If Americans were convinced of the Fed’s commitment, they’d buy and borrow more now, he says.

TO BE NOTED: From Bloomberg:

"U.S. Needs More Inflation to Speed Recovery, Say Mankiw, Rogoff

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By Rich Miller

May 19 (Bloomberg) -- What the U.S. economy may need is a dose of good old-fashioned inflation.

So say economists including Gregory Mankiw, former White House adviser, and Kenneth Rogoff, who was chief economist at the International Monetary Fund. They argue that a looser rein on inflation would make it easier for debt-strapped consumers and governments to meet their obligations. It might also help the economy by encouraging Americans to spend now rather than later when prices go up.

“I’m advocating 6 percent inflation for at least a couple of years,” says Rogoff, 56, who’s now a professor at Harvard University. “It would ameliorate the debt bomb and help us work through the deleveraging process.”

Such a strategy would be risky. An outlook for higher prices could spook foreign investors and send the dollar careening lower. The challenge would be to prevent inflation from returning to the above-10-percent levels that prevailed in the 1970s and took almost a decade and a recession to cure.

“Anybody who has been a central banker wouldn’t want to see inflation expectations become unhinged,” says Marvin Goodfriend, a former official at the Federal Reserve Bank of Richmond. “The Fed would have to create a recession to get its credibility back,” adds Goodfriend, now a professor at Carnegie Mellon University’s Tepper School of Business in Pittsburgh.

Preventing Deflation

For the moment, the Fed’s focus is on preventing deflation -- a potentially debilitating drop in prices and wages that makes debts harder to repay and encourages the postponement of purchases. The Labor Department reported May 15 that consumer prices were unchanged in April from the previous month and were down 0.7 percent from a year earlier.

“We are currently being very aggressive because we are trying to avoid” deflation, Fed Chairman Ben S. Bernanke told an Atlanta Fed conference on May 11.

The central bank has cut short-term interest rates effectively to zero and engaged in what Bernanke calls “credit easing” to spur lending to consumers, small businesses and homebuyers.

Bernanke, 55, said the risk of deflation was receding and that the Fed was ready to reverse course when needed to maintain stable prices and prevent an outbreak of undesired inflation. The Fed has implicitly defined price stability as annual inflation of 1.5 percent to 2 percent, as measured by a price index based on personal consumption expenditures.

Lifting Prices, Wages

Even after all the Fed has done to stimulate the economy, some economists argue that it needs to do more and deliberately aim for much faster inflation that would also lift wages.

With unemployment at a 25-year high of 8.9 percent, workers are being squeezed. Wages and salaries rose 0.3 percent in the first quarter, the least on record, according to the Labor Department, as companies including Memphis, Tennessee-based based package-delivery company FedEx Corp. and newspaper publisher Gannett Co. of McLean, Virginia slashed pay.

Given the Fed’s inability to cut rates further, Mankiw says the central bank should pledge to produce “significant” inflation. That would put the real, inflation-adjusted interest rate -- the cost of borrowing minus the rate of inflation -- deep into negative territory, even though the nominal rate would still be zero.

If Americans were convinced of the Fed’s commitment, they’d buy and borrow more now, he says.

Mankiw, currently a Harvard professor, declines to put a number on what inflation rate the Fed should shoot for, saying that the central bank has computer models that would be useful for determining that.

Gold Standard

In advocating that the Fed commit itself to generating some inflation, Mankiw, 51, likens such a step to the U.S. decision to abandon the gold standard in 1933, which freed policy makers to fight the Depression.

Faster inflation might be preferable to increased unemployment, or to further budget stimulus packages that push up the national debt, says Mankiw, who was chairman of the Council of Economic Advisors under President George W. Bush.

The White House has forecast that the budget deficit will hit $1.84 trillion this fiscal year, or 12.9 percent of gross domestic product. Rogoff doubts that politicians will be willing to reduce that shortfall by raising taxes as much as needed. Instead, he sees them pressing the Fed to accept faster inflation as a way of easing the burden of reducing the deficit.

Easier Debt Repayment

Inflationary increases in wages -- and the higher income taxes they generate -- would make it easier to pay off debt at all levels.

“There’s trillions of dollars of debt, in mortgage debt, consumer debt, government debt,” says Rogoff, who was chief economist at the Washington-based IMF from 2001 to 2003. “It’s a question of how do you achieve the deleveraging. Do you go through a long period of slow growth, high savings and many legal problems or do you accept higher inflation?”

Laurence Ball, a professor at Johns Hopkins University in Baltimore, says it’s risky to try to engineer a temporary surge in inflation because it might spark a spiral of rising prices.

Even so, he sees good reasons for the Fed to lift its implicit, medium-term inflation target to 3 percent to 4 percent from 1.5 percent to 2 percent now.

To battle recession, the Fed had to cut interest rates to 1 percent in 2003 and zero in the current period. That implies its inflation target has been too low because it’s left the Fed running up against the zero bound on nominal interest rates.

Inflation Advantage

“The basic advantage of pushing inflation a little higher is that it would make it less likely that we run into the problem of the interest rate hitting zero and the Fed not being able to stimulate the economy if necessary,” Ball says.

John Makin, a principal at hedge fund Caxton Associates in New York, wants the Fed to go further and target the level of prices instead of simply a rate of inflation. Such a policy would mean that if inflation fell short of 2 percent over a period of time, the Fed would have to push inflation above that rate subsequently to make up for the shortfall and keep prices rising on the desired trajectory.

While that might sound radical, it’s the same sort of policy that Bernanke advocated Japan follow in 2003 to fight deflation. In a speech in Tokyo that year, then-Fed Governor Bernanke called on the Bank of Japan to adopt “a publicly announced, gradually rising price-level target.”

‘Bad for Creditors’

Some investors are already worried that Bernanke will go too far. “We’re on the path of longer-term, higher inflation,” says Axel Merk, president of Merk Investments LLC in Palo Alto, California. “It’s good for debtors but it’s bad for creditors. It’s dangerous and irresponsible.”

Billionaire investor Warren Buffett, chairman of Berkshire Hathaway Inc. in Omaha, Nebraska, suggested that faster inflation was all but inevitable.

“A country that continuously expands its debt as a percentage of GDP and raises much of the money abroad to finance that, it’s going to inflate its way out of the burden of that debt,” he told the CNBC financial news television channel on May 4, adding, “That becomes a tax on everybody that has fixed- dollar investments.”

To contact the reporter on this story: Rich Miller in Washington rmiller28@bloomberg.net"

The US grew rapidly in the 1950’s and 1960’s with a relatively heavily regulated banking system. Why not again?

TO BE NOTED: Via the Economist's View:

The “New Normal” for Growth

by Kenneth Rogoff

Cambridge – Markets are bubbling over signs of “green shoots” in the global economy. An increasing number of investors see a strong rebound coming, first in China, then in the United States, and then in Europe and the rest of the world. Even the horrible growth numbers of the last couple quarters don’t seem to discourage this optimistic thinking. The deeper the plunge, the stronger the rebound, some analysts say.

Perhaps these optimists are right. But how strong an expansion can one reasonably expect when the worst is finally over? Is the “new normal” going to be the same as the “old normal” of the boom years from 2002 to 2007?

I have trouble seeing how the US and China, the main engines of global growth for two decades, can avoid settling on a notably lower average growth rate than they enjoyed before the crisis.

