‚Giving Health Care a Chance to Evolve‘

Robert Frank discusses market failures in health insurance markets, and how the president's health care plan helps to overcome them:

Giving Health Care a Chance to Evolve, by Robert Frank, Commentary, NY Times: ...Nearly every economic analysis of the health care industry rests on the observation that individually purchased private insurance is not a viable business model...
The fundamental problem is that ... people ... with serious pre-existing conditions ... are likely to need expensive care. Any company that issued policies to such people at affordable rates would be driven into bankruptcy, its most profitable customers lured away by competitors offering lower rates made possible by selling only to healthy people.
Economists call this the adverse-selection problem. Because of it, unregulated private markets for individual insurance cannot accommodate the least healthy — those who most desperately need health insurance.
Many countries solve this problem by having the government provide health insurance for all. In some, like Britain, the government employs the care providers. Others, like France, reimburse private practitioners — as does the Medicare program for older Americans. ...
Modeled after proposals advanced by the Heritage Foundation, the American Enterprise Institute and other conservative research organizations in the 1990s, the main provisions of the president’s health care law were intended to eliminate the most salient problems associated with the current system. ...
It isn’t that people should buy health insurance because it would be good for them. Rather, failure to do so would cause significant harm to others. Society will always step in to provide care — though in much more costly and often delayed and ineffective forms — to the uninsured who fall ill. To claim the right not to buy health insurance is thus to assert a right to impose enormous costs on others. Many legal scholars insist that the Constitution guarantees no such right. ...
What’s important now is how ... the law will ... extend coverage to tens of millions who now lack it. In addition, new insurance exchanges will provide a broader array of care options. ... The point worth celebrating is that last week’s ruling will at last enable our distinctly dysfunctional health care system to evolve into something better.

[More on market failures in health insurance markets here and here.]

Mainstream Economics is a Cult


Neoclassical Economics Is Based on Myth

Neoclassical economics is a cult which ignores reality in favor of shared myths.

Economics professor Michael Hudson writes:

[One Nobel prize winning economist stated,]  “In pointing out the consequences of a set of abstract assumptions, one need not be committed unduly as to the relation between reality and these assumptions.”


This attitude did not deter him from drawing policy conclusions affecting the material world in which real people live....


Typical of this now widespread attitude is the textbook Microeconomics by William Vickery, winner of the 1997 Nobel Economics Prize:

“Economic theory proper, indeed, is nothing more than a system of logical relations between certain sets of assumptions and the conclusions derived from them… The validity of a theory proper does not depend on the correspondence or lack of it between the assumptions of the theory or its conclusions and observations in the real world.  A theory as an internally consistent system is valid if the conclusions follow logically from its premises, and the fact that neither the premises nor the conclusions correspond to reality may show that the theory is not very useful, but does not invalidate it. In any pure theory, all propositions are essentially tautological, in the sense that the results are implicit in the assumptions made.”

Such disdain for empirical verification is not found in the physical sciences.

http://i.imgur.com/aoSKU.jpg"Our models show there is no chance of water"

Neoclassical economists created the mega-banks, thinking that bigger was better.  They pretend that it's better to help the big banks than the people, debt doesn't existhigh levels of leverage are good, artificially low interest rates are fine, bubbles are great, fraud should be covered up, and insolvent institutions propped up.

Indeed, even after a brief period of questioning their myths - after the 2008 economic crisis proved their core assumptions wrong - they have quickly regressed into their old ways.

 Government Economic Leaders Surprised that Real World Isnt Responding to their Magic Pixie Dust

Economics professor Steve Keen notes:

Neoclassical economics has become a religion.  Because it has a mathematical veneer, and I emphasize the word veneer, they actually believe it’s true. Once you believe something is true, you’re locked into its way of thinking unless there’s something that can break in from the outside and destroy that confidence.

Paul Heyne said:

The arguments of economists legitimate social and economic arrangements by providing these arrangements with quasi-religious justification. Economists are thus doing theology while for the most part unaware of that fact.

Economics professor Bill Black told me:

The amount of fraud that drove the Wall Street bubble and its collapse and caused the Great Depression is contested [keep reading to see what Black means]. The Pecora investigation found widespread manipulation of earnings, conflicts of interest, and insider abuse by the nation’s most elite financial leaders. John Kenneth Galbraith’s work documented these abuses. Theoclassical economic accounts, however, ignore or excuse these abuses.

