interest rates

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Bits and Pieces

This is an abnormally quiet week for economic data. Just about the only news we will see is the usual weekly unemployment claims series on Thursday. So that gives me an opportunity to catch up on a number of bits and pieces.

Inflation and Interest Rates

The talk about the need for a tightening in monetary policy, and therefore a hike in interest rates persists. I have no idea why. Even the Fed is starting to send out public signals about its possible lifting of rates. Some Fed governors are giving speeches warning that rates may need to be raised even before unemployment has begun to fall. The basis for all this nonsense is that during the crisis the Fed pumped an enormous amount of cash into the economy. And I mean enormous. Under normal circumstances this injection of liquidity would, possibly, spur a bout of inflation once the economy starts to grow – which it now has. Monetary hawks – with the conservative wing of the Fed and some cable TV analysts in the van – are jumping to the immediate conclusion that, given the size of the stimulus, we need an aggressive counter measure sooner rather than later if we are to avoid a nasty bout of inflation. They are wrong. Dangerously so.

“We will get nowhere if the only alternative to the social bias of the Democrats is simply a load of hysterical religiously driven, socially segregated, and backward looking name calling.Can we have an actual debate please?”

There is no evidence at all that inflationary expectations are building: the best place to look is in the market for inflation proofed government bonds – that infamously jittery bond markets should be a talisman for the inflation fearing crowd. But that market is quiet: the expectation seems to be for about 1.5% inflation over the next few years. That’s well within the 2.0% boundary the Fed has been talking about.

Plus: the economy is operating at an level well below capacity. There is just no room for inflationary pressure as long as capacity levels are so low compared with the economy’s potential. As growth picks up – and after unemployment starts to drop – we can re-visit this argument, but for now inflation is simply a red herring being touted by folks who didn’t like the extent of government intervention in the first place. They cannot wait for the Fed to disengage, not based upon empirical evidence, but on ideological grounds. Given this morning’s minor news that ‘mass’ lay-offs reached an all time high during the third quarter I just don’t see where pressure on prices is going to come from – certainly the labor market will not be the source of inflation.

Finally, on this topic, I should remind you that we are at an unprecedented point in terms of policy limitations. The Fed’s own analysis indicates it should be running overnight interest rates at about -5% [yes negative 5%], since it cannot we are stuck with just one oar – fiscal policy a la Keynes. Any empirically based analysis also tells us that getting the economy back to a point where the Fed’s indicator is for positive rates is months, and maybe even years, away.

So raising rates at the moment would be foolish. It would be a repetition of the mistakes of the 1930’s, and we all know how that worked out. The monetary hawks screwed up then and, apparently, want to repeat their error. Let’s hope Bernanke and crew ignore them.

Silly Arguments About Housing and Health Care

This won’t take long: I keep reading silly comments by right wingers that health care reform will force companies to do business with people who cannot afford to buy their services. The precedent being used is the Community Reinvestment Act that forces commercial banks to do business in minority dominated areas. CRA is being routinely blamed as the cause of the sub-prime mess: after all ‘those people’ cannot afford loans and the nice banks were forced into making rotten loans by those CRA advocates. This is such rubbish it’s hard to know where to begin. The best debunking of this argument, which is now a staple of the rightist analysts, is that the vast majority of sub-prime loans were made by organizations not covered by CRA. It could not, therefore, be the cause of the awful underwriting standards that led to the cave in of residential real estate. In addition: the amounts of money to be lost in commercial real estate will be a much larger amount, and most of those loans went to large developers and their corporations, very few of whom qualify, even remotely, as ‘minority’.

Bank Regulation

The forces are gathering for a fight over the re-regulation of finance. Given the ridiculous way in which the industry is flaunting its recovery – those bonus stories will be back with a vengeance very soon – the two sides are digging in for a heated debate. In this context the focus should be on ‘too-big-to-fail’ and on little else. What the industry proved to us all over the past few years is that it is not competent. It makes foolish and almost childlike errors on a regular basis. Plus, as those bonuses indicate, it cannot be trusted to regulate itself. It behaves exactly as if it were a supremely spoiled child – screaming when the toys are taken away, and snickering when it gets its won way. It has become a mammoth schoolyard bully. I am tired of repeating this: as long as we subsidize the industry’s profits by underwriting its losses, we give it free range to rent seek and rob us blind. That ‘great recovery’ is on our dime. It is not due to any great skill. Yet the managers of the big banks want us to believe they should reap huge rewards for ‘turning the industry around’. The appropriate language with which to respond to that claim is not to be printed here. Suffice to say the leaders of the big banks are simply morally unfit to engage in public discourse about regulation.

