How to Deal with Financial Tornadoes

Being retired affords me some personal options. For example, I can sleep until noon and Betty dusts around me. It also gives me the flexibility to take on some overseas teaching. I have been fortunate enough to teach for the last two months in an MBA program in Seoul, Korea. My contract provides an unlimited supply of kimche in return for economics lectures. It seems pretty fair to me! Anyway, I am now in Bloomington with great intentions to rake leaves and otherwise be a productive household unit.

While in Korea I read my usual newspapers and watched a little business/political news and tried to write my blogs from afar. I am struck, however, as I sit here in little Bloomington Indiana at how common are the political breakdowns in most countries. The political breakdown and  government malfunction have got to be a defining signature of our times. In my last blogs I nibbled around the edges to try to understand why we get such bad policy and today I try a different angle. This one focuses on the difference between problems and big problems – or dealing with challenges versus emergencies.

Many of the important policies we are dealing with daily have had and will have relatively enduing consequences. The stimulus programs will have effects that last for years. Today we are confronted with a new debate about how best to improve the jobs situation. In parallel is a very heated question of taxation of rich persons. Health care policy and what to do about entitlements require policies and solutions that will be with us for decades. In short, our government is bent on making policies that could not be considered temporary – these are changes whose impacts will last. These are solutions whose effects will endure.

The heft and durability of policies should, I think, reflect the nature of the challenges they seek to resolve. For example, if your kid stole a pack of cigarettes you would probably not send him to prison for 50 years. If your house burns to the ground you would not rebuild your house without a stove. If a tornado destroys your house you would not move to Venice Beach California or a place that almost never has tornados. If you got a stomach ache, you wouldn’t quit eating.

Most experts agree that the financial collapse and the ensuing recession and slow growth period, including the continuing dismal performance of unemployment came about because of a once-in-a lifetime-event.  I would not call it a random event but the swiftness, the depth, and the very sources of problems made it a rarity among economic shocks.  Tornados and fires are tragedies that sometimes unfold for reasons, but the truth is that most people never encounter these problems. If you live through one such event the likelihood is that you will not endure a second one. When someone is unlucky enough to experience one such tragic event, it is reasonable that they wonder what they could have done to prevent the problem and what they should do in the future.

It is equally reasonable to conclude that sometimes because of the severity of the negative consequences of such rare events, that people come to the wrong conclusions and sometimes make tragic decisions about how to avoid them in the future. I am afraid that is what is happening today with respect to economic events since 2007. Let’s go back to the tornado example. Surely moving to Venice Beach seems pretty outlandish unless you always wanted to live near Muscle Beach and were afraid to admit it. Less extreme would be to rebuild a house that has a basement, so you would be safer if another tornado did impact you. In between those extremes might be building a house that could stand the high winds of any tornado. I am guessing that such a house could be very expensive and well beyond the financial resources of most people. No matter which choice is made, however, there are financial consequences.

With respect to our current high rate of unemployment and slow economic growth, it seems to me we are barking up the wrong policy trees, especially if you believe that the economic shocks of 2008 were macroeconomic tornados – once in-a-life-time shocks that may never happen to us again. The negative economic consequences of the financial crisis are all around us and it is easy political picking to find demons and red herrings. Let’s blame it all on the capitalist system. Let’s blame it on rich people. Let’s blame it on China. Let’s blame it on globalization. Let’s blame it on….

If 2008 and thereafter really were the results of a rare event that has some small possibility of returning in the future then it seems to me that we want to do three things. First, realize that nothing you do right now will make the past go away. Second, don’t change things forever that have very little to do with a rare event. Third, whatever you do make sure that you are focused on what really may have caused the problem and attack those causes directly and with a budget that seems commensurate with the probable return of the problem.

So let’s create two lists. First we list all those things that did not cause 2008 and thereafter. Second, let’s list those things that we think did cause it and which could happen again without remediation.

List 1. Did not cause it:  people without healthcare insurance, rich people, insufficient taxes paid by rich people, the capitalist system, unions, worker demands, China, oil companies, inadequate infrastructure, air pollution, unemployed teachers and policemen, a disdain of small business to hire workers, immigrants

List 2. Did cause it: excessive leverage by financial and other firms, households incurring too much debt, governments incurring too much debt, unrealistic expectations about housing prices, corrupt practices among some individuals in financial firms, Fed policy that left interest rates too low for too long, realization that government revenues are insufficient for current and future liabilities, earthquake

Before you get too hot under the collar…note that List 1 does not imply that there are no problems with respect to income distribution, poverty, de-regulation, re-regulation, business costs including employee health and pension benefits. There are problems that need addressing in all those and other areas. But the point is to try to prioritize and to focus on cause and effect .If high unemployment and slow growth are the result of something – then let’s stick to those things. Let’s not use the current economic malaise as a cheap excuse to solve all of man’s ills.

Let me end this with a few words about the recent protests.  Those who have lost their jobs, houses, retirement incomes, and other means of living in the last several years have a right to be disappointed and angry. They have a right to peacefully protest and make their grievances known. There is much wrong with this country and we should all demand better solutions. But it helps no one to throw the baby out with the dirty bath water. What we all want is for things to get better. To do that with limited resources we have to focus and we have to be logical. Capitalism has served this country and most of the world well. Just imagine how the world has changed in the years since I was about 14 years old walking around Miami as Kennedy faced down the Soviets over rockets in Cuba. Since then country after country gave up central planning for some form of capitalism. It hasn’t been perfect and there are many things we can do to improve capitalism as it serves people of all incomes – but surely if we have learned anything it is that central planning is not a superior system.  We already have a mixed capitalist-socialist system. The financial crisis and resulting global slowdown will not be improved by radical departures from capitalism. Let’s keep our eye on the ball and not be diverted by people who are just using this crisis as a means to their own ideological ends.

Howling Wolf

On October 13 Martin Wolf wrote a column in the Financial Times called Time has Come for Intelligent Policy Making (http://www.ft.com/intl/cms/s/0/f4d3fdce-f42f-11e0-bdea-00144feab49a.html#axzz1auKt9tCY ). He ends the article with the following quote:

There are two big points here. First, fiscal and monetary policy converge when interest rates are close to zero. The authorities have to co-operate closely, to prevent an unnecessary disaster. As Deng Xiaoping said: “It does not matter if a cat is black or white, so long as it catches mice.” Who cares if a policy is called fiscal or monetary, so long as it works? Second, without economic growth, it is almost impossible to deleverage an economy. The prime minister revels in his pre-Keynesian views. When weak demand is the immediate constraint on output that is simply terrifying.

What is terrifying is that Wolf, a very influential writer, fails to recognize facts and continues to render advice that will truly harm the world for many years to come. He makes two important errors. First he believes that the present macroeconomic problem is deficient demand. Second he thinks that if past stimulus policies have failed then it behooves government to try them again – now with bigger doses of policy and with more coordination between the government and the central bank.

His belief that the main macro problem is a deficiency of demand or spending is like believing that driving accidents involving drunk drivers result from speeding. It is true that these accidents are correlated to driving speeds just as economic malaise is heightened by under-spending. But correlation is not causation. The accidents were caused by people drinking too much. Our lack of spending derives from very specific causes like years of unsustainable debt, a housing and financial crisis, a European sovereign debt crisis, and the attendant effects these trends have had on both Wall Street and Main Street. Calling for policy to induce people to spend more is like putting up new speed limit signs for drunks. Neither of these solutions addresses the root problem and the result is that neither will work. To the extent that Wolf continues to advise governments to focus on deficient demand means policymakers who follow his advice continue to avoid progress on true causes and thus threaten to make things worse.  

It is interesting that Wolf does not appear to read Wolf. In other columns he is quite lucid about the financial roots of our problems and is instructive on the need for private investors and tax payers to share in the solution burdens. Why he avoids his own advice and keeps coming back to strongly advise stimulus policies aimed at deficient demand is an interesting question. Maybe he doesn’t understand cause and effect? Maybe he believes the situation is so dire that cause and effect seem to be less important than trying ANYTHING to solve the problems. This is not 2008. I just don’t understand why he is so willing to throw caution to the wind and grab at straws.

This brings me to my second point. Wolf wants to see more stimulus and he wants a coordinated monetary and fiscal policy. Apparently the past programs were not enough. But Wolf doesn’t really say how much would be enough. By most measures the past fiscal and monetary injections were huge. And while there may not have been explicit coordination, the Fed and the US government were doing plenty without sending texts or tweets to each other. In theory a solo fiscal policy might lead to higher interest rates as government borrowing crowds out private borrowing. But that didn’t happen this time. I have read nowhere that rising interest rates have prevented recovery. Wolf seems to believe that if the Fed buys the government bonds that will somehow provide even more spending oomph. But does he really believe interest rates are not low enough now for people to want to buy a home or for firms to buy another machine? Does he really believe that the simple announcement of a new, large, and coordinated stimulus will cause people to run in droves to Amazon.com and Walmart with confidence and zest?

