AIG as beard

AIG passed on most of the bailout money it received to twenty large banks, Deutsche Bank and Goldman Sachs being the top two recipients. I argued that AIG was kept alive so it can act as a beard and enable the Obama administration to continue recapitalizing financial firms covertly, because overt recapitalization would require creditors to take a haircut, which seems to be unacceptable to the Govt.

A slightly old, but good, post on Calculated Risk shows other ways that AIG is acting as a beard, enabling the Obama administration to continue to try and recapitalize by stealth:

What this all means is that the statements by major banks, i.e. JPM, Citi, and BofA, regarding abnormal profitability in January and February were true, however these profits were 1) one-time in nature due to wholesale unwinds of AIG portfolios, 2) entirely at the expense of AIG, and thus taxpayers, 3) executed with Tim Geithner's (and thus the administration's) full knowledge and intent, 4) were basically a transfer of money from taxpayers to banks (in yet another form) using AIG as an intermediary.

Don't look for it in the NYTimes though.

Adam Posen puts it well from the bully pulpit:

What the Obama team is proposing is disconcertingly similar to the actions of Japanese Prime Ministers Hashimoti, Obuchi, and Mori in 1995 and 1998: Rather than ask the legislature for straightforward recapitalization money, you have the political leadership preferring to risk overpaying current owners of toxic assets rather than forcing sales. For all of Japan’s supposed intervention in markets, its government still lacked the stomach for taking over banks, let alone closing them.

The IMF's advice to America

I have no idea how good the IMF's advice has been to developing countries historically, certainly Paul Keating didn't think much of Geithner, but it's still worth reading Simon Johnson's account of what the IMF would tell the US if the US needed money from the IMF (which it does not). Market's are up, and things are looking sunnier, but it's hard to disagree with this:

The conventional wisdom among the elite is still that the current slump “cannot be as bad as the Great Depression.” This view is wrong. What we face now could, in fact, be worse than the Great Depression—because the world is now so much more interconnected and because the banking sector is now so big.

We really don't know. And a great deal depends on what politicians decide to do. Japan, again, is instructive:

But the U.S., of course, is the world’s most powerful nation, rich beyond measure, and blessed with the exorbitant privilege of paying its foreign debts in its own currency, which it can print. As a result, it could very well stumble along for years—as Japan did during its lost decade—never summoning the courage to do what it needs to do, and never really recovering.

Japan's been stumbling for 25 years now, trapped in deflation as public debt -- running at about 250% of GDP -- is still not large enough to meet the Japanese demand for savings. Why does the Japanese Government tax at all? It truly boggles the mind. It also does not make me feel better about the US. Johnson again:

“It doesn’t matter how much Hank Paulson gives us, no one is going to lend a nickel until the economy turns.” But there’s the rub: the economy can’t recover until the banks are healthy and willing to lend.

See that -- two sentences back to back, written by someone who claims to be free of the "jedi mind control" the financial industry is able to exert over politicians and academics alike. "No one is going to lend a nickel until the economy turns"... "the economy can't recover until the banks are healthy and willing to lend." If the US Govt stopped draining private spending power through taxes -- not spending anything more, just reducing the fiscal drag it casts every week through FICA, and every April 15th -- the economy would turn. Loans would be paid down. Defaults would fall. Layoffs would taper. Spending would increase. Incomes would increase. Banks would lend. It isn't complicated, but when Simon Johnson cannot see the connection between two sentences, that he wrote, right next to each other, it does not give one much hope.

The banks have made the world believe that the economy needs them to recover. The truth is that banks aren't nearly as important as they think they are. Well capitalized banks cannot help a broader economy trapped in debt deflation. Rising aggregate demand will make whole any bank, regardless of its capital adequacy.

Watchmen

Totally rocked. Removing the squid was a huge improvement. Didn't miss the pirates. Loved the sound track.

Very slow links

Nothing about these four links is quick.

Download the word doc Seven Deadly Innocent Frauds of Economic Policy and spend some time with it. It's Mosler's clearest entry level explanation of post-Keynesianism I've seen, although maybe I'm just used to it by now. The comments are also very good.

From the comments, see what happens when post-Keynesianism meets extreme Monetarism here and here. At the margin, they are not so different, but I'll write soon about why quantitative easing has been such a bust so far, and why it will continue to be a bust.

