Friday, December 31, 2010

Why Can’t Europe Avoid Another Crisis? Why Can’t the U.S.?

Why Can’t Europe Avoid Another Crisis? Why Can’t the U.S.?
By Simon Johnson

Most experienced watchers of the eurozone are expecting another serious crisis to break out in early 2011. This projected crisis is tied to the rollover funding needs of weaker eurozone governments, i.e., debts falling due in March through May, and therefore seems much more predictable than what happened to Greece or Ireland in 2010. The investment bankers who fell over themselves to lend to these countries on the way up, now lead the way in talking up the prospects for a serious crisis.

This crisis is not more preventable for being predictable because its resolution will involve politically costly steps – which, given how Europe works, can only be taken under duress. And don’t smile as you read this, because this same logic points directly to a deep and morally disturbing crisis heading directly at the United States.

The eurozone needs to – and will eventually – take three steps:
1. Agree on greater fiscal integration for a core set of countries. This will not be full fiscal union, but it will comprise some greater sharing of responsibilities for each other’s debts. There is much room for ambiguity in government accounting and great guile at the top of the European political elite, so do not expect something completely clear to emerge. But Germany will end up underwriting more of the liabilities for the European core – the opposition Social Democratic Party and the Greens are very much pushing Chancellor Angela Merkel in this direction by calling her “unEuropean”.
2. For the core countries, the European central bank (ECB) will receive greater authority to buy up government bonds as needed. Speculators in these securities will be badly burned as necessary. The wild card here is whether Bundesbank president Axel Weber will get to take over the ECB in fall 2011 – as expected and as apparently required by Ms. Merkel. Mr. Weber has been vociferously opposed to exactly this bond-buying course of action. The immovable Weber will meet the unstoppable logic of economic events. Good luck, Mr. Weber.

3. One or more weaker countries will drop out of the eurozone, probably becoming rather like Montenegro – which uses the euro as its currency but does not have access to the ECB-run credit system. Greece is probably the flashpoint; when it misses a payment on government debt, why should the ECB continue to accept Greek banks’ bonds, backed at that point effectively by a sovereign entity in default? The maelstrom will probably sweep aside Portugal and perhaps even Ireland; the chaos will threaten Spain and Italy.

It would be so easy to set up preemptive programs with the IMF for Portugal and Spain, but this will not happen. The political stigma attached to borrowing from the IMF is just too great.

The unfortunate truth is that despite its much vaunted supposed return to preeminence and the renewed swagger of senior officials, the IMF remains weak and of limited value. It is an effective lender to small European countries under intense pressure – Latvia, Iceland, Greece, etc. But the Fund does not have the resources or the legitimacy to save the bigger countries.

At the end of the day, the Europeans will save themselves, with the measures outlined above – only because there will be no other way to avoid wasting 60 years of political unification. But this action won’t “save” everyone; one or more countries will be forced out of full eurozone membership (although they will likely keep the euro as the means of exchange). And the costs to everyone involved will be large and largely unnecessary.

And remember, when the financial markets are done with Europe, they will come to test our fiscal resolve. All the indications so far are that our politicians will also struggle to get ahead of financial market pressure.

There are plenty of places in Europe where you can find an easy political consensus is to cut taxes and increase budget deficits. Sadly, this no longer pacifies markets. The American political elite – right and left – believes that we are different from the Europeans because we issue the dollar and therefore have some special privileges for ever.

But this is not the 1950s. Asia has risen. Europe will sort itself out and become more fiscally Germanic. The Age of American Predominance is over.

Our leading bankers looted the state, plunged the world into deep recession, and cost us 8 million jobs. And now many of them stand by with sharpened knives and enhanced bonuses – also most willing to suggest how the salaries and jobs of others can be further cut. Think about the morality of that one.

Will no one think hard about what this means for our budget and our political system until it is too late?

Saturday, November 27, 2010

Renaissance of the Gold Standard?

by Martin Hutchinson... LINK...

Global opposition to Fed Chairman Ben Bernanke's policy, World Bank President Robert Zoellick's "trial balloon" and statements by some of the new Republican Congressional caucus have caused a modest revival in consideration of the Gold Standard. In my view, the chances of its revival by official means in the next 10 years remain infinitesimal, but there is an increasing probability of private sector activity in that direction. Not only politically, the bombed-out Gold Standard stock may have reached bottom and be beginning a modest revival.

The Gold Standard did not disappear because it caused the Great Depression (it had only modest fingerprints on that disaster) nor because Maynard Keynes called gold a "barbarous relic." In reality, its demise had a much simpler cause: the rising rate of global population growth, which caused it to become damagingly deflationary.

The gold supply is limited. At the end of 2009, the total of all the gold ever mined was about 165,000 tons, worth $7 trillion at today's prices. Most of that total is still in existence, gold being essentially indestructible. However, new mine production in 2008 and 2009—both years enjoying near-record gold prices—was only around 2,500 tons, according to the World Gold Council. Thus even at the peak of the market, gold production is only 1.5% of existing supply. This hard limit on the world's gold supply exerts a considerable monetary effect on a Gold Standard world, limiting its money supply. Without an increase in monetary velocity, the world's gold supply can accommodate global growth of only about 1.5% per annum while maintaining prices constant. If global GDP growth is higher than that, the Gold Standard will be deflationary—prices will decline. If global growth is less than 1.5% per annum, prices may increase somewhat.

During the 18th century, for example, global population rose by 0.4% per annum, from 640 million in 1700 to 980 million in 1800, according to United Nations estimates. Accordingly, if world gold supplies had increased by 1.5% per annum during that century and monetary velocity had remained constant, a global Gold Standard would have accommodated about 1.1% per annum per capita economic growth. In practice global growth during that century averaged 0.56% per annum or 0.15% per capita, so gold supplies were ample to support it, even if mining was less active and successful than in some other periods. Indeed, in actuality the century saw mild inflation in Gold Standard countries.

During the 19th century, global economic growth accelerated, to 1.85% per annum, being 1.34% growth per capita (the result of the Industrial Revolution) and 0.51% per annum population growth. Thus the gold supply became much tighter, particularly towards the end of the century as economic and population growth accelerated. There was a shortage of specie and deflation during the "Hungry Forties" before the Californian gold discoveries of 1849 and another more prolonged period of deflation in 1873-96, before the discovery of new gold deposits in South Africa and the Yukon. During those years, the gold supply was increasing at a rate below its long-term average of 1%-1.5%, so global growth above that level caused the money supply to decline in terms of Gross World Product, and deflation to occur. By the early 1890s, there were multiple calls to abandon the Gold Standard, with proposals for bimetallism and William Jennings Bryan's "Cross of Gold" presidential campaign of 1896.

In practice, mild deflation is not a major economic problem, contrary to Ben Bernanke's theories. With an interest rate close to zero, even prolonged deflation of up to about 1% annually can be tolerated, as real interest rates remain containable. The 1880s, however, showed this to be close to the maximum tolerable level—U.S. prices declined by 22% from 1880 to 1896, an annual 1.5% deflation, and the strains showed.

In 1900-25, with world population growth of about 0.8% per annum, economic growth averaged 2.6% per annum, in spite of the depredations of World War I. Not surprisingly, the Gold Standard came under huge strain. Thus the failure of the 1925-31 British return to the Gold Standard was probably inevitable; by that time, global population and economic growth had reached a level at which the Gold Standard's deflationary effect had become intolerable.

For the quarter-century 1925-50, Keynes was right; with global population growth above 1%, even World War II could not hold economic growth below 2.7%. For the next 20 years, the heyday of the Bretton Woods Agreement monetary system, the equation was even worse. Population growth averaged 1.9%, while economic growth, recovering after World War II, averaged a startling 5.6% annually, with per capita economic growth of 3.7% annually. Even if the Bretton Woods system had been designed as a true Gold Standard, with private gold holding and trading permitted, it would never have stood a chance. In practice, since politically motivated governments controlled the Bretton Woods system, the breakdown came in the form of an explosion in the gold price rather than a tight deflation squeeze.

The good news for gold bugs is that the rate of global population increase peaked in 1963 and has now declined to about 1.1% annually. Judging by 1900-25's experience, that is still too high for a Gold Standard to be comfortable. However, the rate of population increase is continuing to decline; on current UN projections, it will by 2045 have fallen below 0.5% annually. At that level, as the 19th century showed, a Gold Standard is perfectly feasible and not excessively deflationary. Hence the young of today can perhaps hope to lead the world back to a Gold Standard in their later years.

The Gold Standard, however, remains anathema to the political class. This not surprising; as the U.S. is currently showing with its repeated bouts of quantitative easing, the seigniorage of money creation is highly profitable to governments strapped for cash owing to unaffordable social welfare programs. Even by 2045, absent a major economic crisis, it is unlikely that elite political opinion will have moved sufficiently to make Gold Standard re-introduction at an official level anything but a long and bitter struggle.

One advantage of commodity-based money over fiat currency, however, is that it does not require official sanction to come into existence. Whereas paper money requires a central bank and a national credit rating behind it to attain credibility (and even with this sometimes fails to do so, as in Zimbabwe, Weimar Germany or Latin America for much of the 20th century), gold-based money can come into existence through private activity.