Much of Wolf’s conclusions derive from his belief that deflation is a bigger problem than inflation. I will give him that. I do not see imminent inflation for the world economy. But I see that fact different from him. This higher probability of deflation today stems from a belief that monetary and fiscal policy are spent and are NOT the right way to solve our macro problems. The more people listen to Wolf the more worried they become. This worry shows up in uncertainty and a desire to retrench. They don’t spend more when stimulated. The more the government tries to help, the more it nibbles off its own foot. I suggest we keep this Howling Wolf out of the hen house. More stimulus and more coordinated stimulus are going to scare the Hell out of people. What we need is for government to address the causes of housing and financial distress. Only then will we see a resumption of growth in output and employment. A wolf howls at the moon to no avail. I hope the same is true for the Wolf named Martin.

Haircuts, Hazards, and Hand-Grenades

I need a haircut. It has been more than six weeks since my last visit to the Crosstown Barber Shop and the little hairs on the back of my neck are looking unsightly.  But the market’s down and I was hoping to get a little more mileage on the last haircut. And there is the odd chance that government, feeling sorry for old people like me, might come to my rescue with a haircut subsidy.

While the above sounds really silly it is not a bad description of what is happening today around the globe.  Today we use the term haircut to describe the ability or willingness of the private sector to share at least part of the credit losses that have occurred in the last several years. A haircut means that a creditor agrees to take less than the promised or expected return on an asset. When it comes to housing in the US, Ireland and a few other places the haircut has to do with financial institutions that hold bad mortgage loans and/or derivatives tied to these loans. When it comes to European and other banks it has to do with banks and other financial institutions that are holding sovereign debt or the official government debt of Greece and other European nations.

We are not used to talking about haircuts in this manner. In the past, banks and financial institutions that held bad investments were seen as poor decision makers and we generally believe they needed to take care of their own business problems.  If they made bad investments and could not stand behind their debts then they should go into bankruptcy or go out of business. One such institution might try to sell its investments and willingly take a price reduction or haircut in order to maintain cash flow. But this decision was a private one – taken by a troubled financial institution to resolve its difficulties. It was not a matter of public policy.

Today things are different. Today we are in a financial crisis in which the proportions of the problem go well beyond a few firms, a few industries and beyond a few countries. The proportions also go well beyond an amount of debt which could easily be paid with government assistance from a single country or even a consortium of countries. Simply put, the financial crisis has most of us in a very deep hole. If it was not such a deep hole, we would have been out of it by now. If it was not such a deep hole, we would not have so much discussion and such little real action. This is not only a deep hole but it is a new one. Financial crises have come and gone. But most of these past financial crises have been limited to one or a few countries. 

These crises came before the age of GLOBALEV. GLOBALEV is a time when leverage became excessive. GLOBALEV is a time of global interconnectedness that turned the financial industry into a highly interdependent organism.  GLOBALEV is a time when housing and financial market bubbles burst and the negative impacts were quickly transmitted to financial institutions in most countries.

In short, we find most countries of the world sharing a very large financial burden. While bankruptcy and debt reneging/renegotiation might have been appropriate in the past, these solutions won’t work in GLOBALEV. There is too much money involved and too many countries that would be part of a downward cycle of default. Asking private investors to assume the whole load of this debt crisis is like asking me to lift a building. A more relevant question, however, is to ask HOW MUCH of the current debt crisis could realistically be carried by the private sector. That is, how much of a haircut are private financial institutions able to take? One might argue that they should take 100% of the burden. This is the way things ought to work in more normal times. But in GLOBALEV it is not possible.  If we asked all financial institutions to clear their nonperforming debt by tomorrow, the world’s financial system would grind to a quick halt.

Many are quick to point out the phenomenon of moral hazard. And they are correct to do that. If you do not make private financial firms assume the full burden of their investments, then they will assume that they will never have to do that in the future. Whatever harmful practices got them into the current problem would surely continue in the future. So the moral hazard issue is real and worth considering when determining the size of the haircut. With the financial crisis so deep and wide, a moral hazard cannot be avoided.

So if the private financial firms cannot withstand full responsibility for their bad investments, then they must be assumed by society.  GLOBALEV implies there must be a shared responsibility. 

This issue reminds me of people who live in flood plains whose property is destroyed by over-flowing rivers and oceans. Whether they were insured or not, it always seems to be the case that society ends up sharing the costs when homes are destroyed by flooding waters. I always gripe that this is unfair to those of us who do not live near water. But it seems to go on and on. After the waters recede people rebuild in the very same places. It sounds crazy but I think about the outpouring of both private and public relief that is mobilized every time there is severe human misery inflicted by Mother Nature. If tax-payers are unable to protect themselves from irrational home location decisions, it seems that we are equally impotent when it comes to deep financial crises.

Some of you are grinding your teeth right now. But I think it is unavoidable that a financial bailout will be part of the solution to our financial crisis. It will send the wrong signal to bailed-out firms and it will not prevent future disasters from happening in the future, but it will be part of a solution that might work.  It might work because the problem is so deep and it requires more assets than the private sector can now provide.  GLOBLEV requires a tax-payer contribution and the only question is HOW MUCH of the total amount is paid through government. Many options are possible. At one extreme the government can shoulder 99%.  At the other tax-payers might fork over 1%. But more than likely, the amount paid by tax-payers will be somewhere in between. 

Unfortunately HOW MUCH the taxpayer pays has become a political/ideological stick of dynamite. Inasmuch we are several years beyond the beginning of the financial crisis and we have little in the way of policy progress. Much has not been legislated and much of what has been legislated has not been put into practice. Stalling, or not deciding HOW MUCH the taxpayer contributes, is the one and only reason why we are staring down the barrel of a double-dip shotgun and why we have made little or no progress in employment.

Right now most of the news is about Europe and the lack of progress on their sovereign crisis. This negative cloud is hanging over all of us. Why? This cloud exists because Germany leads a group of countries that insists on a larger haircut and a small government contribution. France is part of a block that thinks a larger social portion must be paid. In Europe the usual problem of who pays gets even tougher and more political because it not only pits the creditors against the tax-payers but it pits country against country. If most of the debtors are in southern countries and the richer tax payers are in the north, then it is much more difficult to find a sharing solution that seems fair.

What’s happening in Europe is no different than our experience in the US. We continue to have a huge overhang of mortgage debt. We continue to have banks that sit on a razor’s edge of financial stability. We wonder why housing prices keep falling and no clear end to the housing crisis is in sight. But our politicians, like their cousins in Europe, do not want to admit or deal with deciding on the private haircut and the public split. Conservatives want the market to bear the full brunt.  Liberals want the tax-payers to pick-up a larger share of the debt.  Yet nothing will be accomplished until they admit the reality of the situation and get on with a compromise. In the meantime no jobs bill will restore demand or supply to a nation that sees no solution to GLOBLEV. So long as GLOBDEV remains, banks will not lend and houses will not sell.  Firms will continue to have less than sanguine expectations and will see no need to expand employment.

I personally have no frog in this race when it comes to deciding the size of the private haircut. As I said above, the smaller it is the bigger is the problem of moral hazard. Furthermore, the more tax-payers bear the burden the more our national debt increases and the more our financial reputation is a stake. Shifting the burden of finance from the private to the public therefore has its risks. But then the bigger you make the private haircut, the larger the risk you take with respect to the crumbling of global financial markets. This is a deep hole and there is no free lunch. But the more we pretend this is an ideological problem the more we stall a solution and the longer we languish in economic purgatory. We need some experts to decide the proper ratio of public to private responsibility and then we need politicians to bring home the solution. I am not optimistic we will get what we need anytime soon.

Currency Manipulation and the Wrong Super Hero

This week our US Senate is taking up the issue of China’s currency manipulation. It appears that we have an almost bi-partisan attempt to create even dumber international trade policy. The stock market hasn’t fallen enough – so our Senate has decided it can do even more to impoverish Americans. Way to go Reid! The Republicans who normally wouldn’t go along with this kind of stupidity (since they have their own kind of stupidity) seem to be worried that they need to play this populist card too.  Let’s blame everything on China. China– you bad. US Congress – we good.  So much for intelligent representation and policy!