Finally, I recommend both the post, and the thread, on Interfluidity. Maybe we can help James Surowiecki (whom I've enjoyed reading for years) understand that loans create deposits, not the other way around.

Why you don't need banks for the economy to recover

The Economy drives Banking, Banking does not drive the economy

It is an article of faith that you need healthy banks for the economy to recover. The logic goes that if banks aren't healthy, they won't make loans, and if they don't make loans, the economy cannot grow. A bank is "unhealthy" if it is undercapitalized -- that is to say that it does not have enough equity to meet capital requirements, and therefore cannot engage in additional lending. (Under law, this condition would also trigger FDIC receivership, but that law does not seem to apply today.) If a bank was to write down the value of its assets, then it would also need to write down the value of its equity, and thus put itself into FDIC receivership. Etc.

While the mechanics of the above are true, it is not true that restricted bank lending is causing this "crises". Although it is called a "credit" crises, it is in fact a fall in aggregate demand. Aggregate demand is consumer spending plus consumer investment plus government spending minus taxes.

When the private sector, as a whole, wants to spend less and save more, aggregate demand falls. This increase in savings shows up as an increase in inventory, which gets counted as investment but is nothing like what we would imagine true investment to be (factories, bridges, etc.) Moreover, you will also see credit fall, as instead of taking out money to buy things, people simply pay down existing debt or hoard cash in the bank. The causality is backwards: lower aggregate demand is reducing credit, lower credit is not reducing aggregate demand. Similarly, the cycle will turn the same way: higher aggregate demand will increase the demand for credit, more credit availability will have no impact on aggregate demand if the private sector is still in the midst of deleveraging.

Moreover, falling aggregate demand reduces the private sector's ability to service debt loads, which is what reduces the asset (receivable) quality of banks balance sheets. If you lose your job, you're more likely to default on your mortgage. Again, the received wisdom gets things backwards: bad balance sheets are not harming the economy, the bad economy is harming balance sheets. Once aggregate demand begins to grow, balance sheets will "magically" fix themselves.

Banks are not nearly as important to the economy as they claim they are.

Obama's Bank Bailout enriches Bankers, but does not help the real economy

Obama claims that the banking bailout is critical to get the economy back on track. He is wrong. The banking bailout is critical to lining bankers' pockets, but no more. A growing economy will fix banks, just as it will generate additional lending, which will create more deposits, and additional (real) investment, which will create more savings. Sound lending is important to an economy, but banks are procyclical, and a lagging indicator, not a leading one.

When Regulation cannot work, Fear must

This self-serving "logic" is clear in this resignation letter, which somehow found its way into the NYTimes: AIG: I quit. It will be interpreted as the reason why the US Govt should not claw back the absurd bonuses given to bankers by those who believe that banks are critical to getting the economy back on track. If a regulatory system is continually and systematically gamed, as the financial system clearly does, then the answer is never more regulation (which will simply be gamed around), but retroactive penalties on bad actors. If you cannot set up the right rules in advance, then you must move the goal posts after the fact.

People who claim that the AIG bonuses are small potatoes miss the point: they are very big potatoes to the actors who received them and incentives are a critical factor behind all of this.

The profitability of the businesses with which I was associated clearly supported my compensation. I never received any pay resulting from the credit default swaps that are now losing so much money.

Because he got lucky. Or not. The point is that in every other business, firm profitability impacts individual and group level compensation. If your firm makes net minus infinity, you don't get anything.

The only real motivation that anyone at A.I.G.-F.P. now has is fear. Mr. Cuomo has threatened to “name and shame,” and his counterpart in Connecticut, Richard Blumenthal, has made similar threats — even though attorneys general are supposed to stand for due process, to conduct trials in courts and not the press.

Also wrong. In a word where regulations exist only to be "innovated" around, fear must be the prime motivator, as rule of law cannot be. The CEO should be afraid that all of his money will be confiscated if he blows up the world financial system. He must create compensation structures that massively impoverish people if they blow up the world financial system. Employees must keep a close eye on each other, in case someone is doing something that will blow up the world financial system. This is called "risk management" and it is something that the financial industry should try.

