Hoisted From My Own Comment Elsewhere: The Tyranny of the Middle-Man

I posted this comment over at Russ's place:

Fundamentally, I think you're arguing that liberty begins and ends with autonomy, which is inherently a local thing.  No market can be a "free market" if it depends on the coordination of far-flung resources by a middle-man, as the middle-man will of necessity become the top-dog.  All financialization ultimately boils down to creating a middle-man, an intermediary between market participants and what they seek to acquire.  Whether the commodity in question is money or food, the middle-man can create gluts and shortages at will, and does so to further his own self-interest.

An important point that economist Steve Keen has made about mainstream economics is that it models our economy as if there was no money, as if we were merely bartering.  He makes this point most forcefully here, but you should consider a more undertaking a more complete treatment of the topic in his book, Debunking Economics, most of which you can find in a much more complete but less cogent form here. 

In the movie (but not the book) The Wizard of Oz, Dorothy was admonished to ignore the man behind the curtain.  In modern economics, we're all implored to ignore the man between us and what we want.

And, sadly, we comply.

FYI -- I likely will have a burst of activity over the next week as I will be on vacation with my family.  Be warned, though, I'm trying to find a way to work blogging into my daily life while not distracting from the many other things I want to accomplish.  This inherently means that I'm going to be throwing a lot of seemingly half-formed things out there for consumption.  Trust me, though, I don't throw out half-formed ideas, only half-formed expressions of them.  Challenge me.  Question me.  I'll respond. 

Comments have been acting up lately (Russ, Mr. Falberg and I have all had problems), so feel free to contact me directly at taojonesing@gmail.com

The Automatic Earth Gets It

In a post entitled "Bill Gross, Master of Monetary Psy-Ops," the Automatic Earth lays it out for all to see:

The systemic fear generated from crumbling markets worldwide will first serve to attract scared capital into the Treasury market, as it still remains the only place to go for people with sums of money that won't fit under any mattress. Besides, the only real difference between the U.S. dollar and short-term Treasury bills or notes is that the latter could potentially give you a fixed income over their duration. The fear will then serve to further justify Treasury asset purchase operations by the Fed, the ongoing sociopolitical destruction in the Middle East be damned. So how does Pimco and Bill Gross fit into all of these deceptive monetary tactics? Well, the fact that TRF currently holds a record 38% of its assets in dollar-denominated cash is a telling one. [5].

Every investor knows that the best and quickest way to make money is to own something that virtually no one else does, right before it gets hot and takes off towards the moon and the stars. An unexpected end to QE operations will send the dollar soaring, and as mentioned before, all asset markets plunging except for the U.S. Treasury market. Bill Gross may have dumped all of his Treasury exposure for now, but has any other major financial institution or money manager followed his suit? Has the Fed announced any plans to sell its Treasury holdings back into the primary or secondary markets?

Of course not. These institutions are not worried about rates surging outside of their control anytime soon, and will be glad to make a few extra bucks from higher interest payments (paid by taxpayers) before the "rush to safety" really gets underway. I suspect that, by that time, there would have been a significant reversal in the Treasury holdings of TRF and the superficial justifications for the investment decisions of the omniscient Bill Gross. Perhaps he will continue to have minimal exposure to U.S. Treasuries throughout the year, as a partial hedge to his fund's enormous cash holdings, but that certainly should not be taken as an absolute bet against the Treasury market.

We're nowhere near the endgame.  There is no checkmate in sight.  This is managed deflation, with the Fed and its minions acting out a play to manipulate the emotions that the "investing" public believes to be market signals.  The rules of investing were written by the financial elites to fleece everyone else. 

And the fleecing won't stop until everybody stops playing the game.

Financialism's Flattening of the Economic Hierarchy and What It Means to Macro

As discussed here, my thesis is that the well-understood and widely accepted hiearchy of economic theory (i.e., finance is built on macro which is built on micro) is, in fact an illusion, that finance is normative and drives economic decision-making of firms at the microeconomic level, which is contrary to microeconomics' theory of the firm.  Because the validity of mathematical models of finance depend on the vailidity of mathematical models of macroeconomics which, in turn, depend on the validity of mathematical models of microeconomics, the entire hierarchy of economic theory fails, and the only thing that truly matters is finance.

What I did not discuss in yesterday's post, although I did allude to it here, is that finance is normative at the macroeconomic level, as well.  This is the clear implication of Bill Clinton's famous quote:

You mean to tell me that the success of my program and my re-election hinges on the Federal Reserve and a bunch of fucking bond traders?

Just as corporate executives are rewarded for the ability to maintain the illusion of perpetual exponential growth in their share price at a rate that exceeds inflation, so, too, are the officials of national governments rewarded for their ability to maintain the value of sovereign bonds.
The fact is that money and inflation do not exist in microeconomics, which models a barter system.  The concepts of money and inflation are instead part of macroeconomic theory, which is the level at which monetary policy and fiscal policy operate.  In the U.S., the private Federal Reserve manages monetary policy, while fiscal policy is managed by the federal government. 

While the metrics for measuring governmental success in the secondary bond markets are nominally different, the challenges of a financialized government are the same as those faced by financialized firms.  When, as now, top line growth (measured by GDP for governments, revenues for corporations) appears to be slowing or falling, the only way to show continued, perpetual exponential growth at the bottom line (measured by bond yields for governments, earning for corporations) is to increase margins.  That's the only way to maintain the present value of financial instruments (stocks and bonds) that have already been purchased.  Through this lens, the calls for austerity in the United States are best viewed as calls to increase margins to ensure that Treasury bond holders don't take a haircut. 

