Look at the economy. Fight the illusion of normality. Feel the weirdness.

Summary: I don’t believe I’ve successfully communicated to our readers the extraordinary nature of our times. We too often focus on the details, but ignore this essential aspect of our situation. Since the crash (perhaps starting even before) we’ve sailed beyond the edges of the known economic “space”. We can no longer even see the edges of the map.

Normal science, the activity in which most scientists inevitably spend almost all their time, is predicated on the assumption that the scientific community knows what the world is like. Much of the success of the enterprise derives from the community’s willingness to defend that assumption, if necessary at considerable cost. Normal science, for example, often suppresses fundamental novelties because they are necessarily subversive of its basic commitments.

— Thomas Kuhn’s Structure of Scientific Revolutions (1962)

Edge of the world

Look at the US economy. Marvel at the oddness.

  1. Near-zero interest rates since December 2008 — almost 6 years — scheduled to end in Q2 or Q3 of 2015.
  2. Three rounds of quantitative easing (ending this month) taking the Fed’s balance sheet from $800 billion to $4,500 billion.– a trillion dollars added in the past year.
  3. A mind-bending expansion of the Federal public debt, taking it from $5.1 trillion to $12.9 T (x2.5) — with $809 billion added during the fiscal year just ended (a 6.8% increase, equal to 4.7% of GDP).

That the economy needs such large stimulus in the sixth year of an expansion is unprecedented. Usually by now the economy has overheated from too-fast growth (inflation!), and economists are speculating about the next recession.

How we got here is equally strange. Like the Harry Potter books, since 2007 life has been a series of random plot twists. It will make a great novel; the film adaptation might be even better.

  1. The long-expected housing bust,
  2. followed by the collapse of some US investment banks,
  3. then the collapse of the US banking system, shaking banks around the world,
  4. followed by the collapse of world trade and a global recession in late 2008 (worst since the 1930s),
  5. met by near-zero interest rates, a first round of quantitative easing (QE), and fiscal stimulus,
  6. sparking a “v” shaped bounce in 2009, amidst predictions of return to normal growth,
  7. which by late 2010 faded into another slump (real GDP in Q1 2011 was -1.5% SAAR),
  8. successfully met by another round of fiscal stimulus and a second round of QE,
  9. followed by predictions of return to 3% GDP in 2012,
  10. which didn’t happen (GDP peaked in Q4 2011 at +4.6%),
  11. followed by GDP slowing to near zero (+0.1%) in Q4 2012,
  12. met by a third round of QE in September 2012 (ending this month),
  13. and more forecasts of big growth in 2014, which didn’t happen (current estimates for 2014 are slightly above 2%).

Plus we saw a series of equally astounding events in Europe starting with the Greece bust starting in March 2010. And the July 2012 announcement that the ECB would “do whatever it takes to preserve the euro”. And the December 2012 “hail Mary” pass of Abenomics in Japan, attempting to end their quarter-century slump before the government goes bust.


No economists (and probably nobody else) predicted most of this, despite their confident forecasts (economists often write as if they’re the voice of God). But the persistent failure of their forecasts since 2007 does not mean they should abandon their theories. Kuhn explains why:

If all members of a community responded to each anomaly as a source of crisis or embraced each new theory advanced by a colleague, science would cease. If, on the other hand no one reacted to anomalies or to brand-new theories in high-risk ways, there would be few or no revolutions. In matters like these the resort to shared values rather than to shared rules governing individual choice may be the community’s way of distributing risk and assuring the long-term success of its enterprise.

Katy Perry in "California Gurls"
Weirdness everywhere

Our reactions to these astounding events

The cumulative effect on me of these years has been disorienting, like Dorothy’s visit to Oz. We’ve enjoyed talking with the Lion, Tin Man, and Scarecrow. The yellow brick road is fun. We survived the flying monkeys and the Wicked Witch. When do we go home?

Most people have reacted differently to this series of events. They pretend that we’re still in Kansas, and this is just a New Normal. It’s a consensual hallucination, allowing these people to retain a feeling of stability and comfort. How long can they maintain this illusion, assuming we don’t return to Kansas?


{W}hen the profession can no longer evade anomalies that subvert the existing tradition of scientific practice — then begin the extraordinary investigations that lead the profession at last to a new set of commitments, a new basis for the practice of science. The extraordinary episodes in which that shift of professional commitments occurs are the ones known in this essay as scientific revolutions. They are the tradition-shattering complements to the tradition-bound activity of normal science.

There is an important group struggling to understand these events. How have economists, as a profession, reacted to the failure of their theories? At what point do they decide their theories need radical revision? The re-thinking has already begun. It’s a slow process, requiring a spark of creativity that comes only in its own time. Until then mistakes will be made as economists cope with our rapidly changing world.We have to work with the theory we have today, just as the Great Depression occurred because nobody had read Keynes “General Theory” — published in 1936.

Worse, having the solution is only have the cure. We often recognize genius only too late, as Europe’s leaders ignored Keynes’ insights on the Versailles peace treaty, which might have prevented the Depression and WW2 (The Economic Consequences of the Peace, 1919).

We can only wait for economists to produce new insights that generate operationally useful theories, and hope that we recognize them when hey arrive. Until then we should embrace the weirdness of our world, not ignore it.