Let’s start with the US, the epicenter of the financial crisis, and still the most important economy in the world. In the best of worlds, the US financial sector will emerge from the crisis smaller and more heavily regulated. Not to worry, some economists, say. The US grew rapidly in the 1950’s and 1960’s with a relatively heavily regulated banking system. Why not again?

Sure, but the early post-war financial sector wasn’t called upon in those days to support nearly as diverse and sophisticated an economy as it is today. If authorities set the clock back several decades on banking regulation, can we be so sure they will not also set the clock back on income?

US consumption, the single biggest driver of global growth, is surely headed to a lower level, on the back of weak housing prices, rising unemployment, and falling pension wealth. During the boom, US consumption rose to more than 70% of GDP. In the wake of the crisis, it could fall down towards 60%.

And what about the major political shift the US has experienced? Tired of go-go growth, voters now look for more attention to addressing environmental concerns, health-care issues, and income inequality. But achieving these laudable goals will be expensive, coming on top of the giant budget deficits the US is running to counter the financial crisis. Higher taxes and greater regulation cannot be good for growth.

True, there is room to run the government more efficiently, especially in the areas of education and health care. But will these savings be enough to offset the burden of a significantly larger overall government? I hope so, and certainly the Obama administration is a breath of fresh air after the stunning ineptness of the Bush-Cheney years. But governments all over the world are always convinced that their expansions can be substantially financed by efficiency gains, and that dream usually proves chimerical.

Chinese growth is set to slow over the longer run, as well. Even before the financial crisis, it was clear that China could not continue indefinitely on its growth trajectory of 10% or more. Environmental and water problems were mounting. It was becoming increasingly clear that as China continued to grow faster than almost anyone else, the rest of the world’s import capacity (and tolerance) could not keep up with China’s export machine. China was becoming too big.

With the financial crisis, the Chinese economy’s necessary adjustment towards more domestic consumption has become far more urgent. True, even as exports have collapsed, the government has managed to prop up growth with a huge spending and credit expansion. But, while necessary, this strategy threatens to upset the delicate balance between private- and public-sector expansion that has underpinned China’s expansion so far. The growing role of the government, and the shrinking role of the private sector, almost surely portends slower growth later this decade.

Europe, too, faces challenges, and not just from the fact that it now has the worst downturn of the world’s major economic regions, with Germany’s government warning of a surreal 6% decline in GDP for 2009. The ongoing financial crisis will almost surely slow the integration of the accession countries in Central and Eastern Europe, whose young populations are the single most dynamic source of growth in Europe today.

Not all regions will necessarily have slower economic expansion in the decade ahead. Assuming continuing reforms in countries such as Brazil, India, South Africa, and Russia, emerging markets could well fill some of the growth gap left by the largest economies. But, in all likelihood, after years of steadily revising up its estimates of trend global growth, the International Monetary Fund will start revising them down.

Even after the crisis, global growth is almost certain to remain lower than the pre-crisis boom years for some time to come. This change may be good for the environment, for income equality, and for stability. Governments are right to worry about the quality of growth, not just its speed. But when it comes to tax and profit estimates, investors and politicians need to reorient themselves to the “new normal” – lower average growth.

Kenneth Rogoff is Professor of Economics and Public Policy at Harvard University, and was formerly chief economist at the IMF.

Copyright: Project Syndicate, 2009.
www.project-syndicate.org"

Equity investments are preferable to debt, a contributor to the current financial crisis, Taleb said.

TO BE NOTED: From Bloomberg:

"Global Crisis ‘Vastly Worse’ Than 1930s, Taleb Says (Update1)

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By Shiyin Chen and Liza Lin

May 7 (Bloomberg) -- The current global crisis is “vastly worse” than the 1930s because financial systems and economies worldwide have become more interdependent, “Black Swan” author Nassim Nicholas Taleb said.

“This is the most difficult period of humanity that we’re going through today because governments have no control,” Taleb, 49, told a conference in Singapore today. “Navigating the world is much harder than in the 1930s.”

The International Monetary Fund last month slashed its world economic growth forecasts and said the global recession will be deeper than previously predicted as financial markets take longer to stabilize. Nouriel Roubini, 51, the New York University professor who predicted the crisis, told Bloomberg News yesterday that analysts expecting the U.S. economy to rebound in the third and fourth quarter were “too optimistic.”

“Certainly the rate of economic contraction is slowing down from the freefall of the last two quarters,” Roubini said. “We are going to have negative growth to the end of the year and next year the recovery is going to be weak.”

Federal Reserve Chairman Ben S. Bernanke told lawmakers May 5 that the central bank expects U.S. economic activity “to bottom out, then to turn up later this year.” Another shock to the financial system would undercut that forecast, he added.

‘Big Deflation’

The global economy is facing “big deflation,” though the risks of inflation are also increasing as governments print more money, Taleb told the conference organized by Bank of America- Merrill Lynch. Gold and copper may “rally massively” as a result, he added.

Taleb, a professor of risk engineering at New York University and adviser to Santa Monica, California-based Universa Investments LP, said the current global slump is the worst since the Great Depression that followed Wall Street’s 1929 crash.

The Great Depression saw an increase in global trade barriers and was only overcome after President Franklin D. Roosevelt’s New Deal policies helped revive the U.S. economy.

The world’s largest economy may need additional fiscal stimulus to emerge from its current recession, Kenneth Rogoff, former chief economist at the International Monetary Fund, told Bloomberg News yesterday.

“We’re going to get to the point where recovery is just not soaring and they’re going to do the same again,” he said. “We’re going to have a very slow recovery from here.”

Fiscal Stimulus

The U.S. economy plunged at a 6.1 percent annual pace in the first quarter, making this the worst recession in at least half a century. President Barack Obama signed a $787 billion stimulus plan into law in February that included increases in spending on infrastructure projects and a reduction in taxes.

Gold, copper and other assets “that China will like” are the best investment bets as currencies including the dollar and euro face pressures, Taleb said. The IMF expects the global economy to shrink 1.3 percent this year.

Gold, which jumped to a record $1,032.70 an ounce March 17, 2008, is up 3.6 percent this year. Copper for three-month delivery on the London Metal Exchange has surged 55 percent this year on speculation demand will rebound as the global economy recovers from its worst recession since World War II.

Commodity prices are also gaining amid signs that China’s 4 trillion yuan ($585 billion) stimulus package is beginning to work in Asia’s second-largest economy. Quarter-on-quarter growth improved significantly in the first three months of 2009, the Chinese central bank said yesterday, without giving figures.

Credit Derivatives

China will avoid a recession this year, though it will not be able to pull Asia out of its economic slump as the region still depends on U.S. demand, New York University’s Roubini said.

Equity investments are preferable to debt, a contributor to the current financial crisis, Taleb said. Deflation in an equity bubble will have smaller repercussions for the global financial system, he added.

“Debt pressurizes the system and it has to be replaced with equity,” he said. “Bonds appear stable but have a lot of hidden risks. Equity is volatile, but what you see is what you get.”

Currency and credit derivatives will cause additional losses for companies that hold more than $500 trillion of the securities worldwide, Templeton Asset Management Ltd.’s Mark Mobius told the same Singapore conference today.

