Precipitating the fall
By Jack Rasmus
Rasmus's ZSpace page
Last year we witnessed the emergence of the most serious financial crisis to hit the U.S. and the greater global economy since the 1930s—a crisis that has already begun to precipitate a major recession in the U.S. in 2008 and, in turn, raising the odds for a wider global downturn in 2009.
History will show a remarkable congruence between the conditions, events, and policies of the decade of the 1920s, on the one hand, and the events and policies of the past decade.
The 1920s were characterized by:
an over-extended housing and construction boom in mid-decade that imploded
a slowdown in investment in the productive economy as speculative investment steadily crowded out real investment
a Federal Reserve System that pumped up the money supply without concern for its eventual speculative impact
an increasing imbalance in world trade and currency instability
the near destruction of labor unions—to name the more notable
The progressive destruction of unions over the course of the 1920s, when combined with the radical restructuring of the tax system that provided massive tax cuts for the wealthy and corporations, resulted in a dramatic shift in income distribution toward wealthy investors and corporations from the rest of the working population. By 1928 the wealthiest households had doubled their share to 22 percent of all incomes in the country, according to IRS data. Perhaps more than any single contributory factor, the rapid and extreme growth of income inequality during the decade was eventually responsible for the ultimate financial implosion of 1929 and the consequent depression. The massive shift in incomes that fed the speculation in turn resulted in a further income shift, as super-profits were realized by the wealthy from the speculative investment frenzy. More concentration of income in turn provoked a dizzy spiral of asset price inflation, speculative profits, and a euphoric expectation the process would continue without limit.
The speculative excesses of the 1920s were assisted by a host of shady business practices—in the banking industry in particular—that were condoned by business, media, and the government. Some of the more notable practices included the explosion of buying stocks and securities on margin—or what is sometimes called leveraging. It included practices that ensured the speculation remained near invisible to average investors; practices by which private businesses, responsible for rating investments for the general public, lied to the public as a consequence of conflicts of interest. The government refusal to monitor or check the speculative excesses also contributed.
The foregoing process culminated in a stock market crash, once the cracks in the real economy began to appear and the speculative boom quickly turned to the bust of October 1929. As in all such similar speculative booms and busts, the financial crisis of 1929 in turn exacerbated and accelerated the already declining real economy by freezing up credit for investment, ensuring further corporate defaults, massive job losses, and subsequent decline. Thus, while the increasingly speculative activity was not the sole cause of the crisis, it was a critical and central development provoking the crash and the depression that followed.
As in the 1920s, in the last decade the U.S. has been lurching from one speculative bubble to the next. These include:
the Long Term Capital Management (LTCM) hedge fund bailout of 1998
the Asian debt crisis of 1998 (at the center of which were U.S. money center banks)
the dot-com technology asset bubble of 1999-2000
the recent subprime mortgage bust (the foundations for which were laid in 2003-04)
the recent rapid spread of the subprime crisis in 2007-2008 to other capital markets in the U.S.
The series of speculative bubbles from 1998-2008 in each case were temporarily contained by an unprecedented expansionary monetary policy engineered by the U.S. Federal Reserve under Alan Greenspan. The Greenspan Fed thus contributed to the series of bubbles with money injections designed to stave off the spread of liquidity crises and credit crunches. The temporary fixes did not solve the problem, but postponed the crisis for the short term. The result has been a containment each time that has bottled up pressures, which then emerged once again with subsequent greater effect.
While Federal Reserve policies have thus enabled the speculative flames, the rapid growth of income inequality since 2000 provided the kindling. A major, historic shift in incomes in the U.S. clearly began under President Reagan and continued unabated under Clinton. In recent years, under George W. Bush, that inequality has accelerated. Starting with a share of only 9 percent of total national income, for example, by 2006 the wealthiest 1 percent of households had again raised their total share to the 22 percent they enjoyed in 1928.
As in the 1920s, the rapid rise of income inequality has been driven largely by the restructuring of taxation, as more than $4 trillion of tax cuts were passed in Bush’s first term alone, 80 percent of which is projected to accrue to the wealthiest households and large corporations. Further corporate tax cuts of more than a $1 trillion were passed in his second term. Meanwhile, the rest of the population has experienced income stagnation and reduction as the decline of unions has continued, the post-World War II pension and health-care benefit systems have accelerated their collapse, the shift to part-time and temp jobs from full-time and permanent employment has continued, and millions of high paid jobs have disappeared due to neoliberal trade and offshoring.
The growth of incomes by the wealthy provided the huge pool of income and wealth with which to engage in speculative investment activity. As short term speculative activity resulted in significantly greater returns than real investment activity, more and more investment was shifted into speculative activity or from real investment in the U.S. home market to investment offshore in the so-called emerging markets—in particular, in China and Asia. In addition to the growing income imbalance and the easy money policies of the Greenspan Fed, a third critical element has been the elimination of any semblance of financial regulation and oversight, which was given a coup-de-grace in 1999 with the repeal of the 1930s-era Glass- Steagall Act. Glass-Steagall was supposed to prevent speculative and other abuses.
As Glass-Steagall was being progressively undermined under Reagan, Bush I, and Clinton, the so-called financial revolution was taking off. With that revolution in finance came a corresponding proliferation of new financial structures and relations. When combined with new technologies of computer processing power, soft technologies (e.g. quantitative modeling), networking, and the Internet, the financial system has become the first sector of economy that has been truly globalized. In turn, with globalization has come the further inability to regulate finance capital and, indeed, even to monitor its activity accurately. Thus, deregulation plus technology and globalization has meant further de facto deregulation.
In the past decade U.S. finance capital has been unleashed, as it once was in the 1920s, to do whatever it wishes and to push the speculative investing envelop as far and in whatever direction it pleases. It is therefore no coincidence that since the late 1990s the U.S. economy has veered headlong from one financial crisis to another with virtually no breathing space in between. We are now beginning to see the consequences of this concurrence of total financial deregulation, unchecked financial restructuring, accelerating income inequality, and accommodative government monetary policy which is now yielding even greater financial crisis, U.S. recession, and a threat of global instability.
Derivatives and the Securitization Revolution
If Structured Investment Vehicles (SIVs) and hedge funds are the vehicles of the new speculative and financial crisis, their products amount to a vast array of acronyms like CDOs, ABCP, CBO, CMBS, CLO, CDS, CDPO, and so on. To understand the current financial crisis it is first necessary to understand the so-called securitization revolution that the new institutional structures and financial devices represent. And the securitization revolution is based upon the granddaddy of over-leveraging called derivatives.
Derivatives involve the fictitious development of financial asset products offered for sale to investors, private and corporate. They have no intrinsic value. They derive their value from other real assets or other financial products. They have virtually no cost of production. Their costs of distribution and sale are essentially non-existent. Their market price is largely the outcome of speculative demand and, to a lesser extent, how fast financial institutions can create the original financial assets (e.g., mortgage loans) on which the derivatives are then developed. Moreover, derivatives can be created on top of derivatives in an unlimited pyramid of speculative financial offerings. Like a house of cards, the offerings may be stacked upon each other, until such time as one of the cards slips out of place and brings the rest down with it.
In today’s global economy there are more than $500 trillion in derivatives outstanding. That compares to a global annual gross domestic product for all the nations of the world of less than $50 trillion, and to the U.S. annual GDP of approximately $13 trillion. In other words, there are now more than ten times in derivative contracts than all the real goods and services produced by all economies in the world annually. The world’s wealthiest investor, Warren Buffet, has called derivatives “time bombs both for the parties that deal in them and the economic system.” They represent, according to Buffet, “financial weapons of mass destruction, carrying dangers that, while now latent, are potentially lethal.”
Subprime mortgages represent one relatively small land mine in the panoply of “financial weapons of mass destruction” described by Buffet. Subprimes are an essential element of just one example of super speculative investment built on one form of derivative called a CDO, a Collateralized Debt Obligation. Subprime mortgages lay at the foundation of the CDO’s derivative pyramid. The mortgages themselves represent the value of a real asset—i.e., the housing product on which the mortgage is based. The mortgages are then packaged into the fictitious financial asset package called the CDO, which is then marked up by the financial institution which sells the CDO to wealthy investors, hedge funds, other funds, or corporations. The mortgages themselves are not packaged in original form in the CDO, but instead are broken up, i.e., divided into slices that may be distributed across various CDOs. Only parts of any given subprime mortgage may thus reside in any given CDO offering: parts of other assets are typically sausaged into the same CDO alongside the subprime slice as well. These other assets may themselves be fictitious in character (i.e., not based on any real physical asset) or may be based on some real asset—for example commercial paper issued by some real company to raise funds to carry on or expand its real business; or a loan issued by a bank backed by real collateral (e.g., CLO). Other forms of bundled assets may include fictitious securities issued based on expectations of future ticket sales for sports events, a rock star’s future concert royalties, or even more absurd examples of so-called bonds.
Not all CDOs have subprime mortgages bundled within their packaged market offering. Some may have slices of higher grade mortgages or what are called Alt-A mortgages. Or they may have both. Many CDOs also include what are called Asset Backed Commercial Paper (ABCP). Many companies with doubtful performance and future prospects unable to raise capital more economically from other sources have entered the ABCP market in recent years to raise cash and stave off default. Their commercial paper is then bundled with a CDO and offered to market. Thus shaky subprime mortgages may be packaged with equally shaky corporate commercial paper.
But the banks and other institutions that eventually sell the CDOs were, at least until the recent crisis began to appear in late summer 2007, not all that concerned about the quality of such derivative-CDOs. Their relative unconcern flowed from their ability to buy insurance for the CDO in the form of yet another derivative called a Credit Debt Swap or CDS. Yet another means by which banks attempted to insulate themselves from the shaky quality of speculative investments has been their creation of Secured Investment Vehicles. SIVs are in essence electronic shadow banks set up by investment and commercial banks like Morgan Stanley, Bear Stearns, Citigroup, Bank of America (and virtually every known national or regional major bank in the U.S.) to offload potentially risky CDOs from the banks’ balance sheets, where bank record keeping is subject by law to review by the U.S. Securities and Exchange Commission. With SIVs typically quickly turning over, or selling, to hedge funds and other wealthy investors and corporations, a third safety valve presumably existed.
