Predictions for 2009

The year has only just begun, but I think we've seen enough hints of how the Obama administration will act to make some predictions for 2009. I'll check in again in 2010 to see how I did.

1. Deflation, and not inflation, will continue to be a problem in 2009

The Obama fiscal stimulus plan is, unfortunately, pathetic. I don't know what other word to use for a stimulus that only gives $500 to individuals. It will also be slow to roll out. The upshot is that we won't see anything announced until March, and things will continue to deteriorate into the summer. The usual suspects will be back at the trough by the end of the year. Net, in 2009, CPI will remain stagnant or continue to fall.

2. Unemployment will reach double digits in the US

See above.

3. Europe will do ever worse

I expect to see the euro continue to weaken against the US$. As poorly as fiscal policy is managed here, it is worse across the pond.

4. GM and Chrysler will get their second slug of the bailout under Obama

Their "restructuring plans" will be accepted as adequate, and they will get additional funding from the Government. I do not expect either company to materially change in 2009. They are zombies, but there is no one around to shoot them (twice) in the head.

5. Citibank will not go bankrupt

See above.

6. Oil will remain under $60 a barrel

Since global aggregate demand destruction will continue under weak American and European leadership, expect demand for commodities to remain weak. Cuts by Saudi may help a little, but oil will remain sedate.

7. There will be another sharp fall in equity markets

Equity markets will end the year another ~10% down. People will realize things are not getting better, which will trigger another round of selling.

8. Obama will raise taxes in mid 2009, to disastrous consequences

Just like FDR, Obama will start to worry about the deficit and move to raise taxes midyear. That, of course, will reduce aggregate demand further, and so make the economic situation worse

9. The Fed will maintain ZIRP through the year

Just like Japan, expect interest rates to remain on the floor

10. The Dubai real estate bubble will pop

A combination of falling equities and low oil prices will cause financier Abu Dhabi to reign in lending. That, combined with falling aggregate demand, will reverse momentum in Dubai real estate, and the bubble will pop there too.

Sadly, a grim 2009. I hope that I'm wrong in all of these predictions.

No Stimulus for You!

Stimulus Nazi Paul Krugman is unhappy that Barak Obama might implement some of it through tax cuts

Is Obama relying too much on tax cuts?
I don’t know yet. But news reports this morning certainly raise questions.

Let’s lay out the basics here. Other things equal, public investment is a much better way to provide economic stimulus than tax cuts, for two reasons. First, if the government spends money, that money is spent, helping support demand, whereas tax cuts may be largely saved. So public investment offers more bang for the buck. Second, public investment leaves something of value behind when the stimulus is over.

No Paul. Individuals in the US are overindebted, and will not spend or borrow more until they have paid down their current debts. They may save some of their stimulus, but they will spend some too. If you want them to spend even more, stimulate even more. You can run a payroll tax holiday for as long as you need.

Also, the statist chauvinism of Paul's second assertion is remarkable. A bridge to nowhere is less valuable than an individual paying down their debt, or getting something they value, like healthcare, education, training, improving their house, etc. etc.

I also love the phrase "shovel ready". Shovels have certainly been busy lately.

The delay issues Krugman states, along with the inflexibility of fiscal policy to be ratcheted up and down, are fatal for his "bigger G" stimulus. By the time his Government spending is triggered, unemployment will already have increased the deficit to where it needs to be through lower PX, C, I, and T. Bigger G will overshoot, triggering inflation, so those who managed to hang on to their jobs will see their savings eroded.

Private Savings is the Federal Deficit

Jesse has a very nice post explaining the different kinds of money, and I recommend people read it. However, (s)he ends on an error, which I was prey to until recently also.

Are credit cards or loans Money? No,those are all forms of borrowing something that is not yours that you promise to return with conditions. You are receiving money that was not yours.

Credit Is Not Money.

Credit, or debt, is the 'potential' for money, a way of receiving it.

Whether water is held in a canteen, a well, a cistern, or a private lake, it is still water and it is yours if you own it. So too money is still money if it is yours, no matter under what conditions you hold it or save it for your use.

The cloud of credit, or debt depending on your perspective, is the potential for money as it is defined in our economy. It is a source of money. At a given point in time, you either have the money as your property or you do not.

But the source is not the money itself, and the source can be different and can change over time. In our society borrowing is so common and so technologically convenient that there is little difference in most people's mind between credit and money.

I used to believe the same thing, but I was wrong. Money is not a store of value. Credit is money. It is more useful to think of money as "points" than anything with intrinsic worth, and credit is points in an asset column, and debts are points in a liability column, but the points themselves, those are money and they are money no matter which column they go in.

I tried to explain this on Marginal Revolution, but they banned me from the comments there. Both Brad DeLong and Tyler Cowen ban people they do not agree with in their comments. I prefer Greg Mankiw's approach, which is not to allow comments at all. It's honest, and it avoids echo chambers.

I recommend spending time at Mosler Economics which is really difficult to get into, but really changed my perspective on this stuff. I don't agree with everything, but the "points" mental model for money is much more accurate to reality than the "store of value/gold" model we instinctively carry in our heads.

Here's a pure derivation:

The real (inflation-adjusted) national income, Y, is defined as
Y = G + X – M + PX + I

Y = GNP
G = Govt' spending
X = exports + foreign transfers + property income
M = imports
PX = Private spending
I = Private investment (note, I left this out by mistake the first time. Sorry!)

Subtract T from each side, where T is taxes and government transfers we get

Y – T – PX - I = [G – T] + [X – M]

Private Net Savings = [G – T] + [X – M]

Private Net Savings is GNP - taxes - private spending (PNS is private disposable income less taxes less private spending on consumption less private investment).

So, by identity, PNS equals the Federal deficit (G-T) + the current account surplus (X-M). The current account surplus is the $ value of exports minus the $ value of imports. The US runs a large current account deficit ($ value of imports >> $ value of exports) which is, contrary to popular opinion, a *good* thing. Swapping real goods and services for shiny baubles is always a good trade for those receiving the real goods and services. So, as [X-M] is negative, and we would prefer to keep it good, the [G-T] must grow to support higher demand for PNS. The alternative would be for [X-M] to switch and become positive (US starts exporting, stops importing) which means we are now trading real stuff for foreigners shiny baubles. That day may still
come, but there is no need to hasten it.