“There are going to be more and more losses on the part of companies that have credit derivatives, those who have currency derivatives,” Mobius, who helps oversee $20 billion in emerging-market assets at Templeton, said at the conference. “This is something we’re going to have to watch very, very carefully.”

Taleb is best known for his book “The Black Swan: The Impact of the Highly Improbable.” The book, named after rare and unforeseen events known as “black swans,” was published in 2007, just before the collapse of the subprime market roiled global financial institutions.

To contact the reporters on this story: Chen Shiyin in Singapore at schen37@bloomberg.net; Liza Lin in Singapore at Llin15@bloomberg.net."

the government stands behind the banking system and that their deposits are safe

TO BE NOTED: From Bloomberg:

"Geithner Bets U.S. Can Avoid Japan Trap Through Bank Earnings

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By Rich Miller and Matthew Benjamin

May 8 (Bloomberg) -- Treasury Secretary Timothy Geithner is betting that U.S. banks can do something their Japanese counterparts were unable to accomplish in that country’s “lost decade” of the 1990s: earn their way out of trouble.

The stress-test results released yesterday by regulators found that the 19 largest banks face a $74.6 billion capital hole that may be filled mostly by private money. That compares with the hundreds of billions of dollars seen by outside analysts, including the International Monetary Fund, and takes into account banks’ projected earnings over the next two years.

The “stress-test results are an important step forward,” Geithner said in a statement announcing the results. “Americans should know that the government stands behind the banking system and that their deposits are safe.”

Still, the strategy carries risks for Geithner, 47, who served as a Treasury attaché to Japan from 1989 to 1991. If he’s wrong about the banks’ ability to weather the worst recession in at least half a century, the U.S. may just be postponing the day of reckoning when institutions will have to be shut down and taken over by the government.

“This looks like Japan in 1998, when they didn’t spend enough money on the banks,” said Adam Posen, deputy director of the Washington-based Peterson Institute for International Economics. “They then ended up back in crisis in 2001.”

Paying Off

So far, Geithner’s gamble is paying off. Bank stocks have surged in recent weeks as investors bet the stress tests would give the lenders a clean bill of health. The Standard & Poor’s 500 Financials Index reached its highest level in four months on May 6 as the test results leaked out, before slipping 5.8 points yesterday to 162.3.

Geithner said the strategy was designed to ease the uncertainty that drove bank shares down earlier this year. By exposing the lenders to uniform tests and then publicizing the results, he hoped to reassure investors that their worst fears about the future of the banking system were unfounded.

Regulators led by the Federal Reserve found that nine of the 19 biggest banks, including Goldman Sachs Group Inc. and JPMorgan Chase & Co., don’t need more capital. Bank of America Corp. has the biggest hole -- $33.9 billion -- followed by Wells Fargo & Co., with $13.7 billion. Banks that need to bolster capital have until June 8 to develop a plan and until Nov. 9 to implement it.

Potential Losses

Geithner told reporters that regulators took a conservative approach to toting up potential credit losses and calculating the industry’s ability to absorb them through increased earnings. The forecast of future profits was at the “quite low end of analysts’ expectations,” he said.

The results showed that losses at the banks under “more adverse” economic conditions than most economists anticipate could total $599.2 billion over two years. Mortgage losses present the biggest part of the risk, at $185.5 billion.

Jan Hatzius, chief U.S. economist at Goldman Sachs in New York, said banks may be able to rack up enough earnings over the next two years to cover virtually all the remaining credit losses.

The contraction of the financial industry over the last year, including the demise of Bear Stearns Cos. and Lehman Brothers Holdings Inc., has put those that have survived in a better position to post profits, he said.

With the economy showing signs of being close to a bottom, some of the banks may even end up being overcapitalized, added Sung Won Sohn, an economics professor at California State University in Camarillo, California.

Too Easy?

Critics remain unconvinced and charge that the regulators went too easy on the banks in conducting the tests, which were designed to ensure the firms could keep lending even if the economy deteriorated more than most economists expect.

Examiners used an “adverse scenario” of a 3.3 percent contraction in the economy this year, and an average unemployment rate of 8.9 percent in 2009 and 10.3 percent in 2010. Economists see a 2.5 percent drop in output this year, and unemployment rates of 8.9 percent in 2009 and 9.4 percent in 2010, according to a Bloomberg News survey.

“The stress was not much of a stress,” said Joseph Stiglitz, a Nobel Prize winner in economics and professor at Columbia University in New York.

Skeptics of the plan such as Posen said Geithner was trying to make a virtue out of a necessity. With public opposition to bank bailouts high, the Treasury secretary felt constrained from asking Congress for more money to help the industry. Treasury has about $110 billion left in the $700 billion bank-rescue package approved by lawmakers last year.

Ready for More

Geithner said the Treasury had enough money remaining in the Troubled Asset Relief Program to cover the banking industry’s needs. Still, he made clear that President Barack Obama wouldn’t hesitate to ask Congress for more should that prove necessary.

It was public opposition to bank bailouts that prevented Japanese policy makers from taking more forceful action to aid the country’s financial industry in the 1990s.

Like the U.S., Japan at first responded by putting capital into the banks, in 1998 and 1999. The crisis wasn’t fully resolved until 2002, after the government forced the banks to write down or sell off bad loans and effectively nationalized one institution, according to Takeo Hoshi, dean of the School of International Relations and Pacific Studies at the University of California at San Diego.

“I find more and more similarities to Japan as the situation develops here,” he said.

Relying on Partnerships

Geithner is counting on yet-to-be launched public-private partnerships to buy up the impaired assets that remain on bank balance sheets. The partnerships will be financed by low-cost credit via the Fed and the Federal Deposit Insurance Corp.

R. Glenn Hubbard, a former chief White House economist under President George W. Bush, voiced doubts the partnerships would work and argued that more dramatic action -- and taxpayer money -- will be needed to fix the financial system.

“Some more radical solution is going to be in order,” such as dividing troubled institutions into so-called good banks and bad banks, said Hubbard, who is now dean of the Columbia University Graduate School of Business in New York.

Kenneth Rogoff, a former IMF chief economist who’s now at Harvard University in Cambridge, Massachusetts, also said he fears the administration isn’t being forceful enough. Like Japan in the 1990s, Obama has put forward a big fiscal stimulus program to try to get the economy moving again, yet may have been too cautious in acting to repair the financial system.

“If the banking plan still falls short, the fiscal stimulus will have been wasted to some extent,” Rogoff said. “We could end up like Japan, sliding in and out of recession.”

To contact the reporters on this story: Matthew Benjamin in Washington at mbenjamin2@bloomberg.netRich Miller in Washington rmiller28@bloomberg.net"

Rogoff Doesn't See Quick Recovery From Economic Crisis

TO BE NOTED: From Bloomberg:

Rogoff Doesn't See Quick Recovery From Economic Crisis

And the best way to avoid debt is to use monetary stimulus, not fiscal stimulus.

TO BE NOTED: From The Money Illusion:

“There’s every risk of an overshoot”

Because of the bloated monetary base there has been much concern recently about the supposed risk of future inflation. There are at least four important misconceptions associated with this issue, and I’ll try to address all four in this post. The first misconception is that it will be difficult to pull the excess reserves back out of circulation after the economy recovers and interest rates rise to a more normal level. As Hall recently pointed out, if we continue to pay interest on reserves it would not be necessary to pull those reserves out of circulation in the future, just pay enough interest for banks to want to continue holding them. But for the moment let’s assume that’s not feasible. In the following quotation from the WSJ, Kenneth Rogoff expresses a widely held fear:

“It’s very difficult to pump this money in and pull it out later,” says Kenneth Rogoff, a professor of economics at Harvard University. “There’s every risk of an overshoot.”

