73 The Global Financial Crisis – pothole or mountain? by Steve Keen

(1) The Global Financial Crisis – pothole or mountain? by Steve Keen
(2) Budget Deficit not the problem, but we need a new Reserve Currency - Stiglitz
(3) EU banks not loaning despite cheap money offered by the ECB
(4) 49 of 50 states lose manufacturing jobs

(1) The Global Financial Crisis – pothole or mountain? by Steve Keen

From: ERA <hermann@picknowl.com.au> Date: 01.09.2009 03:16 AM

Date: Tuesday, 1 September, 2009

The Global Financial Crisis – pothole or mountain?

by Steve Keen

Published in August 30th, 2009 {visit the link to see the charts}

http://www.debtdeflation.com/blogs/2009/08/30/debtwatch-no-38-the-gfc%E2%80%94pothole-or-mountain/

Debtwatch No. 38: The GFC - Pothole or Mountain?

"The Marxian view is that capitalistic economies are inherently unstable and that excessive accumulation of capital will lead to increasingly severe economic crises. Growth theory, which has proved to be empirically successful, says this is not true.
The capitalistic economy is stable, and absent some change in technology or the rules of the economic game, the economy converges to a constant growth path with the standard of living doubling every 40 years.
In the 1930s, there was an important change in the rules of the economic game. This change lowered the steady-state market hours. The Keynesians had it all wrong.
In the Great Depression, employment was not low because investment was low. Employment and investment were low because labor market institutions and industrial policies changed in a way that lowered normal employment."

Obviously, I did not write the above. The author was instead Edward C. Prescott, who shared the 2004 Nobel Prize in Economics for the development of real business cycle theory, in his 1999 paper "Some Observations on the Great Depression" (Federal Reserve Bank of Minneapolis Quarterly Review, Winter 1999, vol. 23, no. 1, pp. 25– 31).

This statement is remarkable for a number of reasons I'll discuss below. But though it is extreme, it does express a belief that is endemic in neoclassical economics, that a market economy is inherently stable and will always return to a stable growth path after a shock.

That common belief lies behind the expectations of economists that, now that the GFC has played itself out, the economy will return to trend growth and the emergency measures that attenuated its impact can be withdrawn.

From this perspective, the GFC was a "pothole in the road" caused by the Subprime crisis, a "change in the rules of the economic game" which is now behind us. With the damage caused by the crisis largely contained, normal economic growth can resume. Over time, the unemployment rate will return to pre-crisis levels as the economic car resumes its steady speed along the highway of history.

The alternative perspective is that the GFC was more akin to an abrupt change in the terrain. The "economic car" had been coasting downhill with the gravity of ever-increasing private debt adding to the speed of the car. With the GFC we reached the bottom of the hill, and the car now has to drive uphill as it attempts to maintain its previous debt-enhanced speed while also reducing debt.

Visually at least, the "change in terrain" analogy stands up better than the pothole. I normally show the debt to GDP ratio as a rising function, but the economy's speed gets a boost as the increase in debt makes a positive contribution to aggregate demand, and is slowed down when deleveraging reduces demand. So turning the ratio upside down may give a better idea of the depth of the "Valley of Debt" into which we have fallen:

When Australia began its most recent descent into debt in mid-1964, the average annual increase of 4.2% in the ratio added only a trivial amount to aggregate demand - since at the time debt was a mere 25% of GDP. But at the end of the debt bubble in 2008, when debt had become 165% of GDP, that same rate of debt growth added a huge amount to demand - the economic "car" gained speed as the slope of the debt mountain increased.

We hit the bottom of that mountain in March 2008, and now we're starting to climb out of the valley - though not yet in absolute terms, since thanks to the First Home Vendors Boost, mortgage debt is still growing as business busily delevers (see comments on the data, below). But once deleveraging takes hold, the acceleration caused by racing down Debt Mountain will be replaced by an economic car straining up the Mount Debt Reduction. This change in the terrain will constrain private economic performance until debt has fallen significantly, as it did after the 1890s and the 1930s.