Arguments against the above:

1. It just ain't so

It is so. This is all true and straightforward as accounting identities.

2. You can't just define savings as a residual, what you have left over to make the national income equations balance!

Yes you can. Brad DeLong answers that Walras' Law says you can. My response is that there is no such thing as "active savings" because no vehicle exists that is an actual store of value over time. So people may think they are "actively saving" but in fact all they are doing is increasing the residual left over after everything else, which will drive by the Federal deficit or current account surplus by identity. Sucks to be you.

3. It's not fair that there is one set of rules for currency issuers and another set for currency users.

Fairness does not come into it, the same way fairness does not come into discussions of whether a referee should follow the same rules as the players. The job of a ref is to be a good ref. The job of the players is to play the game. Both have different roles, and both should strive to do a good job in their role. Arguing that refs should pick a team and try to score baskets too blocks the discussion of what makes a good ref, and does not display good understanding of how the Federal banking system actually works.

4. This is just a static model, tells us nothing about how booms and busts happen, or how to run an economy.

Totally true. And incredibly important to remember.

4a. You are wrong about imports being good and exports being bad.

Quite possibly, and there is a good argument for this. Nevertheless, the US is largely a closed economy and I end up ignoring the capital account term below.

5. It just makes no sense. This would then lay the fault of our current depression on surpluses run under Clinton/Rubin in the 90s!

Yes. This blows my mind also.

It helps a little, but not much, to take a balance sheet perspective on the world. When we think about our own household balance sheets, we add up our liabilities (debts) and our assets (checking account etc.) and hope that our assets are greater than our liabilities. If all of our liabilities vanished with a stroke of a pen, then we'd be happy because all we would have is pluses. This would be wrong -- balance sheets always have to balance, and assets always have to equal liabilities. Personal equity sits under the liabilities column.

When it's pointed out to gold bugs that the Fed can print money at will, they like to analogize it to the Fed having a monopoly on an infinite gold mine. This is almost true, but misses one important detail -- the Fed needs to account for each ounce of gold that leaves the mine, not because it is in any danger of running out, but because it wants to keep its books in balance and not pump out too much gold. Counting how much gold is out there in circulation is done via an entry called the "Federal deficit" (G-T). The term is misleading because it makes you think that the Government is somehow in debt, and you worry about whether it will be able to pay everyone back. This is wrong, the Fed can print money, and therefore everyone can get paid.

Let's Ignore the current account (imports/exports) for now, and imagine a God like currency creator, with a celestial t-table.

In the beginning, there was nothing.

And then God said, let there be credit and debit of $100. And it was so.

And then God lent that credit to Man, who now has a debit of $100 to the Government, and a credit of $100 in his bank account. The Government has $100 debit (which he created originally) and a $100 credit (in accounts receivable) to the man. The $100 in the Government's debit column -- also know as the Federal deficit -- equals the amount of money in the man's bank account, also known as Private Savings. The Federal deficit must always equal net private savings.

The picture is complicated a little by banks, because banks act as intermediaries between the Fiat God and lowly Man. Banks can borrow from the Fed, and lend to Man in FDIC insured accounts, which as equivalent to Man borrowing directly from the Fed because the credit risk Man takes on by putting his money in these accounts is the credit risk of the Government, not the bank. Banks can create debt too, in the same way as the Fed, except they borrow from the Fed directly and lend out to Man. When banks stop doing this, then bank debt creation stops and the Fed needs to step in an increase the Federal deficit if it wants to keep aggregate money supply from contracting. This should be the goal of any stimulus.

On the left hand side of the equation, Y – T – PX, PX is falling. To keep the same size, Y has to fall too. Alternatively, you could increase G on the right hand side, or reduce T on both sides to support a larger PX. If you do nothing, that T will fall the hard way, though people losing income which reduced income tax, and so bring the equation into balance that way, but this requires a large increase in unemployment just to support the desire for higher net private savings and that just seems stupid.

So there you have the ugly and stupid math behind recession economics. The demand for net private savings goes up, probably for very good reasons, and the Federal Deficit MUST INCREASE to meet this demand for net private savings. It can increase in two ways: higher government spending, or lower taxes, or both.

Taxes can go down in two ways. People can lose their jobs so they stop having income to tax. Or the government can just cut taxes. Given that it's better to have people employed than not, this seems like a no brainer to me.

If the deficit goes too large, then there is more money available for net private savings than is required, and this extra money is not saved, it's spent. Too many dollars chasing too few goods creates inflation, and that is bad also. It's important to note that money in bank accounts does not contribute to inflation, although it can if everyone decides they no longer want money in the bank.

The problem with increasing G is that it's proven impossible to decrease it again when the times comes, while T bounces up and down like a yo-yo. Big Government advocates, like Paul Krugman, support larger G no matter what the consequences. Increasing G is slow. "Shovel ready" projects cannot be implicated as quickly, or at the scale, of a payroll tax holiday, and are essentially impossible to shut down. Larger G also slows the long run productive capacity of the country, as, by definition, Government is after things other than sheer efficiency and productivity.

So, a larger G solution will 1) increase the deficit by reducing T the hard way -- driving up unemployment, and 2) will then start to increase the deficit in a way that cannot be stopped after the deficit has already reached its new, optimum size, driving up inflation. This inflicts large economic costs on current workers (who will lose their jobs), future workers (who are now in an economy with lower productive capacity) and current and future savers (who will see the value of their "savings" be inflated away).

Whenever you hear anyone say there should be a fiscal stimulus, ask them why it wouldn't be better implemented as an immediate payroll tax holiday, to be ended once CPI picks up, instead of paying government contractors to build bridges to nowhere beginning next summer.

How valuable is liquidity?

I enjoyed this though provoking post from Angry Bear (who I usually do not agree with):

I don't think that "market liquidity" is a good thing.

A sudden decline in the liquidity of assets can create problems as firms can't unwind leveraged positions without extreme market disruption. If the assets had always been illiquid, those leveraged positions would never exist. I think that would be a good thing.

Now there is a class of arguments that rational investors will take highly leveraged positions to profit from asset miss pricing and that this is socially desirable as they will drive asset prices towards their fundamental values. It is hard find these arguments convincing given the enormous increase in asset price volatility which has accompanied the enormous increase in gross long positions and gross short positions not to mention the huge increase in trading volume. My sense is that the average super smart highly trained trader is driving asset prices away from fundamentals. Thus I think honestly reported legal trading strategies are, on average, worsening the quality of the signals financial markets send to the real economy.

