Note to Karl Denninger: Government Debt Does Not Necessarily Equal Deficit Spending

Karl has been using this chart for awhile now:

Attribution: http://market-ticker.org/akcs-www?get_gallerynr=13

In this case, Karl uses the chart to rebut the assertion by Dean Baker that the current national debt levels are not worrisome.  Dean Baker is a pretty smart guy, but he tends to lean farther left than Karl does right, so I felt compelled to dig into who is correct.

While I still don't know the answer to that question, I do know that Karl is wrong at least for the reasons he assets to support his position.  Why?  Because the chart above appears to divide national debt by GDP.  That is, Karl is assuming that government borrowing equals government spending.  That assumption is incorrect at the moment because over a trillion dollars that the Treasury borrowed (by selling treasury bonds)was dumped on the balance sheets of banks as reserves and have not been spent:

As you can see, the ramp in bank reserves corresponds to the ramp in "deficit spending" in Karl's graph.  In order to make Karl's graph correct, he needs to back out these unspent reserves from the Treasury debt to derive the actual deficit spending number, which I suspect will be closer to 6-8% instead of his asserted 12%.  Indeed, if you use the Federal government spending numbers in the BEA's GDP data instead of the Treasury "to the penny" data, it shows only 8.1% of GDP for 2009 was government spending (not necessarily deficit spending), instead of Karl's 12%.

Latest Michael Hudson: How Brazil Can Defend Against Financialization

The article can be found here.

About the only thing I disagree with is his conclusion that the United States has not lost its national sovereignty. I'd argue that it has because our government is no longer beholden to American citizens but to transnational banks.  The sovereignty of the United States springs from its citizens, who no longer have a voice.

Hudson establishes how the rentier (or speculator or finance) competes against productive investment to capture economic surplus.  This is what I've been trying to get at in urging considering the rentier/speculator/finance as something distinct from capital and labor.  I'd prefer not to go down the path of explaining things in Marxist terms (e.g., M-M' and M-C-M') and try to understand the rentier/speculator/finance with its own "aggregate" in macro to stand along side aggregate demand and aggregate supply.  I don't think you can euthanize the rentier unless and until you can measure how much life is left in it.

The natural history of debt and financialization


Today, financial maneuvering and debt leverage play the role that military conquest did in times past. Its aim is still to control land, basic infrastructure and the economic surplus – and also to gain control of national savings, commercial banking and central bank policy. This financial conquest is achieved peacefully and even voluntarily rather than militarily. But the aim is the same: to make subject populations pay – as debtors and as dependent junior trade partners. Indebted “host economies” are in a similar position to that of defeated countries. They lose sovereignty over their own financial, economic and tax policy as their surplus is transferred abroad. Public infrastructure is sold to foreigners who buy on credit, on which they pay interest and fees that are expensed as tax-deductible, despite being paid to foreigners.


The Washington Consensus applauds this pro-rentier policy. Its neoliberal ideology holds that the most efficient path to wealth is to shift economic planning out of the hands of government into those of the bankers and money managers in charge of privatizing and financializing the economy. Almost without anyone noticing, this view is replacing the classical law of nations based on the idea of sovereignty over debt and financial policy, tariff and tax policy. Ideology itself has become an economic weapon. Indebted governments have been told since 1980 to sell off their public infrastructure to foreign investors. Extractive “tollbooth” charges (a.k.a. economic rent) replace moderate or subsidized public user fees, making economies less competitive and painting them even more into a debt corner as the surplus is transferred abroad, largely tax-free.


What the world is experiencing in the face of today’s globalism is a crisis in the character of nationhood and economic sovereignty. Bankers in the North look upon any economic surplus – real estate rent, corporate cash flow or even the government’s taxing power or ability to sell off public enterprises – as a source of revenue to pay interest on debts. The result is a more debt-leveraged economy in every country. Foreign investment, bank lending, the privatization of public infrastructure and currency speculation is now managed from this bankers’-eye perspective.

There is one great exception to relinquishing national policy to foreign control: the United States itself is by far the world’s largest debtor economy. While mobilizing creditor power to force other debtors to privatize their public sectors and acquiesce in a one-sided U.S. trade protectionism, the United States is the only nation able to issue its own currency (Treasury debt) and international bank credit without limit, at a lower interest rate than any other country, and even without any foreseeable means to pay.
. . .