What do these guys want to do? While the exact legislation is changing each day, the basic idea is that China depreciates its currency to create a competitive advantage for its exports. So we have legislation that would ask someone to calculate the degree of advantage China gets from currency manipulation and that would be fed into a Robot that would spit out the size of a tariff to apply to some or all of China’s imports into America. Sounds easy, right? Sounds fair, right? Sounds like it will save American jobs, right? Sounds like it will make 65 year old men more potent and attractive, right?

This reminds me of that cold day back in the 1970s when a car-full of Indiana University economists slid off a snowy highway between Terre Haute and Indianapolis and found themselves in a ditch wishing that a truck driver would stop and help them. We had a lot of PhDs in that car but no one who actually could figure out which end of the car to push. Luckily a truck driver did stop and offered some advice. He suggested that we push the car down further into the ditch and then floor it enough to drive out of the ditch. We concluded that this particular truck driver must have gotten his license from Purdue University and that there was no way in H___ that we were going to push the car down further into the ditch.  That was really stupid advice and even a bunch of professors knew it. We convinced the brawny driver to help us push the car upward and we were soon out of the ditch and on our way to Indianapolis. 

The point is that sometimes you really want to be rescued but sometimes you get a super-hero who just isn’t up for the task. In the case of China we in America feel threatened. We worry about China taking away our jobs and companies. So it is not wrong that we worry about how to better compete with China.  But this idea to tie US import tariffs to an estimate of Chinese currency manipulation is impossible to implement, will not increase US jobs and competitiveness, and will more than likely than not be counter-productive.

First, it is impossible to do. While we may have lots of theoretical models that might tell us how much China’s currency is under-valued, there are so many different ways to calculate this number that even a robot named Curly-Larry & Moe might sputter around in endless loops of break dancing. Then there is the small issue that implementing increased tariffs based on this number is not only novel but is illegal within the rules of the WTO. There is no precedent for this. While it sounds like a desirable thing to treat currency manipulation as a trade barrier worthy of reacting against, the WTO has not sanctioned this kind of retaliation. 

Then there is the question of other countries that routinely depreciate against the dollar to gain competitive advantage. Would it be proper and fair to only single out the Chinese? So are we really going to work Curly, Larry & Moe overtime on Brazil, and the others too? Do we really want to risk a global trade war right now?  In short it is really hard to find any way to actually implement this policy. It’s like making it illegal for Martians to own homes in Nevada. It sounds good to try to keep them out of Nevada – but I am not sure we have a good way to do this.

Second, this policy is not going to work. Notice that over the last years the Chinese currency has appreciated against the dollar. While it might have appreciated somewhat more, it is not the case that Chinese policy has been to reduce the value of yuan.  Other developing countries have done more.  Note also that these increases in the value of the yuan have not worked to reduce the US-China trade imbalance. So why would more work?

The answer is that it won’t work and it is because there are more fundamental factors at work causing the US to have a large trade deficit with China. Simply put, we in the USA make Miss Piggy look anorexic. We don’t save. We consume. The trade deficit is an expression of this imbalance. We buy from China and what we don’t buy from China we buy from other countries to meet our ever growing appetite for goods. If somehow we reduced our trade deficit with China, the spending would show up as a deficit with another country or countries. Of course China has a similar but opposite imbalance – they consume less and save more. This is perfect for us. We want to buy and they want to sell. Currency manipulation has very little to do with this. The problem is saving/spending and not currency values.  Altering fundamental attitudes and habits with respect to saving and spending is not something that can be done easily or quickly. Thus, our politicians would rather grasp at populist policies that do not work instead of doing the hard work of focusing on the real problems and solutions.

Finally is the recognition that it is counterproductive to focus our policy so strongly on currency manipulation and trade protection. Rome is burning and we throw gasoline on the fire. If this legislation were actually to be passed and signed by president Obama, we would not only be not addressing the real problems but we would be inflaming China and other countries. They know about our imbalances and they fully recognize protectionism when they see it. Other countries will not sit around and wait for us to focus on them next. Other countries are experiencing the continuing painful global slowdown and there is much populist demand for more protectionism in countries all over the world. 

Of course China has plenty of weapons beyond a simple trade war. How will we have served our own interests when China reacts by buying fewer US government bonds as the US government is trying to sell another $1.5 trillion of them? Or what happens if China aggressively sells the government bonds it already holds. W should not stir up trouble if there is nothing to gain. We should not stir up trouble if there is so much to lose! Instead, we should be the leader. We should be the leader for the right policies. We should not be the leader of a downward spiral of devastating protectionism.  If there are any real leaders in Congress we can only hope they will quickly step forward and put a quick end to this very harmful legislation.  

Class Warfare

Republicans huff and puff about Democrats’ assault on richer people. Democrats retort that they are not interested in class warfare – they just want to be fair. Finger pointing. Hateful words. My mother is bigger than your mother.

Is there a way to prove who is right or wrong about class warfare? I doubt it but we sure have fun slugging it out. As my Mom used to say, I don’t care who did it. You are both going to your room.

Instead of debating which came first the chicken or the egg let’s try another approach. Let’s just focus in on the question of taxing the rich more.  Taxing the rich is being discussed today as part of a program to reduce future debt and/or find a way to stimulate employment. Taxing the rich, according to some Democrats is a way to generate tax revenue so that future government deficits will be smaller. It seems fair to them since the rich, after all, are rich. Less of their income is devoted to buying goods and so there is less potential to harm spending in an already weak economy.  So the basic intuition of taxing the rich is that this is a way to reduce future deficits without overly slowing the recovery. In terms of fairness, it is believed that the rich have done well in the last 20 years and if anyone can take the load of higher taxes right now, it would/should be them.

Like any proposition, this one needs to be objectively evaluated. I don’t care if you are a Democrat or a Republican, you might not favor taxing the rich more if (1) it did not raise revenue, (2) it did not reduce future deficits, and/or (3) higher taxes for the rich had a negative implication for economic growth and employment

As is usual, I will not prove anything below, but I do hope to show that in 2011 there are many good reasons to believe that higher taxes on the rich will not be a good thing for the country. I’d rather take this approach than argue endlessly about whether or not this is class warfare. Let’s take one thing at a time.

First, what exactly do we mean when we say we are taxing the rich more? As I understand the current proposal it means reducing income tax deductions for persons having taxable income of $200,000+ and imposing a higher tax rate for people who earn a million dollars or more. So to begin with we could have a discussion about whether or not income tax returns of $200,000 imply that people are rich. While a Midwestern college professor living in small town who makes that amount might feel pretty wealthy I am told by people who live on the coasts of the USA that $200,000 per year does not indicate a lifestyle that involves high priced call girls and large shiny cars. And many entrepreneurs who file individual tax returns might quibble about whether such an income level would suggest even medium priced call girls or a Kia Soul.

This question of defining who is rich and who really has the capability to pay the tax and not reduce consumption has some relevance. This is not just a game of defining what rich means.  Is it possible that the current plan hits people who will make real spending cutbacks? Is it possible that entrepreneurs faced with such a tax will compensate by reducing wages or hours of employees? Thus, while it might be plausible to tax the rich for the purposes expressed above, it might be useful to do some serious homework about at what level you might be able to define rich and succeed. But even if this level can be found there is another issue that relates to how the rich will react when they are singled for punishment. Without significant changes in the overall tax code, is it not predictable that very rich people will feel singled out and work extra hard to find ways to exploit the existing code to reduce their tax liability?

Second, speaking of the rich and very rich, let’s talk about saving. Saving is boring. Except for a few exceptional people, most of us would rather have dinner with the in-laws than save. But consider the fact that saving greases the wheels of the economy. Thankfully in most countries there is plenty of saving going into the banks and other financial institutions each month so that entrepreneurs who want to invest have a source of funds. Consider, however the USA right now. The government is not saving. In fact the government is basically running down its saving to the tune of almost $1.5 trillion per year. That is, instead of that amount of money going to private borrowers it is being diverted to the government. The Fed has done its part to replace those savings but that is not a permanent solution. Every country needs for its businesses and households to save. And guess who does most or nearly all of the saving in the USA? That’s right – it is the richer people and the companies. If we aim a bigger tax bite at these richer folks and the small businesses who earn more than $200,000 per year, then this will mostly be seen by a reduction in US saving. Some might continue to save but they will use every loophole still available to park their money in places where they can get a decent after tax return. As a result we will see our preciously small savings going abroad and making our country even more financially dependent on China and other countries. You might call that a very significant unintended effect of taxing the rich more.

So the upshot is that while higher taxes on the rich looks like a nice way to improve the country’s debt problems, mostly what it will do is make them worse. As wealthier people save less or move their saving off shore, it just makes it harder for our banks and financial institutions to survive and make good loans for investments and houses. It also makes it harder for the country to grow. Remember that a country’s aggregate demand is composed of household spending AND spending by business firms for plant, equipment, office buildings, software, etc. Taxing the rich might seem to protect household consumption, but it does very little to similarly shield the rest of the spending. Higher taxes on the rich could very well mean more problems in banking and finance – and less spending and employment.

