Robert Reich: "Double the Stimulus"

I like Robert Reich. He has a wonderful style of writing, at once assertive in his rhetoric and reasonable in his tone. In a recent blog post, (3/13/09) he calls for a new stimulus of roughly equal size to the last stimulus of $787 billion.

That is interesting. The President of the European Union, Czech PM Mirek Topolanek has just made headlines by calling the stimulus the way to hell. Topolanek argues that to ramp up spending during a recession is the wrong move. He's going against the grain, and since his center-right party just lost a vote of no confidence, he probably won't have much influence. It does seem like an unusually provocative statement.

Double the stimulus or road to hell?

In Marxian terms, this recession is all about what is called 'unproductive' economic activity, meaning labor which is not designed to produce value (i.e. activities which directly transform raw materials with labor in order to produce something which meets a human need). Unproductive activity is important, yet it does not directly produce an economic surplus (that amount which is produced which is greater than the needs of the direct producer). Over the last 60 years, the US economy has dramatically increased its unproductive activity, shown nicely in Measuring the Wealth of Nations, by Anwar Shaikh and E. Ahmet Tonak.

The activities of the Federal government, though important, are unproductive in the sense that they are not intended to produce a surplus. That means that government must be funded from a portion of the total surplus produced in the US. Since the crisis facing US capitalism is a crisis of unproductive activity, it cannot be solved by increasing the amount of unproductive activity.

In the years to come, we will see a return to productive economic activity: agriculture and manufacturing will once again dominate the US economy.

Fed "Quarterbacking"

If you want something that will turn you against the study of monetary economics forever, read a series of experts debating what the Fed should've done and how what they did affected the economy. For example, The Wall Street Journal's recent symposium, Did Alan Greenspan Cause the Housing Bubble?

What a tiresome parade of simplistic reasoning and confusion, with the exception of Judy Shelton's piece, "Loose Money and the Derivative Bubble." (She has another great article published on 2/11 called Capitalism Needs a Sound-Money Foundation. (Ms. Shelton is the author of Money Meltdown, which I confess I have not yet read.)

To blame the Chair of the Fed for supposedly disastrous Fed policies is "quarterbacking", as in, how might have that game played out if the quarterback had acted differently? A speculative exercise at best, quarterbacking ignores the interconnected nature of events, supposing that we could go back in time and change one thing, leaving all other things unchanged.

The other problem with Fed quarterbacking is that the Fed is in an impossible position. The Fed's stated mission is to maintain price stability, full employment, and financial stability. Each of these is a sham. Price stability? The Fed issues a fiat currency, and has recently increased the number of Federal Reserve Notes (aka dollars) by several trillion (most of it in electronic form). The Fed is the primary engine of inflation, not price stability.

That the Fed can use wise monetary stimulus to ensure full employment is Keynesian dogma, and it's more or less true during the credit-fueled boom. But when that boom ends, as it must, the Fed becomes ineffective, for the contraction in bank lending tends to counteract the Fed's lowering of the interbank lending rate. This is where we are now, and the Fed's efforts to re-inflate the bubble are likely to create inflation, which will surely interfere with the economic adjustments necessary to begin recovery.

As for financial stability, the Fed presides over a fractional reserve banking system, which is inherently unstable. Like building on a river delta, a flood will periodically come and wash out the banking system, causing banking failures and bank runs, which the system cannot endure.

The housing bubble isn't Alan Greenspan's fault. But it is the fault of the Fed system, which generates credit bubbles which must inevitably pop. Greenspan should've known better. He has long advocated the gold standard. But he just did what everyone wanted him to do: he spiked the punch so we could all get drunk at a decades-long party. Now we're sobering up and cursing the man who sold us the drinks we demanded.

"No reputable economic forecaster is predicting a depression"

Says Edward Leamer, Director of the UCLA Anderson Forecast, on Marketplace. He sees no depression in the near future:

We've frightened consumers to the point where they imagine there is a good prospect of a Great Depression. That certainly is not the prospect. No reputable forecaster is producing anything like a Great Depression. So it's still OK if you spend a little bit. You do not have to put all your money into a mattress.