Little bank credit has gone to finance tangible capital investment. Most such investment has been paid for out of retained business earnings, not bank loans. And as banks and brokerage houses have financed corporate takeovers, the new buyers or raiders have had to divert corporate cash flow to paying back their creditors rather than expanding production. This is how the U.S. and other economies have become financialized and post-industrialized. Their experience should serve as an object lesson for what Brazil and other countries need to avoid.


. . .


It is not widely recognized that most commercial bank loans merely attach debt to existing assets (above all, real estate and infrastructure) rather than being invested in creating new means of production, or to employ labor, or even to earn a profit. Banks prefer to lend against assets already in place – real estate, or entire companies. So most bank loans are used to bid up of prices for assets, especially those whose prices are expected to rise by enough to pay the interest on the loan.


. . .


It is an object lesson for Brazil to avoid. Your nation today is receiving balance-of-payments inflows as foreign banks and investors create credit to lend against your real estate, natural resources and industry. Their aim is to obtain your economic surplus in the form of interest payments and remitted earnings, turning you into a rentier tollbooth economy.

Why would you need these “capital inflows” that extract interest, rents and profits as a return for electronic “computer keyboard credit” that you can create yourself? In today’s world, no nation needs credit from abroad for domestic-currency spending at home. Brazil should avoid letting foreign creditors capitalize its economic surplus into debt service and other payments.


The way to avoid this fate has already been outlined from the French Physiocrats and Adam Smith through John Stuart Mill and Progressive Era reformers. They recommended that by ending the special privileges bequeathed by Europe’s military conquests (privatization of land rent), and by collecting “free lunch” rentier income as the tax base, this revenue could be saved from being privatized and capitalized into bank loans. Taxing land and resource rent lowers the cost of living and doing business not only by removing the tax burden on labor and industry, but by holding down housing and real estate prices.


. . .


The bankers’-eye view of economies


The business plan of bank marketing departments is to capitalize any economic surplus into debt service. Loan officers see any net flow of income as potentially available to be captured as interest payments. Their dream of growth and financial success is to see the entire surplus capitalized into debt service to carry loans. Net real estate rent, corporate cash flow (ebitda: earnings before interest, taxes, depreciation and amortization), personal income above basic spending needs, and net government tax revenues thus can be capitalized into as much as banks will lend. And the more credit they lend, the higher prices are bid up for real estate, stocks and bonds.


So bank lending is applauded for making economies richer, even as families and businesses are loaded down with more and more debt. The easier debt leveraging becomes, the more asset prices rise. Lower interest rates, lower down payments, more stretched-out amortization periods, and even fraudulent “devil may care” lending thus increases the “capitalization rate” of real estate and business revenue. This is applauded as “wealth creation” – which turns out to be debt-leveraged asset-price inflation that can infect an entire economy. It is a far cry from what Adam Smith wrote about in The Wealth of Nations.

The limit of this policy is reached when the entire surplus is turned into debt service. At this point the economy is fully financialized. Income spent to pay debts is not available for new investment or consumption spending, so the “real” economy is debt-shackled and must shrink.

This is why the recent financial takeoff ended in a crash. This is what much the world is witnessing today outside of Brazil and its fellow BRIC countries that have not gone so far down along the neoliberal financialization path toward its culmination in debt deflation and austerity.

. . .

The Excommunicated Neoliberal: More On Henry Simons

For those interested in more info on Simons, his role as a founder of neoliberalism and his eventual excommunication from neoliberalism, I've pulled together a few documents for you.

The first is a paper from the editors of the Road From Mont Pelerin which appears to be a longer, more detailed version of the Chicago School chapter.  You can find that paper here.

The second is a paper that co-opted the title of Simons' famous essay and labeled him a "democratic socialist."  You can find that paper here.

Finally, here is Brad DeLong's defense of Simons as a true neoliberal (found on the neoliberal Cato Institute's website).  You can find that paper here.

