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Home Publications Blogs Beat the Press Brad DeLong Says We Can't Do Anything to Raise Employment Because Billionaire Wall Street Bankers Are Still Too Dumb to Breathe

Brad DeLong Says We Can't Do Anything to Raise Employment Because Billionaire Wall Street Bankers Are Still Too Dumb to Breathe

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Sunday, 09 June 2013 15:25

Brad DeLong has a set of ruminations on the economic situation that we now face, the gist of which is that we better be cautious in using fiscal policy because "we" are worried that the bankers may sink themselves again if interest rates rise back to more normal levels. Let's look at the argument starting with figuring out who "we" is.

While Brad never tells exactly, when he says "we" he is obviously referring to the mainstream of the economics profession. And his "we" actually got considerably more wrong than he gives them credit for in his post. To start with, "we" hugely overestimated the effectiveness of monetary policy in sustaining full employment in the United States. In citing the Fed's successes Brad tells us:

"There was the 2001 collapse of the dot-com Bubble that took $5 trillion of equity wealth down with it. In all of these cases the Federal Reserve was able to react swiftly and smoothly to keep these large financial shocks from having much of an effect on the real economy of production and employment."

That's not what the data show. First of all, from peak to trough we lost $10 trillion in equity value. The crash went far beyond the dot-coms, the stock price of everything from GM to McDonalds plummeted in the stock market crash of 2000-2002.

It turns reality on its head to say there was not much effect on employment from this crash. Employment peaked in February of 2001. It didn't cross this peak again until February of 2005. The employment peak in the private sector was reached in January of 2001. It didn't cross this again until June of 2005. In both cases this was at the time by far the longest stretch without gains in employment since the great depression. 

Looking at employment to population ratios, the EPOP peaked at 64.7 percent in April of 2000. Five years later it was a full 2 percentage points lower. That corresponds to 4.4 million fewer people holding jobs.

It is also worth noting that the federal funds rate was lowered to 1.0 percent in the summer of 2002 and remained at this level for almost two full years. This was the same rate that the ECB had in place following the 2008 meltdown until it recently lowered its overnight rate somewhat further. The 1.0 percent ECB rate was already thought to be pretty much a zero lower bound in the sense that no one believes that further reductions have any substantial payoff in economic activity. For practical purposes the Fed had hit the zero lower bound following the 2001 downturn.

In other words, it was easy to see from looking at the data that recovery from the stock market crash induced recession in 2001 was not easy. It is scary to think that "we" did not recognize that fact at the time and apparently still do not recognize this fact today.

Since the recovery from the 2001 stock crash was difficult, it should have been easy to predict that recovery from the collapse of the housing bubble was going to be difficult. The housing bubble was driving the economy ever since the stock crash.

Bubble driven house prices had raised construction to near record levels. The share of GDP going to residential construction was more than 2 percentage points above its historic average. It was 100 percent predictable that we were going to lose this boom when prices collapsed. Also since the boom led to overbuilding, which manifested itself in the form of record high vacancy rates, it was certainly predictable that construction would fall back to below normal levels. As it was, we lost more than 4 percentage points of GDP in the decline in residential construction following the crash ($640 billion in today's economy).

The equity created by the bubble also led to a wealth effect driven consumption boom with the saving rate falling to near zero. (I would argue that capital gains showing up as income led to an overstatement of income in this period, so the actual saving rate was even lower than the reported saving rate.) In any case, it was fully predictable that consumption would plummet following the loss of $8 trillion in housing wealth associated with the collapse of the housing bubble. If we assume a wealth effect of 5 cents on the dollar, that translated into a loss of $400 billion in annual consumption. (That was also a bubble in non-residential real estate, but we'll ignore this for the moment.)

This means that the combined loss in construction and consumption spending led to a drop in annual demand of more than $1 trillion. What exactly did the Fed have in its bag of tricks that was supposed to replace this amount of demand? What sector(s) of the economy was so sensitive to interest rates that it could plausibly expand to fill this huge gap in demand? Certainly there was nothing that was in evidence as of 2007. Hence "we" should have been able to see that the collapse of the housing bubble posed very serious risks to the economy.