There is a specific sense in which the value of liquidity is overrated, or rather inverted, it becomes a toxic compound that degrade the financial sector as a whole, and that is when trading is structured in such a way that it can produce bank runs. In the Diamond-Dybvig model, long term assets financed by rolling over short term liabilities have two stable prices, one where you can roll over the liabilities, and one where you cannot. In practice, the state where you can roll over short term liabilities is unstable, once these assets fall, they cannot get back up.

You might be able to make an argument that the benefit you get from financing long term assets by rolling over short term liabilities is so great, that even if there is occasional disruption, the net benefit still makes the activity worthwhile. But given that the banking system has already lost more money than it ever made, and there are trillions that still need to be spent, the Empirics suggest that there is no net benefit, only net costs. In this spirit, Angry Bear and I have found common ground -- match the maturities of assets to liabilities and eliminate bank runs from the system once and for all.

Perfection

Beautiful, wonderfully implemented, incredibly useful feature on Google maps. I've wanted this so many times when planning trips. Fantastic!

Happy New Year!

Remarkable article by Mark Ames on why the New York Times' coverage of the Georgian invasion of South Ossetia was ultimately retracted.

State of the Union

This post by Mark Thoma (econ, U Oregon) reflects the typical thinking in academic econ:

Keeping the budget in balance while the economy is struggling is not good policy. If the goal is to stimulate the economy and to create new jobs, then the "clear" lesson - the advice to pay for the spending on infrastructure by raising taxes - is wrong. The new infrastructure does need to be paid for, but the time to do that is when the economy is healthy, not when it is under performing.

The "clear" lesson is, when the private sector deleverages, to maintain money supply, the Federal Government has to leverage up by running a larger deficit. In some ways, you can think of this as reversing the disintermediation between money creation (Fed) and money allocation (banks). You only want to run down the deficit if you have inflation which you want to reduce.

Note that the goal here is to increase the Federal deficit to increase money supply. Picking winners and losers via how that new money is allocated is an entirely different lesson. If you use it to prop up zombie industries (AIG, Bear Stearns, Citi, the entire financial sector, GM, Chrysler etc.) then you get no new productive capacity for this allocation. If you spend it on uselessness (infrastructure in 2008 means bridges to nowhere) then construction workers get rich, but no one else). The best, fastest way to distribute this money into the economy is to announce a payroll tax holiday that will continue until CPI starts to tick up.

Paul Krugman 12/23/08 vs Paul Krugman 12/24/08

Paul Krugman, NYTimes, 12/23/08:

...why so few economists saw the crisis coming. I think it’s a two part question.

I think it’s understandable, though not entirely forgivable, that economists didn’t see the risks of a broad financial breakdown...

The big mystery is the failure to see the housing bubble. The data screamed “bubble”, even in real time. And there was no excuse for believing that such things don’t happen in efficient markets, not with the dead body of the dot-com bubble still warm.

So why did so few people point out the obvious? ...the failure to see the most obvious bubble of my lifetime remains a puzzle.

Paul Krugman, NYTimes, 12/24/08

Keynes’s genius – a very English one – was to insist we should approach an economic system not as a morality play but as a technical challenge.

That’s the point of my favorite Keynes quote, where he declared of the Great Depression, “we have magneto trouble.”

Which Krugman is right? Do we have a bunch of shaman who have no idea what they are doing? Or a bunch of skilled engineers who are working on a well understood, technical system? Paul -- present evidence aside -- are economists shaman or engineers? Is macroeconomics and academic finance phrenology, or a science? Do we have magneto trouble, or are we trying to drive a horse?

A Player, not a Referee

An excellent post by Wretchard on how the official press is used by factions within the Government to attack each other.

Absent any widespread reconsideration of the Post’s actions during Watergate in the three years since Felt’s identity became known, the press in Washington continues to serve as a conduit for leaks of secret information. They publish this information while protecting the leakers, and therefore the leakers’ motives. Rather than being a venue for the neutral reporting of events, journalism thus becomes the arena in which political power plays are executed. What appears to be enterprising journalism is in fact a symbiotic relationship between journalists and government factions.

Remember, everything you read has been put there for a reason.

It ain't over

I had to reprint this remarkable chart (ht Barry Ritholtz)



Many remarkable things about it. Note, that from 1906 to 1940, stocks were essentially flat (with high volatility). That is Japan level abysmal-ness. The slump in the 80s also lasted about 12 years, with two sharp shocks in the middle.

The US has had a high volatility, but flat 13 years, with the near and medium term outlook decidedly gloomy. Will we have 20 years of flat, but high vol, equity prices?

The Rehabilitation of Henry Blodget

Although the Atlantic is no New York Times, this article by Henry Blodget has some really interesting quotes.

First things first: for better and worse, I have had more professional experience with financial bubbles than I would ever wish on anyone. During the dot-com episode, as you may unfortunately recall, I was a famous tech-stock analyst at Merrill Lynch. I was famous because I was on the right side of the boom through the late 1990s, when stocks were storming to record-high prices every year—Internet stocks, especially. By late 1998, I was cautioning clients that “what looks like a bubble probably is,” but this didn’t save me. Fifteen months later, I missed the top and drove my clients right over the cliff.

Later, in the smoldering aftermath, as you may also unfortunately recall, I was accused by Eliot Spitzer, then New York’s attorney general, of having hung on too long in order to curry favor with the companies I was analyzing, some of which were also Merrill banking clients. This allegation led to my banishment from the industry, though it didn’t explain why I had followed my own advice and blown my own portfolio to smithereens (more on this later).

I experienced the next bubble differently—as a journalist and homeowner. Having already learned the most obvious lesson about bubbles, which is that you don’t want to get out too late, I now discovered something nearly as obvious: you don’t want to get out too early. Figuring that the roaring housing market was just another tech-stock bubble in the making, I rushed to sell my house in 2003—only to watch its price nearly double over the next three years. I also predicted the demise of the Manhattan real-estate market on the cover of New York magazine in 2005. Prices are finally falling now, in 2008, but they’re still well above where they were then.

Housing prices are still well above their pre-bubble levels, and already the US Government is shifting huge amounts of money from those who have some, to those who spent it on houses, leaving those who stayed out of housing when the bubble was forming completely high and dry. Yes, they are being "priced out forever" but the culprit is not "all of us".

