Cognitive Biases Used in Propaganda Framing Deficit Debate and Wall Street Handout

Everyone likes to think that they are smarter than the average person. After all, how many of us would be ready to admit that they were in some way, shape or form inferior. Even those friends of ours from high school, and most of us who did not attend private boarding schools know these people, who accorded themselves “street smarts” while telling others that they were merely “book smart,” claim to be better at some things than the average. We all want to feel that we are good at something and even if this is not necessarily the case, we hold on to the illusion that we are somehow more skilled than the average Joe or Jane. Let us call this concept overconfidence.

In the academic literature it is called the overconfidence bias. Cognitive and behavioral psychology as well as behavioral finance and behavioral economics study the concept at length and in depth. Classic examples include asking everyone in a class to rate their driving ability as average, below average or above average. In study after study between 80 and 90 percent of respondents rate their driving ability as above average, which cannot be the case, since only slightly less than half can be above average. Other studies have repeatedly shown that when asked to rate our confidence interval in our statements, we are much more likely to state a much higher confidence level than our accuracy. Most of us like to think that we are smarter than the average, and do not wish to accept that, truthfully, we are probably by definition just about average in many of those attributes that are indeed normally distributed. Some of us might be better at some things than others, obviously, but we are not as superior as we would like to think. Nonetheless, this feeling of being superior, this confidence in our abilities, this sense that we will do better than most everyone else can lead us to take risks we normally would eschew, were it not for the nagging near-certainty that we are better, smarter and more insightful than the others, and that this time, for us, contrary to all evidence and history, things truly will be different, be it in business, investment, games or any other of the myriad activities we engage in where we are in it to win it. Think of housing and stock market bubbles, when real estate speculators and traders or money managers no doubt thought that they would be able to time the market and get rich quickly because of their superior skills and knowledge.  

Standardized testing reinforces this bias by inflating the egos of those whose scores are in the upper percentiles. These are the people who get accepted to the best universities, who go on to graduate school because they had GMAT or GRE tutoring classes, and some of these people think that they are the true producers and “value creators” of society, deserving six or seven or eight figure remuneration because of their superior natural or god-given abilities. Everyone else who is not as successful is either morally deficient or intellectually limited and their plight or poverty is therefore deserved and just.

The fundamental attribution error states that the successes of one’s group, class, clan, or tribe, generally called the in-group, are due to internal factors, such as talents, morality, hard work and intelligence, while failures are due to external, uncontrollable causes; with the mirror image being perceived as the reasons for the failures of the out-group, the others: inferior intelligence, lack of talents, or simply laziness, and with the out-group’s successes being consequently simply a matter of luck and often undeserved. So the fundamental attribution error is to attribute success to internal and failure to external factors for oneself or one’s in-group, and the opposite for those in the out-group.

Nowhere is this phenomena more prevalent and on display than in the United States of America, where the current culture war is further being waged on behalf of the top 1%, or was it 0.1%, or 0.01%, who not only receive most of the income but also own most of the wealth in the country. The current battle about “unsustainable” government spending, government needing to live within its means, and ever-present deficit reduction hysteria, is nothing more than an ideological battle being waged by those with means who believe that they should not have to pay any money for those without means, whom they consider shiftless bums and welfare queens who refuse to work and expect “handouts” from the government. Whatever the percentage of poor who do abuse the system, however large, small or inconsequential it might actually be, this discussion is not about them, it is only being framed in this manner. Framing effects arise when different responses are elicited based on whether the information is presented in a positive or a negative frame. Is the man or woman in dire straits because they were laid off due to downsizing, outsourcing, or company or business failure; or is the person unemployed because they are lazy and want free money from the government. By framing the narrative to portray the less well-off, the unemployed, and the poor in general in the latter manner, stereotypes are being created and reinforced. This is a further cognitive bias at work, the representativeness heuristic, which asks to what extent does A represent B, so to what extend do the poor and unemployed represent my stereotypical image of them. The representativeness bias is thought to be an innate and omnipresent trait, presumably brought about as a function of evolution. The manner in which it is being abused, though, is that through propaganda -- there is no other way to put it -- the unemployed are portrayed as lazy, shiftless, and not wanting to work, but expecting handouts and being able to sit at home drinking or drugging on the taxpayer’s dime. If you work and pay taxes, you are being led to believe that your money is not being spent on military armaments so that the US military can continue blowing up brown people somewhere to make the area safe for liberal capitalism and Halliburton and Bechtel; or that your money is going to bail-out Wall Street; rather, the public is told that taxpayers’ money is going to pay for the immoral and lazy who do not want to work. It is forgotten that the financial system brought about a collapse of the economy bringing along the unemployment that comes with recession and depression. But by reiterating this narrative that the poor and unproductive are unjustly taking money from the rich and productive, powerful interests serving right wing wealth -- see Rupert Murdoch and Roger Ailes along with the Koch brothers, for example -- are framing the discussion to serve their interests, which are to roll back any and all social programs since the New Deal and the Great Society, to take us back to a time when capital was king and the government did not dare tax the hard earned millions or billions of robber barons, when workers knew their place, and corporations would be unhindered in their pursuit of the bottom line, the environment, and the public be damned. Some might say we are already there.

