Research Programs

Recently, some have wondered whether a fiscal stimulus plan could reduce the government’s budget deficit. Many also worry that fiscal austerity plans will only bring higher deficits. Issues of this kind involve endogenous changes in tax revenues that occur when output, real wages, and other variables are affected by changes in policy. Few would disagree that various paradoxes of austerity or stimulus might be relevant, but such issues can be clarified a great deal with the help of a complete heterodox model.

In light of recent world events, this paper seeks to improve our understanding of the dynamics of fiscal policy and financial crises within the context of two-dimensional (2D) and five-dimensional heterodox models. The nonlinear version of the 2D model incorporates curvilinear functions for investment and consumption out of unearned income. To bring in fiscal policy, I make use of a rule with either (1) dual targets of capacity utilization and public production, or (2) a balanced-budget target. Next, I add discrete jumps and policy-regime switches to the model in order to tell a story of a financial crisis followed by a move to fiscal austerity. Then, I return to the earlier model and add three more variables and equations: (1) I model the size of the private- and public-sector labor forces using a constant growth rate and account for their social reproduction by introducing an unemployment-insurance scheme; and (2) I make the markup endogenous, allowing its rate of change to depend, in a possibly nonlinear way, on capacity utilization, the real wage relative to a fixed norm, the employment rate, profitability, and the business sector’s desired capital-stock growth rate. In the conclusion, I comment on the implications of my results for various policy issues.

This paper investigates the causes behind the euro debt crisis, particularly Germany’s role in it. It is argued that the crisis is not primarily a “sovereign debt crisis” but rather a (twin) banking and balance of payments crisis. Intra-area competitiveness and current account imbalances, and the corresponding debt flows that such imbalances give rise to, are at the heart of the matter, and they ultimately go back to competitive wage deflation on Germany’s part since the late 1990s. Germany broke the golden rule of a monetary union: commitment to a common inflation rate. As a result, the country faces a trilemma of its own making and must make a critical choice, since it cannot have it all —perpetual export surpluses, a no transfer / no bailout monetary union, and a “clean,” independent central bank. Misdiagnosis and the wrongly prescribed medication of austerity have made the situation worse by adding a growth crisis to the potpourri of internal stresses that threaten the euro’s survival. The crisis in Euroland poses a global “too big to fail” threat, and presents a moral hazard of perhaps unprecedented scale to the global community.

The paper evaluates the fiscal policy initiatives during the Great Recession in the United States. It argues that, although the nonconventional fiscal policies targeted at the financial sector dwarfed the conventional countercyclical stabilization efforts directed toward the real sector, the relatively disappointing impact on employment was a result of misdirected funding priorities combined with an exclusive and ill-advised focus on the output gap rather than on the employment gap. The paper argues further that conventional pump-priming policies are incapable of closing this employment gap. In order to tackle the formidable labor market challenges observed in the United States over the last few decades, policy could benefit from a fundamental reorientation away from trickle-down Keynesianism and toward what is termed here a “bottom-up approach” to fiscal policy. This approach also reconsiders the nature of countercyclical government stabilizers.

Though the economy appears to be gradually gaining momentum, broad measures indicate that 14.5 percent of the US labor force is unemployed or underemployed, not much below the 16.2 percent rate reached a full year ago. In this new report in our Strategic Analysis series, we first discuss several slow-moving factors that make it difficult to achieve a full and sustainable economic recovery: the gradual redistribution of income toward the wealthiest 1 percent of households; a failure to fully stabilize and reregulate finance; serious fiscal troubles for state and local governments; and detritus from the financial crisis that remains on household and corporate balance sheets. These factors contribute to a situation in which employment has not risen fast enough since the (supposed) end of the recession to significantly increase the employment-population ratio. Meanwhile, public investment at all levels of government fell from roughly 3.7 percent of GDP in 2008 to 3.2 percent in the fourth quarter of 2011, helping to explain the weak economic picture.

For this report, we use the Levy Institute macro model to simulate the economy under the following three scenarios: (1) a private borrowing scenario, in which we find the appropriate amount of private sector net borrowing/lending to achieve the path of employment growth projected under current policies by the Congressional Budget Office (CBO), in a report characterized by excessive optimism and a bias toward deficit reduction; (2) a more plausible scenario, in which we assume that the federal government extends certain key tax cuts and that household borrowing increases at a more reasonable rate than in the previous scenario; and (3) a fiscal stimulus scenario, in which we simulate the effects of a fully “paid for” 1 percent increase in government investment.

The results show the importance of debt accumulation as a consideration in macro policymaking. The first scenario reproduces the CBO’s relatively optimistic employment projections, but our results indicate that this private-sector-led growth scenario quickly brings household and business debt to new all-time highs as percentages of GDP. We note that the CBO makes its projections using an orthodox model with several common, but fundamental, flaws. This makes possible the agency’s result that current policies will reduce the unemployment rate without a run-up in the private sector’s debt—“business as usual,” in the words of our report’s title.

The policies weighed in the second scenario do not perform much better, despite a looser fiscal stance. Finally, our third scenario illustrates that a small, tax-financed increase in government investment could lower the unemployment rate significantly—by about one-half of 1 percent. A stimulus package of this size might be within the realm of political possibility at this juncture. However, our results lead us to surmise that it would take a much more substantial fiscal stimulus to reduce unemployment to a level that most policymakers would regard as acceptable.

The extraordinary scope and magnitude of the financial crisis of 2007–09 required an extraordinary response by the Federal Reserve in the fulfillment of its lender-of-last-resort (LOLR) function. In an attempt to stabilize financial markets during the worst financial crisis since the Great Crash of 1929, the Fed engaged in loans, guarantees, and outright purchases of financial assets that were not only unprecedented, but cumulatively amounted to over twice current US GDP as well. the purpose of this brief is to provide a descriptive account of the Fed's response to the recent crisis—to delineate the essential characteristics and logistical specifics of the veritable "alphabet soup" of LOLR machinery rolled out to save the world financial system. It represents the most comprehensive investigation of the raw data to date, one that draws on three discrete measures: the peak outstanding commitment at a given point in time; the total peak flow of commitments (loans plus asset purchases), which helps identify periods of maximum financial system distress; and, finally, the total amouunt of loans and asset purchases made between January 2007 and March 2012. This third number, which is a cumulative measure, reveals that the total Fed response exceeded $29 trillion. Providing this account from such varying angles is a necessary first step in any attempt to fully understand the actions of the central bank in this critical period—and a prerequisite for thinking about how to shape policy for future crises.

Fiscal austerity is now a worldwide phenomenon, and the global growth slowdown is highly unfavorable for policymakers at the national level. According to our Macro Modeling Team's baseline forecast, fears of prolonged stagnation and a moribund employment market are well justified. Assuming no change in the value of the dollar or interest rates, and deficit levels consistent with the Congressional Budget Office’s most recent “no-change” scenario, growth will remain very weak through 2016 and unemployment will exceed 9 percent.

In an alternate scenario, the authors simulate the effect of new austerity measures that are commensurate with the implementation of large federal budget cuts. Here, growth falls to 0.06 percent in the second quarter of 2014 before leveling off at approximately 1 percent and unemployment rises to 10.7 percent by the end of 2016. In their fiscal stimulus scenario, real GDP growth increases very quickly, unemployment declines to 7.2 percent, and the US current account balance reaches 1.9 percent by the end of 2016—with a debt-to-GDP ratio that, at 97.4 percent, is only slightly higher than in the baseline scenario.

An export-led growth strategy may accomplish little more than drawing a small number of scarce customers away from other exporting nations, and the authors expect no net contribution to aggregate demand growth from the financial sector. A further fiscal stimulus is clearly in order, they say, but an ill-timed round of fiscal austerity could result in a perilous situation for Washington.

By Dan Monaco

The Straddler, Fall 2011. All content © The Straddler

I
The events leading up to and following the financial crisis in 2008 led to widespread deployment of the term “Minsky Moment,” used to describe the painful termination of what Hyman Minsky called “runaway expansion.” In boom times, according to Minsky, stable profit growth resulting from speculative (debt-fueled) risk-taking leads to ever greater speculative risk-taking until the bubble finally bursts and a debt-deflation crisis ensues as investors liquidate their assets to cover their debt liabilities. The longer the “runaway expansion” lasts, the more dramatic the “Minsky Moment” is liable to be.

In June I traveled to the Minsky Summer Seminar at the Levy Institute at Bard College. The train stop closest to Bard is Amtrak’s Rhinecliff station, and the journey to it from New York City takes you up the eastern bank of the Hudson River for about ninety minutes. It’s hard not to be struck by the beauty of the Hudson, broad and grand between its beveled cliffs, a steady, workmanlike current, simultaneously fierce and serene, operating like a paradoxically silent operatic ostinato. Pleasure cruises run between New York City and Albany, and it is not unusual to see a barge heading in this direction or that, evoking the Hudson Valley’s manufacturing history.

Of course, the Hudson River is also infamous for its having been contaminated by toxic polychlorinated biphenyls (PCBs) from General Electric’s manufacturing plants in Hudson Falls and Fort Edward. The result of years of mostly legal dumping of PCBs between 1947 and 1977 led to a large stretch of the river being declared a Superfund Site in 1984. Turmoil, controversy, and legal battles ensued; cleanup dredging began in earnest in 2009.

Knowing this as one looks out a railcar window at the river leads to an odd and occasionally eerie appreciation of the scenery. It might also inspire a thought or two on the occupation of the economist. For there is a sense in which all economists are implicitly charged with advancing recommendations on the appropriate use of an apparatus—call it the labor and money arrangements of man—which one might with only slight exaggeration describe as a sort of savage machinery. This apparatus is capable, when adequately structured, of advancing human well-being; it is capable, too, of setting well-being back, of passing over certain sections of humanity—including populations within nations, nations themselves, continents, and generations.

But there is also a sense in which, at least to the eyes of an outsider, the codes of the profession, and the dominant modes of thought within the field, seem to put the economist who fully acknowledges the potency of the poorly secured munitions ship whose course he is seeking to influence in a bit of an odd position. If he thinks it is best to grapple with the navigation plan, he must still contend with the tendencies of the moiety of his brethren who, in spite of the field’s outsized political and cultural influence, either deny that their conclusions have anything to do with something as complex as the actual practice of seafaring, or who—hewing closely to the field’s first principles—regard an absence of captaincy as the best captaincy, the rarely manned bridge the best manned bridge.

“Economists have lost their credibility because they do not actually deal with the real world,” Dimitri Papadimitriou, President of the Levy Institute, told me in my conversation with him. “But there were and are certainly some economists, including Hyman Minsky, who looked at the real world not as an exception case.”

“Minsky was in some ways a pioneer. He saw that economic theory assumed that everything is known and that there is some tendency of the system to reach for equilibrium and, at times, to reach periods of ‘tranquility,’ as he preferred to call them. Of course, he never believed that stability was possible. He didn’t believe in the invisible hand. There’s a reason why it’s invisible—because it’s not there.”

II
It is characteristic of capitalism, according to Minsky’s John Maynard Keynes, that it fails to maintain full employment,(1) and that its most essential traits are instability and uncertainty.

JMK appeared in 1975, just as the postwar “Golden Age” of global capitalism was coming to an end in a decade marked by oil shocks, unsustainable levels of inflation, the dismantling of the Bretton Woods international monetary system, rising rates of unemployment, and growing popular familiarity with the concepts of “stagflation” (stagnation and inflation) and the “misery index” (unemployment plus inflation).

The 1970s were a crucial period for both economic policy and economic study; the decade’s disruptions were exhibited to impugn the effectiveness of, and ultimately abandon mainstream adherence to, Keynesian economics. As Peter Temin, an economic historian at MIT, told The Straddler in February, there were two reactions within economics to the problems of the 1970s: “One was to patch up [Keynesian] theory and extend it. The other came from people who said that Keynesian theory is terrible—it got us into this mess, we have to do something different. And that fed into this desire to use mathematics to set up elaborate models and to have everything be efficient."(2)

It led, in other words, to the recrudescence of precisely the sort of clean neoclassical models of efficiency, equilibrium, and omniscience from which Keynes, in 1937, had broken by publishing The General Theory of Employment, Interest, and Money.

The return back to neoclassical economics, however, was made easier by its never having really left. The Keynesianism prevailing for a time before, and for the thirty years after, the second World War was in fact a neoclassical synthesis of old ideas and new theory.

In Minsky’s recap of the standard telling, the process of synthesis began with J.R. Hicks’ influential 1937 article “Mr. Keynes and the ‘Classics’,” which introduced an interpretation and a simplified model (IS-LM) by which to understand Keynes. Hicks’ interpretation was the foundation of the influential economist Alvin Hansen’s work “in hammering out the American version of standard Keynesianism."(3) As a result, American (and a great deal of international) economic policy was guided by a neoclassical synthesis called Keynesianism into the 1970s.

Without getting into the neoclassical synthesis’ IS-LM model (which examines the relationships between interests rates and GDP), or the intricacies, such as they are, of neoclassical Quantity Theory (which essentially argues that prices are exclusively related to the amount of money in circulation), the fundamental difference between Keynesianism (whatever the version) and neoclassical theory is that the former argues that some form of government intervention into the economy is necessary to achieve full-employment stability, while the latter holds, to use Minsky’s words, that “a decentralized economy is fundamentally stable."(4)

Johan Van Overtveldt’s history of the Chicago School provides a succinct summary of the worldview underlying neoclassical theory:

The basic assumption of neoclassical economic theory is the proposition that in a competitive market environment, individuals and corporations pursuing their own self-interests necessarily promote the best interests of society as a whole.(5)

Thus, neoclassical economics, whatever its modifications or adjustments, is always in essence a cry for “pure” capitalism, while Keynesianism, whatever its color, is always at heart a proffered solution (more or less “radical,” depending upon one’s interpretation) to the problems of capitalism from within capitalism.

In JMK, Minsky writes that in the 1930s, neoclassical economics had held that events like the onset of depressions were anomalies; once they began there was nothing to do but ride them out. Coming from a different direction, orthodox Marxists “interpreted the Great Depression as confirming the validity of the view that capitalism is inherently unstable. Thus, during the depression’s worst days, the mainstream of orthodox economists and the Marxists came to the same policy conclusions: …nothing useful could be done to counteract depressions."(6)

The General Theory was thus simultaneously a response to worldwide depression, a dramatic (if not a clean) break with neoclassical economics, and an argument that while capitalism is “inherently unstable,” policy solutions from within do exist to ensure that “business cycles, while not avoidable, [can] be controlled."(7)

What made Keynes’ theory possible, in Minsky’s view, was a radical paradigm shift in perception that placed the “fragile” workings of the financial sector at the center of a complex modern capitalist economy:

Whereas classical economics and the neoclassical synthesis are based upon a barter paradigm—the image is of a yeoman or a craftsman trading in a village market—Keynesian theory rests upon a speculative-financial paradigm—the image is of a banker making his deals on a [sic] Wall Street.(8)

In this capitalist economy, full-employment equilibrium—indeed, equilibrium in general—is not possible because each stage of the business cycle contains the loose strands of its own unraveling. Actors operating in a sophisticated financial sector are engaged in “decision-making under conditions of intractable uncertainty” and as a result there are always “processes at work which will ‘disequilibriate’ the system."(9)

Financial collapses are the most pronounced examples of these disequilibriations:

[T]he financial system necessary for capitalist vitality and vigor…contains the potential for runaway expansion, powered by an investment boom. This runaway expansion is brought to a halt because accumulated financial changes render the financial system fragile, so that not unusual changes can trigger serious financial difficulties.… [S]tability…is destabilizing.(10)

III
What of Minsky’s claim that Keynes was basically misinterpreted by mainstream economics? And what of this claim in the context of capitalism’s “Golden Age?” Whether or not the neoclassical synthesis was an accurate interpretation of Keynes, the thirty years following World War II were notable in the history of capitalism for their relatively stable growth and their approximation to full employment. I put these questions to Papadimitriou.

Papadimitriou: Minsky realized that there were some important features that prevented a full-blown crisis from occurring. There were a number of near crises, but Minsky would agree that during the “Golden Age” there was a crucial role that both big government played as well as the big bank [i.e., the Federal Reserve].

Minsky was always interested in what is apt policy versus what particular item one should look for in a policy. Minsky’s own policy was that if you believe stability is destabilizing—that is, there is a tendency for the system to destabilize—you need to be prepared for that and do something about it to prevent it.

Yes, you can assume that private markets can be self-regulating as a result of profit seeking—you don’t want anything bad to happen. But on the other hand, we know that avarice and greed become a lot more important than self-restraint and self-regulation. So my suspicion is that Minsky would have said that you have to be able to rely on something other than policies emanating from traditional economic theory, like the neoclassical synthesis. As, for example, in the same way as Schumpeter had said that there will always be technological innovation, and therefore you will have creative destruction, Minsky was cognizant of financial innovation. And, there is a need, then, for sophisticated instruments of regulation that are required to keep up with financial innovation, especially if you believe that a sophisticated economy as ours is more or less a finance-guided economy. Look what has happened especially now, where the free-market mantra took hold beginning with the Reagan Presidency. Look at the results.

Had Minsky been alive today, he would have said that government doesn’t only have to play a role in expenditures [to generate adequate aggregate demand], but also, a role in industrial policy. And that has been absent. The American economy is superior to other economies in terms of high technology, aerospace, and probably agriculture. But you cannot sustain growth to provide for 300 million people [on these industries alone].

In addition to emphasizing that “there is no final solution to the problems of organizing economic life,"(11) Minsky argued that policies based on a correct interpretation of Keynes would direct government expenditures towards more socially and individually productive ends, and would also promote a more equitable distribution of income. Writing as the neoclassical synthesis was on the verge of giving way, he lamented the military spending and empty consumption of capital-intensive goods that had marked its heyday.

As Keynes summarized The General Theory, he avowed that there were two lessons to be learned from the argument. The first was the obvious lesson that policy can establish a closer approximation to full employment than had, on average, been achieved. The second, more subtle, lesson was that policy can establish a closer approximation to a more logical and equitable distribution of income than had been achieved.

To date [i.e., 1975] the first lesson has been learned, albeit in a manner that makes an approximation to full employment heavily dependent upon government spending in the form of defense production and private investment that sacrifices present plenty for questionable benefits in the future. … [T]he second lesson has been forgotten; the need for policy aimed to achieve justice and equity in income distribution has not only been ignored but it has been so to speak turned on its head.(12)

Raising questions of income distribution and inequality in America tends to lead, in both elite and barroom discourse, to cries of “class warfare” or worse, so I asked Papadimitriou to elaborate a bit on Minsky’s idea of equality in the context of the reality of default American economic ideology.

Papadimitriou: Minsky was very concerned about poverty. He thought the government should approach the poor from the perspective of, “why are they poor?” and seek to restructure the view about what government should do. He was against the idea of government transfers to alleviate poverty. He would have been intolerant of the government’s failure to do now what was done during the Great Depression through employment programs such as the Works Progress Administration and other programs of the New Deal, because he thought that by giving the poor these transfers the government changed their behavior as opposed to providing them with a job—giving them a goal and, to some extent, the capacity to enjoy a standard of living and social inclusion.

Minsky was realistic that the sort of equality connotated by the word “equality” is not achievable—it wasn’t achieved under socialism; it wasn’t achieved under communism. But, nevertheless, the question is, is it appropriate for one-tenth of the population to control that gigantic percentage of wealth, and to command that kind of income, relative to the bottom half, which basically does not have a chance to realize the prosperity that can be achieved in this country.

You can put it in a different way. The government plays the role of a redistributive vehicle. As an example, Minsky and others would be appalled at the Bush tax cuts being continued. They don’t do anything for aggregate demand, they don’t do anything in terms of increasing employment, and they don’t do anything in setting the economy on a path for growth. Therefore, Minsky would have insisted that these tax cuts cause the wrong kind of debt for the government to incur. He would have suggested other policies—for example, promulgating a tax structure that is progressive and not, like the payroll tax, regressive—that could bring about better outcomes. That would not lead to the same maldistribution of wealth we are experiencing currently.

But what about the perception of this maldistribution of wealth? There seems to be an odd phenomenon, arguably not limited to American society, by which the reality of discontent with income and wealth maldistribution is held in check by ambivalent feelings about to what degree it is actually malevolent. Back in April, former U.S. Senator Phil Gramm authored an op-ed in the Wall Street Journal in which he argued that Barack Obama’s presidency had brought about “higher taxes on the most productive members of American society."(13) This is a familiar stance on the right that is not wholly rejected by the population at large: the wealthy may create abundant riches for themselves, but they are the job creators who provide us with employment, and so anything we do to hurt their bottom line just ends up hurting our own. Or, even if that’s a bit hard to take, in any case, any remedy the government would come up with to address maldistribution would be worse than the malady itself.

And this ambivalence has an additional, aspirational contour. There is a famous quote, attributed to John Steinbeck, that runs, “Socialism never took root in America because the poor see themselves not as an exploited proletariat but as temporarily embarrassed millionaires.” I asked Papadimitriou if, putting the question of socialism aside, he thought the attitude towards the rich by the poor was in some ways informed by their seeing themselves not as the poor, “but as temporarily embarrassed millionaires.”

Papadimitriou: The majority of the population has that perspective, and that comes out clearly in the surveys that are run on individuals who are surviving on welfare checks and yet are against taxation because they believe there could be a time that they will be hurt. There is this longing, to go back to Steinbeck’s words, to become a millionaire.

On the other hand, there is another group of the population that is totally disenfranchised, and I doubt that these people have any notion that they will ever actually find a ticket out of their misery. You can see that in the inner cities, and in the increase of homelessness. IV
With respect to creating a culture that is receptive to the idea that there is a role for the government in promoting a more equitable society, the challenge faced by people like the Minskians is fourfold. First, a significant portion of the population at large must agree that the so-called “American Dream” is not alive and well. As Papadimitriou told me, “the ‘American Dream’ is fulfilled only for a segment of the population. Maybe the one percent in the income distribution ladder.”

Second, this same portion of the population must accept that the receding of the “American Dream” is not a result of government malfeasance but has its roots in the present structure of the system in which private actors operate.

Third, there must be widespread willingness to accept that government has a place in bringing about better economic outcomes and more equitable distributions of income.

Fourth, people must be willing to act on these beliefs to press the government to take action. (For all its myriad failings and inefficiencies, the government possesses a quality unique among powerful entities in that it is subject to some form of democratic accountability.)

Just how challenging the current ideological climate makes all of this was well encapsulated in an exchange that took place in July between Paul Krugman and George Will. Just after word emerged of a pending agreement between the House, Senate, and President to raise the ceiling on federal debt in exchange for spending cuts and budgetary reductions, both Will and Krugman appeared on the “roundtable” segment of ABC’s This Week:

Krugman: We used to talk about the Japanese and their lost decade. We’re going to look to them as a role model. They did better than we’re doing. This is going to go on—I have nobody I know who thinks the unemployment rate is going to be below eight percent at the end of next year. With these spending cuts it might well be above nine percent at the end of next year. There is no light at the end of this tunnel. We’re having a debate in Washington which is all about, “Gee, we’re going to make this economy worse, but are we going to make it worse on ninety percent of the Republicans’ terms or a hundred percent of the Republicans’ terms?” And the answer is a hundred percent.

Will: Paul’s right, we are a third of the way to a lost decade. But we’re a third of the way after TARP, the stimulus, Cash for Clunkers, dollars for dishwashers, cash for caulkers, the entire range of stimulus—the Keynesian approach which, by its own evidence, simply hasn’t worked. Now, Paul would double down—

Krugman: In advance—one important point to make is that people like me said, in advance, this wasn’t remotely big enough. It’s not an after the fact—

Will: That’s true.

Krugman: —it’s not coming back afterwards. Right from the beginning, I looked at the numbers—people like me looked at the numbers and said, we’re going to have cutbacks at the state and local level, you’ve got a federal increase which is going to be barely enough to limit those cutbacks. There’s going to be no net fiscal stimulus if you look at government as a whole, which is what happened. So here we are.

Will: It would be good to go to the electorate and have a Krugman election this time, saying, “Resolved, the government is too frugal. Let’s vote."(14)

And so, even in the face and fallout of a disastrous economic collapse brought about by a financial crisis that occurred in the maw of an era of pronounced deregulation and government rollback, the burden of proof remains on anyone who would argue that properly calibrated government intervention into the economy is not only necessary, but is also capable of producing more positive outcomes. (It is, of course, worth noting that many forms of government expenditure—defense and less visible subsidies and tax incentives for large businesses and wealthy individuals being obvious examples—are somehow exempted from categorization as government intervention into the economy.)

Thus, Will, who is somewhat rare among contemporary conservative commentators in broadcast media in that his is the professorial posture of a man who likes to take his arguments on the plane of ideas, was quite comfortable responding to Krugman’s points with nothing more than an arched rhetorical eyebrow, confident (not without cause) that such a response was all that was necessary to refute the most modest and elementary recommendations derived from Keynesianism.

In responding to a crisis which they agree calls for a basic Keynesian response, then, left-of-(rather conservative)-center political actors and analysts (Larry Summers, for example—a hedge-fund liberal and the most prominent embodiment of the “New Keynesian” heirs to the neoclassical synthesis, who was instrumental in developing the partially effective stimulus bill of 2009, and who was also an ardent supporter of financial deregulation in the 1990s—called for additional stimulus in 2011) find themselves in a circular process by which they are:

constrained by politics and ideology which → limits the force of the response which → leads to outcomes that partially attenuate but do not end the crisis which → allows opponents who have helped build constraints on a potential Keynesian response to claim to demonstrate that Keynesianism does not work which → builds even more confining constraints on its application.

And, if, returning to Minsky, he is correct that Keynes has been misinterpreted, the process above is, in some ways, the same process that Keynesianism itself underwent during, and immediately following, the reign of the neoclassical synthesis.

V
Why should Keynes’ theory have “triggered an aborted, or incomplete, revolution in economic thought?” Minsky offers a number of reasons. He suggests, for example, that The General Theory is a “clumsy statement” (“a great deal of the new [theory] is imprecisely stated and poorly explained”); that Keynes’ didn’t have a chance to participate in the interpretative debate following its publication (he was sidelined by a heart attack and then went to work in the war effort); and that it is not possible to perform controlled experiments in the social sciences (a familiar lament).(15) But two of Minsky’s explanations in particular stand out.

1) According to Minsky, “the older standard theory, after assimilating a few Keynesian phrases and relations, made what was taken to be real scientific advances.”

Even though economists had often argued as if the laissez-faire proposition, about the common good being served as if by an invisible hand by a regime of free competitive markets, were firmly established, it is only since World War II that mathematical economists have been able to achieve elegant formal proofs of the validity of this proposition for a market economy—albeit under such highly restrictive assumptions that the practical relevance of the theory is suspect.(16)

Keynes was therefore “made to ride piggy-back on mathematical general-equilibrium theory.”

As an outsider, it is hard not to see in this assimilation a manifestation of a broader tendency in mainstream economics to reach for an equilibrium of another kind. The au fond assumption away from which the field, generally speaking, seems to resist being pulled, and towards which it inevitably claws its way back, is precisely the neoclassical proposition Van Overtreldt describes in the citation above.

Of all of the social sciences, famously incomplete in their ability to comprehend human affairs, economics seems to be the least capable of acknowledging its limitations—or perhaps it is simply the most skilled at cagily hedging those limitations. After all, it seems reasonable to assume that the economic affairs of man are a complex affair, full of inconsistencies, contradictions, and odd behavior. Messy, in other words. And yet, it appears that theories within mainstream economics seeking to account for this mess—or seeking to counter the deleterious consequences of this mess—are at best partially assimilated, and at worst, wholly rejected in favor of models and modes of thought that don’t just envision and promote the benefits of the competitive workings of free and unfettered markets, but that also create an ideal out of them.(17) Further, any deviation is met with a redoubled effort to reinforce and/or retrofit the ideal. As Peter Temin told The Straddler, “The kind of models that many people use—general equilibrium models—start from assumptions of perfect competition, omniscient consumers, and various like things which give rise to an efficient economy. As far as I know, there has never been an economy that actually looked like that—it’s an intellectual construct."(18)

James Kenneth Galbraith’s words to The Straddler back in March of 2010 are of a similar flavor—and go further towards hinting at an explanation of why this might be:

[W]hen we encounter a doctrine of harmonization, of the smoothly functioning realization of the interests of all, the great and the small, which is textbook market economics, people should recognize that this is sand being thrown in their faces—that this cannot possibly be a realistic representation of the world in which we actually live. Take it as an analytic principle that one has to look at the behavior of the great with a cold eye.(19)

There is a famous and oft-cited quote of Keynes from The General Theory which runs:

The ideas of economists and political philosophers, both when they are right and when they are wrong, are more powerful than is commonly understood. Indeed the world is ruled by little else. Practical men, who believe themselves to be quite exempt from any intellectual influence, are usually the slaves of some defunct economist. Madmen in authority, who hear voices in the air, are distilling their frenzy from some academic scribbler of a few years back. I am sure that the power of vested interests is vastly exaggerated compared with the gradual encroachment of ideas.

Minsky agrees and disagrees, proposing that this quote “needs to be amended to allow the political process to select for influence those ideas which are attuned to the interests of the rich and powerful.” That is, ideas are important, but those ideas best suited to the advance and further entrenchment of the “vested interests” are often selected as the most important.

Perhaps it is this process, beyond the limitations of the field qua investigative social science, that accounts for mainstream economics’ radical idealism with respect to the functioning of capitalism.

2) But there is a further point to be made, using the final potential reason Minsky lists for the failure of full-throated Keynesianism to take hold as a point of departure:

[T]he Keynesian Revolution may have been aborted because the standard neoclassical interpretation led to a policy posture that was adequate for the time. Given the close memory of the Great Depression in the immediate post-World War II era, all that economic policy really had to promise was that the Great Depression would not recur. … Questions as to whether the success of standard policy could be sustained and questions of “for whom” and “what kind” and about the nature of full employment were not raised. The Keynesian Revolution may have been aborted because the lessons drawn from the standard interpretation not only did not require any radical reformulation of the society but also were sufficient for the rather undemanding performance criteria that were ruling.(20)

One wonders—in an age of florid and ever-increasing income inequality, stagnating wages for the majority of Americans, the recent development of high and persistent unemployment, and the pronounced deterioration in the quality of experience for the citizen as laborer (not only has job security disappeared, but the erosion of benefits for members of the workforce has increased as a structural adjustment of the meaning of employment continues apace) and for the citizen as consumer (interactions with providers of goods and services leave the consumer not infrequently in a netherworld between simultaneously complex, shoddy, and quickly obsolete products and poor, generally unresponsive support service)—if the implementation of an effective method to remedy the recent trajectory of economic citizenry would now require a radical reformulation of society. Or, what is more likely, if a change in society’s structure that, while not particularly radical, would be perceived as radical by those who have benefitted most from its current arrangements. Perhaps this is why Barack Obama’s speech on September 19th, in which he issued recommendations for tax increases on high-end incomes, and which contained a knowing and preemptive rhetorical strike against those who would call it class warfare, was greeted with cries of class warfare. (Class warfare, incidentally, is a concept with notable and defining instances in the actions of mankind. Examples in modern history include the French Revolution, the Russian Revolution, the Chinese Revolution, and America’s nineteenth-century labor battles. None of these events or movements seem to have had at its vanguard a battering ram in the shape of a modest tax increase.)

While a small sector of the society has been well served by the workings of America’s economic system, the vast majority of the population has reason for discontent. One suspects that this might become even more the case as the future unfolds. Under these circumstances, if you’re interested in defending the status quo, better to fight on the plane upon which you are strongest by wrapping yourself in the rhetorical trappings of American economic ideology and the reassuring tropes of American self-identity than to join the battle on the plane of real-world outcomes and conditions.

And better, too, if you are an economist with a stake in the game—a little too cozy, perhaps, with those who foot the bills, but by no means operating outside of the ethics of the field in which you ply your trade—to retreat to models demonstrating the fundamental correctness of your position, even if these models, in the end, have a dubious relationship to the actual world.

VI
It should be noted that in some ways, Minsky’s pessimism about the possibilities for stability within capitalism, may prove—subsequent to the 2008 “Minsky Moment”—too optimistic for present circumstances.

