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Public Policy Brief No.97
29 January 2009
After the Bust
Abstract“Change” was the buzzword of the Obama campaign, in response to a political agenda precipitated by financial turmoil and a global economic crisis. According to Research Associate Thomas Palley, the neoliberal economic policy paradigm underlying that agenda must itself change if there is to be a successful policy response to the crisis. Mainstream economic theory remains unreformed, says Palley, and he warns of a return to failed policies if a deep crisis is averted. Since Post Keynesians accurately predicted that the US economy would implode from within, there is an opportunity for Post Keynesian economics to replace neoliberalism with a more successful approach.
Palley notes that there is significant disagreement among economic paradigms about how to ensure full employment and shared prosperity. A salient feature of the neoliberal economy is the disconnect between wages and productivity growth. Workers are boxed in on all sides by globalization, labor market flexibility, inflation concerns, and a belief in “small government” that has eroded economic rights and government services. Financialization, the economic foundation of neoliberalism, serves the interests of financial markets and top management. Thus, reversing the neoliberal paradigm will require a policy agenda that addresses financialization and ensures that financial markets and firms are more closely aligned with the greater public interest.
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Working Paper No.555
27 January 2009
Financial Stability: The Significance and Distinctiveness of Islamic Banking in Malaysia
AbstractThis paper explores the significance of Islamic banking in Malaysia for stability in the country’s economy as a whole. Neither conventional theory nor Islamic economics puts forward a systematic explanation of financial intermediation; consequently, neither is capable of identifying destabilizing elements in the system. Instead, a flow-of-funds approach similar to Minsky’s own is applied to the (post-) modern (consumption-led) business cycle and financial (and asset) market.
Malaysia’s structural current account surplus contributes to the overcapitalization of domestic firms. This in turn finances a financial (as opposed to an industrial), consumption-led (instead of investment-led) business cycle, where banking favors destabilizing asset price inflation. Islamic banks operating interdependently with conventional ones contribute to economic destabilization, channelling surplus funds from the corporate to the household sector.
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Working Paper No.554
26 January 2009
Macroeconomic Imbalances in the United States and Their Impact on the International Financial System
AbstractThe argument put forward in this paper is twofold. First, the financial crisis of 2007–08 was made global by the current account deficit in the United States; and second, there is global dependence on the United States trade deficit as a means of maintaining liquidity in financial markets. The outflow of dollars from the United States was invested in US capital markets, causing inflation in asset markets and leading to a bubble and bust in the subprime mortgage sector. Since the US dollar is the international reserve currency, international debt is mostly denominated in dollars. Because there is a high degree of global financial integration, any reduction in the US balance of trade will have negative effects on many countries throughout the world—for example, those countries dependent on exporting to the United States in order to finance their debt.
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Policy Notes No.1
22 January 2009
Obama’s Job Creation Promise
AbstractJob creation is once again at the forefront of policy action, and for advocates of pro-employment policies, President Obama’s Keynesian bent is a most welcome change. However, there are concerns that Obama’s plan simply does not go far enough, and that a large-scale public investment program may face shortages of skilled labor, put upward pressure on wages, and leave women and minorities behind. Both concerns can be addressed by a simple amendment to the Obama plan that will bring important additional benefits. The amendment proposed here is for the government to offer a job guarantee to all unemployed individuals who are ready, willing, and able to participate in the economic recovery—that is, to target the unemployed directly.
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Strategic Analysis
06 January 2009
Flow of Funds Figures Show the Largest Drop in Household Borrowing in the Last 40 Years
AbstractThe Federal Reserve’s latest flow-of-funds data reveal that household borrowing has fallen sharply lower, bringing about a reversal of the upward trend in household debt. According to the Levy Institute’s macro model, a fall in borrowing has an immediate effect—accounting in this case for most of the 3 percent drop in private expenditure that occurred in the third quarter of 2008—as well as delayed effects; as a result, the decline in real GDP and accompanying rise in unemployment may be substantial in coming quarters.
