Gerald O;driscoll (who is one of my favorite thinkers on the economy) says in WSJ article copied below:  “The underlying dilemma [in the EZ] is that governments have promised their citizens more social programs than can be financed with the tax revenue generated by the private sector. High tax rates choke off the economic growth needed to finance the promises. Economic activity gets driven into the underground economy, where it often escapes taxation ...  The sad fact is that there is not enough money in the EU to pay off the public debts incurred by the governments. Most countries have long since squeezed as much tax revenue from their citizens as they can. That is why they have toyed with a tax on financial transactions, the one remaining untaxed activity in all of Europe.”

Do we really want to see how high we can raise taxes in the US before we end up like Europe???  Is there any coincidence that   

O’Driscoll argues that the US is for all practical purposes already there (i.e. building an unsustainable social welfare state);  for one we are linked to the woes of EZ via banking and financial linkages. EX woes are our woes.  Second, and even more important …  “the U.S. has its own large and growing public debt burden. We have not gone as far down the road to entitlements, but we are catching up. If you want to know how the debt crisis will play out here, watch the downward spiral in the EU.”

>>>>

We are in a global recession caused by the aftermath of an easy money credit bubble that went bust.  The US government reduced private debt exposure but merely off loaded private debt onto the public balance sheet thus creating a public debt sustainability crisis.  We are told by the experts and pundits in mainstream media that we need a bipartisan solution that includes higher taxes to return to a sustainable fiscal path.

But how do you raise taxes into a recession, especially a "recession" (period of sub normal growth) that is supposed to last many years (as indicated by the Fed yesterday in their latest report).

The answer cannot be higher taxes and more government interventions in the economy.

As I see it the only realistic answer to the current chronic low-growth, high leverage, high financial risk economy and financial markets is to reduce the regulatory and tax burden on the private sector. 

Only then will we get a rebound in growth which is necessary to facilitate and speed-up the organic private sector creative destruction process.   we need a massive boost to growth to offset the contractionary effect of de-leveraging. 

if we use either fiscal or monetary stimulus to reduce the negative impact of deleveraging, what we do is prevent the market from adjusting to a new sustainable growth dynamic. 

fiscal and monetary stimulus DISTORTS markets by definition.  how are we going to fix the market with new distortions.  it makes no sense, but we are told by all of the experts that if the Fed wasn't such a party pooper, we would be on our way to higher inflation and recovery.

the government can't provide any such free lunch to society via fiscal or monetary stimulus. 

we have learned this lesson over and over and over again through history, but we keep trying anyway to fix government created problems with more government. 
 

As one of the great (but far from perfect) American Presidents said:  government isn’t the solution, it’s the problem.

The “law of no free lunches” (combined with the related “law of unintended consequences”) prevents government intervention in the economy from resulting in win/win outcomes for society.  Whatever good the government tries to do with interventionist policy (e.g. increase transparency and reduce risk in financial sector via regulation, or reduce business cycles via central bank, or reduce income inequality via highly progressive income tax) the result is a predictable constellation of negative unintended consequences that MORE THAN off-set any intended positive gains.

Government intervention is win for the few but lose for the many.   it must be that way.  otherwise the government would gradually take over every key sector of economy -- which it seems is the case today -- and yet the MARKET gets blamed for screwing everything up.

every key sector of US economy is massively distorted via government subsidies.  the idea that the US economy is a wild west model is a total myth.  Europe has its social welfare model.  at least they admit government intervention. 

We have our Subsidy Welfare Model that appears to be more more because subsidies are channeled into ostensibly private firms.  Consider these industries:  housing, banking, education, health, food processing, farming, military industrial complex.  you name it.  the government is massively involved and causing massive distortions.  

it is no coincidence the most subsidized sectors of economy display the worst inflation:  education and health.  We are told the government needs to fix the inflation because private firms are greedy and taking advantage of consumers.  this is silly.  government regs and subsidies drive prices up in health and education -- and then we blame the market and add more government to the equation, which will lead to an even worse outcome.  you might get lower prices (but probably not)  -- but if you do get lower prices the cost will be some combination of lower quality, lower output (forced rationing)  and likely also operating losses funded by tax payers.  look at post office for a perfect model of government managed business. 

lower quality:  check  (compare to FedEx)

forced rationing:  check.  (long lines and no delivery on weekends happening soon)

chronic losses paid by taxpayers:  check  (US post office is making multi billion dollar annual deficits)

the same will happen in any universal healthcare system dreamed up by the experts and do gooder nanny state geniuses who know how to fix social issues if only the idiotic conservatives would get out of the way...

It is no coincidence that there was never a global economic boom and bust cycle like the Great Depression until AFTER the Fed was established in 1913 ostensibly to eliminate such cycles!

The idea that there was large de-regulation (or lack of enforcement of regs) by GW ahead of the financial crisis is a myth.    The very markets that are MOST regulated were the worst impacted in the post Lehman collapse period, including mortgage and banking.  The least regulated financial industries, including hedge funds, were NOT coincidentally the least affected.    New regs fix the previous problem not the new problem that will happen next time.  policy makers ALWAYS fight the last war, and not very well at that!