Next we have Brad giving us warnings that we still need to take Reinhart & Rogoff's debt growth trade-off seriously. It's not clear what empirical work he is relying on in pushing this contention, but it certainly is weak at best (e.g. see here and here). As I have also argued as a theoretical point the idea that there can be any substantial growth penalty from debt per se seems absurd on its face.

Even though our debt to GDP ratio is the highest it has been since the early post-war years, at around 1.0 percent of GDP the interest burden is at a post-war low. We aren't looking at getting back to the early 1990s levels of more than 3.0 percent of GDP for more than a decade. And, even that burden did not preclude a decade of solid GDP growth in the 1990s. If there is in fact a debt-curse then we can buy back debt at steep discounts when interest rates rise, as is predicted by the Congressional Budget Office and other forecasters. We can also sell off assets to get a super-normal return in the form of an extra growth dividend.

But all of this is a side-bar to the highlight of Brad's story:

"If you are Marty Feldstein, you think there is a 20% chance of normalization of interest rates in the United States in each year looking forward, that because of large debt outstanding, the normalization of 10-year Treasury rates carries them not to 4% per year nominal but to 6%, which means that should normalization come that’s a 36% capital loss on bank and shadow bank holdings of 10-year Treasuries and other things of equivalent duration. Given underlying political currents it is not at all clear that the political support for a second rescue of the banking system anywhere exists in any North Atlantic democracy. Hence Stein, Feldstein, and George draw the conclusion that it is time to start raising interest rates so banks can get a wedge between the zero cost of funds from depositors and the amount of money they earned by holding safe medium term assets. Otherwise, they fear, we will soon face a financial crisis worse than 2008-9."

Okay, in case this is not clear, Brad is attributing a view to Martin Feldstein and others that the banks are insufficiently hedged against the risk of a rapid rise in interest rates. Therefore, we should start raising interest rates now (with a hit to growth and jobs) in order to avoid a sudden rise in rates that will send the banks back into insolvency.

Let me put this another way just to make the point more clearly. Martin Feldstein and his ilk supposedly believe that the banks have again put themselves at great risk. If the government (Fed) doesn't take actions to slow the economy today, then the banks may again be put into bankruptcy.

Now Brad sees this as a horrible story for all of us because he seems to think that if the banks go under again there will be nothing that we can do to get the financial system back on its feet. I would argue otherwise, since central banks like the Fed have almost limitless power to re-inflate the economy. (Yes, there are political constraints, but I trust that if faced with the prospect of enduring double-digit unemployment we will be able to overcome the political constraints. Note that contrary to what is often claimed, this is not a one-time deal. If the banks collapse we can restart them a week later, a month later, or even five years later. It is best that the banking system not collapse, but we do know how to re-inflate the financial system and the economy.) 

But let's just focus on the key claim, Brad thinks it is plausible that the banks have again made themselves vulnerable so that a plausible (in his view) set of economic events could wipe them out. Is this to be taken seriously? After all, President Obama assured us that Jamie Dimon and Lloyd Blankfein are very savvy businesspeople (the CEOs of J.P. Morgan and Goldman Sachs, respectively).

As a practical matter I have no idea how vulnerable the major banks are to a rapid rise in interest rates (which I view as highly unlikely), but if they are really that vulnerable, how do we justify letting their CEOs get paid $20 million a year when, if Brad is taken literally, they have put the whole economy in jeopardy yet again. In other words, if we take Brad at his word, we have to keep millions of people out of work because Jamie Dimon and Lloyd Blankfein have made their banks vulnerable to actions that would boost the economy, and if their banks go down, the economy goes down.

I think Brad is 100 percent wrong about the economy's need to keep these banks afloat and that Feldstein is almost certainly wrong about the risk of a sharp rise in interest rates, but if we assume both are right, then it is the best argument yet for breaking up the big banks and radically altering the structure of banking regulation.

 Note: Thanks to Robert Salzberg for correcting typos.

Comments (20)Add Comment
Shadow Banking Black Swan Ready to Appear
written by Robert Salzberg, June 09, 2013 7:49
The shadow banking and derivatives market continues to dwarf the reality based markets so relatively small deviations from the expectations of a few hedge fund gurus could indeed collapse the shadow banking and derivative markets.

