The chart below from the blog Pragmatic Capitalism shows the U.S. Federal government deficit for each quarter since 1952.

Here’s my take, using the same chart a year ago that Pragmatic Capitalism used above today:

The U.S. dollar is the world’s major reserve currency. Especially in the post-Bretton Woods world, this has meant capital account surpluses as foreigners accumulate U.S. dollar reserves. These capital account surpluses translate into current account deficits. So the “normal” situation, as Randy [Wray] put it, absent a depreciating dollar, is a U.S. current account deficit.  Moreover, Randy writes that a private sector surplus is also normal. And I assume this is true absent some sort of malinvestment-induced capital spending or household dissaving spree. So, while Randy puts normal in quotation marks, I think there is something to this state of affairs being the baseline case for the U.S. sectoral financial balances.

[...]

My analysis here says that the Clinton years’ achievement was due largely to a booming economy fuelled by a capital spending binge in the telecom sector and by business generally, mixed with an unsustainable decrease in household savings. Barring a repeat of this – something I would argue is a bad thing – the only way to get around the government deficit is to depreciate the dollar. Right now, getting back to full employment should be the first priority. That would go a long way to reducing the deficit. However, one must  accept that government deficits are inevitable with the world’s reserve currency; the private sector is net saving and the capital account is in surplus. Otherwise, you  really need a major devaluation, a reduction of reserve currency status or a private sector binge. I vote for a reduction of reserve currency status.

-How To Reduce Government Budget Deficits

Clearly then, deficits in and of themselves are nothing unusual. What do I think about deficits as far as the eye can see? I would argue they are the norm since government deficits in aggregate allow the private sector to net save.

What about the forward-looking view? Here’s Fed Chairman Ben Bernanke’s take from earlier today:

Fiscal Policy Challenges

In the remainder of my remarks, I would like to briefly discuss the fiscal challenges facing your Committee and the country. The federal budget deficit widened appreciably with the onset of the recent recession, and it has averaged around 9 percent of gross domestic product (GDP) over the past three fiscal years. This exceptional increase in the deficit has mostly reflected the automatic cyclical response of revenues and spending to a weak economy as well as the fiscal actions taken to ease the recession and aid the recovery. As the economy continues to expand and stimulus policies are phased out, the budget deficit should narrow over the next few years.

Unfortunately, even after economic conditions have returned to normal, the nation will still face a sizable structural budget gap if current budget policies continue. Using information from the recent budget outlook by the Congressional Budget Office, one can construct a projection for the federal deficit assuming that most expiring tax provisions are extended and that Medicare’s physician payment rates are held at their current level. Under these assumptions, the budget deficit would be more than 4 percent of GDP in fiscal year 2017, assuming that the economy is then close to full employment. Of even greater concern is that longer-run projections, based on plausible assumptions about the evolution of the economy and budget under current policies, show the structural budget gap increasing significantly further over time and the ratio of outstandingfederal debt to GDP rising rapidly. This dynamic is clearly unsustainable.

These structural fiscal imbalances did not emerge overnight. To a significant extent, they are the result of an aging population and, especially, fast-rising health-care costs, both of which have been predicted for decades. Notably, the Congressional Budget Office projects that net federal outlays for health-care entitlements–which were about 5 percent of GDP in fiscal 2011–could rise to more than 9 percent of GDP by 2035. Although we have been warned about such developments for many years, the time when projections become reality is coming closer.

I have to agree with Bernanke here. There is no reason for the U.S. to maintain a ‘structural’ deficit of 4 percent. It is unsustainable in that it leads to an ever increasing government debt to GDP. And as American society ages, it is probably going to get worse.

From a structural perspective, in the US, the deficit is caused almost exclusively by defense and non-discretionary spending i.e. military spending and entitlement spending (Medicare, Medicaid, and Social Security).Other discretionary spending is pitifully small compared to these items. In fact, if you were to eliminate all non-defense discretionary spending today, you would still have an enormous budget deficit. And I would add that it will kill aggregate demand in the short-to-medium term.  No one wants to touch non-discretionary spending because its politically radioactive to do so. On this score, I agree with David Stockman.

So what about the Cult of Zero Imbalances – the notion that the deficit must be as close to zero over the business cycle as possible? I would agree with Marshall that this is an artificial political constraint. For example, if nominal GDP is growing at 6% and the budget deficit averages 4%, then the debt-to-GDP ratio is falling inexorably toward zero. Is there a need to move toward a zero balance in this situation?

-Does focusing on deficit reduction reduce deficits?

I would take the following policy view then:

• Cyclical deficits are just that cyclical. Raising taxes or reducing spending before you reach full employment is likely to increase these cyclical deficits.
• Deficit sustainability is an artificial construct. The concept is usually based on a flawed view that taxes fund government expenditures when every dollar, euro, or pound in your pocket is an IOU created by government out of thin air aka fiat currency. Debt-to-GDP constraints are better at framing sustainability. But these too are artificial and are implicit indications of fears of cronyism and government waste.
• Deficits matter only to the degree they steal real resources from productive use. This can be surmised from a rapidly rising debt-to-GDP ratio.