Besides always having been a right wing ideological dream, one could call it Milton Friedman’s “wet dream”, to demolish the social welfare state, to “drown it in a bathtub” as per Grover Norquist`s wishes, currently the unemployed, unions public or private, those on welfare, and all those whose lifetime of work and paying into a system of social security in the expectation of receiving benefits when they retire have seen any government program suddenly become “unsustainable entitlements.” In unison the scream is: “We must cut all social programs or we will go bankrupt,” some louder than others, but all of them singing the same song: the Tea Party, the Republicans, some Democrats, and the President himself, at first unbelievably and unfortunately, but currently obviously and to be expected now that it has become perfectly clear that Obama stands to the right of most civilized conservatives on many issues.

The most insidious lie, however, is not only that the US is going broke because of social welfare programs, but that the US government can go bankrupt at all, after the surreal demonstration of money creation to hand over to an insolvent financial system and their investors and creditors. If one looks at the fact that a sovereign government which is in charge of its own currency can never go bankrupt, something that has long been explained and propounded by Professor L. Randall Wray, Marshall Auerback, Professor Bill Mitchell, Warren Mosler, and many others who understand modern monetary theory; and stunningly admitted by none other than “Helicopter Ben” Bernanke himself, who did indeed drop staggering amounts of money into the laps of the financial sector; and if one finds out from the report of the Special Inspector General of the Troubled Asset Relief Program (SIGTARP report here) presented to Congress by Neil Barofsky, who was in charge of SIGTARP, that up to $23.7 TRILLION were created in guarantees, equity injections, and toxic asset purchases, along with an extensive alphabet soup of programs ostensibly created to bring the US economy back from the brink of Depression and financial Armageddon, then any talk of budget constraint and the US running out of money is ridiculous and disingenuous.

The TARP; regulatory forbearance, which simply means that we will forget a while about bankruptcy rules which state that when you go bankrupt you are out of business, management gets fired and your assets get liquidated to pay your creditors; along with changes in mark-to-market accounting rules which allowed many to get obscenely rich during the bubble years but are now allowing insolvent institutions to hold worthless assets on their balance sheet at inflated prices, further kicking the can down the road in an exercise of extend and pretend; and letting the banking system finance itself at interest rates at 0.25%, money which is then promptly lent back to the government at several percentage points higher, might just strike informed observers as being simply gifts not only to the executives of too-big-to-fail banks for doing such a fantastic job of running their companies into the ground and helping the US economy come to the verge of Depression, but also a bailout of these companies’ bondholders and shareholders, since risk in finance was just a joke, and does not really exist due to the “Bernanke and Uncle Sam put”. “Profits are privatized and losses are socialized,” and everyone should read Yves Smith for her unmatched analysis of the events of the past years.

Once one realizes that for the US government money can simply be created and does not need to be borrowed, and that of the trillions that were created much was simply given away to the US banking and finance sectors and their bondholders, shareholders and creditors, which incidentally also bailed out a lot of foreign banks, then one might realize two things: that free market capitalism no longer exists, if it ever did anyway, when the government selectively chooses whom to rescue and how much money to give away, and that it is not the unemployed, sick and poor who have brought the country to the brink of ruin, but rather an extractive and predatory financial system that has co-opted the government to cater to its needs and not to those of the people. There is a reason it is called “Government Sachs”.