Higher marginal tax rates have been used throughout world history including US history as a means to reduce income inequality and   it never works.  I would like someone to show me a correlation between highly progressive income tax rates, income equality AND robust sustained economic growth.  If you want income equality, the easiest thing to do is raise taxes high enough to kill the economy and thus make everyone equally poor.  actually, when countries have done this in practice, there remains a tiny political elite who remain fabulously wealthy, while the rest of e country suffers.  Consider Soviet russia or North Korea.  Large countries with sustainably low income inequality are very rare.  Japan is one such country.  The cost of low income inequality is 20 years and counting of continuous near recession growth.   Europe has less income inequality than US but also a massive public debt problem that might sink the entire enterprise!!!!

To the extent income inequality causes social tensions, what I can say is that the cause of such exaggerated  income inequality is NOT the market.  the cause of the sort of stretched income inequality that is socially de-stabilizing is well intended government intervention that ends up hurting the poor and favoring the wealthy!!! 

Central banking is a perfect example.  Easy money flows first to asset markets, the rich get richer as their 401k and house value goes up, the poor pay higher rents and get poorer.  Next easy money flows to commodities (gas and food).  The Fed says gas and food inflation is not core inflation, so the easy money policy is maintained while the poor are let to suffer with higher costs and lower disposable income ... all the while the easy money bubble builds up even further.  the rich also have access to cheap credit in order to leverage asset purchases.  The rich get even richer.  This process causing the rich to get richer and poor to get poorer has nothing to do with any inherent evil in the market.

the market is subject to the "garbage in garbage out" problem.  if distorted signals are fed into the market via government intervention (e.g. easy money), the result will be distorted outcomes.  THis is no fault of the market.  The market doesn't fail us, we fail the market.

in fact the market doesn't "do" anything.  the market emerges naturally when free people exchange goods and services and specialize their labor.  it is that simple.

the so called "economy" that emerges from such free trade and specialization is NOT perfect.  free traders who claim the market can solve every problem are dead wrong.

the market is no more perfect than humans.

Raising taxes on a system that is already distorted by easy money will not reduce income inequality.  Higher taxes will merely make the system more distorted, dysfunctional and less able to generate wealth for society over all.

Let me repeat:  There is no such thing as a market failure.  There are only market “features.”  Some features are good and some are bad.  All natural systems (inlcuding we humans) have good and bad features.   Just like life.  yin and yang.  good and evil.  There is no way to eliminate the bad features of the market via government regulations because government regs also inherently possess both good and bad features. 

In the case of free markets, however, the good features by definition outweigh the bad.  Yes there is income inequality in a market.  income inequality is a vital feature of robust and dynamic economies.  Get rid of income inequality and get rid of the market.  perfect equality only occurs when an economy is effectively dead, when everyone is equally poor.  once trade and division of labor occurs, this is when society enjoys the win/win result of higher productivity. 

Everyone “wins” in a free market except some win more than others.  that is a fact of markets.  income inequality isn’t bad per se.   income inequality is no more a failure of markets than hurricanes are a failure of earth weather systems.   We live with and adapt to natural disasters, we don't eliminate or control them.  ( i read recently that scientists are trying to reduce the impact of hurricanes by injecting aerosols into them.  that is going to work about as well as central banking.  doing this might reduce individual storm activity, but in the end the energy will be disippated through more storms or some other channel.) 

The economy is a natural system of exchange just like the earth biosphere or weather systems or any other complex natural system of energy/material exchange.  The key to understanding the economy is not that it is made up of artificial goods and man made services.  the economy does appear to be made up of artificial “stuff” like i-pads.  But, if you look past the artificial goods and services and infrastructure and buildings and cars and airplanes that make up the modern economy what you see is a massive system of exchange.  the natural part of the economy is the exchange part. 

The only way to understand the economy is to understand it not as a pile of man made stuff that is put together by humans in some enlightened design aimed at maximizing social justice and human welfare.  NO.

"The economy" is not planned.  There are centrally planned parts of the economy (e.g. big companies, families, government), but these are component parts that exchange and interact with the larger economy.  the economy is a natural system of exchange.

The process of free trade (=exchange) and division of labor supported by an underlying “natural” system of private property rights (e.g. common law) leads naturally to a totally natural ecosystem we call “the economy.”  The economy is a totally natural (and spontaneously organizing) sub system of the larger earth system.  all sub systems of earth are seemlessly coordinated via ironclad laws of nature.

We cannot engineer outcomes into the economy.  we can’t inject virtue into society.  Government cannot level the playing field -- at least not without causing negative unintended consequences that are togehter worse than the original problem. natural complex systems that spontaneously organize (like the weather and economy) don’t work according to cause and effect rules.  The natural ecosystem pattern that we call “the economy” spontaneously emerges as a result of free trade.  It really is that easy.  Anything that reduces free trade will cause negative unintended consequences for the system as a whole.  Therefore if “we” try to reduce income inequality – via interventions that reduce the freedom of individuals to trade how they want and intend – then this requires a trade off in the form of some constellation of unintended consequences.

No free lunches!!!  The market is not perfect, but it is the best we can do.  if we want to improve the market, we need to think in terms of trade offs.  Lower income inequality = lower growth.  lower income inequality doesn’t mean higher growth as many progressives / liberals claim.  The experts claim that high income inequality is bad, so fixing it must be good.  that is NOT correct.  Income inequality is natural to markets.  what we see as income inequality leading to social stress is not “natural” and it is not a “market failure” that needs to be fixed via new govt intervention.  NO. 

large income inequality can only result from a set of previous well intended (or selfishly motivated) government rules, regulations, taxes and other assorted interventions.  All markets MUST lead to income inequality.  When markets breach some level of income inequality beyond the “natural rate” then this is not the result of market failure, but must be a result of some human intervention (well intended or selfish). 