Wizard of Oz

For More Information

(a)  See all posts about economics.

(b)  Recent posts about this economic cycle:

  1. Are we following Japan into an era of slow growth, even stagnation?, 18 November 2013
  2. Has the Fed blown another housing bubble?, 30 January 2014
  3. The dilemma of the US economy: can’t take off & too close to the brink, 9 July 2014
  4. Has America’s economy entered the “coffin corner”?, 10 July 2014
  5. Economists forecast a boom soon. The numbers show slowing. Who is right?, 21 July 2014
  6. See the true trend of the US economy, hidden in the daily news, 1 August 2014
  7. It’s not too soon to worry about the US economy. There are things worse than slow growth., 18 September 2014
  8. Listen to the slowing US economy, hear echoes of Japan, 24 September 2014
  9. 3 graphs tell the story about the US economy, hidden amidst the noise of the jobs report, 6 October 2014

(c)  About the greatest monetary experiment, ever:

  1. Important things to know about QE2 (forewarned is forearmed), 21 October 2010
  2. Bernanke leads us down the hole to wonderland! (more about QE2), 5 November 2010
  3. The World of Wonders: Monetary Magic applied to cure America’s economic ills, 20 February 2013
  4. The World of Wonders: Everybody Goes Nuts Together, 21 February 2013
  5. The greatest monetary experiment, ever, 20 June 2013
  6. Different answers to your questions about the momentous Fed decision to delay tapering, 20 Sept 2013
  7. Do you look at our economy and see a world of wonders? If not, look here for a clearer picture…, 21 September 2013
  8. Two warnings about quantitative easing, the taper, and what comes next, 27 September 2013
  9. Dr Hunt explains the great monetary experiment. It will be historic, no matter what the result., 20 October 2013
  10. The great monetary experiment enters a new phase, with America as the stakes, 27 October 2013
  11. The key to understanding the future of QE3, and the future of our economy, 12 November 2013
  12. How to predict the outcome of this great monetary experiment, and how we got into this box, 15 November 2013

46 thoughts on “Look at the economy. Fight the illusion of normality. Feel the weirdness.

  1. FM: “The cumulative effect on me of these years has been disorienting, like Dorothy’s visit to Oz. We’ve enjoyed talking with the Lion, Tin Man, and Scarecrow. The yellow brick road is fun. We survived the flying monkeys and the Wicked Witch. When do we go home?

    Most people have reacted differently to this series of events. Let’s pretend that’s we’re still in Kansas, and this is just a New Normal. It’s a consensual hallucination, allowing everybody to retain a feeling of stability. How long will this illusion last, assuming no return to Kansas?”

    I think everybody shares your response, especially the “When do we get to go home” part. The difference comes from how people expect to get back home. Oddly enough the Wizard of Oz illustrates the discussions quite well.

    Far too many people believe that all we have to do is click our heels and wish real hard. These people seem to think that we have actually arrived back home already and just don’t realize it. They want for us to raise interest rates because that is what we have always done when the bad times end. But the bad times aren’t over yet and raising interest rates would cause problems. Keeping interest rates elevated would be catastrophic.

    Why would we keep interest rates elevated when it isn’t working? I don’t know but that seems to be the natural response of proponents of stupidity; if a policy doesn’t work, do it with more vigor!

    The other plan presented by the Wizard of Oz, the balloon, is similar to the hopes of many economists that things will heal naturally without major policy changes. Unfortunately, this not a good plan for success either. The winds of economic change are howling and the balloon has no way to control its course. Its likely future is to crash into something very hard while moving very fast.

    The one advantage of our current situation is that it has minimized the current cost to the US at the cost of adding an unknown future risk. Economically we are the envy of the developed world because we’ve made fewer obvious mistakes than anybody else.

    So what is the right course? I don’t know. But I suspect that it can be found much more in the writings of John Maynard Keynes. The big issue is that aggregate demand is staying the same while the population is slowly rising. This, combined with increasing workplace automation, which reduces the number of workers needed, is slowly making the life of the average American harder.

    Another issue is that the flow of new goods and services are being constricted by the current financial situation and large organizations that are successfully defending their economic advantages using legislation and lawsuits. Comcast is an excellent example.

    For the moment, much like our current mad war on terrorism, I see no way out. And like everybody else, I very much want to return to normal.

    P.S. – A possible solution is to let loose our slightly crazed economists on individual states and perform experiments in the old-fashioned scientific method. Create a hypothesis, create a way to test the hypothesis’s predicted outcomes, perform the test, discover the results, repeat. Nobody sane would wish this upon themselves because most tests generate failing results but that is how science advances.

    Eventually, after numerous failures that cause enormous upheavals and failing businesses, we’d probably find the solution to this problem. But the search for the cure might be more deadly than the current malaise.

    1. Pluto,

      I agree with most of what you say. Carrying the metaphor of Oz further is helpful!

      “Why would we keep interest rates elevated when it isn’t working?”

      I believe you over-simplify the situation. For good reason is the Fed determined to raise rates, as we see in the Open Market Committee minutes (the Sept minutes being released today). First, this is an old expansion. They need to prepare for the next downturn. That means “reloading”; they cannot lower rates is they’re at zero. Second, low rates (mis-setting the price of money) are distorting the economy and markets.

