All things being equal

As a predictor of economic and financial gloom it is always tempting and wonderfully schadenfreude-like to say I told you so. In fact, I did this the other day.

But I've got to admit that I did not expect the current crisis to freeze out the credit markets as quickly and as terribly as it has done. My feeling over the past few years has been that the coming recession would be a gradual affair with many stops and starts. I predicted that the driving force behind the slowdown would be Peak Oil, and that the effect of declining oil production would lead to a Depression-like economic hit - though with a difference. What was this difference? Not much deflation, no severe decline in GDP and no big unemployment spikes beyond 20%. Instead, we would see a severe restriction in economic growth over a long period which would see unemployment levels being persistently high but without spiking. Probably the best post I made about this subject was back in March.

Yet somehow my prediction was too conservative. It seems like the US economy was much more fragile than I thought, and the current crisis seems to be leading into a more 1930s type depression with big falls in GDP and big spikes in unemployment.

One of my favourite little phases that I have created is "All things being equal - but all things are not equal". This is, in a sense, a way of describing a "Salient Oversight" - a part of the equation that has been missed. That I should be guilty of a salient oversight is wonderfully ironic.

So what is this salient oversight that I had missed? It began a little over two months ago when I saw this graph:

I even posted about it here.

The first time I saw that graph it frightened the heck out of me. It still does. The reason is not because it somehow disproved my basic belief that Peak Oil would create a horrible depression. Rather, it showed me that the US economy was ripe for disaster anyway.

Let me explain the issue with this graph. The graph shows that US credit market debt exceeds GDP by around 350%. The fact that credit markets have debt levels that exceed GDP is obviously not always a problem - the 1950 to 1980 period never saw credit market debt increase or decline precipitously despite a series of recessions and periods of high and low inflation.

But then, of course, we see the 1930s spike. That spike did not cause the great depression - it was a result of it. Moreover, credit market debt increased during that period not because people were borrowing lots in that period (the opposite in fact), but because GDP was declining while debt levels slowly increased.

And then we see the exponential curve from 1985 until today. By itself, any exponential curve should warn us of terrible danger. The lesson? The US economy was ripe to collapse. The high oil prices from 2004 onwards - brought about by production plateaus being reached as a precursor to oil supply peaking - and the subsequent interest rate hikes was what eventually set off the current crisis.

Back in 2005 I predicted that there were four things which which would create a "perfect economic storm" that would severely damage the US and world economy. These were:

1. Peak Oil
2. US Government debt
3. The collapse of the housing bubble (now referred to as the subprime meltdown)
4. An unsustainable current account deficit
   

In retrospect, the enormous amounts of credit market debt were not a 5th reason I should've added. This is because reasons 3 & 4 - the housing bubble and the current account deficit - were integral parts of the credit market debt. As the curve continued exponentially upwards and the credit market continued to create massive levels of debt, a housing bubble formed along with the desire of the market to invest in US Dollar assets (which led to a current account deficit).

But as I have mentioned before, none of this has removed the threat of Peak Oil. Instead, it has made the situation intolerably worse. Peak Oil was always going to cause a massive economic shift - but that it should occur during a time when the world's economy was already at a turning point is a horrible convergence of events. In many ways I feel like the forecaster who predicted a category 5 hurricane and the deaths of thousands, only for the hurricane to be category 6 (if that were possible) and cause the deaths of tens of thousands.

So now that I am even more gloomy, what will happen?

It is obvious that the current economic crisis will result in a substantial contraction in world economic output. This crisis was of its own making but was set off probably earlier than expected because of high oil prices that were the direct result of oil production plateaus. The economic contraction will inevitably result in a drop in demand for oil, but the danger posed by Peak Oil still remains. Once the world economy begins to recover, oil production issues will stifle growth and economic expansions will be severely limited. Unemployment levels are likely to spike high in places, and in the US I believe that unemployment levels in the "teens" is likely. Moreover, while a recovery will result in employment growth, the continued high oil price of oil will keep unemployment levels uncomfortably high for many years.

Again, the only solution to this is for the US and other countries to follow the austerity guidelines of the Washington Consensus that I have posted about here. Moreover, in order to wean ourselves off oil dependence, nations must invest in public transport and in the design of electric road vehicles.

And as for you, the reader, I simply suggest that you pay off debt as fast as you can and live within your means.

4000 words

Scary quotes

I've been scanning econ-comments recently. "We're all going to die" comments are a dime-a-dozen amongst the gold-loving Ron Paul fractional banking haters that have been around for years, so they don't really matter since the elephant powder is obviously working its charm.

But what is really interesting are these quotes:

I don't get angry about economics related things often, but I am right now (I could not have posted what I was really thinking). Congress needed to get something done. This is completely disfunctional. Disgusting. This shows no regard for people who might lose their jobs over this. I know a lot of you think we can get through this - you are nuts to take that chance, this is extraordinarily dangerous - why do you think all the economists are so scared, the ones you've trusted in the past, the vast majority are willing to say "hold your nose" but please, please vote yes (even Galbraith, Baker, Krugman, all of them).

- Mark Thoma, Associate Professor, Department of Economics, University Of Oregon

So what we now have is non-functional government in the face of a major crisis, because Congress includes a quorum of crazies and nobody trusts the White House an inch.

As a friend said last night, we’ve become a banana republic with nukes.

- Paul Krugman, Professor of Economics and International Affairs at Princeton University.

And if this run accelerates - as it may now - a total meltdown of the US financial system could occur. We are thus now in a generalized panic mode and back to the risk of a systemic meltdown of the entire financial system. And US and foreign policy authorities seem to be clueless about what needs to be done next.

- Nouriel Roubini, Professor of Economics and International Business, New York University.

Experts in any field are usually judicious and careful in their pronouncements. But even a seasoned vulcanologist with PhDs coming out of his ears will still be running through the street shouting warnings as the Volcano erupts nearby.

In short - even my judiciousness over the past 2-3 years appears misplaced in the light of these alarming comments by financial experts. They say run. We'd better run.

Wait... what?

It's amazing what happens after one night's sleep.

I live in Australia. I went to bed last night at 1.30am watching the market tank and commenting on Calculated Risk comments threads. 1.30am Australian time equals 11.30am New York Time.

So I wake up this morning, turn on the news and discover that congress "failed the bail".

None of this really affects the medium-long term. But in the short term it led to some wild share price rides.

We can only hope that the Swedish model (nationalization) gets presented as a real alternative.

PS - I have a job interview in just over 2 hours.

Update:
I've been reading around the blogs. Econ-bloggers are pretty much unified in their shock at what has happened, with the notable exception of Mish who has been leading the charge against The Big Bailout^TM. As far as lefty bloggers are concerned the attitude is more mixed. Kos is happy that congress did the right thing but others I have read seem more interested in blaming McCain for everything. All this indicates that, politically, the issue is not Republican vs Democrat or Conservative vs Progressive, but seems more based upon what is seen to be a good idea vs a very bad idea.

Update 2:
The bill was derailed by Republicans. Yet even Michael Moore was against the bailout. Shows just how divisive the bill was that House Republicans and Michael Moore can agree on something.

So what's next?

You can almost hear the sound of billions of people on planet Earth going "WHEW!". Despite shortcomings in The Big Bailout^TM, there was no real doubt that the bailout itself was needed. And if there are some major problems with its details, Congress can just create an eventual alternative.

The news was greeted by a 1.5% increase in the value of the US Dollar as investors all around the world celebrated the weekend meeting's outcome.

But what happens now?

There is every chance that this coming week will see a continuation of the market turmoil we've been having for the past few weeks. Wachovia is teetering on the edge, and the failures of financial firms and banks in the last fortnight - some with decades of service in the economy - will still rattle people.

Then again, there is also every chance that this week won't see much happen at all. There's not even any assurance that Wall Street stock indexes will rise today - here in Australia they dropped 2% despite the success of The Big Bailout^TM

As a self-proclaimed futurist and econ-prophet, I can say, yet again, that I am absolutely no good when it comes to actual dates. My record in predicting in the short-term is patchy. Yet when it comes to the long term, I am more than happy to point at my record.

Put simply, The Big Bailout^TM is not going to turn the economy around. There is still a long way for the economy to fall. Unemployment will, I believe, exceed the November and December 1982 figures of 10.8% sometime within the next 12-18 months. Moreover, I believe that GDP will decline in 2008 Q3 (now), 2008 Q4 and 2009 Q1 at least.

