Monthly Archives: October 2011

1 from The Truth on Vimeo.

Extra credit opportunity!

For extra credit, email me an one-paragraph answer to each of these questions:

1. What was the most relevant factual economic information given in the documentary?

2. Did the presenter offer a model or theory to organize or explain those facts? If the answer is yes, describe it shortly.

3. What were the conclusions drawn by the documentary from the facts presented?

4. State your own opinion and/or comments regarding the content of the documentary?

Please do not create a Word document or attach anything. Just write the answers in a plain email to me.


Just three recent cases that make the point.

Case 1:
The Costliest Mistake In All Of Economics
Joe Weisenthal | Oct. 16, 2011, 1:37 PM | 6,484

This week saw something stunning: The world’s most famous bond manager, Bill Gross, was forced to send out an apology to investors over his dismal performance this year.

It’s obvious why he had to do it. With equity markets incredibly volatile, people think of their bond investments as their anchor of stability, smoothing out volatility and canceling out losses in any climate. The PIMCO Total Return Fund (PTTAX) has failed to do that, and is actually down over the last year. As such, his fundraising numbers have shriveled.

PTTAX 1-Year Performance


What made his year so bad? Well, as he puts it, he expected a “new normal” (2% growth, 2% inflation) but things have gotten much worse, causing a rush into long-term fixed income instruments which he was betting against.

But going back over his writings over the past year, you can see that his error actually went much deeper.

A key reason he’s shied away from U.S. debt (up until now) is his fear of massive U.S. deficits, and the belief that these deficits would turn investors away from our debt.

His August 2011 letter — which was basically written right at the peak of the chart above — lead off with three bullet points that got right to his thinking at the time

  • ​Nothing in the Congressional compromise reached over the weekend makes a significant dent in our $1.5 trillion deficit.
  • In addition to an existing nearly $10 trillion of outstanding Treasury debt, the U.S. has a near unfathomable $66 trillion of future liabilities at “net present cost.”
  • Aside from outright default, there are numerous ways a government can reduce its future liabilities. They include balancing the budget, unexpected inflation, currency depreciation and financial repression.

Because he expected “unexpected inflation,” “currency depreciation,” and “financial repression” he was not going to be exposed to U.S. Treasuries. Instead, he wrote:

Based on historical example at Moody’s and Standard & Poors, it just might take 50 years for them to downgrade U.S. credit, but be that as it may, you and PIMCO as savers and savings intermediaries can take precautionary or even retaliatory measures to preserve purchasing power. Favor countries with cleaner “dirty shirts” and higher real interest rates: Canada, Mexico, Brazil and Germany come to mind. Shade equity and fixed income investments away from dollar based indexes towards those of developing nations with stronger growth prospects. Purchase commodity based real assets before reserve surplus nations do.

This was an extremely costly conclusion to make. Fear of deficits, and the belief that higher deficits would be bad for fixed income, clearly cost PIMCO a lot of money.

Other economists saw the blunder in real time.

In June of this year, right before the Total Return Fund started going off the rails, Paul Krugman wrote a brutal post called The Decline Of PIMCO Macro:

For the past year or so, however, Pimco seems to me to have been making less and less sense. Gross bet big on the idea that rates would spike when quantitative easing ends; I guess he has three weeks to be vindicated, but it sure doesn’t look like it. And the economic logic was all wrong. Now Mohamed El-Erian is claiming that inflation in China and Brazil is Bernanke’s fault; again, the economic logic is all wrong.

What’s strange about this is that nobody was better at laying out the logic of deleveraging and its consequences than Pimco’s Paul McCulley. But maybe that’s the explanation: McCulley has moved on.

In fairness to Bill Gross, this fear of deficits extends all the way to the top, and by that we mean the decision makers in Washington DC.

While the economy clearly could use more government stimulus, the dominant talk in Washington is all about where to cut back and how to “get our fiscal house in order.” And because Washington is obsessed with this, we had to go through the wrenching debt ceiling fight, which seems to have clearly dealt a confidence blow at the worst possible time.

