Saturday, November 29, 2008

Macro: Under Construction

One of the reasons, I think, that it's been so difficult to understand this latest financial crises is that people are trapped in particular narratives, which bear no relationship to the current situation, that they also cannot see beyond. For example, I give you this post by Megan McArdle, who correctly identifies that there seems to be no laws broken, but then cannot take the next logical step:
In general, I think that we're approaching this crisis the wrong way when we look for a villain. One of the things that has really surprised me--so far, anyway--is just how little criminal activity we've uncovered during this crisis. There's an old accounting saying, "recessions uncover what auditors can't". Enron, Global Crossing, and MCI were not the only companies that played funny games with their books in the late 1990s. A number of technology companies played games with their books, but were able to grow enough to unwind their chicanery with little more than a slap on the wrist from the SEC. Enron, et al. were simply the ones who got caught short when the music stopped. I don't mean to say that all or most companies were guilty of this, because the overwhelming majority weren't. But the problem wasn't unique to Enron, and had they been able to carry on with it longer, there's every chance that they might have been able to get out of their bad positions and stay solvent.
When every law is followed, but the system as a whole still completely collapses, the answer is pretty clear to me: the system is fundamentally broken. In my view, the US financial system (and by extension, the world financial system) simply does not work. It is a bridge that followed firmly established engineering principles, was carefully built to spec, and yet collapsed anyway. There is no point in gluing masonry together or yelling at contractors, one must rethink those established engineering principles.

Paul Krugman has his own narrative. In it, the evil Republicans filled posts with idiots, and now, finally, the grown-ups are coming in to make everything better. *Sigh*. Paul backpedals and says he was only talking about Tim Geithner versus John Snow but please tell me what Snow had to do with of this, and how Geithner's long track record of proven failures in the NY Fed (AIG, Bear, Lehman, Citi, etc.) recommends him.

Neither Paul nor Megan can admit to themselves that the problems are fundamental and structural, that the financial system's engineering playbook is unsound, and yes, this means that academic macroeconomics and finance are, essentially, Fraudulent. Or at least, Scientism. Spend some time in the English Lit department at Harvard and you'll see how bad the modern University is at rejecting drivel. Now ponder that fact that this may also be the case in the Economics department, and that these guys are running the country.

It's not fair to keep picking on Krugman, but he keeps stepping up to the plate. Both he and Mankiw not only believe in Keynesiasm, but think he is the solution to today's problem. First Mankiw:
IF you were going to turn to only one economist to understand the problems facing the economy, there is little doubt that the economist would be John Maynard Keynes. Although Keynes died more than a half-century ago, his diagnosis of recessions and depressions remains the foundation of modern macroeconomics. His insights go a long way toward explaining the challenges we now confront.

According to Keynes, the root cause of economic downturns is insufficient aggregate demand. When the total demand for goods and services declines, businesses throughout the economy see their sales fall off. Lower sales induce firms to cut back production and to lay off workers. Rising unemployment and declining profits further depress demand, leading to a feedback loop with a very unhappy ending.
The solution is for Government to step up and spend. Thank goodness we have a scientific reason for that position, as it was not getting enough airtime in Washington DC. Here's Krugman on the Greatness of Keynes:
The key to Keynes’s contribution was his realization that liquidity preference — the desire of individuals to hold liquid monetary assets — can lead to situations in which effective demand isn’t enough to employ all the economy’s resources. When you don’t understand that principle, you end up writing stuff like this:
Want to see what Keynes actually said? Luckily the key equations are pretty straight forward:
Consumption + Investment + Government Spending + Exports - Imports = Gross National Product

ie C+I+G+X-M= GDP or Y

In this recession, consumption and investment is falling as the housing bubble pops, and the leverage that created it unwinds. Essentially, the monetary base is shrinking as credit (a key element of money) is withdrawn, written down, or written off. Exports were increasing, but the rise of the dollar (as the world rushes to Treasuries) means that that is down too. And, as people spend less, imports fall. All of these declines mean that the economy will go into a recession (GNP will fall). Keynes would argue that if you increase Government Spending enough -- G -- then GNP will rise and the economy can escape recession. Note that he is arguing for a *fiscal* stimulus, greater government spending, as the key to avoid GNP falling. Keynes argued for the Government paying people to "dig holes and fill them up again", and said that this would somehow get the economy back on track. You are quite right to say "huh?"

(The Monetarists say that the solution to the problem is not fiscal, it's monetary. Instead of increasing Government spending, you should cut interest rates and thus increase C and I, without needing to change G. Also, the New Deal was not net fiscal stimulus because although the size of the Government grew, and deficit spending grew, FDR also increase taxes to essentially sterilize whatever stimulating the larger Federal balance sheet was creating. When Obama talks about stimulus on one hand, and higher taxes on the other, he is increasing aggregate demand AND reducing aggregate demand at the same time. Not encouraging.)