On a brighter note Bernie Sanders from Vermont has presented a bill in the Senate to order the Treasury department to break up the big banks. He won’t get anywhere because our lame administration seems to think it can get the same effect – controlling too-big-to-fail banks – by putting in place better methods for winding up bank holding companies. I see this as a punt by Obama. Even if they get the right legislative power there is no certainty that a future administration would use it: the public cry over ‘socialist’ take over of a private bank – no matter how defunct – will drown out any effort to wind it up. Instead we will most likely opt for the easy route: more bail out money. The one thing I have learned throughout this crisis is that the big banks have inordinate political power. Our political process is corrupted by the money that flows through it, so I remain skeptical of seeing any hard nosed re-regulation. Instead I expect a series of bureaucratic shuffles and kluges. We will probably get some form of watered down Consumer Finance Protection Agency, and a few new rules on bankruptcy proceedings for banks. That and higher capital ratios. The problem is that the banks that failed this time round did not go down because they were insolvent – they had capital, albeit with stupid leverage ratios – they became illiquid.

This raises an interesting policy point: the focus of our underwriting should be liquidity, not capital. An private organization should be on the hook for its own capital. If it becomes insolvent, that is a private matter for the shareholders and creditors to hash out. So solvency is a ‘private good’. In contrast, liquidity is a ‘public good’. It is something we all need – we all want to be able to get our hands on our own cash when we want or need to. This means that we, the taxpayers, have a true interest in ‘socializing’ the underwriting and protection of the payments system – we all share in its benefits – but we have little or no ongoing interest in the solvency of the big banks. The tricky part is that the big banks have become so large that, in order to save the public good, we have to bail out the private good too.

Hence the need to chop the banks down in size.

It won’t happen any time soon here, but there are signs that other countries are getting that message: the European courts have already forced the break up of one or two organizations, and the British government has ordered the break up of its big banks too.

The Berlin Wall and the Plight of Capitalism

One last thing: given this week’s celebrations of the twenty years since the fall of the Berlin Wall, and all the attendant crowing about the triumph of capitalism, we should all reflect on what has happened since. The post-wall years have produced much worse growth in household incomes than the deep Cold War years. It isn’t even close. If this is the fruit of the triumph of capitalism, then most Americans didn’t get much of a share. The victory was hollow. I attribute this to the lack of balance: the Cold War enforced a sense of proportion. The loss of an ideological competitor allowed America to indulge in unfettered capitalism – think de-regulation in particular – in the mistaken view that it was capitalism being verified and not simply socialism being proven false. Those two are not the same thing of course. The collapse of socialist economics is not the same as the proof of free market economics. Unfortunately the ideological drift of America since Reagan lulled us into forgetting that observation. The consequence is the current crisis and the ongoing ‘disproof’ of the free market hypothesis.

Now, perhaps, we can return to the balance of the post war era: rein in capitalism enough to restrict its inequalities, but not enough to stifle its creativity. The middle class boomed under such a balance and has been squeezed since it was led to believe in free market supremacy.

Time to rebalance.

But that requires two sides in the argument. And from what I see emanating from the Republicans right now, which is simply populist right wing dogma rather than policy recommendations, we are a long way from having such an argument. We need a Republican party engaged in debate, not simply enraged. Fiscally conservative policies are needed over the medium term. We will get nowhere if the only alternative to the social bias of the Democrats is simply a load of hysterical religiously driven, socially segregated, and backward looking name calling.

Can we have an actual debate please?

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Break Up The Banks

When it comes to bank reform the Obama administration has constantly rejected any action that might be construed as radical. This is despite the radical nature of the problem. The crisis last year exposed to all of us just how vulnerable the entire economy is to the peculiar and often predatory activities of the country’s largest banks. That these banks screwed up royally is beyond dispute. That they contrived through their collective incompetence to sink the world economy into such a deep recession that many of us feared a repeat of the 1930’s is also beyond dispute. That they destroyed trillions of dollars of wealth – both for their shareholders and for those unfortunate enough to exist within their orbit – is unequivocally one of the worst examples of disastrous management in history. All these things have had enormous and ongoing ramifications: the cost to us all is almost incalculable and will reverberate for a generation at least.

The implosion was epic.

It called for radical reaction.

“When three current, or former, chief central bankers all agree I think we should take notice.”

But all we have seen is deference and an almost supine attitude towards the banks. Every time a radical solution has been proffered it has been set aside politely as potentially ‘destabilizing’ for those precious financial markets whom we dare not ruffle. Poor things, these bankers have sensitive feelings and might get scared if we thrash them the way they deserve it.

Remember the call for nationalization? It was set aside as being ‘un-American’; as being too radical; as being … well, upsetting. Upsetting for whom? The little dears who run the banks and their shareholders. Those nice folks on the trading desks who funnel all that money into their bonus pools.

So instead of surgery we were given something roughly equivalent to the old ‘take an aspirin and see me in the morning’ routine. We, or rather those in power, did as little as they could.

First they slowed down the conversation and avoided anything that could disturb the bankers whose jitters were charted daily in all the financial media. We all started to speak more softly and in more understanding tones about the vast complexity of finance and banking – all that sea of toxic waste was misunderstood. It wasn’t toxic if you looked at it correctly. We, on the outside, simply were not in the position to make snap judgements about the value of those CDS’s, CDO’s, MBS’s and the other denizens of the alphabet soup down on Wall Street. So we were told by the likes of Tim Geithner. As he tried to calm down the firestorm of anger we discovered not only that our best and brightest bankers were dumb as all hell, but that they seemed to think we would pay for their trillion dollar errors without exacting a reciprocal cost. Which we did. Urged on by the likes of Geithner, Summers and the other ‘experts’ who ran in fear of the industry’s woes.