      ZIRP is powerful medicine, but has serious side-effects. If the economy has accelerated to 3%+ growth, as most economists believe, then raising rates is necessary.

    2. I agree with everything you wrote, FM. ZIRP is VERY powerful medication and it does cause VERY serious side effects. I also agree that the Fed would be powerless against another recession and we are about due for one, perhaps overdue.

      Yes, most economists believe we have finally accelerated growth to 3% and that would be a good thing if it is true.

      But I still believe that the economy is not as strong as most economists think and that raising interest rates will trigger some very nasty problems, particularly in the sub-prime lending market and the stock market.

      Growth in aggregate demand still doesn’t look sustainable to me over the next few years because everybody seems to be using their extra buying power to purchase autos and other items that cannot be paid for with immediate cash. This means that aggregate demand will be depressed by the monthly amount of the auto loan for the length of time that the auto loan, which as you have pointed out is expanding.

      I would be very happy to be proven wrong on this, by the way.

      This is why I compared ZIRP with the war on terror. Once we start down the trail of madness, all options involve pain and it is hard to know which course is the best for the future and causes the least amount of damage over the long run.

  2. In physics if you start with the assumptions that the rules apply everywhere (invariance under translation) and at every angle of view (invariance under rotation) you can deduce or induce all of classical physics. Newtons laws of motion, conservation of momentum and energy and so on. This is the symmetry principle. Thus very simple starting constraints can lead to profoundly sophisticated principles.
    Steve Keen is doing a similar kind of modeling for macroeconomic theory. He starts with just the assumptions that we live in a double entry bookkeeping ledger world. That banks uniquely create new money by lending to firms who pay workers. These assumptions take the form of constraining equations describing the stocks and flows of money in the economy. The solutions are rich in complexity due to nonlinear behaviors. Paul Krugman argues that this approach is wrong because banks just intermediate between savers and borrowers. They don’t create money by lending. One of these is wrong. I side with Keen.
    We got in this mess by credit money creation by banks at a rate greater than GDP growth. Worse this credit money went into speculative investments in real estate and equities. Now that same credit money is trying to disappear by debt default. The disappearance of money is deflationary. The deflation is seen in asset prices which rose during the credit expansion. Extending and pretending (GAAP is still suspended) combined with Fed money printing and continued bank lending to speculators is keeping the game going.
    Progress will come one dead economist at a time. Too slow IMO.

    1. Peter,

      “We got in this mess by credit money creation by banks at a rate greater than GDP growth.”

      Perhaps. Bank lending has grown ~1.25%/year faster than GDP, but there’s not an obvious relationship between the two series — nor is it clear what’s the correct level for the prevailing conditions of GDP growth, interest rates, taxation, and inflation.

      “Worse this credit money went into speculative investments in real estate and equities.”

      That’s probably false for any long period of time. Shorter-term booms and busts are an inherent part of the business and credit cycles, and have been for centuries.

      “Now that same credit money is trying to disappear by debt default.”

      False. Default levels’s ace been falling since 2009, and most are low vs. historical averages.

      “The disappearance of money is deflationary.”

      “The deflation is seen in asset prices which rose during the credit expansion.”

      False. We have had many credit cycles since WW2. In none has there been actual deflation (as there was during the early 1930s), due to prompt and powerful action by the Fed. Falling asset prices is not “deflation”, which is a fall in the broad prices of goods and services.

    2. Lending is not just FDIC bank lending but should include all private sector debt. This has grown faster than GDP especially over the last ten years.
      Trying to disappear is not the same as disappearing… Yet. The Fed has countervailed successfully so far by forcing capital into the FIRE sector assets. (By lowering interest rates)
      Inflation is new money (by e.g. Fed printing to finance deficits ) bidding up the price of goods and services.
      Deflation is money disappearance (e.g. By taxation or retiring debt) lowering price of goods and services.
      Status quo economists thus believe new money appears by policy decisions by fiscal and monetary authorities and is thus under control by central bank and tax authorities. The neoclassicals thus believe inflation is caused by policy decisions.
      Keen on the other hand asserts that the effective money supply is not under the control of policy setters but rather is a free wheeling aspect of our poorly controlled banking system including shadow banking. This creates a potential for instability in which banks first overlend to asset speculators who then drive up asset prices. Eventually these borrowers default when the assets cannot meet the debt service cash flow requirements. This is Minsky in a nutshell.
      A new favorite saying on the web is “Just because it hasn’t happened yet doesn’t mean it won’t happen”.

    3. Peter,

      Too much of this is grossly wrong for rebuttal (life is short; experience has taught me that it’s a waste of time). You appear to be listening to tin foil hat sources. I will just mention two items.

      You *specifically* mentioned “bank lending” as credit creation. Extending this to all borrowing is not appropriate as only banks have ability for fractional reserve lending. Other lending is just shifting around of cash. Different dynamics.

      Inflation is a change in the price level, not “creation of new money”. You don’t get to make up you own meanings, like Humpty Dumpty.

    4. Peter,

      I don’t know what you mean by “intertwined”, or what any of this has to do with your original false statements or this post (probably nothing). Please attempt to keep your comments relevant to the post.

