Better Than Bush?

Is being better than Bush good enough? I surely hope not!

By that measure, my 8-year old son could be a better president -- he's a bright kid, but would likely stammer in front of the cameras to the same degree that Bush did.
What you could count on from him though, is that even if he didn't have sufficient insight and experience to improve the world much, he would at least have the good sense not to screw it up and make it much worse either.

No, I don't think my 8-year old would order invasions of foreign countries, nor condone torture, nor would he tell Americans after 9/11 that the best thing they could to to fight terrorism was to keep shopping, nor would he be inclined to offer tax cuts for the rich while doing nothing for the poor, nor would he continue his vacation while a national emergency was occurring in New Orleans, nor would he undercut the fight against HIV/AIDS in Africa by cutting funding for condoms, nor would he allow U.S. veterans returning from Iraq to be deprived of sufficient health care, or of those fighting there to be deprived of adequate equipment, etc. etc. etc. ad nauseum.

Anyways, enough rambling, the point is, being better than Bush is child's play. We need a helluva lot more than that right now. And Obama should be measured not against Bush, but against what a real president should do.

And, on that basis, albeit after only a short time in office, he is already falling short, not just of expectations, but of his responsibility.

After 9/11, Bush had a global groundswell of popular support -- he had an incredible mandate and opportunity to do what was necessary and what was right. And Bush squandered that goodwill.

Now, Obama-mania has provided the new president with a similar mandate and opportunity to do what is necessary and what is right. The whole world is eagerly awaiting, not just a lucid speaker, but a new approach, a new direction, a new plan. And, so far, he too is squandering that goodwill.

His honeymoon is certainly not over yet. But if he persists on the course he has charted for himself so far, he will let down many many millions of people who bought into his twin messages of the "audacity of hope" and of "change you can believe in".

Cases in point:

- on the morning that the front page headlines announced Obama's call for a new era of responsibility, President Obama stuck with his appointee for Secretary of the Treasury, Timothy Geithner, despite clear evidence that Mr. Geithner had deliberately cheated the U.S. of the taxes he owed (See Another Geithner ethics compromise (let them eat cake edition))

- Obama ordered the bombing of two villages in Pakistan, in a move that seems to do little to distance Obama from his predecessor (See Obama's Vietnam?)

- Obama and his economic team decided in its first week of office to stir up protectionist sentiments by having Geithner bash China, accusing them of currency manipulation; this notwithstanding the need to very soon issue a lot of Treasury notes and bonds, of which China is normally a major buyer -- needless to say, a very odd time to choose to piss off one of the most crucial financiers of U.S. deficit spending (See Geithner's China bash)

- despite hope that an Obama administration would employ an effective fiscal stimulus, presumably having learned from the failure of the Bush administration's tax rebates in 2008 to have much effect, its become clear that Obama has negotiated from a position not of strength, given both his popularity and his Democratic majority, but from a position of weakness, allowing the Republicans to water down the stimulus plan, with too much in the form of tax cuts, and way too delayed, as, according to the CBO, only a small portion of the infrastructure planning will be deployed by September

In that vein, Roger Ehrenberg has a great post at his blog Information Arbitrage, I just don't get it:

Why is the market so jazzed by the sketchy details we have over the "new" bailout plan? Buying bad assets, but at what price? Who is bearing the cost, the US taxpayer or the bank's common stockholders and debtholders? Early handicapping is that the taxpayer is going to take it on the chin. This is bad for many, good for a few. Not much of an improvement over TARP: The Horror Movie. I just don't get it.

Corporate earnings across most sectors have been awful with prospects that are not encouraging. Banks, even those that have been "bailed out" one or more times, are still posting stunning losses. The Fed and other central banks are getting cheers for pushing rates progressively closer to zero. Is this really the panacea that the equity markets have indicated over the past several trading days? I just don't get it.

I eagerly await the details of the stimulus plan. $800+ billion is certainly a lot of money. But how much of this monumental sum will be squandered on projects that have little impact on job creation? How much horse-trading will be done on the floor and between President Obama and Congress to get something, anything, done? The stuff I've read so far is not terribly impressive. I am concerned that the incredible momentum of Obama's electoral victory might be wasted if a more transformational plan does not emerge that receives bipartisan support. Yet the equity markets roll on. I just don't get it.

Americans are, by nature, an optimistic people. This is a very fine attribute that has served us well at many points in our history. But there are times when an abundance of realism is called for, and when actions need to be strong, swift and transforming. But few of the steps we've witnessed to date fall into that bucket, except the sheer amount of money spent with little to show for it. I just don't get it.

Many smart people have put forth ideas for dramatically re-shaping the financial sector and for using high-impact, high-ROI fiscal stimulus to get people working and to enhance the infrastructure and competitiveness of our nation. Yet precious few of these idea seem to be getting through. Maybe it is just too early in the new Administration to expect such things in our programs. But when $800 billion stimulus packages are getting approved by the House and there are few bold, sweeping moves contemplated by the legislation, it appears that our voices are falling on deaf ears. I just don't get it.

Just maybe the Fed can push rates to zero and China and Japan will continue buying Treasuries. Just maybe fear will keep the dollar strong while we run multi-trillion dollar deficits and keep rates across the curve low. Just maybe Citigroup and Bank of America can be bailed out without trashing common shareholders and certain debtholders, and cost US taxpayers less than if they were taken over and worked out. Just maybe millions will get back to work because low rates will help banks rebuild their balance sheets, enable businesses to borrow and invest, create a massive mortgage refinancing windfall and get consumers spending again. Just maybe we don't need an upgrading of our physical and technology infrastructures; it's good enough. Just maybe all of our dreams really will come true.

I just don't get it.

Nor do I.

Worthwhile Reading - Chinese New Year Edition

A truly global slump. Do not look to the emerging economies for good news. Brad Setser, Follow the Money.

Inflation v. Deflation. Cassandra Does Tokyo. (hat tip, naked capitalism)

Scandinavian bank nationalizatin and due process. John Hempton, Bronte Capital.
(without a fair process that is consistently adhered to, private capital will stay away, for fear of what might happen to it with ad hoc government measures; no fair process means no private capital means nationalization becomes a self-fulfilling prophecy)

Peter Schiff was wrong. Michael Shedlock, Global Economic Trend Analysis.
(though at moments it seems otherwise, this is more than just a diatribe against Schiff for stubbornly losing a lot of his clients' money on the basis of a failed investment thesis; its a pretty good review of Mish's rationale for a grinding Japan-like deflationary outcome)

Nationalize now. Barry Ritholtz, The Big Picture.

America's banks need to hold a yard sale. Meredith Whitney, FT.

Quarterly Letter. Jeremy Grantham, GMO. (hat tip, Paul Kedrosky)
(argues that private debt needs to be halved, and speedily, or U.S. risks falling into Japanese malaise)

Roubini, Edwards predict slump in S&P 500 on China. Bloomberg.
(Roubini predicts shrinking demand from China will result in 20% sell-off in global equities; Edwards points out that emperor has no clothes on, foresees China slowdown leading to 40% drop in S&P to 500)

Bankers' pay as sign of the apocalypse. Paul Kedrosky, Infectious Greed.

Bad news: we're back to 1931. Good news: it's not 1933 yet. Ambrose-Evans Pritchard, Telegraph.

All Nationalization, All the Time

I keep finding new articles on differing perspectives on nationalization: why, when, how, etc.

But rather than keep posting more of them, I'll just refer you to interfluidity, where Steve Waldman has already nicely collated them for us at the end of his post Nationalize like real capitalists, in which he argues:

The reason to nationalize a bank is because the bank has failed and its former owners have no legitimate claim to its assets. The government has been forced to offer support with public money, thereby purchasing the corpse fair and square. We take the bank into public ownership because taxpayers who have been conscripted to accept extraordinary losses are entitled to whatever gains follow the reorganization they finance.

By the by, Waldman was already singing this tune back in September, in Real capitalists nationalize.

Worthwhile Reading - Jan 21st Edition

Seriously alarmed. Ambrose-Evans Pritchard, Telegraph.
says world on brink of disaster if England forced into situation of having to default on its debt, which is a position it may be forced into if it nationalizes its financial institutions and all their trillions of $s of foreign liabilities, which are twice the size of the entire British economy

three from John Hempton at Bronte Capital on the way he views nationalization should be pursued when necessary:
A slogan for the new administration: nationalization after due process,
Luigi Zingales has it right, and
Buiter's modest proposal.

Roubini predicts U.S. losses may reach $3.6 trillion. Bloomberg.

Debt Disaster

John Kemp, from Reuters, who wrote about the Triffin Dilemma I linked to on the 18th, says that the U.S. and UK on brink of debt disaster (hat tip, Joe).

