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.

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