Speaking extemporaneously on a panel at the Levy Institute in June, the Washington University economist Steven Fazzari pointed up the potential for a cycle to get stuck at a particular stage:

What’s the converse of “stability is destabilizing?” Instability is stabilizing. I don’t know that Hy[man Minksy] would have ever said that, but the theory does imply this to some extent because it is a theory of indefinite cycles. So you get the boom, you hit the peak, you get the crisis, the crisis is cleansing—it may be extremely painful, but you wipe out the weaker units and you reestablish the conditions for growth again when the balance sheets are in some sense repaired. I think that’s the basic theory, the basic story.

So in that context, if you want to tie my question—what will be the aggregate demand generating process going forward—to a Minsky perspective, you have to ask how long will it take for balance sheets to be repaired? How long will it be until more robust conditions in the financial system are established?

A necessary condition for a more robust recovery is the improvement of the household balance sheet—leading to a restoration of better consumption, given that consumption is such a big part of demand. But I’m actually not fully convinced that this is sufficient. It’s necessary, but I’m not sure it’s sufficient.

Income distribution is a fundamental structural problem that goes beyond finance. The growth model in the US over the past three decades was one of relatively stagnant income growth across much of the income distribution, plugging the hole in demand with more consumer borrowing. So balance sheet improvement can help but it doesn’t seem to me that it deals with the additional issue of the income distribution. And there’s nothing on the table from a policy perspective or a structural perspective that would change this.

In other words, absent some significant event or dramatic change in policy, the fuse may have blown on the washing machine, leaving us stuck on soak.

Paul Davidson, editor of the Journal of Post Keynesian Economics, made a similar argument in his remarks at the Institute:

From the end of World War I to the beginning of World War II, the unemployment rate in the UK was double digits, except for one year when it was 9.7. That doesn’t sound like a cyclical problem to me, and it didn’t sound like it to Keynes, who basically argued that the economy had settled down at a long-run, stable unemployment rate which was very high. Just look at Japan in the 1990s and 2000s—and, I’m afraid to say, maybe a decade or two in the United States, beginning in 2007. So it’s not the ups and downs of a roller coaster—the capitalist system can be stable at less than full employment.

No one can know what will happen as the avenues to affluence and the economic expectations (be they grand or modest) that people have for their lives are more and more ostentatiously occluded for more and more members of the population. It’s not likely to be pleasant, as grievances tend to manifest themselves in all sorts of odd and often irrational ways (the Tea Party being Exhibit A in our own times). But it’s also always possible, of course, that the worm will turn and those who benefit least will fix their attention on those who benefit most. Perhaps this is American capitalism’s fundamental anxiety—indeed, perhaps it always has been. But in the aftermath—and in the midst—of its greatest crisis in eighty years, a heightened unease may help account for its pronounced defensiveness,(21) and the rigidity of its scholarly underpinnings.

VII
There remain broader questions. Though we are in a tough spot today partially because consumers are less able to play their accustomed role in demand generation, Minsky’s speculation that “[t]he joylessness of American affluence may be due to the lack of a goal, the acceptance of a standard in which ‘more’ is really not worth the effort"(22) rings no less true in these circumstances.

As of 1975, according to Minsky, “[t]he combination of investment that leads to no, or minimal net increment to useful capital, perennial war preparation, and consumption fads [had] succeeded in maintaining employment.” But though the period of the “Golden Age” had been remarkable in purely quantitative economic terms, in America it had “put all—the affluent, the poor, and those in between—on a fruitless inflationary treadmill, accompanied by…deterioration in the biological and social environment."(23)

And so, even if we accept that an economy should be geared towards full-employment with stable growth, a reasonably equitable distribution of income, and the potential to enjoy prosperity and affluence as goals, what form will this growth take? What do we mean by prosperity and affluence? And what are qualitative contours by which to gauge the well-being of members of our society?

At a time where a move back to some contemporary approximation of the moderate principles underlying the neoclassical synthesis would be regarded as radical, perhaps it is worth putting these larger, qualitative questions on the table as well.

Perhaps, too, it is time to urge the field of economics to wrestle with the complexity of a system whose limitations it is best not to elide in simplified models that have a Panglossian sanguinity at their core. And perhaps too it would be well to investigate the complexities that are actually produced by the limits of the capabilities of field.

For, as Minsky writes as he closes JMK, if, like Keynes, we think it best to live under an economic system “that sustains the basic properties of capitalism,” it should not be “because of the virtues of unfettered capitalism but in spite of its defects, which, though great, can in principle be controlled. ...[I]f capitalism is to be controlled so that the basic triad of efficiency, justice, and liberty is achieved, then the design of the controls will have to be enlightened by an awareness of what was obvious to Keynes—that with regard to both the stability of employment and the distribution of income, capitalism is flawed."(24)

Notes

1. “Full employment” is generally understood to mean a situation in which every person of working age who wants to work has a job, which is of course different than saying every person of working age has a job. In practical terms, unemployment rates below three, four, or even five percent—like those seen in the 50s and 60s, and again in the 90s—have typically been considered reasonably close approximations to full employment, not least because of the perceived relationship between low unemployment rates and the danger of an “overheating” economy leading to high rates of inflation. Indeed, there is a not uncontroversial concept in economics, the NAIRU (Non Accelerating Inflation Rate of Unemployment), which argues that there is a rate of unemployment (sometimes infelicitously termed the “natural” rate of unemployment) below which an economy ought not go lest it risk unsustainable rates of inflation. It is a subject of some debate precisely what this rate is, or if it is the same rate at all times, or if it is even a useful concept, but it’s typically claimed to be in the neighborhood of five percent.

It is also worth noting, of course, that the official rate of unemployment is always lower than the actual rate of unemployment because official measurements fail to include significant portions of the nonworking population. For example, in September of 2011, the unemployment rate in the United States stood at 9.1 percent, or 14 million, according to the Department of Labor. But there were an additional 2.5 million, or 1.6 percent, who were officially not counted (how many were unofficially not counted is another matter):

“In September, about 2.5 million persons were marginally attached to the labor force, about the same as a year earlier.… These individuals were not in the labor force, wanted and were available for work, and had looked for a job sometime in the prior 12 months. They were not counted as unemployed because they had not searched for work in the 4 weeks preceding the survey.…

“Among the marginally attached, there were 1.0 million discouraged workers in September…. Discouraged workers are persons not currently looking for work because they believe no jobs are available for them.”* (*United States Department of Labor. Employment Situation—September 2001. Washington D.C.: Bureau of Labor Statistics, 2011. http://www.bls.gov/news.release/pdf/empsit.pdf [bold type in original].)

The so-called “underemployed,” people who would like to work full time but are working in part-time jobs, are also not included in official measures of unemployment.

2. “What’s Natural? Peter Temin in Conversation with The Straddler.” The Straddler, springsummer2011. http://www.thestraddler.com/20117/piece5.php

3. Minsky, Hyman P. John Maynard Keynes. New York: McGraw Hill, 2008. 32.

4. Ibid. 2.

5. Overtveldt, Johan van. The Chicago School. Evanston, IL: Agate B2, 2007. 52.

6. Minsky. Op. cit. 6

7. Ibid. 7.

8. Ibid. 55.

9. Ibid. 11, 59.

10. Ibid. 11.

11. Ibid. 166.

12. Ibid. 158.

13. Gramm, Phil. “The Obama Growth Discount.” Wall Street Journal. 15 Apr 2011.
http://online.wsj.com/article/SB10001424052748703983104576262763594126624.html [my emphasis].

14. “Roundtable.” This Week with Christiane Amanpour. ABC: 31 Jul 2011.
http://abcnews.go.com/ThisWeek/video/roundtable-part-budget-endgame-14198610.

15. Minsky. Op. cit. 11-15.

16. Ibid. 15. Minsky continues:

“It turns out that the accomplishments of pure theory during the 1950s and 1960s are more apparent than real, when the problems of a financially sophisticated capitalist economy are under consideration.… Thus the purely intellectual pursuit of consistency between what was taken to be an elegant and scientifically valid microeconomics and a presumably crude macroeconomics has turned [o]ut to have been a false pursuit; microeconomics is at least as crude as macroeconomics.”

17. As one of The Straddler’s contributing editors, Gary Peatling, observes:

“I’m wondering if this unreality of neoclassical economics is itself a defense mechanism. Since a really unregulated economy is impossible (and is not even desired by the richest and most powerful vested corporate interests), any failure can be blamed on residual regulation. Hence the tenets are always irrefutable, in the manner of what Karl Popper termed a ‘bad science’ (although Popper might not have identified this). Also I’m reminded of John Ruskin’s comment that political economy was like science of gymnastics devised on the assumption that humans have no skeletons.” (Peatling, Gary. Personal communication. October 25, 2011)

18. Temin. Op. cit.

19. “The Predators’ Boneyard: A Conversation with James Kenneth Galbraith.” The Straddler, springsummer2010. http://www.thestraddler.com/20105/piece2.php

20. Minsky. Op. Cit. 16.

21. A comparatively mild articulation of this defensiveness was on display in a sympathetic 2010 New York Times Magazine profile of “lifelong Democrat” Jamie Dimon, CEO of Chase Bank:

“The executive I encountered was on a mission to reclaim a respected place for his industry, even as he admits that it committed serious mistakes. He was adamant that government officials—he seemed to include President Obama—have been unfairly tarring all bankers indiscriminately. ‘It’s harmful, it’s unfair and it leads to bad policy,’ he told me again and again. It’s a subject that makes him boil, because Dimon’s career has been all about being discriminating—about weighing this or that particular risk, sifting through the merits of this or that loan.” (Lowenstein, Roger. “Jamie Dimon: America’s Least-Hated Banker.” New York Times Dec. 1, 2010. www.nytimes.com/2010/12/05/magazine/05Dimon-t.html)

22. Minsky. Op Cit. 164.

23. Ibid. 163.

24. Ibid. 165.

Financial Reform and the Real Economy

A conference organized by the Levy Economics Institute of Bard College with support from the .

This year’s Minsky conference marks the Levy Institute’s 25 anniversary, and the third year of the Ford–Levy joint initiative on reforming global financial governance. This initiative aims to examine financial instability and reregulation within the theoretical framework of Minsky’s work on financial crises. Minsky was convinced that a program of financial reform must be based on a critique of the existing system that identifies not only what went wrong, but also why it happened. Speakers addressed the ongoing effects of the global financial crisis on the real economy, and examined proposed as well as recently enacted policy responses. Should ending too-big-to-fail be the cornerstone of reform? Do the markets’ pursuit of self-interest generate real societal benefits? Is financial sector growth actually good for the real economy? Will the recently passed US financial reform bill make the entire financial system, not only the banks, safer?

Explosion in the 1990s versus Implosion in the 2000s

Orthodox and heterodox theories of financial crises are hereby compared from a theoretical viewpoint, with emphasis on their genesis. The former view (represented by the fourth-generation models of Paul Krugman) reflects the neoclassical vision whereby turbulence is an exception; the latter insight (represented by the theories of Hyman P. Minsky) validates and extends John Maynard Keynes’s vision, since it is related to a modern financial world. The result of this theoretical exercise is that Minsky’s vision represents a superior explanation of financial crises and current events in financial systems because it considers the causes of financial crises as endogenous to the system. Crucial facts in relevant financial crises are mentioned in section 1, as an introduction; the orthodox models of financial crises are described in section 2; the heterodox models of financial crises are outlined in section 3; the main similarities and differences between orthodox and heterodox models of financial crises are identified in section 4; and conclusions based on the information provided by the previous section are outlined in section 5. References are listed at the end of the paper.

The Gold Report

Business Insider, October 19, 2011. Copyright © 2011 Business Insider, Inc. All rights reserved.

The Gold Report: Many of the resource companies in Pinetree Capital’s investment portfolio are gold companies. Gold went from above $1,900/ounce (oz.) in early September to around $1,600/oz. currently. Now, European central banks have sold 1.1 million metric tons of gold into the market to drive the price lower. Pinetree’s share price has followed gold lower and your exposure to gold remains high. What’s Pinetree’s pitch to investors right now?

Marshall Auerback: We had a very significant run up in the gold price, so some correction is understandable. But the conditions that created the run-up to $1,900/oz. have not dissipated. If anything, they’ve become more pronounced, notably in the Eurozone, where investors must begin to seriously consider the possibility of a break-up of the European monetary union and the implications that has for gold. And if you look at the monetary overhangs in places like China and Japan, it’s hard to find stores of value there either. So we have had some significant spec liquidation, some central bank sales—a plus, as central bankers are usually a great contrary indicator—and yet the price appears to have stabilized around $1,600/oz. Gold stocks, in contrast, still reflect valuations that are substantially lower than the current gold price. It is also important to note that the capital markets, in contrast to late 2008, have not shut down. Good quality mining projects can still obtain funding, especially for projects with robust economics, which a number of our holdings possess.

Pinetree has a unique structure. We raise money from the markets, which means that our longer-term funding requirements are, to some degree, shaped by market perceptions and market enthusiasm for resource stocks. But it also means we are not subject to monthly, daily or quarterly redemption pressures, so we can hold on to some smaller names that now offer the most compelling value they have offered in years.

TGR: A few years ago, Pinetree went from being focused on technology and biotechnology stocks to resource-based equities.

MA: Yes, the fundamental thesis has not changed. The developing world is likely to remain the dominant social, political and economic theme for at least the next few generations. Commodity prices have soared because the depletion of readily available resources is now finally outstripping the ingenuity of mankind to extract these resources. That is not just our view. Jeremy Grantham of GMO believes that this has changed the fundamental trend in real commodity prices, though the explosive nature of these prices in recent years has no doubt been amplified by speculation and historically unprecedented and ultimately unsustainable fixed investment in China. So you will get periodic corrections, especially during periods of global economic slowdown, but we don’t think this changes the long-term thesis. The portfolio composition has changed somewhat to reflect a changed economic environment of less base metals, more precious metals, but that is a tactical, as opposed to strategic, decision.

TGR: Did that one-month, $300-dollar drop in the gold price ruin gold’s reputation as a safe-haven investment?

MA: Not really. The price rise was, like other commodities, undoubtedly amplified by the actions of trend-following speculators. These are generally weak holders, and they tend to get shaken out when there are market gyrations of the sort that we have experienced over the past few months. But the fundamental reasons for holding gold have, if anything, grown stronger over the past few months.

TGR: Is the fear-trade gone? Is gold now trading strictly on supply and demand fundamentals?

MA: Given the way that markets have traded toward the end of the quarter, where you get maximum incentive to “paint the tape” in an upward direction, we think it is way too premature to suggest that the fear trade is over. Ultimately, though, gold is a supply/demand story. The market has been in fundamental deficit for decades and only the sales and leasing of gold by the central banks have prevented an even more acute price explosion.

TGR: The market is always about timing, but timing is even more important now given the rampant volatility in the markets. Fearing an economic collapse, many investors exited the junior sector once the volatility started in August. Many of those same investors remain on the sidelines today and some probably want to get back in. Is there something they should wait for—like a bottoming of the gold price—or is now the time to return?

MA: We think the time when you get maximum valuation is during these periods of turbulence and fear, when the baby gets thrown out with the bathwater. The good stuff is thrown out along with the bad as redemption pressures mount. Since we are in a comfortable position vis-à-vis our cash positions, we are in a good position to capitalize. Especially as Pinetree, for reasons explained before, doesn’t face comparable redemption pressures.

TGR: Our readers are primarily retail investors who like the high-risk, high-reward nature of the precious metals juniors. Pinetree is essentially a retail investor with lots of cash and a crack research team. How is Pinetree playing the current market? Have you been adding to your positions on the market dips? Have you sold off? Have you held tight? Give us the scoop.

MA: We try to “feed the ducks while they’re quacking,” in the sense that we recognize that many of these holdings are small and illiquid, and we tend to take large, strategic stakes. When our assessments are largely validated by market action, then we find that it is a good time to reduce, particularly because with these smaller, less liquid names, we are almost always going to be a bit early because we have to trim when there is good demand. This is especially the case when the company’s development has largely tracked what our analysts forecasted and with that comes the growing popularity of the shares with the broader market. Selling in those kinds of situations gives us the flexibility to take on new deals or, as is the case today, to buy from distressed sellers.

TGR: What are your favorite five gold plays in the Pinetree Capital portfolio?

MA: Gold Canyon Resources Inc. (GCU:TSX.V) is one. We are big believers in this deposit. The initial resource should be out by the end of this year and is promising to be several million ounces with grades exceeding most other bulk tonnage deposits in Canada. Looking at the dimensions of the deposit, specifically the new extension to the southeast, the potential here continues to grow far beyond what the company’s initial resource will give it credit for.

Queenston Mining Inc. (QMI:TSX) is the consolidation of key past producing mines in the prolific Kirkland Lake mining camp. There is an Agnico-Eagle Mines Ltd. (AEM:TSX; AEM:NYSE) take-out potential. Extensive drilling on the Upper Beaver and the South Mine complex joint venture with Kirkland Lake Gold Inc. (KGI:TSX) continues to add ounces.

RoxGold Inc. (ROG: TSX.V) is operating in Burkina Faso and has just raised the money needed to acquire 100% of its flagship asset. High-grade deposits are very hard to come by and the results it has consistently seen show potential for just that. With mid-major companies operating in the region, as RoxGold continues to add size, it becomes more and more likely to be an attractive candidate for a take-out.

Continental Gold Ltd. (CNL:TSX) recently reported a very large high-grade resource on its Buritica gold/silver/base metals deposit in Colombia. If you look around right now there aren’t too many deposits that hold size and grade like this one and, with 250 kilometers of assays to come since the resource was calculated, there is still a lot of upside from here.

Mawson Resources Ltd. (MAW:TSX; MWSNF:OTCPK; MRY:Fkft) is exploring at Rompas in Finland, a new discovery with bonanza gold where samples up to 22,723 grams per ton (g/t) gold and 43.6% uranium have been identified. The weighted average of all channel samples from the 2010 program is 0.59m at 203.66 g/t of gold and 0.73% uranium within a sampling footprint of 6.0 km. strike and 200–250m width. More than 300 discovery sites have now been identified within the mineralized footprint. At this very early stage of exploration, Rompas has to be considered as one of the most exciting global gold discoveries (with a uranium credit) to emerge into the marketplace, in terms of its high grades and hundreds of surface showing over a large area.

TGR: What are three gold plays Pinetree has positions in that few have ever heard of?

MA: Redstar Gold Corp. (RGC:TSX.V) is exploring in Alaska where properties have limited historical drilling. However, the company has seen very high grades. Currently, it is drilling up there and with the recent addition of the International Tower Hill Mines Ltd. CEO to their board, there is reason for interest. The company also has a joint venture with Confederation Minerals Ltd. (CFM:TSX.V) up in Red Lake. Thus far, Redstar has seen very high grades over 200 g/t over narrow widths stretching over a potentially several kilometer-long strike length. This kind of project requires lots of drilling; however, thus far, there has been some good continuity of success and with any sort of thicker intervals, this would be a project well worth the interest.

Prosperity Goldfields Corp.’s (PPG:TSX.V) exploration is headed up by Quinton Hennigh, who is also on the board of Gold Canyon and is heading up its exploration program. Stock had a large run-up prior to results, which the market clearly saw as disappointing. Despite this, we think these results show great promise given that Prosperity was the first in the area and the potential size of this deposit is very large. This project is in Nunavut; however, a winter camp has been set up and, relative to the region, the infrastructure is better than most.

Terreno Resources Corp. (TNO:TSX.V) is focused on a few different resources in South America. The company just raised $2.8 million and so it is cashed up to move forward on the initial exploration of both precious/base metal projects in Argentina as well as their phosphate/potash exploration in Brazil. It has had some solid trench results thus far down in Argentina, which is promising. The phosphate/potash market seems to be one of the few places where most analysts agree there will be a lift in pricing in the future so we are excited to see the exploration results.

TGR: Let’s switch gears to silver. Does Pinetree believe silver is a better near-term investment than gold?

MA: No, we think gold is likely to be the better performer if a global recession becomes the predominant concern, as opposed to systemic issues. That said, there have been some fairly violent moves to the downside over the last few weeks. The bear talk on China has really been overdone. Remember, China has over $2 trillion in foreign exchange reserves, so it has ample firepower to combat the forces of recession. In the very short term, we could get these massively oversold conditions worked off if it looked like the world was not coming to an end and silver could have a nice pop. Look at the U.S. data recently:

• Since late August, the U.S. economic data has surprised somewhat to the upside.
• Initial unemployment claims rose less than expected; September chain store sales look stronger than expected; Ford Motor Company’s sales for September were up 9%.
• It looks as though GDP growth may come in better than 2% annually in both the third and fourth quarters, surpassing recent pessimistic expectations.

As far as China itself goes, suddenly all the analysts, economists and portfolio managers that were all bulled up on China two years ago, a year ago and even six months ago have become all beared up on China. We are hearing about an imminent hard landing in China from everyone. So why the sudden bearishness about China?

It is claimed that China’s informal credit market is out of control. Property developers and businesses are starved for credit; business investment and real estate will fall. A hard landing is at hand. Let’s put this informal credit market into perspective.

This informal credit market is estimated at 3–4 trillion yuan RMB. The Chinese economy is now estimated at something north of 40 trillion yuan. According to Fitch, the formal credit market plus the shadow banking system totals about 70 trillion yuan.

When one looks at these numbers one can see that the growth of informal lending and the extremely high interest rates on informal lending represent a problem in China. But it does not impact a significant share of aggregate expenditures.

The real problem lies with the banking system and the shadow banking system.

TGR: Is this important credit market now poised to take Chinese aggregate demand down?

MA: We doubt it. Interest rates in the banking system are negative in real terms. The banking system is still expanding at a double-digit annual rate. Interest rates in the shadow banking system are much higher; they are no doubt positive in real terms, but it appears they are not usurious. In any case, this credit is still being allowed to expand at a very rapid rate. Will the authorities be able to deal with problems in the banking system or shadow banking systems, which are the credit markets that matter?

The answer is probably yes. The biggest credit excesses and the biggest white elephant fixed investments in this cycle lie with the local authorities. The Chinese government in one fell swoop removed half a trillion dollars of such loans off the backs of these local authorities. A half a trillion dollars! That is as large as the entire alleged informal credit market that everyone is getting so beared up about.

Longer term, the Chinese economy is an out-of-control Ponzi economy. Labor force growth will go negative. Surplus labor in agriculture is depleting. Fixed investment is impossibly high relative to a falling warranted rate of growth. Very bad things will eventually happen. However, the Chinese economy is also an extreme command economy. Extraordinary measures will be taken to avert these very negative outcomes.

The Chinese economy is highly indebted. The Chinese central government is not. Before the proverbial you-know-what hits the fan, the Chinese government will use its balance sheet to keep the white-elephant over-investment juggernaut going. Do not underestimate the fiscal capacity of the Chinese government and its willingness to use it. We do not think the excesses today in the Chinese informal credit market are a reason to get very beared up on China all of a sudden. The Chinese bear story will unfold progressively over a long time.

The real threat in China is inflation. China’s fixed investment has become increasingly credit dependent. To keep the fixed-investment juggernaut going and avert a hard landing, there must be sustained rapid money and credit expansion. There is already a large monetary overhang. The combination of these flow and stock dynamics threaten a very high inflation down the road. Which again makes the long-term case for gold very bullish.

TGR: Where is Pinetree getting its exposure to silver?

MA: Apogee Silver Ltd. (APE:TSX.V). The company’s primary focus is the Pulacayo-Paca Property located in southwestern Bolivia. The property includes the historic Pulacayo mine, which was the second largest silver mine in Bolivia’s history with historical production exceeding 600 million ounces of silver. Although there is obviously some risk with dealing in Bolivia, there are still many operating mines and we feel the deposit warrants the risk.

Southern Silver Exploration Corp. (SSV:TSX.V; SEG:Fkft) recently acquired the Cerro Las Minitas property in Durango, Mexico. There is a history of production right in the middle of the property and thus far, the company’s initial holes have been promising. This is a very early stage project and there is a lot more definition needed before a resource can be laid out; however, Southern Silver is in a good region and we feel the property certainly has potential.

TGR: What are some investment themes that you expect to play out in the coming months?

MA: We think that the markets could surprise again to the upside as we have apparently discounted a double dip recession, whereas a slowdown might be more accurate. This period might end up being closer to 1998 than 2008.

The trouble with the view that we are heading for another 2008 is that all crises are different. But they do share one common element: the inability of markets to perceive that when a market discontinuity is fresh in the minds of investors (e.g., 2008); it seldom repeats until that institutional memory is dissipated. Now, I believe that European banks are insolvent conditional upon the PIIGS collectively being insolvent. Clearly, this is the case for Greece (although the European Central Bank (ECB) could easily forestall this if it keeps buying Greek debt), but for the others, this is unclear—and, particularly in the case of Spain and Italy, a function of the rates at which they can borrow. So while the ECB provides a liquidity backstop, they have the room to adjust. Of course, the missing ingredient is growth. Europe already looks as though it has slid into recession. I would argue that recession, as opposed to systemic risk and bank runs, is already priced into European stock markets. But nothing is certain.

While the current crisis in Europe is worse than the 1998 crisis with LTCM and Russia, in 1998 it was thought that the entire system would collapse. Remember in 1998 Fed funds were 5%, not zero; 10-year notes, above 4%, not 2%+; 2-year notes were 5%; SPX was 30x earnings, not 15x. We had not gone through a 1974-style liquidation in reverse parabola terms except for the one day 1987 sell-off, as we did in 2008–2009. Real estate (houses) was not selling for prices yielding 10%–15% on lower-end real estate, but that is where the focus of foreclosures is felt. The story will be told in the next eight trading days.

TGR: Thank you for your insights.

As Pinetree Capital’s corporate spokesperson, Marshall Auerback is a member of Pinetree’s board of directors and has some 28 years of global experience in financial markets worldwide. He plays a key role in the formulation and articulation of Pinetree’s investment strategy. Auerback is a research associate for the Levy Institute and a fellow for the Economists for Peace and Security.

Yet another rescue plan for the European Monetary Union (EMU) is making its way through central Europe, but no one is foolish enough to believe that it will be enough. Greece’s finance minister reportedly said that his nation cannot continue to service its debt, and hinted that a 50 percent write-down is likely. That would be just the beginning, however, as other highly indebted periphery nations will follow suit. All the major European banks will be hit—and so will the $3 trillion US market for money market mutual funds, which have about half their funds invested in European banks. Add in other US bank exposure to Europe and you are up to a potential $3 trillion hit to US finance. Another global financial crisis is looking increasingly likely.

We first summarize the situation in Euroland. Our main argument will be that the problem is not due to profligate spending by some nations but rather the setup of the EMU itself. We then turn to US problems, assessing the probability of a return to financial crisis and recession. We conclude that difficult times lie ahead, with a high probability that another collapse will be triggered by events in Euroland or in the United States. We conclude with an assessment of possible ways out. It is not hard to formulate economically and technically simple policy solutions for both the United States and Euroland. The real barrier in each case is political—and, unfortunately, the situation is worsening quickly in Europe. It may be too late already.

By Catherine Hollander

National Journal, October 11, 2011. Copyright © 2011 by National Journal Group Inc.

The U.S. job market has shown lackluster growth recently, to put it mildly.

The September employment report, released on Friday, revealed that nonfarm payrolls added just 103,000 jobs last month—not horrific, but still under the threshold economists say they need to cross in order to dent unemployment. The Senate is likely to vote on the job-creation proposals in President Obama’s $447 billion American Jobs Act this week, but the bill’s passage is a long shot.

As they consider the legislation, lawmakers may want to reflect on their counterparts across the Atlantic.

While each economy faces unique obstacles to growth, fellow developed countries like Germany, Denmark, and France have implemented programs analogous to some found in Obama’s jobs bill with success. These include job-search programs accompanying unemployment benefits and stepped-up apprenticeship programs.

Other countries have developed programs not found in the president’s legislation, such as mechanisms to certify workers who have gained skills on the job rather than in the classroom.

Unemployment insurance programs vary widely from country to country. As of 2007, the most recent year for which data was available, the U.S. paid employees 13.6 percent of their previous earnings on average, compared with 24.7 percent in the Organisation for Economic Co-operation and Development as a whole, which counts the U.S. and 33 other wealthy countries as members.

The U.S. also has short-lasting unemployment benefits compared with most of the other OECD members. By itself, this provides a “powerful incentive” for the unemployed to look for their next job, according to Gary Burtless, an economist at the Brookings Institution.

But other OECD countries have deployed different incentives to get recipients of unemployment benefits back to work. Many low-paying jobs in the U.S. pay around the same as the benefits. Other countries have ensured work earnings are higher than unemployment benefits, incentivizing recipients to look for a job, according to Stefano Scarpetta, the OECD’s Deputy Director for Employment, Labour, and Social Affairs. 

Some OECD countries have bolstered their programs to help the recipients of unemployment insurance re-enter the workforce. France and others have made unemployment benefits conditional on searching for a job and participating in re-employment programs. The U.S. has paid less attention to investing in such labor market institutions, Scarpetta said.

He recommended focusing on “training, apprenticeship, and skills” to boost unemployment among the most vulnerable sectors of the population -- the young and long-term unemployed. Countries such as Germany and Denmark stepped up their traditional apprenticeship programs in response to the economic downturn. The pumped-up programs have a strong track record of landing apprentices with jobs, Scarpetta said.

The American Jobs Act proposes to do this through new training for the recipients of unemployment insurance -- so-called “bridge to work” programs modeled after efforts in Georgia and North Carolina. These programs allow long-term unemployed workers to continue receiving unemployment benefits while they pursue work-based training.

Such training could have secondary benefits, eliminating unwanted social trends such as crime and depression that are associated with high unemployment levels, according to Dimitri Papadimitriou, president of Bard College’s Levy Economics Institute. He called the training programs a “very good idea.”

But Papadimitriou cautioned that without a more general economic recovery, simply training unemployed workers doesn’t guarantee jobs. Others fear it will be difficult to find employers willing to bring in unpaid trainees. They like to maintain control over the hiring process, Brookings’s Burtless said.

It would be more fruitful in the long run to reform the way the U.S. thinks about employment training, he said.

Several OECD countries, including Portugal, have created mechanisms by which workers who drop out of school but gain skills on the job can have those skills certified, making them more attractive to potential employers.

The U.S. places too much emphasis on formal educational credentials and not enough on skills acquisition, Burtless said. A European-style certification program could make on-the-job training more valuable by providing workers with proof that they have a transferable skill.

Such a program runs the risk of locking workers into too-rigid skill certifications, which could harm their ability to appear flexible in a changing workforce, according to Randall Eberts, president of the Upjohn Institute for Employment Research. It would not provide immediate unemployment relief, and it would take time for employers and workers to recognize the value of the certificate, but it could provide a huge help in the long run to a large portion of workers who complete their training on the job, Burtless said.

Some economists were hesitant to make comparisons between the U.S. and the smaller European countries, whose economies operate in a different political environment. And it will ultimately take strong overall economic growth to turn around the labor market. Supply-side changes will have a limited impact without an accompanying improvement in demand, Papadimitriou argued.

But in the end, the point is not that other developed countries have it all figured out—it’s that no one does, and looking at programs that have been implemented abroad can be a useful jumping-off point for discussions of job-creation measures in the U.S.

Interview with Pavlina R. Tcherneva

September 8, 2011. © 2011 by Wisconsin Public Radio

As Obama tours the East promoting his jobs bill, and jobs forums spring up across Wisconsin, Research Associate Tcherneva and host Ben Merens talk about what should be done now to address unemployment. Full audio of the interview is available here.

By Agostino Fontevecchia

Forbes, August 30, 2011. © 2011 Forbes.com LLC™. All Rights Reserved.

“[This] recession has turned into a prolonged and very unusual slump in growth, preventing a labor-market recovery,” explained Dimitri Papadimitriou, head of the Levy Economics Institute, in a recent paper called Not Your Father’s Recession. The economist makes the argument that post-crisis GDP growth rates are about 11.9% off of historical standards, which, along with the employment-to-population ratio, suggest the current macroeconomic environment is a lot more challenging than in other recessions and will need the intervention of government to recover.

“Considering the already severe slump in job creation, it hardly matters whether such a downturn would constitute the second dip of a ‘double-dip’ recession, a continuation of the ‘Great Recession,’ or a confirmation that the economy has entered a Japanese-style ‘lost decade,’” wrote Papadimitriou, adding that a labor-market recovery appears unlikely without help from the government, and the data proves it.

Economics hasn’t come to terms with the possibility of a market economy stagnating over a protracted period because its models are based on constant growth. The reality is that market economies have grown relentlessly during the XX century.