Ponzi Economy

While Bernie Madoff was wrong to break the law and cheat wealthy, gullible people out of their money (and should be thrown in prison), Krugman's analogy between Madoff and the American Economy is Grade A CYA.

Yet surely I’m not the only person to ask the obvious question: How different, really, is Mr. Madoff’s tale from the story of the investment industry as a whole?

The financial services industry has claimed an ever-growing share of the nation’s income over the past generation, making the people who run the industry incredibly rich. Yet, at this point, it looks as if much of the industry has been destroying value, not creating it. And it’s not just a matter of money: the vast riches achieved by those who managed other people’s money have had a corrupting effect on our society as a whole.

The same could be said for the trades of academic finance and macroeconomics, graduates of which fill the nation's universities, government departments, and yes, banks. Bernie's fraud was of the straightforward kind, and while $50B is no small sum, it is still a trifle compared to the $6T or so (and counting) in real wealth destroyed by the fraud that is Academic Finance and Macroeconomics.

The $6T loss was not caused by anyone breaking the law, it was caused by a system which is fundamentally, structurally unsound. And the people in charge with studying and designing this system had no clue. But the same individuals who had no idea what was going on pontificate at length -- after the fact -- about what went wrong, how to fix it, and who the winners and losers should be. It makes me nostalgic for Bernie.

Ford SmartGauge Instument Panel

For those who like cars and customer experience, it's worth checking out this demo on the new Ford SmartGauge Instrument Panel. Essentially, two high-def LCD panels make up the core part of the dash where the speedo and other instruments sit. The video has a nice walkthrough.

Some comments.

The initial experience is nice -- you unlock the car from your remote keyfob, and the interior is bathed in blue light. Makes it easy to find your car in a dark parking lot, and is also simply cool.


Once you are in the car, but have not put in the key, the blue panels are replaced with a cheesy grass and blue sky image. This looks too much like Windows booting up to me, but I don't think it's a big negative.


The nicest moment is when you turn the car on. The instrument panel visually unfolds, and the red speedo needle cranks all the way clockwise, before returning to zero. The effect is quite beautiful, and for those into performance cars, having the needles in the gauges crank over and settle back is a really nice touch. This is my favorite part.



As for the instrument panel itself, I'm mixed. I think that things like the temp readout should be hidden. Most people do not care what temp their car is, they only want to know if it's overheating, and whether or not the heater will work. There are much better ways to do both of these. Also, the warning lights are the same tiny, incomprehensible icons. Again, given the flexibility of the new display, Ford could do better.

I like how there are both a fuel and battery level indicators, and while there are elements of the graphic design I don't love, I think they work well. The charging/discharging affordance on the battery indicator is discrete and efficient, as is the amber/yellow/red low fuel light warning system on the fuel gauge.

The immediate feedback you get on your economy will motivate people to hypermile, which I think is a good thing, and so I would make this even clearer. I understand what they were trying to do with the long term fuel economy reading (the plant on the right) but I'm not sure I love the final executive. That said, I'm sure this was something that design fought long and hard for, so we'll have to see how it works in the real world.

Austrians vs Keynes

A little bit of cognitive dissonance for me at Marginal Revolution. Tyler Cowen, who is plugging through GT, says:

Keynes admits that with economic development labor gets very specialized, or very closely connected to particular capital goods, so yes there are capital complementarities of the Austrian kind. But Keynes thinks such fragilities will only help his argument, while rendering the analytics too messy. He declares his intention to proceed with homogeneous magnitudes of capital and labor.

This chapter often fails to receive its proper due; it is very important for understanding the location of Keynes in the history of economic thought.

With this one chapter, Austrian capital theory falls off the map.

Austrian capital theory certainly did fall off the map, but there is clearly nothing in Keynes GT that pushed it. If you can find an actual argument for why capital complementarities with labor can be brushed over, please also tell me how the Government giving money to ditch diggers will help unemployed investment bankers.

For another perspective on why Austrian capital theory "fell" off the map, you can check out Rothbard's biography of Keynes (pdf). If the crappy models aren't bad enough for you, then you can always read about the person himself.

Zombie infrastructure

If John Maynard Keynes had lived during a period of high labor specialization, and high Federal taxes on labor, he would not have recommended "digging a ditch and filling it up again" as a useful target of deficit spending during a recession. Under Keynes' GT, the goal is to increase aggregate demand by increasing the Federal deficit, and this can be done through lower taxes, higher spending, or both. The key is to raise the deficit as quickly as possible in ways that also increase real goods and services available to the economy. In Keynes times, this was hiring men to work the land with shovels.

Fast forward to 2008, aggregate demand is falling, and the Government wants to run deficits to boost it. So, academic economists, who have never had to make a payroll never mind handle a shovel, dust off their old copies of the General Theory, and parrot back "infrastructure spending". "Infrastructure spending" has become this talismanic utterance, bested only by the more potent phrase "shovel-ready infrastructure spending", that if repeated often enough will result in magical economic growth.

Japan has tried this for the past 20 years, and failed. The US is going down the same path as Japan by propping up zombie firms, and expanding the monetary base in half hearted ways which do not, net, increase aggregate demand or increase the amount of real goods and services available in the economy.

If Keynes was alive today he would not call for "infrastructure spending", he would call for the Government to pick up the tab for FICA taxes, and to keep picking this up until CPI began to tick up in a serious way.

Not so NICE

Fantastic article on NICE, the UK agency that determines whether a given medical treatment is worth its price or not.

A clinical trial showed that the pill, called Sutent, delays cancer progression for six months at an estimated treatment cost of $54,000.

But at that price, Mr. Hardy’s life is not worth prolonging, according to a British government agency, the National Institute for Health and Clinical Excellence. The institute, known as NICE, has decided that Britain, except in rare cases, can afford only £15,000, or about $22,750, to save six months of a citizen’s life.

But this makes no sense:

Britain’s National Health Service provides 95 percent of the nation’s care from an annual budget, so paying for costly treatments means less money for, say, sick children. Before NICE, hospitals and clinics often came to different decisions about which drugs to buy, creating geographic disparities in care that led to outrage. (Such disparities are common in the United States, even for federal Medicare patients.)

Sick children provide excellent return on investment for treatments. A positive intervention in a child can yield years of benefits. Why don't children always win?

