Friday, January 9, 2009


Joseph Stiglitz has an interesting column this morning. I think his point is a good one -- everyone is single-mindedly focused on the crisis and the stimulus that is meant to solve it as a kind of silver bullet. We hear almost no serious discussion of any real macro-economic reform that would change the forces that led us up to this brink to begin with. Do we really want to restore the same meta-stable disequilibium we had before this started?

I am not sure that there is sufficient appreciation of some of the underlying problems facing the global economy... For a long time,... without American profligacy, there would have been insufficient global aggregate demand. In the past, developing countries filled this role, running trade and fiscal deficits. But they paid a high price, and fiscal responsibility and conservative monetary policies are now the fashion.

Indeed, many developing countries, fearful of losing their economic sovereignty to the IMF – as occurred during the 1997 Asian financial crisis – accumulated hundreds of billions of dollars in reserves. Money put into reserves is income not spent.

Moreover, growing inequality in most countries of the world has meant that money has gone from those who would spend it to those who are so well off that, try as they might, they can't spend it all. ...

Many bits have been spilled recently over the validity of Tyler Cowen's claim that this whole cycle began with the decision to bail out LTCM back in 1998. I hardly agree that this was the birth of moral hazard, but I do think that this moment in financial history was crucial, not from the perspective of the borrowers (Goldman Sachs, Morgan Stanley, LTCM, The United States of America) but from the perspective of the savers (Russia, Brazil, China, the Gulf States). Nowadays you cannot pick up the WSJ without hearing about how "banks aren't lending", and about how we have to prevent people from "putting their money into the mattress". But this is exactly what the rest of the world has effectively been doing for the last 10 years. China buying trillions of dollars worth of US treasuries is effectively putting its money in the mattress -- a lot of money and a big mattress, but the analogy is exact.

Macroeconomically, the mattress is just defined as that place where savings go to die -- i.e. are not turned into productive investment. As far as I can make out, this was the basic insight of Keynes. Normally, investment is equal to savings. In depressions, people save just fine thank you, but they put this money away rather than risk investing it in any risky economic proposition like, in those days, a bank. This touches off the vicious cycle of cutbacks, even lower investment, unemployment, lower consumption and savings, and finally deflation, which then serves to vindicate the original fear, as people notice that their neighborhood who did have the temerity to invest saw that money lose its value. In the end, everybody stops doing everything, in capitalism's version of mass catatonia, and the only option you are left with to get things moving is the mass hysteria of a war.

So ... the US government is where savings go to die ... is basically what I'm saying. That doesn't have to be true, but it certainly has been since 1998. And now the US is this giant, bloated soggy macro mattress.

Prior to the crisis, there were still private mechanisms by which the savings of the rest of the world could be turned into investment. This was known as the sub-prime housing bubble. Instead of China using its savings to invest in its own factories, it gave this money to the US governement, who then passed it on to the private sector via the gigantic US housing subsidy. We "invested" in houses, their prices sky-rocketed, and we then took the money out as a loan against the house and spent it on cheap plastic shit from China, which closed the loop by providing them with more savings.

That mechanism is broken (though not in the way many, including myself, originally envisioned -- the housing bubble burst before the Chinese got sick of buying Treasuries, rather than as a result of this) and the new one people are proposing is to have the US government (and every other developed government) do the investing itself, rather than rely on the low rates created by this Chinese willingness to save. This was Keynes solution too -- to have the government step in, reposses that mattress, and do the investing itself.

And in fact, incredibly, that just might work. We can debate whether the second part of this mechanism is on the verge of a breakdown -- but so far, the part where China and others lend to the US government has held up pretty well. I do worry that if times get tough, the rest of the world may want to open up the mattress with a knife. But one big thing we have going for us is that they all know that if they all try to do this a the same time, nobody will get anything. The financial version of mutually assured destruction.

Having the US government invest Chinese savings can work. Or at least it can get us back to where we were before the private mechanisms for this broke down. But is that really the solution we want to have for the long-term? And once we start down that road, how do we come back to an economy where investment decisions are made privately? This solution only works so long as you can think "Chimerica" can hold together as a unit. The Chinese save, we invest, and the co-dependence of this relationship is reinforced by the centralization of savings decisions on their side, investment decisions on our side, and the catastrophic consequences that both sides can see if this breaks down. If there were millions of Chinese savers trying to coordinate with millions of American investors, there would be no chance for this to work. If there's just CHINA on one side and AMERICA on the other, it might.

Or it might not. This is the fundamental problem with following Mohammed El-Erian's investment advice in yesterday's FT -- don't fight the super-Fed sounds like great advice, but the converse, following along with them, seems tricky because:
  1. ... badges, we don't need no stinking badges ... These guys are in charge by default, and they have no plan, so following along with them could be like sailing dead into the wind with the boom whipping back and forth. Here Mr. Dr. PIMCO is a bit disingenuos because you know that as a former IMF guy, manager of the Harvard endowment, current manager of the world's largest bond fund, author, and all-around financial superhero, he is front-running the Fed following trade.
  2. Even the guys in charge of the finances are at the mercy of the politicians. Any day now we are going to get the charming and probably trade-able spectacle of the Republicans temporarily holding up Obama's new stimulus bill. They'll pass the thing eventually, just like they did the TARP. But one of these days some measure will fail and the government will end up investing in solid gold office towers in Duluth. The Chinese will get pissed, we'll get pisseder, and the whole thing will come careening down. The history of the last time we let the government do the investing provides ample evidence of this problem, though hopefully this time we won't have to destroy so much of Europe in order to solve it.
Now, we can come back to Stiglitz's point. Even if this Keynesian scheme might work, it's certainly not the optimal solution. He suggest three things to move towards a more stable system:

We need not just temporary stimuli, but longer-term solutions. ...

First, we need to reverse the worrying trends of growing inequality. More progressive income taxation will also help stabilise the economy, through what economists call "automatic stabilisers". It would also help if the advanced developed countries fulfilled their commitments to helping the world's poorest by increasing their foreign-aid budgets to 0.7% of GDP.

Second, the world needs enormous investments if it is to respond to the challenges of global warming. Transportation systems and living patterns must be changed dramatically.

Third, a global reserve system is needed. It makes little sense for the world's poorest countries to lend money to the richest at low interest rates. The system is unstable. The dollar reserve system is fraying, but is likely to be replaced with a dollar/euro or dollar/euro/yen system that is even more unstable. Annual emissions of a global reserve currency (what Keynes called Bancor, the IMF calls SDRs) could help fuel global aggregate demand and be used to promote development and address the problems of global warming.

This year will be bleak. The question we need to be asking now is, how can we enhance the likelihood that we will eventually emerge into a robust recovery?

This may seem a bit vague and general, but I think it actually helps. Second, it addresses the question of what the government should invest in, if it's going to be the one doing the investing. We have some obvious places to look here. The US needs a new infrastructure so that driving around the Bronx doesn't feel like driving around Beruit, and China needs a new atmosphere so that the folks in Bejing don't choke to death on their first breath of modernity. Third, it address the need for a new monetary system that isn't unilaterally controlled. If the current system is a defacto detente between China and the US, let's make that official, and have one global reserve currency that everybody has a say in controlling. I don't really see how this is different than the gold standard with a fancy name, but, hey I'm not an IMF economist either. And finally, First, on a fundamental level, capitalism cannot work if one group does the working, and another group does the high living. After all, who's going to buy the products of High Living Inc. if not the workers? A complete class bifurcation is theoretically possible (though it relies on the rich consuming an ever increasing amount of stuff or being content with an ever more dubiously increasing claim on the consumption of future stuff) but it is hardly stable.

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