Black explains:

[Neoclassical economists believed that] fraud is impossible because securities markets are “efficient” and act as if they were guided by an “invisible hand.” Markets cannot be efficient if there is accounting control fraud, so we know (on the basis of circular reasoning) that securities fraud cannot exist. Indeed, when [mainstream economists] try to explain why the securities markets automatically exclude frauds their faith-based logic becomes even more humorous.

Alex Andrews notes in the Guardian:

Greenspan's confession [that his assumption that fraud is not a big problem for the economy was totally wrong] was seen by many for precisely what it was: a crisis of faith, the faith that unrestricted free markets would always act benevolently. [Note: As we show below, neoclassical economists do not really believe in free markets.  As such, they are blind cultists, rather than thinking people of faith.] It revealed what a few had been arguing for some time, that the character of neoliberal economics is essentially religious. This is counter-intuitive. Surely the policy of Greenspan and others is based on an understanding of the science of economics, particularly in the mainstream neoclassical form that is most often taught in universities around the world? It is certainly the case that neoclassical economics appears scientific. This is because it deploys huge quantities of complex mathematics, giving it the veneer of being what it has long hoped to be, a kind of social physics.




Equations prove free markets work, but only in a sterile world of mathematical abstraction that relies on ridiculous assumptions such as perfectly competitive markets. It is little surprise then that Jean-Philippe Bouchaud, writing in the journal Nature, calls for a "scientific revolution" in economics.


Once economics loses its status as science, its religious aspects become more obvious. Robert H Nelson has spent his career trying to show that economics is religious in character. Through "the gospel of efficiency" after the second world war, Nelson argues that economists promised progress, a removal of sin, heaven on earth. Economists play the role of priests, defining good and bad behaviours that make this salvation possible.




It is clear that this is a market theodicy, justifying the ways of the market to men. When neoliberal politicians warn against governments interfering in the market, lest the irrational and temporary will of the electorate interfere with the "spontaneous order" of markets, this now seems like a dire warning that we must not "play God" and attempt to control the mysteries of the market that in our finitude, our "bounded rationality", we cannot properly fathom.

Harpers noted in 2005 that neoclassical economics - underneath it's veneer of math and science - is actually a twisted form of Protestant religion in disguise:

Economics, as channeled by its popular avatars in media and politics, is the cosmology and the theodicy of our contemporary culture. More than religion itself, more than literature, more than cable television, it is economics that offers the dominant creation narrative of our society, depicting the relation of each of us to the universe we inhabit, the relation of human beings to God. And the story it tells is a marvelous one. In it an enormous multitude of strangers, all individuals, all striving alone, are nevertheless all bound together in a beautiful and natural pattern of existence: the market. This understanding of markets—not as artifacts of human civilization but as phenomena of nature—now serves as the unquestioned foundation of nearly all political and social debate.




Economics departments around the world are overwhelmingly populated by economists of one particular stripe. Within the field they are called “neoclassical” economists, and their approach to the discipline was developed over the course of the nineteenth century.




Neoclassical economics tends to downplay the importance of human institutions, seeing instead a system of flows and exchanges that are governed by an inherent equilibrium. Predicated on the belief that markets operate in a scientifically knowable fashion, it sees them as self-regulating mathematical miracles, as delicate ecosystems best left alone.


If there is a whiff of creationism around this idea, it is no accident. By the time the term “economics” first emerged, in the 1870s, it was evangelical Christianity that had done the most to spur the field on toward its present scientific self-certainty.


When evangelical Christianity first grew into a powerful movement, between 1800 and 1850, studies of wealth and trade were called “political economy.” The two books at the center of this new learning were Adam Smith’s Wealth of Nations (1776) and David Ricardo’s Principles of Political Economy and Taxation (1817).




Ricardo concluded that the interests of different groups within an economy—owners, investors, renters, laborers—would always be in conflict with one another. Ricardo’s credibility with the capitalists was unquestionable: he was not a philosopher like Adam Smith but a successful stockbroker who had retired young on his earnings. But his view of capitalism made it seem that a harmonious society was a thing of the past: class conflict was part of the modern world, and the gentle old England of squire and farmer was over.


The group that bridled most against these pessimistic elements of Smith and Ricardo was the evangelicals. These were middle-class reformers who wanted to reshape Protestant doctrine. For them it was unthinkable that capitalism led to class conflict, for that would mean that God had created a world at war with itself. The evangelicals believed in a providential God, one who built a logical and orderly universe, and they saw the new industrial economy as a fulfillment of God’s plan. The free market, they believed, was a perfectly designed instrument to reward good Christian behavior and to punish and humiliate the unrepentant.