The solution to reducing income inequality in America is not to increase marginal taxes on the rich or to subsidize education or level the playing field or any other well intended intervention.  The solution is to unwind the non-market causes of income inequality, number one of which is easy money.  Get rid of the Fed and get rid of all subsidies aimed at leveling the playing field. 

these two proposals are unlikley to get traction of course because politicians don’t want to get rid of easy money because easy money pays for all of the interventions and subsidies the politicians say are necessary to fix market failures (but which are really just convenient ways to pay off special interest groups).

Until we get rid of central banks, we will always be stuck in a self defeating cycle of more govt interventions implemented to fix the unintended consequences of some previous interventions.  This is the Road to Serfdom described by FA Hayek.

• NOVEMBER 2, 2011

Why We Can't Escape the Eurocrisis

EU and U.S. debt are interlinked through the banking system.

By GERALD P. O'DRISCOLL JR.

When is a bailout not a bailout? When the bailor is short of funds. The recently announced debt plan in the European Union comes up short in almost all respects.

The debt crisis is not just an EU problem, but a trans-Atlantic financial crisis. The overwhelming debt problems on either side of the pond are interlinked through the banking system.

First to the EU. The underlying dilemma is that governments have promised their citizens more social programs than can be financed with the tax revenue generated by the private sector. High tax rates choke off the economic growth needed to finance the promises. Economic activity gets driven into the underground economy, where it often escapes taxation.

Nowhere is this truer than in Greece, which has a long history of sovereign defaults in the 19th and 20th centuries. There is a bloated public sector, and competitive private enterprise is hobbled by regulation and government barriers to entry. Successive Greek governments ran chronic budget deficits, and the Greek banks lent to the government. Banks in other EU countries, such as France, lent to the Greek banks.

In Greece and elsewhere in the EU, the banks support the government by purchasing its bonds, and the government guarantees the banks. It is a Ponzi scheme not even Bernie Madoff could have concocted. The banks can no longer afford to fund budget deficits, yet they cannot afford to see governments default. Governments cannot make good on their guarantees of the banks.

Enlarge Image

Close

Getty Images

Details differ by country. In Ireland, problems began with an overheated property sector that brought down the banks. The economy went into depression, which threw the government's budget into deficit. Further aggravating the deficit was the government's decision to guarantee bank deposits, converting private, financial-sector debt into public-sector debt. The details differ from Greece, but the linkage between the government and the banks is the common factor.

France's growth is weak to nonexistent. Germany's economy has performed well since the recession, but concerns are growing regarding its banks' exposure to greater EU risk. And U.S. banks and financial institutions are exposed to EU banks through funding operations, issuance of credit default swaps and unknown exposure in derivatives markets.

The Federal Reserve has engaged in currency swaps with the European Central Bank to support the dollar needs of EU banks. The ECB deposits euros (or euro-denominated assets) with the Fed and receives dollars in return. It promises to repay dollars plus interest.

The Fed maintains they cannot lose money because the ECB promises to repay the swaps in dollars. And yet, with the world awash in greenbacks, it is unclear why the Fed and the ECB even needed to engage in these transactions—except that it suggests funding problems at some EU banks. And if neither EU banks nor the ECB can secure enough needed dollars in global markets, there is a serious counterparty risk to the Fed. The ECB can print euros but not dollars. Sen. Richard Shelby (R., Ala.), ranking member of the Senate Banking Committee, was correct to raise concerns about the Fed's policy last week. Losses on the Fed's balance sheet hit the U.S taxpayer, not EU citizens.

The sad fact is that there is not enough money in the EU to pay off the public debts incurred by the governments. Most countries have long since squeezed as much tax revenue from their citizens as they can. That is why they have toyed with a tax on financial transactions, the one remaining untaxed activity in all of Europe.

Greece is the first of other sovereign defaults to come. With last week's bailout, the EU leaders might have bought time, perhaps a year. But at some point, the ECB will cave and monetize the debt, leading to euro-zone inflation.

The debt calculus changed dramatically this week with the announcement of a Greek referendum on the bailout agreement next January. If voters reject the agreement, the ultimate outcome is unpredictable.

Americans must not be smug about the suffering of Europeans—our financial system is thoroughly integrated with theirs. Moreover, the International Monetary Fund will most likely be involved in the event of future bailouts and will likely need large funds from its members, which ultimately means the taxpayers.

And, of course, the U.S. has its own large and growing public debt burden. We have not gone as far down the road to entitlements, but we are catching up. If you want to know how the debt crisis will play out here, watch the downward spiral in the EU.

Meanwhile, expect more volatility in financial markets. U.S. traders in particular simply have not grasped the enormity of the EU debt crisis.

Mr. O'Driscoll, a senior fellow at the Cato Institute, is a former vice president of the Federal Reserve Bank of Dallas and later Citibank.

neither the left or right is willing to talk the language of trade offs

Ken Rogoff is right on when he diagnoses the current cycle as a Great Contraction, not a Great Recession.   (see must read article copied below). 

