Tag Archives: Policy and Reform

The Fed As Super Duper Regulator? Will We be Duped Again?

Posted on July 10, 2009 by | Comments Off on The Fed As Super Duper Regulator? Will We be Duped Again?
By L. Randall Wray

Treasury Secretary Geithner is floating a plan that would consolidate more power in the hands of the Fed. The idea is that because it failed so miserably over the past decade to recognize a series of asset bubbles and growing systemic risk, it should be placed in charge of assessing and controlling systemic risk. You’ve got to love the logic. Could it have anything to do with the fact that Geithner came from the NY Fed where he used to cozy-up to Wall Street banks?

Three economists with widely different perspectives trashed the idea in hearings before the Subcommittee on Domestic Monetary Policy and Technology, Committee on Financial Services, U.S. House of Representatives, July 9, 2009.

“I do not know of any single clear example in which the Federal Reserve acted in advance to head off a crisis or a series of banking or financial failures,” said Allan H. Meltzer, professor of political economy at Carnegie Mellon University and the author of a history of the Fed.

John Taylor went on: “The administration proposal would grant to the Fed significant new powers, more powers than it has ever had before,” he told lawmakers. “My experience in government and elsewhere is that institutions work best when they focus on a limited set of understandable goals.”

James Galbraith, a long time Fed critic weighed in:

“Chairman Greenspan actively encouraged consumers to sign up for the innovative adjustable-rate mortgage products that would, eventually, destroy the system. Right up to July, 2007 in public statements and testimony before Congress, Chairman Bernanke continued to say that problems in the housing sector were manageable, and that the “predominant risk” was inflation. No doubt this emphasis reflected the macroeconomic priorities of the Federal Reserve at the time. Perhaps there was, also, a calculated desire to maintain public confidence. But that is precisely the problem. An effective systemic-risk regulator would not have those conflicting considerations.”

Those who followed the 1980s Savings and Loan fiasco will recall how that crisis was created by Chairman Volcker’s decision to raise interest rates to historic levels no matter how much that devastated the nation’s thrifts plus a hands-off treatment by regulators—who actually encouraged them to take on big risks to try to grow their way back to profitability. Indeed, top regulators saw their role as something akin to “cheerleading”, best represented by FDIC Chairman William Seidman’s enthusiastic statement that “bankers are our friends”, so encouraged his agency to operate like a “trade association” for the industry. Needless to say, cheerleaders do not make good regulators. (See my article here)

To be sure, the FDIC has done a much better job in recent years (and Chairwoman Sheila Blair has been a thorn in the side of both Geithner and previous Treasury Secretary Paulson). In his testimony Galbraith makes a good case for putting the FDIC—not the Fed–in charge of regulating systemic risk. The reason is that bankers more easily capture the Fed for the simple reason that most decision-making takes place in Washington at the FOMC meetings, where the regional Fed presidents take turns voting on monetary policy. Many of these come directly out of the banking sector (of course Chairman Bernanke does not), and all represent the interests of their member banks. Don’t forget, the private banks own the Fed, although the Fed is legally a creature of Congress. Imagine the outcry if we sold the Treasury to the highest bidder to create a similar Frankenstein creature. (A cynic might argue that “Government Sachs” already bought the Treasury—but let’s not go there.)

Whether the Super Duper Regulator is placed under the auspices of the FDIC, the Fed, or elsewhere, however, I am skeptical that it will do much good in the absence of thorough-going reform of the financial system. The fact is that the biggest financial institutions are too big to supervise, too powerful to regulate, and too big to fail. Practically by definition, anything that hurts the profitability of one of these behemoths will increase systemic fragility. Further, as students of the S&L crisis know, powerful financial institutions are able to buy lots of friendship in Congress (think Charles Keating and Senator John McCain).

Thus, it appears that the proposal for a Super Duper Regulator is an attempt to make a run around any real reform, which would have to start with the recognition that any institution that is too big to fail and too big to manage and too big to supervise and too big to regulate is also too big to save, thus, too big to retain.

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Think Unemployment Claims Show a Glimmer of Hope? Think Again.

Posted on July 9, 2009 by | 4 comments

by Pavlina R. Tcherneva

Last week 565,000 people filed first time jobless claims. Although this is the smallest number since January 2009, it is hardly cause for celebration. The unemployment claims data is highly volatile, and numbers reported during holiday weeks are especially poor indicators of employment trends. More telling is the number of continuing unemployment claims, which hit yet another record high of 6,883,000.