At the center of this early evangelical doctrine was the idea of original sin: we were all born stained by corruption and fleshly desire, and the true purpose of earthly life was to redeem this. The trials of economic life—the sweat of hard labor, the fear of poverty, the self-denial involved in saving—were earthly tests of sinfulness and virtue. While evangelicals believed salvation was ultimately possible only through conversion and faith, they saw the pain of earthly life as means of atonement for original sin.  




The extreme among them urged mortification of the flesh and would scold anyone who took pleasure in food, drink, or good company. Moreover, they regarded poverty as part of a divine program. Evangelicals interpreted the mental anguish of poverty and debt, and the physical agony of hunger or cold, as natural spurs to prick the conscience of sinners. They believed that the suffering of the poor would provoke remorse, reflection, and ultimately the conversion that would change their fate. In other words, poor people were poor for a reason, and helping them out of poverty would endanger their mortal souls. It was the evangelicals who began to see the business mogul as an heroic figure, his wealth a triumph of righteous will. The stockbroker, who to Adam Smith had been a suspicious and somewhat twisted character, was for nineteenth-century evangelicals a spiritual victor.


By the 1820s evangelicals were a dominant force in British economic policy.




Victorian evangelicals took a similar approach to the crisis in Ireland between 1845 and 1850 ...the potato famine.




The phrase “political economy” itself began to connote a cruel disregard for human suffering. And so a generation later, when the next phase of capitalist boosterism emerged, the term “political economy” was simply junked. The new field was called “economics.” What had got the political economists into trouble a generation before was the perception, from a public dominated by Dickens readers, that “political economy” was mostly about politics—about imposing a zealous ideology of the market. Economics was devised, instead, as a science, a field of objective knowledge with iron mathematical laws. Remodeling economics along the lines of physics insulated the new discipline from any charges filed on moral or sentimental grounds. William Stanley Jevons made this case in 1871, comparing the “Theory of Economy” to “the science of Statical Mechanics” (i.e., physics) and arguing that “the Laws of Exchange” in the marketplace “resemble the Laws of Equilibrium.”




Today we often think of science and religion as standing in opposition, but the “scientific” turn made by Jevons and his fellows only served to enshrine the faith of their evangelical predecessors. The evangelicals believed that the market was a divine system, guided by spiritual laws. The “scientific” economists saw the market as a natural system, a principle of equilibrium produced in the balance of individual souls.




U.S. policy debate, both in Congress and in the press, proceeds today as if the neoclassical theory of the free market were incontrovertible, endorsed by science and ordained by God. But markets are not spontaneous features of nature; they are creations of human civilization, like, for example, skating rinks.




The claim that markets are products of higher-order law, products of nature or of divine will, simply lends legitimacy to one particularly extreme view of politics and society.

Similarly, Philip Pilkington writes:

Taken at a very base level, the notion that there is an ‘invisible hand’ that irons out inconsistencies and increases the efficiency of the production and circulation of goods is basically the same claim that Hegel made about history being moved by a force called Reason. (Indeed, Adam Smith was one of Hegel’s references, perhaps even one of his key references). This claim, when made by either Smith or Hegel, can be traced back in turn to the Protestant tradition of predestination. The reasoning here is absolutely metaphysical and like the metaphysicians of yore it carries with it a moral lesson to be passed on to disciples.




Economists make huge generalisations about the people they study. They assume, for example, a single consumer that consumes the same goods and then projects this onto all consumers.


This is pure metaphysical reasoning. The economists concoct an idea in their heads which they then use to construct a theoretical edifice which falls apart when the original idea is shown to be false. They then derive a sort of ‘moral code’ from this construct which tells people how they should behave. In this case, students are told that this is how people should behave if they are to produce efficiently and effectively.


How is this different from the shaman who makes up a myth about the origins of the tribe and then derives moral lessons from this myth that he then teaches to the tribes-people? It’s not.




Economic ideas – such as the myth of the ‘single consumer’ – serve the function of ‘limiting principles’ for the way people in our contemporary society are allowed to think about the world. To think outside these ‘symbolic boundaries’ is not to be taken seriously. And yet, these boundaries are simply metaphysical constructs built up by economists and then disseminated to the population at large as a type of moral system.


Economics, then, is the totem – its simple moral lessons, the taboos. And this is how we in the modern world organise our thoughts and actions.




Adam Smith’s ‘hidden hand’ – is the direct descendent of Protestant predestination.




Economics has become, once again, a metaphysical doctrine boiled down to a few crass moralisms that are spoon-fed to the educated public.




It is really a subtle way of telling people what to do and assuring them that such authority is founded on some sort of Natural or Divine Law.




