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Automatic destabalization

From the Economist:

The restructuring of Dubai Inc has begun. Nakheel shed 15% of its staff in December and has continued to pare its numbers since. Sheikh Muhammad’s own Dubai Holding has also cut staff. “Last year, people would talk about how many houses they owned,” says one Dubai veteran. “Now, they talk about how many friends have lost their jobs.” Other economies benefit from automatic fiscal stabilisers as the unemployed stop paying taxes and start spending welfare benefits. The UAE suffers from an automatic destabiliser: 30 days after a foreigner loses his job, he loses his right to stay. Once they leave, Dubai’s ex-expats will spend nothing in the economy they leave behind.

It is true that the West, particularly the US post 1930s, has automatic stabilizers that increase the size of the Federal deficit when aggregate demand falls. In this way, unemployment triggers fiscal expansion, which funds net private sector savings and stabilizes aggregate demand. It could be done through simply cutting taxes, but Govts prefer to do it the hard way (exhibit A: the Obama administration).

Dubai runs net surpluses, is a currency user, and has Abu Dhabi who, as an oil exporter, can sort of print dollars but sort of not. I need to think through whether reducing population is the right automatic stabilizer for that kind of economy.

Mankiw's basic accounting error

We live in a fiat world, where assets and liabilities have to balance, but Harvard econ profs seem to think we are still on some gold standard, where money is an asset to its holder, and a liability to no one. Greg Mankiw's misconception is clear:

If we want to prop up aggregate demand to promote full employment, what is the alternative to monetary policy aimed at producing negative real interest rates? Fiscal policy. Essentially, the private sector is saying it wants to save. Fiscal policy can say, "No you don't. If you try to save, we will dissave on your behalf via budget deficits." That fiscal dissaving would push equilibrium interest rates upward. But is that policy really welfare-improving compared to allowing interest rates to fall into the negative region?

Private sector savings is funded by Federal deficits. If the private sector wants to save, it will either shrink aggregate demand and fail, or it will be generate larger deficits and succeed. Greg's fiscal policy makes no sense. For the private sector to save the public sector *must* dissave, the same way every asset must be balanced by a liability. It's an iron law of accounting. Public deficits, far from thwarting a private demand to save, are necessary and sufficient to enable that saving.

As for whether fiscal dissaving pushes equilibrium interest rates upwards, surely the example of Japan shows that interest rates respond to whether fiscal deficits are large enough fund private savings demand. Japan's been at ZIRP for years, and public debt runs at 250% of GDP.

How Unemployment Stops Deleveraging

Equity Markets have bounced into spring, and Barak Obama sees "glimmers of hope" in the economy. News follows prices, so we shall see where prices end up in the coming months, but the economy seems to be falling more slowly.

Unemployment figures show why this is:

In the US, aggregate demand (the sum of Government spending, private spending on consumption and investment, and the current account surplus) has been falling, primarily because the private sector has stopped taking on more debt and is paying down the debt it already has. It has had to do this because it had burdened itself with more debt than it could support out of income, and asset appreciation has to end eventually.

When one sector delevers, another sector has to lever up in order to support aggregate demand. As consumers stopped spending, business stopped booking income, which lead to falling profits, increased unemployment, lower spending, etc. etc. This is Keynes' "paradox of thrift". The Government can step in and lever up to counteract this delevering, but Obama, not wanting to let this crises go to waste, picked slow Government spending increases over fast tax cuts to increase the deficit. The federal deficit funds private savings, the Government needs to spend in order to give us the money we need to pay taxes and net save. If Obama had reduced the fiscal drag the Government imposes on the private sector, by suspending the payroll tax, we would have seen aggregate demand remain up, banks remain healthy, etc. etc.

Thankfully, there are automatic stabilizers in the economy that work through employment. When someone because unemployed, they start eating through their savings, stop paying taxes, and draw on Government unemployment benefits. All of these "automatic stabilizers" reduce private sector savings, and increase the Federal deficit, thus supporting aggregate demand. It's doing things the ugly way, but when the administration picked a slow fiscal stimulus instead of a payroll tax holiday, unemployment was the only thing left to drive up the deficit in the short term.

So, unemployment is good for the economy so long as it drives up the federal deficit, and the economy is faltering through increasing private sector savings reducing aggregate demand. There are much easier ways to get to this nominal result so it's hard to say too much good about it, though.