The first paper includes this interesting little reference to seeking funding from Rockefeller:

In expressing his admiration of Simons’ financial savvy, Hutchins writes: “It sounds to me as though you would get us a million dollars from Mr. Rockefeller and another million, by way of apology, from Harry Luce. When the money comes in, I will split it with you” (SPRL, Hutchins to Simons, November 5, 1943, box 3, file 58).

UPDATE: For Ray, here's an interesting section from the first paper, which suggests substantial influence from the organization funding Hayek's work:

In 1946, Leonard Read, a businessman and crusader, had obtained a loan from the

Volker Fund to buy property in Irvington, NewYork and create the Foundation for

Economic Education (FEE), an organization the Volker Fund subsidized in perpetuity.

43

Read tended to see the world in black and white, which was why he had earned

Luhnow’s trust: “There was no big tent in Read’s world. There was only a core group of

ideas. You could either take them or leave them….” Not surprisingly, Read advocated a

inflexible stratagem for defeating socialism: “to move beyond denunciation to ‘upholding

its opposite… expertly, proudly, attractively, persuasively’” (quoted in Hoover, 2003, p.

188).

44

Apparently, the late Simons was not sufficiently infused with political virtue for

Read, because he would shortly criticize Simons’ posthumously published

Policy for a Free Society

Economic:

Some of us here have carefully gone over the galleys of “Economic Policy for a

Free Society’ by Henry Simons. We had hoped this was a piece we might assist

in distributing, but it is so well loaded with the advocacy of collectivistic ideas,

that it falls entirely out of our field. The book states many positions with which

we are in agreement, but personally, I do not believe that the cause of individual

liberty and a free market economy will be aided by it (quoted in HPHI, Letter

from Read to Director, Nov. 24, 1947, Box 58 F William Volker Funds 1939-48).

Undoubtedly passages such as the following from

discomfort at the Volker headquarters:

The afflictions of bureaucracy and ossification fall no less surely on vast private thanon governmental enterprises. The efficiency of gigantic corporations is usually a vestigial reputation earned during early, rapid growth—a memory of youth rather

than an attribute of maturity. Grown large, they become essentially political bodies,

run by lawyers, bankers, and specialized politicians, and persisting mainly to

preserve the power of control groups and to reward unnaturally an admittedly rare

talent for holding together enterprise aggregations which ought to collapse from

excessive size (Simons 1948, p. 246).

Once again, Hayek was called upon to smooth ruffled feathers. He wrote Luhnow:

“I am writing to draw your attention to Henry Simons’ book,

Society…

to be any prospect of preserving the competitive system and a free society generally… it

is certainly in the spirit of that book that Director will conduct his investigation at

Chicago” (Hayek Papers, Hayek to Luhnow, December 8, 1947, box 58, folder: William

Volker Fund: 1939-48).

At this crucial juncture, we can observe the major protagonists engaged in intense

negotiations as to what it would mean to launch the Chicago School. A number of things

become apparent, which have been altogether absent from previous accounts. First, it was

the legacy of Henry Simons that was perceived to be at issue in the fledgling project. The

mere fact of a seminar identifying itself as being “pro-free market” did not cut the

mustard when it came to concocting a credo that all parties could subscribe to. Secondly,

Luhnow and the Volker officers were not mere accessories to the rise of the Chicago

school: they were hands-on players, determined and persistent in making every dollar

count. Third, all and sundry depended upon Hayek to keep the project on even keel: no

one else on home ground seemed to command the intellectual gravitas or deft punctilio to

herd the cats. In particular, Frank Knight was nowhere to be seen in the archival records

of these negotiations. Nevertheless, even with Hayek and Director pulling the strings,

success was not a foregone conclusion.

After all, the objective was to produce an

entailed something more than a minor adjustments of accent when transporting the text

Across the Pond. The politics of postwar America presumed not only a powerful state,

but also a configuration of powerful corporations whose international competitors had

mostly been reduced to shadows of their former selves. In promoting ‘freedom’, they

were primarily intent upon guaranteeing the freedom of corporations to conduct their

affairs as they wished. Thus, the Volker Fund was not interested in bankrolling a classical

liberal economic position like that of Henry Simons, for that position did not adequately

correspond to its objectives. It is our contention that the Volker Fund pushed for a

reformulation of classic liberalism in the American context to conform to its Cold War

anti-socialist agenda.