But what about the Fed's dual mandate to maintain price stability and ensure maximum employment?  First, the so-called dual mandate needs to be read in its entirety to understand what it really says:

The Board of Governors of the Federal Reserve System and the Federal Open Market Committee shall maintain long run growth of the monetary and credit aggregates commensurate with the economy's long run potential to increase production, so as to promote effectively the goals of maximum employment, stable prices, and moderate long-term interest rates.

Second, it must be understood that the Fed abandoned targeting monetary and credit aggregates in the 1980s, after Paul Volker proved that targeting monetary and credit aggregates did not actually have any effect on employment or inflation.  Milton Friedman and other Chicago School monetarists were proven wrong, and the Fed went back to tweaking the federal funds rate.

At this point, the Fed merely works with federal officials to protect existing Treasury bond holders and keep future Treasury bond yields as low as possible.  If that means a bunch of American fall into poverty, so be it. 

But what about consumers?  Aren't they an important part of economic theory, as well?  Yes, they are, but economic theory is non-operative in a financialist economy.  All that matters to the managers of corporations and governments is maintaining the illusion of perpetual exponential growth.  That's why Obamacare screwed consumers by evergreening biologic patents (Pharma can't lose current profits and maintain the illusion of perpetual exponential growth), and that's why the "Food Tyranny" bill is rumbling its way through Congress right now, a gift to Monsanto and factory farms.

Early Thoughts About the Financial Crisis in 2009

I've come a long way in my thinking since this post from March 2009.  At the time, I was resisting the memes of all comers regarding the cause of the financial crisis (e.g., the neoliberal Austrian's "the Fed did it along with all the poor people" and the liberals' "the banks did it"), and I was still thinking like a corporate executive.  I'd say the biggest shift in my thinking is that I used to believe that the banks were effecting the policy of the U.S. government, but now I believe that the U.S. government was effecting the policy of the banks.  Another big change is that I no longer think that the regulation we have on the books is sufficient to control the behavior of banks, who have invented new mechanisms to achieve their fraud, mechanisms not addressed by current regulations.

I also no longer frequent websites like Hullabaloo or TPM because I think they identify too much with the Democratic Party (they're not as bad as Kos, though).
 

What's Next: Rethinking Economics and U.S. Economic Policy

UPDATED 3/9/09 - While attempting to track down the underlying GDP data, I discovered I had misread the chart in Dean Baker's book, which refers to percentage of corporate profits, not GDP. Because of the contribution of MEW to real GDP over the last eight years, I don't know that this difference will be fatal to my thesis, but I will track the data down and shake things out.

I'm a data junkie at heart. To paraphrase Neo, I need data, lots of data. Why? Because I prefer to figure things out for myself, and the more information I have, the better I can see what others don't.

In my two-month quest to educate myself about the economy, I have gotten my hands on and at least partially reviewed on the order of forty books, some as old and revered as Smith's Wealth of Nations and others that are freshly printed screeds about the current crisis and its origins (e.g., Dean Baker's Plunder and Blunder).

I've also become something of a econ blog junkie. I visit my favorites many times a day and follow their links to source material. Calculated Risk is one of my favorites because of the wealth of data and charts.

I take a daily look at liberal political blogs like Firedog Lake, Hullabaloo and Talking Points Memo, which tend to provide the raw data and not just the opinions they've arrived at. Because it tends to be much more ideological and inflexible, I only occassionally look at DailyKos, which had this screed today, entitled "America's Lost Decade":

http://www.dailykos.com/storyonly/2009/3/8/13649/98119/998/703785

The problem that I have with the rant is that it ignores the larger picture and focuses instead on laying blame on the bankers and Wall Street. That's not only not helpful, it could be harmful.

The Banks Didn't Bring Us Here On Their Own; They Were Effecting U.S. Policy.

If you take a look at the U.S. economic data that has been summarized in books such as Shiller's Irrational Exuberance, Baker's Plunder and Blunder, and Reich's Supercapitalism, you will be forced to conclude that the ascendancy of the Financial sector of our economy to its acme in 2006 could not have come about but for the economic policy of the U.S. government as introduced by Reagan and carried through to this day by Obama. This economic policy, advocated by the neoclassical economists like Milton Friedman, focused on "free markets" and "globalization." U.S. investors-- individuals and corporations alike-- were encouraged by tax incentives, accounting rules and sometimes by monetary incentives (i.e., cash) to invest their capital outside of the United States. [Note: although it was published in 2005, I find the data and analysis of Irrational Exuberance the most compelling.]

The result of this economic policy was the ascendancy of the Finance sector : in 1980, the Finance sector accounted for only 15% of corporate profits, in 2004 it was 30% of the corporate profits and remained about 25% of the GDP in 2007. (See, e.g., Figure 1.1 of Plunder and Blunder) . This makes a lot of sense. As U.S. capital was invested in manufacturing infrastructure overseas, we saw domestic production of goods drop, and we had to look to something else to be the engine of growth for the U.S. economy that our manufacturing industries once served as. And that something had to grow fast enough not only to make up for the drop-off in production by the manufacturing sectors but also to provide the expected increase in overall growth that is needed to have a healthy economy generating wealth. So our economy was retooled to be driven by the service sectors of the economy, and the biggest winner of all was the Finance sector, which was deregulated and told to get out there and be fruitful. [Note: I eventually will update this post with some data that illustrate the point.] And the Finance sector, was very, very fruitful.

Unfortunately, most of the apparent fruitfulness has proven to be illusory, and the stock market today stands where it was ten years ago. Hence, we have somebody over at the DailyKos referring to the last ten years as a "lost decade" for America.

