deregulation eroded the Federal Reserve's power to stabilise the economy

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"Hamstrung Fed?

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KEVIN DRUM links to a piece by the Nation's William Greider on how deregulation eroded the Federal Reserve's power to stabilise the economy. Mr Greider writes:

When deregulation began nearly thirty years ago, some leading Fed governors, including [Paul] Volcker, were aware that it would weaken the Fed's hand, and they grumbled privately. The 1980 repeal of interest-rate limits meant the central bank would have to apply the brakes longer and harder to get any response from credit markets. "The only restraining influence you have left is interest rates," one influential governor complained to me, "restraint that works ultimately by bankrupting the customer."

....The central bank was undermined more gravely by further deregulation, which encouraged the migration of lending functions from traditional bank loans to market securities, like the bundled mortgage securities that are now rotten assets....In 1977 commercial banks held 56 percent of all financial assets. By 2007 the banking share had fallen to 24 percent.

The shrinkage meant the Fed was trying to control credit through a much smaller base of lending institutions. It failed utterly.

Not long ago, in the pages of the Wall Street Journal, Alan Greenspan wrote along similar lines. After suggesting that it was the global savings glut which depressed long-term mortgage rates that caused the housing bubble (and not the Fed) he said:

If it is monetary policy that is at fault, then that can be corrected in the future, at least in principle. If, however, we are dealing with global forces beyond the control of domestic monetary policy makers, as I strongly suspect is the case, then we are facing a broader issue.

Global market competition and integration in goods, services and finance have brought unprecedented gains in material well being. But the growth path of highly competitive markets is cyclical. And on rare occasions it can break down, with consequences such as those we are currently experiencing. It is now very clear that the levels of complexity to which market practitioners at the height of their euphoria tried to push risk-management techniques and products were too much for even the most sophisticated market players to handle properly and prudently.

The solution is improvements in regulatory practice, according to Mr Greenspan. But both Mr Greenspan and Mr Greider seem to be of the opinion that the Fed was powerless in this respect. Earlier this week, my colleague disagreed with this assessment:

There was, of course, an alternative between letting the bubble inflate and inviting recession. Had Mr Greenspan and his colleagues concluded housing prices were too high and there was value in taming them, they could have used regulatory tools instead of monetary policy. They could have insisted on a margin requirement for home purchases—no one could put down less than 20% unless they obtained mortgage insurance. (At the peak of the bubble, the widespread use of second liens made 100% loan-to-value mortgages without insurance commonplace.) This would have been politically difficult since it would have deprived lots of people the opportunity to own a home, in violation of America’s credo. It would have also contradicted Mr Greenspan’s own deregulatory impulses. He resisted raising margin requirements on stocks in the 1990s in part out of a conviction that only small investors would be affected; big sophisticated players would find a way around them.

Mr Greider recommends that the regulatory system be widened to include the shadow banking system, but the shadow banking system arose in order to skirt regulatory limits—to lever up more effectively. Mr Greenspan also wants us to put in place a regulatory system which, "will ensure responsible risk management on the part of financial institutions, while encouraging them to continue taking the risks necessary and inherent in any successful market economy", but it's difficult to imagine what such a perfect system might look like. Financial players live to get around the rules and increase leverage. Given enough time, financial tools will develop to accomplish this goal.

Assuming we're comfortable with an independent and powerful Fed, I think the necessary changes are much more modest. The Federal Reserve has explicit policy goals—price stability, low unemployment. It's a safe bet that a president wouldn't nominate someone for the position of Fed chairman who believed the Fed shouldn't interfere in the economy to achieve those goals. And yet, multiple presidents had no problem nominating an Ayn Rand acolyte with a visceral distaste for regulatory interference to the chairmanship.

Regulations ought to be flexible; as Mr Greider rightly notes, the capital requirements necessary amid a boom are quite different from those necessary during a crisis. The Fed should be charged with limiting financial leverage and systemic risk, and should have some flexibility in achieving these goals (as it has flexibility in tweaking the economy's money supply). Then we won't have non-interventionists in an explicitly interventionist position, and Fed chairmen won't have the luxury of shrugging off dangerous imbalances as someone else's problem."

Me:

Don the libertarian Democrat wrote:

March 20, 2009 20:49

I know that this is going nowhere so far, but I like the idea of a guaranteed/narrow banking sector, as opposed to a self-insured/supervised/no government guarantees investment sector.

The Fed using rates to slow the whole economy or issuing warnings doesn't seem viable, and, you're correct, the rules of investment are made to be broken. I'm not advocating this, just describing reality. I just can't see the Fed slowing the economy on a theory, or regulators being one step ahead of investors. I think that time travel is more viable than both of those eventualities.

"For Schumpeter, there was something both noble and tragic about the spirit of capitalism."

Robert Skidelsky in the Guardian:

"Testifying recently before a United States congressional committee, former Federal Reserve chairman Alan Greenspan said that the recent financial meltdown had shattered his "intellectual structure". I am keen to understand what he meant.

Since I have had no opportunity to ask him, I have to rely on his memoirs, The Age of Turbulence, for clues. But that book was published in 2007 – before, presumably, his intellectual structure fell apart.

In his memoirs, Greenspan revealed that his favorite economist was Joseph Schumpeter, inventor of the concept of "creative destruction"( ALL THIS MEANS IS THAT BUSINESSES COME AND GO. IT IS NOT PROFOUND. ). In Greenspan's summary of Schumpeter's thinking, a "market economy will incessantly revitalise itself from within by scrapping old and failing businesses and then reallocating resources to newer, more productive ones". Greenspan had seen "this pattern of progress and obsolescence repeat over and over again".

Capitalism advanced the human condition, said Schumpeter, through a "perennial gale of creative destruction", which he likened to a Darwinian process of natural selection to secure the "survival of the fittest"( A VERY BAD ANALOGY. BUT COMMON. ). As Greenspan tells it, the "rougher edges" of creative destruction were legislated away by Franklin Roosevelt's New Deal, but after the wave of de-regulation of the 1970s, America recovered much of its entrepreneurial, risk-taking ethos. As Greenspan notes, it was the dot-com boom of the 1990s that "finally gave broad currency to Schumpeter's idea of creative destruction".

This was the same Greenspan who in 1996 warned of "irrational exuberance" and, then, as Fed chairman, did nothing to check it. Both the phrase and his lack of action make sense in the light of his (now shattered) intellectual system.

It is impossible to imagine a continuous gale of creative destruction taking place except in a context of boom and bust. Indeed, early theorists of business cycles understood this. (Schumpeter himself wrote a huge, largely unreadable, book with that title in 1939.)

In classic business-cycle theory, a boom is initiated by a clutch of inventions – power looms and spinning jennies in the 18th century, railways in the 19th century, automobiles in the 20th century. But competitive pressures and the long gestation period of fixed-capital outlays multiply optimism, leading to more investment being undertaken than is actually profitable. Such over-investment produces an inevitable collapse. Banks magnify the boom by making credit too easily available, and they exacerbate the bust by withdrawing it too abruptly. But the legacy is a more efficient stock of capital equipment.

Dennis Robertson, an early 20th-century "real" business-cycle theorist, wrote: "I do not feel confident that a policy which, in the pursuit of stability of prices, output, and employment, had nipped in the bud the English railway boom of the forties, or the American railway boom of 1869-71, or the German electrical boom of the nineties, would have been on balance beneficial to the populations concerned." Like his contemporary, Schumpeter, Robertson regarded these boom-bust cycles, which involved both the creation of new capital and the destruction of old capital, as inseparable from progress.

Contemporary "real" business-cycle theory builds a mountain of mathematics on top of these early models, the main effect being to minimise the "destructiveness" of the "creation". It manages to combine technology-driven cycles of booms and recessions with markets that always clear (ie there is no unemployment).

How is this trick accomplished? When a positive technological "shock" raises real wages, people will work more, causing output to surge. In the face of a negative "shock", workers will increase their leisure, causing output to fall.

These are efficient responses to changes in real wages. No intervention by government is needed. Bailing out inefficient automobile companies such as General Motors only slows down the rate of progress. In fact, whereas most schools of economic thought maintain that one of government's key responsibilities is to smooth the cycle, "real" business-cycle theory argues that reducing volatility reduces welfare!

It is hard to see how this type of theory either explains today's economic turbulence, or offers sound instruction about how to deal with it. First, in contrast to the dot-com boom, it is difficult to identify the technological "shock" that set off the boom. Of course, the upswing was marked by super-abundant credit. But this was not used to finance new inventions: it was the invention( ONE COULD ARGUE THIS ). It was called securitised mortgages. It left no monuments to human invention, only piles of financial ruin.

Second, this type of model strongly implies that governments should do nothing in the face of such "shocks". Indeed, "real" business-cycle economists typically argue that, but for Roosevelt's misguided New Deal policies, recovery from the Great Depression of 1929-1933 would have been much faster than it was.

Equivalent advice today would be that governments the world over are doing all the wrong things in bailing out top-heavy banks, subsidising inefficient businesses, and putting obstacles in the way of rational workers spending more time with their families or taking lower-paid jobs. It reminds me of the interviewer who went to see Robert Lucas, one of the high priests of the New Business Cycle school, at a time of high American unemployment in the 1980s.
"My driver is an unemployed PhD graduate," he said to Lucas. "Well, I'd say that if he is driving a taxi, he's a taxi-driver," replied the 1995 Nobel laureate.