Besides the problem with relatively unregulated derivatives markets, the concentration of wealth itself creates a natural destabilizing force because concentration of wealth at the top,(and away from consumers), naturally contracts an economy because those at the top are already maximizing their consumption and more money for them, in general, means less spending from the masses.

The real problem continues to be that banks and financial institutions backed by the federal government are allowing to engage in the derivatives markets and gamble with government insurance against default.

Whoops!!! 2 typos in previous post corrected with ( )
written by Robert Salzberg, June 09, 2013 8:10
The shadow banking and derivatives market(s) continue to dwarf the reality based markets so relatively small deviations from the expectations of a few hedge fund gurus could indeed collapse the shadow banking and derivative markets.

The real problem continues to be that banks and financial institutions backed by the federal government are allowing(ed) to engage in the derivatives markets and gamble with government insurance against default.
This Is What Happens When Wacky Weed Is Legalized People!
written by Paul Mathis, June 09, 2013 9:33
Whatever Brad is smoking out in Berkeley, he needs to stop right now before he hurts himself! Colombian Sunk is wicked stuff that can mess up your mind. Just put down the keyboard and walk away from the computer.
...
written by watermelonpunch, June 09, 2013 10:00
I think Brad is 100 percent wrong about the economy's need to keep these banks afloat and that Feldstein is almost certainly wrong about the risk of a sharp rise in interest rates, but if we assume both are right, then it is the best argument yet for breaking up the big banks and radically altering the structure of banking regulation.


And silly me... here I still am just trying to wrap my head around why we still have a system where ANYONE could ever have some idea, for whatever reason, to worry about big banks, to the point of thinking it's necessary to throw ordinary people under an even bigger bus than we're already under, in order to save bankers & banks from even the slightest wisp of risk.

What's wrong with people?
Huh ...
written by squeezed turnip, June 10, 2013 12:35
well, Delong really messed up on this. First Harvard economists now Berkeley economists (yes, Akerlof too) are proving to have major intellectual failings in understanding the market-based finance system (aka shadow banks), seemingly doing some backbends to accomodate the philosophies of Those In Power. I used to think of UCB and Harvard as bastions of the left; heck, Rich DeVos of Amway fame used to call Harvard the "Kremlin on the Charles".So what is up with these B.S. defenses of the power elite's power and wealth grab?
liquidity versus solvency
written by David, June 10, 2013 12:47
Re Robert Salzburg's points, it is also useful to read Perry Mehrling's "money view" of the shadow banking system, summarized pretty well here in FT alphaville back in February: http://ftalphaville.ft.com/201...l-system/?

But the meat of the argument is found here, from a 2011 Mehrling blogpost: http://ineteconomics.org/blog/...king-ystem

The Federal Reserve Act of 1913 created the Fed as a democratically accountable analogue to the former private lender of last resort, J. P. Morgan, and his club of New York bankers. The issue of the current day is how to create a similarly accountable alternative to the club of New York dealers. This is the subtext of current debate about moving derivatives trading to central counterparty clearinghouses or exchanges.
...
written by JayR, June 10, 2013 9:13
"...I have no idea how vulnerable the major banks are to a rapid rise in interest rates..." Why would the rates have to rise rapidly? If you have a lot of 30 year loans at very low rates then a gradual rise over several years should have the same affect. A good question is what happens if you get say 4% inflation and you have a ton of loans at 3.8%? Another question is do bankers currently have incentives, say to get very large bonuses(20 million), to engage in activity now that generate spectacular short term profits at the expense of a bank that will massively implode later? If the answer to that question is yes and the banker thinks he will not suffer or that the government will bail him out then it seems like the banker would be stupid not to engage in some really terrible decisions.
Fiscal Stimulus
written by jonny bakho, June 10, 2013 9:26
Tech collapse was an opportunity for BigG to buy lots of tech and put it in schools and to expand high speed to rural areas. Bush did none of that.