But one of the most important issues that I have spoken of in recent times is the potential for capital flight - when investors sell off US investments and purchase other currencies (such as the Yen and the Euro). Despite the bailout I still think this is a danger. Why?

We need to remember that The Big Bailout^TM has not and will not magically cure the ails of the sharemarket. Putting aside all the complaints about socialism for the rich and the importance of moral hazard, The Big Bailout^TM has merely been a massive transfer of debt from the market to the government. Instead of the market having to pay for their sins, The Big Bailout^TM has had its wrongdoings transferred onto taxpayers and, as a result, the relative strength of the US dollar.

While this form of financial propitiation has the purpose of limiting the net damage, it remains to be seen whether the transference will end up crucifying both taxpayers and Wall Street. Any crash in the value of the dollar would drive the economy quickly into an economic apocalypse that will have many yearning for a messiah to come and save them.

And yes, if you know anything about Christian Theology, I agree that the last two paragraphs might come off as cheesy.

But all this comes back to the points I have made recently about The Washington Consensus. If the US Dollar is to remain healthy (and by that I mean not falling through the floor) then harsh policy measures need to be put into place - and the sooner the better.

Back in February I argued that Austerity is the cure to America's ills. Just as an obese, unhealthy person should cut down on their food and exercise more if they are to return themselves to health, so too must the US go through a period of lower consumption and harder work. America's days of being the world's biggest consumer and borrower are over - in its place must come a period of realignment where the US begins to save and produce.

The Botched Big Bailout

Well it seems that the Big Bailout^TM is getting harder and harder to pass Congress. I haven't been looking for the finer details, but I pretty much gather that the major problems are:

• The nature of the bailout, which seems to be throwing money at banks and financial institutions rather than buying them out (which was the Swedish model).
• The idea that bad behaviour should be rewarded.
• The idea that the US government is engaging in the worst sort of "socialism for the rich".
• The threat posed to public debt, which is already too high.
• The belief that the market should simply run its course.
• The fear that the bailout will have little or no impact on the problem.
• The fear that the bailout grants too much power to the US Treasury.
  

There is a sizeable group of Republicans who are refusing to pass the bailout in its current form. Essentially the issue is one of trust - is Hank Paulson's bailout sufficient enough to solve the problem or not?

My personal opinion is that both sides of the argument have merit. The Democrats and Republicans who support the bailout are doing so because they truly fear the consequences of the current economic crisis. The Republicans opposing the bailout are doing so out of fear that the consequences of the bailout will outweigh the benefits.

This is not a time for partisanship, yet I don't think anyone is being too partisan here. It's not that I have confidence that Congress will make the decision (I don't), but, in this particular case, I am not questioning their motives. There is enough fear and doubt on both sides to make the decision hard to make.

So let me offer some level of solution, not that anyone will listen to me, of course.

I believe that some sort of bailout is needed. I'm not convinced that the Paulson plan is the best way to do it, which is why it is good that Congress is debating these measures. The best outcomes we can possibly hope for is for the money to give financial institutions some breathing space while the economy tanks and, eventually, recovers enough so that the billions used in the bailout get paid back over time. In other words, the bailout has to take resources from the future in order to secure the present.

The more I look at the Swedish solution, the better it looks. Rather than throwing money at the problem (which seems to be the Paulson plan), it would be better if the government bought out the struggling financial firms - in other words, nationalization. This would allow the institutions to keep running and providing (albeit limited) levels of credit without the threat of bankruptcy. Yet the nationalization will be temporary - lasting no more than ten years maximum. In that time the financial company is made leaner and meaner and then eventually unleashed back into the market when the Federal government fully privatizes it - with the proceeds from privatization paying back the debt accrued from the original buyout.

Moreover, I suggested earlier the importance of instituting some form of market capitalization tax as a means to pay back the debt as well. I am absolutely certain that the Swedish model I propose in the previous paragraph will NOT result in all of debt being paid off. Therefore another form of revenue should be instituted. I am loathe to suggest income tax rises since I believe that the people of America should be the last to directly pay tax to save Wall Street. A market capitalization tax (Market capitalization is when a listed company's share price is multiplied by the amount of shares) would be a broad-based tax upon all publicly owned companies that would help pay off the debt. In essence, future Wall Street profits would be taxed to pay for the present rescue - which is why I describe it as "taking resources from the future to secure the present".

I gotta tell you though that even with the best bailout there is nothing that will stop the US from going into a deep recession. As I have said in comments threads on other blogs, the best thing to do at the moment is for individuals to pay off debt and live within their means. Moreover, even with hundreds of billions of dollars (or even more) being hurled at the problem, US economic policy in the medium to long term should be focused upon the points I have reiterated before and yet again remind you:

• Cut military spending
• Raise taxes on the rich
• Run a fiscal surplus to pay off debt
• Use interest rates to keep inflation low
• Re-regulate the financial industry to prevent such a crisis from occurring again
• Fire Ben Bernanke
• Create a universal health care system that will cut present health costs

I still think that a crash in the US dollar is likely and that the coming recession will probably end up rivalling the great depression - and I say this even if a bailout goes ahead. There is nothing anyone can do to reverse the problem, but there is plenty that can be done to limit any future damage.

GDP figures due today

The revised 2008 Q2 GDP figures are due out today. Click here to view the actual release when it happens, which will be 12.30GMT/8.30EDT.

And, as usual, I will be commenting in the 30 minutes after the release, along with linking to sites which deal with it.

Just to summarise what has happened so far with the 2008 Q2 figures:

• The original release (July) had 2008 Q2 GDP at 1.9%.
• The second release (August) revised Q2 upwards to an unbelievable 3.3%.
• The August release created a storm of commentary from many econ bloggers about the reliability of the 2nd release - the argument being that there was something amiss about the GDP deflator.
• The questions about the 2008 Q2 GDP figures were lost in the turmoil of the last two weeks.

What's my take on the third release (due in just less than an hour)? Well I'm glad you asked. Caveat - my predictions on short-term releases like this have been more than educated guesses and I have got them wrong in the past, so take my opinions here with a grain of salt.

I certainly think that the 3.3% figure from last month is not going to be repeated. There will probably be a downward revision of GDP. I think there's a 50% chance of the revision hitting somewhere between 1.9% and 3.3%, a 50% chance of the revision being below 1.9%, a 10% chance of a negative reading (a contraction in the GDP) and a 3% chance of my Mathematics skills improving.

As soon as the figures get released I'll post a direct download link so you can peruse it yourself. Stay tuned here for updates.

Update 12.34GMT/8.34EDT

2.8%

Direct download here. (pdf, 156kb)

I still think this is too high but this is revision #2 so the chances of it being wrong this time around are much less. The growth probably has a lot to do with the stimulus checks and interest rates. 2008 Q3, however, is looking like a bloodbath and will be released next month.

Update 12.39GMT/8.39EDT

So far no one has picked it up. It's not low enough to make people baulk and isn't high enough to give anyone any confidence.

Update 12.50GMT/8.50EDT

Bloomberg finally says something:

The U.S. economy expanded at an annual rate of 2.8 percent in the second quarter, slower than the previous estimate, as consumer spending and trade added less to growth.

The revised figures were down from a preliminary estimate of 3.3 percent issued last month, the Commerce Department said today in Washington. Measures of inflation were higher than previously projected. Net exports and business investment contributed less to the gain in gross domestic product than the prior estimate, the report showed.

Consumer spending has since stalled, businesses have put investment plans on hold, builders have scaled back and credit markets have seized up. Economists at JPMorgan Chase & Co. and Morgan Stanley this week cut third-quarter GDP forecasts and Federal Reserve Chairman Ben S. Bernanke warned the economy may falter without a $700 billion bank rescue.

...

Economists had projected growth would remain unchanged at 3.3 percent, according to the median of 76 estimate in a Bloomberg News survey. Forecasts ranged from 3 percent to 3.7 percent. Today's report is the final of three estimates.

...

Today's gross domestic product report showed that the Fed's preferred measure of inflation, which is tied to consumer spending and strips out food and energy costs, rose at a 2.2 percent annual rate, higher than forecast and faster than the 2.1 percent previously estimated. Prices overall came in less than anticipated.