Both Keynes and the Monetarists are wrong. The key to an economy avoiding recession lies in a change in the money supply, a change that can come about both through fiscal and monetary means. Lowering interest rates increases the money supply, as in a fiat currency world, banks borrow directly from the Fed, and then loan that money out to businesses and consumers. As the Fed's interest rate reaches zero, banks can make more and more marginal loans (since the floor on their spread is the Federal fund rate). When banks make loans, they increase the money supply -- remember, credit is money, and loans create deposits. So lower interest rates mean more money.

But expanding the Government balance sheet increases the money supply too! If the Fed spends $1B to pay people to dig holes and fill them in again, this debit on their balance sheet represents real money that has been credited to those workers. The Federal Government does not get money from taxes -- it does not need to, it can print its own -- so any debit on the Fed's balance sheet is, by definition, a credit (savings) somewhere in the private sector. (I understand that this implies ever larger Government deficits are required to increase private savings, but that's what the accounting identities say. I do not understand the full meaning of this.)

It is this fundamental equivalence between monetary policy and fiscal policy when it comes to their impact on money supply that Bernanke talks about when he says that a Government can always create inflation. But I don't think even he fully understands the implication of fiat banking, which is why both monetary (0.5% Federal Fund rate and falling) and fiscal (TARP giving money to banks) have produced dismal results to date.

As the Austrians would say that "Mr. Keynes's aggregates conceal the most fundamental mechanisms of change!" Which is absolutely true! If you cannot understand how the Government running a deficit to pay people to dig holes and fill them up again helps an economy with a too-expensive housing sector, now correcting, and a too-large financial sector, now contracting, you are on to something. It does not make sense. And we have real economists wondering about this too (although Greg has not won a Nobel Prize, and Nobel Prize winnings economists can make sense of it all).
For example, here is the conclusion of Andrew Mountford and Harald Uhlig (a prominent econometrician now at the University of Chicago) in an empirical study called "What are the Effects of Fiscal Policy Shocks?":
Our main results are that
- a surprise deficit-financed tax cut is the best fiscal policy to stimulate the economy
- a deficit[-financed government] spending shock weakly stimulates the economy.
- government spending shocks crowd out both residential and non-residential investment without causing interest rates to rise.
These finding are not consistent with standard Keynesian theory, according to which government spending multipliers are larger than tax multipliers and crowding out occurs through increases in interest rates.
If the data does not fit the model, Krugman does not care.
The key to Keynes’s contribution was his realization that liquidity preference — the desire of individuals to hold liquid monetary assets — can lead to situations in which effective demand isn’t enough to employ all the economy’s resources.
I think his key intellectual difficult is this:
For—though no one will believe it—economics is a technical and difficult subject.
It may be difficult, but it is not technical. Civil Engineering is a technical subject. Back in the day, engineers massively overbuilt walls, towers, aqueducts etc. because they did not have the physics and mechanics to actually calculate torsional loads, weight bearing capacity, etc. so they just made things extra big and strong -- just in case. Now that they understand physics and mechanics, they can build more efficiently, to tighter tolerances, because they now just how slim they can make a pylon and still have the bridge stay up. Does that seem to describe macroeconomics or finance in any sense at all to you? Academic economists published lots of papers, with increasingly elaborate equations, none of which work. Industrial economists build increasingly elaborate models, to multiple decimal places, and then levered themselves to the eyeballs based on what those models said. And it all blew up. A truly technical field, like civil engineering, has models that work and you can build to tight tolerances. This leaves Economics as a difficult field, but it's just not Technical, and pretending that it is has lead us to our current mess. Keynes General Theory, like all Macroeconomics, is closer to the Drake equation than Newton's Laws of Physics.

This post has gotten too long -- let me wrap things up.

The mechanism by which fiscal expansion (kind of) works is that the Government creates new money, that it then gives to whomever. In this case, to date, it's been financial firms, but it may soon also include government contractors who are also civil engineers to build roads etc. ("Infrastructure" is to economists what "billiard balls" are to physicists. I encourage you to go down to your local pool hall and see how many physicists you find there.)

This new money reduces the value of existing money by diluting it. So, this is a transfer of wealth from those who have money (savers) to those who have received this new money. Eventually you transfer enough of it, and those who did not have money start spending again, and those who had money have less to spend, but they were saving it anyway, so this does not show up in current GDP figures.

If the amount of extra money created is greater than the amount goods and services increase, you get inflation. The key here is to note that the reason for increasing the money supply is to increase (or sustain) the amount of goods and services in the economy. If the amount of goods and services fall, you get unemployment (less work, same number of people, it takes time for individuals to retool, in the meanwhile they are out of work). Note that it is clear in this model why it's better for the Government to increase its deficit and give that money directly to consumers, ideally through tax cuts as those are fastest. Consumers spend money on stuff they actually want, which increases the amount of goods and services in the economy, instead of building bridges to nowhere, which does not. Keynes has no insight whatsoever into this, or any, transmission mechanism, and this is why the bailouts to date have been useless.