Although Schumpeter brilliantly captured the inherent dynamism of entrepreneur-led capitalism, his modern "real" successors smothered his insights in their obsession with "equilibrium" and "instant adjustments". For Schumpeter, there was something both noble and tragic about the spirit of capitalism. But those sentiments are a world away from the pretty, polite techniques of his mathematical progeny."

I have to say that Schumpeter's world view was not close to mine. It was tragic, but more like the Eternal Return of Nietzsche. The current Mechanistic Economics is a melange of slightly useful theories and models. Nothing more.

"If regulators had been less concerned with protecting the fund’s creditors, our current problems might not be quite so bad."

Tyler Cowen approaches my view in the NY Times:

"Bailout of Long-Term Capital: A Bad Precedent?

By TYLER COWEN

THE financial crisis is a result of many bad decisions, but one of them hasn’t received enough attention: the 1998 bailout of the Long-Term Capital Management hedge fund. If regulators had been less concerned with protecting the fund’s creditors, our current problems might not be quite so bad( I TOTALLY AGREE ).

Long-Term Capital was advised by finance quants, or quantitative analysts, who made a number of unsound, esoteric bets, including investments in interest rate derivatives. When Russia’s inability to pay its debts roiled global markets, the fund, saddled with high-leverage and off-balance-sheet obligations, was near collapse.

Because Long-Term Capital owed large sums to banks and other financial institutions, the Federal Reserve Bank of New York organized a consortium of companies to buy it out and cover the debts. Alan Greenspan, then the Fed chairman, eased monetary policy to restart capital markets, which were starting to freeze up. Long-Term Capital’s shareholders were wiped out, but none of the creditors took losses.( ALL TRUE )

At the time, it may have seemed that regulators did the right thing. The bailout did not require upfront money from the government, and the world avoided an even bigger financial crisis( WE SHOULD HAVE DEALT WITH THE ISSUE EXPLICITLY ). Today, however, that ad hoc intervention by the government no longer looks so wise. With the Long-Term Capital bailout as a precedent, creditors came to believe that their loans to unsound financial institutions would be made good by the Fed — as long as the collapse of those institutions would threaten the global credit system. Bolstered by this sense of security, bad loans mushroomed.( THAT'S MY POSITION )

Of course, there were many reasons for the reckless lending and failures of risk management that led to the most recent systemic credit shocks( TRUE ). And we have now entered the realm of trillion-dollar bailouts, vast contagion across financial institutions, rapid deleveraging of banks and an economic crisis that some people are starting to compare to the Great Depression.

The Long-Term Capital episode looks small when viewed against all of that. But it was important precisely because the fund was not a major firm( YES ). At the time of its near demise, it was not even a major money center bank, but a hedge fund with about 200 employees. Such funds hadn’t previously been brought under regulatory protection this way. After the episode, financial markets knew that even relatively obscure institutions — through government intervention — might be able to pay back bad loans.( THAT'S MY POSITION )

The major creditors of the fund included Bear Stearns, Merrill Lynch and Lehman Brothers, all of which went on to lend and invest recklessly and, to one degree or another, pay the consequences. But 1998 should have been the time to send a credible warning that bad loans to overleveraged institutions would mean losses, and that neither the Fed nor the Treasury would make these losses good.( EXACTLY )

What would have happened without a Fed-organized bailout of Long-Term Capital? It remains an open question. An entirely private consortium led by Warren E. Buffett might have bought the fund, but capital markets might still have frozen because of the realization that bailouts were not guaranteed.( HERE'S WHERE I DISAGREE. WE SHOULD HAVE BAILED THEM OUT, BUT IMMEDIATELY CHANGED THE SYSTEM EXPLICITLY )

And Fed inaction might have had graver economic consequences, especially if a Buffett deal had fallen through. In that case, a rapid financial deleveraging would have followed, and the economy would have probably plunged into recession. That sounds bad, but it might have been better to have experienced a milder version of a downturn in 1998 than the more severe version of 10 years later.( IT'S A FAIR POINT )

In 1998, there was no collapsed housing bubble, the government’s budget was in surplus rather than deficit, bank leverage was much lower, and derivatives markets were smaller and less far-reaching. A financial crisis related to Long-Term Capital, however painful, probably would have been easier to handle than the perfect storm of recent months.( I HAVE TO AGREE )

The ad hoc aspect of the bailout created a precedent for what has come to be called “regulation by deal” — now the government’s modus operandi. Rather than publicizing definite standards and expectations for bailouts in advance, the Fed and the Treasury confront each particular crisis anew( THAT'S IT ). Decisions are made as to whether a merger is possible, whether a consortium can be organized, what kind of loan guarantees can be offered and what kind of concessions will be extracted in return. So far, every deal — or lack thereof, in the case of Lehman Brothers — has been different.( THAT'S IT )

While there are some advantages to leaving discretion in regulators’ hands, this hasn’t worked out very well. It has become increasingly apparent that the market doesn’t know what to expect and that many financial institutions are sitting on the sidelines, waiting to see what regulators will do next. Regulatory uncertainty is stifling the ability of financial markets to engineer at least a partial recovery. ( ALL TRUE )

John Maynard Keynes famously proclaimed that “in the long run we are all dead.” From the vantage point of 1998, today is indeed the “long run.”

We’re not quite dead, but we are seriously ailing. As we look ahead, we may be tempted again to put off the hard choices. But perhaps the next “long run,” too, is no more than 10 years away. If we take the Keynesian maxim too seriously, and focus only on the short run, our prospects will be grim indeed."

My only disagreements are:
1) The S & L Bailout was more important, both because of its size and the poor record of prosecuting crimes associated with it.
2) Because LTCM was relatively small, it simply added to the strength of the guarantee.
3) LTCM could have been handled differently, penalizing creditors to some extent. Then, we should have developed Bagehot's Principles into an explicit policy.

However, I'm beginning to believe that LTCM should have been allowed to fail, because it might have made a difference. And yet, there were other government interventions, and the S& L Crisis was still on the books, so to speak. That's the point at which we should have developed an explicit policy based on Bagehot's Principles.

"In fact, they are in the nature of swindles. "

Skidelsky on the New Straits Times:

"ECONOMICS, it seems, has very little to tell us about the current economic crisis( TRUE ). Indeed, no less a figure than former United States Federal Reserve chairman Alan Greenspan recently confessed that his entire "intellectual edifice" had been "demolished" by recent events. Scratch around the rubble, however, and one can come up with useful fragments. One of them is called "asymmetric information".

This means that some people know more about some things than other people. Not a very startling insight, perhaps. But apply it to buyers and sellers. Suppose the seller of a product knows more about its quality than the buyer does, or vice-versa. Interesting things happen -- so interesting that the inventors of this idea received Nobel Prizes in economics.

In 1970, George Akerlof published a famous paper called The Market for Lemons. His main example was a used-car market. The buyer doesn't know whether what is being offered is a good car or a "lemon". His best guess is that it is a car of average quality, for which he will pay only the average price.

Because the owner won't be able to get a good price for a good car, he won't place good cars on the market. So the average quality of used cars offered for sale will go down. The lemons squeeze out the oranges.

Another well-known example concerns insurance. This time it is the buyer who knows more than the seller, since the buyer knows his risk behaviour, physical health and so on.

The insurer faces "adverse selection", because he cannot distinguish between good and bad risks. He, therefore, sets an average premium too high for healthy contributors and too low for unhealthy ones. This will drive out the healthy contributors, saddling the insurer with a portfolio of bad risks -- the quick road to bankruptcy.

There are various ways to equalise the information available -- for example, warranties for used cars and medical certificates for insurance. But, since these devices cost money, asymmetric information always leads to worse results than would otherwise occur.

All of this is relevant to financial markets because the "efficient market hypothesis" -- the dominant paradigm in finance -- assumes that everyone has perfect information and, therefore, that all prices express the real value of goods for sale( IT'S A MODEL ).

But any finance professional will tell you that some know more than others, and they earn more, too. Information is king. But just as in used-car and insurance markets, asymmetric information in finance leads to trouble.

A typical "adverse selection" problem arises when banks can't tell the difference between a good and bad investment -- a situation analogous to the insurance market.

The borrower knows the risk is high, but tells the lender it is low( THIS IS FRAUD ). The lender who can't judge the risk goes for investments that promise higher yields. This particular model predicts that banks will over-invest in high-risk, high-yield projects, i.e. asymmetric information lets toxic loans onto the credit market.

Other models use principal/agent behaviour to explain "momentum" (herd behaviour) in financial markets.

Although designed before the current crisis, these models seem to fit current observations rather well: banks lending to entrepreneurs who could never repay, and asset prices changing even if there were no changes in conditions.

But a moment's thought will show why these models cannot explain today's general crisis. They rely on someone getting the better of someone else: the better informed gain, at least in the short-term, at the expense of the worse informed. In fact, they are in the nature of swindles( THAT'S EXACTLY WHAT THEY ARE ). So these models cannot explain a situation in which everyone, or almost everyone, is losing -- or, for that matter, winning -- at the same time.

The theorists of asymmetric information occupy a deviant branch of mainstream economics. They agree with the mainstream that there is perfect information available somewhere out there, including perfect knowledge about how the different parts of the economy fit together.