So, deficits are the norm if you want a net savings position for the private sector. But, yes, I do think the US deficits are too high. We are far from full employment and the promises we have made to Americans on Social Security and healthcare are NPV negative. This ensures a diversion of real resources into those sectors and I believe this will erode growth as it already has in aged economies like Japan, Germany and Italy.

This is me thinking out loud.

Now you know I explained a few months ago why questioning Italy’s solvency leads inevitably to monetisation, subsequently adding why Investors will buy Italian bonds after ECB monetisation. So far, this view of the sovereign debt crisis is accurate. But what about so-called moral hazard?

In the second post on why investors might buy Italian sovereign bonds I wrote:

The point is that this is a moral hazard. The only way to credibly force countries within the euro zone to get onboard with fiscal tightening is fiscal integration.

Here I was referring to the quid pro quo that is present European economic policy whereby the ECB monetises and the peripheral governments cut. I have talked a lot about why this is an unsustainable policy. But I wanted to discuss a different moral hazard for a bit, the hazard of regulatory forbearance.

Here’s what I wrote just after Lehman failed about regulatory forbearance in America’s savings and loan crisis of the 1980s:

The FDIC has a chronology of the Savings and Loan crisis on its website. I think they do a pretty good job of highlighting all the key points without slanting things for political purposes. See the link at the end of the post for the chronology.

The S&L crisis bears keeping in mind as many comparisons to that period regarding deregulation, risk, and bailouts are now being made. One note about the S&L crisis that I should make is that relaxing accounting rules caused the crisis to mushroom in size. And this bears noting as the onerous FAS 157 is creating quite a stir right now. Basically, the accounting rule mandates marking-to-market of various securities.

I am sympathetic to calls to relax the rule as it is pro-cyclical, meaning it naturally swings along with the business cycle. Marking to market causes balance sheets to be inflated during booms like the one we just had and it may cause them to be artificially deflated during busts like the present one.

However, experiences like the Savings and Loan crisis show that relaxing accounting rules in order to bail out financial institutions is probably a bad idea and leads to much greater losses. It is better to take the losses in the first place and move on.

So, it remains a dilemma as to how we can regulate FAS 157′s pro-cyclicality while safeguarding our financial system. I don’t have the answer. But, expect to hear much more about this rule going forward.

-S&L crisis chronology and accounting rules, 1 Oct 2008

So what happened in the S&L crisis is that in the early 1980s American banks got slammed by Volcker’s high interest rates. Lending long and borrowing short meant that they were losing money as short rates skyrocketed. What’s more is that the S&L model was busted by money market funds which competed with the S&L’s low cost deposit funding base. The fix was what is known as regulatory forbearance, which is a fancy way of saying regulators looked the other way as insolvent banks continued to operate as if they were solvent.

The thinking here was that giving the banks a bit of time to “earn” their way back into solvency would keep the 1980-1982 crisis from becoming another Great Depression. There was no Great Depression in 1982. But S&L executives ended up loading up on risky high yield assets, knowing that it was a heads-I-win tails-you-lose situation since their banks were already insolvent. Many like Charles Keating turned to fraud and looting, what criminologist and law professor Bill Black calls control fraud.

The aftermath of this episode was the conviction of more than one thousand senior bank executive insiders and a law mandating prompt corrective action for insolvent banks, a law being flagrantly flouted right now I might add. The thinking today is much the same as it was in 1982. The US was first in terms of regulatory forbearance. In the US, mark to market accounting did come under assault as I anticipated. And its relaxation spurred an enormous rally in bank shares and the markets more generally as I predicted in real time (see here and here).

Now it’s Europe’s turn. Regulators are giving continued life to clearly undercapitalised/insolvent financial institutions. These institutions are like the undead, doing the things that one normally does but with the potential that they and their zombie-ness will come back to haunt us all. Now, the ECB is offering its Long-Term Refinancing Operation for European financial institutions. This is essentially free money and these undead institutions also get to take part. If you are the CEO of Big Euro Bank, an insolvent European bank, what would you do at this juncture?

Here’s how I told the story in the US case, using fictional ‘Big Bank’ CEO Phil. It was a post called Asymmetric information and corporate governance in bank bailouts from June 2009:

the stress tests showed that Phil’s bank was in relatively good shape – at least compared to Big Bank’s peers. On the back of this information, Big Bank was able to issue a huge slug of new shares at a price 200% above its trough share price and fill any apparent gaps in Big Bank’s capital.  In fact, under the guidelines of the stress test, Big Bank could pay back all of the TARP money it received and return to business as usual.

There was one problem, however, and Phil knew it.  You see, Phil had become a lot more worried about the health of his bank after being caught flat-footed when the credit crisis hit.  The company had done a significant amount of work to get to grips with likely credit exposure.  And while the situation was good for Big Bank under the conditions predicted in the government’s stress tests, Phil knew that the conditions were not good at all in more adverse scenarios.  What should Phil do?