People have stopped spending because they want to repair their household balance sheets. They have negative equity because their assets are too small relative to their liabilities, so they are building up their assets. They will not start borrowing again until they have sufficient cash to give them (net) positive equity. The sooner they repair their balance sheets, the sooner they will start spending again. Giving money to banks so they can make cheap loans does not help consumers rebuild their balance sheets. Instead, banks are just using it to patch up their own balance sheets, which is great for them, but it does not help aggregate demand.

So, step 1 should be to increase the deficit, but have this money go directly to consumers. Keep doing this until household balance sheets are repaired, and we see consumer spending picking up. At this point, turn off the money tap.

As for banks -- nationalize the lot of them, liquidate the bad ones, can their management, and re-privatize the ones that are left. In the meantime, everyone borrows directly from the Fed.

Mosler has a nice piece explaining the logic here.

Tuesday, November 25, 2008

Putting Humpty Dumpty together again

It's been funny, and a little depressing, to see how mired even bright and well intentioned people can become in their past prejudices and beliefs. The $306B bailout of Citigroup, TARP, Sheila Bair's "prop up home prices program", China's "keep exports growing" program, etc. etc. are all focused on somehow, some way, returning their worlds to the way "things used to be", never mind that the way "things used to be" was unsustainable, lead to calamity, and was not actually that good even if one were to ignore its catastrophic-ness. (Is catastrophic-ness a word?)

The well paid, value destroying bankers in the City and Wall Street are undoubtedly waiting for this whole thing to blow over so they can get back to business as usual.

Detroit is waiting for its next big slug of money from the Government so it too can get back to making bad cars no one wants, and fulfilling past pension obligations.

Home builders are in line for a big slug of money from the Government so they can get back to making houses like it's 2002-2007.

Airlines are going to be asking for money again in 2009 as the collapse in corporate travel finally starts showing up in their bookings.


And in the midst of all this corporate activity, aiming to turn the clock back to 2002, we have the usual suspects of newspaper pundits and economists hailing the arrival of Tim Geithner and Larry Summers as grown-ups who are finally going to put things right. Excuse me? Geithner, in his position at the NY Fed, has been intimately involved in the bailout attempts over the past 12 months which have gone precisely nowhere. While I am sure he's a smart guy, he's already been very actively involved and so far has shown nothing positive for his efforts.

I'm also glad for Larry Summers that he has rehabilitated himself after his disastrous showing at Harvard, but is Summer really any better than Bernanke? Does anyone really believe that Bernanke has shown us the value of all his Great Depression understanding in this crises? Suppose that Summers had been Fed Chairman for the past 8 years, wouldn't we all be even more excited of Bernanke was coming in to replace him? I can see the headlines now "Great Depression Expert to take over Fed During Worst Crises in US Economy since the 30s". Why is the reverse seen as a positive sign?

I think Megan makes two great points in a couple of recent posts.

First, the New Deal (and Great Depression economics) is nothing like what we think it is. This issue has become so politicized that it is frankly impossible today to get any truthful account of what actually happened. So, whenever you read anything about how the New Deal gives us clear direction on what to do wrong, you should know that that person is actually just dressing up whatever they believe in New Deal rhetoric (one way or the other). Was it Keynesian (even though Keynes had yet to publish General Theory)? Maybe. It certainly had elements that Keynes would have approved of, but also elements that he would not have. And who really cares? The General Theory is obviously wrong, and the only reason Krugman et al keep trotting out G, I, E, T etc. is that they really don't know any better. Macroeconomics is fraudulent. The equations around the General Theory, Monetarism, etc. etc. are scientism, and bunk. It really is rubbish, and its disheartening to see how long actual Drivel can survive in the Academy, which purports to discover Truth. The only way to get a sense of what the New Deal was actually like is to read contemporary accounts. Here is one such account. Here is an excerpt from it (Thanks to Mencius Moldbug)
Washington was swarming with young lawyers, economists, bankers, and professors-in-exile, all bent on reorganizing the cosmos, rearranging the stars and planets. Programmed like a computer with bits and tags of literature, I mouthed Wordsworth's famous apostrophe to the early weeks of the French Revolution: "Bliss was it in that dawn to be alive,/ But to be young was very heaven!"

The times were ebullient, and yeast was in the air. Each morning we awoke to read with excitement of Roosevelt's latest outrageous move. It was épater les bourgeois in political and economic terms or - more precisely for us - it was épater les vieillards, a form of exercise that inevitably lifts the hearts of anyone under thirty. The old order had discredited itself; we would conjure up a new and better one in its place. Certain lines from Wordsworth's Prelude expressed what we thought we were up to, for it did indeed seem to us a time:
In which the meager, stale, forbidding ways
Of custom, law, and statute, took at once
The attraction of a country in romance!
When Reason seemed the most to assert her rights...
We were, so we thought at the time, not so much interested in smashing pillars and pulling down temples as in designing the shape and form of our New Jerusalem. Discussion might circle for a time - sometimes it seemed to circle for long alcoholic hours - but it invariably settled on the architecture of that refulgent city.