They differ only in believing that not everyone possesses it. In Akerlof's example, the problem with selling a used car at an efficient price is not that no one knows how likely it is to break down, but rather that the seller knows well how likely it is to break down, and the buyer does not( FRAUD ).

And yet the true problem is that, in the real world, no one is perfectly informed. Those who have better information try to deceive those who have worse( FRAUD ); but they are deceiving themselves that they know more than they do.

If only one person were perfectly informed, there could never be a crisis -- someone would always make the right calls at the right time.

But only God is perfectly informed, and He does not play the stock market.

"The outstanding fact," John Maynard Keynes wrote in his General Theory of Employment, Interest and Money, "is the extreme precariousness of the basis of knowledge on which our estimates of prospective yield have to be made." ( TRUE )

There is no perfect knowledge "out there" about the correct value of assets, because there is no way we can tell what the future will be like( TRUE )

Rather than dealing with asymmetric information, we are dealing with different degrees of no information. Herd behaviour arises, Keynes thought, not from attempts to deceive, but from the fact that, in the face of the unknown, we seek safety( THAT'S THE MAIN POINT. SAFETY ) in numbers. Economics, in other words, must start from the premise of imperfect rather than perfect knowledge. It may then get nearer to explaining why we are where we are today. "

I'm wondering why he assumes that there are no laws concerning business transactions?

"That could prompt a re-writing of history that restores demands for a return to true full employment with diminished income inequality."

I love these kind of Yves Smith posts:

"Disingenuous New York Times Story on Global Imbalances

Since I am endeavoring to spend some time with my family, forgive me for dispatching this New York Times story, "Dollar Shift: Chinese Pockets Filled as Americans’ Emptied."

The article buys, hook, line and sinker, then- Fed-governor Ben Bernanke's depiction of so-called global imbalances (the US borrowing from abroad to fund overconsumption; Japan, China, Taiwan, and the Gulf States running significant, persistent trade surpluses and oversaving). Bernanke chose to position the problem as a "savings glut" which had the convenient effect of placing responsibility for the problem overseas, particularly on the Chinese, who kept the renminbi cheap via a hard peg to the dollar( THIS ISN'T QUITE THE SAVER COUNTRY VS SPENDER COUNTRY DICHOTOMY. IT'S WHAT I CALL THE GIANT POOL OF MONEY SLOSHING AROUND THEORY, WHICH, IN MY MIND, IS MECHANISTIC, AND SO NOT USEFUL ). Key bits:

In March 2005, a low-key Princeton economist who had become a Federal Reserve governor coined a novel theory to explain the growing tendency of Americans to borrow from foreigners, particularly the Chinese, to finance their heavy spending.

The problem, he said, was not that Americans spend too much, but that foreigners save too much. The Chinese have piled up so much excess savings that they lend money to the United States at low rates, underwriting American consumption.

This colossal credit cycle could not last forever, he [Ben Bernanke] said. But in a global economy, the transfer of Chinese money to America was a market phenomenon that would take years, even a decade, to work itself out. For now, he said, “we probably have little choice except to be patient.”....

Yves here. As far as I am concerned, this was rationalization of a clearly unstable and unsustainable pattern. But rather than try to find a way out, or at least keep it from becoming more pronounced, Bernanke recommended doing nothing. And it was NOT a market phenomenon, but the result (on the surface, at least) of China pegging the RMB at an artificially low level. Did we explore the possibility of WTO sanctions for the currency manipulation as an illegal trade subsidy( I AGREE WITH DOING THIS )? Apparently the US was acutely aware of this as a possibility, and took great care not to give private parties any grounds for using the RMB as the basis for a WTO action. This comes late in the article:

At the last minute [in 2006], however, Mr. Bernanke deleted a reference to the exchange rate being an “effective subsidy” for Chinese exports, out of fear that it could be used as a pretext for a trade lawsuit against China( MISTAKE ).

So we knew we had the nuclear option in our hands, and there was no will to use it. One has to wonder if there were any threats made in private. My gut says no, given the history here.

Back to the piece:

China, some economists say, lulled American consumers, and their leaders, into complacency about their spendthrift ways( SILLY ).

The problem with this characterization is it make the US a passive party and a victim in a paradigm that we embraced( FROM MY PERSPECTIVE, IT'S AUTOMATIC, OR MECHANISTIC. NOTHING FORCES HUMANS TO SPEND BUT THEIR DESIRES ). And let us not forget it takes two to tango. If China ran a savings glut, the rest of the world in aggregate had to consume (overspend and borrow enough) to take up the slack. But it most certainly did not fall upon the US to put up its hand and do it virtually solo (the EU runs a slight trade surplus).

Funny, some (many?) Chinese bureaucrats say that the US conned China into taking worthless paper (US Treasuries)( THEY KEEP BUYING THEM ) in return for valuable Chinese products. Two can also play the blame game.

And the New York Times buys hook, line, and sinker into the "gee, we really had no choice" party line( AGAIN, IT'S A SILLY THEORY ):

To be sure, there were few ready remedies. Some critics argue that the United States could have pushed Beijing harder to abandon its policy of keeping the value of its currency weak — a policy that made its exports less expensive and helped turn it into the world’s leading manufacturing power. If China had allowed its currency to float according to market demand in the past decade, its export growth probably would have moderated. And it would not have acquired the same vast hoard of dollars to invest abroad( TRUE, BUT I'M MORE BOTHERED BY THE SUBSIDY ISSUE ).

Others say the Federal Reserve and the Treasury Department should have seen the Chinese lending for what it was: a giant stimulus to the American economy, not unlike interest rate cuts by the Fed( I'VE ALREADY SAID THAT I DON'T HOLD INTEREST RATES TO BLAME. AT MOST, THESE ARE INCENTIVES. NO ONE IS FORCED TO DO ANYTHING, AND CERTAINLY IT DOES NOT JUSTIFY PROFLIGACY ). These critics say the Fed under Alan Greenspan contributed to the creation of the housing bubble by leaving interest rates too low for too long, even as Chinese investment further stoked an easy-money economy. The Fed should have cut interest rates less in the middle of this decade, they say, and started raising them sooner, to help reduce speculation in real estate( THAT WOULD HAVE CAUSED HOWLS ).

The story also conveniently makes the global imbalances problem sound as if it is all about the US and China (and by implication, of relatively recent origin) when in fact it has long been in the making but the vital indicators moved into the danger zone in the post 2002 era (US trade deficits rising to unprecedented levels as a % of GDP, savings plunging to zero) and were ignored.

In fairness, the Times piece later suggests that the Greenspan Fed was far too sanguine, that the Chinese were highly resistant to pressure regarding revaluing their currency, while the Japanese went along with the 1985 Plaza accord which called for a stronger yen (I remember when it was 250 to the dollar).

While we admittedly have more leverage over Japan than China, the flip side is the Chinese wanted badly to win on this issue and we caved. I sincerely doubt we tried very hard, since as the story clearly indicates, the officialdom rationalized global imbalances as a "market phenomenon" when it was anything but( SUBSIDIES DO OFTEN EFFECT THE MARKET, BUT NOT MECHANICALLY ).

The article points out that we used cheap Chinese funding poorly:

But Americans did not use the lower-cost money afforded by Chinese investment to build a 21st-century equivalent of the railroads ( WHAT WOULD THAT BE? ). Instead, the government engaged in a costly war in Iraq, and consumers used loose credit to buy sport utility vehicles and larger homes( AS OPPOSED TO WHAT? ). Banks and investors, eagerly seeking higher interest rates in this easy-money environment, created risky new securities like collateralized debt obligations.

Let us turn to economist Thomas Palley for an alternative point of view as to where the problem originated, which in turn suggests other courses of action. Note that the material from Palley comes from 2007 and early in 2008, yet the Times gave no consideration to his or other dissenting-from-orthodox views.

Palley starts with the observation that our recent expansion was unbalanced. He sees the big problems as record trade deficits (the result of an overvalued dollar), and (related but somewhat separate) the erosion of manufacturing.

The emphasis on the role of manufacturing is interesting and credible. When you consider the lead times, inflexibility, and transportation costs of manufacturing in Asia (remember, even goods like furniture, which involve round-trip shipping, are often made in China) one has to wonder how we screwed up, particularly when I hear from clothing designers that the reject rate on Chinese garments is typically 50%. ( SO THEY'RE NOT PROFITABLE? )

One would think there would be a role for at least for highly-flexible, high quality manufacturing that took advantage of geographic proximity, ability to do small runs at competitive prices, and high reliability( HOW WOULD ONE KNOW WITHOUT MARKETING IT? ). It would never be as large as China's output, but it would cream the high end of the market (and with them, presumably high margins) and also keep core skills at home( MAYBE ). And the US is still competitive in highly capital intensive and highly demanding manufacturing, such as coated paper (unlike newsprint, coated paper production is very difficult to keep running at the near-constant output level that its huge capital base requires).

Part of the problem, as we have discussed earlier, is that we have taken a naive stance in trade negotiations. We seem seduced by the idea of open markets, when in fact what we have is a system of managed trade( TRUE ). And our trading partners, who for the most part are keen to preserve employment, protect certain key industries, and have trade surpluses, seem to have achieved better outcomes than we have( TRUE ).

A 2007 Wall Street Journal article, "Is Productivity Growth Back In Grips of Baumol's Disease?" supports Palley's hypothesis about the value of manufacturing:

In the 1960s, Mr. Baumol, now at New York University, and William G. Bowen, an economist who later became president of Princeton University, argued that because productivity growth in labor-intensive service industries lags behind that in manufacturing, productivity growth in service-oriented economies tends to sag.