I warned everyone about inflation didn't I? And all those economists got it wrong while I got it (50%) right.

Update 13.00GMT/9.00EDT

Nothing left to say about GDP. However I do recommend any and every reader here to go over to Calculated Risk and join in the Haloscan discussions there. They can be quite interesting and people often discuss events as they happen on the comments thread. Just go to the top article and click on the comment tag and read people's wisdom / panic.

No gas in Charlotte, North Carolina

From the Charlotte Observer:

Much-needed fuel appears to be on the way to the western Carolinas, including Charlotte, even as honking rush-hour commuters idled in lines and occasionally fought at stations that weren't out of gas.

At least one man was charged with pulling a gun during a dispute at a gas pump, police say.

Witnesses told Taylorsville police that Todd Lackey pointed a .45-caliber handgun at another driver after they pulled up to a pump at the same time and started arguing. Lackey fled, but witnesses got his license plate number and police later charged him with assault by pointing a gun.

Earlier Thursday, a deputy director for the U.S. Department of Energy told local officials that a large shipment of gasoline should arrive in Asheville and Spartanburg, S.C., today and "an extremely large shipment" in Charlotte tomorrow, Charlotte Mayor Pat McCrory said.

During a news conference at the Government Center uptown, McCrory said he had spoken to Energy Department Acting Deputy Secretary of Energy Jeffrey Kupfer, who told him about the shipments.

Motorists in Charlotte have waited in line for hours over the last two days as fuel shipments dried up because Gulf hurricanes temporarily disrupted refinery production. Rush hour commuters in Thursday afternoon traffic slowed down as they passed gas stations, looking for tell-tale bags on the pumps.

Many of the stations ringing Charlotte's uptown were out of gas. On South Boulevard at Ideal Way a small Shell station was crammed with cars that were lined up for blocks waiting, clogging traffic, honking and slowing the afternoon rush.

Update:
Here's a US gasoline supply graph from The Oil Drum:

Too big to ...?

An interesting question was asked by "JS" at a recent Calculated Risk comments thread that I was just reading through:

Is there a new category beyond "too big to fail"? Something like so big its gravity collapses and creates a black hole?

Being the wordsmith and poet that I am, I immediately recognised what the new category is:

Too Big to Bail

Deconverted from Greenspanism

Finally some are seeing sense. Brad DeLong, UC Berkley economist and former Clinton advisor, has publicly announced that he has given up his faith in "Greenspanism":

For a decade now, I have been a follower of Greenspanism --the doctrine that I name after former Fed Chair Alan Greenspan that the constraint on expansionary monetary policy is inflation and inflation alone. The idea is that the first priority of the central bank is to maintain low consumer price inflation, and that the second priority is--given low current and forecast consumer price inflation--to maintain maximum employment and purchasing power--and the third priority of the central bank is that there is no other third priority.

Opposing Greenspanism is what I call Mussaism[2]. Mussaism--the doctrine I name after former IMF Chief Economist Michael Mussa--holds that there are two constraints on central bank activity. The central bank must insure:

1. No large asset bubbles.
2. Consumer price stability.

Only after it has successfully achieved these two higher priorities can it then even begin to worry about:

3. Maximum employment and purchasing power.

The Greenspanist retort to the Mussaites--a retort I would have said I believed 100% a year and a half ago, 90% a year ago, and 60% last March--is that creating unemployment and idle factories because you are scared of what might happen when irrational exuberance dies away and asset prices collapse is a crime; that modern central banks are powerful; that they can successfully manage whatever crisis is provoked when it happens; and that it is easier to sweep after the elephants have gone through than to try to stop them--especially when stopping them requires the destruction of millions of jobs.

I don't see how I can maintain my belief in Greenspanism today[3].

Therefore I abjure, I recant, and I do penance. I transfer my allegiance and fealty to Michael Mussa, who is my new guru.

To which I replied in the comments:

I would argue that inflation was NOT a priority of Greenspan's - the inflation rate was way too high even though it was "low" by historical standards. Moreover, even with "low" inflation between 2003 and 2005, real interest rates were negative and were the main cause of the investment bubble.

So I would amend the central bank's mission as follows:

1) Maintain absolute price stability (an average of zero inflation over the course of the business cycle).

2) Positive real interest rates... always.

The above together will prevent asset price bubbles and help maintain economic growth and employment.

One of the problems of the later Greenspan era were two major asset price bubbles - the tech boom and the subprime boom. Both bubbles popped and caused a recession (the latter being the more serious one, although it could probably be argued that the two are linked). Moreover, both bubbles were blown up during a period of "low" inflation.

"Inflation targeting" is one major mission of central banks. The Fed, unlike the European Central Bank and other international central banks, does not have a hard and fast rule like the ECB (eg inflation kept below 2%). Absolute Price Stability is simply inflation targeting that ensures "zeroflation" over the course of the business cycle. This is not deflation (since deflation is not price stability either) and nor is it a knee-jerk reaction to cyclical price rises (eg food and oil). The idea is that interest rates are adjusted to ensure that a cycle of slight inflation and slight deflation balance one another out.

And, as I commented at DeLong's site, the creation of asset price bubbles will be prevented by such strict monetary policy.

We told you so (sadly)

Econ bloggers like myself have been saying for years that a big crash was coming. This sort of prediction was not the sort of thing you would find in the deepest, darkest corners of the internet amongst conspiracy theorists and DIY economists - rather, it was the result of study, thinking, logic and discussion.

As a result, we Cassandras (the red headed lady you can see in the picture) have been cursed with the knowledge of the future without the means to convince anyone who mattered.

My own prediction came about in August 2005. In that prediction I spoke about a "perfect storm" (a phrase that was not used as often as it is now of course) which included four main points:

• A housing market crash.
• A US Dollar crash.
• Rising oil prices caused by peak oil.
• Government debt becoming unsustainable.

It would be nice to think that I was the only one saying these things, but credit where it's due - a whole host of doomsayers were discussing these issues before I took them up. But, as far as I know (and this is self-promotion time), I was the only one to put them all together.

And it's annoying because if I had the means I could have made myself quite rich if I had invested enough money into markets I knew would be affected. Back in 2004 when I first understood Peak Oil I was kicking myself with annoyance that I didn't have the means to purchase shares in oil companies that I knew would shoot up as Peak Oil got worse.

And it's annoying also because people in power were totally ignorant of the dangers. Take Ben Bernanke - in July 2007 he was assuring everyone around the world that the subprime bubble was contained. One month later the market tanked and since then the world has been in perpetual economic crisis. Why is it that people like Bernanke get to be in well paid positions of power while Cassandras like myself, who saw the coming storm, get ignored.

As soon as Bernanke dropped rates last year I made the prediction that oil would go beyond $100. In January of this year I predicted that the US would be stagflating. In March this year I even proposed my own version of The Big Bailout^TM that has since become rather important.

The reason why I posting this is that I'm feeling rather cheesed off. I don't like the fact that the world is about to go through the Second Great Depression^TM. I don't like the fact that people are losing jobs and going through emotional and financial stress, leading to marriage breakdowns, suicide and crime. I don't pretend to hope for a utopia but I I unashamedly believe that good policy and foresight can help limit the damage caused by human stupidity.

So there is no schadenfreude, no gleeful shouts of joy over rising bankruptcies, rising unemployment and economic decline amongst us economic Cassandras. Only head shaking and annoyance.

The Far Left Side.

How about a Market Capitalization Tax?

I've been thinking about ways and means of raising the revenue to pay for The Big Bailout^TM. I came up with this idea today but, as usual, someone else has beaten me to the theoretical punch some time ago. (see here, pdf, 455kb)

Basically the idea would be to tax every and any company listed on US sharemarkets. A tax is paid to the Federal government on a percentage of the listed company's market capitalization. This tax revenue is then used solely to pay back The Big Bailout^TM and remains in place until the money has been paid back, with interest.

What tax rate should apply? One solution is a quarterly tax of 0.2% of a company's market capitalization (see here). In any case, whenever a listed company's market capitalization goes up, they are required to pay more tax - and pay less tax when it goes down. A quarterly tax could be based upon the average market capitalization of the previous three months.

Given the nature of the financial crisis and the fairness of punishing those responsible rather than burdening everyone with the debt, a "Cap Tax" is probably the best solution.

Unless someone takes my Zero Tax Proposal seriously that is.

Fallen is Babylon the great!