      Yes, non-bank institutions (mostly investment banks) became involved in some activities similar to one of the functions banks do (credit intermediation). This had bad effects in 2007-2008, largely because the numerous & powerful regulators of investment banks were asleep during the real estate boom — despite the widespread recognition in the financial community that bad things were happening.

      This was an assist to the much larger failure of bank executives — and bank regulators — to maintain the integrity of bank accounting and balance sheets.

      The IMF paper is part of the justification efforts of these industries and their regulators to conceal their failures, and move forward. Nicely written, as usual.

      “Good thing we have firewalls between”

      Glass Steagell Act of 1932 (the “firewall”) was slowly eroded starting in the late 1960s. In 1999 the Gramm–Leach–Bliley Act formally repealed those prohibitions.

      “Like Goldman … turned into reserve banks”

      “Reserve bank” refers to institutions performing functions of a central bank. In the US that means the district banks of the Federal Reserve system. Goldman was designated a commercial bank holding company, a very different thing.

    5. The question is who controls bank lending and how. Neoclassicals like PK say banks are constrained from lending by the reserve requirement set by the Fed. Keen asserts that banks are never constrained in aggregate this way because if the Fed tried to restrict lending by being tight with reserves the payment system would collapse. He asserts that banks never consider reserve requirements but rather make the loan and then acquire reserves by interbank lending or other means. They know that in agogregate the Fed will never let the system run out of reserves because of the payment function the banking system performs.
      If the Fed cannot influence bank lending through reserve requirements how is lending controlled? Unfortunately the answer is not very well. Minsky’s idea was that soon after a crash lending is controlled by fear but as time goes by it is controlled by greed. The greed feedback loop is lending to speculators drives up asset prices justifying more loans driving up prices and so on.
      I can’t tell whether you don’t agree with this or you don’t understand it. Maybe both?

    6. Peter,

      Your previous comments have proven you have almost no understanding about credit or economics. You misuse basic terms, misunderstand basic comments, and give false data.

      This comment is gibberish. Your self-confidence in these comments is sad to see.

      I suggest you read some mainstream economists and learn from them rather than mocking them. Guessing, you attitude prevents you from learning anything from your reading in these matters.

      I’m done. Experience has shown that I can keep correcting your basic definitional and factual errors — but you’ll learn nothing, and continue to spout gibberish.

    7. The post is on paradigm change. I’m telling you what two known iconoclasts have said and are saying. Also I’m pointing out how these new ideas fit the fact pattern better than the current dogma. Elaborating: Minsky noted that after the Great Depression lenders applied strict ratio rules to prospective borrowers. Real estate assets were valued at one hundred times their monthly rental income for example. He saw that eventually these rules eroded and lenders began assuming asset prices would rise independent of their cash flows. In the extreme just preceding the next crash asset prices and the loans secured by these prices/valuations get way out of whack. Houses sell for many hundreds of times the monthly rental income for example. Keen took Minsky’s ideas and extends them by suggesting that this instability is not a psychological phenomenon but rather a mathematical one. Simple and plausible rules for how bankers behave combined with noting that the banking system creates new marginal demand purely through the act of new lending gives rise to model equations that exhibit the behavior seen by Minsky. I find it weird that you post on iconoclastic paradigm change and then complain that comments on same are full of iconoclastic irreverent crap. Really?

    8. Peter,

      You — who obviously know little about these things — are spouting nonsense. It’s good material filtered through a randomized.

      If you wish to convey what experts say, use quotes and citations.

      I’ve been nice about this, but enough is enough.

    9. Why do public debates about these admittedly abstruse theory conflicts matter? Because policy flows from theory. Winning theories set policy. There is a new idea being floated to do a helicopter drop to the bottom 80%. The most prominent appeared in Foreign Affairs but Keen too has militated for this kind of fiscal policy paid for by printing. Without a supporting theoretical basis getting at least some credibility this idea has zero chance. Pity. It just might work.
      Anyway thanks for providing that public forum FM.

    10. Peter,

      For perspective, your first 3 posts discussed nothing remotely about paradigm change in economic theory.

      Discussion about the boundaries of a scientific paradigm requires deep knowledge of the field. In economics that’s far above my pay grade. I considered linking to some recent discussions about the problems in macroeconomic theory, but decided they would be too technical for this audience.

    11. My bad. I forget that not everyone loves physics. Some say Quantum Mechanics was the big Kahoona of paradym shifts but QM was the response to an experiment (the photoelectric effect) that existing theory failed to explain. I say symmetry is the real game changer. A purely axiomatic construction from trivial predicates yields all of physics and with extension super symmetry and unified field theory. No contest.
      Done by a woman by the way. Anyway my first post was meant to be about massive disruption and the power of pure logic.

    12. Peter,

      That’s quite a reading FAIL.

      Yes, there have been paradigm changes in physics (duh).

      You first comment was, like your others, riddled with simple errors as you prattle on about a subject you know little about. In that sense it was not about paradigm change.