For further details on the Macro-Modeling Team’s latest projections, see the December 2008 Strategic Analysis Prospects for the US and the World: A Crisis That Conventional Remedies Cannot Resolve.
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Strategic Analysis
24 December 2008
Prospects for the United States and the World: A Crisis That Conventional Remedies Cannot Resolve
AbstractThe economic recovery plans currently under consideration by the United States and many other countries seem to be concentrated on the possibility of using expansionary fiscal and monetary policies alone. In a new Strategic Analysis, the Levy Institute’s Macro-Modeling Team argues that, however well coordinated, this approach will not be sufficient; what’s required, they say, is a worldwide recovery of output, combined with sustainable balances in international trade.
Download Strategic Analysis, December 2008 PDF (656.93 KB) -
Working Paper No.553
22 December 2008
Insuring Against Private Capital Flows
AbstractFollowing an analysis of the forces behind the “global capital flows paradox” observed in the era of advancing financial globalization, this paper sets out to investigate the opportunity costs of self-insurance through precautionary reserve holdings. We reject the idea of reserves as low-cost protection against the vagaries of global finance. We also deny that arrangements giving rise to their rapid accumulation might be sustainable in the first place. Alternative policy options open to developing countries are explored, designed to limit both the risks of financial globalization and the costs of insurance-type responses. We propose comprehensive capital account management as an alternative to full capital account liberalization. The aims of a permanent regulatory regime of capital controls, with respect to both the aggregate size and the composition of capital flows, are twofold: first, to maintain sufficient macro policy space; second, to assure a good micro fit of external expertise incorporated in foreign direct investment as part of a country’s development strategy.
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Working Paper No.552
16 December 2008
Hypothetical Integration in a Social Accounting Matrix and Fixed-price Multiplier Analysis
AbstractThis study proposes a simple modification to a Social Accounting Matrix (SAM) in order to analyze the multiplier effects of a new sector. A different input composition, or technology, of the sector makes a conventional analysis of final-demand injections on existing sectors invalid. Author Kijong Kim shows that the modification—so-called hypothetical integration—is an efficient way to incorporate the difference into the SAM, rather than costly full-scale rebalancing. He applies this method to the case of the Expanded Public Works Programme in South Africa, and demonstrates that the proposed approach effectively represents the labor intensity requirement of the program and a new-factor income distribution.
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Working Paper No.551
02 December 2008
Small Is Beautiful
AbstractThis paper examines the relationship between farm size and yield per acre in Turkey using heretofore untapped data from a 2002 farm-level survey of 5,003 rural households. After controlling for village, household, and agroclimatic heterogeneity, a strong inverse relationship between farm size and yield is found to be prevalent in all regions of Turkey. The paper also investigates the impact of land fragmentation on productivity and labor input per acre, and finds a positive relationship. These results favor labor-centered theories that point to higher labor input per decare as the source of the inverse size-yield relationship.
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Working Paper No.550
20 November 2008
An Empirical Analysis of Gender Bias in Education Spending in Paraguay
AbstractGender affects household spending in two areas that have been widely studied in the literature. One strand documents that greater female bargaining power within households results in a variety of shifts in household production and consumption. An important source of intrahousehold bargaining power is ownership of assets, especially land. Another strand examines gender bias in spending on children. This paper addresses both strands simultaneously. In it, differences in spending on education are examined empirically, at both the household and the individual level. Results are mixed, though the balance of evidence weighs toward pro-male bias in spending on education at the household level. Results also indicate that the relationship between asset ownership and female bargaining power within the household is contingent on the type of asset.
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Working Paper No.549
14 November 2008
Excess Capital and Liquidity Management
AbstractThese notes present a new approach to corporate finance, one in which financing is not determined by prospective income streams but by financing opportunities, liquidity considerations, and prospective capital gains. This approach substantially modifies the traditional view of high interest rates as a discouragement to speculation; the Keynesian and Post-Keynesian theory of liquidity preference as the opportunity cost of investment; and the notion of the liquidity premium as a factor in determining the rate of interest on longer-term maturities.
