James Galbraith: No Return to Normal

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James Galbraith has written a very good analysis of the crisis and why the policies being followed in the USA (and, by implication, here) will not work.

I reproduce some extracts here to give you a flavour of the article, but I recommend a read of the full paper in the Washington Monthly–thanks to blog member Warren Raftshol for bringing it to my attention. The emphasis added to some points is mine.

No Return to Normal. Why the economic crisis, and its solution, are bigger than you think.

The deepest belief of the modern economist is that the economy is a self-stabilizing system. This means that, even if nothing is done, normal rates of employment and production will someday return. Practically all modern economists believe this, often without thinking much about it. (Federal Reserve Chairman Ben Bernanke said it reflexively in a major speech in London in January: “The global economy will recover.” He did not say how he knew.) The difference between conservatives and liberals is over whether policy can usefully speed things up. Conservatives say no, liberals say yes, and on this point Obama’s economists lean left. Hence the priority they gave, in their first days, to the stimulus package.

But did they get the scale right? Was the plan big enough? Policies are based on models; in a slump, plans for spending depend on a forecast of how deep and long the slump would otherwise be. The program will only be correctly sized if the forecast is accurate. And the forecast depends on the underlying belief. If recovery is not built into the genes of the system, then the forecast will be too optimistic, and the stimulus based on it will be too small…

Why did the CBO reach this conclusion? On depth, CBO’s model is based on the postwar experience, and such models cannot predict outcomes more serious than anything already seen. If we are facing a downturn worse than 1982, our computers won’t tell us; we will be surprised. And if the slump is destined to drag on, the computers won’t tell us that either. Baked into the CBO model we find a “natural rate of unemployment” of 4.8 percent; the model moves the economy back toward that value no matter what. In the real world, however, there is no reason to believe this will happen. Some alternative forecasts, freed of the mystical return to “normal,” now project a GDP gap twice as large as the CBO model predicts, and with no near-term recovery at all…

Three further considerations limited the plan. There was, to begin with, the desire for political consensus; President Obama chose to start his administration with a bill that might win bipartisan support and pass in Congress by wide margins. (He was, of course, spurned by the Republicans.) Second, the new team also sought consensus of another type. Christina Romer polled a bipartisan group of professional economists, and Larry Summers told Meet the Press that the final package reflected a “balance” of their views. This procedure guarantees a result near the middle of the professional mind-set. The method would be useful if the errors of economists were unsystematic. But they are not. Economists are a cautious group, and in any extreme situation the midpoint of professional opinion is bound to be wrong.

The most likely scenario, should the Geithner plan go through, is a combination of looting, fraud, and a renewed speculation in volatile commodity markets such as oil. Ultimately the losses fall on the public anyway, since deposits are largely insured. There is no chance that the banks will simply resume normal long-term lending. To whom would they lend? For what? Against what collateral? And if banks are recapitalized without changing their management, why should we expect them to change the behavior that caused the insolvency in the first place?…

In other words, Roosevelt employed Americans on a vast scale, bringing the unemployment rates down to levels that were tolerable, even before the war—from 25 percent in 1933 to below 10 percent in 1936, if you count those employed by the government as employed, which they surely were. In 1937, Roosevelt tried to balance the budget, the economy relapsed again, and in 1938 the New Deal was relaunched. This again brought unemployment down to about 10 percent, still before the war…

The New Deal rebuilt America physically, providing a foundation (the TVA’s power plants, for example) from which the mobilization of World War II could be launched. But it also saved the country politically and morally, providing jobs, hope, and confidence that in the end democracy was worth preserving. There were many, in the 1930s, who did not think so.

What did not recover, under Roosevelt, was the private banking system. Borrowing and lending—mortgages and home construction—contributed far less to the growth of output in the 1930s and ’40s than they had in the 1920s or would come to do after the war. If they had savings at all, people stayed in Treasuries, and despite huge deficits interest rates for federal debt remained near zero. The liquidity trap wasn’t overcome until the war ended.

It was the war, and only the war, that restored (or, more accurately, created for the first time) the financial wealth of the American middle class. During the 1930s public spending was large, but the incomes earned were spent. And while that spending increased consumption, it did not jumpstart a cycle of investment and growth, because the idle factories left over from the 1920s were quite sufficient to meet the demand for new output. Only after 1940 did total demand outstrip the economy’s capacity to produce civilian private goods—in part because private incomes soared, in part because the government ordered the production of some products, like cars, to halt…

Third, in the debt deflation, liquidity trap, and global crisis we are in, there is no risk of even a massive program generating inflation or higher long-term interest rates. That much is obvious from current financial conditions: interest rates on long-maturity Treasury bonds are amazingly low. Those rates also tell you that the markets are not worried about financing Social Security or Medicare. They are more worried, as I am, that the larger economic outlook will remain very bleak for a long time

A paradox of the long view is that the time to embrace it is right now. We need to start down that path before disastrous policy errors, including fatal banker bailouts and cuts in Social Security and Medicare, are put into effect. It is therefore especially important that thought and learning move quickly. Does the Geithner team, forged and trained in normal times, have the range and the flexibility required? If not, everything finally will depend, as it did with Roosevelt, on the imagination and character of President Obama.