A similar, if more extreme, picture applies in the USA, where private debt is now 300% of GDP. In contrast to Australia, the USA's debt ratio began to rise as soon as WWII ended: on average, US private debt rose 2.9% faster than GDP every year until 2008, taking the debt ratio from 45% at the end of the War to 300% now. Deleveraging from this level of debt must exert a substantial break on economic performance, by diverting income from expenditure to debt reduction.

I am therefore one of a minority of economic commentators who regard "deflation and deleveraging" as the main dangers facing the global economy in the near future (curiously, this minority might include Australian Prime Minister Kevin Rudd). From my perspective, the Global Financial Crisis marks "a change in the terrain": for decades, rising debt has turbocharged economic performance; now falling debt will be a drag on economic activity.

The vast majority of economists who perceive the GFC as a pothole on the road that is now behind us do not consider debt and deleveraging in their analysis. Their models have neither credit nor money nor private debt in them, so from their point of view, there is no terrain at all beneath the car - merely a long flat highway of history along which the economic car drives at the speed it is underlying "real" economic performance.

This failure to even consider the role of private credit in a capitalist economy is an endemic weakness in conventional "neoclassical" economics, which ignores the dynamics of credit for a variety of reasons that are both ideological and illogical.

The ideology is apparent in Prescott's comments on the Great Depression, quoted above. The lack of logic is evident when you compare a key statement in that paper - that "Growth theory, which has proved to be empirically successful, says this is not true" - with the results of some very careful empirical research by the very same author just ten years earlier. There he (and co-author and Nobel Prize recipient Finn Kydland) concluded that the empirical data contradicted neoclassical growth theory:

"The purpose of this article is to present the business cycle facts in light of established neoclassical growth theory, which we use as the organizing framework for our presentation of business cycle facts. We emphasize that the statistics reported here are not measures of anything; rather, they are statistics that display interesting patterns, given the established neoclassical growth theory.

In discussions of business cycle models, a natural question is, Do the corresponding statistics for the model economy display these patterns? We find these features interesting because the patterns they seem to display are inconsistent with the theory." (Finn E. Kydland & Edward C. Prescott, "Business Cycles: Real Facts and a Monetary Myth", Federal Reserve Bank of Minneapolis Quarterly Review, vol. 14, no. 2, pp 3-18, p. 4).

One key pattern in actual economic data that went against the predictions of neoclassical economic theory was the relationship between broad measures of the money supply and government-created "Base Money". The standard "money multiplier" view is that:

1.The government creates "Base Money" via deficit spending, and credits that money to private individuals via social security, goods purchases etc.;

2.These private individuals then deposit that money in bank accounts;

3.The banks then retain a proportion of these deposits and lend out the rest, creating credit money (and debt).

If this view were empirically correct, then an analysis of money over time would show that "Base Money" was created first and "Credit Money" was created later, with a time lag.

In fact, what Kydland and Prescott found was that the empirical data was the opposite of this: credit money was created first, and Base Money was created later, with a lag of up to a year:

"There is no evidence that either the monetary base or M1 leads the cycle, although some economists still believe this monetary myth. Both the monetary base and M 1 series are generally procyclical and, if anything, the monetary base lags the cycle slightly.

The difference in the behavior of M1 and M2 suggests that the difference of these aggregates (M2 minus M1) should be considered. … The difference of M2-M1 leads the cycle by even more than M2, with the lead being about three quarters.

The fact that the transaction component of real cash balances (M 1) moves contemporaneously with the cycle while the much larger nontransaction component (M2) leads the cycle suggests that credit arrangements could play a significant role in future business cycle theory. Introducing money and credit into growth theory in a way that accounts for the cyclical behavior of monetary as well as real aggregates is an important open problem in economics."