Tax Payer "Profit" is an Oxymoron

Taxpayers, aka the Government, can print all of the money they need, anytime they want. The very concept of "profit" to a currency issuer is completely nonsensical. Their only goal should be maximizing the quantity of real goods and services in the economy, long term.

Some Government actions may cause a higher budget deficit, but put in place better incentive structures to prevent capital misallocation and financial blowups in the future. The true cost of this crises is not just the trillions going down the drain now, but also the trillions misspent on McMansions in the middle of nowhere, empty shopping malls, and office buildings that no one will ever fill. Those represent real opportunity cost. Moreover, the double digit unemployment rate, shuttering factories, and collapsing businesses are real capital destruction too. It is completely worthwhile to run a higher deficit, get capital reallocated correctly, and have a banking system in perennial morbid fear of blowing up.

Geither's stealth bailout continues

No shortage of comments on Geither's latest PIPP plan. It's the same as the Paulson plan -- the Government covertly recapitalizes politically connected banks -- except that it is more deceptive and more expensive.

A while ago I argued that the cost of financing should not drive the price of an asset. Whether Amazon's stock is worth $100 should not depend on how good a margin deal by broker gives me. I was wrong, the price of assets can be entirely driven by financing costs, and this is doubly true for financial assets.

If banks acknowledged their losses, they would not be able to make their capital requirements, and under law (hah!) would need to be shut down by the FDIC. To avoid that fate, Geither is offering super cheap financing to leveraged buy out shops so they can buy those bank assets and create a price that will let the banks maintain the fiction of having adequate capital. This will be touted as a "market" solution to "price discovery" but it is no such thing. True price discovery does not involve sweetheart deals with the Treasury. And this is before you go into all the ways the "auction" will be manipulated, and all the agreements to make creditors whole should they "overpay" for the assets and make banks whole at a loss to themselves (and tax payers). Truly, it is the greatest transfer of money from workers to the hyper rich investor classes the world has ever seen.

Will it help the economy? No. The economy is deleveraging as it seeks a debt load that it can serve out of income. The Government is engineering high unemployment to keep pressure on real wages and benefit capital. I don't think the current stock market bounce will last, but I have been long financials.

Paul Krugman, who is causing nightmares in the Obama administration, is right:

We had vast excesses during the bubble years, and I don’t think we can fix the damage with the power of positive thinking plus a bit of financial engineering.

We could fix the problem by reducing fiscal drag through a payroll tax holiday, but, as Rahm Emmanual said, that would be a waste of a good crises.

Banks are procyclical. Fixing them will not fix the economy, but restoring aggregate demand will. All these interventions do it enrich already wealth bankers and leave fewer real goods and services for non-bankers. Brad DeLong is wrong, but by taking a stance opposite Krugman's, get's into the Grey Lady:

The purpose of the Geithner plan is to boost financial asset prices and so make it easier for businesses to obtain financing on terms that will allow them to expand and hire. The plan would take about $465 billion of government money, combine it with $35 billion of private-sector money, and use it to buy up risky financial assets.

Nope. Businesses will expand and hire when they see more demand. Higher financial asset prices will not help that, although it will keep Citi and BofA in existence.

Rolling Stone nails the financial crises, names names

I enjoyed this Rolling Stones (of all publications) article on the financial crises. It names the key antagonists, and also highlights how "stricter regulation" will not work, and why retroactive legislation, like the AIG bonus clawback, is necessary.

That guy — the Patient Zero of the global economic meltdown — was one Joseph Cassano, the head of a tiny, 400-person unit within the company called AIG Financial Products, or AIGFP. Cassano, a pudgy, balding Brooklyn College grad with beady eyes and way too much forehead, cut his teeth in the Eighties working for Mike Milken, the granddaddy of modern Wall Street debt alchemists. Milken, who pioneered the creative use of junk bonds, relied on messianic genius and a whole array of insider schemes to evade detection while wreaking financial disaster. Cassano, by contrast, was just a greedy little turd with a knack for selective accounting who ran his scam right out in the open, thanks to Washington's deregulation of the Wall Street casino. "It's all about the regulatory environment," says a government source involved with the AIG bailout. "These guys look for holes in the system, for ways they can do trades without government interference. Whatever is unregulated, all the action is going to pile into that."