The next ploy, after the soothing talk, was to institute that famous set of ‘stress tests’ to evaluate the soundness of the top banks. That the tests were rigged in favor of the banks is obvious when we examine the measures of economic distress used. What is less known is that the regulators who administered the tests had little hope of getting enough support, time, or information from the banks to make the tests anything but a flimsy cover for a pre-determined fix. There was no way that those tests would have produced a result that could have fueled the call for nationalization, or even any other form of milder intervention.

Instead we forked over gobs of cash at favorable rates to plug the gaps that the banker’s incompetence had blown throughout their various balance sheets.

Then we all sat and watched while the Federal Reserve Board and the Treasury department contrived to flood the economy with enough cash – liquidity in banker speak – to float the universe. We all gamely pretended that this cash would end up as loans to regular folks who, after all, were the ones providing it. But those of us who understand a little more knew that would never happen: the banks were always going to hoard the cash. They’re scared, and frightened people tend to sit on safe piles of cash. So no sooner had the Fed doled the cash out than the banks stuffed it straight under the mattress – or their equivalent, which is the Fed’s own vault. So much for stimulating lending.

Then we had to endure the recriminations and faux effrontery as AIG traders were paid extortionate bonuses not to leave the business they had ruined and then handed over to us to bail out.

After that came a round of accounting ruses designed to help the poor banks report profits even though there were none. Along with that came other accounting changes to turn preferred stock into equity – which is simply re-branding one form of capital and calling it something else, as if semantics were a way of injecting cash. We were led to believe that this ruse suddenly implied the banks were well capitalized. Believe it if you wish. I don’t. But even better: test it for yourself. Apply semantics to your next bank statement. Talk to it. If you urge it hard enough perhaps you can put a lot of zeros after all those ones you see. Nonsense. From where I come from adding cash usually requires some to be handed over, not simply to change the name of what’s there already.

But that only serves to show how little I know.

All the while this tinkering was going on we watched as the Fed held interest rates so low they scarcely register on anyone’s scale. That’s good for us, but it’s better for the banks who have to borrow: it helps them make profits. And that’s what the administration was hoping would happen.

You see, the strategy all along has been to buy time. Do nothing radical, and buy time. Time heals, as we all know. As long as the taxpayer safety net was in place the banks could earn, or as I just suggested rig, profits and thus replace the capital they had blown on the gambling schemes that had threatened to sink them.

That’s what happened – banks started to report profits and the administration breathed a great sigh of relief. It had managed to avoid doing anything disruptive. The great financial markets started to repair themselves and by the late summer we had all begun to forget those calls for reform that had seemed so urgent late last year and early this.

Were the banks grateful for being left untouched?

Not one bit.

First they started to resist, mightily, the administration’s one real reform: the introduction of a consumer protection agency within banking. It would, we were told, stifle innovation. Given the fruits of the last great wave of financial innovation – toxic derivatives – most of us probably would agree that less rather than more innovation from these clowns is preferable. But money talks and banks have lots – courtesy of us. So Congress has begun to water down consumer protection, and the likely legislation, when, and if, it is signed into law will afford plenty of leeway for the industry to continue to produce impenetrably worded and dubiously useful products for our benefit.

Second they all started to announce that they were going to reward themselves for a job well done. Bonuses are back with a vengeance. This after only a year since the entire industry had to be saved from its own stupidity. Nothing is a better statement of the shattering hubris of bankers than the indignation they all express when we, the folks who saved their skins, question the social value of those bonuses. It is also a statement of the political security that the banks feel that they can flaunt their pay in our faces even while unemployment keeps rising and the tab for bailing them out remains unpaid.

That security is provided by the administration’s demonstrable bias towards the banks. Nowhere throughout this sorry saga has there been a line drawn in the sand. Every time a crisis appeared the solution chosen was then one most beneficial to the banks. Not once was the public anger allowed to lap over into action. Instead we have been treated to a steady diet of public statements about how wrong those bonuses are coupled with a deeply compliant and non confrontational attitude behind the scenes.

The inevitable result of this inaction, and the unwillingness to ruffle those magical markets, has been to compound the problems that gave rise to the original crisis.

The flood of liquidity sloshing about will, unless it is syphoned off via restrictive policies, flow through the traders hands into whatever scheme they next create, making another bubble a near certainty.

The ongoing taxpayer safety net remains in place, at no cost to the banks. So the socialization of bank losses and the privatization of bank profits rumbles on – as those insulting bonuses indicate. We are still on the hook for the banks inability to play nicely or safely with our money. Remember this: we provide blanket insurance to the financial industry nowadays, we underwrite their capital. If they screw up again we will pay. But we exact no fee for this unbelievable benefit. None. We are reduced to ineffective complaints about pay and bonuses. Complaints that are treated with derision by the industry.