Papadimitriou illustrates it with a chart overlaying an exponential growth line to an inflation adjusted-GDP series from 1967 to today. The match is almost exact all the way to 2007; today, real GDP is “11.9 per cent less than one would have expected based on earlier data.”

It’s no surprise that a depressed U.S. economy has kept output at multi-year lows. Recent revisions show Q2 GDP growing at a meager 1%, suggesting post-recession growth came from now-exhausted stimulus packages. Papadimitriou takes it one step further, arguing that average GDP, as illustrated by 12-quater, 20-quarter, and 28-quarter moving averages, has been declining since 2000.

One of the most worrying signs of the U.S.’ generalized economic weakness is the state of labor markets, particularly when compared with other post-recession recoveries.

Employment-to-population ratios bottom out 18 to 37 months after the onset of the recession in each of the previous six cases of output contraction. This time around, 43 months after the beginning of the recession, the trend continues to be negative, with the ratio down 4.6% to 58.1% in what has been almost four years of negligible recovery in labor markets.

With Chairman Ben Bernanke choosing to stay on the sidelines and the private sector immersed in a cycle of deleveraging, Papadimitriou points the finger at government, noting “the [federal] government has barely begun the task of creating the new jobs needed to deal with this disaster.”

Further stimulus will face staunch opposition in Congress, with Tea Party candidates taking the reins of the Republican Party on a cut spending-platform. The White House has leaked, though, an announcement that President Obama will unveil a new jobs plan, which is expected to be some sort of stimulus, in September.

It remains to be seen whether the situation in Europe will worsen, or if a moderate improvement in economic conditions in the second half of the year, coupled with Obama’s coming plan, will help push the economy out of the gutter.

The export-led growth paradigm is a development strategy aimed at growing productive capacity by focusing on foreign markets. It rose to prominence in the late 1970s and became part of a new consensus among economists about the benefits of economic openness.

According to Thomas I. Palley, this paradigm is no longer relevant because of changed conditions in both emerging-market (EM) and developed economies. He outlines the stages of the export-led growth paradigm leading to its adoption worldwide, as well as the various critiques of this agenda that have become increasingly prescient. He concludes that we should reduce reliance on strategies aimed at attracting export-oriented foreign direct investment and institute a new paradigm based on a domestic demand–led growth model. Otherwise, the global economy is likely to experience asymmetric stagnation and increased economic tensions between EM and industrialized economies.

By Alexander Eichler

Huffington Post, August 22, 2011. Copyright © 2011 TheHuffingtonPost.com, Inc. | “The Huffington Post” is a registered trademark of TheHuffingtonPost.com, Inc. All rights reserved.

During the 2008 financial crisis, when the nation’s banking system seemed on the verge of collapse, President George W. Bush authorized a $700 billion bailout of the financial industry. The U.S. Treasury implemented that program, known as TARP, in an effort to stave off economic catastrophe.

At the same time, and in the years that followed, the Federal Reserve was undertaking its own rescue operation, in the form of private, previously undisclosed loans to banks and other institutions—lending as much as $1.2 trillion, nearly twice the amount of the Treasury bailout, according to a data analysis performed by Bloomberg News and published on Monday.

The scope of the Fed’s private lending had previously only been guessed at, but figures obtained under the Freedom of Information Act by Bloomberg News show that the nation’s central banker issued loans to more than 300 institutions between August 2007 and April 2010, including over 100 loans of $1 billion or more.

While the Fed’s loans likely helped to prevent a complete implosion of the global banking system, analysts say they fear the loans may have contributed to an atmosphere of complacency on Wall Street. Banks that received emergency cash infusions during the crisis may now believe the Fed will always be there to bail them out of trouble, the thinking goes.

“It is a classic case of moral hazard,” Dimitri Papadimitriou, president of the Levy Economics Institute of Bard College, told The Huffington Post.

The Federal Reserve itself had argued that the details of its emergency loans should be kept out of the public eye, claiming that the reputations of the firms involved could suffer if they were seen to be taking money from the government in order to stay afloat. Many of the banks that borrowed from the Fed had previously appealed to the Supreme Court to keep those records secret.

However, an invocation of the Freedom of Information Act forced the Fed to release more than 29,000 pages of documents, revealing the extent to which the financial sector relied on Federal Reserve dollars during the worst days of the crisis.

Given the extraordinary size of the loans, the public has a right to know what happened, said David Jones, an executive professor at the Lutgert College of Business at Florida Gulf Coast University.

“It’s completely valid at some point to say, ‘Who did the borrowing?’“ Jones told The Huffington Post. “It was appropriate, under this special set of circumstances, to divulge the information.”

Among the largest borrowers were Bank of America, which borrowed $91.4 billion; Goldman Sachs, which was in debt for $69 billion; JPMorgan Chase, which borrowed $68.6 billion; Citigroup, which borrowed $99.5 billion and Morgan Stanley, the biggest borrower of all, to which the Fed loaned $107 billion.

In addition, the Fed issued sizable loans to a number of foreign banks, including the Royal Bank of Scotland, which borrowed $84.5 billion; Credit Suisse Group, which borrowed $60.8 billion and Germany’s Deutsche Bank, to which the Fed lent $66 billion. Nearly half of the 30 largest borrowers were European firms, according to Bloomberg News.

While the amount of lending that took place is remarkable, some argue that the Fed’s error was not in issuing the loans, but rather in doing so without setting stronger policy reform conditions for the money.

Dean Baker, co-director of the Center for Economic and Policy Research, told The Huffington Post that Federal Reserve Chairman Ben Bernanke could have attached a “quid pro quo” to the emergency loans—stipulating, for example, that the money would only come through if the banks agreed to do business in a less risky way going forward.

“This is the moment all the banks were on their backs,” Baker said. “The Fed ran to the rescue and got nothing in return.”

A previous disclosure in December found that the Fed issued $9 trillion in low-interest overnight loans to banks and other Wall Street companies during the crisis. The $1.2 trillion figure represents the peak amount of outstanding loans, which occurred on December 5, 2008, according to Bloomberg News.

Some critics contend that while the Fed was right to support the financial sector, the government didn’t do enough to help ordinary citizens who were also seeing their wealth evaporate during the crisis.

Papadimitriou told The Huffington Post that the Fed issued many of its biggest loans during the Bush administration, and that “they didn’t appear to have any difficulty supporting the financial sector, but very much difficulty supporting the real sector, households.”

Consumer spending suffered and unemployment spiked in the wake of the financial crisis, and the economy remains weak today. Output is low, consumer confidence is down and millions are still out of work—factors that have some economists worried about the possibility of a double-dip recession.

The TARP bailout, led by the Treasury, was the subject of much popular ire when it occurred, since it was seen as a case of the government throwing money at the financial sector at the expense of everyday Americans. Similarly, the Fed’s $1.2 trillion in emergency loans were primarily aimed at keeping major financial institutions on their feet.

“One would assume banks are too interconnected, you have to help all of them,” Papadimitriou said. “But if you take households in total, they are also all interconnected. They are also too big to fail.”

New Economic Perspectives, August 13, 2011. Copyright © 2010 KPFK. All Rights Reserved.

Senior Scholar Wray joins Masters for a macroeconomic analysis of adverse economic trends at home and abroad amid dire predictions of a double-dip recession in the United States and defaults in Europe, connecting the dots to see if we are indeed at a Smoot-Hawley moment where the Congress, instead of reversing economic decline, has accelerated it. Full audio of the interview is available here.

This paper begins by recounting the causes and consequences of the global financial crisis (GFC). The triggering event, of course, was the unfolding of the subprime crisis; however, the paper argues that the financial system was already so fragile that just about anything could have caused the collapse. It then moves on to an assessment of the lessons we should have learned. Briefly, these include: (a) the GFC was not a liquidity crisis, (b) underwriting matters, (c) unregulated and unsupervised financial institutions naturally evolve into control frauds, and (d) the worst part is the cover-up of the crimes. The paper argues that we cannot resolve the crisis until we begin going after the fraud, and concludes by outlining an agenda for reform, along the lines suggested by the work of Hyman P. Minsky.

President Dimitri B. Papadimitriou and Research Scholar Greg Hannsgen make the case that the recession has turned into a prolonged and very unusual slump in growth, preventing a labor-market recovery—and the government lags far behind in creating the new jobs needed to deal with this disaster.

Reevaluating the Role of Fiscal Policy

Conventional wisdom contends that fiscal policy was of secondary importance to the economic recovery in the 1930s. The recovery is then connected to monetary policy that allowed non-sterilized gold inflows to increase the money supply. Often, this is shown by measuring the fiscal multipliers, and demonstrating that they were relatively small.

This paper shows that problems with the conventional measures of fiscal multipliers in the 1930s may have created an incorrect consensus on the irrelevance of fiscal policy. The rehabilitation of fiscal policy is seen as a necessary step in the reinterpretation of the positive role of New Deal policies for the recovery.

This paper traces the rise of export-led growth as a development paradigm and argues that it is exhausted owing to changed conditions in emerging market (EM) and developed economies. The global economy needs a recalibration that facilitates a new paradigm of domestic demand-led growth. Globalization has so diversified global economic activity that no country or region can act as the lone locomotive of global growth. Political reasoning suggests that EM countries are not likely to abandon export-led growth, nor will the international community implement the international arrangements needed for successful domestic demand-led growth. Consequently, the global economy likely faces asymmetric stagnation.

With quantitative easing winding down and the latest payroll tax-cut measures set to expire at the end of this year, pressing questions loom about the current state of the US economic recovery and its ability to sustain itself in the absence of support from monetary and fiscal policy.

We present strong empirical evidence favoring the role of effective demand in the US economy, in the spirit of Keynes and Kalecki. Our inference comes from a statistically well-specified VAR model constructed on a quarterly basis from 1980 to 2008. US output is our variable of interest, and it depends (in our specification) on (1) the wage share, (2) OECD GDP, (3) taxes on corporate income, (4) other budget revenues, (5) credit, and the (6) interest rate. The first variable was included in order to know whether the economy under study is wage led or profit led. The second represents demand from abroad. The third and fourth make up total government expenditure and our arguments regarding these are based on Kalecki’s analysis of fiscal policy. The last two variables are analyzed in the context of Keynes’s monetary economics. Our results indicate that expansionary monetary, fiscal, and income policies favor higher aggregate demand in the United States.

By Dimitri B. Papadimitriou

May 26, 2011. Copyright © 2011 New Geography

It's been more than three years since the Great Recession began, and it's no longer debatable that the federal spending in its wake did not provoke inflation. Years of forecasts by fiscal conservatives about the result of government expenditures have proved to be wrong. After three fiscal stimulus packages, core inflation—which excludes the volatile prices of oil and commodities—remains very much in check. The core rate is the most reliable guide to future inflation, and it has not trended upward.

Headline inflation, however, the rate that does include these two, has increased. Is the recent uptick in gas and food prices a game-changer on inflation? Does it mean that predictions of an inflation tsunami were well-founded? And what's the best course to follow now?

Many commodity prices have made double and triple digit gains over the past year. The changes are more than a blip—cotton futures, for example, have risen 162 percent—even if the cost of oil continues to decline. These prices are notoriously subject to rapid change for reasons that don't reflect the structure of the U.S. economy. Factors can include Middle East politics, weather, activity in the developing world, and, most significantly today, speculative profiteering.

Gold and other commodities have become a hot destination for players—money managers—as these markets have become the rare opportunity for high returns. In the absence of federal regulation and supervision, the low interest rates that are so crucial to business growth and to the vast majority of Americans have been allowed to feed into the permissive speculative superstructure.

The run-up has clearly impacted the poor and the hungry in the undeveloped world. In academic and policy circles, there's a high level confidence that commodities account for only a small share of GDP in wealthy countries, and so aren't of concern as long as core inflation is under control. At the Levy Institute, in contrast, our research shows that even in the developed world expensive food, energy, and materials can crowd out other household purchases. Consumer budgets can be hurt even before serious headline inflation appears.

If commodity prices were to continue to climb broadly and sharply, the Federal Reserve could face the prospect of a serious episode of cost-push inflation, similar to what we saw in the 1970s and '80s. Fed Chairman Ben Bernanke might find himself occupying the chair of Paul Volcker in more ways than one.

This kind of inflation is caused neither by the effects of low interest rates on the broader economy, nor by government spending. And, as with any symptom of ill health, the cause dictates the appropriate treatment. So if Bernanke's response was to raise interest rates dramatically in the hope of abating inflation to some arbitrarily low target, it would be a risky mistake. An interest rate rise would be a serious danger to growth and job creation. Business and labor are far too fragile to deal with a double whammy from rising gas and food prices coupled with monetary policy tightening.

A better response would be "watchful waiting," a phrase seen in the December 1996 minutes of the FOMC (Federal Open Market Committee) meeting. A commodity price inflation could remain at least somewhat isolated.

Higher commodity prices will be used as an excuse to charge that the Fed's supposedly lax policy has unleashed an inflationary flood of cash throughout the economy. But the Fed's so-called "easy money" is parked at the Fed itself, as bank reserves, since banks are not lending. This can't cause inflation either. Logic hasn't stopped newly re-branded Republican presidential candidate Newt Gingrich, who recently admonished that "The Bernanke policy of printing money is setting the stage for mass inflation."

Those who purchase securities for long-term investment evidently disagree. Bond traders aren't anticipating an inflationary surge. Just look at the yield spread between inflation-indexed and non-indexed Treasury securities of the same maturity. It has remained almost constant over the past year. In other words, buyers who want their returns insulated from inflation are paying only slightly more for protection than they were last year. That flatness—the unwillingness to pay a premium for inflation insurance—indicates that long-term bond buyers haven't revised their inflation forecasts.

Also unlikely to revise their predictions: inflation doom-drummers, even as energy prices level, and wages, another inflation indicator, are by no means jumping. Like eons of "the-end-is-nigh" prognosticators, they don't exactly have a great track record. Back in spring 2008, a frenzied Glenn Beck urged Fox viewers to "Buy that coat and shoes for next year now." Some of his Washington cohorts are coy about inflation's estimated time of arrival. Republican House Majority Leader Eric Cantor, for example, tells us that "fears" of "future" inflation are "hanging over the marketplace." Others, like former Pennsylvania Senator Rick Santorum, say it's already arrived (Obama brought it). The accusations continue despite a lengthy stretch of the lowest inflation rates in modern US history, even with the current commodities rise.

Paul Ryan (R-WI) has been hailed as both a truth sayer and a soothsayer on the economy. He recommends that the Federal Reserve raise interest rates now to head off inflation "before the cow is out of the barn," ignoring the pain this would cause families and businesses. Here's my recommendation: Don't trust predictions about the future from those who've misread the present, and been very wrong in the past.

Dimitri Papadimitriou is President of the Levy Economics Institute of Bard College, and Executive Vice President and Jerome Levy Professor of Economics at Bard College.

By Dimitri B. Papadimitriou

May 13, 2011. Copyright © 2011, Los Angeles Times

For 20 years, U.S. exports have trailed imports. Addressing the imbalance could hugely boost the job market.

One school of thought about the so-called jobless recovery of the American economy blames high unemployment on the federal deficit. But that’s blaming the wrong deficit.

To achieve an authentic recovery that includes new jobs, the deficit we need to cut is in trade.

For 20 years, America’s exports have been surpassed by its imports, with a big bite of that trade deficit composed of oil imports. Addressing the imbalance could have a huge effect on the job market, but only if it goes beyond reducing imports. We need to actively strengthen exports as well.

Even if the economic recovery continues, as is likely, joblessness will remain a colossal disaster. The unemployment rate is hovering at about 9%, and for some groups it is far higher. Nearly 16% of African Americans are unemployed, with young people and Latinos not far behind. The United States is about 19 million jobs behind the curve if employment is to return to its pre-recession levels. Among the world’s most developed nations, the G-7, we have the highest unemployment. Here at the Levy Economics Institute, even in our best-case growth scenario, we see unemployment dropping only to about 7%—way above healthy levels—by 2015. We’re not alone in that pessimism: The figures vary, but the prevailing outlook, including from the Federal Reserve is that job-seekers face years of pain.

Exports are key to meeting the urgent need for new jobs. The White House estimates that every $1 billion in exports creates 5,000 jobs. This makes it crucial for companies to find more customers in the rest of the world.

In addition to aircraft and other transport vehicles, U.S. industrial equipment, pharmaceuticals, chemicals, semiconductors and agricultural products—raw and processed—have a track record of success in the global marketplace, along with millions of goods from medium-size and small companies.

There are things that could be done to help American exporters. A devaluation of the dollar beyond the current downward creep would be a start. A weaker dollar would reduce the cost of our exports in foreign markets, in turn generating demand from buyers abroad. It would also encourage American consumers to buy domestic products because our goods would have a price advantage over imported ones. And the resulting rise in exports would have a side benefit: reducing the national budget deficit, because GDP growth and lower unemployment would mean larger government revenues and less spending on safety-net programs.

Devaluation does have some downsides, of course. Over the long haul, it can cause inflation, but that is not an immediate danger because core inflation is currently at or near record lows. Still, consumers would probably be paying more in the short term for oil and other imports.

In the long term, international monetary reforms would certainly be a preferable route to devaluing the dollar. Global imbalances are on the G-20 radar screen, but a serious policy response has yet to be floated. One helpful monetary reform would be to expand Special Drawing Rights—artificial, blended currency units governed by the International Monetary Fund—as supplemental currency reserves. This could only be done by an accord among the G-20 countries. International agreements take time—the World Trade Organization’s Doha talks will soon celebrate their 10th anniversary—so moving the dollar’s exchange rate is a better short-term solution.

Even then, ramping up American exports will be difficult. The White House has set a goal of doubling exports over five years, but the current mania for spending cuts may work against that ambition. In the House of Representatives, the Small Business Committee has advocated rescinding $30 million in Small Business Administration grants to states for promoting exports and sharply cutting the SBA’s Office of International Trade. These savings would be counterproductive and would work against the nation’s best interests.

It’s true that our trade account balance has recently improved. The better figures, though, aren’t a sign of healthy growth or an upcoming job surge. They reflect more a drop in imports rather than a growth in exports, and the drop has come because of less demand for goods in the recession’s shadow and amid ongoing financial fears.

Exports are starting to rise. But making sure that the upward curve continues will be crucial to addressing our still-worrisome unemployment rate.

Dimitri B. Papadimitriou is president of the Levy Economics Institute of Bard College and a professor of economics there. He is a former vice chairman of Congress’ Trade Deficit Review Commission

Pema Levy Interviews James K. Galbraith

The American Prospect, May 5, 2011. © 2011 by The American Prospect, Inc.

A deal is taking shape between Congress and the administration on the debt-ceiling vote, and it will likely include some spending cuts in exchange for increasing the amount the government can borrow.

As these negotiations play out, we’re constantly warned that the debt-ceiling fight has high stakes. Refusing to raise the ceiling will prevent us from paying debts and will destroy the faith our bondholders—that is, China—have in us. Or will it? The Prospect talked with James K. Galbraith, the Lloyd M. Bentsen Jr. Chair in Government/Business Relations at the University of Texas at Austin, about just how accurate the doomsday predictions really are.

Everyone says that if we don’t raise the debt ceiling soon, we’ll have a financial disaster on our hands. How accurate are these catastrophic predictions?

Failure to raise the debt limit would be, for sure, a bad idea. Whether it would produce a fiscal and bond market Armageddon, I think, is really doubtful.

This is a group of politicians saying, give me cuts or I will shoot the economy. So that’s the political problem that we face. And one way I think to handle that problem is to point out that what the hostage-takers have in their hands may well not be a nuclear grenade; it might be something much less cataclysmic.

A few weeks ago, the ratings agency Standard & Poor’s warned that the United States could lose its AAA rating on U.S. debt (securities, bonds, etc.), which could have serious repercussions for the economy. How do you gauge the chances of a downgrade?

One can’t judge what Standard & Poor’s or Moody’s will do, because they’ve gotten most everything else wrong in the last decade. These are firms that graded vast mounds of worthless mortgage-backed paper as AAA because of the crafty ways it was securitized. These are firms that never to my knowledge downgraded a major corporate fraud—Enron and so forth—more than a few days in advance of its collapse. And they routinely give cities lower ratings than they should based upon the default rates on those instruments. They have no particular competence in Europe, either. So, it’s a little bit unpredictable what a corporation with that track record is going to do.

Is there a danger we’ll default?

If you read the 14th Amendment, Section 4, it says that the [validity of the] debt of the United States authorized by law—including pensions, by the way, so including Social Security—shall not be questioned. So long as we are run by the Constitution, we’re going to pay the debt.

One fear is that not raising the ceiling will cause a global panic or at least a ripple effect if the U.S. fails to pay its foreign creditors. What will foreign creditors do if we default on our bonds?

Let’s suppose that the Treasury actually says to the People’s Bank of China, sorry, we can’t write a check to you right now. Well, in the case of the People’s Bank of China, the bond that they hold would become a defaulted bond, but it would still be there. And the Treasury would still recognize its obligation on that bond and would presumably be willing to pay accrued interest on it. The Treasury would probably say, it’s going to be a few days while we resolve this, and the People’s Bank of China would, in my view, probably do nothing.

If I were sitting in the position of a foreign holder of U.S. Treasury securities in that situation, the last thing I would want would be a panic. I would want this problem to go away.

And if there is a panic?

I think the right analogy to that would be the failure of Congress to pass the [Troubled Asset Relief Program] on the first round. The stock market went down by 800 points. That sent a very powerful political wake-up call, and suddenly people changed their positions. The most likely thing if we actually go to this stage where there is real turmoil would be that Congress—the hostage-takers—would drop their guns.

So the question I would have then is: Does it make sense to give the hostage-takers what they want? Which are massive cuts. And I think it does not make sense by any stretch of the imagination to agree that the debt ceiling shall be the point of leverage for coming to a decision, which is what the Republicans want and unfortunately what some Democrats like Kent Conrad want.

This would be an act of just gross negotiating folly to set the precedent that the debt-ceiling negotiations become the way in which the extremists get what they want.

This Q&A has been edited for length and clarity.

By general agreement, the federal budget is on an “unsustainable path.” Try typing the phrase into Google News: 19 of the first 20 hits refer to the federal debt. But what does this actually mean? One suspects that some who use the phrase are guided by vague fears, or even that they don’t quite know what to be afraid of. Some people fear that there may come a moment when the government’s bond markets would close, forcing a default or “bankruptcy.” But the government controls the legal-tender currency in which its bonds are issued and can always pay its bills with cash. A more plausible worry is inflation—notably, the threat of rising energy prices in an oil-short world—alongside depreciation of the dollar, either of which would reduce the real return on government bonds. But neither oil-price inflation nor dollar devaluation constitutes default, and neither would be intrinsically “unsustainable.”

After a brief discussion of the major worries, Senior Scholar James Galbraith focuses on one, and only one, critical issue: the actual behavior of the public-debt-to-GDP ratio under differing economic assumptions through time. His conclusion? The CBO’s assumption that the United States must offer a real interest rate on the public debt higher than the real growth rate by itself creates an unsustainability that is not otherwise there. Changing that one assumption completely alters the long-term dynamic of the public debt. By the terms of the CBO’s own model, a low interest rate erases the notion that the US debt-to-GDP ratio is on an “unsustainable path.” The prudent policy conclusion? Keep the projected interest rate down. Otherwise, stay cool: don’t change the expected primary deficit abruptly, and allow the economy to recover through time.

Functional Finance and Full Employment

Forty-five years ago, the A. Philip Randolph Institute issued “The Freedom Budget,” in which a program for economic transformation was proposed that included a job guarantee for everyone ready and willing to work, a guaranteed income for those unable to work or those who should not be working, and a living wage to lift the working poor out of poverty. Such policies were supported by a host of scholars, civic leaders, and institutions, including the Rev. Dr. Martin Luther King Jr.; indeed, they provided the cornerstones for King’s “Poor Peoples’ Campaign” and “economic bill of rights.”

This paper proposes a “New Freedom Budget” for full employment based on the principles of functional finance. To counter a major obstacle to such a policy program, the paper includes a “primer” on three paradigms for understanding government budget deficits and the national debt: the deficit hawk, deficit dove, and functional finance perspectives. Finally, some of the benefits of the job guarantee are outlined, including the ways in which the program may serve as a vehicle for a variety of social policies.

Four Fragile Markets, Four Years Later

In this brief, Research Scholar Greg Hannsgen and President Dimitri B. Papadimitriou focus on the risks and possibilities ahead for the US economy. Using a Keynesian approach and drawing from the commentary of other observers, they analyze publicly available data in order to assess the strength and durability of the expansion that probably began in 2009. They focus on four broad groups of markets that have shown signs of stress for the last several years: financial markets, markets for household goods and services, commodity markets, and labor markets. This kind of analysis does not yield numerical forecasts but it can provide important clues about the short-term outlook for the country’s economic well-being, and cast light on some longer-run threats. In particular, dangers and stresses in the financial and banking systems are presently very serious, and labor market data show every sign of a widespread and severe weakness in aggregate demand. Unless there is new resolve for effective government action on the jobs front, drastic cuts in much-needed federal, state, and local programs will become the order of the day in the United States, as in much of Europe.

Don’t Forget Finance

Given the economy’s complex behavior and sudden transitions as evidenced in the 2007–08 crisis, agent-based models are widely considered a promising alternative to current macroeconomic practice dominated by DSGE models. Their failure is commonly interpreted as a failure to incorporate heterogeneous interacting agents. This paper explains that complex behavior and sudden transitions also arise from the economy’s financial structure as reflected in its balance sheets, not just from heterogeneous interacting agents. It introduces “flow-of-funds” and “accounting” models, which were preeminent in successful anticipations of the recent crisis. In illustration, a simple balance-sheet model of the economy is developed to demonstrate that nonlinear behavior and sudden transition may arise from the economy’s balance-sheet structure, even without any microfoundations. The paper concludes by discussing one recent example of combining flow-of-funds and agent-based models. This appears a promising avenue for future research.

The US economy grew reasonably fast during the last quarter of 2010, and the general expectation is that satisfactory growth will continue in 2011–12. The expansion may, indeed, continue into 2013. But with large deficits in both the government and foreign sectors, satisfactory growth in the medium term cannot be achieved without a major, sustained increase in net export demand. This, of course, cannot happen without either a cut in the domestic absorption of US goods and services or a revaluation of the currencies of the major US trading partners.

Our policy message is fairly simple, and one that events over the years have tended to vindicate. Most observers have argued for reductions in government borrowing, but few have pointed out the potential instabilities that could arise from a growth strategy based largely on private borrowing—as the recent financial crisis has shown. With the economy operating at far less than full employment, we think Americans will ultimately have to grit their teeth for some hair-raising deficit figures, but they should take heart in recent data showing record-low “core” CPI inflation—and the potential for export-led growth to begin reducing unemployment.

Remedies for High Unemployment and Fears of Fiscal Crisis

In recent years, the US public debt has grown rapidly, with last fiscal year’s deficit reaching nearly $1.3 trillion. Meanwhile, many of the euro nations with large amounts of public debt have come close to bankruptcy and loss of capital market access. The same may soon be true of many US states and localities, with the governor of California, for example, publicly regretting that he has been forced to cut bone, and not just fat, from the state’s budget. Chartalist economists have long attributed the seemingly limitless borrowing ability of the US government to a particular kind of monetary system, one in which money is a “creature of the state” and the government can create as much currency and bank reserves as it needs to pay its bills (this is not to say that it lacks the power to impose taxes). In this paper, we examine this situation in light of recent discussions of possible limits to the federal government’s use of debt and the Federal Reserve’s “printing press.” We examine and compare the fiscal situations in the United States and the eurozone, and suggest that the US system works well, but that some changes must be made to macro policy if the United States and the world as a whole are to avoid another deep recession.

 

The stability of the international reserve currency’s purchasing power is less a question of what serves as that currency and more a question of the international adjustment mechanism, as well as the compatibility of export-led development strategies with international payment balances. Export-led growth and free capital flows are the real causes of sustained international imbalances. The only way out of this predicament is to shift to domestic demand–led development strategies—and capital flows will have to be part of the solution.

The Need for More Profound Reforms

There is no justification for the belief that cutting spending or raising taxes by any amount will reduce the federal deficit, let alone permit solid growth. The worst fears about recent stimulative policies and rapid money-supply growth are proving to be incorrect once again. We must find the will to reinvigorate government and to maintain Keynesian macro stimulus in the face of ideological opposition and widespread mistrust of government.

A common refrain heard from those trying to justify the results of the recent midterm elections is that the government’s fiscal stimulus to save the US economy from depression undermined growth, and that fiscal restraint is the key to economic expansion. Research Associate Marshall Auerback maintains that this refrain stems from a failure to understand a fundamental reality of bookkeeping—that when the government runs a surplus (deficit), the nongovernment sector runs a deficit (surplus). If the new GOP Congress led by Republicans and their Tea Party allies cuts government spending now, deficits will go higher, as growth slows, automatic stabilizers kick in, and tax revenues fall farther. And if extending the Bush tax cuts faces congressional gridlock, taxes will rise in 2011, further draining aggregate demand. Moreover, there are potential solvency issues for the United States if the debt ceiling is reached and Congress does not raise it. This chain of events potentially creates a new financial crisis and effectively forces the US government to default on its debt. The question is whether or not President Obama (and his economic advisers) will be enlightened enough to embrace this “teachable moment” about US main sector balances. Recent remarks to the press about deficit reduction suggest otherwise.

A Review of the Literature

This paper provides a survey of the literature on trade theory, from the classical example of comparative advantage to the New Trade theories currently used by many advanced countries to direct industrial policy and trade. An account is provided of the neo-classical brand of reciprocal demand and resource endowment theories, along with their usual empirical verifications and logical critiques. A useful supplement is provided in terms of Staffan Linder’s theory of “overlapping demand,” which provides an explanation of trade structure in terms of aggregate demand. Attention is drawn to new developments in trade theory, with strategic trade providing inputs to industrial policy. Issues relating to trade, growth, and development are dealt with separately, supplemented by an account of the neo-Marxist versions of trade and underdevelopment.

A Structural VAR Analysis

This paper investigates private net saving in the US economy—divided into its principal components, households and (nonfinancial) corporate financial balances—and its impact on the GDP cycle from the 1980s to the present. Furthermore, we investigate whether the financial markets (stock prices, BAA spread, and long-term interest rates) have a role in explaining the cyclical pattern of the two private financial balances. We analyze all these aspects estimating a VAR—between household and (nonfinancial) corporate financial balances (also known as the corporate financing gap), financial markets, and the economic cycle—and imposing restrictions on the matrix A to identify the structural shocks. We find that households and corporate balances react to financial markets as theoretically expected, and that the economic cycle reacts positively to corporate balance, in accordance with the Minskyan view of the operation of the economy that we have embraced.

The stability of the international reserve currency’s purchasing power is less a question of what serves as that currency and more a question of the international adjustment mechanism, as well as the compatibility of export-led development strategies with international payment balances. According to Senior Scholar Jan Kregel, export-led growth and free capital flows are the real causes of sustained international imbalances. The only way out of this predicament is to shift to domestic demand–led development strategies—and capital flows will have to be part of the solution.

In this new policy brief, President Dimitri B. Papadimitriou and Research Scholar Greg Hannsgen evaluate the current path of fiscal deficits in the United States in the context of government debt and further spending, economic recovery, and unemployment. They are adamant that there is no justification for the belief that cutting spending or raising taxes by any amount will reduce the federal deficit, let alone permit solid growth. The worst fears about recent stimulative policies and rapid money-supply growth are proving to be incorrect once again. In the authors’ view, we must find the will to reinvigorate government and to maintain Keynesian macro stimulus in the face of ideological opposition and widespread mistrust of government.

Budget Deficits Are Inevitable Result of Low Economic Growth and Lost Tax Revenues, and a Normal Part of Boom-Bust Cycle, Scholars Say

The global abatement of the inflationary climate of the past three decades, combined with continuing financial instability, helped to promote the worldwide holding of US dollar reserves as a cushion against financial instability outside the United States, with the result that, for the United States itself, this was a period of remarkable price stability and reasonably stable economic expansion.

For the most part, the economics profession viewed these events as a story of central bank credibility, fiscal probity, and accelerating technological change coupled with changing demands on the labor market, creating a model of self-stabilizing free markets and hands-off policy makers motivated by doing the right thing—what Senior Scholar James K. Galbraith calls “the grand illusion of the Great Moderation.” A dissenting line of criticism focused on the stagnation of real wages, the growth of deficits in trade and the current account, and the search for new markets. This view implied that a crisis would occur, but that it would result from a rejection of US financial hegemony and a crash of the dollar, with the euro and the European Union (EU) the ostensible beneficiaries.