Why had I not heard Cassano's name before?

When Morgan presented their plans for credit swaps to regulators in the late Nineties, they argued that if they bought CDS protection for enough of the investments in their portfolio, they had effectively moved the risk off their books. Therefore, they argued, they should be allowed to lend more, without keeping more cash in reserve. A whole host of regulators — from the Federal Reserve to the Office of the Comptroller of the Currency — accepted the argument, and Morgan was allowed to put more money on the street.

Capital requirements seem to be impossible to implement.

But in the late Nineties, a few years before Cassano took over AIGFP, all that changed. The Democrats, tired of getting slaughtered in the fundraising arena by Republicans, decided to throw off their old reliance on unions and interest groups and become more "business-friendly." Wall Street responded by flooding Washington with money, buying allies in both parties. In the 10-year period beginning in 1998, financial companies spent $1.7 billion on federal campaign contributions and another $3.4 billion on lobbyists. They quickly got what they paid for. In 1999, Gramm co-sponsored a bill that repealed key aspects of the Glass-Steagall Act, smoothing the way for the creation of financial megafirms like Citigroup.

Phil Gramm still has his job.

In the biggest joke of all, Cassano's wheeling and dealing was regulated by the Office of Thrift Supervision, an agency that would prove to be defiantly uninterested in keeping watch over his operations. How a behemoth like AIG came to be regulated by the little-known and relatively small OTS is yet another triumph of the deregulatory instinct.

Why haven't I heard about OTS?

When AIG finally blew up, the OTS regulator ostensibly in charge of overseeing the insurance giant — a guy named C.K. Lee — basically admitted that he had blown it. His mistake, Lee said, was that he believed all those credit swaps in Cassano's portfolio were "fairly benign products." Why? Because the company told him so. "The judgment the company was making was that there was no big credit risk," he explained.

Why have I never heard of CK Lee? He still has his job too.

When asked why Blankfein was there, one of the government officials who was in the meeting shrugs. "One might say that it's because Goldman had so much exposure to AIGFP's portfolio," he says. "You'll never prove that, but one might suppose."

Market analyst Eric Salzman is more blunt. "If AIG went down," he says, "there was a good chance Goldman would not be able to collect." The AIG bailout, in effect, was Goldman bailing out Goldman.

Key quote here -- the AIG bailout is just a shelter for a Goldman bail out. Since the Obama administration cannot openly bail out banks, they are trying to do so covertly. AIG spoiled things by having these bonuses with terrible optics. Anyway, read the whole thing.

Why I support the AIG bonus clawback

The House has voted a 90% tax on AIG bonuses (.pdf) in an effort to clawback bailout money that simply lined the pockets of those responsible for blowing up the financial system. While the bill is not perfect, I support it.

The financial services industry gamed capital requirements by using that now famous derivative soup: CDO, MBS, SIV etc. The only way to combat regulatory evasion is to create and apply new rules retroactively. This is not the first time that the financial services industry has gamed regulations -- they have a history of it, and each chapter contains a massive boom (where bankers get rich) followed by a massive bust (where the Government steps in and pays bankers). Additional regulations are a coda to stop the last incident from happening again, but bankers, understandably, keep coming up with new incidents. Retroactive regulation stops the absurdity. If you don't like retroactive regulation, then stop all financial innovation (which I am also OK with, btw. I just want this cycle to stop).

Another argument against the clawback is that the bonus money is small fries compared to the size of the actual bailout. This misses the point that it is not small fries to the recipients of the money. Bonuses are about creating the right incentives, and giving massive bonuses for awful performance to the employees of a firm that only exists as a ward of the state sets the wrong incentives.

There is also the fact that some principal bad actors at AIG have already flown the coop. This is a good reason to go after them as well, but not a good reason to now clawback current bonuses.

Finally, some argue that the real scandal at AIG is how the bailout money has simply made the counter-parties (Goldman Sachs, et al) whole when they should be taking big haircuts. I agree, but the Treasury bailed out AIG so they could, stealthily, make the counter-parties whole. There is no political will for a TARP 2, so the Obama administration is being actively deceitful about their continual transfer of taxpayer money to wealthy bankers. Those ludicrous non-recourse loans are one channel, AIG is another. If you don't like that, you should be asking for Geither's head on a platter (I'm also OK with this), not blocking the clawback.