Subprime mortgages, bundled within CDOs, issued by SIVs, and held off balance sheet by the big banks represent a highly profitable enterprise for the banks. First, the banks make money from fees issuing the CDO. Second, they are able to offload assets from their bank balance sheets thereby both reducing capital carrying costs as well as making available more bank reserves for loaning out at interest. Third, their SIVs make money from marking up and selling the CDOs as well as from insuring them at an additional charge with credit debt swaps. It is therefore not surprising that mainline investment and commercial banks experienced compound profit growth of more than 20 percent per year collectively for each year from 2004 through 2006—i.e., roughly the period of the most explosive growth of subprime mortgages bundled with CDOs.
The above scenario is sometimes referred to as an example of the so-called securitization revolution in finance. Securitization is the process of assembling assets on which new securities are issued and then sold to investors who are (in theory) paid from the income flow created by the assets. The more risky the assets contained within the CDOs, the lower the credit ratings but the higher the potential return. The justification for the highly speculative and high risk character of the offerings is that by slicing the CDOs into tranches, based on the degree of risk in the assets in the given CDO, the risk would be dispersed among a large population of investors. In reality, however, the result was the dispersion of contagion not dispersion of risk from the risky investments.
In 1998 the total international volume of securitized offerings amounted to less than $100 billion. By 2003 it had risen only to $200 billion, more than $500 billion in 2005, and exceeded $1 trillion in 2006.
Bursting the Subprime-CDO Bubble
Business press pundits repeatedly query about why so many subprime mortgages were issued to home buyers who clearly could not qualify for mortgage loans on any reasonable criteria or would be unable to make payments once interest rates inevitably rose to normal levels. What the pundits don’t understand is that, given the increasing trend over time toward a greater relative mix of speculative to total investment arrangements in the capitalist economy, it is quantity, not quality, of investment opportunity that takes precedence. Since 2003 the practice of banks had been to encourage mortgage loan companies to produce more loans regardless of the quality. Mortgage loan companies in turn encouraged real estate brokers to deliver more loans without consideration of quality. And real estate brokers did whatever was necessary to close the deal with home buyers.
No matter if the total volume of mortgage loans by 2005-06 were more subprime than not. The quantity of loans, not their quality now mattered most. And quantity was only part of the new profit model. Finance profitability was becoming less and less dependent on the issuance of loans per se, but increasingly on derivatives and their supporting institutions. By 2005 more than $635 billion of subprime loans were issued. In 2006 the amount was another $600 billion and the cumulative total by 2007 was more than $1 trillion.
By mid-2006 it had become clear that the subprime mortgage market was in freefall. Home buyers with subprime mortgages were now defaulting on payments at record rates and foreclosures were beginning to rise. By late summer 2007 it was estimated that there would be two to three million potential foreclosures over the next few years. The value of subprime mortgages quickly plummeted and with them many of those CDOs in which they were imbedded. The subprime mortgage market virtually shut down. It was not possible to accurately estimate the magnitude of the losses from the subprimes since they were sliced and distributed within different CDO offerings. And if the losses for the subprime elements in CDOs could not be accurately valued, the CDOs could not be accurately valued. Nor could the asset backed commercial paper often bundled with the CDOs. And so on.
The typical response of investors in such situations is to ask how much their investments were under water. When they cannot be accurately told, their next response is often “sell my investment and give me the cash remaining.” But with no markets for subprimes by late 2007 their remaining value was impossible to estimate. No sales meant no price meant no possible valuation estimate and in turn no cash out. Investors, like the banks and their SIVs, were locked together in many cases in a death spiral, unable to bail out and destined to ride the doomed vehicle into the ground.
By late 2007 various estimates place the value of expected losses from the subprime market collapse from Goldman Sachs’s low of $211 billion and the OECD’s estimate of $300 billion to estimated losses— based on the ABX Index, the official measure of subprime mortgage securities’ value—at approximately $400 billion. In stark contrast to these estimates the losses admitted by the major banks as of year end 2007 amounted to only a paltry $60 billion. More, indeed, much more in terms of bank losses and bank write-downs are yet to come in 2008.
But subprime losses and write-downs on bank balance sheets were only part of the bigger picture.
Spreading the Subprime-CDO Pain
The estimated total volume of all CDOs worldwide (not all of which have subprime mortgages bundled with them) is, according to the OECD, approximately $3 trillion in total value. Approximately half that total is held by hedge funds, a fourth by banks, and the remaining exposure by asset managers and insurers.
As noted, many of CDOs also bundled commercial paper—sometimes with subprimes and often without. But asset backed commercial paper appears equally at risk as subprime mortgages and the consequences of its collapsed are yet to be fully realized.
Like the subprime mortgage market, the ABCP market experienced a sharp run up between 2003-07 in conjunction with the acceleration of CDOs and other derivatives. Many companies in trouble financially and unable to raise capital to continue turned to the ABCP to issue commercial paper on their remaining real assets to raise cash for operations or investment purposes. Much of their risky commercial paper was bundled with CDOs. But like the subprime market, the ABCP market has virtually shut down as well since the advent of the financial crisis in late summer 2007. The ABCP market in the U.S. peaked at $1.2 trillion in August 2007 and had fallen to $700 billion by year end. By June 2008 an additional $300 billion is projected to come due. That’s another $300 billion banks may have to provide for on their balance sheets, in addition to the $400 billion in additional subprimes coming due. In Europe the commercial paper market is also declining rapidly, having fallen 44 percent by October 2007 to $172 billion from a May peak of $308 billion.
With the ABCP market largely shutting down, many corporations straining to stay in business in recent years by selling their commercial paper will likely begin to default. That means a sharp rise in business bankruptcies. For example, non-farm business debt rose by 30 percent in 2004 and continued thereafter at above average levels. Many CDOs helped hold off defaults and failures between 2003-07 by imbedding their commercial paper. But with the shutdown of the ABCP markets, pressures for corporate defaults will be released with the consequent result of sharp increases in corporate bankruptcies in 2008-09. The corporate ratings agency, Moody’s, predicts an increase in default fates between four and ten times in the period immediately ahead, the highest since the peak fallout from the dot-com bust in 2002.
How the current financial crisis has been spreading at an historically rapid rate from the subprime to other capital markets, and how the crisis is being transmitted in turn from those latter markets to the general economy in the U.S.—thereby guaranteeing a recession in the U.S. in 2008 and threatening to expand globally in 2009—will be addressed in Part II of this analysis.
From Financial Crisis to Recession, Part II
Symptoms appear of a fundamental financial instability
By Jack Rasmus
Rasmus's ZSpace page
Part I of this series appeared here in the March issue of Z Magazine
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In testimony before the U.S. Congress House Financial Services Committee at the close of February 2008, U.S. Federal Reserve Bank (Fed) Chair Ben Bernanke acknowledged for the first time what many in finance, banking, and government policy circles have quietly begun to admit: that the current financial crisis is now spreading rapidly beyond the subprime residential mortgage sector to other credit markets and that monetary policy action by the Fed (i.e., lowering interest rates) appears increasingly unable to do much about either the financial crisis or the emerging recession.
As Bernanke admitted to the Committee on February 27, 2008: "The (recent) economic situation has become distinctly less favorable," with the residential mortgage market decline accelerating, non-residential construction "is likely to decelerate sharply in coming quarters," consumer spending and the business sector will both slow significantly, and general credit conditions likely to "tighten substantially." Moreover, "the risks to this outlook remain to the downside." Bernanke admitted that the Fed, despite repeatedly lowering short term interest rates since September 2007, had failed to lower long term interest rates. In fact, long term rates—which have a far greater impact on consumer and business spending and thus on the likelihood of recession—have actually begun to rise "across the board."
What follows is a description of how the financial crisis has been spreading at a rapid rate in the U.S., from the subprime mortgage to other credit markets, and how that contagion is beginning to penetrate the real (non-financial) economy, causing the deep recession now emerging in the U.S.
July-December 2007
The subprime mortgage crisis that erupted publicly in July-August 2007 did not cause the current financial crisis, but was just one of several (and now growing) symptoms of a deeper more fundamental financial instability. Speculation in subprime mortgages—fueled by the new securitization and derivatives revolutions in finance, virtual deregulation of finance capital since the late 1990s, new technological forces, and widespread corruption and fraud on numerous fronts—produced a housing asset price bubble of epic dimensions between 2003-2006. Mortgage borrowing rose more than $4 trillion between 2003-6 with $2 trillion of that issued in subprime mortgages. That's approximately $1 trillion a year for 4 consecutive years. Today, the subprime mortgage market has virtually evaporated, with much of the non-subprime market in turn rapidly coming to a standstill.
With the evaporation of the subprime market came a collapse in prices and value for subprime mortgage securities (bonds). Because of the magnitude of the speculation ($2 trillion) in subprime mortgages, the magnitude of losses by banks and financial institutions was immense as well. According to rating agencies Moody's and Standard & Poor's, by early 2008 the losses totaled a minimum of $400 billion. Other foreign bank sources estimate the potential losses from subprimes in the U.S. at $600 billion. Banks and finance institutions have thus far written off only $120 billion. That leaves $280-$480 billion to go.
The massive nature of the losses quickly led to the collapse of other credit markets most closely related to the subprime market. Subprimes were often bundled with other securities before being sold as repackaged deals by banks and hedge funds to investors, with commercial paper called asset backed commercial paper (ABCP). As subprimes collapsed by $600 billion in 2007, the ABCP market plummeted by about $500 billion along with it within a matter of a few months. Contagion from the subprime market also infected the non-subprime mortgage market (called Alt-A mortgages). Similarly, the ABCP market infected the non-asset backed broad commercial paper market. In turn, the commercial property mortgage market plummeted by several hundred billion dollars by the end of 2007, with projections for its likely shut down to occur by mid-2008.