There is some evidence that this is happening. Austria's Raiffesen Zentralbank now offers its clients gold-based accounts, and other banks are likely to follow. The SWIFT international payments system now allows payment in gold, an essential element in a currency's infrastructure in today's markets. Governments worldwide are competing to depreciate their currencies (or, like the hapless EU, watching their currencies come under fire as the weaker members of their union get into difficulties). At some point, a major exporter with a good competitive position—if you asked me to guess, from China or Germany—could start invoicing its customers in gold.

When that happens, a very important barrier will have been crossed. Once gold-denominated trade paper comes into existence, it will form the nucleus of a short-term money market, in the same way as the eurodollar market for assets and liabilities outside the United States arose in Europe after 1957 or so. Within a few years, gold bonds will be issued—once a company has gold-denominated receivables, it will have a natural hedge for such financing, which will remain cheap in interest terms even after conventional currency interest rates rise. It has happened before, in the formation of the eurodollar and eurobond markets in 1957-65. This time, once gold invoicing happens, the gold money and bond markets are likely to spring up quite quickly.

Banks, even outside Austria and Switzerland, will quickly get up the curve of offering gold-denominated accounts once their corporate customers demand them. They will find that a substantial demand exists at the retail level also. Here, modern technology will be very helpful. An ordinary citizen will be able to use a gold-denominated account for day-to-day transactions by means of a debit card, without the need to carry round expensive sovereigns or double eagles. A payment of $9.50 for a sandwich will be satisfied by the debit card, which will pay dollars (say) to the sandwich bar while debiting the account about 0.007 ounces of gold, using that day's gold price.

The card holder will pay perhaps 1% extra for everything, to cover the cost of the gold/dollar exchange transactions; but on the other hand, since his cash holdings are in gold, he will very likely gain much more than that percentage in dollar terms each month. His wealth will be expressed as so many ounces of gold (or kilos, if he is European), but he will never need to hold physical gold at all—or any other currency, though probably he will get a few dollars from the bank's cash machine each month for expenditures for which his debit card is not accepted.

In this way, both corporate and individual users will be able to move their transactions and holdings to gold, with the banks adapting to meet their needs. The banks will remain regulated by national authorities, and will have to manage their gold assets, liabilities and capital in such a way as to avoid breaching the authorities' leverage ratios, based on the gold price at the end of each reporting period.

If the world's monetary authorities come to their senses quickly enough, adopting Volckerite/Bundesbank monetary policies to restore confidence in their currencies, this private Gold Standard will remain a minor addition to the global financial landscape, perhaps dying away after a few years. If the authorities attempt to suppress the market, it will move underground or offshore, like the eurobond market in its early years—and their suppression attempts will in most countries be rebuked by an angry electorate. If they continue with sloppy monetary policies, then since the gold price will continue rising against all other currencies, gold will come to be seen as the most reliable available store of value and a perfectly acceptable unit of account.

At that point, the private gold standard could come to replace national currencies for most transactions. Governments will attempt to enforce usage of their currencies for tax payments, etc., but they will find themselves at a considerable disadvantage through doing so. They will also lose the vast majority of the seigniorage profit they have enjoyed since paper currencies became universal after World War II. Needless to say, this will cause a financial crisis, and a loss of confidence in the governments' own bonds. Their only remedy at that stage will be to move to gold themselves, cementing the dominance of a global monetary system entirely outside the control of governments and monetary authorities.

Central banks will find themselves unable to meddle with the new monetary system, since they do not control it—only the residual paper currencies will be subject to central bank monetary policy. A true Gold Standard on the basis of free banking will have been created more or less by accident. Banks will find that Basel III leverage requirements are much too generous in a Gold Standard system, so will have to deleverage themselves or face a liquidity crisis and apply for a bailout. Doubtless governments forced to bail out banks would insist that they reorient their business towards the shrinking economic area in which paper money is used—in which case such banks would quickly find themselves irrelevant to the new economic order. Their competitors, seeing the disastrous business- and bonus-destroying results of bailouts, would deleverage to a safe level.

For the world's governments, this would be a disaster. For everyone else, it would be a huge liberation. That is reason enough to encourage the beginnings of the private sector Gold Standard development now, rather than waiting until 2045 in the hope that governments will then establish an official Gold Standard.

As for deflation, don't worry too much about it. The day-to-day debit card-based Gold Standard will initially use very little metallic gold, so will not be particularly deflationary. The money supply will be established by trial and error, as banks that over-leverage and keep inadequate gold reserves discover the perils of fiat money banking without fiat money. In equilibrium, the money supply will be constrained by the physical gold supply, but by that time, we may be approaching 2045.

Sunday, November 07, 2010

What Can Be Done...

By Paul Davidson:

After the shellacking the Democrats and Obama took in this November election, it is clear that the old time religion of classical economics will be coming back into fashion. The result is likely to be further economic disaster.

I am not surprised by the failure of the Obama Administration to win over the American people to a progressive economic program. On pages 13 to 18 of my book THE KEYNES SOLUTION: THE PATH TO GLOBAL ECONOMIC PROSPERITY – ( written in January 2009) -- I compared what I expected of Obama vis-à-vis what Roosevelt did in the first few years of his administration.

I cited a letter written by Keynes and published in December 1933 in the New York Times where Keynes warned the president that there were two goals -- Recovery and overdue social Reforms. But Keynes warned if one goes for the social reforms before full economic recovery (full employment) was achieved, then any reforms "will upset the confidence of business... And it will confuse thought ". Instead Keynes recommended just concentrate on recovery. Once the president succeeds at achieving that goal, then reforms will come much more easily!

I suggested that if Obama followed the “jump start” advice of his economic advisors for a small “stimulus” program just to get the private economy turned around , then the nation would not get the full recovery we needed and all reform as well as full recovery will be jeopardized.
Given the politics of austerity, we face maybe a decade of economic disaster. Progressive heterodox economists must get out in front with a Keynes-style of economic thinking – for Keynes’s analytical framework is the only complete available one that is not just a variant of classical theory. Keynes theory of liquidity can deal with full employment recovery, international trade imbalances, policies to prevent inflation and deflation, and an understanding of the role of financial markets in a money using entrepreneurial economy. – what Soros calls a reflexivity economy.

It is necessary to immediately put forth a consistent plan for not only the domestic economy but also for the international payments system to end the huge trade imbalances that have occurred --Mr. Geithner's call for devaluing the dollar relative to the Chinese yuan will not do it.
Nor will relying on some Old or New Keynesian variants of classical economics such as Stiglitz's assymetric information or some other MIT or Harvard New Keynesianism --since all these models assume that the economic system is a classical system except for some ad hoc restraint on the flexiblity of prices or constraint on obtaining complete information about a future predetermined by today's market fundamental. In the long run all these mainstream "Keynesian" models will provide a full employment solution when fixities are removed and full information preceived. It is only these ad hoc constraints that prevent short run optimal results -- theerfore the implication of these mainstream models is get government out of the way and the market, in the long run, will prove to be optimal!

My book THE KEYNES SOLUTION provides a complete alternative program to the various classical models that is going to dominate Washington in the next few years – as Obama tries to compromise with the conservatives such as Paul Ryan and Tea Party people like Rand Paul.

The American people are being interpreted as saying no more deficits—but what they really want back is prosperity and jobs for all who are willing to work. And if we can show them why these goals require governemnt deficits to get to prosperity , they will accept that. We have to get into the public forum the kind of progressive program that is in the Roosevelt tradition and currently can be an economic foundation to provide a good economic future for years to come.

Until we can provide a single consistent program for economic prosperity, all the other goals of progressive thinkers will remain in the dustbin!! The conservatives and their classical theory will dominate, even though they are wrong – because, as they say in politics, “You can not beat Somebody with Nobody”.

The only body of economic thinking available to take on, and beat, classical thinking, is Keynes’s original analytical foundation – and not the Keynesianism of Samuelson, or the New Keynesianism of Stiglitz and other MIT and Harvard graduates.

And remember that the original Keynes analysis implied a nonergodic stochastic process (Keynes called “uncertainty”) is fully compatible with the reflexivity analysis put forth by George Soros. It is when people fear uncertainty that they demand liquidity rather than goods and services. And given all the cash bankers and businesses are sitting on, can anyone doubt the problem is one of too much uncertainty and private demands for liquidity -with the resulting lack of aggregate demand for goods and services?


Paul Davidson
Editor, Journal of Post Keynesian Economics
Bernard Schwartz Center for Economic Policy Analysis
21 Stratford Drive E. Unit D
Boynton Beach, Florida 33436
phone and fax number: (561)369-1951
Manuscripts for Journal of Post Keynesian Economics can be submitted electronically

Friday, October 22, 2010

Foreign Exchange Rates – The "New" "Old" Weapon of Choice in Trade Wars

Satyajit Das...

During the European debt crisis, in a matter of days, the dollar strengthened by around 10%. The weakness of the Euro and resultant appreciation of the Renminbi by over 14% reduced Chinese exporter’s earnings and competitiveness. Some of the moves reversed equally quickly when markets stabilised. Volatility of currency exchange rates has increased markedly in recent months.

To paraphrase Oscar Wilde, the US dollar has no enemies, but is intensely disliked by its friends, especially key investors like the Chinese. The Euro is now the "Drachmark" (a derisory combination of the former Greek Drachma and German Deutschemark). Investors assumed that the Euro would be a new Deutschemark, supported by German commitment to fiscal and monetary rectitude avoiding Gallic and Mediterranean extravagance. Instead, investors have been left holding a currency underpinned by unexpected German extravagance and Gallic and Mediterranean rectitude.

