Fin/Inv

by cactus

A Tale of Two Clients - And Lessons Lehman Learned Late or Not at All

My first "real" job (i.e., after grad school) was at what was then a Big 6 accounting firm (and is now a Big 4 accounting firm) doing "transfer pricing." I wasn't right for the job (or the environment), nor was the job (or the environment) right for me. But I did learn a lot about how the world works.

One of the big clients serviced by the transfer pricing group from the office I was working is a household name. Other than North Koreans and people with some form of mental impairment, I doubt there's anyone anywhere in the world over age eight who would fail to recognize the company name or its logo. And to be honest, I'm not sure about the North Koreans. Another big client has a name that is only slightly less recognizable. I'll call them Co. 1 and Co. 2.

Now, when I was there, Co. 1 was very aggressive on tax issues - which means it was willing to push the envelope and see how far it could push the IRS. The odd fine or two for going too far was just a cost of doing business, and it expected its highly priced Big 6 accounting firm to produce, ahem, tax plans that fit the bill. Essentially that meant coming with, ahem, tax plans that were cutting edge enough that the IRS hadn't seen them yet but that on the face of it resembled something that had in the past gotten an official OK, either through a regulation or some court decision. That would be enough to get a law firm to write a letter saying it was their opinion this was OK, no matter how much what was being done might sound, to the uninitiated, to be questionable or even illegal. Incidentally - on the rare occasions when the firm came up with a scheme on its own, it was the job of its advisers (i.e., accounting firms and law firms) to get the client to make sure that whatever changes were necessary to keep things on the right side of the blurry line were made.

Co. 2 took more the pussycat approach with the IRS. They seemed to feel that if they didn't push too hard, they'd avoid a lot of hassle from disputes with the IRS. They were, of course, right, and it cost the Big 6 accounting firm, but then the Big 6 accounting firm wasn't exactly losing money on this client so it was happy to oblige.

In other words, accounting firms are like criminal attorneys - they represent the client and try to do what their client believes is in their best interest. They advise their client when they think their client has taken a suboptimal turn, but when the client wants to do X, if its not explicitly illegal, the firm finds a way to make it happen.

All of which is to say, if the allegations that came out last week about Lehman's accounting schemes are true, and if as those stories indicate, Lehman was forced to find a non-American law firm to sign off on what they were doing, one of the following must be true:
a. Ernst & Young personnel working on the account had no idea what Lehman was doing.
b. E & Y personnel working on the account knew what Lehman was doing (perhaps having peddled the scheme to Lehman themselves) but had no idea it was an obvious no-no to the IRS.

Either way, it looks to a casual outsider like me that E & Y had a B-team made up of PONIs (partner of no importance) on the job, and that should have been obvious to Lehman. Now Lehman should have been a big enough client to warrant a few POGIs (partner of great importance). If Lehman did not seek out out or deliberately avoided the best possible representation, they were guaranteeing an eventual disaster. Deliberate ignorance or deliberate evasion (the allegations would imply one of these two to be true) of the law doesn't go over well when the doo-doo hits the fan.

But it goes the other way too. E & Y's POGIs should have realized that Lehman's business model involved taking big risks. Why would they have assumed that Lehman was going to be satisfied with orthodox accounting practices? And as the old saying goes, you don't send a boy to do a man's job. The Anderson/Enron debacle is a clear demonstration that if some partners certify a client's shenanigans, and those shenanigans come to light, the entire firm will take a hit. (And that, of course is the flip side of everyone benefits from the shenanigans as long as they haven't been forced to a complete halt.)

So, what do you think about the situation?

Cactus

American Conservative Magazine considers who is feeling the the new anger against 'liberals' from the Feb.17 Mt. Vernon statement of the Conservative statement of principles:

One of the things that many people have noticed since the release of Mount Vernon statement on Wednesday is the sharp contrast between the youth of the creators (my link) of the Sharon statement and the notable absence of students and young people from the latest gathering. Christopher Buckley quotes Sam Tanenhaus on this point, “The new/old submission seems more like Geriatrics Against Obama.” Fifty years ago, one could have written, as Nile Gardiner does today, that “conservatism is the future” with some reason for believing the claim to be true, and in the decades that followed there was a significant conservative political coalition that seemed to be growing in strength over time. Today it is increasingly difficult to believe anything of the kind.
....
On average, Millennials’ underlying social and political views put them well to the left of their elders. If you dig into the full report, you will see that the recent Republican resurgence owes almost everything to the dramatic shift among members of the so-called “Silent Generation,” whose voting preferences on the generic ballot have gone from being 49-41 Democrat in 2006 to 48-39 Republican for 2010. There have been small shifts in other age groups toward the Republicans, but by far it is the alienation of voters aged 65-82 that has been most damaging to the Democrats’ political strength*. As we all know, these are the voters who are far more likely to turn out than Millennials, which is why Democratic prospects for this election seem as bad as they do even though the Pew survey says that Democrats lead on the generic ballot in every other age group. Among Boomers, Democrats lead 46-42, and among Gen Xers they barely lead 45-44. In other words, the main reason why the GOP is enjoying any sort of political recovery is that many elderly voters have changed their partisan preferences since the last midterm. Republicans remain behind among all voters younger than 65. That does not seem to herald the future revival of movement conservatism of the sort Gardiner is so embarrassingly praising.

To be sure, the U.S. government deficit is shocking; but it's not anymore shocking than the recession through which we have all lived. Tax receipts plummeted (see the second chart from this post) and spending on cyclical social programs (like unemployment benefits) is surging. This adds up to an exponentially rising budget deficit, and thus an increasing debt burden.

The resulting hysteria leads to headlines like that from Reuters on March 11, 2010: "Fed's Dudley: Waiting to fix fiscal problems risky".

Be very careful when reading these articles, as the title implies that William Dudley, president of the New York Federal Reserve Bank, is advocating "fixing fiscal problems" right now - cutting spending and/or raising taxes now - while that is not the case at all. According to Reuters, Dudley says:

The issue, Dudley said, is not fiscal stimulus, which he noted had been necessary in the United States to stabilize the economy, even though it drove up the deficit. That spending is temporary, he added. The bigger long-term problem for the United States and other advanced economies is structural deficits -- those likely to persist absent changes in tax and spending policies.

A link to Dudley's speech. He does refer to structural deficits that may result from recent countercyclical policy. However, these long-term structural deficits have essentially nothing to do with the current downturn, in my view. In fact the effects of the current deficits are simply a speed bump on the road to structural indebtedness.

Just look at the CBO's extended-baseline projection for the long-term budget published in June 2009.

This above scenario projects the spending share on social security, Medicare and Medicaid, and Other Federal Noninterest Spending through the medium and long term under current law. Notice the blip that is 2009 and 2010?

What is key to this outlook is the assumption on economic growth and productivity trends (among others, of course!). GDP is assumed to grow an average 2.2% per year. I didn't delve into this full report and conduct a full alternative scenario test. But it is pretty clear that GDP growth of anything less than 2.2% (on average) - holding all else equal, of course - would have a deleterious impact on the outlook for government financing.