While many economists think that the economy is experiencing a labor market shock which will correct sooner or later, data on the duration of unemployment paints a different picture. Problems with the labor market have been brewing for decades.

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Time For the Third Stimulus Package

Posted on July 9, 2009 by | 4 comments
by L. Randall Wray

According to Paul Krugman “voices calling for stronger stimulus are, may I say, sorta kinda respectable — several Nobelists in the bunch, plus a large fraction of the prominent economists who predicted the housing crash before it happened.”

Professor Krugman provides a link to those who argued that the second stimulus was too small, as well as to those who are already calling for a third stimulus. Three UMKC-affiliated professors are listed, including yours truly. With some immodesty, I’d like to point out that Wynne Godley and I were already calling for a stimulus package in 1999. We were worried that a tightening fiscal stance forced our economy to rely on unsustainable private sector deficits. We said:

“Growing government budget surpluses combined with growing trade deficits have generated record private sector deficits. Unless households continue to reduce their saving—creating an increasingly unsustainable debt burden—the impetus that has driven the expansion will evaporate.”

Of course the economy did quickly collapse into recession, but emerged due to restoration of a budget deficit plus a growing domestic private sector deficit. Over the years, many of us continued to warn that the budget remained too tight while private sector deficits were unsustainable. It all went on far longer than we expected, which does not prove us wrong but rather means that the slump will be immensely worse than it would have been had it come to an end earlier. That is why many of us believe the stimulus is orders of magnitude too small. The private sector is left with a monumental debt overhang and things will not get better until private balance sheets recover.

The best thing that the government can do now is to stop the job losses and to start creating jobs. We are not talking about a couple of million new jobs at this point—we need 6.5 million to replace those already lost, plus another 1-2 million to provide jobs for those who would have entered the labor force (high school and college graduates, for example) if the economy had not collapsed. Reports this morning show that President Obama’s approval rating is falling—below 50% in the swing state of Ohio—and job loss is a big part of the reason. Pessimism is setting in and it will be hard to overcome because it is well-founded. Job losses are devastating for communities—retailers are hit, real estate prices continue to fall, and state and local governments are forced to cut spending.

Many are looking back to 1937, when fiscal policy inappropriately tightened and threw the economy back into depression; indeed the collapse in 1937 was faster than the original crash that started the Great Depression off. To some extent that is not the correct analogy because most of the second stimulus package has yet to be spent, and recent data reported by Mike Norman shows that the federal deficit has actually increased in recent days. But it is still not enough, as evidenced by the growing economic stress around the country.

I realize that it is important for Congress to settle on some dollar figures for a third stimulus because that is the way that budgeting works. But in truth it is impossible to say beforehand how much we will need to stop the carnage. As James Galbraith has been warning, it is better to err on the upside. So far we have done the opposite—with the predictable result that the economy continues on a path toward another great depression.

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The Carnage Continues: Time To Ramp Up the Stimulus

Posted on July 7, 2009 by | 5 comments

By L. Randall Wray

Some like to see green shoots everywhere, but that is becoming an increasingly audacious hope. Here are four related stories from the July 5th edition of the New York Times:

Tax Bill Appeals Take Rising Toll on Governments By JACK HEALY

Homeowners across the country are challenging their property tax bills in droves as the value of their homes drop, threatening local governments with another big drain on their budgets…. The tax appeals and reassessments present a new budget nightmare for governments. In a survey conducted by the National Association of Counties, 76 percent of large counties said that falling property tax revenue was significantly affecting their budgets…. Officials in some states say their property tax revenue is falling for the first time since World War II.

Safety Net Is Fraying for the Very Poor By ERIK ECKHOLM

Government “safety net” programs like Social Security and food stamps have pulled growing numbers of Americans out of poverty since the mid-1990s. But even before the current recession, these programs were providing less help to the most desperately poor, mainly nonworking families with children… The recession is expected to raise poverty rates, economists agree, although the impact is being softened by the federal stimulus package adopted this year…. “It’s a good thing we have the stimulus package,” Mr. {Arloc} Sherman said. “But what happens to the most vulnerable families in two years, when most of the provisions expire?”

Employment Report Sours the Market By JEFF SOMMER

A grim report on unemployment on Thursday let the air out of the stock market…. In a monthly report, the Labor Department said that 467,000 jobs were lost in June. In surveys, most economists expected 100,000 fewer jobs lost. The unemployment rate edged up to 9.5 percent from 9.4 percent the previous month, to its highest level in 26 years, and virtually all analysts expect joblessness to mount in the coming months.