He is, of course, correct --- except in terms of tense. They are not on the brink, they're there. People keep fooling themselves that this is a liquidity crisis; its not, its an insolvency crisis. Our debts are unsupportable based on our incomes.

Its worth reading his full article, but here's the key excerpt:

the necessary condition for resolving the debt crisis is a reduction in the outstanding volume of debt, an increase in nominal GDP, or some combination of the two, to reduce the debt-to-GDP ratio to a more sustainable level.

From this perspective, it is clear many of the existing policies being pursued in the United States and the United Kingdom will not resolve the crisis because they do not lower the debt ratio.

In particular, having governments buy distressed assets from the banks, or provide loan guarantees, is not an effective solution. It does not reduce the volume of debt, or force recognition of losses. It merely re-denominates private sector obligations to be met by households and firms as public ones to be met by the taxpayer.

This type of debt swap would make sense if the problem was liquidity rather than solvency. But in current circumstances, taxpayers are being asked to shoulder some or all of the cost of defaults, rather than provide a temporarily liquidity bridge.

In some ways, government is better placed to absorb losses than individual banks and investors, because it can spread them across a larger base of taxpayers. But in the current crisis, the volume of debts that potentially need to be refinanced is so large it will stretch even the tax and debt-raising resources of the state, and risks crowding out other spending.

Trying to cut debt by reducing consumption and investment, lowering wages, boosting saving and paying down debt out of current income is unlikely to be effective either. The resulting retrenchment would lead to sharp falls in both real output and the price level, depressing nominal GDP. Government retrenchment simply intensified the depression during the early 1930s. Private sector retrenchment and wage cuts will do the same in the 2000s.

New debt (government or otherwise) is no cure for excessive old debt. As a society, we westerners have borrowed too much from our future, for the last decade or two buying stuff we don’t need with money we don’t have. Time to pay the piper. Which means aggregate demand (AD) way below aggregate supply (AS); which means falling prices as companies try to clear inventory, and more layoffs and falling incomes as companies cut capacity; which leads to even lower AD, so AS has to keep getting slashed => vicious circle!

The public sector is trying to pick up slack for the private sector fall-off, but (a) it will fall short of what’s necessary (as argued by Krugman, etc.), as the private sector retrenchment is simply too big to counteract, (b) fiscal deficits are simply an intergenerational wealth transfer to current from future taxpayers who will ultimately have to pay it back, at a time when demographics works against that dynamic of kicking the can down the road, and (c) therefore, the more government tries to fill that gaping AD-AS gap, the sooner the ultimate day of reckoning when global imbalances unwind in a most disorderly manner, as foreigners stop throwing good money after bad and refuse to finance U.S. deficits. So U.S. interest rates will ultimately skyrocket as everyone finally acknowledges that the U.S. simply does not have the productive capacity to allow it to pay off its debt, requiring it to either default, or repay its bills with tremendously devalued dollars.

Nationalize, Already!

Given precedents, this isn't that hard to figure out. Japanese-style zombie-banks, bad! Swedish-style nationalization, good! We seem to, as Krugman and others keep having to point out, keep coming back to the SuperSIV idea, which is as bad then, despite all the recent acrobatics around it, as it was when the MLEC was first proposed.

I've seen no-one explain that any better than Felix Salmon, in his post Why Nationalization is the Best Alternative, at Portolio.com:

Kevin Drum is a bit like Joe Nocera: he's reluctant to nationalize, but he doesn't really say why.

It's wise to be wary of nationalization. It should be a last resort, and I've gotten a sense recently that a lot of people are talking about it awfully casually. Still, it's true that there are some benefits to nationalization, and one of them is that it allows us to avoid the problem of valuing and buying up toxic assets from troubled banks. If the government owns the whole bank, then the bad stuff can be easily hived off without any kind of valuation at all, and then left to sit for a while before it's sold off -- which is what the Swedes did.If we have to nationalize, then we have to nationalize. But we should understand the precedents before we do, and go ahead only if we have to.

The only argument I can find in here is an argument in favor of nationalization, not against it. Why should nationalization only be a last resort?

Let's work from an ex hypothesi assumption that a certain bank -- let's call it Citigroup -- is insolvent. This is not an unreasonable assumption, given what happened to the likes of Lehman Brothers and Washington Mutual. But I don't want to get into the details of Citi's balance sheet here: I want to ask what we should do if we've already determined that its assets, many of which fall into the "toxic" category, are significantly smaller than its liabilities.

Now the red-blooded American way of dealing with insolvent companies is bankruptcy: either Chapter 11, where the company continues as a going concern, or some kind of liquidation. For a bank, Chapter 11 is pretty much impossible, since you're not going to find anybody to provide debtor-in-possession financing to keep it going. Except the government. And if the government is in possession, then, hey, you've just nationalized the bank.

As for liquidation, that's not an option, because Citigroup is too big to fail. Dumping Citi's trillions of dollars of assets onto the market in a fire sale would depress asset prices worldwide so much that we'd enter a global depression, not just one in the US.

So what about the bad-bank option? The government buys Citi's toxic assets, taking them off Citi's balance sheet, and leaving behind a healthy bank. Sounds good -- except remember that, ex hypothesi, Citi is insolvent. If the government buys the toxic assets for what they're worth, then that doesn't help, since the amount of money that Citi gets in return isn't enough to pay off the loans that Citi essentially took out against those assets. In housing parlance, Citi's underwater on its recourse loan, and when you're underwater on a recourse loan, selling the house at its market price doesn't make you any less insolvent.

So maybe the government deliberately overpays for the toxic waste? That's a recipe for opacity, and it's very hard to systematize. If you're willing to pay 150% of market prices for Citi's bad assets, shouldn't you do that for everybody else's, too? Even perfectly healthy banks which don't need the money? Or do you just decide that Citi, because it's too big to fail, is going to get a big handout which no one else qualifies for? If you do make that determination, why not just go the whole hog and write a check to the bank outright, and put it straight into Tier 1 equity? Oh, wait, you can't do that, because that's called buying equity, and if you spent that much money on Citi's equity, you'd end up with a majority stake in the bank -- which is nationalization.

Essentially, any government purchase of toxic assets can be split into two components: the market price, and a subsidy. If the subsidy is greater than half the market capitalization of the bank, and the government doesn't end up controlling the bank, then there's something very fishy going on indeed.

It's worth bearing in mind here the first TARP proposal, which envisaged the government buying up bad assets at some kind of long-term value price which was greater than the distressed market price. That never happened, the bad assets stayed on the banks' balance sheets -- and then, in the fourth quarter, we saw some absolutely monster write-downs from those loans' end-September marks, including $15 billion at Merrill Lynch alone. You still think that the end-September marks were distressed bargain-basement prices?

Then there's the insurance proposal -- which is cropping up now in the UK after being rolled out in an ad hoc fashion with Citi and BofA here in the US. Robert Peston explains how it works:

Our biggest banks would identify their bad loans and foolish investments. And they would then pay a fee to a new state-backed insurer to protect themselves from losses over a certain level on these stinky assets.But the banks would retain these bad assets on their balance sheets. They would not be transferred to a new toxic bank. We as taxpayers wouldn't own the stinky loans - though we would be liable for losses on them over a certain level.

This has all the same problems of the create-a-bad-bank idea: the government still has to come up with a price (a/k/a expected default rate) for the bad assets, and there will still be a huge implicit subsidy, in many cases greater than the bank's market capitalization, for any institution which takes the government up on its offer. After all, the mark-to-market value of the insurer is certain to be massively negative, otherwise Warren Buffett would have set up something like this already on a for-profit basis.

Finally, the government could take the Irish approach, and target the banks' liabilities rather than their assets. Keep the assets on the banks' balance sheets, and simply guarantee all of their unsecured debts. After all, there's a government guarantee on a lot of the unsecured debt already, and there has been for years: it's called the FDIC deposit guarantee.

This is basically a massive bailout for all the banks' bondholders, who thought they were buying risky leveraged single-A bank debt, and who will suddenly find it backed by the full faith and credit of the US government. At this point, it doesn't matter if a bank is insolvent, because it can roll over its debt indefinitely, since that debt has a government guarantee. Indeed, it should be quite happy to lever up as much as it's allowed, and spend its cheap new funds on all manner of risky assets, since that gives shareholders the best chance of making lots of money and recovering some of the billions of dollars that they have lost. It's akin to taking a man with a large debt, pointing him in the direction of a casino, and telling him he has unlimited credit to try and pay that debt off. The best way for the government to avoid the obvious outcome in such a situation is for the government to take over and run the bank: nationalization. Since the government has an interest in protecting its own liabilities, rather than maximizing shareholder value, the chances of crazy gambles will be minimized. In any case, since the government is taking virtually unlimited downside, it should by rights have all the upside as well -- i.e.,
ownership.