      Your inability to admit these simple mistakes is sad. No more

    13. Great idea:
      Here is an outtake from Minsky’s 1977 paper on his financial instability hypothesis.:

      The nat­ural start­ing place for ana­lyz­ing the rela­tion between debt and income is to take an econ­omy with a cycli­cal past that is now doing well. The inher­ited debt reflects the his­tory of the econ­omy, which includes a period in the not too dis­tant past in which the econ­omy did not do well. Accept­able lia­bil­ity struc­tures are based upon some mar­gin of safety so that expected cash flows, even, in peri­ods when the econ­omy is not doing well, will cover con­trac­tual debt pay­ments. As the period over which the econ­omy does well length­ens, two things become evi­dent in board rooms. Exist­ing debts are eas­ily val­i­dated and units that were heav­ily in debt pros­pered; it paid to lever. After the event, it becomes appar­ent that the mar­gins of safety built into debt struc­tures were too great, As a result, over a period in which the econ­omy does well, views about accept­able debt struc­ture change. In the deal-making that goes on between banks, invest­ment bankers, and busi­ness­men, the accept­able amount of debt to use in financ­ing var­i­ous types of activ­ity and posi­tions increases. This increase in the weight of debt financ­ing raises the mar­ket price of capital-assets and increases invest­ment. As this con­tin­ues the econ­omy is trans­formed into a boom econ­omy. – See more at: http://www.debtdeflation.com/blogs/2008/03/10/time-to-read-some-minsky/#sthash.4ZdPehdX.dpuf

    14. Peter,

      I’ll state this more clearly. That you cite Minsky as challenging the reigning paradigm of macroeconomics shows your lack of knowledge about these things.

      Minsky was not outside the paradigm when that was written 4 decades ago (it was just a quiet corner of theory). Now it’s quite mainstream. I doubt you can find a single macroeconomist who disagrees.

      From your comments here, it’s clear you have not the faintest idea as to the outlines of the current macro paradigm. Few laypeople are. Why should they be?

    15. Minsky believed that new credit money creation was endogenous. That is, it was created inside the banking system at a rate under control by individual banks themselves. This is from the same 1977 Minsky paper:
      Increased avail­abil­ity of finance bids up the prices of assets rel­a­tive to the prices of cur­rent out­put and this leads to increases in invest­ment. The quan­tity of rel­e­vant money, in an econ­omy in which money con­forms to Keynes’ def­i­n­i­tion, is endoge­nously deter­mined, The money of stan­dard the­ory— be it the reserve base, demand deposits and cur­rency, or a con­cept that includes time and sav­ings deposits—does not catch the mon­e­tary phe­nom­ena that are rel­e­vant to the behav­ior of our econ­omy. – See more at: http://www.debtdeflation.com/blogs/2008/03/10/time-to-read-some-minsky/#sthash.5DCxrOEz.
      This is way outside the mainstream. Neoclassicals like PK believe new credit money creation is exogenous in origin. That is, under the control of an external authority like the Fed. This is the starting assumption of IS-LM models. The so called loanable funds assumption that the money quantity is fixed exogenously by the Fed and banks merely intermediate meaning they move that fixed amount between savers and borrowers. The endogenous view of money creation is a frontal assault on status quo economic theory. This is what Keen is saying now. This is what Keen is trying to debate Krugman on now. This is where the paradigm shift underlying macroeconomics needs to occur.

    16. Here is the Wikipedia for Minsky’s financial instability hypothesis.
      Here is an outtake:

      McCulley writes that the progression through Minsky’s three borrowing stages was evident as the credit and housing bubbles built through approximately August 2007. Demand for housing was both a cause and effect of the rapidly expanding shadow banking system, which helped fund the shift to more lending of the speculative and ponzi types, through ever-riskier mortgage loans at higher levels of leverage. This helped drive the housing bubble, as the availability of credit encouraged higher home prices. Since the bubble burst, we are seeing the progression in reverse, as businesses de-leverage, lending standards are raised and the share of borrowers in the three stages shifts back towards the hedge borrower.
      Note the reference to shadow banking. New credit money was created by these banks. Krugman would say this is impossible. Someone is wrong.

    17. This stuff matters because policy hinges on theory. Here is a good idea that has little theoretical support.
      Keen also promotes this kind of approach. Give printed money to the bottom instead of the top of the wealth distribution. This is why I’m angry with PK. He won’t give these ideas a second thought. What if it turns out they’re right?

    18. Just in time for this thread comes a book review highly relevant to this topic:

      Here is an outtake:
      personally mentored several of these men in Europe or in the United States. Others have mentioned the influence in Japan of Schumpeter’s well-known theories on innovation and entrepreneurship; Metzler, however, focuses on the Austrian’s “Faustian” concept of banks’ inflationary creation of money “out of nothing” as the driver of capitalist industrial development. According to Metzler, this concept, which Japanese economists embraced from the start but their Anglo-American counterparts have mostly forgotten or ignored, explains the mechanism by which Japan financed its postwar recovery and “miracle.”