So Many Foreclosures, So Little Logic By GRETCHEN MORGENSON

LAST week, the stock market tumbled on news that housing foreclosures and delinquencies rose again in the first quarter. The Office of the Comptroller of the Currency said that among the 34 million loans it tracks, foreclosures in progress rose 22 percent, to 844,389. That figure was 73 percent higher than in the same period last year…. But the most fascinating, and frightening, figures in the data detail how much money is lost when foreclosed homes are sold. In June, the data show almost 32,000 liquidation sales; the average loss on those was 64.7 percent of the original loan balance.

What do these reports have in common? They provide powerful evidence that the federal government is not doing enough to help the “real” economy. As Sam Gompers famously responded when asked what workers wanted–“More!”—our nation’s state and local governments, households, workers, and poor need more help, now. We have tried the Reagan/Paulson/Rubin/Geithner “trickle down” approach of targeting relief to Wall Street, but the only thing trickling down is misery. The only way to stop the downward spiral is to substitute trickle-up policy—and even if nothing trickles-up, at least we will have helped those most in need.

I have already outlined a comprehensive recovery package so will here simply summarize four policies that would bring immediate relief.

1. Payroll tax holiday: This provides nearly $2500 of tax relief per year for each worker, with the same amount of relief going to that worker’s employer. The total stimulus to the economy would be somewhere around $650 billion per year. The relief is well-targeted (to workers and employers), immediate (take home pay rises as soon as the holiday takes effect), simple to administrate, and can be phased out (if desired) after the economy recovers.

2. State and local government assistance: The current stimulus package provided some relief to state and local governments, but was so little that it is forcing them to make Hobson’s choices: cut poor children from Medicaid roles or decimate universities? Furloughs for firefighters or postpone bridge repairs? Increase real estate taxes or raise fees for services? Only the federal government can resolve revenue shortfalls by providing funding to keep state and local governments running. Perhaps $400 billion, allocated by population (a bit over $1200 per capita) across state and local governments would be sufficient. If President Obama really could reform healthcare, that would generate tremendous savings for state governments that are saddled with exploding Medicaid costs to cover low income and elderly patients. Until then, direct grants are required. As I have argued, for the long-term we need a permanent program of federal transfers to states, with some of that attached to a requirement that they reduce reliance on regressive taxes.

3. Jobs to reduce poverty: Last week Pavlina Tcherneva provided an excellent argument for direct job creation by the federal government. We have already lost 6 million jobs, and Tcherneva notes that unemployed plus discouraged workers total about twice that number. However, a plausible case can be made that we are short more than 20 million jobs—as Marc Andre Pigeon and I demonstrated a decade ago. Further, as Stephanie Kelton and I showed, a substantial amount of America’s poverty problem is really a jobless problem. We found that in 2002 the poverty rate of families with no member working reached nearly 26%; on the other hand, if the family had at least one member working full-time, the poverty rate fell to just 3.5%. Our conclusions were similar to those offered by Hyman Minsky: “The achievement and sustaining of tight full employment could do almost all of the job of eliminating poverty” (1968, p. 329); “a large portion of those living in poverty and an even larger portion of those living close to poverty do so because of the meager income they receive from work” (p. 328). Minsky believed that “a suggestion of real merit is that the government become an employer of last resort” (1968, p. 338). Thus, not only will direct job creation reverse the trend toward ever-higher unemployment rates, but it will also go a long way toward filling the growing holes in the social safety net.

4. Homeowner relief: The plan offered by Warren Mosler provides an alternative to the current painful foreclosure process. When banks begin to foreclose, the government would step in to purchase the property at the lower of market price or outstanding mortgage balance. Of course, establishing market price in a glut is not simple and I will leave it to real estate market experts to compose a plan. What is more important is to keep people in their homes. Mosler proposes that the federal government would rent homes back to the dispossessed owners (Dean Baker has a similar plan) for a specified period (perhaps two years) at fair market rent. At the end of that period, the government would sell the home, with the occupant having the right of first refusal to buy it. By itself, this proposal would do little to stop spiraling delinquencies and foreclosures, and home prices will probably continue to decline for many months (or even years). However, as the other parts of this stimulus package begin to spur recovery, the real estate sector freefall will (eventually) be halted. I am somewhat ambivalent about continued falling house prices—on one hand, this will make housing more affordable; on the other it is devastating for families. Still, reducing evictions by offering a rental alternative will help reduce the pain of foreclosure. It might also allow the process to speed up (with smaller losses for banks) since many families would choose to stay-on as renters, with the possibility that they could later buy their homes at more reasonable prices.