The cumulative credit contraction for just these 5 inter-related markets amounted to more than $1.6 trillion, occurring in less than 6 months, with associated bank losses and write downs estimated at around $600-$800 billion.
January-February 2008
The construction (housing-commercial) and closely related commercial paper markets' decline almost immediately began to spill over to the corporate bond markets, in particular the so-called high yield corporate or junk bond market which contracted by 90 percent by January 2008 compared to January 2007, dropping by more than $900 billion. Like the ABCP market, the junk bond market is where economically shaky corporations go to raise funds by issuing and selling their unsecure bonds. With ABCP and junk bond credit markets collapsing, corporations that previously relied on them are predicted to default in record numbers. Default rates are predicted to surge from one percent to more than ten percent, according to both Moody's and Standard & Poor's. That in turn means massive further losses for banks on top of subprime and commercial property mortgage losses already occurring. It also means that as those corporations default, many going bankrupt and out of business, the result will be widespread layoffs over the next 18 months.
Rising corporate defaults and anticipated subsequent bank losses translate into rising interest rate costs for otherwise stable companies. From the corporate junk bond market, the credit contraction has spread to more mainstream business credit markets, like the commercial and industrial bank loans and short term commercial paper markets. Together, these two represent credit markets that most medium and smaller sized corporations most heavily rely upon to finance business operations. The two markets had a combined total of $3.3 trillion in outstanding credit issued to business in August 2007. By early 2008 that amount had declined by more than $300 billion.
Another credit market taking a dive by early 2008 was the leveraged buyout (LBO) market. This was a hot speculative investment area in which companies arranged loans and other financing through investment banks in order to buy out other companies or go private in order to avoid government oversight of speculative and other even more shady business practices. By early 2008 more than $200 billion in loans for leveraged buyouts were left hanging without interested buyers. This meant banks and original investors would eventually have to absorb the losses themselves.
But the even bigger news of early 2008 was the growing likelihood of bond insurer companies, like MBIA, Ambac, and others (called monolines) facing downgrading and perhaps default themselves. These companies insured other companies' bonds and loans, promising to pay investors for corporate and other bond defaults should they occur. But with combined reserves of only $20-$30 billion on hand, the half dozen bond insurers are themselves grossly underfunded. Their combined liabilities (i.e., insurance commitments) amount to more than $1.9 trillion. Moreover, they too speculated in subprimes as well as other derivative investments in the amount of $572 billion. It has become increasingly clear to investors and markets that the reserves monolines were woefully inadequate. Rating agencies had conveniently overlooked their condition during the speculative run-up. But Moody's and S&P are now threatening to downgrade the bond insurers. Should that occur, countless corporations and banks that purchased their insurance could face severe downgrades as well, resulting in further losses and defaults.
The precarious position, and potentially huge losses of the monolines prompted global financier George Soros recently to comment, "There is a growing concern about the monolines...there is also a potential problem with money market funds which could be holding doubtful assets." Soros's concern was echoed by JP Morgan CEO, Jamie Dimon, who added, "If one of these entities (bond insurers) doesn't make it, the secondary effect could be terrible." That secondary effect would be the downgrading and consequent default of hundreds of billions in corporate bonds—on top of the already projected 10 times increase in corporate defaults in 2008.
Some analysts predict that the bankruptcy or even major downgrade of one or more bond insurers could easily spill over to the $3.3 trillion money market fund market or the $2.5 trillion municipal bond market, precipitating an institutional run on the banks that would be quite unlike individual depositors' bank runs in the 1930s and before. Early indications of just such a possible scenario began to emerge in February 2008, as key sectors of the muni bond market began to dry up. With about half of municipal bonds insured by the bond insurers, the safety of muni bonds began to be questioned. Two key segments of the muni market contracted sharply—i.e., auction rate and variable rate municipal bonds, which finance around $330 billion and $500 billion, respectively. Strategically critical for state and local government funding, shrinking trades at muni markets threatened significant cost increases and funding problems for local governments. Many state and local government authorities now face excessive borrowing costs at a time of accelerating recession and lower tax revenues.
Another insurer avenue also began to come under pressure by early 2008. This was the derivatives-based credit default swaps market. Virtually nonexistent prior to 2002, outstanding credit default swaps now total more than $45 trillion, bigger than the total U.S. government bond and housing markets combined. Most securities in this market reside in a shadow banking system, itself largely a product of the post-2001 period, set up by banks to park risky assets "off balance sheet" and hidden from investors and government oversight agencies alike (an arrangement similar to that at the now defunct ENRON Corp., for which that company's senior management were indicted and jailed). Like the monolines, credit default swap derivatives are designed to insure against defaults. But if corporate bond defaults approach normal levels of 1.25 percent, Bill Gross, managing director of the world's largest bond fund, Pimco, publicly pointed out that $500 billion in credit derivative contracts would result in losses of at least $250 billion.
Perhaps an early red flag of the beginning of just such a fracturing of the $45 trillion credit derivatives market was the dramatic losses announced in January by the major French bank, Societe General, which raised the possibility that the problem was not limited to subprimes and asset backed paper, but was actually far more widespread, just as Pimco head Bill Gross had predicted.
Signs of major problems in the insurance industry also emerged in early 2008, as AIG Inc., the largest insurance company by assets, announced record losses of $11.5 billion due to credit default swaps trading. The picture by the end of February 2008 was one of a rapidly spreading credit contraction, in part the product of accelerating write downs and losses.
The losses and credit contraction do not include additional potential losses and contraction in consumer credit—in particular in areas of auto loans, credit card debt, and student loans. Evidence now appearing suggests significant losses are anticipated in these markets as well. Major credit card companies like American Express and others have announced record level loss provisioning and set asides in anticipation of consumer defaults. A growing list of public universities have announced shutting down student loan programs due to sharply rising borrowing costs. General Electric Corp. announced its intent to exit the consumer credit markets altogether. Thus, the mortgage, bank, and corporate debt problem appears by early 2008 to be infecting consumer markets. Like excessive corporate debt, total household debt from 2003-07 roughly doubled, rising by nearly $7 trillion.
Financial Crisis Is Creating Recession
How do these financial losses translate to a deepening recession in the general U.S. economy? The short answer is that financial losses have two immediate consequences. First, losses on financial institutions' balance sheets mean losses must be restored by raising additional real capital. If not, the institutions themselves may default. They can borrow from other banks, from the Federal Reserve, or, as has recently been the case, from what are called sovereign wealth funds, which are foreign government owned investment funds. The first option is a problem when banks are suspicious of each other's financial viability. Interbank borrowing thus dries up, as it almost did in late 2007. Borrowing from the Federal Reserve is the second option and has been occuring since late 2007 under especially favorable terms by the Fed. But Fed loans have thus far proved insufficient to cover the anticipated magnitude of future losses by the banks. Similarly, sovereign wealth funds located in Dubai, Singapore, and elsewhere have injected funding into the banks by purchasing partial ownership of Merrill Lynch, Citicorp, and others. But the amounts are measured in the low tens of billions, nowhere near the high hundreds of billions of losses to date and anticipated.
Given the still massive anticipated losses and likely insufficient available funding, banks turn to loan out the funds they do have. So they raise interest rates to record levels. These interest rates are not the short-term interest rates of 3 to 4 percent at which the Fed loans money to the banks. Banks' rates offered to customers are long-term interest rates—essentially bonds and long-term loans—loaned out at 7 percent, 10 percent, or more. Rising long-term rates raise the cost of borrowing by non-bank corporate customers and to consumers buying durable products like cars, furniture, homes, etc.
In an accelerating recession, banks are reluctant to lend and corporations equally reluctant to borrow. Only the most exposed companies are willing to borrow at the high rates, which means in many cases they will eventually go under—thus Moody's and S&P's predictions of a 10 times increase in corporate default rates over the next 18 months. Lower investment and business spending translates eventually into layoffs, defaults in auto, credit card, and student loans, and thus further momentum in the direction of recession.
The above process then takes on psychological dimensions at some point, which worsens the economic decline. Fear and uncertainty over still unannounced, further bank losses leads to lack of confidence in the banking system and even further reluctance to loan or borrow. Another psychological scenario is when fear of losses in the subprime mortgage market lead to concerns of losses as well in non-subprime residential mortgage, commercial property markets, and closely associated markets like asset backed commercial paper. Borrowing rates rise and investors turn away from borrowing not only in subprime and related markets, but other mortgage markets. Prices of property then nose dive across the board. This kind of debt price deflation, when spreading from an isolated to associated credit markets, is historically closely associated with depressions rather than recessions.
Another example: concerns that the bond insurers (monolines) and credit default swaps will not be able to cover anticipated defaults leads investors to withdraw in growing numbers from even safe credit markets like muni bonds, about half of which outstanding are insured. In turn state and local governments reduce spending, lay off workers, reduce benefits for others, raise property taxes and various fees, etc.—all which translate into further recessionary pressures.
A third example: rising financial institution losses translate into rising rates and to a tightening of credit terms for consumers as well as business borrowers. Credit card rates rise, terms become more onerous, banks start charging consumer customers more fees, auto loan rates rise, student loans become harder to get with higher rates, state and local governments must spend more to borrow and in turn pass on costs to citizens in higher local fees, property taxes, and lower spending (resulting in less hiring or layoffs). Increasingly, consumers default on auto, student, and credit card loans.