      The book requires some patience in navigating, as it begins with globalhistorical and theoretical chapters sandwiching a chapter introducing the principal characters—including Schumpeter and his Japanese acolytes—before turning to the analysis of Japan’s postwar experience. Throughout, Metzler underscores Schumpeter’s century-old insight that the inflationary creation of credit, primarily by banks, is “the financial fountainhead of modern capitalist development” (p. 1). The inflation caused by the operation of banks’ manufacturing money and lending it to industries through “bookkeeping entries” produces “forced savings” from the wider society; as Metz ler puts it, “modern money in the broad sense used by economists is mainly created by private banks in the act of lending money they do not yet ‘have’” (p. 211). Japan’s postwar planners clearly understood this process, stating in the Economic Planning Agency’s 1957 White Paper that, “from the viewpoint of banks as a whole, something is created from nothing” (p. 190). Furthermore, such paper credits act as “orders”—new claims to existing goods and services—so that, as Schumpeter saw it, “banks under capitalism functionally resembled a state planning board under socialism” (p. 47). Schumpeter’s emphasis on “the indicative aspect of capital” (p. 46) seems to have enhanced the appeal of his dynamic, developmental approach in the eyes of Japan’s postwar economic planners, who learned from the failure of deflationary stabilization in the interwar period and built on techniques of the wartime “controlled economy” to manage a successful “inflationary stabilization” after World War II.

  3. FM asserts: “That the economy needs such large stimulus in the sixth year of an expansion is unprecedented.”

    No, actually not. There is another instance where the U.S. economy needed enormous ongoing stimulus even six years after the initial collapse — the Great Depression that began in October 1929. By 1937, 8 years after the initial collapse, FDR and his brain trust believed that the U.S. economy had recovered sufficiently to start balancing the federal budget once again. The result was a catastrophic resumption of the Great Depression.

    In 1937, after five years of sustained economic growth and a steadily declining unemployment rate, the Roosevelt Administration began to worry more about possible inflation and the size of the federal deficit than the ability of the economy to sustain the recovery. As a consequence, in the fall of 1937, FDR supported those in his administration who advocated a reduction in federal expenditures (i.e. stimulus spending) and a balanced budget. The results — which included a massive reduction in the number of people employed by such programs as the WPA — were catastrophic. From the fall of 1937 to the summer of 1938, industrial production declined by 33 percent; wages by 35 percent; national income by 13 percent; and not surprisingly, the unemployment rate rose by roughly 5 percentage points, with an estimated 4 million workers losing their jobs.

    The economic downturn caused by the decline in federal spending was commonly referred to as the “Roosevelt recession,” and to counter it, FDR asked Congress in April of 1938 to support a substantial increase in federal spending and lending. Unlike the current situation, Congress backed FDR’s request, and as a result, the recovery was soon underway again.

    Source: Repeating Our Mistakes: The “Roosevelt Recession” and the Danger of Austerity, The Roosevelt Institute website.

    Pluto remarks: “Why would we keep interest rates elevated when it isn’t working? I don’t know but that seems to be the natural response of proponents of stupidity; if a policy doesn’t work, do it with more vigor!”

    That’s the European economic strategy, not the American one. The U.S. has successfully kept interest very low — so low that in fact the TIPS inflation-indexed U.S. treasury bonds actually pay a slight negative return after inflation. Meaning that if you buy a TIPS treasure bond, you will wind up with slightly less money when you cash in the bond at maturity (after accounting for inflation) than you had when you bought the bond. And yet people all over the world clamor to buy U.S. TIPS bonds. Why? Because U.S. TIPS bonds represent a safe haven for investment. You may not make money, but at least all the money you invest won’t evaporate in a puff of smoke…the way money invested in real estate or tech stocks or companies like Enron did.

    To the contrary: the big problem facing the U.S. economy remains our retreat to the zero lower bound. With a prime rate effectively at zero, after accounting for inflation, there is no further room for economic stimulus, since the government cannot offer negative interest rates on T-bills or to banks. At the same time, near the zero lower bound, printing more money does nothing, since it is not the quantity of money in the economy that matters, but the amount of money that circulates.

    In the aftermath of a colossal financial crash, however, everyone hordes cash. Banks horde cash because their deposits have drawn down while their bad loans have skyrocketed, and banks must maintain a certain percentage of cash on hand to cover reserves lest federal regulators shut them down. Too, banks must pay off all those bad real estate loans — for even a bank forecloses and writes the bad loan off, it must sell the property at a loss and record that loss as red ink on its balance sheet, so banks need hard cash and lots of it to cover those losses.

    In the aftermath of a vast financial crash, businesses don’t invest because aggregate demand has collapsed. Investment would be wasted, since consumers aren’t buying. So businesses horde cash instead of spending it.

    Meanwhile, consumers horde cash because they have lost their life savings and their houses are under water and they need every dime to avoid losing what little remains of their assets.

    So neither banks nor businesses nor consumers spend money into the economy. This means that while vast amount of cash have flooded the U.S. economy, very little of it circulates. And so inflation remains near zero, and deflation looms as a real possibility.

    The danger facing the U.S. economy in 2014 was perfectly described by Walter Bagehot in 1878 in his classic book Lombard Street:

    The history of the trade cycle had taught me that a period of a low rate of return on investments inexorably leads towards irresponsible investment.… People won’t take 2 per cent and cannot bear a loss of income. Instead, they invest their careful savings in something impossible – a canal to Kamchatka, a railway to Watchet, a plan for animating the Dead Sea.

    And so another financial bubble slowly builds. When this one bursts, what recourse will America’s economy have? None. Unlike 2009, states are now penniless, unemployment has skyrocketed, and the federal government finds itself saddled with much greater debt and far larger deficits than back then.