That being said, although the excesses of the Finance industry are absolutely the cause of our current economic situation, getting angry at the bankers won't help us get out of the current situation, nor will it help us to restructure the U.S. economy to grow sustainably into the future while avoiding this kind of problem again, if at all possible.

Indeed, I'd argue that focusing too much attention on the bankers will only increase the chances that are going to repeat the mistakes that led up to the current crisis. Why? Because the problem starts with neoclassical economics and the willful blind spots (e.g., inanities such as the Efficient Market Hypothesis) that its adherents have created to match the "facts" to the policy. "Oh, the data don't fit the model? No problem, just assume the data away," seems to be a touchstone of neoclassical economics, particularly Friedman and the Chicago School. For a taste of what I am talking about, check out this post by Prof. Steve Keen:

http://www.debtdeflation.com/blogs/2009/01/31/therovingcavaliersofcredit/

If past is prologue-- and I'm focusing on what happened in the wake of the Great Depression-- there is going to be a strong push to dramatically increase regulation of the Finance sector of the U.S. economy. People are already starting to howl for it.

While more regulation is necessary, we better be careful about how and when we implement it. Why? Because we don't have anything just yet that can replace the Finance sector as the growth engine for the U.S. economy. And we won't be able to figure out what the new growth engine (or, preferably, growth engines) are unless and until we sit down and rethink our economic policy.

This is the challenge that Obama, Bernanke and Geithner really face: neoclassical economic theory, or at least our implementation of it, has failed so spectacularly and so quickly that we don't have any other sector of the economy to turn to as the next engine of growth. As much as I hate the term, I have to call this event a Black Swan, albeit a Black Swan that arose from hubris more than anything else.

The U.S. Needs to Rethink Its Economic Policy Before We Get Too Far Down the Path of Increasing Regualtion to Punish An Industry That Was Just Doing What Was Expected of It from a Policy Perspective.

Am I saying that we have to scrap globalization and "free" markets? Nope. I think that those policies implemented wisely will win in the end. I just don't think that they can be implemented wisely if we continue to rely upon the flawed models of neoclassical economics as our guide.

Here is the current outline of my prescription for fixing this mess:

1. Scrap neoclassical economic theory and start over by accepting that markets are inherently unstable (i.e., adopt an approach that is Post Keynesian in nature)
2. Retool U.S. economic policy to be more balanced, both in terms of encouraging more domestic investment of capital for the production of goods and in terms of encouraging a distribution of domestic investment across multiple sectors of the domestic economy so that we can reduce the risk of the epic failure of one sector dragging the whole economy down as the Finance sector has. This is going to require a massive restructuring of corporate tax policy. Just closing corporate tax "loopholes" is not going to cut it; we're also going to have to reduce the marginal tax rates and get every corporation paying U.S. corporate taxes. We should do for corporate income taxation what Reagan allegedly did for personal income taxation. (I say "allegedly" because I don't accept the assertion but I haven't investigated it myself to say one way or the other whether it's true; I've seen arguments on both sides, though.)
3. Completely overhaul corporate accounting rules and disclosure rules for public companies to help investors and regulators to understand what is really going on. I will detail my thinking in a later post. My bottom line here is that current rules have led to significantly overstating the rewards generated by public companies while substantially understating the risks they've undertaken, thus ultimately causing our Minsky Moment.
4. Finally, we need to reconsider how we report economic indicators such as the GDP. My greatest concern here is that we were fooled by the combination of (1) the dominance of the Finance sector and (2) the part played by Mortgage Equity Withdrawal (MEW) in propping up the GDP starting in 2001. As a result, we overestimated the true health of the economy. People like Nouriel Roubini saw the explosion of private debt and rightly intuited that we were in for a big fall, but it sure would be nice if somebody were to point out in economic data such as the GDP how different sectors of the economy depend on one another and can falsely inflate the data. To illustrate this concern-- as I fear I am not explaining it well-- I will ask the following question: If we were to attribute spending arising from MEW to the Finance Sector instead of the sectors that received that money as income, what would we see? I think we'd see that our economy depends much more on the Finance sector than we realize, i.e., that it is responsible for more than 50% of the real GDP. Being so dependent on one sector of the economy simply isn't healthy.

Once we've taken these steps we'll be in a position to determine what additional regulations may be necessary. I suspect, however, that we'll find little additional regulation will be necessary.

The Postcatastrophe Economy: A Summary

I recently finished reading Eric Janszen's The Postcatastrophy Economy: Rebuilding America and Avoiding the Next Bubble.

While I continue to believe that Janszen's book is the best I've read regarding the ongoing economic crisis, I find myself strangely disappointed.  The reason?  The book starts out amazingly strong, but it fails to carry the same levels of energy and clarity into the second half.  In fact, I'd argue that towards the end, Janszen undermines some the clarity of the first half of the book.  Nevertheless, as a whole, the book represents quite an achievement for an entrepeneur turned investment advisor. 

The book is divided into three sections.  First, he describes the FIRE (finance, insurance, real estate) economy that caused the current crisis.  Second, he describes his solution and alternative to the FIRE economy, which he calls the TECI (transportation, energy, communication, infrastructure).  Finally, he provides his "midterm macro forecast."

The first section, which spans a little over half the book, details the FIRE economy, how it operates, and how it led to the crisis that began in 2007 and continues today.  Janszen is clearly familiar with the economics of Michael Hudson, which form the foundation of Janszen's analysis of the FIRE economy, but Janszen extends Hudson's economic theories and synthesizes them into something that is far more accessible to the lay person than Hudson's original works.  He also introduces the interesting metric of "dollar-of-debt" per "dollar-of-GDP."

