Dani Rodrik on Europe's way out of the financial crisis

In his Project Syndicate column, Harvard Professor Dani Rodrik lays out his plan for how Europe could end its current financial crisis and and restore economic growth.

Regular readers will immediately recognize that Professor Rodrik's plan is essentially your humble blogger's blueprint for economic recovery with one difference.

Professor Rodrik thinks that banks need to be recapitalized immediately by their sovereigns when in fact they are designed so that they can be recapitalized over several years using retained earnings.

Letting the banks recapitalize themselves through retained earnings frees up the sovereigns to use their resources pursuing stimulative economic policies.

The eurozone periphery suffers from both a stock problem and a flow problem. It has too large a debt stock, and too little competitiveness to achieve external balance without significant domestic deflation and unemployment. 

What is required is a two-pronged approach that targets both problems simultaneously. 

The prevailing approach – targeting debt through fiscal austerity and competitiveness through structural reform – has produced unemployment levels that threaten social and political stability.Comments 

So, what can be done differently?Comments 

The most direct way to address the debt problem is a write-down, coupled with recapitalization of those banks that will suffer large losses as a result. This may seem extreme, but it simply recognizes the reality that much of the existing debt will not be paid back without new flows of official financing. 

As the IMF now acknowledges, it might have been better to restructure Greek debts from the outset than to engage in a “holding operation.” 

CommentsDebt reduction by itself clears the way for growth, but does not directly trigger it. 

Policies that directly target expenditure rebalancing within the eurozone and expenditure switching within the peripheral economies are also needed. 

These include: policies to boost eurozone-wide demand and stimulate greater spending in creditor countries, especially Germany; policies that aim to reduce non-tradable prices; income policies to reduce the peripheral economies’ private-sector wages in a coordinated fashion; and a higher ECB inflation target to allow room for movement in the real exchange rate via nominal changes.Comments 

These policies would require Germany to accept higher inflation and explicit bank losses, which assumes that Germans can embrace a different narrative about the nature of the crisis. And that means that German leaders must portray the crisis not as a morality play pitting lazy, profligate southerners against hard-working, frugal northerners, but as a crisis of interdependence in an economic (and nascent political) union. Germans must play as big a role in resolving the crisis as they did in instigating it.Comments 

France will most likely play a critical role as well. France is big enough that if it threw its support fully behind the peripheral countries, Germany would be isolated and would need to respond. But, so far, France remains eager to separate itself from the southern countries, in order to avoid being dragged down with them in financial markets.

FT's Martin Wolf calls for UK to fix it banks, but not its monetary policy

In his Financial Times column, Martin Wolf calls for the UK to fix its banks, but leave its monetary policy unchanged.

Mr. Wolf bases his call on the observation that

The UK is suffering from a combination of the banks’ unwillingness and inability to lend and potential clients’ inability and unwillingness to borrow. 

The BoE’s easing is “pushing on a string”.

This is an interesting observation as it contains a kernel of truth surrounded by a forest of falsehood.

Regular readers know that a bank's lending function is separate from how it funds the loan.  It is separate because banks have many different ways of funding the loan including on-balance sheet, syndicating the loan to other banks or selling the loan to investors.

Banks have the ability to lend, but they are showing an unwillingness to lend.

Why?

Banks are senior secured lenders.  In this role, they require collateral.  When the financial crisis hit, it created doubts about the value of the collateral, particularly the real estate collateral.

These doubts were made worse by the financial regulators adoption of regulatory forbearance.  Under regulatory forbearance, the banks engage in 'extend and pretend' and turn non-performing debt into 'zombie' loans.

The bankers know how much of their portfolio is in 'zombie' loans.  Psychologically, it is difficult to assign a high collateral value to real estate pledged for a new loan when one can see the huge overhang of real estate in the 'zombie' loans.  The result is both the apparent unwillingness to lend and potential clients' inability to borrow (inability reflects a lack of collateral after the bank discounts for 'zombie' loan overhang).

The way to address this problem and restart lending is to have the banks recognize their losses on the excess public and private debt in the financial system.  In recognizing their losses, the banks need to write-down the debt to a level where the borrowers can afford to service the debt.