And not least: all of the big banks have become bigger. Our problems are much larger than before. If you thought bailing our the banks was expensive last year, just wait for the next bail out. We all learned how dangerous a bank that is too big to fail is – just one can destroy an economy as large as ours, which is why we can’t let it fail. Imagine the damage an even larger bank could do.

Which brings me to this:

Break up the banks.

The only practical way to resist the banking industry’s control over us is to legislate them away. Compel them to deconstruct themselves into smaller and therefore manageable pieces. There is no other way to avoid being bankrupted by the gambling they all do. It is urgent that we force the big banks to scale down in the way that Standard Oil was broken up in the past.

I had given up on this possibility – as usual the Obama administration sent out word that it wanted to avoid a clash with the industry.

Then I read that no less a free market guru than Alan Greenspan advocates just that – break up the banks he argued in a recent speech. Next came his predecessor, Paul Volcker – break up the banks he suggested in an interview this week. But both these men are out of power. They are not sitting in on the policy meetings, so even though their voices carry weight, they will not be able to carry the day. They need help from the inside.

Enter Mervyn King.

He is the current head of the Bank of England.

His mantra?

Break up the banks.

His ill tempered and forceful speech to a banking industry conference this week has set the world on fire. His advocacy of radical surgery will be very hard to ignore since he actually can force action.

The big banks, not just here, but worldwide, have grown to the point where they dictate economic policy. We run scared every time they sneeze. They syphon off capital that should be flowing to industry and to consumers and channel it into ever more arcane and useless vehicles that serve no social value whatever, And they expect us to pick up the pieces every time they screw up.

Enough.

It’s time for some old fashioned capitalism.

Make them pay for their own mistakes.

Let them fail. Let the bankers go bankrupt on their own dime not ours.

For us to be able to allow such a failure, we need the banks to be smaller. A lot smaller. We can break them up. We could even continue to underwrite the socially valuable parts – the consumer and business lending operations, or ‘commodity’ banks deserve our help since they help fund the economy. The gamblers … well let them rot in their own mess.

So don’t just break the banks up. Separate the businesses along the old commercial [good] versus investment [bad] banking lines that used to exist before deregulation muddied the waters.

This makes sense because the two kinds of banking are as different as night and day. Society needs dull and boring commercial banks. We don’t need those gamblers with their securitized mumbo jumbo and derivatives a-go-go that seem to serve only the pay checks of the gamblers themselves and their coterie of hangers- on like the accountants, lawyers, and rating agencies who all have a hand in that same till.

When three current, or former, chief central bankers all agree I think we should take notice.

It is time for Obama to channel Teddy Roosevelt and break up the banks.

But I’m not holding my breath.

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Keynes Versus Reagan

There is something of a Keynesian revival going on right now. The bookshelves are filling with a wide variety of biographies, examinations of theory, comparisons with monetarism, and other angles all designed to give some insight into the Keynesian theory and why it has become so fashionable currently.

In that vein I have been reading Robert Skidelsky’s book: “Keynes: The Return of The Master” and recommend it highly. It is especially strong on the comparison between Keynesian ideas and those of what Skidelsky calls the ‘New Classicals’ which has been the prevailing dogma of the past few decades.

“It took a massive crisis and the loss of trillions of dollars of wealth for us to be reminded that the world is actually, gasp, a quite complicated place”

Those of you who follow what I say here regularly are aware, probably far too acutely so, of my dislike for modern economic theory upon which I lay much of the blame for the current economic mess we are in – the rest of the blame goes to the politicians who enacted New Classical ideas without truly having a clue as to their ramifications.

The larger point that needs to be made is that we have lived through an era where ideologically driven politicians co-opted an economic theory, and acted upon it, precisely because, on the surface at least, that theory supported their ideology. It gave a patina of intellectual soundness to the politics even if the politicians in question could not have delved too deeply into the theory at all.

And this is conjunction of economics with politics which forms the most interestingpart of Skidelsky’s analysis.

The immediate post-war years, from roughly 1950 through 1970, was a golden era of economic performance throughout the western and industrial world. All modernized economies, not just America, shook off the tribulations of World War II and emerged reinvigorated. Growth was strong throughout the world and unemployment very low by historical standards: the UK was typical of Europe with an average unemployment rate of about 1.6% during those decades, while it was the US that appeared to have lingering unemployment problems because it averaged around 4.8%. The vaunted flexibility of the American labor markets, so much lauded nowadays, actually produced a steadily higher level of unemployment than the far more rigid markets of Europe and Japan.