Their famous example was a classical string quartet -- there are always four players in a quartet and it always takes about the same amount of time to perform a set piece of music. You can't get any more music out of the same number of musicians over that same period of time. Broadening that to other types of services, the implication is that rich countries such as the U.S. that tend to veer toward services would face higher prices as wages and costs rise....

Sectors where productivity is high and average labor cost low "are those things that can be automated and mass-produced," Mr. Baumol, now in his mid-80s and still teaching, said in an interview. "And things where labor-saving is below average are things that need personal care -- these are health care, education, police protection, live stage performance... and restaurants."

Uh-oh.

U.S. job growth has been concentrated in those latter sectors. More than half of the 1.6 million jobs added in the private sector in the past year have been in food services, health care and social services. Food services alone account for more than 20% of all new jobs this year, including government....

Population aging will shift more of the U.S. economy toward one-on-one services. The Labor Department estimates that between 2004 and 2014, seven of the 10 fastest-growing occupations will be in health care, and health-care employment will double the national average. Employment in leisure and hospitality will also outpace the average, though not by as much"

Here's the whole post from the WSJ:

"By BRIAN BLACKSTONE

Is Baumol's disease back?

Named for economist William Baumol, the theory argues that the labor-intensive nature of some services acts as a constraint on productivity growth in an economy that increasingly produces services. It's relevant again years after some economists pronounced it "cured."

Between the mid-1970s and mid-1990s, annual productivity growth in the U.S. nonfarm business sector averaged about 1.5%. In the past decade, it has averaged about 2.6%. For a couple of years in the early 2000s it was near 4%, and Mr. Baumol's idea looked destined to join others in economics that looked good in theory but wrong in practice.

Yet last week's downward revisions of U.S. productivity growth for the past three years( IS THAT AN ERA NOW? ) suggest that the trend is closer to 2%, and shows that productivity growth has slowed for four straight years.

At the same time, employment in traditionally( AS IN THE PAST ) less-productive sectors such as health care and leisure is growing rapidly, while employment in higher-productivity business services is growing more slowly; in manufacturing and retail trade, it is flat or shrinking. Therein may( HERE WE GO AGAIN ) lie clues into whether the recent dip in productivity growth is a major turn or a temporary lull( SO NO ONE KNOWS ).

That's where Baumol's disease comes in( IT'S JUST A DESCRIPTION OF A FACT. NOT AN EXPLANATION ).

In the 1960s, Mr. Baumol, now at New York University, and William G. Bowen, an economist who later became president of Princeton University, argued that because productivity growth in labor-intensive service industries lags behind that in manufacturing, productivity growth in service-oriented economies tends to sag.

Their famous example was a classical string quartet -- there are always four players in a quartet and it always takes about the same amount of time to perform a set piece of music. You can't get any more music out of the same number of musicians over that same period of time. Broadening that to other types of services, the implication is that rich countries such as the U.S. that tend to veer toward services would face higher prices as wages and costs rise( AND? ).

But something happened in the last decade.

The information-technology boom( THIS IS WHERE I SEE THE PROBLEM ) led to rapid efficiency gains not just in the production of high-tech equipment, as expected, but also in services such as retailing -- which had long been assumed to have little prospect for much improvement. The quartet can now be heard on iPods and even cellphones, meaning that even if musicians themselves aren't more productive, the methods of distribution are.

In fact, it is in services -- particularly in retail and wholesale trade, in something called the "Wal-Mart effect" -- where economists credit a good part of productivity gains in the late 1990s and early 2000s. That led Brookings Institution economists Barry Bosworth and Jack Triplett to conclude in an influential 2003 paper that Baumol's disease "has been cured."

Along similar lines, a pair of economists from the Federal Reserve -- Carol Corrado and Paul Lengermann -- argued in a recent paper that much of the growth in the U.S. economy since 2000 can be accounted for by strong multifactor productivity growth -- which includes labor as well as inputs such as capital and materials -- in industry, a "remarkable turnaround" in finance and business services, and an "end to the drops" in productivity in personal and cultural services.

Still, the Fed economists and their co-authors estimated that from 2000 to 2004, multifactor productivity growth averaged just 0.2% a year in personal and cultural services (which include health care, social assistance, recreation and food services, among others), compared with almost 2% for finance and business, 2.6% for distribution and 5.4% for high tech.

Sectors where productivity is high and average labor cost low( THAT'S GOOD? ) "are those things that can be automated and mass-produced," Mr. Baumol, now in his mid-80s and still teaching, said in an interview. "And things where labor-saving is below average are things that need personal care -- these are health care, education, police protection, live stage performance... and restaurants."

Uh-oh.

U.S. job growth has been concentrated in those latter sectors. More than half of the 1.6 million jobs added in the private sector in the past year have been in food services, health care and social services. Food services alone account for more than 20% of all new jobs this year, including government( WHO'S PAYING FOR THESE SERVICES? PAUPERS? ).

Going back to Baumol's disease, it still takes a bartender( WHO'S PAID FOR HIS ABILITY TO SCHMOOZE AND GET BOUGHT DRINKS AND GIVEN TIPS ) the same two minutes it always has to make a gin-and-tonic( THEY CAN WATER IT DOWN ). And an "end to the drops" in productivity referred to in the Fed paper may not be enough to sustain living standards over generations( WHO THE HELL KNOWS THAT? ).

While there's surely a cyclical component to recent job gains and losses -- areas such as health care and personal services tend to lag the business cycle -- there are longer-term forces at work( I DON'T SEE THEM FROM THAT GRAPH ).

Population aging will shift more of the U.S. economy toward one-on-one services. The Labor Department estimates that between 2004 and 2014, seven of the 10 fastest-growing occupations will be in health care, and health-care employment will double the national average. Employment in leisure and hospitality will also outpace the average, though not by as much.

"If what we're starting to see is an increase in personal services -- nursing homes, care for the elderly -- as they become bigger and bigger, that would create a very important composition story( SO WE DON"T WANT THEM TAKEN CARE OF ? )," says Martin Baily, a productivity scholar at the Peterson Institute for International Economics, a Washington think tank.

If employment and sector-specific productivity trends continue, "I would start heading toward 1.5%" annual productivity growth over the long term, says Mr. Bosworth. Still, he doesn't think that will happen; he stands by his notion that Baumol's disease( SO FAR ALL THIS MEANS IS LESS PRODUCTIVITY. I DON'T SEE THE CAUSALITY. I UNDERSTAND HIS EXPLANATION, BUT THAT'S DIFFERENT ) has been cured, in part because medical care -- the ultimate test of Baumol's theory because it's set to account for so much of the economy -- holds promise for "big productivity gains."

There are other reasons for optimism. The U.S. is very competitive globally in high-paying and high-productivity services, so any expansion of trade could positively affect the job mix domestically.

Asked whether Baumol's disease spells doom for productivity, its namesake replies "yes and no."

"It is true that in money terms our productivity will be slowed down by the shift in labor from agriculture, manufacturing and services like telecommunications into services like health care and education," Mr. Baumol says.

"But if you count the number of students who have graduated or the number of people who have been taken care of after a heart malfunction, that is not going down." And the benefits of education and health care, on future output, can be hard to measure.

As for the disease that bears his name, not only does Mr. Baumol say it hasn't been cured, he adds: "I can brag and apologize that we've made the longest-lasting [correct] prediction that's ever been made in economics."

Back to Yves Smith:

"Palley argues that the Fed, despite having given lip service to global imbalances, is in fact operating from and supporting a flawed paradigm.

From Palley:

The U.S. economy has been in expansion mode since November 2001. Though of reasonable duration, the expansion has been persistently fragile and unbalanced. That is now coming home to roost in the form of the sub-prime mortgage crisis and the bursting house price bubble.

As part of the fallout, the Federal Reserve is being criticized for keeping interest rates too low for too long, thereby promoting credit and housing market excess. However, the reality is low rates were needed to sustain the expansion. Instead, the root problem is a distorted expansion caused by record trade deficits and manufacturing’s failure to fully participate in the expansion.

If the Fed deserves criticism it is for endorsing the policy paradigm that has made for this pattern. That paradigm rests on disregard of manufacturing and neglect of the adverse real consequences of trade deficits.

By almost every measure the current expansion has been fragile and shallow compared to previous business cycles. Beginning with an extended period of jobless recovery, private sector job growth has been below par through most of the expansion. Though the headline unemployment rate has fallen significantly, the percentage of the working age population that is employed remains far below its previous peak. Meanwhile, inflation-adjusted wages have barely changed despite rising productivity.( HE NOTES MY PROBLEM, WHICH IS RISING PRODUCTIVITY. WE NEED TO ATTACK THE JOBLESS PART OF THE GROWTH. HOWEVER, I'M MORE OF A TECHNOLOGY THAN MANUFACTURING PERSON. )

This gloomy picture justified the Fed keeping interest rates low. However, it begs the question of why the economic weakness despite historically low interest rates, massive tax cuts in 2001 and huge increases in military and security spending triggered by 9/11 and the Iraq war( THIS DEBT IS A MAJOR PROBLEM )?