Before, we get into what Phil actually does, I should point out that this is a classic case of asymmetric information in which Phil, as a bank insider, has a lot more knowledge of Big Bank’s financial condition than the government, shareholders, or the investing public at large. Well, I would like to believe that Phil would do the prudent thing and remain ‘over-capitalized’ until he was sure that he could lend prudently without jeopardizing his firm’s capital base. But, there is clearly no incentive for that.  After all, hadn’t Phil been beaten over the head before Congress for ‘not’ lending money?  Why did Phil have so many billions of dollars inexcess reserves at the Fed?  Why was he preventing the economy from regaining its footing? Was Phil hiding something?  Perhaps Phil and his executive team need to be replaced?  On second thought, Phil decides the over-capitalization route is suicidal.

As it turns out, Phil’s internal credit gurus told him there is a 60% chance that the company can lend and make shed loads of money as the economy recovers.  There is a lesser but not insignificant 30% chance that the company is under-capitalized if the economy remains fragile and a 10% chance that the company is severely-undercapitalized in a real worst-case scenario.  Big Banks lawyers and accountants have told Phil that he can legitimately claim to the public that Big Bank is well-capitalized and proceed lending.

Phil is optimistic that things will turn out well.  The fact that his underwater options depend on it is no small incentive to feel that way.  But, he has nagging doubts about the downside scenarios of which the public and the government are largely unaware.  So Phil decides to ‘reach for yield’ by taking a slightly aggressive strategy which will ensure that the company can make a lot of money now while interest rate spreads are high.  That way, if things turn down, he will have a huge cushion with which to work.

Of course, he could get burned again and be forced into an under-capitalized position.  That would be embarrassing. But, a bailout is likely if worse comes to worst and no CEOs were replaced the last go around.  Sure they made noises about replacing Vikram Pandit, but he is still in office.  And, anyway, Phil is a member of the club – the exclusive cadre of well-experienced bank executives who run America’s banking system.  Surely he would land on his feet after a time.

If you are the CEO of Big Euro Bank, the easiest thing to do would be to load up on Italian and Spanish government bonds expecting a bailout and knowing they are too big to fail. You don’t buy Greek or Portuguese bonds because they aren’t too big to fail. In the meantime, you make a tremendous yield pick up over German bunds for free since your company is probably already insolvent. You can pay out bonuses as usual and record profits as usual, all in the expectation that your yield pickup play will eventually hep you “earn” your way back into solvency during the period of regulatory forbearance. And anyway, if you’re wrong and need to take losses, you will have gained more in salary and bonus than you otherwise would have. Heads you win, tails the taxpayer loses.

Here’s the question in two parts? Isn’t this what’s happening right now? And if this really is what is happening, how does this story end?

I was on CNBC yesterday ahead of Ben Bernanke’s speech explaining the FOMC’s recent decision to add an explicit inflation target to its decision to extend its rate easing/permanent zero policy. If I find a video, I will post it below. Here are some thoughts I have since put together on the US economy first.

I just wrote this week’s premium content post. I concluded that the Fed’s Rate easing and Obama’s Mortgage refi plan are bullish. Here’s a brief view on why.

• The Fed is out of bullets on interest rate policy and has turned to other nonconventional measures like targeting medium-term inflation and interest rates and using a communications strategy as an expectations anchoring mechanism to increase its influence on medium-term outcomes. This campaign began as early as last February with now-Vice Chair Janet Yellen’s Unconventional Monetary Policy and Central Bank Communications. I think this is small beer and said so yesterday on CNBC.
• Moreover, President Obama recognizes that the Republicans in Congress have his removal from office as a top priority for 2012 and will not allow him to add to budget deficits, especially if it adds stimulus to the real economy. So, despite Bernanke’s saying the Fed cannot do more, legislated fiscal stimulus is off the table. Therefore President Obama is using Fannie and Freddie as a vehicle to add stimulus via the mortgage market.
• The combination of the US President’s State of the Union mortgage announcement and the Fed’s aggressive monetary policy the very next day demonstrates a monetary agent and fiscal agent working hand in hand to achieve twin goals of full employment and price stability. We should expect the Fed to continue supporting fiscal policy rather than working at cross purposes to it. This is the most important bullish point.

P.S. – I have a lot more on what this means for the US economy and asset markets, including the mortgage market and REITS at Credit Writedowns Pro. I think this is a very big deal actually. I am therefore moving to a more bullish view on both the US real economy and US asset prices, with Europe and Iran being the major identifiable factors that could cause the secular deleveraging trend to re-assert itself. It will certainly help Obama in a bid for re-election, especially if Republicans commit electoral suicide and nominate the polarising Newt Gingrich for President.

The video prelude on Europe, where I am less optimistic is below. Right now, Europe is in deflationary mode while the US is still in expansionary mode. The difference owes almost entirely to economic policy. Sorry I don’t have the video of what we had to say as Bernanke came on and that was more important. Here’s Brian Sullivan on the setup though.