A third line of argument was articulated by two figures with substantially different perspectives on the Keynesian tradition: Wynne Godley and Hyman P. Minsky. Galbraith discusses the approaches of these Levy distinguished scholars, including Godley’s correlation of government surpluses and private debt accumulation and Minsky’s financial stability hypothesis, as well as their influence on the responses of the larger economic community.

Galbraith himself argues the fundamental illusion of viewing the US economy through the free-market prism of deregulation, privatization, and a benevolent government operating mainly through monetary stabilization. The real sources of American economic power, he says, lie with those who manage and control the public-private sectors—especially the public institutions in those sectors—and who often have a political agenda in hand. Galbraith calls this the predator state: a state that is not intent upon restructuring the rules in any idealistic way but upon using the existing institutions as a device for political patronage on a grand scale. And it is closely aligned with deregulation.

In this new brief, President Dimitri B. Papadimitriou and Research Scholar Greg Hannsgen evaluate the current path of fiscal deficits in the United States in the context of government debt and further spending, economic recovery, and unemployment. They are adamant that there is no justification for the belief that cutting spending or raising taxes will reduce the federal deficit, let alone permit solid growth. The worst fears about recent stimulative policies and rapid money-supply growth are proving to be incorrect once again. In the authors’ view, we must find the will to reinvigorate government and to maintain Keynesian macro stimulus in the face of ideological opposition and widespread mistrust of government.

Facts on the Ground

The developed world faces a cyclical deficiency of aggregate demand, the product of a liquidity trap and the paradox of thrift, in the context of headwinds born of ongoing structural realignments. According to Paul McCulley, PIMCO, front-loaded fiscal austerity would only add to that deflationary cocktail. This is why the market vigilantes are fleeing risk assets, which depend on growth for valuation support, rather than the sovereign debt of fiat-currency countries. McCulley bases his outlook on the financial balances approach (double-entry bookkeeping) pioneered by the late Wynne Godley, who was a distinguished scholar at the Levy Institute. Godley’s analytical framework, says McCulley, should be the workhorse of discussions on global rebalancing.

After the Crisis: Planning a New Financial Structure

A conference organized by the Levy Economics Institute of Bard College with support from the .

On April 14–16, more than 200 policymakers, economists, and analysts from government, industry, and academia gathered at the NYC headquarters of the Ford Foundation for the Levy Institute’s annual Minsky conference on the state of the US and world economies. This year’s conference drew upon many Minskyan themes, including reconstituting the financial structure; the reregulation and supervision of financial institutions; the relevance of the Glass-Steagall Act; the roles of the Federal Reserve, FDIC, and the Treasury; the moral hazard of the “too big to fail” doctrine; debt deflation; and the economics of the “big bank” and “big government.” Speakers compared the European and Latin American responses to the global financial crisis and proposals for reforming the international financial architecture. Moreover, central bank exit strategies, both national and international, were considered.

Senior Scholar James K. Galbraith argues the fundamental illusion of viewing the US economy through the free-market prism of deregulation, privatization, and a benevolent government operating mainly through monetary stabilization—the prevailing view among economists over the past three decades. The real sources of American economic power, he says, lie with those who manage and control the public‑private sectors—especially the public institutions in those sectors—and who often have a political agenda in hand. Galbraith calls this the predator state: a government that is intent, not upon restructuring the rules in any idealistic way, but upon using the existing institutions as a device for political patronage on a grand scale. And it is closely aligned with financial deregulation.

A Critique of This Time Is Different, by Reinhart and Rogoff

The worst global downturn since the Great Depression has caused ballooning budget deficits in most nations, as tax revenues collapse and governments bail out financial institutions and attempt countercyclical fiscal policy. With notable exceptions, most economists accept the desirability of expansion of deficits over the short term but fear possible long-term effects. There are a number of theoretical arguments that lead to the conclusion that higher government debt ratios might depress growth. There are other arguments related to more immediate effects of debt on inflation and national solvency. Research conducted by Carmen Reinhart and Kenneth Rogoff is frequently cited to demonstrate the negative impacts of public debt on economic growth and financial stability. In this paper we critically examine their work. We distinguish between a nation that operates with its own floating exchange rate and nonconvertible (sovereign) currency, and a nation that does not. We argue that Reinhart and Rogoff’s results are not relevant to the case of the United States.

How to End America's Trade Deficits

Now that America’s financial institutions have been brought back from the brink, the greatest threat to global economic stability is the gigantic trade imbalance between the United States, China, and other trading partners. A second big threat to economic stability, in the longer run, is global warming. Both problems are related to America’s addiction to cheap imports and foreign oil—bad habits that a clever cap-and-trade system could help us kick at last.

Why We Should Stop Worrying About U.S. Government Deficits

This brief by Yeva Nersisyan and Senior Scholar L. Randall Wray argues that deficits do not burden future generations with debt, nor do they crowd out private spending. The authors base their conclusions on the premise that a sovereign nation with its own currency cannot become insolvent, and that government financing is unlike that of a household or firm. Moreover, they observe that automatic stabilizers, not government bailouts and the stimulus package, have prevented the US economic contraction from devolving into another Great Depression. The authors dispense with unsubstantiated concerns about deficits and debts, noting that they mask the real issue: the unwillingness of deficit hawks to allow government to work for the good of the people.

This paper sets out to investigate the forces and conditions that led to the emergence of global imbalances preceding the worldwide crisis of 2007–09, and both the likelihood and the potential sustainability of reemerging global imbalances as the world economy recovers from that crisis. The “Bretton Woods 2” hypothesis of sustainable global imbalances featuring a quasi-permanent US current account deficit overlooked that the domestic counterpart to the United States’ external deficit—soaring household indebtedness—was based not on safe debts but rather toxic ones. We critique the “global saving glut” hypothesis, and propose the “global dollar glut” hypothesis in its stead. With the US private sector in retrenchment mode, the question arises whether fiscal expansion might not only succeed in filling the gap in US domestic demand but also restart global arrangements along BW2 lines, albeit this time based on public debt—call it “Bretton Woods 3.” This paper explores the chances of a BW3 regime, highlighting the role of “dollar leveraging” in sustaining US trade deficits. Longer-term prospects for a postdollar standard are discussed in the light of John Maynard Keynes’s “bancor” plan.

This paper argues that modified versions of the so-called “New Cambridge” approach to macroeconomic modeling are both quite useful for modeling real capitalist economies in historical time and perfectly compatible with the “vision” underlying modern Post-Keynesian stock-flow consistent macroeconomic models. As such, New Cambridge–type models appear to us as an important contribution to the tool kit available to applied macroeconomists in general, and to heterodox applied macroeconomists in particular.

This paper investigates the spread of what started as a crisis at the core of the global financial system to emerging economies. While emerging economies had exhibited some resilience through the early stages of the financial turmoil that began in the summer of 2007, they have been hit hard since mid-2008. Their deteriorating fortunes are only partly attributable to the collapse in world trade and sharp drop in commodity prices. Things were made worse by emerging markets’ exposure to the turmoil in global finance itself. As “innocent bystanders,” even countries that had taken out “self-insurance” proved vulnerable to the global “sudden stop” in capital flows. We critique loanable funds theoretical interpretations of global imbalances and offer an alternative explanation that emphasizes the special status of the US dollar. Instead of taking out even more self-insurance, developing countries should pursue capital account management to enlarge their policy space and reduce external vulnerabilities.

Research Scholar Gennaro Zezza updates the Levy Institute’s previous Strategic Analysis (December 2009) and finds that the 2009 increase in public sector aggregate demand was a result of the fiscal stimulus, without which the recession would have been much deeper. He confirms that strong policy action is required to achieve full employment in the medium term, including a persistently high government deficit in the short term. This implies a growing public debt, which is sustainable as long as interest rates are kept at the current low level. The alternative is an ongoing unemployment rate above 10 percent that would represent a higher cost to future generations. 

By James K. Galbraith

By James K. Galbraith, Thought and Action, The NEA Higher Education Journal, Fall 2009.

This article is partly a response to Paul Krugman’s piece in the Sunday New York Times of September 6, 2009, on the failures of the economists in the face of the crisis. Here, Senior Scholar James K. Galbraith takes up the challenge of identifying some of those economists—the “nobodies” of the profession—who did see it coming, and who have not gotten the credit they deserve. He also points out the urgent need to expand the academic space and the public visibility of ongoing work that is of actual value when faced with the many deep problems of economic life in our time—an imperative for university administrators, for funding agencies, for foundations, and for students.

 

Though recent market activity and housing reports give some warrant for optimism, United States economic growth was only 2.8 percent in the third quarter, and the unemployment rate is still very high. In their new Strategic Analysis, the Levy Institute’s Macro-Modeling Team project that high unemployment will continue to be a problem if fiscal stimulus policies expire and deficit reduction efforts become the policy focus. The authors—President Dimitri B. Papadimitriou and Research Scholars Greg Hannsgen and Gennaro Zezza—argue that continued fiscal stimulus is necessary to reduce unemployment. The resulting federal deficits would be sustainable, they say, as long as they were accompanied by a coordinated and gradual devaluation of the dollar, especially against undervalued Asian currencies—a step necessary to prevent an increase in the current account deficit and ward off the risk of a currency crash.

What Are the Lessons of the New Deal?

As the nation watches the impact of the recent stimulus bill on job creation and economic growth, a group of academics continues to dispute the notion that the fiscal and job creation programs of the New Deal helped end the Depression. The work of these revisionist scholars has led to a public discourse that has obvious implications for the controversy surrounding fiscal stimulus bills. Since we support a new stimulus package—one that emphasizes jobs for the 9.8 percent of the workforce currently unemployed—we have been concerned about this debate. With Congress, the White House, pundits, and the press riveted on the all-important health care debate, we worry that they are also distracted by skirmishes over economic theory and history, while millions wait for a new chance to do meaningful work and effective, if imperfect, policy tools are readily at hand. (See also, Public Policy Brief No. 104.)

Did the New Deal Prolong or Worsen the Great Depression?

Since the current recession began in December 2007, New Deal legislation and its effectiveness have been at the center of a lively debate in Washington. This paper emphasizes some key facts about two kinds of policy that were important during the Great Depression and have since become the focus of criticism by new New Deal critics: (1) regulatory and labor relations legislation, and (2) government spending and taxation. We argue that initiatives in these policy areas probably did not slow economic growth or worsen the unemployment problem from 1933 to 1939, as claimed by a number of economists in academic papers, in the popular press, and elsewhere. To substantiate our case, we cite some important economic benefits of New Deal–era laws in the two controversial policy areas noted above. In fact, we suggest that the New Deal provided effective medicine for the Depression, though fiscal policy was not sufficiently countercyclical to conquer mass unemployment and prevent the recession of 1937–38; 1933’s National Industrial Recovery Act was badly flawed and poorly administered, and the help provided by the National Labor Relations Act of 1935 came too late to have a big effect on the recovery.

A wave of revisionist work claims that “anticompetitive” New Deal legislation such as the National Industrial Recovery Act (NIRA) and the National Labor Relations Act (NLRA) greatly slowed the recovery from the Depression; in this new public policy brief, President Dimitri B. Papadimitriou and Research Scholar Greg Hannsgen review these claims in light of current policy debates and cast into doubt the argument that NIRA and NLRA significantly prolonged or worsened the Depression. Moreover, Social Security, federal deposit insurance, and other New Deal programs helped usher in an era of relative prosperity following World War II. When it comes to combating the current recession and employment slump, it is the successful experience with relief and public works, and not the repercussions of pro-union and regulatory legislation, that offer the most relevant and helpful lessons.

By Stephen Mihm

Since the global financial system started unraveling in dramatic fashion two years ago, distinguished economists have suffered a crisis of their own. Ivy League professors who had trumpeted the dawn of a new era of stability have scrambled to explain how, exactly, the worst financial crisis since the Great Depression had ambushed their entire profession.

Amid the hand-wringing and the self-flagellation, a few more cerebral commentators started to speak about the arrival of a “Minsky moment,” and a growing number of insiders began to warn of a coming “Minsky meltdown.”

“Minsky” was shorthand for Hyman Minsky, a hitherto obscure macroeconomist who died over a decade ago. Many economists had never heard of him when the crisis struck, and he remains a shadowy figure in the profession. But lately he has begun emerging as perhaps the most prescient big-picture thinker about what, exactly, we are going through. A contrarian amid the conformity of postwar America, an expert in the then-unfashionable subfields of finance and crisis, Minsky was one economist who saw what was coming. He predicted, decades ago, almost exactly the kind of meltdown that recently hammered the global economy.

In recent months Minsky’s star has only risen. Nobel Prize–winning economists talk about incorporating his insights, and copies of his books are back in print and selling well. He’s gone from being a nearly forgotten figure to a key player in the debate over how to fix the financial system.

But if Minsky was as right as he seems to have been, the news is not exactly encouraging. He believed in capitalism, but also believed it had almost a genetic weakness. Modern finance, he argued, was far from the stabilizing force that mainstream economics portrayed; rather, it was a system that created the illusion of stability while simultaneously creating the conditions for an inevitable and dramatic collapse.

In other words, the one person who foresaw the crisis also believed that our whole financial system contains the seeds of its own destruction. “Instability,” he wrote, “is an inherent and inescapable flaw of capitalism.”

Minsky’s vision might have been dark, but he was not a fatalist; he believed it was possible to craft policies that could blunt the collateral damage caused by financial crises. But with a growing number of economists eager to declare the recession over, and the crisis itself apparently behind us, these policies may prove as discomforting as the theories that prompted them in the first place. Indeed, as economists re-embrace Minsky’s prophetic insights, it is far from clear that they’re ready to reckon with the full implications of what he saw.

In an ideal world, a profession dedicated to the study of capitalism would be as freewheeling and innovative as its ostensible subject. But economics has often been subject to powerful orthodoxies, and never more so than when Minsky arrived on the scene.

That orthodoxy, born in the years after World War II, was known as the neoclassical synthesis. The older belief in a self-regulating, self-stabilizing free market had selectively absorbed a few insights from John Maynard Keynes, the great economist of the 1930s who wrote extensively of the ways that capitalism might fail to maintain full employment. Most economists still believed that free-market capitalism was a fundamentally stable basis for an economy, though thanks to Keynes, some now acknowledged that government might under certain circumstances play a role in keeping the economy—and employment—on an even keel.

Economists like Paul Samuelson became the public face of the new establishment; he and others at a handful of top universities became deeply influential in Washington. In theory, Minsky could have been an academic star in this new establishment: like Samuelson, he earned his doctorate in economics at Harvard University, where he studied with legendary Austrian economist Joseph Schumpeter, as well as future Nobel laureate Wassily Leontief.

But Minsky was cut from different cloth than many of the other big names. The descendent of immigrants from Minsk, in modern-day Belarus, Minsky was a red-diaper baby, the son of Menshevik socialists. While most economists spent the 1950s and 1960s toiling over mathematical models, Minsky pursued research on poverty, hardly the hottest subfield of economics. With long, wild, white hair, Minsky was closer to the counterculture than to mainstream economics. He was, recalls the economist L. Randall Wray, a former student, a “character.”

So while his colleagues from graduate school went on to win Nobel prizes and rise to the top of academia, Minsky languished. He drifted from Brown to Berkeley and eventually to Washington University. Indeed, many economists weren’t even aware of his work. One assessment of Minsky published in 1997 simply noted that his “work has not had a major influence in the macroeconomic discussions of the last thirty years.”

Yet he was busy. In addition to poverty, Minsky began to delve into the field of finance, which despite its seeming importance had no place in the theories formulated by Samuelson and others. He also began to ask a simple, if disturbing question: “Can �it’ happen again?”—where “it” was, like Harry Potter's nemesis Voldemort, the thing that could not be named: the Great Depression.

In his writings, Minsky looked to his intellectual hero, Keynes, arguably the greatest economist of the 20th century. But where most economists drew a single, simplistic lesson from Keynes—that government could step in and micromanage the economy, smooth out the business cycle, and keep things on an even keel—Minsky had no interest in what he and a handful of other dissident economists came to call “bastard Keynesianism.”

Instead, Minsky drew his own, far darker, lessons from Keynes’s landmark writings, which dealt not only with the problem of unemployment, but with money and banking. Although Keynes had never stated this explicitly, Minsky argued that Keynes’s collective work amounted to a powerful argument that capitalism was by its very nature unstable and prone to collapse. Far from trending toward some magical state of equilibrium, capitalism would inevitably do the opposite. It would lurch over a cliff.

This insight bore the stamp of his advisor Joseph Schumpeter, the noted Austrian economist now famous for documenting capitalism's ceaseless process of “creative destruction.” But Minsky spent more time thinking about destruction than creation. In doing so, he formulated an intriguing theory: not only was capitalism prone to collapse, he argued, it was precisely its periods of economic stability that would set the stage for monumental crises.

Minsky called his idea the “Financial Instability Hypothesis.” In the wake of a depression, he noted, financial institutions are extraordinarily conservative, as are businesses. With the borrowers and the lenders who fuel the economy all steering clear of high-risk deals, things go smoothly: loans are almost always paid on time, businesses generally succeed, and everyone does well. That success, however, inevitably encourages borrowers and lenders to take on more risk in the reasonable hope of making more money. As Minsky observed, “Success breeds a disregard of the possibility of failure.”

As people forget that failure is a possibility, a “euphoric economy” eventually develops, fueled by the rise of far riskier borrowers—what he called speculative borrowers, those whose income would cover interest payments but not the principal; and those he called “Ponzi borrowers,” those whose income could cover neither, and could only pay their bills by borrowing still further. As these latter categories grew, the overall economy would shift from a conservative but profitable environment to a much more freewheeling system dominated by players whose survival depended not on sound business plans, but on borrowed money and freely available credit.

Once that kind of economy had developed, any panic could wreck the market. The failure of a single firm, for example, or the revelation of a staggering fraud could trigger fear and a sudden, economy-wide attempt to shed debt. This watershed moment—what was later dubbed the “Minsky moment”—would create an environment deeply inhospitable to all borrowers. The speculators and Ponzi borrowers would collapse first, as they lost access to the credit they needed to survive. Even the more stable players might find themselves unable to pay their debt without selling off assets; their forced sales would send asset prices spiraling downward, and inevitably, the entire rickety financial edifice would start to collapse. Businesses would falter, and the crisis would spill over to the “real” economy that depended on the now-collapsing financial system.

From the 1960s onward, Minsky elaborated on this hypothesis. At the time he believed that this shift was already underway: postwar stability, financial innovation, and the receding memory of the Great Depression were gradually setting the stage for a crisis of epic proportions. Most of what he had to say fell on deaf ears. The 1960s were an era of solid growth, and although the economic stagnation of the 1970s was a blow to mainstream neo-Keynesian economics, it did not send policymakers scurrying to Minsky. Instead, a new free market fundamentalism took root: government was the problem, not the solution.

Moreover, the new dogma coincided with a remarkable era of stability. The period from the late 1980s onward has been dubbed the “Great Moderation,” a time of shallow recessions and great resilience among most major industrial economies. Things had never been more stable. The likelihood that “it” could happen again now seemed laughable.

Yet throughout this period, the financial system—not the economy, but finance as an industry—was growing by leaps and bounds. Minsky spent the last years of his life, in the early 1990s, warning of the dangers of securitization and other forms of financial innovation, but few economists listened. Nor did they pay attention to consumers’ and companies’ growing dependence on debt, and the growing use of leverage within the financial system.

By the end of the 20th century, the financial system that Minsky had warned about had materialized, complete with speculative borrowers, Ponzi borrowers, and precious few of the conservative borrowers who were the bedrock of a truly stable economy. Over decades, we really had forgotten the meaning of risk. When storied financial firms started to fall, sending shockwaves through the ”real” economy, his predictions started to look a lot like a road map.

“This wasn’t a Minsky moment,'' explains Randall Wray. “It was a Minsky half-century.”

Minsky is now all the rage. A year ago, an influential Financial Times columnist confided to readers that rereading Minsky's 1986 “masterpiece”—“Stabilizing an Unstable Economy”—“helped clear my mind on this crisis.” Others joined the chorus. Earlier this year, two economic heavyweights—Paul Krugman and Brad DeLong—both tipped their hats to him in public forums. Indeed, the Nobel Prize–winning Krugman titled one of the Robbins lectures at the London School of Economics “The Night They Re-read Minsky.”

Today most economists, it’s safe to say, are probably reading Minsky for the first time, trying to fit his unconventional insights into the theoretical scaffolding of their profession. If Minsky were alive today, he would no doubt applaud this belated acknowledgment, even if it has come at a terrible cost. As he once wryly observed, “There is nothing wrong with macroeconomics that another depression [won't] cure.”

But does Minsky’s work offer us any practical help? If capitalism is inherently self-destructive and unstable—never mind that it produces inequality and unemployment, as Keynes had observed—now what?

After spending his life warning of the perils of the complacency that comes with stability—and having it fall on deaf ears—Minsky was understandably pessimistic about the ability to short-circuit the tragic cycle of boom and bust. But he did believe that much could be done to ameliorate the damage.

To prevent the Minsky moment from becoming a national calamity, part of his solution (which was shared with other economists) was to have the Federal Reserve—what he liked to call the “Big Bank”—step into the breach and act as a lender of last resort to firms under siege. By throwing lines of liquidity to foundering firms, the Federal Reserve could break the cycle and stabilize the financial system. It failed to do so during the Great Depression, when it stood by and let a banking crisis spiral out of control. This time, under the leadership of Ben Bernanke—like Minsky, a scholar of the Depression—it took a very different approach, becoming a lender of last resort to everything from hedge funds to investment banks to money market funds.

Minsky’s other solution, however, was considerably more radical and less palatable politically. The preferred mainstream tactic for pulling the economy out of a crisis was—and is—based on the Keynesian notion of “priming the pump” by sending money that will employ lots of high-skilled, unionized labor—by building a new high-speed train line, for example.

Minsky, however, argued for a “bubble-up” approach, sending money to the poor and unskilled first. The government—or what he liked to call “Big Government”—should become the “employer of last resort,” he said, offering a job to anyone who wanted one at a set minimum wage. It would be paid to workers who would supply child care, clean streets, and provide services that would give taxpayers a visible return on their dollars. In being available to everyone, it would be even more ambitious than the New Deal, sharply reducing the welfare rolls by guaranteeing a job for anyone who was able to work. Such a program would not only help the poor and unskilled, he believed, but would put a floor beneath everyone else's wages too, preventing salaries of more skilled workers from falling too precipitously, and sending benefits up the socioeconomic ladder.

While economists may be acknowledging some of Minsky’s points on financial instability, it's safe to say that even liberal policymakers are still a long way from thinking about such an expanded role for the American government. If nothing else, an expensive full-employment program would veer far too close to socialism for the comfort of politicians. For his part, Wray thinks that the critics are apt to misunderstand Minsky. “He saw these ideas as perfectly consistent with capitalism,” says Wray. “They would make capitalism better.”

But not perfect. Indeed, if there's anything to be drawn from Minsky’s collected work, it's that perfection, like stability and equilibrium, are mirages. Minsky did not share his profession's quaint belief that everything could be reduced to a tidy model, or a pat theory. His was a kind of existential economics: capitalism, like life itself, is difficult, even tragic. “There is no simple answer to the problems of our capitalism,” wrote Minsky. “There is no solution that can be transformed into a catchy phrase and carried on banners.”

It's a sentiment that may limit the extent to which Minsky becomes part of any new orthodoxy. But that’s probably how he would have preferred it, believes liberal economist James Galbraith. “I think he would resist being domesticated,” says Galbraith. “He spent his career in professional isolation.”

Stephen Mihm is a history professor at the University of Georgia and author of “A Nation of Counterfeiters” (Harvard, 2007).

By Dirk Bezemer

September 7, 2009. Copyright 2009 The Financial Times Limited.

From the beginning of the credit crisis and ensuing recession, it has become conventional wisdom that “no one saw this coming.” Anatole Kaletsky wrote in The Times of “those who failed to foresee the gravity of this crisis”—a group that included “almost every leading economist and financier in the world.” Glenn Stevens, governor of the Reserve Bank of Australia, said: “I do not know anyone who predicted this course of events. But it has occurred, it has implications, and so we must reflect on it.” We must indeed.

Because, in fact, many had seen it coming for years. They were ignored by an establishment that, as the former Federal Reserve chairman Alan Greenspan professed in his October 2008 testimony to Congress, watched with “shocked disbelief” as its “whole intellectual edifice collapsed in the summer [of 2007].” Official models missed the crisis not because the conditions were so unusual, as we are often told. They missed it by design. It is impossible to warn against a debt deflation recession in a model world where debt does not exist. This is the world our policymakers have been living in. They urgently need to change habitat.

I undertook a study of the models used by those who did see it coming.* They include Kurt Richebächer, an investment newsletter writer, who wrote in 2001 that “the new housing bubble—together with the bond and stock bubbles—will [inevitably] implode in the foreseeable future, plunging the US economy into a protracted, deep recession”; and in 2006, when the housing market turned, that “all remaining questions pertain solely to [the] speed, depth and duration of the economy’s downturn.” Wynne Godley of the Levy Economics Institute wrote in 2006 that “the small slowdown in the rate at which US household debt levels are rising resulting from the house price decline, will immediately lead to a sustained growth recession before 2010.” Michael Hudson of the University of Missouri wrote in 2006 that “debt deflation will shrink the ‘real’ economy, drive down real wages, and push our debt-ridden economy into Japan-style stagnation or worse.” Importantly, these and other analysts not only foresaw and timed the end of the credit boom, but also perceived this would inevitably produce recession in the US. How did they do it?

Central to the contrarians’ thinking is an accounting of financial flows (of credit, interest, profit and wages) and stocks (debt and wealth) in the economy, as well as a sharp distinction between the real economy and the financial sector (including property). In these “flow-of-funds” models, liquidity generated in the financial sector flows to companies, households and the government as they borrow. This may facilitate fixed-capital investment, production and consumption, but also asset-price inflation and debt growth. Liquidity returns to the financial sector as investment or in debt service and fees.

It follows that there is a trade-off in the use of credit, so that financial investment may crowd out the financing of production. A second key insight is that, since the economy’s assets and liabilities must balance, growing financial asset markets find their counterpart in a growing debt burden. They also swell payment flows of debt service and financial fees. Flow-of-funds models quantify the sustainability of the debt burden and the financial sector’s drain on the real economy. This allows their users to foresee when finance’s relation to the real economy turns from supportive to extractive, and when a breaking point will be reached.

Such calculations are conspicuous by their absence in official forecasters’ models in the US, the UK and the Organisation for Economic Co-operation and Development. In line with mainstream economic theory, balance sheet variables are assumed to adapt automatically to changes in the real economy, and can thus be safely omitted. This practice ignores the fact that in most advanced economies, financial sector turnover is many times larger than total gross domestic product; or that growth in the US and UK has been finance-driven since the turn of the millennium.

Perhaps because of this omission, the OECD commented in August 2007 that “the current economic situation is in many ways better than what we have experienced in years. . . . Our central forecast remains indeed quite benign: a soft landing in the United States [and] a strong and sustained recovery in Europe.” Official US forecasters could tell Reuters as late as September 2007 that the recession in the US was “not a dominant risk.” This was well after the Levy Economics Institute, for example, predicted in April of that year that output growth would slow “almost to zero sometime between now and 2008.”

Policymakers have resisted inclusion of balance sheets and the flow of funds in their models by arguing that bubbles cannot be easily identified, nor their effects reliably anticipated. The above analysts have shown that this is, in fact, feasible, and indeed essential if we are to “see it coming” next time. The financial sector is just as real as the real economy. Our policymakers, and the analysts they rely on, ignore balance sheets and the flow of funds at their peril—and ours.

*“No One Saw This Coming”: Understanding Financial Crisis Through Accounting Models, MPRA

The writer is a fellow at the economics and business department of the University of Groningen in the Netherlands.

Did Roosevelt’s “Anticompetitive” Legislation Slow the Recovery from the Great Depression?

A wave of revisionist work claims that “anticompetitive” New Deal legislation such as the National Industrial Recovery Act (NIRA) and the National Labor Relations Act (NLRA) greatly slowed the recovery from the Depression; in this new public policy brief, President Dimitri B. Papadimitriou and Research Scholar Greg Hannsgen review these claims in light of current policy debates and cast into doubt the argument that NIRA and NLRA significantly prolonged or worsened the Depression. Moreover, Social Security, federal deposit insurance, and other New Deal programs helped usher in an era of relative prosperity following World War II. When it comes to combating the current recession and employment slump, it is the successful experience with relief and public works, and not the repercussions of pro-union and regulatory legislation, that offer the most relevant and helpful lessons.

This paper presents the main features of the macroeconomic model being used at The Levy Economics Institute of Bard College, which has proven to be a useful tool in tracking the current financial and economic crisis. We investigate the connections of the model to the “New Cambridge” approach, and discuss other recent approaches to the evolution of financial balances for all sectors of the economy. We will finally show the effects of fiscal policy in the model, and its implications for the proposed fiscal stimulus on the US economy. We show that the New Cambridge hypothesis, which claimed that the private sector financial balance would be stable relative to income in the short run, does not hold for the short term in our model, but it does hold for the medium/long term. This implies that the major impact of the fiscal stimulus in the long run will be on the external imbalance, unless other measures are taken.

An SFC Look at Financialization and Profit-led Growth

Many heterodox strands of thought share both a concern with the study of different phases or growth regimes in the history of capitalism and the use of formal short-run models as an analytical tool. The authors of this new working paper suggest (1) that this strategy is potentially misleading, and (2) that the stock-flow consistent (SFC) approach, while providing a general framework that may facilitate dialogue among those currents, is particularly well suited to all those who think that macroeconomic models may illuminate historical quests.

To save America—indeed, the global economy as a whole—the private/public sector balance has to shift, and the neoliberal economic model on which the country has been based for the past 25 years has to be modified. In this new working paper, Marshall Auerback details why the role of the state needs to be reemphasized.

The abandonment of a mixed economy and corresponding diminution of the role of government was hailed as the “rebirth of individualism,” yet it caused rising inequality and the decline of median wages, and led to the widespread neglect of public goods vital to its citizens’ welfare. Meanwhile, the country ran through the public investment it had made from the 1930s to the 1970s, with few serious challenges from policymakers or mainstream economists.

The neoliberal model was also aggressively exported: the “optimal” growth strategy for all emerging economies was supposedly one that emphasized limited government, corporate governance, rule of law, and higher levels of state-owned and -influenced enterprise—in spite of significant historical evidence to the contrary. Not even the economic wreckage in Mexico, Argentina, Thailand, Indonesia, and Russia seemed sufficient to challenge, let alone overturn, the prevailing paradigm.

That is, until now: in reaction to the financial crisis, many governments—led by the United States—are enacting massive economic stimulus packages and taking a central role in promoting economic growth strategies. This reemergence of state-driven capitalism constitutes a “back to the future” investment paradigm, one that is consistent with a long and successful pattern of economic development. But once we get beyond the pothole patching and school repairing, what industries can be pushed forward using public seed capital or through Sematech-like consortiums? What must be brought to the fore is the need for a new growth path for the United States, one in which the state has a significant role.  There are already indications that the private sector is beginning to adapt to this new, collaborative paradigm.

Meeting the Challenges of Financial Crisis

A conference organized by The Levy Economics Institute of Bard College with support from the Ford Foundation.

On April 16 and 17, more than 150 policymakers, economists, and analysts from government, industry, and academia gathered at the NYC headquarters of the Ford Foundation for the Levy Institute’s annual Minsky conference on the state of the US and world economies. This year’s conference focused on the extraordinary challenges posed by the current global financial crisis. Topics included current conditions and forecasts, macro policy proposals by the Obama administration and others, the rehabilitation of mortgage financing and the banks, financial market reregulation, proposals to limit foreclosures and modify servicing agreements, regulation of alternative financial products (derivatives and credit default swaps), the institutional shape of the future financial system, and international responses to the crisis.

Federal government and Federal Reserve (Fed) liabilities rose sharply in 2008. Who holds these new liabilities, and what effects will they have on the economy? Some economists and politicians warn of impending inflation. In this new Strategic Analysis, the Levy Institute’s Macro-Modeling Team focuses on one positive effect—a badly needed improvement of private sector balance sheets—and suggest some of the reasons why it is unlikely that the surge in Fed and federal government liabilities will cause excessive inflation.