Let’s get back to the fairness issue. Measuring changes in fairness is to look at how the low, middle, and high income people have prospered over the last 10 years. It is absolutely true that of these groups, the wealthier ones have done the best. But does that mean that a policy to redirect money from the pockets of the wealthy to the pockets of others will improve things? I doubt it. Do we really think that the issues that plague the very poorest will be solved through another government poverty program? If you are concerned about wasting society’s money, do you really trust government to use these dollars to make a real dent in poverty? I doubt it. And the proof of this is the very fact that in the face of rising poverty we have not one single clearly espoused and forcefully lobbied analysis of poverty. Name one politician who is pushing a clear program to reduce poverty in the USA. You can’t because instead of one good program we have a mess of individual programs that are rife with inefficiency and corruption. That’s the way these politicians want it.  They make it look like they advocate for the poor every day and every way and the end result is all talk and no action. The rich are an easy target. But will taking from the richest really help the people who might benefit the most?  Give me a real poverty program to replace the current mess and I think the rich would be happy to vote for it and pay for it.

The same basic story relates to the middle class – a group that has suffered because of industrialization, globalization, reduced power of unions, bunions, and more. In the name of helping the middle class we have a myriad of conflicting and wasteful programs not to mention an almost constant outcry for business regulation and against any program that appears to assist business. We come back over and over and over to this silly notion that prosperous business comes out of the hide of the middle class. Some people honestly believe that for business succeed they must injure or take advantage of their workers.  It is so simple and wrong that most people forget the notion that it is a healthy business that hires more people. Imagine a time in the last 100 years when it wasn’t true that employment rose rapidly because businesses were thriving. How can one argue against creating a better climate for business flexibility, creativity, and competitiveness?

The present proposals to extract more income taxes from the rich won’t work and they won’t improve fairness. Class warfare or not, they simply miss the point. They won’t help the poor or the middleclass and will only be one more attempt to dupe the nation into supporting an inefficient government. If our policy makers really cared about the poor and the middle class then we should have seen a real program aimed at specific problems.

I have one last point. I took the high road here. But one has to wonder why it is that the President can believe that it is fair when half the country’s citizens don’t pay any income taxes. I suspect he would have a lot more luck in raising taxes from those who can afford to pay the extra taxes if he would just stop repeating his mantra about millionaires and billionaires and just get to the hard business of a comprehensive tax reform. It is silly to think that the country’s debt and other issues can be solved by taxing rich people more.  He could end up soaking the rich if he would just elucidate a program that examines the whole tax system and treats all people with dignity and respect. 

When the Lender of Last Resort Fails

Charlie only had one life jacket on his pontoon boat. Pete fell overboard and Charlie thought about throwing it to him but then realized that if he did, he would no longer have one for himself.  Being a true friend he threw it to him but unfortunately Pete went over the falls anyway – life jacket and all. Then Charlie noticed the leak in the boat.

I studied a lot of macro but I never got to the chapter that says what happens when the lender of last resort fails.  It is a widely shared view that the Fed has the right and the privilege to be the lender of last resort. So if the US economy is sinking and sinking badly, the Fed is supposed to use monetary policy to keep us all from drowning. We saw the lender of last resort activity in the last couple of years. Now the Fed has announced that it will be the lender of last resort for French and other European banks.

It all sounds pretty rational. Economic systems are prone to boom and bust cycles. We think we learned from the Great Depression and from other financial crises that monetary policy should play a stabilizing role. But one thing we didn’t learn is what happens when the central bank plays the role of lender of last resort and they fail. That is, Pete goes over the waterfall and there are no life jackets left. What now?

If there will be a lesson to be learned from the present global financial crisis it will be that central banks really did play their lender as last resort roles. Europeans often bemoan the fact that the European Central Bank did not bail out Greece and other countries fast enough or with enough gusto, but even the ECB has come forth with plenty of cash. Now the FED, ECB, and a few other central banks are printing money to help key European banks get enough dollars. There is enough money out there to sink a very large boat.

What is reassuring to some folks and frightening to others is that the lender of last resort role has no finite amount of ammunition. Unlike Charlie’s life jacket, the Fed has plenty of bullets. Why? Because modern central banks can print money whenever they want.  It is virtually costless to pump out another $100 billion. The problem is not so much the number of bullets – it is their impact. Maybe we should be using pharma as our example. Mike has a headache. Give him a couple of aspirins. Mike still has a headache. Give him a few more aspirins. The truth is that Mike has a headache because is wearing the wrong size undershorts. Aspirin isn’t going to help. Mike needs a bigger thong.

When the Fed was doling out all that dough last year did it ever wonder what would be left for them to do in a double dip? I don’t know what goes on behind those gold laden walls, but I didn’t hear much on this topic. And their seeming unflagging duty to pour in even more money recently suggests that the thought has not even entered their minds.  If one tranche wasn’t enough try two. If two wasn’t enough try three. It’s just math. It’s math at least until you realize that more and more aspirin in going to give Mike a bad stomach problem to complicate his undershorts issue. 

So there are two points to cover. First, why didn’t the earlier money expansions work? Second, why are they creating even worst problems as a result of the monetary addiction? The first part is easy. Monetary stimulus (and fiscal stimulus) do not address the most pressing problems. The causes of the Wall and Main Street problems were financial – too much leverage on top of two much leverage.  Very little has been done to solve those problems because politicians don’t have the guts to tell people there is no easy way out of that dilemma. So they prefer to drag us through a decade of horrible economic malaise instead. Don’t rip off the band-aid. Pull it off a little at a time. Only a politician would do this. Doctors don’t get paid for being popular. They rip off band-aids with fervor and sometimes glee. Our politicians use money as a drug to counter some of the negative side-effects of the slow band-aid pull.

So the answer to question 1 is simple – politicians give us money instead of real solutions. The second question is more interesting. Okay – so we slowly bleed for a while. Isn’t that better than the intense pain of a quick solution? I think the answer is no. Here are five why.

Reason #1. Weakening the economy for a long time makes it very sensitive to every economic virus that goes around. A strong patient bounces back from the flu quickly. The weak one may not survive. What economic shocks are around the corner? Clearly whether it is a jolt in energy prices or a spike in food prices after flooding, the economy will adjust more slowly and with less elasticity. This is very risky behavior!

Reason #2. Keynes was very specific in his book the General Theory that when credit markets lack confidence, the impact of monetary policy on output and employment all but disappears. There may still be a few people around who trust Bernanke, but as more and more money seems to work less and less, we are getting closer and closer to Keynes’ liquidity trap wherein money is totally useless to stimulate the economy.

Reason #3. The low interest rate environment just compounds our problems. So long as people cannot get decent returns on assets they will pressure financial institutions to innovate and create ways for them to take higher risk and get high returns. Banks would rather facilitate this madness than loan money to entrepreneurs. Isn’t it interesting that the Fed says they are saving us yet what they are really doing is engineering a repeat of the past financial crisis! Why does the Fed want to perpetuate leverage and risky investments? This could mean more downgrades and another financial crisis

Reason #4. All this focus on monetary policy diverts our attention away from reforms that would regulate the most egregious factors in the housing and financial markets. It is true that the positive effects of these kinds of policies will be slow in coming. But the longer you wait, the more the problems fester. The more the problem festers the more we raise the probability that a new shock will throw us for a loop.  

Reason# 5.The Fed has discounted an increase in inflation despite the fact that most indicators and expectations measures show it is bubbling below the surface. Despite all this economic sluggishness and large and persistent excess capacity, the psychological link between money and inflation remains as strong as ever. Inflation will not simply rise gradually. At some point it will explode. When it does it will be too late for the Fed to reverse engines. Bernanke stares at the cameras and solemnly says for us to trust him. The Fed is a very modern and scientific institution. When the economy recovers and inflation begins to be a larger threat, the Fed with utmost precision will remove money in the perfect amounts that will guarantee growth in output with stable inflation. Woowee. And if you believe that have I got a bridge to sell you!

In short, the Fed is entering uncharted waters. They seem to see no end and no risk to their policy of lender of last resort. They REALLY need to think about this some more. It is a very dangerous game they are playing with our jobs and welfare.  

Macroeconomic Policy and Fooling the Public

As policy leaders dispense with logic and grab at policy straws aimed at further demand stimulation, it is good to review the essential assumptions underlying the Keynesian model’s optimism about aggregate demand policy. The key assumption is something called Wage Illusion. A second one has gotten less notice but is something we might call Business Optimism illusion. I was going to call it Snake Oil but I had another JD and calmed down a bit.