No doubt because the actors in the drama were relatively older - lawyers and young Ph.D's in economics rather than undergraduates - the reaction bore no resemblance to the later disorder of the sixties, when "trashing" seemed an end in itself. Though we had read some history, no one thought himself a young Robespierre. Perhaps also because the New Deal was a fresh experience for America (though not for Europe), with government for the first time giving explicit meaning to the welfare clause, we felt hope in the air. Later, in the sixties, much of the new welfare legislation served the bureaucracy more than the commonweal, but in those days of unlimited expectations our basic credo was simple: Nothing that had been done till then was good enough nor was there anything we could not do if we set our minds to it.

To be sure, I was little more than a spear-carrier with few speaking lines. Unlike many of the leading actors, I had, at that time, not even met Felix Frankfurter, let alone clerked for Holmes or Brandeis. Most of the problems with which the New Deal was grappling were for me matters of first impression; I was, by any rational standard, spectacularly ill-equipped. Although assigned to work on developing credit facilities for farmers, I had never, in spite of my Iowa background, spent a night on a working farm - but then neither had my colleagues, including, I suspect, Henry Morgenthau. That, however, did not deter us. In the atmosphere of New Deal Washington, inexperience was no impediment; one learned fast and improvised boldly. Even professionally, I could not have been more of a neophyte; I had never so much as written a contract to sell a fifty-dollar dog! Yet one of my first professional tasks was to draft and help negotiate a contract for the sale of $75 million worth of Federal Farm Board cotton. It was such a formidable document - seventy or eighty pages in length and replete with intricate internal brokerage arrangements - that, in retrospect, I am amazed that I was not terrified by the assignment. But I took it in stride, as we all did in those days. We were young and nothing was impossible.
I'm sure you can hear the echoes of "yes we can" echoing through the 80 years that separate 1930 to 2008.

What is the consequence of trying to put Humpty back?

I have a very simple model of the economy, money supply, and the interaction of the two.

Suppose the supply of money in an economy is X. Suppose the total quantity of goods and services available to trade is Y. If X and Y both grow by the same amount, the prices remain the same. If X grows faster than Y, you get inflation (higher CPI). If Y grows faster than X, you get deflation (lower CPI).

Right now, X is shrinking fast. Credit is a critical component of money supply, and it is getting smaller. Large quantities of money, in the stock market and in real estate, have been destroyed. When you hear about "deflation", this is what is being described.

At the same time, the Fed is printing enormous quantities of money through new credit provision, and through out and out transfers (deficit spending with key constituents -- banks currently but all kinds of folks in the future -- being credited as the national exchequer is debited). We are not seeing inflation because the net effect of these two changes in money supply is still negative. Money is being destroyed faster than it's being created, and the quantity of real goods and services available (Y) has declined slightly, but not that much.

Sooner or later, the deflationary effects of falling equity and real estate are going to play out, but the money expansion mechanisms the Fed has put in place (TARP, etc. etc.) will remain. It is going to be almost impossible for the Fed to turn off these life support systems when they need to, and the consequence is going to be dramatic inflation. I see 2009 as being the year when more and more money is pumped into the wrong parts of the system, prices finally reach bottom, and we see X increase at a pace >> Y, and the value of dollars get dramatically diluted away. To tame this beast, Obama is going to have to stand up and say "No you can't" to lots and lots of people, as Summers simply increasing the Federal Funds discount rate is not going to do the trick. We are well past the world of monetary policy and deep in the real of fiscal stimulus, which means we need Acts of Congress cutting subsidies of Favored Constituents. Don't hold your breath.

And in the midst of this Comedy of Errors we have earnest tracts like the following:
But more to the point, I don't think anything he said rules out positive net present value investments in infrastructure. We should make these investments in any case if we want the economy to grow robustly, now just happens to be a good time to have the construction and maintenance work done since people need jobs, inputs to production are relatively cheap, and the political atmosphere is accommodating.
Ah yes, Infrastructure Spending, the great White Knight who will make all our monetary ills go away! It is childlike to see how much support the idea of " Infrastructure Spending" has gotten as a mechanism for Stimulus! Is there any reason why "Infrastructure Spending" be granted this Hallowed Place is being The right mechanism for fiscal measures? And just to think, 12 months ago we were mocking Bridges to Nowhere.

Infrastructure Spending will be allocated the way Infrastructure Spending is always allocated -- it will be based on political expediency, not whether it is a positive net present value or not. If Infrastructure was based on positive net present value, we'd have sky scraped being built in San Francisco, and 8 story apartment complexes built in Cambridge, MA, and I don't see a whole lot of either going on. Since this spending will not be positive net present value, X will increase by more than Y and this will devalue the dollar.

If you want positive NPV spending, simply give money to People via lower taxes. Have Government pay FICA for as long as necessary, and let people allocate that money based on whatever they think. But since FDR did not do this, it did not make its way into textbooks, so it is not the solution parroted by those who have spent 8+ years of their lives memorizing those same texts.

