Saturday, March 2, 2013

Is slow growth America's and western economies' new normal?

In his very interesting Washington Post blog post, Jim Tankersley asks the question of whether slow growth is the new normal?

Your humble blogger has said since the beginning of the financial crisis that based on the policies pursued by the global policymakers the answer is "yes".

In fact, I predicted in 2007 that the policies being pursued would leave the global economy at best in a Japan-style economic slump, more likely in a downward spiral and at worse in a depression.

Perhaps more importantly, your humble blogger has discussed at length what policies have to be adopted to end this period of slow growth and restore a higher level of growth across the global economy.
Good economists are great storytellers. They sculpt narratives .... Like a novel, a good economic forecast has action and characters and, in the end, helps you make a little better sense of the world. 
Unless it turns out to be wrong.
Fortunately for my regular readers, I have been right about both what is happening to the global economy and why it is happening.
Consider the dominant story that economic forecasters have been telling you for years now: The U.S. economy just can’t catch a break. 
It has been poised time and again to rocket back to a growth rate that would recapture all the ground lost in the Great Recession, while delivering big job gains. But every time, some outside event scuttles things. 
The euro crisis flares up. A Japanese tsunami scrambles global supply chains. Lawmakers play chicken with the federal debt limit....
This is the dominant story of economic forecasters who failed to predict our current financial crisis and/or have a vested interest in promoting the current mix of policies.
Now consider the possibility that the can’t-catch-a-break story gets it backward. What if the economy isn’t particularly unlucky? 
Actually, the real economy is horribly unlucky.

It is horribly unlucky in that it has economists who failed to predict the financial crisis offering opinions on what it will take to recover from the financial crisis.  Opinions that policymakers for better or worse appear to rely on in setting policy.

Having a Nobel Prize in Economics does not convey the right to open one's mouth in absolute ignorance.

In fact, having a Nobel Prize in Economics conveys the responsibility for truthfully answering the Queen of England when she asked the economics profession if everything was going so wonderfully, how did the economics profession miss seeing the crisis coming.

The answer is that the economics is known as the dismal science because of its track record in forecasting financial crises.

As a result, any suggestion that an economist makes based on a model that missed the financial crisis is highly unlikely to actually positively address the problem that caused the financial crisis in the first place.
What if it’s basically doing what we should expect it to?
It is performing as I predicted.
What if something has changed, thanks to fallout from the recession, or a string of bad policy choices, or both, and growth has shifted into a lower gear?
It is a string of bad policy choices that has caused growth to shift into a lower gear.

You don't need to be an economist to predict that if the burden of the excess debt in the financial system was placed on the real economy it would negatively impact growth.

Placing the burden on the real economy means that capital that is needed for growth, reinvestment and support of the social programs is diverted to debt service payments.

This diversion of how capital generated by the real economy is used guarantees a negative impact on economic growth.
What if this slow and fragile expansion is as good as we’re likely to get for a while? 
Until policymakers abandon the current policies that are damaging the real economy (think zero interest rate policies and austerity for example), this slow growth is as good as it will get.
This is an alternative story that economists across the ideological spectrum have begun to explore. If it’s correct, the implications for economic policy are big....
It has taken five years to realize that maybe we should examine the policies that were adopted in response to the financial crisis to see if maybe they were fundamentally flawed.

Your humble blogger could save economists a great deal of time.  They can simply read my earlier posts and see why the policies were fundamentally flawed.

More importantly, by reading the earlier posts, they can see what policies need to be adopted.
Where our stories diverge is on the reasons those forecasts were wrong.
Please note, your humble blogger's forecasts weren't wrong and I got the financial crisis.
Here’s the standard explanation, from a sharp economist named David E. Altig, the executive vice president and director of research at the Federal Reserve Bank of Atlanta. 
Altig says the economy would have grown faster if a bunch of unanticipated problems — most notably the European financial crisis, in all its iterations, and the now-frequent instances of fiscal brinkmanship in Washington — hadn’t popped up to rattle consumers and business executives. 
This is how many Fed and CBO economists view the past few years, and why they remain so optimistic that faster growth is just around the corner..... 
History explains their thinking: In past recessions, the economy has lost ground, only to roar ahead in later years to return to its historical growth trends. ...
“It’s still the story of the unlucky shocks” and of growth eventually bouncing back to make up its lost output, Altig says. He adds: “We’re keeping hope alive with our forecast.”
Even though the models didn't predict the financial crisis, the Fed is following policies that the models say should work.  And the reason that the models are still not predicting what is going on is a series of unlucky breaks.

Excuse me, but maybe the Fed's models don't work because the assumptions that go into the models are fatally flawed.  Oops.
For the gloomy story, meet Kevin Warsh, a former Fed governor .... 
It goes like this: U.S. policymakers have tried for several years to splash gasoline on the flames of growth in hopes of stoking a bonfire. They’ve thrown in the $800 billion of tax cuts and spending increases contained in the 2009 economic stimulus bill, as well as the extraordinary measures the Fed has taken in an attempt to boost employment: holding short-term interest rates near zero for years and buying an unprecedented amount of long-term securities such as Treasury bonds in order to push down long-term interest rates. 
Warsh’s story is that those efforts didn’t work, and to make matters worse, they dampened the economy’s longer-run growth prospects.... 
The reason the economy has been underperforming, Warsh says, is that policymakers responded poorly to the financial crisis.
Yes they did and Mr. Warsh was one of the policymakers involved in the response.
They focused on short-term growth boosts and neglected what you might call basic economic infrastructure investments. 
They didn’t open big new markets for international trade in order to expand exports, and they didn’t streamline the tax code to promote investment.
I guess Mr. Warsh needs to publicly reaffirm that he is a card carrying Republican and confirm that economists truly bring little to the table when it comes to discussing policies for recovering from a bank solvency led financial crisis.

