fiscal policy

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The False Allure of Austerity

I go away for a while and things get out of hand.

I am shocked at the current spate of calls for austerity worldwide. It’s an epidemic of Puritanical self-loathing. None of which makes any sense.

It should be obvious, but evidently is not, that the economy is still weak. Last week’s poor retail sales figures tell us that the recovery is fragile. Yet we are being treated to a constant stream of calls for belt tightening and the abandonment of both fiscal and monetary stimulus. The only motivation for such calls that I can come up with is just such a Puritanical desire to inflict pain. A pain, which, I should add, will cure nothing. In fact it will add immeasurably to our difficulty.

It is odd to see this desire to inflict pain so rampant. It is as if people need to witness dislocation and angst as part of the therapy.

Maybe it is an attribute of the helplessness they feel: their theories are bankrupt and offer no way forward, so they call for pain. It is as if they see the destruction of millions of families as a necessary part of the ‘natural healing’ process.

Oh. Wait. That’s exactly what they see.

Read the work of any of the most famous ‘free market’ economists: Hayek, Schumpeter, Friedman, Lucas et al, and it is riven through with statements calling for the therapeutic cleansing offered by recession or depression. The very essence of Schumpeter’s famous ‘creative destruction’ is the tearing down of dysfunctional aspects of the economy, and their, hoped for, replacement by newer and better pieces. Luckily for these economists they had all managed to cleanse their theories of actual human beings, so the inherent human cost of ‘creative destruction’ is nicely hidden from the sensitive eyes of academia. Plus they were all comfortably tenured so they never faced the ordeal that they called forth for the rest of us.

They are all wrong.

There is a more human economics. That is what Keynesianism is all about. We have learned from Keynes that we can manage the worst parts of a crisis, and thus mitigate its impact. The cost is a current deficit. That cost is less than the lost wealth implied by allowing events to run their own course. In times of deep crisis, such as we faced in 2007 and 2008, the cost appears huge. To the uneducated or to the alarmist that cost seems insurmountable. The numbers being thrown around today are truly massive and so create fears in the voting public that government is being profligate.

It is not.

Indeed the better theoretical argument is that government is not being profligate enough. We are still a way from the safety of solid economic groound. Raising interest rates or cutting back on government spending both run the needless risk of adding to our crisis. Unemployment remains stubbornly high. Consumption is still sputtering. Investment is weak. State spending is being slashed. All these are features of recession not expansion. Yet we are treated to calls for austerity.

Get out the hair shirts we must be punished for our sins.

It was Augustine who brought self loathing into western religion and who told slaves to accept their lot in life because they must have done something really awful for God to have made them slaves. This wreaks of a pessimistic abandonment of hope. It was economists like Hayek and Schumpeter who riddled economic orthodoxy with similar opinions. Workers must have been truly awful for the ‘market’ to want to punish them this much. We need to punish workers for their errors, that way we can cleanse the system and go forward with our precious markets intact.

Except of course that the market is an abstraction that masks the reality of a collective known as ‘us’. When we strip away that abstraction and see that it us we are hurting with austerity, it becomes a little easier to turn a deaf ear to the experts calling for such austerity.

It’s our wealth they are talking about. I would prefer to roll the dice now in the chance that Keynes was right, rather than be condemned to certain depression and its associated poverty, simply because a few economists got caught up in a wave of puritanical zeal.

In any case there is no evidence the hair shirt is rewarded. The interest rate spreads on Irish debt are worse than those on Spanish debt. But it is the Irish who are lauded for having swallowed the puritan medicine. Something’s amiss.

Maybe the credit markets are peopled by closet Keynesians?

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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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Headline Rant

For a variety of reasons I haven’t had time to write about the news for a day or so. Suffice to say that there was nothing of importance to comment on – except, maybe, for retail sales which remain on a growth path. Instead allow me to rant about a couple of stories out there in the financial media.

The first is the story in the Financial Times about proposed derivative regulation here in the US. The sub-title for the story reads: “Banks claim provision in US regulation would rock markets”. Presumably this is supposed to be a bad thing. After all the markets being rocked is always related to us as a negative.

But maybe, just maybe, we shouldn’t give a damn. Maybe those markets need to be rocked. Maybe those markets serve no purpose. Maybe society can get along very well without those derivatives.