And the merchants of the earth weep and mourn for her, since no one buys their cargo anymore, cargo of gold, silver, jewels, pearls, fine linen, purple cloth, silk, scarlet cloth, all kinds of scented wood, all kinds of articles of ivory, all kinds of articles of costly wood, bronze, iron and marble, cinnamon, spice, incense, myrrh, frankincense, wine, oil, fine flour, wheat, cattle and sheep, horses and chariots, and slaves, that is, human souls.

The fruit for which your soul longed has gone from you, and all your delicacies and your splendors are lost to you, never to be found again!

The merchants of these wares, who gained wealth from her, will stand far off, in fear of her torment, weeping and mourning aloud, "Alas, alas, for the great city that was clothed in fine linen, in purple and scarlet, adorned with gold, with jewels, and with pearls! For in a single hour all this wealth has been laid waste."

(Revelation 18, thanks to the internet monk)

Tax increase plan must follow bailout

Details, details, details.

I'm personally not interested in the finer points of the Paulson bailout plan. Whether it is an undemocratic grab for power or some sort of corporate welfare is really not the issue for me. I reluctantly agree that some sort of bailout is necessary, but I am no real supporter of Paulson and Bernanke, nor the financial system that got itself into this mess in the first place. Without some sort of relief, the US credit system would seize up and, although this is somewhat deserved, the collatoral damage for the rest of the economy would be too high.

So, the bailout is necessary. But I'm not going to stop there. With such a massive amount of debt added to the public accounts, the Federal government will be paying back this debt for years to come. Short term relief? Yes. But long term pain as the government struggles to repay the debt.

WIthout some way of paying for the debt, the only option seems to be tax increases. The bailout plan is just too large, and US government spending is just too (relatively) small for any form of expenditure cutting on behalf of the government - unless, of course, Americans are happy to suddenly give up Social Security or shut down the military.

And the ones who should shoulder these tax increases? Why not the ones who got the US into this mess in the first place? There seems no choice but to increase income taxes on the highest marginal tax rate. The corporate tax rate should also be increased.

Naturally, such proposals would leave some spluttering into their gin and tonics. "Raise taxes?" they say, "What a preposterous thing to suggest! Don't you know that lower tax rates encourage economic growth? If we raise taxes during a recession, we'll be killing the goose that lays the golden egg!".

To which I reply - look at what low corporate taxes and low income taxes have brought about. The popping of the housing bubble and the credit crisis were not caused by horrible, yucky increases in taxation. In fact, the bubble and the credit crisis came about AFTER tax rates were LOWERED.

Others would not just be spluttering into the gin and tonics but also be locking and loading their assault rifles. "The Federal guvmint is just TOO big!", they say "Taxation and government are violence! If the guvmint raises taxes, I'll be shacking up in Idaho!"

To which I reply good riddance. Go to Idaho to protect yourself from the guvmint while the rest of the country suffers under the hand of corporate irresponsibility.

Yes, this is another fine mess you've got us into corporate America and the political shills you have bought and paid for who pass legislation to make you richer.

But back to Paulson and Bernanke. Yeah, congress, give them the money. But raise taxes too. In fact, insist that no bailout plan be passed without Paulson, Bernanke and Bush adding tax increases to the bill.

Angry Bear blogger goes frikkin' bananas!

Divorced One Like Bush (his internet nickname... don't ask) has published a devastating critique of the role of the financial sector in America's economy. It has to be the best thing I have ever read on the site - and includes any of my own posts they have published there.

Quotes:

There is only one solution to this and no one, not anyone is pointing it out: Put the financial sector of the economy back in alignment with the productive sector. What got us in this mess is our (well not all of us) belief that the financial sector can stand on it's own as a primary wealth/money creator. It can not. Never could. But, believing it put the impetus to the creation of “vehicles” for creating trades. You know all those securitized whatevers, and alphabet monikers, and insurance for insurance for insurance based on alphabet monikers of securitized whatevers. What did people expect would happen when you turn the part of your system that is dependent on activity in an other part for it's existence into a stand alone money creator. If you are going to keep generating money from money, then you are going to have to keep coming up with new “product”.

...

Get it? We take an industry subservient to the needs of production and turn it into a competitor of production. I can polish and sell rocks without a bank to borrow from. I can accumulate wealth over time. My business may grow slowly and so may my wealth, but I can do it. But, remove all none financial activities and what does financial do to survive? What does it do to survive with no one needing a loan, backing, no desire to produce in a way that increases our productivity such that we have more time to purse happiness (that constitution purpose)? We treat finance as if it is the chicken/egg question. It is not. Finance came second and is dependent.

There's a "head in hands" element happening here among a lot of econ-bloggers. As the financial situation gets worse, bloggers like Divorced One Like Bush are shaking their heads in frustration at the stupidity of overpriced Wall Street bigwigs and the policies they have helped to create. Things have moved on now from the "Watch out, something bad is going to happen if we don't do something soon!" narrative of the past 3-4 years to the "I WISH SOMEONE LISTENED TO ME! NOW WE'RE ALL GOING TO DIE!", narrative appearing now which is, of course, something I have been doing of late.

What if?

One of my great fears is that this current economic crisis will lead to a crash in the value of the US Dollar. This is something I have been predicting since at least 2005 and now seems more certain than ever.

Of course, what prompts me to write this is the recent drop in the US Dollar. Is this the beginning of the end? I honestly don't know. The thing about predicting economic trends the way I do is that the event occurring is more certain than when it occurs. The US Dollar may jump back up to last week's levels in the next 24 hours, but the downward trend is more likely to occur at some point than any time before. It's like geologists making predictions about earthquakes or volcanic eruptions - the signs are all there that it will happen, but the actual time and date is unknown. When it comes to the US Dollar crashing, the same principle is in effect.

So, assuming I am correct, what will happen to America after the Dollar crash?

1. Economic decline - even more.

It's hard to imagine, but the most obvious effect of a currency crash is economic decline. In normal circumstances this would be bad enough, but, if judicious economic and financial analysts are to be believed, America is already facing the worst economic conditions since the Great Depression. The subprime bubble has spread financial contagion all throughout the US. Big companies are going bankrupt, the sharemarket is volatile and unemployment is rising. And that is all happening before a dollar crash.

If and when the dollar crashes, the effects of the crash will reverberate throughout the economy. While the current credit crisis is hitting mainly financial firms while manufacturing and services take some serious collateral damage, a crash in the dollar will heighten these effects. Banks and financial firms that could have been saved from bankruptcy won't be saved. Firms that could've survived battered and bruised will go under. People who would've been able to keep their jobs throughout the original crisis will lose them. A dollar crash will take the damage already done and make it worse.

In terms of official statistics, you can already see GDP reclining. 2008 Q3 will most likely see economic decline when the stats get released in October. Unemployment, already at 6.1%, is likely to increase. But a dollar crash will make these worse. GDP will continue to decline for 2 or more quarters after the dollar crash, and unemployment will continue to rise.

As I have pointed out above, economists and financial analysts see this crisis as being the worst since the Great Depression. This means that unemployment is likely to reach, at the very least, the levels of the early 80s recession - 10.8% in November and December 1982. Now add to this the dollar crash and you can add a few more points to that level. Unemployment of 12% or more is likely.

2. Inflation and the policy problems that follow it.

The most obvious effect of a dollar crash will be a substantial increase in inflation. The United States is a consumer-based economy rather than a producer-based economy. This means that much of America's economic life depends upon the consumption of imported goods. If and when the dollar crashes, the price of all goods and services will increase.

A dollar crash will make imported goods more expensive to import. Americans will therefore find that everything from gasoline to teddy bears will begin to cost more.

Debate still rages over whether this crisis will lead to increased inflation or deflation. The "Deflationistas" - those who believe that prices will drop - argue that a credit crunch of the sort we are experiencing has historically led to deflation, that is, falling price levels. These people are actually correct in a sense, as any economic contraction leads to lower levels of demand for goods and services, which will inevitably lead to downward pressure on prices. Unfortunately, these deflationistas don't take into account something as serious as a crash in the dollar. If the value of the US dollar is ignored in calculations, then deflation is a natural conclusion for those who are studying the current credit crisis. The problem is, though, that recent history - namely the 1997 Asian Economic Crisis and the 1998 Russian economic crisis - shows that any credit crisis in economies with floating currencies (ie, currencies that are traded in the marketplace and change in value accordingly) eventually leads to capital flight - a situation in which people take assets and money out of an economy in order to invest it in another. What happened in 1997 and 1998 was that investors ran from Asia and Russia and invested in the US Dollar.