Let me first say that Rogoff has been very good on the need for an explicit inflation target for the Fed; in fact I seem to recall him suggesting a target of 6%, so he is not someone oblivious to the need for monetary stimulus. In addition, it’s easy to make generalizations when talking to the press, so I really don’t know whether he is actually all that worried about this issue. But some people clearly are. And this reflects a misunderstanding of monetary theory.

During the 1960s, 1970s and early 1980s there was a lot of concern about inflation gaining momentum, and then being hard to stop. Once inflation expectations start to rise, wage increases accelerate, and the core inflation rate also rises. At this point it is hard to put the genie back in the bottle. Reducing inflation once expectations have risen; runs into the well-known Phillips Curve problem. But that problem should never occur unless the central bank is grossly negligent. After 1982 central banks around the world figured out how to keep inflation under control. The key is to tighten monetary policy aggressively at any sign of an upswing in inflation expectations. As long as the Fed doesn’t let nominal/indexed bond spreads exceed 3%, there will be no severe problem of inflation overshooting. (That’s not to say they will be perfect, there certainly may be the occasional problem of slightly above target inflation.)

The second misconception is that monetary stimulus requires a massive increase in the monetary base. I have said from the beginning that if my policy were pursued the monetary base would probably be much lower than it is today. Now that the world’s leading expert on interest payments on reserves has endorsed my signature proposal, let’s look more closely at how the plan would actually work.

Before the crisis there was about $800 billion in cash, $80 billion in required reserves, and less than $8 billion in excess reserves. (I don’t recall the exact figures, but it doesn’t matter.) After the Fed started paying interest on reserves in early October, excess reserves ballooned up to about $800 billion, 100 times the normal level. With a penalty rate on excess reserves that number would go back down to less than $8 billion. In that case to prevent hyperinflation the Fed would need to pull almost all the extra $800 billion out of circulation. It’s hard to know how big a QE would be needed with a penalty rate on excess reserves; it depends on how credible the policy is. But in my view less than $100 billion would be required to hit any reasonable inflation or NGDP target.

Why so little? Because with a penalty rate on excess reserves all the extra $100 billion would go into cash in circulation. I did my dissertation on cash, and I can tell you that cash demand is nothing like what we learn in our textbooks. Because of the fear of theft, transactions balances are amazing small, even at near zero interest rates. Many people only carry a few hundred dollars, or even less. Where is the other more than $2000 per capita? Hoarded by tax evaders, criminals, and foreigners. And it is very costly for those groups to quickly adjust the size of their cash balances. They prefer the anonymity of cash, and thus often don’t have large amounts of financial assets to exchange for cash when rates fall.

I have no idea what would happen if the Fed tried to force even another $100 billion into circulation. It is possible that it would be put into safety deposit boxes, if T-bill yields went negative. But I think a much more likely outcome is that even before they got anywhere near $100 billion extra cash in circulation, there would be such a reaction in inflation sensitive markets (commodities, stocks, bond yields) that the Fed would fear overshooting their nominal target. It would be easy to generate 2% expected inflation, or 5% NGDP growth. To summarize, although I often do thought experiments about the Fed doubling the money supply, keep in mind that in the real world a bloated base is a sign of failure, of deflationary policies (i.e. the U.S. 1933, Japan 2002, the U.S. 2008.) I don’t expect my proposal to fail, and hence I believe the base would be much lower.

[BTW, should I start calling my proposal the "Sumner/Hall/Woodward plan?"]

The third misconception relates to the cost of maintaining interest payments on reserves after we return to normal. Hall clearly favors maintaining the program indefinitely, as he has advocated interest on reserves since 1983. In a recent post David Beckworth addressed some of the same issues as Hall and Rogoff:

Once the economy begins to recover I see four potential paths the Fed could take with regards to the large buildup of excess reserves:

1. The Fed could do nothing and allow the inflationary pressures to emerge.
2. The Fed could reverse the buildup of excess reserves and in the process stall the economic recovery.
3. The Fed could pay even higher rates on the excess reserves and potentially incur large fiscal costs.
4. The Fed could pray for super-robust economic growth that would allow the economy to quickly grow (i.e. increase real money demand) into the money supply. This would be the cure all solution–no need to reign in the buildup of excess reserves and no need to worry about inflation.

Number (4) is pipe dream. I suspect some combination of numbers (1) and (2) will be the likely outcome. Note that if the Fed pulls a Paul Volker and focuses solely on number (2) it would not only stall the economic recovery but may also incur some fiscal costs. This is because the Fed could have a negative equity position on its balance sheet by that time–interest rates will eventually go up and, in turn, push down the prices on securities currently held by the Fed–that would require it to either borrow securities from the Treasury or issue its own debt in order to reign in the expanded monetary base. The bottom line is there are no easy options ahead for the Fed once the recovery begins.

I agree that we can’t rely on 4, and shouldn’t do 1. As I’ve already indicated I don’t think we need fear option 2 as much as most others do. I don’t expect inflation to build up the head of steam we saw in the late 1970s. But I’d also like to address point 3. I haven’t yet made up my mind about the desirability of interest-bearing reserves in normal times. But I don’t think it need be as costly as many might assume.

Go back to my earlier numbers and remember that no interest would be paid on cash. So the Fed could still earn about as much seignorage as ever on the gradual increase in cash demand over time (say about $40 billion a year assuming 5% growth.) They would lose the seignorage on reserves, but reserves are normally very small. What about the huge cost of paying interest on the now bloated reserves—including an extra $800 billion in excess reserves under Hall’s plan? That should be a wash. Hall envisions them paying interest at about the same rate as earned on government securities. So if interest rates were 5% then the Fed would pay banks $40 billion a year on the $800 billion in excess reserves. But on the other hand that reserve demand would not exist in the long run without the interest incentive, so the Fed would also hold $800 billion more Treasury debt than otherwise, and thus reduce the net debt held by the public by that amount.

The extra cost would then be merely the interest on the much smaller required reserves. And although I believe Hall favors interest on required reserves to avoid the distortion of a tax on money, there is no reason why the interest on reserves program couldn’t be limited to excess reserves. Banks must hold required reserves whether they want to or not. [BTW, as with Rogoff, I often agree with David Beckworth. His blog is worth checking out if you haven't seen it.]

The fourth misconception involves the politics of inflation. A worldly, sophisticated reader will say “yes, your reassurances about inflation are fine in theory, but history shows that governments that run up massive debts will eventually resort to inflation—it’s the easiest way to get out from under a heavy debt burden.” I have two responses to this. First, I’m not sure countries with large debts inevitably resort to inflation. I seem to recall that Italy and Japan both have large debt/GDP ratios, and both still have low inflation. But perhaps it is too soon to judge. After all, there is a risk premium in Italian government bonds right now.