Things start to break down in the second section, which presents Janszen's vision of a solution to the FIRE economy, which I find compelling but not fully baked.  Janszen is clearly speaking from a position of legitimacy as a technology entrepeneur, and it is clear that his experience shades his judgment of what needs to be done.  This is when some of his blindspots become apparent.  First, his vision is one that caters to people like him, which is a common failing whenever somebody tries to plot a course for the future.  The good news is that his vision is complete enough that it can easily be extended to be more inclusive.  Second, while he understands the economics of the FIRE sector, it is not clear that he grasps how many of our laws, regulations and "rules of thumb" would have to fundamentally change in order to fully break free of the FIRE economy and the embrace the TECI economy.  This is not fatal to implementing his vision, it just means that this is a much larger undertaking than he realizes.  That's why I call his solution merely a vision of a solution.

Things almost fall apart in the final section, primarily because he puts on his investment advisor hat.  I'm not saying that his predictions about things like "peak cheap oil" or gold will prove wrong.  What I'm saying is that, in spite of his understanding of the FIRE sector, he does not seem to truly he understand that he is actually a "speculation advisor" not an investment advisor, and in that role he actually perpetuates the financialization of the real economy by the FIRE sector.  When he cannot see his role in perpetuating the FIRE economy, how can he be correct that the FIRE economy is already over?  Answer: he can't be.

At the end of the day, I do not believe these relatively minor flaws detract from the genius of the book, which is found in the first two sections.  Janszen probably felt it necessary to tack on the third section to treat the preparation of the book as a business expense (advertising), and some people will find the third section alone justifies buying the book.

Neoclassical Economics Are to Henry George What Neoliberal Economics are to John Maynard Keynes

I recently learnd about Henry George, a 19th century thinker who figured out in the 1870s that the boom-bust cycle is caused by debt-financed speculation and rent seeking.  At the time, he limited his conclusion to debt-financed land speculation, but that's because the secondary equity and bond markets weren't nearly as established in the 1870s as they were in 1907 and later in 1929.  (Note: there are a number of 19th century investing texts available at Google Books, and they show that the stock exchanges even in the 1890s were nowhere near what they became by the 1920s.  Take a look around there, you'll find it fascinating.)

As Keynes would later do, George proposed his own solution for euthanizing the rentier, which he called the "Single Tax."  (My understanding of George's proposal are admittedly cursory, so I'm not going to try to explain them in any kind of detail.)

The response by the rentiers was to fund political economists to develop a new doctrine of political economy, and neoclassical economics was born (at least, this is what Mr. George believed motivated the establishment of this new doctrine).

The key feature of neoclassical economics was that it treated land as capital.  According to the classical economics of Smith, Ricardo, Say et al., there were three players in (or drivers of) the economy: labor, land and capital.  Essentially, George's Single Tax sought to tax land rents out of existence to leave only labor and capital standing.  The neoclassical economists obliged George by "disappearing" land from their lexicon and treating it merely as another form of capital.

Neoclassical economics came to dominate the scene, and George's Single Tax proposal ultimately went nowhere.

Then we had the Great Depression, and John Maynard Keynes offered his own solution to the rentier problem (although he was politic enough to not explicitly assign blame for the Great Depression to the financial speculators). 

The first step in undermining Keynes was the so-called "neoclassical synthesis," that grafted some of Keynes' ideas onto neoclassical doctrine.

The second step in undermining Keynes was to repeat what had been done to Henry George: the rentiers funded the founding of the neoliberal movement and its economics in the Chicago and Austrian schools. 

Today's "neoclassical" orthodoxy is, in fact, the Chicago School, which is distinctly neoliberal.  Thus, as much as Steve Keen still labels the orthodoxy neoclassical, it is more appropriate to label it neoliberal.

Where neoclassical economics whittled the economic drivers from three (labor, land and capital) to two (labor and capital), neoliberal economics left us with only capital.  There is no labor any longer.  There are only consumers.  And the rentier segment of capital is the only part of it that continues to grow.

That Other Friedman: Tommy Boy Recognizes the Problem, Fails to Blame Himself

To me, Thomas Friedman defines the term "useful idiot."  A tireless cheerleader for neolib/neocon policies, you can always count on Tommy Boy to butcher the English language to almost make a point.

Over the weekend,  Tommy Boy had an opinion piece calling for a third political party to "rip open [our] two-party duopoly."  While I have no real issue with the concept of the third party, I think the problems we face do not spring from the two-party system but from the common neolib/neocon ideology that underlies both parties' policies, a primary feature of which is Tommy Boy's own Chicago School neoliberal economics.

Here's how TOF ("That Other Friedman") sets up his argument:

There is a revolution brewing in the country, and it is not just on the right wing but in the radical center. I know of at least two serious groups, one on the East Coast and one on the West Coast, developing “third parties” to challenge our stagnating two-party duopoly that has been presiding over our nation’s steady incremental decline.

Sorry, there is no "revolution" brewing, and there's no "radical center."  The "center" is defined by the neoliberal Washington Consensus and its financialized economy.  Maybe some of Tommy Boy's neoliberal elite buddies are tired of the polarizing rhetoric of the two parties, but it is doubtful that anybody he knows would actually govern differently.

“We basically have two bankrupt parties bankrupting the country,” said the Stanford University political scientist Larry Diamond. Indeed, our two-party system is ossified; it lacks integrity and creativity and any sense of courage or high-aspiration in confronting our problems. We simply will not be able to do the things we need to do as a country to move forward “with all the vested interests that have accrued around these two parties,” added Diamond. “They cannot think about the overall public good and the longer term anymore because both parties are trapped in short-term, zero-sum calculations,” where each one’s gains are seen as the other’s losses.