Because people are easily manipulated and susceptible to cognitive and behavioral biases, and because they have a short attention span and are more concerned with celebrity gossip than their own lives, not realizing that they are giving away their life energy to illusions created to keep them docile and distracted, highway robberies and sleight-of-hand such as TARP et. al. can brazenly be pulled and the biggest robbery in history does not concern citizens whose governments now have any protesters beaten bloody by riot police with batons and teargas. It is “bread and circuses” as it has been for most of human history. But when either the “bread” or the “circus” are missing, then people are forced to think about their own existence and maybe, just maybe, see through the corporatist fascist propaganda and wake up enough to become informed, indignant, independent and irrepressible.  

Money Creation to Bail Out Wall Street's Bad Bets But No Money For Social Security

Economist Michael Hudson has long pointed out that the US taxpayer has basically been robbed at metaphorical gunpoint by Wall Street bankers, whose bad bets gone bad have been bailed out to the tune of $13 trillion by transferring their bad bets onto the public, that is the US taxpayer balance sheet. 

Here is an excerpt from a must read article explaining that the US can create money out of thin air and has done so to bail out banker's bets while claiming that there is no money for medicare, medicaid, social security etc., basically anything that would help the downtrodden, or poor, or even the middle class.

What has made the post-2008 crash most remarkable is not merely the delusion that the way to get rich is by debt leverage (unless you are a banker, that is). Most unique is the crash’s aftermath. This time around the bad debts have not been wiped off the books. There have indeed been the usual bankruptcies – but the bad lenders and speculators are being saved from loss by the government intervening to issue Treasury bonds to pay them off out of future tax revenues or new money creation. The Obama Administration’s Wall Street managers have kept the debt overhead in place – toxic mortgage debt, junk bonds, and most seriously, the novel web of collateralized debt obligations (CDO), credit default swaps (almost monopolized by A.I.G.) and kindred financial derivatives of a basically mathematical character that have developed in the 1990s and early 2000s.

These computerized casino cross-bets among the world’s leading financial institutions are the largest problem. Instead of this network of reciprocal claims being let go, they have been taken onto the government’s own balance sheet. This has occurred not only in the United States but even more disastrously in Ireland, shifting the obligation to pay – on what were basically gambles rather than loans – from the financial institutions that had lost on these bets (or simply held fraudulently inflated loans) onto the government (“taxpayers”). The government took over the mortgage lending guarantors Fannie Mae and Freddie Mac (privatizing the profits, “socializing” the losses) for $5.3 trillion – almost as much as the entire national debt. The Treasury lent $700 billion under the Troubled Asset Relief Plan (TARP) to Wall Street’s largest banks and brokerage houses. The latter re-incorporated themselves as “banks” to get Federal Reserve handouts and access to the Fed’s $2 trillion in “cash for trash” swaps crediting Wall Street with Fed deposits for otherwise “illiquid” loans and securities (the euphemism for toxic, fraudulent or otherwise insolvent and unmarketable debt instruments) – at “cost” based on full mark-to-model fictitious valuations.

Altogether, the post-2008 crash saw some $13 trillion in such obligations transferred onto the government’s balance sheet from high finance, euphemized as “the private sector” as if it were the core economy itself, rather than its calcifying shell. Instead of losing on their bad bets, bad loans, toxic mortgages and outright fraudulent claims, the financial institutions cleaned up, at public expense. They collected enough to create a new century’s power elite to lord it over “taxpayers” in industry, agriculture and commerce who will be charged to pay off this debt.

If there was a silver lining to all this, it has been to demonstrate that if the Treasury and Federal Reserve can create $13 trillion of public obligations – money – electronically on computer keyboards, there really is no Social Security problem at all, no Medicare shortfall, no inability of the American government to rebuild the nation’s infrastructure. The bailout of Wall Street showed how central banks can create money, as Modern Money Theory (MMT) explains. But rather than explaining how this phenomenon worked, the bailout was rammed through Congress under emergency conditions. Bankers threatened economic Armageddon if the government did not create the credit to save them from taking losses.

Even more remarkable is the attempt to convince the population that new money and debt creation to bail out Wall Street – and vest a new century of financial billionaires at public subsidy – cannot be mobilized just as readily to save labor and industry in the “real” economy. The Republicans and Obama administration appointees held over from the Bush and Clinton administration have joined to conjure up scare stories that Social Security and Medicare debts cannot be paid, although the government can quickly and with little debate take responsibility for paying trillions of dollars of bipartisan Finance-Care for the rich and their heirs.