 Having said that, Rogoff is still stuck with the silly idea that policy makers can fix  macro problems with fiscal and/or monetary policy.  Rogoff  argues money printing (i.e. increasing the Cpi target to 4 - 6% for several yrs) will solve the current debt deleveraging problem.  Easy money doesn’t and cannot create national wealth.  If it did we could just print money and all live happily ever after. 

The only realistic solution to a debt deleveraging cycle (caused by an easy money cycle previously) is economic stimulus in the form of supply side reform.  Supply side reform encourages entrepreneurial risk taking, which is the engine of any robust and dynamic economy capable of delivering sustainable “high” growth. 

Money printing and fiscal stimulus are two sides of same insidious “easy money” coin.  Printing money ultimately means borrowing growth from the future.  Fiscal stimulus also means borrowing growth from the future in the form of economic activity paid for with debt. 

Professional mainstream economists  are in the business of figuring out what I call “free-lunch” policy options.  They “sell” their services to policy makers and politicians (on both the left and the right) who are in the business of getting elected by convincing the public they can implement free lunch policies as long as the public votes for them.   Policy makers and professional economists are in a mutual symbiotic relationship because professional economists design free lunch policies (that can’t work in the real world because free lunches don’t happen in the real world) and politicians sell these bogus policies to a gullible public. 

The real world works according to hard and fast trade-offs. 

Neither the government or the market is a silver bullet.  Neither the government or the market can magically provide free lunch solutions to social problems.

Let us start with the premise that life isn’t fair and the government can’t level the playing field.  Let's also understand that the "market" cannot miraculously fix poverty or fill in all of the pot holes in streets or provide universal health care. 

The market also can’t work if it is infected with central bank fiat money printing.  The political right loves the central bank printing press just as much as the left.  The right is hypocritical for claiming to be a friend of the market when it also supports a central bank printing press.  The right needs the central bank to pay for a massive military industrial complex and to provide a back stop bailout mechanism for big finance. 

Obviously, the left supports the central bank because it helps facilitate debt financing for social welfare programs.

Neither the political left or right is willing to talk the language of trade-offs because to talk trade-offs means upsetting special interest groups. 

Bottom line:  the government can't fix social problems.  if we want the government to solve  macro level social and economic "problems," we MUST accept lower economic dynamism and a lower rate of GDP growth.  Politicians promise higher sustainable growth AND lower income inequality AND less poverty AND universal healthcare if only the government got involved in green energy, education, technology R&D development, etc. etc. etc.

Sorry to pop the bubble .... "IT" doesn't work that way.  if government  gets involved then quality must go down and/or price must go up and/or rationing must be implemented.  You don't get better quality at lower price if government takes over.  sorry.  no free lunches.

if you want universal health care and other trappings of a European welfare society, then you have to admit that the system will eventually blow up as the EZ is blowing up under the weight of duel burdens of low growth and high public debt. 

of course the political right nearly took us over the cliff by supporting central bank financing of a guns and butter policy redux from the 1960s while simultaneously claiming the market should be allowed to work.  De-regulation doesn't work when the market is distorted by massive injection of central bank facilitated easy money. 

Sound money is the only policy anchor that forces politicians to consider trade offs.  which is why we've been told sound money can't work in a democracy.  the public doesn't want to be told it has to live by trade offs and politicians don't want to be held accountable to telling the public it can't have its cake and eat it too.

i don't agree.  i think the public is smarter than that.  i believe the public can understand in the concept of tradeoffs because that is the way real life works. 

The Second Great Contraction

Kenneth Rogoff

2011-08-02

The Second Great Contraction

CAMBRIDGE – Why is everyone still referring to the recent financial crisis as the “Great Recession”? The term, after all, is predicated on a dangerous misdiagnosis of the problems that confront the United States and other countries, leading to bad forecasts and bad policy.

The phrase “Great Recession” creates the impression that the economy is following the contours of a typical recession, only more severe – something like a really bad cold. That is why, throughout this downturn, forecasters and analysts who have tried to make analogies to past post-war US recessions have gotten it so wrong. Moreover, too many policymakers have relied on the belief that, at the end of the day, this is just a deep recession that can be subdued by a generous helping of conventional policy tools, whether fiscal policy or massive bailouts.

But the real problem is that the global economy is badly overleveraged, and there is no quick escape without a scheme to transfer wealth from creditors to debtors, either through defaults, financial repression, or inflation.

A more accurate, if less reassuring, term for the ongoing crisis is the “Second Great Contraction.” Carmen Reinhart and I proposed this moniker in our 2009 book This Time is Different, based on our diagnosis of the crisis as a typical deep financial crisis, not a typical deep recession. The first “Great Contraction” of course, was the Great Depression, as emphasized by Anna Schwarz and the late Milton Friedman. The contraction applies not only to output and employment, as in a normal recession, but to debt and credit, and the deleveraging that typically takes many years to complete.

Why argue about semantics? Well, imagine you have pneumonia, but you think it is only a bad cold. You could easily fail to take the right medicine, and you would certainly expect your life to return to normal much faster than is realistic.

In a conventional recession, the resumption of growth implies a reasonably brisk return to normalcy. The economy not only regains its lost ground, but, within a year, it typically catches up to its rising long-run trend.