Despite sclerotic growth, public debt approaching 200% of GDP and a budget where borrowing is greater than tax revenues, the Japanese Yen has risen to its highest level against the dollar in 15 years. China is even switching some of its currency reserves into Japanese government bonds with returns only apparent under powerful electron microscopes.

Fears about the value of any currency have seen a resurgent interest in gold. Traders are now reading their John Milton: "Time will run back and fetch the age of gold."

Amongst currencies, it is simply a race to the bottom. On 27 September 2010, the Brazilian Finance Minister Guido Mantega stated the obvious speaking of an "international currency war" as governments around the globe compete to lower their exchange rates to boost competitiveness. In the words of English philosopher Thomas Hobbes it is "war of every man against every man".

Arcane currency shenanigans point to deeper, unresolved economic issues that policymakers are unwilling or unable to confront but whose resolution is crucial to a sustainable recovery and growth. The odd thing is that the problem is not new, having been there all along.

Since the end of the de facto gold standard and Bretton Woods, currencies increasingly have become weapons of choice in trade and economic wars. In the German and Japanese model of economic development, an undervalued currency is a key mechanism for maintaining competitive costs and high levels of exports to drive growth. Successive generations of emergent countries, most notably China, copied the model.

Despite tensions, the model worked well in a world of strong economic growth and increasing trade. It was a question of dividing growing wealth. The model is more problematic in a world of low growth.

Currently, the world may be entering a period of lower growth. Consumer spending, funded in developed countries by debt, has slowed. Given significant over capacity in many industries, business investment is weak. Under increased pressure from money market vigilantes, governments are cutting spending and raising taxes, embracing the "new austerity".

As growth slows, maintenance of competitiveness requires businesses to manage costs brutally. Cheaper currency values assist in remaining competitive, avoiding the need to overtly cut costs by reducing wages or cutting benefits, explicitly lowering living standards. During the global financial crisis, the repeated manouevering of China, Japan and Germany to maintain the low value of the Renminbi, Yen and Euro against the dollar was designed to maintain export volumes to cushion the worst effects of the recession.

To a large extent, it reflects the underlying structure of economies heavily geared to exports. Angela Merkel has repeatedly stated that she sees no change to the export driven German economic model in the near term. For Japan, falling living standards combined with an aging, falling population means increasing dependence on exports. For China, increasing wages pressures and domestic inflation means that rising production costs must be offset by other means, including an undervalued currency.

The problem of shifting models is great. In 1985, the Plaza Accord forced Japan to effectively revalue the Yen, setting off a rise from Yen 230 per dollar to Yen 85 per dollar. The rise in the Yen reduced Japanese export competitiveness and led to a recession. To stimulate the economy, the Bank of Japan and Government pumped large amounts of money into the economy. Rather than assisting recovery, the money set off a commercial real estate and stock market boom that collapsed spectacularly at the end of 1989 plunging Japan into the "ushinawareta junen" - the Lost Decade.

Aware of the Japanese experience and at risk of repeating the experience, China has fervently resisted revaluing its currency, despite pressure from the US. Recently, Chinese leaders have spoken about the economic and social catastrophe that would result from a major reminbi revaluation.

Chinese Premier Wen Jiabao told an European business conference that: "If we increase the yuan by 20 percent-40 percent as some people are calling for, many of our factories will shut down and society will be in turmoil. If China’s economy goes down, it’s not good for the world economy." In order to forestall, European calls, led by French President Sarkozy, for a revaluation of the Renminbi, Wen cunningly voiced support for Chinese purchases of Greek debt. Wen urged Europe not to "join the choir to press China to allow more yuan appreciation."

The unstable currency order creates distortions, frequently preventing action to deal with economic problems. It leads to countries pursuing odd and sometimes contradictory policies.

For example, financial triage, cutting the unsustainable and unlikely to survive countries out of the Euro, would restore their competitiveness through devaluation. But Germany is unlikely to allow weaker countries to leave the common currency precisely to avoid a sharp increase in the value of the Euro, making its exports less competitive. Contrary to popular view, Germany has much to lose from changes in or abandonment of the Euro.

Recent German economic performance has benefited from the effects of a stronger Yen relative to the Euro making its exports more competitive. German corporate profitability has recovered strongly to pre-crisis levels. More recently, Japan has intervened in currency markets to prevent the Yen testings its 1995 high of Yen 79.75 against the dollar.

Interest rate policies pursued, in part, to manage currencies also perpetuate economic dislocations. Paralleling the events after the Asian monetary crisis in 1997/1998, the flight to dollars during periods of European instability pushes down interest rates on U.S. government debt.

The possible reintroduction of quantitative easing (it used to called "printing money" in a less politically correct world) reflects, in part, attempts by policymakers to influence currency values. Paradoxically, lower interest rates reduce pressure for required deleveraging and deficit reduction by lowering the cost of servicing debt.

Major reserve currencies, like the dollar, Euro and Yen, provide some ability to offset changes in value by invoicing trade in their own currencies. Unfortunately, for minor currencies, the fact that trade continues to be denominated in the major currencies creates difficulties where a one day move in foreign exchange markets can wipe out the entire profit margin. The higher volatility means that the cost of hedging the risk of such currency moves is large, reducing profitability.

The currency crisis highlights the "beggar thy neighbour" policies pursued by many economies. China, Japan and Germany have consistently pursued policies that emphasise high domestic savings, low domestic consumption and an undervalued currency to drive its export driven economies. These global imbalances contributed significantly to the current financial problems.

A global economic order where a few countries save and lend to finance their exports while other countries act as consumers of last resort is unsustainable. A system where each country seeks to maximise its own competitive position and financial security at the expense of trading partners is not viable.

An emerging toxic combination of inflexible global currency arrangements, a destructive cycle of currency devaluations, trade restrictions and the need of governments to rein in spending to balance budgets is reminiscent of the 1930s. They threaten a period of prolonged global economic stagnation.

The globalization of complex financial relationships, much lauded before the crisis, is now proving a liability in resolving the crisis. Optimists must rely on Israeli politician Abba Eban's observation that "History teaches us that men and nations behave wisely once they have exhausted all other alternatives."

Wednesday, September 22, 2010

A Money Mechanics Theorem...

The Theorem of Catastrophic Dis-Equilibria__As aggregate onshore wealth is de-taxed, aggregate offshore transaction wealth’s credit productivity drastically increases unimpeded, as the total aggregate onshore credit productivity is decimated__due to exchange rate, tax and tax haven systems’ necessary historical computerized mechanics of such dis-equilibria__unless government intervention be enacted by new laws, to re-balance these three systems’ unnecessary money and law sytems’ highly nefarious catastrophic mechanics…


Abstract: This note argues that Taleb’s “black Swan” argument regarding uncertainty is equivalent to Knight’s epistomological concept of uncertainty. Moreover both Behavioral economists and Post Walrasians use an epistomolical concept of uncertainty. This view differences significantly and immensely from Keynes’s idea that uncertainty is an ontological concept.

Key words:: uncertainty, risk, black swans, Taleb, Knight, Keynes, Post Walrasians, Behavorial Theory
JEL Index Classification: D80, E12, G32
In his excellent analysis Terzi [2010] recognizes that Taleb’s black swans are merely rare events (outliers whose probability is perhaps one in 100 or 1 in a thousand or more). The rare appearance of these black swans is already preprogrammed into nature’s ergodic plan for the economy. These black swans exist and will ultimately be seen and experienced as the first (or a unique event) although current history (going back to 1AD) may be too short to have discovered any black swans as yet. In this brief note, I wish to show that Taleb’s black swan argument is merely a new varient of Frank Knight’s concept of uncertainty [Knight, 1921]

Frank Knight, an economist in the early 20th century, was one of the first to recognize the possibility of epistemological uncertainty for certain economic processes. Knight explicitly distinguished between quantifiable risks and uncertainties. Knight wrote that__

"the practical difference between the two categories, risk and uncertainty, is that in the former the distribution of the outcome in a group of instances is known (either through calculation a priori or from the statistics of past experience), while in the case of uncertainty, this is not true, the reason being in general that it is impossible to form a group of instances, because the situation dealt with is in a high degree unique" (Knight, 1921, p. 233).

In other words, when uncertain events occurred in Knight’s model of reality it was because past history had not turned up previous similar “black swan” events. In an ergodic universe, any single event will appear to be unique to the observer only if she does not have a sufficient a priori or statistical knowledge of reality to properly classify this event with a group of similar conditional events.

Knight (1921, p. 198) explains that uncertainty involving "unique events" occurs only when agents possess a "partial knowledge" of the cosmos or what today’s mainstream economists call “incomplete information”. Knight's reflection on the immutability of the economic cosmos is somewhat ambiguous. Knight appears to argue that as a stylized fact uncertainty is an epistemological factor in an ontological immutable reality when he wrote Knight, (1921, p. 210) that the__

"universe may not be knowable...[but] objective phenomenon [reality] ... is certainly knowable to a degree so far beyond our actual powers ... [and therefore] any limitation of knowledge due to lack of real consistency [i.e., ergodicity] in the cosmos may be ignored".

In other words, Knight suggests that any lack of knowledge about external reality that might be attributed to a lack of real consistency over time in the cosmos is insignificant and may be ignored when compared to humans's cognitive failures to identify a predetermined external (ergodic) reality of “unique” events.