I will not address here the preposterous argument that failure of the economy to swiftly recover is evidence against the Keynesian belief that government spending is the answer. Leaving to the side the Wall Street bail-outs (that do little to stimulate production and jobs), only a small portion of the stimulus package has been spent to date. There is evidence, however, that the automatic stabilizers (falling federal tax revenue and rising federal spending) are doing some good already—and would eventually pull the economy out of this depression. However, there is no reason to wait for our ship to hit bottom before it slowly resurfaces. Active, discretionary, targeted policy can reduce suffering and generate the forces that will be required to overcome substantial headwinds created by the private sector as well as by our state and local governments. Only the federal government has the fiscal wherewithal to lead us out.

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BIS Report Warns That Main Problems Have Not Been Solved

Posted on July 6, 2009 by | Comments Off on BIS Report Warns That Main Problems Have Not Been Solved

by Eric Tymoigne

The Bank for International Settlements (BIS) in its 79th Report makes several interesting points that are consistent with what has been argued on this blog. Echoing an argument made by William Black, the BIS notes that we must thoroughly analyze banks’ balance sheets in order to rebuild the financial system: “A major cause for concern is the limited progress in addressing the underlying problems in the financial sector . . . a precondition for a sustainable recovery is to force the banking system to take losses, dispose of non-performing assets, eliminate excess capacity and rebuid its capital base. These conditions are not being met. . . The banks must . . . adjust by becoming smaller, simpler and safer.”

The report also notes rightly that worries about “exit strategies” for current central banks’ policies are misplaced, because “even if central banks are not able to shrink their balance sheets, they can withdraw liquidity through repurchase operations or the issuance of central bank bills or by making it more attractive for banks to hold reserves.” As noted in previous posts by Scott Fullwiler and L. Randall Wray, there are straightforward means for a central bank to always meet its interest rate targets, and these strategies are not intrinsically inflationary.

The report also recognizes that “there must be a mechanism for holding securities issuers accountable for the quality of what they sell. This will mean that issuers bear increased responsibility for the risk assessment of their products.” The Report, however, does not go far enough in recognizing that some products should be banned even if used by “sophisticated” financial institutions. Not all financial innovations are a desirable sign of progress. This is especially so if they promote Ponzi finance, which should be a central criterion to judge the safety of a financial product and an institutional organization.

A final interesting point is the acknowledgement that price stability and economic growth are not guaranteed by fine-tuning policies, and that there is a need to manage financial stability. Indeed, the crisis has shown that price stability does not guarantee financial stability and that, contrary to what most economists believed until very recently (and some still believe), the fine-tuning of inflation by interest rates is of limited effectiveness. “The crisis has confirmed that the monetary and fiscal policy framework that delivered the Great Moderation cannot be relied upon to stabilize prices and real growth forever . . . policymakers must be given an explicit financial stability mandate and that they will need additional tools to carry it out.”

However, the way financial stability should be promoted is highly contentious. Most economists argue that the causes of financial instability are imperfections of markets (asymmetry of information, mispricing, etc.) or of individuals (lack of financial education, irrationality, etc.). Hyman Minsky provided a very different explanation of financial instability that did not rely on imperfections and bubbles but on the intrinsic mechanisms of market economies over a long period of economic growth. According to Minsky, over periods of long-term expansion, economic growth and the maintenance of competitiveness require the growing use of Ponzi finance. As a consequence, not only illegal and fraudulent activities, but also legal economic activities become financially fragile. He advocated policies that strongly discourage the use of Ponzi practices (e.g., tax incentives) and/or an outright elimination of legal and illegal Ponzi processes, no matter how necessary they may seem to be for the (short-term) improvement of standards of living and competitiveness. This, rather than improvements of risk-management techniques or improvements in the management of asset prices (detection and pricking of bubbles), would help to prevent financial instability. That would require a much more flexible regulatory system that includes all financial institutions and products, without any exception, and that constantly monitors innovations (i.e. new ways of using existing products or new products) to prevent the emergence of Ponzi processes.

