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Today’s Liberals Could Ruin Canada | Jason Clemens

February 27, 2014 8:01 am / 1 Comment on Today’s Liberals Could Ruin Canada | Jason Clemens

Today’s Liberals Could Ruin Canada | Jason Clemens.

Posted: 02/26/2014 5:28 pm

The policy direction of the Liberal Party of Canada and its leader Justin Trudeau, as evidenced by the speeches, motions, and debate at the recent national party conventionseem to indicate that the party is rejecting the successful pragmatism of the 1990s. Instead, the federal Liberals favour a more interventionist and activist government, much like that of the current Ontario Liberal government. If such policies are enacted, the results would be ruinous for Canada.

One of the central themes repeated consistently at the convention was the need for the federal government to incur more debt in order to finance infrastructure and other long-term spending. Mr. Trudeau and his policy advisers seem to have been influenced greatly by U.S. economist Larry Summers. Mr. Summers, who served in the Clinton and Obama administrations, is a vocal advocate for more expansive government spending using debt as a method by which to stimulate the economy.

One problem of many for this approach is that it belies history, both in the U.S. and Canada. Bill Clinton and Jean Chretien enjoyed enormous economic and political successby doing the opposite. U.S. President Obama and the Ontario Liberals have struggled with a weak economy by doing exactly what Mr. Trudeau now proposes for the entire country.

Beginning in 1995, the Chretien Liberals cut program spending by almost eight per cent in just two years and continued to constrain spending even after balanced budgets were achieved for the following three years. Federal program spending as a share of the economy declined from over 17.1 per cent in 1992-93 to just under 12 per cent by the end of the decade. Federal debt was reduced from 67.1 per cent in 1995-96 to roughly 30 per cent by the time the Tories took over. And critically, the Liberals enacted a series of tax cuts and reforms aimed at making our economy more efficient and competitive.

The results, contrary to the rhetoric of Mr. Summers, were stunningly positive. Over the decade spanning 1997 when the federal budget was first balanced to roughly 2007, Canada led the G7 in both economic growth and business investment. Our record on job creation was unparalleled, more than doubling the U.S. rate and higher than any G7 country. And poverty rates fell by more than 40 per cent.

These actual results stand in stark contrast to the predictions of Mr. Summer: “To start, this means ending the disastrous trend towards less and less government spending and employment each year and taking advantage of the current period of slack to renew and build out our infrastructure.”

Of additional concern is the naiveté that Mr. Summers continues to display and has apparently now infected Mr. Trudeau with in terms of the actual ability of governments to do the things he advocates. Mr. Summers was front and centre in advocating for and shepherding through the Obama stimulus, which contained hundreds of billions of dollars for “shovel-ready” projects. Mr. Summers insisted that the mark of success of such policies were that they were timely, temporary, and targeted. The reality of what happened is that, not surprising, politics affected the program. High priority projects were shelved for more politically expedite ones. Projects were delayed and hung up in red tape and bureaucrat infighting. The assumption that government can simply flick a switch and spend efficiently is both conceptually and historically false.

Mr. Summers can be forgiven for not being aware of the actual experience in Ontario. The same cannot be said of Mr. Trudeau. The large and continuing deficits in Ontario, despite economic growth, coupled with heavy-handed interventionism in a host of sectors has placed Ontario on a path of decay, not prosperity. Economic growth in the province has remained sluggish despite large-scale deficits and debt accumulation. (As a measure of the province’s problems — Ontario is markedly worse on every measure of indebtedness compared to California.)

It’s not at all clear how the country will benefit from Ontario-style policy when such policies have been an abject failure. The country would benefit from a return to the sound policies of the Chretien era in the 1990s — balanced budgets, reducing debt, decentralization of responsibility and authority for services to the provinces, better value-for-money focused spending by the federal government, and incentive-based tax relief and reform. That’s a recipe for success for any government, or government in waiting. The Trudeau Liberals should look back to this period rather than down south for their policy ideas.

This piece was co-written by Milagros Palacios, Senior Research Economist, Fraser Institute.

Joseph E. Stiglitz argues that bad policies in rich countries, not economic inevitability, have caused most people’s standard of living to decline. – Project Syndicate

February 7, 2014 6:51 am / 1 Comment on Joseph E. Stiglitz argues that bad policies in rich countries, not economic inevitability, have caused most people’s standard of living to decline. – Project Syndicate

Joseph E. Stiglitz argues that bad policies in rich countries, not economic inevitability, have caused most people’s standard of living to decline. – Project Syndicate.

FEB 6, 2014 6

Stagnation by Design

NEW YORK – Soon after the global financial crisis erupted in 2008, I warned that unless the right policies were adopted, Japanese-style malaise – slow growth and near-stagnant incomes for years to come – could set in. While leaders on both sides of the Atlantic claimed that they had learned the lessons of Japan, they promptly proceeded to repeat some of the same mistakes. Now, even a key former United States official, the economist Larry Summers, is warning of secular stagnation.

The basic point that I raised a half-decade ago was that, in a fundamental sense, the US economy was sick even before the crisis: it was only an asset-price bubble, created through lax regulation and low interest rates, that had made the economy seem robust. Beneath the surface, numerous problems were festering: growing inequality; an unmet need for structural reform (moving from a manufacturing-based economy to services and adapting to changing global comparative advantages); persistent global imbalances; and a financial system more attuned to speculating than to making investments that would create jobs, increase productivity, and redeploy surpluses to maximize social returns.

Policymakers’ response to the crisis failed to address these issues; worse, it exacerbated some of them and created new ones – and not just in the US. The result has been increased indebtedness in many countries, as the collapse of GDP undermined government revenues. Moreover, underinvestment in both the public and private sector has created a generation of young people who have spent years idle and increasingly alienated at a point in their lives when they should have been honing their skills and increasing their productivity.

On both sides of the Atlantic, GDP is likely to grow considerably faster this year than in 2013. But, before leaders who embraced austerity policies open the champagne and toast themselves, they should examine where we are and consider the near-irreparable damage that these policies have caused.