In 1930, John Maynard Keynes wrote: “The world has been slow to realise that we are living this year in the shadow of one of the greatest economic catastrophes of modern history.” The same holds true today: we are in the shadow of a global catastrophe, and we need to come to grips with the crisis—fast. According to Senior Scholar James K. Galbraith, two ingrained habits are leading to our failure to do so. The first is the assumption that economies will eventually return to normal on their own—an overly hopeful view that doesn’t take into account the massive pay-down of household debt resulting from the collapse of the banks. The second bad habit is the belief that recovery runs through the banks rather than around them. But credit cannot flow when there are no creditworthy borrowers or profitable projects; banks have failed, and the failure to recognize this is a recipe for wild speculation and control fraud, compounding taxpayer losses.

Galbraith outlines a number of measures that are needed now, including realistic economic forecasts, more honest bank auditing, effective financial regulation, measures to forestall evictions and keep people in their homes, and increased public retirement benefits. We are not in a temporary economic lull, an ordinary recession, from which we will emerge to return to business as usual, says Galbraith. Rather, we are at the beginning of a long, painful, profound, and irreversible process of change—we need to start thinking and acting accordingly.

New Strategic Analysis Argues that Coordinated Effort to Address Imbalances in International Trade Is Necessary to Restore Sustained Growth and Full Employment

The Federal Reserve’s latest flow-of-funds data reveal that household borrowing has fallen sharply lower, bringing about a reversal of the upward trend in household debt. According to the Levy Institute’s macro model, a fall in borrowing has an immediate effect—accounting in this case for most of the 3 percent drop in private expenditure that occurred in the third quarter of 2008—as well as delayed effects; as a result, the decline in real GDP and accompanying rise in unemployment may be substantial in coming quarters.

For further details on the Macro-Modeling Team’s latest projections, see the December 2008 Strategic Analysis Prospects for the US and the World: A Crisis That Conventional Remedies Cannot Resolve.

The economic recovery plans currently under consideration by the United States and many other countries seem to be concentrated on the possibility of using expansionary fiscal and monetary policies alone. In a new Strategic Analysis, the Levy Institute’s Macro-Modeling Team argues that, however well coordinated, this approach will not be sufficient; what’s required, they say, is a worldwide recovery of output, combined with sustainable balances in international trade.

Money Manager Capitalism and the Financialization of Commodities

In a new public policy brief, Senior Scholar L. Randall Wray shows how money manager capitalism—characterized by highly leveraged funds seeking maximum returns in an environment that systematically underprices risk—has destabilized one asset class after another, with commodities being simply the latest. Policymakers must fundamentally change the structure of our economic system and reduce the influence of managed money, Wray argues, in order to break the speculative boom-and-bust cycle.

A bursting asset bubble inevitably requires central bank action, usually when it is already too late and with adverse spillover effects. In this sense, the Federal Reserve and other central banks already target asset prices; yet, by taking aim at them only on the way down—as in the current housing and credit crisis—the "Big Banks" create a self-perpetuating cycle of perverse incentives and moral hazard that often gives rise to yet another round of bubbles.

The US central bank's current premise is that policymakers cannot and should not target asset bubbles. However, the housing story has rendered untenable the prevailing belief that bubbles are impossible to spot ahead of time. The warning signals were ubiquitous—for example, price charts showing home values rising impossibly into the stratosphere, and Wall Street's increasing reliance on housing-backed bonds for its record-setting profits. It has become abundantly clear that there was plenty the Fed could have done to discourage speculative behavior and put a stop to predatory lending.

Recent US experience has bolstered the view that asset prices must come under the central bank's purview in order for the economy to retain some semblance of stability. Former Fed Chairman Paul Volcker recently called for a broader regulatory role for the central bank in light of the housing-centered credit crisis. Indeed, Treasury Secretary Henry Paulson's latest plan for tackling the crisis involves giving the Fed vast new authority to regulate investment banks, not just depository institutions. However, news analyst Pedro Nicolaci da Costa argues that attitude changes among regulators will be even more important than shifts in mandate in ensuring that regulators like the Fed do their jobs properly.

Policy Lessons from America’s Historic Housing Crash

Treasury Secretary Henry Paulson’s latest plan for tackling the housing-centered credit crisis involves giving the Federal Reserve vast new authority to regulate investment banks, not just depository institutions. However, news analyst Pedro Nicolaci da Costa argues that attitude changes among regulators will be even more important than shifts in mandate in ensuring that regulators like the Fed do their jobs properly.

This paper considers a plan proposed by Warren Buffett, whereby importers would be required to obtain certificates proportional to the amount of non-oil goods (and possibly also services) they brought into the country. These certificates would be granted to firms that exported goods, which could then sell certificates to importing firms on an organized market. Starting from a relatively neutral projection of all major variables for the US economy, the authors estimate that the plan would raise the price of imports by approximately 9 percent, quickly reducing the current account deficit to about 2 percent of GDP. They discuss several problems that might arise with the implementation of the Buffett plan, including possible instability in the price of certificates and retaliation by US trade partners. They also consider an alternative version of the plan, in which certificates would be sold at a government auction, rather than granted to exporters. The revenues from certificate sales would then be used to finance a reduction in FICA payroll taxes. The authors report the results of simulations of the alternative plan’s effects on macroeconomic balances and GDP growth. Notably, the alternative plan would lessen the severity of the growth recession expected in our base projection.

Peering Over the Edge of the Short Period

This paper argues that institutionally rich stock-flow consistent models—that is, models in which economic agents are identified with the main social categories/institutional sectors of actual capitalist economies, the short period behavior of these agents is thoroughly described, and the “period by period” balance sheet dynamics implied by the latter is consistently modeled—are (1) perfectly compatible with John Maynard Keynes’s theoretical views, (2) the ideal tool for rigorous post-Keynesian analyses of the medium run, and (3) therefore crucial to the consolidation of the broad post-Keynesian research program.

Credit, Markets, and the Real Economy: Is the Financial System Working?

The focus of this year's conference was the current economic and financial crisis in the United States and its effects on the world economy. Topics included the causes and consequences of the "Minsky moment"; the impact of the credit crunch on the economic and financial market outlook; dislocations and policy options; margins of safety, systemic risk, and the American subprime mortgage market; financial markets regulation-reregulation; the inefficiency of computer-driven markets; currency market fluctuations; and exchange rate misalignment.

The conference was held April 17–18, 2008, at the Levy Institute's research and conference center at Blithewood, on the campus of Bard College, Annandale-on-Hudson, New York.

Credit, Markets, and the Real Economy: Is the Financial System Working?

In April 2008, top policymakers, economists, and analysts from government, industry, and academia gathered at the Levy Institute’s research and conference facility in Annandale-on-Hudson, New York, to present their insights about the American economy and the financial sector in the context of Minsky’s economic theories. Participants discussed Minsky’s financial instability hypothesis and the ability of monetary policy to stabilize financial markets and the economy, as well as the role of the Federal Reserve and its ability to function as a systemic lender of last resort. Speakers frequently compared events in the 1930s (the New Deal era) to the present, and they considered the prospect of another debt deflation rivaling the Great Depression. They also examined today’s complex and fragile financial system (e.g., the advent of securitization) and potential solutions to the mortgage crisis. Other related topics included the timing, cause, and length of recession; the nature and effectiveness of proposed economic stimulus packages; regulatory failures and the reformulation of policy; and the deleveraging process and potential financial losses.

This paper seeks to explain the causes and consequences of the United States subprime mortgage crisis, and how this crisis has led to a generalized credit crunch in other financial sectors that ultimately affects the real economy. It postulates that, despite the recent financial innovations, the financial strategies—leveraging and financial risk mismatching—that led to the present crisis are similar to those found in the United States savings-and-loan debacle of the late 1980s and in the Asian financial crisis of the late 1990s. However, these strategies are based on market innovations that have heightened, not reduced, systemic risks and financial instability. They are as the title implies: old wine in a new bottle. Going beyond these financial practices, the underlying structural causes of the crisis are located in the loose monetary policies of central banks, deregulation, and excess liquidity in financial markets that is a consequence of the kind of economic growth that produces various imbalances—trade imbalances, financial sector imbalances, and wealth and income inequality. The consequences of excessive risk, moral hazards, and rolling bubbles are discussed.

New Study Argues Government Expenditure More Effective Than Tax Rebates

This paper traces the evolution of housing finance in the United States from the deregulation of the financial system in the 1970s to the breakdown of the savings and loan industry and the development of GSE (government-sponsored enterprise) securitization and the private financial system. The paper provides a background to the forces that have produced the present system of residential housing finance, the reasons for the current crisis in mortgage financing, and the impact of the crisis on the overall financial system.

As the government prepares to dispense the tax rebates that largely make up its recently approved $168 billion stimulus package, President Dimitri B. Papadimitriou and Research Scholars Greg Hannsgen and Gennaro Zezza explore the possibility of an additional fiscal stimulus of about $450 billion spread over three quarters—challenging the notion that a larger and more prolonged additional stimulus is unnecessary and will generate inflationary pressures. They find that, given current projections of even a moderate recession, a fiscal stimulus totaling $600 billion would not be too much. They also find that a temporary stimulus—even one lasting four quarters—will have only a temporary effect. An enduring recovery will depend on a prolonged increase in exports, the authors say, due to the weak dollar, a modest increase in imports, and the closing of the current account gap.

According to Senior Scholar L. Randall Wray, the current crisis in financial markets can be traced back to securitization (the “originate and distribute” model), leverage, the demise of relationship-based banking, and a dizzying array of extremely complex instruments that—quite literally—only a handful understand.

What Can We Learn from Minsky?

In this new Public Policy Brief, Senior Scholar L. Randall Wray explains today’s complex and fragile financial system, and how the seeds of crisis were sown by lax oversight, deregulation, and risky innovations such as securitization. He estimates that the combined losses throughout the entire financial sector could amount to several trillion dollars, and that the United States will feel the effects of the crisis for some time—perhaps a decade or more.

 

Wray recommends enhanced oversight of financial institutions, much larger stimulus packages, and creation of a new institution in line with President Franklin D. Roosevelt’s Home Owners’ Loan Corporation.

 

In their latest Strategic Analysis, Distinguished Scholar Wynne Godley, President Dimitri B. Papadimitriou, and Research Scholars Greg Hannsgen and Gennaro Zezza review recent events in the housing and financial markets to obtain a likely scenario for the evolution of household spending in the United States. They forecast a significant drop in borrowing and private expenditure in the coming quarters, with severe consequences for growth and unemployment, unless (1) the US dollar is allowed to continue its fall and thus complete the recovery in the US external imbalance, and (2) fiscal policy shifts its course—as it did in the 2001 recession.

Suggestions for a New Agenda

The failure of the Doha Development Round of World Trade Organization (WTO) negotiations in July 2006 was the first major collapse of a multilateral trade round since World War II. Research Associate Thomas Palley sees the failure as an event that could mark the close of a 60-year era of trade policy largely centered on increasing market access and reducing tariffs, quotas, and subsidies. Doha’s demise represents an opportunity to challenge the intellectual dominance of the current WTO paradigm, to expose the failings of the neoliberal model of economic development, and to reposition the global trade debate.

By Wolfgang Münchau

FT.com, September 3, 2007. Copyright 2007 The Financial Times Limited. “FT” and “Financial Times” are trademarks of the Financial Times

“Financial operations do not lend themselves to innovation. What is recurrently so described and celebrated is, without exception, a small variation on an established design. . . . The world of finance hails the invention of the wheel over and over again, often in a slightly more unstable version.” —John Kenneth Galbraith, A Short History of Financial Euphoria

The late John Kenneth Galbraith would have enjoyed this summer. He was no expert on modern credit markets but his analysis of historic bubbles fits our most recent boom and bust episode with uncanny precision.

All historic bubbles were accompanied by a sharp rise in leverage. A salient feature of modern bubbles is the emergence of innovative financial products. No matter whether we are talking about junk bonds or modern collateralised debt obligations (CDOs), as Galbraith has pointed out, such products boil down to variants of debt secured on a real asset.

By historic standards, our credit bubble is probably one of the largest ever, given the sheer size of the market itself and the degree of euphoria that was characteristic in the final stages of the boom. While the fallout was initially concentrated in the financial sector itself, it would be surprising if the ongoing problems did not trickle down into the real economy. The availability of credit affects house prices and numerous studies have demonstrated the interlinkages between US house prices and US economic growth.

So what should central banks do? I suspect that central banks are not going to be the main actors in any rescue operation, but rather governments. Central banks' room for manoeuvre to cut interest rates is more constrained this time than during the most recent recession. But more important, this is not the kind of crisis that can easily be stopped by a few hasty rate cuts or bank bail-outs. If your subprime mortgage exceeds the value of your house by 10 per cent, and if the monthly payments exceed your income, no positive interest rate could bail you out. Your only hope is some serious debt relief.

The economists Dimitri Papadimitriou, Greg Hannsgen and Gennaro Zezza last week published a study* in which they demonstrated the danger to US economic growth posed by the present real estate crisis. Their policy recommendations go significantly beyond the usual bail-out calls. They argue that it is almost impossible for policymakers to stop the decline in real estate prices, but “if the Fed and Congress can work to stop any incipient recession, they will prevent job losses, which are one of the main contributors to foreclosures. An effective job-creation method could be some form of employer-of-last-resort programme that offers government jobs to all workers who ask for them”.

We should remember that the subprime market is not the only unstable subsection of the credit market. Once US consumption slows, we should prepare for a crisis in credit card and car finance CDOs. And once corporate bankruptcies start to rise again as the cycle turns down, both in the US and in Europe, we will probably hear about problems with collateralised loan obligations. The credit market is very deep and offers significant potential for contagion.

In this sense, the debate about whether this is a liquidity or a solvency crisis is beside the point. Banks may look at their CDO investments as a source of temporary illiquidity, but may sooner or later realise that they are sitting on a pile of junk. The fiscal and monetary authorities should therefore assume that they are confronted with a solvency crisis. Bailing out the odd bank, as the Germans did last month, is not going to be sufficient and perhaps not even necessary.

Instead, the monetary and fiscal authorities should stand ready to support the economy if and when needed. Lower interest rates will probably be part of any such deal, but a large part of the help will invariably come from fiscal policy. The US Federal Reserve will probably cut interest rates soon and the European Central Bank will almost certainly postpone the rate rise it unwisely preannounced only a few weeks ago. I am convinced the next interest rate movement both in the US and the eurozone will be downwards.

One of the problems the monetary authorities have to deal with is moral hazard. This is not a theoretical issue, as some suggest, but a far more immediate concern. Moral hazard is the result of asymmetric expectations, as markets expect the central bank to bail out the financial sector during a time of crisis. The problem of moral hazard is to some extent related to the monetary policy strategy of central banks, with their mechanistic focus on a single consumer price index. Such strategies often have no space for asset prices, but markets know fully well that central banks must invariably take account of asset prices during sharp downturns. One way out of this asymmetry is for central banks to include asset prices into their policy frameworks in some form or other.

This said, a bail-out of the financial system will probably become unavoidable, but it should be accompanied with structural policy changes. Tighter financial regulation is probable. The role of the ratings agencies is bound to change too. And central banks should reconsider their monetary policy frameworks. They are part of the problem.

*Cracks in the Foundations of Growth, Levy Institute, www.levyinstitute.org/pubs/ppb_90.pdf

Longstanding speculation about the likelihood of a housing market collapse has given way in the past few months to consideration of just how far the housing market will fall, and how much damage the debacle will inflict on the economy. This paper assesses the magnitude of the impact of housing price decreases on real private expenditure, examines the role of new types of mortgages and mortgage-related securities, and analyzes possible policy responses.

What Will the Housing Debacle Mean for the U.S. Economy?

With economic growth having cooled to less than 1 percent in the first quarter of 2007, the economy can ill afford a slump in consumption by the American household. But it now appears that the household sector could finally give in to the pressures of rising gasoline prices, a weakening home market, and a large debt burden. The signals are still mixed; for example, while April’s retail sales numbers caused concern, May’s were much improved, and so was the ISM manufacturing index for June. Consumption growth indicates a slowdown. This Public Policy Brief examines the American household and its economic fortunes, concentrating on how falling home prices might hamper economic growth, generate social dislocations, and possibly lead to a full-blown financial crisis.

What Will the Housing Debacle Mean for the U.S. Economy?

With economic growth having cooled to less than 1 percent in the first quarter of 2007, the economy can ill afford a slump in consumption by the American household. But it now appears that the household sector could finally give in to the pressures of rising gasoline prices, a weakening home market, and a large debt burden.

Despite being arguably one of the most active areas of research in heterodox macroeconomics, the study of the dynamic properties of stock-flow consistent (SFC) growth models of financially sophisticated economies is still in its early stages. This paper attempts to offer a contribution to this line of research by presenting a simplified Post-Keynesian SFC growth model with well-defined dynamic properties, and using it to shed light on the merits and limitations of the current heterodox SFC literature.

The collapse in the subprime mortgage market, along with multiple signals of distress in the broader housing market, has already drawn forth a large body of comment. Some people think the upheaval will turn out to be contagious, causing a major slowdown or even a recession later in 2007. Others believe that the turmoil will be contained, and that the US economy will recover quite rapidly and resume the steady growth it has enjoyed during the last four years or so.

Yet no participants in the public discussion, so far as we know, have framed their views in the context of a formal model that enables them to draw well-argued conclusions (however conditional) about the magnitude and timing of the impact of recent events on the overall economy in the medium term—not just the next few months.

This paper deploys a simple stock-flow consistent (SFC) model in order to examine various contentions regarding fiscal and monetary policy. It follows from the model that if the fiscal stance is not set in the appropriate fashion—that is, at a well-defined level and growth rate—then full employment and low inflation will not be achieved in a sustainable way. We also show that fiscal policy on its own could achieve both full employment and a target rate of inflation. Finally, we arrive at two unconventional conclusions: first, that an economy (described within an SFC framework) with a real rate of interest net of taxes that exceeds the real growth rate will not generate explosive interest flows, even when the government is not targeting primary surpluses; and, second, that it cannot be assumed that a debtor country requires a trade surplus if interest payments on debt are not to explode.

Global Imbalances: Prospects for the U.S. and World Economies

The 2007 Hyman P. Minsky Conference focused on monetary and fiscal policies for continued growth and employment; currency markets fluctuations and the consequent exchange-rate misalignments, as well as possible cures; and the United States' households and trade deficits, their implications for growth and employment, and their effect on the conduct of monetary and fiscal policy. The US role in the global marketplace was examined in view of the current international economic landscape.

 

The conference was held April 19–20, 2007, at the Levy Institute’s research and conference center at Blithewood on the campus of Bard College, Annandale-on-Hudson, N.Y.

In a series of articles and books, Harold Vatter and John Walker attempted to make the case that the American economy suffers from chronically insufficient demand that leads to growth below capacity. Of particular interest are a 1989 Journal of Post Keynesian Economics article that extends Domar's work on the supply side effects of investment spending and a 1997 book that provides a comprehensive analysis of the evolution of the US "mixed" economy. Their analysis of secular growth complements the well-known writings of Hyman Minsky, who also emphasized the role of the "big government" and the "big bank" in stabilizing an unstable economy over the cycle. This article will summarize, provide support for, and extend the Vatter and Walker approach, concluding with an examination of some of the dangers facing the US economy today. As appropriate, the ideas of Minsky will be used to supplement the argument.

Tax Reform Advice for the New Majority

Anyone who reads a newspaper knows that most Americans have accumulated excessive levels of debt, and realizes that as interest rates climb, it becomes more difficult to service financial liabilities. To add insult to injury, wage growth has been slow, while prices—especially for energy—have risen sharply. What is not clear, however, is the fact that taxes have also been rising rapidly, relative to both income and government spending. In this Policy Note, we concentrate on the last issue, and argue that many middle-income earners will find themselves unprepared for the coming surprise in April.

Approaching the issue of mounting global imbalances from the perspective of the "Bretton Woods II hypothesis," this paper argues that the popular preoccupation with China's supposed export-led development strategy is misplaced. It also suggests, similar to Japan's depression, subdued growth in Euroland for most of the time since the Maastricht Treaty has been of first-order importance in these developments. Germany is identified as being at the heart of the European trouble. Globally, there is an ongoing clash between two approches to macroeconomic policy making: a highly dogmatic German approach, and a very pragmatic Anglo-Saxon one. The low levels of interest at which global demand imbalances have been smoothed out financially reflect deficient global demand in an environment of vast supply-side opportunities. After contributing greatly to the build-up of imbalances, Euroland is unlikely to play any constructive part in their unwinding. Hampered by an exchange-rate policy vacuum, a small-country mindset, and soaring intra-area imbalances, Euroland is also illpositioned to cope with fading external growth stimuli.

A Rendezvous with Reality

Over the past decade, deficit spending by consumers has supported the United States economy. Research Associate Robert Parenteau analyzes the financial balance of American households and finds that the pace of deficit spending is likely to stall and, possibly, reverse course. This reversion will jeopardize US profit and economic growth, as well as the growth of countries dependent on export-led development strategies. His research supports the position of other Levy Institute scholars who have urged policymakers to recognize the consequences of current imbalances in the US economy.

Policies for the U.S. Economy

In this new Strategic Analysis, we review what we believe is the most important economic policy issue facing policymakers in the United States and abroad: the prospect of a growth recession in the United States. The possibility of recession is linked to the imbalances in the current account, government, and private sector deficits. The current account balance, which is a negative addition to US aggregate demand, is now likely to be above 6.5 percent of GDP and has been rising steadily for some time. The government balance has improved, again giving no stimulus to demand, which has therefore relied entirely on a large and growing private sector deficit. A rapidly cooling housing market is one of the signs showing that this growth path is likely to break down.

We focus first on the current account deficit. Our analysis suggests that a necessary and sufficient condition to address this problem, without dire consequences for unemployment and growth, is that net export demand grow by a sufficient amount. For this to happen, three conditions need to be satisfied: foreign saving has to fall, especially in Europe and East Asia; US saving has to rise; and some mechanism, such as a change in relative prices, should be put in place to help the previous two phenomena translate into an improvement in the US balance of trade.

A Rendezvous with Reality

Over the past decade, deficit spending by consumers has supported the United States economy. Research Associate Robert Parenteau analyzes the financial balance of American households and finds that the pace of deficit spending is likely to stall and, possibly, reverse course. This reversion will jeopardize US profit and economic growth, as well as the growth of countries dependent on export-led development strategies. His research supports the position of other Levy Institute scholars who have urged policymakers to recognize the consequences of current imbalances in the US economy.

Gomory, Baumol, and Samuelson on Comparative Advantage

The theory of comparative advantage says that there are gains from trade for the global economy as a whole. In this second brief of a three-part study of the international economy, Research Associate Thomas Palley observes that comparative advantage is driven by technology, which can be influenced by human action and policy. These associations have huge implications for the distribution of gains from trade and raise concerns about the future impact of international trade on the US economy. Palley calls for strategically designed US trade policy that can influence the nature of the global equilibrium and change the distribution of gains from trade.

Recent works by Ralph Gomory and William Baumol and Paul Samuelson use pure trade theory to question the distribution of trade gains across countries over time and to challenge commonly held beliefs. These microeconomic and trade theorists identify a new issue: the dynamic evolution of comparative advantage and its impact on the distribution of gains from trade, which depends on changing global demand and supply conditions. (See also, Public Policy Brief No. 85.)

Toward Convergence and Full Employment

The theory of comparative advantage says that there are gains from trade for the global economy as a whole. In this second brief of a three-part study of the international economy, Research Associate Thomas Palley observes that comparative advantage is driven by technology, which can be influenced by human action and policy. These associations have huge implications for the distribution of gains from trade and raise concerns about the future impact of international trade on the US economy. Palley calls for strategically designed US trade policy that can influence the nature of the global equilibrium and change the distribution of gains from trade. Recent works by Ralph Gomory and William Baumol and Paul Samuelson use pure trade theory to question the distribution of trade gains across countries over time and to challenge commonly held beliefs. These microeconomic and trade theorists identify a new issue: the dynamic evolution of comparative advantage and its impact on the distribution of gains from trade, which depends on changing global demand and supply conditions. (See also, Public Policy Brief No. 85.)

The Growing Burden of Servicing Foreign-owned U.S. Debt

Can the growth in the current account deficit be sustained? How does the flow of deficits feed the stock of debt? How will the burden of servicing this debt affect future deficits and economic growth? President Dimitri B. Papadimitriou and Research Scholars Edward Chilcote and Gennaro Zezza address these and other questions in a new Strategic Analysis.

A Cri de Coeur

Many papers published by the Levy Institute during the last few years have emphasized that the American economy has relied too much on the growth of lending to the private sector, most particularly to the personal sector, to offset the negative effect on aggregate demand of the growing current account deficit. Moreover, this growth in lending cannot continue indefinitely.

In the mid-to-late 1980s, the American economy simultaneously produced—for the first time in the postwar period—huge federal budget deficits as well as large current account deficits, together known as the “twin deficits”. This generated much debate and hand-wringing, most of which focused on supposed “crowding-out” effects. Many claimed that the budgetdeficit was soaking up private saving, leaving too little for domestic investment, and that the “twin” current account deficit was soaking up foreign saving. The result would be higher interest rates and thus lower economic growth, as domestic spending—especially on business investment and real estate construction—was depressed. Further, the government debt and foreign debt would burden future generations of Americans, who would have to make interest payments and eventually retire the debt. The promulgated solution was to promote domestic saving by cutting federal government spending, and private consumption. Many pointed to Japan’s high personal saving rates as a model of the proper way to run an economy.

A Critique of Neoclassical Consumption Theory with Reference to Housing Wealth

The development of the permanent income/life cycle consumption hypothesis was a key blow to Keynesian and Kaleckian economics. According to George Akerlof, it "set the agenda" for modern neoclassical macroeconomics. This paper focuses on the relationship of housing wealth to neoclassical consumption theory, and in particular, the degree to which homes can be treated collectively with other forms of "permanent income." The neoclassical analysis is evaluated as a partly normative and partly positive one, in recognition of the dual function of the neoclassical theory of rationality. The paper rests its critique primarily on the distinctive role of homes in social life; theories that fail to recognize this role jeopardize the social and economic goods at stake. Since many families do not own large amounts of assets other than their places of residence, these issues have important ramifications for the relevance of consumption theory as a whole.

Public and Private Debts and the Future of the American Economy

Today’s federal budget deficits are a preoccupation of many American citizens and more than a few political leaders. Is the American government going bankrupt? Does our fiscal condition warrant radical surgery, as some now prescribe? Or, are we in such deep trouble that there is no plausible route of escape?

A Theory of Intelligible Sequences

This paper sets out a rigorous basis for the integration of Keynes-Kaleckian macroeconomics (with constant or increasing returns to labor, multipliers, markup pricing, et cetera) with a model of the financial system (comprising banks, loans, credit money, equities, and so on), together with a model of inflation. Central contentions of the paper are that there are virtually no equilibria outside financial markets, and the role of prices is to distribute the national income, with inflation sometimes playing a key role in determining the outcome.

The model deployed here describes a growing economy that does not spontaneously find a steady state even in the long run, but which requires active management of fiscal and monetary policy if full employment without inflation is to be achieved. The paper outlines a radical alternative to the standard narrative method used by post-Keynesians as well as by Keynes himself.

Rising home prices and low interest rates have fueled the recent surge in mortgage borrowing and enabled consumers to spend at high rates relative to their income. Low interest rates have counterbalanced the growth in debt and acted to dampen the growth in household debt-service burdens. As past Levy Institute Strategic Analyses have pointed out, these trends are not sustainable: household spending relative to income cannot grow indefinitely.

Can the Symbiosis Last?

The main arguments in this paper can be simply stated:

1) If output in the United States grows fast enough to keep unemployment constant between now and 2010, and if there is no further depreciation in the dollar, the deficit in the balance of trade is likely to get worse, perhaps reaching 7.5 per cent by the end of the decade.

2) If the trade deficit does not improve, let alone if it gets worse, there will be a large further deterioration in the United States’ net foreign asset position, so that, with interest rates rising, net income payments from abroad will at last turn negative and the deficit in the current account as a whole could reach at least 8.5 per cent of GDP.

Is it sufficiently realized how intractable those account imbalances—and how dangerous their potential consequences at home and abroad—have now become?

Analytical Results and Methodological Implications

In dealing with the problematic relationship of morality to rational choice theory, neoclassical economists since Lionel Robbins have often argued that they can incorporate moral values into consumer theory by putting those values into the utility function. This paper tests the viability of such an approach in the context of international finance. The moral value at stake is autonomy, which may be lost when borrowers must submit to the edicts of international financial institutions. When such a value is inserted into the utility function of a small economy, the growth rate of consumption and the level of investment change. Furthermore, potential borrowers may lose their ability to credibly commit to paying back loans, resulting in a complete absence of borrowing where it might otherwise take place. The author argues that while this model illustrates the possibility of analyzing a noneconomic value (sovereignty) through rational choice theory, it also shows that standard methods of empirical inference, policy evaluation, and welfare analysis may fail in such a situation. To answer questions that mix morality and economics, economists must seek tools other than conventional rational choice theory.

The latest batch of numbers from the United States makes for a disturbing read. The GDP growth rate of GDP has been adequate. However, the current account deficit was 6.3 percent of GDP in the fourth quarter of 2004, and the terrible trade figures for January and February promise an even bigger deficit in the first quarter of 2005 (BEA 2005). Let no one suppose that this deterioration is a temporary effect that will automatically turn around soon.

Despite being arguably the most rigorous form of structuralist/post-Keynesian macroeconomics, stock-flow consistent models are quite often complex and difficult to deal with. This paper presents a model that, despite retaining the methodological advantages of the stock-flow consistent method, is intuitive enough to be taught at an undergraduate level. Moreover, the model can easily be made more complex to shed light on a wealth of specific issues. 

As we projected in a previous Strategic Analysis, the United States' economy experienced growth rates higher than 4 percent in 2004. The question we want to raise in this Strategic Analysis is whether these rates will persist or come back down. We believe that several signs point in the latter direction. In what follows, we analyze the evidence and explore the alternatives facing the US economy.

Why Net Exports Must Now Be the Motor for U.S. Growth

The American economy has grown reasonably fast since the second half of 2003, and the general expectation seems to be that satisfactory growth will continue more or less indefinitely. This paper argues that the expansion may indeed continue through 2004 and for some time beyond. But with the government and external deficits both so large and the private sector so heavily indebted, satisfactory growth in the medium term cannot be achieved without a large, sustained, and discontinuous increase in net export demand. It is doubtful whether this will happen spontaneously, and it certainly will not happen without a cut in domestic absorption of goods and services by the United States which would impart a deflationary impulse to the rest of the world. We make no short-term forecast. Instead, using a model rooted in a consistent system of stock and flow variables, we trace out a range of possible medium term scenarios in order to evaluate strategic predicaments and policy options without being at all precise about timing.

Edited and with an introduction by Dimitri B. Papadimitriou

This unique volume presents, for the first time in publication, the original doctoral thesis of Hyman P. Minsky, one of the most innovative thinkers on financial markets. Dimitri B. Papadimitriou’s introduction places the thesis in a modern context, and explains its relevance today. The thesis explores the relationship between induced investment, the constraints of financing investment, market structure, and the determinants of aggregate demand and business cycle performance. Forming the basis of his subsequent development of financial Keynesianism and his “Wall Street” paradigm, Minsky investigates the relevance of the accelerator-multiplier models of investment to individual firm behavior in undertaking investment dependent on cost structure. Uncertainty, the coexistence of other market structures, and the behavior of the monetary system are also explored.

 

In assessing the assumptions underlying the structure and coefficient values of the accelerator models frequently used, the book addresses their limitations and inapplicability to real-world situations where the effect of financing conditions on the balance sheet structures of individual firms plays a crucial and determining role for further investment. Finally, Minsky discusses his findings on business cycle theory and economic policy.

This book will greatly appeal to advanced undergraduate and graduate students in economics, as well as to policymakers and researchers. In addition, it will prove to be valuable supplementary reading for those with an interest in advanced microeconomics.

Published By: Edward Elgar Publishing, Inc.

Stock-flow Consistent Models As an Unexplored "Frontier" of Keynesian Macroeconomics

This paper argues that the Stock-Flow Consistent Approach to macroeconomic modeling can be seen as a natural outcome of the path taken by Keynesian macroeconomic thought in the 1960s and 1970s, a theoretical frontier that remained largely unexplored with the end of Keynesian academic hegemony. The representative views of Davidson, Godley, Minsky, and Tobin as different closures of the same SFC accounting framework are presented, and similarities and problems discussed.