The Netflix Prize

I recommend this great article on the Netflix Prize: a $1M bounty that will be given to whomever can increase the quality of its recommendation engine by 10%. Lots of interesting information; my favorite was:
Interestingly, the Netflix Prize competitors do not know anything about the demographics of the customers whose taste they’re trying to predict. The teams sometimes argue on the discussion board about whether their predictions would be better if they knew that customer No. 465 is, for example, a 23-year-old woman in Arizona. Yet most of the leading teams say that personal information is not very useful, because it’s too crude. As one team pointed out to me, the fact that I’m a 40-year-old West Village resident is not very predictive. There’s little reason to think the other 40-year-old men on my block enjoy the same movies as I do. In contrast, the Netflix data are much more rich in meaning.
Broadcast advertisers are obsessed with demographic data, because that's how airtime is identified and sold. But it's a poor and distant cousin to actually knowing about individuals' actions and preferences. Let me phrase it this way: would you rather know someone's age and sex, or would you rather know the last 5 queries they typed into Google?

Friday, November 21, 2008

Sense and nonsense about Deflation

Deflation, like inflation, is a confusing word that conflates price changes due to a change in money supply, with price changes due to a change in some underlying supply/demand dynamic in the good itself. For example, if the Government prints a lot of money (increases money supply) but new manufacturing technology in China makes TVs cheaper to produce, the net impact on the price you pay for your new flat screen may be positive or negative depending on which effect was bigger. Our past 100 years as seen a massive increase in money supply that has swamped the also dramatic increases in productivity. A bottle of coke that cost 10 cents in 1908 should cost 1 cent in 2008, not $1.50.

When Nouriel Roubini talks about deflation, like most commentators he's referring to the net effect of money supply and underlying supply/demand dynamics on price. If prices are going down, then we're in"deflation". But he brings out the standard canard about why this is bad:
Second, when there is deflation there is no incentive to consume/spend today as prices will be lower tomorrow: buying goods today is like catching a falling knife and there is an incentive to postpone spending (consumption and investment spending) until the future: why to buy a home or a car today if its price will fall another 15% and purchasing today would imply having one’s equity in a home or a car fully wiped out in a matter of months? Better to postpone spending. But this postponing of spending exacerbates the vicious cycle of falling demand and supply/employment/income and prices.
Does this make any sense to you? Does it match your own spending habits over the past 10 or 20 years?

Computers are a product category that experience dramatic deflation. Your $1000 Dell today is worth $500 next year, and $100 the year after that. And while computers continue to become dramatically more powerful and cheaper, and people consider holding off so they can buy that new model, there are still plenty of consumer sales.

Cars are another product category with dramatic deflation. A $25K Subaru WRX today will outperform a $70K Ferrari built in the 1970s. The cars of tomorrow will be even better, and cheaper. But there are plenty of car sales.

Look at other goods categories that have experience dramatic price deflation due to cheap labor in China: clothes, toys, consumer electronics. All of them have become much cheaper through the 90s, and yet people still buy plenty of them.

One area where falling prices might give people pause is housing, but housing remains overpriced in almost all areas in the US (based on equivalent rents) and it should give one pause. The real "problem" with deflation is that it makes the real cost of debt higher. But haven't we been hearing that the US, as a whole, needs to be less indebted?

People aren't buying cars now because cars are a big ticket item that it's easy to postpone for 6-12 months. People aren't buying houses now because houses are still too expensive compared to rents, and without price appreciation to gamble on, it makes no economic sense. This "people won't spend if prices fall" does not fit with empirical observations.

Thursday, November 20, 2008

Money's role in plunder

I strongly recommend this excellent post by Arnold where he posits how money is intimately intertwined with Government power. Part of me wants to say "duh", but fully embracing the reality of fiat money is hard, especially when our intuitive sense is tied to this atavistic idea of "store of value".

Fiat money comes into existence when it is issued by a Government. First the Government creates the loan, then the loan creates the deposits. Demand for Government money comes from requiring taxes in that fiat currency, and the secondary market comes into existence as individuals exchange goods and services to get the money to pay taxes, and net save. Fiat currency by definition is entirely a creation of the Government.

The role of the banking system is administrative -- someone needs to tally all the credits and debits -- and it should also be to assess credit risk (how likely is this loan to be repaid). The Government creates the money to be loaned out, but it wants an intermediary to decide who should get it and who should not based on their assessment of credit risk.

As Kling says, the standard view is a medium of exchange view, where money makes trade between producers easier. This view gets us to a "money is a store of value" concept, a gold standard, etc. etc. But in fact, fiat money is just willed into existence by a sufficiently powerful Government. The strength of fiat money depends on the strength of the Government's ability to demand and collect taxes.

Arnold seems to find something sinister in this, but it's just the way fiat currency works.

Tuesday, November 18, 2008


Yahoo!'s Jerry Yang seems to be worth -$1.8B. I'm still shocked when anyone who lived through the dot com crash doesn't sell when the sellings good.

Wednesday, November 12, 2008

The memory hole

On Sept 29, Congress voted down the original Paulson Plan, where he sought $700B to buy troubled assets from banks.

On Sept 30, the responsible media, and Brad DeLong blamed the subsequent drop in the stockmarket (which was not even that subsequent) on Congressional Republicans, and declared the vote to be a terrible mistake.