The aftermath of a typical deep financial crisis is something completely different. As Reinhart and I demonstrated, it typically takes an economy more than four years just to reach the same per capita income level that it had attained at its pre-crisis peak. So far, across a broad range of macroeconomic variables, including output, employment, debt, housing prices, and even equity, our quantitative benchmarks based on previous deep post-war financial crises have proved far more accurate than conventional recession logic.

Many commentators have argued that fiscal stimulus has largely failed not because it was misguided, but because it was not large enough to fight a “Great Recession.” But, in a “Great Contraction,” problem number one is too much debt. If governments that retain strong credit ratings are to spend scarce resources effectively, the most effective approach is to catalyze debt workouts and reductions.

For example, governments could facilitate the write-down of mortgages in exchange for a share of any future home-price appreciation. An analogous approach can be done for countries.  For example, rich countries’ voters in Europe could perhaps be persuaded to engage in a much larger bailout for Greece (one that is actually big enough to work), in exchange for higher payments in ten to fifteen years if Greek growth outperforms.

Is there any alternative to years of political gyrations and indecision?

In my December 2008 column, I argued that the only practical way to shorten the coming period of painful deleveraging and slow growth would be a sustained burst of moderate inflation, say, 4-6% for several years. Of course, inflation is an unfair and arbitrary transfer of income from savers to debtors. But, at the end of the day, such a transfer is the most direct approach to faster recovery. Eventually, it will take place one way or another, anyway, as Europe is painfully learning.

Some observers regard any suggestion of even modestly elevated inflation as a form of heresy. But Great Contractions, as opposed to recessions, are very infrequent events, occurring perhaps once every 70 or 80 years. These are times when central banks need to spend some of the credibility that they accumulate in normal times.

The big rush to jump on the “Great Recession” bandwagon happened because most analysts and policymakers simply had the wrong framework in mind. Unfortunately, by now it is far too clear how wrong they were.

Acknowledging that we have been using the wrong framework is the first step toward finding a solution. History suggests that recessions are often renamed when the smoke clears. Perhaps today the smoke will clear a bit faster if we dump the “Great Recession” label immediately and replace it with something more apt, like “Great Contraction.” It is too late to undo the bad forecasts and mistaken policies that have marked the aftermath of the financial crisis, but it is not too late to do better.

Kenneth Rogoff is Professor of Economics and Public Policy at Harvard University, and was formerly chief economist at the IMF.

Popcorn vs Domino theory of Financial Crisis

“Although there are legitimate concerns about contagion, the fundamental problem facing Europe is one of governments becoming too big to be supported by the economy … Both in Europe and the U.S., structural weakness stems from government excess and slow economic growth. More important than stemming contagion is reversing the policies that created the problem in the first place.”

Great quote from full op/ed copied below:  "The Euro Crisis: Doubting the 'Domino' Effect"

My Two Cents:  … One insidious manifestation of Big Government not explicitly recognized by the author of the WSJ op/ed ( Ed Lazear) is easy money facilitated by the Fed.   You can’t get to Big Government without a central bank willing and able to fund massive public debt accumulation by printing massive amounts of un-backed government fiat money.  The ECB pretends to be a vigilant protector of sound money – and on a relative basis it may in fact pursue a more sound monetary policy than the Fed.   but central banks were originally invented to do the bidding of politicians (who needed a captive purchaser of public debt issued to pay for welfare and/or war fare projects which otherwise would be unaffordable via direct taxation).   

so there is no such thing as a “sound money” central bank.   this is clearly the case with the ECB as evidenced by the massive debt accumulation in the EZ.  Central banks = Big Debt = Big government.  The political left and right in the US are equally guilty of using the Federal Reserve to fund special interest group support.   The establishment of the Fed is a perfect example when bipartisan support for a policy or public institution is NOT healthy!!!

We don’t want bipartisan support if it means equal support for policies that each party uses to buy off their respective special interest groups!! 

That is exactly the situation we have now with the Fed.  

The left uses the central bank to fund the social welfare complex,  the right uses the central bank to fund the military industrial complex and both the left and the right support the entitlement complex.    IT is no coincidence that social security reform is called the third rail of US politics.  Neither party is willing to talk straight about unaffordable entitlements funded by debt!!!! 

OCTOBER 31, 2011

The Euro Crisis: Doubting the 'Domino' Effect

Preventing a Greek default will not reverse the lackluster growth that has plagued the other vulnerable countries for many years now.

By EDWARD P. LAZEAR

It seems everyone is worried that problems in Europe will derail our fragile recovery. For this reason, markets breathed a sigh of relief when the Europeans came up with a plan to provide yet another reprieve to Greece. The main worry, now somewhat eased, was that a Greek default would spread to countries like Italy, Spain and Portugal.

Although there are legitimate concerns about contagion, the fundamental problem facing Europe is one of governments becoming too big to be supported by the economy. Unless Europe solves its fundamental problems with meaningful structural reform, a temporary debt restructuring, no matter how clever, will fail to right the ship. Closer to home, the same issues that threaten Europe may soon become immediate concerns to Americans.

To understand why, consider two theories of economic destruction, which can be labeled the domino theory and the popcorn theory. Everyone knows the domino theory; it is the analogy that is commonly used to denote contagion. If one domino falls, it will topple the others, and conversely, if the first domino remains upright, the others will not fall. It is this logic that underlies most bailout strategies.