While there are some who believe that economics and especially macroeconomic can be reduced to the terms hocus pocus (ie total nonsense) I cling to the notion that macro and macro policy have a basis in logic. When President Obama or one of his policy advisors recommends a stimulus package, the recommendation does not come out of the blue – it comes from a well spelled-out analytic framework. I keep resisting the urge to use this word – but I really should admit that our real world policy is based on THEORY. Whew, I went ahead and said theory. I feel a bunch better now.

One theory says that you might want to try stimulating demand as a way to exit a recession or improve the growth of the economy? Most of us learned something called Neo-Keynesian theory.  It turns out that Monetarists and Supply-Siders also pay homage to the Neo-Keynesian Model (NKM). While these groups of economists may disagree on policies and various technical aspects of the NKM, they tend to use the NKM to support their recommended policies. You might call the NKM an agreed common battleground. Monetarists and Neo-Keynesians do not usually agree about policy but they use the NKM to duke-it-out.

So let’s get back to stimulating the economy with a policy to increase spending or aggregate demand. It all sounds so reasonable. Give people tax cuts and they will spend. Give people bigger subsidies and they will spend. Have the government build roads and bridges and the people that build these roads and bridges will receive income from the government and they will spend. You have to admit, it sounds pretty straight forward and easy. Woowee!

I see that some of you are getting red in the face and are ready to inhale large quantities of funny cigarettes. So let me agree that the above oversimplified. Some of those people who receive the new incomes have big debts to pay and do not spend all of the money. And we know that at some point some tax payer will have to pay for the government handouts – and those who pay the extra taxes will spend less. So you can understand why some people might be doubtful that the government can create as much spending as I alluded (deluded?) to above. But that argument has already been made widely and loudly and I don’t want to get into that in my remaining three million pages below.

Let’s take a really big breath and just ASSUME that the government policy I described above does lead to more spending. So now we can imagine shops with more customers and companies enjoying higher sales and possibly higher profits. What does the NKM say happens next? First, business firms work down some of their inventories and given sanguine expectations about future sales they begin to hire more workers.  Workers are pleased as punch to take the job offers and are quite willing to accept the employment.  

According to the NKM, the firms have excellent foresight but the workers are a little dim. The workers are afflicted with a macro-disease called wage illusion. That is, they are willing to work at a very low wage simply because they are asked. It is sort of like the plain girl at the dance who agrees to have her feet tromped on by any hayseed who requests a quick belly rub (that means dance for you people with dirty minds). Firms are assumed by the NKM to fully appreciate the fact that a stronger economy will bring about higher prices and make the worker worth the bargain. The worker, however, is assumed to not anticipate or not care about the higher prices that will further erode their buying power.

Upshot – Wage illusion is the key and critical assumption of NKM that translates an increase in spending into an increase in employment. From there it is all (Four) roses and JD – once employment increases this facilitates even more spending and we are on the Staten Island Ferry bound for glory.

So what about this wage illusion thing? My guess is that if this psychological/informational disparity ever existed between workers and managers, it does not have a pot to piss in today. I use words like piss in a pot so that economists like Paul Krugman will understand what I am saying. And when I say today, I mean anytime after about 1969. After 1969, when inflation was beginning its notorious charge into the upper atmosphere, very few workers were not paying attention to the myriad ways that inflation eroded the buying power of their incomes. I recall when the coal miners went on strike at the end of the 1970s and were demanding a three-year wage hike of something like 39%. That doesn’t sound like dim workers to me. Today’s papers show Greek workers smashing pumpkins and otherwise displaying their displeasures with Greek austerity programs that would diminish their incomes.  Wage illusion simply has no relevance to today’s situation. Without wage elusion, you have more resistance of workers to job offers. It is not as easy as the NKM assumes to find and hire workers at wages that are favorable to firms, given the state of the economy.

And this brings me to the second part of the NKM illusions – the one about the firms having optimistic views about future prices and profits as a result of the government’s new program and the ensuing first round of spending.  Note that in the NKM once the spending starts flowing the firms soon decide they need more goods and to get the extra goods they need more workers.  So we might ask the following question. What makes the firms so sure that this new spending is going to be permanent? After all, the avowed stimulation policies of the government are meant to be temporary. By design they will be removed soon in the future. So maybe the NKM was assuming something we might call OPTIMISM ILLUSION when it automatically assumed that firms would place their stamp of approval on the fiscal stimulus and fall over each other trying to hire a bunch of workers.

So there we are. Our fellow macro policy activists assume: (1) labor wage illusion and (2) Business Optimism Illusion. What happens if neither of these illusion assumptions really hold today? What happens if workers acknowledge that prices will rise in the future? What happens if firms are somewhat skeptical that government has addressed underlying factors that caused the recession in the first place? I wrote a blog post in the past where I likened recent monetary and fiscal stimulus to pushing the blood back into the patient. We want the doctors to address what caused the blood to flow out – not push the blood back in.  What if business firms worry that the government has not adequately addressed housing, finance, too big to fail, excessive and corrupt leverage, excessive government regulation of business, and other factors that caused the recent recession?

Wouldn’t it be nice to use a version of the NKM that assumes that both workers and managers are rational enough to take care of themselves properly? Do we really want our policies based on assumptions about illusions and people who do not know how to take care of themselves? I doubt it.

So if you agree with me you understand that liberal macro activists are misleading our poor government leaders into doing things to the economy that will either have little effect or will make things much worse. Also, if you agree with me, you can quote me on this new concept called Business Optimism Illusion and support my nomination for the Nobel Prize (for excessive creativity)) or at least for the Guinness Book of Records. Or you could just send money. 

The Scorpion and the Turtle make Friends and Fiscal Balance

A scorpion asked a turtle to take him across the stream. The turtle said no because he knows scorpions are mean and will sting him. The scorpion explains he REALLY needs to get across the stream and that he is really a different kind of scorpion. He promises to be good. Mid-stream the scorpion stings the turtle. As they are both going under the turtle asks him why he stung him ensuring sure death for both of them. The scorpion replies – I am a scorpion. That is what scorpions do.

So is the scorpion/turtle a democrat or a republican? To me it doesn’t matter. They are playing a dangerous game. The question is why. It seems to me that politicians are more polarized than ever. It is a normal state of affairs to have difference of opinion and heated arguments. After all there are strong ideologies separating the parties here and everywhere. But both parties are using extreme tactics that get us nowhere. Republicans shout that liberals are ruining the country with too much government spending. Democrats respond that conservatives are destroying the country by hurting the poor and middleclass. These charges are typical. But the Democrats ran roughshod during Obama’s first two years and the Tea Party is playing dangerous games now. How does an objective person explain why things are so bad today? I don’t think one can blame it totally on one party or the other. What changed such that there is so much animosity and intransigence on both sides?

I don’t pretend to have the answers. But I do think that if we knew more about the causes of this political mess, then maybe we might have a hope of ending it. Finger pointing from both sides does little to create the healing and it appears to be making things worse. Thanks to conversation with some of my friends, I have come up with 5 trends that explain current political radicalism in the US and elsewhere. What do you think? Did I miss something?

First, it might be that problems are worse now. They may also be more complicated or different from past problems. As a result there is a real lack of consensus about what to do. Mike, there are little green men eating your Hosta leaves! Maybe I should use deer repellent? No, you better call in the B52s. Jerk! Butthead!

Second, we are now much closer to the day when the aging of the population finally has arrived – we can’t keep putting off financing solutions. So long as the baby boom generation was not yet 65, we could be nice to each other and talk about solutions. Well the baby boom is defined as starting with people born in 1946. Count it out – they are now 65 years old. Many started on Social Security as early as 62 and most of them are joining Medicare as soon as we hit 65. While the problems will surface only gradually the reality of not imposing a real plan hit home when S&P downgraded our debt. It is real and large and now we have to do something about looming debt. Politicians call these programs entitlements but many people see these programs more like a pension that was earned through a lifetime of work. It is NOT hard to see why such different views could inspire heated discussion.

Third, the social state has grown for 50+ years and Obama Care provided one more example of expansion. Perhaps that was the proverbial straw that energized support/attack of the whole social state. Many of us watch things grow and change and despite some displeasure we optimistically hope that things will work out okay. But then all of a sudden we reached a limit and years of concern turn into rage.  Ds are sick and tired of Rs moaning about the welfare state. Rs are fed up with increasing scope and size of government. Why the cork popped in the last few years I don’t know, but it ain’t champagne that is flowing.