Given how messy all of these alternatives are, why not simply go down the nationalization route? It's transparent and easy to understand: if a bank is insolvent (and the FDIC is good at making those determinations), then simply nationalize it. That's what the Swedes did, and that's what we should do too.

So I'm interested in what Kevin means when he talks about a situation where "we have to nationalize". Does he mean any situation where a too-big-to-fail bank is insolvent? Or are there further criteria he has in mind?

Worthwhile Reading - Jan 18th Edition

The Swedes did nationalize. Steve Waldman, interfluidity.

Worry about a fall in China's demand for the world's goods, not a fall in China's demand for Treasuries. Brad Setser, Follow the Money.

Considering China's options in weakening global economy. David Dollar, East Asia & Pacific on the rise. (hat tip, Setser)

Global imbalances and the Triffin dilemma. John Kemp, Reuters. (hat tip, naked capitalism)

Time to take the banks into full public ownership. Willem Buiter, FT. (hat tip, naked capitalism again)

More on the bad bank. Paul Krugman, Conscience of a Liberal.

Monetary union has left half of Europe trapped in depression. Ambrose Evans-Pritchard, Telegraph.

Eastern Europe braced for a violent 'spring of discontent'. Jason Burke, Guardian.
(my concern is that the rioting that's already happened in Athens, Riga and elsewhere will ultimately spread from emerging economies to developed economies, including the U.S. when unemployment nears 10%; I wouldn't be surpirsed if it starts in California, given all that state's problems finding money to pay the bills)

Mauldin's Crystal Ball

John Mauldin is enough of a realist to dismiss the optimistic assumptions of many out there that this will be a short recession, not too different in kind or degree than most recessions, and that the economy will, with all the stimulus thrown at it, bounce back to normal (whatever that is, exactly) in short order.

But he is also enough of an optimist to disbelieve the more pessimistic assumptions of some out there that, at the very least, we will enter a Japanese-like decade long period of economic malaise, or, worse, we have already entered a deflationary depression from which there is no escape, even with all that government stimulus.

So, what does Mauldin foresee: the muddle-through middle-ground, of course.

Deflation? Stimulus? Deleveraging? Recession? A soft depression? A return to a bull market? With all that is going on, how does it all end up? When we get to where we are going, where will we be? In chess, the endgame refers to the stage of the game when there are few pieces left on the board. The line between middlegame and endgame is often not clear, and may occur gradually or with the quick exchange of a few pairs of pieces. The endgame, however, tends to have different characteristics from the middlegame, and the players have correspondingly different strategic concerns. And in the current economic endgame, your strategy needs to consist of more than hope for a renewed bull market.

Rather than looking at just one year, in this week's letter we take the really long view and ask what the end result or endgame will look like. There are three possible scenarios (and multiple combinations) that I can think of, we will explore each. Any of them could happen, so we will need to look at some signposts to get an idea of what is actually going to occur. I can make the following prediction that will be absolutely correct: Whatever scenario I lay out here, events and time will change what actually happens. But this will give you an insight into my longer-term biases, and that should be useful. As I tell my kids, put on your thinking caps.

Employment Numbers Are Worse Than Posted

First, I have to address some more government data that can be misleading. We were told Thursday that initial unemployment claims were "only" 524,000. The talking heads immediately said that was proof the economy is simply bad, not falling off a cliff. Again, like last week, that seasonally adjusted number masks the real number, which was 952,151. That is not a typo. There were almost 1 million newly unemployed last week! That is up over 400,000 from the same week in 2008, while the seasonally adjusted number was up only 200,000. Last week the real number was 726,000, so this is a material rise of over 225,000, yet the seasonally adjusted number suggests a rise of only 57,000 from last week.

The continuing claims data leaped over 500,000 to (again, not a typo!) 5,832,746. The length of time people are staying unemployed is also rising rapidly. We are up almost 1.5 million new continuing claims in just the last five weeks. That is a stunning rise of over 30% in unemployment claims in just over a month. The data is truly ugly, but it is what it is.

When you are in periods where there are deep outliers to the data because of very real turning points in the economy (such as we are going through now), the seasonally adjusted numbers can mask the real underlying trends, both up and down.

Aye, Captain, I'm Giving Her All I've Got!

Let me repeat a point I made last week, which is important and necessary for us to grasp if we are to understand where we are headed.

We are in completely uncharted territory in terms of the economic landscape. Like the USS Enterprise in Star Trek, we are boldly going where no man has gone before. But the captains of our fleet are Keynesians to their core (and they don't have any Vulcan advisors). They don't have any historical maps to guide us back to a functioning economy; they only have theory. The North Star they are guiding us by, for good or ill, is John Maynard Keynes, with a slight nod to Milton Friedman.

It is not a question of whether or not there will be massive stimulus. The question is simply how much and for how long. And my wager, as outlined below, is that it will be far larger than anyone would want to admit today. Think of Scotty, aboard the Enterprise, when Captain Kirk demands more power, "But Captain, I'm giving her all she can take. She's ready to explode!" (But he always finds a little bit more.) Let's set the scene for where we are today. The US likely just experienced a 4th quarter with GDP down over 4%. Some estimates suggest 5%. For all of 2009 we are likely going to be down at least 1-2%, which will make this the longest recession since the Great Depression. Unemployment is headed to at least 9%. Consumer spending will be off by at least 3% this year and again in 2010, as consumers start to find virtue in savings, which should rise in the US to 6% within a few years. Housing prices are going to drop another 10-15%, taking homes back to a level
where they may be more affordable.

Corporate earnings are going to be dismal for at least the first two quarters, with forward estimates being lowered again and again. (For a thorough analysis of earnings, look at the January 2, 2009 issue in the archives.) Global trade is falling rapidly, and it is likely that we will see a global recession this year, which will result in further negative feedback on US, European, and Japanese exports.

On a more positive note, oil is below $40, which is more of a stimulus to consumers than anything anticipated by the incoming Obama administration (at least as far as consumers go). With short-term rates at zero, adjustable-rate mortgages are actually not the problem anticipated a year ago, and many homeowners are rushing to refinance their homes at lower rates. Large banks have indicated a willingness to actually cut the principle and interest on troubled mortgages, which might lower the number of defaults.

Conversely, the number of defaults is high and rising -- throughout the developed world. It is likely to be 2011 before the housing market finds a real bottom and housing construction can begin to rise.

The credit markets are still in disarray. While there are some signs that the frozen markets are thawing, the Fed and the US Treasury are having to provide more bailout capital to large US banks. Citigroup is breaking up. Bank of America needs massive amounts of capital to digest Merrill. The hole that is AIG just keeps getting deeper. It is going to take several years for the credit markets to function at anything close to normal, as we simply vaporized a whole credit industry worldwide. To think it will take anything less is simply naive. And in the meantime, the various central banks of the world, along with their governments, are going to step in to fill the need for credit.

Obama has signaled that he needs the remaining $350 billion of Troubled Asset Relief Program money as soon as possible, although his delegated Treasury Secretary, who will run the program, may be in some trouble, as he failed to pay taxes on his income from his stint at the IMF. (This is not an "Oops, I forgot!" The IMF does not withhold income taxes from its employees. However, he was given a memo about the taxes he owed. And he did pay them for two years when he was audited and caught. He clearly knew the nature of the taxes due the two prior years, yet did not come clean on those years. Dumb move for someone on a fast-track career and who clearly has an impressive intellect. He has got to be kicking himself. Since the Treasury Secretary is in charge of the IRS, this is not good for Obama. Someone on his team should have vetted this more thoroughly. I do think Geithner is otherwise as qualified as anyone else on the short list, but this is a very large cloud hanging over him.)

The auto industry is reeling. Without a lot more government funds, it is unlikely that GM or Chrysler will survive without going through bankruptcy. The industry needs to shed about 20% of capacity. No amount of government funding will change that reality. Beyond autos, industry after industry is on the ropes. I could go on and on, but you get the picture that is facing the Obama administration and the entire rest of the developed world.

So, how do we get out of this mess? As noted above, the captains of our collective ships are Keynesians. They are going to provide as much stimulus as needed.

Problem #1: Deflation

We got the Consumer Price Index numbers today, and they tell a tale of deflation. On an annualized basis, the CPI for the last three months was a negative -12.7%! Even core CPI, which is without food and energy, was a minus 0.3%. The CPI for 2008 was just 0.1% for the whole year. This was the smallest calendar-year increase since 1954, and it's down from 4.1% for 2007. (To see the whole release and data, you can go to www.bls.gov.) I outlined the problem of deflation last week in my 2009 Forecast so I will not go into detail, except to note that central bankers are going to fight tooth and nail any tendency for deflation to catch hold in the economic mind of the country. It is simply part of their DNA.