The popcorn theory emphasizes a different mechanism. When popcorn is made (the old fashioned way), oil and corn kernels are placed in the bottom of a pan, heat is applied and the kernels pop. Were the first kernel to pop removed from the pan, there would be no noticeable difference. The other kernels would pop anyway because of the heat. The fundamental structural cause is the heat, not the fact that one kernel popped, triggering others to follow.

Many who believe that bailouts will solve Europe's problems cite the Sept. 15, 2008 bankruptcy of Lehman Brothers as evidence of what allowing one domino to fall can do to an economy. This is a misreading of the historical record. Our financial crisis was mostly a popcorn phenomenon. At the risk of sounding defensive (I was in the government at the time), I believe that Lehman's downfall was more a result of the factors that weakened our economic structure than the cause of the crisis.

Enlarge Image

Close

Corbis

Consider the events of 2007-08 that either preceded or had nothing to do with Lehman. World liquidity showed major signs of tightening by early August 2007. The recession began in December 2007. Bear Stearns failed and was rescued in early 2008. The auction-rate securities markets failed in the first half of 2008, monoline insurers encountered major difficulties during the spring, and, if not for some creative behind-the-scenes work, the student-loan market would have failed by that summer. The Dow Jones Industrial Average had lost about 3000 points from its peak by September 2008.

The week before Lehman failed, Fannie Mae and Freddie Mac, both on the edge of bankruptcy, were placed into conservatorship. On the weekend that the Lehman deal fell through, Merrill Lynch, also on the brink, was saved by Bank of America. By that weekend AIG was already showing signs of likely failure, as were Washington Mutual and Wachovia. Although GM and Chrysler crashed post-Lehman and were kept alive by a government loan, their troubles resulted from the decline in auto sales, coupled with noncompetitive costs. The sum of these events was more than enough to be called a financial crisis and to worsen the recession that was already under way.

Lehman's demise may well have been an exacerbating factor in the financial crisis and perhaps things might not have been as bad had Lehman not failed. Most directly, the Reserve Primary Fund, a money-market mutual fund that held $785 million in Lehman-issued securities, couldn't meet investor requests for redemptions at par value. That likely triggered a run on money markets. Other markets may also have been affected by Lehman's demise. One does not have to deny the role of contagion to believe that Lehman was not the domino that toppled the others.

But our financial crisis was caused by factors that affected the entire system, just as all corn kernels pop when they are warmed by the same flame. This lesson is important because interpreting our crisis as primarily a contagion event leads to the wrong strategies for dealing with potential disasters. After Lehman, Europeans seem to be so taken with worries of contagion that they are failing to emphasize remedies that actually have a chance of making things better. In their case, and in ours, the solution is primarily a reduction in the bloated size of government expenditures that come about by making promises that cannot be kept.

Especially in Italy and Portugal, as in Greece, the government has grown more rapidly than the economy, which has meant unsustainable government borrowing. Preventing a Greek default will not reverse the lackluster growth that has plagued the other vulnerable countries for many years now. As for the U.S., our economy will be stronger if Europe's health improves, but we must address our own underlying structural problems that are associated with a doubling of our 2008 debt levels by next year. No bailout of another economy will restore our fiscal health or that of Europe.

The cases of Estonia and Turkey attest to the effectiveness of structural change. After a significant economic contraction in 2001, Turkey embarked on a new path of rapid fiscal consolidation. By the end of 2002, growth was 6% and by 2004, 9%. Rather than slowing the economy further, government tightening was associated with strong and almost immediate growth. More recently, Estonia, which experienced almost a 20% contraction by the end of 2009, instituted fiscal reforms. Among them was a 10% reduction in government operating expenses and a flattening of the pension growth trajectory. In 2010, the year following the reforms, growth had already turned positive, to around 3%, and it is forecast to be above 6% for 2011.

These two examples, and that of our own financial crisis, suggest that fundamental problems need to be addressed early and forcefully. Both in Europe and the U.S., structural weakness stems from government excess and slow economic growth. More important than stemming contagion is reversing the policies that created the problem in the first place.

Mr. Lazear, chairman of the President's Council of Economic Advisers from 2006-09, is a professor at Stanford's Graduate School of Business and a Hoover Institution fellow.

For liberals, income inequality is the new global warming

my radar goes up whenever the mainstream media (read: progressives and/or liberals) begin to argue that some topic is so settled already it is politically incorrect to debate anymore.  global warming has that status.    James Pethokoukis argues that liberals are trying to turn income inequality into a similar kind of taboo topic in an article i've copied at bottom of this blog post titled:

For liberals, income inequality is the new global warming

 

I am not going to say there is no such thing as global warming or that there isn't evidence of rising income inequality in the US.  The debate about whether or not there is global warming obscures the much more important question: can we do anything about these problems?

I can say with the same certainty I have when i assume a ball will fall to the ground if i drop it from a building that liberal/progressive top-down government imposed solutions to either global warming or income inequality will only make things worse such that either the problem is solved by killing the economy -- such that rich and poor are made equally poor, or the problem is not solved and the solution still adversely impacts the economy while leaving the most at-risk households worse off than before the well intended intervention.

