Monday, June 7, 2010

In the long run, even Keynes is dead

I remember writing a strategic piece for work at the beginning of this year.  To be provocative, I started off with the observation that, despite the apparent recovery in the economy and financial markets (at the time), we were in the midst of the second Great Depression.  And I think the first 6 months of this year have borne out that observation.  I don't mean because the stock market has tanked in the last few weeks, or even specifically because the Greeks are giving the Germans the finger.  These things are symptoms of an underlying disease called "debt", and it's precisely them same disease that caused GD 1.0, even if the exact symptoms may look quite different this time.

The essence of debt is trust.  And the essence of a depression is a collective loss of trust.  This is why a depression seems so "irrational".  How is it that we can't just make what we made yesterday?  We didn't run out of people, or fuel, or ideas.  What ingredient did we have in such abundance in 2007 or 1927 that is now suddenly in such short supply?  What we have is a shortage of trust.

Debt is the quantitative version of trust.  I'll work more and consumer less now and you'll consume more now and work to pay me back later.  That basic promise of trust is made at lots of levels, from the unspoken accord about sharing the dish-washing duty, right up to the biggest and most liquid market on the planet. 

GD 1.0 was a failure of that trust on the private level.  The crash of '29 was only the trigger for that loss of trust; the real collapse happened when people lost faith in the banks where they had stored those promises of a brighter future, a destruction of trust that was a self-fulfilling prophecy.  And GD 1.0 was eventually solved by a restoration of trust -- people began to trust the banks and those promises again because they trusted their governments.  In fact, they came to trust their governments so much that they ran off a cliff for them.  Trust is always a crowd phenomenon, even when it happens between two individuals.

GD 2.0 is a new twist on the same problem.  Underlying everything is the same crisis of trust, the same panic of promises, the same fear that all that hard work won't get us what we imagined.  Only this time the crisis reaches all the way up to our trust in government.  Fundamentally, we no longer trust that our system of portioning out promises is fair.  We no longer trust our governments when they say, "get back to work and we'll make sure everybody gets their share".  Why work when it seems so obvious that the game is rigged against you?  Why dedicate yourself to the arduous cooperation needed to carry out any large project when it's every man for himself?

Obviously, an economist will talk about all this as question of monetary or fiscal policy.  He'll tell you about multipliers and balance sheet recessions and inflation and optimal currency zones.  He'll make the same argument Keynes so correctly made (more correctly than he might have hoped) so long ago:

The right thing, overwhelmingly, is to do things that will reduce spending and/or raise revenue after the economy has recovered — specifically, wait until after the economy is strong enough that monetary policy can offset the contractionary effects of fiscal austerity. But no: the deficit hawks want their cuts while unemployment rates are still at near-record highs and monetary policy is still hard up against the zero bound.

But what about Greece and all that? Look, right now sovereign debt problems are taking place in countries with a very specific problem: they're part of the euro zone, AND they're badly overvalued thanks to huge capital inflows in the good years; as a result they're facing years of grinding deflation. Counties not in that situation are not facing any pressure from the markets for immediate cuts; as of this morning, 10-year bonds were yielding 3.51 in Britain, 3.21 in the US, 1.27 in Japan.

And he'll miss the point that our fundamental problem is that we no longer trust the last line of defense.

So how much we spend on supporting the economy in 2010 and 2011 is almost irrelevant to the fundamental budget picture. Why, then, are Very Serious People demanding immediate fiscal austerity?

The answer is, to reassure the markets — because the markets supposedly won't believe in the willingness of governments to engage in long-run fiscal reform unless they inflict pointless pain right now. To repeat: the whole argument rests on the presumption that markets will turn on us unless we demonstrate a willingness to suffer, even though that suffering serves no purpose.

So wise policy, as defined by the G20 and like-minded others, consists of destroying economic recovery in order to satisfy hypothetical irrational demands from the markets — demands that economies suffer pointless pain to show their determination, demands that markets aren't actually making, but which serious people, in their wisdom, believe that the markets will make one of these days.

These market responses look less irrational than they seem at first when you realize that they are the final desperate flailings of a bankrupt system of trust. 

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