Knight (1921, p. 198) suggests, rather than dogmatically claims, that it "is conceivable that all changes might take place in accordance with known laws", i.e., the future is determined by ergodic laws. Thus Knight left the theoretical door slightly ajar for his analysis to be based primarily on the concept of a predetermined immutable cosmos. The primary difference between risk and uncertainty for Knight is that uncertainty exists only because of the failure of human's "actual powers" to process the information "knowable" about the programmed economic cosmos.

Since probabilistic risks can be quantified by human computing power, Knight argued that the future is insurable against risky probabilistic occurrences. The cost of such insurance, or self-insurance, will be taken into account in all entrepreneurial marginal cost calculations (or by contingency contracts in a complete Arrow-Debreu general equilibrium system). This insurance process permits entrepreneurs to make profit-maximizing rational production and investment choices even in the short run when dealing with risky known processes.

The existence of what appears to be uncertain or "unique" events, on the other hand, arises because humans do not have sufficient cognitive powers to group correctly these uncertain outcomes by their common characteristics. Hence for Knight agents cannot capture the insurance costs of these "uncertain" events in their marginal cost computations. Isn’t that what Taleb has argued when he suggests that the “risk management” highly mathematical models developed by “quants” on Wall Street were not able to capture the insurance risk involved if a black swan in financial markets did occur?

If we accept Knight's position that we can ignore the possibility of a "lack or real consistency in the cosmos", then the objective probabilities associated with what Knight labels "uncertain" events are already programmed into the consistent cosmos. It is just that the short run does not provide a sufficiently large sample, for enough black swans to appear to calculate the probabilistic risk of encountering a black swan. In the long run, those entrepreneurs who in their price - marginal cost calculations include these insurance costs "as if" they knew the objective probabilities implicit in Knight's unchanging reality will make the efficient decision and will, in Knight's system, earn profits. These are the Darwinian entrepreneurial “agents who know how to build robustness” in the market system that are the heroes of Taleb’s (and Knight’s) view of the economy.

In essence, Knight appears to be a precursor for what Colander (2006) calls the Post Walrasian theorists, or others call Behavioral theorists , of today. These Post Walrasians or Behavioralists erect ad hoc models suggesting that agents may not always act with the economic rationality of classical theory’s decision makers because often the decision makers do not have the computational power to process sufficient information about the presumed ergodic future__

David Colander [2006, p. 2] notes that “Post Walrasians assume low-level information processing capabilities and a poor information set”. Nevertheless underlying this Post Walrasian analytical approach is the belief that the “true structure” governing the economic future is a Walrasian economic system [see Mehrling, 2006, p. 78 , Kirman, 2006, p. xx, Brock and Durlauf, 2006, p. 116]. Unfortunately, such theories have no unifying underlying general theory to explain why such “irrational” behavior exists. Behavioral theorists can not explain why those who undertake classical non-rational behavior have not been made extinct by a Darwinian struggle with those real world decision makers who take the time to act rationally or who, at least, make decisions that are consistent with those they would make “as if” they knew the underlying Walrasian system.

Had behavioral theorists, Post Walrasians and Taleb adopted Keynes’s general theory as their basic framework, irrational behavior can be explained as sensible behavior if the economy is a non-ergodic system. Or as Hicks (1977, p. vii) succinctly put it, "One must assume that the people in one's models do not know what is going to happen, and know that they do not know just what is going to happen." In conditions of true uncertainty, people often realize they just do not, and can not, possess a clue as to what rational behavior should be.

Tuesday, August 24, 2010

Paul Davidson Joined the Advisory Board of the Institute for New Economic Thinking...

New York, NY, August 24, 2010 – The Institute for New Economic Thinking (INET) has appointed Paul Davidson, Editor of the Journal of Post Keynesian Economics and Holly Chair of Excellence Professor Emeritus, University of Tennessee, to its advisory board. Paul Davidson, is the 31st distinguished individual to join INET’s Advisory Board, including five Nobel Prize winners.

Professor Paul Davidson is currently a Senior Fellow at the Schwartz Center for Economic Policy Analysis, The New School. He has taught at number of prestigious institutions including: University of Pennsylvania, Rutgers University, and Bristol University (UK). Davidson served as the Assistant Director of the Economic Division of the Continental Oil Company and has testified before 20 congressional committees over the years on various economic questions. He has authored co-authored or edited 22 books, including: The Keynes Solution: The Path to Global Economic Prosperity, Economics For A Civilized Society (co-author), Financial Markets, Money and the Real World, and Post Keynesian /macroeconomic Theory: A Foundation For Successful Economic Policies For the Twenty-first Century.

“I share the Institute’s commitment to education, open dialogue, and the support of the next generation in effecting change,” commented Paul Davidson. “I am dedicated to advancing the Institute’s vital initiatives and honored to join its distinguished Advisory Board.”

“As a distinguished educator and champion of Keynesian Economics, Paul Davidson is a invaluable addition to the INET community that held its inaugural conference at King’s College, University Cambridge, where Keynes himself debated economic theory and instigated reform,” commented Dr. Robert Johnson, Executive Director of INET. “His presence and counsel will undoubtedly have an important impact on the Institute and its work.”

About the Institute for New Economic Thinking:
Launched in October 2009 with a $50 million pledge from George Soros, the Institute for New Economic Thinking promotes changes in economic theory and practice through conferences, grants and education initiatives. The Institute embraces the professional responsibility to think beyond the inadequate methods and models of the world’s financial infrastructures and will support the creation of new paradigms in the understanding of economic processes. For more information please visit
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Paul Davidson
Editor, Journal of Post Keynesian Economics
Bernard Schwartz Center for Economic Policy Analysis
66 Country Club Drive
Monroe Township, New Jersey 08831
Paul Davidson

The Myth of the “Credibility of Markets”

by Marshall Auerback...

It is time to distinguish between the truths and the myths propagated by Wall Street.

A few days ago, I wrote a piece suggesting that President Obama’s attack on the proposed GOP threat to Social Security masked a more fundamental threat posed by members of his own party. Sadly, this analysis appears to be confirmed today in Mike Allen’s politico playbook:

“–ADMINISTRATION MINDMELD: The virtue of action on Social Security is that it demonstrates the ability to begin to affect the long-run deficits. Social Security isn’t the biggest contributor to the problem - that’s still health-care costs. But it could help a little bit, buy time, and strengthens the odds of a political consensus behind other spending cuts or tax increases. Most importantly, it would establish more CREDIBILITY with the MARKETS. The mood of the world at the moment (slightly excessive, from the administration’s point of view) is that if you don’t do anything with spending cuts, it doesn’t get you credibility.” (My emphasis).

This, in a word, encapsulates the Administration’s perverse Wall Street-centric thinking. Credibility with the American people takes a back seat to this amorphous concept called “the markets”, and the corresponding need to maintain “credibility”.

But how are we to divine the true aspirations of the markets? Is this really a legitimate basis for government policy? Private portfolio preference shifts (which are manifested daily in the capital markets) are probably the area least amenable to economic analysis. There are no cookie cutter models here (and economists LOVE models).

Consider the case of a currency: How does one respond to a weaker currency? The conventional response seems to be, “Raise interest rates and eventually you’ll re-attract the capital because you will re-establish ‘credibility’ with the markets”. That was essentially the IMF advice to East Asia in 1997. But, as that experience demonstrated, sometimes raising rates can actually trigger additional capital flight if it is perceived to be a panicked reaction to something. And Japan today clearly demonstrates that low rates per se do not necessarily prefigure a weaker currency. What does a 10 year Japanese government bond yielding less than 1% tell us about “the markets”? Does it reflect approval with a country that has a public debt to GDP ratio about 2.5 times higher than the US?

To paraphrase Milton (the poet, not Friedman), sometimes they also serve who only stand and wait!

Markets are an amorphous concept, which reflect heterogeneity of viewpoints. Some people today are buying gold because they foresee a Weimar style hyperinflation emerging in the face of all of this government spending. Some buy it because they envisage the death of fiat currencies and view the yellow metal as the ultimate insurance policy. Some invest because they consider gold the only real form of money. Some people view it as a barbarous relic and ignore it altogether. How does a government respond to these varying points of view? What’s the right policy response?

The myth that markets, not governments, ultimately determine rates has, of course, been legitimized to some degree by virtue of the fact that our institutional monetary arrangements still reflect archaic gold standard type thinking (whereby a certain amount of gold on hand was required to fund government operations). But we went off the gold standard decades ago. Still we have laws which mandate that all net government spending is matched $-for-$ by borrowing from the private market. So net spending appears to be “fully funded” (in the erroneous neo-liberal terminology) by the market. But in fact, all that is actually happening is that the Government is coincidentally draining the same amount from reserves as it adds to the banks each day and swapping cash in reserves for government paper.The resultant bond market drain is there to ensure that the central bank maintains control of its reserve rate. It has nothing to do with “funding” government operations itself.

If you think that sounds radical then consider the following question posed by my friend, Professor Bill Mitchell: If a government bond auction “fails” (i.e. the government doesn’t find enough buyers for the paper it issues during that particular sale), does this mean that your Social Security cheque is going to bounce? Will national infrastructure projects be suddenly halted because the net spending is not “funded”? Do we have to stop fighting a war in Afghanistan? The answer to all of these questions is the same: Of course not! The net spending will go wherever the Government intends it to go - after all the Government needs no funds to spend because it first creates the currency which is ultimately required to be spent in the real economy. The private sector does not produce dollars (if it did, it would represent a jailable offence called counterfeiting).