He also points out that things are bad if Michelle Bachmann is the voice of reason. The galling nature of bailing out banker's bad bets while preaching austerity for everyone else is augmented when one is made aware that the US government is not constrained in any way shape or form. The Modern Money primer is a good place to start getting acquainted with the way money is created, and the implications of these facts for any discussion about government solvency, entitlement programs, benefits or austerity and "belt tightening" for everyone except financiers whose casino capitalism bad bets are being bailed out by the government.


Full article by Michael Hudson here.

ECONNED -– The Movie, Um, Video!

Awsome video from Yves Smith!

ECONNED – The Movie, Um, Video!
A very talented movie/commerical/trailer editor, who for some bizarre reason insists on going nameless (but if you want his coordinates, don’t hesitate to ping me) assisted by Ben Fisher in a major role (finding images and video clips) and Richard Smith in a minor role (extensive sanity checking) put this together.

This may inspire McLuhan-esque debates, since I wanted something true to the medium, as in visceral and immediate, rather than the usual talking head sort of piece.

Enjoy! Oh, and turn the sound up

Buy this book! Econned: How Unenlightened Self Interest Undermined Democracy and Corrupted Capitalism

Make sure you get the upcoming book from my friend Yves Smith of www.nakedcapitalism.com fame.

Countdown 3/2/10: Excerpt from Econned
Folks, the time has come when I must start shamelessly promoting my book, Econned: How Unenlightened Self Interest Undermined Democracy and Corrupted Capitalism, which is being released March 2, 2010.

I thought the extract below would give readers an idea of what the book is about, with one caveat. Econned goes into some detail about crisis mechanisms (as in why it got as bad as it did) and has unearthed a heretofore unexamined hedge fund trading strategy that turned the subprime mania into the detonator of the global debt bomb (and yes, we have the goods).

Enjoy!

In 1776, Adam Smith published The Wealth of Nations. In it, he argued that the uncoordinated actions of large numbers of individuals, each acting out of self-interest, sometimes produced, as if by “an invisible hand,” results that were beneficial to broader society. Smith also pointed out that self-interested actions frequently led to injustice or even ruin. He fiercely criticized both how employers colluded with each other to keep wages low, as well as the “savage injustice” that European mercantilist interests had “commit[ted] with impunity” in colonies in Asia and the Americas.

Smith’s ideas were cherry-picked and turned into a simplistic ideology that now dominates university economics departments. This theory proclaims that the “invisible hand” ensures that economic self-interest will always lead to the best outcomes imaginable. It follows that any restrictions on the profit-seeking activities of individuals and corporations interfere with this invisible hand, and therefore are “inefficient” and nonsensical.

According to this line of thinking, individuals have perfect knowledge both of what they want and of everything happening in the world at large, and so they pass their lives making intelligent decisions. Prices may change in ways that appear random, but this randomness follows predictable, unchanging rules and is never violently chaotic. It is therefore possible for corporations to use clever techniques and systems to reduce or even eliminate the risks associated with their business. The result is a stable, productive economy that represents the apex of civilization.

This heartwarming picture airbrushes out nearly all of the real business world. Yet uncritical allegiance to these precepts over the last thirty years has produced a world in which corporations, especially in finance, are far less restricted in their pursuit of profit. We show in this book how this lawless environment has led the financial services industry to pursue its own unenlightened
self-interest. The industry has become systematically predatory. Employees of industry firms have not confined their predation to outsiders; their efforts to loot their own firms nearly destroyed the industry and the entire global economy. Similarly destructive behavior by other players, often viewed through a distorted lens that saw all unconstrained commercial behavior as virtuous, added more
fuel to the conflagration.

Some economists have opposed this prevailing ideology; indeed, comparatively new lines of inquiry focus explicitly on how economic actors can fool themselves or others into making poor, even destructive, choices.

But when the economics profession has used the megaphone of its authority to dominate discussions with policymakers and the public, it has spoken with one voice, and the message has been the one described here. We therefore confine our criticism to these particularly influential ideas.

Theories that fly in the face of reality often need to excise inconvenient phenomena, and mainstream economics is no exception. Idealizing the rational aspects of business decisions means refusing to notice behavior that is predatory, destructive, criminal, or simply stupid. Believing that risk is manageable through mechanical systems has required not just unrealistic assumptions but also willful
blindness to clear signs of danger.

