James K. Galbraith and the Sorceror’s Stone

Forecasts of economic activity are always a mixture of alchemy and bias.  You always have to check the assumptions before you evaluate the output.  Assumptions can turn a model up side down or inside out.  Economist James K. Galbraith gave a speech this month at the Minsky Conference.  His speech included terse evaluations of some of the biggest baseline forecasting models including one used by the Congressional Budget office.  He found some of the rationale  “purely mystical”.  He’s currently questioning what some folks see as a future “Obamaboom” that assumes a really quick turnaround in the economy followed by manic expansion.  (This scenario is actually coming out of bank economists and you know how well they’ve been assessing things recently.)

Galbraith looks at this giddy scenario skeptically, and rightly so.  I want to discuss his caveats.  He has reservations about this overly optimistic scenario similar to mine.  Yesterday, during discussion of my post, I was asked about the L shaped recovery scenario.  This is something I find likel, although I’m not using sophisticated models to wank out numbers.  I mentioned that I thought it likely because of some structural changes going on in the underlying economy.  Laurie asked me if I could elucidate further.  I did a little of that yesterday.  I’ll continue it today.

Basically, I see the households and their relationship to debt and their assets undergoing some fundamental changes.  House values are way down and unlikely to escalate to bubble levels again which is going to deprive households of their big cash cow.  Also, I don’t really see the credit markets churning out the kinds of expedient loans they did in the past.  If anything, I see banks becoming overly prudent in their underwriting practices–a sort’ve over reaction to the subprime toxins.  Because household spending represents about 67% of our overall economy’s spending, any significant drawback of consumer spending, or the relationship between what they spend, save, pay in taxes and buy in imports is going to have a significant impact on the multiplier process.

I just see a new American thrift paradigm.  I don’t think that households will be enabled by banks any more.  I think their wealth (primarily houses and retirement savings) will not recover to levels that will make the feel secure about their futures.  I think the uncertainty of the job market will make them spooked for some time.  All of this means, to me, a  very long drawn out slow, scuttling along the bottom, L shaped recovery.

Galbraith’s reservations are similar to mine.  Here is is first reservation.  It is basically the same argument that I was making yesterday and that I made above.  Households are not in the position to increase their debt and will not be able to do so for some time.

The first caveat concerns the debt position of the household sector.  The Levy Institute Strategic Analyses see no alternative to a continuing paydown of household debts, on average and in relation to income – until such time as more “normal” levels are restored. Then there are the effects of the flight to liquidity and the collapse of home equity and therefore of debt collateral.  And (to some, though I do not share this view) there is a question whether the banks would be willing to lend, even if willing borrowers with good credit and sound collateral were to present themselves.

His second caveat has to do with the relationship between how much consumers will spend on domestic good v. imported goods.  The more we buy imports, the more we export stimulus to the rest of the world.  This reservation was something I’d not really considered before, but it’s a good one.  Galbraith argues that our love of imports is not only likely to decrease our current demand, but impact the demand for capital by business.  This decreases growth potential in the future.

A second caveat concerns the marginal propensity to import in the upturn, particularly if a large part of the domestic capital stock (especially in the automotive sector) is wiped out by bankruptcy or otherwise in the slump.  Twenty years ago in a book called Balancing Acts and an article entitled, “North-South Trade and the Destabilization of the North” I described a process of “trade-distorting business cycles,” in which differential rates of capital destruction ensure that each successive upturn has a larger import component than the one before.  The result is an unbalanced and largely jobless recovery, at least until capital spending in the technology sectors takes over, far down the road

The third caveat is that the financial markets and sector will not recover any time soon.  In fact, he argues that it might just be the case that the U.S. becomes a more risky bet and that we will experience capital flight.

The third caveat concerns shoes that may yet drop, in domestic finance (commercial mortgages, credit card debt, insurance companies, credit default swaps) or in overseas. The world break-down of the 1930s occurred, in part, because of the system’s failure to coordinate a settlement of German reparations. Germany owed Britain and France, who owed America, which had lent to Germany, and no one was willing to be the first to sacrifice their link in the chain. Something similar is going on today, in the breakdown of the carry trade from the US to Western Europe to Central Europe, and while the situation is surely manageable in principle no one can be certain that it will be managed in practice

All of his reservations have serious implications for the future of the U.S. recovery. I believe they are quite logical and have a high probability of occurrence.   I may have gotten more pessimistic, if possible, after reading the transcript to his speech.  He concludes with a discussion about what these three caveats will bring to a recovery if they come to fruition.

It will surely be very slow to restore employment. At present writing jobs are being lost at the rate of over 600,000 per month.  To reverse this in six months would require a swing to job creation of the same amount, or a net swing of 1.2 million jobs a month for half a year. This is not going to happen – not even close. Among many reasons, homebuilding is likely to be depressed for a long time, while elsewhere production gains will be backed by productivity increases.  As a result, we can expect the human wreckage of this slump to persist and to deepen as the period of unemployment lengthens.  Without direct employment measures, many of the people most hurt will not again find decent jobs.

– As a result of the administration’s determination to save the big banks, we will emerge from this slump with an unreformed financial sector in the hands of the same people who produced the disaster in the first place. While some bad assets will recover value, many will not, and losses will either go unrecognized or they will be transferred, via the public-private partnerships, first off the balance sheets of the banks and then to the taxpayer,  when the mortgages default, via the non-recourse feature of the FDIC’s loans. We could assess the likelihood of this happening, if we chose, by the simple step of auditing the loan tapes underlying a fair sample of sub-prime securities, to determine the prevalence of missing documentation, misrepresentation and prima facie fraud.  Such a study would constitute minimum due diligence and that fact that one is not underway is a very bad sign.

– In the expansion the early easy buck, especially for speculators, may well be in commodities, especially oil. A rapid increase in imported energy costs would reverse the effective stimulus now being given by low oil prices.  It will also generate CPI inflation, perhaps inducing the Federal Reserve to slam on the brakes.  There is little reason to hope that the recovery will be allowed to march us all the way back to full employment unless we overcome our vulnerability to volatile oil prices, and nothing in the plans so far suggests we have faced up to that elementary necessity.

– A turnaround could bring the deficit hawks back out of the woodwork, arguing vociferously that “now is the time” for tax increases and entitlement cuts.  Should they prevail, the process could be thrown into reverse, in a recapitulation of Roosevelt’s balance-the-budget recession of 1937-38.

None of these things make for a very bright outlook.  However, Galbraith ended his speech with suggestions to prevent their occurrence and impact.  The first was a call for the Treasury to change its bank rescue plans.  This is something many economists have been calling for since it was first introduced.  It’s about time some one in the administration listens.  The second is to strengthen the social safety nets.  If we do plummet towards depression, this will be an absolute necessity.  We do not need to create a human disaster as well as the financial. His third suggestion is that we build infrastructure and institutions.  This just makes sense because if we’re to spend huge amounts of money any way, it might as well be something that will lend to our future capacity as well.  The last is to appreciate and strengthen our institutions of governance and law.

Galbraith’s father was an important figure in all of the Democratic Administrations from FDR to LBJ.  What a shame his son isn’t in a similar position to influence the current Democratic Administration.   Maybe then, our policies would reflect similar priorities and move us in same forward direction that those adminstrations did.