More fundamentally, how, pray tell, does one presume that the private sector can net save (in this case, dollars) something it cannot net produce?

Isn’t it true that the government is in a unique position because only it has the capacity to create new net financial assets? Now, granted, this simple observation does not readily apply to the euro zone because the individual countries concerned have effectively ceded that authority, thereby circumscribing an adequate fiscal response to their crisis (a point I have made before). But when the operations of government are examined in this light, it establishes that the Obama Administration’s ongoing fixation with “long term deficit reduction” and “establishing credibility with the markets” is as foolhardy as conducting human sacrifices to placate a deity.

Yet government policy responses today on issues like Social Security or Medicare reflect a misguided belief system and a genuine failure to understand the basis of modern money. Scaling back Social Security will certainly drive unemployment up higher than it is already going becomes it robs people of the very income required to sustain growth. Not a very sensible strategy if you truly care about implementing “change that people can believe in”.

Unfortunately, until these Wall Street-centric beliefs are fully exposed for the myths that they are, we can expect to see more dispiriting headlines of the sort reflected in Mike Allen’s latest politico playbook.

Marshall Auerback is a Senior Fellow at the Roosevelt Institute, and a market analyst and commentator.

Monday, August 02, 2010

Making Dollars and Sense of the U.S Government Debt...

Paul Davidson

Abstract: This paper explain why, given Keynes’s General Theory, worries over
the size of the government’s national debt per se is foolish. It is more important
to educate politicians and the public that government fiscal policy should be designed to make sure that aggregate market demand will produce sufficient profits
so that entrepreneurs will hire all domestic workers willing and able to work.
Empirical evidence is provided to demonstrate the correctness of this concept
of fiscal policy of the balancing wheel for full employment effective demand.

Key words: deficits, national debt.

No economic topic encourages more political demagoguery than the
“unsustainable” national deficits that face the Obama administration as
it tries to extricate the economy from this Great Recession that began
in 2007. Even President Obama has appointed a commission to develop
a plan to assure a reduction in future deficits by lowering government
expenditures or raising taxes.

A sage once said, “Those who cannot remember the past are condemned
to repeat its errors.” So let us review the past history of the national debt
to make sure we avoid its errors and repeat its successes.

Is the national debt too large? In 1790, the newly founded U.S. government
assumed the debts that had been incurred during the Revolutionary
War. Thus, from the very beginning, the U.S. national debt was
approximately $75 million. In 1835, President Jackson reduced the debt
to close to a zero balance. By 1837, however, the economy went into a
steep recession that lasted approximately six years and the national debt
increased dramatically. Since then, the U.S. government has always had
a significant outstanding debt.

During World War I, the national debt increased substantially from approximately
$6 billion in 1916 to over $27 billion in 1919. The prosperous
decade of the “roaring twenties” saw a decline in the national debt
as tax receipts exceeded government spending. By 1929, the total debt
had been reduced to $16.9 billion. This 1920s experience indicates that
when the private sector is spending sufficiently to buy all the products
that industry can produce in a fully employed economy, then there is no
need for the government to deficit spend merely to maintain a prosperous
economy. The 1920s prosperity, however, was partly the result of
significant bubbles in the stock market and in real estate. (Shades of the bubble of the 1990s and the housing bubble of early 2000s.)

In 1929, private spending suddenly slowed causing a devastating drop
in business profits. Unemployment rose rapidly as the United States
entered the Great Depression. Tax revenues fell from $4 billion in 1930
to less than $2 billion in 1932. When Roosevelt took office in 1933, the
national debt was almost $20 billion; a sum equal to 20 percent of the
U.S. gross domestic product (GDP).

During its first term, the Roosevelt administration ran large annual
deficits between 2 and 5 percent of GDP. By 1936, the national debt had
increased to $33.7 billion or approximately 40 percent of GDP. Many
“experts” of that era said disaster awaited the nation if the government
continued to deficit spend and thereby burden future generations with this
huge debt. Accordingly, as a part of his reelection campaign, Roosevelt’s
fiscal year 1937 budget submitted to Congress in 1936 cut government
spending dramatically. As a result, in 1937, the economy fell into a steep
recession. Tax revenues declined and the national debt increased to $37
billion. The government resumed significant deficit spending in 1938
and the economy quickly recovered. By 1940, the economy had grown
substantially while the national debt rose to $43 billion.

When the United States entered the war in 1941, the fear of deficits and
the size of the national debt were forgotten. The important thing was to
defeat the enemy. In the war years from 1941 to 1945, the GDP doubled
while the national debt increased by more than 500 percent as Roosevelt
financed much of the war expenditures by government borrowing. By the
end of the war in 1945, the national debt had increased to $258 billion
and was equal to approximately 120 percent of GDP.

Rather than bankrupting the nation, this large growth in the national
debt promoted a prosperous economy. By 1946, the average American
household was living much better economically than in the prewar
days. Moreover, the children of that Depression–World War II generation
were not burdened by having to pay off what then was considered
a huge national debt. Instead, for the next quarter century, the economy
continued on a path of unprecedented economic growth and prosperity
with the Eisenhower administration launching the biggest public works
project—the interstate highway system—and the Kennedy–Johnson
administration spending large sums on sending a man to the moon and
the escalating Vietnam War. At the same time, the inequality in the distribution
of income was significantly narrowed. It was the golden age
of economic development for the United States as the rich grew richer
while the poor gained even more in a rapidly rising level of income that
created a large American middle class.

As a child of the Depression and a young teenager during the World
War II, I have never felt burdened by the huge government deficits that
accrued due to government spending during the Great Depression and
the war that followed. The legacy that the Great Generation who were
adults during the depression and the war left to their children was an
economy of abundance and prosperity. I inherited an economy that made
finding a good job easy for me and all of my cohorts and provided excellent
opportunities to improve our living standards. If this is burdening
children and grandchildren, I hope the current generation can create such
a “burden” for their progeny.

The moral of this history of the national debt and the economy during
the Great Depression and World War II is that we have nothing to fear
about running big government deficits when, during a recession with
significant unemployment, the federal government is the only spender
that can take the responsibility to sufficiently increase the market demand
for the products of our industries and thereby maintain a profitable entrepreneurial
system. For government to spend less in the hopes of keeping
down the size of the national debt will cause market demand to remain
slack, thereby impoverishing both our business firms and our workers.
The idea that capitalism works best when spenders cause healthy growth
in market demands and thereby generate profits and jobs for the community
was the basic message of Keynes theory.

This was clearly demonstrated when government spending increased
during the years 1933–36 and 1938–45. When Roosevelt cut spending
in 1937, the sharp recession showed that at that stage of recovery, no
other spenders were willing or able to take over from government the
role of generator of market demand and profits for American businesses.
Had Roosevelt, in 1938, continued on the path of keeping government
spending in check in order not to increase the total national debt, the
result would have been to propagate the poorly performing economy
of 1937. When the war broke out and no further thought was given to
the size of the national debt, government spending quickly pushed the
economy to a profitable full employment status. Keynes’s ideas that the
role of government fiscal policy was to make sure that the total demand
for goods and services provided profit opportunities to encourage business
firms to hire all workers who wanted a job was validated by this
historical record.

Business firms will hire more workers only when they expect the market
demand for their products is increasing. Today, who are these buyers who
will be willing to buy significantly more products from factories located
in the United States in order to end this Great Recession? Clearly households
suffering from high unemployment, decreasing market values for
their homes, large credit card debt, and shrinking pension funds are not
likely to rush to buy significant more goods and services. Entrepreneurs
with existing excess facilities and facing declining or at most not rapidly
rising market demands are unlikely to invest significantly in new plant and
equipment. Moreover, foreigners such as China with its large savings of
U.S. dollar earnings appears unlikely to spend more dollars to buy more
U.S.‑produced goods. With falling property and sales tax revenues, local
and state governments such as California are cutting spending on public
services and reducing purchases from domestically located firms. Only
the Federal government can afford to buy significant additional products
to stimulate market demand for American products.

Just as we expect the Federal government to spend whatever is necessary
to protect us from foreign enemies during a war, we should also
expect the government to spend whatever is necessary to protect us
from the economic terrorism of a great recession. The public must be
educated to understand that a civilized society is one that assures both
domestic workers and enterprises prosper and that the intelligent use of
government fiscal policy can assure that total market demand is always
sufficient to generate domestic profits large enough to create a fully
employed economy.

Some argue that tax revenues must finance all government spending
so that the federal budget is always balanced without deficits, or at least
annual deficits do not increase the debt-to-GDP ratio. As history shows,
however, even during World War II when America was attacked by foreign
nations (remember Pearl Harbor?) the U.S. government did not finance
the entire defense of this nation by raising taxes. Instead, during the war
years, deficits expanded dramatically while no one worried (correctly)
about burdening future generations with debt.

If wars are not sufficient (or necessary) reasons to raise taxes or cut
government spending sufficiently to balance the budget while protecting
the nation, then why should defending the nation against serious economic
threats require a balanced budget or a lower deficit? Our politicians and
the public must be educated to understand that when total demand for
domestically produced goods is low so that recession and depression
threaten, then government must deficit spend as much as necessary to
encourage domestic entrepreneurs to hire all American workers who
are willing and able to work. If, on the other hand, market demand for
domestically produced goods and services exceed America’s full employment
productive capacity, then government must increase taxes and
reduce spending in order to reduce aggregate demand to a level that can
be met by a fully employed labor force.