So, in the midst of the worst financial crisis in over seventy years, a dollar crash would inevitably lead to upward pressure on prices- namely, inflation. What these inflationary levels might become depends upon how far the currency crashes - the more the currency crashes, the higher inflation will get.

In the midst of this situation, what can the government do? Very little I'm afraid. The only government institution charged with the task of controlling inflation is the Federal Reserve Bank. Faced with a dollar crash and spiralling inflation, what would the Fed do? Standard monetary policy is for central banks to raise interest rates to control inflation. In the past, the Federal Reserve has indeed lifted rates whenever inflation began to worry them.

The problem with raising interest rates is that, while it ends up controlling inflation, it also acts to dampen economic activity. If the Federal Reserve should raise rates in response to inflation brought about by the dollar crash, the effect upon an already deteriorating economy would be devastating. Yet to keep rates low and to endure inflation in the hope that the economy might be given a chance to recover is a process which has historically never worked - the 1970s, for example, saw central banks all over the world ignore inflation and focus on employment and economic growth. Despite this, neither the economy nor levels of employment nor inflation were ever fixed. It was only until Paul Volcker bit the bullet and killed off inflation with high interest rates in the early 1980s that inflation, economic growth and employment ended up getting fixed. In other words, the only way for central banks to improve economic conditions and levels of employment is to focus solely upon inflation. In our particular situation, with a potential dollar crash looming, the only thing the Federal Reserve Bank could do in response is to raise rates.

I need to reiterate: There is nothing that the President, Congress or the Federal Reserve Bank can do to solve this problem. The only thing they can do is to limit the damage and remove the policies that caused the problem in the first place. As I have mentioned before, the only thing that the Government can do is:

• Cut military spending
• Raise taxes on the rich
• Run a budget surplus and pay off public debt
• Use interest rates to keep inflation low
• Regulate the financial industry with more common sense laws
• Fire Ben Bernanke
  

As I said, none of these things will solve the crisis, but they will give a better grounding for the eventual economic recovery.

I would also add to this list the following:

• Institute a Universal Health Care system, and raise taxes to pay for it.
  

I don't put this here just because I'm a pinko commie subversive, but because it also makes economic sense. The United States of America could cut its total health care costs by one third if it instituted a Universal Health Care system similar to those already in operation in other Western nations. The US spends around 15% of GDP on health care while comparable Western nations spend around 10% of GDP and have the same - if not better - health outcomes. Cutting health care costs by deprivatising and regulating the health industry will have enormous social and economic benefits.

3. A Current Account Surplus as America recovers.

Although I often joke that a dollar crash will be "financial armageddon", I know that things will eventually turn around. Even the great depression ended, although those who suffered through it thought it might never end. The same is true in this case. The current crisis added to a dollar crash will cause some very serious economic damage, but a recovery will naturally follow (although the speed of this recovery might not be as fast as people hope).

One thing that will happen as America - and the world - recovers from an economic disaster and dollar crash is that the US will eventually become a net exporter. Moreover, the United States will eventually end up running a current account surplus. This will be the natural effect of a dollar crash.

If and when the US Dollar crashes, one result will be that American goods and services - even manufactured goods - will become more competitive on the world market. While the dollar crash will naturally hurt every part of the economy, international demand from US manufacturing will increase. America's economic recovery will be in many ways due to an increase in demand for American goods. Instead of being a consumer nation, the US will become a producer nation after the dollar crash.

Moreover, it is also likely that the world's producer nations - especially those who have run massive trade surpluses like Japan and China - will end up becoming consumer nations. This will be because the dollar crash will end up overturning current trade balances. It may seem strange to believe that Japanese consumers might end up buying US manufactured goods, but, if a dollar crash occurs then the natural corollary will be a rise in the value of the Yen and other world currencies. When a currency rises, imported goods become cheaper to buy and exported goods become more expensive to sell.

4. A New International Economic Order.

One eventual result of this crisis will be a new economic world order. I'm not talking conspiracy theories or a one world government here, I'm talking about a more integrated world economy in which trading nations agree to abide by treaties that will determine what sort of policies are implemented in national economies.

Such treaties already exist. Supranational entities like the United Nations, the World Bank, the International Monetary Fund and the World Trade Organisation all exist as a way of creating and developing international co-operation in economic areas. An even more advanced supranational entity - the European Union - has even greater power over how member countries may run their affairs.

For anyone who insists upon national sovereignty, such entities are despicable and evil. For those of us who know just how important common rules and policies are for international economic well-being, such entities are exceptionally important (although certainly not perfect).

The importance of any future economic agreement rests upon the damage done at present. Although the US is a sovereign nation and its economic downturn is entirely its own fault, the damage that it will create will spread around the globe. No nation linked in with the world economy will escape damage, although it is clear that the US will be the nation most badly affected. Given that this is the case - that one nation's economic stupidity can lead to economic pain for all nations - economic treaties and agreements will be put in place to ensure that all nations who participate in the world economy follow "the rules" to prevent their own contagion from affecting everyone else. One aspect of this agreement may be common monetary policy, whereby central banks will pursue the same goals, such as having common inflation targets. Another agreement may be universal rules applied to financial sectors, which would not only prevent economic problems in one nation, but in all nations who are part of the treaty. In America's case, accounting principles would be better suited following international rules rather than the homegrown American ones.

Conclusion

For some, a dollar crash will lead to financial armageddon. But, just like in the Great Depression, the United States and the rest of the world will recover and learn from the mistakes that were made. Unemployment may sky-rocket and the economy may decline, but they will both recover eventually.

Unfortunately I'm not as confident as I could be at this point. Peak Oil will make it very difficult for economies to recover over the next 10-20 years, while Global Warming won't stop just because humans have had some economic problems. Both of these issues will require much thought and changes in economic and social behaviour - changes which will cost but which are necessary if people's lives are to be saved. Moreover, the economic and social challenges posed by both Peak Oil and Global Warming need a workable economy to be faced.

Der US-Dollar ist wieder defekt

That's a six month graph looking at the value of the US Dollar from INO.com. Although there is always going to be a chance that it might bounce back, I would argue that we're seeing the beginnings of capital flight.

Oil also leaped in price by 16 percent. So much for inflation being smothered by the credit crisis. Investors are voting with their wallets.

Comics for Today

The Far Left Side.

Crimson Dark.

US Dollar now under pressure

Bloomberg 1:

Treasury Secretary Henry Paulson's plan to end the rout in U.S. financial markets may derail the dollar's three-month rally as investors weigh the costs of the rescue.

The combination of spending $700 billion on soured mortgage-related assets and providing $400 billion to guarantee money-market mutual funds will boost U.S. borrowing as much as $1 trillion, according to Barclays Capital interest-rate strategist Michael Pond in New York. While the rescue may restore investor confidence to battered financial markets, traders will again focus on the twin budget and current-account deficits and negative real U.S. interest rates.

``As we get to the other side of this, the dollar will get crushed,'' said John Taylor, chairman of New York-based International Foreign Exchange Concepts Inc., the world's biggest currency hedge-fund firm, which manages about $15 billion.

Bloomberg 2:

Sept. 22 (Bloomberg) -- The dollar fell for the first day in three against the yen on speculation a U.S. government plan to buy soured mortgage-related assets from banks will widen the country's budget deficit.

The dollar traded near a two-week low against the euro on speculation the combination of spending $700 billion on mortgage securities and $400 billion to guarantee money-market funds may rattle investors' confidence in the U.S.'s ability to repay debt.

``Problems with the U.S. deficit will haunt the dollar,'' said Masanobu Ishikawa, general manager of foreign exchange at Tokyo Forex & Ueda Harlow Ltd., Japan's largest currency broker. ``This is a reason for the dollar to go lower. Spending such a large amount on this rescue package will remind traders that the fiscal health of the U.S. is set to worsen.''

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The Farleftside

It's here.

Haumea - the new dwarf planet

Finally there's a name better than 2003 EL₆₁

Crisis delayed

I honestly don't think anything important will happen today. The market will probably go up again (2% or more) but there won't be any major announcements.