There is not such thing as market failures that require government intervention.  So called market failures are natural (albeit negative) unintended consequences of a system of free exchange, private property rights and division of labor.  Income inequality is natural to any market system because markets require division of labor which leads to income inequality.  equality can only be achieved by making everyone equally poor and destitute, such as we see in North Korea today.

When income inequality becomes stretched beyond what would be its natural distribution in a free market economy, the cause of this exaggerated inequality can be assumed with certainty to be some government intervention in the economy that was implemented with all good intentions but that resulted in negative unintended consequences, including facilitating income compression in poor households and wealth accumulation in already wealthy households.  the rich get richer and the poor get poorer not because of any flaw in free markets, but because of well intended government policies that ineluctably lead to negative unintended consequences.

central banking and fiat money is a perfect example:  easy money creates asset bubbles that benefit the rich and price inflation that hurts the poor disproportionally.  the rich get richer and the poor get poorer!!!  and then liberals blame the evil market.  division of labor must lead to income inequality, but it doesn't lead to the sort of exagerrated income inequality we see in modern economies organized around fiat money central banking systems. 

global warming can be understood through a similar analytical lens.  carbon dioxide emissions are a natural feature of the modern economy. (and CO2 emissions are a natural feature of human existence!!!  why do we think of CO2 emissions as artificial when we humans emit CO2!!???)

and who is to decide what is the optimal level of CO2 emissions in a society or economy at any given level of economic development??  are we supposed to believe that we can model the earth climate and economy and calculate what total CO2 emissions should be, and then implement a global policy that delivers the required target results???

It is impossible for humans to model the global economy let alone the earth climate, let alone implement policies that engineer outcomes in either!!!  we have seen what happens when man tries to engineer outcomes in the economy.

remember it was only after the Fed was established in 1913 (ostensibly to eliminate business cycles which were assumed to hurt poor households worst) did we get the largest economic boom and bust cycle in the history of the world!!!  so much for curing business cycles.

should we assume that experts can manage the economy AND the earths climate simultaneously???

Just because we see a problem in society does not mean we can fix it or that we have a moral obligation to fix it.  IF the economy was an artificial construct of humans designed and planned by humans, THEN maybe we would have a moral obligation to fix what we actively created. 

HOWEVER, we have no such moral obligation because the economy is a spontaneously organized complex system of exchange.  it is not artificially man-made like a computer or a car. 

the old proverb "the road to hell is paved with good intentions" is consistent with what we now know about the law of unintended consequences when humans attempt to intervene in natural complex systems. (including and especially with well intended public policy).

why don't we listen to the intuitive logic of proverbs and instead listen to the expert testimony of so called modern science?? 

The conclusion that man must be at fault for global warming and therefore that he has a moral obligation to fix global warming is based on the erroneous assumption that man is responsible for designing and artificially creating the human economy in the first place.

no one designed the economy.  the economy is NOT a man-made artificial construct.  man has designed component parts of the economy like cars and computers.  and there are small islands of central planning and design in the economy, such as we see with corporations and urban planning. 

but no one designed the larger pattern of interaction and exchange that characterizes the larger (invisible) "thing" we call "the economy" or "the market." 

liberals and conservatives fight over whether global warming or income inequality is real while Rome burns.  it doesn't matter if global warming is real.  even if it is real, we cannot do anything about it via direct policy intervention.

the only way to fix global warming is to let the market find its own optimal level of CO2.  that means REDUCING government interventions (like central banking) and other assorted distortions such as subsidies, taxes and regulations.  the road to sustainable growth does NOT entail doubling down on the very failed policies that have caused exaggerated distortions of natural (albeit negative) features of the market with new policies that will only sow new distortions and problems.  the only way to do reduce income inequality or to fix a global warming "problem" (if there is one)  is to identify and REMOVE the well intended government policies aimed at fixing so called "market failures" such as business cycles and income inequality. 

YES, the market is imperfect but it is still the best we can do.  WE do live in the best of all possible worlds if only we would let it emerge without screwing everything up with well intended central planning and public policy interventions.

the fundamental cause of global warming is too much growth fueled by easy money created by central banks.  no central bank = no global warming.  it is that simple.   the human economy is not "artificial" in the sense that it is man made.  there are artificial components that make up what we consider to be the economy.  like i mentioned already we see artificial products everywhere: roads, cars, computers, houses, phones, etc etc.  But just because the components of the human economy are artificial DOES NOT MEAN by definition that the economy itself is artificial.

this is a key point!!!  the economy is a natural system of exchange, just like the amazon rain forest.  

Exchange is the key natural feature of the economy that gives it form and function.  man made artificial components do not define the modern economy.  what defines the economy is exchange and division of labor.  without exchange there is no economy.  

if we let the market work, it will develop in the best way considering the physical constraints imposed by the real world.  will it be perfect?? no.  there will always be natural disasters in the economy same as in the earth system.  We should not try to fix natural disasters (such as hurricanes or earthquakes)???  i read in scientific american that some climatologists are arguing we can reduce the force of hurricanes by injecting aerisols into emergent hurricanes.  This is pure insanity!! what hubris to assume that we humans can micro manage the earth's weather patterns without causing some negative unintended consequence somewhere else in the system.  we cannot fix hurricanes or earthquakes any more than we can fix so called market failures, which are really just negative unintended consequences of a naturally robust and dyanammic system that requires a dynamic process of creative destruction to deliver productivity gains over time. 

