Ezra Klein is Economically Illiterate

Did you ever read an article and then come across a line or two that you so fundamentally disagree with that you stop reading at that point?  I just did that in this column by Ezra Klein.  Here is the offending text:

The point of austerity is to solve a deficit problem ... The Bush tax cuts, which were passed to pay down a surplus, should be rescinded now that deficits have returned.

My take is that there is no "deficit problem".  The deficit in and of itself doesn't hurt anyone.  In fact, most Keynesians (which most Democrats are to some degree) think the deficit is too small at the current time, exactly the opposite of what Klein is saying here!

Our current problem is high unemployment, not inflation.  Excessive deficits are inflationary.  We have an unemployment problem, not a deficit problem. I see no point in continuing to read the article when the author so fundamentally misinterprets the current state of the economy...

Budget Deficits Drive Profits

My understanding, via Bill Mitchell and Michael Kalecki is that budget deficits drive corporate profits.  Corporate CEOs aren't good at macroeconomics and most don't understand this. Their efforts to reduce fiscal deficits will ultimately backfire (be careful what you wish for).  More significantly, the U.S. pension system is now dependent upon corporate profits, through 401K and similar plans which encourage saving via stock market investments.

Focusing on the Wrong Deficit

There has been one big change in the U.S. economy over the last 30 years -- globalization.  Inflation is down, unemployment is up, wages are down, profits are up, and fiscal deficits are up because of this.  All of these are secondary to the primary effect of globalization, which is itself due in large part to improved communications technology.

http://www.data360.org/dsg.aspx?Data_Set_Group_Id=270

Investment Musings

Our society is highly dependent upon the value of assets such as stocks and bonds.  Typically, for example, our government leaders will take action when the stock market plummets.  We last witnessed this in the fall of 2008 when the financial system teetered on the edge of collapse, the stock market plunged, and Congress (both Democrats and Republicans) and the Federal Reserve stepped in to rescue the financial system by bailing out banks and related financial institutions.  The Democrats were also able to push a stimulus bill through Congress, thanks to the voters throwing out the Republicans who had been in power when collapse took place.

In terms of investments, the role of the government in maintaining asset prices varies between stocks and bonds.  U.S. Treasury debt held by the public amounts to about $11.5 trillion.  The total value of the U.S. stock market is about $14 trillion.  Both of these investment classes are extremely important to middle class Americans, and to the health of the overall U.S. economy.  A precipitous drop in value for either of these asset classes will create an overwhelming demand for government action.

In this post, I consider just U.S. Treasury bonds and U.S. stocks (equities).

The United States government, through the federal reserve, has fairly direct control over the prices of U.S. Treasury bonds.  This is seen in the ongoing quantitative easing operations, in which the Federal Reserve is directly purchasing U.S. Treasury bonds.  Any precipitous fall in Treasury prices can be met by Fed purchases to shore up the price, and this would be accepted as legal and, nowadays, conventional practice.  Thus, U.S. Treasury bonds are a relatively safe purchase.  Of course, the principle and interest payments are guaranteed by the U.S. government.  But also, with the logic expressed above, there is also a likelihood that the government will intervene if necessary to protect the prices of longer term bonds.

Equity prices, on the other hand, cannot directly or conventionally be maintained by government action.  There is no government guarantee on principle or dividend, and there is no provision for direct government purchase of stocks to boost prices.  The government has and can be expected to intervene indirectly to boost stock prices, but such action may not always be effective.

During the past 30+ years of Reaganomics and the ownership society, we have seen every possible trick used to stimulate the capitalist sphere of the economy and, by extension, stock prices.  Interest rates have been lowered to zero, to encourage the accumulation of private debt.  Labor has been outsourced and offshored to cut costs, while union power has disappeared and worker benefits, especially pensions, have dwindled.  Regulations and taxes on capital have been cut.  All of these indirect methods have been successful in maintaining stock prices, although for the last 12 years stocks have stopped rising.