When the public and politicians recognize that a primary function of
government fiscal policy is to act as a balancing wheel for aggregate
demand to be sufficient to encourage America’s entrepreneurs to create
jobs for all our workers, we will have developed the political will to
develop a perpetual prosperous American civilized society.
At that point of time, our next task will be to develop an international
financial and payments system that will provide for global full employment
and prosperity.

Friday, July 09, 2010

Why the Fiscal Commission Does Not Serve the American People...

by James K. Galbraith

President Obama and his economic team face a daunting challenge: how to deliver economic growth they know can only come from deficit spending, while deferring into the future the “fiscal consolidation” which is being pressed on them by practically everyone, from Peter G. Peterson to Angela Merkel.

Clearly the “bipartisan deficit commission” — like practically all bipartisan commissions – was a device to deflect this pressure. The President created the Commission while pressing for a stronger growth strategy, and has sent every discreet signal (notably in the commission’s minuscule operating budget) that the exercise should not be taken seriously.

Nevertheless, there is a danger that the Commission will take a path — “stimulate now but austerity later” – that will lead to unnecessary, economically-damaging and socially destructive cuts in Social Security and Medicare. And there is a danger that such cuts will be stampeded through Congress in the months immediately following the 2010 elections.

In a statement made on behalf of Americans for Democratic Action to the Commission, I make the case against cutting Social Security and Medicare as a “deficit strategy” — on the grounds that it’s not necessary and it won’t work. Instead, we need an economic policy built on realistic assumptions and focused on our actual economic problems: jobs, the state-local budget crisis, public investment, energy and climate change. In my statement to the Commission, I have tried to explore these issues a bit further:

Statement to the Commission on Deficit Reduction by James K. Galbraith, Lloyd M. Bentsen, jr. Chair in Government/Business Relations, Lyndon B. Johnson School of Public Affairs, The University of Texas at Austin, and Vice President, Americans for Democratic Action. June 30, 2010.

Mr. Chairmen, members of the commission, thank you for inviting this statement.

I am a professional economist, but I have served in a political role, as Executive Director of the Joint Economic Committee of the United States Congress. I am offering this statement on behalf of Americans for Democratic Action, an organization co-founded in 1949 by (among others) Eleanor Roosevelt, John Kenneth Galbraith, Arthur M. Schlesinger, jr., and Ronald Reagan. Accordingly I would like to begin with a political comment.

1. Clouds Over the Work of the Commission.

Your proceedings are clouded by illegitimacy. In this respect, there are four major issues.

First, most of your meetings are secret, apart from two open sessions before this one, which were plainly for show. There is no justification for secret meetings on deficit reduction. No secrets of any kind are involved. Nothing you say will affect financial markets. Congress long ago — in 1975 — reformed its procedures to hold far more sensitive and complicated meetings, notably legislative markups, in the broad light of day.

Secrecy breeds suspicion: first, that your discussions are at a level of discourse so low that you feel it would be embarrassing to disclose them. Second, that some members of the commission are proceeding from fixed, predetermined agendas. Third, that the purpose of the secrecy is to defer public discussion of cuts in Social Security and Medicare until after the 2010 elections. You could easily dispel these suspicions by publishing video transcripts of all of your meetings on the Internet, and by holding all future meetings in public. Please do so.

Second, there is a question of leadership. A bipartisan commission should approach its task in a judicious, open-minded and dispassionate way. For this, the attitude and temperament of the leadership are critical.

I first met Senator Simpson when we were both on Capitol Hill; at Harvard he became friends with my late parents. He is admirably frank in his views. But Senator Simpson has plainly shown that he lacks the temperament to do a fair and impartial job on this commission. This is very clear from the abusive response he made recently to Alex Lawson of Social Security Works, who was asking important questions about the substance of the commission’s work, as well as calling attention to the illegitimate secrecy under which you are operating.

A general cannot speak of the President with contempt. Likewise the leader of a commission intended to sway the public cannot display contempt for the public. With due respect, Senator Simpson’s conduct fails that test.

Third, most members of the Commission are political leaders, not economists. With all respect for Alice Rivlin, with just one economist on board you are denied access to the professional arguments surrounding this highly controversial issue. In general, it is impossible to have a fair discussion of any important question when the professional participants in that discussion have been picked, in advance, to represent a single point of view.

Conflicts of interest constitute the fourth major problem. The fact that the Commission has accepted support from Peter G. Peterson, a man who has for decades conducted a relentless campaign to cut Social Security and Medicare, raises the most serious questions. Quite apart from the merits of Mr. Peterson’s arguments, this act must be condemned. A Commission serving public purpose cannot accept funds or other help from a private party with a strong interest in the outcome of that Commission’s work. Your having done so is a disgrace.

In my view you also should not have accepted help from the Economic Policy Institute, even though EPI’s positions on the merits are substantially closer to mine.

Let me now turn to the economic questions. A first economic question is, what caused the deficits and rising public debt? The answer comes in two parts: present deficits and projected future deficits.

2. Current Deficits and Rising Debt were Caused by the Financial Crisis.

Overwhelmingly, the present deficits are caused by the financial crisis. The financial crisis, the fall in asset (especially housing) values, and withdrawal of bank lending to business and households has meant a sharp decline in economic activity, and therefore a sharp decrease in tax revenues and an increase in automatic payments for unemployment insurance and the like. According to a new IMF staff analysis, fully half of the large increase in budget deficits in major economies around the world is due to collapsing tax revenues, and a further large share to low (often negative) growth in relation to interest payments on existing debt. Less than ten percent is due to increased discretionary public expenditure, as in stimulus packages.

This point is important because it shows that the claim that deficits have resulted from “overspending” is false, both in the United States and abroad.

3. Future Deficit Projections are Generally Based on Forecasts which Begin by Assuming Full Recovery, but this Assumption is Highly Unrealistic.

Unlike the present deficits, expected future deficits are not usually considered to be due to continued recession and high unemployment. To understand how the discussion of future deficits is being framed, it is necessary to grasp the work of the principal forecasting authority, the Congressional Budget Office. CBO’s projections proceed in two steps. First, they wipe out the current deficits, over a very short time horizon, by assuming a full economic recovery. Second, they create an entirely new source of future deficits, essentially out of whole cloth. The critical near-term assumption in the CBO baseline concerns employment. CBO claims to expect a relatively rapid return, over five years, to high levels of employment, and the baseline incorporates a correspondingly high rate of real growth in the early recovery from the great crisis. If this were to happen, then tax revenues would recover, and ordinarily the projected deficits would disappear. This is what did happen under full employment in the late 1990s.

But under present financial conditions this scenario of a rapid return to high employment is highly unrealistic. It can only happen if the credit system finances economic growth, which implies a rising level of private (household and company) debt relative to GDP. And that clearly is not going to happen. On the contrary, de-leveraging in the private sector is sure to remain the rule for a long time, as mortgages and other debts default or are paid down, and as many households remain effectively insolvent due to their mortgage debt.

With high unemployment, high public deficits are inevitable. The only choice is between an active deficit, incurred by putting people to work or otherwise serving national needs — such as providing a decent retirement and health care to the aged — and a passive deficit, incurred because at high unemployment tax revenues necessarily fail to cover public spending. Cutting public spending or raising taxes, now or in the future, by any amount, cannot reduce a deficit due to high unemployment. The only fiscal effect is to convert an active deficit into a passive one — with disastrous economic and social effects.

4. Having Cured the Deficits with an Unrealistic Forecast, CBO Recreates them with Another, Very Different, but Equally Unrealistic Forecast.

In the CBO models, high future deficits and rising debt relative to GDP are expected. But the source is not a weak economy. It is a set of assumptions describing an economy after full recovery from the present crisis. In the CBO forecasts, big future deficits arise from a combination of (a) rapidly rising health care costs and (b) rising short-term interest rates, in the context of (c) a rapid return to high employment and (d) continued low overall inflation. This combination produces, mechanically, a very large net interest payout and a rapidly rising public debt in relation to a slowly rising nominal GDP.

Even if CBO were right about recovery, which it is not, this projection is internally inconsistent and wholly implausible. It isn’t going to happen. Low overall inflation (at two percent) is inconsistent with the projected rise of short-term interest rates to nearly five percent. Why would the central bank carry out such a policy when no threat of inflation justifies it? But the assumed rise in interest rates drives the projected debt-to-GDP dynamic.

Similarly, the rise in projected interest payments is inconsistent with low nominal inflation. Interest payments rising to over 20 percent of GDP by mid-century would constitute new federal spending similar in scale to the mobilization for World War II. Obviously this cannot happen with two percent inflation. And although a higher inflation rate is undesirable, arithmetically it means a lower debt-to-GDP ratio.

Finally, rapidly rising health care costs and low overall inflation are mutually consistent only if all prices except health care are rising at less than that low overall inflation rate — including energy and food prices in a time of increasing scarcity. This too is extremely unlikely. Either overall health care costs will decelerate (relieving the so-called Medicare funding problem) or the overall inflation rate will accelerate — reducing the debt-to-GDP ratio.

In sum: the economic forecasts on which you are being asked to develop a credible plan for reducing deficits over the medium term are a mess. The unemployment and growth forecasts are implausibly optimistic, while the inflation and interest rates projections are implausibly pessimistic and mutually inconsistent.

Good policy cannot be based on bad forecasts. As a first step in your work — long overdue — the Commission should require the development of internally consistent, and factually plausible, economic forecasts on which to base future deficit and debt projections.