Hayek, would just have to learn to adjust.Economic Policy were provokingEconomic Policy for a Freeit seems to me to represent the kind of attitude which must be taken if there isAmerican Road to Serfdom, and this45 The participants in the Free Market Study, and even eventually
Footnotes:

43

organizations (see “Leonard E. Read’s Small Tent Strategy,”

North, in this article, also portrays the powerful influence Read had on the libertarian movement and the

adamant, uncompromising philosophical stance of Read.

Gary North, a previous Volker staff member, refers to FEE as the granddaddy of all libertarianwww.lewrockwell.com/north/north117.html).

44

conveyed a similar philosophy: “We lean to freedom (speaking for myself) mainly because the world seems

to be moving in the opposite direction at an accelerating and, we think, a dangerous pace” (quoted in

Director 1952, p. 296).

Many felt that the left was winning the war for hearts and minds in the late 1940s. In 1952, Knight

 

Income Inequality: A Necessary But Insufficient Condition for Financial Instability

Recently, a lot of people (including the IMF) have been looking to income inequality as a potential cause of the current economic situation.  There are certainly a lot of data that indicate a correlation between periods of severe income inequality and financial crises.

While income inequality certainly played a roll in the recent credit crisis, financial speculation caused it. What income inequality did was (1) increase demand for household debt for those in the lower 90% of household incomes and (2) increase demand for financial speculation for those in the top 10% of household incomes.

When income and specifically wages are spread more evenly across all income levels, more people are able to accumulate savings and, therefore, are able to avoid incurring debt.  On the other hand, fewer people accumulate savings of sufficient size that they are willing to risk some or all of their savings by engaging in financial speculation.

When income inequality is as high as it is now, it aligns the interests of both the savers and the non-savers with those of the financial sector.  The non-savers in the bottom 90% of households earn 65% of the wages, which provides a diversified base across which to extend credit at the highest rates possible (the top decile won't pay a premium for access to credit).  On the other hand, the top 10% are confronted with the possibility that their savings are a wasting asset in face of potential inflation.  As we know from Prospect Theory, losses "loom larger" than gains, and inflation is perceived as a certain loss, so "putting your money to work" making more money is a no-brainer.  Add to the mix things like hedge, which can make outsized gains due to leverage, and it is very easy for a high net-worth individual to be enticed to participate in financial speculation (which he has been taught to think of as just a higher risk form of "investing"). 

Things got really dangerous when asset-backed derivatives coupled the increased debt of the bottom 90% of households to the financial speculation of the top 10% of households and the financial sector.  Ever increasing savings increased the demand for asset-backed derivatives, which increased the demand for new borrowers, which further incrased savings, and so on.

The primary reason that I think we need to consider finance (or speculators) as separate and distinct from capital and labor in economics is that finance's interests compete with both capital (who must choose between investing capital in increasing productive output and speculation) and labor (whose stagnant wages encourage taking on an increasing debt burden to maintain the illusion of making progress).  Because finance ostensibly serves both capital (through investment banking) and labor (through commercial banking), they bridge the gap and provide a feedback loop that can potentially be self-reinforcing, particularly as demand for financial speculation becomes large enough due to the increased concentration of wealth in a small portion of households.  Classifying finance as part of either capital or labor prevents its influence on the economy from being adequately understood (all we can understand now are aggregates of debt and income after the fact).

Fannie and Freddie Acquitted

Several neoliberals/libertarians have argued that Fannie and Freddie caused the housing bubble, including Ron Paul.

It turns out that the evidence is in, and the verdict is not guilty:

Fannie / Freddie Acquitted


The Conservator’s Report on Fannie and Freddie is out.


Fannie Mae and Freddie Mac are members of a long list of individuals and entities including Gary Condit, Tom Delay, Michael Jackson, Rod Blagojevich and JonBenet Ramsey’s parents. These are folks who were unjustly tried and convicted in the popular press essentially on the grounds that they were creepy or otherwise unsavory characters.


As I hope to continue to argue, being creepy, a bad person, or even a usual suspect does not make one automatically guilty of any particular crime. In this case government subsidies in the housing market are a bad idea for a host of reasons and have been for years. I will testify to this with vigor and passion.


