Europe in Crisis?

Have been away for almost a week. A Memorial Service for a dear friend, organized in a 100 year old vacation house at a lake in upper New York state. Here's the view from the deck at sunset:

My friend died three hours after his twin grandchildren were born. He knew they had arrived - six weeks early. A miracle. So the service combined spreading some of Grampa's ashes in the lake and doing a baptism-like ceremony with the twins (boy and girl), using lake water to touch the sign of the cross on each of their foreheads. Very sweet. Lovely. Special and sacred time.

I have been thinking and reading a lot about Europe. The Financial Times has great articles on what's going on. Look for the "live coverage" link.

So what's going to happen? Is Europe in crisis, or not? The experts mostly say yes. The market says maybe. Stocks were up Monday and Tuesday; down today. Late Sunday, rumors of a deal surfaced: 50% Greek bond write down, recapitalization of the banks, and a large EFSF (European Financial Stability Facility) war chest to do this, plus support the debt of shaky sovereigns. Two trillion Euro, with the EFSF gearing up thru the ECB (European Central Bank). Most all European officials denied this was happening. It took until Wednesday, it seems, for the market to decide this very desirable deal probably wouldn't happen.

Why not? The ECB, originator of the Euro, has essentially the same powers as the Fed in the US to create money and issue debt. The Fed created about $16 trillion of new money in the post-crisis 2008-2010 period, much of it in the form of loans through TALF (Term Asset-Backed Securities Loan Facility). This is what Secretary Geithner is urging the Europeans to do. It was highly successful here. It should work in Europe. But will the ECB do it, and probably put this crisis to rest? I am really not sure. If I had to place an up or down bet tonight, I would bet No. What's up?

First, the Germans in particular look at what's happening as a "debt crisis", brought on by undisciplined, noncompetitive countries in South Europe (the GIIPS - Greece, Ireland, Italy, Portugal and Spain). Wolfgang Schauble, German Finance Minister, says "You cannot solve a problem using the same approach (debt) that was the cause of the trouble in the first place." Fiscal consolidation, in other words, austerity, is the key to solving the problem. Bleed the patient, until he is healed - this seems to be the argument. Many experts say this won't work. I agree.

Second, the ECB's charter apparently prohibits "monetary financing", or printing/creating new money to support sovereign states in the Eurozone. The German High Court has just ruled that Germany can take part in the EFSF, but any new contingent liabilities must be precleared by a committee of the Bundestag. European leaders are much less willing to throw liquidity at the problem than the Fed. They feel there are legal restrictions against such a move. And many of the key leaders feel that only austerity combines economic and moral correctness.

The Germans (Austrians, Dutch, Finnish, etc.) are wrong. If this attitude prevails, as well it might, the Eurozone will begin to unwind. They may bandaid their way through the Greek crisis (the current 21% bond haircut on Greek debt is nowhere near enough); but even if they do, markets will stay unsettled because there will be no Lender of Last Resort, like the Fed, who will stand up and say: "We will provide whatever liquidity is needed. Period." Without that, this is and will be a crisis. It will blow up by a market attack on either a weak sovereign (Italy, Spain) or one or more weak banks. And if it blows, it will quickly cross the Atlantic, flatten one or more banks, and put us into a second recession.

My odds: 51% of a blowup; 49% for an intelligent resolution, with Germany saying "Sue me" to opponents, and Merkel taking the lead in setting up a Euro facility big enough to quench this uncertainty, as Geithner/Bernanke did in 2008/9.

Pray for good sense AND a large dollop of compassion.

Austerity Doesn't Work

A short post tonight. I have been playing with my new find - the data sourcing and chart-making system at the St. Louis Fed; called FRED, for Federal Reserve Economic Data. There is a ton of economic and financial information, for the US and selected international countries. You can tailer your graphs for a certain time period; you can adjust the scales; and you can combine data sets. It's a blast!

I have been wondering how austerity is working in England and some of the GIIPS countries. I have read in a variety of blogs that the evidence is not good at all for the "austerians" ( a play on the Hayek/von Mises-inspired Austrian school that leads the charge for cutting government and deficits); but I wanted to see for myself.

The following four charts show Real GDP and Unemployment trends, 2000 - Q1orQ2,2011, for England, Portugal, Ireland and Greece. Unfortunately FRED does not have much 2011 current GDP info on the GIIPS. Take a look at the charts and assume that the GDP line is moving down in 2011:

GDP was flat to down in most recent months in the UK. Unemployment continued up.  In the New York Times on June 22, 2010, shortly after Cameron and the Conservatives swept into office, the fierce austerity proposals were called "an historic gamble". From my vantage point, it does not look like it's working out that well.

And here are Greece, Ireland and Portugal:

In all cases, assume that the GDP line (left scale; blue on top for Greece; red in the lower two for Ireland and Portugal) moves down in the uncharted months of 2011.

Why does anyone think austerity works? Dollars/euros are dollars/euros. Those that come via government spending do not poison the economy. And when you remove these government dollars, bad things happen. If your economy is overheated, and there is too much demand pushing against the country's productive capacity, then there is a reason for retrenchment, for pulling dollars out of the economic flows, through cutting deficits or raising taxes - but not when unemployment is high and the economy is flat on its back. The "austerian" arguments are absurd.

