simply Capitalism

I enjoyed this Blogging Heads video featuring Arnold Kling, and Russell Roberts discussing the roots of the economic crisis. Both came to the Austrian school from others, specifically Keynsianism, and Monetarism.

In this video they discuss a little bit of the history of these schools and their arrival at an Austrian perspective. I enjoyed their initial discussion of “perils of Econ 101” where they illustrate the danger in macroeconomics of rationalism (using the C + I + G formula). They do a nice job of illustrating how one must go back to reality to ground the theory (“curing cancer vs. filling holes”).

The discussion is technical rather then philosophical, but it is a well-reasoned discussion. They correctly identify government policy in the housing market as the root of the crisis, and they concretize how that happened. They question the use of stimulus and the model that Ben Bernanke is using to prescribe such actions.

Labels: stimulus

One of the troubling issues that arise during a recession, especially when we have arbitrary central bank monetary policy makers casting about looking for solutions to new problems is that there is a strong tendency to see inflation bandied about as a possible tool of monetary policy. RationalTheorist has looked at possible indicators of coming price inflation.

There are a couple of key reasons that inflation is considered as a policy tool. First, whether government officials believe in the value of inflation as a monetary policy, there is an implicit temptation to use inflationary policy to deal with the problems of financing massive government spending programs, such as the recent TARP, Obama stimulus package, and the FED’s various credit facilities. Inflation rewards those who hold debt, since an inflating money supply in the face of fixed debt payments means that debt loads shrink. A key problem that the FED has today is how it is going to issue enough debt in the form of Treasury bills in order to fund the stimulus programs. In addition, because asset values are inflated, any effort by the government to buy so-called “toxic assets” at prices that are too high will be ameliorated as the values of those assets would artificially inflate.

This temptation alone should give one concern about what might happen in the future. However, the second reason should give one even more concern. There are those who explicitly believe that inflationary policy is actually beneficial for the economy during a recession. Two examples have popped up recently in the media; one from a report of a Fed governor’s remarks, “FED’s Bullard: U.S. Facing Risk of Sustained Deflation” and the other from a Financial Times op-ed “Coordinated Inflation Could Bail Us All Out.” (free registration may be required)

The basic argument here is that monetary inflation (i.e. inflation of the money supply) can be used to combat a “deflationary trap” or deflationary spiral. The argument for a deflationary spiral says that due to a contraction in spending at the outset of a recession demand, and thus price, drops. However this leads to cutbacks and layoffs in the private sector and as a result, average incomes drop, and average debt levels actually rise. This in turn forces even more saving, with resultant demand drops and further cutbacks. This process is said to continue on in a spiral, eventually destroying the economy. This effect does happen during a recession, but I question its severity, and whether or not monetary inflation is proper to combat it.

In an economy that has been over-stimulated as ours has, a correction in asset values must occur. If we’ve been improperly subsidized to build too many houses over the last decade, then the price of housing must come down. Part of what we’re seeing is the market’s natural response to reset these asset values. This will hurt those who’ve over-estimated their ability to absorb risk (and should be a strong reminder why we don’t government interfering and creating distortions in the economy in the first place); however, it must occur. But the existence of falling asset values is its own stabilizer to continued fall because falling prices stimulates demand. Not everyone in the economy sees their incomes and asset values fall, and for those who do not, falling prices create an incentive to consume, thereby stabilizing deflationary pressures.

But the secondary and even more important issue here is that one cannot combat demand deflation with monetary inflation. Yes, inflating the money supply will cause prices to rise, seemingly reversing falling prices; however the mechanism of price movements are completely different in each case and one is not an antidote to the other. In a time of recession such as this where market distortions have resulted in the destruction of investment capital, what is needed is recapitalization. We need to use our current productive capability to accumulate savings (which if deposited become investment capital). Those who have over-borrowed need to pay down debt or sell off assets and their concurrent liabilities. Those who are in the best shape risk-wise can afford to spend, and those who are in worse shape should save and get rid of debt.

However, inflation destroys this process. Inflation destroys real wage levels, i.e. productive capability. It favors those who have large debts, and it destroys the value of accumulated assets. It is unjust. Those who have over-borrowed see their debts effectively forgiven. Those who were prudent and have saved see their assets destroyed.