During those years the prevailing economic regime was based upon a set of ideas and institutions that owed their existence to Keynesian or quasi-Keynsian theory. The objective of public policy was to manage the balance between inflation and unemployment using the insights of a piece of economic theory called the ‘Phillips curve’. The idea being to keep the economy operating at full employment through the constant use of government interventions in the marketplace. Since full employment in these years was defined just as it sounds, very low or negligible unemployment, intervention was both frequent and, often, heavy handed. An accepted byproduct of this activity was a relatively constant and slightly higher level of inflation – the Phillips curve was designed to give policy makers insight into the balance they needed to make to keep the economy nudging towards full employment and away from either runaway inflation or, worse, deflation. The twin scourges of deflation and joblessness were etched so deeply in the public’s mind that the modest rate of inflation was seen as an acceptable cost for strong job markets.

Institutionally these policies were supported by strong unions – they negotiated long term wage deals that limited damaging fluctuations in incomes; by quiescent businesses who benefitted from predictable business conditions and an consistent inflation rate that made debt burdens easy to manage; by tight currency and exchange rate controls built around the dollar; and by trade arrangements that limited capital flows but encouraged tariff reductions – these latter two are known collectively as the Bretton Woods system after the locale at which they were negotiated.

This whole edifice is suffused with Keynsian thinking. Economists were generally thought to be using Keynsian ideas, even in the US where the older classical ideas still had a strong academic presence.

The upshot was a golden era for wealth creation: average GDP throughout the industrial world grew 4.8% annually and in no year did GDP growth worldwide fall below the IMF’s benchmark of recession of 3% growth. I should add that this IMF benchmark works because it includes fast growing countries like China whose annual growth is around 9%. For them a drop of a few percent would feel like a recession even though there would still be growth. Because there are enough such countries the IMF argues that the world as a whole is in recession when its annual growth slips below 3%. When more mature countries like the US slip a few percent they drop into negative GDP movement and so our local definition of recession is different. Along with this steady growth the average inflation rate was 3.9%; and the unemployment rate, as I have noted was very low.

All this ended in the 1970’s.

The massively inflationary funding of the Vietnam war combined with the oil crisis undermined the Keynesian vision of employment management: unemployment rose quickly right around the world despite government actions designed to limit it. Worse: the presumed relationship between inflation and unemployment – the Phillips curve – broke down. We had both high inflation and high unemployment at the same time. These were the years of ‘stagflation’.

The apparent break down of Keynesian thinking opened the door for a counter-revolution in economics led by Milton Friedman and his colleagues at the University of Chicago. In broad terms their new vision of the economy, which was a modified and more rigorous version of the Classical theory of David Ricardo, argued that it was exactly the government interventions that were causing all the problems, and that the proper focus of policy should be to minimize government, lower taxes, control inflation, and allow the ‘self-correcting’ mechanisms of the marketplace take care of the rest.

In other words the focus of policy should shift from demand management – keeping wages high and unemployment low – towards supply management – keeping taxes low, deregulating markets, weakening unions, and eliminating government programs.

This was supposed to unleash the power of capitalist wealth creation by getting rid of all the rigidities and inefficiencies that were alleged to be the natural counterpart of government intervention.

Allow business to run free of control and it would produce wealth sufficient to lift everyone, even those who are not part of the business elite.

This new theoretical system – dubbed the New Classical system – swept into dominance on the backs of a parallel political shift towards the right in the US and the UK. The apparent collapse of Keynesian economics was associated, successfully by conservative politicians, with meddlesome and rotten government. In a replay of the early 1800’s the resurgence of a heavily individualistic politics and a deregulated market system can be seen as a reaction to the supposed endemic corruption of government. Ricardo had belabored the superiority of markets over governments for exactly the same reasons Friedman gave: governments, they said, can never be as efficient as free markets in the allocation of scarce resources. And since allocation is what an economy is presumed to be for, it follows that government ‘is the problem’.

The near simultaneous arrival of Reagan in the US and Margaret Thatcher in the UK, both equipped with New Classical notions of market effectiveness, marked the end of Keynes domination of economic policy. From 1980 through last year the Friedmanite agenda reined supreme. So much so that Keynes fell off the curriculum in many top universities.

Let me reprise the main point of difference between the two economic theories: Keynes places great emphasis on the notion that markets cannot be relied upon to self correct – they face too much pure uncertainty [not simply risk] to be automatically equilibrium seeking. To the far more mathematically driven and purist Friedman this possibility was apostasy of the very worst kind: the New Classicals see markets as the apogee of mechanical and smoothly operating systems, that, if left alone by government, will absolutely always converge on the ‘best’ solution. In this sense Friedman was simply channeling Ricardo.

To get this supply side vision enacted the whole fabric of the older regime had to be tossed overboard: unions had to be restricted as impediments to the market’s ability to adjust – don’t forget that to a devout New Classical economist there is no involuntary unemployment: anyone who doesn’t have a job is ‘choosing’ not to work; the foreign exchange, trade and capital flow restrictions of Bretton Woods were replaced with floating exchange rates and globalized markets; business was unfettered from regulation; and the central bank was focused upon inflation management in order to provide business with a consistent environment in which to take risks.