In fact, you can go back even further, to Obama’s first days in office, and the original stimulus, and see that fear of deficits and bond vigilantes was one factor in making the original stimulus too small.

So literally every American (not just those in the Total Return Fund) who depends on a robust recovery is hurt by this misplaced fear of deficits.

It’s because the misplaced fear of higher deficits is so costly that Richard Koo of Nomura recently wrote that we should not even be uttering anything about them, even when talking about the long term!

Arguing need for longer-term fiscal consolidation is irresponsible

The insistence that fiscal consolidation is necessary in the longer term is like the doctor who, faced with a patient who has just been admitted to the intensive care ward, repeatedly questions the patient about his ability to afford the treatment. This is both lacking in decency and irresponsible.

If the patient loses heart after learning the cost of the treatment, he may end up spending even longer in the hospital, leading to a larger final bill. Completely ignoring the policy duration effect of fiscal policy and constantly insisting on longer-term fiscal consolidation was what prolonged Japan’s recession.

And really, the costliness of deficit fears is all over the place. Kyle Bass has been betting against the Japanese Yen for awhile now due to Japan’s deficit issues, only to watch the yen race to mult-decade highs.

Unfortunately, no matter how badly the theory (that higher deficits will cause interest rates to shoot up) fails to jibe with reality, the misconception persists. Just two weeks ago, a well-known newspaper’s op-ed page was railing on Bernanke for keeping the bond vigilantes at bay via quantitative easing, wailing that if only the Fed weren’t involved, the market would be forcing some real discpline on Congress via higher rates.

The fact of the matter is that this connection between deficits and rates is patently false.

This is true over the long term, as seen here comparing the US debt to the 10-year rates:


And it’s true over the short term. Here’s a look at deficits and 10-year rates just during the Bush administration.


Until this misconception goes away, we’re almost certainly going to see plenty more policy mistakes, as well as big investors losing their shirts by betting the wrong way.

Read more:

This is from Paul Krugman’s own blog:

October 16, 2011, 5:50 PM

Gross Miscalculation

Somehow I missed this: Joe Weisenthal informs us that Bill Gross has publicly apologized for getting the bond market so wrong, predicting a spike in interest rates when QE2 ended. As Weisenthal points out, however, Gross’s exaggerated fear of deficits was very widespread; it was, indeed, what all the Very Serious People were obsessing about, even as the real economy was falling apart.

Weisenthal also points out that I called this in real time. If you want to have some fun, read the vituperative comments on that post.

The thing is, all it took to get this right was understanding IS-LM, and taking it seriously.

Case 2:

Flashback: Paul Krugman

  • Jonathan Cohn

  • October 14, 2011 | 9:42 am

The political constraints on the Obama Administration in January, 2009, were very real. Even if the president had pushed for a much bigger stimulus, it’s unlikely Congress would have passed one, at least as long as the filibuster remained in place.

Still, this excerpt from a Paul Krugman column is downright eerie:

This really does look like a plan that falls well short of what advocates of strong stimulus were hoping for — and it seems as if that was done in order to win Republican votes. Yet even if the plan gets the hoped-for 80 votes in the Senate, which seems doubtful, responsibility for the plan’s perceived failure, if it’s spun that way, will be placed on Democrats.

I see the following scenario: a weak stimulus plan, perhaps even weaker than what we’re talking about now, is crafted to win those extra GOP votes. The plan limits the rise in unemployment, but things are still pretty bad, with the rate peaking at something like 9 percent and coming down only slowly. And then Mitch McConnell says “See, government spending doesn’t work.”

Yup. The only thing Krugman got wrong was the unemployment rate. It peaked even higher, topping 10 percent. (See above.)

This is from Paul Krugman’s blog again:

October 13, 2011, 8:43 AM

Legends Of The Fall (Of 2009)

Mike Konczal has some thoughts on the Obama administration’s economic missteps, and mentions that there were reports in Fall 2009 that the administration was afraid of the invisible bond vigilantes:

Noam Schieber at the New Republic was getting word from Treasury as early as late 2009 that they thought that they needed “some signal to U.S. bondholders that it takes the deficit seriously” and “spending more money now [on stimulus] could actually raise long-term rates, thereby offsetting its stimulative effect.” This naturally lead to wanting to strike “grand bargains” with the other side, a path that lead the administration down some bad roads in terms of the agenda.