Horror at Central Bank ignorance

Both Paul and Brad are horrified that advocates of Ricardian equivalence do not understand the implications of their own model. Fair enough. Others may be horrified that macroeconomists, operating on the global stage to influence policy, do not understand how Government spending and taxation works. Here's Paul:

If the government introduces a new program that will spend $100 billion a year forever, then taxes must ultimately go up by the present-value equivalent of $100 billion forever. Assume that consumers want to reduce consumption by the same amount every year to offset this tax burden; then consumer spending will fall by $100 billion per year to compensate, wiping out any expansionary effect of the government spending.

Nope. Government is a currency issuer. Non-Government is a currency user. Government spending creates money, Government taxation "uncreates" it. The Government never needs to tax in order to spend. If the Government spends an extra $100B a year forever, with no increase in taxes, it will inject an extra $100B/year into the private sector, which may trigger inflation, or it may not, depending on what the private sector does with that money. Right now, money is being saved, so it will not trigger inflation, although it may help support aggregate demand and employment. If the Government increases taxes by $100B/year, that will sterilize the impact of the spending, and thus reduce the money the private sector has available to save. In inflationary times, this will reduce inflation. In deflationary times, it will further reduce aggregate demand, and increase unemployment.

"Ricardian equivalence" is based on the gold standard notion that the Government needs to tax first in order to spend. This is non-operative in the fiat world we live in.

Advocates of Government spending should understand how Government spending works.

Gaming PPIP for fun and profit

Just two strategies. Jeffrey Sachs:

Consider a toxic asset held by Citibank with a face value of $1 million, but with zero probability of any payout and therefore with a zero market value. An outside bidder would not pay anything for such an asset. All of the previous articles consider the case of true outside bidders.

Suppose, however, that Citibank itself sets up a Citibank Public-Private Investment Fund (CPPIF) under the Geithner-Summers plan. The CPPIF will bid the full face value of $1 million for the worthless asset, because it can borrow $850K from the FDIC, and get $75K from the Treasury, to make the purchase! Citibank will only have to put in $75K of the total.

Citibank thereby receives $1 million for the worthless asset, while the CPPIF ends up with an utterly worthless asset against $850K in debt to the FDIC. The CPPIF therefore quietly declares bankruptcy, while Citibank walks away with a cool $1 million. Citibank's net profit on the transaction is $925K (remember that the bank invested $75K in the CPPIF) and the taxpayers lose $925K.

Rortybomb:

Let’s say you are a bidder for Bank A. You know your banking asset is worth $50, and you also know the asset Bank B has is worth $50. You call your buddy up, the trader at B, and make a deal. Happens all the time. You go to bid, and you bid $80 for B’s asset. Then you wait. If B doesn’t come through, you are screwed out a lot of money. And hey, isn’t this wrong? Well, you are pretty sure one of those Rubin-protégé government whiz-kids has given someone who knows someone you know a wink-wink about this. You take a drink, steady the nerves. Then, the bid comes back for your asset - $80 from B. You have each bid up each others assets and traded them. And now the government is screwed.

At Enron, they called that something like the Death Star. Or Ping Pong.

Getting it backwards

I like Megan, but this article made me laugh:

If you can't or won't read the notes to a 10-K or 10-Q, you should not be investing in bank stocks. Let me put that another way. IF YOU CAN'T OR WON'T READ THE NOTES TO FINANCIAL STATEMENTS, YOU SHOULD NOT BE INVESTING DIRECTLY IN STOCKS.

Cool, we are on the same page. Next:

But we are not doing this to fool investors; we're doing it because of regulatory capital requirements. The problem with things like reserve ratios is that while in theory they should be countercyclical, in practice they aren't.

By reserve ratios, she almost certainly means capital requirements. The notion that reserves somehow constrain lending is completely wrong, and is at the heart of all the ineffectual monetary policy littering the financial landscape today. Bank lending is constrained by capital requirements on the supply side, and quality borrowers on the demand side, with the driving factor today being on the demand side.

Also, capital requirements (what Megan means when she says "reserve ratios") are NOT countercyclical in theory. They are PRO-CYCLICAL in theory, which is great because they are also PRO-CYCLICAL in practice. The notion that credit extension drives the economy is the biggest fraud that the financial sector has perpetrated on us, and has everyone from the Obama administration on down believing that you need to FIRST fix the banks to THEN fix the economy, whereas in real life, restoring aggregate demand to the economy FIRST would "magically" "fix" the banks. "Magically" because no one would understand how helping consumers save will help restore aggregate demand, and "fix" because banks aren't broken, they're just pro-cyclical and the cycle is against them right now.

Maybe you need to understand banking, capital requirements, reserve requirements, and aggregate demand as well as reading 10-Ks and 10-Qs to the necessary qualifications for investing in banking stocks.

Social Security: Real vs Nominal

Mike Shedlock has the usual complaints about social security, but his arguments reveal that he does not understand the difference between "real" and "nominal".