Wolfgang Münchau wrote a piece that was carried online today at Der Spiegel. I haven’t seen an English language version so I thought I would say a few words about the piece I saw in German. Münchau says that Standard and Poors was right – not necessarily about the ratings downgrades, but rather that Europe was fixated on the wrong problem, budget deficits. in his view – and mine- this is only going to make things worse. Austerity has already led to a worsening outlook for Europe with even Germany now expecting 0.7% growth for all of 2012.

In Münchau’s view, the reason for the downgrades was that Europe is fighting the wrong battle. S&P even said in their message on the downgrades that an austerity-centered approach would make matters worse. Wolfgang noticed that German Chancellor Merkel and her Finance Minister Schäuble responded to this message by exhorting Europe to push through their austerity packages more quickly. Clearly they don’t get it.

Wolfgang goes on to say that the problem is not in the public sector but in the private sector, where high debt, deleveraging and then recession caused a gaping hole to open up in the public sectors’ balance sheets. Moreover, in what Münchau calls the single currency “strait jacket”, the economies of Euroland have diverged rather than converged and that has meant current account imbalances and private debt accumulation in the periphery.

To me this situation looks pretty hopeless frankly. Policy makers in Europe just don’t get it. The best we are going to get is austerity and partial monetisation by the ECB until the union breaks or sovereign debtors default and banks are recapped. The question is why are they leading us down the abyss. Wolfgang says it’s because the government deficit story is an easier narrative to tell and simpler to attack within the existing institutional limitations of Euroland. That makes some sense politically, but it tells me that this crisis will continue to get worse.

Source: Wir bekämpfen die falsche Krise, Spiegel

Since the possibility of further social tensions leading to nationalism is something on my radar screen, I thought I would post these videos from Euronews and Al Jazeera. In a good economy, these issues are nothing to get concerned about. But in a bad economy, especially one wracked by austerity and unemployment, tensions will have political consequences.

This story seems to be breaking out. Here’s how the Street.com puts it:

Private antitrust litigation pitting some five million retailers against Visa(V), MasterCard(MA), and 13 large banks, including Bank of America(BAC) and Citigroup(C) has slipped under the radar of many analysts and investors who follow those companies, but the case may deliver a multi-billion dollar shock to bank bulls in the coming months.

Aside from Bank of America and Citigroup, the other banks that appear to have the most at stake as a result of the litigation in the U.S. Eastern District of New York are US Bancorp (USB)and JPMorganChase(JPM). All four face billions in potential losses.

So why are these big name retailers suing the big banks. It’s this chart from TheStreet.com’s article that appears to be the smoking gun. Credit card interchange fees are the highest by a large margin.

Clearly those charges that go into the bank and credit card companies’ coffers are either absorbed by retailers or passed on to consumers.

This is a big case. Watch for how it gets resolved.

Bloomberg wrote the following paragraphs about a recent interview with Mohamed El-Erian. What i thought was interesting was his belief that the Fed is out of bullets. Monetarists and Keynesians believe the Fed can still be effective by managing expectations. So the Fed is on a mission to improve its communication of interest rate policy.

Like El-Erian, I am sceptical of this policy turn, but what else can the Fed do? They say they have lots of tools left. Do they? My own scepticism stems from the lack of a transmission mechanism. QE is just the fed swapping bonds for reserves and this has no direct channel to credit creation in a system dependent on credit demand instead of supply. The Fed’s new communication strategy is small beer in the absence of fiscal measures. Bernanke has said as much and it sounds like El Erian is saying the same.

As for QE3, in August I told you the easing has already begun. The Fed knows that the quantitative part of QE has been a bust and so they have moved in a different direction to provide unconventional monetary stimulus. I believe they will continue to do so and will resist expanding the Fed’s balance sheet.

Much more below.

PIMCO CEO and co-CIO Mohamed El-Erian spoke with Bloomberg Television’s Betty Liu, Dominic Chu and Michael McKee about Europe’s crisis, the U.S. economy and where to invest safely in this environment.

El-Erian said that the Fed “doesn’t have enough policy instruments to deal with the challenges facing the economy” and that QE3 will not work.  On investing opportunities, he said that “In the short term, the U.S. dollar is the best place.”

Video for viewing here: http://www.bloomberg.com/video/83907050/

El-Erian on the unpredictability in global markets leading to extreme events around the world:

“Normally, we’re used to thinking of a bell shaped distribution. There’s a dominant theme and very thin tails. Today we’re looking at something different. We’re looking at a distribution that is much flatter and the tails are much fatter. Think of Europe.  Increasingly, most people agree that Europe can no longer kick the can down the road. One of two things is likely to happen.  Either the euro fragments completely or you strengthen the euro zone but change its construct. That is what the fiscal compact we just heard is about. Increasingly, as you look around the world, we are moving towards a bimodal distribution that has significant implications for how you invest.”