Those who think that this sort of policy can be a good thing suffer from a form of macro-economic rationalism. That is, they view the economy as an aggregate machine, a sort of “black box.” They have correlated increasing money supply with rising prices and recession with falling prices and simply see one as a way to combat the other. Faced with a condition of falling prices, they know they can make prices rise by printing money. It is as if they are pulling levers and turning knobs on this black box simply to keep the gauges reading what they were. They care little what the fundamental mechanisms of each are. The articles I referenced show this.

From the WSJ blog:

Bullard also said a more systematic approach to countering deflation would entail more communication about what the Fed is trying to accomplish. He suggested setting “quantitative targets for monetary policy, beginning with the growth rate of the monetary base.”

“By expanding the monetary base at an appropriate rate, the FOMC [the Fed's policy-making Federal Open Market Committee] can signal that it intends to avoid the risk of further deflation and the possibility of a deflation trap,” Bullard said.

In his comments on the economy, Bullard said “macroeconomic expectations are very fluid and volatile.” He added “the current recession is a global phenomenon” and “it seems likely that output and employment will continue to shrink in the first half of 2009.”

“There is a risk that core prices may continue to stagnate or decline slightly for some time to come,” Bullard said.

The article is devoid of any reference to what market prices should be, or any mechanisms of operation of the market. Output and employment are falling, therefore the FED should act to increase prices. The “gauge” does not read correctly therefore we have to pull this “lever” to make it do so.

Even more brazen or bizarre is the Financial Times article, where the author clearly advocates for an inflationary policy, after explicitly and correctly articulating the various positive effects of such a policy, while all but ignoring the negative effects.

It [an inflationary policy] would help government finances by inflating away 10 per cent of total government debt. This lowers the interest burden for future taxpayers. Since taxes are levied primarily on income, this has both equity and efficiency benefits. It is (more) equitable as the cost of recession will be borne by wealth holders as well as income generators, and it is (more) efficient in that it reduces the extent of incentive-reducing tax rises on income in the future.

Companies will benefit in two ways. First, a portion of their debt will disappear, with the benefit being the largest for those companies that have debts with fixed interest, such as corporate bonds.

Second, while real wages seem to be downwardly flexible, nominal wages are less so. Higher inflation allows more companies and workers to agree to real wage cuts than would otherwise be the case. This is both useful for those firms that are currently uncompetitive, and preferable for society, because wage cuts are more equitable than unemployment.

A rise in inflation also means that declines in real house prices translate into less negative equity, freeing up the housing market. This is beneficial for labour mobility and helpful to the real economy because additional house sales spur economic activity.

Banks would gain in three ways. Inflation reduces future bad debts by making debt servicing easier. It makes defaults less costly because real collateral is more likely to exceed nominal debt. Finally, it makes existing bad debts less onerous on the balance sheet. This reduces the need for government recapitalisations and “bad banks” and increases the ability of governments to sell recently acquired banks. This, in turn, reduces the debt burden on future taxpayers.

An extra 2 points of inflation for five years is not a “get out of jail free card”. Bank shareholders, rightly, will still lose greatly from their managers’ decisions. Future taxpayers will, inevitably, still bear most of the cost of counter-cyclical government spending.

It is not costless. Regrettably, prudent savers will see their assets reduced. That might be the price society has to pay to keep the banking system afloat without crippling future taxpayers.

In terms of direct costs, the negative effects are equal and opposite to the claimed benefits. For every dollar that a debt holder’s obligation is lessened, the capital lender is punished by an equal amount. To call that a “cost” is to suggest that when a thief steals from you, that your loss is simply a “cost” of the benefit he gains. When the costs equal the benefit, there is no benefit. The indirect costs however are even greater because it is the asset holders that will restart the economy and it is they who are punished in an inflationary environment. Inflation destroys the very process of recapitalization that the recession will facilitate if left alone!

The rising debt levels that the United States is experiencing should concern those who see it as a temptation on the part of regulators to use inflation to “finance” their efforts. However, when inflation is explicitly advocated as a monetary policy by those in power, it is all but sure to rear its ugly head. It can only prolong the recession.

Labels: INFLATION, stimulus, TARP

Two more expensive failures this week from our government. I am of course speaking of the Obama stimulus package which the Senate passed on Tuesday and the Treasury Department’s proposed plan for its continued effort to shore up our financial system, also unveiled on Tuesday. If someone had asked me to predict the worst possible scenario for these two efforts I would have suggested that a huge stimulus package (which fundamentally does nothing to help) and “more of the same” from Treasury (which doesn’t address the fundamental problems in the banking sector) would have been my picks. That is exactly what we received.

