“After nearly two years of global economic and financial upheaval, shockwaves are still being felt, as we have seen with recent developments in Europe and the resulting financial market volatility,” Naoyuki Shinohara, the IMF’s deputy managing director, said in Singapore on Wednesday. “The global outlook remains unusually uncertain and downside risks have risen significantly.”

They are right in that uncertainty and risk are high.  I don’t think they’ve changed much, though, in recent weeks.   What has changed has been people’s perception of the risk.

For some reason, unfathomable to me, people started getting giddy about our economic prospects last August or so.  There were some good data points, but you had to look at them only in a cursory manner, and you had to ignore other discouraging data to believe we were headed for a robust recovery.

A more in-depth analysis and a broad look at the data gave no reason for a giddy attack.  The gains were mostly transitory, driven by temporary government programs.  Consumers, businesses, and governments were still over-leveraged.  The financial sector was still weak.

Still, it became consensus that our economic challenges were behind us.  The stock markets soared, and this was taken as another sign of economic prosperity just around the corner.

Now, the stock markets are down again, and some economists are talking about new risk.  I’d say the risks were there all along, and our forecast reflected those risks.

I believe the probability of at least one sovereign default is disturbingly high, and the financial sector will be hard hit if one or more sovereign defaults materialize.  Bailouts will only postpone the day of reckoning, and a delayed reckoning will be more difficult.

We’ll be lucky if that is all we see. Multiple defaults are not out of the question, and the riots in Greece show how difficult it is to cut government spending.  Any social disturbances will only increase the economic pain and delay the ultimate recovery.  Multiple defaults too will exacerbate the economic problems.

I’ll talk about the environment as a luxury good. People who don’t know where their next meal is coming from don’t much care about the environment. It is also true that rich working women have very few children.

Obvious conclusion: Capitalism and Feminism can save the world.

For the Ventura River, we need to see some investment is removing the Matilija Dam, cleaning up the old oil refinery, and improving the sewage plant’s output.

You would think that the United States savings rate would be high and rising.

China, by contrast, is in the midst of a real estate boom and its economy is growing at or near double-digit rates. The Chinese are also poor, with annual 2008 per-capita GDP estimated by the World Bank at $3,263 U.S. dollars, while ours was $46,716. Certainly, we’re better able to afford saving. Yet, the Chinese are saving half of their meager income.

What is going on?

One reason for the disparity is that China has no safety net, no unemployment insurance, no medical insurance, no social security, nothing. Also, the Chinese government is a potent source of potential volatility. The Chinese have seen a lot of bizarre behavior by their governments over the past 100 years or so.

So, the Chinese have a large precautionary reason to save. They have another reason. They are likely to keep or bequeath their savings. There is no indication that, as potentially volatile as it is, the Chinese government is likely to tax away its citizen’s wealth. They may end up in jail for visiting an unapproved web site, but the government is not likely to tax away their savings.

The Western World has safety nets. They are inefficient safety nets, and they are often burdened with questionable incentives, but safety nets exist. Most of us have insurance that pays for all but a small portion of our medical care. We have unemployment insurance. The precautionary motive to save is less.

There are other reasons for Westerners not to save. Our incentives are all screwed up (technical term). In the West, virtue (saving) is taxed and vice (profligate spending) is rewarded. We have programs for people who are at risk of foreclosure. We have bailouts for big businesses that took outrageous risks. We have bailouts for countries and states that have decades of making irresponsible spending commitments. These will be paid for by people who save.

The West’s incentives are to dis-save. Baby Boomers, in particular, know they have the votes to be bailed out and they see the momentum to have the “wealthy” (savers) and the unborn pay for the bailout.

This is very ironic. Capital is safer in the, presumably, communist China than in the, presumably, capitalist West.

• Keep it simple. Simple regulation is cost-effective regulation. Simple regulation minimizes both regulatory costs to the government and compliance costs to the regulated firms, costs eventually borne by consumers or taxpayers. Complicated regulation invites lawsuits and encourages efforts to avoid the regulation.