Obama wants an extra $825 billion in his stimulus package, in addition to the $350 billion in TARP monies. The Fed has started to buy mortgage assets, and that could be $500 billion or more. That is in addition to some $300 billion plus and growing in commercial paper, in addition to bank assets, etc.

Let me predict right here that this is merely the first installment. The problems described above are very large. It is one thing to make credit cheap and yet another to make consumers either want to borrow more, or be able to convince a lender that borrowers can repay their debts. On the one hand, the government is providing capital to banks and hoping they will lend it, and on the other hand the regulators are telling them to reduce lending and increase their capital. Their commercial mortgages on a mark-to-market basis are imploding. Consumer credit risk is high and rising. What's a bank to do?

Let's add it up. In the US, we have seen massive wealth destruction on personal balance sheets. At the end of the third quarter the losses totalled $5.6 trillion, between housing and stocks. They could be over $10 trillion at the end of the fourth quarter. (Source: Hoisington) The losses will almost certainly top $12 trillion by the middle of the year as housing continues to deteriorate. Pick any country in the developed world or much of the developing world, and it's the same picture: wealth destruction.

We have seen at least a trillion dollars of capital on financial companies' balance sheets disappear; and given the recent spate of bailouts, it is likely to get worse. As I have been pounding the table about, a credit crisis and imploding balance sheets, a housing crisis, and a massive earnings shortfall that yields a relentless stock market drop are all independently deflationary. The combined forces are massively so. To think that a mere trillion or so dollars in stimulus will be enough to reflate the US and the world economies is simply not realistic. Let me offer a simplistic definition of what I mean by reflation: it's when the velocity of money stops falling for at least two quarters and the economy emerges from outright recession. And much of the proposed stimulus is not really stimulus. Temporary tax cuts, as much as I like them, that are not targeted at getting small businesses recharged (which is where the real growth in jobs will come from) will likely be saved, much in the way that the last stimulus package did little real good for the economy, and simply put us another $177 billion in debt that our kids will have to pay. Helping keep people in their homes when they are already over their heads in debt is not really stimulus, however noble it sounds. Over 50% of mortgages that are reduced and rewritten are delinquent again within 6 months. That does not bode well for future efforts. Better to let the home go at some price to someone who can afford it. Tough love, but realistic.

Giving money to states to allow them to continue to spend beyond their budgets is not stimulus. And why should Texas pay for a profligate California? We have our own problems. The Robin Hood approach to stimulus programs is nonproductive and only encourages bad budgeting habits.

What will work? Infrastructure development, although that takes time, and some real thought should be given as to which projects are undertaken, rather than allocating according to which Senator has the most seniority. Spending on defense equipment, which must all have US content (which will be distasteful to the left), is real stimulus. Upgrading technology in a number of areas qualifies, although past experience suggests governments are not good at spending new tech money wisely. Spending on green technologies? Creating a million new jobs in clean tech? Get real. How do we go from less than a 100,000 real clean-tech jobs to 1,000,000 in five years, let alone one? And three million new jobs? Really? From where? What government program could do this? In what universe? It makes for nice feel-good talk, but has no bearing on reality.

Don't get me wrong. In the midst of the late 1970s malaise, when the gloom was as thick as it is today, the correct answer to the question, "Where will all the new jobs come from?" was "I don't know, but they will." And it is still the correct answer. The US free market system is still the most dynamic economy in the world, and I truly believe that we will see new industries spring up, which will be a jobs dynamo. But that will take time. It is not a short-term solution, and by short-term I mean 1-2 years.

My bet is that in the third quarter, when earnings reports come out and are terrible, unemployment is over 8% and pushing 9%, and there is no evidence of a recovery, that we will see more stimulus from both the Fed and Congress. Count on it. The Fed and the Keynesian captains of our economic ship are "all in." If the current plans do not reflate the economy, they are not going to say, "Well, that is too bad. We did what we could. Now we just have to go ahead and let the US economy catch Japanese disease." Not a chance. They will up the ante.

And they will keep trying to "jump start" the economy until it works. Obama told us to expect trillion-dollar deficits for years to come. Give him this: he is being candid and honest.

The Fed, and I think other central banks, are going to step in and be the buyers of last resort for a whole host of debts, both corporate and consumer. There are those who worry about creating inflation, because they actually do have to print money to buy these debts. While I would prefer a world where a central bank does not intervene in the markets, the time to fix the problem of excess leverage was a decade ago. Allowing banks to go to 30:1 leverage based on "value at risk" models and other financial wizardry that clearly neither the banks nor the regulators understood, was simply bad policy, and we are paying for it. As Woody Brock so wisely notes, 30:1 leverage is not three times more risky than 10:1 leverage, it is 25 times more risky. (Trust me, or at least Woody, on the math.) As an aside, many European banks were even more highly leveraged.

The End Game

The US (and indeed soon the whole world) is in a deep recession. The US is going to try and combat that recession with stimulus on a scale never before tried. It is a grand experiment. On the one hand is the theory that you can allocate stimulus and keep the velocity of money from falling. On the other hand is the theory that once the deleveraging process starts, there is not much you can do about it: it is going to work its way through the economy. We are about to find out which theory is correct.

So, let's look at three possible outcomes, with the best outcome first. The basic optimistic assumption is that, while this recession is deep and the worst in the post-WWII era, it is still just a recession. Free-market economies eventually recover. Recessions do their work of reducing excess capacity, and the businesses which survive enjoy increased market share and potential for profits to rise. And corporations do indeed have on balance stronger than usual balance sheets going into this recession, except for most financial corporations. Another exception is businesses that were bought by private equity firms with large leverage. Many of those will have to be restructured. And those that have too much leverage or were too aggressive with expansion programs? They will go the way of all overleveraged flesh.

Besides, the optimistic scenario holds, the massive amount of stimulus being applied to the US economy is on a scale never seen. It will work, just as an easy monetary policy has always worked. (Except in the '70s, but we won't make that mistake again! We learned our lesson, yes we did! Volker can stay in retirement.) This scenario assumes that the psyche of US consumers has not actually been seared all that much, and that they will return to their spending habits as soon as they are able. It also assumes this is a normal business-cycle recession. There really is no endgame. It is business as usual. There has been no fundamental altering of the US dynamic. Banks will start lending again, businesses and consumers will start borrowing, and things get back to normal. Deflation is just some bugaboo that a weird coterie of economists and investment writers harp on to scare the children into behaving more rationally. It can't really happen here. And besides, the Fed can print enough money to make deflation go away. The real worry will be if they overshoot and inflation comes roaring back.

Problem # 2: Pushing on a String

The economy clearly let leverage run to an irrational level. You've seen the graphs. US debt to GDP is now over 300% and has risen precipitously in the last ten and especially the last five years. Leverage and debt fueled the growth of the economy, but debt growth hit a wall and now the deleveraging process is the painful result. This brings us to the worst-case scenario: that all the efforts of the Fed will go for naught and that we are in a liquidity trap.

A liquidity trap is a situation in monetary economics in which a country's nominal interest rate has been lowered nearly or equal to zero to avoid a recession, but the liquidity in the market created by these low interest rates does not stimulate the economy. In these situations, borrowers prefer to keep assets in short-term cash bank accounts rather than making long-term investments. This makes a recession even more severe, and can contribute to deflation. (Wikipedia)

And there is no question, at least in my mind, that the economy, if left to its own devices, would fall into a soft deflationary depression, which would take years to climb out of. The contention of those who believe that we are headed for such a state of affairs is that no matter what the Fed does, excesses on the part of consumers and unrestrained government deficit spending is going to create a Perfect Storm. First of deflation and then, because the Fed is going to try to re-inflate the economy by printing money, we will see a resurgence in inflation and a collapse or, at the very least, a serious drop in the value of the dollar. Further, to expect foreign governments to continue to buy depreciating dollars and allow the dollar to continue to be the world's reserve currency is not realistic. And of course, there are those who think we will eventually see hyperinflation as the Fed is forced to monetize the national deficits, with gold going to $3,000 (or higher!). And Obama, with his talk of trillion-dollar deficits for an extended period, certainly adds fuel to that fire.

If, and it is a big but possible if, the Fed is indeed pushing on a string, then we are likely to see 15% unemployment, yet another lost decade for the stock market, and a real calamity in the pension, endowment, and insurance worlds, which are planning on 8% long-term portfolio returns to meet their obligations. And while I think it is a possibility we must be mindful of, it is not the most likely scenario.

The Muddle Through Middle

Now, we come to the third scenario and -- no surprise to long-time readers -- the one I think is most likely. I think that after we climb out of recession, we Muddle Through for an extended period of time. Follow my reasoning, and remember that I am often wrong but seldom in doubt! And please allow me some room to speculate. I can guarantee that I have some (or most) of the particulars wrong. But I think I have the general direction we are heading in.

