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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  • 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.

  • Above link should be:

    From Mish Sed­lock

  • Chiswick

    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?

  • Bull­turned­bear

    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.

  • M Quin­lan
  • chew­man


    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.