Contradictions of Monetary and Fiscal Policy
Both Fed monetary policy and the recent $168 billion Congressional tax cut package will prove grossly insufficient in dealing with the current financial crisis and the recession. Rapid deflation (i.e., price collapse) is now occurring in the general housing and commercial property markets and may soon spread to other non-construction markets as corporate defaults rise and additional bank losses are reported. Debt deflation in housing and property markets is the inevitable consequence of prior (housing and property) asset price inflation, which was produced by excessive speculation. Excessive speculation breeds extraordinary inflation and eventually just as extraordinary deflation. But deflation is the greater danger.
When debt deflation spreads from housing to other sectors of the economy, the real crisis begins. Companies facing rising costs and unavailability of funds to finance day to day business, turn to raising revenue on an emergency basis by selling their products below market prices. This raises immediate cash necessary to operate or even stay in business, but sets in motion a downward price spiral—i.e., deflation—that ultimately accelerates losses and the need for still further price cuts. This is what especially distinguishes depression from recession. Efforts to raise revenue by price cutting, moreover, is often accompanied with cutting costs by mass layoffs. Thus rising unemployment accompanies the deflation in parallel. The U.S. economy is approaching the cusp, heading in that direction.
Fed interest rate reductions of more than 3 percentage points by March 2008 has assisted banks' sagging profitability, but has not succeeded in heading off the general credit crisis and recession. The crisis has continued to outrun Fed actions as long term interest rates have risen and thus pushed the economy further into recession. The Fed may have even assisted the momentum toward recession by its recent lowering of short term interest rates. For example, lower rates have resulted in an accelerating decline of the U.S. dollar and a growing shift from the dollar to the Euro and other currencies as the preferred medium of global trade and financial transactions. The financial crisis is rapidly translating into a parallel currency crisis—which is also a characteristic of depressions as compared to recessions.
The fall of the dollar is also provoking another speculative price bubble, in the form of rapidly rising commodity prices—e.g., food grains, food commodities, raw material commodities, metals, and, of course, oil. As the dollar falls, OPEC and Middle Eastern oil producers have been raising their prices to offset the fall of their investments held in dollars. Oil prices have shot up over $100 a barrel. Rising commodity prices translate into U.S. consumers' reduced spending power, which in turn reduces consumption dramatically, and feeds the recession. Oil and other commodity speculators may also push up the prices of oil and food even further before it reaches the U.S. consumer, but the Fed action initiates and feeds the whole process. Thus, Fed efforts to stave off recession actually provide more impetus for recession. At some point the Fed will likely give up on lowering interest rates as a consequence. When that happens, yet another psychological effect will occur and the impact will be immense. By that action the Fed will in effect admit it cannot do anything about the crisis.
On the fiscal side, the recent $168 billion Congressional (and Bush) package to stimulate the economy will also prove ineffective. First, a good portion of the tax cut package are business tax cuts that will largely have no effect in a recessionary downturn. In a period of accelerating recession, lower tax cuts for business do not stimulate net investment. Business may absorb the tax cuts, but delay decisions to invest while actually reducing employment. A good part of the business tax cuts will also likely be shuffled to offshore expansion by corporations that will have no effect on U.S. economic conditions, a trend that has been occurring for several years now. Finally, what business spending does occur as a direct consequence of tax cuts will be more than offset by mass industry layoffs coming later this year.
Little of the consumer tax rebate will translate into new spending. Many consumers, now deeply in debt, will use rebates to pay off record debt. Perhaps only a third of the $168 billion will constitute actual new consumer spending. And that consumer spending will be largely offset by reductions in spending and higher fees by state and local government, as tax revenues plummet due to recession while costs of borrowing rise significantly. Before the November 2008 election it will become increasingly clear that the recent Congress-Bush fiscal package was a classic example of too little too late.
Should the crisis and recession continue to accelerate, new solutions will be required. As during the Depression of the 1930s, new solutions may require a major overhaul of the Federal Reserve System, the return of something like the Reconstruction Finance Corp. government agency of that period, and a fundamental re-regulation of the financial sector in the U.S., and reversal of policies since the 1980s that have resulted in a massive redistribution of income that has fed the speculative excesses of recent decades—to name just a few.
Scenario 2008-09
Fundamental structural and in some cases radical reform of the U.S. political economy will be necessary to deal with the economic crisis. This crisis may include some of the following features:
Widespread corporate defaults and mass layoffs occurring later in 2008 and into 2009
Continuing revelations of further losses by banks and financial institutions
The collapse of one or more of the mainstream banks in the U.S., setting off a major stock market correction of an additional 20-30 percent
A further decline of 10-20 percent of the dollar in international currency markets
Continued rise in oil and commodity prices as offshore speculators continue to take advantage of the U.S.'s worsening dual financial-devaluation crisis
Deflation spreading from housing and other asset investments in the U.S. to goods and services. Record U.S.
(unified) budget deficits of $700 billion plus
Growing general awareness that traditional monetary and fiscal policies are increasingly ineffective in addressing financial crisis and recession
Whomever is president in 2009 will almost certainly have to confront the growing reality that the rest of the global economy is also slipping, along with the U.S., into a synchronized downturn.
Z
--------------------------------------------------------------------------------
Jack Rasmus is the author of The War At Home: The Corporate Offensive From Ronald Reagan to George W. Bush (2006) and The Trillion Dollar Income Shift: Essays on Income Inequality in America (forthcoming).
Thursday 27 March 2008
Wednesday 26 March 2008
Who is the State working for: the banks or the public?
Who is the State working for: the banks or the public?
March 26, 2008 By Damien Millet
and Eric Toussaint
Source: Committee for the Abolition of Third World Debt (CADTM)
Damien Millet's ZSpace Page
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In many respects, the ongoing international financial crisis throws into sharp relief the deceit and denials of those who promote financial globalization, whether they sit on the board of the big private banks or move in the higher spheres of the State. Over recent years, the dominant discourse was that all was fine on the debt front: with the introduction of new products, such as the securitization of debts, the risk had been spread among a number of players. No crisis could be expected, profits were astronomical and growth was sustained.
Today, the edifice is crumbling. How could it be otherwise, when big banks conduct huge operations off the books, erect a house of cards with dubious credit and contribute to the creation of a speculative real estate bubble that eventually bursts? Far from spreading the risk, the system achieved the contrary, with the big banks having accumulated its weaknesses. Each of them then tried to pass the hot potato to its already troubled neighbor.
Instead of acknowledging their mistakes and assuming the consequences, the big banks sought help from the State -- whose actions they are normally quick to disparage. They did not hesitate to seek strong public intervention from the same State they usually consider as too interventionist. In fact, the big banking lobbies have always insisted that the public authorities must respect market forces -- the sole mechanism able to efficiently distribute resources and fix prices at their real values.
Like obedient underlings, the US and European authorities did as they were asked: you do not refuse a favor to the directors of the big banks that support the main presidential candidates and who move in the same close-knit circles... Thus, the rulers quickly came to the rescue of private interests. On the menu: nationalization of the troubled banks, exchange of devalued and distressed debt securities for fresh cash (to the tune of 200 billion dollars in the US), cash injection, rescue plans, decreased interest rates...
In Britain, one of the spearheads of neoliberal globalization, the crisis floored the bank Northern Rock in September 2007, leading to its nationalization in February 2008. Once the ship has been steadied at public expense, it will pass back into private hands. Similarly, in the United States, when Bear Stearns, the country's fifth most important investment bank, found itself short of credit on 13 March, the financial authorities organised a rescue with the help of JP Morgan Chase, which subsequently bought Bear Stearns at a bargain price.
This crisis clearly proves that when management of the world economy is ruled by the logic of maximum profit, society pays an enormous price. The banks have gambled with the savings and cash deposits of hundreds of millions of individuals. Their mistakes have led to huge losses and human tragedy, as was the case with the bankruptcy of the Enron multinational in 2001. Around 25,000 Enron employees found themselves with a paltry pension because the company's pension fund had been diluted by the directors, who had quietly sold their shares for nearly a billion dollars.[1]
In terms of North and South, the similarities are striking. In the South, the debt crisis of the early 1980s was caused by the unilateral increase of interest rates by the United States, leading to a massive hike in the repayments of Third World countries that the banks had encouraged to take out loans at variable interest rates. Simultaneously, the plummeting prices of raw materials and oil prevented them from coping, forcing them ever deeper into a crisis. The International Monetary Fund (IMF), remote-controlled by the United States and the other great powers, then imposed drastic structural adjustment programs on developing countries. The recipe, as in countries of the North, was as follows: a decrease in social spending, complete and immediate economic liberalization, an end to control over the flow of capital, complete opening of the market, massive privatizations. However, contrary to what is taking place in the North, the states of the South have been prevented from reducing interest rates and giving credit to banks, causing serial bankruptcies and severe recessions. Finally, just like today, the State was forced to bail out the troubled banks before privatizing them, usually to the benefit of the major North American and European banking multinationals. In Mexico, the cost of rescuing the banks, in the second half of the 1990s, represented 15% of the Gross Domestic Product (GDP). In Ecuador, a similar manoeuvre in 2000 cost the country 25% of its GDP. Everywhere, the internal public debt rose massively because the cost of the rescue plan for the banks was borne by the State.
The economic deregulation of the last decades has been a fiasco. The only constructive solution would be a complete reversal of priorities: strict constraints on private companies, massive public investments in sectors that can ensure fundamental human rights and protection of the environment, the recovery by public powers of the decision-making levers to favor the general interest.
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Thursday 20 March 2008
Has market fundamentalism had its day?
Johann Hari
Thursday, 20 March 2008
The sound of scenery collapsing and actors staggering off the stage on Wall Street and in the City of London is echoing all over the world. The reporting of these events is mostly couched here in the anodyne language of economic cycles – there is "market turbulence" and "a down-turn on the way". This makes us think of it all as the economic equivalent of the tsunami – one of those horrible things that erupts every now and then, beyond our control. But this is a lie.
The financial crises of the past year, culminating in the de-clawing of the Bear Stearns bear-pit over the past week, are the direct result of pursuing an ideology to its logical end-point. This financial bubble could only take place because we have been living in an ideological bubble – one of market fundamentalism.