After consulting a citizens group, the institute decided that the nation should spend the same amount saving or improving the life of a 75-year-old smoker as it would a 5-year-old.

Ah, that makes sense. It is also highly informative about the value of consulting citizens' groups.

Does not understand Federal Reserve Banking

Brad DeLong, like all macroeconomists I've ever met, has no understanding of Federal Reserve banking, fiat money economics, or Mises. Mises was thrown under the bus a long time ago, but not getting 1) and 2) is like a physician not knowing about bacteria and viruses. Check out this reaction to Mises

Mises says:

"[T]he gold standard appears as an indispensible element of the body of constitutional guarantees that make the system of representative government function.... What the foes of the gold standard are asking for is... to intensify very considerably the already-prevailing upward trend of prices and wages.... Such a policy of radical inflationism is, of course, extremely popular.... How pale is the art of sorcerers, witches, and conjurors when compared with that of the government's treasury department! The government, professors tell us, 'can raise all the money it needs by printing it'[1]. Taxes for revenue, announced a chairman of the Federal Reserve Bank of New York, are 'obsolete'[2]. How wonderful!... Eventually... the cleverly-concocted plans of inflation collapse. Whatever compliant government economists may have said, inflationism is not a monetary policy that can be considered as an alternative to a sound-money policy...."

DeLong responds:

this citation to Beardsley Ruml's "Taxes for Revenue Are Obsolete" is a gross and illegitimate distortion.

Ruml writes that while state and local governments must ultimately raise all the money to finance their spending through taxation, the federal government has extra freedom of action because of "the elimination, for domestic purposes, of the convertibility of the currency into gold." How should the government use this freedom of action? The first of the policy considerations it should have in mind, Beardsley Ruml says, is: "Do we want a dollar with reasonably stable purchasing power over the years?... [T]he most important single purpose ot be served by the imposition of federal taxes is the maintenance of a dollar which has stable purchasing power.... [W]ithout the use of federal taxation all other means of [price] stabilization... monetary policy... price controls... subsidies, are unavailing..." That is the opposite of what von Mises wants his readers to think Ruml's meaning is.

But both Ruml and Mises are right, DeLong is wrong. State and local governments are currency users, not currency issuers, so they must raise all their money to finance spending through taxation. The Federal Government is unique in that it is a currency issuer, and so does not need to finance spending through taxation, it can simply create the money ex nihilo. So why tax at all? Most importantly, the Federal Government must tax to create demand for the fiat currency it, and it alone, can create. There is one simple reason why my region of NorCal does not run on winterspeakBucks, and it has everything to do with the size of my standing army, and nothing to do with my ability to print out little pieces of paper with "N winterspeakBucks" written on them.

The secondary reason to tax is to reduce aggregate demand, and so keep the money supply from growing too much faster than the real quantity of goods and services in the economy (which would show up in the CPI as inflation). I cite this as a secondary reason because there are many ways to control money supply, including interest rates, deficit spending, etc. But please note, at no point does the Federal Government need to tax in order to spend. The Fed spends first, and then taxes to sterilize that increase in money supply.

So, Ruml is saying that the Fed needs to tax to create demand for fiat money, and then tax again to reduce aggregate demand and take the quantity of fiat money available in excess of that required for private saving, out of the system. Only in a fiat money system can the Fed control money supply. Compare and contrast this with third world countries who are unable to tax, and unable to have all the economic activity in their country be in their local currencies.

Mises is saying that politics, being what it is, will not control money supply wisely or well, that the incentive to create extra money and give it to favored interests is too great, and it will all end in hyperinflation which debases the currency entirely. Best to take it out of Government hands and have a fixed money supply, which in a world of rising productivity would result in an environment of mild and continuos deflation.

They are both exactly right. Taxation is central to generating fiat currency, and controlling inflation. And government has been unable to resist ultimately hyper-inflating fiat currency. The US$ has lost well over 90% of its value over three generations, which is not hyperinflation but it's certainly not a "stable source of value" either. Harvard economists are calling for 6% inflation for two years as if inflation can be turned on, and then turned off so easily. Volker raised interest rates to 20% to stop inflation in the 70s, a feat that seems impossible in the 21st century's political climate where even millionaire investment bankers cannot be allowed to become redundant, even for a few weeks.

Brad DeLong, however, Macroeconomist, writer for the NYTimes, Obama cabinet hopeful, clearly does not understand Austrian economics, which is forgivable given they were excommunicated from the Temple long before DeLong went to grad school, but sad since some of their ideas are not only brilliant, but also correct. What is not forgivable is that DeLong also does not understand Federal Reserve Banking, which is an indictment of him, and his profession.

Macro: Under Construction

One of the reasons, I think, that it's been so difficult to understand this latest financial crises is that people are trapped in particular narratives, which bear no relationship to the current situation, that they also cannot see beyond. For example, I give you this post by Megan McArdle, who correctly identifies that there seems to be no laws broken, but then cannot take the next logical step:

In general, I think that we're approaching this crisis the wrong way when we look for a villain. One of the things that has really surprised me--so far, anyway--is just how little criminal activity we've uncovered during this crisis. There's an old accounting saying, "recessions uncover what auditors can't". Enron, Global Crossing, and MCI were not the only companies that played funny games with their books in the late 1990s. A number of technology companies played games with their books, but were able to grow enough to unwind their chicanery with little more than a slap on the wrist from the SEC. Enron, et al. were simply the ones who got caught short when the music stopped. I don't mean to say that all or most companies were guilty of this, because the overwhelming majority weren't. But the problem wasn't unique to Enron, and had they been able to carry on with it longer, there's every chance that they might have been able to get out of their bad positions and stay solvent.

When every law is followed, but the system as a whole still completely collapses, the answer is pretty clear to me: the system is fundamentally broken. In my view, the US financial system (and by extension, the world financial system) simply does not work. It is a bridge that followed firmly established engineering principles, was carefully built to spec, and yet collapsed anyway. There is no point in gluing masonry together or yelling at contractors, one must rethink those established engineering principles.

Paul Krugman has his own narrative. In it, the evil Republicans filled posts with idiots, and now, finally, the grown-ups are coming in to make everything better. *Sigh*. Paul backpedals and says he was only talking about Tim Geithner versus John Snow but please tell me what Snow had to do with of this, and how Geithner's long track record of proven failures in the NY Fed (AIG, Bear, Lehman, Citi, etc.) recommends him.