Deficits, Debt, Deflation, and Depreciation

Recent economic commentary has been filled with “D” words: deficits, debt, deflation, depreciation. Deficits—budget and trade—are of the greatest concern and may be on an unsustainable course, as federal and national debt grow without limit. The United States is already the world’s largest debtor nation, and unconstrained trade deficits are said to raise the specter of a “tequila crisis” if foreigners run from the dollar. Federal budget red ink is expected to imperil the nation’s ability to care for tomorrow’s retirees. While public concern with deflationary pressures has subsided, concern continues regarding America’s ability to compete in a global economy in which wages and prices are falling. In fact, the current situation is far more “sustainable” than that at the peak of the Clinton boom, which had federal budget surpluses but record-breaking private sector deficits. Nevertheless, it is time to take stock of the dangers faced by the US economy.

Policies and Prospects in an Election Year

Wynne Godley, our Levy Institute colleague, has warned since 1999 that the falling personal saving and rising borrowing trends that had powered the US economic expansion were not sustainable. He also warned that when these trends were reversed, as has happened in other countries, the expansion would come to a halt unless there were major changes in fiscal policy.

Not long ago, official circles insisted that monetary policy was the most desirable tool, that fiscal deficits were not only unnecessary but also harmful (ERP 2000, pp.31–34; Greenspan 2000). Some economists, notably Edmund Phelps of Columbia University, went so far as to suggest that the economic expansion was not caused by rising demand, but rather because growth had become 'structural' (Financial Times, August 9, 2000).

This paper reviews the general tenets of "stock-flow consistent" and the "formal Minskyan" literatures and argues that the advantages and weaknesses of the latter become clearer when analyzed with the tools of the former. It also analyzes a small but representative and influential sample of seminal "formal Minskyan" models, particularly the Taylor-O'Connel model, in light of a fully consistent "Minskyan artificial economy." The paper also shows these models often assume oversimplified hypotheses (that don't do justice to the richness of Minskyan analyses) and, more seriously, often ignore the logical implications of these hypotheses. Finally, the authors arugue that most of these problems can be tackled when "formal Minskyan" models are phrased as "closures" of the "general Minskyan" accounting framework described in the paper.

Preliminary Results

Stock-flow consistent models may be considered the rallying point for heterodox authors interested in modeling macroeconomic relations, since these models incorporate real and financial relations in an entirely consistent way, therefore providing macroeconomic constraints to individual behavior. The present model expands on the Godley-Lavoie model of growth, which was based on a two-asset world, with only bank deposits and the shares issued by private corporations. The present model incorporates the financial relations among the central bank, private banks, and the fiscal policy of government, showing the endogeneity of money under different assumptions on banks' behavior. The model is used to analyze the relationship between the distribution of income and growth, and to study the impact of monetary policy.

 

The Theory and Policy Implications of the Commodification of Finance

Over the past 20 years, finance has become commodified. Firms increasingly obtain finance from securities markets, instead of borrowing from commercial banks with which they have long-term relationships, while Fannie Mae and Freddie Mac package a growing number of mortgages into bonds. When loans are priced by impersonal markets rather than by individual bankers, they become more like commodities. As in many cases when goods are commodified, this trend has important policy implications. This paper describes new Keynesian and social economics perspectives on the difference between traditional and securitized loans, and points out weaknesses in their account of the significance of banking relationships. A social theory of banking, and, particularly, of risk perception, is then developed. Finally, the policy implications of the commodification of finance are examined in light of the social theory.

 

A Reprieve but Not a Pardon

These are fast-moving times. Two years ago, the Congressional Budget Office (CBO, 2001) projected a federal budget surplus of $172 billion for fiscal year 2003. Within a year, the projected figure had changed to a deficit of $145 billion (CBO 2002). The actual figure, near the end of fiscal year 2003, turned out to be a deficit of about $390 billion. And just one month ago, President Bush submitted a request to Congress for an additional $87 billion appropriation for war expenditures, over and above the $166 billion tallied so far. It is widely anticipated that even this will have to be revised upward by the end of the coming year (Stevenson 2003; Firestone 2003).

A Note of Caution

The current account deficit of the United States has been growing steadily as a share of GDP for more than a decade. It is now at an all-time high, over 5 percent of GDP. This steady deterioration has been greeted with an increasing amount of concern (U.S Trade Deficit Review Commission 2000; Brookings Papers 2001; Godley 2001; Mann 2002). At The Levy Economics Institute, we have long argued that this burgeoning deficit is unsustainable. A current account deficit implies a growing external debt, which in turn implies a continuing shift in net income received from abroad (net interest and dividend flows) in favor of foreigners. We have also noted that with the private sector headed toward balance, a growing current account deficit implies a corresponding growing “twin” deficit for the government sector (Papadimitriou et al. 2002; Godley 2003). This latter scenario has already come to pass: the latest figures show that the general government deficit rose to an annual rate of more than 4 percent of GDP in the first quarter of 2003 and will certainly rise even more in the near future, since the federal deficit alone is officially projected to reach 4 percent by the end of this fiscal year (CBO 2003).

For the first time since the 1930s, many worry that the world's economy faces the prospect of deflation—accompanied by massive job losses—on a global scale. In a rather hopeful sign, policymakers from Euroland to Japan to America all seem to recognize the threat that falling prices pose to markets. Given the singleminded pursuit of deflationary policies over the past decade, this does come as something of a surprise. But policymakers—especially central bankers—in Europe and the United States seem to have little inkling of how to stave off deflation, with the result that prices are already falling in much of the world. Contrary to widespread beliefs, the worst outcome will not be avoided if the only response is to balance budgets and introduce new monetary policy gimmicks. To the contrary, policymakers should increase deficits to at least 7 percent of GDP.

Methodology and Results

This paper provides the details of the construction of new quarterly measures of the real GDPs of the 36 trading partners that are taken into consideration by the Federal Reserve in its "broad exchange rate" indexes. These new measures have some important advantages. First, they allow the construction of various income aggregates and sub-aggregates, which makes it possible, for example, to match the Federal Reserve's "broad," "major-currency," and "other important" trading partner effective exchange rates and, more broadly, to discuss the geographical and geopolitical determinants of US trade. Second, they allow the construction of variants of the two different types of measures that are utilized in the literature, namely direct and export-share-weighted sums of trading-partner real GDPs. Finally, given that our new measures of GDP for these countries can be directly compared to each other, they can be of interest for other researchers who need a consistent dataset on a quarterly basis.

The consumer has been on a tightrope since the bursting of the "new economy" bubble, as losses in equity markets have been partly offset by gains in real estate and fiscal support and mortgage refinancing have partly offset increased consumer cautiousness. The consumer will remain on a tightrope in the near future, but if the economy were to stumble, the fragile consumer might contribute to turning the downturn into a deep and protracted recession. There are two risks to the continuation of consumer resilience. The first arises from the fact that this has been a jobless recovery. The second arises from a growing personal sector imbalance that is fueled by the growing property bubble. Hence, the short-term outlook remains uncertain, but the long-term one is bleak.

The Role of Investment

The anemic US economic recovery and the threat of a double-dip recession stem from the weakness of investment, due to excess capacity created in the euphoric years of the "new economy" bubble. The current imbalances in the corporate sector (i.e., the all-time-high indebtedness in the face of falling asset prices) are preventing investment from picking up and are laying the foundations for a new, long-lasting expansion. Tax reductions may create a cyclical upturn in the short run, and may promote the anemic recovery, but such stimulus to demand is unsustainable in the long run. The root of the problem is the imbalance in the corporate sector, which will take time for correction.

A Changing Strategic Predicament

Right through the boom years prior to 2001, the American economy faced a strategic predicament in that the main engine of growth (credit-financed private spending) was unsustainable, from which it followed that the whole stance of the government's fiscal policy would have to be radically changed if the New Economy were not to become stagnant. The boom was indeed broken, because private expenditure fell relative to income. The potentially dire effects on the level of activity were mitigated by a transformation in the fiscal policy stance, accompanied by a radical change in attitudes toward budget deficits, which suddenly became respectable. This analysis argues that a new strategic predicament is on the horizon as a result of the exceptionally large and growing balance of payments deficit.

The long economic expansion was fueled by an unprecedented rise in private expenditure relative to income, financed by a growing flow of net credit to the private. On the surface, it seemed that the growing burden of the household sector’s debt was counterbalanced by a spectacular rise in the relative value of its financial assets, but this was never a match among equals, and the great meltdown in the financial markets has proved this imbalance to be true. The private sector has dramatically cut back its acquisition of new credit and reversed the path of its financial balance, but this adjustment has been uneven within the sector: the business sector has suffered a huge drop in investment while the household sector has continued to borrow.

Notwithstanding the great achievements of the American economy, the growth of aggregate demand during the past several years has been structured in a way that would eventually prove unsustainable. During the main period of economic expansion, the fiscal stance tightened at a much greater pace than in any period during the previous 40 years, and net export demand progressively deteriorated to record deficit levels. It follows that the expansion aggregate demand had been driven by a similarly unprecedented expansion of private expenditure relative to income, financed by growing injections of net credit, which caused the indebtedness of the nonfinancial private sector to escalate to unprecedented levels. The conclusion drawn was that this process must come to an end at some stage, and that when it did, the entire stance of fiscal policy would have to move in an expansionary direction, and that for economic growth to be sustained indefinitely, net export demand would have to recover as well.

The United States should now be prepared for one of the deepest and most intractable recessions of the post–World War II period, with no natural process of recovery in prospect unless a large and complex reorientation of policy occurs both here and in the rest of the world. The grounds for reaching this somber conclusion are that very large structural imbalances, with unique characteristics, have been allowed to develop. These imbalances were always bound to unravel at some stage, and it now looks as though the unraveling is well under way. There may be no spontaneous recovery because the unraveling that has started is a reversion toward what, in the relevant sense, is a normal situation. This consideration leads us to take issue with some distinguished commentators, such as Alan Blinder (2001) and Laura Tyson (2001), who apparently assume that because a spontaneous recovery will occur relatively soon, any fiscal relaxation should be temporary. The general predicament is made worse by a deteriorating world economy; US exports fell sharply in the first seven months of 2001, when the balance of payments was already heavily in deficit.

A Rejoinder to Goldman Sachs’s J. Hatzius’s “The Un-Godley Private Sector Deficit” in US Economic Analyst (27 July)

Distinguished Scholar Wynne Godley and Research Scholar Alex Izurieta respond to Jan Hatzius’s rebuttal of their July 2001 Strategic Analysis, in which they stated that the American economy was probably already in recession, and that a prolonged period of subnormal growth and rising unemployment was likely unless there were another round of policy changes. Hatzius, a senior economist with Goldman Sachs, vigorously disagreed.

 

There is no chance that events will right themselves in a few weeks, or that we will be saved by such underlying factors as technology and productivity growth or by lower interest rates or the provisions of the recent tax act. Rather, we are in for a crisis; the sooner this is recognized and acted upon, the better.

Prospects and Policies for the U.S. Economy: A Strategic View

The American economy is probably now in recession, and a prolonged period of subnormal growth and rising unemployment is likely unless there is another round of policy changes. A further relaxation of fiscal policy will probably be needed, but if a satisfactory rate of growth is to be sustained, this will have to be complemented by measures that raise exports relative to imports.

Consensus opinion sees the United States' economy growing by around 3 percent per year over the next few years, a high enough rate to keep unemployment low and outpace Europe. One problem with the consensus view is that it pays little heed to the very unusual nature of the American expansion. A minor downturn prompted by a bit of inflation and higher interest rates is one thing, and easily fixed by conventional means. But America's boom was unique and so, alas, will be its bust.

Income Distribution and the Return of the Aggregate Demand Problem

It is widely believed that the current economic slowdown will be mild and temporary in nature, the result of a momentary wobble in the stock market. This paper argues that the slowdown stands to be more deep-seated, owing to contradictions in the existing process of aggregate demand generation. These contradictions are the result of deterioration in income distribution. They have been held at bay for almost two decades by a range of different demand compensation mechanisms: steadily rising consumer debt, a stock market boom, and rising profit rates. However, these mechanisms are now exhausted, confronting the US economy with a serious aggregate demand generation problem. Fiscal policy adjustments may be the only way out of this impasse, but such adjustments should be accompanied by measures to rectify the structural imbalances at the root of the current impasse. Absent this, the problem of deficient demand will reassert itself, and the next time around public sector finances may not be in such a favorable position to deal with it.

Notes on the U.S. Trade and Balance of Payments Deficits

If the United States’ balance of trade does not improve, the country could eventually find itself in a “debt trap,” the author says. The aim of this paper, the second in a series offering Godley’s strategic analysis, is to display what seems reasonably likely to happen if world output recovers but otherwise past trends, policies, and relationships continue. The potential usefulness of the exercise is to warn policymakers of dangers that may exist and to help them think out what policy instruments are, or should be made, available to deal with worst cases, should they arise.

Medium-term Prospects and Policies for the United States and the World

Conference on Inequality in the Industrialized and Developing Countries * Special Feature on Inventories and the US Business Cycle * History of Wage Inequality in America * Finance in a Classical and Harrodian Cyclical Growth Model * Financing Long-Term Care * Rhetorical Evolution of the Minimum Wage * Seven Unsustainable Processes * Computers and the Wage Structure

Applications to Asia

Four factors in the current financial crisis in Asia have surprised observers. First, although capital flows in Asia appeared stable, the crisis was precipitated by the reversal of the very large proportion of short-term lending. Second, although Asia appeared to be an example of the maxim that capital flows to the region with the highest rates of return, now it appears that risk-adjusted returns were lower in Asia than in other regions. Third, although the foreign lending banks are the most sophisticated operators in global finance, they seem to have had difficulty assessing risk. Fourth, contrary to the belief that foreign equity investors will not liquidate their positions in response to currency devaluation, the equity and foreign exchange markets collapsed together. According to Visiting Scholar Jan Kregel, these four factors may be explained by the role of derivatives contracts in the flow of funds to Asia.

The U.S. Balance of Payments, International Indebtedness, and Economic Policy

According to Wynne Godley, the significance of the deficit in the United States' balance of payments has been underestimated in both public policy and academic discussions, despite the fact that American markets are increasingly dominated by foreign manufacturers. Godley analyzes the problem posed by the current balance of payments deficit. Breaking down the current account into its component parts, he traces the cause of the deficit. He refutes the arguments of other economists that the balance of payments deficit is self-correcting, unimportant, or the result of other domestic forces (namely, too low a level of national saving), and outlines policy approaches to solving the problem. Godley notes that although the strategic problems posed are specific to this country and the United States may have to take unilateral action to solve them, the problems have arisen because there is no significant international regulation of the system as a whole. Inherent flaws have developed in the system of international production, trade, and payments as that system has expanded and become increasingly deregulated. “All the difficulties that exist, or that are foreshadowed in this brief, would be best resolved by energetic international cooperation, of which there is at present little sign.”

U.S. and Global Finance Prospects, by Robert Barbera; The Performance of the Economy Since the October 1987 Crash, by David A. Levy

Robert Barbera and David A. Levy offer contrasting assessments of the United States' economy during the late 1980s and early 1990s. Barbera suggests that the behavior of the economy was typical for the early part of a recessionary stage in a standard business cycle: policymakers and business leaders, believing the downturn to be temporary, prolong economic distress by delaying action to reverse the trend. As hopes of recovery fade, they are forced to take drastic measures; corporations aggressively purge themselves of excesses and the Federal Reserve eases, thereby precipitating an economic rebound. Levy disagrees, asserting that the economic stagnation of that period was not simply a recessionary stage of the business cycle. Such a stage is characterized by overspeculation in inventories or short-term disruptions in demand, not by an extended period of severely reduced economic activity. Levy contends that massive federal government spending and the presence of financial safeguards (such as deposit insurance) were the only things containing the current recession from becoming a depression.

Edited by Dimitri B. Papadimitriou

Business accounting defines profits as total revenue minus total costs. Economic theory uses various definitions of profits according to what is being measured (for example, return to ownership, national income profits, real profits) and for what purpose. The concept of profits, however, cannot and should not be reduced to a matter of measurement, but should be considered in terms of the role of profits in the workings of an economic system. The papers in this volume provide original insights into secular and cyclical changes in production and employment, and the interrelationships among profits, corporate investment and financing, instability, and government deficits.

Published By: Palgrave Macmillan, Ltd.
St. Martin's Press

By Chris Isidore

CNNMoney, May 14, 2012. © 2012 Cable News Network. A Time Warner Company. All Rights Reserved.

Investors are getting increasingly worried about whether Greece will remain in the eurozone. And they should.

There are a series of upcoming events that could spell the end of a deal, put in place nearly three months ago, to restructure Greee’s debt under strict terms dictated by the European Union, International Monetary Fund and European Central Bank, known as the troika.

“The threat from Greece remains real, and Greece exiting the euro area would likely have contagion effects that cannot easily be addressed in the current set-up,” said Bank of America Merrill Lynch analysts in a note Monday. “The next weeks are crucial.”

Greece has been struggling under a mountain of debt, as it tries to push through unpopular austerity measures and get its economy on solid footing. Without a cohesive government, that battle just got tougher.

Here’s what next in the Greek political drama, and what it could mean for the rest of Europe and the global economy.

Where do things stand after last week’s national elections? There is still no party that has been able to form a new government. The two parties from the previous ruling coalition that supported austerity and the debt deal, New Democracy and Pasok, only have 149 seats between them and 151 are needed.

So far, none of the other parties are willing to join them, given Greek voters’ anger over the harsh austerity measures.

If Greek President Karolos Papoulias is not able to bring together a new ruling coalition by Thursday, he is expected to call for another round of voting, likely in mid-June.

What is likely to happen if new elections are held in June? Recent polls and various experts seem to agree that the Coalition of the Radical Left, also known as Syriza, would be the top vote getter in the next round. Syriza has gained solid support since finishing second in last week’s round of voting.

If it can form a majority coalition with other anti-austerity parties, that would leave Greece with a government opposed to the earlier deals made with the EU, IMF and ECB, which has to approve funds for Greece that would allow the government to pay its bills and make its bond payments.

Whether the June election result would lead to a disorderly default and a Greek exit from the euro is far less clear.

“Even Syriza is not really interested in getting out of the euro. Their primary focus is to renegotiate the bailout package,” said Dimitri Papadimitriou, economics professor and expert on Greece from Bard College.

But without financial support from the so-called troika, it will be tough for Greece to meet its financial obligations.

Can Greece stop paying its bills and still stay in the eurozone? That is the biggest unknown, and probably the biggest worry for markets.

Elisabeth Afseth, fixed income analyst for Investec Bank in London, said if Greece stops paying its bills, that will mean the end of the funding it so desperately needs. If that happens, it won’t have much choice but to start issuing its own currency to pay its ongoing bills.

How Greece can stay in the eurozone

But Papadimitriou said that other European leaders are also loath to have Greece exit the euro, due to the shock it might cause for the continent’s already-fragile financial system. Therefore, he said, it is possible, albeit unlikely, that there could be yet another new deal even if Greece stops paying what it owes.

“I would expect the European finance ministers’ meeting to have intense discussions this week,” he said. “The best case for keeping Greece within the euro would be for the rest of Europe to be proactive in trying to come up with a renegotiated deal suitable for all parties. But I’m not optimistic.”

What’s the best case scenario for Greece leaving the euro? In the best case, the ECB steps in and contains the so-called contagion effect.

While the central bank’s drumbeat has been to not be the lender of last resort, it has also made it clear that it would do everything in its power to keep the crisis from spreading.

Greek euro exit won’t mean tragedy

A dozen European countries are already in recession thanks to Germany’s surprise growht, the entire EU and eurozone managed to stave off recession in the first quarter.

Even in this best case scenario, one in which measures to prop up the non-Greek sovereign debt work, the austerity measures needed to pay for them would send the remaining countries of the eurozone and EU into an even deeper, more prolonged downturn.

Yields could soar on government debt for Portugal and Ireland, let alone much larger economies like Spain and Italy, vastly increasing the costs for the remaining European governments that are paying for various bailouts.

That would also weigh on the already slowing growth in both the United States and Asia.

How bad could things get? Things could be worse than that—far worse.

“I don’t think anyone at the present time can quantify the contagion effect of a disorderly exit of Greece from the eurozone,” said Papadimitriou. “No one can predict the markets. They have a mind of their own.

In a worst-case scenario, the Greek exit prompts other countries to leave the euro, as voters there follow Greek voters’ lead and rebel against austerity measures.

“As it stands now, there’s no precedence for leaving,” said Afseth. “If Greece leaves, all of sudden there is precedent.”

If larger countries follow Greece out of eurozone, it could cause a meltdown in the European banking sector, which holds billions of euros of sovereign debt of the other troubled economies, as well as private sector loans to consumers.

In turn, businesses in those countries would be unable to pay given their suddenly devalued currency.

While U.S. authorities have said U.S. banks have relatively limited exposure to European sovereign debt, the major banks here do have exposure to the European banking system, so a meltdown in European markets would be felt in the United States and around the globe.

Background Briefing: Ian Masters Interviews Dimitri B. Papadimitriou

With Greece teetering and increasing doubts about the solvency of Spanish banks, Masters and Papadimitriou discuss the growing likelihood of a cascading crisis in the eurozone and its potential impact on US elections in November. Full audio of the interview is available here.

This paper investigates the causes behind the euro debt crisis, particularly Germany’s role in it. It is argued that the crisis is not primarily a “sovereign debt crisis” but rather a (twin) banking and balance of payments crisis. Intra-area competitiveness and current account imbalances, and the corresponding debt flows that such imbalances give rise to, are at the heart of the matter, and they ultimately go back to competitive wage deflation on Germany’s part since the late 1990s. Germany broke the golden rule of a monetary union: commitment to a common inflation rate. As a result, the country faces a trilemma of its own making and must make a critical choice, since it cannot have it all —perpetual export surpluses, a no transfer / no bailout monetary union, and a “clean,” independent central bank. Misdiagnosis and the wrongly prescribed medication of austerity have made the situation worse by adding a growth crisis to the potpourri of internal stresses that threaten the euro’s survival. The crisis in Euroland poses a global “too big to fail” threat, and presents a moral hazard of perhaps unprecedented scale to the global community.

By Daniel Wagner

Bloomberg Businessweek, May 6, 2012. Copyright 2012 Bloomberg L.P. All Rights Reserved.

Financial markets will likely stumble this week after elections in Greece and France cast a pall of uncertainty over Europe's efforts to solve its debt crisis.

Greek voters on Sunday voted mostly for two parties that want to change the nation's international bailout terms or even overturn the rescue deal, according to early projections of the election results. Greece won't have a government until parties with divergent worldviews can form a governing coalition.

Greek voters are reacting against spending cuts imposed on the recession-weary nation by the international lenders whose bailouts are keeping it afloat.

French President Nicolas Sarkozy lost in a runoff election to Socialist candidate Francois Hollande. Hollande has criticized France's austerity program and wants to encourage growth by boosting government spending.

Sunday's votes raise serious doubts about whether voters will swallow the current plan of international bailouts coupled with severe cost-cutting, economists said.

Many experts believe the austerity program is necessary to keep bond investors from panicking about the possibility that more European nations will default or require bailouts.

But a growing number say the cuts have been too much, too fast. They say the region's economy can't return to growth unless governments stop tightening the fiscal noose and start spending again to create demand.

Much depends on the reaction of investors in debt issued by European nations, said Dimitri Papadimitriou, president of the Levy Economics Institute at Bard College. If they fear that the crisis response is losing momentum, they will likely demand higher interest rates -- not just from Greece, but from other nations seen as carrying too much debt.

The result would be rising borrowing costs for Greece as well as countries that haven't received bailouts, like Italy and Spain. Rising borrowing costs sent global stock markets diving last year. Uncertainty about the path forward in Europe may mean a return to extreme market volatility after several months of relative calm.

Background Briefing: Ian Masters Interviews Dimitri B. Papadimitriou

As stocks continue to plunge in Europe and on Wall Street, Masters and Papadimitriou revisit the malaise in the eurozone, where the cost of Spanish debt has reached unsustainable levels, austerity has proven to be disastrous, and there is no money for stimulus. Full audio of the interview is available here.

Since last month’s Greek bond swap, various European leaders have declared the eurozone crisis over or “almost over.” But Euroland’s current economic reality begs to differ. No matter how much cheap money the ECB provides or how high the EC “firewall” rises, the region’s economic malaise can’t be cured without massive government intervention—the implementation of strong, proactive economic policies that will put people back to work, increase state revenues, and improve the standard of living.

The root of Europe’s sovereign debt crisis can be found in the fact that investors are concerned that countries in the periphery might default, causing them to demand a higher yield on government bonds. What’s needed is a way of giving peripheral debt a high degree of safety while allowing peripheral countries to remain users of the euro.   A simple solution to this problem would be for peripheral countries to begin issuing a new type of government debt: the “tax-backed bond.” Tax-backed bonds would be similar to current government bonds except that they would contain a clause stating that if the country failed to make its payments when due—and only if this happens—the bonds would be acceptable to make tax payments within the country in question. This tax backing would set an absolute floor below which the value of the asset could not fall, assuring investors that the bond is always “money good,” leading to lower bond rates and thus ensuring that peripheral countries would not be driven to default.

Writing Down Debt, Returning to Democratic Governance, and Setting Up Alternative Financial Systems—Now

The five-year-long crisis of Western finance capitalism is pushing advanced liberal societies to a breaking point. If governments continue to be proxies of finance capital and aspiring political leaders cheerleaders for their financial backers, a catastrophic economic scenario is not really as far-fetched as some might like to think. Governments, industries, and households are under debt bondage, with the result that revenues from every sector of the economy are being diverted toward interest payments and late fees for various loans taken out on largely exploitative, even fraudulent terms. Now, after years of building up a Ponzi financial regime, Western capitalism faces its ultimate test. Will it collapse, giving rise to long-term economic instability and authoritarian political regimes? Or will it find the strength and the wisdom to make a comeback?

By David Berman

The Globe and Mail, March 26, 2012. © Copyright 2012 The Globe and Mail Inc. All Rights Reserved.

Remember Greece? The financial crisis there might be dimming in the minds of many investors ever since the euro zone found the necessary money to bail out the country and creditors agreed to a debt restructuring. However, not everyone believes that everything is well.

Take C. J. Polychroniou, a research associate and policy fellow at Levy Economics Institute of Bard College: He argues in a new policy paper [One-Pager No. 28] that Greece is about to become a “zombie debtor” and, in a “doomsday scenario,” will be forced to leave the euro zone. In other words, everyone’s greatest fears are about to be revisited.

“The bond swap is a temporary fix and will not pull Greece out of its debt spiral,” he said in a one-page release. Part of the problem is that the latest bailout by the euro zone comes with harsh austerity measures, and these measures are going to undermine Greece’s economic growth and its ability to meet debt payments.

“The most optimistic projections suggest that Greece will return to a budget surplus by 2015,” Mr. Polychroniou said.

“However, even then, the predicted primary surplus of €20-billion won’t cover more than 30 per cent of the cost of carrying its debt. . . . In sum, Greece is not only bankrupt but also remains trapped in a dark, endless tunnel.”

If he's right, global stock markets could be in for a round of turbulence. Europe's sovereign-debt crisis has weighed heavily on stocks, off and on, over the past two years. Most recently, the crisis helped drag the S&P 500 down nearly 19 per cent from last July to the end of September.

Since then, a combination of European action in holding off a messy Greek default and upbeat U.S. economic news have driven stocks to four-year highs.

Του Δημητρη Παπαδημητριου

Kathimerini, March 18, 2012. © 2012 H KAΘHMEPINH All rights reserved.

Οι διαπραγματεύσεις για το δεύτερο πακέτο διάσωσης και την αναδιάρθρωση του ελληνικού χρέους επιτέλους ολοκληρώθηκαν. Η καθυστέρηση είχε ως αποτέλεσμα να γίνουν ακόμη πιο οδυνηρές οι περικοπές μισθών, δαπανών και συντάξεων. Στο μεταξύ, οι ηγεσίες του ΔΝΤ, της ΕΚΤ και της Ε. Ε. έχουν δρομολογήσει την κατεύθυνση της ελληνικής πολιτικής για τα επόμενα χρόνια. Το έθνος θα υποστεί επώδυνα μέτρα λιτότητας, στα οποία θα συμπεριλαμβάνονται οι απολύσεις χιλιάδων υπαλλήλων.

Μέσα σε αυτό το ασφυκτικό πλαίσιο, πώς μπορεί να αποκατασταθεί η ανταγωνιστικότητα της ελληνικής οικονομίας; Ο βασικός, ουσιώδης και άμεσος στόχος θα πρέπει να είναι η μείωση της ανεργίας Και αυτό διότι:

Ÿ Οι μακροπρόθεσμες συνέπειες της ακραίας ανεργίας είναι γνωστές. Η συρρίκνωση της οικονομίας παγιώνεται. Και οι δεξιότητες των εργαζομένων φθίνουν και γίνονται παρωχημένες, με αποτέλεσμα να γίνεται ακόμη πιο δύσκολη η επανένταξή τους στην αγορά εργασίας.

Ÿ Η μαύρη εργασία διογκώνεται εις βάρος της επίσημης οικονομίας. Στην περίπτωση της Ελλάδας δεν είναι απλώς μία ακόμη στατιστική. Εκτιμάται ότι ο γκρίζος τομέας αποτελεί το ένα τέταρτο περίπου του Ακαθάριστου Εθνικού Προϊόντος.

Ÿ Η ανισότητα αυξάνεται. Στην Ελλάδα, την Ιρλανδία, την Πορτογαλία και την Ισπανία, η αύξηση αυτή υπολογίζεται σε 10%. Ως εκ τούτου, λαμβάνουν χώρα επικίνδυνες ιδεολογικές μετατοπίσεις.

Ÿ Η κοινωνική συνοχή αποδομείται με ταχείς ρυθμούς. Η φτώχεια, οι άστεγοι και το έγκλημα αυξάνονται, η δημόσια υγεία υπονομεύεται, η κατάθλιψη, οι αυτοκτονίες και οι προσωπικές τραγωδίες πολλαπλασιάζονται.

Η Ελλάδα βρίσκεται αυτή τη στιγμή στο μονοπάτι μιας τέτοιας αποκάλυψης. Μεταξύ 2009 και 2011, η ανεργία αυξήθηκε κατά 94%. Σήμερα βρίσκεται στο 21% και μπορεί να φτάσει το 25% μέχρι το τέλος του χρόνου. Μεταξύ των νέων φτάνει το 50% και αναμένεται επίσης να αυξηθεί ακόμη. Οι κατεστραμμένες ζωές περιλαμβάνουν περισσότερους από 20.000 αστέγους, την ώρα που η φτώχεια και οι αυτοκτονίες ακολουθούν την ανιούσα.

Οι διαστάσεις χιονοστιβάδας που αναμένεται να λάβει η ανεργία αποτελούν από μόνες τους μια τροχοπέδη στην οικονομική ανάπτυξη. Μέχρι σήμερα, η ελληνική κυβέρνηση αντιδρούσε στο φαινόμενο αυτό με περιορισμένης έκτασης παρεμβάσεις, που είχαν σκοπό τη διατήρηση θέσεων εργασίας στον ιδιωτικό τομέα. Η έμφαση που δόθηκε ήταν στη μείωση των ημερών εργασίας (με την ελπίδα ότι περισσότεροι άνθρωποι θα πρέπει να μοιράσουν έτσι τις διαθέσιμες θέσεις) και στην επιδότηση των ασφαλιστικών εισφορών.

Οπου δοκιμάστηκαν όμως μέτρα εκ περιτροπής εργασίας -στην Ολλανδία, στο Βέλγιο, στη Γαλλία, στην Αυστραλία, στην Ιαπωνία και ακόμη και στις ΗΠΑ- απέτυχαν να δημιουργήσουν θέσεις εργασίας. Το ίδιο συνέβη και με την επιδότηση των θέσεων, η οποία έτεινε να στρεβλώνει τις αποφάσεις των εργοδοτών, που προτιμούσαν να ανταλλάζουν τους δικούς τους υπάλληλους με τους επιδοτούμενους.