My second and much more important response is that even if this argument is true, it is not an argument against monetary stimulus involving massive QE, rather it is a strong argument for just such a policy. Consider the Italian example I just mentioned. Why did Italian bonds suddenly become so risky in 2008? After all, they have had a high debt/GDP ratio for quite some time. Clearly the reason is the dramatic slowdown in NGDP growth, which worsens the budget situation in real terms. Thus the tight money policies of the ECB have increased the risk of the Italian government defaulting on its debt. And one way of avoiding explicit default, is to return to the lira and then depreciate the currency. Or if enough European governments get into trouble perhaps they can pressure the ECB to inflate at some future date.

Deflationary monetary policies almost inevitably raise the debt/GDP ratio. If debt leads to inflation, the best way to avoid inflation is to avoid debt. And the best way to avoid debt is to use monetary stimulus, not fiscal stimulus. David Beckworth does raise one argument that slightly cuts the other way. If the Fed buys a lot of government bonds, and later sells them back at a lower price (once interest rates have risen) then they may suffer some capital losses. But recall that if markets are efficient then the expected gain or loss on Fed purchases is roughly zero, and even in the worst case, the sort of extreme estimates of capital losses tossed around by people like Krugman tend to be around $200 billion, far smaller than the cost of fiscal stimulus.

There are actually only very small risks of inflation overshooting. But as with America in the 1930s, and Argentina in 2001, there are huge risks to our free market economy from continuing these deflationary monetary policies."

But to say that these were justifiable sovereign defaults does not mean that they were not sovereign defaults. Similar circumstances could arise agai

TO BE NOTED: BUITER:

"The green shoots are weeds growing through the rubble in the ruins of the global economy

April 8, 2009 3:20am

The Great Contraction will last a while longer

This financial crisis will end. The Great Contraction of the Noughties also will come to an end. But neither the financial crisis nor the contraction of the global real economy are over yet. As regards the financial sector, we are not too far - probably less than a year - from the beginning of the end. The impact of the collapse of real economic activity and of the associated dramatic increase in defaults and insolvencies by non-financial enterprises and households on the loan book of what is left of the banking sector will begin to show up in the banks’ financial reports at the end of the summer and in the autumn. By the end of the year - early 2010 at the latest - we will know which banks will survive and which ones are headed for the scrap heap. With the resolution of the current pervasive uncertainty about the true state of the banks’ balance sheets and about their off-balance-sheet exposures, normal financial intermediation will be able to resume later in 2010.

Governments everywhere are doing the best they can to delay or prevent the lifting of the veil of uncertainty and disinformation that most banks have cast over their battered balance sheets. The banking establishment and the financial establishment representing the beneficial owners of the institutions exposed to the banks as unsecured creditors - pension funds, insurance companies, other banks, foreign investors including sovereign wealth funds - have captured the key governments, their central banks, their regulators, supervisors and accounting standard setters to a degree never seen before.

I used to believe this state capture took the form of cognitive capture, rather than financial capture. I still believe this to be the case for many, perhaps even most of the policy makers and officials involved, but it is becoming increasingly hard to deny the possibility that the extraordinary reluctance of our governments to force the unsecured creditors (and any remaining non-government shareholders) of the zombie banks to absorb the losses made by these banks, may be due to rather more primal forms of state capture.

History teaches us that systemic financial crises are protracted affairs. A most interesting paper by Carmen M. Reinhart and Kenneth S. Rogoff, “The Aftermath of Financial Crises”, using data on 10 systemic banking crises (the “big five” developed economy crises (Spain 1977, Norway 1987, Finland, 1991, Sweden, 1991, and Japan, 1992), three famous emerging market crises (the 1997–1998 Asian crisis (Hong Kong, Indonesia, Malaysia, the Philippines, and Thailand); Colombia, 1998; and Argentina 2001)), and two earlier crises (Norway 1899 and the United States 1929) reaches the following conclusions (the next paragraph paraphrases Reinhart and Rogoff).

First, asset market collapses are deep and prolonged. Real housing price declines average 35 percent over six years; real equity price declines average 55 percent over a downturn of about 3.5 years. Second, the aftermath of banking crises is associated with large declines in output and employment. The unemployment rate rises an average of 7 percentage points over the down phase of the cycle which lasts on average over four years. Output falls (from peak to trough) an average of over 9 percent, but the duration of the downturn averages around 2 years.

Nothing more can be expected as regards a global fiscal stimulus. Indeed, the G20 delivered nothing in this regard. It would have been preferable to maintain the overall size of the planned (or rather, expected) global fiscal stimulus but to redistribute the aggregate (about $5 trillion over 2 years, as measured by the aggregated changes in the national fiscal deficits) in accordance with national fiscal spare capacity (I believe the World Bank calls this ‘fiscal space’). This would mean a smaller fiscal stimulus for countries with weak fiscal fundamentals, including the US, Japan and the UK, and a larger fiscal stimulus for countries with strong fiscal fundamentals, including China, Germany, Brazil and, to a lesser degree, France.

The effect of the Great Contraction on potential output growth

Furthermore, a likely consequence of the fiscal stimuli we have already seen or are about to experience is a negative impact on the medium- and long-term growth potential of the global economy. The reason is that, if fiscal solvency is to be maintained, there will have to be some combination of an increase in the tax burden and a reduction in non-interest public spending in most countries when this contraction is over. The inevitable effect of the crisis and the contraction is a higher public debt burden and therefore a larger future required primary government surplus (as a share of GDP). Almost any increase in the tax burden will hurt potential output - just the level of the path of potential output if you are a classical growth groupie, both the level and the growth rate of the path of potential output if you are an adept of the endogenous growth school.

In the study of Reinhart and Rogoff cited earlier, the authors conclude that the real value of government debt tends to explode following a systemic financial crisis, rising an average of 86 percent in major post–World War II episodes. The principal cause of these public debt explosions is not the costs of “bailing out” and recapitalizing banking system. The big drivers of these public debt burden increases are rather the collapse in tax revenues that comes with deep and prolonged output contractions (the operation of the automatic stabilisers) and discretionary counter-cyclical fiscal policies.

For political expediency reasons, cuts in public spending are likely to fall first on maintenance, public sector capital formation and other forms of productive public expenditure, including spending on education, health and research. Welfare spending in cash or in kind is likely to be the last to be cut. The result is again likely to be a lower level (or level and growth rate) of the path of potential output.

The risk of ’sudden stops’ in the overdeveloped world

In a number of systemically important countries, notably the US and the UK, there is a material risk of a ’sudden stop’ - an emerging-market style interruption of capital inflows to both the public and private sectors - prompted by financial market concerns about the sustainability of the fiscal-financial-monetary programmes proposed and implemented by the fiscal and monetary authorities in these countries. For both countries there is a material risk that the mind-boggling general government deficits (14% of GDP or over for the US and 12 % of GDP or over for the UK for the coming year) will either have to be monetised permanently, implying high inflation as soon as the real economy recovers, the output gap closes and the extraordinary fear-induced liquidity preference of the past year subsides, or lead to sovereign default.

Pointing to a non-negligible risk of sovereign default in the US and the UK does not, I fear, qualify me as a madman. The last time things got serious, during the Great Depression of the 1930s, both the US and the UK defaulted de facto, and possibly even de jure, on their sovereign debt.

In the case of the US, the sovereign default took the form of the abrogation of the gold clause when the US went off the gold standard (except for foreign exchange) in 1933. In 1933, Congress passed a joint resolution canceling all gold clauses in public and private contracts (including existing contracts). The Gold Reserve Act of 1934 abrogated the gold clause in government and private contracts and changed the value of the dollar in gold from $20.67 to $35 per ounce. These actions were upheld (by a 5 to 4 majority) by the Supreme Court in 1935.