In policy circles today economists play the role of the court-priest. They deploy their esoteric and impenetrable ‘knowledge’ to tell policymakers what they should and should not do. To constrain economists to simply explain how the system works is to give them a role closer to that of the lawyer. The policymaker consults a lawyer to figure out what he or she can or cannot do and then makes a decision from there. Similarly, he or she might consult the economist, if the latter was seen as an operational role rather than as that of a seer.


This would, of course, threaten the role of the economist in society today. One can imagine that it is rather nice to be thought of as a divine, laying down metaphysical principles about the ‘inner’ workings of the world and deriving from these timeless truths and moral certainties that we mere mortals can then submit to. So, one can also imagine that these preachers and their flocks will respond to such a challenge with moral outrage. It is the outrage of a priest who has been told that his God is an invention, concocted in his mind to be used as leverage over his fellow men.

Neoclassical Economists Do NOT Believe in a Free Market

While many of the above quotes claim that neoclassical economists worship the free market, this is not actually true.

As I’ve previously noted:

When Mahatma Gandhi was asked what he thought about Western civilization, he answered:

I think it would be a good idea.

I feel the same way about free market capitalism.


It would be a good idea, but it is not what we have now. Instead, we have either socialism, fascism or a type of looting.


If people want to criticize capitalism and propose an alternative, that is fine . . . but only if they understand what free market capitalism is and acknowledge that America has not practiced free market capitalism for some time.




People pointing to the Western economies and saying that capitalism doesn’t work is as incorrect as pointing to Stalin’s murder of millions of innocent people and blaming it on socialism. Without the government’s creation of the too big to fail banks, Fed’s intervention in interest rates and the markets, government-created moral hazard emboldening casino-style speculation, corruption of government officials, creation of a system of government-sponsored rating agencies which had at its core a model of bribery, and other government-induced distortions of the free market, things wouldn’t have gotten nearly as bad.




Being against capitalism because of the mess we’ve gotten in would be like Gandhi saying that he is against Western civilization because of the way the British behaved towards India.

And - in the same way that the village shaman was often enlisted to promote and justify the chief's power as being divinely-ordained and unquestionable, many of today's neoclassical economists justify the acts of the ruling political class as being "economically sound", even when such acts are antithetical to free market economics.

Postscript 1:  Of course, for free market economics to become a real science, it will have to take into account realities such as imperfect information, externalities, the ability of powerful criminals to warp markets, people's behavioral idiosyncrasies  and other real world factors.

Postscript 2:  Just as it is unfair to blame the behavior of a crazy cult leader on religion as a whole, it is improper to blame our broken economic system on free market capitalism. It is the neoclassical economists who have broken our system.

Long the Most Expensive Burrito (by Ryan Mallory)


I can't remember or not if I've ever bought Chipotle Mexican Grill (CMG) before (as a stock), but considering my incredible passion for all things burritos, this particular long position that I just got in on is particularly exciting for me. In fact, if the stock can rebound and move higher, I'd rather my brokerage pay out the profits in burritos rather than actual money - just a personal choice.  

Nonetheless, the risk/reward is great on the setup. Below $367, and I'm out, and above $412, I close out the position for a nice profit and begin considering a future as a CMG franchisee. 

Oh yes, I got in at $378.44, which as of this posting, is still prime for picking. 

Here's the CMG trade setup.

Chipotle Mexican Grill CMG

Check out Ryan's Blog at SharePlanner.com

Guest Post: Whitewashing The Economic Establishment

Submitted by John Aziz of Azizonomics

Whitewashing The Economic Establishment

Brad DeLong makes an odd claim:

So the big lesson is simple: trust those who work in the tradition of Walter Bagehot, Hyman Minsky, and Charles Kindleberger. That means trusting economists like Paul Krugman, Paul Romer, Gary Gorton, Carmen Reinhart, Ken Rogoff, Raghuram Rajan, Larry Summers, Barry Eichengreen, Olivier Blanchard, and their peers. Just as they got the recent past right, so they are the ones most likely to get the distribution of possible futures right.

Larry Summers? If we’re going to base our economic policy on trusting in Larry Summers, should we not reappoint Greenspan as Fed Chairman? Or — better yet — appoint Charles Ponzi as head of the SEC? Or a fox to guard the henhouse? Or a tax cheat as Treasury Secretary? Or a war criminal as a peace ambassador? (Yes — reality is more surreal than anything I could imagine).