'The U.S. recession is wreaking havoc on yet another front: the Social Security trust fund.

With unemployment rising, the payroll tax revenue that finances Social Security benefits for nearly 51 million retirees and other recipients is falling, according to a report from the Congressional Budget Office. As a result, the trust fund's annual surplus is forecast to all but vanish next year -- nearly a decade ahead of schedule -- and deprive the government of billions of dollars it had been counting on to help balance the nation's books'....And given that every cent of the fund has been spent, exactly how is the treasury supposed to repay that fund in light of $9.3 trillion (with a T) budget deficits when the "surplus" is a mere $16 Billion (with a B)?

Finally, why does everyone continue the charade of calling Social Security a "trust fund" when it's clearly not a fund and there cannot possibly be any trust in it?

Think about it -- the Government is a currency issuer, it has no need to "balance its books", nor will it ever bounce a check. Ever. Even Zimbabwe does not bounce cheques (although with it's recent move to the dollar, that might change). He is correct that there is no "fund", as SS obligations are merely part of the Government overall obligations. It certainly makes no sense for a currency issuer to keep a reserve of its own currency. Does American Airlines need to keep a reserve of it's frequent flier miles?

I first heard this analogy from Mosler, and it's extremely helpful. Imagine that the US as 300M retirees, and only one worker. Those worried about the SS "shortfall" (whatever that means) are concerned that the 300M retirees will not have enough money to pay the one worker for all the stuff that they want. This is the "nominal" view, and it is clearly ridiculous -- the problem is not how much money the retirees have or do not have, the problem is whether the worker is productive enough to make all the stuff the 300M retirees want.

The Obama Administration is bumping it's head against the same invisible wall. Take a walk outside -- you will see that the US has plenty of stuff. It also has plenty of needs, and plenty of idle resources to put to work. The problem of falling aggregate demand is entirely *nominal* -- people do not have enough zeros after whatever number is in their bank account. Solution: add a zero to every bank account. Or stop uncreating money through a payroll tax holiday. Whatever, it's a nominal problem, not a real problem. If you go to a third world country, you'll see real problems there.

Instead, the Obama administration, keep engaging in a number of increasingly expensive and deceitful practices to increase the number of zeroes in the accounts of bankers. This is because they think bankers are as important to the economy as bankers think. They are wrong. Banks are pro-cyclical, and will turn once the economy does. Banks are in the business of making loans that will be paid back, although they exited that business from 2000-2007. Once the non-bank private sector is able to pay back loans, and is interested in taking on debt, banks will revive. The Obama administration remains focused on the wrong part of the nominal economy -- it should just help the non-bank private sector save by running up its deficit.

On this crises, Michael Lewis said:

Since the beginning of the crisis I’ve wondered why the government has found neither the will nor the way to attack the root of the problem -- the people who borrowed money to buy homes they shouldn’t have bought.

Now I think I understand. It would be too simple. People would understand a lot of small payments to the guy down the street who doesn’t deserve them, and become outraged. Far better to throw trillions at opaque corporations, the inner workings of which no one still really understands.

He's wrong. People would be OK if the Govt gave a small payment to the guy down the street who doesn't deserve them so long as they get the same payment. One is a transfer, while the other simply raises all boats. The problem is that the transfer is not going to the financial industry.

Quick posts

Excellent, illustrated explanation of the put options embedded in the Obama Administration stealth bank recapitalization program (PPIP). BofA and Citi are the primary beneficiaries, but the way PPIP is structured, it's a big hand out to the whole industry.

The big G20 news is the $1T funding of the IMF. The key element there is "$", as this facility essentially means that the US Gov is making unsecured dollar loans to other countries. (Well, the loans might be secured with pesos and stuff, but who cares). I cannot tell the difference between this and the swap lines the Fed opened up last year, except the swap lines were transparent and this facility is patently not.

I don't know how the US Gov is setting up this $1T facility. If it deficit spends to fund it now, that will be OK, but to the extent it increases demand for US$, it will undo the stimulative effect that high unemployment is having domestically. Aggregate demand is falling because the US is not creating money (deficit spending) fast enough to supply the demand for private dollar savings. To the extent that the IMF increases or supports demand for private dollar savings, it sterilizes the effect of the deficits the US decided to grow through unemployment. Michigan -- we need another 10% in the bread line!

Maybe the bankruptcy of Chrysler and GM will finally create enough unemployment, and deficits, to stimulate the economy and put a floor under aggregate demand. Obama decided to go ugly, and he's getting there!

In other news, Obama's shadow Treasury Secretary seems to have nigh bankrupted Harvard. They had too much money anyway.