We are in a serious recession. We have to allow time for both the housing market and the credit markets to heal. This will take at least two years. I think we have permanently seared the psyche of the American consumer. Consumer spending is likely to drop at least 6-7% over the next two years, and maybe more. The combination of all three bubbles (consumer spending, credit, and housing), which were made possible by increasing leverage and poor lending standards, is by definition deflationary. (I know, I keep repeating, but most readers do not really get the rather disturbing implications.)

The US government in general and the Fed in particular will react to the problem. Most of the government stimulus, other than that used to reliquefy the banking system, build useful infrastructure, and encourage small business to expand, will be wasted or have little short-term effect. The Fed (and central banks around the world), on the other hand, do have the potential to succeed with a "shock and awe" type of stimulus program.

The problem is the Velocity of Money. (You can see this explained in my December 5, 2008 letter.) There is just no way of knowing when the Fed programs will really create some traction. Anyone who shows you a model that says such and such an amount of stimulus is needed is from the government, trying to tell you that this time we really do know what we're doing. Any such models are based on assumptions about things we have no way of knowing.

The Fed (and the US government) are going to continue to run deficits and print money until the economy begins to reflate. That is one thing I truly believe. Will it be a total of $2 trillion? Three? Four? More? I don't know. How large will the Fed balance sheet be in a few years? I don't know. And neither does anyone else. There are just too many damn variables.

But I do believe that at some point there will be some inflationary traction. And combined with an economy resetting itself at some new level of consumer spending, and with a basically resilient US free-market system, a recovery will begin. But here's the problem. Let's assume, and we can, that we find this new set point for the US economy (see the "Economic Blue Screen of Death"). And that the economy begins to grow, but the Fed has injected a lot of liquidity. Now some of that liquidity is "self-liquidating." By that I mean, commercial paper is typically 90 days. The Fed simply has to begin to wind down its commercial paper investments, and it takes away some of the liquidity it created. Those mortgages they bought? Each month, as payments are made, a little liquidity is taken back from the economy. And if inflation is an issue, they can begin to withdraw that liquidity or raise rates. Of course, that will serve to slow the economy down, but better a slower Muddle Through Economy than a return to the high stagflation of the '70s.

That gets us to 2011-12. The economy is growing, albeit slower than anyone would like, but government deficits are still in the trillion-dollar range, as Obama and the Democratic Congress have increased the entitlement programs, locking in big deficits for a long time. High deficits put the dollar under pressure. The demand from voters is to get the deficit under control. However, the Social Security surpluses are beginning to dwindle. And just like in the early '80s, we have a Social Security crisis. Some combination of higher taxes, reduced benefits for wealthier
Americans, later retirement ages, and a different methodology of indexing for inflation will be the order of the day.

But Social Security is the relatively easy problem. Medicare benefits will be at nose-bleed levels and will swamp the ability of the government to fund it and other government programs. Democrats will never allow the programs to be cut back. And getting the 60-plus Republican senators needed for such cuts is just not likely to happen by 2012-2014. The problem will be dealt with by cuts in some government programs, but mostly by tax hikes on the "rich" and increased contributions by participants. Since many of the rich are the very small business people who we need to create jobs, this is going to be very anti-growth, extending the Muddle Through Economy for yet another few years. And if taxes are raised too much in 2010 when the Bush tax cuts go away, then we could see a relapse back into a recession.

Such an environment of higher taxes and slow growth is not good for corporate earnings. Earnings in the recent years have been at all-time high levels as a percentage of GDP. Earnings as such are mean reverting, and thus are unlikely to rise back to previous levels in terms of percentage of GDP. (Of course, in nominal terms they should rise.) This is going to put a constraint on stock market growth. Pension plans, endowments, insurance companies, and individual investors who are counting on 8% long-term compound returns from their stock portfolios are as likely to be disappointed in the next five years as they were in the last ten. The environment I am describing is one of compressing price to earnings ratios, much like the period from 1974 to 1982. This environment is going to force the creation of new investment programs and products based on income generation. And that is one of the forces that will bring about a real recovery in the middle of the next decade. Investment capital will be made available to businesses that can generate low double-digit or high single-digit returns, as well as new technologies with the promise to deliver new paths to profits.

The second major force will be the arrival of new waves of technological change. We will see a biotech revolution beyond our current comprehension. It has the real potential for solving a great deal of the Medicare entitlement program problems. For instance, it is likely we will have a real cure for Alzheimer's within five years. Since that is as much as 7% of US medical costs, that can create a real cost reduction. The same for heart disease, obesity, cancer, and a host of other medical conditions that will start to be dealt with by a new generation of therapies. That is going to create a new, very real bull market in biotech.

I expect to see a new generation of wireless broadband that powers whole new industries. And it will not just be green tech, but entirely new forms of energy generation that drive the cost of energy down and, combined with other new technologies, make electric cars practical. And along about the end of the decade, the nanotech world begins to really get into gear.

And just as the tightly wound, low P/E ratios of the early '80s gave way to a spring-loaded major bull market as new technologies became the driver for a whole new set of public companies, we could (and should!) see a repeat of that performance. There is a new bull market in our future.

The problem is getting from where we are today to that next dawn. The definition of insanity is to keep repeating what you have done in the past and expect a different result. We are in a long-term secular bear market. P/E ratios are going to decline over time to low double digits. Hoping that stocks somehow rebound to new highs and that the economy is going to go back to what we saw in 1982-1999 or 2003-2006 is not a strategy. You need to be proactive and take charge of your portfolio, looking for absolute-return types of investments for the next 4-5 years. Simply using a traditional 60-40 split of stocks and bonds is not going to get you to retirement nirvana. It will lead to retirement hell.

I believe that Mauldin's presumption of the future benefits of technological innovation has a lot of merit. Similarly, his historical perspective that, even at the bleakest moments in the past, there was a brighter future on the horizon, even if it was hard to predict how it might come about exactly, has a lot going for it as well.

But what I find less convincing is his presumption that government will keep interjecting itself into the economy (as Mauldin acknowldeges will be necessary) with more and more rounds of stimulus in its effort to find the magic elixir that fixes the world, and that it will do so without creating an even bigger mess. Government interventions haven't been particularly successful so far, and more often than not they've come with negative unintended consequences. The more times the government goes to that well, the more likely it seems to me that those unintended consequences really blow up in its face.

Why-o-why is restarting credit the be-all-end-all?

So, we've got this little problem of everyone being in too much debt. And the economy is seizing up and apparently, we're told, its because the banks have stopped lending. They should just lend more and everything would be okay! As the always-insightful Steve Randy Waldman explains in his post Expand transfers, not credit, we've fallen into this groupthink mode and have forgotten that credit, in and of itself, is not necessarily a good thing --- it depends on what that credit is used for. And extending more credit to an already debt-loaded consumer so he or she can consumer more is simply inane. As Waldman notes, we need to rethink this from the ground up:

I have a little secret. Please don't tell anyone. I am glad that the banks, for all the hundreds of billions of dollars we are giving them, are not lending. That is not because I want banks to improve the quality of their balance sheets. On the contrary, I don't want banks at all, at least not banks anything like what we've had. I don't want to "use all of our resources to preserve the strength of our banking institutions". Since we have already bought and paid for our nation's banking institutions, we are within our rights to, um, transition them to a different business model. Let's do that.

But credit is the lifeblood of a capitalist economy, right? I keep hearing that line. It's a dumb line.

Credit, also known as debt, is one of several arrangements by which a party with the power to command resources but lacking aptitude or interest in managing a productive enterprise delegates wealth to another party who is capable of creating value but unable to command sufficient resources. You would be forgiven for not noticing, given how habitually we misuse credit, but supplying credit is really just a subspecies of the practice that used to be called "investing". There are a variety of other arrangements that serve the same economic function. Perhaps you have heard the terms like "common stock" and "cumulative preferred equity"? In fact, credit is to investing what heroin is to painkillers: Unusually appealing, in a certain
way. Hard to kick once you're on it. Almost certain to, um, cause problems, eventually. Our overall goal ought not be to kickstart the credit economy, but to kick the habit and move towards financing arrangements that are more equity-like than debt-like. That's going to be hard to do, because historically, we've subsidized the hell out of debt financing, especially bank credit, and alternatives are underdeveloped. But with the exception of war, no still-practiced human institution provokes catastrophe as regularly or as grandly as the misuse of debt. We ought to phase out banks as we've known them since before Bagehot's time, and move to a regime of what are lately referred to as "narrow banks" (banks that lend only to the government that issues the currency of their deposits). We should encourage the development fine-grained equity markets and local-market investment funds to replace bank financing.