I was hearing the same thing, with more specifics; as I wrote at the time,

Well, what I hear is that officials don’t trust the demand for long-term government debt, because they see it as driven by a “carry trade”: financial players borrowing cheap money short-term, and using it to buy long-term bonds. They fear that the whole thing could evaporate if long-term rates start to rise, imposing capital losses on the people doing the carry trade; this could, they believe, drive rates way up, even though this possibility doesn’t seem to be priced in by the market.

Even then, this seemed awesomely wrong-headed: policy makers were being scared off dealing with a real economic disaster by threats that existed only in their imagination. Now, of course, it looks even worse.

Case 3:

October 11, 2011, 6:39 PM

Who You Gonna Bet On, October 2011

Sorry, but if I am not for myself, who will be for me? For readers new to this, back in 2010 Business Week ran a story contrasting my pessimistic views with the bullish outlook of hedgie John Paulson, and making it clear that only a fool would believe the views of some bearded professor.

Today in the FT: Paulson’s costly bet on US rebound unravels.

It’s also worth noting not just that things have in fact gone badly, but the way they’ve gone badly: not via surging interest rates and inflation, but via weak demand associated with low rates, and with markets now expecting very low inflation looking forward.

The point isn’t that I’m infallible, which (as my wife can tell you) is very far from true. It is that Keynesian analysis has worked in this crisis, and those who refused to believe it have lost money as well as credibility.

Click on the link almost at the end of this piece to see what, according to the Business Insider, the demonstrators at Occupy Wall Street (#OWS) are protesting against:

CHARTS: Here’s What The Wall Street Protesters Are So Angry About…

Henry Blodget | Oct. 11, 2011, 1:03 PM | 2,117,336 | 352

The “Occupy Wall Street” protests are gaining momentum, having spread from a small park in New York to marches to other cities across the country.

So far, the protests seem fueled by a collective sense that things in our economy are not fair or right.  But the protesters have not done a good job of focusing their complaints—and thus have been skewered as malcontents who don’t know what they stand for or want.

(An early list of “grievances” included some legitimate beefs, but was otherwise just a vague attack on “corporations.” Given that these are the same corporations that employ more than 100 million Americans and make the products we all use every day, this broadside did not resonate with most Americans).

So, what are the protesters so upset about, really?

Do they have legitimate gripes?

To answer the latter question first, yes, they have very legitimate gripes.

And if America cannot figure out a way to address these gripes, the country will likely become increasingly “de-stabilized,” as sociologists might say. And in that scenario, the current protests will likely be only the beginning.

The problem in a nutshell is this: Inequality in this country has hit a level that has been seen only once in the nation’s history, and unemployment has reached a level that has been seen only once since the Great Depression. And, at the same time, corporate profits are at a record high.

In other words, in the never-ending tug-of-war between “labor” and “capital,” there has rarely—if ever—been a time when “capital” was so clearly winning.

Click here to see what the protesters are so upset about >

Nouriel Roubini teaches economics at Stern (NYU). He predicted a serious downturn in the economy since the mid 2000s. This article is about the effects of inequality on the performance of the economy.


The Instability of Inequality


The Instability of Inequality

NEW YORK – This year has witnessed a global wave of social and political turmoil and instability, with masses of people pouring into the real and virtual streets: the Arab Spring; riots in London; Israel’s middle-class protests against high housing prices and an inflationary squeeze on living standards; protesting Chilean students; the destruction in Germany of the expensive cars of “fat cats”; India’s movement against corruption; mounting unhappiness with corruption and inequality in China; and now the “Occupy Wall Street” movement in New York and across the United States.