Dr. Leamer also sees the economy in a "healing cycle" by the second half of 2009, without "significant growth", but with fewer of the "large negatives" we've seen so far.

We shall see. I do not think that the errors and excesses of the boom years will be corrected by then. My guess is that the inflationary recession will continue for a period of years rather than quarters, particularly since government policy seems driven to prevent markets from reaching equilibrium, and the Fed is producing monumental amounts of new money, much of it secretively, off its balance sheet. Estimates of Fed off-balance sheet money creation are in the trillions of dollars.

Here are a few analyses of the magnitude of these Fed activities: ritholtz.com/blog, nowandfutures.com (this site also has a reconstruction of M3, the broad monetary aggregate that was discontinued by the Fed in 2006.)

Webcast with Karl Case "The Economy and the Housing Crisis"

I got an invitation from Pearson, one of the textbook publishers that is always trying to sell me their texts, to participate in a live webcast with Karl E. Case, Professor of Economics at Wellesley College and founding partner of the real estate research firm Fiserv Case Shiller Weiss, which produces the S&P Case Shiller Index. The Case Shiller Index is, in my view, the best of the real estate indices.

If you want to check it out, it's March 31st, 12-1 EST.

Go to: www2.eventsvc.com/pearson

They want you to register first.

I'm interested because Karl Case has said housing has hit bottom, and I'd like to know his reasons. There will be a Q&A after the talk, so I'll report back on it.

Outrage Over AIG Bonuses

It's been interesting to watch the back-and-forth over the $165 mil in bonuses to the AIG execs and financial wunderkinds in the division that wrecked the company.

On the one side, AIG is like, well, we're still in business, so it's business as usual. The "performance" part of the bonuses was based on a Panglossian assessment of the profitability of the credit default swaps. (Jack Adamo of Forbes has a nice article on this.)

It sure makes the government look bad to be completely behind the curve on this. Congress knew about the bonuses for months, but only acts once the public gets upset.

Is AIG stock a candidate for a short sell? I'd say so. The stock more than tripled in price recently, going from a low of $0.35 to a high of $1.28 today. The short interest is currently 5.9%.

A former student sent me a note asking about AIG - is it a good idea to invest in it, since it seems like the government is behind it, so it can't fail, right? I said it was extremely speculative, since AIG is sitting on God-knows-how-much in liabilities, but in the short term, I expect the stock to rally to $1, making it a good play if you have the stomach for the risk.

At this point, I expect the rally to take the Dow to 8300 before resuming its downward course, and I expect AIG will be punished by the market soon.

And yes, I try to only list my good calls...

Should We Cap Interest Rates?

A new article in Harper's Magazine (subscriber only, but here is an interview where he gives the main points) by Thomas Geoghegan offers an interesting solution to the problem of financial collapse: cap interest rates.

His argument is provocative: by deregulating interest rates, we encouraged the massive growth of the financial sector, for the simple reason that capital can obtain much higher rates of return through lending consumers money at high interest rates than it can get in, say, manufacturing. Securitization separated the lender from the owner of the debt, which created an incentive for lenders to engage in misleading practices and really sell the idea of debt to consumers. The average working family got killed by higher and higher interest rates.

He's right about so much of this that I find it frustrating that he arrives at the conclusion of capping interest rates.

Yes, the growth of the financial sector was because of higher profit rates; yes, securitization separates lender from owner of debt, creating some bad incentives; and yes, the average household is getting killed by high interest rates. But to cap interest rates would simply mean that much of the lending to consumers would simply dry up or be driven underground at much higher interest rates. (The classic deal with a loan shark is "a point a week", or 52% yearly interest.)

High adjustable-rate interest is simply the market's response to inflation. Eliminate the inflation, and you will eliminate high interest rates. Indeed, the sooner the market correctly prices the asset-backed securities that are based on debt, the better, because that will be the day when this scheme is finally buried once and for all.

To get the government involved in this process would be a mistake. Government-based pricing does not tend to produce good outcomes, it tends to produce shortages and surpluses.

The Architect of the Obama Stimulus Plan

Professor Bob Pollin, one of my old professors from the University of Massachusetts Amherst wrote an influential article in The Nation called How To End the Recession which had a big impact on the Obama Administration.