The rush to ramp up "consumer credit" is particularly dumb. Usually, financial investing involves funding wealth generating projects in exchange for a share of the anticipated wealth. Consumer credit funds current consumption in exchange for a share of, um, what exactly?

In theory, there's a good answer: consumer credit funds current consumption in exchange for a share of anticipated future wealth that is believed to be endowed already. Economists talk about consumption smoothing, how it may be optimal for a consumer whose income is volatile to borrow during periods of low income and repay (or save) during periods of high income in order to maintain a constant standard of living. That's very well in models where consumers know the true distribution of their future income, where the spread between borrowing and lending interest rates is not very large, and where consumer preferences are time-consistent. In practice, none of these conditions hold even approximately. As we are learning, the future is a very uncertain place. Consumers, like Wall Street quants, may inadequately extrapolate the distribution of their future income from recent observations. They have no access to the true distribution. The interest rates consumers pay for unsecured credit (think credit card rates) are often several times what they receive on money they save. In the world as it is, consumers ought to borrow only to counter severe downward shocks to income, pay off borrowings quickly, and build buffers of precautionary savings, since the cost of dissaving is much less then the cost of borrowing. (You lose 4% interest on your CD, rather than paying 12% interest on your credit card.)

Some consumers behave this way, but very many do not, suggesting that consumers are myopic, overvaluing consumption today in a manner that they themselves will come to regret in the future. If consumers are myopic, if self-today has different preferences than self-tomorrow, then whether taking on credit is a good idea is beyond the comfort zone of positive economics. Credit availability creates winners (self-today) and losers (self-tomorrow), while interest payments reduce the size of the overall pie available to the time series of selves. In the way that economists suggest "free trade" to be good — winners, losers, gains overall — myopic consumers imply that the absense of a credit constraint is bad. Thank goodness the banks aren't lending!

There are obvious wrinkles and objections — What about credit for cars, or home mortgages, or education? The analysis changes when the borrowing is exchanging one pre-existing long-term liability for another. (We are born short basic shelter, and, in much of America at least, short a cheap car as well.) Education can be viewed as an ordinary, wealth generating investment project that in theory could be equity rather than debt financed, but that might be too tricky in practice. It's not my intention to suggest that consumer credit is always bad, only to defend the commonplace notion that for many people and under many circumstances, even loans that will be never be defaulted can be positively harmful, and as a matter of policy we should not be exhorting banks to issue or consumers to accept credit.
But if we let consumer credit contract, and if investment demand is derived from consumption demand, doesn't that spell macroeconomic disaster? There is an alternative. It is called "transfers". What's good about credit from a simple Keynesian perspective isn't that loans get repaid tomorrow, but that they get spent today. If what consumers would do with funds would be better for the economy than what banks are doing with funds, we ought to stop the massive transfers of funds from buyers of government debt to banks, and transfer the funds directly to consumers. If you think that Americans consume too much, and that we need to grit our teeth and endure a "reduction in our standard of living", fine. I disagree, strongly, but at least you're consistent. Then the government shouldn't transfer to anyone, banks shouldn't be encouraged to lend, consumption, investment, and GDP should be allowed to fall until we find a new level. I think that's foolishly pessimistic, though. Americans may need to change the mix of our consumption, but overall I think our standard of living is not only supportable, but improvable, and that our goal should be to get the rest of the world to live as well as we do, rather than to reconcile ourselves with some pseudomoral poverty. The world is full of human want, which we should strive to meet by working to increase our capacity to produce. Problems arise when want and purchasing power are misaligned. We can improve that by redistributing some of the purchasing power from those with lesser to those with greater use for current consumption. If that sounds Commie to you, note that is precisely the function that consumer credit traditionally serves, just without all the residual claims, a large fraction of which will prove to be illusory (at least in real terms). That is, transfers are just a more honest way of doing precisely what a credit expansion does, except without the trauma that comes
from learning that much of the money lent to fund current consumption will never be repaid.

I'm trying to come up with a reasonable opposing view, a case for pushing consumer credit but opposing transfers. Perhaps you can help, because I just can't do it. One might argue on philosophical grounds against coercive transfers, but coercive transfers are a precondition of restarting bank lending, and we've already made transfers to banks on such a scale that banning them now would be like robbing a jewelry store, then piously arguing future looters should be shot. One might argue that bank lending is "smarter" than public transfers would be, that the patterns of consumption and investment that result from private sector credit allocation will lead to superior productive capacity and more sustainable patterns of consumption than direct transfers. Given the awful quality of aggregate investment this decade and the volatility now faced by consumers who were recently credit flush but who under any reasonable lending standard must now be credit constrained, it is hard to be enthusiastic about the special wisdom of bank-mediated credit allocation.

Of course, once we start redistributing purchasing power, there's the thorny question of who gets what. I have an answer to that, it is my new mantra. Transfer flat. Cut checks to every adult in the economy of interest, regardless of whether they pay taxes or have a job. Flat transfers are easy to understand and they pass the smell test for "fair". As an income source unrelated to work, flat transfers increase workers' bargaining power with employers by reducing the cost of refusing a raw deal. (Supplementary income is a better means of enhancing labor bargaining power than unionization, which serves the same purpose but may limit the flexibility and efficiency of production.) Finally, flat transfers align purchasing power in the economy with the problem that we want markets to solve — We want an economy that serves some people dramatically more than others, in order to preserve incentives to produce and excel. But we also want an economy that meets every person's basic needs, even those of people who are unable or unwilling to offer marketable goods or services. We won't let people starve, so why not fund a basic income, however miserly, rather than relying on an inefficient social services bureaucracy or taxing the virtuous by relying on charity?

Tax Pigou and progressive. Transfer flat. Encourage equity. Contain the banks.

Bernanke Ignoring Fisher and Minsky (to Our Peril)?

Common wisdom is that we are fortunate to have one of the world's foremost experts on the Great Depression leading the Fed at this time. Steve Keen, the author of debunking Economics, questions this assumption. In Bernanke an Expert on the Great Depression?? (hat tip, Yves Smith), Keen reviews Bernanke's analysis and finds it lacking. In particular, he believes that any "understanding" of the Depression that minimizes the role of the build-up in private debt in the 1920s is simply faulty.

A link to this blog from a US legal advisory website the Practising Law Institute’s In Brief ( “DEFLATION IN THE REAL WORLD“) reminded me of Bernanke’s book Essays on the Great Depression, which I’ve been aware of for some time but have yet to read. I’ll make amends on that front early this year; fortunately, an extract from Chapter One is available as a preview on the Princeton site (I couldn’t locate the promised eBook anywhere!; in what follows, when I quote Bernanke it is from the original journal paper published in 1995, rather than this chapter).

To put it mildly, Bernanke’s analysis is not promising.

The most glaring problem on first glance is that, despite Bernanke’s claim in Chapter One “THE MACROECONOMICS OF THE GREAT DEPRESSION: A Comparative Approach” that he will survey “our current understanding of the Great Depression”, there is only a brief, twisted reference to Irving Fisher’s Debt Deflation Theory of Great Depressions, and no discussion at all of Hyman Minsky’s contemporary Financial Instability Hypothesis (and a blogger informed me that his entire reference to Minsky in the book amounted to one discussion and one footnote, which I’ll get to later on).

While he does discuss Fisher’s theory, he provides only a parody of it–in which he nonetheless notes that Fisher’s policy advice was influential:

“Fisher envisioned a dynamic process in which falling asset and commodity prices created pressure on nominal debtors, forcing them into distress sales of assets, which in turn led to further price declines and financial difficulties. His diagnosis led him to urge President Roosevelt to subordinate exchange-rate considerations to the need for reflation, advice that (ultimately) FDR followed.

He then explains that neoclassical economists in general readily dismissed Fisher’s theory, for reasons that are very instructive:

Fisher’s idea was less influential in academic circles, though, because of the counterargument that debt-deflation represented no more than a redistribution from one group (debtors) to another (creditors). Absent implausibly large differences in marginal spending propensities among the groups, it was suggested, pure redistributions should have no significant macroeconomic effects. ” (Bernanke 1995, p. 17)

Bernanke himself does try to make sense of Fisher within a neoclassical framework, which I’ll get to below; but the general neoclassical reaction to Fisher that he describes is a perfect example of the old (and very apt!) joke that an economist is someone who, having heard that something works in practice, then ripostes “Ah! But does it work in theory?”.

It is also–I’m sorry, there’s just no other word for it–mind-numbingly stupid. A debt-deflation transfers income from debtors to creditors? From, um, people who default on their mortgages to the people who own the mortgage-backed securities, or the banks?