The bigger point though, as Steve Keen and Randall Wray have alluded to, is that DeLong’s list is the left-wing of the neoclassical school of economics — all the same people who (to a greater or lesser extent) believed that we were in a Great Moderation, and that thanks to the wonders of modernity we had escaped the old world of depressions and mass unemployment. People to whom this depression — judging by their pre-2008 output — was something of a surprise.

Now the left-wing neoclassicists may have done less badly than the right-wing neoclassicists Fama, Cochrane and Greenspan, but that’s not saying much. Steve Keen pointed out:

People like Wynne Godley, Ann Pettifors, Randall Wray, Nouriel Roubini, Dean Baker, Peter Schiff and I had spent years warning that a huge crisis was coming, and had a variety of debt-based explanations as to why it was inevitable. By then, Godley, Wray and I and many other Post Keynesian economists had spent decades imbibing and developing the work of Hyman Minsky.

To my knowledge, of Delong’s motley crew, only Raghuram Rajan was in print with any warnings of an imminent crisis before it began.

DeLong is, in my view, trying to whitewash his contemporaries who did not see the crisis coming, and inaccurately trying to associate them with Hyman Minsky whose theory of debt deflation anticipated many dimensions of the crisis. Adding insult to injury, DeLong seems unwilling to credit those like Schiff and Keen (not to mention Ron Paul) who saw the housing bubble and the excessive debt mountain for what it was — a disaster waiting to happen.

The most disturbing thing about his thesis is that all of the left-neoclassicists he is trying to whitewash have not really been very right about the last four years at all, as DeLong freely admits:

The third surprise, however, may be the most interesting. Back in March 2009, the Nobel laureate Robert Lucas confidently predicted that the US economy would be back to normal within three years. A normal US economy has a short-term nominal interest rate of 4%. Since the 10-year US Treasury bond rate tends to be one percentage point above the average of expected future short-term interest rates over the next decade, even the expectation of five years of deep depression and near-zero short-term interest rates should not push the 10-year Treasury rate below 3%.

Yet we are supposed to take seriously the widely proposed solution? Throw money at the problem, and assume that just by raising aggregate demand all the other problems will just go away?

As I wrote back in August 2011:

These troubles are non-monetary: military overspending, political and financial corruption, public indebtedness, withering infrastructure, oil dependence, deindustrialisation, the withered remains of multiple bubbles, bailout culture, systemic fragility, and so forth.

These problems won’t just go away — throwing money around may boost figures in the short term, but the underlying problems will remain.

I believe that the only real way out is to unleash the free market and the spirit of entrepreneurialism. And the only way to do that is to end corporate welfare, end the bailouts (let failed institutions fail), end American imperialism, and slash barriers to entry. Certainly, cleaning up the profligate financial sector would help too (perhaps mandatory gladiatorial sentences for financial crimes would help? No more paying £200 million for manipulating a $350 trillion market — fight a lion in the arena instead!), as would incentives to create the infrastructure people need, and move toward energy independence, green energy and reindustrialisation.

Then again, I suppose there is a silver lining to this cloud. The wronger the establishment are in the long run, the more people will look for new economic horizons.

Walter Jon Williams Epubs

Walter Jon Williams:

Year One: It’s been roughly a year since I started making my backlist available in epub formats, so this seems a good time to shuffle through the records and come to some kind of conclusion.

And the conclusion is this:

Thank God for Amazon!

Even if Amazon is yet another megalomaniacal Internet company bent on annihilating all competition and achieving total world domination in its chosen field (250 points!), Amazon has still provided more options for writers than anyone since Gutenberg. The Kindle broke open the world market for ebooks, and created opportunities for people like me, with considerable backlist, to find new readers for their work.

So far I’ve made 11 novels available, along with two novellas and a novelette.   Books are available on Amazon, via Barnes & Noble, and on Smashwords, which distributes to Apple, Kobo, and Sony, among others.  Sales have been growing month by month...

Why Germany’s TARGET2-Based Eurozone Preservation Mechanism Is Merely A Ticking Inflationary Timebomb

We have covered the topic of the German TARGET2 imbalances previously, both from the perspective of what catalysts can lead the Bundesbank to suffering massive losses (the one most widely agreed upon being a collapse of the Eurozone, which explains why even discussions of that contingency are prohibited in Europe), from the perspective of its being an indirect current account deficit funding mechanism, and from the perspective of what is the maximum size TARGET2 imbalances, funded primarily by the Bundesbank, can grow to before eventually causing irreperable damage to the Bundesbank. Still, there appears to be ongoing mass confusion about the topic, with numerous economists proposing contradictory theories, all of which supposedly rely on traditional economic models. Today, to provide some additional and much needed color, we once again revisit the topic of TARGET2, and this time we look at arguably the most critical question: what happens when the TARGET2 imbalance bubble ultimately pops. And here is where the true cost to Germans becomes apparent, because there is no such thing as a "borrowing from the future" free lunch. Which is precisely what TARGET2 does, only instead of a direct cost, the post-TARGET2 world will result in the now traditional indirect cost of all monetary experiments gone awry: runaway inflation.