And remember: Europe is one year ahead of us. We can look at what has happened as a result of their choosing different forms of harsh austerity. None of it is good at all. Why in the world do we want to copy their path? 

The answer is that we don't. The path is a guaranteed loser. Here's hoping we all wake up in time to make a difference.

What's Up With Europe?

Treasury Secretary Geithner just returned from a whirlwind trip to Europe, where he visited with European Finance Ministers and gave them his considered opinion on what to do in the current debt crisis: lots of liquidity, he said; do something like our TALF program (Term Asset-Backed Lending Facility) which began in early 2009 and ended in 2010; let banks and sovereigns supply assets, then load them with liquidity provided by the European Central Bank (ECB). Apparently, his words were not well received, at least not by the very solvent, inflation hawk, Northern Europeans (Austria, Germany, Netherlands, Finland).

Geithner was telling the Europeans to do exactly what he and Bernanke did in 2009-2010. In a huge and essentially invisible lending program, the Fed put out about $16 trillion in short-term lending to pretty much any bank, here and abroad, that asked for money. This was only made public when Bloomberg took the Fed to court over a Freedom of Information Act request for what they loaned out during this period. If they had needed Congress' approval, it never would have been given. Take a look at the following chart, where I show M1 money supply (currency, bank reserves, demand deposits) and what happened to our core inflation rate (CPI less food and energy prices):

There was an enormous increase in money supply during and after the crisis, and another surge now, driven in part by QE2 (Quantitative Easing, Phase 2). You will notice that this money supply surge has had no effect on inflation, which ought to give inflation hawks pause, but doesn't.

Why was Geithner poorly received? The inflation hawks of Northern Europe are fiercely opposed to providing unconditional liquidity to weak sovereigns and weak banks; neither the sovereigns (Greece etc.) nor their banks deserve it, and such a process would lead to serious inflation and a debasing of the Euro. And the solvent sovereigns will eventually have to pick up the pieces.

Let's look at a telling example of the growing market distress, reflecting differing levels of "discomfort" with different sovereigns. The chart shows the trends in the cost of credit protection (ensuring against default) for the Eurozone countries:

Greece, Ireland and Portugal top the chart, followed (not much behind) by Italy and Spain (PIIGS - Portugal, Italy, Ireland, Greece, Spain; although some are now reversing that and writing GIIPS). The market expects Greece to default, and most probably Ireland and Portugal as well.

One of the problems is the amount of sovereign debt they need to roll over in the next year (taken from Europe on the Brink, a briefing report by the Petersen Institute):

So what has changed? Presumably all this debt didn't arise overnight. Somehow the European sovereigns have been able to roll over their debt in prior years. Why is this seen to be such a problem now? And herein lies the rub. When Greece (and then Ireland) had to formally ask for fiscal relief in a formal manner, the system began paying attention in a very different way; the "decision-making troika", the ECB, the EU, and the IMF did what the IMF has been doing for many years: demand serious austerity measures and cuts to government spending before providing assistance.

The Eurozone's monetary system worked on quite relaxed and seemingly safe rules, practices, and underlying assumptions: there will never be a sovereign default (the ECB with its own fiat currency - the Euro - would see to that); banks under Basel III were allowed, in fact, encouraged to stock up on sovereign bonds on their balance sheets, and were not required to hold any risk capital against this asset class; the ECB accepted sovereign paper as collateral and loaned at low rates with only modest haircuts (only recently did they make some adjustments for the credit-rating of the sovereign issuing the paper). A sovereign, running short, could tell their banks to buy their paper; the banks would do so, and take the paper to the ECB, and get the cash to pay for the bonds to their sovereigns.

But when Greece ran very short and made a formal request for a bailout, everything began to change. What had been invisible subsidies of weaker sovereigns through monetary transactions, suddenly became visible in the request for bailouts. Here's a remarkable chart that shows the extent to which Germany(and other Northern European countries) has been funding the GIIPS:

These are "cross-border" payments that would be paid off annually in sovereign countries not part of a currency zone, but in Europe are allowed to accumulate. Normally invisible. But when the discussion becomes political, fully visible now, and sure to incite nationalist sentiments. "Why should we pay for the profligate Greeks, Irish, Portuguese, etc," say the Northern Europeans. And so it begins.

Which brings us to today. The ECB could make this all go away by declaring that there will be no sovereign or bank defaults, that the ECB stands ready to provide whatever liquidity is necessary, and that they will provide whatever funding the weaker sovereigns need to get them through the crisis. 

Would this calm the markets? The inflation hawks will strenuously disagree, but many economists would say yes. This is, in effect, what Secretary Geithner was counseling. Will the ECB do this? After all, deficit/inflation hawk Trichet is leaving his post as head of the ECB, and Mario Draghi from a Southern Country - Italy - is soon taking the helm. Might he reverse Trichet's course? It's possible, but I seriously doubt it. The deficit and inflation hawks have, this far, carried the day. They fear a huge outburst of inflation and a debasement of the Euro if the ECB were to provide all this liquidity. Germany fears that they will have to pick up the tab of the eventual sovereign defaults, through their large share in the capital base of the ECB.