Every downturn eventually comes to an end. The mark of a good policy is that it succeeds in making the downturn shallower and shorter than it otherwise would have been. The mark of the austerity policies that many governments embraced is that they made the downturn far deeper and longer than was necessary, with long-lasting consequences.

Real (inflation-adjusted) GDP per capita is lower in most of the North Atlantic than it was in 2007; in Greece, the economy has shrunk by an estimated 23%. Germany, the top-performing European country, has recorded miserly 0.7% average annual growth over the last six years. The US economy is still roughly 15% smaller than it would have been had growth continued even on the moderate pre-crisis trajectory.

But even these numbers do not tell the full story of how bad things are, because GDP is not a good measure of success. Far more relevant is what is happening to household incomes. Median real income in the US is below its level in 1989, a quarter-century ago; median income for full-time male workers is lower now than it was more than 40 years ago.

Some, like the economist Robert Gordon, have suggested that we should adjust to a new reality in which long-term productivity growth will be significantly below what it has been over the past century. Given economists’ miserable record – reflected in the run-up to the crisis – for even three-year predictions, no one should have much confidence in a crystal ball that forecasts decades into the future. But this much seems clear: unless government policies change, we are in for a long period of disappointment.

Markets are not self-correcting. The underlying fundamental problems that I outlined earlier could get worse – and many are. Inequality leads to weak demand; widening inequality weakens demand even more; and, in most countries, including the US, the crisis has only worsened inequality.

The trade surpluses of northern Europe have increased, even as China’s have moderated. Most important, markets have never been very good at achieving structural transformations quickly on their own; the transition from agriculture to manufacturing, for example, was anything but smooth; on the contrary, it was accompanied by significant social dislocation and the Great Depression.

This time is no different, but in some ways it could be worse: the sectors that should be growing, reflecting the needs and desires of citizens, are services like education and health, which traditionally have been publicly financed, and for good reason. But, rather than government facilitating the transition, austerity is inhibiting it.

Malaise is better than a recession, and a recession is better than a depression. But the difficulties that we are facing now are not the result of the inexorable laws of economics, to which we simply must adjust, as we would to a natural disaster, like an earthquake or tsunami. They are not even a kind of penance that we have to pay for past sins – though, to be sure, the neoliberal policies that have prevailed for the past three decades have much to do with our current predicament.

Instead, our current difficulties are the result of flawed policies. There are alternatives. But we will not find them in the self-satisfied complacency of the elites, whose incomes and stock portfolios are once again soaring. Only some people, it seems, must adjust to a permanently lower standard of living. Unfortunately, those people happen to be most people.

Read more at http://www.project-syndicate.org/commentary/joseph-e–stiglitz-argues-that-bad-policies-in-rich-countries–not-economic-inevitability–have-caused-most-people-s-standard-of-living-to-decline#huJ4BlicZg9e2A6X.99

The Emerging Market Collapse Through The Eyes Of Don Corleone | Zero Hedge

January 29, 2014 8:07 pm / Leave a comment

The Emerging Market Collapse Through The Eyes Of Don Corleone | Zero Hedge.

Submitted by Ben Hunt of Epsilon Theory

It Was Barzini All Along

Tattaglia is a pimp. He never could have outfought Santino. But I didn’t know until this day that it was Barzini all along.

— Don Vito Corleone

Like many in the investments business, I am a big fan of the Godfather movies, or at least those that don’t have Sofia Coppola in a supporting role. The strategic crux of the first movie is the realization by Don Corleone at a peace-making meeting of the Five Families that the garden variety gangland war he thought he was fighting with the Tattaglia Family was actually part of an existential war being waged by the nominal head of the Families, Don Barzini. Vito warns his son Michael, who becomes the new head of the Corleone Family, and the two of them plot a strategy of revenge and survival to be put into motion after Vito’s death. The movie concludes with Michael successfully murdering Barzini and his various supporters, a plot arc that depends entirely on Vito’s earlier recognition of the underlying cause of the Tattaglia conflict. Once Vito understood WHY Philip Tattaglia was coming after him, that he was just a stooge for Emilio Barzini, everything changed for the Corleone Family’s strategy.

Now imagine that Don Corleone wasn’t a gangster at all, but was a macro fund portfolio manager or, really, any investor or allocator who views the label of “Emerging Market” as a useful differentiation … maybe not as a separate asset class per se, but as a meaningful way of thinking about one broad set of securities versus another. With the expansion of investment options and liquid securities that reflect this differentiation — from Emerging Market ETF’s to Emerging Market mutual funds — anyone can be a macro investor today, and most of us are to some extent.

You might think that the ease with which anyone can be an Emerging Markets investor today would make the investment behavior around these securities more complex from a game theory perspective as more and more players enter the game, but actually just the opposite is true. The old Emerging Markets investment game had very high informational and institutional barriers to entry, which meant that the players relied heavily on their private information and relatively little on public signals and Common Knowledge. There may be far more players in the new Emerging Markets investment game, but they are essentially one type of player with a very heavy reliance on Common Knowledge and public Narratives. Also, these new players are not (necessarily) retail investors, but are (mostly) institutional investors that see Emerging Markets or sub-classifications of Emerging Markets as an asset class with certain attractive characteristics as part of a broad portfolio. Because these institutional investors have so much money that must be put to work and because their portfolio preference functions are so uniform, there is a very powerful and very predictable game dynamic in play here.