My question is whether these indirect methods have run their course, and if it is possible or even likely that stocks will fall considerably before effective government action will be taken to save the pensions of retiring baby boomers, many of which are invested in the stock market.  Clearly, interest rates cannot be cut any further.  And there is little political support for further reduction of taxes and relaxation of regulations, as these tactics have clearly shown marginal utility over the last 12 years.  Labor power is already very weak, and it is difficult to imagine that the national pie can be further redistributed to capital.  Moreover, this would be counterproductive since aggregate demand is clearly lacking.  Finally, many would-be consumers lack collateral and credit worthiness, so aggregate demand cannot be boosted by measures to encourage household borrowing.

So what will the government do if we again slip into recession and stock prices fall?  The obvious solution is to boost aggregate demand by increasing spending and decreasing taxes on middle and lower income people, those who would be likely to spend any such windfalls.  Actually, this tactic is another that has been tried again and again over the past 12 years, mainly via tax cuts which are the only stimulative actions supported by Republicans.  While these repeated tax cuts (including, in some cases, outright payments to citizens) have provided temporary jolts, they have not been enough to offset the otherwise deteriorating employment and wage situation.  Now it seems likely that the temporary payroll tax cut will be ended, thus reversing this stimulus.  Of course, the "Bush tax cuts" are due to expire and are the subject of intense "fiscal cliff" negotiations.  At best we are now looking at the status quo in terms of net government spending to boost consumption.  The most likely outcome of the fiscal cliff negotiations is a slight tightening.

In my opinion, the most likely scenario going forward is for diminishing corporate profitability and falling stock prices, as wage income and aggregate demand languish due to the factors mentioned above, as well as to the global slowdown that is currently occurring.  The political situation is such that both parties are in favor of reducing government deficits.  The Republicans control the House, where spending must originate, and the Democrats control the other 2 branches of government.  There are stark philosophical differences between the two parties, as well as distrust and attention to power rather than good governance.  Thus, there is unlikely to be concerted action to effectively address the problem of a stagnant economy and falling stock prices.

Compounding this bleak outlook is, ironically, the fact that corporate balance sheets are strong.  So the downturn is unlikely to be a repeat of the financial crisis of 2008, which demanded immediate and overwhelming action to save capitalism.  Rather, it is more likely that there will be a fairly gentle, but ultimately devastating, downward trajectory.  Partisan maneuvering will take precedence over emergency rescue action for the foreseeable future.  Eventually, the voters will demand change, and perhaps that will be the time to invest in the stock market again, assuming that Democrats prevail and take action to boost aggregate demand and income security (e.g. wages, pensions, health insurance) for the majority of working Americans.

The Most Marvelous Thing (MMT)

The most marvelous thing to come out of blogging is the dissemination of modern monetary theory (MMT).  MMT explains how the economy really works.  I was an economics major in college (University of Michigan, 1974) specializing in macroeconomics, but I never really learned how the economy works until I started reading the MMT blogs about 4 years.

One of my favorite blogs on the web is Kevin Drum'g blog on Mother Jones.  Kevin is a political blogger, and not an expert on economics.  Over the years I've seen him pose a number of questions about economics on his blog.  As the years went by, I noticed, to my amazement, that I was able to answer his questions, using the information I had learned at the MMT blogs.  Here are some examples:

• What is money?
• How do banks work?  How does money get created and destroyed?
• Will the bond vigilantes strike against U.S. Treasury bonds?
• How important is it to balance the fiscal budget?
• What is the best way to manage the U.S. economy?
• What does the Federal Reserve do?  How much power do they have?  Are they part of the U.S. government?
• What is quantitative easing?  Will it stimulate the economy?  Can the Fed do more?  How about nominal GDP targeting?

If anybody wants answers to any of these questions, let me know.  Just don't be like Kevin Drum  and get some sort of mental block preventing comprehension of perfectly straightforward concepts.  That gets tiring.  

But read Kevin anyway.  Like I said, his blog is my favorite...

Blog About Japan -- Deployment

Deployment -- combo of deflation and high levels of employment.  Opposite of stagflation.  That's the ongoing "disaster" in Japan.

UPDATE:  Here's a sobering article:
Has Chinese Currency Manipulation Succeeded in Breaking Japanese Manufacturers?

My takeaway is that the conventional wisdom, as represented to some extent by the Economist, remains far removed from reality.  We may be on the verge of a deflationary trap, and the serious people are worrying about big government and deficit.  See Japan:

Meanwhile, the brutal deflation that accompanied the bust persists. Falling prices have translated into massive wealth destruction. Stop-and-go monetary and fiscal stimulus accomplished little. Consumer prices have declined for seven of the past 10 years. 

