative. This means that businesses are refusing to invest in new plant, equipment, or workers because they are afraid of the future. These negative expectations are driving – perhaps not driving is a better way of looking at it – the entire economy at present.

And, as the FT hints at, the prospect of deflation will make matters much, much, worse. Firms just won’t invest if the economy is about to fall into a deflationary spiral. On the contrary, because deflation acts to create a positive return on plain old cash – which increases in value as deflation drives prices lower through time – it makes sense to build up cash reserves rather than spend it on speculative stuff like factories etc.

The same goes for households. Cash becomes king in a much bigger way than usual. The loss normally created by holding cash rather than investing it is eliminated by deflation, and the incentive to grow is sucked out of the economy.

Under those circumstances those debt burdens come into focus very rapidly.

Forgive me for saying it, but we need a healthy dose of inflation along with that stimulus. Not exactly what the textbook tells us, but exactly what Keynes would advocate.

Why are we even arguing about this?

Oh yea … politics.

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