Thursday, March 5, 2009

The Equilibrationists

Tim Duy has some somewhat rambling reflections on the "Bernanke Paradigm".  They fit vaguely together with my own rambling reflections on why so many people seem so fundamentally unable to grasp the dynamic engulfing the economy, and why, as a result, they tend to support a lot of very half-assed measures for dealing with it.  BARF, TALF, the stimulus package, and the housing plan are so far but drops in the proverbial bucket.

The question is of course extremely technical.  And we really don't understand macroeconomics, so it's very difficult to judge between the validity of the various proposed answers (I am reminded again of McCloskey's essay about why economics is not a science).  But it seems to me that one basic problem that keeps popping up in the responses is the assumption that the economy was more or less in equilibrium before the crisis.  Even people like Paul Krugman, who I expect does not believe in the efficient markets hypothesis in any strong form, seem to assume that the problem is one of restarting a stalled engine -- as Keynes put it we have magneto trouble (magneto, for those as ignorant as I, turns out to be some ancient British word for what early cars used to juice the spark plugs -- Krugman translates this as alternator, though that analogy confuses me).  This unspoken underlying assumption of equilibrium may be related to some deep debate between neo-classical economics and the Austrian school; given that I don't really understand that debate, I may be just re-phrasing some version of a well known argument when I complain that there is more to our current problem than simply jumping the engine, and that there were some fundamental structural problems that built up in the boom and pushed things very very far from perfect equilibrium, if such a thermodynamically improbable animal exists to begin with.

This debate is abstract and academic until you realize that it has real consequences for what you think we should do.  If we just have a credit crunch or liquidity crisis, then the solution is simply technical -- print more money and restore confidence and the engine will start again immediately, and of its own accord.  If you think there are more fundamental problems of one sort or another, then some other solution may be warranted, and you might expect that opening up the choke and givin'er a jump may not produce the desired result. 

But let me back up a step and trace the whole argument.  At first, the temptation when the economy suddenly stalls seems to be to think that this is punishment for our sins.  Somehow, inevitably, these moments of financial panic and crisis are preceeded by a euphoric new era bubble and followed by a major downturn in economic activity of all sorts.  We jump immediately from correlation to causation, and insist that the downturn is caused by the excesses of the past.  Greed, fraud, and risk-taking are all roundly condemned as having ruined the puritanical paradise.

Unfortunately, while it may satisfy our sense of morality, what Paul Krugman has called the Hangover Theory has some problems with it.  After all, a sudden stop in economic activity just doesn't seem to make sense.  The workers are still there.  The factories can still produce stuff.  All of the inputs are still available and the consumers presumably still want the newly out-putted color televisions just as much as before they got laid off.  In fact, the bubble that preceeded the hangover served to get us all off of our keisters and out building railroads or internet companies (or houses) even faster than we might have normally.  Greed, in short, is productive.  So, how is the bubble a bad thing, and exactly what is a bubble?  Or, in other terms, what exactly is a recession or depression?  If we all just kept doing what we were doing yesterday, we could all just keep on doing what we were doing yesterday ¿no?  Is a downturn no more than the madness of a collective depression fit to match the mania that preceeded it?  Tulips to turnips?

If you think about this response for a moment, it starts to grow on you.  "Yeah ... what the hell are we thinking ... everybody back to work!".  This is the stalled car view.  It implies that all we need is some trick to get us out of our funk, and everything will go back to normal.  Martin Wolf (via Paul Krugman via Mark Thoma) does a nice job of explaining how Keynes provided the spark to get the whole thing going again:

Keynes's genius – a very English one – was to insist we should approach an economic system not as a morality play but as a technical challenge. 
So great, now instead of a hangover, we have a little of the hair of the dog that bit us.  The solution to our bubble is another bubble, though this time one backed by the sound Keynesian stimulus of the government.  "Bubble" here loses all meaning.  No price is too high for an asset, and there is no limit to the amount of stuff we can produce if we all just keep working our asses off. 

Except I still feel like there's something wrong with this solution.  There's a reason we're not all waking up from our nightmare and going back to work immediately.  There's a reason that the economy has this tendency to liquidate after the excess buildups of bubble.  Irving Fischer pointed out in 1933 that it's the debt, stupid.  The reason that these enormous crashes and panics occur just after some period of euphoric investment is because that investment was driven by borrowed money, and suddenly the guy you borrowed it from wants it back. 

From the perspective of the system as a whole (presuming that the money wasn't lent to us by martians) this is no excuse to stop working.  My debt is your credit; they all net to zero; forced liquidation of everything in order to try and pay off the debts is like mass suicide, so let's skip it and get on with things.  In theory I think this makes perfect sense.