5. The Only Way to Reduce Public Deficits is to Restore Private Credit.

The conclusion to draw from the above argument is that large deficits going forward are likely to have the same source as they do right now: stubbornly high unemployment.

The only way to reduce a deficit caused by unemployment is to reduce unemployment. And this must be done with a substantial component of private financing, which is to say by bank credit, if the public deficit is going to be reduced. This is a fact of accounting. It is not a matter of theory or ideology; it is merely a fact. The only way to grow out of our deficit is to cure the financial crisis.

To cure the financial crisis would require two comprehensive measures. The first is debt restructuring for the entire household sector, to restore private borrowing power. The second is a reconstruction of the banking system, effectively purging the toxic assets from bank balance sheets and also reforming the bank personnel and compensation and other practices that produced the financial crisis in the first place. To repeat: this is the only way to generate deficit-reducing, privately-funded growth and employment.

As a former top adviser in the Clinton White House, co-chairman Bowles no doubt knows that privately-funded economic growth produced the boom years of the late 1990s and the associated surplus in the federal budget. He must also know that the practices of banks and investment banks with which they were closely associated worked to destroy the financial system a decade later. But I would wager that the Commission has spent no time, so far, on a discussion of the relationship between deficit reduction and financial reform.

To be clear: unemployment can be cured without private-sector financing, if public deficits are large enough — as was done during World War II. But if the objective is to reduce public deficits, for whatever reason, then a large contribution from private credit is essential.

One more time: without private credit, deficit reduction plans through fiscal austerity, now or in the future, will fail. They cannot succeed. If at the time the cuts take effect the economy is still relying on public expenditure to fund economic activity, then reducing expenditure (or increasing taxes) will simply reduce GDP and the deficits will not go away.

Further, if the finances of the private sector could be fixed, then an austerity program would be entirely unnecessary to reduce public debt. The entire national experience from 1946 to 1980, when public debt fell from 121 to about 33 percent of GDP and again from 1994 to 2000, proves this. In those years the debt-to-GDP ratio fell mainly because of creditdriven economic growth — certainly not because of public-sector austerity programs. And this is why the deficits returned, in 1980-2 and in 2000, once the credit markets froze up and the private economy entered recession.

Thus until the private financial sector is fully reformed — or supplemented by parallel financing institutions as was done in the New Deal — high deficits and a high public-debt-to-GDP ratio are inevitable. In the limit, if there is no private financial recovery, debt-to-GDP will converge to some steady-state value, probably near 100 percent - a normal number in some countries - and at that point the public deficit will be the sole engine of new economic growth going forward. Only when the private sector steps up, will the debt-to-GDP ratio begin to decline.

For this reason, a Commission report focused on “entitlement reform” rather than “financial reform” would be entirely beside the point. Entitlement cuts, no matter how severe, cannot and will not achieve deficit reduction. They cannot “meaningfully improve the long-term fiscal outlook,” as required by your charter. All they will accomplish is to impoverish vulnerable Americans, impairing the functioning of the private economy and the taxing capacity of the government.

6. Social Security and Medicare “Solvency” is not part of the Commission’s Mandate.

I note from Chairman Simpson’s conversation with Alex Lawson that the Commission has taken up the questions of the alleged “insolvency” of the Social Security system and of Medicare. If true, this is far outside any mandate of the Commission. Your mandate is strictly limited to matters relating to the deficit, debt-to-GDP ratio and fiscal stability of the U.S. Government as a whole. Social Security and Medicare are part of the government as a whole, so it is within your mandate to discuss those programs — but only in that context.

To make recommendations about the matching of benefits to payroll taxes — now or in the future — would be totally inappropriate. Within your mandate, the levels of payroll taxes and of Social Security benefits are relevant only insofar as they influence the current and future fiscal position of the government as a whole. Their relationship to each other is not relevant. You are not a “Social Security Commission” and there is no provision in your Charter for a separate discussion of the alleged financial condition of either program taken on its own. Such discussions, if they are occurring, should be subjected to a point of order.

The usual “solvency” arguments directed at the Social Security system and at Medicare as separate entities are in any event complete nonsense. These programs are just programs, like any others, in the Federal Budget, and the Social Security and Medicare “systems” are thus fully solvent so long as the Federal Government is. Further, as explained below, under our monetary arrangements there is no “solvency” issue for the federal government as a whole. The federal government is “solvent” so long as U.S. banks are required to accept US. Government checks — which is to say so long as there is a Federal authority in the Republic. This point has been demonstrated repeatedly in times of stress, notably during the Civil War and World War II.

7. As a Transfer Program, Social Security is Also Irrelevant to Deficit Economics.

Political discussions of “long-term fiscal sustainability” — including in the Charter for this Commission — make an economic error when they loosely use the word “entitlements” and suggest that supposed economic dangers of federal deficits (for instance, rising real interest rates) can be reduced by “entitlement reform.” As a matter of economics, this is not true.

“Government Spending” — as any textbook will verify — is a component of GDP only insofar as the spending is directly on purchases of goods and services. That alone is what economists mean by the phrase “government spending.” GDP is the final consumption of produced goods and services, and government is one of the major consuming sectors; the others being private business (investment) and households (consumption).

Social Security is a transfer program. It is not a spending program. A dollar “spent” on Social Security does not directly increase GDP. It merely reallocates a dollar from one potential final consumer (a taxpayer) to another (a retiree, a disabled person or a survivor). It also reallocates resources within both communities (taxpayers and beneficiaries). Specifically, benefits flow to the elderly and to survivors who do not have families that might otherwise support them, and costs are imposed on working people and other taxpayers who do not have dependents in their own families. Both types of transfer are fair and effective, greatly increasing security and reducing poverty — which is why Social Security and Medicare are such successful programs.

Transfers of this kind are also indefinitely sustainable — in fact there can intrinsically be no problem of sustainability with transfer programs. Apart from their effect on individual security, a true transfer program uses (by definition) no net economic resources. The only potential macroeconomic danger from “excessive” transfers is that the transfer function may be badly managed, leading to excessive total demand and to inflation. But there is no risk of this so long as the financial crisis remains uncured. Under present conditions Social Security and Medicare are bulwarks for stabilizing a total demand that would otherwise be highly deficient.

Similarly, cutting Social Security benefits, in particular, merely transfers real resources away from the elderly and toward taxpayers, and away from the poor toward those less poor. One can favor or oppose such a move on its own merits as social policy - but one cannot argue that it would save real resources that are otherwise being “consumed” by the government sector.

The conclusion to be drawn is that Social Security should in any event be off the agenda of your Commission, as it is a transfer program and not a program of public spending in the economic sense. In particular it does not use capital resources and will not drive up interest rates. This is true whether the “Social Security System” is in internal balance or not.

8. Markets are not calling for Deficit Reduction; now or later.

Let me turn next to a larger economic question. Do deficit projections matter? Are they important? Was the President well-advised to frame the mandate of the Commission as he did?

What, in short, are the economic consequences of a high public deficit and a rising debt-to-GDP ratio, and what (if any) benefits are to be expected from creating an expectation that deficits will come down and that the debt-to-GDP ratio will fall?

The idea that US economic policy should aim for a path of reduced deficits in the future, is shared by liberals and conservatives, and it is, from a political standpoint, a very powerful idea. The Commission’s charter takes for granted that this goal is desirable. It specifies that your objective is to achieve a balanced “primary budget” — net of interest payments, by 2015.

Yet your charter does not say why this is an appropriate goal. It cites no study to which one might refer. It does not explain why 2015 is the right target date, as opposed to (say) 2025 or even 2050. It does not spell out the economic consequences — if any — of failing to meet the stated objective.

Does the requirement make economic sense? I shall tackle that question in two parts. The first accepts the view most people hold of the fiscal and financial world. The second reflects, from an operational standpoint, how that world actually works in practice.

Most informed laymen believe that the Federal government must borrow in order to spend. They believe that the interest rate on Treasury securities is set in a market for government bonds. The markets impose discipline on the government. Thus their idea is that “fiscal responsibility” will produce low long-term interest rates and tolerable borrowing conditions for the federal government, while “irresponsibility” will be punished by higher, and eventually intolerable, debt service costs.

Accepting this view for the moment, what does the present level of long-term interest rates tell us? As I write, thirty year Treasury bonds are yielding just over four percent — or just a little more than half their yield a decade back. On the argument just given, this must be an extraordinary success of virtuous policy. It seems that Wall Street has made a strong vote of confidence in the fiscal probity of our current policies. This vote is unqualified, backed by money, contingent on nothing. It therefore represents a categorical rejection, by Wall Street itself, of the CBO’s doomsday scenarios and all other deficit-scare stories.

On this theory, it follows that the mandate to reduce the primary deficit to zero by 2015 is unnecessary. Such an action can hardly reduce interest rates — neither short nor long-term — which are already historically low.

But wait a minute, some may say. Yes interest rates are low at the moment. But bond markets are fickle, they can turn on a dime. And what then?

Yes, it is possible that interest rates could rise. But the problem with this argument is that it takes us away from the premise of rationality. If bond markets are fickle and arbitrary, who is to say what they will do in response to any particular policy? In the face of irrational markets, the sensible policy is to borrow heavily for so long as they are offering a good deal. One may say that all good things end, and perhaps they will. But if markets are irrational, then by construction you cannot prevent this by “good behavior.”