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Coherently Confronting US Macro Challenges

Posted on July 3, 2009 by | 1 comment
Many investors, policy makers, and economists find themselves unnerved by current economic conditions, and reasonably so. Depression or recovery, deflation or run away inflation, private or public insolvency – debates rage on all fronts. The disarray reflects in part the uncharted waters the global economy has sailed into over the past year, but it also reflects the inadequacy of contemporary macro frameworks. The financial balance approach is a simple yet powerful lens that can help clarify relationships that otherwise remain elusive at the macroeconomic level. Without this lens, it is hard to think coherently about the options available and their possible consequences.

We first encountered the financial balance approach[1] in the work of Wynne Godley at the Levy Institute for Economics over a decade ago, but this framework also informed the contributions of Hy Minsky and Dr. Kurt Richebacher in anticipating the conditions that give rise to financial instability at the level of the economy as a whole. It is not a difficult approach to follow, but it has proven very useful in thinking through the implications of recent credit bubbles and episodes of financial instability.

We can enter this approach from the standard macro observation that in any accounting period, total income in an economy must equal total outlays, and total saving out of income flows must equal total investment expenditures on tangible assets. The financial balance of any sector in the economy is simply income minus outlays, or its equivalent, saving minus investment. A sector may net save or run a financial surplus by spending less than it earns, or it may net deficit spend as it runs a financing deficit by earning less than it spends.

Furthermore, a net saving sector can cover its own outlays and accumulate financial liabilities issued by other sectors, while a deficit spending sector requires external financing to complete its spending plans. At the end of any accounting period, the sum of the sectoral financial balances must net to zero. Sectors in the economy that are net issuing new financial liabilities are matched by sectors willingly owning new financial assets. In macro, fortunately, it all has to add up. This is not only true of the income and expenditure sides of the equation, but also the financing side, which is rarely well integrated into macro analysis.

We can next divide the economy into three major sectors: the domestic private sector (including households and businesses), the government sector, and the foreign sector and ask a simple question relevant to current developments. What happens if the domestic private sector tries to net save, with no attending change in the government or foreign sector financial balances?

If households attempt to net save by spending less than they are earning, and businesses attempt to net save (reinvesting less than their retained earnings), then nominal incomes and real output will be likely to fall. Money incomes and economic activity will tend to contract until private savings preferences are reduced (with essential goods and services taking up a larger share of household income as incomes fall), or until depreciation leaves businesses and households inclined to invest once again in durable assets. Common sense suggests that a drop in private income flows while private debt loads are high is an invitation to debt defaults and widespread insolvencies – that is, unless creditors are generously willing to renegotiate existing debt contracts en masse.

In other words, such a configuration is an invitation to Irving Fisher’s cumulative debt deflation spiral which has been discussed on this website and in prior Richebacher letters. So unless some other sector is willing to reduce its net saving (as with the foreign sector recently, via a reduction in the US current account deficit as US imports have fallen faster than US exports) or increase its deficit spending (as with the federal budget balance of late) then the mere attempt by the domestic private sector to net save out of income flows, given the existing private debt overhang, can prove very disruptive.

In fact, the US economy has dipped into a mild version of Fisher’s debt deflation process as nominal GDP has fallen, wage and salary income flows have fallen, the CPI and other inflation measures have dropped into deflation, and private debt delinquencies and defaults are still spreading. Following the shocks to tangible and financial asset prices, credit availability, and the labor market, the US private sector, by our calculations, has swung from a 4.5% of GDP deficit spending position three and a half years ago to a 4% net saving position as of Q1 2009. This exceeds the 8% of GDP swing in the private sector financial balance witnessed as the tail end of the 1973-5 recession – it is an enormous adjustment, to put it mildly.

Had the current account deficit (which, remember, is the trade balance plus net income flows related to asset holdings, equals foreign net saving) not shrunk from 6% to 2% of GDP over the same period, while the combined government fiscal deficit increased from 1.5% to 6% of GDP, then the attempt by the private sector to complete such a dramatic swing in its financial balance position would have ended in a very sharp and severe debt deflation.

From an Austrian School perspective, nothing less than that is required to wipe the slate clean of excess private debt and to free up productive resources misallocated during the credit boom years. However, the political appetite for an Austrian solution appears to have all but disappeared following the global repercussions of the Lehman derailment. Investors and policy makers looked into the abyss, and they could not stomach what they saw. Even Germany Chancellor Merkel, who appears to have the most Austrian orientation among G7 policymakers, has chosen to introduce some degree of fiscal stimulus and financial sector intervention in the German economy.