While these protests have no unified theme, they express in different ways the serious concerns of the world’s working and middle classes about their prospects in the face of the growing concentration of power among economic, financial, and political elites. The causes of their concern are clear enough: high unemployment and underemployment in advanced and emerging economies; inadequate skills and education for young people and workers to compete in a globalized world; resentment against corruption, including legalized forms like lobbying; and a sharp rise in income and wealth inequality in advanced and fast-growing emerging-market economies.

Of course, the malaise that so many people feel cannot be reduced to one factor. For example, the rise in inequality has many causes: the addition of 2.3 billion Chinese and Indians to the global labor force, which is reducing the jobs and wages of unskilled blue-collar and off-shorable white-collar workers in advanced economies; skill-biased technological change; winner-take-all effects; early emergence of income and wealth disparities in rapidly growing, previously low-income economies; and less progressive taxation.

The increase in private- and public-sector leverage and the related asset and credit bubbles are partly the result of inequality. Mediocre income growth for everyone but the rich in the last few decades opened a gap between incomes and spending aspirations. In Anglo-Saxon countries, the response was to democratize credit – via financial liberalization – thereby fueling a rise in private debt as households borrowed to make up the difference. In Europe, the gap was filled by public services – free education, health care, etc. – that were not fully financed by taxes, fueling public deficits and debt. In both cases, debt levels eventually became unsustainable.

Firms in advanced economies are now cutting jobs, owing to inadequate final demand, which has led to excess capacity, and to uncertainty about future demand. But cutting jobs weakens final demand further, because it reduces labor income and increases inequality. Because a firm’s labor costs are someone else’s labor income and demand, what is individually rational for one firm is destructive in the aggregate.

The result is that free markets don’t generate enough final demand. In the US, for example, slashing labor costs has sharply reduced the share of labor income in GDP. With credit exhausted, the effects on aggregate demand of decades of redistribution of income and wealth – from labor to capital, from wages to profits, from poor to rich, and from households to corporate firms – have become severe, owing to the lower marginal propensity of firms/capital owners/rich households to spend.

The problem is not new. Karl Marx oversold socialism, but he was right in claiming that globalization, unfettered financial capitalism, and redistribution of income and wealth from labor to capital could lead capitalism to self-destruct. As he argued, unregulated capitalism can lead to regular bouts of over-capacity, under-consumption, and the recurrence of destructive financial crises, fueled by credit bubbles and asset-price booms and busts.

Even before the Great Depression, Europe’s enlightened “bourgeois” classes recognized that, to avoid revolution, workers’ rights needed to be protected, wage and labor conditions improved, and a welfare state created to redistribute wealth and finance public goods – education, health care, and a social safety net. The push towards a modern welfare state accelerated after the Great Depression, when the state took on the responsibility for macroeconomic stabilization – a role that required the maintenance of a large middle class by widening the provision of public goods through progressive taxation of incomes and wealth and fostering economic opportunity for all.

Thus, the rise of the social-welfare state was a response (often of market-oriented liberal democracies) to the threat of popular revolutions, socialism, and communism as the frequency and severity of economic and financial crises increased. Three decades of relative social and economic stability then ensued, from the late 1940’s until the mid-1970’s, a period when inequality fell sharply and median incomes grew rapidly.

Some of the lessons about the need for prudential regulation of the financial system were lost in the Reagan-Thatcher era, when the appetite for massive deregulation was created in part by the flaws in Europe’s social-welfare model. Those flaws were reflected in yawning fiscal deficits, regulatory overkill, and a lack of economic dynamism that led to sclerotic growth then and the eurozone’s sovereign-debt crisis now.

But the laissez-faire Anglo-Saxon model has also now failed miserably. To stabilize market-oriented economies requires a return to the right balance between markets and provision of public goods. That means moving away from both the Anglo-Saxon model of unregulated markets and the continental European model of deficit-driven welfare states. Even an alternative “Asian” growth model – if there really is one – has not prevented a rise in inequality in China, India, and elsewhere.