There is no clear path out of the deflationary trap. Federal Reserve Chairman Ben Bernanke, then a professor at Princeton, counseled the Japanese in 1999 to open the monetary floodgates. “Japanese monetary policy,” he wrote, “seems paralyzed, with a paralysis that is largely self-induced. Most striking is the apparent unwillingness of the monetary authorities to experiment, to try anything that isn’t absolutely guaranteed to work.”

Japanese officials counter that they’ve tried monetary stimulus, including zero interest rates and quantitative easing, but had meager results.
Richard Koo, chief economist at Nomura Research in Tokyo, argues that because Japan is stuck in a balance-sheet recession in which companies and households are retrenching, low interest rates are not stimulative because neither businesses nor households wish to borrow. He advocates massive fiscal stimulus, saying government spending is the only way to put a floor under sagging aggregate demand. Critics say past fiscal stimulus has ballooned the national debt to 200% of GDP.

Actually, Japan has low unemployment and zero inflation, with universal health care and good infrastructure.  Japan just totally fucks with the conventional wisdom in a number of respects.  The ration of GDP to national debt is totally irrelevant to the economic welfare of the country, while the universal and affordable national health care is something I wish we had here in the U.S.
Some lessons from Japan:

- monetary policy, using low interest rates and QE, can't always generate inflation
- national debt as a percent of GDP is irrelevant
- there is more to economic well-being than fast GDP growth

Kevin Drum is an Economic Illiterate

Drum posts today that:

higher inflation would be good. The simplest way to see this is to look at interest rates. Once the Fed has reduced interest rates to zero, it can't go any further. But what if the economy is so bad that all the standard models suggest you need negative interest rates to get the economy back on track? 

What he doesn't realize is that all his "standard models" are wrong.  They say that reducing interest rates is stimulative.  What they don't get is that the government pays the interest  Lower rates mean less money injected by the government into the economy.  So lower rates are deflationary, 180 degrees different from Drum's assumption.

Drum assumes that government lends money to the private sector and that lower rates means lower borrowing costs for the private sector.  However, the private sector does not generally borrow from the government to finance loans.  Rather, there is a pool of money available for loans that is the product of past government deficits.  The money has been spent into the economy by the government, and the government pays interest on this money (Treasury bonds or interest on reserves).

When the Fed lowers interest rates, the opportunity cost of lending by any single bank is lowered, since it will collect less interest on money that is saved.  That will stimulate private money creation (bank lending) in the short run, but those debts will have to be paid back, so the effect is contractionary after a year or two.  In 2012, after 30 years of steadily declining interest rates intended to boost short term private sector debt, there is little more short term gain to be achieved, as consumers are paying back money previously borrowed from the private sector.

So the net effect of continually decreasing interest rates is a double whammy to the economy:

1. Less money is provided to the economy by the government.
2. Private debt can only be juiced so far before it becomes a burden to the economy.

Anyone, like Drum, who imagines that low interest rates generate inflation, is extremely short-sighted.  Take a minute to look at the history of interest rates in the United States and Japan and you will see the proof of the point I am making.  For example: US_Inflation_rate_vs_3month_T_bill_rate --



Note that interest rates track inflation and the two are positively correlated.  Compare this reality to Drum's assumption that interest rates are inversely correlated with inflation...

Inflation Expectations and Quack Economists

There have been a lot of quack economists recommending that the Fed raise inflation expectations as a means of increasing overall economic activity and employment.  The following graph (from Cullen Roche) shows pretty clearly that this has not been effective:



Inflation expectations have spiked a couple of times in recent years and inflation, as measured by CPI, has jumped a couple of times.  But wages have steadily decreased.  Thus, increasing inflation has been of the bad type (food, gasoline) which decreases purchasing power for workers whose wages have continued to decrease.  Goosing inflation expectations is quack economic medicine which has masked a continuing deterioration in purchasing power...

Risks of Additional "Monetary Easing"

Back on August 1, Kevin Drum commented:

Easier monetary policy might or might not be effective, but it seems like even the Fed thinks it would be a pretty low risk thing to try. So why not try it? 
Kevin Drum, 8/1/2012

Since then, I've been collecting reasons why this might not be a good idea.  