I have a lot of respect for Professor Pollin. He is the co-founder of the Political Economy Research Institute and a long-time advocate for working Americans. He is the author of Contours of Descent, a good book about the US economy during the 1990s. (Click here for a review I wrote of the book). Nonetheless I must differ with him that a stimulus of the kind and magnitude he offers will end the recession. (In the article, he calls for a stimulus of $300 bil, so that has been enthusiastically exceeded by the Obama Administration)

The recession will continue until all the disastrous business blunders that accumulated during the distortions of the boom years have been purged.

During a credit-fueled boom like the one we've just observed, the economy accumulates investment mistakes, due to the patterns that emerge that look sustainable but are not. For example, due to the easing of lending standards, the rate of homeownership rose from about 65% to nearly 70%. Millions more people owned homes than before. That incredible rise in real estate buying and selling fueled a boom in home construction. It is now abundantly clear that many of the new homeowners should not have purchased their homes. They did not have the income to purchase the home they did at that price.

All the economic activity that grew up around booming home prices now must be directed toward other ends. The number of realtors, which increased 50% (thanks to the Political Calculations blog for a nice analysis) from 2001 to 2006, must return to historical levels. Home construction must fall. Home prices must fall until they reach a level of historical affordability.

The reality is that an economic stimulus of $300 bil such as what Professor Pollin proposed, or the more ambitious version that the Obama Administration created will not encourage the kind of restructuring to which I refer above. Instead it will slow down the necessary adjustment, and add inflationary pressure to the mix.

A Prediction for the Dow

In the spring of 2006, my father and I predicted a financial crisis would hit the US. (We assumed that this crisis would be driven by dollar depreciation, which has not yet occurred). We continue to feel strongly that the dimensions of the coming crisis are still not grasped by most Americans. In January 2008, I predicted the Dow would fall to 7000. Given what has now occurred, our concerns were mild. Yes, an estimated $60 tril of paper wealth has been destroyed globally, but there is much more to come.
Over the next five or ten years, the US will sink into a deep recession. Unemployment will rise dramatically as the restructuring of the American economy proceeds. We see the Dow falling to 400. Yes, four hundred.
Given the endless parade of bad news and bearish forecasts for the economy, it may seem that the worst has already happened, and there is nowhere to go but up. Indeed, some analysts (for example here and here) have called a market bottom. The US consumer is not spending, unemployment is rising, the highest officeholders in the land call it the worst situation since the Great Depression... you might say, how many other shoes are there waiting to drop (or be thrown)?
What has not yet occurred is a serious threat to the dollar's status as the world's reserve currency. That threat will come, for the world cannot continue to finance American profligacy. When the eventual flight from the dollar occurs, it will cause much worse damage even than the unbelievable carnage in asset prices (click here for a chart of the Dow over the last year) we've already seen.