About Steve Keen

I am Professor of Economics and Head of Economics, History and Politics at Kingston University London, and a long time critic of conventional economic thought. As well as attacking mainstream thought in Debunking Economics, I am also developing an alternative dynamic approach to economic modelling. The key issue I am tackling here is the prospect for a debt-deflation on the back of the enormous private debts accumulated globally, and our very low rate of inflation.
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31 Responses to James Galbraith: No Return to Normal

  1. Oops, sorry for the doubel post

    From Mish Sedlock

    Deflation Economics

    Conditions today are essentially the same as during the great depression. I talked about this in Humpty Dumpty On Inflation. When I wrote that piece, I listed 15 conditions one would expect to see in deflation and the score was a perfect 15-15. I recently added a 16th: bank failures. Click on link to see the conditions table.

    Those who stick to a monetary definition of inflation pointing at M2, M3, MZM, or base money supply, as well as definitions that involve prices are selecting a definition of inflation that makes absolutely no practical sense.

    It is the destruction of credit, coupled with the fact that what the Fed is printing is not even being lent that matters, not some Humpty-Dumptyish academic definition that has no real world application!

    I have long been arguing that we are in deflation based on the following definitions: Inflation is a net expansion of money and credit. Deflation is a net contraction of money and credit. In both definitions, credit needs to be marked to market.

    Mathematical Model

    I can express the above mathematically.

    Fm = Fb + MV(Fc)

    Fm = Fiat Money Total
    Fb = Fiat Monetary Base
    Fc = Fiat Credit, the amount of credit on the balances sheets of institutions in excess of Fb

    MV(Fc) is the market value Fc

    Inflation is an expansion of Fm
    Deflation is a contraction of Fm

    If only base money was lent out (no fractional reserve lending), MV(Fc) would equal zero. The equation ensures we do not double count credit in Fm.

    MV is a function of time preference and credit sentiment (ie. Belief that one can be paid back). As long as that belief was high, banks were willing to lend.

    Because (at the moment) Fc (credit) dwarfs Fb (base money), the system can only hold together as long as there is belief credit can be paid back and as long as there are not defaults. Needless to say, the perceived belief that Fc can be paid back is under attack, both by rising defaults, and by sentiment. That is why MV(Fc) is collapsing.

    In other words, the mark to market value of credit is contracting faster than base money is rising.

    While Keen’s endogenous money model doesn’t presently account for base money changes, since credit money dwarfs base money, base money is ignorable.

    Cash injections of the order of 0.25 gdp ($3.5 trillion US/year) are necessary to shorten the depression to a mere 4-5 years. After prices start to rise, the injections have to stop, of course, because they become highly inflationary.

    Galbraith’s suggestion that money could be injected via social security payment increases is one method. However, I am looking forward to getting $1000/month so that I can pay off my credit cards.

  2. Chiswick says:

    I just noticed that Steve Keen is in the Daily Telegraph talking about the mini boom in lower priced houses because of the Govt first home owners scheme…The Govt has hinted it will not continue this program but most people think they will…..if they do so, will this continue the mini boom?….and for the record, what percentage from this point does Steve Keen estimate that real estate prices will fall?

  3. Bullturnedbear says:

    Hi Stats and others,

    Great discussion. When will Oz start Quantitative easing? Who could predict with certainty? I still think sentiment (demand) is driving the government herd. When the people demand that the government stop printing and borrowing, the tap will be turned off.

    That’s probably where I disagree with James Gal. I don’t think the American people will have a stomach for endless debt creation to be paid back by their children’s children. Eventually or soon the people will demand that the US government pull their head in and only spend what they can generate.

    I read recently that China started “investing” directly in a big way into equities, property and other productive assets in early 2007. Doesn’t that just scream of herd behaviour? China joined the herd late in the game and got smashed. The article wasn’t clear but I got the impression, they divested between $300B and $600B. What’s that worth now half? Ouch! At least their treasuries grown positively for many years.

    On investing in agriculture, oil, aged care, education. I have some opinion about agriculture. I have been researching this area for many years. I think farm land has been an even bigger ponzi scheme than residential property. I have asked agri-bankers “why on earth would you buy farm land? The productive yield for some farms is under 1%. Without blinking the agri-bankers answer “because the land is in short supply and the value will just keep going up”. Wrong answer.

    I think the inflated valuations and over indebtedness are huge in the farm sector. I am a big fan of farming. It is essential production. But I would need to see a crash in values before I put my money there or I recommend anyone else put their money there.

    I noticed Jim Rogers talking down the US and talking up the likelihood of a depression recently. He then went on to say that he thinks agriculture was the way to go. He would be putting his money (his clients’ money) into ag. He has a vested interest in raising more money from investors and needs to tell people a story that they can relate too.

  4. chewman says:


    As one who has been involved in and around the agricultural game all of my life, I have long thought of farm land as just an extension of the general real estate ponzi scheme. I know many people who have either bought into farm land or expanded solely on the basis that it “will be worth more” in the future.

    It was interesting to see “values” in my local area go from $400/acre in about 2000 to $1500-2000/acre recently. Considering they’d been at $400 for about 20 years prior, why did they suddenly go through the roof? Especially when the last few years have also seen the worst “drought” in living memory. The last time there was a decent dry spell in Australia, you couldn’t give stock or farms away. How many millions has the farming sector received in drought assistance since 2000 and yet prices have still gone up?

    In other words, for the last few years farm prices, as with all real estate, have been totally detached from the income received. Hopefully this will change in the near future, but I wouldn’t hold my breath given all the vested interests involved.

    I was reading the other day the opinions of a real estate “investor” saying how good an investment it is etc. etc. If it’s such a good investment, why does the govt. have to spend billions on FHOG, negative gearing, depreciation allowances etc. to keep people in the game? The “investors” have been living off the public purse, not any productive contribution to the world.

    Get rid of all the market distorting incentives and then let’s see how good real estate is.

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