Well then, put your hands up, all those creditors who now feel substantially better off courtesy of our contemporary debt-deflation…

What??? No-one? But surely you can see that in theory…

The only way that I can make sense of this nonsense is that neoclassical economists assume that an increase in debt means a transfer of income from debtors to creditors (equal to the servicing cost of the debt), and that this has no effect on the economy apart from redistributing income from debtors to creditors. So rising debt is not a problem.

Similarly, a debt-deflation then means that current nominal incomes fall, relative to accumulated debt that remains constant. This increases the real value of interest payments on the debt, so that a debt-deflation also causes a transfer from debtors to creditors–though this time in real (inflation-adjusted) terms.

Do I have to spell out the problem here? Only to neoclassical economists, I expect: during a debt-deflation, debtors don’t pay the interest on the debt–they go bankrupt. So debtors lose their assets to the creditors, and the creditors get less–losing both their interest payments and large slabs of their principal, and getting no or drastically devalued assets in return. Nobody feels better off during a debt-deflation (apart from those who have accumulated lots of cash beforehand). Both debtors and creditors feel and are poorer, and the problem of non-payment of interest and non-repayment of principal often makes creditors comparatively worse off than debtors (just ask any of Bernie Madoff’s ex-clients).

Back to Bernanke’s take on Fisher, rather than the generic neoclassical idiocy on debt-deflation. Firstly, Bernanke’s “summary” of Fisher’s argument starts with asset price deflation: ”Fisher envisioned a dynamic process in which falling asset and commodity prices created pressure on nominal debtors…”.

Sorry Ben, but (to use a bit of crude Australian vernacular), this is an “arse about tit” reading of Fisher. Fisher’s dynamic process began with excessive debt, not with falling asset prices. You have confused cause and effect in Fisher’s theory: excessive debt and the deleveraging process that engendered lead to falling asset and commodity prices as symptoms (which then amplify the initial problem of excessive debt in a positive feedback process). To make this concrete, Fisher referred to:
“two dominant factors, namely over-indebtedness to start with and deflation following soon after” (Fisher 1933, p. 341)

I hope that’s clear enough that, in Fisher’s argument, overindebtedness is the first factor and deflation the second–and in fact, Fisher argues that overindebtedness causes deflation, if the initial rate of inflation is low enough (he also countenances the situation in which inflation is higher and deflation doesn’t eventuate, which he argues won’t lead to a Depression). Before I discuss Bernanke’s own attempt to express what his misinterpretation of Fisher in neoclassical form, it’s worth setting Fisher’s own causal sequence out in full. In his Econometrica paper, Fisher argued that the process that leads to a Depression is the following:

“(1) Debt liquidation leads to distress selling and to

(2) Contraction of deposit currency, as bank loans are paid off, and to a slowing down of velocity of circulation. This contraction of deposits and of their velocity, precipitated by distress selling, causes

(3) A fall in the level of prices, in other words, a swelling of the dollar. Assuming, as above stated, that this fall of prices is not interfered with by reflation or otherwise, there must be

(4) A still greater fall in the net worths of business, precipitating bankruptcies and

(5) A like fall in profits, which in a “capitalistic,” that is, a private-profit society, leads the concerns which are running at a loss to make

(6) A reduction in output, in trade and in employment of labor. These losses, bankruptcies, and unemployment, lead to

(7) Pessimism and loss of confidence, which in turn lead to

(8) Hoarding and slowing down still more the velocity of circulation. The above eight changes cause

(9) Complicated disturbances in the rates of interest, in particular, a fall in the nominal, or money, rates and a rise in the real, or commodity, rates of interest.”
(Econometrica, 1933, Volume 1, p. 342)

In its own way, this is a very simple process to both understand and to model. To understand it, all we have to do is look at the current economic situation in the USA–all nine stages of Fisher’s process are already well under way there. I’ve also modelled the debt component of this process in my papers on financial instability (and the deflation aspect too in other research I’ve yet to publish, but which will be in my forthcoming book for Edward Elgar, Finance and Economic Breakdown [expected publication date is 2011]).

So why didn’t Bernanke–and other neoclassical economists–understand Fisher’s explanation and develop it?

Because an essential aspect of Fisher’s reasoning was the need to abandon the fiction that a market economy is always in equilibrium.

The notion that a market economy is in equilibrium at all times is of course absurd: if it were true, prices, incomes–even the state of the weather–would always have to be “just right” at all times, and there would be no economic news at all, because the news would always be that “everything is still perfect”. Even neoclassical economists implicitly acknowledge this by the way they analyse the impact of tariffs for example, by showing to their students how, by increasing prices, tariffs drive the supply above the equilibrium level and drive the demand below it.

The reason neoclassical economists cling to the concept of equilibrium is that, for historical reasons, it has become a dominant belief within that school that one can only model the economy if it is assumed to be in equilibrium.

From the perspective of real sciences–and of course engineering–that is simply absurd. The economy is a dynamic system, and like all dynamic systems in the real world, it will be normally out of equilibrium. That is not a barrier to mathematically modelling such systems however–one simply has to use “differential equations” to do so. There are also many very sophisticated tools that have been developed to make this much easier today–largely systems engineering and control theory technology (such as Simulink, Vissim, etc.)–than it was centuries ago when differential equations were first developed.

Some neoclassicals are aware of this technology, but in my experience, it’s a tiny minority–and the majority of bog standard neoclassical economists aren’t even aware of differential equations (they understand differentiation, which is a more limited but foundational mathematical technique). They believe that if a process is in equilibrium over time, it can be modelled, but if it isn’t, it can’t. And even the “high priests” of economics, who should know better, stick with equilibrium modelling at almost all times.

Equilibrium has thus moved from being a technique used when economists knew no better and had no technology to handle out of equilibrium phenomena–back when Jevons, Walras and Marshall were developing what became neoclassical economics in the 19th century, and thought that comparative statics would be a transitional methodology prior to the development of truly dynamic analysis –into an “article of faith”. It is as if it is a denial of all that is good and fair about capitalism to argue that at any time, a market economy could be in disequilibrium without that being the fault of bungling governments or nasty trade unions and the like.

And so to this day, the pinnacle of neoclassical economic reasoning always involves “equilibrium”. Leading neoclassicals develop DSGE (”Dynamic Stochastic General Equilibrium”) models of the economy. I have no problem–far from it!–with models that are “Dynamic”, “Stochastic”, and “General”. Where I draw the line is “Equilibrium”. If their models were to be truly Dynamic, they should be “Disequilibrium” models–or models in which whether the system is in or out of equilibrium at any point in time is no hindrance to the modelling process. Instead, with this fixation on equilibrium, they attempt to analyse all economic processes in a hypothetical free market economy as if it is always in equilibrium–and they do likewise to the Great Depression.

Before the Great Depression, Fisher made the same mistake. His most notable contribution (for want of a better word!) to economic theory was a model of financial markets as if they were always in equilibrium.

Fisher was in some senses a predecessor of Bernanke: though he was never on the Federal Reserve, he was America’s most renowned academic economist during the early 20th century. He ruined his reputation for aeons to come by also being a newspaper pundit and cheerleader for the Roaring Twenties stock market boom (and he ruined his fortune by putting his money where his mouth was and taking out huge margin loan positions on the back of the considerable wealth he earned from inventing the Rolodex).

Chastened and effectively bankrupted, he turned his mind to working out what on earth had gone wrong, and after about three years he came up with the best explanation of how Depressions occur (prior to Minsky’s brilliant blending of Marx, Keynes, Fisher and Schumpeter in hisFinancial Instability Hypothesis [here's another link to this paper]).

Prior to this life-altering experience however, as a faithful neoclassical economist, Fisher portrayed the market for loans as essentially no different from any other market in neoclassical thought: it consisted of independent supply of and demand functions, and a price mechanism that set the rate of interest by equating these two functions–thus putting the market into a state of equilibrium.

However even with this abstraction, he had to admit that there were two differences between the “market for loanable funds” and a standard commodity market: firstly that the loanable fund market involves commitments over time, whereas in standard neoclassical mythology, commodity markets are barter markets where payment and delivery take place instantaneously; and secondly, it is undeniable that sometimes people don’t live up to those commitments over time–they go bankrupt.

Fisher dealt with these differences in the time-honoured neoclassical manner: he assumed them away. He imposed two conditions on his models: “(A) The market must be cleared—and cleared with respect to every interval of time. (B) The debts must be paid.” ( Irving Fisher, 1930, The Theory of Interest. New York: Kelley & Millman p. 495)

Fisher did discuss some problems with these assumptions, but in keeping with the neoclassical delusion that one couldn’t model processes out of equilibrium, these problems didn’t lead to a revision of his model.

Of course, if Fisher had been a realist, he would have admitted to himself that a model that presumes the economy is always in equilibrium will be a misleading guide to the behaviour of the actual economy. But instead, as seems to happen to all devotees of neoclassical economics, he began to see his model as the real world–and used it to explain the Stock Market bubble of the 1920s as not due to “irrational exuberance”, but due to the wonderful workings of a market economy in equilibrium.