On Oct 2 (approx) TARP was finally passed, and there was wide rejoicing, as the responsible media declared it a victory for right thinking people.

On Sept 30, the day after TARP 1 was killed, the S&P opened at 1164. It has since fallen to 850 despite TARP 2 being passed. Moreover, Paulson has abandoned the plan behind TARP 1, and instead is doing what TARP 2 enabled him to do but TARP 1 did not.

I have yet to see a single story retracting any of the pieces of received wisdom that were widely distributed by the responsible media on Sept 30.

1) The stock market decline on Sept 29 had nothing to do with TARP 1 failing.
2) TARP 1 was a bad plan, and it was good that it failed.
3) The original Congressional vote against TARP 1 was correct.

Note that all of this happened two months ago, and yet the recorded history is completely different from actual, easily recalled events.

Tuesday, November 11, 2008

Money Supply vs Real Goods and Services

On the road this week, so blogging will be light.

There was a great article yesterday (Monday) in the WSJ describing how the Fed and Treasury made decisions through the crises. It was a realistic portrait of decent people, doing their best, in difficult, harried times. Sadly, I cannot find it, but if you have the link, please email me and I'll put it up.

It was also clear that Bernanke and Paulson are fundamentally stumbling around in the dark, being purely reactive, and focusing on making things "go back to the way they were." Even though the "way things were" was suboptimal.

A moment now to talk about money supply and inflation.

Suppose an economy has a money supply of X. Suppose it also has a supply of real goods and services, Y.

If X increases by 10%, and Y increases by 10%, there should be no change in aggregate price indices since you have (proportionally) the same amount of money, chasing the same amount of goods and services. Note that anyone saving money in X has been diluted by this 10% increase in X. I used to think that a perfect, globally balanced basket of currencies would be perfectly hedged against inflation but I was wrong -- it does not protect you from dilution.

Alternatively, suppose X increases by 20%, and the supply of real goods and services increases by only 10%. Here you have dilution as before, and you will also have rising prices show up in the CPI, and thus be termed "inflation" by economists and the press.

The fall in real estate prices and other asset classes has shrunk X. The supply of real goods and services has contracted also, but not as much. So, X has decreased more than Y has decreased. This is why we are in deflation and the economy is also shrinking.

The Government is printing a huge amount of money and giving it to financial institutions. They may also start giving it to automakers. Since both industries are a net destroyer of value, this means that the increase in X will not be met by a concomitant increase in Y. If they "stimulate" too much, then X > Y and we'll get inflation. Maybe a lot. If they "stimulate" too little, then money supply will continue to fall, and we will stay deflationary. If they "stimulate" just right, then any increase in X will be met by an increase in Y, and we won't see a change in prices, but the supply of goods and services will increase.

Please note that all of these scenarios will result in "dilution" and punish anyone holding dollar bills. The Press and economists seem to think that China's current account surplus with the US means that China is in a better position than the US, but they've been exporting real, useful good and services in exchange for paper. I know which I would rather have.

Also, please note that the majority of Government actions to date have focused on supporting particular industries, which guarantees that in the increase in money supply will exceed the increase in real good and services. State owned enterprises that continually hemorrhage money (AIG, Fannie, Freddie, GM, Ford, Chrysler, Citi, Goldman, JP Morgan, AMEX etc.) are inflationary in that the money they get from the Government goes into general circulation, increasing supply, while the goods and services they produce are not commensurate to that increase in supply. This will be dilutive and inflationary (X increases, and the increase in X is greater than the increase in Y).

Friday, November 07, 2008

When is unemployment not unemployment?

It's interesting to compare these two pieces on what to count as unemployment. First Tabarrok:
So why are there multiple series on unemployment for the 1930s? The reason is that the current sampling method of estimation was not developed until 1940, thus unemployment rates prior to this time have to be estimated and this leads to some judgment calls. The primary judgment call is what do about people on work relief. The official series counts these people as unemployed.

Rauchway thinks that counting people on work-relief as unemployed is a right-wing plot. If so, it is a right-wing plot that exists to this day because people who are on workfare, the modern version of work relief, are also counted as unemployed.

Moreover, it's quite reasonable to count people on work-relief as unemployed. Notice that if we counted people on work-relief as employed then eliminating unemployment would be very easy - just require everyone on any kind of unemployment relief to lick stamps. Of course if we made this change, politicians would immediately conspire to hide as much unemployment as possible behind the fig leaf of workfare/work-relief.
But if the Government did have a large work-relief person, there would be no unemployment. If someone gets up in the morning, goes to an office building, does activity for 8 hours, collects a paycheck and goes home, that's employment whether it's part of a work-relief person or not. If we're going to stop counting people who work for the Government as employed, then the US has a 40% unemployment rate, not a 6% rate.

Compare and contrast with the Employer of Last Resort proposal from Mosler:
The U.S. Government can proceed directly to zero unemployment by offering a public service job to anyone who wants one as a supplement to the current budget. Furthermore, by fixing the wage paid under this ELR program at a level that does not disrupt existing labor markets, i.e., a wage level close to the existing minimum wage, substantive price stability can be expected.