Fourth, maybe we have too much TV/electronic news/entertainment. Is there a shred of news left? There is some notion that stuff happens every day and someone dispassionately decides what is important enough to inform and attract viewers – who then run out and buy large quantities of vacuum cleaners, soap, and heavily discounted car insurance. In the good old days when Walter Cronkite gave the news we had great confidence that it was unbiased. We also thought the earth was flat. Anyway, there used to be a time in a news program when the OPINION light went on and we all knew that was not news. It was an opinion. Well, despite Fox’s claim to be fair and balanced, there ain’t no opinion light and we are all pretty sure that news is chosen to fit the conservative agenda. Of course, all the other outlets are the same serving carious other agendas.

Finally, there is the idea that the public either doesn’t care or are simply easier to fool. None of the four above suggested causes makes any sense if you have an informed, educated, and energized public. For example, thoughtful voters know when the press is biased and can find ways to get better information. Or just because macro problems are more severe or more complicated, it doesn’t follow that an intelligent public can be duped into accepting untried and risky political policies. But if we have grown intellectually lazy then it is easy to see how and why our politicians have taken the low road. It is not effective to use logic about complicated economic and financial trends if the public just wants pretty, leggy newscasters and outrageous politicians who scream at each other in high definition, blue ray, 3D, 4G amazing colors.

So what do you think? What is behind all this nonsense? What makes today’s politicians take the low road? If I am right the best way to return to some normalcy is an energized and informed public. One way to get that result is a calamity. It seems wasteful to go through another financial collapse and a double-dip economy  to get citizens more focused. It would be much better if a leader stepped up who could deliver the right message. He or she would definitely occupy a grand place in our future history books.The President gets a chance to do that this week. Somehow I am not too optimistic. 

Micky and Goofy Duke it out at Disney World

Let’s suppose you are at Disney World with your kids and you see Goofy and Mickey outside the It’s a Small World ride in mortal combat against each other. Before you know it, all the other cartoon characters have taken sides and now you have a real gang war going – hair pulling, tail tweaking, and everything! This is NOT why you came to Disney World and this scene is not anything you want your kids to see. You feel pretty helpless because it might take some time to notify the park management to stop the fracas.

That helplessness is what many of us feel about Washington right now. Elections are off into the future and meanwhile we have to watch selfish politicians demolish our country. It ain’t pretty!

It doesn’t take a genius to recognize dysfunctional government and its deleterious effects. Even the President underscored this point. But he is not above the fray. His bus tour was more about reelection than healing or else he wouldn’t have said millionaire/billionaire about a zillion times a day.  “Mommy – Charles hit me first.” Charles retorts,” No Mommy, Pete hit me first.” Who cares who hit first? The truth is that both parties are out of control. They both need extended stays in time-out.

The Rs cling to a notion of no tax increases which at minimum is an undefined statement. Despite its lack of clear meaning it serves as a war cry that rallies the troops. The Ds attain the same pitch by screaming about rich people. Again, no one really wants to define a rich person but the message is pretty clear. This is enough to get the smoke rising and the tribes chanting. Thanks to 24 hour news/entertainment the politicians who most effectively promote this environment of misinformation and hatred get the rewards of air time and notoriety.

At the heart of all this is something of value – determining to what extent liberal and conservative ideology is promoted. We all know that legislative manifestation of ideology swings back and forth from left to right and this is probably a good thing. It is dizzying but it is doable. This bickering across parties about their ideological bases is both desirable and expected. But somehow this got out of whack. It is worse than usual and it appears that nothing will get done before the election to improve things. Like good Tar Heels (of North Carolina) both sides are stuck in place with little hope for change.

What burns my butt is that the discussion is so disingenuous and harmful. At the heart of the bickering is the extent of entitlement and how you pay for it. To portray entitlement recipients or millionaires as somehow less than human is wrong and damaging. Worse yet – to act as if taking money from the rich and channeling it to entitlements will somehow improve the plight of the disadvantaged is extremely naïve and harmful.  Can the rich pay more? Sure. But in the way things are now being handled you cannot blame the rich for reacting negatively. There is more than one way to catch bees…

I am reminded of the issue of handicapped parking. I was in a parking lot at a strip mall the other day and noticed this obviously handicapped woman limping in from a distant space. Then I noticed that even though there were a large number of handicap spaces, they were all taken. It seems that nowadays almost everyone has a handicapped hang tag – people with real but minor permanent handicaps get hang tags and people with temporary health issues often use their temporary tags much longer than necessary. No matter how fast they increase the number of special spaces – there are more people wanting them. Is that what the original law imagined? Did we really want to create a new and escalating entitlement called handicap? I don’t think so and I felt really sorry for the limping lady.

What am I saying? Basically that our entire entitlement edifice needs to be looked at again in terms of real needs. It is possible to be a D or an R and believe that we are NOT doing a very good job with respect to people in our society who need help. It is also possible to admit that we are helping people at a very high cost who may not really need the help. By the way, I would apply this very same argument to military spending. We REALLY need to look at the effectiveness of all dollars we spend as a nation.

But you know, it isn’t going to happen because Mickey and Goofy are shouting at each other. What happened to our country that we have rewarded those who would rather get air time than actually do the work they are paid to perform? Real entitlement reform and fair tax reform are possible but it won’t happen if our leaders reduce their public and private communication to such enlightening conversation as we have been hearing. Hey R you guys are mean and rich and you gotta pay more taxes. Hey D you guys are dumb and you ain’t gonna get my money. It’s my money and my mom said so.

My next blog post will get into how and why things have deteriorated so far and maybe what we can do about it. For the time being, instead of focusing all of their attention on finger-pointing it seems to me that the real leaders ought to be stressing how similar and interdependent we all are.  Boys and girls are different but they both are human beings and have more in common than differences. A policy to stamp out men sounds like fun at a girls night out but surely the next morning they would realize that they need us guys for a thing or two. The same goes for liberals and conservatives. Neither party wins by mortally wounding the other. Both parties and the country will gain when they begin to earnestly emphasize how we benefit from each other. Maybe Goofy and Mickey will find a way to lead us out of this mess.

Nixon Rides Again. Will panic rule policy again?

As the President and Congress take R&R after a grueling year of doing nothing, we might want to ponder what is going to come next in the way of policy. In the Financial Times letters to the editor section on August 22 there was a letter explaining that orthodox economics was no longer applicable – we need to try some novel approaches for our current economic problems. The President leaked that he has a great new plan that will be released with great fanfare at a future exciting prime time press conference.  As we all wait with bated breath, we might want to recall the 1970s. The 1970s are known for many things. While disco often comes to mind and I could write a whole blog about why I loved and still love disco, my macro background makes me recall the 1970s for macro reasons. For example, we had three recessions during the 1970s. The term stagflation was coined in the 1970s to describe a new form of economic disease that found inflation and unemployment rising at the same time. Perhaps as a result of the latter my most salient memory of the 1970s is how stupid macro policy was. And that brings us to today. I think we learned a lot about stupid policy in the 1970s and we are about to repeat those errors again. Why? Does history have to repeat itself? I wish it wasn’t so. But when people start to panic our friends in Washington feel obligated to follow suit. Unlike times when leaders like Roosevelt and Churchill met crisis with level heads and big cigars, our leaders run to Twitter and Tweet about how the other guy is a big poopy-head.

Nixon was a conservative guy. At least that’s what we thought. But then along came stagflation. Arthur Burns said to Richard one day – Richard, let’s go break into a building. No, just kidding. Burns said, Richard – if inflation is increasing you have to reduce spending. If unemployment is increasing you have to increase spending. Richard wasn’t dumb so he asked Burns what happens if inflation and unemployment were both rising. Burns put down his stogie, peered out the window and said, Richard I suggest you find another job. We don’t have any theory about what to do in that situation. Richard then discussed the matter with several hanging portraits and came up with a brilliant solution. He would out-do the Soviets. He would control every price and wage in the USA. It makes sense, right? If prices and wages are rising too fast, then just put a lid on them. He could ask Burns to juice up the money supply and increase spending while at the same time telling workers and firms he would cut off their heads if they raised prices.

Nixon imposed the Wage and Price Controls starting in August of 1971 and finally ended them in 1974 after almost destroying the US economy. Nixon didn’t count on several things – I guess that is what you call the law of unintended consequences. For one thing, businesses mostly found ways to get around the controls. As usual, the bright folks get by just fine. For example candy producers discovered if you made the candy bar smaller they could raise price per ounce even though the price of the bar remained the same. So we mostly ate smaller candy bars and drove in lower quality cars. The price index showed no change but we were definitely paying more for the things we wanted. Second, as OPEC was starting to flex its muscles, Nixon realized there was little his controls could do to stop the impending impacts on prices of oil and food prices. Yes food, the ugly cousin of energy, had also raised his pimply head as droughts and other calamities had cattlemen shooting their herds because they couldn’t afford to feed them. They did not shoot their teenage kids thankfully because there were laws against that. As a result the never successful W&P controls started making exceptions and were never the same again. Of course since Nixon was also the clever guy who ended the Gold Exchange Standard, he had to deal with the effects of a declining dollar on the cost of QE2 Transatlantic cruises and a variety of other things US citizens wanted to buy from abroad at rising prices.