As far as I know, the only monetary action under consideration is additional asset purchases, i.e. more bond swaps for reserves.   Here are some reasons why this "monetary easing" might be counterproductive:

- Lowering interest rates (by liquidating bonds) is fundamentally deflationary.  Injections of 5% or more annual interest paid on long term bonds are replaced by reserves which earn 1/4% interest.  See Ed Harrison, for example:

in periods of low credit demand growth, it is the effect on lost interest income that overwhelms the effect on credit growth. In fact, I would argue that this policy actually helps tip economies into deflation... the same people who were concerned about low rates stealing interest income become coupon clippers, knowing that deflation will bail them out. Suddenly, your economy is trapped in a deflationary rut – and central bank policy of zero rates helped to get it there.

- Banks make money by borrowing short and lending long.  You can only reduce long term rates so much before such a business model collapses.  Ed Harrison again:

the signs of malinvestment excess from extremely low interest rates are all around us. When recession hits, these losses will crystallize. And there will be no steep yield curve to bail out the banks as we saw in in the early 1990s. The banks will have to take it on the chin like the Japanese banks did in 1997 – and we know what happened there...

- Focus on Fed fixes diverts attention from the fiscal fixes that are needed.

- Removal of interest bearing bonds leads some investors to alternative investments such as commodities, pushing up the price of gasoline, for example.  Any inflation caused by debt monetization is in assets, which is the bad kind of inflation in the present economy.

- Money market funds are already unstable, as they are not legally guaranteed but cannot be allowed to fail. Reducing the interest on reserves from the current 1/4% to 0% could cause failure in this part of the financial system.  The prospect of further bailouts for the banks and the wealthy will not be popular and could cause political turmoil.  Here's a post by Cardiff Garcia of FTalphaville on this subject:

The ECB’s recent decision to lower its deposit rate to zero raised speculation in the market that the FOMC might be considering the reduction or elimination of the 0.25 per cent interest the Fed pays on excess reserves.

interest on excess reserves is like a safe asset for banks — you can consider it an imperfect near-substitute for the Treasuries and agency MBS that the Fed has removed from the market. And along with the unlimited deposit insurance on non-interest bearing accounts, it is (from a certain point of view) a kind of ongoing bailout for money market fund investors.

The risks, in sum, are that rates will plunge to zero or negative, money market funds and their investors would panic as their sources of yield disappeared, and that banks will follow Bank of New York Mellon’s lead last year and consider the (politically uber-controversial, btw) possibility of charging fees on deposits.

Money market funds would likely be subsidised for a time by their sponsors, but that can’t be counted on to the extent that it was before the crisis. Were this to pass, we couldn’t with any certainty predict the consequences — but given the panic that ensued when Reserve Primary broke the buck, it’s worth taking none of this lightly.

But in addition to general chaos in money markets, here are three more possible worries resulting from the above...

it is just as possible to imagine how, regrettably and almost perversely, negative rates would actually make things worse. How they would lead to higher demand for money itself — to deflationary expectations.

So if the economy slides back into recession in 2013, which is a likely prospect given the approaching fiscal cliff and our highly polarized and dysfunctional political environment, visions of hyperinflation caused by debt monetization may give way to a deflationary reality.  We'll see soon enough...

Second Dip Coming?

A good post by Ed Harrison got me thinking about the severity of the next recession.  The economy has been weak for the last 5 years (and was unhealthy for the previous 8 or so).  Some people (the majority of the outspoken financial community) seem to think that this means we are due for a bull market / growing economy.  My take is that we are not out of the woods yet, and in fact may be taking some counterproductive measures.  Moreover, the (neo)liberal Democratic commentariat is just as counterproductive in one respect as everybody else.

Specifically, I think that efforts to use monetary policy to boost the economy may be counterproductive.  To start with, monetary policy is massively misunderstood, as noted in my March 2012 post here.  The ongoing push, mainly by the (neo)liberals, to push interest rates down even further may be deflationary in the long run.    This is obvious from the fact that interest paid by the federal government represents money given to the private sector.  In other words, lower interest payments decrease the fiscal deficit.