But I expect more in the near future. The weekend might see some interesting discussions about other financial giants or even big companies. One of the big three automobile manufacturers (Ford, GM, Chrysler) will have to go at some point methinks.

Negative real interest rates, credit crunches and capital flight

Here's some quick research I've done on real interest rates around the world:

The source for this information are two charts published weekly in The Economist (dated 19 September 2008), under the section "Economic and Financial Indicators" (click here, scroll down on the right hand side, and click on Output, prices and jobs for inflation figures. Then click on Trade, exchange rates, budget balances and interest rates for 10 year bond rates).

As you can see from this quick bit of table-creation from Openoffice.org, there are quite a number of countries around the world who are running negative real interest rates.

Negative Real Interest rates occur when the inflation rate exceeds interest rates. In this situation, money loses its value - not just when it is in people's wallets but also in their savings accounts. Anyone who has money stashed away in a savings account is essentially losing wealth, since inflation exceeds the interest paid on these accounts. As a result, money is quickly used either to purchase goods and services or invested in anything that will exceed the inflation rate. This may be shares, or it may be property, or it may be flowers - whatever the market sees as potentially exceeding the inflation rate.

In this scenario, of course, a self-fulfilling cycle begins. Since inflation punishes liquidity, money is used in such a way as to devalue it. Thus inflation begets inflation. Moreover, since investments that exceed inflation become more and more valuable, a "bubble" begins to form. Thus inflation-beating investments beget inflation-beating investments. The end result is an eventual popping of the inflation-beating investment, an increase in liquidity and a drop in inflation - until the cycle begins anew.

This is pretty much what has happened to the US since 2003. As I mentioned before, real interest rates in the US were negative between late 2002 and the end of 2005. This situation has been repeated since 2007 Q3 and continues today. It was during that 2002-2005 period that the housing bubble began to grow. The growth in housing prices exceeded the inflation rate, causing the market to invest in it and inflate it - an inflation-beating investment begetting inflation-beating investments. Now that this bubble has collapsed there has been a rush back to liquidity.

The danger that now exists for the US - and in all places where negative real interest rates are being experienced - is that an economic recovery is now highly dependent upon the creation of new investment bubbles. Since US interest rates have been driven down so low, even those who have rushed to liquefy their investments have placed their money in loss-making accounts - inflation is still eating away at people's bank accounts. The difference, of course, is that bank accounts (and treasury bonds and other "safe" investments) are not declining nearly as fast as shares and property prices.

One of the end results of negative real interest rates - when they have been going on too long - is capital flight. Capital flight is pretty much what I have already described above (people liquefying their investments and putting money into bonds) but is felt in the value of national currency. In other words, capital flight is when investors not only liquefy shares and other assets, but also end up selling the currency and buying another currency that is more attractive.

This process is what hit Asia in 1997 and also created the Russian financial crisis in 1998. In both of these cases, investors not only liquefied their investments but also sold off the currency to invest in something safer (which turned out to be the US Dollar, mainly). In both cases, these nations did not just suffer credit crunches, but also quickly depreciating currencies. In the end they were left with ruined financial sectors and substantial levels of inflation caused by increased import costs. The current accounts of these nations also flipped from deficits to surpluses, since imported goods became expensive and exported goods became more attractive to overseas buyers.

It is important to note that bubbles and busts and credit crunches can still occur when real interest rates are positive. However, since bonds and bank accounts compete more effectively with inflation-beating investments, the bubbles and busts are reduced to "peaks and troughs" - what is know today as the business cycle. The higher real interest rates are, the safer an economy is from internal imbalances like the formation of investment bubbles. But since the world economy is so powerfully linked, "contagion" can still spread from one economy to the next, even if that economy has been running positive real interest rates.

I have spoken before about the potential of a damaging fall in the value of the US Dollar. At the present moment, the credit crunch in the US has led to a liquefying of investments and zero bond yields. Yet America's negative real interest rates, if they remain, will eventually lead overseas investors to ditch the dollar in favour of other currencies (such as the Euro and the Yen). At that point the credit crunch would develop into capital flight and lead not only to a financial crash comparable to the great depression but also damaging levels of inflation (caused by dollar devaluation) that would outstrip any deflationary effects caused by the credit crunch.

If the United States of America were any other nation, the IMF would probably be advising them to make policy changes based upon the Washington Consensus. I see little choice in doing anything else. Central Banks (like the European Central Bank and the Bank of Japan) could use their vast financial power to rebalance any runs on the US Dollar, but I seriously wonder whether such a process would be workable over the long term. Financial austerity is the key to rebalancing the US economy, and I would think that any intervention on behalf of non-American central banks to prop up the Dollar would have to come at a price - that being austerity measures (policy changes based upon the Washington Consensus) forced upon the US by foreigners. Thus foreign central banks would be able to provide the US with financial help in the same way as the IMF and the World Bank would be.

There is a question, however, as to just how much foreign central banks could possibly prop up the dollar without harming themselves. The US is too big an economy to fail, yet it may be too big to help if and when any capital flight takes place. Moreover, with the international community also suffering financially from America's economic meltdown, it may end up being a case of nations looking after themselves first and foremost.

The onus is therefore upon the US to solve its own problems. The Washington Consensus is a good place to start. From this policy should come positive real interest rates, fiscal responsibility and better regulations for the financial market. Moreover, in the face of capital flight, the Federal Reserve has no choice but to raise interest rates to control any resulting inflation.

The alternative to this would be a continuation of negative real interest rates and either the creation of another damaging investment bubble and/or eventual capital flight. This process would ruin the US economy for years to come and bring untold harm upon the international financial system.

US Dollar dropping again

The Coordinated Central Bank action to pump money around is having an effect - the US Dollar has dropped by 1% in the last six hours.

I'm thinking this has to be a no-win situation. The credit crunch is leading to a flight into cash, which is drying up as share prices drop. The central banks pump more money in to compensate, but end up devaluing the currency.

In other words, the problem gets transferred into the value of the dollar. Look out for capital flight (as I mentioned earlier) and a plunging dollar. Ouch.

Weekly Jobless week ending September 13 2008

With all the big news happening on Wall Street, it is quite easy to forget the regular economic releases that go on. Today's release is the weekly unemployment figures.

These figures, of course, are based on the previous week's activities, so any big job losses occurring this week aren't going to be in it.

My prediction is that the figures are not going to be good, but they won't be incredibly bad either. 2008 Q3 is looking more and more like a economic contraction (even when taking this week's financial meltdown out of the equation) so I would assume that the figures will indicate a steady rise in unemployment but not some amazingly horrible figure. A number between 450,000 and 460,000 is probably the worst it would get.

Anyway, it is 12.05GMT and the release is at 12.30GMT. See you in less than 30 minutes. (Click on the link above to go directly to the release).

Update 12.34GMT
455,000. Not awful, but still bad. September 2008 unemployment is still looking at least 6.5% from my perspective.

It's time to follow The Washington Consensus

I've just finished scanning my way through The Washington Consensus. Until now I didn't realise how much neoliberal economic theory I had imbibed over the years, which is supremely ironic considering my support for big government ideas like universal health care, free public education and industry regulation - essential components of Democratic Socialism.

The Washington Consensus was, according to Wikipedia:

initially coined in 1989 by John Williamson to describe a set of ten specific economic policy prescriptions that he considered to constitute a "standard" reform package promoted for crisis-wracked developing countries by Washington, D.C-based institutions such as the International Monetary Fund (IMF), World Bank and the U.S. Treasury Department.

And here were the ten policy prescriptions (again, copied and pasted from Wikipedia):

• Fiscal policy discipline.
• Redirection of public spending from subsidies ("especially indiscriminate subsidies") toward broad-based provision of key pro-growth, pro-poor services like primary education, primary health care and infrastructure investment;
• Tax reform – broadening the tax base and adopting moderate marginal tax rates;
• Interest rates that are market determined and positive (but moderate) in real terms;
• Competitive exchange rates;
• Trade liberalization – liberalization of imports, with particular emphasis on elimination of quantitative restrictions (licensing, etc.); any trade protection to be provided by low and relatively uniform tariffs;
• Liberalization of inward foreign direct investment;
• Privatization of state enterprises;
• Deregulation – abolition of regulations that impede market entry or restrict competition, except for those justified on safety, environmental and consumer protection grounds, and prudent oversight of financial institutions;
• Legal security for property rights.