Japan provides a perfect case study of what not to do when the economy is recovering from a financial crisis: raise taxes too soon. You do that, and the probability of a "lost decade" rises quickly. You suffer a lost decade, and the outlook on the structural budget looks a lot worse than that illustrated above.

Marshall Auerback has argued time and time again that the government should run deficits until private saving adjusts so that the economy can stand on its own two feet, i.e., grow. As long as the currency floats and is fully convertible, the government's debt burden will not become a solvency issue. Hence, his interview titled fighting deficit hysteria.

I would say, rather, that the deficit hysteria is appropriate, but very much misallocated intertemporally toward the short-term outlook.

Part II coming to a post near you!

This article is crossposted with News N Economics

Since we are on the topic of men, business, and regulations, Yves Smith points us to a relevent avenue for thought:

Indefensible Men.

On the right is a poll put up by the San Francisco FED that I translated to here. I personally use cash and checks to monitor my emotional response to spending, which can become numb using all credit card purchases. Online payments work if not automatic. Then again, I don't use a lot of checks.

Business accounts (sole proprietorships) I treat differently. Quirky behavior which works for me.

Rdan here...Our loyal opposition Reader Sammy sends along this in your face question:

Regulators could have prevented AIG collapse. Really?

Say what you want about AIG, and it is pretty much open season on them, but just prior to their collapse, AIG was:

1) The largest insurance company in the US, in the business of assessing risk.
2) One of less than 10 companies rated AAA
3) A member of the Dow 30 Industrial Average.

So you think some Insurance Examiner could have foreseen the risk that eluded all the rating agencies, and all the counterparties (including Goldman) and prevented it? As Seth and Amy would say on Saturday Night Live: "Really?"

Even though SEC regulators allowed Bernie Madoff's ponzi scheme to continue for 20 years, even after they were tipped off?

Not even to mention that what brought AIG down was not underwriting risk, but collatoral posting covenants buried deep in the documents.

I can imagine the conversation:

Brilliant Civil Service Examiner (circa 2003): "Mr. Greenburg it looks like you have a dangerous amount of exposure in CDS, if housing prices decline, or you get downgraded, you will have to post immense amounts of collatoral. I'm going to recommend to my superiors that you to cease and desist"

Greenburg: "Hey Frank (Catalano), fire up the Cray and show the Examiner your simulations. I am sure he will be more than satisfied. If not he should direct further questions through the offices of Sens. Dodd and Schumer, or maybe Bush and Obama."

Some bureaucrat could have sounded the alarm? "Really?!"

Reader Sammy asks.

Robert Waldmann

Jonathan Chait has a very good article on Paul Ryan in The New Republic. In it he displays striking confusion on simple arithmetic.


It's worth keeping in mind that the current tax system in this country is only very slightly progressive. State and local taxes are regressive, federal taxes are somewhat progressive, and the net effect redistributes income, very slightly, from the rich to the not-rich:

It is true that the tax system is only very slightly progressive. It makes no sense to talk about whether the tax system redistributes income from the rich to the non-rich. The tax system redistributes income from the rich and the non-rich to the public sector. To assess redistribution from the rich to the non-rich one has to look at what the public sector does with the money. Even if one assumes that the public sector provides no valuable services (not I think Chait's view or even, for that matter, Ryan's) much of the money is sent right back as old age pensions, disability pensions and some more as unemployment insurance, housing vouchers, and even a tiny bit of TANF,



The standard model of redistribution used by lazy economists is a flat tax which finances an equal grant to all citizens. According to Chait, there is no redistribution since the tax code is not progressive at all. It is not very hard to calculate what the effect of the public sector on income inequality would be if pre-tax and transfer income were unaffected by taxes and transfers (this is not an interesting calculation but it isn't very hard). Here one finds a much larger effect of the central government tax and transfer system in Europe than in the USA even though the US federal tax system is more progressive. The amount of redistribution has a lot to do with the scale of taxes and transfers and, across developed countries, very little to do with progressiveness.

Chait should check with his fan Matt Yglesias who vastly overstates the importance of this simple fact.

Speaking of whom, a commenter recently wrote that Yglesias was “mathematically illiterate.” I was puzzled and replied that I thought he was very good with numbers. I'm not going to search through threads to find the exchange and so just let me apologize here. After reading this

"three countries in Western Europe (Sweden, France, Denmark, and Austria)"

I must admit that I was wrong.

By the way, I remain wildly enthusiastic about increasing the progressivity of the US tax code. This is partly because I am partisan and increased progressivity is very popular. It is also partly because, other things equal, increased progressivity implies increased transfers from the rich to the poor. It's just other things aren't zero.

Tom aka Rusty Rustbelt

Perfect Babies and C-Section Complaints

Some issues are like spring flowers, always returning.

The "too many C-Sections" debate is recurring again, raising issues of cost and clinical judgment (some women want sections for cosmetic reasons).

Problem is, Americans expect perfect babies, and if babies are not perfect it is time to call the lawyers.

(John "lover boy" Edwards became very rich filing junk science Cerebral Palsy cases against Ob-gyns.)

The last time I did a cost study on an Ob-gyn practice, all of the contribution margin from Ob was going to malpractice premiums, most of the expenses and all of the physician incomes were derived from gyn services (as I remember the premiums were about $140,000 per physician). So why deliver babies?

Certainly there is malpractice, and it is (in my opinion) malpractice not to do a quick section on a distressed baby (as one of my doc friends said, "we were all trained in the 2 minutes C-section drill). Proper compensation for legitimate cases is important.

Ob-gyns are becoming employees are a means of shifting risk and cost to hospitals and integrated networks. Difficult cases are referred up the specialist chain, often to academic centers (often many miles from home). Medical students are avoiding OB as a specialty.

This is no way to run a health care system, and the plans moving through Congress do not address these issues.

Tom aka Rusty Rustbelt

"Mr Geithner warns that US hedge funds, private equity groups and banks could be discriminated against if proposals to restrict the access of EU investors to funds based outside the 27-country bloc are included in the final law." Geithner Warns of Rift Over Regulation

as declared over this:

"Germany and France on Wednesday called on the European Union to consider banning speculative trading in credit default swaps and set up a compulsory register of derivatives trading." Call For Ban ON CDS Speculation

Once again Geithner has shown whose interests are more important. It certainly isn't Main Street when it comes to exports/imports. God forbid, some other country begin to regulate Wall Street though!

$238 billion to maintain very low capital gains and divdiends rates (mostly of value to wealthy who receive most of the capital income);
$359 billion for extension of the child tax credit, refundability and AMT rules
$359 billion for so-called "marriage penalty relief"
$18.4 billion for education incentives

The tax measures in the purported "temporary recovery measures" cost just less than $100 billion and include many provisions that are not going to do anything to stimulate the economy, in all likelihood, such as more expensing provisions for small businesses, more bonus depreciation for certain properties, and more tax credits for certain types of investments.

Additional "tax cuts" touted in the budget are similarly hard to justify since they increase the "consumption tax" features in the income tax--expanding the "saver's credit" is a too costly $27 billion over ten years; and expanding the "american opportunity tax credit" is another $58 billion.