Since the 2008 Crisis the Corleone Family has had a pretty good run with their Emerging Markets investments, and even more importantly Vito believes that he understands WHY those investments have worked. In the words of Olivier Blanchard, Chief Economist for the IMF:

In emerging market countries by contrast, the crisis has not left lasting wounds. Their fiscal and financial positions were typically stronger to start, and adverse effects of the crisis have been more muted. High underlying growth and low interest rates are making fiscal adjustment much easier. Exports have largely recovered, and whatever shortfall in external demand they experienced has typically been made up through an increase in domestic demand. Capital outflows have turned into capital inflows, due to both better growth prospects and higher interest rates than in advanced countries. … The challenge for most emerging countries is quite different from that of advanced countries, namely how to avoid overheating in the face of closing output gaps and higher capital flows. — April 11, 2011

As late as January 23rd of this year, Blanchard wrote that “we forecast that both emerging market and developing economies will sustain strong growth“.

Now we all know what actually happened in 2013. Growth has been disappointing around the world, particularly in Emerging Markets, and most of these local stock and bond markets have been hit really hard. But if you’re Vito Corleone, macro investor extraordinaire, that’s not necessarily a terrible thing. Sure, you don’t like to see any of your investments go down, but Emerging Markets are notably volatile and maybe this is a great buying opportunity across the board. In fact, so long as the core growth STORY is intact, it almost certainly is a buying opportunity.

But then you wake up on July 9th to read in the WSJ that Olivier Blanchard has changed his tune. He now says “It’s clear that these countries [China, Russia, India, Brazil, South Africa] are not going to grow at the same rate as they did before the crisis.” Huh? Or rather, WTF? How did the Chief Economist of the IMF go from predicting “strong growth” to declaring that the party is over and the story has fundamentally changed in six months?

It’s important to point out that Blanchard is not some inconsequential opinion leader, but is one of the most influential economists in the world today. His position at the IMF is a temporary gig from his permanent position as the Robert M. Solow Professor of Economics at MIT, where he has taught since 1983. He also received his Ph.D. in economics from MIT (1977), where his fellow graduate students were Ben Bernanke (1979), Mario Draghi (1976), and Paul Krugman (1977), among other modern-day luminaries; Stanley Fischer, current Governor of the Bank of Israel, was the dissertation advisor for both Blanchard and Bernanke; Mervyn King and Larry Summers (and many, many more) were Blanchard’s contemporaries or colleagues at MIT at one point or another. The centrality of MIT to the core orthodoxy of modern economic theory in general and monetary policy in particular has been well documented by Jon Hilsenrath and others and it’s not a stretch to say that MIT provided a personal bond and a formative intellectual experience for a group of people that by and large rule the world today. Suffice it to say that Blanchard is smack in the middle of that orthodoxy and that group. I’m not saying that anything Blanchard says is amazingly influential in and of itself, certainly not to the degree of a Bernanke or a Draghi (or even a Krugman), but I believe it is highly representative of the shared beliefs and opinions that exist among these enormously influential policy makers and policy advisors. Two years ago the global economic intelligentsia believed that Emerging Markets had emerged from the 2008 crisis essentially unscathed, but today they believe that EM growth rates are permanently diminished from pre-crisis levels. That’s a big deal, and anyone who invests or allocates to “Emerging Markets” as a differentiated group of securities had better take notice.

Here’s what I think happened.

First, an error pattern has emerged over the past few years from global growth data and IMF prediction models that forced a re-evaluation of those models and the prevailing Narrative of “unscathed” Emerging Markets. Below is a chart showing actual Emerging Market growth rates for each year listed, as well as the IMF prediction at the mid-year mark within that year and the mid-year mark within the prior year (generating an 18-month forward estimate).

Pre-crisis the IMF systematically under-estimated growth in Emerging Markets. Post-crisis the IMF has systematically over-estimated growth in Emerging Markets. Now to be sure, this IMF over-estimation of growth exists for Developed Markets, too, but between the EuroZone sovereign debt crisis and the US fiscal cliff drama there’s a “reason” for the unexpected weakness in Developed Markets. There’s no obvious reason for the persistent Emerging Market weakness given the party line that “whatever shortfall in external demand they experienced has typically been made up through an increase in domestic demand.” Trust me, IMF economists know full well that their models under-estimated EM growth pre-crisis and have now flipped their bias to over-estimate growth today. Nothing freaks out a statistician more than this sort of flipped sign. It means that a set of historical correlations has “gone perverse” by remaining predictive, but in the opposite manner that it used to be predictive. This should never happen if your underlying theory of how the world works is correct. So now the IMF (and every other mainstream macroeconomic analysis effort in the world) has a big problem. They know that their models are perversely over-estimating growth, which given the current projections means that we’re probably looking at three straight years of sub-5% growth in Emerging Markets (!!) more than three years after the 2008 crisis ended, and — worse — they have no plausible explanation for what’s going on.

Fortunately for all concerned, a Narrative of Central Bank Omnipotence has emerged over the past nine months, where it has become Common Knowledge that US monetary policy is responsible for everything that happens in global markets, for good and for ill (see “How Gold Lost Its Luster”). This Narrative is incredibly useful to the Olivier Blanchard’s of the world, as it provides a STORY for why their prediction models have collapsed. And maybe it really does rescue their models. I have no idea. All I’m saying is that whether the Narrative is “true” or not, it will be adopted and proselytized by those whose interests — bureaucratic, economic, political, etc. — are served by that Narrative. That’s not evil, it’s just human nature.

Nor is the usefulness of the Narrative of Central Bank Omnipotence limited to IMF economists. To listen to Emerging Market central bankers at Jackson Hole two weeks ago or to Emerging Market politicians at the G-20 meeting last week you would think that a great revelation had been delivered from on high. Agustin Carstens, Mexico’s equivalent to Ben Bernanke, gave a speech on the “massive carry trade strategies” caused by ZIRP and pleaded for more Fed sensitivity to their capital flow risks. Interesting how the Fed is to blame now that the cash is flowing out, but it was Mexico’s wonderful growth profile to credit when the cash was flowing in. South Africa’s finance minister, Pravin Gordhan, gave an interview to the FT from Jackson Hole where he bemoaned the “inability to find coherent and cohesive responses across the globe to ensure that we reduce the volatility in currencies in particular, but also in sentiment” now that the Fed is talking about a Taper. Christine Lagarde got into the act, of course, calling on the world to build “further lines of defense” even as she noted that the IMF would (gulp) have to stand in the breach as the Fed left the field. To paraphrase Job: the Fed gave, and the Fed hath taken away; blessed be the name of the Fed.