In practice, creditors are loathe to give up their claims not simply for moral reasons, but for reasons of self-interest.  We know you've got the money.  We takes the money.  This sort of thinking leads directly to the cycle of mass liquidation you saw in the Great Depression.  Even if everything collectively nets to zero, the individual incentive of each creditor is to liquidate the estate of the debtor in an attempt to get his money back.  This problem is especially acute if that creditor has yet another creditor presuring him.  Once the stress starts talking, things get fucked fast -- a worker may have loaned his money to the bank who loaned it to a factory who loaned it to the worker to buy the product that the factory makes.  As we've seen with counter-party issues and CDS trades this year, that kind of circle can be a nightmare to unwind, even if it nets to zero in the long run.  So what at first seems like mass irrationality -- to be blamed on a failure of animal spirits, fear of fear itself, or simple lack of monetary liquidity, as you wish -- actually turns out to be mass rationality from an individual perspective, and collective madness from the perspective of the group.

At this point, the State enters, to solve what is clearly a prisoner's dillema type problem of collective action.  It seems to me that the State has a few options for dealing with things.

If the State were socialist, it could just redistribute money at will and cancel all debts.  After this reboot, there would be no remaining reason not to just go back to what you were doing before.  Of course, arguably, this simply teaches everyone that there's not much point in working in the first place.

If the State didn't want to violate the sanctity of previous private contract and simply redistribute wealth, it could itself borrow money and spend it.  In a closed system, it can either borrow that money from one particular group (the creditors obviously), essentially replacing the private debt they are owed with public debt, or it can borrow equally from everyone in the form of reducing taxes.  From a cash flow perspective, either of these things are going to be accomplished by printing money, though in both cases the money might initially take the form of little pieces of paper with IOU written on them -- aka Treasury bonds.  You can either give these to the creditors, who if they believe that they will someday be worth something will accept them in lieu of the proceeds from liquidation, or you can give them to everyone, which, again, if they believe they will be worth something, will pacify them enough so that they go back to work.  You can decide later whether you want to simply print more money to back these up when they come due, causing inflation, or whether the economy is doing better, and you want to raise taxes to pay them off, resulting in no net growth in the money supply.  The net redistributive effect of this scheme depends on how you tax folks when it comes time to make that decision.

In the end, this mechanism isn't really all that different from lowering interest rates.  Instead of pushing on a string, you shove it down people's throats.  If you believe that fundamentally there's nothing really out of whack about the economy, it's not clear to me exactly why this would work if the interest rate thing didn't, unless the whole explanation is one of timing.  Lowering interest rates is sure not to work if the economy has already fallen into deflation.  At that point, offering people loans even at 0% rates is unappealing because if prices are falling, the real interest rate may still be fairly high.  You need instead to support the price level by spending money (or simply fixing prices or creating inflation).

Again, as far as I can tell, this solution rests on the assumption that people were not too far in debt.  Of course, defining "too far in debt" is tricky, because you can just keep rolling it over so long as you believe that the guy who owes it to you will keep coming to work in an effort to pay it off.  The sharecroppers were "too far in debt" but that didn't stop the system from going on for a long time.  Ultimately, being too far in debt is a question of confidence and trust, which is the point of having the government assume the debt built up in the bubble, or the debt necessary to keep the economy growing while the bubble debt is gradually paid down. 

So finally, what if people are simply too far in debt.  And the government is too far in debt and nobody really trusts it.  Now you've broken through the assumptions of the equilibrium model I think.  You've admitted that something was out of whack and that we now have to devote a bunch of energy to gradualy netting out the imbalance in the economy caused by one group being too far in debt and the other having too many claims against them. 

And this is, I think, ultimately, my point.  Past a certain point, debt must be netted.  Nobody trusts the government enough to let it go into debt deeply enough to replace the private debt coming due.  Nor do they wish to let the government instantly net things via socialism or instant inflation (same difference). However, something must be done, so that we don't end up netting things the old-fashioned way, that is via liquidation. 

So we reach a stalemate.  Nobody fails and nobody can succeed.  You are left with a gradual netting out that causes a sort of frictional loss in economic growth because of the paradox of thrift.  The lenders don't lend because the debtors are too far in debt.  The debtors don't borrow because they are too far in debt. Instead they save up to pay down their debt, which destroys demand because we cannot all save at the same time.  And the government borrows enough to keep the whole system from collapsing, but not enough to prevent people from feeling like they need to save. 

Perhaps capitalism itself puts a limit on inquality. 

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