No, we don't have "two bankrupt parties bankrupting the country," we have a morally bankrupt ideology-- neoliberalism-- bankrupting the country, and the fundamentals of that ideology are shared by both parties as well as by Tommy Boy.  The reason why neoliberals "cannot think about the overall public good and the longer term" is because neoliberalism deleted the very concept of  "the overall public good" (i.e., "there is no society"), and the financialized neoliberal economy forces politicians to focus on the short term.  That's how neoliberalism works: citizens are reduced to narcissistic consumers and political and business leaders have to focus on their respective "business cycles" to ensure they stay on top.

We have to rip open this two-party duopoly and have it challenged by a serious third party that will talk about education reform, without worrying about offending unions; financial reform, without worrying about losing donations from Wall Street; corporate tax reductions to stimulate jobs, without worrying about offending the far left; energy and climate reform, without worrying about offending the far right and coal-state Democrats; and proper health care reform, without worrying about offending insurers and drug companies.

Spoken like a true neoliberal technocrat. 

“If competition is good for our economy,” asks Diamond, “why isn’t it good for our politics?”

If competition were good for the economy, we'd have it.  We don't.  The reality is that competition is BAD for a financialized economy because real competition disrupts the illusion of perpetual growth that makes the FIRE sector a lot of money.  J.P. Morgan realized in the late 19th century that competition is bad for business, if you're an investment banker.   Monopoly is a feature of neoliberal policy.

We need a third party on the stage of the next presidential debate to look Americans in the eye and say: “These two parties are lying to you. They can’t tell you the truth because they are each trapped in decades of special interests. I am not going to tell you what you want to hear. I am going to tell you what you need to hear if we want to be the world’s leaders, not the new Romans.”

That's a good idea in theory, but in practice all we're likely to see from a third party is somebody like Tommy Boy pimping the same neoliberal policies that got us into this mess.  The problem is not the polticial system but the rules that define how that system operates, and those rules are embodied in the neoliberal Washington Consensus.  All the political theater is just a show meant to distract the masses from what's really happening, and Tommy Boy is playing his own role by keeping people focused on the spectacle of politics instead of the reality that neoliberal policies like "free" trade and globalization (both championed by TOF) are the real cause of the economic disaster that we're living through.

The Postcatastrophe Economy

I'm now halfway through Eric Janszen's excellent The Postcatastrophe Economy: Rebuilding America and Avoiding the Next Bubble.

The first half of the book is devoted to providing his analysis of where the economy is right now and how it got there.  His views are quite consistent with my own, but it is clear that he has been thinking about the issues longer and has a more complete view of the field.

I'll provide a full review of the book when I'm finished.  I can say just from reading the first half that the book is a must read.

Latest Michael Hudson: Taking Krugman to Task

Hudson's latest piece, "America's China Bashing," can be found here.

Here are some choice statements:

The U.S. and foreign economies alike are suffering from the idea that the way to get rich is by debt leveraging, and that the wealth of nations is whatever banks will lend – the “capitalization rate” of the available surplus. The banker’s dream is to lend against every source of revenue until it ends up being pledged to pay interest. . . .

But Paul Krugman and Robin Wells blame China for Wall Street’s junk mortgage binge. Instead of pointing to criminal behavior by the banks, brokerage companies, bond rating agencies and deceptive underwriters, they take the financial sector off the hook:  . . .

This sounds more like what one would hear from a Wall Street lobbyist than from a liberal Democrat. It is as if the real estate bubble didn’t stem from financial fraud, junk mortgages, NINJA loans or the Federal Reserve flooding the U.S. economy with credit to inflate the real estate bubbles and sending electronic dollars abroad to glut the global economy. It’s China’s fault for running large trade surpluses “at the rest of the world’s expense.” . . .

The FIRE sector’s business plan has priced U.S. labor out of world markets. There seems little likelihood of making Chinese and German workers pay rents or mortgage interest as high as the United States? How can American economic strategists force them to raise the price of their college and university tuition so that they must take on the enormous student loans of the magnitude that Americans have to assume? How can they be persuaded to follow the high-cost U.S. practice of adding FICA-type wage withholding to the cost of living to save up pensions, Social Security and medical insurance in advance, instead of the pay-as-you-go basis that Germany quite rightly follows?

Such suggestions are a cover story for America’s own financial mismanagement. The U.S. idea for global equilibrium is to demand that that the rest of the world follow suit in adopting the short-term time frame typical of banks and hedge funds whose business plan is to make money purely from financial maneuvering, not long-term capital investment. Debt creation and the shift of economic planning to Wall Street and similar global financial centers is confused with “wealth creation,” as if it were what Adam Smith was talking about.

A Proposal

China is trying to help by voluntarily cutting back its rare earth exports. It has almost a monopoly, accounting for 97 per cent of global trade in these 17 metallic elements. These exports are “price inelastic.” There is little known replacement cost once existing deposits are depleted. Yet China charges only for the cost of digging these rare metals out of the ground and refining them. They are used in military and other high-technology applications, from guided missile steering systems and computer hard drives to hybrid electric automobile batteries. This has prompted China to recently cut back its exports to save its land from environmental pollution and, incidentally, to build up its own stockpile for future use.

So I have a modest suggestion. If and when China starts re-exporting these metals, raise their price from a few dollars a pound to a few hundred dollars. According to a theory put forth by Paul Krugman and the U.S. Congress, this price increase should slow demand for Chinese exports. It also would help promote world peace and demilitarization, because these rare metals are key elements in missile guidance systems. China should build up its national security stockpile of these key minerals for the future – say, the next prospective five years of production. Let this be a test of the junk paradigms at work.