can we monitor natural disasters and limit their impact on human society in the natural economy and in the earth system???  yes!!  yes! yes?  but, lets not be so naive as to believe we can fix the natural disasters directly and not adversely impact the larger earth system. 

there are no free lunches.  you don't get to have the positive unintended consequences delivered by the market (e.g. productivity gains, new technology, improving standard of living) if you try to eliminate the negative unintended consequences (such as CO2 emissions, income inequality, pollution, business cycles, etc, etc).  

we CAN make a difference in the world on a micro level.  person to person we can help people in need.  but we cannot engineer and design macro or social pattern outcomes into the economy.   natural systems must be allowed to emerge and to create their own future without intervention.  

another way to say this idea is that humans are like gods in some ways.  humans are creative like no other species on earth.  creativity is the purview of the gods or God.  but just because we can be creative in a certain limited domain on earth doesn't mean we can be creative and god-like in all domains on earth. 

in the domain of natural spontaneously forming systems, like the earth's biosphere or modern economy, we cannot be like Gods.  natural spontaneously forming complex systems have a future that is radically unpredictable.  if we try to enforce certain macro outcomes in a natural system we are begging unintended consequences that can boomarang and result in outcomes completely contrary to our intentions (especially good intentions).  

natural systems are defined by both creation and destruction.  you don't get to have one without the other.  you don't get productivity gains and rising standard of living without the underlying dynamics that lead to income inequality and pollution. 

there are no free lunches in "life" because life occurs within the natural laws that govern the behavior of spontaneously organizing natural complex systems! 

in spontaneously organizing complex systems, there is no order without disorder.  there is no success without failure.  you don't get the good without the bad.   

government promises to eliminate the bad and to maintain the good aspects of society are free lunch promises that can't possibly work in the real world.  the real world behaves according to laws of nature that define the behavior of natural complex systems -- and that do not allow for free lunches!

that is one of the great ironies of the progressive world view:  progressives accuse radical free market types as impractical dreamers.  progressives claim they live in the real world and try to fix real problems.  if liberals understood the rules of natural systems like the economy, they would understand how foolish it is to claim to be able to fix (negative unintended) natural features of a natural complex system like the human economy.  it is true that free market types are out to lunch when/if they claim that all social and macro economic problems can be solved as long as we turn the problem over to the free market.   

the notion that markets solve all problems is as silly as the notion that humans can intervene with enlightened public policy aimed at fixing (or ameliorating) natural market features such as income inequality.  Markets are inherently unfair, imperfect, volatile, dynamic, unpredictable and beyond human control or modelling or prediction.  

the so called "market failures" that are really just natural flaws and negative unintended consequences of free exchange are exactly the features that interact with human ingenuity and hard work and risk taking -- and lead spontaneously and unpredictably in an organic process of creative destruction that ultimately leads to the invisible (but REAL) thing that we call "the economy."      

well, ok, here is Pethokoukis' awesome article after all ....  well worth reading...

For liberals, income inequality is the new global warming

By James Pethokoukis

October 27, 2011, 11:57 am

Liberals think there are lots of ideas that intelligent Americans just aren’t supposed to challenge.

If they do, they’ll be labeled “deniers,” intentionally raising a nasty comparison to Holocaust rejectionists. It’s politics at its absolute lowest.

Among the unchallengeable dogmata: the Obama stimulus created millions of jobs, Obamacare will save trillions of dollars, Dodd-Frank prevents future bank bailouts, and policy uncertainty isn’t an issue hampering the recovery. And, of course, global warming poses an existential threat to civilization and humanity. Make that an “undeniable” threat.

You can now add “income inequality” to the list, thanks to New York magazine’s Jonathan Chait. In a column headlined “The Ideological Fantasies of Inequality Deniers,” Chait writes: “Rising income inequality, like climate change, is an ideologically inconvenient issue for conservatives. … The underlying facts, like the facts of climate change, are stark. Over the last few decades, income growth for most Americans has slowed to a crawl, while income for the very rich has exploded.”

In a way, Chait is correct that income inequality really resembled global warming. Both are issues that, to the extent they are even problems, could be be fixed though faster economic growth. And both serve as handy excuses for the Left to raise taxes and expand government.

The reality about “exploding income inequality” and wage stagnation is far different than what Chait, the Obama White House, and Elizabeth Warren (D-Occupy Wall Street) contend. One example: Brand new research from the University of Chicago’s Bruce Meyer and Notre Dame’s James Sullivan finds “median income and consumption both rose by more than 50 percent in real terms between 1980 and 2009. … Our results provide strong evidence that the well-being of the middle class and the poor has improved considerably over the past thirty years.”

Those results aren’t above challenge. But there certainly seems to be legitimate counter-arguments and evidence to the “exploding income inequality” meme. Indeed, differing household demographics and differing inflation measures between incomes levels means the “rise in American inequality has been exaggerated both in magnitude and timing,” according to Northwestern University’s Robert Gordon. That and other studies undercut a new CBO analysis showing massive income gains for the “1 percent” at the expense of everyone else. But maybe Gordon is a denier, too; another guy on the Koch-RNC payroll. Except Gordon is an Obama supporter.

America needs an informed debate on how the American middle class can prosper in the future the way it has in the past—even if it is ideologically inconvenient for Chait and other liberals.