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Policy Notes No.6
11 November 2008
Time to Bail Out: Alternatives to the Bush-Paulson Plan
AbstractWhile serving as chairman of the Federal Reserve Board, Alan Greenspan advocated unsupervised securitization, subprime lending, option ARMs, credit-default swaps, and all manner of financial alchemy in the belief that markets “work” to reduce and spread risk, and to allocate it to those best able to assess and bear it—in his view, markets would stabilize in the absence of nasty government intervention. But as Greenspan now admits, he could never have imagined the outcome: a financial and economic crisis of biblical proportions.
The problem is, market forces are not stabilizing. Left to their own devices, Wall Street wizards gleefully ran right off the cliff, and took the rest of us with them for good measure. The natural instability of market processes was recognized long ago by John Maynard Keynes, and convincingly updated by Hyman P. Minsky throughout his career. Minsky’s theory explained the transformation of the economy over the postwar period from robust to fragile. He pointed his finger at managed money—huge pools of pension funds, hedge funds, sovereign wealth funds, university endowments, money market funds—that are outside traditional banking and therefore largely underregulated and undersupervised. With a large appetite for risk, managed money sought high returns promised by Wall Street’s financial engineers, who innovated highly complex instruments that few people understood.
In this new Policy Note, President Dimitri B. Papadimitriou and Research Scholar L. Randall Wray take a look back at Wall Street’s path to Armageddon, and propose some alternatives to the Bush-Paulson plan to “bail out” both the Street and the American homeowner. Under the existing plan, Treasury would become an owner of troubled financial institutions in exchange for a capital injection—but without exercising any ownership rights, such as replacing the management that created the mess. The bailout would be used as an opportunity to consolidate control of the nation’s financial system in the hands of a few large (Wall Street) banks, with government funds subsidizing purchases of troubled banks by “healthy” ones.
But it is highly unlikely that relieving banks of some of their bad assets, or injecting some equity into them, will increase their willingness to lend. Resolving the liquidity crisis is the best strategy, the authors say, and keeping small-to-medium-size banks open is the best way to ensure access to credit once the economy recovers. A temporary suspension of the collection of payroll taxes would put more income into the hands of households while lowering the employment costs for firms, fueling spending and employment. The government should assume a more active role in helping homeowners saddled with mortgage debt they cannot afford, providing low-cost 30-year loans directly to all comers; in the meantime, a moratorium on foreclosures is necessary. And federal grants to support local spending on needed projects would go a long way toward rectifying our $1.6 trillion public infrastructure deficit.
Can the Treasury afford all these measures? The answer, the authors say, is yes—and it is a bargain if one considers the cost of not doing it. It is obvious that there exist unused resources today, as unemployment rises and factories are idled due to lack of demand. Markets are also voting with their dollars for more Treasury debt. This does not mean the Treasury should spend without restraint—whatever rescue plan is adopted should be well planned and targeted, and of the proper size. The point is that setting arbitrary budget constraints is neither necessary nor desired—especially in the worst financial and economic crisis since the Great Depression.
Download Policy Note 2008/6 PDF (364.87 KB) -
Working Paper No.548
10 November 2008
On Democratizing Financial Turmoil
AbstractThe paper uses Minsky’s financial instability hypothesis as an analytical framework for understanding the subprime mortgage crisis and for introducing adequate reforms to restore economic stability. We argue that the subprime crisis has structural origins that extend far beyond the housing and financial markets. We further argue that rising inequality since the 1980s formed the breeding ground for the current financial markets meltdown. What we observe today is only the manifestation of the ingenuity of the market in taking advantage of moneymaking opportunities, regardless of the consequences. The so-called “democratization of homeownership ” rapidly turned into record-high delinquencies and foreclosures. The sudden turn in market expectations led investors and banks to reevaluate their portfolios, which brought about a credit crunch and widespread economic instability. The Federal Reserve Bank’s intervention came too late and failed to usher in adequate regulation. Finally, the paper argues that a true democratization of homeownership is only possible through job creation and income-generation programs, rather than through exotic mortgage schemes.