Neither Paul nor Megan can admit to themselves that the problems are fundamental and structural, that the financial system's engineering playbook is unsound, and yes, this means that academic macroeconomics and finance are, essentially, Fraudulent. Or at least, Scientism. Spend some time in the English Lit department at Harvard and you'll see how bad the modern University is at rejecting drivel. Now ponder that fact that this may also be the case in the Economics department, and that these guys are running the country.

It's not fair to keep picking on Krugman, but he keeps stepping up to the plate. Both he and Mankiw not only believe in Keynesiasm, but think he is the solution to today's problem. First Mankiw:

IF you were going to turn to only one economist to understand the problems facing the economy, there is little doubt that the economist would be John Maynard Keynes. Although Keynes died more than a half-century ago, his diagnosis of recessions and depressions remains the foundation of modern macroeconomics. His insights go a long way toward explaining the challenges we now confront.

According to Keynes, the root cause of economic downturns is insufficient aggregate demand. When the total demand for goods and services declines, businesses throughout the economy see their sales fall off. Lower sales induce firms to cut back production and to lay off workers. Rising unemployment and declining profits further depress demand, leading to a feedback loop with a very unhappy ending.

The solution is for Government to step up and spend. Thank goodness we have a scientific reason for that position, as it was not getting enough airtime in Washington DC. Here's Krugman on the Greatness of Keynes:

The key to Keynes’s contribution was his realization that liquidity preference — the desire of individuals to hold liquid monetary assets — can lead to situations in which effective demand isn’t enough to employ all the economy’s resources. When you don’t understand that principle, you end up writing stuff like this:

Want to see what Keynes actually said? Luckily the key equations are pretty straight forward:

Consumption + Investment + Government Spending + Exports - Imports = Gross National Product

ie C+I+G+X-M= GDP or Y

In this recession, consumption and investment is falling as the housing bubble pops, and the leverage that created it unwinds. Essentially, the monetary base is shrinking as credit (a key element of money) is withdrawn, written down, or written off. Exports were increasing, but the rise of the dollar (as the world rushes to Treasuries) means that that is down too. And, as people spend less, imports fall. All of these declines mean that the economy will go into a recession (GNP will fall). Keynes would argue that if you increase Government Spending enough -- G -- then GNP will rise and the economy can escape recession. Note that he is arguing for a *fiscal* stimulus, greater government spending, as the key to avoid GNP falling. Keynes argued for the Government paying people to "dig holes and fill them up again", and said that this would somehow get the economy back on track. You are quite right to say "huh?"

(The Monetarists say that the solution to the problem is not fiscal, it's monetary. Instead of increasing Government spending, you should cut interest rates and thus increase C and I, without needing to change G. Also, the New Deal was not net fiscal stimulus because although the size of the Government grew, and deficit spending grew, FDR also increase taxes to essentially sterilize whatever stimulating the larger Federal balance sheet was creating. When Obama talks about stimulus on one hand, and higher taxes on the other, he is increasing aggregate demand AND reducing aggregate demand at the same time. Not encouraging.)

Both Keynes and the Monetarists are wrong. The key to an economy avoiding recession lies in a change in the money supply, a change that can come about both through fiscal and monetary means. Lowering interest rates increases the money supply, as in a fiat currency world, banks borrow directly from the Fed, and then loan that money out to businesses and consumers. As the Fed's interest rate reaches zero, banks can make more and more marginal loans (since the floor on their spread is the Federal fund rate). When banks make loans, they increase the money supply -- remember, credit is money, and loans create deposits. So lower interest rates mean more money.

But expanding the Government balance sheet increases the money supply too! If the Fed spends $1B to pay people to dig holes and fill them in again, this debit on their balance sheet represents real money that has been credited to those workers. The Federal Government does not get money from taxes -- it does not need to, it can print its own -- so any debit on the Fed's balance sheet is, by definition, a credit (savings) somewhere in the private sector. (I understand that this implies ever larger Government deficits are required to increase private savings, but that's what the accounting identities say. I do not understand the full meaning of this.)

It is this fundamental equivalence between monetary policy and fiscal policy when it comes to their impact on money supply that Bernanke talks about when he says that a Government can always create inflation. But I don't think even he fully understands the implication of fiat banking, which is why both monetary (0.5% Federal Fund rate and falling) and fiscal (TARP giving money to banks) have produced dismal results to date.

As the Austrians would say that "Mr. Keynes's aggregates conceal the most fundamental mechanisms of change!" Which is absolutely true! If you cannot understand how the Government running a deficit to pay people to dig holes and fill them up again helps an economy with a too-expensive housing sector, now correcting, and a too-large financial sector, now contracting, you are on to something. It does not make sense. And we have real economists wondering about this too (although Greg has not won a Nobel Prize, and Nobel Prize winnings economists can make sense of it all).

For example, here is the conclusion of Andrew Mountford and Harald Uhlig (a prominent econometrician now at the University of Chicago) in an empirical study called "What are the Effects of Fiscal Policy Shocks?":
Our main results are that
- a surprise deficit-financed tax cut is the best fiscal policy to stimulate the economy
- a deficit[-financed government] spending shock weakly stimulates the economy.
- government spending shocks crowd out both residential and non-residential investment without causing interest rates to rise.
These finding are not consistent with standard Keynesian theory, according to which government spending multipliers are larger than tax multipliers and crowding out occurs through increases in interest rates.

If the data does not fit the model, Krugman does not care.

The key to Keynes’s contribution was his realization that liquidity preference — the desire of individuals to hold liquid monetary assets — can lead to situations in which effective demand isn’t enough to employ all the economy’s resources.

I think his key intellectual difficult is this:

For—though no one will believe it—economics is a technical and difficult subject.

It may be difficult, but it is not technical. Civil Engineering is a technical subject. Back in the day, engineers massively overbuilt walls, towers, aqueducts etc. because they did not have the physics and mechanics to actually calculate torsional loads, weight bearing capacity, etc. so they just made things extra big and strong -- just in case. Now that they understand physics and mechanics, they can build more efficiently, to tighter tolerances, because they now just how slim they can make a pylon and still have the bridge stay up. Does that seem to describe macroeconomics or finance in any sense at all to you? Academic economists published lots of papers, with increasingly elaborate equations, none of which work. Industrial economists build increasingly elaborate models, to multiple decimal places, and then levered themselves to the eyeballs based on what those models said. And it all blew up. A truly technical field, like civil engineering, has models that work and you can build to tight tolerances. This leaves Economics as a difficult field, but it's just not Technical, and pretending that it is has lead us to our current mess. Keynes General Theory, like all Macroeconomics, is closer to the Drake equation than Newton's Laws of Physics.