On where he sees the most market impact:

“First, it is not just risk. It is also opportunity. One exciting thing about this world is that when there are major transformations, there are both risks and opportunities. The biggest risk is interest-rate risk in sovereign space is becoming credit and default risk. The most extreme example is Greece. It used to be viewed as interest-rate risk–in the government bucket as stable. It has now become default risk. We may as well see haircuts in excess of 50%.  The biggest risk is that people’s mindsets don’t evolve to understand that the underlying characteristics are changing.”

On whether the Federal Reserve should move on QE3:

“The Fed does not have enough policy instruments to deal with the challenges facing the economy. They’re trying to use communication as an extra tool now. WE have used rates, we have had QE, now you see them using communication, trying to push investors to take on more risk. The problem is two-fold. One is there is disagreement on the FOMC. Secondly, it is not a very effective policy instrument. There are not just limited benefits, but there are also costs and risks. The Fed is in a difficult position. It is trying to be active, but it does not have effective instruments at this stage.”

On whether the U.S. is stuck in a liquidity trap:

“That’s one of the views.  Which is why not just jump start the whole thing and give a high inflation target and hope the system reflates. Critics talk about how difficult it is to produce the right outcome. You could overshoot and create a different problem.   The fundamental issue is that the Fed cannot solve this alone. It is a bridge to somewhere. This has to include other agencies stepping up to the plate. So far, only the Fed has been doing its job. The others seem to be asleep at the wheel.”

On whether QE3 is appropriate for the economy at this time:

“I do not think that on its own [QE3] can produce the outcomes we want. The outcomes would be higher job creation and contained inflation. That is the fundamental issue. The Fed is willing to do things, but it cannot guarantee unfortunately outcomes. For good outcomes, we need other agencies to also be doing their jobs.”

On what needs to happen over the next few months to get over the mountain of debt facing European nations:

“We’re seeing an important shift in the narrative. It goes from saving the periphery to strengthening the core. We need to see Germany and France to agree on how they will ‘refound’ the euro zone. Secondly, we need to counter the continued fragility of the banks. We just heard about an Italian bank. Third, we need to be able to mix that containment with growth. Finally, we need to decide how the burden will be shared in the peripheral economies that are insolvent. It is quite a list. They will have to do a lot of work. Hopefully they will be able to do it.”

On how Europe’s crisis will affect the U.S. and whether it will be a situation where nations around the world go up and down together:

“I think it will be a bit of the latter because it is a massive head wind. No matter how strong your internal dynamics are, there is this massive headwind called Europe. The banks are interlinked around the world. A lot of companies sell in Europe or export to Europe. We cannot avoid Europe. It is a significant headwind everybody has to cope with.”

On the need for investors to stay defensive while remaining agile enough to take advantage of opportunities:

“One lesson from these big macro themes is that they tend to be indiscriminate. That is another way to say that they cause sell-offs in credit and stocks that are fundamentally sound. By focusing on the fundamentals and respecting the technicals, there are opportunities to be selectively offensive. Uncertainty and unpredictability should never lead to paralysis. It leads to figuring it out how the risk is changing and how the return is changing. We’re living in an exciting world where there are lots of realignments. Sources of risks and returns are changing.”

On where to invest safely right now:

“In the short term, the U.S. dollar is the best place. It is the cleanest dirty shirt. There aren’t pure shirts anymore out there, so you have to focus on the cleanest dirty shirt. In addition to dollar exposure for the short term, stay focused on some emerging currencies that continue upward migration in terms of wealth and income. Stay away from the high-beta currency that are likely to be incredibly volatile in this less predictable world.”

On whether U.S. stocks are also the ‘cleanest dirty shirt’:

“They are. But in this case, we have to ask the question. Alcoa is going to be very important as will other firms. To what extent are they being hit on revenue? To what extent can they continue to contain costs? We’re going to get lots of information.”

Now, I am quite certain that issues like the job guarantee are exactly why many people reject MMT. It is too drastic a change in economic policy. Even if you believe that we can never achieve free markets and that it is foolish to strive to do so, it doesn’t mean you accept permanent government intervention. For me, It’s not either or — or as George Bush put it “either you’re with us or the Terrorists”.

What I like about the job guarantee idea is that it provides an automatic mechanism through which to stabilise unemployment without creating cash for clunkers schemes or bailing out specific sectors of the economy. It works well in creating a counter-cyclical stabilisation for any economy. I actually could envision a world in which some of the unemployed always worked in the private sector or  in public works, paid for by government as an alternative to unemployment insurance. And that’s why I dubbed the Job Guarantee Unemployment insurance for the 21st century in 2009.

But there is a lot not to like. Moreover, European economies where government intervention is more accepted are far more likely to use a mechanism like this.