So what will happen? The Petersen Institute lists three possibilities: first, individual European sovereigns get really tough in their austerity programs and convince the markets that budgets will balance; second, there is a hard rejection of the current "moral hazard"/unconditional liquidity guarantee by the ECB, leading to sovereign and bank debt restructuring on an organized, structured basis; and third,  a "muddling along" strategy that satisfies no one and leads to disorganized sovereign and bank defaults.

I think it's too late for number one. Number two would require political consensus that I don't see yet. So number three - muddling along until something blows up, is where I come out.

How soon? One week. Six months. And most likely, somewhere in the middle.

What will happen here? Gretchen Morgensen had a great piece in the New York Times this morning where she says that "What is Over There Will Be/Is Already Over Here." One of the key unknowns is which banks in the US have written the over $60 billion of credit insurance (CDS, or Credit Default Swaps) on European sovereigns and banks, and will they be able to deliver. She also points out that though US Money Market Funds have pulled back from Europe, they still have huge exposure to European banks.

A crisis in Europe will be a crisis here. Geithner and Bernanke will provide liquidity like lightning. But I still think it will take down one or more US banks.

Some Questions and Observations

From time to time, I need to step back, try to move a bit out of the fray, and seek a broader perspective. It helps to make observation notes and/or pose questions. So I'll engage in this exercise with you:

1. Do we really think these income trends can continue in the US without a serious tearing of the social fabric?

2. We are told that unleashing business investment is the key to renewed growth. Eliminating regulations, providing more certainty for forward planning, and most of all, tax relief is what is needed. But it turns out business is loaded down with money:

Does anyone out there really believe business needs anything more than a lot more demand and orders?

3. Is there even a remote reason why we think the consumer is going to start spending? After decades of dis-saving, essentially funding the housing boom and then the bust, the consumer wants to, needs to, and is in fact saving again. He/she will not be the growth engine for the economy, unless something radical happens (rewriting of their balance sheet by major mortgage debt forgiveness):

4. How can anyone say the US is overtaxed? Taxes as a percent of GDP are at their lowest level since the 1950s'. And what about the claim that half the US doesn't pay taxes? Look at the employment taxes (Medicare, Social Security and Unemployment). This is a major piece of the US tax burden and mostly born by middle class workers. Everyone in the US who works pays a serious chunk of change in taxes.

5. Corporate earnings have been stunning. More or less steady volumes/revenues with many fewer workers. Wall Street has been thrilled. Does anyone think this trend can hold up? Take a look at this chart from John Hussman:

This tells us that with earnings having hit an historic high as a share of GDP, the next five years will almost definitely be lousy.

6. And how do you feel about our rush to austerity? If Republicans have their way, transfer payments to workers will be cut off as soon as possible. Take a look at this chart and ask yourself what that will do to our already stressed consumer:

The above data points and questions don't even include the tsunami brooding over Europe.

And a final question: do Republicans truly believe what they are saying, that the country needs lower taxes, less regulation, big budget cuts and an unwinding of the social safety net? Do they really believe if all of this happened that we would have a stronger economy? Or is this just seen as the best way to beat Obama?

What troubles me the most is I think both are true: they believe their own rhetoric AND they think it's the path to beat the President.

The Gathering Storm

After posting Saturday's blog, found two more very knowledgeable market sources with timely information about the coming economic storms: John Mauldin and John Hussman of Hussman Funds. I want to show a few of the charts I found in their reports:

First, from John Mauldin's most recent Frontline report:

Next, from John Hussman:

Hot (frightened) European money seeking safe haven at the US Fed for next to no return. A high probability of a second (double-dip) recession in the US. Wage income as a percent of GDP falling strongly. Unsustainable transfer payments supporting (for now) consumer demand. Add this to the fact that 45% of US Households are either underwater or within 5% of being underwater. The US consumer is completely out of gas, and will retrench for a long time to come. Consumers: we're broke, so no extra spending. Business: no orders and no new demand, so no new investment. Conservative economists who think business investment is held back by tax, regulation and other government-sourced uncertainty concerns, are just plain wrong. If consumers were spending, business would start coming to the table with new investment. Without that new consumer spending, they will remain on the sidelines.

And all of this is happening at a time when Europe is literally on the edge of an economic precipice. We are looking at a textbook case of debt deflation: debt fears have pushed a number of countries into fierce austerity programs - cutting public budgets to try to eliminate deficits and thus reduce the debt burden. But cutting government spending reduces demand, which reduces GDP, and then drops tax revenues more than what the budget was cut. Then the country must borrow more to keep current on debt payments, which raises debt service costs, which increases deficits, and the negative, self-reinforcing circle continues.

In a "normal" economic situation, the debtor would go into "bankruptcy", or some form of debt restructuring (for a sovereign). But for countries like Greece, Ireland and Portugal in the European Union, this is not an option unless the other members of the EU agree. And in this case, this means Angela Merkel and Germany. I am not perfectly sure of this, but I think Merkel and Germany could stop this potential train wreck, not by imposing more and more onerous conditions on Greece, but by agreeing to a full restructuring of the Greek debt. This would entail  40-60% haircuts taken by all the banks (which would then have to be recapitalized, probably taken over by their sovereigns).