To further illustrate the current situation, we can use the 1973-5 recession as a rough guide – after all, as mentioned above, that is when domestic private net saving jumped to its highest share of GDP in the post WWII period. Currently, we appear to have an even deeper recession, and we know the drop in the ratio of household net worth to disposable income is over four times that experienced in the 1973-5 episode. What happens if private net saving preferences run all the way up to 10% of GDP, with say an additional 4% of GDP increase from the household side, and another 2% from the business side?

If the swing evident from 2006 is any indication, the hypothetical 4% increase in the household financial balance as a share of GDP will take the current account back to balance (for the first time in nearly two decades) from its recent 2% of GDP deficit position. To further contain debt deflation dynamics, given a domestic private sector attempting to save 10% of GDP, the combined fiscal balance will need to expand out to 10% of GDP, or else private income will fall further. The reduction in foreign net saving and the increase in fiscal deficit spending will then match the increase in private net saving from Q1 2009 values assumed above.

If the combined government deficit aims for 12-13% of GDP while the domestic private sector is shooting for 10% and net foreign saving is zero, then the odds improve that an economic recovery can take root alongside a larger private sector deleveraging than we witnessed in Q1 2009. Household and business incomes will be buttressed by tax cuts and government spending, which will allow higher private spending for any given private saving target. In other words, in a worst case scenario, it does appear debt deflation dynamics can be contained and reversed, but at the price of a rather large fiscal deficit that in essence validates higher domestic private sector net saving. The linkages between rising private sector net saving and deflation, and between fiscal deficits and private net saving, are currently poorly understood, but the financial balance approach helps bring some clarity to these questions.

Normally, the business sector tends toward a deficit spending position as profitable investment opportunities exceed retained earnings. This makes a certain amount of sense: debt imposes future cash flow commitments on borrowers, and using debt to expand productive capacity allows the borrower to have a decent shot at generating sufficient cash flow to service debt. Notice this is not usually the case with consumer debt, except perhaps with the case of mortgages used to purchase rental properties, or credit cards used to finance new small businesses. Households do not directly increase their income earning capacity, and hence their debt servicing capacity, by purchasing a flat screen TV or a larger house on credit. Of course, businesses that use credit to buy back shares or complete a merger or acquisition similarly are not directly enhancing their ability to service debt with new productive capacity, so the intended use of new debt is relevant in either sector.

Richard Koo makes the related point in his book, “The Holy Grail of Macroeconomics”, that following the bursting of an asset bubble, businesses often move into a debt reduction mode that takes over their usual search for profitable opportunities. For the current post bubble period, reeling fiscal deficit spending back in before the business sector is headed back toward its more “natural” deficit spending position, or before the rest of the world has found its way to a faster pace of recovery than the US (thereby aiding US export growth), could prove disruptive.

Ideally then, fiscal deficit spending would be designed to encourage businesses to reinvest in more efficient technology or in new product innovation, both of which could help improve US export competitiveness. Alternatively, public/private cooperation in R&D projects like Sematech could be explored with various emerging energy technologies, for example, in order to reduce US energy dependence. Such moves would speed the transition away from deep fiscal deficit spending which began riling investors in longer dated Treasury debt back in March. Nevertheless, such a shift in the fiscal deficit was required for the domestic private sector to return to a net saving position and begin reducing its debt load without setting off a full blown debt deflation.

At best, favorable effects on business investment will arise be secondary or peripheral results of some of the infrastructure and green tech investments in the current fiscal stimulus package, generally due to ramp up in 2010 and 2011. Unfortunately, since few economists work with the financial balance approach we shared with you above, policy makers are not yet emphasizing this type of policy design. Nevertheless, the financial balance approach does offer a more coherent way of thinking about the macroeconomic dynamics currently underway, and the plausible paths ahead. From this framework, we can see the situation is indeed difficult, but not insurmountable, as some of the necessary adjustments in US sector financial imbalances are already in motion. Deflation in the US does look like it can be contained and reversed, but the quest for a new growth model – one that does not rely on serial asset bubbles, household deficit spending and debt accumulation, and imported consumer goods leading to a perpetually rising current account deficit – remains ahead. No doubt it will test the ingenuity and adaptability of an entire generation – a generation that through the abundance of credit, may have forgotten that in order to consume, one must first produce.