In the case of the UK, the de facto sovereign default took the form of the conversion in 1932 of Britain’s 5% War Loan Bonds (callable 1929-1947) into new 3½ % bonds (callable from 1952) on terms that were unambiguously unfavourable to the bond holders. Out of a total of £2,086,000,000 outstanding, £1,500,000,000, or something over 70%, was converted voluntarily by the end of 1932, thanks both to the government’s ability to appeal to patriotism and joint burden sharing in the face of economic adversity and to ferocious arm-twisting and ‘moral suasion’.

I believe both defaults were eminently justified. There is no case for letting the interests of the holders of sovereign debt override the interests of the rest of the community, regardless of the financial, economic, social and political costs involved. But to say that these were justifiable sovereign defaults does not mean that they were not sovereign defaults. Similar circumstances could arise again.

While I consider an inflationary solution to the public debt overhang problem (and indeed to the private debt overhang problem) to be more likely in the US and even in the UK than a sovereign default (or ‘restructuring’, ‘conversion’ or ‘consolidation’, as it would undoubtedly be referred to by the defaulting government), neither can be dismissed as out of the question, or even as extremely unlikely.

Central banks: a mixed bag

Central banks, with the notable exception of the procrastinating ECB, are doing as much as they can through quantitative easing and credit easing to deal with the immediate crisis. Unfortunately, some of them, notably the Fed, are providing these short-term financial stimuli in the worst possible way from the point of view of medium- and longer-term economic performance, by surrendering central bank independence to the fiscal authorities.

When the Fed lends on a non-recourse basis to the private sector with only a $100 bn Treasury guarantee for a possible $1 trillion dollar Fed exposure (as with the TALF), when the Fed purchases private securities outright with just a similar 10-cents-on-the-dollar Treasury guarantee or when the Fed is party to an arrangement that transfers tens of billions of dollars to AIG counterparties - money that is likely to be extracted ultimately from the beneficiaries of other public spending programmes or from the tax payer, either through explicit taxes or through the inflation tax - the Fed is acting like an off-balance sheet and off-budget special purpose vehicle of the US Treasury.

When the Chairman of the Fed stands shoulder-to-shoulder or sits side-by-side with the US Treasury Secretary to urge the passing of various budgetary proposals - involving matters both beyond the Fed’s mandate and remit and beyond its competence - the Fed is politicised irretrievably. It becomes a partisan political player. This is likely to impair its ability to pursue its monetary policy mandate in the medium and long term.

The G20 wind egg

The global stimulus associated with the increase in IMF resources agreed at the G20 meeting earlier this month will be negligible unless and until these resources actually materialise. The statements, declarations and communiqués of the G20, including the most recent ones highlight the gaps between dreams and deeds.

Even the promise of an immediate increase in bilateral financing from members of $250 bn is not funded yet. Only $200 have been promised firmly - $100 bn by Japan and $100 bn by the EU. Prime Minister Brown announced that the PRC had committed another $40 bn, but apparently he had forgotten to clear this with the Chinese.

As regards the plan to incorporate in the near term, the immediate financing from members into an expanded and more flexible New Arrangements to Borrow would be increased by up to $500 billion (that is by another $250 bn). Unfortunately, nobody has volunteered any money yet. It therefore has no more substance than past commitments by the international community to fund the achievement of the Millenium Development Goals.

Then there is the promise that the G20 will consider market borrowing by the IMF to be used if necessary in conjunction with other sources of financing, to raise resources to the level needed to meet demands. That is classic official prittle-prattle - suggesting the IMF borrow without providing it with the resources (capital) to engage in such borrowing.

There is also $6 bn for the poorest countries, to be paid for by IMF gold sales and profits. Nice, but chicken feed.

Finally there is the decision to support a general allocation of SDRs equivalent to $250 billion to increase global liquidity, $100 billion of which will go directly to emerging market and developing countries. The problem is that this requires the approval of the US Congress, which is deeply hostile to any additional money for any of the Bretton Woods institutions. A special allocation of SDRs is also out of the question, because the US has not yet ratified the fourth amendment to the IMF’s articles (approved by the IMF’s Board of Governors in 1997!).

So apart from the $240 bn (or perhaps only $200 bn) already flagged well before the G20 meeting, the only hard commitment to additional resources (or to resources that have any chance of being available for lending and spending during the current contraction) is the $6 bn worth of alms for the poor from the sale of IMF gold. That’s what I call a bold approach!

The Multilateral Development Banks may well be able to increase their lending by $100 bn as announced by the G20, even with existing capital resources.

The increase in trade credit support announced at the G20 meeting is very modest indeed - $250 bn could be supported (mainly through guarantees, I suppose) over the next two years.

As regards protectionism, we must be grateful for the vast difference between today’s relatively mild manifestations and the virulent protectionism of the 1930s. But again, the last few G20 meetings have yielded not a single concrete protectionism-reducing measure.

Conclusion

There are signs that the rate of contraction of real global economic activity may be slowing down. Straws in the wind in China, the UK and the US hint that things may be getting worse at a slower rate. An inflection point for real activity (the second derivative turns positive) is not the same as a turning point (the first derivative turns positive), however. And even if decline were to end, there is no guarantee that whatever growth we get will be enough to keep up with the growth of potential. We could have a growing economy with rising unemployment and growing excess capacity for quite a while.

The reason to fear a U-shaped recovery with a long, flat segment is that the financial system was effectively destroyed even before the Great Contraction started. By the time the negative feedback loops from declining activity to the balance sheet strenght of what’s left of the financial sector will have made themselves felt in full, financial intermediation is likely to be severely impaired.

All contractions and recoveries are primarily investment-driven. High-frequency inventory decumulation causes activity to collapse rapidly. Since inventories cannot become negative, there is a strong self-correcting mechanism in an inventory disinvestment cycle. We may be getting to the stage in the UK and the US (possibly also in Japan) that inventories stop falling an begin to build up again.

An end to inventory decumulation is a necessary but not a sufficient condition for sustained economic recovery. That requires fixed investment to pick up. This includes household fixed investment - residential construction, spending on home improvement and purchases of new automobiles and other consumer durables. It also includes public sector capital formation. Given the likely duration of the contraction and the subsequent period of excess capacity, even public sector infrastructure spending subject to long implementation lags is likely to come in handy. A healthy, sustained recovery also requires business fixed investment to pick up.

At the moment, I can see not a single country where business fixed investment is likely to rise anytime soon. When the inventory investment accelerator goes into reverse and starts contributing to demand growth, and when the fiscal stimuli kick in, businesses wanting to invest will need access to external financing, since retained profits are, after a couple of years of declining output, likely to be few and far between. But with the banking system on its uppers and many key financial markets still disfunctional and out of commission, external financing will be scarce and costly. This is why sorting out the banks, or rather sorting out the substantive economic activities of new bank lending and funding, that is, sorting out banking , must be a top priority and a top claimant on scarce public resources.

Until the authorities are ready to draw a clear line between the existing banks in western Europe and the USA, - many or even most of which are surplus to requirements and have become parasitic entities feeding off the tax payer - and the substantive economic activity of bank lending to non-financial enterprises and households, there will not be a robust, sustained recovery."

the real high-stakes poker involves choosing a new philosophy for the international financial system and its regulation.