Επιτέλους, λοιπόν, τώρα προστέθηκε και μία ακόμη επιλογή σε μικρή κλίμακα. Πρόκειται για το έκτακτο πρόγραμμα του υπουργείου Εργασίας και Κοινωνικής Ασφάλισης, για την επ’ αμοιβή κοινωνική εργασία, με αρχικό στόχο 55.000 ανέργους, οι οποίοι θα προσφέρουν τις υπηρεσίες τους σε ΜΚΟ και θα ωφελήσουν τις κοινότητές τους. Ανάλογο πρόγραμμα του υπουργείου Εσωτερικών, χωρίς τη συμμετοχή ΜΚΟ, θα δημιουργήσει 120.000 ακόμη θέσεις εργασίας.

Η προσέγγιση αυτή αποτελεί την καλύτερη ελπίδα της ελληνικής κυβέρνησης για να ανακόψει την αύξηση της ανεργίας και να αποφύγει την περαιτέρω καταστροφή. Τα προγράμματα αυτά έχουν σχεδιαστεί με τέτοιο τρόπο ώστε να αποφευχθούν φαινόμενα νεποτισμού, διαφθοράς και ευνοιοκρατίας που είδαμε στο παρελθόν. Αν η στόχευση, η εποπτεία και η αξιολόγησή τους γίνουν με σωστό τρόπο, τότε τα αποτελέσματα θα είναι εντυπωσιακά.

Η εναλλακτική λύση θα ήταν να βασιστεί η κυβέρνηση στον ιδιωτικό τομέα για να δημιουργήσει αρκετές θέσεις εργασίας, ώστε να περιοριστούν τα αστρονομικά ποσοστά ανεργίας. Τι ρεαλιστικές πιθανότητες υπήρχαν να γίνει κάτι τέτοιο σε μια χώρα που οι δουλειές είναι ήδη πολύ λίγες και ο δημόσιος τομέας, ο οποίος τώρα συρρικνώνεται, δημιουργεί το 40% του ΑΕΠ; Είναι δύσκολο να είναι κανείς αισιόδοξος.

Μία ανάκαμψη με μπροστάρη τον ιδιωτικό τομέα θα απαιτούσε κολοσσιαία αύξηση νέων επιχειρήσεων, μεγάλων επενδυτικών σχεδίων και εισροών κεφαλαίων από το εξωτερικό. Παραδοσιακά, οι επενδυτές που θα μπορούσαν να τα κάνουν όλα αυτά βρίσκουν την Ελλάδα μη ελκυστικό τόπο για δραστηριοποίηση.

Η ελληνική οικονομία χαρακτηρίζεται επίσης από πολύ υψηλά ποσοστά αυτοαπασχολούμενων και μικρών επιχειρήσεων, που φτάσουν στο 35% του εργατικού δυναμικού. Τα αποσταθεροποιητικά αποτελέσματα της ανεργίας περιλαμβάνουν και την πτώση της ιδιωτικής κατανάλωσης και των πωλήσεων στο λιανεμπόριο. Η μείωση της παγκόσμιας ζήτησης επιτείνει το πρόβλημα. Καθώς, λοιπόν, η οικονομία συρρικνώνεται, πώς μπορούν να επιβιώσουν αυτές οι επιχειρήσεις;

Πριν από την κρίση, η ανάπτυξη στην Ελλάδα βασιζόταν στη δημόσια κατανάλωση και στις προσλήψεις στο Δημόσιο. Τώρα που το Δημόσιο συρρικνώνεται, το εύρος των πολιτικών απασχόλησης πρέπει να μεγαλώσει. Τα προγράμματα δημιουργίας θέσεων κοινωφελούς εργασίας επ’ αμοιβή είναι η καλύτερη ελπίδα της κυβέρνησης.

Ο κ. Δημήτρης Παπαδημητρίου είναι πρόεδρος του Ινστιτούτου Οικονομικών Levy, εκτελεστικός αντιπρόεδρος και καθηγητής Οικονομικών στο Κολλέγιο Bard της Νέας Υόρκης.  

Nearly two years after becoming the first eurozone member-state to be bailed out by the European Union (EU) and International Monetary Fund (IMF), Greece is officially bankrupt. True, there was never any doubt about the outcome, but Greece’s restructuring of nearly 200 billion euros in private debt and the agreement for a new bailout package signify something much bigger—namely, the formal conversion of a sovereign nation into an EU/IMF zombie debtor, and a doomsday scenario that includes its forced exit from the eurozone.

We live in a terrifying world of policymaking—an age of free-market dogmatism where the economic ideology is fundamentally flawed. Europe’s political leadership has applied neo-Hooverian (scorched-earth) policies that are shrinking economies and producing social misery as a result of massive unemployment.

Large-scale government intervention is critical in reviving an economy, but the current public-policy mania, which imposes fiscal tightening in the midst of recession, can only lead to catastrophic failure. The bailouts, for example, do not solve Greece’s debt crisis but simply postpone an official default. What is needed is a political and economic revolution that includes a return to Keynesian measures and a new institutional architecture—a United States of Europe.

A Historic Monetary Policy Pivot Point and Moment of (Relative) Clarity

Not since the Great Depression have monetary policy matters and institutions weighed so heavily in commercial, financial, and political arenas. Apart from the eurozone crisis and global monetary policy issues, for nearly two years all else has counted for little more than noise on a relative risk basis.

In major developed economies, a hypermature secular decline in interest rates is pancaking against a hard, roughly zero lower-rate bound (i.e., barring imposition of rather extreme policies such as a tax on cash holdings, which could conceivably drive rates deeply negative). Relentlessly mounting aggregate debt loads are rendering monetary- and fiscal policy–impaired governments and segments of society insolvent and struggling to escape liquidity quicksands and stubbornly low or negative growth and employment trends.

At the center of the current crisis is the European Monetary Union (EMU)—a monetary union lacking fiscal and political integration. Such partial integration limits policy alternatives relative to either full federal integration of member-states or no integration at all. As we have witnessed since spring 2008, this operationally constrained middle ground progressively magnifies economic divergence and political and social discord across member-states.

Given the scale and scope of the eurozone crisis, policy and actions taken (or not taken) by the European Central Bank (ECB) meaningfully impact markets large and small, and ripple with force through every major monetary policy domain. History, for the moment, has rendered the ECB the world’s most important monetary policy pivot point.

Since November 2011, the ECB has taken on an arguably activist liquidity-provider role relative to private banks (and, in some important measure, indirectly to sovereigns) while maintaining its long-held post as rhetorical promoter of staunch fiscal discipline relative to sovereignty-encased “peripheral” states lacking full monetary and fiscal integration. In December 2011, the ECB made clear its intention to inject massive liquidity when faced with crises of scale in future. Already demonstratively disposed toward easing due to conditions on their respective domestic fronts, other major central banks have mobilized since the third quarter of 2011. The collective global central banking policy posture has thus become more homogenized, synchronized, and directionally clear than at any time since early 2009.

The coordinated contractionary policy on the part of the European Union is inspired by its belief that this is the most effective way to tackle the eurozone’s “debt crisis.” However, by ignoring the endemic problems of unemployment, poverty, and homelessness—all of which have as their underlying cause the contraction of economic activity—European economic policy reveals a growing gap with the real world.

Di Federica Bianchi e Paola Pilati

L'Espresso, February 23, 2012

L’austerità imposta dall’Europa alla Grecia non funziona. Ma esistono ricette alternative che puntano allo sviluppo. A base di eurobond e di distretti industriali.

President Dimitri B. Papadimitriou and Senior Scholar L. Randall Wray argue that the common diagnosis of a “sovereign debt crisis” ignores the crucial role of rising private debt loads and the significance of current account imbalances within the eurozone. Profligate spending in the periphery is not at the root of the problem. Moreover, pushing austerity in the periphery while ignoring the imbalances within the eurozone is a recipe for deflationary disaster.
 
The various rescue packages on offer for Greece will not ultimately solve the problem, say the authors, and a default is a very real possibility. If a new approach is not embraced, we are likely seeing the end of the European Monetary Union (EMU) as it currently stands. The consequences of a breakup would ripple throughout the EMU as well as the shaky US financial system, and could ultimately trigger the next global financial crisis.

Improving Competitiveness by Reducing Living Standards and Increasing Poverty

Greece’s new EU/IMF bailout package is all about private sector wage cuts and an overhaul of labor rights. In short, it will do absolutely nothing to address the nation’s economic crisis because it is not designed to rescue Greece’s embattled economy. In fact, it will have the unwanted effect of keeping the nation locked in a vicious cycle of debt—and leading, finally, to its exit from the eurozone.  

A Proposal for Ireland

Euroland is in a crisis that is slowly but surely spreading from one periphery country to another; it will eventually reach the center. The blame is mostly heaped upon supposedly profligate consumption by Mediterraneans. But that surely cannot apply to Ireland and Iceland. In both cases, these nations adopted the neoliberal attitude toward banks that was pushed by policymakers in Europe and America, with disastrous results. The banks blew up in a speculative fever and then expected their governments to absorb all the losses. The situation was similar in the United States, but in our case the debts were in dollars and our sovereign currency issuer simply spent, lent, and guaranteed 29 trillion dollars’ worth of bad bank decisions. Even in our case it was a huge mistake—but it was “affordable.” Ireland and Iceland were not so lucky, as their bank debts were in “foreign” currencies. By this I mean that even though Irish bank debt was in euros, the Government of Ireland had given up its own currency in favor of what is essentially a foreign currency—the euro, which is issued by the European Central Bank (ECB). Every euro issued in Ireland is ultimately convertible, one to one, to an ECB euro. There is neither the possibility of depreciating the Irish euro nor the possibility of creating ECB euros as necessary to meet demands for clearing. Ireland is in a situation similar to that of Argentina a decade ago, when it adopted a currency board based on the US dollar. And yet the authorities demand more austerity, to further reduce growth rates. As both Ireland and Greece have found out, austerity does not mean reduced budget deficits, because tax revenues fall faster than spending can be cut. Indeed, as I write this, Athens has exploded in riots. Is there an alternative path?

In this piece I argue that there is. First, I quickly summarize the financial foibles of Iceland and Ireland. I will then—also quickly—summarize the case for debt relief or default. Then I will present a program of direct job creation that could put Ireland on the path to recovery. Understanding the financial problems and solutions puts the jobs program proposal in the proper perspective: a full implementation of a job guarantee cannot occur within the current financial arrangements. Still, something can be done.

By Uri Friedman

Foreign Policy, February 13, 2012. © 2012 The Foreign Policy Group, LLC. All Rights Reserved.

There’s something puzzling about the austerity bill embraced by the Greek parliament overnight. The package includes measures such as government layoffs that seem logical for a country flirting with default. But news reports are also discussing private-sector wage cuts. How is the government able to slash salaries in the private sector, and why would it imperil much-needed tax revenue by reducing people’s incomes and embarking on what Reuters is calling “among the most radical steps backwards inflicted in peacetime in modern Europe?”

For starters, the Greek government isn’t strongarming companies into cutting salaries; it’s modifying labor law by lowering the minimum wage by 22 percent to €586 a month (around $780)—roughly on par with Portugal’s—with a 32 percent cut for workers under age 25. Greece’s foreign lenders—the European Commission, European Central Bank, and International Monetary Fund—have long demanded the cuts in exchange for a second bailout, and over the weekend Greek Prime Minister Lucas Papademos publicly endorsed the measure, which had nearly torn his governing coalition asunder only days earlier. The austerity program may be a bitter pill to swallow, Papademos allowed, but it will stave off bankruptcy and “restore the fiscal stability and global competitiveness of the economy.”

Platon Tinios, an economist at the University of Piraeus in Greece, explains that the cuts championed by international financial organizations are intended to structurally revamp economies and make them more competitive. “Greece has a very rigid labor market, which has translated in the past 10 years into what essentially was jobless growth,” he explains. “The point is to intervene in the labor market so as to increase the probability of jobs being created faster when the recovery comes.”

Or, as the New York Times put it earlier this month, the goal of reducing Greece’s minimum wage is to “make Greek workers, who are generally less productive than workers elsewhere in Europe, able to compete more effectively inside the eurozone, where countries share a common currency that does not allow devaluations to help even out differences in labor costs.”

Indeed, the EU and IMF forced a similar reduction in living standards in Latvia—through a process known as “internal devaluation”—though there is heated debate about whether it worked and whether the Latvian model can be applied to Greece.

Dimitri Papadimitriou, an economics professor at Bard College and the president of the Levy Economics Institute, is highly skeptical of the IMF’s “neoliberal policy.” He says it hasn’t worked in Latin America or Portugal and won’t work in Greece, which doesn’t have an export-driven economy like Germany does.

Labor demand cannot be stoked simply by lowering the cost of production on the supply side, Papadimitriou argues. “If you had a good industrial base ... you could produce a lot more [by lowering wages] because the demand is there either from abroad or domestically,” he explains. “But in the absence of that, interference with private-sector labor is not something that will solve the problem.” Papadimitriou adds that reducing wages could put a dent in tax revenues and pension contributions.

Tinios, meanwhile, is less concerned about those possibilities. “In the medium term, what’s more important is to create more jobs, and reducing the minimum wage doesn’t mean that hundreds of thousands of Greeks will be paid less tomorrow; it will mean that new job offers will be made at the lower minimum wage,” he notes, though he concedes that struggling firms may be more likely to slash existing salaries if the minimum wage is reduced.

There’s also the question of whether, in cutting wages, Greece is chasing the wrong demon. “If our political system had, over the years and especially the last two years, addressed the essential problems of competitiveness in our economy—the excessive number of laws and bureaucracy, the corruption, the bloated and wasteful state, the closed markets, the antibusiness environment—then we wouldn’t be forced to discuss wage costs today,” Federation of Greek Industries President Dimitris Daskalopoulos declared earlier this month.

The ultimate lesson, of course, is that Greece is choosing from a menu of awful options. As the Associated Press noted over the weekend, “ Greece is trapped in a lose-lose predicament: It must deepen an austerity plan begun in 2010 that will throw many more people out of work. Or it must default on its debts, abandon Europe’s single currency, and see its banking system implode.”

For now, Greek leaders appear to have averted their eyes, held their noses, and chosen the former. 

Bloomberg Radio, February 10, 2012. © 2012 Bloomberg L.P. All Rights Reserved.

Dimitri Papadimitriou, president of the Levy Economics Institute of Bard College, discusses whether or not Greece will hold together. Papadimitriou talks with Kathleen Hays and Vonnie Quinn on Bloomberg Radio's “The Hays Advantage.” Full audio of the interview is available here.

By Bob Moon

Marketplace, February 10, 2012. © Marketplace from American Public Media

As riots in Athens grew violent today, Greek Prime Minister Lucas Papademos took a “take it or leave it” stance with his cabinet ministers. Either get behind the new austerity measures or quit. Six of them chose to leave.   On Sunday the Greek parliament votes on whether or not to accept another round of deep cuts lashed out in an hard-fought agreement reached yesterday.   For Wall Street, it’s a scene right out of Groundhog Day, the movie where the lead character wakes up day after day, only to play out the same scene over and over. News of an agreement—markets go up. Next-day second thoughts and fears—markets go down. Meanwhile, the world economy is waiting.   While it looks to some like Greece just won’t take its bitter medicine, others say more austerity is essentially political theater.   Dimitiri Papadimitriou is the head of the Levy Economics Institute of Bard College. He says the parties that negotiated the new austerity measures—the European Central Bank, the European Union and the International Monetary Fund—cannot realistically expect them to be implemented.   It’s a case of more austerity without a plan for growth, says Papandimitriou. And that’s a bitter pill for a country with no real manufacturing or industry to rely on. Even industries that could flourish in Greece—solar and wind energy or drilling for oil in the Ionian Sea—will be impossible if Greece is back to the drachma.   Still, Papadimitriou says he’s much less optimistic today about whether Greece can pull off this tightrope act of saying yes to austerity but not crushing the will of its people. He says, “I’m afraid that Greece might throw in the towel and leave the Euro.”

By Dimitri B. Papadimitriou

The Huffington Post, February 9, 2012. Copyright © 2012 TheHuffingtonPost.com, Inc. All rights reserved.

The latest negotiations between Greece and its lenders have ended, at least momentarily. Athens has agreed to endure ever-more painful pension, spending, and wage cuts, with monthly minimum salaries dropping 20 percent. The powerful leaders of ”the troika”—the International Monetary Fund, the European Union, and the European Central Bank—have charted the direction of Greek public policy for years to come: substantial austerity measures, including the lay-offs of thousands of workers.

Within those confines, how can Greek competitiveness be rebuilt? The overwhelming, key, and most urgent imperative should be to raise employment levels. Here's why:

• The long-term effects of extreme unemployment on an economy have been well documented. The loss of output is permanent. Workers' skills deteriorate and become outdated, making the labor pool unattractive to potential employers.
   
• “Informal” work—the “shadow” sector—swells at the expense of the nation's formal economy, and in Greece, the grey-market is not just a statistical ding. It's widely estimated to compose (as is also the case in Italy) more than one quarter of the GNP.
   
• Inequality increases. In Greece, Ireland, Portugal and Spain the recent rise is estimated to be as much as 10 percent. Dangerous ideological shifts accelerate, too.
   
• Social cohesion disintegrates rapidly. Poverty, homelessness, and crime go up, along with poor health, depression, suicide rates and countless personal tragedies.

Greece now stands directly in the path of this onrushing apocalypse express. Between spring 2009 and mid 2011, its unemployment rose a heart-stopping 91.8 percent. The overall unemployment rate is now 20 percent; among youths, it's close to 40 percent, and expected to keep climbing. The damaged lives include 20,000 homeless, living in makeshift shelters during a miserably severe European winter, and an upswing in suicides and poverty.

As joblessness continues to snowball—and if the odds-makers in the credit markets are right, expect an avalanche—the unemployed themselves can involuntarily become a powerful force that prevents economic growth.

Until now, the Greek government has responded with small interventions to preserve jobs in the private sector. The emphasis has been on shortening the workweek (with the thought that more people would share the available work), and on employment subsidies.

But in places where reduced workweeks have been tried—Germany, the Netherlands, Belgium, France, Australia and Japan—they have failed to generate jobs. Employment subsidies have also been unsuccessful; they've tended to distort market mechanisms by interfering with employer decisions, and current workers end up being traded for newly subsidized ones.

Now, finally, in addition to those policies, a better option is being tried on a small scale: A labor department direct public service job creation program with an initial target of 55,000 jobs. Participants are entitled to up to five months of work per year, in projects—implemented by non-governmental organizations—that benefit their communities. A similar, streamlined, Interior department program, this one without NGO participation, will generate up to 120,000 openings.

This approach is the Greek government's best shot at slowing the nosedive in employment, and at circumventing further catastrophe. The plans have been designed to specifically address and avoid the nepotism, corruption, and favoritism that plague poorly conceived "workfare" schemes. With proper targeting, monitoring, and evaluation as the projects move along, the outcomes should be impressive.

The alternative to an active government labor policy is to rely on the private sector to provide enough work to derail astronomical unemployment. What is the realistic likelihood for this in a nation where jobs are already scarce, and where the public sector, now being dismantled, has composed 40 percent of the economy? It's hard to be optimistic.

A privately fueled reboot of Greece would require colossal input from start-ups, large ventures, and foreign capital. Historically, these investors have found Greece unattractive. Its competitiveness is likely to erode further as the engineered recession advances beyond the first phase of austerity. The massive unemployment fallout will seriously degrade the climate that's desirable to the same private sector sources being counted on to make Greece more competitive.

Greece's economy is also characterized by a high percentage of self-employment and small businesses, totaling about 35 percent of all workers. The destabilizing events that accompany high unemployment include a downward push on retail sales and other consumption; global demand shock is amplifying the problem. As the economy contracts, how will these enterprises survive without intervention?

Before the crisis, Greece drove its growth with public spending and jobs. Now that the government is shrinking, the range of employment policies needs to grow. Public service job creation programs are the government's best prospect. During the coming years of austerity, thousands of Greek workers will remain idle because policymakers believe that this makes economic sense. It simply does not.

Dimitri Papadimitriou is president of the Levy Economics Institute of Bard College, which, with underwriting from Greece's Labour Institute, has been instrumental in the design and implementation of a social works program of direct job creation throughout Greece. He recently co-authored a report (see Direct Job Creation for Turbulent Times in Greece) on Greek labor trends.

The 2007–08 global financial crisis was the second most disastrous global economic event of the last 80 years. Thanks to severe austerity measures and a fanatical commitment to fiscal consolidation, Europe’s overall economy is now close to stagnation and extremely high levels of unemployment prevail in many countries, especially in the eurozone periphery. In Greece, the situation is completely out of control, with the standard of living rapidly declining to 1960s levels and the number of unemployed having reached one in five. The second bailout plan will do nothing more than buy extra time for the European Union to build firewalls to prevent the spread of Greek contagion—and prepare the ground for Greece’s exit from the euro.  

By Paul La Monica

CNN Money, February 8, 2012. © 2012 Cable News Network. A Time Warner Company. All Rights Reserved.

NEW YORK (CNNMoney)—Stop me if you’ve heard this before. Greece is close to getting another bailout from the European Union, International Monetary Fund and European Central Bank, the so-called troika.

Greece may also be close to a deal with creditors that will cut its Cyclops-sized debt load.

By the time I finish writing this column, an agreement with bondholders and a new aid package from the troika may finally be reached. Or there could be 17 conflicting news reports about the status of the various talks.

Either way, one thing is certain. Even if Greece is able to wind up avoiding a disorderly, chaotic default, the recent market rally related to Greece might be a bit excessive.

The U.S.-listed shares off National Bank of Greece (NBG) have more than doubled so far this year. A new Greek stock exchange-traded fund that launched last December, the Global X FTSE Greece 20 ETF (GREK), is up nearly 40% in 2012.

National Bank of Greece is the largest holding in the fund, but it also includes the Athens-listed shares of companies such as bottler Coca-Cola Hellenic and Greek gambling firm OPAP.

Of course, the rally in Greek stocks comes off a highly depressed base. The Athens Stock Exchange tumbled more than 50% in 2011. As long as Greece can avoid default, Greek stocks, and for that matter other European stocks, should rebound a little.

Greece facing “dramatic dilemma”

The ECB has helped matters by giving banks cheap three-year loans that some banks appear to have used to buy up the sovereign debt of some of the most problematic European nations. Credit contagion fears have diminished somewhat as a result.

“Despite the day to day noise on Europe, the market believes policies are in place to put a fence around the sovereign debt problems,” said Doug Cote, chief market strategist for ING Investment Management in New York.

That may be true. The austerity measures that need to be put into place in Greece and other eurozone nations may cut debt in the long-term. But it will come at the expense of economic growth in the short-term.

The global economy is still in a fragile state. In fact, a key (albeit admittedly wonky) measure that tracks international shipping prices for various commodities known as the Baltic Dry Index is hovering near a 25-year low.

Shipping is an extremely important part of the Greek economy. Shares of several Greek freight companies, such as DryShips (DRYS), Navios Maritime Holdings (NM), Diana Shipping (DSX) and Paragon Shipping (PRGN), have started to bounce back this year after a disastrous 2011 on hopes of a global economic rebound.

But if the BDI, which rose on Tuesday for the first time in more than a month, continues to remain near multi-decade lows, then that could be more troubling news for the shippers and the Greek economy.

“Greece is highly dependent on shipping from an employment perspective. It’s hard to be confident,” said Dimitri Papadimitriou, president of the Levy Economics Institute at Bard College in Annandale-on-Hudson, N.Y. “Greece and the rest of Europe should have just anemic economic growth. After a while, the markets may not view that as substantial progress.”

What’s next for Europe?

Greece can’t afford any more bad breaks right now. The worst may be over. But that doesn’t mean it’s time to sound the all-clear signal for Greece.

“The reason there is optimism about Greece is that leaders are moving towards solving something,” said Michael Bapis, managing director and partner at the Bapis Group of HighTower Advisors, a financial services firm in New York.

“But this is just the beginning of fixing the problem,” he added. “A lot of work has to be done.”

And it’s also important to note that any deal with the troika could be met with resistance in Greece, particularly if even stricter government spending cuts are proposed.

“It’s a cautious euphoria because investors are only looking at the short-term. Of course, there should be an agreement between the troika and the Greek government,” Papadimitriou said. “But you can’t assume that a Parliament that is in disarray will approve more austerity measures.”

In other words, let’s not bust out a celebratory shot of ouzo just yet.

It’s a mistake to interpret the unfolding disaster in Europe as primarily a “sovereign debt crisis.” The underlying problem is not periphery profligacy, but rather the very setup of the European Monetary Union (EMU)—a setup that even now prevents a satisfactory resolution to this crisis. The central weakness of the EMU is that it separates nations from their currencies without providing them with adequate overarching fiscal or monetary policy structures—it’s like a United States without a Treasury or a fully functioning Federal Reserve. Without addressing this basic structural weakness, Euroland will continue to stumble toward the cliff—and threaten to pull a tottering US financial system over the edge with it.

Είναι βιώσιμη;

A Post-Keynesian Interpretation of the European Debt Crisis

Conventional wisdom suggests that the European debt crisis, which has thus far led to severe adjustment programs crafted by the European Union and the International Monetary Fund in both Greece and Ireland, was caused by fiscal profligacy on the part of peripheral, or noncore, countries in combination with a welfare state model, and that the role of the common currency—the euro—was at best minimal.This paper aims to show that, contrary to conventional wisdom, the crisis in Europe is the result of an imbalance between core and noncore countries that is inherent in the euro economic model. Underpinned by a process of monetary unification and financial deregulation, core eurozone countries pursued export-led growth policies—or, more specifically, “beggar thy neighbor” policies—at the expense of mounting disequilibria and debt accumulation in the periphery. This imbalance became unsustainable, and this unsustainability was a causal factor in the global financial crisis of 2007–08. The paper also maintains that the eurozone could avoid cumulative imbalances by adopting John Maynard Keynes’s notion of the generalized banking principle (a fundamental principle of his clearing union proposal) as a central element of its monetary integration arrangement.

As the eurozone crisis continues, and while the US economy continues to muddle through, we need to reexamine what is actually going on, and sharpen our political-economy tools by considering that what may be taking place today in the advanced economies is not just a banking or a financial crisis but a broader crisis of capitalism.

Background Briefing: Ian Masters Interviews Dimitri B. Papadimitriou

Copyright © 2011 KPFK. All Rights Reserved.

Masters and Papadimitriou discuss the looming financial crisis in the eurozone, the possibility of contagion, and the OECD's warning of an impending recession in Europe and the UK unless the European Central Bank takes action. Full audio of the interview is available here.

The Future of the Eurozone

With the crisis in the eurozone threatening the integrity of the European Union itself. German Chancellor Angela Merkel continues to brush aside calls to permit the European Central Bank to act as lender of last resort, and she remains steadfast against suggestions for the issuing of a eurobond. Yet Germany does have a plan for the eurozone, even if many prefer not to see it—a plan centered on Darwinian biopolitics and neoliberal economics.

As the crisis in Europe spreads, policymakers trot out one inadequate proposal after another, all failing to address the core problem. The possibility of dissolution, whether complete or partial, is looking less and less farfetched. Alongside political obstacles to reform, there is a widespread failure to understand the nature of this crisis. And without seeing clearly, policymakers will continue to focus on the wrong solutions.

Although it didn't originate with an economist, the malaprop “It’s déjà vu all over again” is invariably what springs to mind in the aftermath of virtually any euro summit of the past few years, all of which seem to end with the requisite promise of a so-called “final solution” to the problems posed by the increasingly problematic currency union. But it’s hard to get excited about any of the “solutions” on offer, since they steadfastly refuse to acknowledge that the eurozone’s problem is fundamentally one of flawed financial architecture. Today’s crisis has arisen because the creation of the euro has robbed nations of their sovereign ability to engage in a fiscal counterresponse against sudden external demand shocks of the kind we experienced in 2008. And it is being exacerbated by the ongoing reluctance of the European Union, European Central Bank, and International Monetary Fund—the “troika”—to abandon fiscal austerity as a quid pro quo for backstopping these nations’ bonds.

The European Union’s survival depends on its ability to reform, either through enlargement—greater economic and fiscal coordination in the direction of some sort of federal state—or by getting smaller, with the eurozone becoming a true optimum currency area. Most analysts support the former proposition. But the rush to strengthen and expand the Union is precisely what led to the current crisis in the eurozone.

One of the reasons for the failure of Europe’s governing bodies to resolve the eurozone crisis is resistance to debt buyouts, national guarantees, mutual insurance, and fiscal transfers between member-states. Stuart Holland argues that none of these are necessary to convert a share of national bonds to Union bonds or for net issues of eurobonds—two alternative approaches to the debt crisis that would offset default risk and, by securing the euro as a reserve currency, contribute to more balanced global growth.

The cancellation of the October 26 meeting of the European Union’s council of finance ministers, or Ecofin, has further eroded confidence in its ability to solve the burgeoning sovereign debt crisis in the eurozone. A viable strategy is needed now—and as Stuart Holland illustrates, two viable strategies are even better than one.

Who Pays for the European Sovereign and Subprime Mortgage Losses?

In the context of the eurozone’s sovereign debt crisis and the US subprime mortgage crisis, Senior Scholar Jan Kregel looks at the question of how we ought to distribute losses between borrowers and lenders in cases of debt resolution. Kregel tackles a prominent approach to this question that is grounded in an analysis of individual action and behavioral characteristics, an approach that tends toward the conclusion that the borrower should be responsible for making creditors whole. The presumption behind this style of analysis is that the borrower—the purportedly deceitful subprime mortgagee or supposedly profligate Greek—is the cause of the loss, and therefore should bear the entire burden.

By John Cassidy

Rational Irrationality Blog, The New Yorker, November 2, 2011. © 2012 Condé Nast Digital. All rights reserved.

To many Americans, the European debt crisis is a bit like the Asian bird flu of a few years back: a mystery virus that appears from nowhere and threatens to destroy us. To those of us who grew up in northern Europe, and especially Britain, it is the tragic culmination of a fractious political and intellectual debate that goes back almost a quarter of a century.

Twenty years ago, in advance of the 1992 Maastricht Treaty, which paved the way for a monetary union and the creation of the euro, a big dividing line in British politics was between pro-Europeans, who supported these efforts, and “Eurosceptics,” who vehemently opposed them. Most Eurosceptics were on the right, and their spiritual leader was Margaret Thatcher, who viewed Europe through the lens of small-government conservatism. “We have not successfully rolled back the frontiers of the state in Britain only to see them re-imposed at a European level, with a European super-state exercising a new dominance from Brussels,” Thatcher famously commented in 1988.

On the center and the left, most politicians and intellectuals supported further European integration, including a monetary union and common currency. But a few brave souls demurred. Some were old-school socialists and trades unionists, who viewed the European Economic Community, as it was then called, as a ghastly bosses’ plot. But one was a posh Cambridge economic forecaster called Wynne Godley. Previously, Godley had been best known for his critical stance on Mrs. Thatcher’s domestic economic policies and her embrace of monetarism. After Godley’s repeated criticisms of its policies, the Thatcher government slashed the funding to his taxpayer-financed economic institute in Cambridge.

Assiduous readers of this blog will recall that last week I mentioned Godley, who died in 2010, in my post about Keynes. He was an interesting fellow. A professional oboe player before becoming an economist, he worked at the British Treasury department in the nineteen-fifties and sixties, and then taught at Keynes’s old home, King’s College, Cambridge. In the mid-nineties, he moved for part of each year to the Levy Institute at Bard College, a haven for heterodox thought, where he became one of the first economists to query the debt-financed prosperity of the Greenspan-Bernanke years. Today, though, I would like to draw attention to an article he wrote in October, 1992, for the London Review of Books entitled “Maastricht and All That.” (Thanks to Gavyn Davies, who now blogs regularly and informatively at the Financial Times’ Web site, for reminding me about it.)

Unlike many Eurosceptics, Godley wasn’t anti-European or anti-government—far from it. His problem with the plan for a common currency was that it didn’t provide for enough government. The failure of the Maastricht Treaty to set up a proper fiscal policy for the entire euro zone alongside a common currency meant the entire scheme was half-baked and ultimately unworkable. He wrote,

Although I support the move towards political integration in Europe, I think that the Maastricht proposals as they stand are seriously defective, and also that public discussion of them has been curiously impoverished…. The central idea of the Maastricht Treaty is that the EC countries should move towards an economic and monetary union, with a single currency managed by an independent central bank. But how is the rest of economic policy to be run? As the treaty proposes no new institutions other than a European bank, its sponsors must suppose that nothing more is needed. But this could only be correct if modern economies were self-adjusting systems that didn’t need any management at all.