As Goldman summarizes:

Who ultimately pays for TARGET2 losses? Higher inflation part of the bill


[T]he important point in the context of the financial risk for Germany from the growing TARGET2 imbalances is that, in the event of a break-up of the Euro area, the price paid would not necessarily be in the form of a massive recapitalisation of the Bundesbank, which could endanger the solvency of the German government itself. Rather, it would come in the form of higher inflation, as Germany faced the financial costs of the Bundesbank’s rising net claims vis-à- vis the other Euro area central banks.

In other words, if Goldman sought to appease Germans' fears about the aftermath of providing what effectively equates to "costless" bailouts, in the form current account deficit funding for the PIIGS, by telling them the final cost may well be a tide of runaway inflation, one which may come far sooner than most expect, we are skeptical they have succeeded.

Full report from Goldman:

Assessing the financial risks of TARGET 2 for Germany

As Germany recorded current account surpluses from the early 2000s, its financial exposure to the rest of the world rose. While Germany’s net international investment position (NIIP) was close to zero at the turn of the century, it had risen sharply to close to €1trn by 2011. This significant rise in German net foreign asset ownership also necessarily implied an accumulation of the financial risks associated with these assets. However, both the ownership and composition of these net claims against the rest of the world have changed significantly over time: banks and other financial institutions have reduced their net holdings of foreign assets substantially since the start of the crisis in 2007, while there has been a sharp increase in the public sector’s foreign exposure.

The rise in the net foreign asset position of the public sector has taken place through two channels:

  • The financial help provided to the Euro area periphery through the EFSF and—in the case of the first Greek programme—other government-owned institutions has led to a direct increase in financial exposure for the German government.
  • The other, and more relevant channel in terms of the volumes involved, has been the Bundesbank’s TARGET2 claims against the Eurosystem.

It is thereby no coincidence that the increase in net foreign assets on the Bundesbank’s balance sheet roughly matches the decline seen on banks’ balance sheets. Thus, the TARGET2 imbalances, at least so far, have mainly replaced financial risk that was previously sitting on private-sector balance sheets.

Further movement of capital from the periphery to Germany—for example, as peripheral households transfer deposits to Germany—would imply additional, genuinely new external financial risk for Germany, reflected in a further rise in TARGET2 claims.

But it is important to bear in mind when assessing Germany’s external financial risk that, as a central bank, the Bundesbank’s ability to deal with financial losses incurred as a result of these exposures is of a different character to the ability of the private sector or government. In particular, the operational capacity of the Bundesbank would not necessarily be significantly impaired even if it were forced to run temporarily with significant negative equity.

A current account surplus implies more foreign assets

Throughout the 1980s, Germany recorded a rising current account surplus (see Chart 1). This surplus quickly turned into a deficit as the reunification boom led to a sharp increase in imports. It took until 2001 before this current account deficit was turned back into a surplus. The combination of weak domestic demand, a recovery in competitiveness and strong external demand then pushed the current account surplus to a record high of around 7.5% of GDP in 2007.

As a consequence of the growing current account surpluses recorded over the past ten years, Germany net international investment position (the difference between all foreign assets owned by the German private and government sector and German assets owned by foreigners) has increased sharply (see Chart 2). At the end of 2011 Germany’s NIIP stood at close to €1trn.

The assets that make up Germany’s NIIP include bonds (whether issued by governments or corporates), loans, stocks and foreign direct investment. But regardless of the specific characteristic of the underlying asset, they all also represent a financial risk to some degree, in the  sense that the return on these assets is not certain—and could even be zero.

Changes in sectoral risk exposure to the periphery

The aggregate figures for the NIIP blur the significant differences that exist at the sectoral level. Chart 3 shows the NIIP broken down into different sectors, such as Monetary Financial Institutions (MFIs) (which are mostly commercial banks), non-financial corporates and private households, the government and the Bundesbank.