Now compare that list to the list of policy decisions I have been proposing as a way of mitigating America's current economic plight:

• Cut military spending
• Raise taxes on the rich
• Run a fiscal surplus to pay back public debt
• Use monetary policy to keep inflation low
• Create and enforce stricter financial regulation so this doesn't happen again
• Fire Ben Bernanke
  

Who would've thought about prescribing for America what America prescribed for developing economies under financial stress?

If you check out the points of The Washington Consensus, there are many points which apply.

Fiscal Policy Discipline.
This pretty much fits in with my "cut military spending, raise taxes on the rich and run a surplus to pay back debt". The important thing here is that fiscal policy - how a government spends its money - should be disciplined. In other words, there should never be any large amounts of public debt. As I have pointed out multiple times before, America's public debt is too high as it is and will go even higher in the aftermath of this current financial crisis. Had the US government under Bush been fiscally disciplined, the level of public debt would have been a lot smaller, and the cost of bailouts and fiscal stimuli been more sustainable. Moreover, neither the US government nor the market can spend its way out of the current financial crisis. Spending more will make it worse. Austerity is needed.

Redirection of public spending from subsidies toward broad-based provision of key pro-growth, pro-poor services.

I haven't really touched on this because the US doesn't have much in the way of subsidies except for the mind-blowingly stupid agricultural subsidies and protection in place. What has occurred, however, is a "subsidy" in the form of tax cuts for the rich. In other words, the cutting of taxes for the rich since 2001 might as well be the same as government subsidies for certain industries. These tax cuts were certainly not enjoyed by the poor, whose plight is shown up by median wage data which shows wages in 2008 to be below that of 2001. Moreover, according to The Washington Consensus, "pro-growth, pro-poor services" are things like increased spending on health care and basic education - two areas which have suffered in America's recent history.

Tax reform – broadening the tax base and adopting moderate marginal tax rates.

Tax should be simple and should be broad. Taxing one industry more than another leads to an economic imbalance. Again, this part of the Consensus can be applied to the Bush tax cuts because such tax cuts ended up narrowing the tax base. Moreover, by decreasing taxes for the rich, more money than normal would have been pumped into investments. The current financial crisis has seen this money disappear.

Interest rates that are market determined and positive (but moderate) in real terms.

As I have argued elsewhere on this blog, the Federal Reserve ran negative real interest rates from 2003-2005, and from mid-2007 onwards. This has occurred under the chairmanships of both Alan Greenspan and Ben Bernanke.

John Williamson, one of the main proponents of The Washington Consensus, writes that positive real interest rates "discourage capital flight" and "increase savings". Capital flight is now a real danger to the US economy, a process which would lead to a severe devaluation of the US dollar.

Privatization of state enterprises.

Fannie and Freddie - need I say more?

Deregulation.

This is obviously and interesting one. Some people think that this would involve cutting away government rules and letting the market go haywire - in other words, what has been occurring recently. Yet such deregulation in The Washington Consensus is qualified - only regulation which will result in better economic performance should be set up. This naturally includes instances where unregulated markets end up destroying themselves and the wealth of others. In the case of America's financial market, better rules and regulations should be set up to prevent this crisis from occurring again.

...

In summary, I submit again that the only policy direction the US should go in now is to follow the points of The Washington Consensus that they themselves helped to create. Moreover, I submit again that there is no other choice. The crisis has hit, the seeds that were sown are now being reaped. Watching the Treasury and the Fed act like incompetent third-world officials making panic-stricken, knee-jerk decisions is more than enough evidence for anyone who looks at this issue judiciously.

This doesn't look good

This is a FRED graph that is looking rather sad. It measures net capital inflow into the United States. The series stops in April 2008 so this doesn't measure anything since then, but if it did it would probably show some sort of upward trend. It matches the devaluation of the US dollar in the "cliff dive" at the end.

I'm not fully cognizant as to what it means, except that the jagged peaks and troughs since 2004 look very sharp and dangerous compared to pre-2000 levels. It also measures billions of dollars, which naturally go up when the money supply increases, which means that any pre-2000 comparison on the graph is probably nominal rather than real.

A new financial order needed?

Reuters:

Threatened by a "financial tsunami," the world must consider building a financial order no longer dependent on the United States, a leading Chinese state newspaper said on Wednesday.

The commentary in the overseas edition of the People's Daily said the collapse of Lehman Brothers Holdings Inc (LEH.P: Quote, Profile, Research, Stock Buzz) "may augur an even larger impending global 'financial tsunami'."

The People's Daily is the official newspaper of China's ruling Communist Party, and the overseas edition is a smaller circulation offshoot of the main paper.

Its pronouncements do not necessarily directly reflect leadership views, but this commentary by a professor at Shanghai's Tongji University suggested considerable official alarm at the strains buckling world financial markets.

China's central bank earlier this week cut its lending rate for the first time in six years, a move analysts said was aimed at bolstering the economy and the battered stock market.

"The eruption of the U.S. sub-prime crisis has exposed massive loopholes in the United States' financial oversight and supervision," writes the commentator, Shi Jianxun.

"The world urgently needs to create a diversified currency and financial system and fair and just financial order that is not dependent on the United States."

Kenneth Rogoff:

One of the most extraordinary features of the past month is the extent to which the dollar has remained immune to a once-in-a-lifetime financial crisis. If the US were an emerging market country, its exchange rate would be plummeting and interest rates on government debt would be soaring. Instead, the dollar has actually strengthened modestly, while interest rates on three- month US Treasury Bills have now reached 54-year lows. It is almost as if the more the US messes up, the more the world loves it.

But can this extraordinary vote of confidence in the dollar last? Perhaps, but as investors step back and look at the deep wounds of America’s flagship financial sector, the public and private sector’s massive borrowing needs, and the looming uncertainty of the November presidential elections, it is hard to believe that the dollar will continue to stand its ground as the crisis continues to deepen and unfold.

If this crisis goes any further and deeper, the chances of a run on the dollar intensify. The US Dollar's recent rise in value has been swift, especially when compared to its long term devaluation over the past year: The value of the Dollar dropped around 10% between August 2007 and the middle of March 2008 (source), a process which was accompanied by a rise in the price of oil and increasing levels of inflation.

There are reasons why the US Dollar is likely to fall.

The first is that interest rates in the US are so low that any overseas investors buying government bonds are unlikely to see a decent return. Interest rates are higher in the Eurozone, Australia and other places in the world.

The second is that, with the sharemarkets tanking in the US, overseas investors are unlikely to want to keep up direct investments in US companies. Put simply, the US is a toxic place to invest and international investors are likely to sell their US shares and then retreat from the US entirely.

Thirdly, the US economy, by running a current account deficit for such a long time, is geared towards borrowing and consumption. A recession will cause domestic consumption to drop, resulting in an eventual rebalancing of the current account - a process which will make US dollars less valuable for investors to hold.

I can assure you beyond any doubt whatsoever that any panicked sell-off of the US Dollar would be the last thing the US needs. This credit crunch is packing some serious damage already. Add to that inflationary pressures of a tanking currency and there will be a stagflationary period the likes of which America has never seen before.

The only real way to prevent the dollar from falling - and the only way to save it once a fall begins - is for the Fed to increase interest rates. Raising rates during a recession may seem counter-intuitive, but I can guarantee you that the alternative, hyperstagflation, would be even worse.

CRAs

From CNBC, for Beamer:

And here.

Disclaimer - I don't know much about it but the "CRA meme" seems to have been discredited as being a cause of the subprime crisis.

Socialism for the rich - continued

NYT:

Fearing a financial crisis worldwide, the Federal Reserve reversed course on Tuesday and agreed to an $85 billion bailout that would give the government control of the troubled insurance giant American International Group.

The decision, only two weeks after the Treasury took over the federally chartered mortgage finance companies Fannie Mae and Freddie Mac, is the most radical intervention in private business in the central bank’s history.

With time running out after A.I.G. failed to get a bank loan to avoid bankruptcy, Treasury Secretary Henry M. Paulson Jr. and the Fed chairman Ben S. Bernanke convened a meeting with House and Senate leaders on Capitol Hill about 6:30 p.m. Tuesday to explain the rescue plan.