The "tax cuts for businesses" include two items that should hit the trash heap--hopefully Sandy Levin is going to toss these out:

almost $8 billion for eliminating capital gains taxation on investment in small business stock (this will be just another tax break to equity funds and all those hugely wealthy investors, not a break for little businesses or little guys)
$70.5 billion for making the research & experimentation credit permanent- (this is another item that doesn't belong in an income tax--letting companies get a credit for R&D means that something that is just a normal cost of business is treated as reducing the tax owed on a dollar for dollar basis. That's a nutty policy to put in place, but it is something that the corporations have lobbied for year after year after year, and Congress keeps giving it to them)
The biggest revenue raiser is capping itemized deductions, which would garner almost $300 billion over 10 years, but the Dems in Congress have practically rolled over on that one already.

[hat tip to taxprof]

Rdan here: Final vote passed the bill.

by Linda Beale

The Chicago School--why does anybody still listen to it?
I have frequently written here about the problems of "freshwater" economics--the school personified by Milt Friedman and the extremist "free market" ideology that views government as the enemy, the "markets" as always right, and any public role in economic development as "socialism". As I've noted, this ideology misses many points about the role of government in creating a space where markets can function as they should and where individuals can have maximal personal liberty while pursuing better lives and respecting a societal decision that valuing each individual means allocating society's resources in ways that support, rather than brutalize, those at the bottom.

The Nieman Foundation, connected with Harvard's journalism school, has an interesting watchdog website that includes a number of controversial articles raising questions about the way today's media tend to accept without questioning the "received wisdom" of the past (including the ideological views of the "free market" right). As part of a series on the economic collapse, the site includes an article by Henry Banta (a partner at Lobel, Novins & Lamont) noting the consensus developing among a small but diverse group of economists, professors, and those interested in how the economy works about the failure of efficient market theory. That's a post worth reading, since it focuses on this issue. (My posts, perhaps to readers' chagrin, tend to throw these criticisms in as asides in the course of analyzing one position or another being put forrward unthinkingly by proponents of that theory.). Enjoy. Henry Banta, Republicans are locked in a passionate embrace with a corpse and won't let go, Nieman Watchdog, Feb. 11, 2010.

crossposted with ataxingmatter

Today I was thinking about tightening cycles in emerging markets; and more specifically, about that in China. Because let’s face it, China matters. China matters to the rest of Asia via competition for export income. China matters to Europe via competition for jobs. China matters to Brazil via domestic production via imports. China matters.

The inflation pressures are building in key emerging economies, especially in the BIICs (Brazil, India, Indonesia, and China) – see this previous post regarding my new acronym, and this article at the Curious Capitalist (curiously posted just shortly after my post), which leaves my omitted “R” but relays the intuition behind the second “I”.

Although the inflation is not prevalent in any BIIC except India, really, I wanted to comment about why it will build…quickly.

First round, the construction of consumer prices is heavily weighted toward food and energy costs across the BIICs. Indonesia, India, and China are highly susceptible to food price shocks (either driven by shortages or demand growth). Expect this as a first-round driver of inflation as the global economy recovers further. It’s already happening.

Second round, the BIICs are growing quickly and nearing, or are already at, potential. Annual industrial production growth has recovered or surpassed its pre-crisis rate in China, Brazil, and India, 19%, 16%, and 17%, respectively. This is expected, given the drop-off in world trade (an illustration can be found from this May 2009 pos), but unsustainable as the output gap closes.

Third round, interest rate differentials. This year, the BIICs' central banks are expected to raise policy rates. In fact, Brazil, China, and India have already boosted reserve requirements. But with US rates expected to stay low for an “extended period”, international interest rate differentials will change and monetary flows will shift. Capital inflows can lead to inflation if not properly sterilized.

To date, inflows are not properly sterilized, as evidenced by the ongoing accumulation of reserves and rising money supply growth (again, I refer you to my previous post on M1 growth rates.

The chart above illustrates the one-year-ahead nominal interest-rate differential between the 2yr forward government rate for each respective BIIC country versus the 2 yr forward US Treasury rate. The forward differentials for China and India are on a steady upward trajectory, while those for Brazil and Indonesia are simply steady. I believe that this appropriately represents the sterilization efforts and monetary policy management on the part of the BIICs’ central banks: more managed in Brazil and Indonesia, not as much in China and India.

So where does this analysis leave us? With a very interesting policy mix in the emerging market space. In fact, in my view this is the riskiest part of the emerging market cycle: the recovery. If policymakers get this wrong, we could see a lot of price action, final goods and assets alike, on the horizon.

This is a guest contribution by Marshall Auerback, Braintruster at the New Deal 2.0

by Marshall Auerback

A new book by Kenneth Rogoff and Carmen Reinhart, "This Time It's Different: Eight Centuries of Financial Follies", has occasioned much comment in the press and blogosphere (see here and here)

The book purports to show that once the gross debt to GDP ratio crosses the threshold of 90%, economic growth slows dramatically.

But that's too simplistic: a ratio is just a number. Debt to GDP is a ratio and the ratio value is a function of both the numerator and denominator. The ratio can rise as a function of either an increase in debt or a decrease in GDP. So to blindly take a number, say, 90% debt to GDP as Rogoff and Reinhart have done in their recent work, is unduly simplistic. It appears that they looked at the ratio, assumed that its rise was due to an increase in debt, and then looked at GDP growth from that period forward assuming that weakness was caused by debt instead of that the rise in the ratio was caused by economic weakness. In other words, they have the causation backwards: Deficits go up as growth slows due to the automatic countercyclical stabilizers.They don't cause the slow down, etc.

After the Second World War, the debt ratio came down rather rapidly—mostly not due to budget surpluses and debt retirement but rather due to rapid growth that raised the denominator of the debt ratio. By contrast, slower economic growth post 1973, accompanied by budget deficits, led to slow growth of the debt ratio until the Clinton boom (that saw growth return nearly to golden age rates) and budget surpluses lowered the ratio.

From 1991 through 2001 the growth of government debt had been falling and since then rising most recently at a faster pace. The raw data comes courtesy of the St. Louis Fed (and attached spreadsheet).

The Ratio of the rates of change of Debt / GDP is rising faster than the change in Debt indicating that both the increase in Debt and the fall in GDP are contributing to a rising Debt / GDP ratio. For policy makers who obsess about a rising Debt / GDP ratio, they fail to understand that austerity measures that cut GDP growth will cause a rise in the Debt to GDP ratio. Basically, it boils down to this simple observation: it is foolish, dangerous, and thoroughly counterproductive to treat fiscal balances in isolation. In particular, setting a fiscal deficit to GDP target equal to expected long run real GDP growth in order to hold public debt/GDP ratios at a completely arbitrary (indeed, literally pulled out of thin air) public debt to GDP ratio without for a moment considering what the means for the feasible range of current account and domestic private sector financial balance is utterly nonsensensical.


It is crucial that investors and policy makers recognize and learn to think coherently about the connectedness of the financial balances before they demand what is being currently called fiscal sustainability. As it turns out, pursuing fiscal sustainability as it is currently defined will in all likelihood just lead many nations to further private sector debt destabilization. To put it bluntly, if the private sector continues to pursue a high net saving/financial surplus position while fiscal retrenchment is attempted, unless some other bloc of nations becomes large net importers (and the BRICs are surely not there yet), nominal GDP will fall in the fiscally "sound" nations, the designated fiscal deficit targets WILL NEVER BE ACHIEVED (there can also be a paradox of public thrift), and private debt distress will simply escalate.