The point is that most derivative activity nowadays serves no purpose other than to pad bank trading incomes. Yes, basic derivatives are worthy. They help businesses and farmers hedge against product price movements. That is the time honored value for derivatives. But banks indulge in derivative activity far beyond that basic level. They ‘innovate’ and create derivatives that have no underlying value at all. They gamble. And when the house of cards collapses they present us with the bill as if their importance is self evident.

Well it isn’t.

At least as they are currently constructed.

For a bank to be worthy of social protection it has to serve socially acceptable purposes. Managing the payments system is one. Channelling credit into productive assets is another. Gambling for their own account is clearly not such a socially productive purpose.

Lifting the protection of derivative gambling activities may disrupt the market, but that disruption is a sensible and worthwhile cost if we then rid ourselves of the downside costs of supporting and subsidizing the gamblers who infest banking.

So: who cares what the big banks say? Their interests and ours are diametrically opposed.

A second headline that irked me this weekend was this absurdity in MarketWatch.com: “The War on Capitalism”.

This gem was a story about how European reaction to market movements was an attack on capitalism.

Ummm.

Maybe the market movement was an attack on Europe?

Somehow financial writers fall into the intellectual trap of assuming that any action to limit or mitigate market activity is an attack on capitalism. As if capitalism was a natural phenomenon and anything to restrict it was artificial.

Sorry.

No.

Capitalism is no more natural than any other human arrangement. It exists as a device of our creation. It is not an artifact of nature.

Moreover the violence that capitalism can wreak on the calm of everyday life is enormous. Witness the massive human cost of our latest crisis, the causes of which sit firmly in the unrestricted economic domain known as capitalism. We never read of the ‘attack on society by capitalism’, but such a headline would have as much legitimacy as the absurdity in MarketWatch.

Capitalism is a device we use to create wealth. Untended it has extremely bad social consequences: monopolies, vast concentrations of wealth, and a destabilizing effect on democracy. None of these are beneficial. All impose vast costs of society. So society fights back to impose a balance. We restrict excessive wealth o eliminate legislative distortions; we limit the free abuse of our environment; we prohibit anti-social activities; and we spread the wealth in order to enforce social calm. This balance was the essence of Eisenhower style Republicanism in the immediate post war era. It was replaced by Reaganism, which meant that unfettered capitalism could launch attacks with abandon on our social fabric.

One such attack was the self-serving profit seeking of the banking sector over the past two decades. The banks syphoned off wealth for themselves and added no value in return. Yet they expected a bail out. The capitalists at the helm of those banks are still safely ensconced in their lavish lifestyles, while over 8.5 million Americans are out of work. If that is not an attack, I don’t know what is.

That a headline writer can point to an effort to rein in the rampant damage being done by unfettered capitalism as ‘an attack’, and mean that as a negative statement, is testimony to the warped mindset prevalent in the media.

We are the agents of capitalism. We are also the agents of government. We, the people, reside in our own domain. We legislate, we control, we own, and we act on capitalism and government equally. Neither is a naturally occurring phenomenon. It is not possible to ‘attack’ capitalism because it is artificial. It can be limited. It can be managed. It can be restricted within borders of our setting. It is ours to play with. We are not the puppets of capitalism. Rather it is ours to organize and manage.

So placing a limit on capitalism is not an attack, but is simply a changing of the acceptable boundaries. It is an attempt to re-establish the balance between the benefits of capitalism and the costs it imposes. Only an unbalanced zealot would se such a move as an ‘attack’.

Then again I wouldn’t expect a headline writer paid by Rupert Murdoch to have a clue about the economy.

One last thing:

Is it just me or is it really annoying that the idiots who sank the economy and plunged us all into a sea of red ink, and now the very folks who are warning us all of the consequences of that red ink?

I would feel a whole lot better about taking the credit markets seriously if they were now inhabited by new crew of people. Not the self aggrandizing fools who built the foundations of their banks on the sands of trading desk, deal dominated, gambling. These self-serving and self-declared ‘experts are now the people lecturing governments everywhere about the folly of debt. They warn in grave tones of the impending ‘downgrades’ of debt ratings and the need for austerity.

Austerity, that is for us.

None of them seem to suffer bouts of ‘needed’ austerity. Not judging by those bonus payouts at least.

If every banker involved in creating the crisis had been fired and forced into personal bankruptcy, I would take the advice of those left much more seriously. Since the bankers seem all to have survived in ruddy health I think we are entitled to look at them with a certain skepticism.