The Reagan revolution was, at heart, a return to the premises of the Classical economists of the 1800’s. Crucially as the memory of the Great Depression faded from the public’s attention, so did the lessons learned: even some of the most discredited ideas of the Classicals were rehabilitated. Say’s Law, which argues that production will bring about sufficient demand – an idea Keynes had thoroughly debunked – re-emerged as supply side economics. The re-emergence of Say’s Law meant that the idea that aggregate demand can fall even when supply remains strong, the central motivation for Keynesian policy prescription, could be dismissed as impossible.

The outcomes?

Well the numbers don’t seem to bear out the New Classical argument.

The Reagan era has seen world GDP growth of 3.2% – down from 4.8%. This may not seem a lot but the world’s wealth would be 50% greater had the Keynes era of 4.8% been maintained.

Not just this but the world has, according to the IMF definition, had no less than six recessions in the Regan era compared with none under the Keynes regime. Things have become a lot more bumpy – which is what we would expect whenever markets have to keep adjusting without the smoothing influence of government.

And this dubious record has come at a great cost: unemployment has risen everywhere, in some places quite sharply. This is particularly true in Europe average unemployment rates have skyrocketed from the low 1% to 2% range to the persistent 7% and above range: the UK average went from 1.6% to 7.4%, while the US went from 4.8% to 6.1%.

Finally the vaunted ‘tight money’ inflation targeting of the Reagan era produced an average inflation rate of 3.2%. This is better than the 3.9% of the Keynes era, but not so significantly so that the unemployment cost is warranted.

Then we reach last year and our current crisis.

The wheels finally fell off the Reagan era ideology and the New Classical theory: deregulated markets span out of control. Financial systems teetered on the precipice of oblivion. Interest rates were ineffective as policy levers – we had reached the much feared ‘zero bound’ at which interest rate changes have no further effect. Nowhere in sight was the vaunted self-correction so beloved and admired by Friedman and through him Reagan.

The only policy lever left to fend of total collapse was a solid dose of Keynesian fiscal stimulus. Government intervention, the very devil incarnate, turns out to be the only possible remedy to our ills – as long as we want to avoid a depression.

Keynes roared back along with the lessons drawn from the 1930’s.

Hence the current interest.

My perspective has been Keynsian all along: the New Classical vision and its associated Reagan style ‘rugged individualism’ has seemed naive and utopian to me since I first came across them. They are ideas that look impressive on paper, but they place a massive burden for their efficacy on a set of assumptions simply untenable in the real world. It was a reaction to this naivete that drove Keynes to try to move economics into a more realistic realm. He rejected the purity and mechanistic movement of Classical theory. He viewed uncertainty as endemic to human discourse. He supported capitalism only as modified and contained within boundaries that limited its excesses – he was also strongly anti-socialist, preferring a ‘middle way’. He imagined a higher ethic for wealth creation than simple materialism. He decried what he saw as the inherent instability of financial markets. And he loathed the implications of huge inequalities of income distribution, which he saw as destabilizing democracy itself.

Friedman, Reagan, Lucas, and Bush and all the other champions of the deregulatory, free wheeling, supply side regime of the past three decades have a much simpler and far less nuanced view of society than Keynes did. The burden of the Great Depression and its incalculable human cost was too distant in their minds to shape or inform their ideas. They believed in simple mechanisms, simple relationships, simple cause and effect connections, and simple rules. Above all they believed government to be an irredeemably corrupt and pernicious influence on human affairs.

It is as if they were tilting, as the Founding Fathers did, against government in the guise of a corrupt 18th century monarch. They overlaid such a monarch’s sins onto todays’ modern technocratic and bureaucratic democracy. It is an epic failure of intellectual grasp, and an extraordinary attempt to recapture the sensibilities of a late 1700’s coffee house.

That we were duped by their portrayal of that simplicity is a testimony to our own decadence and lack of education. The allure of the New Classical and Reagan vision lies within its easily understood maxim: ‘the government is bad’. They were wrong. Keynes had already taught us that. It took a massive crisis and the loss of trillions of dollars of wealth for us to be reminded that the world is actually, gasp, a quite complicated place. A place where naive visions and simple solutions can very often condemn us to disaster.

So Keynes is back. Let’s hope we don’t forget him so quickly this time.

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Interest Rates … Time For A Raise?

No. No. No.

Not at all.

One of the oddest discussions now taking place in economic policy making circles is the one that concerns when, and how fast, interest rates should be raised. I find it odd simply because there is no analytical, theoretical, support anywhere for a raise. It is likely to stay that way for many months. So why is it that practically every day I see articles opining on the subject, and read of miscellaneous Federal officials – usually from the more obscure regions of the Federal Reserve System – making tough statements about how it mat be necessary for the fed to raise rates even if unemployment has not improved.

“Tighter money now would not just slow the recovery, it would eliminate it.”

Say what?

Frankly a raise in rates could not be more catastrophic. So what’s with all this talk?

Traders. That’s what.

The only people who could conceivably benefit from higher rates are within the trading community. Everyone else would lose. And lose big.