The problem, though, is that once you embrace the Narrative of Central Bank Omnipotence to “explain” recent events, you can’t compartmentalize it there. If the pattern of post-crisis Emerging Market growth rates is largely explained by US monetary accommodation or lack thereof … well, the same must be true for pre-crisis Emerging Market growth rates. The inexorable conclusion is that Emerging Market growth rates are a function of Developed Market central bank liquidity measures and monetary policy, and that all Emerging Markets are, to one degree or another, Greece-like in their creation of unsustainable growth rates on the back of 20 years of The Great Moderation (as Bernanke referred to the decline in macroeconomic volatility from accommodative monetary policy) and the last 4 years of ZIRP. It was Barzini all along!

This shift in the Narrative around Emerging Markets — that the Fed is the “true” engine of global growth — is a new thing. As evidence of its novelty, I would point you to another bastion of modern economic orthodoxy, the National Bureau of Economic Research (NBER), in particular their repository of working papers. Pretty much every US economist of note in the past 40 years has published an NBER working paper, and I only say “pretty much every” because I want to be careful; my real estimate is that there are zero mainstream US economists who don’t have a working paper here.

If you search the NBER working paper database for “emerging market crises”, you see 16 papers. Again, the author list reads like a who’s who of famous economists: Martin Feldstein, Jeffrey Sachs, Rudi Dornbusch, Fredric Mishkin, Barry Eichengreen, Nouriel Roubini, etc. Of these 16 papers, only 2 — Frankel and Roubini (2001) and Arellano and Mendoza (2002) — even mention the words “Federal Reserve” in the context of an analysis of these crises, and in both cases the primary point is that some Emerging Market crises, like the 1998 Russian default, force the Fed to cut interest rates. They see a causal relationship here, but in the opposite direction of today’s Narrative! Now to be fair, several of the papers point to rising Developed Market interest rates as a “shock” or contributing factor to Emerging Market crises, and Eichengreen and Rose (1998) make this their central claim. But even here the argument is that “a one percent increase in Northern interest rates is associated with an increase in the probability of Southern banking crises of around three percent” … not exactly an earth-shattering causal relationship. More fundamentally, none of these authors ever raise the possibility that low Developed Market interest rates are the core engine of Emerging Market growth rates. It’s just not even contemplated as an explanation.

Today, though, this new Narrative is everywhere. It pervades both the popular media and the academic “media”, such as the prominent Jackson Hole paper by Helene Rey of the London Business School, where the nutshell argument is that global financial cycles are creatures of Fed policy … period, end of story. Not only is every other country just along for the ride, but Emerging Markets are kidding themselves if they think that their plight matters one whit to the US and the Fed.

Market participants today see Barzini/Bernanke everywhere, behind every news announcement and every market tick. They may be right. They may be reading the situation as smartly as Vito Corleone did. I doubt it, but it really doesn’t matter. Whether or not I privately believe that Barzini/Bernanke is behind everything that happens in the world, I am constantly told that this is WHY market events happen the way they do. And because I know that everyone else is seeing the same media explanations of WHY that I am seeing … because I know that everyone else is going through the same tortured decision process that I’m going through … because I know that everyone else is thinking about me in the same way that I am thinking about them … because I know that if everyone else acts as if he or she believes the Narrative then I should act as if I believe the Narrative … then the only rational conclusion is that I should act as if I believe it. That’s the Common Knowledge game in action. This is what people mean when they say that a market behavior of any sort “takes on a life of its own.”

For the short term, at least, the smart play is probably just to go along with the Barzini/Bernanke Narrative, just like the Corleone family went along with the idea that Barzini was running them out of New York (and yes, I understand that at this point I’m probably taking this Godfather analogy too far). By going along I mean thinking of the current market dynamic in terms of risk management, understanding that the overall information structure of this market is remarkably unstable. Risk-On / Risk-Off behavior is likely to increase significantly in the months ahead, and there’s really no predicting when Bernanke will open his mouth or what he’ll say, or who will be appointed to take his place, or what he or she will say. It’s hard to justify any large exposure to public securities in this environment, long or short, because all public securities will be dominated by this Narrative so long as everyone thinks that everyone thinks they will be dominated. This the sort of game can go on for a long time, particularly when the Narrative serves the interests of incredibly powerful institutions around the world.

But what ultimately saved the Corleone family wasn’t just the observation of Barzini’s underlying causal influence, it was the strategy that adjusted to the new reality of WHY. What’s necessary here is not just a gnashing of teeth or tsk-tsk’ing about how awful it is that monetary policy has achieved such behavioral dominance over markets, but a recognition that it IS, that there are investment opportunities created by its existence, and that the greatest danger is to continue on as if nothing has changed.

I believe that there are two important investment implications that stem from this sea change in the Narrative around Emerging Markets, which I’ll introduce today and develop at length in subsequent notes.

First, I think it’s necessary for active investors to recalibrate their analysis towards individual securities that happen to be found in Emerging Markets, not aggregations of securities with an “Emerging Markets” label. I say this because in the aggregate, Emerging Market securities (ETF’s, broad-based funds, etc.) are now the equivalent of a growth stock with a broken story, and that’s a very difficult row to hoe. Take note, though, the language you will have to speak in this analytic recalibration of Emerging Market securities is Value, not Growth, and the critical attribute of a successful investment will have little to do with the security’s inherent qualities (particularly growth qualities) but a great deal to do with whether a critical mass of Value-speaking investors take an interest in the security.