Possible. But it might just be a bridge too far. And if Greece goes, the European banking system will unravel in unpredictable ways. The contagion will find our shores soon thereafter. Our Fed is very good at liquidity rescues, but markets for financials will be hammered, and with no appetite for TARP II, we could be looking at restructuring one or more banks.

Anniversaries and Other Comparisons

Tomorrow is the 10th anniversary of 9/11. I am praying mostly that America, and all her families and people will pass a safe day. My daughter flies from Tampa to Baltimore tomorrow afternoon. I pray for her safety as well. The best thing about today versus September, 2011? We are no longer so afraid. And we have given up the less useful part of our innocence.

Right now, I want to look at another comparison: September, 2008, just before the financial world collapsed and now, September, 2011. The New York Times Business section did a story, comparing stock performance of top financial companies, in New York and Europe, in 2008, running up to the Lehman collapse on September 12, and the performance of the same financials thus far in 2011. Here are the two charts:

Striking, isn't it? Is there a Lehman moment ahead? I'm afraid to say, it's possible. This time the shock will come from Europe and spread to the US. A sovereign default (Greece). A breakdown in interbank funding. A run on one or more of the larger country banks (Spain, Italy, possibly France). A less than lightning response from the ECB (whose senior finance director, Jurgen Stark, a German, quit on Friday in apparent protest over the ECB's buying Spanish and Italian bonds to support liquidity in those countries). And Europe will begin to melt down. 

US banks would be next. Bank of America, closely followed by Citi, are our weakest banks, as the market (see above) tells us. Would they survive? Possibly, and possibly not. The Fed would act with lightning speed, again. But market based equity would have been driven down, and this time, the Government will not put it back in. No TARP II. One, or both banks, would be put into the new Resolution Authority, and we would have a chance to see if Dodd-Frank gives us a workable mechanism to shut down a Too Big To Fail bank. The chances? Who knows. I say they are one in three, but that is "spurious accuracy", as one of my B School profs used to say. I just know they are not zero.

What would happen then? A double dip recession. More unemployment. Would Washington be able to respond? I am really not sure. It might take the 2012 elections, contested clearly on the parties' very different views on the role of government in supporting and, yes, stimulating the economy, to decide the issue. I think Obama, and a progressive  view of the role of government, would carry the day. But I am not the slightest bit sure.

Rocky times ahead, I fear. Very possibly nowhere near as dire as portrayed above. But I feel it is prudent to prepare for possibly stormy seas.

I have asked my daughter to text or call me as soon as she touches down in Baltimore tomorrow afternoon.

Was Anybody Listening?

I think most of the commentators missed a key point in last night's speech. The President intends to tie his American Jobs Act into the Super Committee's deliberations. He told us that the entire bill ($450 billion price tag, a number he did not mention in his speech) will be added on to the $1.5 trillion deficit reduction target, giving $1.95 trillion. He told Republicans (again) that they need to allow taxes on the wealthy and a closing of corporate and other loopholes, not as class warfare, but as simple fairness and sharing of the load. He told Democrats that they must be ready to make changes in Medicare and Medicaid, or risk losing the programs, given the aging of the US population and the rapid growth in healthcare costs. He said he will submit his plan to Congress a week from Monday, September 19. I think this Grand Plan will be a $2 trillion (possibly greater) deficit reduction plan, including all of the following:

                    * selected budget cuts over 10 years
                    * specific changes to Medicare/Medicaid
                    * ending Bush tax cuts for the wealthy
                    * corporate and personal tax reform with revenue targets
                    * a new spending plan - The American Jobs Act

The six Super Committee Democrats will propose this. If just one Republican agrees, this goes to both Houses of Congress for an up or down vote before Christmas. The House might vote it down. Republicans might stonewall in the Super Committee. In either case they are voting against a strong jobs package - consensus estimates have the AJA growing the economy up to 2%, reducing unemployment up to 1%, and creating up to 1.5 million jobs. And they would be doing this why exactly? To deny Obama a big win and to prevent tax cuts from going up on just 2% of the population.

If one Republican goes along on the Super Committee, and the House supports the bill on an up or down vote, this will be an enormous win for the President: the grand budget deal he couldn't quite get this summer; a decoupling of the Bush tax cuts for the wealthy from those cuts for the middle class; and his entire American Jobs Act.


Republicans will howl that the President should not be allowed to put his Jobs Act into the Super Committee's deliberations; that he shouldn't put in new spending when the process was set up to find ways to reduce the deficit. The President/the Democrats will respond that he is adding in additional spending cuts equal to the new spending; that they are tied together; that you don't get the one without the other; and that agreements are made between people and can be adjusted by the same people. And who knows: there might not be any prohibition against this in the original agreement.

In any case, the Republicans will have to shoot down a clean shot at helping the economy, creating jobs, and supporting the middle class in a way that is fully funded. At the same time they would be shooting down a first ever offer by a Democratic President to trim Medicare/Medicaid benefits. And again folks will ask: and why exactly are they opposing all these good things? And I can't think of a good answer. In the last three years of solid opposition, Republicans have been fighting the fierce fight against Obamacare, Cap and Trade, creeping socialism, government takeover of the economy, or that has been their story, and it has found some resonance with the American public. Now they're opposing jobs for Americans and an enormous budget deal, and doing so for no good reason.