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Policy Notes No.5
24 October 2008
Will the Paulson Bailout Produce the Basis for Another Minsky Moment?
AbstractAs the House Committee on Financial Services meets to hear the expert testimony of witnesses concerning the regulation of the financial system, the measures that have been introduced to support the system are laying the groundwork for a new domestic financial architecture. Hyman Minsky suggests that the basic principle behind any reformulation of the regulatory system should limit the size and activities of financial institutions, and should be dictated by the ability of supervisors, examiners, and regulators to understand the institutions’ operations. Following Minsky’s preference for bank holding company structures, Senior Scholar Jan Kregel proposes the creation of numerous types of subsidiaries within the holding company. The aim would be to limit each type of holding company to a range of activities that were sufficiently linked to their core function and to ensure that each company was small enough to be effectively managed and supervised.
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Working Paper No.547
23 October 2008
Minsky and Economic Policy
AbstractRecently, national newspapers all over the world have suggested that we should reread John Maynard Keynes, and that Hyman P. Minsky provides a valuable framework for understanding the world in which we live. While rereading Keynes and discovering Minsky are noble goals, one should also remember the mistakes that were made in the past. The mainstream interpretation and implementation of Keynes’s ideas have been very different from what Keynes proposed, and they have been reduced to simple “fiscal activism.” This led to the 1950s and 1960s “Keynesian” era, during which fine-tuning was supposed to be a straightforward way to fix economic problems. We know today that this is not the case: just playing around with taxes and government expenditures will not do. On the contrary, problems may worsen. If one wants to get serious about Keynes and Minsky, one should understand that the theoretical and policy implications are far-reaching. This paper compares and contrasts Minsky’s views of the capitalist system to the tenets of the New Consensus, and argues that there never has been any true Keynesian revolution. This is illustrated by studying the Roosevelt and Kennedy/Johnson eras, as well as Keynes’s reaction to the former and Minsky’s critique of the latter. Overall, it is argued that the theoretical framework and policy prescriptions of Irving Fisher, not Keynes, have been much more consistent with past and current government policies.
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Working Paper No.546
20 October 2008
Do the Innovations in a Monetary VAR Have Finite Variances?
AbstractSince Christopher Sims’s “Macroeconomics and Reality” (1980), macroeconomists have used structural VARs, or vector autoregressions, for policy analysis. Constructing the impulse-response functions and variance decompositions that are central to this literature requires factoring the variance-covariance matrix of innovations from the VAR. This paper presents evidence consistent with the hypothesis that at least some elements of this matrix are infinite for one monetary VAR, as the innovations have stable, non-Gaussian distributions, with characteristic exponents ranging from 1.5504 to 1.7734 according to ML estimates. Hence, Cholesky and other factorizations that would normally be used to identify structural residuals from the VAR are impossible.
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Public Policy Brief No.96
08 October 2008
The Commodities Market Bubble
AbstractMoney manager capitalism—characterized by highly leveraged funds seeking maximum returns in an environment that systematically underprices risk—has resulted in a series of boom-and-bust cycles in equities, real estate, and commodities. Because subsequent cycles have been increasingly damaging to the broader economy, we are now at the point where we are experiencing the most severe financial crisis since the Great Depression. Hasty interventions (bailouts) by Congress, the Treasury, and the Federal Reserve are attempting to keep the financial industry solvent, in the belief that government inaction would result in a prolonged recession.
In this new public policy brief, Senior Scholar L. Randall Wray shows how money manager capitalism (financialization) has destabilized one asset class after another. He concludes that policymakers must fundamentally change the structure of our economic system, break the cycle of booms and busts, and reduce the influence of managed money—as well as prevent the next speculative boom in yet another asset class.