Second, there’s a Big Trade here related to the predictable behaviors and preference functions of the giant institutional investors or advisors that — by size and by strategy — are locked into a perception of Emerging Market meaning that can only be expressed through aggregations of securities or related fungible asset classes (foreign exchange and commodities). These mega-allocators do not “see” Emerging Markets as an opportunity set of individual securities, but as an asset class with useful diversification qualities within an overall portfolio. So long as market behaviors around Emerging Markets in the aggregate are driven by the Barzini/Bernanke Narrative, that diversification quality will decline, as the same Fed-speak engine is driving behaviors in both Emerging Markets and Developed Markets. Mega-allocators care more about diversification and correlations than they do about price, which means that the selling pressure will continue/increase so long as the old models aren’t working and the Barzini/Bernanke Narrative diminishes what made Emerging Markets as an asset class useful to these institutions in the first place. But when that selling pressure dissipates — either because the Barzini/Bernanke Narrative wanes or the mega-portfolios are balanced for the new correlation models that take the Barzini/Bernanke market effect into account — that’s when Emerging Market securities in the aggregate will work again. You will never identify that turning point in Emerging Market security prices by staring at a price chart. To use a poker analogy you must play the player — in this case the mega-allocators who care a lot about correlation and little about price — not the cards in order to know when to place a big bet.

In future weeks I’ll be expanding on each of these investment themes, as well as taking them into the realm of foreign exchange and commodities. Also, there’s a lot still to be said about Fed communication policy and the Frankenstein’s Monster it has become. I hope you will join me for the journey, and if you’d like to be on the direct distribution list for these free weekly notes please sign up at Follow Epsilon Theory.

Davos 2014: Larry Summers attacks George Osborne’s austerity programme | Business | theguardian.com

January 24, 2014 6:37 am / 1 Comment on Davos 2014: Larry Summers attacks George Osborne’s austerity programme | Business | theguardian.com

Davos 2014: Larry Summers attacks George Osborne’s austerity programme | Business | theguardian.com.

Larry Summers and George Osborne

Larry Summers, Bank of Japan governor Haruhiko Kuroda and George Osborne. Photograph: Denis Balibouse/Reuters

George Osborne‘s handling of the economy was strongly attacked byLarry Summers as the former US Treasury secretary poured criticism on the UK’s austerity programme, its welfare cuts for poor people and its strategy for preventing a housing bubble.

Summers, a long-running critic of the coalition government, said the chancellor was wrong to blame the eurozone crisis for the weakness of business investment and that governments should be spending more on infrastructure to tackle the threat of “secular stagnation”.

“I see less need to impose cuts on people who are vulnerable in the US context than the chancellor sees in the European context”, Summers said in a session on the future of monetary policy at the World Economic Forum in Davos.

Making it clear that he believed Britain would have done better to follow the US approach in which tackling the budget deficit has been seen as less important than restoring growth, Summers said: “It’s several years since the US exceeded its peak GDP before the crisis – that still hasn’t happened in the UK.”

The chancellor put up a staunch defence of his approach, noting Britain was creating jobs, had sound economic policies and a new system for controlling the City that was the envy of the world. Osborne said businesses had been sitting on their cash while the euro was going through “a near-death experience” but predicted that investment spending was now about to start to rising.

The chancellor responded to Summers’s charge that Britain, unlike the US, had failed to raise national output above its pre-recession levels by saying that the UK had suffered a deeper slump and was more dependent on the financial sector for its growth.

“We did have a much bigger fall in GDP [than in the US], and the impact of the crisis was even harder because our banking sector was a larger share of the economy than in America.

“The great recession in the UK had an even greater effect – and we were one of the worse effected of any of the western economies.”

But Summers, the man once a front-runner to succeed Ben Bernanke at the Federal Reserve responded to Osborne’s claim that the Bank of England had tools to rein in the property market by pointedly rubbishing the initiative.

“I worry about macro-prudential complacency”, Summers said, a reference to the notion that central banks can head off problems before they arise by actions to restrain the animal spirits of lenders.

Noting that policymakers had failed to spot the stock market crash of 1987 and the sub-prime mortgage crisis, Summers said he was unclear about how macro-prudential policies would work and said tougher measures were needed to make markets safe from “ignorance and error”.

Osborne said he agreed with the need for more infrastructure spending, but added there was no “free lunch”. Governments needed to take tough decisions elsewhere in your budgets, in areas such as welfare spending.

“Without a credible fiscal policy, as many other countries learned in this crisis, you don’t have a credible monetary policy and your market rates go up.

“So while infrastructure spending is needed, you need to make hard choices as finance minister as how to pay for it.”

Summers rejected Osborne’s argument that high borrowing costs in troubled eurozone countries were the result of governments over-spending and losing the trust of financial markets.

He said high borrowing costs were due to the specific nature of the eurozone currency – the fixed exchange rate and the inability of individual countries to tailor their economic policies to their own needs.

The Negative Natural Interest Rate and Uneconomic Growth

January 15, 2014 7:29 am / Leave a comment

The Negative Natural Interest Rate and Uneconomic Growth.

by Herman Daly, originally published by The Daly News  | TODAY

In a recent speech to the International Monetary Fund economist Larry Summers argued that since near zero interest rates have not stimulated GDP growth sufficiently to reach full employment, we probably need a negative interest rate. By this he means a negative monetary rate set by the Fed to equal the “natural” rate, which he believes is now negative. The natural rate, as Summers uses the term, means the rate that would equalize planned saving with planned investment, and thereby, as Keynes taught us, result in full employment. With near zero monetary rates, current inflation already pushes us to a negative real rate of interest, but that is still insufficiently negative, in Summers’ view, to equalize planned investment with planned saving and thereby stimulate GDP growth sufficient for full employment. A negative interest rate is a stunning proposal, and it takes some effort to work out its implications.