Any economic model that does not properly address inequality will eventually face a crisis of legitimacy. Unless the relative economic roles of the market and the state are rebalanced, the protests of 2011 will become more severe, with social and political instability eventually harming long-term economic growth and welfare.

Nouriel Roubini is Chairman of Roubini Global Economics, Professor of Economics at the Stern School of Business, New York University, and co-author of the book Crisis Economics.

Feldstein teaches economics at Harvard and was president Reagan’s chief economics adviser.  He’s calling the government to contribute with half of the cost of an adjustment in mortgage debt to prevent the further depreciation of U.S. housing.  He reasons that if house prices continue to fall, that is going to erode the wealth of many more people than those currently “underwater,” and lead to a worsening of the economic conditions.


How to Stop the Drop in Home Values

Published: October 12, 2011

Cambridge, Mass.

Wesley Bedrosian

HOMES are the primary form of wealth for most Americans. Since the housing bubble burst in 2006, the wealth of American homeowners has fallen by some $9 trillion, or nearly 40 percent. In the 12 months ending in June, house values fell by more than $1 trillion, or 8 percent. That sharp fall in wealth means less consumer spending, leading to less business production and fewer jobs.

But for political reasons, both the Obama administration and Republican leaders in Congress have resisted the only real solution: permanently reducing the mortgage debt hanging over America. The resistance is understandable. Voters don’t want their tax dollars used to help some homeowners who could afford to pay their mortgages but choose not to because they can default instead, and simply walk away. And voters don’t want to provide any more help to the banks that made loans that have gone sour.

But failure to act means that further declines in home prices will continue, preventing the rise in consumer spending needed for recovery. As costly as it will be to permanently write down mortgages, it will be even costlier to do nothing and run the risk of another recession.

House prices are falling because millions of homeowners are defaulting on their mortgages, and the sale of their foreclosed properties is driving down the prices of all homes. Nearly 15 million homeowners owe more than their homes are worth; in this group, about half the mortgages exceed the home value by more than 30 percent.

Most residential mortgages are effectively nonrecourse loans, meaning creditors can eventually take the house if the homeowner defaults, but cannot take other assets or earnings. Individuals with substantial excess mortgage debt therefore have a strong incentive to stop paying; they can often stay in their homes for a year or more before the property is foreclosed and they are forced to move.

The overhang of mortgage debt prevents homeowners from moving to areas where there are better job prospects and from using home equity to finance small business start-ups and expansions. And because their current mortgages exceed the value of their homes, they cannot free up cash by refinancing at low interest rates.

The Obama administration has tried a variety of programs to reduce monthly interest payments. Those programs failed because they didn’t address the real problem: the size of the mortgage exceeds the value of the home.

To halt the fall in house prices, the government should reduce mortgage principal when it exceeds 110 percent of the home value. About 11 million of the nearly 15 million homes that are “underwater” are in this category. If everyone eligible participated, the one-time cost would be under $350 billion. Here’s how such a policy might work:

If the bank or other mortgage holder agrees, the value of the mortgage would be reduced to 110 percent of the home value, with the government absorbing half of the cost of the reduction and the bank absorbing the other half. For the millions of underwater mortgages that are held by Fannie Mae and Freddie Mac, the government would just be paying itself. And in exchange for this reduction in principal, the borrower would have to accept that the new mortgage had full recourse — in other words, the government could go after the borrower’s other assets if he defaulted on the home. This would all be voluntary.

This plan is fair because both borrowers and creditors would make sacrifices. The bank would accept the cost of the principal write-down because the resulting loan — with its lower loan-to-value ratio and its full recourse feature — would be much less likely to result in default. The borrowers would accept full recourse to get the mortgage reduction.

Without a program to stop mortgage defaults, there is no way to know how much further house prices might fall. Although house prices in some areas are already very low, potential buyers continue to wait because they anticipate even lower prices in the future.

Before the housing bubble burst in 2006, the level of house prices had risen nearly 60 percent above the long-term price path. So there is no knowing how far prices may fall below the long-term path before they begin to recover.