Mr. Warsh would like to expand exports so that the real economy could generate more capital to be used to pay off the existing debts.  However, this policy choice assumes that paying off the existing debts is the right choice.

There is another better choice that was made by Iceland.  Rather than try to pay off the existing debts, Iceland made its banks recognize upfront the losses on the excess debt in the financial system.  As a result, its real economy was protected and has continued to grow.

Meanwhile, Mr. Warsh's policy has burdened the US real economy with the debt service payments on the excess debt in the financial system.  In addition, his policy has the US chasing after exports when every other country, like the UK and EU, that adopted similar policies is chasing after exports.  It is simply not likely that the US will prevail in the chase for exports.

So let's see, we could make the banks recognize losses and the real economy could return to its normal growth path or we could put the debt service burden of the excess debt on the real economy and hope we can win the chase for exports.
Meanwhile, Warsh said, lawmakers added new regulations to the financial system that solidified an oligopoly at the top of the banking industry, one that has served to restrict the flow of credit to small businesses and entrepreneurs....
I agree with Mr. Warsh's summary of what the policymakers have achieved in "reforming" the financial system.

Regular readers know that I would repeal all of the Dodd-Frank Act except for the Consumer Financial Protection Bureau and the Volcker Rule.  In place of all those complex rules and regulatory oversight contained in Dodd-Frank, I would put transparency and market discipline.

Specifically, I would require the banks to provide ultra transparency and disclose on an ongoing basis their current global asset, liability and off-balance sheet exposure details.  This information allows market participants to independently assess each bank, link a bank's cost of funds to the risk it takes and to exert discipline on the banks.

I would require all structured finance securities provide observable event based reporting on all activities like a payment or delinquency involving the underlying collateral and report these activities to all market participants before the beginning of the next business day.  This lets market participants know what they are buying and know what they own.
Slow growth is the consequence of those policies, Warsh says. 
He fears the consequence of prolonged slow growth is a drop in the economy’s potential to grow. ... Executives have lost confidence in the economy’s ability to expand and willingness to invest in it. 
“We’ve been in this period of the new malaise for so long that workers and companies have lowered their expectations for what the U.S. economy can do,” Warsh says. 
If that’s the case, it’s as if our fireball pitcher has undergone arm surgery, and instead of throwing 95-mph fastballs, he’s stuck at 85 mph. Warsh says an infusion of better, long-run-focused policies is the only way to bring that velocity back — a second surgery of sorts. 
Warsh concedes that there isn’t a lot of data to back up his case. ... To this, Warsh likes to quote one of his mentors, the great free-market economist Milton Friedman: “Milton used to say, ‘everything we know in economics we teach in Econ 1, and everything else is made up.’ ”...
Great quote.

I have written a number of posts on how the economics profession doesn't understand the most basic principle of Econ 1:  the necessary condition for the invisible hand to operate properly is that market participants have access to all the useful, relevant information in an appropriate, timely manner so they can independently assess this information and make a fully informed decision.

It was the opacity in the financial system that lead to the financial crisis and it is the opacity in the financial system that prevents a recovery.

Until this opacity is addressed, we are going to continue muddling along.
This brings us to a third story... Two ideas are central to this story. 
First is that the recession didn’t just dig a big hole for the economy to climb out of, it also messed with the ladder. This is the basic theory set forth by the economists Carmen Reinhart and Kenneth Rogoff in their book “This Time is Different”: Financial crises weaken the financial system, slowing growth for years until the system heals....
I realize this post is overly long, but it is necessary to once again debunk the work of Reinhart and Rogoff.

Their work ignores what I call the learning curve.  Specifically, there is a chance that we have learned over the centuries how to deal with a bank solvency led financial crisis.  So in fact, this time could be different.

This bank solvency led financial crisis has two elements present that allow for a quick recovery (see Iceland).

First is the notion of deposit insurance.  With deposit insurance, depositors no longer care about a bank's book capital level (depositors are taught this as kids when they open up an account and are reassured that the government guarantees they will get their money back).

As a result, banks are fully capable of operating with low or even negative book capital levels.  At these levels, the taxpayers are effectively their silent equity partners.

Second is the notion of central banks providing access to funds as a lender of last resort.  This assures that the banks have liquidity even when they have low or even negative book capital levels.

Together, deposit insurance and lender of last resort, position the banks to protect the real economy from the burden of the excess debt in the financial system.  Specifically, the banks can recognize upfront the losses on the excess debt.

Then, over the next several years, the banks can retain their earnings to rebuild their book capital levels.

I realize that this might be bad for banker bonuses, but it is very good for the real economy as it keeps the real economy on a higher growth path (diverting capital from the real economy to debt service on the excess debt is what puts the real economy on a lower growth path).
This has prompted some wondering aloud, and it has given rise to perhaps the most interesting new story you hear from economists: Um, there’s a lot we don’t know about the economy. ... 
When you miss so regularly on your forecasts, Altig says, “it’s easy to think we have to rethink everything we think we know.” But, he adds, “You can be wrong for a very long period of time and still have the underlying structure and story about the economy correct. That’s not crazy. I guess that’s where I would be right now. It’s not like you have to throw out how you think about these things. You just have to have the same humility you always have.”
Economists and humility are not two words that go together.

Humility would imply that economists state clearly that they don't know what is going on and missing regularly on their forecasts confirms this.  Humility would further imply that economists then say that they will refrain from offering any policy recommendations until such time as they can demonstrate through their forecasts that they do have some insight into what is going on.

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