This post has gotten too long -- let me wrap things up.

The mechanism by which fiscal expansion (kind of) works is that the Government creates new money, that it then gives to whomever. In this case, to date, it's been financial firms, but it may soon also include government contractors who are also civil engineers to build roads etc. ("Infrastructure" is to economists what "billiard balls" are to physicists. I encourage you to go down to your local pool hall and see how many physicists you find there.)

This new money reduces the value of existing money by diluting it. So, this is a transfer of wealth from those who have money (savers) to those who have received this new money. Eventually you transfer enough of it, and those who did not have money start spending again, and those who had money have less to spend, but they were saving it anyway, so this does not show up in current GDP figures.

If the amount of extra money created is greater than the amount goods and services increase, you get inflation. The key here is to note that the reason for increasing the money supply is to increase (or sustain) the amount of goods and services in the economy. If the amount of goods and services fall, you get unemployment (less work, same number of people, it takes time for individuals to retool, in the meanwhile they are out of work). Note that it is clear in this model why it's better for the Government to increase its deficit and give that money directly to consumers, ideally through tax cuts as those are fastest. Consumers spend money on stuff they actually want, which increases the amount of goods and services in the economy, instead of building bridges to nowhere, which does not. Keynes has no insight whatsoever into this, or any, transmission mechanism, and this is why the bailouts to date have been useless.

People have stopped spending because they want to repair their household balance sheets. They have negative equity because their assets are too small relative to their liabilities, so they are building up their assets. They will not start borrowing again until they have sufficient cash to give them (net) positive equity. The sooner they repair their balance sheets, the sooner they will start spending again. Giving money to banks so they can make cheap loans does not help consumers rebuild their balance sheets. Instead, banks are just using it to patch up their own balance sheets, which is great for them, but it does not help aggregate demand.

So, step 1 should be to increase the deficit, but have this money go directly to consumers. Keep doing this until household balance sheets are repaired, and we see consumer spending picking up. At this point, turn off the money tap.

As for banks -- nationalize the lot of them, liquidate the bad ones, can their management, and re-privatize the ones that are left. In the meantime, everyone borrows directly from the Fed.

Mosler has a nice piece explaining the logic here.

Putting Humpty Dumpty together again

It's been funny, and a little depressing, to see how mired even bright and well intentioned people can become in their past prejudices and beliefs. The $306B bailout of Citigroup, TARP, Sheila Bair's "prop up home prices program", China's "keep exports growing" program, etc. etc. are all focused on somehow, some way, returning their worlds to the way "things used to be", never mind that the way "things used to be" was unsustainable, lead to calamity, and was not actually that good even if one were to ignore its catastrophic-ness. (Is catastrophic-ness a word?)

The well paid, value destroying bankers in the City and Wall Street are undoubtedly waiting for this whole thing to blow over so they can get back to business as usual.

Detroit is waiting for its next big slug of money from the Government so it too can get back to making bad cars no one wants, and fulfilling past pension obligations.

Home builders are in line for a big slug of money from the Government so they can get back to making houses like it's 2002-2007.

Airlines are going to be asking for money again in 2009 as the collapse in corporate travel finally starts showing up in their bookings.

Etc.

And in the midst of all this corporate activity, aiming to turn the clock back to 2002, we have the usual suspects of newspaper pundits and economists hailing the arrival of Tim Geithner and Larry Summers as grown-ups who are finally going to put things right. Excuse me? Geithner, in his position at the NY Fed, has been intimately involved in the bailout attempts over the past 12 months which have gone precisely nowhere. While I am sure he's a smart guy, he's already been very actively involved and so far has shown nothing positive for his efforts.

I'm also glad for Larry Summers that he has rehabilitated himself after his disastrous showing at Harvard, but is Summer really any better than Bernanke? Does anyone really believe that Bernanke has shown us the value of all his Great Depression understanding in this crises? Suppose that Summers had been Fed Chairman for the past 8 years, wouldn't we all be even more excited of Bernanke was coming in to replace him? I can see the headlines now "Great Depression Expert to take over Fed During Worst Crises in US Economy since the 30s". Why is the reverse seen as a positive sign?

I think Megan makes two great points in a couple of recent posts.

First, the New Deal (and Great Depression economics) is nothing like what we think it is. This issue has become so politicized that it is frankly impossible today to get any truthful account of what actually happened. So, whenever you read anything about how the New Deal gives us clear direction on what to do wrong, you should know that that person is actually just dressing up whatever they believe in New Deal rhetoric (one way or the other). Was it Keynesian (even though Keynes had yet to publish General Theory)? Maybe. It certainly had elements that Keynes would have approved of, but also elements that he would not have. And who really cares? The General Theory is obviously wrong, and the only reason Krugman et al keep trotting out G, I, E, T etc. is that they really don't know any better. Macroeconomics is fraudulent. The equations around the General Theory, Monetarism, etc. etc. are scientism, and bunk. It really is rubbish, and its disheartening to see how long actual Drivel can survive in the Academy, which purports to discover Truth. The only way to get a sense of what the New Deal was actually like is to read contemporary accounts. Here is one such account. Here is an excerpt from it (Thanks to Mencius Moldbug)

Washington was swarming with young lawyers, economists, bankers, and professors-in-exile, all bent on reorganizing the cosmos, rearranging the stars and planets. Programmed like a computer with bits and tags of literature, I mouthed Wordsworth's famous apostrophe to the early weeks of the French Revolution: "Bliss was it in that dawn to be alive,/ But to be young was very heaven!"

The times were ebullient, and yeast was in the air. Each morning we awoke to read with excitement of Roosevelt's latest outrageous move. It was épater les bourgeois in political and economic terms or - more precisely for us - it was épater les vieillards, a form of exercise that inevitably lifts the hearts of anyone under thirty. The old order had discredited itself; we would conjure up a new and better one in its place. Certain lines from Wordsworth's Prelude expressed what we thought we were up to, for it did indeed seem to us a time:
In which the meager, stale, forbidding ways
Of custom, law, and statute, took at once
The attraction of a country in romance!
When Reason seemed the most to assert her rights...
We were, so we thought at the time, not so much interested in smashing pillars and pulling down temples as in designing the shape and form of our New Jerusalem. Discussion might circle for a time - sometimes it seemed to circle for long alcoholic hours - but it invariably settled on the architecture of that refulgent city.