[1] Very simply, if income (Y) equals expenditures (E) at the level of the whole economy, and we split the economy into three sectors, domestic private (dp), government (g), and foreign (f) then the following holds true:

Y = E
Ydp + Yg + Yf = Edp + Eg + Ef
(Ydp-Edp) + (Yg-Eg) + (Yf – Ef) = 0

The first term in parentheses is the domestic private financial balance, the second is the combined government financial balance, and the third term is the inverse of the current account balance, since US imports are income to foreign producers, and US exports are expenditures of foreign economic agents. The sum of the domestic private financial balance and the combined government financial balance minus the current account balance must net to zero.

This is an ex post accounting identity that must hold true. It could equally be derived using the saving equals investment identity for the economy as a whole. Values for these concepts can be derived from the Fed’s Flow of Funds quarterly report. In general, nominal income adjusts to reconcile divergences in planned investment relative to intended saving.

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Bring the Stubborn Unemployment Numbers Down Now

Posted on July 2, 2009 by | 18 comments

by Pavlina R. Tcherneva

Every month this year (perhaps with the exception of May) economic forecasters were stunned by the unexpectedly high unemployment numbers. Today the Bureau of Labor Statistics reported that in June employers shed 467,000 jobs, pushing the unemployment rate to 9.5%, a 25-year high. With an ever gloomier jobs picture, President Obama’s economic team has started to change its tune with respect to the promised job creation. The first economic report on the job impact of his recovery plan carefully phrased the objectives to include “creating or saving” at least 3 million jobs by the end of 2010. Those early projections called for peak unemployment of 8% in the third quarter of this year, far less than today’s actual unemployment rate of 9.5%

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A Message to President Obama: Stop Priming the Pump, Hire the Unemployed

Posted on July 2, 2009 by | 2 comments
by Pavlina R. TchernevaMany have called President Obama’s stimulus plan a return to Keynesian policy. Some of us who like reading Keynes professionally or for leisure have already been scratching our heads. I have wondered in particular whether the plan isn’t set up to work in a manner completely backwards from what Keynes himself had in mind when he advocated economic stabilization by government.

There are two things to remember about Keynes’s fiscal policy proposals: 1) government spending was always linked to the goal of full employment (the absence of both cyclical and structural unemployment) and 2) to achieve macro-stability and full employment, the government had to employ the unemployed directly into public works.

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Government Deficits Generate Household Savings

Posted on June 30, 2009 by | 5 comments

by L. Randall Wray

A Bloomberg report by Rich Miller and Alison Sider recently noted that “Americans are shutting their wallets and building their nest eggs at the fastest pace in 15 years.” It went on: [T]he household savings rate rose to 6.9 percent in May, the highest since December 1993, as personal spending increased less than incomes. The rate in April 2008 was zero. Most of the rise in income in May was due to one-time government stimulus payments to seniors, said Nigel Gault, chief U.S. economist at IHS Global Insight in Lexington, Massachusetts.
These should not be surprising events, as we have explained in previous posts (here, here and here). Government sector spending creates private sector income; government sector deficits create private sector savings. These are identities that virtually no one recognizes. I can recall that during the Clinton administration’s budget surpluses, the Wall Street Journal ran two front-page stories side-by-side, one congratulating the government for finally getting its budget in order—supposedly adding to national savings–and the other chastising consumers for spending more than their incomes—reducing national savings. The rising Obama budget deficit will help our private sector to accumulate savings and retire debt, part of the necessary remedy to the run-up of debt that occurred over the past dozen years. Unfortunately, fiscal policy remains too tight, as evidenced by continued (and, I think, growing) stress in the retail sector.

The report goes on: “the trend will put the country’s finances in better balance and reduce its dependence on Chinese investment”. Now this is utterly confused. Yes, our household sector’s finances will improve and might eventually recover—if the fiscal stance loosens and job losses are turned around to employment growth. However, the US did not, indeed in a significant sense cannot, rely on the Chinese. Our spending is in dollars, and we are the source of those dollars. Needless to say, every dollar spent by the Chinese was generated by us. In fact, we “financed” their accumulation of dollars, mostly through our current account deficit (we bought more stuff from them than they bought from us). This allowed them to “net save” in dollar assets. As our trade deficit with China shrinks (by the way, not necessarily a good thing for us!), China’s net saving in dollars will also shrink. It is quite unlikely that the trade balance will reverse any time soon (China is not going to become a net importer in the near future), so China will continue to accumulate dollar assets although (probably) at a reduced pace. But that does not “finance” US domestic spending.