I haven't heard or seen one analyst say that the President could get his entire plan approved. I am saying he is planning to put this through the Super Committee, and he will either get all of it (huge win), or none of it (completely defining the choice facing the electorate in 2012).

Many smart analysts have always said that Obama's game is a long one. Andrew Sullivan at the Daily Beast,  Steve Benen at the Washington Monthly, P. M. Carpenter, and Andrew Sprung come to mind. I believe the President endured the "slings and arrows of outrageous fortune" this summer, to either get a Grand Bargain then, or to get to precisely where he is now. I am reminded of MacArthur before the Inchon landing in Korea, when, in a stroke, everything on the immediate map changed, overnight.


I think that is what we are witnessing. Awesome.

Why do We Want Austerity Exactly?

Here is Wolfgang Schauble, German Finance Minister, in an op-ed in the Financial Times on September 5 (my highlights) titled "Why Austerity is Only Cure for Eurozone".


"Whatever role the markets may have played in catalysing the sovereign debt crisis in the eurozone, it is an undisputable fact that excessive state spending has led to unsustainable levels of debt and deficits that now threaten our economic welfare. Piling on more debt now will stunt rather than stimulate growth in the long run. Governments in and beyond the eurozone need not just to commit to fiscal consolidation and improved competitiveness – they need to start delivering on these now. The recipe is as simple as it is hard to implement in practice: western democracies and other countries faced with high levels of debt and deficits need to cut expenditures, increase revenues and remove the structural hindrances in their economies, however politically painful. Some progress has already been achieved in this respect, but more needs to be done. Only this course of action can lead to sustainable growth as opposed to short-term volatile bursts or long-term economic decline. There is some concern that fiscal consolidation, a smaller public sector and more flexible labour markets could undermine demand in these countries in the short term. I am not convinced that this is a foregone conclusion, but even if it were, there is a trade-off between short-term pain and long-term gain. An increase in consumer and investor confidence and a shortening of unemployment lines will in the medium term cancel out any short-term dip in consumption. These efforts will inevitably bear fruit, but it will not come overnight. This time, we will have to take the longer view. For too long we have forsaken long-term gains for short-term gratification with the result we all know."


There it is, perfectly clear, not the slightest bit tricky or evasive, and not the slightest hint of uncertainty: the voice of neoclassical economic orthodoxy. And this guy matters. He's the power alongside Angela Merkel in Germany. He speaks for her in discussions with the ECB (European Central Bank) and its current leader, fellow conservative Jean-Claude Trichet. Many millions of Europeans will feel the affects of Schauble's austerity. Many millions.

And he's wrong. Just like Boehner and Republicans are wrong in the US. Austerity is not the cure; it is an extension of the problem.

This is why our choice of economists to admire matters a great deal. Conservative US economists would applaud Schauble's words. Keynesian and MMTers are horrified. How can pulling demand out of an economy help to cure it? If this formula is accurate:

                                        GDP = C + I + G + (X - M)

Then how can reducing G increase GDP? The conservative answer: reducing Government spending increases confidence, unleashing spending by both consumers hand business. Or as Schauble argues:

"An increase in consumer and investor confidence and a shortening of unemployment lines will in the medium term cancel out any short-term dip in consumption."


This is what Hoover tried, with no luck. This is also what FDR was finally convinced by conservatives to do in 1937, which put the US back into recession. Why are we trying this again? Have we learned nothing? Apparently not, for when we tossed Keynes out the window in the 1970s', to be replaced by Milton Friedman, Eugene Fama and George Lucas, we gave up any substantive access to fiscal policy.

To present a more detailed refutation of Schaubel, I turn to Martin Wolf, one of the economic wisemen of journalism, writing for many years for the Financial Times. I would describe him as a Keynesian, with close ties to MMT (Modern Monetary Theory). In his FT column today, he takes a look at Sectoral Balances in both the US and the UK:

Here is Wolf's analysis:


"The massive fiscal deficits of today, particularly in countries where huge financial crises occurred, are not the result of deliberate Keynesian stimulus: even in the US, the ill-targeted and inadequate stimulus amounted to less than 6 per cent of gross domestic product or, at most, a fifth of the actual deficits over three years. The latter were largely the result of the crisis: governments let fiscal deficits rise, as the private sector savagely retrenched.To have prevented this would have caused a catastrophe. As Richard Koo of Nomura Research has argued, fiscal deficits help the private sector deleverage."


In other words, the massive deficits, starting in 2008 in both the US and the UK happened as a result of retrenchment by the private sector, both Households and Business. Beginning in 2008 (a bit earlier in the UK) both Business and Household spending lines move up on the graph, which means moving from being a source of spending (values below the 0 line/x axis) to being a use of spending (values above the x axis). In the case of Business in the UK, in 2008 this demand category was already in a Use position; it just moved up as a greater User of funds/demand. In other words, both businesses and consumers aggressively retrenched, causing the deficit blowout. If the Private Sector wants to retrench, the Public Sector MUST be in deficit, as long as the external balance is negative (above the line for both the US and UK - more imports than exports, USING funds, not acting as a Source of funds).


Schauble is wrong in his very first declaration, that it is "indisputable" that excessive public spending has caused the problem. And because he has the problem wrongly identified, it's no surprise he gets the solution wrong - i.e., his call for austerity. You cannot force consumers to spend, or businesses to invest when they want to retrench. The Government Sector must listen to the Private Sector and support its desire to repair their balance sheets with deficit spending.