No doubt because the actors in the drama were relatively older - lawyers and young Ph.D's in economics rather than undergraduates - the reaction bore no resemblance to the later disorder of the sixties, when "trashing" seemed an end in itself. Though we had read some history, no one thought himself a young Robespierre. Perhaps also because the New Deal was a fresh experience for America (though not for Europe), with government for the first time giving explicit meaning to the welfare clause, we felt hope in the air. Later, in the sixties, much of the new welfare legislation served the bureaucracy more than the commonweal, but in those days of unlimited expectations our basic credo was simple: Nothing that had been done till then was good enough nor was there anything we could not do if we set our minds to it.

To be sure, I was little more than a spear-carrier with few speaking lines. Unlike many of the leading actors, I had, at that time, not even met Felix Frankfurter, let alone clerked for Holmes or Brandeis. Most of the problems with which the New Deal was grappling were for me matters of first impression; I was, by any rational standard, spectacularly ill-equipped. Although assigned to work on developing credit facilities for farmers, I had never, in spite of my Iowa background, spent a night on a working farm - but then neither had my colleagues, including, I suspect, Henry Morgenthau. That, however, did not deter us. In the atmosphere of New Deal Washington, inexperience was no impediment; one learned fast and improvised boldly. Even professionally, I could not have been more of a neophyte; I had never so much as written a contract to sell a fifty-dollar dog! Yet one of my first professional tasks was to draft and help negotiate a contract for the sale of $75 million worth of Federal Farm Board cotton. It was such a formidable document - seventy or eighty pages in length and replete with intricate internal brokerage arrangements - that, in retrospect, I am amazed that I was not terrified by the assignment. But I took it in stride, as we all did in those days. We were young and nothing was impossible.

I'm sure you can hear the echoes of "yes we can" echoing through the 80 years that separate 1930 to 2008.

What is the consequence of trying to put Humpty back?

I have a very simple model of the economy, money supply, and the interaction of the two.

Suppose the supply of money in an economy is X. Suppose the total quantity of goods and services available to trade is Y. If X and Y both grow by the same amount, the prices remain the same. If X grows faster than Y, you get inflation (higher CPI). If Y grows faster than X, you get deflation (lower CPI).

Right now, X is shrinking fast. Credit is a critical component of money supply, and it is getting smaller. Large quantities of money, in the stock market and in real estate, have been destroyed. When you hear about "deflation", this is what is being described.

At the same time, the Fed is printing enormous quantities of money through new credit provision, and through out and out transfers (deficit spending with key constituents -- banks currently but all kinds of folks in the future -- being credited as the national exchequer is debited). We are not seeing inflation because the net effect of these two changes in money supply is still negative. Money is being destroyed faster than it's being created, and the quantity of real goods and services available (Y) has declined slightly, but not that much.

Sooner or later, the deflationary effects of falling equity and real estate are going to play out, but the money expansion mechanisms the Fed has put in place (TARP, etc. etc.) will remain. It is going to be almost impossible for the Fed to turn off these life support systems when they need to, and the consequence is going to be dramatic inflation. I see 2009 as being the year when more and more money is pumped into the wrong parts of the system, prices finally reach bottom, and we see X increase at a pace >> Y, and the value of dollars get dramatically diluted away. To tame this beast, Obama is going to have to stand up and say "No you can't" to lots and lots of people, as Summers simply increasing the Federal Funds discount rate is not going to do the trick. We are well past the world of monetary policy and deep in the real of fiscal stimulus, which means we need Acts of Congress cutting subsidies of Favored Constituents. Don't hold your breath.

And in the midst of this Comedy of Errors we have earnest tracts like the following:

But more to the point, I don't think anything he said rules out positive net present value investments in infrastructure. We should make these investments in any case if we want the economy to grow robustly, now just happens to be a good time to have the construction and maintenance work done since people need jobs, inputs to production are relatively cheap, and the political atmosphere is accommodating.

Ah yes, Infrastructure Spending, the great White Knight who will make all our monetary ills go away! It is childlike to see how much support the idea of " Infrastructure Spending" has gotten as a mechanism for Stimulus! Is there any reason why "Infrastructure Spending" be granted this Hallowed Place is being The right mechanism for fiscal measures? And just to think, 12 months ago we were mocking Bridges to Nowhere.

Infrastructure Spending will be allocated the way Infrastructure Spending is always allocated -- it will be based on political expediency, not whether it is a positive net present value or not. If Infrastructure was based on positive net present value, we'd have sky scraped being built in San Francisco, and 8 story apartment complexes built in Cambridge, MA, and I don't see a whole lot of either going on. Since this spending will not be positive net present value, X will increase by more than Y and this will devalue the dollar.

If you want positive NPV spending, simply give money to People via lower taxes. Have Government pay FICA for as long as necessary, and let people allocate that money based on whatever they think. But since FDR did not do this, it did not make its way into textbooks, so it is not the solution parroted by those who have spent 8+ years of their lives memorizing those same texts.

The Netflix Prize

I recommend this great article on the Netflix Prize: a $1M bounty that will be given to whomever can increase the quality of its recommendation engine by 10%. Lots of interesting information; my favorite was:

Interestingly, the Netflix Prize competitors do not know anything about the demographics of the customers whose taste they’re trying to predict. The teams sometimes argue on the discussion board about whether their predictions would be better if they knew that customer No. 465 is, for example, a 23-year-old woman in Arizona. Yet most of the leading teams say that personal information is not very useful, because it’s too crude. As one team pointed out to me, the fact that I’m a 40-year-old West Village resident is not very predictive. There’s little reason to think the other 40-year-old men on my block enjoy the same movies as I do. In contrast, the Netflix data are much more rich in meaning.

Broadcast advertisers are obsessed with demographic data, because that's how airtime is identified and sold. But it's a poor and distant cousin to actually knowing about individuals' actions and preferences. Let me phrase it this way: would you rather know someone's age and sex, or would you rather know the last 5 queries they typed into Google?