In fact, if austerity measures are based on measures of debt relative to economic growth there is a very real risk of a downward spiral where economic growth declines at a faster pace than government debt and the rising Debt / GDP ratio leads to ever greater austerity measures. At a minimum, focusing only on the debt side of the equation risks increasing the Debt / GDP ratio that is the object of purported concern is likely to lead to policy incoherence and HIGHER levels of debt as GDP plunges. The solution is to recognize that the increase in the ratio is in some fair measure the result of declining economic growth and that only by increasing economic growth will the ratio be brought down. This may cause an initial rise in the ratio because of debt financing of fiscal stimulus but if positive economic growth is achieved the problem should be temporary. The alternative is to risk a debt deflationary spiral that will be much more difficult (and costly) to reverse.

This article is crossposted with News N Economics

by Linda Beale

Banking Matters--Bing's Views

The Bing Blog is one of those well-written something about everything we've all thought about blogs that everybody should read at least every once in a while. So let me suggest a proper post for your introduction, if you haven't looked there before. It's a list of suggestions for what every bank ought to do. I doubt if there's a soul amongst us who would disagree with any of them--except, perhaps, the bank personnel and especially managers who put the current rules into place. See The Bing Blog, New Banking Rules We'd Like to See, Mar. 2, 2010.

Here's a sample of the new rules suggested:

I’d like there to be a rule that the bonuses a bank pays to its top 10 executives cannot exceed its profits.

(Beale here again) I could add a bunch, but one of the obvious ones Bing leaves out is: "no bank can send out a statement changing its rules to provide even higher fees and service charges in which it touts the rules as though they are for the client's benefit while setting them to work in ways that will inevitably lead to more profits for the banks."
__________________________________
crossposted with ataxingmetter

(Rdan here...as we develop thought on economic issues facing us today, a nod to excellent writing in the past is important. Newcomers need to know past wisdom exists, and readers of five years ago can use this wisdom again as we visit today's trends in the knowledge of predictions 2003-2005. I also have been reviewing PGL's and Calculated Risk's posts here at Angry Bear.)

Are Earnings Rising or Stagnant? Published June, 2005 by Kash

This question is not as easy to answer as it may first appear. In working on various posts last week I came across an apparent contradiction in the official data on compensation: some series show it rising in real terms, while others show it barely able to keep up with inflation. This discrepancy was also noted by a few readers, who deserve credit for their sharp eyes.

So I thought I’d take a bit of time to sort out these conflicting data series for myself. Here’s what I found. (A warning and apology here: what follows is a relatively econ-geeky post about data details that many may find uninteresting... and I won't be offended if you stop reading here.)

There are three major sources for time series data on earnings: “Hourly Compensation,” from the BLS’s Productivity and Costs (P&C) dataset; the Employment Cost Index (ECI), which provides compensation series broken into the two sub-categories of wage/salary earnings and benefits; and the “Average Hourly Earnings” provided in the monthly employment report as part of the Current Employment Statistics (CES). The following two charts show the behavior of these different series since 1990. All series express hourly compensation rates in real terms.


Note: all series are expressed in real (inflation-adjusted) terms using the PCE deflator.

What explains the sometimes substantial differences between these series? There are several factors that contribute to the discrepancies, but let me point out the most important ones. (For a more complete description of their differences see this paper by Joseph Meisenheimer in the May 2005 issue of the Monthly Labor Review.)

First of all, two of the series – the CES series and the “ECI: wages and salaries only” series – do not include benefits that workers receive. In the charts, those are the pink and green series. Comparing the two ECI series shows that in the past three years or so, a significant gap has opened up between workers’ take-home pay and the amount of compensation that employers are paying, including benefits. I would argue that this is directly attributable to the soaring cost of health insurance since about 2000. Even if workers’ pay has been rising in real terms, nearly all of the increases have been going to pay higher health insurance premiums.

Secondly, the different series include and exclude different types of income and different types of workers. The table below summarizes the different types of workers and income that each series excludes.


Finally, it should be noted that the ECI differs from the other series in that it comes from a survey that is intended to compare the wage rate in a particular job over time, not the wage rate of a person. (The sample is 35,000 specific jobs across the country.) In other words, the survey compares what each job in the sample pays at one point in time to what it used to pay earlier. Furthermore, in constructing the average wage rate across the economy, the ECI holds the number and types of jobs constant at the proportions in the base year (which I believe was just changed from the year 1990 to the year 2000). What this means is that the ECI will not accurately reflect how a change in the composition of jobs in the economy might affect average wages.

Each of the series thus has its own strengths and weaknesses, and there’s no right answer as to which series is best. They each tell us slightly different things, and the differences between them tell us still more. For example, the surge in the P&C measure during the period 1998-2001 probably reflects the large-scale adoption of payments through stock options. The divergence between the wage/salary series and the total compensation series reflects the growing burden of health insurance. And the recent rise of the P&C measure compared to the ECI measure may reflect higher rates of compensation growth in for-profits firms compared to non-profit firms, or large increases in the compensation of self-employed business owners, or a change in the composition of jobs in the economy that the ECI hasn’t caught up with.

A note about income inequality: to the degree that some of the excluded groups (in the table above) may have different levels of income than others, the differences between the series may also suggest something about changes in income inequality. A word of caution about that, however: if you want to find evidence of income inequality, I think there are much better measures (such as the Census Bureau’s income data) than these compensation measures. There is too much else going on in these series to be able to safely attribute anything on the charts above to changes in income inequality.

So what’s my answer to the title question of this post? Personally, if I had to choose just one series to use it would be the P&C series. In addition to being arguably the most complete series, it seems to have done the best job of matching my sense about how the economy has done over the past 20 years. When asked, I think that most people would agree that income growth was indeed much lower during 2002 and 2003 than it had been during the late 1990s; the P&C series bears that out, while the ECI series doesn’t. Meanwhile, the CES series excludes benefits, which I think are a major part of the story today.

But let me reiterate the point that I have made several times now: just because real compensation is rising, that doesn’t mean that people are better off, particularly if nearly all of the gains are just going to paying higher health insurance premiums. This data persuasively illustrates that nearly all of our real compensation gains today (and I do think we're seeing them) are being eaten up by the monster that we call a health care system in the US. Until we address the profound inadequacies of our health care system, this trend will only get worse.

Kash

by cactus

A NonReview of Yves Smith's Econned, Plus Some Questions About Selling Books

I've been swamped - a lot of work at work, deadlines for my book (more on that below), and family issues to contend with so for the past few weeks I've been cooped up with zero downtime. Friday I managed to crawl out of my hole... at least for the time being. I remembered that Yves Smith's book, Econned, was due out. Yves' blog, Naked Capitalism is one of my daily reads and I've been looking forward to her take on the whole Great Recession.

Long story short, I visited two bookstores - both had sold out. I placed an order for the book at Barnes and Noble and was told it would be available this week.