Or as Martin Wolf says in the title of his piece - "We Must Listen to What the Bond Market Tells Us." Yields are moving quickly towards Japanese levels (in the US and the UK, each of which has their own currency, where European countries do not). The markets are telling us that the problem is an economic slump, not inflation and certainly not default.

Schauble has it wrong for the Eurozone. Boehner, Republicans and the majority of US economists also have it wrong.

As Wolf says, we should listen to the markets, and urge our Government to borrow at low rates and invest in the country's future. In a future post, will tackle the question of building up debt levels and what this means for the future.

Does Anyone Understand Macroeconomics - Part 2

So why does it matter if we have two, apparently competing schools of economic thinking? Let me try putting down a list of questions. Try answering them one by one before reading ahead. Here they are:

          1. Are deficits bad?
          2. Are deficits inflationary?
          3. Will deficits cause interest rates to rise?
          4. Does Government need taxes to fund spending?
          5. Does Government need to issue debt to fund deficits?
          6. When/if Government "prints money" (called "monetizing the debt"), is this inflationary?
          7. Does Government spending cause GDP to grow?
          8. Is Government spending different from Consumer or Business spending?
          9. Can the US go broke?
          10. Would the US be in serious trouble if China dumped its $2 trillion in US Government bonds?


Six months ago, I would have answered Yes to all the above questions. Conservative economists would answer yes to all of these questions, except number 7, where they would argue that Government spending causes an equal reduction in Private spending, so there is no or minimal effect on GDP.

Here are my answers now:

          1. Only when the economy is operating at capacity.
          2. Same answer as #1.
          3. If the economy is not at or near capacity, no. In fact, there will be downward pressure on rates, depending on whether the Fed is paying an interest rate on excess reserves.
          4. No
          5. No
          6. No, unless it translates into increased spending when the economy is at capacity.
          7. Yes
          8. No
          9. No
          10. No


I do not expect you to take my word for it. I want you to seriously consider the possibility that I might be right, and to begin to investigate for yourselves. You will find there is an opinion spectrum. The MMT views (mine) will be on one end of the continuum; conservative economists will be on the other end; and Keynesians will be in the middle, with perhaps a slight leaning towards the MMT end.

Paul Krugman, a dedicated Keynesian, engages in argument with MMTers from time to time. His primary disagreement areas would be questions 6, 9, and 10. He thinks the US can go broke, if not through default, then through hyperinflation. And he puts much more emphasis on inflationary monetary impacts, except in times (like now) when the economy is in a "liquidity trap", which is derived from Keynes and means that interest rates have become ineffective; cash and short term debt is interchangeable; and there is an apparently endless demand for more Government paper. In "normal times", however, "printing money" will move us into headlong inflation. If not stopped, this can tun into hyperinflation, like Weimar Germany. MMTers are scornful of this position.

Now try this thought experiment: consider the implications that MMTers might be right. Some of you will simply not be able to do this, because it will go deeply against the grain of how you have learned to perceive and understand the world. But as a thought experiment, what would it mean if the MMT view were correct? I will suggest just a few possibilities:

     1. As a nation, we would be less afraid.
     2. We would understand that there is no "debt crisis".
     3. We would understand that deficits are normal, in fact, necessary. If the private sector wants to save (like now) and the trade sector is in deficit (which it almost always is in the US), then the Government must be in deficit.
     4. We would know that when the economy has huge excess capacity (high unemployment, low plant utilization), deficits are not inflationary. When the economy tightens, they are.
     5. We would know that high unemployment is not necessary, that there is much we can and must do to put people back to work.
     6. We would know that China does not own us, that if they dumped our bonds (which they have little incentive to do), the Fed would buy them up and interest rates would not skyrocket.
     7. We would know that our debt does not need to overwhelm us, and that if real interest rates stay below the rate of GDP growth, our debt to GDP rates will stabilize at very manageable levels.
     8. We would know that the unfunded entitlement scare is just that, a scare. With reasonable, even modest tweaks, Social Security will be self-funding again. Healthcare costs, which have grown faster than GDP, are a problem. But we don't need to give up on it and turn Medicare/Medicaid into a premium support program.
     9. America was strong, is strong, and will remain strong into the future. It's not that there is no work to do. It's just that the work and the horizons are much less constrained than we have been thinking.


Imagine that you are a Republican strategist. What I have just written would be terrible news. Almost your entire agenda would be rendered meaningless. You could still push for lower taxes, which the MMTers would applaud. But deficit/debt cutting would be mostly out. There would be very apparent reasons to support and improve Government, so they can institute and implement positive, employment-building policies. And worst of all, for some on the Right, the attack on entitlements would have no more rationale. We would have come to know that the US can set broad, inclusive and just policy goals, and that they have the resources to accomplish them. We need not be a country of fear. We can seriously become a nation of hope.

More soon. For those interested in learning more, Professor Bill Mitchell's blog is a good place to start. Every Friday afternoon, he has a five or six question quiz, and on Saturday he puts out incredibly detailed answers. In four months of trying, I have gotten one 5, a couple of fours, but mostly 3s' and below. A great teaching vehicle.