The answer is the over-valued dollar and the trade deficit, which more than doubled between 2001 and 2006 to $838 billion, equaling 6.5 percent of GDP. Increased imports have shifted spending away from domestic manufacturers, which explains manufacturing’s weak participation in the expansion( DOES HE WANT TARIFFS? ). Some firms have closed permanently, while others have grown less than they would have otherwise. Additionally, many have reduced investment owing to weak demand or have moved their investment to China and elsewhere( HOW ARE THESE COUNTRIES SUPPOSED TO GROW? ). These effects have then multiplied through the economy, with lost manufacturing jobs and reduced investment causing lost incomes that have further weakened job creation.

The evidence is clear. Manufacturing has lost 1.8 million jobs during the expansion, which is unprecedented. Before 1980 manufacturing employment hit new peaks every expansion. Since 1980 it has trended down, but it at least recovered somewhat during expansions. This business cycle it has fallen during the expansion. The business investment numbers tell a similar dismal story, with spending being much weaker than in previous cycles( WHAT ABOUT TECHNOLOGY? ).

These conditions compelled the Fed to keep interest rates low to maintain the expansion. That policy worked, but by stimulating loose credit and a house price bubble that triggered a construction boom. Thus, residential investment never fell during the recession and has been stronger than normal during the expansion. Construction, which accounted for 5 percent of total employment, has provided over twelve percent of job growth. Meanwhile, higher house prices have fuelled a borrowing boom that has enabled consumption spending to grow despite stagnant wages. This explains both increased imports and job growth in the service sector.

The overall picture is one of a distorted expansion in which manufacturing continued shriveling while imports and services expanded. This pattern was carried by an unsustainable house price bubble and rising consumer debt burdens, and that contradiction has surfaced with the implosion of the sub-prime mortgage market and deflation of the house price bubble.

The Fed is now trying to assuage markets to keep credit flowing, and it will likely soon lower interest rates. On one level that is the right response and it may even work again – though it does increasingly seem like sticking fingers in the dyke to prevent the flood. However, the deeper problem is the policy paradigm behind the distorted expansion, which is where the Fed is at fault and where it deserves criticism.

The ideological and partisan Alan Greenspan wholeheartedly endorsed corporate globalization and promoted the White House and Treasury’s unbalanced expansion policies. The Fed’s professional economics staff also seems to have dismissed domestic manufacturing’s significance and endorsed corporate globalization in the name of free trade. Consequently, the Fed has tacitly supported the underlying policy paradigm that has given rise to America’s distorted expansion. Despite talk about reducing global financial imbalances, the Bernanke Fed still seems locked in to this paradigm and that is where constructive criticism should now be directed.( I CAN SEE THE POINT OF THE DISTORTING ASPECT OF MANAGED TRADE, BUT I CAN'T CREDIT ALL OF THE LOSSES IN MANUFACTURING TO THAT )

And Palley gave a broader view of the fundamental problem in an early 2008 post:

The last twenty-five years have witnessed a boom in the reputation of central bankers. This boom is based on an account of recent economic history that reflects the views of the winners....

That said, there are other less celebratory accounts of the Great Moderation [the post 1980 smoothing of business cycles] that view it as a transitional phenomenon( ISN'T EVERYTHING? ), and one that has also come at a high cost. One reason for the changed business cycle is retreat from policy commitment to full employment( THIS IS HELLISHLY HARD TO DO ). The great Polish economist Michal Kalecki observed that full employment would likely cause inflation because job security would prompt workers to demand higher wages( WHAT ABOUT INCREASED PRODUCTIVITY? BY THE WAY, JUST GETTING A RAISE IN AN INFLATIONARY ENVIRONMENT DOESN'T AUTOMATICALL GUARANTEE THAT YOU HAVE MORE BUYING POWER THAN BEFORE ). That is what happened in the 1960s and 1970s. However, rather than solving this political problem( HOW WOULD THAT GO ? ), economic policy retreated from full employment and assisted in the evisceration of unions( WHEN I HAD VIEWS BASED ON "THE SHARE ECONOMY", UNION MEMBERS DIDN'T LIKE IT ). That lowered inflation, but it came at the high cost of two decades of wage stagnation( WHAT ABOUT BUYING POWER? ) and a rupturing of the link between wage and productivity growth.( I'M NOT FOLLOWING HIS REASONING )

Disinflation also lowered interest rates, particularly during downturns. This contributed to successive waves of mortgage refinancing and also reduced cash outflows on new mortgages. That improved household finances and supported consumer spending, thereby keeping recessions short and shallow( WASN'T THAT GOOD? ).

With regard to lengthened economic expansions, the great moderation has been driven by asset price inflation and financial innovation, which have financed consumer spending. Higher asset prices have provided collateral to borrow against, while financial innovation has increased the volume and ease of access to credit. Together, that created a dynamic( WHAT'S A DYNAMIC? TOO MECHANISTIC ON THE ONE HAND, NOT SPECIFIC ENOUGH ON THE OTHER ) in which rising asset prices have supported increased debt-financed spending, thereby making for longer expansions. This dynamic( MECHANISTIC. DYNAMIC HERE SOUNDS LIKE AN ENGINEERING TERM ) is exemplified by the housing bubble of the last eight years.

The important implication is that the Great Moderation is the result of a retreat from full employment combined with the transitional factors of disinflation, asset price inflation, and increased consumer borrowing. Those factors now appear exhausted. Further disinflation will produce disruptive deflation. Asset prices (particularly real estate) seem above levels warranted by fundamentals, making for the danger of asset price deflation. And many consumers have exhausted their access to credit and now pose significant default risks.

Given this, the Great Moderation( THIS WAS OVERDONE ) could easily come to a grinding halt. Though high inflation is unlikely to return( I AGREE ), recessions are likely to deepen and linger( WHY ? ). If that happens the reputations of central bankers will sully, and the real foundation and hidden costs of the Great Moderation may surface. That could prompt a re-writing of history that restores demands for a return to true full employment with diminished income inequality( I'M FOR THESE THINGS, BUT I DON'T FOLLOW HIS REASONING. IT READS MORE LIKE A CAUSALITY MISHMASH. ). How we tell history really does matter."

"but the critics never mention the reason for the low rates nor their benefits."

Bob McTeer takes the blame for turning the water on in the Spigot Theory, which I don't credit:

"When recession becomes an issue, as it now is, the remedy involves increasing total spending, or aggregate demand, to match the capacity of the economy to produce goods and services at full employment( TRUE ).

One way to view aggregate demand is by its spending components such as consumption, investment, and government spending. This "Keynesian approach facilitates a focus on fiscal policy( TRUE ).

An equally valid approach that highlights monetary policy is to treat aggregate demand as the money supply (M) times its velocity (V). MV gives you the same spending totals as above( YES ).

A third approach, rarely used, is productivity (output per hour worked) times the number of hours worked. That too gives the same result. It's like describing the same thing in different languages.( OK )

Productivity growth came into prominence in the late 1990s because its acceleration had very positive results. It enabled employers to give pay increases without increasing their unit labor costs. That permitted an easier monetary policy with less worry about inflation. We had faster growth with falling inflation( YES ).

Remarkably, faster productivity growth continued as we climbed out of the recession in 2002. That was a mixed blessing since business expanded with little or no expansion in employment. Rising output coinciding with rising unemployment led to the term "jobless recovery."( YES. THAT'S SOMETIMES AN ODDITY OF AN INCREASE IN PRODUCTIVITY )

While rising productivity was increasing our standard of living, it also depressed employment growth, which is probably not a desirable tradeoff when the economy is weak( I AGREE ). Rising employment spreads the benefits of growth more widely( YES ).

As 2002 progressed, the recovery sputtered and a double dip recession threatened. Falling inflation threatened to morph into actual deflation. Fear of deflation, was the main reason the Greenspan Fed allowed the Federal funds rate to go so low, eventually reaching one percent. Alan Greenspan is routinely blamed for those low interest rates fueling the housing boom, but the critics never mention the reason for the low rates nor their benefits( TRUE. SAME PLAN AS THIS TIME ).

Whether the policy was justified or not, I left my fingerprints at the scene. At the September 2002 FOMC meeting, I dissented, along with Governor Ned Gramlich, in favor of reducing rates. We didn't prevail at that meeting, but the vote to ease was unanimous at the next meeting, on November 6.

I wrote the following rational for the minutes, which are now public:

Messrs. Gramlich and McTeer dissented because they preferred to ease monetary policy at this meeting. The economic expansion, which resumed almost a year ago, had recently lost momentum, and job growth had been minimal over the past year. With inflation already low and likely to decline further in the face of economic slack and rapid productivity growth, the potential cost of additional stimulus seemed low compared with the risk of further weakness.

So, you see, it wasn't Chairman Greenspan's fault. It was mine."

I would have voted with McTeer. But, as I say, I don't hold Low Interest Rates as the cause of our crisis. My main complaint against Greenspan is not recognizing problems and voicing concerns about them. He was too much of a cheerleader for some dubious views about current Political Economy.

"What happened to the ideology? On closer inspection, it turned out to be something of a cover all along."

Robert Reich also has a pretty good idea of our Political Culture:

"Greenspan’s real failure of imagination was his inability to believe there are useful market rules beyond those that protect private property and prevent outright fraud. This, presumably, was why he kept insisting for so long that government be held at bay( WHO KNOWS WHAT HE REALLY BELIEVES? ).