All that is a good sign for Yves Smith, and I wish her well. But I was wondering... what can one do to make one's book more likely to do well? Obviously, with a book coming out later this year - in August - its something I have an interest in knowing. (The book is already for sale at some online locations. Here's the Amazon link to the book. As an FYI, given how little the bio of me is, there's a surprising amount that's incorrect.)

The book is - we think - a bit unique. We looked at a how a large number of issues - from abortion to crime to the economy - evolved over the length over each administration from Ike to GW. (In a few instances, where the data is reliable, we go back to Hoover.) And we let the data speak, as regular readers can imagine from the posts I've written. I'll give you an example - my own political views, as one can imagine from the fact that I occasionally post at Angry Bear, are generally slightly left of center. And when this project started some years ago, I hewed closely to what one might term a slightly left of center view on crime, namely that the way to reduce crime is to focus more on rehabilitation. But the data shows that the Presidents under whom crime fell by the most were the ones who, once you account for demographics, put cops on the street, locked people up, and threw away the key. And that is precisely what we show.

I'm not sure I'm happy that the results on crime are what they are. Philosophically, I'd be a lot more comfortable being able to state that we should spend more time and effort and resources on rehabilitation relative to punishment, but the data shows what it shows. And my comfort level, frankly, is irrelevant, when it comes to determining what reduces crime. And the one thing my co-author and I agreed on from the start was that we would post the data (in a nice graphical format thanks to Nigel Holmes, a brilliant artist the publishing company hired to make our graphs look nice), whatever it showed.

Now, that is going to cause a major problem. See, on some issues, there doesn't seem to be much of a relationship between a governing philosophy and outcomes. For instance, stock market performance seems to be unrelated to the president's party, or even to how well the economy did. But (its not exactly a surprise to readers of this blog) on a lot of issues, particularly the economic ones, Democrats tend to outperform Republicans. And we think we're able to nail the cause of this disparity. We also feel we're able to do a good job of showing that the cause is related specifically to the occupant of the White House, as opposed to, say, Congress, God's will, the public's voting patterns, or whatever else.

And as regular readers know, stating that politicians that followed a certain policy produced better economic outcomes than politicians who followed the opposite policies seems to leads to uncomfortable conclusions for some people. As uncomfortable, for instance, as my epiphany on looking at the data on crime. But some people simply refuse to give up cherished beliefs. Its easier to attack the messenger. So though we call it like it is, and we call it for Republicans when Republicans have the better argument, I have zero doubt whatsoever that our book is going to labeled "liberal." Which is a pity, because the book is not intended to cheerlead. In fact, its intended to poke and prod both sides into keeping what works from their side and giving up what doesn't.

OK. So there it is. That's what the book is about. How do we sell it? Anyone have concrete ideas? Bear in mind, this has to be something we can do. People always tell me to go on the Daily Show or some similar program. I don't exactly have any media exposure (my co-author does), but I'd love to do it. However, there are a lot of people trying to go on TV to peddle their wares or their opinion. Heck, even people who know they're going to get publicly humiliated by Jon Stewart show up with big smiles on their face. And my guess is that a lot of people think, like I do, that they have something unique that can change the world if word gets out. So what do I do from here?

A few minor steps I've taken...
1. I took out websites in my name and the book's name. What should go on them at this time?
2. I took out twitter accounts in my name the book's name. I've never used twitter before in my life. What do I do with these now?
____________________________________
by cactus

The Fed of San Francisco just published a note on Okun's Law and the Unemployment Surprise of 2009.

In the paper they conclude that strong productivity was the main reason employment growth was weaker than the traditional relationship that Okun's law implied.

Of course, we at Angry Bear have long known this. I have published this chart that shows that roughly before 1974 that a one percentage point growth in real GDP generated a 0.3 percentage point growth in employment. This is what Okun's law is based on. But during the era of low productivity growth, 1974 to 1995 a percentage point growth in real GDP generated almost a 0.5 percentage growth in employment.

But since productivity growth rebounded in 1995, every percent increase in real GPD was accompanied by almost a 0.9% gain in productivity so that employment barely rose 0.1% -- a significantly lower rate than Okun thought.



The data in the chart is the long term trend and ignores the cyclical pattern in productivity where productivity growth peaks in a recession or early recovery period and slows as the expansion continues. That is why productivity growth has long been widely considered a leading indicator. It is also why you get patterns such as the San Francisco Fed found for 2009, and why we now seem to have jobless recoveries.

by Daniel Becker
I came across a presentation called Make Markets be Markets sponsored by the Roosevelt Institute which is tied to New Deal 2.0.  Here is the full report here (pdf).

The following are two videos, first by Simon Johnson, second by Elizabeth Warren,  from the full presentation (see here).

I have not read the full report or watched all the event, but thought these would be of interest.

Simon Johnson on the Doom Cycle (MMBM) from Roosevelt Institute on Vimeo.



Elizabeth Warren on Consumer Protection (MMBM) from Roosevelt Institute on Vimeo.

Yesterday I argued that Latvia's cost-cutting efforts are evident compared to a cross-section of European Union countries. Latvia's efforts, while commendable, were very much a function of the emergency IMF loan in December 2008 and the ensuing recession in 2009.

After an email exchange with Marshall Auerback, and thinking more about the cross-section of Europe, I now see a very scary trend emerging across Europe: the fight for exports.

To be sure, Latvia's efforts are of note, as the acceleration in hourly labor costs dropped from a 22% pace spanning 2007-2008 to just 2.8% in the first three quarters of 2009 compared to the same period in 2008 (the Eurostat data are truncated at Q3 2009).

But look at the similar wage-cutting behavior occurring across the European Union, especially in the Eurozone hopefuls (Latvia, Lithuania, and Estonia are preparing to adopt the euro in coming years).

The battle for exports has begun. Compared to the same period in 2008, Q1-Q3 2009 annual hourly labor costs growth are down 4.9% in Lithuania, 0.8% in the U.K., and 0.5% in Estonia. In fact, every country across the 26 countries listed except Belgium, Germany, Greece, and Spain, saw the rate of hourly wage growth decrease since 2008. The currency is pegged, so the only mechanism to increase external competitiveness is through price (wages) declines. To be sure, this growth model cannot work for the Eurozone as a whole.

Latvia's model: drop wages to increase export income. Greece: drop wages to increase export income. France, Germany, Spain, Portugal, etc., etc. It's impossible that the whole of the Eurozone will drop wages to increase export income. It's especially bad for countries like Latvia or Hungary, where the lion's-share of trade occurs withing the boundaries of Europe.

And what happens when export income does not provide the impetus for aggregate demand growth? Well, there's not much left. Can't devalue the currency (via printing money), and tax revenues will fall faster than a ten-pound weight: rising deficits; rising debt; rising debt service (via surging credit spreads). Sovereign default seems like a near-certainty somewhere in the Eurozone!

This article is crossposted at News N Economics

Rebecca Wilder

by Tom aka Rusty Rustbelt

RANDOM ECONOMIC OBSERVATIONS WHILE TRAVELING THE RUSTBELT

Even while on vacation the CPA/consultant side of my brain is engaged sometimes (although my grandchildren engaged the Super Mario and Spongebob Squarepants side of my brain).