Stewart vs. Cramer: Short Selling Backlash

[Written for the Borsen-Kurier]
Judging from the cable news cycle, the most important story of the last week in the US was a face-off between Jon Stewart, comedian and host of The Daily Show (you can watch the show here), Comedy Central’s fake news network, and Jim Cramer, a former hedge fund trader and host of CNBC’s Mad Money. How did it happen that arguably the most serious journalist in the US, virtually the only interviewer who is willing to ask truly tough questions, is a comic specializing in, as he puts it, “fart jokes”?
Stewart played a clip from the end of 2006, which showed Cramer being interviewed and revealing some of his secrets of short selling: “You want to spread rumors about the company,” he said, “it’s against the rules, but the SEC won’t find out.” After the clip, Stewart says: “I want the Jim Cramer on CNBC to protect me from that Jim Cramer.” Cramer squirmed and capitulated, trying to make it seem that he’s doing everything he can to prevent the kind of abuses he’s just been shown to be adept at, and promising to do a better job as a financial reporter. “That would be great,” said Stewart, pressing on, “but this is about more than you.” It’s about the network, the show, the whole focus on short-term gain at the expense of the little guy, about gaming the system, about the average investor “capitalizing your adventure”.
He’s right, of course, in that financial markets can function like a poker game. As Warren Buffett put it, if you’ve been playing poker for half an hour and you don’t know who the sucker is, it’s you. Shows like Mad Money are designed to draw in more suckers, who then make amateurish blunders, which the pros exploit.
What should be done?
It doesn’t seem to make much sense to try to ban rumor-mongering. But should we ban or try to restrict short-selling? Has short-selling caused the financial meltdown? Short-selling is the practice of borrowing shares, selling them, then waiting for a lower price, which allows the investor to buy back the shares, and return them to the lender, pocketing the difference. The practice of short-selling is having its 400th anniversary this year, and it remains controversial, because it puts the investor in the position of hoping for a decline, and for the last 400 years, short sellers have been blamed for causing markets to fall.
But such a position is untenable. Though it is true that every short sale begins with selling, and each act of selling exerts downward pressure on a stock, the number of short sellers in a market tends to be small, and short sellers tend to be professional (or at least experienced) traders.
Because markets tend to price in available information, rumors cannot bring prices down for long. If a stock is undervalued by the market, its price will eventually rise, just as overvalued stocks will fall. Short sellers do a valuable service by putting pressure on overvalued stocks. Either the shorts are correct, and the stock falls back to a lower value, or the shorts are wrong, in which case they lose money. There is no more effective discipline for traders than losing money. Blaming short-sellers for falling stock prices is like blaming a vulture for the death of a zebra. A vulture is incapable of killing a zebra, but the vulture obviously benefits from the zebra’s death; the rest of the ecosystem benefits from the vulture stripping the carcass.
Short selling did not cause the US stock market to fall. The stock market fell because it had reached a monumentally overvalued condition. To restrict short selling not only locks the barn after the horse is gone, it discourages traders from taking positions which correct overvalued prices.

Weakness = Strength? Lasting Prosperity Cannot Occur Through Currency Depreciation

[Written for the Borsen-Kurier]
Perhaps the most under-reported story in the US is one that hints at the future of the dollar: China plans a technical change in the way international transactions are made by its multinational corporations, allowing these transactions to be settled in its own currency, the Yuan, rather than in dollars, Euros, or another ‘hard’ currency. Though the move does not affect the exchange rate between the Yuan and the US dollar, it is a move that undermines the dollar’s reserve currency status; No doubt China would like to put the Yuan in the dollar’s place.
These days a curious idea seems to hold sway: that a country can get economic growth by destroying its own money. Currency Depreciation Can Spur Boom In Exports, Lead to Economic Recovery, reads the subtitle of a recent Wall Street Journal article, which cites the US in 1933 and the Asian tigers (and Russia) during the 1990s. All of these economies supposedly reached prosperity through reducing the value of their currencies.
The US accuses China of holding the Yuan ‘artificially low’, giving Chinese products an unfair advantage in the US market. As the US dollar weakens against the Euro, and the unwinding of the Yen carry trade causes the Yen to strengthen, Europe and Japan can no longer count on exports to the US to produce growth.
Each country wants their currency to be both strong and weak at the same time, as weakness helps exports, while strength leads to increases in foreign investment and the ability to issue bonds at attractive rates.
Since we live in a world of fiat money, where the value of a currency depends on little more than the resolve of central banks to defend it using their foreign exchange reserves coupled with their reticence (or lack thereof) to create more money, weakening a currency against the US dollar simply requires the rate of money creation be greater than the rate of growth of the US money supply.
Clearly, the entire world cannot employ this strategy. There must be some anchor. That anchor, of course, has been the US dollar for the last 60 years. But now the US wants to play the same game; but how can the world’s reserve currency survive a regime of massive indebtedness? As the dollar fades, some of the benefit of a reserve currency may also be lost: the anchor that helped world trade flourish during the eras of Bretton Woods I (1945-1971) and what some have called ‘Bretton Woods II’ (1971-present) will be lost. Will the distrustful beggar-thy-neighbor trade policies of an earlier era return? It seems likely that there will be a period of chaos which will disrupt global trade until a suitable substitute is found. There is one choice for a medium to conduct international settlement that is widely seen as ‘the gold standard’, which is… uh… the gold standard.