I couldn't agree more, but this is not what neoclassical economists did. Instead they continued to develop models in which money and debt played no role.

Despite his excellent empirical work on monetary dynamics in "Real Facts and a Monetary Myth", Prescott's "Great Depression" paper made no reference to credit at all as an explanatory factor in the Great Depression. Instead - I'm not joking - he blamed the Depression on a "change in labor market institutions and industrial policies that lowered steady-state, or normal, market hours".

Except for this bizarre argument that the Great Depression was the result of the voluntary response of workers to unspecified changes in labour market conditions that made labour less desirable, this lengthy quote from Prescott is representative of standard neoclassical thinking about crises like the GFC:

"Essentially, business cycles are responses to persistent changes, or shocks, that shift the constant growth path of the economy up or down. This constant growth path is the path to which the economy would converge if there were no subsequent shocks. If a shock shifts the constant growth path down, the economy responds as follows. Market hours fall, reducing output; a bigger share of output is allocated to consumption and a smaller share to investment; and more time is allocated to leisure. Over time, market hours return to normal, as do investment and consumption shares of output, as the economy converges to its new lower constant growth path. The level of the new path is lower, not the growth rate along the path.

I've just described the response of the economy to a single shock. In fact, the economy is continually hit by shocks, and what economists observe in business cycles is the effects of past and current shocks. A bust occurs if a number of negative shocks are bunched in time. A boom occurs if a number of positive shocks are bunched in time. Business cycles are, in the language of Slutzky (1937), the "sum of random causes."

The fundamental difference between the Great Depression and business cycles is that market hours did not return to normal during the Great Depression. Rather, market hours fell and stayed low. In the 1930s, labor market institutions and industrial policy actions changed normal market hours. I think these institutions and actions are what caused the Great Depression."

So the Great Depression was a conscious choice by American workers to enjoy more leisure, in response to unspecified changes in the labour market  ([Later in the same essay, he states: "Exactly what changes in market institutions and industrial policies gave rise to the large decline in normal market hours is not clear....").

It would be bad enough if Prescott were merely an obscure academic economist, but he is far from obscure: he and Kydland shared the Nobel Prize in Economics for the development of neoclassical growth theory. As ridiculous as his argument is, it does accurately state the conclusions of the neoclassical "real business cycle" model. As is often the case, you find a much clearer - and therefore far more obviously absurd - statement of neoclassical economic theory when you go to the source, rather than relying on a second-hand account from a textbook or run-of-the-mill practitioner.

So the confidence that the vast majority of economists have that the GFC is now behind us, and the "normal" trend rate of growth will resume, is fundamentally based on the belief that credit and debt dynamics do not matter.

I beg to differ. Though the enormous government stimulus has attenuated the immediate impact of debt deleveraging, it has done nothing to reduce the outstanding level of private debt. Instead even sub-par growth has become dependent on continuing government stimuli, and whenever those stimuli are removed, the economy will falter.

Total private debt rose by a mere A$1 billion last month, versus as much as A$30 billion during the height of the debt bubble. But were it not for the First Home Vendors Boost (let's call it what it is), Australia would now be firmly in the grips of deleveraging.

END OF COMMENTARY

COMMENTS ON THE DATA - A Mortgage & Government Led Recovery?

Total private debt rose by a mere A$1 billion last month, versus as much as A$30 billion during the height of the debt bubble. But were it not for the First Home Vendors Boost (let's call it what it is), Australia would now be firmly in the grips of deleveraging.

Nonetheless the debt to GDP ratio fell yet again, because the rate of growth of debt is now substantially below the rate of growth of GDP - even though that is now also anaemic.

The breakdown of debt shows that the business sector is rapidly deleveraging, while mortgage and government debt is escalating - and both those are the result of government policy.

Without the First Home Vendors Boost, it is highly unlikely that mortgage debt would still be rising today. Mortgage debt peaked as a percentage of GDP in March 2008, and fell for the remainder of the year until the First Home Vendors Boost.