The ELR program allows for the elimination of many existing government welfare payments for anyone not specifically targeted for exemption, as desired by the electorate. Minimum wage legislation would no longer be needed. Labor would welcome the safety net of a guaranteed job, and business would recognize the benefit of a pool of available labor it could draw from at some spread to the government wage paid to ELR employees. Additionally, the guaranteed public service job would be a counter- cyclical influence, automatically increasing government employment and spending as jobs were lost in the private sector, and decreasing government jobs and spending as the private sector expanded.

The ELR proposal also has characteristics similar to the current Federal unemployment compensation policy. There are, however, significant differences as unemployment is 1) compensation is payment for not working, 2) temporary, 3) does not cover everyone, and, 4) is less than the proposed ELR wage.
If the Government steps up as Employer of Last Resort, giving anyone a job who wants one, then involuntary unemployment -- by definition -- goes to zero. Such a program would dramatically increase the Federal Deficit, but Mosler does not care about deficits.

Tabarrok, however, did not raise deficits as his objection. His problem was that politicians would conspire to hide unemployment behind work relief, but nothing would be hidden! Work relief numbers would be public just as unemployment numbers are now! Moreover, if the price of work relief was appropriately set, it would not take skilled workers from the private sector. Mosler calls this work relief pool a "buffer stock" of workers, a buffer stock superior to unemployment (which is the current buffer stock). He is certainly correct in this. He also says that government deficit to pay this buffer stock does not matter, and people can disagree with him there.

Thursday, November 06, 2008

90 day moratorium

Our very own Arnie is proposing a 90 day moratorium on foreclosures in California. John Dizard thinks this is a terrible idea:
Let's take the 90-day moratorium idea. There are about 3m houses in the foreclosure process. During that 90-day moratorium, the mortgage servicing companies - that is the people who make the collection calls, do the restructuring and forward the payments to the mortgage securities owners - would have to continue to make up the missed payments. They would need to finance those payments by issuing notes, typically 360-day paper. Those servicers that were not bank-owned, and could not be financed by a parent holding company, would have to raise money at rates that are already high - say 600 basis points over Libor - and rising. If they could get the money at all.

If one of the non-bank servicers were to go bankrupt during the 90-day moratorium - a distinct possibility - the trusts holding the mortgages it was servicing would have to find new servicers. There would be a time gap during which no calls would be going out to delinquent homeowners. Past experience indicates that during the servicer disruption the foreclosure rate on a troubled pool would rise from 25 per cent to 35 per cent.
The key element that took Japan's equity and real estate collapse, and turned it into two decades (and counting) of economic stagnation was eliminating price discovery. In the US, housing has to come back inline with incomes before economic growth can resume. Right now, prices are below peak (leaving recent buyers and aggressive HELOCers underwater) but still above rent-equivalent levels. So there is financial pressure to sell, but a financial disincentive to buy. Keeping prices above their market clearing rate will just drag this crises on.

Wednesday, November 05, 2008

Towards a new financial system

First, congratulations to Barack Obama! And good luck -- he'll need it.

Second, two interesting articles about a new financial system. In the first one, Steve Waldman yearns for a financial system that actual pairs investors with investment opportunities, instead of taking "savings" and using it for anything but. Be sure to read the comments too.

This other article is a discussion on how payout structure can dramatically alter people's behavior wrt to saving. The effect can be large -- individuals can forgo increasing their consumption by 21 times in 30 days just because it is so difficult for them to resist small temptations and save.

Of course, Keynesians would have you believe that saving is the problem.

IDEO to go

For those of you who have never been in an IDEO (or IDEO inspired) office, they're pretty awesome. There is now a company offering IDEO-style offices for very-short-term lease. Cool!

Hyde Park

Slate's Megan O'Rourke has a partial description of Hyde Park, Chicago -- a place where I spent a very happy couple of years in my yoot. She talks about how it's economically and racially integrated, and mentions some local restaurants like Valois and Medicis. And of course, the presence of the most intellectually rigorous university in the US, the University of Chicago.

But the reality of life in Hyde Park is not the bucolic neighborhood that Megan describes. The University is part tower, part fortress, and it shields its nervous students from an area that is riddled with crime and murder. Walking around Hyde Park at night was scary, and I'm a fairly tall guy. Chicago proper is also scared of Hyde Park, as there are is no metro link between the neighborhood and the city. I was told that the green line extended down there once, but it was taken down to keep the two areas separated. South Side Chicago was, before the 1960s, a nice place with restaurants, and fantastic jazz clubs, but after the Civil Rights movement it descended into the hell hole it is today. And unlike Harlem, there's been no gentrification to turn things around.

Hyde Park has more Nobel Prizewinners than restaurants, and two bars -- one of which is student run. In my time there, the greatest recreational innovation was a bowling alley burger place. While Hyde Park is not the worst managed ten square miles in the US, it is governed appallingly. One hopes that this does not foreshadow the Obama administration, but the article might foreshadow how it will be covered in the responsible press.