Too many economists suffer from Friedman's disease. Friedman oversold monetary policy as a toll for economic management. Yes monetary policy is important, but monetary policy, no matter how good, cannot compensate for bad or inadequate regulatory and fiscal policy.

Many academic economists prefer the monetary area because it is the world of the wealthy elites. Fiscal policy often involves both politics and lower classes that our academic elites choose to avoid. Regulatory policy is often dismissed by academics who prefer taxation or convoluted regulatory schemes to direct mandates.

Friedman had a point about the utility of monetary policy. However, monetary policy has been oversold to the point of becoming an excuse for inaction. In our current situation, monetary policy has done its job by making borrowing costs very cheap. The BigFailure is fiscal policy that is not using cheap borrowing to increase demand for domestic labor, goods and service. The Fed has offered Congress a punch bowl and Congress won't touch it.
...
written by liberal, June 10, 2013 9:40
squeezed turnip wrote,
...(yes, Akerlof too)...


What did Akerlof say?

So what is up with these B.S. defenses of the power elite's power and wealth grab?


As I've said many times before, it's a vindication of one of economics' claims---that incentives matter. In economists' case, the incentive is to whore themselves out to the rich and powerful.

I could be mistaken about this, but my guess is that Dean, as economists go, isn't outstandingly wealthy, despite making accurate calls on the dot com bubble and the housing bubble (and the latter much earlier than almost anyone). Why? Because he has a liberal-left orientation. If he used his higher IQ to suck up to the rich, he himself would be much richer.

I don't know whether it's because he has more moral fiber than most economists, or because he was born with a good bullshit meter that he can't turn off even if he wanted to.
Economists Love Monetary Policy
written by steve williams, June 10, 2013 11:30
When tecnocrats/economists sleep, they dream of three control knobs on the Federal dashboard labeled M1, M2 and M3. What could be simpler or more effective? And the knobs go to eleven! That's the way I was taught at a Public Utilities executive school in the '70s. Fiscal policy is much harder.
Why Brad DeLong Gets It Wrong
written by Jesse, June 10, 2013 12:03
The first order of business would be to make the banking system more resilient. And that requires breaking up the TBTF banks, which hold the economy hostage and are absorbing monetary stimulus and distorting pricing of risk.

Brad does not address this, and neither does Krugman, because at the end of the day they are carrying water for the status quo on the Big Finance side as opposed to BigOil/BigDefense.

Careerists often find it difficult to see things on which their comfortable lifestyles depend on their not seeing or speaking.

I am not saying he is being disingenuous. I mean, he did say some years ago that Alan Greenspan 'never made a policy decision with which I disagreed.'

What more can one say in response to an incredible admission of failure of judgement than that?
yes but
written by Peter K., June 10, 2013 1:10
I'd cut him some slack. He admits to be wrong before the bubble burst and he seems to be spitballing, free-assoicating here. He agreed with Krugman's criticisms.

Two things: he does short change regulation. He emphasizes how investors have forgotten the Great Depression. I guess this could be an indirect, oblique argument for more regulation. He should be saying Greenspan was the worst policymaker ever.

Two: the Fed's interest on excess reserves. I don't fear for the banks because they're now quasi public-private (always have been actually) like Fannie/Freddie. The Fed is giving the money and could (will) raise the IOER so there isn't a rush of money and inflation, and it will shore up their balance sheets. How fair this is however....

...
written by watermelonpunch, June 10, 2013 2:54
liberal wrote:
or because he was born with a good bullshit meter that he can't turn off even if he wanted to.

LOL I've long assumed that to be the case... though I've usually wondered if it was just me projecting my own 'issue' of that onto Dean Baker. ha ha ha

But I don't think that it's just that we have a lot of sociopathic immoral economists & economic commentators. More just that the atmosphere in public political discourse is so divisive that policy advocates are basically locked into taking one side or another, or being dismissed completely. And yeah, it could be that there's more money on one side of it.

But the way I see it, Dean Baker does something a little bit different here, and that's what sets him apart.
He's offering people The Red Pill.
I really don't care what his personal motives are for doing so, but I could see a plethora of various incentives to do so - sadly also a plethora of deterrents. :/

I applaud Dean Baker.