On the road...

Blogging will be light.

Dilbert Land

Everything about this is so Dilbert. The FDIC mechanism, the fact that the FDIC did not collect premiums for the last 10 years, and Calculated Risk's reaction to this. First, the crime:

WASHINGTON - The federal agency that insures bank deposits, which is asking for emergency powers to borrow up to $500 billion to take over failed banks, is facing a potential major shortfall in part because it collected no insurance premiums from most banks from 1996 to 2006.

The Federal Deposit Insurance Corporation, which insures deposits up to $250,000, tried for years to get congressional authority to collect the premiums in case of a looming crisis. But Congress believed that the fund was so well-capitalized - and that bank failures were so infrequent - that there was no need to collect the premiums for a decade, according to banking officials and analysts.

To which Calculated risk was shocked shocked! "Hoocoodanode?"

Who cares?

FDIC means that the Government assumes responsibility for bank liabilities (deposits) up to $100K, and now $250K. The Govt collected a "premium" to put in a "rainy day fund" to be able to make the depositors whole.

But the Government is the monopoly currency issuer. It does not need a "rainy day fund" anymore than a bowling alley needs to keep "points" stockpiled. So, all the "premium" did was tax banks, no money was set aside anywhere, it was simply "uncreated" to the extent the Government chose to enforce its own rules at all. By why maintain this ludicrous fiction in the first place? If the Government wants to tax banks, it should simply tax banks. FDIC should be eliminated, and the Govt should simply back all commercial bank deposits. Not only would this be True, but it would also get rid of the abominable money market fund, a destabilizing scam if there ever was one. Banks do not need deposits to make loans, in fact, bank lending creates deposits. Use capital requirements to control credit. Back deposits to eliminate runs.

The Behavioral Case for a Payroll Tax Holiday

Conventional wisdom is settling on the idea that the Obama "stimulus" was too small. This is probably true, but hard to judge since none of it has gone into effect yet. It is clear that the "stimulus" was too slow and also did nothing for households, who continue to delever, rendering it, unstimulative. A true stimulus, which I do not expect to see, is a payroll tax holiday. Here's a behavioral explanation for why this works:

A more compelling explanation for why rebates haven’t worked very well is that they have been handed out as lump sums. You might think that handing people a big chunk of change is a perfect way to get them to spend it. But it isn’t, because people don’t treat all windfalls as found money. Instead, in the words of the behavioral economist Richard Thaler, people put different windfalls in different “mental accounts,” which in turn influences what they do with the money

A tax holiday would instantly increase incomes for households, and instantly make employees cheaper for businesses. A simple, effective way to restore aggregate demand.

The other thing which is sort of working in the US, but may be doing all the heavy lifting in Germany, are automatic stabilizers:

The German system has stimulus measures built in that have not to be passed by government once a recession is there.

There is a comfortable unemployment insurance and social security fund that Americans can only dream of. There is a thing called Kurzarbeit that enables companies to reduce on duty hours for their workforce in difficult times and receive a subsidy from the employment agency to make up for the reduced wages for their employees. Thus in contrast to most other countries they can keep their work force but at the same time cut cost.

Automatic stabilizers increase the deficit during a fall in employment due to reduced aggregate demand, helping to replace that loss. They can also support a higher level of general unemployment, though.

Good thread

A great post, by Interfluidity, followed by an excellent thread. Recommended.

Ganging up on Geithner

I had a front row seat at the Asian debt crises of 1998, which blew up Long Term Capital amongst others. I did not know Geithner was involved, but Paul Keating's assessment of the situation is mirrors my own:

Geithner thought Asia's problem was the same as the ones that had shattered Latin America in the 1980s and Mexico in 1994, a classic current account crisis. In this kind of crisis, the central cause is that the government has run impossibly big debts.

The solution? The IMF, the Washington-based emergency lender of last resort, will make loans to keep the country solvent, but on condition the government hacks back its spending. The cure addresses the ailment.

But the Asian crisis was completely different. The Asian governments that went to the IMF for emergency loans - Thailand, South Korea and Indonesia - all had sound public finances.

The problem was not government debt. It was great tsunamis of hot money in the private capital markets. When the wave rushed out, it left a credit drought behind.