TO BE NOTED: From Korea Times via the Economist's View:

Brave New Financial World

By Kenneth Rogoff
Project Syndicate

CAMBRIDGE ― A huge struggle is brewing within the G-20 over the future of the global financial system. The outcome could impact the world ― and not only the esoteric world of international finance ― for decades to come.

Finance shapes power, ideas, and influence. Cynics may say that nothing will happen to the fundamentals of the global financial system, but they are wrong. In all likelihood, we will see huge changes in the next few years, quite possibly in the form of an international financial regulator or treaty.

Indeed, it is virtually impossible to resolve the current mess without some kind of compass pointing to where the future system lies.

The United States and Britain naturally want a system conducive to extending their hegemony. U.S. Treasury Secretary Timothy Geithner has recently advanced the broad outlines of a more conservative financial regulatory regime.
Even critics of past U.S. profligacy must admit that the Geithner proposal contains some good ideas.

Above all, regulators would force financiers to hold more cash on hand to cover their own bets, and not rely so much on taxpayers as a backstop.

Geithner also aims to make financial deals simpler and easier to evaluate, so that boards, regulators, and investors can better assess the risks they face.

While the rest of the world is sympathetic to Geithner's ideas, other countries would like to see more fundamental reform.

Russia and China are questioning the dollar as the pillar of the international system. In a thoughtful speech, the head of China's Central Bank, Zhou Xiaochuan, argued the merits of a global super-currency, perhaps issued by the International Monetary Fund.

These are the calmer critics. The current president of the European Union's Council of Ministers, Czech Prime Minister Miroslav Topolanek, openly voiced the angry mood of many European leaders when he described America's profligate approach to fiscal policy as ``the road to hell."

He could just as well have said the same thing about European views on U.S. financial leadership.

The stakes in the debate over international financial reform are huge. The dollar's role at the center of the global financial system gives the U.S. the ability to raise vast sums of capital without unduly perturbing its economy.

Indeed, former U.S. President George W. Bush cut taxes at the same time that he invaded Iraq. However dubious Bush's actions may have been on both counts, interest rates on U.S. public debt actually fell.

More fundamentally, the U.S. role at the center of the global financial system gives tremendous power to U.S. courts, regulators, and politicians over global investment throughout the world. That is why ongoing dysfunction in the U.S. financial system has helped to fuel such a deep global recession.

On the other hand, what is the alternative to Geithner's vision? Is there another paradigm for the global financial system?

China's approach represents a huge disguised tax on savers, who are paid only a pittance in interest on their deposits. This allows state-controlled banks to lend at subsidized interest rates to favored firms and sectors.

In India, financial repression is used as a means to marshal captive savings to help finance massive government debts at far lower interest rates than would prevail in a liberalized market.

A big part of Russia's current problems stems from its ill-functioning banking system. Many borrowers, unable to get funding on reasonable terms domestically, were forced to take hard-currency loans from abroad, creating disastrous burdens when the ruble collapsed.

Europe wants to preserve its universal banking model, with banks that serve a broad range of functions, ranging from taking deposits to making small commercial loans to high-level investment-banking activities.

The U.S. proposals, on the other hand, would make universal banking far harder, in part because they aim to ring-fence depository institutions that pose a ``systemic risk" to the financial system.

Such changes put pressure on universal banks to abandon riskier investment-bank activities in order to operate more freely.

Of course, U.S. behemoths such as Citigroup, Bank of America, and JP Morgan will also be affected. But the universal banking model is far less central to the U.S. financial system than it is in Europe and parts of Asia and Latin America.

Aside from its implications for different national systems, the future shape of banking is critical to the broader financial system, including venture capital, private equity, and hedge funds.

The Geithner proposal aims to reign in all of them to some degree. Fear of crises is understandable, yet without these new, creative approaches to financing, Silicon Valley might never have been born. Where does the balance between risk and creativity lie?

Although much of the G-20 debate has concerned issues such as global fiscal stimulus, the real high-stakes poker involves choosing a new philosophy for the international financial system and its regulation.

If our leaders cannot find a new approach, there is every chance that financial globalization will shift quickly into reverse, making it all the more difficult to escape the current morass.

Kenneth Rogoff is professor of economics and public policy at Harvard University, and was formerly chief economist at the International Monetary Fund (IMF). For more stories, visit Project Syndicate (www.project-syndicate.org).

* Expects 1970s-like inflation when we come out of recession.

From Clusterstock:

"Rogoff: The Worst Is Over? Are You Kidding?

Henry Blodget|Mar. 16, 2009, 9:37 AM|5

Print

Tags: Economy, Financial Crisis, Depression

Ken Rogoff of Harvard has been right about the global economic collapse. Unlike others, he also hasn't recently turned bullish.

A friend summarizes Rogoff's excellent G20 interview with David Brancaccio (embedded below)

Lots of interesting observations from an economist far more respected than Roubini but just as bearish:

* Things are worse overseas: some countries simply can't bail out their banks -- liabilities are 3 to 5 times GDP.

* May take 2 years before housing bottoms

* Ditto for equity markets

* Expects 1970s-like inflation when we come out of recession.

* Could have decade of Japanese in-and-out-of-recession if we don't seriously deal with banking system.

One of the money quotes (at 18:36): ?There is only one end game to this, to use the chess analogy, which is that most of the large financial institutions have to go through some kind of bankruptcy.?

Shortly after that, he's critical of the Obama administration for not "taking the bull by the horns" and taking a "wishing it away" approach to the economy.

.

• Buzz up!

Me:

Don the libertarian Democrat (URL) said:

Mar. 16, 11:08 AM

Great interview. We are going to inflate, and we need to seize these big banks. On Quantitative Easing, here's my plan:

Read W.Buiter "Helicopter Money" here:

http://www.nber.org/~wbuiter/helijpe.pdf

What does all this tell us?

From Free Exchange:

"Barro of bad news

Posted by:

Economist.com | WASHINGTON

Categories:

Business cycles

MACROECONOMIC historians to your data sets, the global downturn has seemed to call. Carmen Reinhart and Kenneth Rogoff have given us a detailed survey of the economic consequences of financial crises—work which revealed that crisis-driven recessions tend to be longer and deeper than other species. Today, in the Wall Street Journal, Robert Barro explains the findings of his examination of stock market behaviour and economic downturns. He also sounds a rather ominous warning:

In applying our results to the current environment, we should consider that the U.S. and most other countries are not involved in a major war (the Iraq and Afghanistan conflicts are not comparable to World War I or World War II). Thus, we get better information about today's prospects by consulting the history of nonwar events -- for which our sample contains 209 stock-market crashes and 59 depressions, with 41 matched by timing. In this context, the probability of a minor depression, contingent on seeing a stock-market crash, is 20%, and the corresponding chance of a major depression is only 2%. However, it is still the case that depressions are very likely to feature stock-market crashes -- 69% for minor depressions and 83% for major ones.

Emphasis mine. Mr Barro defines a minor depression as a fall in real GDP per capita of 10% or more, and a major depression as a fall in real GDP of 25% or more. His study seems to differ from that of Ms Reinhart and Mr Rogoff in that they examine financial crises as precipitators of recession, while Mr Barro examines stock market crashes as barometers of recession. That is, a recession brought on by a collapse in stock prices might or might not be severe, but a recession coincident with a broad and deep market crash suggests dangerous conditions indeed. Markets recovered much of their value following the crash of 1929, for example, but began a sustained decline in 1930 as the extent of the financial damage became clear.