The whole discussion is simply an aspect of the ongoing war within the economics world about whether a stimulus was a good idea and whether the Fed has gone too far in pumping money into the economy.

I touched on some of this at the end of last week, but let’s review the facts anyway.

The Fed raises and lowers interest rates as its primary management tool as it tries to keep the economy growing at an even rate. The objective is to prevent surges in inflation and to balance the threat of inflation against the threat of unemployment. The recent bias has been to ‘manage’ inflation’ aggressively on the principle that a low and steady inflation rate provides a strong basis for a healthy economy.

There is a rule of thumb called the ‘Taylor Rule’ which provides an analytical background for policy as the Fed goes about this balancing act. Essentially the Taylor Rule – developed by John Taylor, a conservative economist from Stanford, is a regression analysis that provides a good fit with actual Fed policy over the last few decades. The Fed itself doesn’t openly say that it uses the taylor Rule, but it reports on where rates would be if it did. As I just noted for most of the last few years rates have tracked the rule well.

The problem we have now is that, given the gap between actual output and potential output in the economy, and given the very high unemployment we ore now experiencing, the Taylor Rule indicates that the Fed should be holding the Fed Funds rate – its primary weapon in rate management – at -5%. That’s right, minus 5%. Or maybe even closer to minus 6% depending on your view of the unemployment trend.

Since it is not possible to run negative nominal interest rates – imagine what would happen if the bank had to pay you interest when if borrowed from it – the Fed is stuck. It has hit what economists call the ‘zero bound’. So even though all the signs are that we need lower rates to get the economy moving, we cannot go there. This is why the Fed has had to resort to all sorts of unorthodox and never before seen methods to get cash into the economy. The result of these methods – collectively called ‘unconventional easing’ in the jargon of monetary economists – is that the banking system is awash with cash. Cash that is going nowhere because banks are refusing to lend while they are afraid of future loan losses.

This is where the interest rate ‘hawks’ – those who want to lift rates sooner rather than later – enter the discussion.

Generally speaking the hawks are folks who objected to the unconventional easing in the first place. They saw that sea of cash as an inevitable trigger of future inflation, and have lived in terror of it ever since. They are the ones using emotive phrases such as the ‘upcoming great inflation’ and urging a quick reversal of the easy money strategy currently dominating Fed policy. They are also the kind of analysts who see inflation as the only object of Fed policy – they argue that the Fed has no impact on unemployment except as a derivative of its primary function as regulator of tight money. Therefore targeting an unemployment rate, or even worrying too much about it, is irrelevant to the formation of sound Fed policy.

Needless to say most of these people are conservative politically and very oriented towards money market matters.

They are also nuts.

There is nothing in any theoretical tract that I am aware of that would argue for higher interest rates any time soon. Nothing. On the contrary, using that Taylor Rule and plugging in forecast activity in the economy, it seems that we should be continuing our current easy money policy regime until the unemployment rate has fallen to somewhere around 7% to 7.25%. No one that I know of thinks we will reach that happy point for a few quarters. Most think we won’t arrive at that level of unemployment until 2011 at the earliest. Raising rates before then would be seriously, and possibly fatally, damaging to the recovery.

It is not as if we have no history to guide us. The Fed made exactly this mistake in the late 1930’s. It raise rates too soon and choked off what appeared to be a healthy recovery sending the economy lurching straight back into depression. A depression that only the wartime build up of the early 1940’s ended.

So why are the hawks so aggressive in trying to force rates up?

Because they are money market people and are fearful of the reaction of the bond market to continued easy money as the recovery begins to take hold. The bond market is very sensitive to inflation, it builds inflation ‘expectations’ into its interest rate requirements. This is very rational behavior. After all a bond can have a very long life – up to 30 years – so an investor is exposed, theoretically, to a variety of risks not least of which is having the value of their investment depreciated by high and prolonged inflation. Conversely, a borrower such as the US government is quite happy to see high inflation since the money that they eventually have to pay back will be expressed in currency considerably diminished in value by that inflation.

It is because the hawks and the bond markets are suspicious that the government would like to encourage a higher rate of inflation – so as to reduce the impact of the deficit on future generations – that they want to see the breaks slammed on early. Inflicting a little bit of good old Puritanical pain on the unemployed is of no consequence to the hawks as long as the dollar remains strong. Maintaining that strength, for them, is paramount, and can only be accomplished by running rate up as soon as the recovery begins. That means raising rates early next year at the latest.

So that is the debate. Those in favor of an early rate hike have no theory to support them, they simply are biased towards a tight money policy so as to maintain bond values. They see all that cash sloshing around on bank balance sheets as the most dangerous aspect of the current economic situation. they want those bank reserves drained as soon as possible. Even if that slows the recovery.

They apparently forget the 1930’s lesson.

Tighter money now would not just slow the recovery, it would eliminate it.

Nothing could be worse.

Having a bond market bias is not necessarily a good credential for a central banker. In fact it is, currently at least, the acme of a disqualification criterion.