They emerged just after 7:30 p.m. with Mr. Paulson and Mr. Bernanke looking grim, but with top lawmakers generally expressing support for the plan. But the bailout is likely to prove controversial, because it effectively puts taxpayer money at risk while protecting bad investments made by A.I.G. and other institutions it does business with.

What frightened Fed and Treasury officials was not simply the prospect of another giant corporate bankruptcy, but A.I.G.’s role as an enormous provider of financial insurance to investors who bought complex debt securities. That effectively required A.I.G. to cover losses suffered by the buyers in the event the securities defaulted. It meant A.I.G. was potentially on the hook for billions of dollars worth of risky securities that were once considered safe.

If A.I.G. had collapsed — and been unable to pay all of its insurance claims — institutional investors around the world would have been instantly forced to reappraise the value of those securities, which in turn would have reduced their own capital and the value of their own debt.

“It would have been a chain reaction,” said Uwe Reinhardt, a professor of economics at Princeton University. “The spillover effects could have been incredible.”

Okay, now for my "yes but".

I agree. AIG, like Fannie and Freddie, needed to be bailed out. By taking on the financial problems of one organisation, the Federal Reserve can then dilute its negative effects upon the economy. Rather than AIG getting a bullet in the heart, the Fed catches it, breaks it up into little pieces, and then hurls each little piece at taxpayers and businesses - hurting them but not killing them. In a massive financial emergency, such an action will help mitigate the negative effects of one company's distress. It is, in other words, a classic socialist action - the many paying for the pain of one.

Nevertheless, the Fed is playing with fire here. America's entire financial system is based upon free market ideas that sets aside direct government interference in the marketplace and desires less regulation imposed upon them by this government. With the American financial industry partly collapsing, it could be argued that if the government should turn up to mitigate market failure then the government should also be there when things are going well, regulating the industry and profiting from it through tax revenue.

At some point, the money paid by the Fed and the US Treasury for Bear Stearns, Fannie Mae & Freddie Mac and AIG has to be accounted for. Money has to be found to rebalance government coffers.

Of course, both the Fed and the US government share in the blame for the current financial mess. Both Congress and the White House have, since 2001, decided to be fiscally irresponsible and cut taxes during an economic expansion. Moreover, the Fed kept interest rates ridiculously low under Greenspan from 2003-2005 and has created negative real interest rates during that period and also more recently under Bernanke. Negative real interest rates were one of the reasons why an investment bubble formed, and one of the reasons why it has popped so badly.

But let's get real. Were any Wall Street bigwigs warning the Bush government to stop cutting taxes or telling the Fed to raise interest rates? No. It was pressure from the financial markets that dictated America's expansionary fiscal and monetary policy in recent years. While we can certainly find time to blame Bush, Bernanke and Greenspan for kowtowing to the market, we should also find time to blame the financial market itself for promoting such ruinous policies.

Which means that, of course, the financial markets are simply reaping what they sowed. They profited from a bubble, now they are paying for it popping.

Except that they're not - at least not at the moment.

Where is the government going to get the money to pay for their "socialism for the rich"? Will they raise business taxes? Will they increase the top tax rate? It is the rich who created this financial black hole, so why not make them pay for it?

Of course the government could simply increase income taxes on everyone, which will then burden everyone with the problems created by a few. The government could also decide to cut defense expenditure or health expenditure to cope with the increase in debt. They could also just print money if they want to and create a Weimar hyperinflationary event. Or they could just ignore the debt, keep borrowing whatever they need, and then watch the US Dollar eventually crash.

My solution?

• Cut military spending
• Raise taxes on the rich
• Run a fiscal surplus to pay back public debt
• Use monetary policy to keep inflation low
• Create and enforce stricter financial regulation so this doesn't happen again.
• And, of course, fire Bernanke.
  

Overnight Rates more than double

Bloomberg:

The cost of borrowing in dollars overnight more than doubled to the highest since 2001 amid speculation the collapse of Lehman Brothers Holdings Inc. may cause more financial institutions to fail.

The overnight dollar rate soared 3.33 percentage points to 6.44 percent today, its biggest jump, according to the British Bankers' Association. Lehman filed for bankruptcy yesterday after succumbing to mounting credit-market losses.

``It's all a mess out there, it's unbelievable, it's very tough,'' said Padhraic Garvey, head of investment-grade strategy in Amsterdam at ING Bank NV. ``There really is no sign of this going away. If the Fed were to cut rates, it's not necessarily going to solve anything.''

Demand for short-term cash is surging even as central banks seek to revive lending through emergency cash injections. The increase underscores how, far from improving, the credit squeeze that started in August last with the collapse of the U.S. subprime-mortgage market is worsening.

Sinking ship, meet rats.

Lazy me on CPI

Sorry. Didn't do the whole buildup thing for the CPI.

It is -0.1% for August, which is 5.4% annual.

Direct download (pdf, 108.9kb)

My take: Lower than I predicted but then my short term prediction stuff is still being sorted out. There is all sorts of evidence that 2008 Q3 is going to see a substantial decline in GDP and this report shows it too. 5.4% inflation over a twelve month period is still too high so we're still going to see stagflation this month and maybe next month.

Update:
August Unemployment was 6.1%. This means that the Misery Index is 11.5 and stagflationary. This is the highest Misery Index level since June 1991 (11.6).

Bloody Sunday and Black Monday

Well, things are looking bad for Wall Street today. Here's some interesting, sobering, frightening and <insert emotional adjective here> reports from around the web.

From the NYT:

“My goodness. I’ve been in the business 35 years, and these are the most extraordinary events I’ve ever seen,” said Peter G. Peterson, co-founder of the private equity firm the Blackstone Group, who was head of Lehman in the 1970s and a secretary of commerce in the Nixon administration.

And from the WAPO:

The failure of the nation's fourth-largest investment firm offers a profound test of the global financial system, and government and private officials had been bracing Sunday night for an upheaval in a range of financial markets that have never before experienced the bankruptcy of such a large player. To keep cash flowing normally through these markets, the Federal Reserve announced new lending procedures, while 10 major banks combined to create a new $70 billion fund.

And this from the Sydney Morning Herald:

"Merrill Lynch is off the map and so is Lehman in the space of a weekend," said a banking analyst at a major investment house, who spoke on the conditions of anonymity. "It's unprecedented for the last 100 years."

"At this moment, it's hard to know the exact implications," he said.

He said one area Lehman's failure could hit local firms would be in the "massive" over-the-counter derivatives trading which affects foreign exchange, interest rates and equities markets in Australia.

The Australian Securities Exchange moved immediately to suspend Lehman from pariticpating in trade this afternoon, after the US bank signalled its intention to file for Chapter 11 bankruptcy in New York.

Lehman's failure, amid the chaos wracking the financial markets, hammered Australian banking stocks.

...

Investors struggled for parallels to the meltdown affecting shares, outlooks and asset values, more than a year after the subprime lending crisis emerged in the US.

"If you go back to other crashes, like in 1987, it was done all in one hit," said Rick Klusman, head of institutional trading at Aequs Securities. "Now the losses are so big they're trying to ride them through two and three quarters."

"It's the worst situation for the US banking system since The Great Depression."

Bloomberg:

Lehman Brothers Holdings Inc., the fourth-largest U.S. investment bank, succumbed to the subprime mortgage crisis it helped create in the biggest bankruptcy filing in history.

The 158-year-old firm, which survived railroad bankruptcies of the 1800s, the Great Depression in the 1930s and the collapse of Long-Term Capital Management a decade ago, has filed a Chapter 11 petition with U.S. Bankruptcy Court in Manhattan today. The collapse of Lehman, which listed more than $613 billion of debt, surpasses WorldCom Inc.'s insolvency in 2002 and Drexel Burnham Lambert's failure in 1990.

Paul Krugman:

Will the U.S. financial system collapse today, or maybe over the next few days? I don’t think so — but I’m nowhere near certain. You see, Lehman Brothers, a major investment bank, is apparently about to go under. And nobody knows what will happen next.

Nouriel Roubini:

All of the independent broker dealers are going to disappear. In March it was Bear Stearns. Tonight it was Lehman and Merrill Lynch. Morgan Stanley and Goldman Sachs should go find a buyer tomorrow. The business model of broker dealers is fundamentally flawed. They cannot survive.

And then there's this, from Donald Luskin, one of John McCain's economic "advisors":

...we're on the brink not of recession, but of accelerating prosperity.