• Regulate the smallest possible number of firms. Regulation is a market distortion and tends to limit innovation. Because of the September 2008 collapse, some people are not convinced of the benefits of financial innovation. This is unfortunate. Financial innovation is, on net, positive. Consider the Farmer who hedges against bad weather by using futures or the airlines that hedge against higher gasoline costs. We need to encourage financial innovation.

• Preserve incentives. We’ve all encountered either government monopolies or government regulated monopolies. The DMV, the Post Office, and utilities come to mind. We’ve also seen the innovation that followed the elimination of the phone monopoly. Bad regulation provides perverse incentives. Good regulation maintains incentives for quality, service, and innovation.

• Maximize market feedback. Markets have built in incentives that are beneficial to society. Where possible, we should allow that feedback to do its magic. It is the cost-effective way to preserve incentives.

• Minimize moral-hazard problems. Moral-hazard issues result from free or under-priced insurance. It is currently pervasive, and it is our single largest source of unnecessary systematic risk. The too-big-too-fail concept in particular has resulted in excessive risk taking, with disastrous results. Similarly, FDIC insurance was under-priced, as evidenced by the FDIC accelerating the collection of future premiums, and the results are self-evident.

• Minimize political influence. Political influence in economic matters is counterproductive. It is clear to me that the vast majority of political types are trying to optimize something other than economic activity or efficiency. Whether the political objective is maximizing the likelihood of reelection, rewarding supporters, or simply greedy corruption, we need to avoid the results.

• Regulation is not protection. Regulators often become partners with the regulated. Sometimes this is because the regulator expects to be eventually employed by the regulated. The regulator may have been employed by the regulated, or may become friends with the regulated, or may be corrupt and accept bribes. In all cases, we are ill served when the regulator is protecting the regulated.

• Regulation should not be adversarial. The purpose of regulation is not to punish the regulated. We have a legal system to provide punishment when it is needed. Adversarial regulation will encourage evasion. The best approach is arms-length, fair, and firm.

It could be that the question is so basic and obvious that everyone knows the answer: “It’s to prevent bubbles or business cycles.”

That can’t be the correct answer.

Here’s a great quote from David Brooks (HT to Greg Mankiw):

“The premise of the current financial regulatory reform is that the establishment missed the last bubble and, therefore, more power should be vested in the establishment to foresee and prevent the next one.”

Right.

The problem with writing regulation to prevent bubbles or business cycles is that it can’t be done. There is no theoretical reason or empirical evidence that regulators are any better at anticipating bubbles or business downturns than anyone else, and nobody is any good at it. So, why write regulation for that purpose?

That is not to say that there are no reasons to write financial regulation. I believe there are, but we’ve been doing it for the wrong one. Here are my proposed reasons:

• Minimize or eliminate direct losses to innocent bystanders

• Minimize the economic impact of a systemic financial crisis

That’s just my opinion, and I can think of many people who might have more or better ideas on the topic. So, I’d love to see a serious discussion about the topic. The result would be better regulation.

New unemployment claims also rose to 444,000, again exceeding “consensus expectations.”

There was also a report that will receive much less attention, but it is important. Inventories increased in November, the most recent month for which data are available. If inventories were increasing over the Christmas shopping season, and sales were declining, retailers ended the year with excessive inventory. That means reduced production in the first and second quarters of 2010.

2009’s third quarter output (GDP) growth was positive, and many expect a very impressive positive number for the fourth quarter, some as high as five percent. If the fourth quarter does come in with a strong GDP growth rate, it will be hailed as the harbinger of a soon-to-be-realized vigorous recovery.

Don’t buy that, and you won’t be disappointed.

That vigorous recovery may eventually come, but it is unlikely to come in 2010. Whatever growth generated in second-half of 2009 was government-supported consumption, ephemeral, not a solid foundation for economic growth, certainly not the basis for sustained vigorous job growth.

A vigorous recovery will be a result of investment, technological growth, and improved productivity. Recent productivity numbers have been encouraging, but in large part, they are probably the result of firms downsizing. Technological growth and solid job growth require investment, and that is the problem.