Also try New Economic Perspectives. Started by a group in the Economics Department at the University of Missouri - Kansas City, but has expanded to gather many of the MMTers writing today.
      

Does Anyone Understand How Macroeconomics Works?

There is an important point that is mostly missed by analysts trying to understand the divide between Democrats and Republicans or between progressives and conservatives. The different sides have different economic textbooks, based on fundamentally different assumptions about how the economy works - and specifically, how macroeconomics works.

When people look at the physical world, there are still many "laws of physics, nature, etc." that all sides in the political debate accept. Gravity causes things to fall, moving toward the source of that gravity, which in our case, is the mass of the earth. The distance (D) we travel can be determined by multiplying our speed (R) times the time (T) that we travel (D = R x T). We could compile a very long list of these generally shared, mostly scientific assumptions, precepts and rules.

There are some areas of divergence: where no consensus has been achieved, or where a rival scientific hypothesis has been developed - evolution and climate change come to mind. But in these two cases, if you poll the scientific community, you would find practical consensus: over 90% of the scientific community would agree with Darwin (versus Intelligent Design) and global warming as humanly caused (versus global cooling, or no proof of human causation of warming).

In economics, there is no professional consensus. Back in the 1930s', Keynes attacked the classical consensus that said government spending could not effect demand, and therefore would not help in a recession. Through the 1940s', 1950s', and 1960s', it looked like Keynes had carried the day: there was a consensus that government had a responsibility to support demand and thus maintain employment, when the country moved into recession. Government should spend aggressively in the downturn, then pull back and move towards balance. But then came the 1970s', and stagflation (which Keynesian theory seemed unable to explain), and the consensus fell apart.

Milton Friedman brought us monetarism which argued that fiscal policy was mostly ineffective. Remember that this was the decade of high inflation, that was only brought to heel with Volcker's tough Fed leadership and high Fed interest rates, beginning in 1979. Friedman's central dictum that "inflation is always and everywhere a monetary phenomenon" has made a deep and lasting impact on our economic consciousness, even though Keynesians would say Friedman was only partly correct.

But what developed with and after Friedman was "the Chicago School", led by Robert Lucas and Eugene Fama. This School argued for rational expectations, efficient markets, and general equilibrium theory. Macroeconomics as developed by Keynes was completely discarded, and replaced with new Macro theories that came out of generalizing from single firm or individual  microeconomic maximizing algorithms, that were ramped up to a general economy level. Government could never help (government spending would be offset by a reduction in private spending); it could only hurt(regulations would always interfere with the efficient market). Markets always cleared; the price set in the market was always the right price; there never was and never could be any such thing as an asset bubble. Markets tend toward equilibrium; and they can be very effectively modeled. Risk, like other market dynamics, can be quite predictably modeled, and therefore mitigated. Deficits were always inflationary. And a pattern of continuing and escalating deficits will lead to hyperinflation, currency revulsion, and sovereign default.

The Chicago School was renamed Freshwater Economics (to account for a number of Economic Departments at midwestern universities that supported the Chicago arguments) and was seen to be in competition with Saltwater Economics (where economists at coastal universities still argued the Keynesian case). In my impression, the Freshwater folks are far ahead of the Saltwater Keynesians: they have most of Wall Street, all of the Republican Party, and seemed to have converted our President. Obama came into the Presidency a Keynesian; but his calls for austerity and deficit reduction and his "story" that the government is just like an individual household - all of this moves him, at least for a time, into the Freshwater camp.

Why does this matter? If you believe that it is an economic truth that government spending cannot help in a recession, you will fight tooth and nail to prevent stimulus spending. If you believe deficits are always inflationary, deficits like those we are experiencing will terrify you. And if you believe too many deficits and too much mounting debt will eventually lead to the death through default of the United States, you will be in a state of panic. And this, of course, is just what Republicans are counting on.

As folks who read this blog surely know, I am with the Seawater folks. And more specifically, I am a recent convert to MMT (Modern Monetary Theory), which stands unequivocally on the side of government spending to support demand; the manageability of inflation; and the inability for a sovereign nation like the US with its own currency to go broke. But in this age of political polarization, it is important to remember that our opponents do often speak from what they feel are solid scientific and economic foundations.

Tomorrow, will work through a short list of questions, where the different economic schools take very different positions.

 

What Should We Do - Part 2

Zero job growth. Up a tiny bit in the private sector. Down the same amount in public jobs. Net: zero new jobs.

Europe is on the edge. Most analysts are undecided: they're not sure if the situation there is bad or really bad.

Stocks are down, but the market seems undecided as to whether it will move back up or drop further down. Bonds are surging, setting records for low long term yields. Last week, financials were hammered, BOA most of all, but the damage was widespread. The FHFA, the conservator for Fannie and Freddie, broke with Treasury and filed 17 separate suits against individual banks and investment banks, claiming (for the first time) fraud, and seeking significant restitution. Some forecast that the drag from financials will be too much for the market to shrug off, so we are headed south

Some very few bright spots: auto sales are strong, and the Big Three are profitable and have added workers. Business profits continue strong, but this has been based on productivity, not revenue growth. Companies are getting the same output with many fewer workers, raising margins sharply and giving strong bottom lines. But this cannot continue forever. At some point, you need to build revenue.