The conclusion from this section is that one cannot logically argue that markets insist on deficit reduction. Either the markets are rationally unworried about deficits, or they are acting irrationally right now, in which case they can hardly “insist” on anything.

9. In Reality, the US Government Spends First & Borrows Later; Public Spending Creates a Demand for Treasuries in the Private Sector.

As noted, the above argument is based on the common belief that the government must borrow in order to spend, and thus that the government faces “funding risks” in private markets. Such risks exist, of course, for private individuals, for companies, for state and local governments, and for national governments such as Greece that have ceded monetary sovereignty to a central bank. But the situation of the United States government is quite different.

The U.S. government spends (and the Federal Reserve lends) in a very simple way. It does so by writing checks — in fact simply by marking up numbers in a computer. Those numbers then appear in the bank accounts of the payees, who may be government employees, private contractors, or the recipients of federal transfer programs.

The effect of government check-writing is to create a deposit in the banking system. This is a “free reserve.” Banks of course prefer to earn interest on their reserves. Thus they demand a US Treasury bond, which pays more interest without incurring any form of credit or default risk. (This is like moving a deposit from a checking to a savings account.) The Treasury can meet that demand, or not, at its option — it can permit, or not permit, the stock of US Treasury bonds in circulation to increase.

So long as U.S. banks are required to accept U.S. government checks — which is to say so long as the Republic exists — then the government can and does spend without borrowing, if it chooses to do so. And if it chooses to issue Treasuries to meet the demand, it can do that as well. There is never a shortfall of demand for Treasury bonds; Treasury auctions do not fail.

In the real world, the government creates demand for bonds by spending above the level drained by taxation from the system. The extent to which those bonds are held locally, or abroad (another common source of worry) depends on the US current account deficit. This also has nothing to do with approval or disapproval by foreign bankers, central bankers, or their governments of American deficit policy. A foreign country cannot acquire a US Treasury bond unless someone outside the United States has acquired dollars to pay for them, which is generally done by running a trade surplus with the United States. And when foreigners do acquire those dollars, then like domestic banks they prefer to earn interest, which is why they buy Treasury bonds.

Insolvency, bankruptcy, or even higher real interest rates are not among the actual risks to this system. The actual risks in this system are (to a minor degree) inflation, and to a larger degree, depreciation of the dollar. However at the moment there is wide agreement that a lower dollar would be a good thing — against the Chinese RMB and now also the euro. So it is difficult to believe that the goal of deficit reduction per se serves any coherent, or presently desirable, economic objective.

We can conclude that there is actually no economic justification for the target of reducing the primary deficit to zero by 2015 or any other date. The right economic objectives are to meet real problems, not those conjured from thin air by economists. Bringing about a rapid end to unemployment, caring properly for an aging population, cleaning up the Gulf of Mexico, coping with our energy insecurity and with climate change are all far more important objectives than reducing a projection of future budget deficits.

10. The Best Place in History (for this Commission) Would be No Place At All.

Most people assume that “bipartisan commissions” are designed to fail: they are given thorny (or even impossible) issues and told to make recommendations which Congress is free to ignore or reject. In many cases — yours is no exception — the goal is to defer recognition of the difficulties for as long as possible.

You are plainly not equipped by disposition or resources to take on the true cause of deficits now and in the future: the financial crisis. Recommendations based on CBO’s unrealistic budget and economic outlooks are destined to collapse in failure. Specifically, if cuts are proposed and enacted in Social Security and Medicare, they will hurt millions, weaken the economy, and the deficits will not decline. It’s a lose-lose proposition, with no gainers except a few predatory funds, insurance companies and such who would profit, for some time, from a chaotic private marketplace.

Thus the interesting twist in your situation is that the Republic would be better served by advancing no proposals at all.

Thank you again for the opportunity to present this statement.

Sunday, June 20, 2010

The Ground of All Grounds...

The arguments of cause and effect are as old as history and philosophy herself, and probably best divided by those who classed the arguments within or without the self__those grounding or non-grounding their results within themselves, or without. The trouble is, few if any of these well known thinkers and philosophers ever tried to align both sources, and the mechanics involved to arrive at a full, proper and true answer, except C.S. Peirce, and this is the main reason I so strongly keep recommending him as our source of interpretations of history's/philosophy's true ideas as pertaining to cause and effect, and supply and demand__For I don't think one can reach the bottom of this deep well, otherwise...

Tis only by deep reflections into our own mental mechanics, we can truly see how the world works, by discovering how our own reflective validity, joins our own stored memories, and our direct objective perceptions. If we choose only one or two of these three processes, we will never reach the truth, as the truth only works the way nature designed us to work__allowing us full discovery, if we but pay attention to the complete mechanical processes at work__The first and foremost, work of nature__the second of how we deal with our direct perceptions of the real object world__and, the third of how we purposely organize the use of our deep reflective memories into systems' understanding organizations. We have choices of whether to just view the world superficially, with direct observations, comtemplate slightly what we choose to commit to memory, and later hap-hazardly retrieve, or use our full analytic capacity to rework what we and nature store in our memories__into viable and fully workable conceptions of reality. Most choose either to use just one or two steps of the process__as did most every thinker alive, or to use two, but most never use all three processes effectively. Going the distance of the triadic process, and following it through to completion, as only a very few philosophers accomplished through the millennia__Plato, Aristotle, Ibn Sina, Kant and Peirce, etc.__is the only possible way to see the world's true causes and effects, within the supply and demand house of horrors__to some__and simply the lack of thorough investigation to others...

I tend to see the above as no more than a very simple house of 'Monopoly Contract Mechanics', which if seen as a single piece of paper__known capable of being simply bet up and down at will__globally__by the 'Tac-Head Elite Grinches'__at will__while the 'Pin-Head Un-Educated Liberal Fluff-Balls', are unknowingly manipulated, by this fully known 'Capitalism Game', by the 'Grinches...' Most haven't the intellectual resources to see how this simple 'Monopoly Game' fully works, but it's all governed by the simplest of foreign exchange mathematics__no more complicated than first grade maths. No matter the 'Pin-Head Liberals' desires, the 'Grinches' are 30 years ahead of them, by locking every needing family into home and vehicle contracts, small business contracts and the social dynamic laws and contracts to keep the civil order for the 'Grinch's Game of Monopoly-Capitalism'__Monopoly, by the constitutionally guaranteed corporate contracts, article 1, all the way from the Nation's founding fathers. It isn't the point there's no way to escape this monopolistic madness__The point is the 'Pin-Head Liberals' aren't smart enough to know the exit__which is also in the Constitution under Article 1, section 8, #5...

First though, the 'Pin-Head Liberals' have to learn how to do first grade math, to figure out how exchange rates over-tax the poor and middle-class liberals and de-tax the 'Tac-Head Grinches.' Look at the single global contract system like this__Divide everything up into three sectors, as many of my past Pythagorean graphs have illustrated__Gov. in one section box__Corporations in a second section box__and, the Liberals in the third box. Let Gov. equal the laws__The Corporations the Money__and the Liberals the Labor and Resources... Now, say labor tries to raise wages through union activity or such other means__There's not only Gov. to block the path with laws, there's the Corps. with access to the International Markets of Global Finance and Trade__where they have a choice of much cheaper labor and resource markets to buy in, and still are left with much higher demand price markets to sell in__All due to what the 'Pin-Head Liberals' are completely blind to__The 'Global Exchange Rates of Corp. Contract Finance and Trades...' Were the 'Liberal Pin-Heads' ever to awake to first grade maths, maybe we could get to the bottom of 'Cause and Effect'__as it's no more complex than China 10, America 1__ Europe 2__as to simple example 'Exchange Rates.' Though these aren't the exact numbers, for ease of explanation, they'll work...

Now, let's see what happens when we add market and trade dynamics of future contracts. Labor only has three year contracts__yet thirty year mortgages. Businesses(Big Corps.) have access to dynamic dated contracts. Government acts by the whims of money's power manipulations, usually by the Corp's. lobbyists__So this easily leaves the 'Pin-Head Liberal Workers' to be almost fully manipulated__but, the foolish 'Liberals' think this is the dynamics in play__Them, against the Corp's., and a Gov. Conspiracy in cahoots with them__It's not, as it doesn't have to be__The Corps. have the 'Foreign Exchange Market' to manipulate any move either Labor or Gov. make... If Labor wishes for higher wages, Corp's. outsource Labor and Resource demands to China, at a 10 to 1 advantage__Corp's. If Gov. wishes to move against Corp's., Corp's. domicile their taxable home charters in a foreign nation or 'Tax Haven' at another 10 to 1 advantage__Corp's. against Gov. and the People__Labor is taxed the difference. If Labor and Gov. both choose to move against the Corp's., Corp's have access to between $500 trillion and $600 trillion dollars worth of derivative contracts(global transactions turnover rates)__while the entire world only has $55 trillion of real GNP economies__so, they can actually threaten whole Gov.'s with__by simply moving these highly cost effectives__against gov. and people contracts__around the world at the speed of light, through the For-X', faster than the Gov. or people can even think about it__and the Corp.'s having dynamic contracts, and Gov. and People, being locked into fixed contracts__What do you think the outcome is going to be...??? The 'Corp's are going to win every time, until you learn how they manipulate and feed, at the trow of the 'For-X. Market__Currency X-Rates...'

This is why we need people educated to 'True Ground'__To fully understand, 'Supply and Demand'__'Cause and Effect'__Is a purposely 'Rigged Game'__As now 'Legally Constituted...'