So what is the real problem facing the economy, and how will decreasing the fiscal deficit affect the fundamentals? The basic problem is stagnating wage incomes, which have gotten out of whack with asset prices and consumption habits. The gap has been filled with unsustainable household debt, and this is still a problem. While housing prices have come down substantially, other asset prices, including the common stocks that many depend upon for retirement, are still overvalued. Decades of investment incentives (e.g. reduction of capital gains tax) have led to excess investment.

By seeking to further reduce interest rates in order to stimulate more investment, the neo-liberals are foolishly trying to reblow the same bubble that popped 4 years ago. Only deficit spending can provide the needed boost to household income that is needed.  As noted above, reducing interest rates reduces the desparately needed fiscal stimulus.  Trying to reignite private borrowing will just exacerbate the problem. When the next downturn comes, zero interest rates will be telling indicator of deflation, not the go signal that so many seem to assume….

Will Corporate Bosses Keep Republicans in Line?

The corporate bosses that call the shots in the Republican Party can't have been happy with the debt ceiling shenanigans last year. Rich people do not look kindly on anyone messing with their financial instruments. This year we face the "fiscal cliff". Corporate folks surely do not want economic warfare, which can only hurt them.

Obama should have a lot of leverage to follow through on his pledge to raise taxes on the wealthy. In return he'll probably make concessions on entitlements. That is, if (relative) sanity prevails. If this is how it plays out (a best case, as far as the status quo goes), then this will have a slight depressing effect on the economy next year, as increased taxes for the wealthy will mean less money around to invest in stocks and other assets. 

Here are a few things that could go wrong and make 2013 even worse:

- The temporary payroll tax cuts are allowed to expire.  This is actually likely and will be a significant blow to the economy in 2013.
- Romney gets elected and foolishly cuts government spending.
- Israel and/or U.S. attacks Iran and oil supply is disrupted.
- Obama caves and cuts spending sooner rather than later.
- A faction of Republicans favors economic pain to teach the Dems (another) lesson.  Chaos ensues, as in the debt ceiling negotiations.  To save face, the Republicans insist on some stupid budget cuts.

Here's How Screwed Up the Conventional Economic Wisdom Is

Conventional economic wisdom:
1. Interest rates for government debt are determined by the market, and are susceptible to strikes by bond vigilantes.
2. The Fed (central bank) is all powerful and can control inflation and unemployment. The only thing it can't do is control interest rates (see item 1 above).

Real World:
In fact, the only the thing the Fed does control is the interest rates on government debt.

Conclusion:
The conventional wisdom on the role of the central bank and monetary policy is exactly wrong...

The Coming Revolution

Call me a naive Pollyanna, but I believe that both parties have moved so far away from the interests of the middle class that significant change with regard to workers' rights is becoming more of a possibility.  Disillusionment with the status quo is off the charts.  

One of the major factors in the recent ascendance of capitalists at the expense of workers was the co-opting of much of the middle class through 401k plans and other similar initiatives which greatly expanded the number of voters benefiting from high returns to capital.   Can this be rolled back?  I believe so, since capitalism as always contains the seeds of its own destruction.  

Politicians have been afraid to let stock values fall.  This was seen clearly in the fall of 2008 when the bailout was rushed through in response to panicking markets.  The longer this goes on, the more overvalued markets become, and the higher the potential for a crash.  And fundamental values are actually harmed as a higher percentage of national income is devoted to capital at the expense of labor, as capital prices rise and consumption potential falls.  

With the public already massively disillusioned with the last set of bailouts for the 1%, the stage is set for political chaos the next time markets panic.  If the political system fails to prop up the markets in which many of us have invested our life savings, the ownership society we've built over the last 30 years will collapse.   If the government does prop up the markets again, both the right and the left will revolt unless the socialist intervention extends deeper into the middle class.

This is the setting that will greet President Mitt Romney, should he win the presidential election in November.  Obama has been a decent president, but has been victimized by a dysfunctional political system and will have trouble overcome racial favoritism.  Should the tone deaf Romney win, all the pieces will be in place for a middle class or 99% revolt.  Once that gets rolling, it will become self-sustaining.  As laws favoring capital are rolled back, stock market values will fall in reflection of the less friendly investment climate.  The ownership society and markets will take another credibility hit, and the rising tide favoring workers and social insurance programs will sweep away the opposition...