Debt write-downs should not create equity for the borrower.  Where there is a buyer for the collateral who would pay more than the borrower, the collateral should be sold.

The idea that the BoE's easing, like the other central banks, is "pushing on a string" is totally false.  This policy was known in advance to be good for bankers and bad for the real economy.

It was good for bankers in that it maximized the banks' reported earnings and banker bonuses since the beginning of the financial crisis.  There is nothing like zero cost funds to temporarily boost banks' net interest margin, particularly when the banks are carrying 'zombie' loans.

It was bad for the real economy in that it triggered economic headwinds like the Retirement Plan Death Spiral that crushed current demand.  Under the Retirement Plan Death Spiral, both individuals and companies make up for the shortfall in earnings on their retirement assets by reducing current consumption.

The way to address the problem with monetary policy and support the real economy is to reverse the policy and restore interest rates to a minimum of 2%.

Martin Wolf and Ken Rogoff agree: "it is not too late to change course"

The Financial Times' Martin Wolf and Harvard professor Ken Rogoff have taken different paths, but they both agree that the current approach to handling the bank solvency led global financial crisis that began on August 9, 2007 is not working and that "it is not too late to change course".

Mr. Wolf sets out in his column what would be included in this change of course.

The right approach to a crisis of this kind is to use everything: policies that strengthen the banking system; policies that increase private sector incentives to invest; expansionary monetary policies; and, last but not least, the government’s capacity to borrow and spend.

Professor Rogoff lays out in his Guardian column what he thinks is wrong with the current approach and therefore what should be included in this change of course.

No one seems to have the power to impose a sensible resolution of its peripheral countries' debt crisis. Instead of restructuring the manifestly unsustainable debt burdens of Portugal, Ireland, and Greece (the PIGs), politicians and policymakers are pushing for ever-larger bailout packages with ever-less realistic austerity conditions.

Interestingly, both Mr. Wolf and Professor Rogoff have come to champion your humble blogger's blueprint for fixing the financial crisis.

For both individuals, the starting point is dealing with the excess debt in the global financial system.  As Professor Rogoff points out:

In a debt restructuring, the northern eurozone countries (including France) will see hundreds of billions of euros go up in smoke.... These hundreds of billions of euros are already lost, and the game of pretending otherwise cannot continue indefinitely....

But the sooner the underlying reality is made transparent and becomes widely recognised, the lower the long-run cost will be.

The way to deal with this excess public and private debt is by adopting the Swedish Model and requiring the banks to absorb upfront the losses on this debt.

By having the banks absorb the losses on the excess debt, the burden of servicing this debt is lifted from the real economy.  Currently, capital that is needed for reinvestment, growth and supporting the social contract is being diverted to servicing this debt.  Ending this diversion will boost the growth rate of the real economy.

Regular readers know that a modern banking system is designed so that the banks can absorb these losses and still continue to operate and support the real economy.

Banks can do this as a result of the combination of deposit insurance and access to central bank funding.  With deposit insurance, when banks have low or negative book capital levels, taxpayers effectively become the banks' silent equity partner.

After absorbing the losses, the banks then rebuild their book capital levels through retention of 100% of pre-banker bonus earnings.

To make sure the bankers don't gamble on redemption while the banks are rebuilding their book capital levels, banks must be required to provide ultra transparency and disclose on an ongoing basis their current global asset, liability and off-balance sheet exposure details.  With this information, market participants can exert discipline on the bankers to restrain risk taking.

Once the losses have been recognized, to jumpstart the economy, governments need to adopt fiscal stimulus.

At the same time, central banks need to remove the economic headwinds caused by zero interest rate policies and quantitative easing.  They need to restore short term interest rates to Walter Bagehot's lower bound of 2%.

Increasing interest rates from zero to two percent is actually good for economic growth as it ends the Retirement Plan Death Spiral.  Zero interest rates triggered this death spiral as savers, both individuals and companies, reduced their current consumption to offset the lack of earnings on their retirement savings.

In place of austerity, what comes next?