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Posted in L. Randall Wray, Paulson/Geithner Plans, Policy and Reform, The Federal Government Deficit, Uncategorized

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Why The Stimulus Isn’t Working

Posted on June 29, 2009 by | 4 comments

by Stephanie Kelton

President Obama’s economic advisors are predicting that the recession will come to an end sometime this year, as fiscal stimulus spending kicks into high gear. But the conditions for an economic recovery have not been laid.

What the left hand giveth (see table), the right is quickly taking away.

And I’m not talking about the “right-wing.” I’m talking about state and local governments across the nation, who are unwittingly pulling the rug out from under the federal government and thwarting any chance for a sustainable recovery by 2010.

But it isn’t their fault. Tax revenues have fallen off a cliff, leaving states with a cumulative budget gap of more than $100 billion for fiscal ’09.

To deal with these shortfalls, states have laid off or furloughed thousands of employees, raised taxes and fees, and slashed spending on education and other social programs – some, many times over. It was supposed to balance their ’09 budgets. But it wasn’t nearly enough.

As it turns out, state officials were far too optimistic about the ’09 revenue picture, and they are scrambling to deal with widening shortfalls before the end of the fiscal year (which, by the way, is tomorrow for all but a few states). At this stage in the game, there are only a couple of ways for states to balance their ’09 budgets (it’s too late for more tax hikes and spending cuts). Most are expected to do one of two things: (1) tap rainy day funds or (2) use federal stimulus money.

For example, Ohio is expected to dip into its $948 million rainy day fund in order to deal with its worst-ever decline in tax revenue. Meanwhile, Massachusetts Gov. Deval Patrick has indicated that his state will be forced to use some of its federal stimulus money to plug a budget gap of nearly $1 billion by June 30.

The problem, of course, is that the macroeconomic effects of these micro-level policies are working at odds against the federal stimulus effort. Jobs that are being created (or saved) through the left hand of the Obama stimulus package are disappearing at least as rapidly as the right hand slashes billions from state budgets.

And, while Obama’s advisors are focused on the silver lining in the recent job data (losses are slowing), the employment picture remains bleak. The following table shows the change in unemployment rates – by state – since the start of the recession and from April ’09 to May ’09.

All but two states saw an increase in unemployment last month, and fourteen states are now in double-digit territory. President Obama’s economic team has admited that the national average will probably reach double-digits, but they anticipate a turnaround as a flood of stimulus money makes its way into the economy later this year.

But Obama’s advisors may be overlooking the fact that much of the stimulus money isn’t going to be there to fund new projects and drive economic growth. This is because states like Massachusetts are diverting stimulus money away from future projects in order to cover past (2009) budget shortfalls.

And the worst may be yet to come. States are bracing for even bigger revenue shortages next year, and governors across the nation are warning of deeper cuts in fiscal 2010. And right now, no single state poses a bigger threat to the nation’s economic recovery than California.

With an estimated $24 billion budget shortfall and a July 1 deadline to close its deficit, California’s top officials asked the federal government for emergency funding to help alleviate further drastic cuts in state spending. But the president’s top economic advisors – including Treasury Secretary Timothy Geithner, and White House economists Lawrence Summers and Christina Romer – rejected Gov. Schwarzenegger’s request for aid, choosing, instead, to admonish the governor for failing to put California’s fiscal house in order.

The Washington Post reported that Gov. Schwarzenegger was denied federal assistance because White House officials feared that it would lead to “a cascade of demands from other states.” This kind of head-in-the-sand thinking will have tragic consequences.

States need more aid, and they need it now. The White House should be faced with a cascade of demands, and these demands should come from a broad coalition of governors, who storm the White House – cameras rolling – to explain the dire consequences of denying them emergency aid. Randy Wray suggested, in a previous post, that states need another $400 billion or so, and that seems like a reasonable figure. I would urge our nation’s governors to immediately request an additional $1,000 per resident.

As I have argued in a previous post, the Obama administration’s initial forecasts were far too rosy, and the Economic Recovery & Reinvestment Act didn’t provide enough aid for states. More needs to be done, and it needs to be done now. Every dollar slashed from a state budget undermines a dollar of federal stimulus spending.

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Posted in Paulson/Geithner Plans, Policy and Reform, Stephanie Kelton, Uncategorized

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