But now the United States has chosen to deal with the financial crisis by buying up a significant fraction of the shares of the nation’s major banks and its largest insurance company, underwriting the loans of a large portion of the nation’s home-lending industry, and is on the verge of underwriting the nation’s largest automobile makers. Yet little if any of this largesse has found its way to the broader public( A VERY BIG SOCIAL PROBLEM WITH THE BAILOUTS ) – to homeowners in danger of defaulting on their mortgages and losing their homes, small businesses close to insolvency, state and local governments cutting public services because of budget shortfalls, families unable to afford health insurance, or young people unable to obtain loans to finance university tuition. ( TREASURY AND THE FED ARE TRYING NOW )

The ideology of a perfectly self-correctly free market( THEY DO NOT BELIEVE IN THAT AT ALL ) has given way to what might be described as a raid by America’s biggest banks and corporations on the public purse, supposedly justified( ACTUALLY JUSTIFIED AS NECESSARY TO THE FUNCTIONING OF OUR SYSTEM, AND CONSIDERED A FORM OF FDIC INSURANCE THAT ONLY A FEW PEOPLE SEEM TO BE AWARE OF ) by benefits to the broader public which seem never to materialize( THE INVESTMENT CLASS IS THE BROADER PUBLIC IN THEIR VIEW ). What happened to the ideology?( THE ONE ABOUT GOVERNMENT GUARANTEEING TO HELP THEM IN A CRISIS? IT'S WORKING OUT JUST AS PLANNED. SURELY YOU KNOW THAT? ) On closer inspection, it turned out to be something of a cover all along( THAT'S IT ).

During the same years Greenspan called for deregulation of financial markets( ONLY THESE ), Wall Street was accelerating its bankrolling of the U.S. Congress( THAT'S THE FDIC INSURANCE I WAS REFERRING TO ). Securities and investment firms contributed larger and larger amounts of money – not just to conservative Republicans who might expect such support but also to Democrats who had never been so graced before( OF COURSE. THAT'S OUR SYSTEM ). According to Center for Responsive Politics, Wall Street firms dramatically increased their contributions to both parties during these years. Their share of total donations to the Democratic Senatorial Campaign Committee, for example, rose continuously, from 5 percent during the 1999-2000 election cycle to 15 percent by the 2007-2008 cycle.

The money was accompanied, and often raised, by Wall Street lobbyists who pushed Congress in the same direction Greenspan urged – blocking regulation of derivatives, weakening oversight of subprime mortgage lending, and preventing the Securities and Exchange Commission from doing its job. ( IN OTHER WORDS, GETTING GOVERNMENT OFF THEIR BACKS WHEN IT SUITED THEM )

To take but one example, the collapses of Enron, WorldCom, and several other giant corporations in 2002 revealed a troubling pattern of credit-rating agencies repeatedly assuring investors that such companies were good investments until just before they went under. When the Securities and Exchange Commission asked Congress for additional authority to oversee the credit-rating agencies, Wall Street and its lobbyists blocked the measure( IT WAS CLEAR WHY BACK IN THE S & L CRISIS ). With hindsight, it’s clear why. Wall Street investment banks were paying the agencies to rate various mortgage backed securities after first advising the firms that issued them – and collecting fees – on how to package them to get high ratings. Years later many of these same securities, based on risky loans, would prove to be worthless, threatening financial institutions worldwide. ( ALL TRUE )

Apparently Greenspan hasn't learned anything from all this( HE'S NOT SURPRISED. COME ON. ), but the rest of us have no excuse. The real choice ahead is between democratic capitalism and authoritarian capitalism( MELODRAMATIC ) . China is perfecting the latter. But unless we are careful we – the citizens of democratic capitalist nations – will discover that our form of capitalism has become more authoritarian( WE HAVEN'T YET? OH MY. ) than democratic. The current economic crisis surely poses a test for capitalism( A SOCIAL TEST. READ BURKE ). But it is also a test of democracy( AN ECONOMIC TEST. READ HAYEK )."

Our system is a Welfare State in which various Interest Groups compete to get the government's aid and largess. Almost everyone wants government intervention. All they differ in is the details of what they want the government to do. However, De-Regulation is not an end in itself, but a system in which the Government gives certain businesses more leeway while continuing to explicitly and implicitly guarantee government help in a financial crisis. What was not anticipated was the size of the crisis and ineffectiveness of the government's response.

I don't know exactly what Democratic Capitalism means to Reich. We have it. What we've had for the last eight years is just a peculiarly obnoxious form of it. It's up to the New Administration and Congress to do a better job of governing. It's hard right now how to see it being worse.

I suppose that my biggest difference with Reich is that I believe less government would alleviate some of these problems. However, that will not be possible without a growing and prosperous Middle Class, which I do not believe that we have now. I base that belief on using my eyes to see the obvious, which must be much harder to do than it seems.

"Keynes’s prescriptions were guided by his conception of money, which plays a disturbing role in his economics."

Robert Skidelsky on Keynes again in the NY Times:

"Among the most astonishing statements to be made by any policymaker in recent years was Alan Greenspan’s admission this autumn that the regime of deregulation he oversaw as chairman of the Federal Reserve was based on a “flaw”: he had overestimated the ability of a free market to self-correct and had missed the self-destructive power of deregulated mortgage lending. The “whole intellectual edifice,” he said, “collapsed in the summer of last year.”

I have to admit that it is astonishing.

"What was this “intellectual edifice”? As so often with policymakers, you need to tease out their beliefs from their policies. Greenspan must have believed something like the “efficient-market hypothesis,” which holds that financial markets always price assets correctly. Given that markets are efficient, they would need only the lightest regulation. Government officials who control the money supply have only one task — to keep prices roughly stable."

It is very important to understand, or tease out, beliefs from policies. For me, this is the difference between Politics and Political Theory and Political Economy and Economics. I don't believe markets are efficient. I do believe that the Fed's main function is to keep prices roughly stable, with a bias towards slight inflation.

"I don’t suppose that Greenspan actually bought this story literally, since experience of repeated financial crises too obviously contradicted it. It was, after all, only a model. But he must have believed something sufficiently like it to have supported extensive financial deregulation and to have kept interest rates low in the period when the housing bubble was growing. This was the intellectual edifice, of both theory and policy, which has just been blown sky high. As George Soros rightly pointed out, “The salient feature of the current financial crisis is that it was not caused by some external shock like OPEC raising the price of oil. . . . The crisis was generated by the financial system itself.”

This is not very clear. I don't see a lot of explanatory power here. Is the decline in housing prices like the price of oil? Is the tsunami of foreclosures like OPEC or is it part of the financial system itself? I also don't credit the power of low interests rates as the most important cause of the current crisis. Deregulation might have had a part in this drama as well, but I need a little more explanation of what that part entails.

"This is where the great economist John Maynard Keynes (1883-1946) comes in. Today, Keynes is justly enjoying a comeback. For the same “intellectual edifice” that Greenspan said has now collapsed was what supported the laissez-faire policies Keynes quarreled with in his times. Then, as now, economists believed that all uncertainty could be reduced to measurable risk. So asset prices always reflected fundamentals, and unregulated markets would in general be very stable."

So Laissez-Faire Policies entail believing that:
1) All uncertainty can be reduced to measurable risk ( Don't agree )
2) Asset prices always reflect fundamentals ( Don't agree. This involves perception and interpretation )
3) Unregulated markets are generally stable ( We don't have an unregulated market. I could say something banal and pronounce that well-regulated markets are stable. I guess that I just did, for all the lack of specificity and essentially tautological reasoning good it does me )

What's with the focus on Greenspan? Is this going to all be about Central Banks?

"By contrast, Keynes created an economics whose starting point was that not all future events could be reduced to measurable risk. There was a residue of genuine uncertainty, and this made disaster an ever-present possibility, not a once-in-a-lifetime “shock.” Investment was more an act of faith than a scientific calculation of probabilities. And in this fact lay the possibility of huge systemic mistakes."

I agree with Keynes here. Strangely, I thought that Hayek agreed with this.

"The basic question Keynes asked was: How do rational people behave under conditions of uncertainty? The answer he gave was profound and extends far beyond economics. People fall back on “conventions,” which give them the assurance that they are doing the right thing. The chief of these are the assumptions that the future will be like the past (witness all the financial models that assumed housing prices wouldn’t fall) and that current prices correctly sum up “future prospects.” Above all, we run with the crowd. A master of aphorism, Keynes wrote that a “sound banker” is one who, “when he is ruined, is ruined in a conventional and orthodox way.” (Today, you might add a further convention — the belief that mathematics can conjure certainty out of uncertainty.)"

I should say that I'm a big fan of his writing style, which favorably disposes me to him. I would say:
1) People fall back on Narratives
2) That the future follows from the past must in some sense be true, since day follows from night. I thought that Keynes believed that it was very hard to predict the future in various situations, not all situations. In other words, some events are easier to predict than others.
3) I would say that we are part of a society. Run with the crowd is too Mechanistic for my taste.
4) Math cannot conjure certainty from uncertainty, if I understand what he means.

"But any view of the future based on what Keynes called “so flimsy a foundation” is liable to “sudden and violent changes” when the news changes. Investors do not process new information efficiently because they don’t know which information is relevant. Conventional behavior easily turns into herd behavior. Financial markets are punctuated by alternating currents of euphoria and panic."