The chart illustrates three noteworthy points:

  • Banks/MFIs have reduced their NIIP sharply. German banks’ NIIP rose from a negative -€300bn in the middle of 2000 to +€520bn by the end of 2008. Since then, their NIIP has declined to €170bn at the end of last year. Meanwhile, German banks’ gross credit claims against the periphery have declined from almost €600bn to around €300bn (Chart 4).
  • Corporates and private households have seen their NIIP increase further during the crisis. Companies and private households represent the bulk of Germany’s NIIP. Roughly 60% of these assets (€700bn) are portfolio investments, 30% are direct investments, and 10% are lending and deposits held at foreign banks (Chart 5).
  • Foreigners hold a significant share of Germany’s public debt. The German government sector (all levels, excluding Bundesbank) was indebted on a net basis vis-à-vis the rest of the world by more than €1trn at the end of last year.

Exposure to the periphery

Looking at Germany’s country-specific exposure, German net investment in peripheral economies stood at around €1trn at the beginning of 2012, the bulk of which is concentrated in Italy, Spain and Ireland (Chart 6 shows the net investment of all sectors vis-à-vis the countries in the  periphery). Note, however, that these figures do not reflect the net claims of the Bundesbank vis-à-vis the Eurosystem due to TARGET2 imbalances. As a claim on the ECB rather than a specific country, these claims are not against a specific country and are therefore recordedas net investment into the Euro area.

Most German investment in the peripheral countries reflects ownership of companies or production facilities located there. Roughly a third of the net investment in the periphery is lending (Chart 7). Lastly, we take a look at bank lending to peripheral countries (Chart 4). While Germany’s  overall financial exposure to the periphery has been broadly stable, banks have reduced it significantly since the beginning of the crisis.

Pulling all these data together, we can see a clear shift in the composition of Germany’s net foreign asset position: financial institutions have sharply reduced their exposure to the periphery , while the public sector has increased its claims significantly. The main channel through which this transfer of risk has taken place has been the TARGET2 system.

TARGET2 imbalances are on the rise

Commercial banks use the so-called TARGET2 system to facilitate money transfers across the Euro area. One crucial feature of TARGET2 is that claims between national central banks resulting from cross-border money flows between commercial banks are not settled. If, for example, a commercial bank in Greece wants to transfer money to a German bank, the Bank of Greece simply asks the Bundesbank to credit the account of the German commercial bank with that amount and at the same time debit the account of the Bank of Greece with the same amount. As a central bank, there is no funding required for the Bundesbank in this operation. The Bundesbank simply ‘prints’ the money it credits to the account of the German commercial bank.

Before the crisis, flows between the periphery and Germany were broadly balanced. Banks and nonfinancial corporates borrowed from German banks and companies in order to finance, in large part, the trade deficit the periphery held with Germany. This implied that money flowed from the periphery to Germany (to pay the bill for imports) and from Germany to the periphery (to provide a credit such that the bill could be paid). But as German banks reduced their lending to the periphery on account of concerns about counterparty risk (Chart 4), capital flows have become a one-way street. Consequently, the net claims of the Bundesbank against the Eurosystem have risen sharply (Chart 8).

What are the financial risks from TARGET2?

In assessing the financial risk stemming from the increase in the net claims of the Bundesbank against the Eurosystem—the TARGET2  imbalances—it is important to bear in mind that, at least so far, they mostly replace debt held by German banks. Put differently, the financial risk for the country as a whole has not changed significantly on the back of the rising net claims of the Bundesbank.

This may no longer be the case, however, once rising net claims reflect not only normal commercial and investment activities, but rather deposit flight from the periphery to Germany. So far, there is no real evidence that private households or companies are shifting their deposits to Germany in a significant way. But a genuine deposit flight from the periphery to Germany would lead to a significant increase in the  Bundesbank’s net claims.

After all, peripheral private households alone hold more than €1.5trn of deposits. To be sure, the Bundesbank’s rising net claims vis-à-vis the Eurosystem would only represent a financial risk if a country were to leave the Euro area. Moreover, the losses of the Eurosystem are shared among all remaining countries. Thus, the financial risk for Germany has actually been reduced, as potential private losses have been replaced by  losses that will be shared by the Eurosystem. However, in the event of a break-up of the Euro area, the losses from the Bundesbank’s net claims would materialise on the Bundesbank’s balance sheet alone.

Bundesbank operational effectiveness not endangered by potential losses

At this point, it is not possible to calculate the exact size of the Bundesbank’s potential losses in the event of a complete break-up of the Euro area. First, the amount would depend on how much further net claims rise. Second, it is not clear how much of these claims would need to be written down. Arguably, other national central banks/governments would have little incentive, or the economic means, to honour any of these liabilities. But depending on the circumstances of the break-up some mutual agreement about a haircut could be found.