In his Wall Street Journal Heard on the Street column, Simon Nixon looks at the question of "in place of austerity, what comes next?"

The simple answer to Mr. Nixon's question is the combination of the Swedish Model with fiscal stimulus and an end to monetary policies like zero interest rates and quantitative easing.

Regular readers know that a modern banking system is designed to absorb the losses on the excess debt in the financial system.  Under the Swedish Model, banks are required to perform the role for which they are designed.

Specifically, banks recognize upfront the losses on the excess debt.  Each borrower's debt is reduced to a level where the borrower can afford to make the debt service payments.  At the same time, the write-down is limited so that it does not create any equity for the borrower.

With the banks absorbing the losses on the excess debt, the burden of servicing this debt is removed from the real economy.  Capital that is needed for growth, reinvestment and supporting the social contract is no longer diverted to debt service.  As a result, the real economy begins to grow again.

To boost the recovery in the real economy, there should be some fiscal stimulus.

To further boost the recovery in the real economy, monetary policy must be changed to eliminate all the economic headwinds that it is currently creating.  These economic headwinds were triggered by reducing interest rates below Walter Bagehot's minimum threshold of 2% and include for example the Retirement Fund Death Spiral.

UK Guardian: Policy response to financial crisis wrong

In a column by its editors discussing why the Funding for Lending Scheme has failed, the Guardian exposes why the entire policy response to the financial crisis has been wrong since the very beginning of the crisis.

The problem with the government's funding for lending scheme – and indeed its entire strategy for growth – can best be expressed in an old cliche: you can lead a horse to water, but you cannot make it drink. 

With its policy of monetary activism, the coalition has concentrated on laying on the H2O of credit.

Please re-read the highlighted text as the justification used by each of the western governments and Japan for bailing out its banks was to preserve their ability to extend credit.

Regular readers know that this justification was built on a number of false assumptions.

One false assumption was that banks had to have capacity on their balance sheets if they were to be able to extend the credit that the real economy needs for growth.  Your humble blogger has documented why this is assumption is wrong.  The simple fact is that lending and funding for loans are completely separate as for at least the last 4 decades banks have had the alternative of selling the loans that it originates to buyers like insurance companies and pension funds.

The Guardian editorial focuses on a different false assumption.  It focuses on the assumption that there is a great unmet need for credit in the presence of an economy facing a major shortfall in demand.

Ministers have exhorted banks to lend, the Treasury has signed up to the Merlin agreement with financiers – as well as encouraging the provision of £375bn of quantitative easing and the £80bn scheme of funding for lending. 

These wheezes have cost hundreds of billions of pounds and taken up months of policymakers' time – and the net result has been sorely disappointing....

They have been good for banker bonuses though as they have enhanced bank profitability.

Faced with a major shortfall in domestic demand, he has depressed demand still further by laying out the biggest programme of spending cuts ever seen in peacetime Britain. 

And to spur growth, he has relied instead on trying to offer as much credit as possible. Put another way, an unthirsty horse has been offered gallons of surplus water.

Please re-read the highlighted text as it nicely summarizes why the response to the financial crisis has not worked to date (even when there was some stimulus as in the US).

Going by reports this week, Mr Osborne will next week announce yet more policies to boost lending to small and medium-sized businesses; perhaps by more closely targeting the funding for lending scheme administered by the Bank of England. 

This could once be chalked up as foolishness, but now it surely goes beyond that – it is wilful, damaging blindness on the chancellor's part....

Willful, damaging blindness about the ineffectiveness of the policy responses to the financial crisis that began on August 9, 2007 are not limited to the UK's chancellor.  This extends across countries and central banks.

As a group, they choose to implement the Japanese Model that Japan deployed for handling its bank solvency led financial crisis.  As a group, they apparently believed they would get a different result than  a Japan-style economic slump.

As a group, they are unwilling to admit that their experience parallels the Japanese experience and they have pushed their economies into a Japan-style economic slump.  A result predicted by your humble blogger.

One of the reasons that your humble blogger has advocated for adopting the Swedish Model for handling a bank solvency led financial crisis is that it avoids the Japan-style economic slump.  It does this by requiring the banks to recognize upfront all the losses on the excess debt in the financial system.