Here are some questions:

1. Isn’t this a massive paradigm shift toward socialism? Some people may advocate this but why should we believe that such a massive shift will have positive results? Why should we believe that other people will accept such a shift? Why should we accept it?
2. How do we know that employment in JG jobs won’t be considered ‘second-tier’ and have almost no impact on future employability? It could even have a negative impact. See my post “Lessons We Can Learn On How Stimulus And Jobs Programs Failed in Eastern Germany“.
3. In a distorted economy like ours, with excessive reliance on finance, housing, banking, a JG could retard the reallocation of resources and help prop up economic sectors with an overinvestment of real resources.
4. Why should we believe that a JG can make jobs available in sectors where the unemployed have skills? All of the laid off mortgage and finance people are not going to be a natural fit for public works.
5. In any economy, it can skew resource investment. For example, real resources devoted to healthcare must naturally increase as our societies age. Is it not likely that a job guarantee will hasten that change without any public debate by reallocating employment to that sector?

John Carney lays out some more. His overarching criticism, with which I agree, is that the “burden of proof is on the reformer“.  That will always be the case.

Clearly, if JG jobs are created by the private sector and simply paid for by government, that minimises the potential conflict between government and the private sector. But you still have the issue of wages to deal with.

The debate here must start with political philosophy: the role of government in promoting full employment, economic and price stability and the appropriate allocation of resources as well as alleviating poverty in an advanced economy. Pavlina told me that she is hoping to begin the dialogue discussing those issues and then putting the JG in that context. I hope that’s where the discussion heads and will continue to carry posts on this issue by the MMT’ers as a result.

For me, the JG is just an idea at this stage. Crucially, it has no relevance to the current political or macroeconomic situation we face — and it will not until the economy reaches 1933-levels of Depression. My focus therefore is on whether that is a possibility and how to protect you and myself against that possibility.

This is a post about the job guarantee idea in the context of a historic economic crisis.

I intended to write this post on Thursday night as a response to a good post by Pavlina Tcherneva on the job guarantee that is now up on Credit Writedowns, but my schedule didn’t allow it. Now, I have a moment, so here are some quick thoughts on the job guarantee.

This post will not be like other posts you read on the job guarantee. As I said in my last post on the job guarantee, I am not going to discuss what is “real” Modern Monetary Theory since I am not in the position to make that judgment. However, I will give you my two cents on the political economy of state job guarantees.

I have a few competing ideas that I intend to thread through here so this post my deviate from the intended outline. Let me start back to front with the blogging part of the three elements in the title.

Blogging

I wrote Pavlina the following:

“What I think your piece identifies is the need in desperate times for public voices to advocate something strongly and forcefully to prevent something truly horrific from happening. Germany and Hitler and the War come to mind. The same might be said about Serbia and Milosevic for example.  What I heard you saying is that I am in that kind of position as someone with a public voice. Tell me if I got that right.

What I intend to write in response is that I feel I actually have two roles, to advocate and to predict. These two are sometimes in conflict, particularly in times of social and economic stress. But as a situation deteriorates it is the second role which increases in importance in helping people avoid worst case scenarios. How can they protect their wealth. how can they get a job somewhere where they won’t be fired, etc. There is a serious tension in these two roles and I acknowledge that. My writing is increasingly about forecasting and much less about advocacy.

Before I get to why I am putting it this way, I should point out that Pavlina responded that she feels “economists (whether they like it or not) have an advocacy role to play” but that she is more interested in the technical merits of the JG because the blogosphere is filled with a lot of disinformation about what the job guarantee is and what it means about the role of government.

For my part, when it comes to aggressive US policy responses, I think the die has been cast. That means my focus has to be less on advocacy and more on forecasting. Here’s an analogy I thought of on Thursday that works for me.

Say you are the designated emergency responder for your condominium. One day, unexpectedly, a condo resident takes an entire floor of fellow residents hostage and threatens to blow them (and maybe the whole building) up if the condo board doesn’t bail him out of his condo fees. This particular resident lives on the top floor in the penthouse and pays more in fees, although nothing commensurate with his square footage. Now, he’s broke and knows that if he doesn’t pay the whole building will fall into disrepair and cease to operate.

Anyway, now he is threatening to blow the 9th floor up. You know he is a good friend of the Condo board president and that the president has a lot of power to end this standoff and is willing to listen to residents about what to do. What do you do?

Well, in the beginning of the ordeal, your chief role is one of advocacy. You tell the tenants to exhort the condo president to not bail Jack out, but to let Jack sell off his condo and break it up into pieces or face bankruptcy.

But what if the condo president doesn’t take your advice and he bails Jack out at everyone else’s expense, yet Jack continues to hold the ninth floor hostage? At that point, you could continue your advocacy, but the reality is you are an emergency responder and you need to decide whether a catastrophe is likely to occur and prepare residents for that potential catastrophe.

Bottom line: At some point you have to switch from advocate to forecaster.

In October 2010, I made the switch with “Less Policy Advocacy and More Policy Forecasting at Credit Writedowns“. For me, Credit Writedowns is now more about helping people navigate the likely economic turmoil I anticipate and much. much less about advocating specific economic policies. So when I see things like the job guarantee debate in the blogosphere, this is my mindset.