 The housing market is still soft. The pace of foreclosures has slowed dramatically from last year; and many analysts agree the "paperwork problem" is a major cause of the slowdown. Banks simply did not convey the mortgage papers to the securitization trusts, beginning in 2003, which would not have been a problem if they didn't need to foreclose. No one ever would have known. But foreclosures need paperwork, and surprisingly, judges, when they wake up, want to see proper paperwork. Since the papers weren't there, the banks began robosigning. When they were caught a year ago, they stopped for a short while. Now, in a major report from AP, they are at it again. When you don't have the papers, and you need to foreclose, you have to create them. Servicers are trying to claim that they are simply "implementing" the original transfer intent, even when they sign as officers of now defunct mortgage companies.

It's a mess, a HUGE mess, that is finally in the process of being uncovered. Treasury fought this uncovering tooth and nail. They correctly understood how this would derail the housing market. But with last week's events, it looks like they have failed. The truth is coming out. And this may well sink one or more banks. An early indication: US Bank, filed a $1.7 billion suit against BOA, putting ALL the mortgages in a trust they were trustee for back to BOA, saying they were all tainted in some way. This compares to the much cozier deal between BOA, Bank of New York Mellon, and some big bondholders (which is now under full scale attack for being way too easy on BOA), where BOA is only dinged for 2% of the nominal total of $440 billion in MBS bonds.

We cannot have a healthy economy with a sick housing market and our banks potentially about to be rendered insolvent, through exploding legal liabilities.

What's to be done? First, a few numbers. From Calculated Risk:

So 3.7 million homes have been foreclosed or sold by short sale by the end of 2010, with 4.3 million more loans in foreclosure or seriously delinquent. A separate estimate of home mortgages underwater in March of this year from Core Logic as reported in The Huffington Post has a total of 11.1 million home mortgage underwater, or 23.1% of US homeowners with a mortgage. Probably half of the 4.3 million loans in the table above are included in this 11.1 million figure, so will estimate that 13.3 million mortgages are underwater or in foreclosure, about 28% of total homeowners with a  mortgage. Nouriel Roubini has estimated that an additional 8 million home mortgages are "close to underwater", i.e., within 5% of market. If this is a fair number, then 21.3 million home mortgages are underwater (or close to underwater), or almost 45% of homes with mortgages.

Now let's look at the rest of the household financial picture: have households cut down on other, non-mortgage obligations? are they saving more than before the crash? The answer to both questions is yes, according to the von Mises Institute:

The red line is a measure of consumer saving as a per cent of income, measured on the right scale. And the blue line measures non-mortgage obligations, as a per cent of income, measured on the left scale. This is clear and present evidence of why this recession is so tough to solve: this is not a business cycle recession; it is a balance sheet recession, with the balance sheet that got way out of whack belonging to the individual homeowner.

The consumer clearly wants to deleverage. As long as he/she is doing this - and the process will take years - GDP growth will be diminished. Remember:

                              GDP = C+ I + G + (X - M)

And the main driver (70%) is the individual consumer buying, i.e., C. As long as individuals feel the need to save and pay down debt at a higher than normal level, US GDP will struggle.

Is there anything to do to help Main Street, and in the process clear out the logjam in the housing market? And in looking for a policy solution, can we avoid the "moral hazard" problem of helping bad actors and doing nothing for folks who responsibly kept on making all mortgage payments?

I think so. In very broad outline, here is the idea: The Federal Government will buy up mortgages at fair market value and rent houses back at market rates, converting the homeowner's mortgage payment into rent. If the homeowner performs well in making rent payments over three years, he/she has an option to buy at fair market value with 5% personal cash, a 15% second mortgage, and an 80% first mortgage guaranteed by the government (FHA, Fannie, Freddie). This is modeled after the highly successful 100 year plus Danish mortgage program.

FDR's HOLC (Home Owners' Loan Corporation) bought and restructured one million loans for homes that had been foreclosed - with great success. Believe we should shoot for a 5 million home target, possibly more, which would be a huge movement of housing product off the active market and a gigantic deleveraging for consumers. The moral hazard problem would be addressed because homeowners who have stayed current could apply, as well as those facing foreclosure; and the homeowner is giving something up - ownership in the house.

Banks will not like this because they would have to write down their firsts and, most likely, write off their seconds. It might make sense to start with Fannie and Freddy, who already own a bunch of mortgages; but as FHFA Director Demarco's pushback against Treasury is now showing, this guy takes his conservator duties seriously, and will not just do anything Secretary Geithner wants. But there are ways, and, frankly, a banking crisis would make a plan like this easier to do.

How much would this cost? 5 million homes, assume a mortgage of $75,000: total investment - $375 billion.However, this is investment, not expense; and if the market pricing is right, the government should not lose money. The idea would be to package these homes and sell them off to Public/Private Partnerships (PPIP revisited) who would manage the pools of properties, instead of having this fall to the government.

This does not kill the American dream of homeownership - it defers it for a few years, and then it is resupported on a fiscally sound basis. "Dead beat borrowers" are not getting a free ride: they have to give up their ownership rights in the house; they have to pay market rent; and presumably they should be asked to keep up the home.

Is this doable politically? Right now, probably not. If there is a second banking crisis, probably yes. More soon.