As a Keynesian, Godley didn’t believe in self-adjustment. He took it as axiomatic that what had prevented another Great Depression was the worldwide adoption of counter-cyclical policies. Faced with the onset of a recession, governments typically relaxed fiscal policy and devalued their currencies to make their exports more competitive, he pointed out. But inside a monetary union, policymakers wouldn’t have either option available, and the outcome could well be disastrous. Godley ended his essay with these prophetic words:

If a country or region has no power to devalue, and if it is not the beneficiary of a system of fiscal equalisation, then there is nothing to stop it suffering a process of cumulative and terminal decline leading, in the end, to emigration as the only alternative to poverty or starvation. I sympathise with the position of those (like Margaret Thatcher) who, faced with the loss of sovereignty, wish to get off the EMU train altogether. I also sympathise with those who seek integration under the jurisdiction of some kind of federal constitution with a federal budget very much larger than that of the Community budget. What I find totally baffling is the position of those who are aiming for economic and monetary union without the creation of new political institutions (apart from a new central bank), and who raise their hands in horror at the words “federal” or “federalism.” This is the position currently adopted by the Government and by most of those who take part in the public discussion.

More Austerity, a Deeper Slump, and the Surrender of National Sovereignty

It is a well-recognized fact that the Greek economy has been going from bad to worse since the first bailout in May 2010, and a leaked document relating to the bailout talks ahead of last week’s EU summit openly admitted that the policy of expansionary fiscal consolidation had been a blatant failure. So why did it take the EU leadership almost two years to recognize the need for a significant haircut on Greek debt?

Some Remarks on the Current Stability Programs, 2011–14

This paper evaluates whether the 2011 national stability programs (SPs) of the euro area countries are instrumental in achieving economic stability in the European Monetary Union (EMU). In particular, we analyze how the SPs address the double challenge of public deficits and external imbalances. Our analysis rests, first, on the accounting identities of the public, private, and foreign financial balances; and second, on the consideration of all SPs at once rather than separately. We find that conclusions are optimistic regarding GDP growth and fiscal consolidation, while current account rebalancing is neglected. The current SPs reach these conclusions by assuming strong global export markets, entrenched current account imbalances within the EMU as well as the deterioration of private financial balances in the current account deficit countries. By means of our simulations we conclude, on the one hand, that the failure of favorable global macroeconomic developments to materialize may lead to the opposite of the desired stability by exacerbating imbalances in the euro area. On the other hand, given symmetric efforts at rebalancing, the simulation suggests that for surplus countries that reduce their current account, a more expansionary fiscal policy will likely be required to maintain growth rates.

Background Briefing: Ian Masters Interviews Dimitri B. Papadimitriou

October 23, 2011. Copyright © 2011 KPFK. All Rights Reserved.

Pacific Radio host Ian Masters interviews President Dimitri B. Papadimitriou about the looming crisis in the eurozone, the inadequacy of current proposals to resolve it, and the real possibility of contagion on this side of the pond. Full audio of the interview is available here.

Yet another rescue plan for the European Monetary Union (EMU) is making its way through central Europe, but no one is foolish enough to believe that it will be enough. Greece’s finance minister reportedly said that his nation cannot continue to service its debt, and hinted that a 50 percent write-down is likely. That would be just the beginning, however, as other highly indebted periphery nations will follow suit. All the major European banks will be hit—and so will the $3 trillion US market for money market mutual funds, which have about half their funds invested in European banks. Add in other US bank exposure to Europe and you are up to a potential $3 trillion hit to US finance. Another global financial crisis is looking increasingly likely.

We first summarize the situation in Euroland. Our main argument will be that the problem is not due to profligate spending by some nations but rather the setup of the EMU itself. We then turn to US problems, assessing the probability of a return to financial crisis and recession. We conclude that difficult times lie ahead, with a high probability that another collapse will be triggered by events in Euroland or in the United States. We conclude with an assessment of possible ways out. It is not hard to formulate economically and technically simple policy solutions for both the United States and Euroland. The real barrier in each case is political—and, unfortunately, the situation is worsening quickly in Europe. It may be too late already.

The Merkel-Sarkozy Promise to End the Eurozone Crisis

Failure on the part of EU leaders to address the eurozone crisis is in large part due to the fact that Germany and France are at opposite poles—politically, economically, and culturally. In this context, the announcement by Germany’s Angela Merkel and French President Nicolas Sarkozy that they’ve agreed to a comprehensive package of proposals to solve the eurozone debt crisis is definitely a positive development. It indicates that they have set aside their disagreements—surely no small feat, since domestic political concerns have been pulling the two in completely opposite directions—in order to provide the leadership necessary for euro stability.

Can the Blind Heal the Crippled?

Whoever said that economic science is free of ideological bias and political prejudice? Three hundred years of financial and economic crises have meant nothing to die-hard neoliberals, who believe in (among other things) self-regulating markets and trickle-down theory. With so many incorrect assumptions guiding market liberalism, it’s no wonder neoliberals have failed to draw the proper lessons from the Great Depression and turned a blind eye to the real causes of the global financial crisis of 2007–08 and the ensuing recession.

Greece’s Debt Crisis in Context

By Dimitri B. Papadimitriou

Truthout, September 9, 2011. Copyright © 2011 Truthout. All Rights Reserved.

“By 1970, the governments of the wealthy countries began to take it for granted that they had truly discovered the secret of cornucopia. Politicians of left and right alike believed that modern economic policy was able to keep economies expanding very fast—and endlessly. That left only the congenial question of dividing up the new wealth that was being steadily generated.”

Those words, from a Washington Post editorial more than twenty-five years ago, echoed the beliefs not only of politicians and the press, but of mainstream economics professionals resistant to the idea that growth in a market economy would ever stagnate over a protracted period.

And some of the data did fit nicely. Through several recessions and recoveries, inflation-adjusted GDP rose almost in tandem with a line of predicted growth expectations. But in November 2007, something changed. Real GDP dropped down from what was expected by more than 11 percent, and, as this summer’s data has shown, it hasn’t returned to its pre-recession trend.

The unusual slump has provoked a stream of commentary that attempts to define the problem, but it hardly matters whether the downturn is identified as the second dip of a “double-dip” recession, a continuation of the “Great Recession,” a fast-moving slowdown, a slow nosedive, a long-term stall-out, or a confirmation that the economy has entered a Japanese-style “lost decade.” Growth during the 21st century is following a different trend line than it did in the 20th, and employment is also responding in new, different ways from earlier post–World War II recessions.

A range of additional data also indicates that what we’re hearing is not the regular breathing of an economy as it contracts and expands. Annual growth rates and quarterly moving averages—when examined starting in the mid 1970s, as Greg Hannsgen and I did at the Levy Economics Institute [see One-Pager No. 12]—show a steady decline beginning in 2000.

And the employment numbers make the case yet again. Look at the graph below, with separate lines for the past six recessions. It traces employment-to-population ratios, beginning with the first month of each recession. These ratios are used to measure, among other things, how well a nation utilizes its workforce—a kind of labor drop-out rate.

You can see at a glance that the pink line indicating the current recession—yes, that one down near the bottom of the chart—is an outlier in the group. It shows that by the 43rd month of the downturn, the ratio stood at just over 58 percent, meaning that 58 percent of the population was employed. That figure is 4.6 percent less than at the recession’s start, when more than 62 percent were working. And it means that this employment decline is steeper, deeper, and longer than in any of the previous five recessions by a long shot.

Even in the two worst recoveries during the past forty years, this ratio never before declined by more than three percent. By the time the five recessions were this far along, employment had returned either to pre-recession levels, or to a distance from the recession’s start that was, at worst, two percent, compared to the current more than four percent.

Together, this data makes the case that we’re in a prolonged slump that’s highly unusual, and requires action that’s far more aggressive than the usual responses. Job creation should be the government’s urgent, first priority. The nation needs to recognize just how perilous the employment disaster is—and what a marked departure this recession is from any we’ve seen in the modern era.

Dimitri B. Papadimitriou is President of the Levy Economics Institute of Bard College and Executive Vice President and Jerome Levy Professor of Economics at Bard College.

This “Modest Proposal” by authors Varoufakis and Holland outlines a three-pronged, comprehensive solution to the eurozone crisis that simultaneously addresses the three main dimensions of the current crisis in the eurozone (sovereign debt, banking, and underinvestment), restructures both a share of sovereign debt and that of banks, and does not involve a fiscal transfer of taxpayers’ money. Additionally, it requires no moves toward federation, no fiscal union, and no transfer union. It is in this sense, say the authors, that it deserves the epithet modest.

To stabilize the debt crisis, Varoufakis and Holland recommend a tranche transfer of the sovereign debt of each EU member-state to the European Central Bank (ECB), to be held as ECB bonds. Member-states would continue to service their share of debt, reducing the debt-servicing burden of the most exposed member-states without increasing the debt burden of the others. Rigorous stress testing and recapitalization through the European Financial Stability Facility (in exchange for equity) would cleanse the banks of questionable public and private paper assets, allowing them to turn future liquidity into loans to enterprises and households. And the European Investment Bank (EIB) would assume the role of effecting a “New Deal” for Europe, drawing upon a mix of its own bonds and the new eurobonds. In effect, the EIB would graduate into a European surplus-recycling mechanism—a mechanism without which no currency union can survive for long.

Functional Finance and Full Employment

Forty-five years ago, the A. Philip Randolph Institute issued “The Freedom Budget,” in which a program for economic transformation was proposed that included a job guarantee for everyone ready and willing to work, a guaranteed income for those unable to work or those who should not be working, and a living wage to lift the working poor out of poverty. Such policies were supported by a host of scholars, civic leaders, and institutions, including the Rev. Dr. Martin Luther King Jr.; indeed, they provided the cornerstones for King’s “Poor Peoples’ Campaign” and “economic bill of rights.”

This paper proposes a “New Freedom Budget” for full employment based on the principles of functional finance. To counter a major obstacle to such a policy program, the paper includes a “primer” on three paradigms for understanding government budget deficits and the national debt: the deficit hawk, deficit dove, and functional finance perspectives. Finally, some of the benefits of the job guarantee are outlined, including the ways in which the program may serve as a vehicle for a variety of social policies.

The creation of the Economic and Monetary Union (EMU) has not brought significant gains to the Portuguese economy in terms of real convergence with wealthier eurozone countries. We analyze the causes of the underperformance of the Portuguese economy in the last decade, discuss its growth prospects within the EMU, and make two proposals for urgent institutional reform of the EMU. We argue that, under the prevailing institutional framework, Portugal faces a long period of stagnation, high unemployment, and painful structural reform, and conclude that, in the absence of institutional reform of the EMU, getting out of the eurozone represents a serious political option for Portugal.

For the past generation Norway has supplied Europe and other regions with oil, taking payment in euros or dollars. It then sends nearly all this foreign exchange abroad, sequestering its oil-export receipts—which are in foreign currency—in the “oil fund,” to invest mainly in European and US stocks and bonds. The fund now exceeds $500 billion, second in the world to that of Abu Dhabi.

It is claimed that treating these savings as a mutual fund invested in a wide array of US, European, and other stocks and bonds (and now real estate) avoids domestic inflation that would result from spending more than 4 percent of the returns to this fund at home. But the experience of sovereign wealth funds in China, Singapore, and other countries has been that investing in domestic infrastructure serves to lower the cost of living and doing business, making the domestic economy more competitive, not less.

This paper cites the debate that extends from US 19th-century institutional doctrine to the approach of long-time Russian Chamber of Commerce and Industry President Yevgeny Primakov to illustrate the logic behind spending central bank and other sovereign foreign-exchange returns on modernizing and upgrading the domestic economy rather than simply recycling the earnings to US and European financial markets in what looks like an increasingly risky economic environment, as these economies confront debt deflation and increasing fiscal tightness.

The Competitiveness Debate Again

Current discussions about the need to reduce unit labor costs (especially through a significant reduction in nominal wages) in some countries of the eurozone (in particular, Greece, Ireland, Italy, Portugal, and Spain) to exit the crisis may not be a panacea. First, historically, there is no relationship between the growth of unit labor costs and the growth of output. This is a well-established empirical result, known in the literature as Kaldor’s paradox. Second, construction of unit labor costs using aggregate data (standard practice) is potentially misleading. Unit labor costs calculated with aggregate data are not just a weighted average of the firms’ unit labor costs. Third, aggregate unit labor costs reflect the distribution of income between wages and profits. This has implications for aggregate demand that have been neglected. Of the 12 countries studied, the labor share increased in one (Greece), declined in nine, and remained constant in two. We speculate that this is the result of the nontradable sectors gaining share in the overall economy. Also, we construct a measure of competitiveness called unit capital costs as the ratio of the nominal profit rate to capital productivity. This has increased in all 12 countries. We conclude that a large reduction in nominal wages will not solve the problem that some countries of the eurozone face. If this is done, firms should also acknowledge that unit capital costs have increased significantly and thus also share the adjustment cost. Barring solutions such as an exit from the euro, the solution is to allow fiscal policy to play a larger role in the eurozone, and to make efforts to upgrade the export basket to improve competitiveness with more advanced countries. This is a long-term solution that will not be painless, but one that does not require a reduction in nominal wages.

Like marriage, membership in the eurozone is supposed to be a lifetime commitment, “for better or for worse.” But as we know, divorce does occur, even if the marriage was entered into with the best of intentions. And the recent turmoil in Europe has given rise to the idea that the euro itself might also be reversible, and that one or more countries might revert to a national currency. The prevailing thought has been that one of the weak periphery countries would be the first to call it a day. It may not, however, work out that way: suddenly, the biggest euro-skeptics in Europe are not the perfidious English but the Germans themselves.

The Rescue Plan Cannot Address the Central Problem

The trillion-dollar rescue package European leaders aimed at the continent’s growing debt crisis in May might well have been code-named Panacea. Stocks rose throughout the region, but the reprieve was short-lived: markets fell on the realization that the bailout would not improve government finances going forward. The entire rescue plan rests on the assumption that the eurozone’s “problem children” can eventually get their fiscal houses in order. But no rescue plan can address the central problem: that countries with very different economies are yoked to the same currency.

Without Major Restructuring, the Eurozone is Doomed

Critics argue that the current crisis has exposed the profligacy of the Greek government and its citizens, who are stubbornly fighting proposed social spending cuts and refusing to live within their means. Yet Greece has one of the lowest per capita incomes in the European Union (EU), and its social safety net is modest compared to the rest of Europe. Since implementing its austerity program in January, it has reduced its budget deficit by 40 percent, largely through spending cuts. But slower growth is causing revenues to come in below targets, and fuel-tax increases have contributed to growing inflation. As the larger troubled economies like Spain and Italy also adopt austerity measures, the entire continent could find government revenues collapsing.

No rescue plan can address the central problem: that countries with very different economies are yoked to the same currency. Lacking a sovereign currency and unable to devalue their way out of trouble, they are left with few viable options—and voters in Germany and France will soon tire of paying the bill. A more far-reaching solution is needed.

Without Major Restructuring, the Eurozone Is Doomed

Critics argue that the current crisis has exposed the profligacy of the Greek government and its citizens, who are stubbornly fighting proposed social spending cuts and refusing to live within their means. Yet Greece has one of the lowest per capita incomes in the European Union (EU), and its social safety net is modest compared to the rest of Europe. Since implementing its austerity program in January, it has reduced its budget deficit by 40 percent, largely through spending cuts. But slower growth is causing revenues to come in below targets, and fuel-tax increases have contributed to growing inflation. As the larger troubled economies like Spain and Italy also adopt austerity measures, the entire continent could find government revenues collapsing.

No rescue plan can address the central problem: that countries with very different economies are yoked to the same currency. Lacking a sovereign currency and unable to devalue their way out of trouble, they are left with few viable options—and voters in Germany and France will soon tire of paying the bill. A more far-reaching solution is needed.

The recycling problem is general, and is not confined to a multicurrency setting: whenever there are surplus and deficit units—that is, everywhere—adjustment in real terms can be either upward or downward. The question is, Which? An attempt is made to formulate the problem in terms of the European Monetary Union. While the problem seems clear, the resolution is not. It is proposed to engage the issue through a detour consistent with the Maastricht rules. Inadequate as this is, it highlights the limits of technical arrangements when governments are confronted with political economy—namely, the inability to set the rules of the larger game from within a set of axiomatically predetermined rules dependent on the fact and practice of sovereignty. Even so, an attempt at persuasion through clarification of the issues—in particular, by highlighting the distinction between recycling and transfers—may be a useful preliminary. Some of the paper’s evocations, notably on oligopoly, may be taken as merely heuristic.

A Cointegration Method

This paper derives measures of potential output and capacity utilization for a number of OECD countries, using a method based on the cointegration relation between output and the capital stock. The intuitive idea is that economic capacity (potential output) is the aspect of output that co-varies with the capital stock over the long run. We show that this notion can be derived from a simple model that allows for a changing capital-capacity ratio in response to partially exogenous, partially embodied, technical change. Our method provides a simple and general procedure for estimating capacity utilization. It also closely replicates a previously developed census-based measure of US manufacturing capacity-utilization. Of particular interest is that our measures of capacity utilization are very different from those based on aggregate production functions, such as the ones provided by the IMF.

China and India

The narrative as well as the analysis of global imbalances in the existing literature are incomplete without the part of the story that relates to the surge in capital flows experienced by the emerging economies. Such analysis disregards the implications of capital flows on their domestic economies, especially in terms of the “impossibility” of following a monetary policy that benefits domestic growth. It also fails to recognize the significance of uncertainty and changes in expectation as factors in the (precautionary) buildup of large official reserves. The consequences are many, and affect the fabric of growth and distribution in these economies. The recent experiences of China and India, with their deregulated financial sectors, bear this out.

Financial integration and free capital mobility, which are supposed to generate growth with stability (according to the “efficient markets” hypothesis), have not only failed to achieve their promises (especially in the advanced economies) but also forced the high-growth developing economies like India and China into a state of compliance, where domestic goals of stability and development are sacrificed in order to attain the globally sanctioned norm of free capital flows.

With the global financial crisis and the specter of recession haunting most advanced economies, the high-growth economies in Asia have drawn much less attention than they deserve. This oversight leaves the analysis incomplete, not only by missing an important link in the prevailing network of global trade and finance, but also by ignoring the structural changes in these developing economies—many of which are related to the pattern of financialization and turbulence in the advanced economies.

This paper traces the rise of export-led growth as a development paradigm and argues that it is exhausted owing to changed conditions in emerging market (EM) and developed economies. The global economy needs a recalibration that facilitates a new paradigm of domestic demand-led growth. Globalization has so diversified global economic activity that no country or region can act as the lone locomotive of global growth. Political reasoning suggests that EM countries are not likely to abandon export-led growth, nor will the international community implement the international arrangements needed for successful domestic demand-led growth. Consequently, the global economy likely faces asymmetric stagnation.

China occupies a unique position among developing countries. Its success in achieving relative stability in the financial sector since the institution of reforms in 1979 has given way to relative instability since the beginning of the current global financial crisis. Over the last few years, China has been on a path of capital account opening that has drawn larger inflows of capital from abroad, both foreign-direct and portfolio investment. Of late, a surge in these inflows has introduced problems for the monetary authorities in continuing with an autonomous monetary policy in China, especially with large additions to official reserves, the latter in a bid to avoid further appreciation of the country’s domestic currency. Like other developing countries, China today faces the “impossible trilemma” of managing the exchange rate with near-complete capital mobility and an autonomous monetary policy. Facing problems in devising and sustaining this policy, China has been using expansionary fiscal policy to tackle the impact of shrinking export demand. The recent drive on the part of Chinese authorities to boost real demand in the countryside and to revamp the domestic market shows a promise far different from that of the financial rescue packages in many advanced nations.

 

The close integration of China with the world economy over the last two decades has raised concerns from different quarters that relate both to (1) the possible effects of the recent global downturn on China and (2) the second-round effects of a downturn in China for the rest of world.

 

Recovery Prospects and the Future

The global crisis of 2007–09 affected developing Asia largely through a decline in exports to the developed countries and a slowdown in remittances. This happened very quickly, and by 2009 there were already signs of recovery (except on the employment front). This recovery was led by China’s impressive performance, aided by a large stimulus package and easy credit. But China needs to make efforts toward rebalancing its economy. Although private consumption has increased at a fast pace during the last decades, investment has done so at an even faster pace, with the consequence that the share of consumption in total output is very low. The risk is that the country may fall into an underconsumption crisis.

Looking at the medium and long term, developing Asia’s future is mixed. There is one group of countries with a highly diversified export basket. These countries have an excellent opportunity to thrive if the right policies are implemented. However, there is another group of countries that relies heavily on natural resources. These countries face a serious challenge, since they must diversify.

The Risk of Unraveling the Global Rebalancing

This paper investigates China’s role in creating global imbalances, and the related call for a massive renminbi revaluation as a (supposed) panacea to forestall their reemergence as the world economy recovers from severe crisis. We reject the prominence widely attributed to China as a cause of global imbalances and the exclusive focus on the renminbi-dollar exchange rate as misguided. And we emphasize that China's response to the global crisis has been exemplary. Apart from acting as a growth leader in the global recovery by boosting domestic demand to offset the slump in exports, China has in the process successfully completed the first stage in rebalancing its economy, which is in stark contrast to other leading trading nations that have simply resumed previous policy patterns. The second stage in China’s rebalancing will consist of further strengthening private consumption. We argue that this will be best supported by continued reliance on renminbi stability and capital account management, so as to assure that macroeconomic policies can be framed in line with domestic development requirements.

The key factor underlying China’s fast development during the last 50 years is its ability to master and accumulate new and more complex capabilities, reflected in the increase in diversification and sophistication of its export basket. This accumulation was policy induced and not the result of the market, and began before 1979. Despite its many policy mistakes, if China had not proceeded this way, in all likelihood it would be a much poorer country today. During the last 50 years, China has acquired revealed comparative advantage in the export of both labor-intensive products (following its factor abundance) and sophisticated products, although the latter does not indicate that there was leapfrogging. Analysis of China’s current export opportunity set indicates that it is exceptionally well positioned (especially taking into account its income per capita) to continue learning and gaining revealed comparative advantage in the export of more sophisticated products. Given adequate policies, carefully thought-out and implemented reforms, and skillful management of constraints and risks, China has the potential to continue thriving. This does not mean, however, that high growth will continue indefinitely.

By Martin Wolf

October 8, 2008. Copyright 2008 The Financial Times Limited. “FT” and “Financial Times” are trademarks of the Financial Times.

“Things that can’t go on forever, don’t.” —Herbert Stein, former chairman of the US presidential Council of Economic Advisers

What confronts the world can be seen as the latest in a succession of financial crises that have struck periodically over the last 30 years. The current financial turmoil in the US and Europe affects economies that account for at least half of world output, making this upheaval more significant than all the others. Yet it is also depressingly similar, both in its origins and its results, to earlier shocks.

To trace the parallels—and help in understanding how the present pressing problems can be addressed—one needs to look back to the late 1970s. Petrodollars, the foreign exchange earned by oil exporting countries amid sharp jumps in the crude price, were recycled via western banks to less wealthy emerging economies, principally in Latin America.

This resulted in the first of the big crises of modern times, when Mexico’s 1982 announcement of its inability to service its debt brought the money-centre banks of New York and London to their knees.

Carmen Reinhart of the University of Maryland and Kenneth Rogoff of Harvard University identify the similarities in a paper published earlier this year.* They focus on previous crises in high-income countries. But they also note characteristics that are shared with financial crises that have occurred in emerging economies.

This time, most emerging economies have been running huge current account surpluses. So a “large chunk of money has effectively been recycled to a developing economy that exists within the United States’ own borders,” they point out. “Over a trillion dollars was channelled into the subprime mortgage market, which is comprised of the poorest and least creditworthy borrowers within the US. The final claimaint is different, but in many ways the mechanism is the same.”

The links between the financial fragility in the US and previous emerging market crises mean that the current banking and economic traumas should not be seen as just the product of risky monetary policy, lax regulation and irresponsible finance, important though these were. They have roots in the way the global economy has worked in the era of financial deregulation. Any country that receives a huge and sustained inflow of foreign lending runs the risk of a subsequent financial crisis, because external and domestic financial fragility will grow. Precisely such a crisis is now happening to the US and a number of other high-income countries including the UK.

These latest crises are also related to those that preceded them—particularly the Asian crisis of 1997–98. Only after this shock did emerging economies become massive capital exporters. This pattern was reinforced by China’s choice of an export-oriented development path, partly influenced by fear of what had happened to its neighbours during the Asian crisis. It was further entrenched by the recent jumps in the oil price and the consequent explosion in the current account surpluses of oil exporting countries.

The big global macroeconomic story of this decade was, then, the offsetting emergence of the US and a number of other high-income countries as spenders and borrowers of last resort. Debt-fuelled US households went on an unparalleled spending binge by dipping into their housing “piggy banks.”

In explaining what had happened, Ben Bernanke, when still a governor of the Federal Reserve rather than chairman, referred to the emergence of a “savings glut.” The description was accurate. After the turn of the millennium, one of the striking features became the low level of long-term nominal and real interest rates at a time of rapid global economic growth. Cheap money encouraged an orgy of financial innovation, borrowing and spending.

That was also one of the initial causes of the surge in house prices across a large part of the high-income world, particularly in the US, the UK and Spain.

What lay behind the savings glut? The first development was the shift of emerging economies into a large surplus of savings over investment. Within the emerging economies, the big shifts were in Asia and in the oil exporting countries (see chart). By 2007, according to the International Monetary Fund, the aggregate savings surpluses of these two groups of countries had reached around 2 per cent of world output.

Despite being a huge oil importer, China emerged as the world’s biggest surplus country: its current account surplus was $372bn (£215bn, €272bn) in 2007, which was not only more than 11 per cent of its gross domestic product, but almost as big as the combined surpluses of Japan ($213bn) and Germany ($185bn), the two largest high-income capital exporters.

Last year, the aggregate surpluses of the world’s surplus countries reached $1,680bn, according to the IMF. The top 10 (China, Japan, Germany, Saudi Arabia, Russia, Switzerland, Norway, Kuwait, the Netherlands and the United Arab Emirates) generated more than 70 per cent of this total. The surpluses of the top 10 countries represented at least 8 per cent of their aggregate GDP and about one-quarter of their aggregate gross savings.

Meanwhile, the huge US deficit absorbed 44 per cent of this total. The US, UK, Spain and Australia—four countries with housing bubbles—absorbed 63 per cent of the world’s current account surpluses.

That represented a vast shift of capital—but unlike in the 1970s and early 1980s, it went to some of the world’s richest countries. Moreover, the emergence of the surpluses was the result of deliberate policies—shown in the accumulation of official foreign currency reserves and the expansion of the sovereign wealth funds over this period.

Quite reasonably, the energy exporters were transforming one asset—oil—into another—claims on foreigners. Others were recycling current account surpluses and private capital inflows into official capital outflows, keeping exchange rates down and competitiveness up. Some described this new system, of which China was the most important proponent, as “Bretton Woods II,” after the pegged adjustable exchange rates set-up that collapsed in the early 1970s. Others called it “export-led growth” or depicted it as a system of self-insurance.

Yet the justification is less important than the consequences. Between January 2000 and April 2007, the stock of global foreign currency reserves rose by $5,200bn. Thus three-quarters of all the foreign currency reserves accumulated since the beginning of time have been piled up in this decade. Inevitably, a high proportion—probably close to two-thirds—of these sums were placed in dollars, thereby supporting the US currency and financing US external deficits.

The savings glut had another dimension, related to a second financial shock—the bursting of the dot-com bubble in 2000. One consequence was the move of the corporate sectors of most high-income countries into financial surplus. In other words, their retained earnings came to exceed their investments. Instead of borrowing from banks and other suppliers of capital, non-financial corporations became providers of finance.

In this world of massive savings surpluses in a range of important countries and weak demand for capital from non-financial corporations, central banks ran easy monetary policies. They did so because they feared the possibility of a shift into deflation. The Fed, in particular, found itself having to offset the contractionary effects of the vast flow of private and, above all, public capital into the US.

A simple way of thinking about what has happened to the global economy in the 2000s is that high-income countries with elastic credit systems and households willing to take on rising debt levels offset the massive surplus savings in the rest of the world. The lax monetary policies facilitated this excess spending, while the housing bubble was the vehicle through which it worked.

The charts show what happened, as a result, to “financial balances”—the difference between expenditure and income inside the US economy. If one looks at three sectors—foreign, government and private—it is evident that the first has had a huge surplus this decade—offset, as it has to be, by deficits in the other two.

In the early 2000s, the US fiscal deficit was the main offset. In the middle years of the decade, the private sector ran a large deficit while the government’s shrank. Now that the recession-hit private sector is moving back into balance at enormous speed, the government deficit is exploding once again.

Looking at what happened inside the private sector, a striking contrast can be seen between the corporate and household realms. Households moved into a huge financial deficit, which peaked at just under 4 per cent of GDP in the second quarter of 2005. Then, as the housing bubble burst, housebuilding collapsed and households started saving more. With remarkable speed, the household financial deficit disappeared. Today’s explosion in the fiscal deficit is the offset.

Inevitably, huge household financial deficits also mean huge accumulations of household debt. This was strikingly true in the US and UK. In the process, the financial sector accumulated an ever greater stock of claims not just on other sectors but on itself. This frightening complexity, which lies at the root of many of the current difficulties, was facilitated by the environment of easy borrowing and search for high returns in an environment of low real rates of interest. These linked dangers between external and internal imbalances, domestic debt accumulations and financial fragility were foretold by a number of analysts. Foremost among them was Wynne Godley of Cambridge University in his prescient work for the Levy Economics Institute of Bard College, which has laid particular stress on the work of the late Hyman Minsky.**

So what might—and should—happen now? The big danger, evidently, is of a financial collapse. The principal offset, in the short run, to the inevitable cuts in spending in the private sector of the crisis-afflicted economies will also be vastly bigger fiscal deficits.

Fortunately, the US and the other afflicted high-income countries have one advantage over the emerging economies: they borrow in their own currencies and have creditworthy governments. Unlike emerging economies, they can therefore slash interest rates and increase fiscal deficits.

Yet the huge fiscal boosts and associated government recapitalisation of shattered financial systems are only a temporary solution. There can be no return to business as usual. It is, above all, neither desirable nor sustainable for global macroeconomic balance to be achieved by recycling huge savings surpluses into the excess consumption of the world’s richest consumers. The former point is self-evident, while the latter has been demonstrated by the recent financial collapse.

So among the most important tasks ahead is to create a system of global finance that allows a more balanced world economy, with excess savings being turned into either high-return investment or consumption by the world’s poor, including in capital-exporting countries such as China. A part of the answer will be the development of local-currency finance in emerging economies, which would make it easier for them to run current account deficits than proved to be the case in the past three decades.

It is essential in any case for countries in a position to do so to expand domestic demand vigorously. Only in this way can the recessionary impulse coming from the corrections in the debt-laden countries be offset.

Yet there is a still bigger challenge ahead. The crisis demonstrates that the world has been unable to combine liberalised capital markets with a reasonable degree of financial stability. A particular problem has been the tendency for large net capital flows and associated current account and domestic financial balances to generate huge crises. This is the biggest of them all.

Lessons must be learnt. But those should not just be about the regulation of the financial sector. Nor should they be only about monetary policy. They must be about how liberalised finance can be made to support the global economy rather than destabilise it.

This is no little local difficulty. It raises the deepest questions about the way forward for our integrated world economy. The learning must start now.

*“Is the 2007 US subprime financial crisis so different? An international historical comparison.” Working paper 13761, www.nber.org

**The US economy: Is there a way out of the woods? November 2007, www.levyinstitute.org

The writer is the FT’s chief economics commentator and author of Fixing Global Finance, published in the US this month by Johns Hopkins University Press and forthcoming in the UK through Yale University Press.

This paper traces the rise of export-led growth as a development paradigm and argues that it is exhausted owing to changed conditions in emerging market (EM) and developed economies. The global economy needs a recalibration that facilitates a new paradigm of domestic demand-led growth. Globalization has so diversified global economic activity that no country or region can act as the lone locomotive of global growth. Political reasoning suggests that EM countries are not likely to abandon export-led growth, nor will the international community implement the international arrangements needed for successful domestic demand-led growth. Consequently, the global economy likely faces asymmetric stagnation.