The quarterly change in mortgage debt was also trending down from the 2005 peak, and that downward trend has clearly been reversed by the impact of the Boost.

House Prices

The Boost has certainly had the impact the government desired, of arresting the fall in Australian house prices.

It will also almost certainly guarantee that I'll be walking (and running) to Kosciuszko under the first half of the bet with Rory Robertson.[1] The second half of the bet, that the fall from peak to trough will be of the order of 40%, may still see Rory also walking some years hence - and the withdrawal of the Boost may make this occur sooner rather than later.

The reason is twofold. Firstly, the Boost has obviously brought forward some buying by First Home Buyers that would have occurred anyway, as well as enticing in others who might not have considered it otherwise. The withdrawal of that demand will have a strong impact on the sub-$500,000 price range.

But the withdrawal will also affect houses in the $1 million to $1.5 million range as well, because the Boost did far more than merely boost sub-$500,000 prices.

First Home Buyers who were enticed into the market by the additional $7,000 geared that up with additional debt by at least a factor of 4, to result in something like a $35,000 price jump for sub-$500K houses. But the sellers of those houses - the real beneficiaries of the Boost - then received an extra $35,000 in cold hard cash. They then used this as a boost to their own deposits on their purchases of houses further up the chain - and if they also geared by a factor of 4 (ie a 80% marginal level of gearing, which is well within current lending practice), then the prices they paid for houses in the $750K-1.5M range would have risen by $140,000.

This works in reverse as well. When the Boost is withdrawn, not only will sellers of sub-$500K houses find that buyers have $35K less to spend than during the boost, the sellers of $750K-1.5M abodes will find their buyers short about $150K compared to during the boost.

2010 could be an interesting year for Australian house prices.

[1] If the index breaks its current maximum level of 131 in the next release of ABS 6416, I will walk (and run) from Parliament House to Mt Kosciusko as required by the bet in the last weeks of February 2010.

(2) Budget Deficit not the problem, but we need a new Reserve Currency - Stiglitz

Thanks to the Deficit, the Buck Stops Here

From: geab@leap2020.eu  Date: 01.09.2009 09:58 PM

Beware of deficit fetishism. Last week we learned that the national debt is likely to grow by more than $9 billion. That's not great news -- no one likes a big deficit -- but President Obama inherited an economic mess from the Bush administration, and the cleanup comes with an inevitably high price tag. We're paying it now.

Washington Post

Correction to This Article
An earlier version of this article incorrectly stated the projected 10-year federal deficit. The correct sum is $9 trillion.

Thanks to the Deficit, the Buck Stops Here

By Joseph E. Stiglitz

Sunday, August 30, 2009

Beware of deficit fetishism.

Last week we learned that the national debt is likely to grow by more than $9 trillion. That's not great news -- no one likes a big deficit -- but President Obama inherited an economic mess from the Bush administration, and the cleanup comes with an inevitably high price tag. We're paying it now.

There are no easy options. When financial crises strike, economic growth declines and living standards drop, resulting in lower tax revenues and greater need for government assistance -- all of which leads to higher fiscal imbalances.

What really matters is not the size of the deficit but how we're spending our money. If we expand our debt in order to make high-return, productive investments, the economy can become stronger than if we slash expenditures.

There are other consequences, however, that we're missing in the debate over all this red ink. Our budget deficit, as well as the Federal Reserve's ballooning lending programs and other financial obligations, will accelerate a process already well underway -- a changing role for the U.S. dollar in the global economy.

The domino effect is straightforward: Higher deficits spark market concerns over future inflation; concerns of inflation contribute to a weaker dollar; and both come together to undermine the greenback's role as a reliable store of value around the world. Right now, with so much unused capacity in the American economy and so much unemployment -- likely to persist for at least another year or two -- the more pressing worry is deflation (a general decrease in prices), not inflation. But as the economy eventually recovers, the possibility of inflation will loom, and with forward-looking markets, worries about the future often play out in the present. Anxieties about future inflation can lead to a weaker dollar today.