I cannot agree with those who say we should just let house prices continue to fall until they stop by themselves. Although some forest fires are allowed to burn out naturally, no one lets those fires continue to burn when they threaten residential neighborhoods. The fall in house prices is not just a decline in wealth but a decline that depresses consumer spending, making the economy weaker and the loss of jobs much greater. We all have a stake in preventing that.


John Cassidy on economics, money, and more.

OCTOBER 3, 2011


Posted by 
111010_r21364_p233.jpgIn the latest edition of the magazine, I have a longish essay on John Maynard Keynes, whose magnum opus, “The General Theory of Employment, Interest, and Money,” turns seventy-five this year, and who is the subject of several new books. (For the moment, the piece is behind a firewall.) Obviously, it’s not exactly an unexplored subject, but Keynes is one of those pesky fellows who simply won’t go away, despite the best efforts of Rick Perry and many other conservatives to consign him to history.

As somebody who was first taught economics in England, and who has written a lot about market failures, I have always thought of myself as a “Keynesian.” But the task of rereading much of Keynes’s writings and distilling them into five thousand words accessible to the general reader forced me to think hard about what the phrase really means, both in terms of economic theory and current policy applications. Keynes wrote a lot, and over the years his views changed quite substantially. If you search his writings, you can find a quote here or there to back up all sorts of things, including even supply-side economics. (Thanks to Dr. Arthur Laffer for pointing out that one.) But the real essence of Keynes, I eventually decided, can be expressed in these terms:

1. In the short-run, demand is what drives economies, not prices.

2. In a demand-driven economy, many types of unfavorable and self-sustaining outcomes are possible, including lengthy slumps.

3. The role of the government is to sustain demand and help the economy avoid such disastrous outcomes.

I regard these statements as truisms, even though others would dispute them, to varying degrees. Once you get beyond them, things get murky. For example, like most economists of a certain age, I was brought up on the “I.S.L.M.” model, a toy version of Keynesianism due to Sir John Hicks, which allows you to depict the entire economy in the form of two simple curves: one representing investment and saving, the other the supply and demand for money. In policy terms, the I.S.L.M. setup remains immensely useful. Whenever I hear somebody saying, “We should cut taxes on X,” or, “The Fed should do Y,” I automatically think to myself: “What would that do to the I.S. and L.M. curves?” I’d be willing to bet that many of the economists who work at the White House and the Fed go through a similar exercise.

But I.S.L.M. is a crude form of Keynesianism. It depends on the assumption that prices are fixed, which is obviously not true. Conservative economists have always posed this question: In a depressed economy, why won’t prices and wages adjust to restore a full-employment “equilibrium”? Keynes’s answer, which it must be said he never fully integrated into what modern economists would recognize as a “model,” had to do with uncertainty and crowd psychology. When “animal spirits” are depressed, he pointed out, the mere availability of cheap money and cheap labor won’t be sufficient to make businesses invest and expand. Rather, the economy will get stuck in rut.

There’s much more about this is in the piece, together with some speculations about what Keynes would be recommending now. Obviously (at least I think it’s obvious) he would be defending the Obama stimulus and arguing for more of the same. But I think he would also be consumed by the international situation, particularly the European debt crisis. After his experience at the Paris peace talks after the First World War, where he saw the victors impose onerous debts on the Germans and Austrians with disastrous consequences, he would surely be pushing for a restructuring of Greek debt, and probably something similar for Ireland and Portugal, too.

Finally, and I didn’t put this in the piece, I think Keynes would be sympathetic towards the anti-Wall Street protestors who are camping out in downtown Manhattan. Somewhat like George Soros, Keynes was an ardent and skilled speculator in the markets who, nonetheless, had few illusions about the social utility of various fashionable forms of finance. “Speculators may do no harms as bubbles on a steady stream of enterprise,” he wrote. “But the position is serious when enterprise becomes a bubble on the whirlpool of speculation. When the capital development of a country becomes a by-product of the activities of a casino, it is likely to be ill-done.”

Maybe the protestors should reprint that quote in the next edition of their new newspaper, The Occupied Wall Street Journal.

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