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.

Etc.

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 ├ępater les bourgeois in political and economic terms or - more precisely for us - it was ├ępater 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.

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