So, are these anxieties justifiable? And what do they portend for the global financial system?

The worries are justified, even though Fed Chairman Ben Bernanke, recently nominated for another four-year term, assures us that he will deftly manage monetary policy to keep the economy on an even kilter. This is a tough balancing act -- move too quickly or too vigorously, and you plunge the economy into another downturn; too slowly or too weakly, and inflation can be unleashed. Anyone looking at the Fed's record in recent years will be skeptical of its forecasting skills and its ability to get the balance right.

In addition, international markets understand that the United States may face strong incentives to reduce the real value of its debts through inflation, which makes each dollar owed worth less. If market players are worried about inflation (or even if they are worried that others might be worried) that is bad news for the dollar. Holding dollars today represents risk without reward: The returns to U.S. Treasury bills are near zero, and even those most confident in the Federal Reserve must acknowledge the chance that things will not go smoothly.

For decades, other nations have held dollars in their central bank reserves, seeking to give confidence to their country and currency. But in a globalized economy, why should the entire financial system depend on the vagaries of what happens in America?

The current system is not only bad for the world, it is bad for the United States, too. In effect, as other countries hold more dollar reserves, we are exporting T-bills rather than automobiles, and exporting T-bills doesn't create jobs. We used to offset this drag on the economy by running a fiscal deficit. But going forward, we won't find it as easy to do this. And the Fed may not be able to do the trick -- as we have learned, expansionary monetary policy poses its own risks.

Like it or not, out of the ashes of this debacle a new and more stable global reserve system is likely to emerge, and for the world as a whole, as well as for the United States, this would be a good thing. It would lead to a more stable worldwide financial system and stronger global economic growth. The current system entails developing countries putting aside hundreds of billions of dollars a year -- only weakening global demand and contributing to our economic difficulties. Also, there is something a little unseemly about poor countries lending the United States trillions of dollars, now at an interest rate of close to zero.

Discussions on the design of the new system are already underway. The United Nations' Commission of Experts on Reforms of the International Monetary and Financial System -- a body I chaired and which included economists, former and current government officials, financial sector participants, central bankers, and business leaders from Asia, Europe, the United States, Africa, and Latin America -- has argued that a new global reserve currency system may be the most important reform to ensure the long-term health of the world's economy; it also suggested how to design an orderly transition from the dollar-based system.

In its interim report in June, the commission described a number of alternatives. Some involve building on the International Monetary Fund's "special drawing rights," or SDRs -- a kind of "IMF money" -- but making the issuance of this global reserve money annual and more predictable. (Currently, issuances of SDRs are small and episodic.) Other proposed reforms are more complex and ambitious, such as issuing new global reserves in ways and amounts that could be used to stabilize the world's economy or to invest in "global public goods," such as helping developing nations reduce greenhouse gas emissions.

The United States has resisted these changes, but they will come regardless, and it's better for us to participate in the construction of a new system than have it happen without us. The United States has seen great advantages with the dollar as the world's reserve currency of choice, particularly the ability to borrow at low interest rates seemingly without limit. But we haven't seen the costs as clearly: the inevitable trade deficits, the instability, the weaker global economy. The benefits to us are likely to shrink, and rapidly so, as countries shift their holdings away from the dollar.

It is happening already, and the process is likely to accelerate. Chinese authorities, for example, have openly expressed concerns about the value of the country's vast dollar reserves. Not surprisingly, China and other nations holding lots of U.S. debt support efforts to build a new system.

America should show leadership in helping shape this new structure and managing the transition, rather than burying its head in the sand. We may have preferred to keep the old system, in which the dollar reigned supreme, but that's no longer an option.

Joseph E. Stiglitz, the 2001 Nobel Prize winner in economics, is a professor of economics at Columbia University and former chairman of the Council of Economic Advisers during the Clinton administration.