Suppose for a moment that GDP growth, economic growth as we gratuitously call it, entails uneconomic growth by a more comprehensive measure of costs and benefits — that GDP growth has now begun to increase counted plus uncounted costs by more than counted plus uncounted benefits, making us inclusively and collectively poorer, not richer. If that is the case, and there are good reasons to believe that it is, would it not then be reasonable to expect, along with Summers, that the natural rate of interest is negative, and that maybe the monetary rate should be too? This is hard to imagine, but it means that savers would have to pay investors (and banks) to use the funds that they have saved, rather than investors and banks paying savers for the use of their money. To keep the GDP growing sufficiently to avoid unemployment we would need a growing monetary circular flow, which would require more investment, which, in turn, would only be forthcoming if the monetary interest rate were negative (i.e., if you lost less by investing your money than by holding it). A negative interest rate “makes sense” if the goal is to keep on increasing GDP even after it has begun to make us poorer at the margin — that is after growth has already pushed us beyond the optimal scale of the macro-economy relative to the containing ecosphere, and thereby become uneconomic.

A negative monetary interest rate means that citizens will spend rather than save, so savings will not be available to finance the investments that produce the GDP growth needed for full employment. The new money for investment comes from the Fed. Quantitative easing (money printing) is the source of the new money. The faith is that an ever-expanding monetary circulation will pull the real economy along behind it, providing growth in real income and jobs as previously idle resources are employed. But the resulting GDP growth is now uneconomic because in the full world the “idle” resources are not really idle — they are providing vital ecosystem services. Redeploying these resources to GDP growth has environmental and social opportunity costs that are greater than production benefits. Although hyper-Keynesian macroeconomists do not believe this, the micro actors in the real economy experience the constraints of the full world, and consequently find it difficult to follow the unlimited growth recipe.

Summers (along with other mainstream growth economists), does not accept the concept of optimal scale of the macro-economy, nor the possibility of uneconomic growth in the sense that growth in resource throughput could reduce net wealth and wellbeing. Nevertheless, it is at least consistent with his view that the natural rate of interest is negative.

A positive interest rate restricts the total volume of investment but allocates it to the most productive projects. A negative interest rate increases volume, but allows investment in practically anything, increasing the probability that growth will be uneconomic. Shall we become hyper-Keynesians and push GDP growth to maintain full employment, even after growth has become uneconomic? Or shall we back off from growth and seek full employment by job sharing, distributive equity, and reallocation toward leisure and public goods?

Why would we allow growth to carry the macro-economy beyond the optimal scale? Because growth in GDP is considered the summum bonum, and it is heresy not to advocate increasing it. If increasing GDP makes us worse off we will not admit it, but will adapt to the experience of increased scarcity by pushing GDP growth further. Non-growth is viewed as “stagnation,” not as a sensible steady state adaptation to objective limits. Stimulating GDP growth by increasing consumption and investment, while cutting savings, is the only way that hyper-Keynesians can think of to serve the worthy goal of full employment. There really are other ways, and people really do need to save for security and old age, as well as for maintenance and replacement of the existing capital stock. Yet the Fed is being advised to penalize saving with a negative interest rate. The focus is on what the growth model requires, not on what people need.

A negative interest rate seems also to be the latest advice from Paul Krugman, who praises Summers’ insights. It is understandable from their viewpoint because in their vision the economy is not a subsystem, or if it is, it is infinitesimal relative to the total system. The economy can expand forever, either into the void or into a near infinite environment. It does not grow into a finite ecosphere, and therefore has no optimal scale relative to any constraining and sustaining environment. Its aggregate growth incurs no opportunity cost and can never be uneconomic. Unfortunately, this tacit assumption of the growth model is seriously wrong.

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Larry Summers and other growth-obsessed economists are calling for negative interest rates.

Welcome to the full-world economy. In the old empty-world economy, assumed in the macro models of Summers and Krugman, growth always remains economic, so they advocate printing more and more dollars to expand the economy to take over ever more of the “unemployed” sources and sinks of the ecosystem. If a temporary liquidity trap or zero lower bound on interest rates keeps the new money from being spent, then low or even negative monetary interest rates will open the spending spigot. The empty world assumption guarantees that the newly expanded production will always be worth more than the natural wealth it displaces. But what may well have been true in yesterday’s empty world is no longer true in today’s full world.

This is an upsetting prospect for growth economists — growth is required for full employment, but growth now makes us collectively poorer. Without growth we would have to cure poverty by redistributing wealth and stabilizing population, two political anathemas, and could only finance investment by reducing present consumption, a third anathema. There remains the microeconomic policy of reallocating the same GDP to a more efficient mix of products by internalizing external costs (getting prices right). While this certainly should be done, it is not macroeconomic growth as pursued by the Fed.

These painful choices could be avoided if only we were richer. So let’s just focus on getting richer. How? By growing the aggregate GDP, of course! What? You repeat that GDP growth is now uneconomic? That cannot possibly be right, they say. OK, that is an empirical question. Let’s separate costs from benefits in the existing GDP accounts, and develop more inclusive measures of each, and then see which grows more as GDP grows. This has been done (ISEW, GPI, Ecological Footprint), and results support the uneconomic growth view. If growth economists think these studies were done badly they should do them better rather than ignore the issue.

The leftover Keynesians are correct in pointing out that there is unemployed labor and capital. But natural resources are fully employed, indeed overexploited, and the limiting factor in the full world is natural resources, not labor or capital as used to be the case in the empty world. Some growth economists think that the world is still empty. Others think there is no limiting factor — that capital is a good substitute for natural resources. This is wrong, as Nicholas Georgescu-Roegen has shown long ago. Capital funds and natural resource flows are complements, not substitutes, and the one in short supply is limiting. Increasing a non-limiting factor doesn’t help. Growth economists should know this.

Although the growthists think quantitative easing will stimulate demand they are disappointed, even in terms of their own model, because the banks, who are supposed to lend the new money, encounter a “lack of bankable projects,” to use World Bank terminology. This of course should be expected in the new era of uneconomic growth. The new money, rather than calling forth new wealth by employing all these hypothetical idle resources from the empty world era, simply bids up existing asset prices in the full world. Most asset prices are not counted in the consumer price index, (not to mention exclusion of food and energy) so economists unconvincingly claim that quantitative easing has not been inflationary, and therefore they can keep doing it. And even if it causes some inflation, that would help make the interest rate negative.