We offer here another point of view. This book lays bare both the actions leading to the credit crisis and the economic constructs that defended, facilitated, and even exacerbated this behavior. Our case makes clear that if our economic system is to harness the self-interest of individuals to achieve the general
good, it must be supervised within a democratic society and responsive to criticism by outside voices of those who are unafraid to think independently.

Hyman Minsky´s Financial Instability Hypothesis

There is nothing like a crisis of momentous proportions to focus the mind. The intellectual edifice that was neo-classical economics came crumbling down last fall, something admitted by none other than the guru of efficient self-regulating markets himself, Alan Greenspan.



Now a well worn phrase has been that "no one could have seen this coming." Well, that is just not true; many did. And what set them apart from the cheering herd and its Panglossian view that all is for the best in this best of all worlds is that they did not drink from the neo-classical ideological kool-aid.

Hyman Minsky is about the last person asset managers would want to be mentioning in their letters to their clients (I cannot recall where I originally read this, or I would attribute credit). Minsky is perhaps best known for his Financial Instability Hypothesis which is being wonderfully articulated by Steve Keen at his debt deflation blog , along with the good folks over at the Center for Full Employment and Price Stability and many others.

Why the resurgence in interest in Minsky? Well, he explained and expanded ideas set forth by Keynes, who did not believe that markets were efficient and self-regulating. The price of an asset was not always the correct price.

From Keynes´s article in 1937:

Actually, however, we have, as a rule, only the vaguest idea of any but the most direct consequences of our acts. Sometimes we are not much concerned with their remoter consequences, even tho time and chance may make much of them. But sometimes we are intensely concerned with them, more so, occasionally, than with the immediate consequences.

Now of all human activities which are affected by this remoter preoccupation, it happens that one of the most important is economic in character, namely. Wealth. The whole object of the accumulation of Wealth is to produce results, or potential results, at a comparatively distant, and sometimes at an indefinitely distant, date. Thus the fact that our knowledge of the future is fluctuating, vague and uncertain, renders Wealth a peculiarly unsuitable subject for the methods of the classical economic theory. This theory might work very well in a world in which economic goods were necessarily consumed within a short interval of their being produced. But it requires, I suggest, considerable amendment if it is to be applied to a world in which the accumulation of wealth for an indefinitely postponed future is an important factor; and the greater the proportionate part played by such wealth-accumulation the more essential does such amendment become.

By "uncertain" knowledge, let me explain, I do not mean merely to distinguish what is known for certain from what is only probable. The game of roulette is not subject, in this sense, to uncertainty; nor is the prospect of a Victory bond being drawn. Or, again, the expectation of life is only slightly uncertain. Even the weather is only moderately uncertain. The sense in which I am using the term is that in which the prospect of a European war is uncertain, or the price of copper and the rate of interest twenty years hence, or the obsolescence of a new invention, or the position of private wealthowners in the social system in 1970. About these matters there is no scientific basis on which to form any calculable probability whatever. We simply do not know. Nevertheless, the necessity for action and for decision compels us as
practical men to do our best to overlook this awkward fact and to behave exactly as we should if we had behind us a good Benthamite calculation of a series of prospective advantages and disadvantages, each multiplied by its appropriate probability, waiting to he summed.

How do we manage in such circumstances to behave in a manner which saves our faces as rational, economic men? We have devised for the purpose a variety of techniques, of which much the most important are the three following:

(1) We assume that the present is a much more serviceable guide to the future than a candid examination of past experience would show it to have been hitherto. In other words we largely ignore the prospect of future changes about the actual character of which we know nothing.
(2) We assume that the existing state of opinion as expressed in prices and the character of existing output is based on a correct summing up of future prospects, so that we can accept it as such unless and until something new and relevant comes into the picture.
(3) Knowing that our own individual judgment is worthless, we endeavor to fall back on the judgment of the rest of the world which is perhaps better informed. That is, we endeavor to conform with the behavior of the majority or the average. The psychology of a society of individuals each of whom is endeavoring to copy the others leads to what we may strictly term a conventional judgment.

Now a practical theory of the future based on these three principles has certain marked characteristics. In particular, being based on so flimsy a foundation, it is subject to sudden and violent changes. The practice of calmness and immobility, of certainty and security, suddenly breaks down. New fears and hopes will, without warning, take charge of human conduct. The forces of disillusion may suddenly impose a new conventional basis of valuation. All these pretty, polite techniques, made for a well-panelled Board Room and a nicely regulated market, are liable to collapse. At all times the vague panic fears and equally vague and unreasoned hopes are not really lulled, and lie but a little way below the surface.