Download Public Policy Brief No. 96, 2008 PDF (327.99 KB) -
Policy Notes No.4
08 October 2008
A Simple Proposal to Resolve the Disruption of Counterparty Risk in Short-Term Credit Markets
AbstractThe impaired risk assessment caused by the collapse of mortgage-backed securities is the major problem threatening the stability of the American financial system, yet it is not clear that removing these assets from institutional balance sheets, as the government has proposed, will make it easier to assess counterparty risk in short-term credit markets. Resolving the disruption of counterparty risk should be the first objective of policy, argues Senior Scholar Jan Kregel, since these markets provide basic liquidity support for institutions operating in the broader financial markets.
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Working Paper No.545
07 October 2008
Promoting Equality Through an Employment of Last Resort Policy
AbstractUnemployment has far-reaching effects, all leading to an inequitable distribution of well-being. To put an economy on an equitable growth path, economic development must be based on social efficiency, equity—and job creation. Many economists, however, assume that unemployment tends toward a natural rate below which it cannot go without creating inflation. This paper considers a particular employment strategy: a government job creation program, such as an employment guarantee or employer-of-last-resort (ELR) scheme, that would satisfy the noninflationary criteria. The paper analyzes the international experience of government job creation programs, with particular emphasis on the cases of Argentina and India. It concludes by considering the application of an ELR policy to the developing world, and as a vehicle for meeting the Millennium Development Goals.
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Working Paper No.544
29 September 2008
Inflation Targeting in Brazil
AbstractThe monetary policy regime of inflation targeting (IT) has been adopted by a significant number of emerging economies. While the focus of this paper is on Brazil, which began inflation targeting in 1999, the authors also examine the experience of other countries, both for comparative purposes and for evidence of the extent of this “new” economic policy’s success. In addition, they compare the experience of Brazil with that of non-IT countries, and ask the question of whether adopting IT makes a difference in the fight against inflation.
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Working Paper No.543
01 September 2008
Macroeconomics Meets Hyman P. Minsky
AbstractExpanding on an approach developed by financial economist Hyman Minsky, the authors present an alternative to the standard “efficient markets hypothesis”—the relevance of which Minsky vehemently denied. Minsky recognized that, in a modern capitalist economy with complex, expensive, and long-lived assets, the method used to finance asset positions is of critical importance, both for theory and for real-world outcomes—one reason his alternate approach has been embraced by Post Keynesian economists and Wall Street practitioners alike.
Coauthors L. Randall Wray and Éric Tymoigne argue that the current financial crisis, which began with the collapse of the US subprime mortgage market in 2007, provides a compelling reason to show how Minsky’s approach offers us a solid grounding in the workings of financial capitalism. They examine Minsky’s extension to Keynes’s investment theory of the business cycle, which allowed Minsky to analyze the evolution, over time, of the modern capitalist economy toward fragility—what is well known as his financial instability hypothesis. They then update Minsky’s approach to finance with a more detailed examination of asset pricing and the evolution of the banking sector, and conclude with a brief review of the insights that such an approach can provide for analysis of the current global financial crisis.
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Public Policy Brief No.95
29 August 2008
Shaky Foundations: Policy Lessons from America’s Historic Housing Crash
AbstractA bursting asset bubble inevitably requires central bank action, usually when it is already too late and with adverse spillover effects. In this sense, the Federal Reserve and other central banks already target asset prices; yet, by taking aim at them only on the way down—as in the current housing and credit crisis—the "Big Banks" create a self-perpetuating cycle of perverse incentives and moral hazard that often gives rise to yet another round of bubbles.
The US central bank’s current premise is that policymakers cannot and should not target asset bubbles. However, the housing story has rendered untenable the prevailing belief that bubbles are impossible to spot ahead of time. The warning signals were ubiquitous—for example, price charts showing home values rising impossibly into the stratosphere, and Wall Street’s increasing reliance on housing-backed bonds for its record-setting profits. It has become abundantly clear that there was plenty the Fed could have done to discourage speculative behavior and put a stop to predatory lending.