(3) EU banks not loaning despite cheap money offered by the ECB
From: geab@leap2020.eu  Date: 01.09.2009 09:58 PM

Bank credit to businesses in the eurozone shrank further last month despite current favorable conditions on the money markets, sparking fears over the true state of the economy in Europe. Loans to businesses and households in July slowed to the record lowest annual growth ever, according to figures released by the European Central Bank (ECB), the main financial institution of the 16-strong currency union, released on Thursday (27 August).

EU Observer


Slow credit flows spark worries over EU recovery

LUCIA KUBOSOVA

28.08.2009 @ 09:21 CET

Bank credit to businesses in the eurozone shrank further last month despite current favorable conditions on the money markets, sparking fears over the true state of the economy in Europe.

Loans to businesses and households in July slowed to the record lowest annual growth ever, according to figures released by the European Central Bank (ECB), the main financial institution of the 16-strong currency union, released on Thursday (27 August).

In the private sector, credit provided rose by just 0.6 percent compared with July 2008 while economists expected a 1.3 percent annual expansion. In June, loans to businesses amounted to the then minimum of 1.5 percent.

Economists interpret the results as a proof that banks do not provide the cheap money offered by the ECB and other institutions automatically to firms and households which could kick off investments and stronger consumption.

Since the economic crisis broke out last year, the Frankfurt-based bank has pumped a significant amount of liquidity into the eurozone's banking system, including €442 billion in one-year loans in late June. Leading politicians and financial authorities urged banks to lend the extra cash further for the benefit of the real economy.

But Thursday's figures "illustrate how fragile the ongoing recovery is," said Carsten Brzeski from Dutch bank ING, as quoted by AFP. "Of course, a strong slowdown in credit growth is quite normal when the economy is in the middle of a severe recession but the credit cycle needs to follow improved sentiment soon to get the recovery really going."

Several eurozone countries are currently reporting a boost in confidence in their economies both among consumers and firms but they are still cautious about borrowing new money for investments.

Germany, as the key motor of Europe's economy, saw a jump in positive sentiment among shoppers for the fifth consecutive month in August, according to GFK survey published on Thursday.

"Due to stable and even falling prices, consumers are currently left with more in their pockets," the GfK said in a statement, adding: "Currently these developments are apparently displacing possible fears about job security."

Similarly, the business confidence in the EU's biggest economy has also grown stronger for five months in a row.

Along with France, Germany recorded a minor growth in GDP last month, surprisingly stepping out of recession, and sparking hopes for a broader European recovery.

But the poor lending figures might prevent ECB decision-makers from slowly increasing record low interest rates as a result of other positive signs from the economy, economists suggest.

(4) 49 of 50 states lose manufacturing jobs

From: geab@leap2020.eu  Date: 01.09.2009 09:58 PM

Every state but Alaska lost manufacturing jobs during the past 12 months, according to data complied by the U.S. Bureau of Labor Statistics. Alaska's manufacturing sector had 22,100 jobs in July 2009, exactly the same as in July 2008.

Atlanta Business Chronicle

http://www.bizjournals.com/buffalo/stories/2009/08/24/daily32.html

Thursday, August 27, 2009

49 of 50 states lose manufacturing jobs

Business First of Buffalo - by G. Scott Thomas

Every state but Alaska lost manufacturing jobs during the past 12 months, according to a Business First analysis of new federal data.

Alaska’s manufacturing sector had 22,100 jobs in July 2009, exactly the same as in July 2008. Every other state suffered a decline in manufacturing employment during that span, as did the District of Columbia, based on data complied by the U.S. Bureau of Labor Statistics.

Ohio experienced the worst drop, losing 127,000 manufacturing jobs in a year. California and Michigan also had declines in excess of 100,000 jobs.

The overall national loss was 1.52 million manufacturing jobs -- from 13.44 million in July 2008 to 11.92 million in July 2009. ...