Since Wall Street was also assumed to be in equilibrium, stock prices were justified. And he defended the bubble as representing a real improvement in the living standards of Americans, because: “We are now applying science and invention to industry as we never applied it before. We are living in a new era, and it is of the utmost importance for every businessman and every banker to understand this new era and its implications… All the resources of modern scientific chemistry, metallurgy, electricity, are being utilized–for what? To make big incomes for the people of the United States in the future, to add to the dividends of corporations which are handling these new inventions, and necessarily, therefore, to raise the prices of stocks which represent shares in these new inventions.” (Fisher, October 23rd 1929, in a speech to a bankers’ association)

Have you heard that one before: a “new era”? If I had a dollar for every time I saw that twaddle used to justify companies with negative earnings having skyhigh valuations during the Internet Bubble…

Fisher even dismissed the 6% fall in the stock market that had occurred in the day before his speech as due to “a certain lunatic fringe in the stock market, and there always will be whenever there is any successful bear movement going on… they will put the stocks up above what they should be and, when frightened, … will immediately want to sell out.”

The future, he told the assembled bankers, was rosy indeed: Great prosperity at present and greater prosperity in view in the future … rather than speculation … explain the high stock markets, and when it is finally rid of the lunatic fringe, the stock market will never go back to 50 per cent of its present level… We shall not see very much further, if any, recession in the stock market, but rather … a resumption of the bull market, not as rapidly as it has been in the past, but still a bull rather than a bear movement.” (Fisher 1929)

Prior to this speech, he had made his fatefully wrong prediction on the future course of the Dow Jones in the New York Times. For the record, his statement was: “Stock prices have reached what looks like a permanently high plateau. I do not feel that there will soon, if ever, be a fifty or sixty point break below present levels, such as Mr. Babson has predicted. I expect to see the stock market a good deal higher than it is today within a few months.”

Well, so much for all that. The stock market crash continued for three years, unemployment blew out from literally zero (as recorded by the National Bureau of Economic Research) to 25 percent, America’s GDP collapsed, prices fell… the Great Depression occurred.

At first, Fisher was completely flummoxed: he had no idea why it was happening, and blamed “speculators” for the fall (though not of course for the rise!) of the market, lack of confidence for its continuance, and so on… But experience ultimately proved a good if painful teacher, when he developed “the Debt-Deflation Theory of Great Depressions”.

An essential aspect of this new theory was the abandonment of the concept of equilibrium.

In his paper, he began by saying that: We may tentatively assume that, ordinarily and within wide limits, all, or almost all, economic variables tend, in a general way, to ward a stable equilibrium. In our classroom expositions of supply and demand curves, we very properly assume that if the price, say, of sugar is above the point at which supply and demand are equal, it tends to fall; and if below, to rise.

However, in the real world: New disturbances are, humanly speaking, sure to occur, so that, in actual fact, any variable is almost always above or below the ideal equilibrium.

Therefore in theory as well as in reality, disequilibrium must be the rule:
“Theoretically there may be—in fact, at most times there must be— over- or under-production, over- or under-consumption, over- or under spending, over- or under-saving, over- or under-investment, and over or under everything else. It is as absurd to assume that, for any long period of time, the variables in the economic organization, or any part of them, will “stay put,” in perfect equilibrium, as to assume that the Atlantic Ocean can ever be without a wave.” (Fisher 1933, p. 339; emphasis added)

He then considered a range of “usual suspects” for crises–the ones often put forward by so-called Marxists such as “over-production”, “under-consumption”, and the like, and that favourite for neoclassicals even today, of blaming “under-confidence” for the slump.

Then he delivered his intellectual (and personal) coup de grâce:

I venture the opinion, subject to correction on submission of future evidence, that, in the great booms and depressions, each of the above-named factors has played a subordinate role as compared with two dominant factors, namely over-indebtedness to start with and deflation following soon after; also that where any of the other factors do become conspicuous, they are often merely effects or symptoms of these two. In short, the big bad actors are debt disturbances and price- level disturbances. While quite ready to change my opinion, I have, at present, a strong conviction that these two economic maladies, the debt disease and the price-level disease (or dollar disease), are, in the great booms and depressions, more important causes than all others put together… Thus over-investment and over-speculation are often important; but they would have far less serious results were they not conducted with borrowed money. That is, over-indebtedness may lend importance to over-investment or to over-speculation. The same is true as to over-confidence. I fancy that over-confidence seldom does any great harm except when, as, and if, it beguiles its victims into debt. (Fisher 1933, pp. 340-341. Emphases added.)

From this point on, he elaborated his theory of the Great Depression which had as its essential starting points the propositions that debt was above its equilibrium
level and that the rate of inflation was low. Starting from this position of disequilibrium, he described the 9 step chain reaction shown above.

Of course, if the economy had been in equilibrium to begin with, the chain reaction could never have started. By previously fooling himself into believing that the economy was always in equilibrium, he, the most famous American economist of his day, completely failed to see the Great Depression coming.

How about Bernanke today? Well, as Mark Twain once said, history doesn’t repeat, but it sure does rhyme. Just four years ago, as a Governor of the Federal Reserve, Bernanke was an enthusiastic contributor to the “debate” within neoclassical economics that the global economy was experiening “The Great Moderation”, in which the trade cycle was a thing of the past–and he congratulated the Federal Reserve and academic economists in general for this success, which he attributed to better monetary policy: “In the remainder of my remarks, I will provide some support for the “improved-monetary-policy” explanation for the Great Moderation.”
Good call Ben. We have now moved from “The Great Moderation!” to “The Great Depression?” as the debating topic du jour.

On that front, his analysis of what caused the Great Depression certainly doesn’t imbue confidence. This chapter (first published in 1995 in the neoclassical Journal of Money Credit and Banking [ February 1995, v. 27, iss. 1, pp. 1-28]–the same year my Minskian model of Great Depressions was published in the non-neoclassical Journal of Post Keynesian Economics [Vol. 17, No. 4, pp. 607-635]) considers several possible causes:

A neoclassical, laboured re-working of Fisher’s debt-deflation hypothesis, to interpret it as a problem of “agency”–”Intuitively, if a borrower can contribute relatively little to his or her own project and hence must rely primarily on external finance, then the borrower’s incentives to take actions that are not in the lender’s interest may be relatively high; the result is both deadweight losses (for example,
inefliciently high risk-taking or low effort) and the necessity of costly information provision and monitoring)” (p. 17); Aggregate demand shocks from the return to the Gold Standard and its effect on world money supplies; and Aggregate supply shocks from the failure of nominal wages to fall–”The link between nominal wage adjustment and aggregate supply is straightforward: If nominal wages adjust imperfectly, then falling price levels raise real wages; employers respond by cutting their workforces” (p. 21). None of these “causes” includes excessive private debt–the phenomenon that I hope now even Ben Bernanke can see was the cause of the Great Depression–and the reason why he and neoclassical economists like him are no longer discussing “The Great Moderation”.

Whle they were doing that, a minority of economists–myself included–were avidly developing both Fisher and Minsky’s theories of Great Depressions. We are known generally as “Post Keynesian” economists, and there Minsky is an intellectual hero.

And how did Ben handle Minsky? I have yet to read all of the Essays, but a blogger who has made the following comment: In the entire volume (Bernanke, ‘Essays on Great Depression’, 2000, Princeton) there is a single refence to Minsky in Part Two, page 43 - “Hyman Minsky (1977) and Carles Kindleberger (1978) have … argued for the inherent instability of the financial system but in doing so have had to depart from the assumption of rational economic behaviour.” A footnote adds - “I do not deny the possible importance of irrationality in economic life; however it seems that the best research strategy is to push the rationality postulate as far as it will
go.” No need for any comment!!!!!!!

Indeed! Having not properly comprehended the best contemporary explanation of the Great Depression, and dismissed the best modern explanation because it didn’t make an assumption that neoclassical economists insist upon, Bernanke is now trapped repeating history (incidentally, this comment by Bernanke also gives the lie to the “assumptions don’t matter, it’s only the results that count” nonsense thatFriedman dished up as neoclassical economic methodology–neoclassical economists in fact care desperately about their assumptions and are willing to dismiss rival theories simply because they don’t make the same assumptions, regardless of how accurate they are). It is painfully obvious that the real cause of this current financial crisis was the excessive build-up of debt during preceding
speculative manias dating back to the mid-1980s. The real danger now is that, on top of this debt mountain, we are starting to experience the slippery slope of falling prices.

In other words, the cause of our current financial crisis is debt combined with deflation–precisely the forces that Irving Fisher described as the causes of the Great Depression back in 1933.