However, there seems to be a ton of those hawks about so I expect this discussion to run on through the winter. Which is too bad, since it distracts us from managing our way through the transition from our current stimulus supported recovery towards a self sustained one.

A sustainable recovery with more jobs should be our goal. Frankly a little inflation, to help ease debt burdens, would help us get there. No wonder the bond market is getting antsy.

Meanwhile: let’s vote no on any rate increases.

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The Dollar Falls

A few of you have asked what I think about the recent sharp decline in the value of the dollar. In general it’s a good thing. Let’s have more decline.

The problems we have with the dollar stem largely from the flood of money we have created to bail ourselves out of the mess the banks put us in last year. That was a necessary evil, but it unleashed a tide of dollars on the world. The simple laws of supply and demand imply that such a flood will inevitably reduce the value of the dollar. Each incremental issuance of US debt we make to pay our bills needs investors willing to buy them. Under the normal conditions of the last half century the US dollar and US debt has been a bastion for safety for investors. The demand for US debt has been steady because everything else is seen as more risky by comparison. So whenever there was a worldwide recession the US benefitted from an inflow of credit.

We became addicted to this inflow. So much so that we built our economy around being able to get other people’s money to pay for our own spending. Our trade deficit ballooned and has been negative for years – although today’s news is that it shrank a little last month. This was the central premise of the Reagan inspired fiscal policies we have pursued for decades. We were able to run trade and Federal budget deficits precisely because there was a steady stream of foreign investors who had spare cash and wanted to invest it safely.

In fact the existence of those foreign sources of cash is often used as a reason for our real estate bubble: were there no foreign cash we would never have had the money to inflate our house prices the way we did. This is the ‘savings glut’ argument some economists – including, at one time, Bernanke – to explain our bubble problems.

But all good things come to an end.

The world seems sated.

They have so many dollars in their investment portfolios that they are now getting concerned about having too many. So demand is ebbing.

Plus our economy has been exposed as being less reliable than people thought. Other economies are now in better shape and offer better returns. This also reduces demand for US debt.

The effect on the dollar is to depreciate its value. Dollars are so abundant that they are worth less than before. Especially when our interest rates are so low.

In general I think we should look forward to the dollar declining more. Most Americans won’t see much immediate impact. Our products will become cheaper when sold in foreign countries, so that will stimulate demand for American goods. Imports will increase in price and that would make things that are originally produced and priced in foreign currencies – cars for instance – more expensive. But anything that is produced and priced in dollars – oil being a good example – will not change in price in America. That means our trade balance should narrow and our domestic economy will grow a bit faster than it otherwise would.

One of the reasons the stimulus has been slower to percolate through our economy – it has worked, but could have worked sooner – is that it was designed to increase spending. To the degree that the spending was on foreign goods, the jobs the stimulus created were abroad not here. So a declining dollar helps prevent that exporting of jobs.

A more difficult problem, and one with profound long term political impact, is that the flood of dollars and the decline in their value has irritated enough foreign governments that they are actively discussing eliminating the dollar as the world’s primary trading currency. Plenty of commentators here treat this threat as shallow and temporary. I disagree: I think we ought to be very aware of the possibility of such a move. The impact on us would be severe.

Since oil and many other basic commodities are priced in dollars and not in the currency of the country producing them, anyone who is producing such things is getting hammered. The Third World is up in arms because of this. So are the big oil producers. Since this is the same group who feel aggrieved over trade conditions generally they are in the van of those demanding that the dollar lose its pre-eminence. They would prefer a stable currency, or possibly a ‘synthetic’ one made up of a mix of things such as the dollar, gold, and the euro.

But that argument is only just brewing. The point is that the days of the dollar being the world’s currency seem numbered because we have been profligate for thirty odd years and have not run a tight fiscal ship since Reagan cast us adrift in debt. You cannot keep printing money and relying on foreign sources of cash for ever. That was the Reagan way. Unfortunately we built our entire economy around foreign debt.

Throughout history, the world’s largest and richest nation has always been the world’s largest creditor. That was true in ancient Rome and it was true for the British in the 1800’s. It was true here as well up until Reagan. The post Reagan American economy is an historical anomaly: despite its wealth and power it borrows rather than lends to the world. It depletes its capital rather than adds to it. Eventually the game ends. We run out. Goodwill dissipates. And we have to start paying for our standard of living from cash we earn rather than cash we borrow.

Maybe the fall of the dollar signals that we have reached that end.

If so good.

Meanwhile we need to manage the dollar’s decline carefully. Too precipitous and we will have to drive up interest rates so we can keep borrowing enough to pay our bills. That would nip the recovery in the bud.

A lingering and slow decline is more desirable. That would buy us time to start saving enough of our own money so that we don’t need to keep on borrowing abroad.

Nothing’s easy in currency trading. That’s why predicting the dollars value with any notion of precision is a fool’s game. It is a game of trends and not exact values.

So: look for the dollar to fall some more. In general I would expect it to be lower next year than this. But be careful: some of those foreign economies are worse than ours so their currencies will fall faster.

Caveat emptor.

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