From the trauma of the Great Depression to 1973, there was a broad consensus across the democratic world that markets were absolutely essential to generate wealth, but they will also cause all sorts of problems if they are left unregulated. Economists like JM Keynes and JK Galbraith taught us that if you abolish markets, you get starvation; but if you abolish all the democratic checks and balances on markets, you get a system that eats itself. Unregulated businesses will cause unsustainable levels of pollution and inequality, and ultimately start pursuing unhinged business models that cause the whole system to collapse.
But since the 1970s, we have been lectured that these ideas are stale left-overs. Markets work best when all the fetters on them – a democratic state, and democratic trade unions – shrivel like fruit in the sun. Whatever the problem, the solution is to release businesses from all checks and balances.
So we tried it. We now have a global business system that is virtually unregulated, with trade unions crippled and politicians largely bought by the super-rich to serve their interests. And what is the result? Inequality has returned to 1920s levels, and movement between the classes has collapsed. We have bank runs unseen in a century. And now even senior Wall Street figures mutter – with only a hint of hyperbole – about a looming Depression and "the worst crisis since 1929". All we need now is rising unemployment and Zelda and F Scott Fitzgerald boozily waltzing through Wall Street, and we are back where this story began.
The sub-prime mortgage collapse that started the stock market tremors was entirely and exclusively the child of the deregulation mania. Until the Bush era, banks were forbidden by the state from offering unpayably vast mortgages to the poorest people in America. It was plain that such a system would be unfair to consumers, and introduced a wild instability into the financial system. But – hey! – state regulation is always a problem, and market freedom is always the solution – right? Now that the deregulated market has begun to collapse in on itself, the state has had to step back in with a far heavier hand than before, throwing tens of billions at failed banks.
So as we enter a recession – or worse – caused by market fundamentalism, how will our politics change? The world economy now needs an era of re-regulation akin to Franklin Roosevelt's, which regulated the banks, legalised trade unions and made taxation progressive. This will be harder to do because the economy is now globalised. But with political will, it can be done.
Yet this is not necessarily what will happen. The super-rich speak louder than the rest of us – politicians are dependent on their party donations, for one – and are determined to defend their privileges. As an economy contracts, stress-lines open up in a society – and by looking at British politics today, we can see the conflicting directions these fractures could run in.
When the funds for public services dry up, the right instinctively looks downward for places to save cash. The Tories are pledging a crackdown on dis-ability-benefit recipients, and the abolition of services for the poor like SureStart centres and Educational Maintenance Allowances. Refugees are rarely far behind: remember, David Cameron wrote the last Tory manifesto, which committed to end the 1951 UN Convention on Refugees founded in the wake of the Holocaust.
But there is another place for our anger to be directed. Buried in the many dense footnotes to the Budget last week, there was an extraordinary figure. The Treasury has calculated that the super-rich are using avoidance and evasion techniques to wriggle out of paying £41bn in taxes to the British Exchequer every year. To put this in context: if every single disability benefit claimant and every single refugee was a fraud, they would still be ripping us off for less than the super-rich.
If the super-rich paid their taxes as the rest of us are required to, we could increase every pension by nearly 50 percent, or treble spending on primary schools. (I will post some of my suggestions for how to make them do this on our OpenHouse blog.) We are always hearing about the tiny number of dishonest disability and refugee claimants, but hardly anything about this far larger scandal.
As funds for public services dry up in a recession, our politicians can go after the weak people at the bottom, or they can require the strong people at the top – who caused this crisis with their demands for deregulation – to start paying their fair share. Imagine an election poster bearing the faces of the 10 richest men in Britain, asking: you pay your taxes, why shouldn't they? Some European governments are already making this choice: Germany and Italy are engaged in huge programmes of loop-hole closing and prosecutions.
Of course, the cheerleaders for deregulation who unrepentantly led us into this mess announce that requiring the rich to pay their fair share will only drive away investment and send productivity plummeting. An intelligent writer once answered this point, writing: "The Chancellor has been generous in the deployment of new and lucrative tax shelters for the very rich. The theory is that capital will flourish, that industry and innovation will thereby profit and enterprise will be justly rewarded. The realities are more mundane and more squalid. The rewards are for ingenuity in tax avoidance only. The only beneficiaries are the very rich, who show no sign of becoming more productive – only richer."
The writer was Gordon Brown in 1987. Perhaps somebody could show it to him now – a prime minister who had to be jostled into charging the likes of Mohamed Al Fayed a pittance of £30,000 a year. (Cameron would be even worse: his political career has been bankrolled by a man based in the tax haven of Belize, and his "competitiveness" spokesman, John Redwood, has suggested copying the US deregulation of mortgages here.) In the US, both Clinton and Obama are similarly cautious, looking nervously over their shoulders to their big-money donors.
The 1920s nostalgia of the market fundamentalists has brought us to this crisis, where we could be facing our own 1930s. This should shift global politics dramatically to the left – but not if our politicians' responses are as sub-prime as our mortgages.
How to stop the super-rich scam
By Johann Hari
So what do we do about the fact the super-rich are scamming the British tax system for £41bn a year? In my column today, I point out the super-rich are dishonestly wriggling out of paying tax billions that are enough to treble spending on primary schools, or increase every single pension by nearly 50 per cent. This is being repeated across the Anglo-economies, from the US to Australia.
There is a kind of pessimism about our ability to stop the rich unilaterally exempting themselves from the tax system. They live in our societies - dependent on the same police and army and emergency rooms – but they increasingly refuse to pay the membership fees. Indeed, they demand we show “gratitude” just for them gracing us with their presence.
A superb recent report by the tax specialist Richard Murphy for the British TUC – ‘The Missing Billions’ – details a rich range of options to make it much harder for these people to scam us.
The most simple is to introduce into British law something called a general anti-avoidance principle.
It is simply stated that if any step is added into a commercial arrangement for the sole or main purpose of avoiding tax, then this step will be ignored by HM Revenue and Customs. They will tax it anyway. So if you transfer you earnings into your wife or child’s name just to scam us; if you relocate your business on paper just to scam us; we’ll ignore it.
This is not a magic bullet – but it changes the terms of the debate. Instead of the Inland Revenue chasing retrospectively to close loopholes, accountants have to justify them as being more than mere tax avoidance every time.
The next move is to stop the perverse staff cuts at HM Revenue and Customs. By 2011, three hundred tax offices will have been shuttered, and 25,000 staff laid off. This is a totally false economy: each staff member brings in £2,636,588 a year – more than 96.5 times their wages. But if there’s nobody to track down the tax avoiders, we can’t net the cash.
And we can crack down on tax havens. The German government is now using its equivalent of MI5 to track people dodgily shifting their cash to Liechtenstein. Britain needs to be as proactive. We were constantly being told that it was impossible to restrain tax havens, because the money would simply leech to another haven, then another; there would always be somebody prepared to snub the world and reap the rewards. But after September 11th the US demanded every al Qaeda-related bank account be closed – and it happened overnight. If money stashed away to kill people can be tracked, why not money that could save lives too? An international campaign to end this system is in the interests of the 99.9 percent of humanity who will never use a tax haven.
This isn’t about persecuting the super-rich; it’s about requiring them to pay their fair share for the privilege of living and working in a stable democratic society. I pay my taxes; you pay yours. It is time for the people who can most afford it to do the same.
Thursday, 20 March 2008
The sound of scenery collapsing and actors staggering off the stage on Wall Street and in the City of London is echoing all over the world. The reporting of these events is mostly couched here in the anodyne language of economic cycles – there is "market turbulence" and "a down-turn on the way". This makes us think of it all as the economic equivalent of the tsunami – one of those horrible things that erupts every now and then, beyond our control. But this is a lie.
The financial crises of the past year, culminating in the de-clawing of the Bear Stearns bear-pit over the past week, are the direct result of pursuing an ideology to its logical end-point. This financial bubble could only take place because we have been living in an ideological bubble – one of market fundamentalism.
From the trauma of the Great Depression to 1973, there was a broad consensus across the democratic world that markets were absolutely essential to generate wealth, but they will also cause all sorts of problems if they are left unregulated. Economists like JM Keynes and JK Galbraith taught us that if you abolish markets, you get starvation; but if you abolish all the democratic checks and balances on markets, you get a system that eats itself. Unregulated businesses will cause unsustainable levels of pollution and inequality, and ultimately start pursuing unhinged business models that cause the whole system to collapse.
But since the 1970s, we have been lectured that these ideas are stale left-overs. Markets work best when all the fetters on them – a democratic state, and democratic trade unions – shrivel like fruit in the sun. Whatever the problem, the solution is to release businesses from all checks and balances.
So we tried it. We now have a global business system that is virtually unregulated, with trade unions crippled and politicians largely bought by the super-rich to serve their interests. And what is the result? Inequality has returned to 1920s levels, and movement between the classes has collapsed. We have bank runs unseen in a century. And now even senior Wall Street figures mutter – with only a hint of hyperbole – about a looming Depression and "the worst crisis since 1929". All we need now is rising unemployment and Zelda and F Scott Fitzgerald boozily waltzing through Wall Street, and we are back where this story began.
The sub-prime mortgage collapse that started the stock market tremors was entirely and exclusively the child of the deregulation mania. Until the Bush era, banks were forbidden by the state from offering unpayably vast mortgages to the poorest people in America. It was plain that such a system would be unfair to consumers, and introduced a wild instability into the financial system. But – hey! – state regulation is always a problem, and market freedom is always the solution – right? Now that the deregulated market has begun to collapse in on itself, the state has had to step back in with a far heavier hand than before, throwing tens of billions at failed banks.
So as we enter a recession – or worse – caused by market fundamentalism, how will our politics change? The world economy now needs an era of re-regulation akin to Franklin Roosevelt's, which regulated the banks, legalised trade unions and made taxation progressive. This will be harder to do because the economy is now globalised. But with political will, it can be done.