That said, even though we do not know ex ante the size of the losses the Bundesbank faces, we can say that, in principle, these losses would not impair its ability to operate monetary policy. Put differently, it is not the case that the Bundesbank would first need to be recapitalised before it could once again conduct monetary policy at the national level. Indeed, there are several examples of central banks that have operated with negative equity and have been able to maintain price stability. The Bundesbank could, for example, simply insert a claim against the German government on the asset side of its balance sheet in order to maintain its balance sheet in balance in an accounting sense.

Who ultimately pays for TARGET2 losses? Higher inflation part of the bill

This does not mean that potential TARGET2 losses would not imply a significant challenge to the Bundesbank. Its first challenge would be to stabilise inflation expectations. Expectations about future price developments play a crucial role in the inflation process: if economic agents were to expect, for whatever reason, an increase in prices and adjust their economic decisions accordingly, expectations would become self-fulfilling. This is why central banks in general monitor inflation expectations carefully.

How would inflation expectations react if the Bundesbank were to incur significant losses and had to operate with negative equity? Again, there is no easy answer to this but, according to the so-called fiscal theory of the price level, the credibility of a central bank also depends on its solvency. The Bundesbank’s solvency would be questioned if the losses exceeded the net present value of its future income (seignorage). A backof-the-envelope calculation of this net present value suggests the Bundesbank has economic capital of around €2trn. Thus, the Bundesbank has significant capacity to absorb losses before endangering its ability to guarantee price stability.

There is also a more mechanical way of assessing the potential inflation risk stemming from Bundesbank losses on the back of the TARGET2 imbalances. These imbalances are the result of rising deposits on the balance sheets of German commercial banks. These deposits ultimately represent a claim on German GDP, as the holders of the deposits could spend the money sitting in their accounts. Another way to look at this is that rising deposits at German banks imply that monetary aggregates are rising in relation to the underlying German economy.

Whether these deposits would be inflationary or not would depend on several factors—not least how quickly these deposits are spent. But it is clear that the greater the amount of deposits held by non-residents after the breakup, the greater the potential inflationary risk. A high degree of uncertainty surrounds all of this and it is not possible to be more precise about the potential inflationary implications. But the important point in the context of the financial risk for Germany from the growing TARGET2 imbalances is that, in the event of a break-up of the Euro area, the price paid would not necessarily be in the form of a massive recapitalisation of the Bundesbank, which could endanger the solvency of the  German government itself. Rather, it would come in the form of higher inflation, as Germany faced the financial costs of the Bundesbank’s rising  net claims vis-à-vis the other Euro area central banks.

contra Krugman

Paul Krugman writes that Keynesian thought has progressed.

I disagree in comments with the usual

I do not think that Keynesians accept that there is a natural rate of unemployment. The concept is inconsistent with hysteresis. OJ Blanchard and LH Summers are definitely Keynesians. They presented a model without a natural rate in 1986. I don't know about Blanchard but Summers and his former student JB DeLong continue to stress hysteresis (with an open mind about the sum of autoregressive coefficients of unemployment on lagged unemployment so there model might or might not be consistent with a natural rate but with certainly no evidence of any faith in policy invariant stationarity). Also there is this guy named Krugman (have you heard of him) who shows no sign of faith in a natural rate and writes about life long (OK not permanent but life long) effects of low demand on labor market experience.

Finally Wren Lewis refers to the hysteresis effects of the Thatcher deflation when he isn't referring to New Keynesian models with no such effects as successful cutting edge models and great progress on 1960 vintage Keynesian analysis of the possible Phillips curve (by Samuelson and Solow who extensively discussed both outward shifts due to increased expected inflation and outward shifts due to cyclical unemployment becoming structural).

Note also that without using the name "Phillips" because he wrote beforee Phillips, Keynes specifically warned that there wasn't a stable relationship between output and inflation. He noted the case of "flight from the currency" not yet named "hyperinflation" by Cagan rather anticipating the work of say Sargent.

Now it is true that Keynesians were convincedby Friedman mostly that velocity is fairly stable and predictable. But it isn't.

I assert that Keynesian thought hasn't made a both scientific and theoretical advance since Keynes where by scientific I mean actually useful in predicting out of sample and by theoretical I mean not just new parameter estimates made with data not available to Keynes using computers not available to Keynes.

Some semi prominent New Keynesians were amused enough to try to come up with examples. They failed.

In any case certainly not the absense of a stable expectations unaugmented Phillisp curve (as predicted by Keynes) nor the discovery of the LM curve which uh you know doesn't exist.
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