* small businesses are closing at an alarming rate
* cities thought recession-proof (e.g. Columbus Ohio) are suffering badly
* the hotel/motel business is in a depression
* the housing markets are very weak, with occasional signs of life
* commercial real estate, office and retail, is very weak
* the auto parts supplier network is very fragile, any cascade of closings could shut down the auto industry (domestic and foreign) for a period of time
* the cities of Detroit and Toledo, after 40 years of of mismanagement, corruption, globalization and auto industry deterioration, are near collapse, as are the respective school districts (more on these cities in a later post)
* infrastructure is crumbling, but only a few stimulus projects are visible
* we could put thousands of people to work cleaning up environmental problem sites and demolishing (sadly) former manufacturing plants
* state and local governments need tax increases, but tax increases drive businesses south and west and it is tough to raise taxes on the unemployed and underemployed (moving companies are doing well)
* however -- people are hanging in there, somehow, someway

The entire country is suffering to some extent, but these areas have now effectively been in a recession for ten years. Is this the face of the future for the entire country?

Did I mention my grandsons are smart and cute? There is hope for the future.
_____________________________
Tom aka Rusty Rustbelt

Calculated Risk

Steve Waldman

Dean Baker

Felix Salmon is a very smart person who writes very well. Also he once invited me to an instant messenger debate that he posted on his high traffic blog. So I’d like to make only polite criticisms. However, I can’t write well so I will please translate the following to polite in your heads.

Salmon wrote “The CDS market is actually more transparent, with smaller bid-offer spreads”. That is, Salmon equates “the CDS market is actually more transparent”, and “CDSs are more liquid.” Liquid and transparent are not synonyms. Take the metaphors literally, and look at an old analog thermometer. You will find that mercury is liquid but not transparent and glass is transparent but not liquid.
Serious discussion after the jump.




In the sentence which I mock above, Salmon is criticizing an incorrect claim in a New York Times editorial. The claim is “A big part of the problem is that derivatives are traded as private one-on-one contracts. That means big profits for banks since clients can’t compare offerings.”
As noted by Salmon this is not true. It could be true, but, in fact, people know the current price of CDS on something*.

On another topic, Salmon wrote “But it doesn’t necessarily mean lower trading costs for the buy side: just ask anybody who tries to buy and sell bonds listed on the Luxembourg exchange.” I think it is clear who Salmon means by “anyone who tries to buy and sell bonds”. This would not be any firm that ever issued a bond nor does it mean any investor who ever bought a bond. He is thinking of people who try to profit from active trading strategies. “Anyone” means “any trader.” This is Salmon’s point of view. He talks to professional traders. Often he criticizes them, but he thinks about their problems and challenges.

Here, however, he is commenting on an editorial discussing public policy. Obviously Salmon doesn’t think the final aim of public policy is to make the world convenient for traders, but he assumes that making the world convenient for traders will lead to good economic outcomes. He definitely thinks that smart people trying to beat the market make the market work better.

This would make sense if one accepting a strong by semi strong form efficient markets hypothesis where prices are optimal given public information, private information can be obtained at a price, and prices are what they would be if informed traders had rational expectations. This is exactly the dominant assumption in the finance literature. It is also clearly nonsense. Salmon assumes that traders were rational.

dangerous risk-taking is actually a good thing, in financial markets. When people engage in risky behavior on Wall Street, they stand to lose a lot of money, but they know that they stand to lose a lot of money, and government doesn’t end up having to step in and bail them out. The big systemic problems happen when leveraged actors think that they’re not engaging in risky, speculative behavior

So Salmon asserts that dangerous risk taking is a good thing, because when people take risks, they know they are taking risks, except for the people who don’t know they are taking risks. Does Salmon assert that the claim “people always know when they are taking risks” is plainly obviously true or plainly obviously false ? He asserts both, with equal confidence and absence of evidence.

I think I can guess what he thinks. The traders with whom he talks are smart, so they don’t take risks without knowing it. The former CEOs of Lehman and AIG are dumb. The problem is that one can be very smart without having rational expectations.

In the same passage, he also notes a cause of big systemic problems and confidently asserts that it is the only cause of big systemic problems. One could as well argue that all market crashes involve the text “.com.”

To quote Salmon, “What a mess.”

It is very easy to see that outcomes are not what they would be if informed traders were rational. Basically cut out the theoretical middle man. Salmon assumes that high trading volume leads to efficient pricing. High trading volume is what he means by “liquidity” and, here, “transparency.” Trading volumes have changed enormously. High trading volume always comes with high price volatility. Price volatility is vastly greater than it should be (google “Shiller” and “excess volatility”) . It is plainly obvious that, in the real world, markets with a high volume of trade are less efficient (in the sense of the efficient markets hypothesis) than markets with a low volume of trade.

History shows that making markets convenient for traders, including really smart traders, reduces the usefulness of the signals markets send to the real economy. That’s why titans of finance who become treasury secretary like Tobin taxes(note the absence of the word *all* those titans are Nicholas Brady who publicly supported one and Robert Rubin who inquired as to how one could be implemented). It is possible that Rubin is clueless about finance, but that is not the way to bet.

Now Salmon writes many smart things in his post. To paraphrase Salmon “the problem is that it gets to the right destination by using the kind of rhetoric which makes it seem as though the only people who are unhappy about [demanding] proposed [politicall unmentionable] derivatives regulation are the people who don’t understand the derivatives market.”

*I note in this footnote that the problem is that there is a current price of a CDS written on something. There shouldn’t be. Given counterparty risk, there should only be a price of a CDS written by someone on something. Comparing prices and buying the cheapest CDS is a great way to guarantee that if the underlying sercuirty defaults so will the CDS writer. I take that seriously. Sure traders had plenty of data and low bid ask spreads. However, IIUC the data were collected under the totally false assumption that counter party risk was negligible. That’s insane. It is like assuming that a mortgage is a mortgage and it doesn’t matter if the debtor documented income or just claimed income. In each case, totally incorrect assumptions of homogeneity were made so that one could make a big huge data set. Everyone did this so they guaranteed that their assumptions would be false – if someone assumes high or medium quality someone else can make a profit producing low quality.

The desire to play with computers caused people to forget that garbage in means garbage out. If all financiers had been math phobic and computer phobic, the world would be a better place today.

Robert Waldmann

To obamanate V. To open an argument absurdly excessive concessions to one's opponents.

Obamanation gerund of To obamanate.
Obamanation present participle of to obamanate.

I offer this definition in defense of Obama. The word will be defined, and he'd better hope my definition is adopted.

Except for the drop in the workweek and aggregrate hours worked the February employment report was almost a duplicate of the January employment report. In both January and February the payroll survey reported a slight drop in employment and the household survey showed a modest increase in employment. Essentially both reports are showing changes so close to zero that they are well within one standard error of zero.

Generally, the payroll report is considered the better report. But at cyclical turning points the household survey tends to lead the payroll survey. I think that is because the household survey does a superior job of capturing trends changes among small firms and small business tends to respond more quickly to cyclical changes than large firms.