Perhaps the reader feels that this general, philosophical disquisition on the behavior of mankind is somewhat remote from the economic theory under discussion. But I think not. Tho this is how we behave in the market place, the theory we devise in the study of how we behave in the market place should not itself submit to market-place idols. I accuse the classical economic theory of being itself one of these pretty, polite techniques which tries to deal with the present by abstracting from the fact that we know very little about the
future.

I daresay that a classical economist would readily admit this. But, even so, I think he has overlooked the precise nature of the difference which his abstraction makes between theory and practice, and the character of the fallacies into which he is likely to be led.

Keynes, John Maynard (1937). `The General Theory of Employment`, Quarterly Journal of Economics, 51. cited in Shaw, G.K. (198. The Keynesian Heritage: Volume I. pp.11-13

Minsky identified three types of finance: hedge, speculative and Ponzi. Once the Ponzi stage is reached, debt is taken on in the belief that asset prices will continue to rise which will enable the debt to be serviced. Needless to say, once asset prices start to fall many will default. This is what we are seeing now. From Wray and Tymoigne :

Minsky created a famous taxonomy of financing profiles undertaken by investing firms: hedge (prospective income flows are expected to cover interest and principle with a safe margin); speculative (near-term income flows will cover only interest, although it is expected that finance costs will fall, that income flows will rise, or that assets can be sold at a higher price later—in which case revenues will be sufficient to cover principle); and Ponzi (near-term receipts are insufficient to cover interest payments so that debt increases because the Ponzi unit borrows to cover interest payments). Over the course of an expansion, financial stances evolve from largely hedge to include ever rising proportions of speculative and even Ponzi positions. Some Ponzi positions are undertaken voluntarily (due, for example, to expectations that debt can be refinanced at much more favorable terms or that large capital gains can be realized from asset price appreciation), some are fraudulent (a “pyramid” scheme is an example, in which a crook dupes everlarger numbers of suckers to provide the funds to pay the earliest participants), and some result from disappointment (revenues are lower than expected or finance costs rise unexpectedly). Attempts to raise leverage and to move to more speculative positions can be frustrated at least temporarily: if results turn out to be more favorable than expected, an investor attempting to engage in speculative finance could remain hedge because incomes realized are greater than were anticipated. This is because as aggregate investment rises, it has a multiplier impact on effective demand that can raise sales beyond what had been expected. Later, Minsky explicitly incorporated the Kaleckian result that in the truncated model, aggregate profits equal investment plus the government’s deficit.7 Thus, in an investment boom, profits would be increasing along with investment, helping to validate expectations and encouraging even more investment. This added strength to his proposition that the fundamental instability in the capitalist economy is upward—toward a speculative frenzy (as investment generates profits), which breeds more investment.

Here is an in depth look at the work and ideas of Hyman Mynsky.



Macroeconomics Meets Hyman P. Minsky the Financial Theory of Investment

Outlook for Inflation

As always in such debates there is no consensus to be found as to whether the prices will rise or fall in the foreseeable future in the USA. On the one hand, inflation hawks see a Weimar-esque hyperinflationary financial armageddon brought about by what they consider to be profligate government spending and a complicit central bank providing massive liquidity and engaging in „quantitative easing“ all of which, for inflation hawks, is by definition inflationary. The dramatic increase in the monetary base (see Exhibit 1) has led some commentators to predict rapidly rising inflation and high interest rates (Laffer 2009, SeekingAlpha 2009), firmly following Milton Friedman´s mantra that inflation is always and everywhere a monetary phenomenon (Meltzer 2009). But even such a stalwart conservative economist as Mr Laffer admits in his Wall Street Journal piece that the velocity of circulation is important and that banks will eventually lend enough to become reserve constrained again "given enough time."



David Altig, the vice president of the Atlanta Fed, takes issue with Laffer´s claims and points out that bank lending has actually decreased while the monetary base has increased (see Exhibit 2).



This means that money sitting in banks as excess reserves is not in itself inflationary (Thoma 2009) and since the velocity of circulation has dropped (see Exhibit 3 for an historical view) and there is no evidence that consumers or businesses are becoming more rather than less credit worthy, banks have consequently not increased their lending.