This all adds up to people aren't omniscient. I don't think that all markets are euphoric then panicked, then euphoric and then panicked, and I certainly don't believe that this is inevitable. If I did, then that would go a long way towards predicting it.

"Keynes’s prescriptions were guided by his conception of money, which plays a disturbing role in his economics. Most economists have seen money simply as a means of payment, an improvement on barter. Keynes emphasized its role as a “store of value.” Why, he asked, should anyone outside a lunatic asylum wish to “hold” money? The answer he gave was that “holding” money was a way of postponing transactions. The “desire to hold money as a store of wealth is a barometer of the degree of our distrust of our own calculations and conventions concerning the future. . . . The possession of actual money lulls our disquietude; and the premium we require to make us part with money is a measure of the degree of our disquietude.” The same reliance on “conventional” thinking that leads investors to spend profligately at certain times leads them to be highly cautious at others. Even a relatively weak dollar may, at moments of high uncertainty, seem more “secure” than any other asset, as we are currently seeing."

I'm a bit disturbed by this paragraph. I save money in order to have it in case I need it in the future for some unseen event. I find living in general disquieting, money much less so.

"It is this flight into cash that makes interest-rate policy such an uncertain agent of recovery. If the managers of banks and companies hold pessimistic views about the future, they will raise the price they charge for “giving up liquidity,” even though the central bank might be flooding the economy with cash. That is why Keynes did not think that cutting the central bank’s interest rate would necessarily — and certainly not quickly — lower the interest rates charged on different types of loans. This was his main argument for the use of government stimulus to fight a depression. There was only one sure way to get an increase in spending in the face of an extreme private-sector reluctance to spend, and that was for the government to spend the money itself. Spend on pyramids, spend on hospitals, but spend it must."

I call this a fear and aversion to risk and the accompanying flight to safety. I get the point, which is why I believe that a stimulus is worth a shot, after trying lowering interest rates. Is this supposed to be controversial?

"This, in a nutshell, was Keynes’s economics. His purpose, as he saw it, was not to destroy capitalism but to save it from itself. He thought that the work of rescue had to start with economic theory itself. Now that Greenspan’s intellectual edifice has collapsed, the moment has come to build a new structure on the foundations that Keynes laid."

That's basically my purpose. I believe that theories are of limited value, even Keynes' theories. I must not be in Greenspan's camp since I don't find any of this puzzling. As for Keynes, as I've said before, his theories will, in fact, end up being of limited worth as to specifics. We are looking to Keynes as a part of our Narrative that helps us deal with the present. It happens that the policies we're throwing at this crisis resemble Keynes enough that we are conjuring up his ghost to help us deal with it. That's fine. That's how we deal with crises. But we are essentially embarked on a trial and error ride that is more pragmatic than ideological, which is how it should be. It seems to me that what I've just stated is very Keynsian, if by that cognomen is meant one who uses what's truly valuable in Keynes' thought.

"It ignored remarkably prescient warnings that foretold the financial meltdown, according to an Associated Press review of regulatory documents."

This ones making the rounds, but it's worth preserving. From CNN Money:

"WASHINGTON (AP) -- The Bush administration backed off proposed crackdowns on no-money-down, interest-only mortgages years before the economy collapsed, buckling to pressure from some of the same banks that have now failed. It ignored remarkably prescient warnings that foretold the financial meltdown, according to an Associated Press review of regulatory documents.

"Expect fallout, expect foreclosures, expect horror stories," California mortgage lender Paris Welch wrote to U.S. regulators in January 2006, about one year before the housing implosion cost her a job."

Pray you expect them in 2009.

"Bowing to aggressive lobbying -- along with assurances from banks that the troubled mortgages were OK -- regulators delayed action for nearly one year. By the time new rules were released late in 2006, the toughest of the proposed provisions were gone and the meltdown was under way."

They were OK. They were guaranteed by the government, they assumed, if everything went sideways.

"These mortgages have been considered more safe and sound for portfolio lenders than many fixed-rate mortgages," David Schneider, home loan president of Washington Mutual, told federal regulators in early 2006. Two years later, WaMu became the largest bank failure in U.S. history."

On the other hand, they've been considered time bombs waiting to go off when interest rates go up.

"The administration's blind eye to the impending crisis is emblematic of its governing philosophy, which trusted market forces and discounted the value of government intervention in the economy. Its belief ironically has ushered in the most massive government intervention since the 1930s."

That was the deal. Less regulations, with the understanding that the government would intervene in a financial crisis.

"Many of the banks that fought to undermine the proposals by some regulators are now either out of business or accepting billions in federal aid to recover from a mortgage crisis they insisted would never come. Many executives remain in high-paying jobs, even after their assurances were proved false."

Let me repeat that this was the understanding.

"In 2005, faced with ominous signs the housing market was in jeopardy, bank regulators proposed new guidelines for banks writing risky loans. Today, in the midst of the worst housing recession in a generation, the proposal reads like a list of what-ifs:"

This isn't that useful, but...

--Regulators told bankers exotic mortgages were often inappropriate for buyers with bad credit. (Obvious )

--Banks would have been required to increase efforts to verify that buyers actually had jobs and could afford houses. ( Obvious )

--Regulators proposed a cap on risky mortgages so a string of defaults wouldn't be crippling. ( Obvious )

--Banks that bundled and sold mortgages were told to be sure investors knew exactly what they were buying. ( Obvious )

--Regulators urged banks to help buyers make responsible decisions and clearly advise them that interest rates might skyrocket and huge payments might be due sooner than expected. ( Obvious )

By "Obvious", I mean these are all already part of the code of fair business practices, and deviations from these points are either fraud, negligence, or fiduciary mismanagement.

"Those proposals all were stripped from the final rules. None required congressional approval or the president's signature."

Were they stripped from decency and common sense.

"In hindsight, it was spot on," said Jeffrey Brown, a former top official at the Office of Comptroller of the Currency, one of the first agencies to raise concerns about risky lending.'

Hindsight usually is.

"Federal regulators were especially concerned about mortgages known as "option ARMs," which allow borrowers to make payments so low that mortgage debt actually increases every month. But banking executives accused the government of overreacting."

Accused? Is overreacting a crime?

"Bankers said such loans might be risky when approved with no money down or without ensuring buyers have jobs but such risk could be managed without government intervention."

Actually, they could have, given honest bankers.

"An open market will mean that different institutions will develop different methodologies for achieving this goal," Joseph Polizzotto, counsel to now-bankrupt Lehman Brothers, told U.S. regulators in a March 2006."

What goal? Bankruptcy?

"Countrywide Financial Corp., at the time the nation's largest mortgage lender, agreed. The proposal "appears excessive and will inhibit future innovation in the marketplace," said Mary Jane Seebach, managing director of public affairs."

"Inhibit" doesn't mean "preclude".

"One of the most contested rules said that before banks purchase mortgages from brokers, they should verify the process to ensure buyers could afford their homes. Some bankers now blame much of the housing crisis on brokers who wrote fraudulent, predatory loans. But in 2006, banks said they shouldn't have to double-check the brokers."

Fraud. Yes. So why don't we pursue it?

"It is not our role to be the regulator for the third-party lenders," wrote Ruthann Melbourne, chief risk officer of IndyMac Bank."

Just give us the money, and we'll look the other way?

"California-based IndyMac also criticized regulators for not recognizing the track record of interest-only loans and option ARMs, which accounted for 70% of IndyMac's 2005 mortgage portfolio. This summer, the government seized IndyMac and will pay an estimated $9 billion to ensure customers don't lose their deposits."

Last week, Downey Savings joined the growing list of failed banks. The problem: About 52% of its mortgage portfolio was tied up in risky option ARMs, which in 2006 Downey insisted were safe -- maybe even safer than traditional 30-year mortgages.

"To conclude that 'nontraditional' equates to higher risk does not appropriately balance risk and compensating factors of these products," said Lillian Gavin, the bank's chief credit officer."

The were meant to be higher risk. Period.

"At least some regulators didn't buy it. The comptroller of the currency, John C. Dugan, was among the first to sound the alarm in mid-2005. Speaking to a consumer advocacy group, Dugan painted a troublesome picture of option-ARM lending. Many buyers, particularly those with bad credit, would soon be unable to afford their payments, he said. And if housing prices declined, homeowners wouldn't even be able to sell their way out of the mess.

It sounded simple, but "people kind of looked at us regulators as old-fashioned," said Brown, the agency's former deputy comptroller."

Why worry? We're too far down this road.

"Diane Casey-Landry, of the American Bankers Association, said the industry feared a two-tiered system in which banks had to follow rules that mortgage brokers did not. She said opposition was based on the banks' best information.

"You're looking at a decline in real estate values that was never contemplated," she said."

That's preposterous. I saw it coming.

"Some saw problems coming. Community groups and even some in the mortgage business, like Welch, warned regulators not to ease their rules.

"We expect to see a huge increase in defaults, delinquencies and foreclosures as a result of the over selling of these products," Kevin Stein, associate director of the California Reinvestment Coalition, wrote to regulators in 2006. The group advocates on housing and banking issues for low-income and minority residents.

The government's banking agencies spent nearly a year debating the rules, which required unanimous agreement among the OCC, Federal Deposit Insurance Corp., Federal Reserve, and the Office of Thrift Supervision -- agencies that sometimes don't agree.