    1. Thomas,

      “There is another instance where the U.S. economy needed enormous ongoing stimulus even six years after the initial collapse — the Great Depression that began in October 1929.”

      Nope. The difference is why we had similar collapses, but a depression in the 1939s and not now.

      (1). There was no Federal Funds rate in the 1930s. There were 3 month t-bills. Rate were near zero in only two years: 1935-36. We have had lower rates, and since November 2008.

      (2) The Federal govt’s deficits during the 1930s were large by their standards, but not by ours. And they ran from only 1932-1937 (picking up again in 1931).

    2. Overall Thomas’ comments are a classic description of the liquidity trap we are currently in but reality doesn’t quite match the academic description and this time is also different from the 1930’s.

      For example: “Meanwhile, consumers horde cash because they have lost their life savings and their houses are under water and they need every dime to avoid losing what little remains of their assets.”

      That’s reasonable but not accurate. The relentless propaganda from all sides explaining that the economy is in good shape has caused the savings rate to generally decline over the last few years. Also personal credit consumption has been on the rise, mostly for home improvement project and automobiles.

      But the overall velocity of money has been very gradually slowing, which is probably the single most important part of Thomas’ comments.

      As FM has frequently said, we are flying uncomfortably close to stall speed but the economy has shown surprising resilience in avoiding going below stall speed *and* surprising resilience in avoiding going faster that our current speed. There may well be forces at work here that have not been previously defined but I have no idea of where to look for them or how to measure them.

  4. And now comes the IMF to confirm what I’ve been saying about another financial bubble in the making:

    IMF warns period of ultra-low interest rates poses fresh financial crisis threat — almost zero borrowing costs has encouraged speculation rather than hoped-for pick up in investment, says Fund, The Guardian, 8 October 2014.

    Historical evidence suggests that a large economy like the U.S. takes at least a generation to recover after a huge crash like the one in 2008, or 1929.

  5. FM points out correctly that there was no Fed funds rate in 1929 and that the U.S. government only issued 3-month T-bills.

    That’s why the tremendous stimulus from the federal government after FDR’s election in 1932 had to come in a different form. The federal government created a host of alphabet agencies like the CCC to employ people and put money in their pockets so they could spend it. Also, the RFC helped get banks loaning out money again.

    Both these forms of stimulus were much more potent and far more direct than today’s quarterly easings. Fiscal policy, as Keynes noted, is like “pushing on a rope.” Directly putting money into the economy by creating government jobs, even if they’re make-work jobs, does a lot better job of kick-starting the economy.

    The proof is clear — despite all the Fed funds dumped into the economy, jobs creation has not taken off. By comparison, from 1933 plummeted from an estimated 25% in May 1933 to below 10% in June 1937. Today, despite all the crowing about a “dropping unemployment,” the vast majority of the reason for that drop comes down to retiring boomer and discouraged workers who’ve stopped looking for jobs.

    I stand by my statement. Starting with FDR’s first term, the federal government introduced tremendous stimulus into the U.S. economy. And it worked. The stimulus was of a different kind than today’s, mainly involving government-created jobs produced by ad hoc alphabet agencies rather than lowering the prime rate or conducting quarterly easing. But it was still a very economic powerful stimulus.

  6. The fiscal vs. monetary stimulus point resonates with me. Almost 3/4 (70%) of the economy is consumer spending. Getting people to spend more should be the priority. But that hasn’t happened. Before asking “why”, look at who has benefited from the policies that have been implemented–lowering both interest and tax rates. Business profits (both on an absolute basis and as a % of GDP) are at all-time record highs. But most of the workers who helped create those profits are NOT being rewarded, unlike in normal times. That may be the biggest reason for why things aren’t getting better. Maybe it’s the Job Creators that have some ‘splainin to do.

  7. Most of the blame for the slow GDP growth today clearly must be laid to the door of the Republican-dominated House of Representatives. Time and again, the House has adamantly refused to pass any job-creating government spending. In fact, the Republican-dominated House today has fallen into exactly the same fallacy of trying to balance the federal budget by reducing deficits in the aftermath of a huge balance-sheet recession as the fallacy Hoover’s Treasury Secretary Andrew Mellon fell into in 1930:

    Liquidate labor, liquidate stocks, liquidate farmers, liquidate real estate… it will purge the rottenness out of the system. High costs of living and high living will come down. People will work harder, live a more moral life. Values will be adjusted, and enterprising people will pick up from less competent people. — Andrew Mellon, 1930

    This advice is absolutely ruinous in the aftermath of giant financial collapse because balancing the budget and raising interest rates and taxes paradoxically causes revenue to fall, while increasing the value of loans that must be paid back by debtors. In a liquidity trap, advice like Mellon’s condemns the economy to a permanent slump.

    Yet this is the very economic philosophy the Republicans in the House of Representatives have been following since 2009 (and it appears to be the same philosophy adopted by the Fed, inexplicably). Fighting suspected inflation in a near-zero-interest-rate economy is like somebody rushing around screaming “Fire! Fire!” in a flash flood.