Krugman (2009) draws paralles to the liquidity traps faced by Japan in the 1990´s and the US in the 1930´s (see Exhibit 4).





As pointed out by Hoisington and Hunt (2009) only 1.9% of the increase in reserves was available for lending and bank loans fell an annualized 5.4% from December to March. They add that the velocity of circulation of money can be thought of conceptually as being related to leverage and financial innovation. Needless to say, the world has had its fill of financial innovation for some time and currently deleveraging is a pervasive and prevalent phenomenon. The Fed would like nothing better than to increase the velocity of the circulation of money but since it is unable to, for the reasons outlined below, fears of inflation are misplaced and threaten to prevent a robust recovery and lead to a W shaped double dip or worse.

Those who foresee a deflationary spiral point out that the overleveraged US consumer who has seen a massive drop in the value of assets and is facing rapidly rising unemployment will not be able to spend enough to prop up the economy. There would need to be multiple shifts in the aggregate demand curve and with unemployment rampant wages would seriously lag inflation (Hoisington and Hunt 2009). Moreover, unemployed people tend to spend less money, and people who feel poorer because of the drop in their portfolio, IRA, 401k, and house price are also unlikely to spend enough to cause much inflation. That is, asset price deflation can lead to a debt deflation spiral which interacts with the Keynesian paradox of thrift, along with cost cutting deflation and, as pointed out above, the contraction of bank credit, all of which are individually managable, but together a lethal combination (De Grauwe 2009).


To me, the latter view is much more plausible since inflation is not some bogy out to get us lurking in the shadows, but the succesful passing on of price increases by producers to consumers. On June 16, 2009, amid a slew of terribly economic data, Bloomberg.com reported that wholesale prices dropped 5 percent in the past year and that producer prices ex food and energy dropped 0.1 percent in May. Cost-push factors such as an increase in the price of inputs, for example oil, would not be immidiately passed off to consumers who are purchasing less anyway at lower prices. This all but precludes demand-pull factors triggering inflation, since people have to be willing to pay more for certain goods. In order for this latter to occur, consumers have to be willing and able to spend. The US consumer is overleveraged and has maxed out credit cards, which has led to default rates at credit card companies that are more than the unemployment rate (ZeroHedge 2009).

The precipitous drop in property prices and rise in unemployment
(see Exhibit 5 for unemployment data from Calculated Risk) are not going to lead to any inflation.



The implied expectations of inflation in long term treasury bond funds reflect constant expectations (see Exhibit 6, Young 2009).



Moreover, even if demand for commodities, especially oil, increases, then there will still need to be a somewhat positive overall sentiment and, actually, dollar weakness, since, when „bearish“ sentiment predominates, then, in a „flight to safety“ investors paradoxically jump into the currency they love to hate, the dollar, whose appreciation will offset the effect of increased demand for commodities on their price. Furthermore, the last oil bubble was undoubtedly fueled by speculation, and, in my humble opinion, so has the current rally in commodities. Aluminum is a prime example of how the price of a commodity can defy supply and demand.

I do not subscribe to the monetarist doctrine that liquidity is per se inflationary. If no one is spending the money, that is, the velocity of circulation is very low, then there will also not be much of a general increase in prices. It should not be forgotten that world demand and consequently economic performance have dropped off a cliff (Eichengreen and O´Rourke 2009) and that because of rising unemployment and the debt and savings dynamics mentioned above we will not return „to happy days again“ anytime soon. What I mean is that the halcyon days of five or ten years ago of rapidly rising asset prices and moderate CPI increases when everyone felt richer and consequently fed huge increases in the value of assets are gone. The US consumer has started to save after decades of living beyond his means but is still faced with a mountain of debt and low or stagnating wages (see Exhibit 6 from sudden debt).



I do not think that much of an economic recovery is going to take place this year and that for the reasons outlined above inflation will not be a problem in the near future.

Of course, I did say „near future.“ To keep inflation in check once a real recovery does set in will take aggressive and, one would hope, enlightened policy responses. Prevention of another massive asset bubble would also help, but this is unlikely. In his book „A Short History of Financial Euphoria“ (1994) John Kenneth Galbraith said that the financial memory lasts about 20 years, until a new generation of wheelers and dealers will fuel the next asset bubble and assure everyone that this time it is different and asset prices can, indeed and contrary to all historical evidence, rise indefinetly.