What does all this tell us? Well, that there is a real risk of an economic calamity of historic proportions, such that policymakers must work diligently to avoid disastrous errors—sharply contractionary policy, for instance, or a modern day Smoot-Hawley. Or war. But also that things aren't yet that bad. As Mr Barro notes, a 20% chance of a minor depression implies an 80% chance of avoiding a 10% decline in real GDP per head. Given the situation—massive losses of housing and equity wealth, financial collapse, implosion of global demand, and so on—that's a pretty impressive statisic."

Me:

Don the libertarian Democrat wrote:

March 4, 2009 16:42

There's a huge upside to be seen as calling a market top or bottom, but is there any real downside? It seems that if you correctly call the top or bottom, you are seen as knowing what you're talking about. If you incorrectly call the top or bottom, you're seen as simply missing a few salient points, not that you're clueless. If this is correct, then you will always have people calling tops and bottoms, sometimes in the same paragraph.

Is there any way to weed out buffoons in economics or investment? We already know that it's impossible in banking and the overseeing of it. Here's my prediction:

There will be a bestseller entitled "How To Run A Ponzi Scheme And NOT Get Caught". The fact that it will work and go undetected for a long time will be assumed by the author.

"the demons of our past – above all, nationalism – will return. Achievements of decades may collapse almost overnight."

Martin Wolf in the FT:

"Welcome to 2009. This is a year in which the fate of the world economy will be determined, maybe for generations. Some entertain hopes( THE SAVER/EXPORT COUNTRIES ) that we can restore the globally unbalanced economic growth of the middle years of this decade. They are wrong. Our choice is only over what will replace it. It is between a better balanced world economy and disintegration. That choice cannot be postponed. It must be made this year.

We are in the grip of the most significant global financial crisis for seven decades. As a result, the world has run out of creditworthy, large-scale, willing private borrowers. The alternative of relying on vast US fiscal deficits and expansion of central bank credit is a temporary – albeit necessary – expedient( I AGREE ). But it will not deliver a durable return to growth. Fundamental changes are needed.( SUCH AS? )

Already it must be clear even to the most obtuse and complacent that this crisis matches the most serious to have affected advanced countries in the postwar era. In a recent update of a seminal paper, released a year ago, Carmen Reinhart of Maryland University and Kenneth Rogoff of Harvard spell out what this means.* They note the similarities among big financial crises in advanced and emerging countries and, by combining a number of severe cases, reach disturbing conclusions.

Banking crises are protracted, they note, with output declining, on average, for two years. Asset market collapses are deep, with real house prices falling, again on average, by 35 per cent over six years and equity prices declining by 55 per cent over 3½ years. The rate of unemployment rises, on average, by 7 percentage points over four years, while output falls by 9 per cent.

Not least, the real value of government debt jumps, on average, by 86 per cent (see chart). This is only in small part because of the cost of recapitalising banks. It is far more because of collapses in tax revenues.( THESE STUDIES HAVE LIMITED USE )

How far will the present crisis match the worst of the past? The continuing willingness of the world to finance at least the US – though not necessarily the smaller and more peripheral deficit countries, such as the UK – is a reason for optimism. It does allow the US government to mount a vast fiscal and monetary rescue programme.

Yet, as Profs Reinhart and Rogoff note in another paper, this is a global crisis, not a regional one (see chart).** It has reminded us that the US is still, for good or ill, the core of the world economy( TRUE. IT'S GLOBAL BECAUSE IT STARTED IN THE US ). In the big crises of recent decades, US demand has rescued the world. This was true during the 1990s, after the Asian crisis, and again after the stock market crash of 2000. But who, apart from its government, will rescue the US? And on what scale must it act?( VERY LARGE )

This issue is addressed in another seminal paper, the latest in the series co-written by Wynne Godley and two others for the Levy Economics Institute of Bard College.*** The underlying argument is one with which readers of this column should, by now, be all too familiar.

What makes rescue so difficult is the force that drove the crisis: the interplay between persistent external and internal imbalances in the US and the rest of the world. The US and a number of other chronic deficit countries have, at present, structurally deficient capacity to produce tradable goods and services. The rest of the world or, more precisely, a limited number of big surplus countries – particularly China – have the opposite. So demand consistently leaks from the deficit countries to surplus ones.

In times of buoyant demand, this is no problem. In times of collapsing private spending, as now, it is a huge one. It means that US rescue efforts need to be big enough not only to raise demand for US output but also to raise demand for the surplus output of much of the rest of the world. This was a burden that crisis-hit Japan did not have to bear.

What has happened to US private spending follows from the collapse in borrowing: between the third quarter of 2007 and the third quarter of 2008 net lending to the US private sector fell by about 13 per cent of gross domestic product – by far the steepest fall in the history of the series (see chart). With borrowing out of the picture, private net saving – the difference between income and expenditure – is likely to remain positive for years, as households pay down debt, willingly or not.

Given the persistent structural current account deficit, how large does the fiscal deficit need to be to balance the economy at something close to full employment? Assuming, for the moment, that the private sector runs a financial surplus of 6 per cent of GDP and the structural current account deficit is 4 per cent of GDP, the fiscal deficit must be 10 per cent of GDP, indefinitely.

And to get to this point the fiscal boost must be huge. A discretionary boost of $760bn (€570bn, £520bn) or 5.3 per cent of GDP is not enough. The authors argue that “even with the application of almost unbelievably large fiscal stimuli, output will not increase enough to prevent unemployment from continuing to rise through the next two years”.

Now think what will happen if, after two or more years of monstrous fiscal deficits, the US is still mired in unemployment and slow growth. People will ask why the country is exporting so much of its demand to sustain jobs abroad. They will want their demand back( OR THEY WILL ALLOW US TO DEFAULT ). The last time this sort of thing happened – in the 1930s – the outcome was a devastating round of beggar-my-neighbour devaluations, plus protectionism( WE HAVE SOME OF THAT ALREADY. ). Can we be confident we can avoid such dangers? On the contrary, the danger is extreme. Once the integration of the world economy starts to reverse and unemployment soars, the demons of our past – above all, nationalism – will return( I THINK THAT HE'S THE FIRST PERSON I'VE READ WHO AGREES WITH ME ON THIS. ). Achievements of decades may collapse almost overnight.

Yet we have a golden opportunity to turn away from such a course. We know better now. The US has, in Barack Obama, a president with vast political capital. His administration is determined to do whatever it can. But the US is not strong enough to rescue the world economy on its own. It needs helpers, particularly in the surplus countries( SAVER COUNTRIES ). The US and a few other advanced countries can no longer absorb the world’s surpluses of savings and goods. This crisis is the proof. The world has changed and so must policy. It must do so now.( IT'S GOING TO BE TOUGH FOR THE SAVER/EXPORT COUNTRIES. )

* The Aftermath of Financial Crises, December 2008; www.economics. harvard.edu/faculty/rogoff/files/ Aftermath.pdf; ** Banking Crises, December 2008, National Bureau of Economic Research Working Paper 14587, December 2008, www.nber.org; *** Prospects for the US and the World, December 2008, www.levy.org"