Recent US experience has bolstered the view that asset prices must come under the central bank’s purview in order for the economy to retain some semblance of stability. Former Fed Chairman Paul Volcker recently called for a broader regulatory role for the central bank in light of the housing-centered credit crisis. Indeed, Treasury Secretary Henry Paulson’s latest plan for tackling the crisis involves giving the Fed vast new authority to regulate investment banks, not just depository institutions. However, news analyst Pedro Nicolaci da Costa argues that attitude changes among regulators will be even more important than shifts in mandate in ensuring that regulators like the Fed do their jobs properly.
Download Public Policy Brief No. 95, 2008 PDF (207.92 KB) -
Policy Notes
25 August 2008
What’s a Central Bank to Do?
AbstractAs homeowner equity continues to disappear, there is a growing consensus that losses on all mortgages will exceed $1 trillion, with financial losses spreading far beyond real estate. Mortgage rates are spiking, and, more generally, interest rate spreads remain wide, as financial players shun private debt in the rush to safe Treasury securities. Labor markets continue to weaken as firms shed jobs, and state tax revenues have plummeted. In March, the dollar fell to new record lows against the euro and other currencies.
Commodities prices have boomed, fueling inflation and adding to consumer distress.What’s a central bank to do? So far, the Federal Reserve has met or exceeded the market’s anticipations for rate cuts. It has allowed banks to offer securitized mortgages as collateral against borrowed reserves, and opened its discount window to a broad range of financial institutions to guard against future liquidity problems (remember Bear Stearns?). It helped to formulate a rescue plan for Freddie Mac and Fannie Mae, and Chairman Ben Bernanke even supported the fiscal stimulus package that will increase the federal budget deficit—something that is normally anathema to central bankers. Most importantly, Fed officials have consistently argued that, while they are carefully monitoring inflation pressures, they will not reverse monetary ease until the fallout from the subprime crisis is past.
Unfortunately, the policy isn’t working—the economy continues to weaken, the financial crisis is spreading, and inflation is accelerating. The problem is that policymakers do not recognize the underlying forces driving the crisis, in part because they operate with an incorrect model of how our economy works. This Policy Note summarizes that model, offers an alternative view based on Hyman Minsky’s approach, and outlines an alternative framework for policy formation.
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Policy Notes No.3
25 August 2008
What’s a Central Bank to Do?
AbstractAs homeowner equity continues to disappear, there is a growing consensus that losses on all mortgages will exceed $1 trillion, with financial losses spreading far beyond real estate. Mortgage rates are spiking and, more generally, interest rate spreads remain wide, as financial players shun private debt in the rush to safe Treasury securities. Labor markets continue to weaken as firms shed jobs, and state tax revenues have plummeted. In March, the dollar fell to new record lows against the euro and other currencies. Commodities prices have boomed, fueling inflation and adding to consumer distress.
What’s a central bank to do? So far, the Federal Reserve has met or exceeded the market’s anticipations for rate cuts. It has allowed banks to offer securitized mortgages as collateral against borrowed reserves, and opened its discount window to a broad range of financial institutions to guard against future liquidity problems (remember Bear Stearns?). It helped to formulate a rescue plan for Freddie Mac and Fannie Mae, and Chairman Ben Bernanke even supported the fiscal stimulus package that will increase the federal budget deficit—something that is normally anathema to central bankers. Most importantly, Fed officials have consistently argued that, while they are carefully monitoring inflation pressures, they will not reverse monetary easing until the fallout from the subprime crisis is past.
Unfortunately, the policy isn’t working—the economy continues to weaken, the financial crisis is spreading, and inflation is accelerating. The problem is that policymakers do not recognize the underlying forces driving the crisis, in part because they operate with an incorrect model of how our economy works. This Policy Note summarizes that model, offers an alternative view based on Hyman Minsky’s approach, and outlines an alternative framework for policy formation.
Download Policy Note 2008/3 PDF (522.02 KB)