Aftershocked by Reich

Shortly after yesterday's post about a recent Robert Reich interview, I purchased the book he's currently out pimping, Aftershock: The New Economy and America's Future.  I have not read the whole thing yet, but I have read the key chapters in which he sets forth his vision of the problem and his solution to it.

Here's what I can say definitively: this is a book written for economic elites by an economic elite.  What's more, it was not written for economic elites like me, who already believe that having a vibrant middle class is crucial for America's long term success as a nation, but for economic elite who need convincing (i.e., the "let them eat cake!" types). 

Here's what I cannot tell: is Reich really as clueless as he seems, or is he playing dumb to make sure his intended audience (the "cakers") will read the whole book?

Reich's central thesis is that income inequality is the source of America's economic doldrums:

Geithner . . .  misstated the underlying problem, of which the Great Recession was a symptom.  The problem was not that Americans spent beyond their means but that their means had not kept up with what the larger economy could and should have been able to provide them.  The American economy had been growing briskly, and America’s middle class naturally expected to share in that growth.  But it didn’t.  A larger and larger portion of the economy’s winnings had gone to people at the top.

This is the heart of America’s ongoing economic predicament.  We cannot have a sustained recovery until we address it.  It is our social and political predicament.  We risk upheaval and reactionary politics unless we solve it.  The central challenge is not to rebalance the global economy so that Americans save more and borrow less from the rest of the world.  It is to rebalance the American economy so that its benefits are shared more widely in America, as they were decades ago.  Until this transformation is made, our economy will continue to experience phantom recoveries and speculative bubbles, each more distressing than the one before.

Reich explains how the middle class was able to mask the effects of income inequality through three coping mechanisms:Of these measures, only the last one-- taking the money out of politics-- seems to address the underlying system (the tilted playing field) that led to income inequality, but it does so in a purely cosmetic way that cannot address the influence exerted over lawmakers by the largest employers in a congressional district, for example.

Americans also accepted the backward swing of the pendulum because they mitigated its effects. Starting in the late 1970s, the American middle class honed three coping mechanisms, allowing it to behave as though it was still taking home the same share of total income as it had during the Great Prosperity, and to spend as if nothing substantially had changed. Not until these coping mechanisms finally became exhausted in the Great Recession would the underlying reality become evident. (And not until the federal government ended its stimulus and the Fed tightened the money supply would that reality be exposed as more enduring than the Great Recession’s downturn.)

Coping mechanism #1: Women move into paid work . . .
Coping mechanism #2: Everyone works longer hours . . .  
Coping mechanism #3: We draw down savings and borrow to the hilt . . .

Eventually, of course, the debt bubble burst. With it, the last coping mechanism disappeared . . . 

Reich then explains how the disappearance of these coping mechanisms has awakened the middle class to a reality that is very different from what they expected, a reality that appears to be a "rigged game" to make the rich richer even as they are made poorer.  Reich at no time argues that the game is NOT rigged.  Indeed, he admits that it is, and that the income gap will continue to widen unless something is done.

All of this, Reich says, is giving rise to "the politics of anger," something that is a threat to everyone, including the wealthy and the nation as a whole:
So, does Reich offer solutions to level the playing field, to clean up the game so it is no longer rigged but fair?  No.  Reich's proposal merely aims to make "a tilted playing field . . . tolerable" to the middle class through:

I could have grounded my argument in morality: It is simply unfair for a handful of Americans to take home such a large share of total income when so many others are struggling to make ends meet. Or I could have based it on traditional American values: Such a lopsided distribution is at odds with the nation’s history and its ideal of equal opportunity—especially when the deck seems stacked in favor of those at the top. I could have talked about how this degree of inequality undermines the nation’s moral authority and its standing in the world.

I have chosen instead to base my argument on two tangible threats that such inequality poses to everyone—including even the wealthiest and most influential among us. One is economic: Unless America’s middle class receives a fair share, it cannot consume nearly what the nation is capable of producing, at least without going deeply into debt. And debt on this scale is unsustainable, as we have seen. The inevitable result is slower economic growth and an economy increasingly susceptible to great booms and terrible busts. The other threat is political: Widening inequality, coupled with a growing perception that big business and Wall Street are in cahoots with big government for the purpose of making the rich even richer, gives fodder to demagogues on the extreme right and the extreme left. They gain power by turning the public’s economic anxieties into resentments against particular people and groups. Isolationist and nativist, often racist, and willing to sacrifice overall prosperity for the sake of achieving their ends, such demagogues and the movements they inspire can cause great harm. As I’ve shown, the Great Recession has accelerated both troubling trends. With the bursting of the housing bubble, many middle-class homeowners who can no longer use their homes as piggy banks must face the reality of flat or declining wages. The downturn also has forced—or given a ready excuse for—firms to increase profits by shrinking their payrolls, laying off millions of workers and reducing the pay of millions more. It has simultaneously induced firms to ratchet up the pay of their “talent”—the executives and traders who drive the profits. At the same time, the Great Recession has starkly revealed the political power of big business and of Wall Street. Both have been able to enhance their profits by exacting money and other favors from government—even from one under the nominal control of the Democratic Party.

Unless these trends are reversed, the financially stressed middle class will not have the purchasing power to keep the economy growing. This will hurt even those who are well-off. A political backlash could generate a similar result, or worse. Margaret Jones and her Independence Party are fictional, but the anger on which she bases her appeal is not.