Aside from needed electronic transaction balances, people would not keep money in the bank if the interest rate were negative. To make them do so, the alternative of cash would basically have to be eliminated, and all money would be electronic bank deposits. This intensifies central bank control, and the specter of “bail-ins” (confiscations of deposits) as occurred in Cyprus. Even as distrust of money increases, people will not immediately revert to barter, in spite of negative interest rates. Barter is so inconvenient that money remains more efficient even if it loses value at a rapid rate, as we have seen in several hyperinflations. But transactions balances will be minimized, and speculative and store-of value-balances will be diverted to real estate, gold, works of art, tulip bulbs, Bitcoins, and beanie babies, creating speculative bubbles. But not to worry, say Summers and Krugman, bubbles are a necessary, if regrettable, means to boost spending and growth in the era of newly recognized negative natural interest rates — and still unrecognized uneconomic growth.

A bright silver lining to this cloud of confusion is that the recognition of a negative natural interest rate may be the prelude to recognition of the underlying uneconomic growth as its cause. For sure this has not yet happened because so far the negative natural interest rate is seen as a reason to push growth with a negative monetary interest rate, rather than as a signal that growth has become a losing game. But such a realization is a reasonable hope. Perhaps a step in this direction is Summers’ suggestion that the old Alvin Hansen thesis of secular stagnation might deserve a new look.

The logic that suggests negative interest also suggests negative wages as a further means of increasing investment by lowering costs. To maintain full employment via GDP growth, not only must the interest rate now be negative, but wages should become negative as well. No one yet advocates negative wages because subsistence provides an inconvenient lower positive bound below which workers die. On this “other side of the looking glass” the logic of uneconomic growth pushes us in the direction of a negative “natural” wage, just as with a negative “natural” rate of interest. So we artificially lower the wage costs to “job creators” by subsidizing below-subsistence wages with food stamps, housing subsidies, and unpaid internships. Negative interest rates also subsidize investment in job-replacing capital equipment, further lowering wages. Negative interest rates, and below-subsistence wages, further subsidize the uneconomic growth that gave rise to them in the first place.

The leftover Keynesians tell us, reasonably enough, that paying people to dig holes in the ground and then fill them up, is better than leaving them unemployed with no income. But paying people to deplete and pollute the Creation on which our lives and welfare ultimately depend, in order to expand the macro-economy beyond its optimal or even sustainable scale, is surely worse than just giving them a minimum income, and some leisure time, in exchange for doing no harm.

An artificial monetary rate of interest forced down by quantitative easing to equal a negative natural rate of interest resulting from uneconomic growth is not a solution. It is just baling wire and duct tape. But it is all that even our best and brightest economists can come up with as long as they are imprisoned in the empty world growth model. The way out of this trap is to recognize that the growth era is over, and that instead of forcing growth into uneconomic territory we must seek to maintain a steady-state economy at something approximating the optimal scale. Since we have overshot the optimal scale of the macro-economy, this will require a period of retrenchment to a reduced level, accompanied by much more equal sharing, frugality, and efficiency. Sharing means putting limits on the range of inequality that we permit; it has huge moral and social benefits, even if politically difficult. Frugality means using less resource throughput; it results in less depletion and pollution and more recycling and efficiency. Efficiency means squeezing more life-support and want-satisfaction from a given throughput by technological advance and by improvement in our ethical priorities. Economists need to replace the Keynesian-neoclassical growth synthesis with a new version of the classical stationary state.

End this Depression? Never | Business Spectator

November 27, 2013 7:38 am / Leave a comment

End this Depression? Never | Business Spectator.

Larry Summers’ speech at the IMF has provoked a flurry of responses from New Keynesian economists that imply that Summers has located the “Holy Grail of Macroeconomics” – and that it was a poisoned chalice.

“Secular stagnation”, Summers suggested, was the real explanation for the continuing slump, and it had been with us for long before this crisis began. Its visibility was obscured by the subprime bubble, but once that burst, it was evident.

So the crisis itself was a sideshow. The real story is about inadequate private sector demand, which may have existed for decades. Generating adequate demand in the future may require a permanent stimulus from the government – meaning both the Congress and the Fed.

What could be causing the secular stagnation – if it exists? Krugman noted a couple of factors: a slowdown in population growth (which is obviously happening: see Figure 1); and “a Bob Gordon-esque decline in innovation” (which is more conjectural).

Figure 1: Population growth rates are slowing

 

 
Graph for End this Depression? Never

So is a secular trend to lower growth the reason for the continuing stagnation, six years after the crisis began? And is Summers now the Messiah?

Reading Krugman or Miles Kimball, you’d think so on both counts. Kimball headlines his coverage with “Larry Summers just confirmed that he is still a heavyweight on economic policy”, while Krugman states that while he’s been thinking on the same lines, “Larry’s formulation is much clearer and more forceful, and altogether better, than anything I’ve done. Curse you, Red Baron Larry Summers!”

On the issue itself, you’d also think that suddenly the lightbulb has switched on as well, after years in the darkness before and after the crisis. Though Summers’ thesis has its critics (such asStephen Williamson),  there’s a chorus of New Keynesian support for the “secular stagnation” argument, which implies it will soon become the conventional explanation for the persistence of this slump long after the initial financial crisis has passed.

Krugman’s change of tune here is representative. His most recent book-length foray into what caused the crisis – and what policy would get us out of it – was entitled End This Depression Now!. The title screamed that this crisis could be ended “in the blink of an eye”, while the text argued that all it would take is a sufficiently large fiscal stimulus to help us escape the “zero lower bound”. Krugman wrote:

“The sources of our suffering are relatively trivial in the scheme of things, and could be fixed quickly and fairly easily if enough people in positions of power understood the realities.