But Geithner, through his influence on the IMF, imposed the same cure the IMF had imposed on Latin America and Mexico. It was the wrong cure. Indeed, it only aggravated the problem.

East Asian debt markets were financed primarily by hedge funds, all levered, and all with identical "diversification". When Russia defaulted on its ruble denominated debt, the funds all had to make margin calls, requiring them to sell identical positions, which moved those markets against them, requiring additional margin calls, etc. In times of crises, covariance goes to 1. The commercial paper markets went down first.

It's a bad sign that Geithner made the wrong call then. His insistence that the US is in a liquidity crises, when its in a solvency crises is similarly making the situation worse today.

I can see how Asian countries, especially China, would decide to stockpile dollars. While China cannot issue US$, it has a huge stockpile that it can release if needed. China's demand for savings enabled the US to run very large deficits without triggering inflation, but the Rubin/Summers Treasury (which is in place again) ran surpluses in the early 2000s, drawing down private savings. The Y2K business investment boom of 1998, and the Internet bubble of 1998-2000, maintained aggregate demand and kept the economy out of recession in the face of Federal demand destruction. Low rates under Greenspan expanded private debt to substitute for savings from 2000-2007, but private debt of course cannot substitute for Federal deficit funded savings, and that bubble is now deflating. This is the secret macroeconomic history of the US from 1998 to 2009.

(Thanks to Yves for the link)

Martin Feldstein has the pieces, cannot put them together

I liked this oped by Marty Feldstein -- he has so many of the pieces, but just cannot put them together. Household balance sheets are interesting, because the assets tend not to provide the cash flows to finance the liabilities. For example, if you have a house with a mortgage, the house is your asset, the mortgage is your liability, but the income stream to fund that liability comes from your (easily disrupted) income. In the past, people would save cash to provide a buffer in case the income stream was disrupted, but in the 2000s, cash savings was replaced by home equity, and capital gains. Oops.

Previous recessions were often characterized by excess inventory accumulation and over-investment in business equipment. The economy could bounce back as those excesses were absorbed over time, making room for new investment. Those recoveries were also helped by interest rate reductions by the central bank.

This time, however, the fall in share prices and in home values has destroyed more than US$12 trillion of household wealth in the US, an amount equal to more than 75 percent of GDP. Previous reactions to declines in household wealth indicate that such a fall will cut consumer spending by about US$500 billion every year until the wealth is restored. While a higher household saving rate will help to rebuild wealth, it would take more than a decade of relatively high saving rates to restore what was lost.

Investments, whether in real estates or in stocks, are not savings, and conflating those two is a very dangerous mistake that many have now learned the hard way. Lesson learned, they are building up that cushion the old fashioned way, out of cash from their salary. So far so good. But then Marty turns weird:

So the US economy faces a US$750 billion shortfall of demand. Moreover, the usual automatic stabilizers of unemployment benefits and reduced income tax collections will do nothing to offset this fall in demand, because it is not caused by lower earnings or increased unemployment.

Huh? Don't we have an unemployment rate nearing 10%? In fact, given that the Obama "stimulus" will be completely un-stimulative, when it finally gets going in 2010/2011, automatic stabilizers are the only things that are working. Now Marty loses the plot entirely:

Although the recently enacted two-year stimulus package includes a total of US$800 billion of tax reductions and increased government spending, it would be wrong to think that this will add anything close to US$400 billion a year to GDP in each of the next two years. Most of the tax reductions will be saved by households, rather than used to finance additional spending....A second fiscal stimulus package is therefore likely. However, it will need to be much better targeted at increasing demand in order to avoid adding more to the national debt than the rise in domestic spending. Similarly, the tax changes in such a stimulus package should provide incentives to increase spending by households and businesses.

Households, having seen their balance sheets shrink, are working to build them up the old fashioned way -- by saving. After having spent more than they earned, they are now spending less than they earn. They will, for years, build up their balance sheets this way to replace what they have lost in the recession. But Marty decries that "tax reductions will be saved by households" instead of cheering that. Savings from lower taxes is better for aggregate demand than savings through lower consumption. Maybe Marty will cheer that fact that households only get a piddling $400?