    Krugman and DeLong and Tim Duy and Stiglitz and many other competent knowledgable economists have repeatedly pointed out that the real cost (after inflation) of government spending on infrastructure and jobs programs and policies like the Earned Income Tax Credit right now is negative. That is, the U.S. government would actually be getting paid to enact these programs because of the near-zero interest rates and the fact that TIPS bonds are actually selling at a slight negative real interest rate. So it’s absolutely crazy not to be running huge deficits right now to create government jobs and training programs and infrastructure revitalization programs, because with the current situation in the bond market, it costs the U.S. government a negative amount to run those kinds of deficits. That’s what’s unprecedented, to my knowledge. Never before in my lifetime has a government-issued bond ever paid a real negative interest rate. We should take advantage of that and spend like drunken sailors on government jobs programs and infrastructure.

    I’m far from the only person pointing this out. Krugman has been pounding the table about this for years. Ezra Klein has been shouting about this for years. DeLong and Duy and Stiglitz have been vocal about it. But the Republicans in the House of Representatives remain mesmerized by Ayn Rand fantasies and delusions about “fiat money” and suchlike claptrap, and as a result the Republicans are wrongheadedly obsessed with reducing deficits when they should be worried about avoiding deflation and pumping up aggregate demand.

  8. One small point about FM’s remarks on Germany: everything FM says about Germany and the Eurozone is quite true and entirely accurate, but the Eurozone situation isn’t analagous to the U.S. situation. The big difference? The Eurozone lacks any way to adjust the differences between the component national economies, so ruinous austerity must be imposed on individual nations at the periphery of the Eurzone that run deep deficits in order to avoid fracturing the Eurozone and having nations abandon the Euro and drop out of the European economic collective.

    In America, we don’t have those kinds of problems with individual states in the U.S. because they aren’t separate economies with separate political systems that happen the use the same currency. American states are all part of the same political system, and we’re all part of the same economy. Dropping out of the United States is not an option for individual states (unlike the Eurozone) because we settled that issue during the Civil War. As a result, we have a central bank that can relieve these kinds of stresses by adjusting prime rates in the various Federal Reserve regions, and, if necessary, the U.S. can print more of the world’s default currency without having to worry about debasing their currency (since it’s currently the world’s reserve currency and U.S. T-bills remain the preferred safe investment haven for nivestors worldwide) . The Eurozone has no equivalent central bank, the Euro is not at present the world’s reserve currency, and there is no single European bond instrument with the reputation for safety of U.S. treasury bills.

    So the German economic dilemma, while troublesome, isn’t exactly equivalent to the U.S. problems.

  9. A mind-bending expansion of the Federal public debt, taking it from $5.1 trillion to $12.9 T (x2.5) — with $809 billion added during the fiscal year just ended (a 6.8% increase, equal to 4.7% of GDP).

    — from the post

    The federal government ran a budget deficit of $486 billion in fiscal year 2014, the Congressional Budget Office (CBO) estimates—$195 billion less than the shortfall recorded in fiscal year 2013, and the smallest deficit recorded since 2008. Relative to the size of the economy, that deficit—at an estimated 2.8 percent of gross domestic product (GDP)—was slightly below the average experienced over the past 40 years, and 2014 was the fifth consecutive year in which the deficit declined as a percentage of GDP since peaking at 9.8 percent in 2009.

    — from the Congressional Budget Office Monthly Budget Review for September 2014

    Government debt (also known as public debt and national debt) is the debt owed by a central government. […] By contrast, the annual “government deficit” refers to the difference between government receipts and spending in a single year, that is, the increase of debt over a particular year.

    — Wikipedia on Government Debt

    Why the discrepancy (“$809 billion added,” “a 6.8% increase” and “4.7% of GDP” versus “deficit of $486 billion,” “$195 billion less than the shortfall recorded in fiscal year 2013” and “2.8 percent of gross domestic product”)?

    I included the Wikipedia reference not to be pedantic, but because that’s what I checked to be sure I was using generally accepted definitions of “public debt” and “deficit”: the latter being the yearly change in the former.

    1. I do not know why the large discrepancy between the reported deficit and the increase in the public debt.

      The Federal government runs its books on a cash basis (bizarrely, not legal for a public corp), so there should not be accrual differences. However the real deficit — the one that matters — is the increase in the debt.

      Note that none of these numbers show the increase in the Govt’s liabilities — debt plus future obligations for social security, health care, and pensions (which a corporation must show using accrual accounting). That is in the footnotes, and is a far larger number.

    2. Coises,

      I finally got around to reading the Treasury Statement for fiscal 2014. There are changes in the various asset accounts, unusually large (e.g., $63 billion in cash, $129B in “deposit funds”). There is $128 billion in loans (mostly education loans) which increase the debt but not the deficit. There are changes in the retirement accounts (civil service, railroad, and military). A host of changes.

      The Federal government runs on a cash accounting basis (illegal for pubic corporations, for good reason). It’s quite daft, and makes the accounting quite difficult to understand. Over time I believe the increase in the public debt is the best measure of what’s happening, albeit a highly imperfect one (retirement and capital accounts should be broken out separately).

  10. What’s weird, is knowing the America government is infested with exceptionally, incompetent sociopaths who expend an infinite amount of resources to achieve nothing. What’s even weirder FM, is reading Carl Jung’s, Aion and wondering if that was destiny.

    If so, you unlucky bastards are locked out of heaven:


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