Who are they kidding?

Not me, that’s for sure.

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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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Unemployment – The Current Debate

For those of you sick and tired of the banking system and all the fuss being made about its reform, here’s an interesting diversion: how much of our unemployment problem is cyclical? and how much is structural?

This is a vital question.

Cyclical unemployment is that part that is cause specifically by the recession. The jobs lost due to plant closings or efforts by businesses to protect profits during the recession are usually quickly replaced once the economy gets going again. Don’t forget that a recession is the result of a sudden drop in what we call ‘aggregate demand’ – the sum of all the stuff consumers, businesses, and governments inside the economy buy each year. When demand drops businesses are forced to adjust and so they fire workers. Once demand recovers those workers are usually re-hired and the damage done by the recession is quickly overcome.

Structural unemployment si totally different. It is the result of lay-offs by businesses that never get well again and so do not re-hire. This kind of job elimination usually stems from technology changes and similar permanent shifts in the skills required to be an effective employee. The jobs lost in older manufacturing plants are good example – cars still get produced, but we require fewer car workers, and those out of a job in the auto industry find that their skill set is no longer useful anywhere in the economy.

The problem with structural unemployment is that it takes much longer for a worker who needs to learn a new skill, or whose current skill is out of date, to find a new job.

Structural unemployment can also stem not from the worker’s skill set, but from other circumstances that prevent a worker from applying for new work. The current recession is a good example of this latter problem. There are many unemployed people who cannot move from their current location to areas where there are jobs because they cannot sell their current home – this is especially the case for the one-in-four households where there is negative equity in the home. In such a situation remaining unemployed is less financially crippling in the medium term than trying to repay a mortgage in excess of the homes value. Workers in this situation are obviously loathe to bankrupt themselves, and yet face long term unemployment as a side effect of the drop in their home’s value.

The kind of unemployment you think is contributing to the current jobless rate of 9.0%+, helps determine the policies you put in place to deal with it.

The stimulus last year was aimed not at unemployment, but at aggregate demand. Then idea being to restore the economy to a growth path as quickly as possible. It was a side benefit of this approach that jobs would be created. This line of reasoning is why policies aimed at bulking up demand presume that unemployment is cyclical. The notion is that once demand is restored, jobs will automatically reappear.

Given the prolonged and stubborn nature of the unemployment rate during this recession, some analysts have begun to wonder out loud as to wether the US economy faces a major structural problem – our workers are ill suited for the kind of work that are abundant toady.

To an extent I agree with this argument.

Clearly we are facing a very serious long term unemployment problem. We have never had such a high proportion of people unable to get jobs for such long periods. But underneath the headline numbers there are some disturbing trends: many of the people being fired find work quickly – just as in past recessions. What is different this time is that the economy collapsed so hard so fast that the cyclical component of unemployment has ‘leaked over’ into a structural problem. Workers who are out of the workforce for extended periods find it ever harder to re-enter. Their skills erode, and they become progressively less attractive as employees. Given the enormous flood of lost jobs early in this recession there are now a very large number of workers who fall into this category.

We also seem to have a major gap between the jobs the economy can create and the skill set of our workers. In the vernacular, we have far too many factory and construction workers, and far too few service sector and technology workers.

If we believe structural unemployment is the root of our high jobless rate, then attacking it with the kind of stimulus designed to fix the shortfall in demand won’t have much impact. This is because even if demand picks up, businesses don’t want to hire and/or train workers whose skills are inappropriate. The odd outcome of this could be high unemployment and yet a shortage of workers in some industries.

A better set of policies would be a stimulus aimed directly at skill levels, re-training, and even re-location.

One of my frustrations with the stimulus plan of last year was that it was too laden with tax cuts that are well known to be ineffective as a demand stimulus, and yet very light on training and direct employment efforts. It assumed unemployment was more cyclical than structural.

Our jobs problem is clearly both. So our policies need to attack both.

As of now we have been ineffective in our attack on the structural problems within the economy. More to the point: the political will doesn’t seem to be there to make such an attack.

Which is why we need to surface the debate about the true sources of unemployment.

One thing we do know: it isn’t laziness the way the GOP tarnish it as being. It would be helpful if someone on the right could contribute something sensible, rather than resort to Victorian era bromides about lazy workers living of unemployment checks.

But that may be too much to ask.

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