I cannot pretend that the following measures would remedy these problems altogether, but they represent important steps. They would help restore the basic bargain. As such, they would fill the gap in aggregate demand, and would preempt a politics of resentment. Some of these reforms would be costly, but I suggest ways to pay for them so they would not increase the national debt. To the contrary, they are likely to produce a budget surplus. And because they would generate stronger and more sustainable growth than the policies we now have, they would shrink the debt as a proportion of the national economy in years to come. The costs of inaction are far greater. An economy functioning well below its capacity is a terrible waste of all our resources, especially of our people; a society riven by resentment is potentially unstable.

A reverse income tax  (welfare for the working poor)
A carbon tax.  (recouping subsidies in production at the point of consumption)
Higher marginal tax rates on the wealthy.
A reemployment system rather than an unemployment system.  (worker training)
School vouchers based on family income. 
College loans linked to subsequent earnings.
Medicare for all.
Public goods.  (free parks, museums and public transportation)
Money Out of Politics.

Everything else seeks to address income inequality through redistributive taxes and by shifting costs to the government.   While some of the proposals are necessary (e.g., Medicare for all and higher marginal tax rates on the wealthy), none of them are sufficient, alone or together, to address thre real problem, of which income inequality is only a symptom.

Again, Reich's central thesis is that the Great Recession is a symptom of income inequality.  That's not correct. 

The Great Recession was not caused by income inequality but by a major financial crisis, which was itself caused by debt-financed financial speculation.   

The Great Recession is being prolonged by debt inequality, not by income inequality.  The American middle class in these uncertain times feels compelled to pay down what debt it has (which is a good thing because the banks aren't lending).  But paying down existing debt doesn't add to the GDP.  If the American middle class were not so weighed down with debt (i.e., if its debt-to-wage ratio were not so high), it would be out there spending right now, even with the same levels of income inequality. 

Note: Reich asserts that the American middle class turned to debt as a "coping mechanism," but the fact is that debt was pushed on the consumer like a drug.  Starting in the 1980s, the financial sector greatly expanded access to credit and began marketing it like product that everybody had to have.  "What's in your wallet?"

Addressing income inequality will not prevent boom-bust cycles, which are always caused by debt-financed financial speculation. 

Addressing income inequality also will not address debt inequality.  Giving people more money to start just gives the banks more money to siphon off through debt service. 

And giving the middle class a taste of the things the elite take for granted and believe to be important won't change the fact that not everybody comes from the same mold or has the same interests or abilities.  Making college more affordable won't help people who can't or don't want to go to college.  Providing worker training won't create jobs.  Offering private school education won't help kids who struggle to learn in a less challenging curriculum.  Free museums and other cultural experiences don't matter much to most people.

The current system is fundamentally broken, and shuffling money around won't fix it.  The fact is that the only thing America "produces" any more is debt.  Debt is what has fueled our economy for the last thirty years and has masked an ongoing depression for the last ten years.  The only answer the Obama administration sees is more debt, but it isn't going to happen.

The current system is so broken that the playing field can't be leveled.  As long as our private sector, which is dominated by financial institutions, must demonstrate perpetual growth to satisfy shareholder expectations, it will find more and more ways to layer debt on to those willing to accept it (which is everybody but the top decile of American households).

The only way out of our current predicament is to eliminate the dominance of the FIRE sector over our economy, which will require an official industrial policy that encourages investment in what America produces and provides blue collar jobs that provide a living wage.  At the moment, it is possible to make American manufacturing competitive without rejecting globalization through politically expedient tarriffs, but the window of opportunity is closing, and tarriffs will be required if something significant isn't done.

Economist Pat Choate has a much more compelling (and correct) vision than Reich, who seems to be wearing neoliberal blinders (i.e., the very kind of "free market absolutism" that people like Pat Choate and Paul Craig Roberts reject).

Cost Arbitrage Hitting Wall Street In Spite of Continuous Backdoor Bailouts

Wall Street's cannibalization of the real economy is coming home to roost.  As reported on Fox Business (and posted up by Zero Hedge here), Morgan Stanley and other Wall Street firms are freezing hiring and may soon move to cutting jobs, something I don't think it has done since 2008 when the financial crisis was in full bloom.

Wall Street firms, like all publicly traded companies, must show perpetually growing profits from quarter to quarter.  That's the rule they invented, and they have to follow it, too.

Faced with fewer real people trading the secondary markets (it seems to be mostly Wall Street computers pushing prices around these days) and a reduction in borrowing in every private sector, the only way for the Wall Street firms to increase the appearance of profitability is to cut costs, and the easiest way to do that is to lay people off.  (Apparently, the mini flash crashes Wall Street computers seem to be creating weekly, along with other forms of cheating, simply aren't lucrative enough to avoid layoffs.)

And thus Wall Street continues to add to its own demise along with the demise of the U.S. economy.

Public Company M&A: Good for Wall Street, Bad for the Real Economy

There has beeen a spate of mergers and acquisitions among publicly traded companies, including some apparently puzzling moves by Intel and others. 

Today's announcement of Southwest Airlines' proposed acquisition of AirTran Airways provides an excellent opportunity to discuss why such acqusitions are actually a bad thing for the economy.  Although this particular deal, which looks like a relative bargain for Southwest in view of the fact that AirTran has one quarter the top line revenue and the same net income after taxes, does not seem to have the hallmarks of "stupid accounting tricks" (i.e., cost arbitrage through accounting rules) that provide the illusion of increasing shareholder value, the deal is a horizontal combination that will clearly reduce competition and lead to increased costs for consumers while shedding jobs due to "consolidation."

While we're at it, we might as well discuss other attempts to prove shareholder value, such as MSFT's recent move to borrow money to pay dividends in order to avoid paying taxes on repatriated funds.