The Fed, for instance, was reluctant under Alan Greenspan to heavily regulate lending. Similarly, the Office of Thrift Supervision, an arm of the Treasury Department that regulated many in the subprime mortgage market, worried that restricting certain mortgages would hurt banks and consumers.

Grovetta Gardineer, OTS managing director for corporate and international activities, said the 2005 proposal "attempted to send an alarm bell that these products are bad." After hearing from banks, she said, regulators were persuaded that the loans themselves were not problematic as long as banks managed the risk. She disputes the notion that the rules were weakened.

In the past year, with Congress scrambling to stanch the bleeding in the financial industry, regulators have tightened rules on risky mortgages.

Congress is considering further tightening, including some of the same proposals abandoned years ago".

Good work. In a way, this is pointless. However, it's part of the record.

"Fly, Fly, Fly."

Do you enjoy a good allegory? Say, "The Wizard Of Oz"? I do. Of course, I identify with the Flying Monkeys. From GreenLight Advisor:

“The past 30 years of economic history may have produced a daunting sequel to the original Wizard of Oz, written by Frank Baum.

By Hugh Hendry
Last Updated: 10:59AM GMT 27 Nov 2008

Follow the yellow brick road to get a picture of where we are

People blame this crisis on cheap money and greedy bankers. They certainly cannot be exempted. But I take a more fatalist point of view. There has to be a reason for humans to die off in their 70s and 80s. I believe it is so that the memory of a generation’s mistakes is erased, allowing future ages to repeat the folly of greed and fear.

Because of this, I spend a lot of time reflecting on social mood and behaviour. Popular fiction is a particular fascination; I believe it provides a mind map of the social conscience. The Wizard of Oz is a personal favourite. I would contend that bullish markets produce feel-good films, like Disney animation; that bear markets produce depictions of horror and foreboding (think Hammer House of Horror in the 1970s and SAW, its modern equivalent); and that social mood is linked to stock market patterns."

That's right, this is the previously mentioned Hendry.

"The original Frank Baum story was written as a political allegory of America’s entry on to the gold standard in 1879. The strictures of sound money coincided with a vibrant post Civil War economy. The result was deflation: prices fell by 1.7pc pa between 1875 and 1896. The farmer, as depicted by the scarecrow, was held captive by falling agricultural prices and mortgages owed to the big banks, the wicked witch of the east. The spell of tight monetary policy cast a pall over the poor tin woodsman: every time he swung his axe, he chopped off part of his body. It was a depiction of the economy’s shuttered and rusting factories.

The easy-money crowd, Bernanke and Greenspan’s great grandfathers perhaps, argued the responsibility for the economy’s woes lay with an insufficient monetary response. The gold market had a scarcity that choked the US economy into serfdom.

Instead, the populists’ manifesto called for the readmission of more plentiful silver coinage into the system – a point captured by Dorothy’s silver slippers (Hollywood changed them to ruby) as she skipped along the yellow brick road (the gold standard). Print more money and remove us from penury. Consecutive presidential elections were contested on such a return to bimetallism in 1896 and 1900. Surprisingly, the easy-money crowd, proved unsuccessful; they were defeated by powerful bankers such as JP Morgan. However, the story ends with the good witch of the south (the populace) prophesying that Dorothy’s silver slippers (easy-money policy) are so powerful they can fulfil her every wish. This utopia was made possible just 13 years later with the formation of the Federal Reserve. The tin man and the scarecrow would have a more forgiving lender of last resort after all and 71 years later the wizard, called Nixon, went one step further and abolished the need for gold and silver ounces (Oz) when the US reneged on its Bretton Woods commitment to sound money."

What's our allegory?

"The story would feature an apprentice printer called Bernanke. Encouraged by a wicked wizard, Greenspan, he toils at his printing press night and day producing reams of paper money. At first his monetary accommodation seems to bring unbridled prosperity. Boom follows boom, as the business cycle is seemingly abolished, house prices grow to the sky and his political stock rises. In time, the scarecrow is bought-off by crop subsidy; the tin man vacations in Vegas, having refinanced his mortgage for the 13th time. And the sorcerer’s apprentice is promoted to top wizard.

However, Greenspan, now in retirement, finally reveals his scheme has brought only “bogus riches”. The printing presses have created a “zero-sum game” where dollars lose their purchasing power against God’s brew of precious metals. The populace begins to save. Spending is reined in. Even the corporate sector suffers. With consumers no longer spending, there are no profits. Shares slump and the fiat kingdom collapses in anarchy.

And that is pretty much where we are today."

Really?

"I withdrew my hard-earned money from a bank this summer. But it may surprise you to learn that I bought government bonds of long duration. Surely I should have bought gold? Except that I believe the way to make money is to seek opportunities through paradox.

And therein lies our brinkmanship: everyone has skipped our story and read the conclusion. They fear financial anarchy. Gold coins are sold out. Everyone is in. And yet the price of gold has fallen this year. So, for now, I would stick with the bonds. The 18-year British gilt yields 4.8pc but, with the Bank of England likely to follow the Fed and slash rates to 1pc, I believe we could see gilt yields below 3pc. And I promise you that if bond yields broke 3pc there would be a stampede to buy.

At this stage gold might trade close to $500, and those who missed its rally from 2002 would have the solace of schadenfreude when in reality they should be buying the stuff and selling their bonds. What delicious irony: deflationists and inflationists could both claim to be right. But how many will have profited?"

The only allegory I need, personally, is "Paradise Lost".

"a clear policy implication — namely, that financial market reform should be pressed quickly, that it shouldn’t wait until the crisis is resolved."

Paul Krugman has a post today in the NY Times:

"One answer to these questions is that nobody likes a party pooper. While the housing bubble was still inflating, lenders were making lots of money issuing mortgages to anyone who walked in the door; investment banks were making even more money repackaging those mortgages into shiny new securities; and money managers who booked big paper profits by buying those securities with borrowed funds looked like geniuses, and were paid accordingly. Who wanted to hear from dismal economists warning that the whole thing was, in effect, a giant Ponzi scheme?"

I don't see it as a Ponzi Scheme. One could read my thought experiment about looking into some of the more risky and complex inverstments as early as 2005, and being able to conclude that they were simply too risky. A number of things could have been done to keep this crisis from occurring or being this bad, whereas a Ponzi Scheme has Fraud built right into it. But I agree with the basic point, that it's hard to intentionally slow the economy down when so many people are still making money in it. It's one reason that I think it unlikely that the Fed, on its own, using a blunt instrument like raising interest rates across the board, will find it easy to raise rates to slow the economy down. Nevertheless, I believe that middle of the party is the part of the party where real diligence needs to be taken. In other words, focus on emerging problems in the economy when things start really going well, especially for a long period of time. Although it's hard to do, it's necessary.

"There’s also another reason the economic policy establishment failed to see the current crisis coming. The crises of the 1990s and the early years of this decade should have been seen as dire omens, as intimations of still worse troubles to come. But everyone was too busy celebrating our success in getting through those crises to notice.

Consider, in particular, what happened after the crisis of 1997-98. This crisis showed that the modern financial system, with its deregulated markets, highly leveraged players and global capital flows, was becoming dangerously fragile. But when the crisis abated, the order of the day was triumphalism, not soul-searching.

Time magazine famously named Mr. Greenspan, Robert Rubin and Lawrence Summers “The Committee to Save the World” — the “Three Marketeers” who “prevented a global meltdown.” In effect, everyone declared a victory party over our pullback from the brink, while forgetting to ask how we got so close to the brink in the first place.

In fact, both the crisis of 1997-98 and the bursting of the dot-com bubble probably had the perverse effect of making both investors and public officials more, not less, complacent. Because neither crisis quite lived up to our worst fears, because neither brought about another Great Depression, investors came to believe that Mr. Greenspan had the magical power to solve all problems — and so, one suspects, did Mr. Greenspan himself, who opposed all proposals for prudential regulation of the financial system."

There is some truth in this, but it misunderstands the nature of the triumphalism. The system worked because of government and Fed actions that were taken during these years. This led to a complacency in the nature and strength of the implicit and explicit government guarantess of intervention in a financial crisis. It was less relief at our wisdom, than a realization of the nature and depth of government backing of our financial system. The downside of excessive risk was thereby consigned to government accounts and salvation, a view that has proven remarkably prescient.

"And because we’re all so worried about the current crisis, it’s hard to focus on the longer-term issues — on reining in our out-of-control financial system, so as to prevent or at least limit the next crisis. Yet the experience of the last decade suggests that we should be worrying about financial reform, above all regulating the “shadow banking system” at the heart of the current mess, sooner rather than later.

For once the economy is on the road to recovery, the wheeler-dealers will be making easy money again — and will lobby hard against anyone who tries to limit their bottom lines. Moreover, the success of recovery efforts will come to seem preordained, even though it wasn’t, and the urgency of action will be lost.

So here’s my plea: even though the incoming administration’s agenda is already very full, it should not put off financial reform. The time to start preventing the next crisis is now. "

I disagree here as well. The real fear is that we will regulate excessively in the midst of this crisis, focusing in on the problems of this last crisis, and not putting into place a system that focuses less on actual regulation than recognition of the problems in our finacial system, some of which won't need more than supervision, while some might need regulatory oversight.

And to reiterate, just like value investing, we should be especially vigilent and fearful when things are going well, not after they've turned bad. I know it's going to be hard, but it's simply the patience, vision, and wisdom, of the value investor, a strategy that human beings have been able to execute.