A tip for those living there: under no circumstances take a bus from Hyde Park to Midway Airport. It will take so long that you will miss your flight. You may also be murdered on the way.

Excellent analysis of election results

I really liked this analysis of the election results. Basically, there was a small, but broad, shift towards the Democratic party. Youth turnout was the same, but skewed more heavily Democratic. Ethnic minorities across the board also shifted to Obama.

Tuesday, November 04, 2008

In Praise of Savings and Deflation

Dean Baker, whom I like, has a post where he gets very confused about deflation. This is understandable -- the thinking around deflation is very confusing. After all, if iPhones go from being $500 to $200 we are all happier (and richer) but this contributes to deflation. If flying from San Francisco to New York goes from costing $20,000 to $200 (someone invented Southwest) again, this would contribute to deflation, but we would all be happier (and richer). How can something that makes us all happier (and richer) be bad? How can something that impoverishes us all (inflation) be good in small doses, but bad in large doses. If this strikes you as a kind of economic homeopathy then you are not alone.

But first, to Dean:
There is no need to look to credit crunches or deflation. The problem is quite simply a massive lost of housing wealth, compounded by the recent loss of stock wealth. The only cure will be finding alternative sources of demand. In the short-term, government will have to fill the gap. In the longer term, it will be necessary to get the dollar down so that the country's trade is closer to balance.
Housing is a levered instrument, which means that prices are a function of financing. For a long time I believed that financing should have no impact on prices but I was wrong -- for goods purchased primarily with debt, price is directly driven by the cost of that financing. Houses would cost much more if you needed to pay in one lump sum. Since credit is money, a collapse in the price of housing is a reduction in the amount of money in the world. When the amount of money in the world goes down, the value of the remaining money goes up -- the money has been concentrated. The $20K you have in the bank is looking much better now that houses cost $100K instead of $300K.

Alternatively, when money (credit) expands, the value of the money that was there to begin with goes down (the old money is getting diluted). Houses now cost $300K again, and your $20K savings account is too puny again. D'oh!

This expansion/dilution of the money supply can be hidden by changes in demand or technology. Money supply may increase (dilution, causes prices to go higher) but some engineering mastermind figures out how to make an iPhone for 50% less. Prices stay the same, the CPI shows no change, but savers have still been robbed because instead of having access to a $100 iPhone they still have to pay $200 for it. D'oh indeed.

When Greenspan, the great Monetarist, talks about whether or not to factor bubbles into interest rate decisions, I shake my head in disbelief. Credit bubbles are, by definition, an uncontrolled increase in money supply. For a Monetarist, who (correctly) believes that inflation is always and everywhere a monetary phenomenon, ignoring credit growth is like an oncologist ignoring a group of uncontrollably dividing cells. There are clear grounds for a malpractice suit. Also note that there is more to credit than interest rates -- there are down-payments, prepayment penalties, rate resets, subsidies, etc. etc etc. A central banker who thinks he can control money supply (credit) just by controlling interest rates is wrong, he's wrong when the economy is in a liquidity trap, and he's wrong when the economy is in a credit bubble.

Let's take a moment to consider just how much of the economy a central bank needs to control given our current credit infrastructure.

Saturday, November 01, 2008

Keynes gives us no clue

Megan doesn't understand why David Brooks' NYTimes column makes no sense. Brooks calls for infrastructure spending as "stimulus" and Megan thinks this is reasonable:
For starters, Brooks's statement about stimulus doesn't strike me as particularly controversial. The point of stimulus is to use the government to artificially expand aggregate demand by borrowing at fairly low interest rates and spending the money. The problem is, if you send out checks, most of the checks seem to get saved, which creates a closed, useless cycle.
Keynes, the father of the idea of economic "stimulus" tells us nothing about the mechanism for that stimulus
C+I+G = Y
GDP simply equals consumption plus investment plus government spending, but the mechanism by which increased government spending leads to increases in GDP is buried in the type of aggregation that Keynes is fine with, but drives Austrians up the wall. It also provides little guidance of policy makers -- if you want to stimulate, how best to do it?

Megan is too dismissive of mailing checks to consumers. Most of the checks might get saved if they are $1000, but $50,000 would soon find it's way into the economy, and do so in less distortionary (and therefore inflationary) mechanism than simply increasing G.

Keynesians, and "real goods" economists, argue that an increase in money supply is not inflationary so long as it funds projects that are at least equal in worth to that monetary expansion. Money supply can increase by X% so long as the economy also increases by X% and produce no inflation. This is, unfortunately, not the right way to think about it, but it is the dominant paradigm so let's run with it.

Giving money to consumers -- lots of money -- will be spent (at least in part) on stuff that consumers actually want. Increasing G will go to the usual suspects involved whenever G gets larger. Increasing the stock of useless expenditures (Bridges to Nowhere, or the concrete meadow that is modern Japan) grows the economy by less than the increase in money supply, and will so ultimately result in more inflation. At the same time, maintaining this useless stock will be a drag on the economy, reducing growth. And this is how Keynesians take us to the land of stagflation. Next: how Monetarists do not give us a clue either.