The fact is that corporate behavior is being shaped by tax laws and accounting rules, and the Obama administration really needs to think about ways to at least temporarily change that behavior to revitalize the economy.

Anyway, I plan to update this post today or tomorrow to flesh out the discussion.

Bush Tax Cuts Had Severe Negative Impact on Economy

Bruce Bartlett by way of Mark Thoma:

Bruce Bartlett notes that the Bush tax cuts did little to stimulate growth, and that tax cuts of this type are very poor at what we need the most right now, countercyclical stabilization:

Bush Tax Cuts Had Little Positive Impact on Economy, by Bruce Bartlett, Commentary, Fiscal Times: Republicans are heavily invested in permanently extending the tax cuts enacted during the George W. Bush administration, all of which expire at the end of this year exactly as the legislation was written in the first place. To hear Republicans, one would think that the Bush tax cuts were the most powerful stimulus to growth ever enacted and only a madman would even think of allowing any of them to expire.

The truth is that there is virtually no evidence in support of the Bush tax cuts as an economic elixir. To the extent that they had any positive effect on growth, it was very, very modest. Their main effect was simply to reduce the government’s revenue, thereby increasing the budget deficit, which all Republicans claim to abhor.

Saying that the Bush tax cuts had "little positive impact" on the economy is being excessively charitable.  The Bush tax cuts helped ruin the economy by generating free cash flow to fuel more and more financial speculation. 

Wealthy Americans no longer invest in creating productive American businesses, so the primary way to "protect" the value of the money they earn is to engage in financial speculation (i.e., "investing" in the stock market).  Many wealthy Americans sought outsized gains by speculating through hedge funds, who leverage up through factional reserve borrowing.  With so much money seeking yield, asset prices were driven higher and higher, until the point was reached where the only way to keep the bubble going was to extend credit to people who could not afford to pay it back (derivatives must be "derived from" something).

To be fair, Bush's tax cuts could have been a very big positive if the tax and accounting rules encouraged investment into the productive output of the United States.  Unfortunately, our de facto industrial policy does the opposite.

He Who Sets the Rules Gets the Gold: The Financialization of the Real Economy

The primary conclusion of the Pujo Committee in its 1913 report was that there existed a "money trust" that had a community of interest that exerted control over American industry through interlocking boards of directors and modulating the access to credit.  The Pujo report ultimately led to the Federal Reserve Act of 1913, which some proclaimed would break the money trust through government oversight.

A major conclusion of the Pecora Commission of 1934 was that nothing about the "money trust" had changed, that, if anything, it had become more brazen in its abuses since the passage of the Federal Reserve Act.  Unlike the Pujo Committee report, the report of the Pecora Commission led to major legislative reforms including the Glass-Steagall Act, which barred investment banks from operating as commercial banks, and vice versa.

Although the Glass-Steagall Act was not repealed until 1999, the financial sector had substantially undermined it by the early 1980s.  The Graham-Leach-Blilely Act was helpful in hastening the arrival of the current depression, but not necessary.

Financial innovators had already figured out ways to avoid things like reserve requirements (e.g., through repurchase agrements, swap agreements, and, later, derivatives) and naked shorting (e.g., through derivatives again).  With innovations like high frequency trading and dark pools, they were able to avoid the prohibition of pooling arrangements that prevented price discovery.

A major enabler of the financial innovators (i.e., the cheaters) was the Chicago School of Economics, which, for whatever reason, applied some of its best minds to establishing that the stock market shark tank was once again safe for the recreational swimmers.  When I read Justin Fox's The Myth of the Rational Market, I was shocked that economists would concern themselves with speculation in the secondary markets, but there they were doing exactly that!

One of the things that Chicago School economists (and their neoliberal brethren of Austrian stripe) accomplished is the financialization of the real economy.  With the concerted return of monopoly capitalism beginning in the Reagan era, the marked increase in IPOs in the 1990s, and the consolidation of investment banks and commercial banks in the oughts, more of the American economy than ever before was subject to economic decision making driven by "maximizing shareholder value."

But what does that really mean, "maximizing shareholder value?"  With all of the "rules" of valuation in the secondary equity market established through things like the Capital Asset Pricing Model, the "M&M" equations, and discounted cash flow analysis, maximizing shareholder value means maintaining, on a quarterly basis, the illusion of perpetual profit growth beyond the pace of inflation and at or above current consensus expectations. 

In short, the management of publicly traded companies must run their companies to simulate a financial instrument that exhibits perpetual growth that meets or exceeds expectations.

There are only four things that management can do to exhibit the expected growth.  First, it can grow the business organically by increasing sales in existing markets or branching out to new markets.  Second, it can acquire other companies.  Third, it can engage in cost arbitrage (e.g., wage arbitrage, accounting arbitrage, or tax arbitrage).  Finally, it can "cheat," a term that I use broadly to refer to things as relatively inconsequential as timing orders to hit in a desired quarter or as malignant as Enron or S&L-level control fraud. 

Governments are subject to similar pressures through the secondary bond market and are similarly limited in what they can do to meet the expectations of "the market" and maintain the viability of its economy (and currency). 

For all intents and purposes, these objective "rules" for the valuation of stocks and bonds on the secondary market accomplish exactly what the alleged "money trust" did, which is control of American industry and, therefore, the American economy.  The net result is that we are all at the mercy of financial speculators who demand the impossible: perpetual growth in a world of finite resources. 

Damon Vrabel had a great post today about the implications of how the current monetary system run by the rules of financial speculators has pushed debt levels to the saturation point.  A version of Damon's post appears at Max Keiser, but be sure to check out the much meatier original.