Although long-term government interest rates are now very low, they are beginning to rise in response to the outlook for a sharply rising national debt. The national debt held by US and foreign investors totaled about 40 percent of GDP at the end of last year. It is likely to rise to more than 60 percent of GDP by the end of next year, with the debt-to-GDP ratio continuing to increase. The resulting increase in real long-term interest rates will reduce all forms of interest-sensitive spending, adding further to the economy’s weakness.

Marty, like most, gets this completely backwards. Government debt is the mirror image of household debt. Governments must run deficits so the non-Governmental sector can save. If the non-Governmental sector wants to save more, as it does now, the Government must step up and run larger deficits to fund that demand for savings. The alternative is falling aggregate demand, the world we are in now.

Through the looking glass

The S&P is down again today and now traces -56.4% from peak-to-trough, the worst decline on record bar the Great Depression itself (-89%). For some sense for why we are in this world, and why the Obama administration has so far been unable to turn things around despite massive and ongoing transfers to wealth bankers, let's look at this post from Brad Setser:

A global stimulus shortage …

A great title.

China doesn’t exactly want to make it easy to evaluate the size of its stimulus. Bragging about the small size of your fiscal deficit — especially in relation to the US deficit — suggests a rather modest effort.

Yes it does. Federal deficits fund private savings, and if aggregate demand is falling because savings are increasing (as they are in the US) then small deficits are bad.

A bigger Chinese deficit after all would allow the US to run a smaller deficit without shortchanging global demand.

This gets to the crux of the problem -- Setser believes that deficits are bad per se and does not see the critical role they play in funding private sector saving. If they could be renamed "private sector savings" then you'd see how little sense it makes.

Given China’s current account surplus, its abundant domestic liquidity (the government – per Stephen Green of Standard Chartered) had deposits at the central bank equal to 9% of its GDP, and limited government debt (at least explicit debt), China could and should do more.

China should certainly help China, and the US should help the US. If the US funded private savings, China would be glad to soak up that deficit and continue to export its treasure over here. But by strangling domestic aggregate demand, the Obama administration is refusing China's offer of Manhattan for beads. Not wise.

And maybe it is: telling the state banks to lend to support local infrastructure projects could be considered a form of stimulus. It just isn’t the kind of stimulus that looks likely to spur China to consume more.

Obama's "stimulus" has exactly the same problem. First, households must save before they can consume. That isn't as Zen as it might sound.

At this stage, though, I would be happy if China just did enough to keep its current account surplus from rising.

And I would be happy if Obama just reduced fiscal drag in the US by declaring a payroll tax holiday. The US needs fewer barnacles on its economic hull.

“In proportion of GDP,” Jean Pisani-Ferry, director of the Brussels think tank Bruegel, wrote on the National Journal economics blog last week, “the size of the stimulus packages put in place in Europe [is] at best half the size of the U.S. and, unlike [the American effort] several of them are rear, rather than front-loaded.” While Germany’s spending will amount to 1.4 percent of GDP in 2009, French outlays will total only 0.8 percent, and Italy has not put forward any meaningful fiscal boost at all …

The lack of coordination amongst European central bankers means that they are even more unable to fund the European demand for higher savings with higher deficits. Things will get very ugly over there.

Great quotes

I loved this quote from Tim Duy:

Policymakers are assuming that restoring proper functioning in credit markets - and confidence in general - is equivalent to a housing price rebound. They seem incapable of envisioning a world in which this is not the case. This tunnel vision prevents policymakers of trying to devise policy which assumes that the many of the assets in the banking system are simply "bad." For Bernanke and Geithner, there are no bad assets. Only misunderstood assets.

To offer a horribly mixed metaphor, Rome is burning and the King's men and horses are busy with Humpty bits.

It's all so complicated

Help me -- I'm confused. The personal savings rate has gone from negative to positive 5%. And yet, as savings are increasing, aggregate demand seems to be falling. How does that work? The solution, clearly, is to pay Government workers to build roads, and raise taxes. Brilliant!

If you want to see how deeply adrift the Obama administration is, check out this interview of Tim Geithner, who will go down as the worst Treasury Secretary of all time (you're off the hook, Paulson!). He honestly wants to return housing to bubble prices. Oh, and Obama will depress the economy further by reducing aggregate demand some more.