Both reports increase my confidence in last months analysis that the economy is in a transition mode. The period of wide scale lay-offs has ended but firms have yet to begin wide scale employment.




The pre-report apprehensions about the impact of the February snow storms were ill-founded.
The payroll survey reports how many people firms have on their payrolls. So even if people were not able to make it to work, they were still on firms payrolls. Consequently, the storms had no impact on firms payrolls. In the household survey the people who did not make it to work because of the storm would still think they had a job so they would report that they were employed.

Where the storms would have an impact is on the average work week and aggregate hours worked. Consequently the drop in aggregate hours worked and the weakness in weekly average hourly earnings probably was due to the storms. But we will have to wait until next month to really know.




However, the continued weakness in average hourly wages and weekly wages is a feature of this cycle and probably was not impacted by the storms.


Many look at weekly earnings as a leading indicator of consumer spending, and I know I am sometimes guilty of this. But the historic record is that real earnings is actually a lagging indicator of consumer spending at cyclical bottoms. Over the course of an expansion, and at cyclical peaks real income is very much a concurrent indicator of consumer spending. but at bottoms consumer spending is driven more by lower rates, better consumer confidence and lower inflation. Retail sales are highly skewed with the upper 40% of the income spectrum accounting for over 60% of retail sales. So the important factor is people who have stayed employed and those whose income stems from non-wage sources deciding to spend. Often this
is driven by greater wealth; especially from the stock market and rebounding home prices.
We are getting the higher stock market this cycle, but not the rise in home prices.


Historically, once the unemployment rate peaks, as it apparently has this cycle, it continues to fall for one to two years. Even in the last two cycles when the peak unemployment rate lagged the economic trough by months the unemployment rate continue to fall once it had peaked.
So the standard forecast, even by the administration and the CBO, that the unemployment rate will remain around 10% is a forecast of something that has never happened. I'm not saying that weak growth and high productivity can not keep the unemployment rate near the peak of 10%, but it is something that has never happened.

by Bruce Webb

There has been a scattering of stories about how China has slowed or stopped buying U.S. Treasuries. This story offers a possible explanation

LA Times: China's investments in U.S. up sharply

Beijing is using its accumulation of billions of American dollars to step up its investments around the globe. In the last year, Chinese acquisitions in the U.S. have ranged from a relatively obscure theater in Branson, Mo., to stakes in such famous brands as Coca-Cola and Johnson & Johnson.

China's huge stockpile of dollars stems in part from Americans' enormous purchases of relatively inexpensive Chinese manufactured goods and the significantly smaller volume of U.S. exports to the Asian country.

By recycling much of its dollar trove over the years back to the United States with the purchase of U.S. government debt, China has in effect helped Washington finance its deficits.

Now, Beijing is branching out. The country's direct investments overseas rose 6.5% in 2009 to $43.3 billion -- despite a global slump in such investments -- and could jump to $60 billion this year, Chinese state media reported last week.

Formal estimates of Chinese investments in the U.S. last year, excluding bond purchases, range from $3.9 billion -- a figure put out by New York research firm Dealogic -- to $6.4 billion, a number that comes from Derek Scissors, a Heritage Foundation research fellow who tracks China's global transactions

I'll let the econoBears explain the significance here, my flip summary would be "Why rent when you can own". It certainly doesn't indicate that the Chinese are expecting some terrific crash in the medium term.

This is a guest contribution by Marshall Auerback, Braintruster at the New Deal 2.0 at Newsneconomics

By Marshall Auerback

My colleague, Rebecca Wilder, recently concluded a "Tale of Two Recoveries: Malaysia vs Germany" which brought back memories of my own time in the Far East and some of the advisory work I did for the government of Malaysia during the financial crisis of 1997/98.

Before the historical revisionists get hold of this period, it is important to note that Malaysia’s initial response to the crisis was a textbook illustration of how to exacerbate, not alleviate, a financial crisis. Of course, it was a consequence of taking stupid and economically ruinous advice from the International Monetary Fund, which is to economic development what John Meriwether is to asset management. If anybody had any doubts, those of us who observed the crisis first hand realized that the IMF and the so-called “Committee to Save the World” were more interested in saving the first-world banks who were exposed than caring about the local citizens who were scorched by harsh austerity programs. Same old, same old.
It was only when the Deputy PM/Finance Minister was ousted from the Cabinet and his pro-IMF policies completely repudiated, that Malaysia’s economy began its long road back to successful recovery.

There is little question that former PM Mahathir Mohammed was a political thug, but not an economic illiterate. But his sacking of Anwar from the Cabinet and decision to press ludicrous sodomy and abuse of power charges against his former heir apparent foolishly undermined his economic legacy. It is certainly wrong, however, to criticise his response to the Asian financial crisis of 1997/98. Vindicated now with the benefit of hindsight, at the time his embrace of exchange controls, and a 180-degree reversal away from the policies of austerity advocated by the Fund, were viewed as dangerously anti-free market, destined to render Malaysia an investment pariah.

Before the temporary triumph of the so-called “Washington consensus” school of economics in the late 1990s, the so-called “interventionist” East Asian alliance model of capitalism was highly lauded by institutions such as the World Bank and even the IMF itself. A common thread characterizing the economic development of countries such as Thailand, Korea, Singapore, and, yes, Malaysia, were policies which transferred resources away from “unproductive” toward “productive” uses—often in the form of transfers from unproductive groups to productive groups and sometimes in the form of policies to convert unproductive groups into productive ones. Creating “rents” (above normal market returns) by “distorting” markets through industrial policies was essential, first, to induce more-than-free-market investment in activities that the government deemed important for the economy’s transformation, and second, to sustain a political coalition in support of these policies. Disciplining rent-seeking so that it remained consistent with these two objectives was also essential.

It was precisely this model that came under such sustained attack during the late 1990s. Then Secretary of the Treasury Robert Rubin, his Deputy, Lawrence Summers, and their lieutenants saw the crisis as the perfect opportunity to destroy this model once and for all, and to do this, they wanted the International Monetary Fund to impose conditions on the economies of emerging Asia that went far beyond the Fund’s traditional boundaries. Thus the U.S. Treasury kept steady pressure on Fund officials to extract more and more concessions from South Korea, Thailand, Indonesia, and Malaysia including instant resolution of all trade related issues in favor of the United States. The exasperated Asians were soon accusing the IMF of always raising new issues at the behest of the United States—something that the Fund officials readily acknowledged later.

Foremost in the minds of Treasury officials was also the interest of Wall Street, especially American financial services firms. These biases were manifested in the types of IMF conditions imposed on the emerging Asian economies during the height of the crisis, which clearly served the brokerage firms on Wall Street far better than the needs of emerging Asia.

In the early 1990s the economies at the core of the world economy (the U.S., “Euroland,” Japan), began to generate hugely excessive liquidity. In the early 1990s, mutual funds, pension funds, other institutional investors, hedge funds and—last but not least—banks became awash with deposits. They scoured the world for high returns. Investment houses like Goldman Sachs and Morgan Stanley sought the business of arranging the privatizations, securities placements, mergers, and acquisitions that surged on the wave of liquidity—business that became their main growth area. As a consequence, financial capital poured in to “emerging markets” (middle-income countries of recent interest to institutional investors).