“One main theme of this book has been that in a deeply depressed economy, in which the interest rates that the monetary authorities can control are near zero, we need more, not less, government spending. A burst of federal spending is what ended the Great Depression, and we desperately need something similar today.”

Post-Summers, Krugman is suggesting that a short, sharp burst of government spending will not be enough to restore “the old normal”. Instead, to achieve pre-crisis rates of growth in future – and pre-crisis levels of unemployment – we may need permanent government deficits, and permanent Federal Reserve spiking of the asset market punch via QE and the like. Not only that, but past apparent growth successes – such as The Period Previously Known as The Great Moderation – may simply have been above-stagnation rates of growth motivated by bubbles:

Krugman asks: “So how can you reconcile repeated bubbles with an economy showing no sign of inflationary pressures? Summers’ answer is that we may be an economy that needs bubbles just to achieve something near full employment – that in the absence of bubbles the economy has a negative natural rate of interest. And this hasn’t just been true since the 2008 financial crisis; it has arguably been true, although perhaps with increasing severity, since the 1980s.”

This argument elevates the “zero lower bound” from being merely an explanation for the Great Recession to a General Theory of macroeconomics: if the zero lower bound is a permanent state of affairs given secular stagnation, then permanent government stimulus and permanent bubbles may be needed to overcome it.

Or, as Krugman puts it: “One way to get there would be to reconstruct our whole monetary system – say, eliminate paper money and pay negative interest rates on deposits. Another way would be to take advantage of the next boom – whether it’s a bubble or driven by expansionary fiscal policy – to push inflation substantially higher, and keep it there. Or maybe, possibly, we could go the Krugman 1998/Abe 2013 route of pushing up inflation through the sheer power of self-fulfilling expectations.”

So is secular stagnation the answer to the puzzle of why the economy hasn’t recovered post the crisis? And is permanently blowing bubbles (as well as permanent fiscal deficits) the solution?

Figure 2:  A secular slowdown in growth caused by a secular trend to stagnation
Graph for End this Depression? Never

Firstly, there is evidence for a slowdown in the rate of economic growth over time, as well as its precipitous fall during and after the crisis. The growth rate was as high as 4.4 per cent per annum on average from 1950-1970, but fell to about 3.2 per cent per annum from 1970-2000 and was only 2.7 per cent in the noughties prior to the crisis, after which it has plunged to an average of just 0.9 per cent per annum (see Table 1).

Table 1: US Real growth rates per annum by decade
Graph for End this Depression? Never

The sustained growth rate of the US economy is lower now than it was in the 1950s-1970s, and the causes go well beyond the undoubted demographic trend that Krugman nominates and the rather more dubious suggestion of a decline in innovation.

Firstly, the corporate transfer of production from the US (and Europe) to the third world over the last 40 years has substituted low-wage, low-consumption third world workers for high-wage, high-consumption Americans and Europeans. This benefited Western and third-world capitalists, but at the expense of reducing global demand. The free trade that conventional economists champion has in fact help replace the ‘beggar the neighbour’ politics of the protectionist past with ‘beggar thy working class’ politics today.

Secondly, there’s the impact of rising inequality on consumption. Inequality is at unprecedented levels today, possibly the highest it has ever been in human history, according to James K Galbraith, the global authority on this topic. That inequality leads to huge demand for luxury yachts, but diminished demand for almost everything else. Demand in the aggregate could fall.

And there’s a third factor that Krugman alludes to in his post, which I suspect might start to turn up in future in his explanation of the crisis: the rise in household debt during 1980-2010. With the notable exception of Robert Shiller, this wasn’t foreseen by mainstream economists in neither thefreshwater nor saltwater sects.

Figure 3, sourced from the St Louis Fed’s excellent FRED database, and taken from Krugman’s post, outlines this trend.

Figure 3: Ratio of household debt to GDP
Graph for End this Depression? Never

Now, as any well-trained economist knows, it’s a matter of simple logic that what happens to private debt is irrelevant to macroeconomics most of the time because “debt is one person’s liability, but another person’s asset”.

However, private debt does matter during a liquidity trap, because then lenders might get worried about the capacity of borrowers to repay and impose a limit on debt that borrowers have already exceeded, forcing borrowers to repay their debt and spend less. To maintain the full-employment equilibrium, people who were once lenders have to spend more to compensate for the fall in spending by now debt-constrained borrowers.

But lenders are patient people, who by definition have a lower rate-of-time preference than borrowers, who are impatient people.

In the New York Times, Krugman wrote: “Now, if people are borrowing, other people must be lending. What induced the necessary lending? Higher real interest rates, which encouraged “patient” economic agents to spend less than their incomes while the impatient spent more.”

The problem in a liquidity trap is that rates can’t go low enough to encourage patient agents to spend enough to compensate for the decline in spending by now debt-constrained impatient agents.

Krugman elaborates: “You might think that the process would be symmetric: debtors pay down their debt, while creditors are correspondingly induced to spend more by low real interest rates. And it would be symmetric if the shock were small enough. In fact, however, the deleveraging shock has been so large that we’re hard up against the zero lower bound; interest rates can’t go low enough. And so we have a persistent excess of desired saving over desired investment, which is to say persistently inadequate demand, which is to say a depression.

Summers’ thesis now implies that the US economy has in fact been in a liquidity trap for decades, possibly “since the 1980s”, Krugman contends.

This suggests a hypothesis that I wouldn’t at all be surprised to see tested in the pages of theNew York Times. Firstly, America hasn’t always been suffering secular stagnation, nor has it always been in a liquidity trap. Secondly, sound economics tells us that only when the economy is in one does private debt matter macroeconomically. So it should be possible to work out how long the liquidity trap has applied, by working out when the level (or rate of change, or some other measure) of private debt correlated with macroeconomic variables (say the level, or rate of change of unemployment), and when it didn’t.

I await the test of this hypothesis. I might even check it out myself.

Steve Keen is author of Debunking Economics and the blog Debtwatch and developer of the Minsky software program.

 

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