However, that does not mean that Fannie or Freddie caused the housing bubble. Indeed, by my count they were among the biggest victims of it.


The proper question is not: What story is consistent with my general philosophy or worldview?


The proper questions is: What story is consistent with the facts? 

Read the rest here.

To be clear, while I'm glad to see my own conclusions vindicated, (1) I don't think the "Fannie/Freddi did it!" meme will ever go away because it is neoliberal dogma now, and (2) I'd still like to see Fannie and Freddie ended because they provide an easy path for laundering bad loans (and backdoor bailouts).

Financial Speculators Caused the Housing Bubble, Not Policy

One of the primary reasons for recognizing financial speculators as a primary (and currently dominant) force in our economy is to put an end to inane discussions of how bad things mysteriously happen due to "policy" (e.g., monetary policy).  As long as we pretend that financial speculators are affected by things like monetary policy (which history shows they aren't), we won't be able to develop methods for directly measuring and, therefore, understanding, the real effects of speculation on the economy.  Many of the convenient duologies of economics need to be replaced with trilogies (e.g., supply and demand becomes supply, demand and speculation; capital and labor becomes capital, labor and speculation; etc.)

Policy may have created the housing bubble, but which policy is to blame?

There is little dispute that misguided policy choices led to the housing boom-bust cycle from which we are still recovering. The debate about which policies were most culpable, however, rages on. The latest chapter in this dispute is now available in the proceedings from this year's edition of the Kansas City Fed's Jackson Hole Economic Policy Symposium.
In defense of monetary policy, Charles Bean, Matthias Paustian, Adrian Penalver, and Tim Taylor—all of the Bank of England—write this:

"We argue that while relatively low policy rates compared to past experience contributed to the growth in credit and the rise in house prices in the run-up to the crisis, they played only a modest direct role."

Stanford University's John Taylor (still) isn't buying it:

"Their conclusion differs from mine for several reasons. First, they do not take account of much empirical work completed since the 2007 Jackson Hole conference. For example, Jarocinski and Smets (2008) of the European Central Bank estimated a VAR [vector autoregression] for the United States and found evidence that 'monetary policy has significant effects on housing investment and house prices and that easy monetary policy designed to stave off perceived risks of deflation in 2002-04 has contributed to the boom in the housing market in 2004 and 2005.' In a more recent study focusing directly on deviations from policy rules, Kahn (2010) of the Federal Reserve Bank of Kansas City finds that ‘When the Taylor rule deviations are excluded from the forecasting equation, the bubble in housing prices looks more like a bump.' "

I added the links to the papers cited by Taylor because they are thoughtful challenges by thoughtful people, and they deserve to be considered (though the Jaroconski and Smets article requires some tolerance of relatively sophisticated econometrics). That insightfulness, of course, does not mean they are completely persuasive; I still have my doubts.

Really?

From Calculated Risk, we discover that the "recession" ended over a year ago:

The Business Cycle Dating Committee of the National Bureau of Economic Research ... determined that a trough in business activity occurred in the U.S. economy in June 2009. The trough marks the end of the recession that began in December 2007 and the beginning of an expansion. The recession lasted 18 months, which makes it the longest of any recession since World War II.

In determining that a trough occurred in June 2009, the committee did not conclude that economic conditions since that month have been favorable or that the economy has returned to operating at normal capacity. Rather, the committee determined only that the recession ended and a recovery began in that month. A recession is a period of falling economic activity spread across the economy, lasting more than a few months, normally visible in real GDP, real income, employment, industrial production, and wholesale-retail sales. The trough marks the end of the declining phase and the start of the rising phase of the business cycle. Economic activity is typically below normal in the early stages of an expansion, and it sometimes remains so well into the expansion.

The committee decided that any future downturn of the economy would be a new recession and not a continuation of the recession that began in December 2007. The basis for this decision was the length and strength of the recovery to date.

Saying it doesn't make it so.  Any "recovery" that does not include a return to employment levels as they were prior to the recession is not a recovery.  We are in the midst of a full blown depression, and it is going to get a lot worse before it gets better.