As a result, the burden of servicing the excess debt is not placed on the real economy where it would divert capital needed for growth and reinvestment.

But it must surely be evident by now that the main problem is not the lack of loans available to firms; it is that businesses do not see the growing markets or buoyant economy that would justify them spending and borrowing to invest.

The chief executives and managing directors can hardly be blamed for this: as Tuesday's industrial production figures and bleak forecasts from the National Institute of Economic and Social Research indicate, the economy is still stuck in the doldrums. 

While this remains the case, the government's focus on credit is misplaced.

The Guardian editors have eloquently summarized the current state of the global economy and why the policy response to the bank solvency led financial crisis was and still is wrong.

Our economy is headed in the Japanese direction

In his Telegraph column, Roger Bottle argues for a change in policy so the UK (and EU and US too) doesn't end up like Japan.

The similarity is closest with the position that faced Japan after the bursting of its bubble in the early 1990s. And Japan is still waiting for a full recovery even now. 

Japan is still waiting despite the huge growth in the world economy that occurred for the first 15 years after its bubble burst.

Here interest rates are almost at rock bottom. In any case, for lower interest rates to do much good, the banking system needs to work properly. It doesn’t. It is broken. 

Remarkably, the Government has been lily-livered about taking tough action to fix it, while still relying on monetary policy to revive the economy.

It is not a case of the Government being lily-livered.  The Government adopted an explicit policy of not fixing the banking system.

The policy adopted by the Government was the policy of financial failure containment and its corollary, the Geithner Doctrine (Do nothing that would harm the profits or reputation of big and/or politically connected banks).

Unfortunately, this policy has a long track record of never fixing the banking system and never resulting in economic recovery.

This situation is in marked contrast to the recovery from the 1980s and ’90s recessions, when the banking system was robust. Indeed, banks were then eager to expand their lending. Even in the 1930s, we survived “the Great Depression” without a single bank going under. 

Admittedly, the pound has fallen recently, as it did in the prelude to the recoveries of the 1930s, 1980s and 1990s. And it could fall further still. But our major markets are in recession and manufacturing is much smaller. A major boost from net exports looks unlikely. 

This is not a normal recession.

It is a recession triggered by a bank solvency led financial crisis.

The response by policymakers and regulators of protecting bank book capital levels and banker bonuses at all costs is the very thing that leaves the UK, EU and US economies in a Japan-style economic slump.

End protecting bank book capital levels and banker bonuses, end the recession.

Because people are trying to put their balance sheets in order after the borrowing binge, they don’t respond to financial prodding in the usual way. 

So monetary stimulus is less powerful than normal.

There are a number of other reasons that monetary stimulus is less powerful.  At the top of the headwinds the economy is currently experiencing is the Retirement Plan Death Spiral and the threat to the social programs (both medical and retirement).  The response by individuals to both is to cut back on current consumption and try to save more.

However, with monetary policy bound to be in supportive mode, the effectiveness of fiscal expansion may be greater than usual. 

Accordingly, the case for an expansionary fiscal policy is stronger. 

Your humble blogger would argue that simply having an expansionary fiscal policy is inadequate.  The benefits of the expansionary fiscal policy are absorbed in servicing the excess debt in the financial system (substitute public for private debt).

What is needed to address the problem on three fronts.

First, the banks must be required to recognize upfront the losses on the excess public and private debt in the financial system.

Second, fiscal policy must be expansionary.

Third and critically important, monetary policy must be changed so that interest rates reach or exceed Walter Bagehot's 2% minimum.  This is not difficult to do.  Central banks have to halt Quantitative Easing and start pulling reserves out of the banking system.

While the third recommendation is counter-intuitive, it is necessary to end economic headwinds like the Retirement Plan Death Spiral that are triggered by the lack of return on investments.

Arguing against a relaxation of fiscal policy, the Prime Minister has said that there is no “magic money tree”. Yet there is apparently enough of a magic money tree to provide £164 billion in funding to the Government this year. 