Hindsight is fun isn’t it? The lesson in this case is that since policymakers were confused about the economy they started doing new and crazy things. The crazy things probably made the economy worse instead of better. It is no accident that both inflation and unemployment increased in the mid-70s and then again in the late 1970s. Nothing Nixon, Ford, or Carter did had much impact. At least nothing they did had much impact until they actually did the right thing. Carter gets some credit as does Paul Volcker, in that regard.

The right thing is just sticking with basic common sense. One had to be high on their drug of choice to not see in 1970 that the US economy was suffering from rapid growth in spending. You don’t need supply-side gurus to know, even in 1970, that the aftermath of too much government and private spending would be inflation followed by rising business costs. Recall the Vietnam War and the War on Poverty? Inflation was just about zero when the 1960s started but it predictably increased through the decade as it became clear that aggregate demand was lurching ever higher as buyers and sellers began to incorporate higher inflation expectations into their spending and wage behavior.

 It is too bad that we waited so long to do the right thing in the 1970s. It’s like deciding to lose weight only after you doubled your hulk. Things might have gone a little easier if you started to attack that mound of frivolous flesh after about a 10% gain. Anyway, it took until the end of the 1970s before Carter started to tighten the government budget and Paul Volcker raised interest rates to over 20%. That was no fun. But the diet eventually worked. Reagan then discovered supply-side economics after a hot weekend with the gorgeous Maggi Thatcher and that helped to address the problems with the cost side. Viola – tight money with some attention to supply side led to more stability in the next decade.

If we learn from history my guess is once again we won’t do the right thing. Our Washington folks will embrace some lame but popular excuse for a policy and we will live the next five years with all the unintended consequences. I am happy that the President and Congress are on furlough. If they would just stay there until November 2012 we might all be better for it. Doing nothing will look good compared to the novel and fun programs they are about to unfold. 

Macroeconomics: Fairy Tales can come true and so can Nightmares!

What is real and what is fantasy? I think most of us know the difference. The gym I go to has mirrors on most of the walls and despite trying not to actually look at any of them I do once in a while see my entire hulking mass. That is reality despite the fact that it is just a reflection off a glass. Then I close my eyes and imagine the future LSD with the tiny waistline and six pack abs.  Betwixt the fact and the fancy I am motivated to do one more set of sit-ups before adjourning to a sumptuous lunch. This introduction about reality and Fairy Tales brings us to Macroeconomics and GDP. It also brings us to today’s economic difficulties and why our traditional policies seem to make things worse.

GDP exists only in the minds of theoreticians and mathematicians. No one has even bit into a GDP and no one has ever paid a CPI. These are abstractions or fantasies – just like an image of me with a waistline– the fantasies do not in fact exist. But fantasies can matter. Fantasies can be very useful or very devastating. If images help me to be more healthy and youthful then they are valuable despite the fact that they are pure fantasies. If these same images cause me despair and depression, then they are not so helpful. Either way, they are impactful.

GDP is defined as a nation’s output – it is a number that we get by adding up everything that was reported as produced within the borders of a nation. While it is a real concept it has no physical counterpart that we can associate with it. Just imagine all that stuff that got produced last month in a big pile in the street in front of your house. Our imaginations run wild as we think of this one thing that is the result of somehow melting down or bolting together every good and service that got produced that month.

Okay? So a GDP is a concept or a fantasy and is nothing you can really sink your teeth into. The nation’s price level is the same. So is the nation’s interest rate, unemployment rate, exchange rate, and so on. In fact, it is worth pointing out that a nation is also a concept and not so much a real thing. Wikipedia says “… a nation may refer to a community of people who share a common territory and government; and who often share a common language, race, ...”  Try to bite into that!

It is important to do two things with respect to these macro fairytales – first admit that they are not real and second understand to what extent they can be useful (or not). Dr. Seuss books are about fantasy characters that never existed – but they sure did a nice job of helping me put my kids to sleep. The headless horseman of the Legend of Sleepy Hallow, in contrast, wasn’t always the best thing to read right before bedtime! What I try to do in this posting is to argue that today’s situation macro policy is a little more like Sleepy Hollow than Dr. Seuss. Despite what a host of so-called macro experts are saying today, we would be better off ignoring macro and focusing instead on the “little pictures.”

So as a card-carrying macroeconomist let me be the first to admit that GDP, CPI and other things I teach about are figments of our imagination. None of us buys all the goods and services that get produced and few of us directly experience the calculated cost of living. When the unemployment rate is 9% only a small fraction of us experience the actual state of unemployment. And while we might live in Indiana many of us might share more personal characteristics with people from Poland or Canada than the yokel who lives down the street and let’s his dog bark all day (and sometimes all night).

While Macro was A TOPIC OF CONVERSATION BEFORE Sir John Hicks invented the IS/LM Model, that innovation can be given a lot of credit/blame for the propagation of Macro’s usage. For example, Keynes’ widely read and quoted General theory of Employment Interest and Money was instrumental in popularizing macro by focusing attention on national macroeconomic policy. But it took Sir John Hicks’ representation to create an academic or classroom revolution. Before Hicks, Macroeconomics was mostly story-telling among a small group of intellectuals. Today we have Hicksian models taught to millions of university students each year. Each of them learns a model – sometimes offered in mathematical equations but more frequently portrayed with graphs. The star players of these models are labeled Y and r. In expanded versions of the Hicksian IS-LM models are also found N and P. The focus of these models is what determines a nation’s output (Y), interest rate (r), employment (N), and price level (P). Economists and journalists have used these models and similar variants to analyze and debate the roles played by monetary and fiscal policy in generating superior paths for these variables.

Without getting into macro policy debates, let’s agree that whether you attribute this all to Keynes, Hicks, or a host of other great minds, the truth is that they collectively defined and gave us a set of unreal concepts by which to measure the performance of a nation’s economy. They also gave us a set of debatable doctrines that helped us approach the questions of if and how we might improve the nation’s economy.

For example, if measured GDP was forecast to fall by 10% next quarter, we would all be very concerned. Some segment of our population would immediately ask the Fed to begin an expansionary monetary policy. Others would ask for income tax cuts. Still others would prefer a government spending program that enriched entitlements or spent more on shovel-ready projects. These approaches are designed to remedy problems that have broad impact and might be appropriate. But just like you don’t take a bubble bath to wash your hands after a trip to the restroom – macro policies are not always the most appropriate remedies when problems do not stem from macro sources.

If the only tool you have is a shovel, then you are ready to use a shovel for any or all your problems. If you learned a lot of macro, then you are quite ready to approach economic problems as if they could all be remediated by monetary and fiscal policy. But that was never true and never will be. While our macro indicators like GDP are by definition impacted by almost anything, the truth is that the sources of many problems are not national in scope and are not macro issues for the USA:

                A real estate collapse in New York

                Banks failing in California

                Canada stops buying US exports

                The inflation rate hits 10% in China

                US consumers decide to take more Mediterranean cruises

The solution for the person with only a shovel is to buy a saw and a hammer – because some problems are better handled without a shovel. The solution for a country’s economic ills is to realize that not all economic problems are macro problems requiring macro solutions. Some problems are better handled directly.

Despite the fact that some of today’s political leaders cannot walk two feet without mentioning changes in the distribution of income or the plight of the poor, how many of them have fashioned a comprehensive policy aimed directly at the sources of poverty and income inequality? It seems easier to call for tax and spending policies that continually press the entire economy to grow faster. But this is an extremely inefficient way to help a minority of the population catch up to the rest and totally ignores those factors that perennially keep them behind.

Y, r, N, and P are all valuable macro indicators and have their place in policy. But just like a flat tire does not necessitate a full overhaul of the car, changes in these macro variables do not always indicate a need for a national macroeconomic policy. Perhaps if we understood this we would make fewer mistakes and take better care of the peoples’ money.  Could we have averted the last recession if we had paid attention to our knitting? Did real estate need some attention before the bubble burst? Was excessive financial leverage not something that could have been addressed? Could we have worked harder at free trade agreements? Could we have paid more attention to imbalances in global commodities markets and adjust our energy production/uses with specific policies?