Yet this is not necessarily what will happen. The super-rich speak louder than the rest of us – politicians are dependent on their party donations, for one – and are determined to defend their privileges. As an economy contracts, stress-lines open up in a society – and by looking at British politics today, we can see the conflicting directions these fractures could run in.
When the funds for public services dry up, the right instinctively looks downward for places to save cash. The Tories are pledging a crackdown on dis-ability-benefit recipients, and the abolition of services for the poor like SureStart centres and Educational Maintenance Allowances. Refugees are rarely far behind: remember, David Cameron wrote the last Tory manifesto, which committed to end the 1951 UN Convention on Refugees founded in the wake of the Holocaust.
But there is another place for our anger to be directed. Buried in the many dense footnotes to the Budget last week, there was an extraordinary figure. The Treasury has calculated that the super-rich are using avoidance and evasion techniques to wriggle out of paying £41bn in taxes to the British Exchequer every year. To put this in context: if every single disability benefit claimant and every single refugee was a fraud, they would still be ripping us off for less than the super-rich.
If the super-rich paid their taxes as the rest of us are required to, we could increase every pension by nearly 50 percent, or treble spending on primary schools. (I will post some of my suggestions for how to make them do this on our OpenHouse blog.) We are always hearing about the tiny number of dishonest disability and refugee claimants, but hardly anything about this far larger scandal.
As funds for public services dry up in a recession, our politicians can go after the weak people at the bottom, or they can require the strong people at the top – who caused this crisis with their demands for deregulation – to start paying their fair share. Imagine an election poster bearing the faces of the 10 richest men in Britain, asking: you pay your taxes, why shouldn't they? Some European governments are already making this choice: Germany and Italy are engaged in huge programmes of loop-hole closing and prosecutions.
Of course, the cheerleaders for deregulation who unrepentantly led us into this mess announce that requiring the rich to pay their fair share will only drive away investment and send productivity plummeting. An intelligent writer once answered this point, writing: "The Chancellor has been generous in the deployment of new and lucrative tax shelters for the very rich. The theory is that capital will flourish, that industry and innovation will thereby profit and enterprise will be justly rewarded. The realities are more mundane and more squalid. The rewards are for ingenuity in tax avoidance only. The only beneficiaries are the very rich, who show no sign of becoming more productive – only richer."
The writer was Gordon Brown in 1987. Perhaps somebody could show it to him now – a prime minister who had to be jostled into charging the likes of Mohamed Al Fayed a pittance of £30,000 a year. (Cameron would be even worse: his political career has been bankrolled by a man based in the tax haven of Belize, and his "competitiveness" spokesman, John Redwood, has suggested copying the US deregulation of mortgages here.) In the US, both Clinton and Obama are similarly cautious, looking nervously over their shoulders to their big-money donors.
The 1920s nostalgia of the market fundamentalists has brought us to this crisis, where we could be facing our own 1930s. This should shift global politics dramatically to the left – but not if our politicians' responses are as sub-prime as our mortgages.
How to stop the super-rich scam
By Johann Hari
So what do we do about the fact the super-rich are scamming the British tax system for £41bn a year? In my column today, I point out the super-rich are dishonestly wriggling out of paying tax billions that are enough to treble spending on primary schools, or increase every single pension by nearly 50 per cent. This is being repeated across the Anglo-economies, from the US to Australia.
There is a kind of pessimism about our ability to stop the rich unilaterally exempting themselves from the tax system. They live in our societies - dependent on the same police and army and emergency rooms – but they increasingly refuse to pay the membership fees. Indeed, they demand we show “gratitude” just for them gracing us with their presence.
A superb recent report by the tax specialist Richard Murphy for the British TUC – ‘The Missing Billions’ – details a rich range of options to make it much harder for these people to scam us.
The most simple is to introduce into British law something called a general anti-avoidance principle.
It is simply stated that if any step is added into a commercial arrangement for the sole or main purpose of avoiding tax, then this step will be ignored by HM Revenue and Customs. They will tax it anyway. So if you transfer you earnings into your wife or child’s name just to scam us; if you relocate your business on paper just to scam us; we’ll ignore it.
This is not a magic bullet – but it changes the terms of the debate. Instead of the Inland Revenue chasing retrospectively to close loopholes, accountants have to justify them as being more than mere tax avoidance every time.
The next move is to stop the perverse staff cuts at HM Revenue and Customs. By 2011, three hundred tax offices will have been shuttered, and 25,000 staff laid off. This is a totally false economy: each staff member brings in £2,636,588 a year – more than 96.5 times their wages. But if there’s nobody to track down the tax avoiders, we can’t net the cash.
And we can crack down on tax havens. The German government is now using its equivalent of MI5 to track people dodgily shifting their cash to Liechtenstein. Britain needs to be as proactive. We were constantly being told that it was impossible to restrain tax havens, because the money would simply leech to another haven, then another; there would always be somebody prepared to snub the world and reap the rewards. But after September 11th the US demanded every al Qaeda-related bank account be closed – and it happened overnight. If money stashed away to kill people can be tracked, why not money that could save lives too? An international campaign to end this system is in the interests of the 99.9 percent of humanity who will never use a tax haven.
This isn’t about persecuting the super-rich; it’s about requiring them to pay their fair share for the privilege of living and working in a stable democratic society. I pay my taxes; you pay yours. It is time for the people who can most afford it to do the same.
Wednesday 19 March 2008
How dare these soldiers go round getting wounded?
Mark Steel: How dare these soldiers go round getting wounded?
Wednesday, 19 March 2008
Of all the shady reasons for supporting the war in Iraq, the weakest was always how it was our duty to "Support our boys," as they couldn't do their job if people back home were critical. To start with, this doesn't seem logical. Is there any evidence that tank commanders were about to fire off a volley of missiles, but then hesitated saying "Ooh I'm not sure I can go through with it because there was this sniffy letter in The Independent"?
But more important=, what a strange idea that the only true way to support someone is to cheer them into a situation that's likely to get them killed. If these "supporters" ever find themselves looking up at a tower block, with someone 15 floors up threatening to jump off the balcony as friends delicately try to coax him back, they must shout, "Don't undermine him – it's up to all of us to support him – jump, man, jump! Go on – here's Zoe, 22 from Clacton in a G-string and paratrooper's cap. She supports you, so dive!"
Inevitably, once the supported boys started returning from war with bits missing, the governments and newspapers that backed them most enthusiastically decide that they're an embarrassing nuisance. Then their attitude becomes like that of the First World War general who, when he visited a hospital full of soldiers back from the Somme with shell shock, shouted, "Why are you shivering? Only drunkards and masturbators freeze." This must be what causes so many old people to conk out from hypothermia every winter, the filthy minxes.
But that general has been challenged for callousness by defence minister Des Browne, who yesterday went to the High Court to try and prevent a coroner from criticising the Ministry of Defence, during inquests on soldiers killed in Iraq or Afghanistan. The trouble is that a coroner reported, in the inquest into the death of Capt James Phillipson, that the soldier had been given, "a lack of basic equipment". Whereas from now on, presumably, he'll have to say, "The soldier had piles of equipment, so much he didn't know where to put it all. What must have happened is, well, obviously, I've got it – the Taliban magicked it away, with their equipment vanishing cream. So there we are, no one to blame, just one of those things, I'm afraid."
The attempted injunction fits in with the government's attitude to wounded soldiers. For example, families of those who've been disabled have complained about the system for compensation, which only takes into account the three worst injuries received. I'm not an expert on the details of modern warfare, but I'd guess that if you're blown up by a roadside bomb you might be injured in more than three places. This doesn't seem to occur to the Ministry of Defence, who must say to applicants for compensation "All right, Wilkins, so you're trying to tell me that when you were blown across the road by a barrel of explosives you injured not only an arm, a foot and an ear but other bits as well? Do you take us for mugs?"
This procedure has meant that, for example, when Sgt Martin Edwardes came back from Iraq with brain damage, his compensation was £114,000, a fraction of what will be needed to provide him with the 24-hour care he now depends on. Or there's Martyn Compton, who was in a coma for three months, has 70 per cent burns, no ears left, and received £98,000. They'd have got more if they'd been astute enough to suffer three huge injuries instead of dozens of medium-sized ones. Maybe we'll soon see Carol Vorderman asking, "Why not consolidate all your minor amputations into one manageable paralysis?"
Perhaps the next move will be to franchise compensation payments out to the Private Finance Initiative, so disabled soldiers will be instructed to attract investment by converting their wheelchair into a mobile Costa Coffee outlet. Or the system will be made more efficient by placing it into private hands, so the severely wounded will have to attract sponsorship. For example, if they have to use a voice box, it will be programmed to say things like, "Please – take – me – to – the – toilet – Thank – you – this – request – was – brought – to – you – by – Legal – and – General."
Throughout the coverage of the fifth anniversary of the war, there have been discussions around the "mistakes" made in planning the occupation. But the government's attitude towards those whose lives have been wrecked for their vanity project shows the problem wasn't "mistakes", in the execution of the plan, but the whole project. Unless they'll claim, "When we began this operation, whoever could have anticipated that when we invaded the country, some of these chaps would start firing back? I mean – we can't predict everything now, can we?"
Wednesday, 19 March 2008
Of all the shady reasons for supporting the war in Iraq, the weakest was always how it was our duty to "Support our boys," as they couldn't do their job if people back home were critical. To start with, this doesn't seem logical. Is there any evidence that tank commanders were about to fire off a volley of missiles, but then hesitated saying "Ooh I'm not sure I can go through with it because there was this sniffy letter in The Independent"?
But more important=, what a strange idea that the only true way to support someone is to cheer them into a situation that's likely to get them killed. If these "supporters" ever find themselves looking up at a tower block, with someone 15 floors up threatening to jump off the balcony as friends delicately try to coax him back, they must shout, "Don't undermine him – it's up to all of us to support him – jump, man, jump! Go on – here's Zoe, 22 from Clacton in a G-string and paratrooper's cap. She supports you, so dive!"