Our banks are in no condition to fund any vigorous expansion. Indeed, bank loans have been declining since October 2008. Businesses and consumers remain over-leveraged, unable to increase spending on consumption, unable to invest, desperately trying to reduce debt.

We won’t see a vigorous recovery until balance sheets are improved and banks can lend.

Government programs haven’t helped. Most of the spending programs have been consumption based instead of investment based. Some have been outright counterproductive, programs such as foreclosure-delay, paying interest on bank deposits at the Fed, and cash for clunkers. Even worse, the banking problem has been ignored, and now new taxes on banks are being discussed. That is as bad an idea as I’ve heard in a long time.

Scheer doesn’t give his reasons for supporting a new Glass Steagall, but he quotes McCain extensively. McCain’s comments are essentially a populist rant against “fat cat bankers on Wall Street.”

That’s a problem. I’m all for a new Glass Steagall, but let’s get the reasons right. Populist rants only confuse things.

The Glass-Steagall Act, passed in 1933, was part of the response to the Great Depression. The component relevant to today’s debate was the restrictions on the breadth of financial institutions’ operations. Investment banks were restricted from commercial banking, and commercial banks were similarly restricted from investment banking. An investment bank engages in transactions involving capital, securities, mergers and the like. Commercial banks take deposits and make loans.

The repeal of Glass-Steagall, in November 1999, was supported by both political parties. The arguments for repeal were that it would reduce risk by diversification and that advances in financial technology meant that risk was low.

Right.

The diversification argument sounds reasonable: Banks could diversify, and if one business was in trouble, the other probably won’t be in trouble. But, there is a problem with that argument. Financial theory and experience is clear. Stockholders can diversify for themselves. Businesses should concentrate on their core competency, the one where they maintain a comparative advantage.

The diversification argument also implicitly assumes a relatively low correlation between the returns from the various businesses. Financial panics throughout history have demonstrated that when things go bad, the correlation goes to one. When things go wrong, they go wrong everywhere.

The argument that financial technology has improved, and we now know how to do things with low risk is an old one. I refer readers to Reinhart and Rogoff’s book This Time is Different: Eight Centuries of Financial Foll. In it, these respected economists document the plethora of financial panics this type of thinking has created.

We do need to reinstate the separation of bank business. Let’s do it for sound reasons. While we’re at it, let’s limit the maximum size of any corporation. We also need to get rid of the Too Big To Fail concept.

Banks can borrow from the Fed at rates near zero. Then, they can purchase Treasuries for about three percent. Voila, banks have a three percent risk-free return, and no incentive to lend to business.

The conclusion is that the Fed has rates too low.

I disagree.

First, we need to acknowledge that many banks are in no condition to be taking risks, and many of their customers are in no condition to be assuming additional debt. Also, the Fed is paying interest on excess deposits, which is silly, and it complicates the analysis. However, even if banks could lend, borrowers could borrow, and the Fed didn’t pay interest on excess reserves, I don’t think the above analysis is correct.

The easiest way to think about the situation is to ask: what would the banks be doing if there were no Treasuries to buy? They would be investing in something else, something like loaning to businesses and consumers. This is pretty much the definition of crowding out.

The fact is that downside risk still dominates the forecast, and the Fed needs to keep interest rates low, at least for a while longer. If our banks were healthy, this would be a clear-cut example of crowding out. The banks aren’t healthy, but I’m thinking some crowding out is definitely happening.

So, today’s data release showing a second consecutive weekly increase in new unemployment claims surprised many. The press called it unexpected. It was not unexpected or surprising here at CERF. In fact, it is entirely consistent with our forecast.

We think that GDP will decline modestly in the current quarter and in the first quarter of 2010. Then, we expect a very slow recovery, held back by over-leveraged consumers and businesses, but especially by a weak banking system. The recovery in jobs will likely be weak and trail the GDP recovery by a few quarters.

To answer the question, we think the recession is not yet over, and it probably ends in the second quarter of 2010.