Macro is a fantasy but a useful one. But like many useful things it can be used wrongly or poorly. Today we suffer from macro-mania as we struggle with the aftermath of a deep financially-induced recession. Abnormal psychology makes the point that it is the extreme or special cases that help us better understand normality. We are learning from our special situation today that macro tools do not work as well as we thought they would. Maybe it is time to realize that not every problem needs a shovel and not every economic problem is macro. We have a lot of tools we just need to use them. 

TC is PC for Monetary Policy

I learned a new word today – TC. TC is not really a word but it is already being bandied about in the news – Time Commitment.  I have to admit that in all my years of teaching macro and money I never once used that term. Apparently TC implies a promise by the Fed to keep interest rates low for two years. It is kind of like me promising to not eat giant ribeye steaks for two years… it sounds like a sane thing to do but it probably ain’t gonna happen.

That is not to say I am not relieved that the market headed upward yesterday. I appreciate that. But like many things in this world, I am not completely convinced that the relief investors felt yesterday is going to last. I know – you hate it when economists spread gloom and doom – but let’s face it – TC really means two things. First, it means that the Fed did almost nothing yesterday. Second, it means that the Fed raised – not lowered – the riskiness of our economic environment.  I started writing this BEFORE the market opened today but I just looked and it appears that the DJ is down almost 400 points!

Promising to keep interest rates low for two years seems to have reassured frantic investors for a moment but what have they really done with this promise? They did nothing insofar as policy goes to reduce interest rates further. They did nothing to change the amount of reserves in the banking system. They did nothing to generate a new loan or make banks more willing to make loans. They did make a promise – one that cannot and will not be kept. What we most care about for economic activity is longer-term rates and the Fed has no magical or direct influence on these rates. They are set in markets. When the economy slows down or when inflations expectations decrease – interest rates decrease. When the economy speeds up or if inflation signals higher future prices interest rates often rise.

In short TC might be PC (since it appears to have assuaged investors for a day) but it didn’t do one positive thing. But it does promise to come back with a royal boot to the national buttocks. Did you hear anyone saying last week that the reason all hell was coming unglued was because interest rates were too high. I don’t recall because I was being run over by debt ceilings and government debts and Chinese inflation and several other things. But nowhere in that economic haze was anyone crying about high interest rates.

So what gives? Some analysts are pointing out that the economy is very weak. They believe that the Fed’s actions will somehow strengthen the economy and therefore have a continuing positive effect on the stock market. But if trillions of additional reserves supplied by the Fed during the last two years didn’t work, then why would a silly commitment to keep interest rates low for the next two years have any impact on anything?

The most tragic thing about what they did yesterday is that they scared the hell out of us by underscoring two points. First, they admitted that the government has no more tools to use to stimulate the economy – even in the short-run. Second, policymakers at the Fed are so alarmed at the current weak economy that they have to drum up a silly policy that everyone knows has nothing to do with our current ills.

We all know why the market fell and we all know that it has nothing to do with interest rates that are too high. If our problems today have anything to do with monetary policy, they probably stem from too much outstanding money and the risk of higher inflation. Some economists have clearly pointed out that inflation is one of the few ways to “solve” our debt overhang. Rating agencies have also been very clear that such a policy will only lead to future downgrades. So if anything, a policy that ends up with even more monetary policy stimulation increases the risk of more trouble down the road.

Finally, the problems in the market are probably more dominated by non-monetary factors. By admitting that all we have left are monetary tools – we once again take our eye off the ball. If this monetary action takes the heat off Washington and stalls or prevents them from IMMEDIATELY solving our deficit/debt/regulation issues – then the public will once again be duped by our snake oil sales staff in DC. The market seems to be recognizing this fact this morning. But today’s market performance is not the final judge – what matters is the future course of the economy.

I read and heard experts saying that the Fed just HAD to act! They had to show that they are very concerned about the economy. I am afraid that the combination of the government’s inability to act and the Fed’s over-willingness to save the day underscores just what is wrong with our country. This has got to be the height of national irresponsibility. 

Marshall Dillon – Doing the Wrong thing for the Right Reason

Some of us older folks grew up watching a television show named Gunsmoke. Marshall Dillon was always the good guy. Inevitably there were always at least two bad guys getting into an argument in Miss Kitty’s bar, the Longhorn Saloon. She and the Marshall seemed to have a thing for each other. Anyway when the dusty bad guys would drink a little too much firewater at the Long Branch Saloon they inevitably got into highly intellectual discussions and heated debates. On many shows the first cowboy accused the second of having an ugly horse. Can you imagine such a provocation! This led to both cowboys going into the street, drawing their six guns, with the result that one of them ended up being dragged away by Chester, Mr. Dillon’s sidekick. This was where we Boomers first learned about doing the wrong thing for the right reason. No good man could let the reputation of his horse be soiled. So the right thing was to protect the reputation of your steed. But please, killing someone to protect your horse seems a little extreme. I don’t know if this kind of thing really happened out West in those days, but if it did, it seems pretty hard to defend on the surface of it.

Don’t get me wrong. I am not against extreme actions and even killing has its place. Getting Hitler and/or Bin Laden are examples of doing the right things for the right reasons. But I am against wrong things even if they are for the right reasons.

So let’s get to it. Many democrats often say they stick up for the poor and the middle class.  That’s almost a way to identify or define democrats. They never let a good party or a drink go by without mentioning all the good things they want to do for the poor. I think it is a good thing that democrats play this role. It is the right thing for the right reason.

Republicans often stick up for entrepreneurs and investors – big or small. They worry about the free enterprise system and they defend the Constitution. You won’t be in a golf foursome of republicans and not hear how they defended the capitalist system. I think this a good thing that republicans play that role.

So let’s begin this little story by admitting that our government representatives have good goals. I doubt that you would ever hear many democrats say that he or she wanted to ruin the capitalist system. And I don’t think republicans want to hurt or punish the poor. Both sides have admirable goals.

While there are often political and economic tradeoffs as the democrats and republicans duke it out for their chosen constituencies year after year, the result of all this politicking is an economy that generally grows and provides jobs and is one in which some groups get more entitlements than others and some people pay higher taxes than the rest. These results kind of ebb and flow: During one time period the pendulum may swing toward more benefits for the poor and middle class and typically that phase will be followed by a time when the opposite occurs.

The trouble comes when we have years like this year in which these politicians simply do the wrong thing even though they are, as usual, doing these things for the right reasons.  Take the republicans first. In trying to protect the economy they want to see major cuts in government spending. They believe that taxes should not be part of the solution for a large debt because they believe future government will figure out ways to spend all that tax revenue and more and soon we will be back with debt growing. I see nothing wrong with that position. But in a time when republicans are a minority of the government they cannot enforce their will. The usual thing when you are a minority is to forge a compromise where you try to get most of what you want. Trying to do more than that can be very harmful. In addition, while the long-run health of the economy requires a significant cut in spending, doing so too much too soon could jeopardize the speed and strength of the current economic recovery. They were doing the wrong thing when they held the debt ceiling hostage.

You Rs are now wanting Marshall Dillon to shoot me down on Main Street. So let me now turn to the D’s. In trying to protect old people, college students, poor people, union people, and people who do not own their own jets, they are doing the right thing. Those people have seen their incomes and wealth fall both in absolute and relative terms. These people are struggling and it is good that the Ds point this out and represent their interests. 

But even some of the wackiest Ds have to appreciate that the poor, the elderly, students, and others regular folks would do a bunch better if the entrepreneurs and investors were a lot more optimistic about the future. Aiming their ammo at higher taxes for the latter does little to help the people they really want to help. And a lack of sincere and specific attention to limiting government spending does not help solve longer-term issues. Sticking their heels into the mud on entitlements and holding tightly to higher taxes on the rich seems the wrong approach. While the Ds hold the majority of the government now, their own tenacious approach just hardens the rigidity of the Rs. The Rs cannot win but they can surely make sure that we all lose.

Why is it so hard for all of these government representatives to see what history shows us? The rich and the poor are not mortal enemies. If anything they are co-conspirators and jointly derive benefits when the right things are done for the right reasons. It is true that in any given time period, they do not share equally in the benefits, but I am guessing that they do better when they work together than when they treat each other like the cowboys did in Dodge City. When the economy is doing well most of this stuff happens:

                

                Employment and incomes rise across all income classes

                

                Poverty in both absolute and relative terms declines

                

               Government spending on entitlements automatically decrease as fewer people are unemployed and people move out of poverty

               

                Government revenues increase as people and companies earn more incomes and pay more taxes

None of these things are happening now and won’t be happening in the near future so long as both parties do the wrong things for the right reasons. A deal has been made and so far the economic consequences suggest that doing the wrong things for the right reasons is not fooling anyone. As we move to the next stages of debt and deficit resolution we can only hope that all sides come to understand that a divide and conquer approach will do nothing but impoverish us all.