Even if he turns out to be rude to grocery store clerks, or we later find he makes grossly inappropriate jokes at backyard barbecues with elderly family members. LOL
(Just kidding!!)
The Exalted
written by Bill N, June 10, 2013 5:53
Not to put myself into the same class as Delong, but he, as I, try to think of this stuff not as what we would do if we were the Emir of the US, but as what just might be possible. In this post Dean Baker seems to think it would be easy to do a number of things which are not easy to do - eg: simply break up the banks.

Dean is better than this. EG, his excellent "The End of Looser Liberalism"
akerlof supplement
written by squeezed turnip, June 10, 2013 5:59
Here's what Akerlof said at the recent IMF summit:
In sum, we economists did very badly in predicting the crisis. But the economic policies post-crisis have been close to what a good sensible economist-doctor would have ordered.

This man knows the stimulus was too small, but he's too polite to insult his hosts, I guess. Not that I'm going to forgive him the opportunity to make a point: the sensible economists have not done very well in guiding the recovery either. Romer nearly changed history by arguing for the larger stimulus, but the sensible people won out and now we're stuck in an nonsensical, useless mess.

The entire bit is here: http://blog-imfdirect.imf.org/...ic-policy/
slight correction on that last post
written by squeezed turnip, June 10, 2013 6:10
that should have been
Romer nearly changed history by arguing for the larger stimulus, but the "sensible" people won out and now us little people are stuck in an nonsensical, useless mess.


... and the turnip squeezers "job creators" continue to win.
...
written by liberal, June 10, 2013 8:51
Peter K. wrote,
He should be saying Greenspan was the worst policymaker ever.


DeLong has a few good points, but one of the bad ones is that he's said some very positive things about Greenspan over the years.
...
written by liberal, June 10, 2013 9:01
Jesse wrote,
Brad does not address this, and neither does Krugman, because at the end of the day they are carrying water for the status quo on the Big Finance side as opposed to BigOil/BigDefense.


I'm not quite sure that's true. I think, at least in the case of Krugman, that the problem is that like a lot of economists (even Dean), he doesn't think too much about banks/money/finance.
Bond Duration: Are the Banks Prepared?
written by TVeblen, June 11, 2013 11:11
Orwell had a great phrase - "fearful symmetry" and it relates to Dean's silver lining in the debt curse (i.e., Treasury buy's back long-dated debt maturities at deep discounts)and bankers desire not to have a rise in long-term rates. The math of fixed income instruments - like bonds or mortgages - is such that at low rates they face greater price risk. For example, a 10-year bond with a coupon rate of 10% will have a greater percentage increase in its market price if market rates fall to 8% vs. the percentage change loss if interest rates went to 12% (about +13.4% vs. -11.8%). This is an illustration of "bond convexity" and it is a fact of life of banking. So a 30-year mortgage issued at say, 3.75% is going to suffer a greater percent decline if rates move up to 6.75% than if the loan was issued at 9.75% and rates go to 12.75%. The question is how hedged are banks? Does your average community bank CEO have a sharp risk manager who's using "collars" or "options" to reduce this kind of exposure? Are they funding this "insurance" through higher fees? Or are the TBTF banks using their prop trading desks to do this for the smaller banks? The other "fearful symmetry" is that as rates rise and its cheaper for the gov't to buy back its debt, the Treasury securities that banks and insurance companies goes down in value and they'll need more capital to meet the new risk-based standards. So while I'm with Dean on moving to a "utility" model of banking and letting Dimon et al "play in traffic," small banks may be faced with a bad situation if rates begin to spike upwards.
Baker is a Swattie....
written by Indiana Jones, June 12, 2013 9:05
Baker got his BA at Swarthmore, which has produced a lot of liberal no-BS'ers... a lot of the Economic Policy Institute folks graduated from Swat; Elizabeth Economy is one of the only non-BS'ers among "China scholars".... where Swat went terribly wrong was with Robert Zoellick

Quaker values...

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Dean Baker is co-director of the Center for Economic and Policy Research in Washington, D.C. He is the author of several books, his latest being The End of Loser Liberalism: Making Markets Progressive. Read more about Dean.

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