Inevitably, once the supported boys started returning from war with bits missing, the governments and newspapers that backed them most enthusiastically decide that they're an embarrassing nuisance. Then their attitude becomes like that of the First World War general who, when he visited a hospital full of soldiers back from the Somme with shell shock, shouted, "Why are you shivering? Only drunkards and masturbators freeze." This must be what causes so many old people to conk out from hypothermia every winter, the filthy minxes.
But that general has been challenged for callousness by defence minister Des Browne, who yesterday went to the High Court to try and prevent a coroner from criticising the Ministry of Defence, during inquests on soldiers killed in Iraq or Afghanistan. The trouble is that a coroner reported, in the inquest into the death of Capt James Phillipson, that the soldier had been given, "a lack of basic equipment". Whereas from now on, presumably, he'll have to say, "The soldier had piles of equipment, so much he didn't know where to put it all. What must have happened is, well, obviously, I've got it – the Taliban magicked it away, with their equipment vanishing cream. So there we are, no one to blame, just one of those things, I'm afraid."
The attempted injunction fits in with the government's attitude to wounded soldiers. For example, families of those who've been disabled have complained about the system for compensation, which only takes into account the three worst injuries received. I'm not an expert on the details of modern warfare, but I'd guess that if you're blown up by a roadside bomb you might be injured in more than three places. This doesn't seem to occur to the Ministry of Defence, who must say to applicants for compensation "All right, Wilkins, so you're trying to tell me that when you were blown across the road by a barrel of explosives you injured not only an arm, a foot and an ear but other bits as well? Do you take us for mugs?"
This procedure has meant that, for example, when Sgt Martin Edwardes came back from Iraq with brain damage, his compensation was £114,000, a fraction of what will be needed to provide him with the 24-hour care he now depends on. Or there's Martyn Compton, who was in a coma for three months, has 70 per cent burns, no ears left, and received £98,000. They'd have got more if they'd been astute enough to suffer three huge injuries instead of dozens of medium-sized ones. Maybe we'll soon see Carol Vorderman asking, "Why not consolidate all your minor amputations into one manageable paralysis?"
Perhaps the next move will be to franchise compensation payments out to the Private Finance Initiative, so disabled soldiers will be instructed to attract investment by converting their wheelchair into a mobile Costa Coffee outlet. Or the system will be made more efficient by placing it into private hands, so the severely wounded will have to attract sponsorship. For example, if they have to use a voice box, it will be programmed to say things like, "Please – take – me – to – the – toilet – Thank – you – this – request – was – brought – to – you – by – Legal – and – General."
Throughout the coverage of the fifth anniversary of the war, there have been discussions around the "mistakes" made in planning the occupation. But the government's attitude towards those whose lives have been wrecked for their vanity project shows the problem wasn't "mistakes", in the execution of the plan, but the whole project. Unless they'll claim, "When we began this operation, whoever could have anticipated that when we invaded the country, some of these chaps would start firing back? I mean – we can't predict everything now, can we?"
Saturday 15 March 2008
Ideas from left field
Ideas from left field
Sport, like life, is pure Darwinism. It is too innovative to be confined by one political theory
* Ed Smith
* The Guardian,
* Saturday March 15 2008
We are all too familiar with debates about sport and political controversies - should we allow an Olympic games in China? Should England play cricket in Zimbabwe? - but we hear little about sport and political ideas. Does the history of sport demonstrate the rightness, or otherwise, of a political world view? If sport had to don political colours, would it wear a red strip or a blue one?
The Marxists, as is often the case, have some of the prose stylists. CLR James, the doyen of all sports writers, was a Marxist class warrior as well as a wonderful cricket writer. Marxism runs through James's Beyond a Boundary rather like Catholicism courses through Graham Greene's fiction: they are all too keen to advocate their respective faiths, rather less good at getting their narratives to embody them.
Far from proving James's Marxist ideals, Beyond a Boundary undermines them. Any static ruling establishment, no matter how well-intentioned, quickly morphs to become very similar to the one it replaced.
The book's convincing strand about the spirit and ingenuity of early black West Indian cricketers proves that, far from cricket needing more Marxism, Marxism needs to learn from West Indian cricket. "Never trust the teller," as DH Lawrence put it, "trust the tale."
To high Tories, of course, the history of sport proves that civilisation is gradually collapsing - it has been all downhill since the demise of the Corinthians. This amateur, and usually victorious, football team rolled penalties back to the opposition goalkeeper (no foul could possibly be intentional) and retired one of their own team should an opposition player leave the field injured.
High Tories cherished the fact that British sports were once governed by institutions that belonged to neither the free market nor the state - the Royal and Ancient, the MCC, the All England Croquet Club. Now business, they say, has vulgarised sport and the government is meddlesome. Who needs either?
For interventionist social democrats, sport proves that something must be done, even if they're not sure what or how. The free market must be curtailed! Fairness must increase! Loyalty can't vanish! Local identity mustn't be lost! We must sort everything out! The centre-left sits very much on the sporting moral high ground - but often in the expensive seats near the halfway line.
In fact, I would argue the history of sport challenges all these political systems of thought. Sport, like life, advances through evolutionary individualism, not top-down institutional diktat. Unfortunately for those who like to control sport from the centre, you simply can't stop people getting better at sport by their own devices.
Sport is about problem solving. A challenge is set: kick the ball into the net; hit the ball over the boundary; jump over the bar. Rules are (eventually) agreed - no kicking of opponents; don't pick up the ball with your hands; stay within this area, and so on. From then on, it is pure Darwinism - players innovate constantly, sometimes deliberately, sometimes by accident.
When the great Australian cricketer Greg Chappell compiled a list of the game's foremost champions, he discovered that an extremely high proportion learned their methods on their own, without first being taught the received wisdom of traditional technique. As a boy, Don Bradman practised at home, hitting a golf ball against the wall with a stick. Garry Sobers played beach cricket. Javed Miandad learned to survive on uneven surfaces on the Karachi streets. Jeff Thomson emerged out of the Sydney surf to learn he could bowl 100mph with a completely unique action.
Gifted human beings, if they address a physiological challenge with their full attention and talents, invariably come up with pretty good solutions. When they are exceptional, they rewrite convention and the game inches forward.
Sportsmen, inevitably always searching for competitive advantage, can't resist asking left-field questions. Why shouldn't I jump over the high-jump bar head first (the Fosbury flop)? Why shouldn't I aim my sweep shot towards off-side where there aren't any fielders (the reverse sweep)? The winning innovations, like dominant genes, survive and are absorbed into the mainstream; the bad ones never get off the ground.
This is taking place all over the sporting world, beyond the control of administrators or writers of textbooks. As such, sport is irreverent, constantly changing and essentially resistant to authority. Sport never stands still long enough to be effectively ensnared by an over-arching political theory. It is much too interesting for that.
Sport, like life, is pure Darwinism. It is too innovative to be confined by one political theory
* Ed Smith
* The Guardian,
* Saturday March 15 2008
We are all too familiar with debates about sport and political controversies - should we allow an Olympic games in China? Should England play cricket in Zimbabwe? - but we hear little about sport and political ideas. Does the history of sport demonstrate the rightness, or otherwise, of a political world view? If sport had to don political colours, would it wear a red strip or a blue one?
The Marxists, as is often the case, have some of the prose stylists. CLR James, the doyen of all sports writers, was a Marxist class warrior as well as a wonderful cricket writer. Marxism runs through James's Beyond a Boundary rather like Catholicism courses through Graham Greene's fiction: they are all too keen to advocate their respective faiths, rather less good at getting their narratives to embody them.
Far from proving James's Marxist ideals, Beyond a Boundary undermines them. Any static ruling establishment, no matter how well-intentioned, quickly morphs to become very similar to the one it replaced.
The book's convincing strand about the spirit and ingenuity of early black West Indian cricketers proves that, far from cricket needing more Marxism, Marxism needs to learn from West Indian cricket. "Never trust the teller," as DH Lawrence put it, "trust the tale."
To high Tories, of course, the history of sport proves that civilisation is gradually collapsing - it has been all downhill since the demise of the Corinthians. This amateur, and usually victorious, football team rolled penalties back to the opposition goalkeeper (no foul could possibly be intentional) and retired one of their own team should an opposition player leave the field injured.
High Tories cherished the fact that British sports were once governed by institutions that belonged to neither the free market nor the state - the Royal and Ancient, the MCC, the All England Croquet Club. Now business, they say, has vulgarised sport and the government is meddlesome. Who needs either?
For interventionist social democrats, sport proves that something must be done, even if they're not sure what or how. The free market must be curtailed! Fairness must increase! Loyalty can't vanish! Local identity mustn't be lost! We must sort everything out! The centre-left sits very much on the sporting moral high ground - but often in the expensive seats near the halfway line.
In fact, I would argue the history of sport challenges all these political systems of thought. Sport, like life, advances through evolutionary individualism, not top-down institutional diktat. Unfortunately for those who like to control sport from the centre, you simply can't stop people getting better at sport by their own devices.
Sport is about problem solving. A challenge is set: kick the ball into the net; hit the ball over the boundary; jump over the bar. Rules are (eventually) agreed - no kicking of opponents; don't pick up the ball with your hands; stay within this area, and so on. From then on, it is pure Darwinism - players innovate constantly, sometimes deliberately, sometimes by accident.
When the great Australian cricketer Greg Chappell compiled a list of the game's foremost champions, he discovered that an extremely high proportion learned their methods on their own, without first being taught the received wisdom of traditional technique. As a boy, Don Bradman practised at home, hitting a golf ball against the wall with a stick. Garry Sobers played beach cricket. Javed Miandad learned to survive on uneven surfaces on the Karachi streets. Jeff Thomson emerged out of the Sydney surf to learn he could bowl 100mph with a completely unique action.