Kleptocracy

Let me switch gears and talk about an interrelated topic, Kleptocracy, for a second. To my recollection, I was one of the first in the economic blogosphere to talk about the US political system using terms like kleptocracy or crony capitalism. This framing began as “a populist interpretation of the latest Boom-Bust cycle” in March 2008. But at the time, it was only a thesis, a suggestion. Since that time, it has become an integral part of how I view the political economy dynamics in the US and in Europe.

The central thesis is that government has come to work hand in hand with powerful private sector interests to promote an ideology, a religion I have dubbed corporatism masquerading as liberty which is really a convenient way of maintaining an ever more unequal distribution of income without significant social unrest. Now that policy rates have reached their nadir without the expected economic and asset reflation, social unrest is increasing and belief in the ideology is shaken.

The point here is that we lost the brief moment where “change” had any momentum in early 2009. The economic structure that remains intact is largely the same as it was in 2008. In fact, in the financial services industry in the US, Jon Huntsman correctly pointed out yesterday in a Fox News Op-Ed that the big banks are even larger today than before the crisis. So, we have a momentous conflict building between increasing social unrest and a more entrenched status quo.

My view is that the only way wholesale change is going to occur is if and when the economic system collapses entirely as it did in 1873 and again in 1929. To me, these are the antecedents for this particular economic crisis. So until then, we will have a slow growth economy punctuated by fits of recession and deleveraging until these issues are resolved. In saying that I am not fully discounting the possibility that the crisis gets resolved by socialising losses. However, I believe that this requires threading a needle and that eventually the policy errors will accumulate and bring the crisis to a head.

Job Guarantee

So, in the context of this world view, the job guarantee is a political non-starter right now.

My view: a job guarantee will never happen in the US unless we have a deep Depression like the one that began in 1929.

What about the merits of the job guarantee then — advocacy, if you will? Let me say from the start that I have drunk from the cup of free market ideology just like everyone else. So it could well be that I have been brainwashed by the corporatist propaganda. While that may be true, so-called free markets are about liberty and freedom to me, not about corporatism and ideology. I fully recognize that government exists for a reason and will always exist in a large stratified society. Government, by its very existence, is always redistributive. So, the real questions about government concern how many checks to put on its coercive power and what kinds of redistribution are warranted to make government both efficient and effective.

It is a lie to say that we can ever achieve absolutely free markets and it is foolish to strive to do so.

On the other side, MMT proponents like Bill Mitchell believe that the job guarantee, where government always supplies jobs to the unemployed is core to Modern Monetary Theory. This is the antithesis of the free markets. You could call it market socialism or socialism if you like.

Now, I am quite certain that issues like the job guarantee are exactly why many people reject MMT. It is too drastic a change in economic policy. Even if you believe that we can never achieve free markets and that it is foolish to strive to do so, it doesn’t mean you accept permanent government intervention. For me, It’s not either or — or as George Bush put it “either you’re with us or the Terrorists”.

What I like about the job guarantee idea is that it provides an automatic mechanism through which to stabilise unemployment without creating cash for clunkers schemes or bailing out specific sectors of the economy. It works well in creating a counter-cyclical stabilisation for any economy. I actually could envision a world in which some of the unemployed always worked in the private sector or  in public works, paid for by government as an alternative to unemployment insurance. And that’s why I dubbed the Job Guarantee Unemployment insurance for the 21st century in 2009.

But there is a lot not to like. Moreover, European economies where government intervention is more accepted are far more likely to use a mechanism like this.

Here are some questions:

1. Isn’t this a massive paradigm shift toward socialism? Some people may advocate this but why should we believe that such a massive shift will have positive results? Why should we believe that other people will accept such a shift? Why should we accept it?
2. How do we know that employment in JG jobs won’t be considered ‘second-tier’ and have almost no impact on future employability? It could even have a negative impact. See my post “Lessons We Can Learn On How Stimulus And Jobs Programs Failed in Eastern Germany“.
3. In a distorted economy like ours, with excessive reliance on finance, housing, banking, a JG could retard the reallocation of resources and help prop up economic sectors with an overinvestment of real resources.
4. Why should we believe that a JG can make jobs available in sectors where the unemployed have skills? All of the laid off mortgage and finance people are not going to be a natural fit for public works.
5. In any economy, it can skew resource investment. For example, real resources devoted to healthcare must naturally increase as our societies age. Is it not likely that a job guarantee will hasten that change without any public debate by reallocating employment to that sector?

John Carney lays out some more. His overarching criticism, with which I agree, is that the “burden of proof is on the reformer“.  That will always be the case.

Clearly, if JG jobs are created by the private sector and simply paid for by government, that minimises the potential conflict between government and the private sector. But you still have the issue of wages to deal with.

The debate here must start with political philosophy: the role of government in promoting full employment, economic and price stability and the appropriate allocation of resources as well as alleviating poverty in an advanced economy. Pavlina told me that she is hoping to begin the dialogue discussing those issues and then putting the JG in that context. I hope that’s where the discussion heads and will continue to carry posts on this issue by the MMT’ers as a result.