And even the Chancellor would not advocate trying to cut this to zero immediately. So, on the subject of magic, the question should rather be what is so magical about the current planned level of borrowing? 

The issue is not one of principle but of pragmatism – it is all about the right amount to borrow. 

I think Mr. Bottle puts too fine a point on how much the government should borrow.

The market recognizes that the government is pursuing an expansionary fiscal policy to give the economy a boost.  So long as the money is being spent in a productive fashion that boosts the size of the economy and therefore generates a return in the long run, think repairing and improving infrastructure, markets will be very supportive.

Joseph Stiglitz: Path to Prosperity

Nobel Prize winning economist Joseph Stiglitz observed that the only thing lying between the real economy and the path to prosperity was the excess debt in the financial system.

Regular readers know that this is precisely what your humble blogger has been saying since the beginning of the financial crisis.

And, the path could be easily unblocked by having the banks perform the role they are designed to perform and recognize upfront the losses on the excess debt in the financial system.

‎"Gone through the crisis... we should realize that the resources in our economy, in the United States, in Europe, today is the same as it was five years ago. We have the same human capital, the same physical capital, the same natural capital, the same knowledge... We have the same creativity that has led to the unprecedented increases in standard of living that the world has never seen before. So, we have all these strengths, they haven't disappeared. 

What has happened is, we're having a fight over claims, claims to resources. We've created more liabilities... but these are just paper. 

Liabilities are claims on these resources. But the resources are there. 

And the fight over the claims is interfering with our use of the resources. 

So, the point is the following: we should recognize that if we could only get our resources back to work, we ought to be back to prosperity. In fact, we ought to have more prosperity than we had before, because before our economy was distorted... by a bubble in the United States, by a financial sector that was overbloated... We had a distorted economy. 

So, today if we could only get our resources back to work in ways that enhance the well-being, to use the creativity of the citizens of Europe and America then we will have unprecedented prosperity." - Joseph Stiglitz

Please re-read the highlighted text as it is always nice to have a Nobel prize winning economist confirming your humble blogger's blueprint for economic recovery.

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.

UK's economic strategy has failed

In a scathing Guardian editorial, Larry Elliott looks at each element of the UK's fiscal and monetary policy and find it unfit for the purpose of getting the UK out of an economic slump that is actually worse than during the Great Depression.

Your humble blogger needs to repeat the point that the economic performance the UK has experienced is actually worse than during the Great Depression.

Why have I repeated this point?

Because how many times have we heard politicians and financial regulators say that their response to the financial crisis that started on August 9, 2007 saved us from a second Great Depression.

The performance of the UK's economy puts to rest the myth that the fiscal and monetary response to the financial crisis saved the UK from a second Great Depression.

I know that a bunch of economists will argue that the UK is not having a second Great Depression because the unemployment rate hasn't reached 25%.  The reason it hasn't reached 25% has to do with the economic stabilizing programs that were put in place by the generation that experienced the Great Depression and has nothing to do with the response to the current financial crisis.

Regular readers know that your humble blogger predicted and explained why the UK's fiscal and monetary policies would be unsuccessful before they were implemented.  I get absolutely zero satisfaction out of having been shown to have been right.

Fortunately, because the UK's economy has performed as I predicted, it strongly suggests that my blueprint for restoring the UK economy to robust health is likely to work.

What is my blueprint?

First, look at Iceland.  What is important to notice about Iceland is that it forced its banks to recognize upfront the losses on the excess public and private debt in the financial system.

The starting place for restoring the UK economy is to make the same requirements of UK banks.  I know that the bankers will complain bitterly about this, but their banks are designed to absorb these losses and continue to support the real economy.

Second, understand that austerity is not a policy prescription for restoring growth to an economy.  What is a policy prescription for restoring growth to an economy is to focus spending on items that benefit UK taxpayers like social programs and infrastructure and not on bailing out banks.

Third, understand that monetary policy can contribute to economic headwinds and end those policies like interest rates below 2% and quantitative easing that create these economic headwinds.  Abandoning these policies will actually stimulate demand as savers can spend what they are currently setting aside to offset the lack of earnings on their savings.