Gifted human beings, if they address a physiological challenge with their full attention and talents, invariably come up with pretty good solutions. When they are exceptional, they rewrite convention and the game inches forward.
Sportsmen, inevitably always searching for competitive advantage, can't resist asking left-field questions. Why shouldn't I jump over the high-jump bar head first (the Fosbury flop)? Why shouldn't I aim my sweep shot towards off-side where there aren't any fielders (the reverse sweep)? The winning innovations, like dominant genes, survive and are absorbed into the mainstream; the bad ones never get off the ground.
This is taking place all over the sporting world, beyond the control of administrators or writers of textbooks. As such, sport is irreverent, constantly changing and essentially resistant to authority. Sport never stands still long enough to be effectively ensnared by an over-arching political theory. It is much too interesting for that.
Wednesday 12 March 2008
PSBR or PSNCR
PSNCR - Explanation
The PSNCR - public sector net cash requirement - used to be called the PSBR - the public sector borrowing requirement. They are the same thing. They measure the amount the government has to borrow to meet all its expenditure commitments. Governments frequently spend more than they are earning in tax revenue, and so have to borrow to plug the gap.
There are two ways to measure the value of the PSNCR. The first is to look at the PSNCR as an amount of money - usually in billions of pounds (£bn). This is useful as a measure, but we may also want to consider how significant this figure is in the overall context of the economy. £5bn sounds a lot of money (and we would all like a share of it !), but in terms of the overall level of GDP it is fairly insignificant. So the other way to measure the PSNCR is as a percentage of GDP.
The PSNCR tends to vary with the trade cycle. This happens because as the level of growth changes the governments expenditure and tax revenue will also change automatically. For example, imagine the economy is going into recession. As people lose their jobs, incomes fall and this means less income tax. They will also spend less which means the government gets less from VAT and other indirect taxes. At the same time they will need to be paid benefits, and this means an increase in government expenditure. The overall effect of the recession therefore has been to increase the PSNCR.
PSNCR and the Trade Cycle - Why does it vary?
The PSNCR tends to change along with the state of the economy. When things are going well and the economy is booming, the PSNCR will tend to be falling (unless the government is going mad spending on other things!). This is because a booming economy means low unemployment and low unemployment means less spending on benefits. Not only that, but when people are employed they will spend more, and this will boost VAT and other indirect tax receipts.
The impact of a recession on the PSNCR will be the opposite. Increasing unemployment means more spending on benefits, increasing the level of government expenditure. Unemployed people don't pay income tax, and others may find their incomes falling. The combination of these two effects means that the government receives less income tax. Spending also will fall as people have less money and are more reluctant to spend what they do have because of uncertainty about the future. As spending falls so does the government's revenue from indirect taxes
So boom periods should help to lower the PSNCR, while recessions and economic slowdown will tend to push it back up again.
PSNCR Theories - Cyclical or Structural - What determines it?
Theory 1 (PSNCR and the trade cycle) shows that the PSNCR will tend to vary with the economic cycle. If this happens over a number of years and the PSNCR fluctuates around an average value of zero, then the government doesn't need to worry about it too much. A recession may increase it, but the onset of recovery will help it fall again. If this is the case then the PSNCR is termed a cyclical PSNCR.
However, it will often be the case that the value that the PSNCR fluctuates around is far from zero. This means that the government is borrowing all the time. In other words, it is borrowing over the long term. Where this happens, this part of the PSNCR is termed a structural PSNCR. Governments do need to worry more about a structural PSNCR as it is a long-term one, and they need to think about how they can reduce it. They have two main alternatives:
If they don't do either of these, there will be a permanent PSNCR and the national debt
- Increase taxes
- Reduce government expenditure
PSNCR and the Money Supply - The effect of borrowing on the money supply
If the PSNCR is high, this means that the government is spending much more than it is receiving in tax revenue. It follows then that it is putting more money into the banking system (from its spending) than it is taking out of it (from taxes). This will increase the money supply in the economy. This may be undesirable as many economists believe that excessive money supply growth will cause inflation. This is a view held particularly by Monetarist economists and Classical economists.
The aim of governments should therefore be to keep the value of the PSNCR down to help keep money supply growth down.
PSNCR and the National Debt - How indebted are we?
The national debt is the total amount of borrowing accumulated by the government that is still outstanding. It is the total amount that the government owes to individuals and institutions.
Think of the national debt as the level of water in a tank. Each year the government borrows more. The amount it borrows is the PSNCR. This is equivalent to a tap filling up the tank - the amount of water (debt) is growing. However, at the same time, the government pays off some of its debts each year. This is like water flowing out of the tank.
If the amount flowing into the tank (the PSNCR) is greater than the amount going out (debt paid off), then the water level (the national debt) will rise. If on the other hand the amount flowing into the tank (the PSNCR) is smaller than the amount going out (debt paid off), then the water level (the national debt) will fall.
The diagram below shows this:
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Laffer and Phillips curve
The Laffer curve is used to illustrate the concept of "taxable income elasticity", which is the idea that government can maximize tax revenue by setting tax rates at an optimum point and that neither a 0% tax rate nor a 100% tax rate will generate government revenue.
The curve is most understandable at both extremes of income taxation—zero percent and one-hundred percent—where the government collects no revenue. At one extreme, a 0% tax rate means the government's revenue is, of course, zero. At the other extreme, where there is a 100% tax rate, the government collects zero revenue because (in a "rational" economic model) taxpayers presumably change their behavior in response to the tax rate: either they have no incentive to work or they avoid paying taxes, so the government collects 100% of nothing.It however does not mean that a 50 % tax rate maximises the tax revenue.
The Phillips curve is a historical inverse relation between the rate of unemployment and the rate of inflation in an economy. Stated simply, the lower the unemployment in an economy, the higher the rate of change in wages paid to labor in that economy.
Alban William Phillips, a New Zealand-born economist, wrote a paper in 1958 titled The relationship between unemployment and the rate of change of money wages in the United Kingdom 1861-1957, which was published in the quarterly journal Economica. In the paper Phillips describes how he observed an inverse relationship between money wage changes and unemployment in the British economy over the period examined. Similar patterns were found in other countries and in 1960 Paul Samuelson and Robert Solow took Phillips' work and made explicit the link between inflation and unemployment: when inflation was high, unemployment was low, and vice-versa.
In the 1920s an American economist Irving Fisher noted this kind of Phillips curve relationship. However, Phillips' original curve described the behavior of money wages. So some believe that the Phillips curve should be called the "Fisher curve."
In the years following Phillips' 1958 paper, many economists in the advanced industrial countries believed that his results showed that there was a permanently stable relationship between inflation and unemployment. One implication of this for government policy was that governments could control unemployment and inflation within a Keynesian policy. They could tolerate a reasonably high rate of inflation as this would lead to lower unemployment – there would be a trade-off between inflation and unemployment. For example, monetary policy and/or fiscal policy (i.e., deficit spending) could be used to stimulate the economy, raising gross domestic product and lowering the unemployment rate. Moving along the Phillips curve, this would lead to a higher inflation rate, the cost of enjoying lower unemployment rates.
Stagflation
In the 1970s, many countries experienced high levels of both inflation and unemployment also known as stagflation. Theories based on the Phillips curve suggested that this could not happen, and the curve came under concerted attack from a group of economists headed by Milton Friedman—arguing that the demonstrable failure of the relationship demanded a return to non-interventionist, free market policies. The idea that there was a simple, predictable, and persistent relationship between inflation and unemployment was abandoned by most if not all macroeconomists.[edit] NAIRU and rational expectations
In the diagram, the long-run Phillips curve is the vertical red line. The NAIRU theory says that when unemployment is at the rate defined by this line, inflation will be stable. However, in the short-run policymakers will face an inflation-unemployment rate tradeoff marked by the "Initial Short-Run Phillips Curve" in the graph. Policymakers can therefore reduce the unemployment rate temporarily, moving from point A to point B through expansionary policy. However, according to the NAIRU, exploiting this short-run tradeoff will raise inflation expectations, shifting the short-run curve rightward to the "New Short-Run Phillips Curve" and moving the point of equilibrium from B to C. Thus the reduction in unemployment below the "Natural Rate" will be temporary, and lead only to higher inflation in the long run.
Since the short-run curve shifts outward due to the attempt to reduce unemployment, the expansionary policy ultimately worsens the exploitable tradeoff between unemployment and inflation. That is, it results in more inflation at each short-run unemployment rate. The name "NAIRU" arises because with actual unemployment below it, inflation accelerates, while with unemployment above it, inflation decelerates. With the actual rate equal to it, inflation is stable, neither accelerating nor decelerating. One practical use of this model was to provide an explanation for Stagflation, which confounded the traditional Phillips curve.
The rational expectations theory said that expectations of inflation were equal to what actually happened, with some minor and temporary errors. This in turn suggested that the short-run period was so short that it was non-existent: any effort to reduce unemployment below the NAIRU, for example, would immediately cause inflationary expectations to rise and thus imply that the policy would fail. Unemployment would never deviate from the NAIRU except due to random and transitory mistakes in developing expectations about future inflation rates. In this perspective, any deviation of the actual unemployment rate from the NAIRU was an illusion.
However, in the 1990s in the U.S., it became increasingly clear that the NAIRU did not have a unique equilibrium and could change in unpredictable ways. In the late 1990s, the actual unemployment rate fell below 4 % of the labor force, much lower than almost all estimates of the NAIRU. But inflation stayed very moderate rather than accelerating. So, just as the Phillips curve had become a subject of debate, so did the NAIRU.
Further, the concept of rational expectations had become subject to much doubt when it became clear that the main assumption of models based on it was that there exists a single (unique) equilibrium in the economy that is set ahead of time, determined independent of demand conditions. The experience of the 1990s suggests that this assumption cannot be sustained.
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