For me, the JG is just an idea at this stage. Crucially, it has no relevance to the current political or macroeconomic situation we face — and it will not until the economy reaches 1933-levels of Depression. My focus therefore is on whether that is a possibility and how to protect you and myself against that possibility.

The UK was always going to be an important laboratory experiment for the US, as it imposed austerity by choice. This strategy has demonstrably failed, as the UK economy looks to have gone back into recession, public borrowing is on the rise, business and consumer confidence and spending have collapsed and unemployment is rising inexorably. Larry Summers’ claim last year that the whole idea of an expansionary fiscal contraction is “oxymoronic” looks to have been right.

The various Republican presidential candidates who have moved from Iowa to my home state of New Hampshire for this week’s primary have collectively argued for European-style retrenchment – which simply hasn’t worked. Drastic cuts in public spending any time soon, as proposed by several of these candidates, look wildly irresponsible given the headwinds the US economy is facing from abroad.

-David Blanchflower, The Guardian

If you argue that austerity works in cutting deficits over the longer-term but the short-term pain is worth it, that’s a different argument than the one Republicans are making – and one not likely to get one elected, which is why they’re not making it. But even so, the spectre of debt deflation looms heavily as much in the US as in Europe. After all, BofA is not trading in the single digits because of irrational despondence. The banking sector in the US is still very sick – and will remain so for the foreseeable future.

Blanchflower argues, as I did last January and again last April, that the medium-term performance differential between the US and the UK will do much in telling us how well expansionary fiscal contraction works. So far, it’s a bust.

I had seven major conclusions. Here’s what I said:

1. “Double dip recessions are not the norm; they are the exception… So, you really need to see powerful secular forces to overcome this self-reinforcing dynamic. Once a technical recovery begins, we should expect it to continue and blossom into a full-blown cyclical recovery. Obviously, I am talking about the medium-term, not the long-term here. But the point is that we have been in recovery for over one-and-a-half years in the US. Odds are that this will continue for some time to come (through 2011 at least).”
2. “I am cautious about this outlook because I still believe the US is in a cyclical upturn within a larger depression. The concept that the structural problems of excessive household indebtedness and an over-reliance on financial services and housing can be solved by money printing and fiscal stimulus leaves me cold. My thesis is that these remedies mask problems only due to the cyclical upturn. If the recovery is not used to whittle the problem away, the next recession will be as bad or worse than the last.”
3. “Europe: the sovereign debt crisis refuses to go away. The European periphery is hurting but the crisis has infected the core via Belgium and Italy. I expect the crisis to get worse before decisive action is taken because that’s how politicians usually respond. There are three options for the euro zone: monetisation, default, or break-up. The question is whether this – in and of itself – deals a fatal blow to recovery in Europe.”
4. “US states and municipalities: Meredith Whitney has put this crisis front and center. My take is similar to the one on Europe:  The question is whether this – in and of itself – deals a fatal blow to recovery in the US, infecting the global economy. Here, I have always felt that the budget issues would only become dire in a cyclical downturn as declining asset prices created public sector pension losses. In an upturn, tax revenue increases as do accounting gains from asset prices… I do not think this is a 2011 event.”
5. “Housing: House price declines have resumed in the UK and the US. They never stopped in Ireland and Spain. The housing double dip is in progress… At this point, I see it as the biggest near-term risk for the U.S. in 2011.”
6. “Currency Wars: a lot of good is done simply by having economic growth. It takes a lot of political heat off politicians. The currency wars are really a political event because they are caused by a lack of aggregate demand.  When the pie shrinks, individual countries feel obliged to implement beggar-thy-neighbour policies to maintain their standards of living by taking a larger share of the pie. The developed economies have felt this ‘pie shrinkage’ most acutely. So it is they who are driving the so-called currency wars forward. The emerging markets are merely reacting in kind. I say “First the rate reductions, then money printing, then the currency war, then the tariffs, then…. hopefully economic recovery.”
7. “Commodity price Inflation: There is a real threat to recovery from commodity price inflation. We have already begun to see signs of food price riots, food price controls and the like in emerging markets. Additionally, Brent crude is at 27-month highs, closing in on $100 a barrel. Just think back to 2008; this type of commodity price inflation was toxic and sowed the seeds of its on demand destruction.”

Looking back, the thrust of this prognosis – basically, being guardedly bullish – proved to be on the money. While I was optimistic, I was cautious enough to point out the downside risks, some of which – Europe and commodity price inflation – materialised. But none of the problems proved fatal to the cyclical upturn in the US or globally although Europe has returned to recession. The US equity markets held their own as a result.

Mid-year, I think my outlook looked the worst. The only hurdles that didn’t come to a head were municipal problems and the currency wars. Commodity price inflation did create demand destruction. Europe’s sovereign debt crisis worsened considerably. And Housing double dipped.  That’s when bad things could have happened. Europe and the US avoided the most egregious policy errors and recovery has continued.

Will the outlook be as benign in 2012… or better? Stay tuned. I will cover this in one of my first newsletters. Look for more information on launch early next year.