Capital flows to developing nations in Asia and Latin America jumped from about $50bn a year before the end of the Cold War to about $300bn a year by the mid-1990s. From 1992-96, Indonesia, Malaysia, Thailand, and the Philippines were all experiencing money and credit growth rates of between 25-30 per cent a year. Emerging market stock markets boomed, nearly doubling their share of world capitalization between 1990 and 1993.

Proponents of capital liberalization justified these inflows on the grounds of (a) maximizing the efficiency of capital worldwide, (b) allowing a specific country to invest more than could be financed from its own savings, (c) bringing modern financial institutions into the country, and (d) deepening the liquidity of the country’s financial system and lengthening investor horizons, thereby making markets more efficient and more stable. In the end the case for free capital flows came down to the classic theory of comparative advantage, as though trade in dollars was essentially similar to trade in widgets.

In reality, however, the funds went into increasingly marginal and speculative developments and simply exacerbated an underlying credit bubble. Although they did not speak out at the time, a number of prominent economists and financiers have since pointed out the dangers of such “gypsy capital”. Joseph Stiglitz, for example, argued that the origins of the Asian financial crisis rested, in the first place, with the excessively rapid financial and capital market liberalization that the U.S. Treasury had pushed on these economies, on behalf of Wall Street, and over the protests of the Council of Economic Advisors, of which he was the chairman. “At the Council of Economic Advisors we weren’t convinced that South Korean liberalization was a matter of U.S. national interest, though obviously it would help the special interests of Wall Street” (Globalization and Its Discontents, New York: W. W. Norton, 2002, p. 102).

Similarly, Jagdish Bhagwati, one of free trade’s most passionate supporters for developing nations, argued that the idea of free trade had been “hijacked by the proponents of capital mobility”.

The end result of this drive to liberalise capital accounts in immature emerging economies was a series of booms and busts, culminating in financial crisis. Capital flows into emerging markets turn out to be less a diversification of assets, more another instance of “investment herding”, especially within regions, where market allocation was propelled less by differences between countries in their “fundamentals” (including “good” or “bad” policy) than by “push factors”—macro push factors like the amount of excess liquidity in different parts of the core zone of the world economy; and micro push factors like the incentives on institutional money managers and the corresponding drive to match the “benchmark weightings” devised by pension fund consultants, many of knew nothing of the various underlying markets. Money managers tend to be evaluated relative to the median performance of money managers in the same asset class. This encourages them to move in and out of markets together, producing “herding” or “trend chasing” or “positive feedback trading” and the crisis of 1997/98 was a textbook illustration of that phenomenon.

Malaysia was heading down this road in 1997. The currency, the ringgit, was collapsing, as the contagion effects from Thailand, Korea and Indonesia gradually extended into the country. Although Anwar had not placed the country under a formal imf program, he had been following the imf recipe: to forestall capital flight, fiscal policy was tightened and interest rates were hiked in order to protect the external value of the currency.

Based largely on their experience in Latin America, the Fund had already imposed directly these measures on Thailand, Indonesia, and Korea. The problem, however, is that whereas fiscal deficits have tended to be large and inflation chronic in Latin America, in the economies of emerging Asia, budgets had long been roughly in balance. In addition, as the Funds’ economists were unschooled in the links between macro conditions and corporate balance sheets, they failed to perceive the danger of high real interest rates in economies with high debt/equity ratios and low inflationary expectations. High real interest rates have deflationary and crisis-signalling consequences that prompt capital outflows regardless of the attractions of the high rates themselves.

Which is precisely what began to occur in Malaysia. The Malaysian economy experienced a contraction of credit growth from 30 percent in 1997 to minus 5 percent in 1998, reflecting a massive pullback of bank loans. The ringgit plunged, as capital outflows accelerated. A real estate collapse loomed.

Ultimately, seeing the failure in these policies, Prime Minister Mahathir sacked Anwar, and re-imposed capital controls to insulate his economy from the deleterious consequences of rapid hot money outflows. (The trumped-up political charges, which led to the latter’s imprisonment, only came later.) Monetary and fiscal policy became expansionary, the ringgit was pegged to the US dollar, and crisis credit conditions began to diminish as domestic rates were reduced drastically. Although Western finance ministries and institutional investors protested apocalyptically and predicted that Malaysia would remain beyond the pale of the investment world for the foreseeable future, six months later even The Economist, one of the IMF’s great apologists, was forced to acknowledge that the embrace of capital controls had done “short-term wonders” in assisting recovery.

This is all old history. But it is worthwhile recalling the actions of the Fund in the context of what it is advising countries like Iceland and Latvia to do today. Or when considering the hair shirt economics which seems to be championed by Germany’s economic elites.

by Rebecca Wilder

The Federal Open Market Committee (FOMC) is making tough decisions right now. Its mandate, “to promote effectively the goals of maximum employment, stable prices, and moderate long-term interest rates”, is a seriously tall order given current economic conditions.

The unemployment rate sits at 9.7%, while prices have bounced back to 2.6% Y/Y in January. On the surface of it, inflation appears to be gaining some traction; but the big numbers are representative of base effects, and that is really all. The drag on prices remains very real.

But there is one little kink in the headline figures of unemployment that complicates an already complicated task: extended unemployment insurance. From the FOMC's Jan. 26-27 minutes:

Though participants agreed there was considerable slack in resource utilization, their judgments about the degree of slack varied. The several extensions of emergency unemployment insurance benefits appeared to have raised the measured unemployment rate, relative to levels recorded in past downturns, by encouraging some who have lost their jobs to remain in the labor force. If that effect were large--some estimates suggested it could account for 1 percentage point or more of the increase in the unemployment rate during this recession--then the reported unemployment rate might be overstating the amount of slack in resource utilization relative to past periods of high unemployment.

Why would extended unemployment benefits increase the unemployment rate? In order to claim unemployment benefits, one must be "in the labor force"; and that means looking for work. Therefore, some workers who would otherwise be classified as "not in the labor force" remain in the work force as "unemployed". Therefore, the current unemployment rate is elevated above the rate that would occur without the extended benefits. The Fed suggests this differential to be roughly 1% point.

I am in no way proposing that the extended benefits be rescinded; nor am I deluding myself into thinking that the labor market is anything short of awful. But Fed policy is calibrated to the non-inflation-generating level of the unemployment rate. And the current unemployment rate may be closer to the long-run level than the headline number suggests.

I have talked about this before (see this post) from another angle: the long-run level of unemployment may be a moving target right now, i.e., it's likely rising. Therefore, if the long-run level of unemployment is rising and subsidies are masking the true level of the current unemployment rate, then we may very well get some inflation while the economy is still weak.

Of course, I do not believe that we are even near such a threshold level; but it does complicate an already complicated situation. A modified Taylor rule demonstrates the implications for policy.

The chart above illustrates the estimated Taylor Rule using the current unemployment rate (in blue line) versus one in which 1% point is shaved off the unemployment rate for every month since January 2008 (green line). The modified rule does suggest that the Fed policy rate is currently at (or now below) the prescribed rate.

Just some food for thought. Rebeca Wilder crossposted with Newsneconomics