The stimulus bill is predicated upon the flawed view that the economy is in some sort of deflationary spiral, i.e. that the problem is fundamentally one of consumer panic, and for which the antidote is a government burst of spending. By putting money back into the pockets of Americans it is thought we can restore their confidence as they see that burst of spending stop economic decline. This of course ignores the question of how such spending is financed, through the sale of Treasury notes, in effect pulling that money from the pockets of consumers before putting it back, and mortgaging future taxpayers to do it.

On the other hand, there are real structural issues in the financial sector. But Treasury’s plan was almost universally panned across the economic spectrum, even before Treasury Secretary Tim Geithner had finished laying it out. Where he was specific enough to give details, the plan looked like a version of the pervious TARP, with Treasury providing capital to banks, albeit somewhat more “judiciously.” The plan was short on details where most needed, in the area of restructuring bad assets on bank balance sheets. For initial responses to the Treasury plan see naked capitalism posts “Geithner Plan Smackdown” and “Geithner Plan: Fiasco” and Andrew Sullivan’s Geithner Reax Part I and Part II.

Both efforts promise nothing substantive will change, and that the government will spend incredible sums attempting it.

It’s time for a new batter: the free market. Unfortunately, I am very pessimistic that this batter will get his chance at bat. There are two reasons for this.

First, the conventional wisdom being promoted is that the free market is the culprit that got us unto this mess. This is especially prevalent within the current administration. A question during Obama’s press conference on Monday night illustrates this point.

Q: Thank you, Mr. President.  In your opening remarks, you talked about that if your plan works the way you want it to work, it's going to increase consumer spending.  But isn't consumer spending or overspending how we got into this mess?  And if people get money back into their pockets, do you not want them saving it or paying down debt first before they start spending money into the economy?

THE PRESIDENT: Well, first of all, I don't think it's accurate to say that consumer spending got us into this mess.  What got us into this mess initially were banks taking exorbitant, wild risks with other people's monies based on shaky assets.  And because of the enormous leverage where they had $1 worth of assets and they were betting $30 on that $1, what we had was a crisis in the financial system.  That led to a contraction of credit, which in turn meant businesses couldn't make payroll or make inventories, which meant that everybody became uncertain about the future of the economy, so people started making decisions accordingly -- reducing investment, initiated layoffs -- which in turn made things worse.

This statement by Obama shows both his negative view of the free market, and his Keynesian view that the crisis is a problem of consumer confidence. One can hardly be expected to look to the free market for the best solution to the crisis, when free market forces are supposedly responsible. This was the basic narrative put forth both by President Bush, and by then candidates Obama and McCain at the time of the crisis.

Upon further study though economists are coming to understand the role of government intervention in the housing market, fueled by the desire to stimulate home ownership, and resulting in the “originate to distribute” mortgage model, and the cheap money policy of the 2001-2005 Federal Reserve Board. Both of these interferences are key causes of the financial crisis.

The second reason that we won’t see the free market allowed to clean up this mess is that the free market will not preemptively step in while government is continuing to act in an arbitrary fashion. As long as government acts unpredictably, free market capital will sit on the sidelines.

Why is this?

The market is not a unified body acting in concert. It is made up of many small players, each acting to advance their own interests. Government, by contrast, is much larger and when it interferes in the market, it makes very large moves. Those moves are not necessarily profit driven and so are much less predictable. They ebb and flow according to political considerations. Thus, small, private, profit-driven interests will not act if such interests stand to lose in the wake of large, unpredictable actions taken by government.

So a banker maybe willing to buy distressed assets from an ailing bank, but only at a price that will net him a profit given today’s market conditions. When government steps in to buy these assets, at prices that show no concern for profit made, the private banker will stand back. He cannot outbid the government for these assets since he would lose money as well.

When a bank becomes insolvent and cannot raise new capital, it goes into bankruptcy. During bankruptcy new investors will provide capital, but only if the bank is restructured so that it has a healthy balance sheet. When government provides "bail-out” capital to banks without regard for their balance sheets, would-be private investors cannot follow along. Those conditions would assure them losses, just as the government is sure to lose their "bail-out" capital.

Just as government regulation takes away man’s ability to use his mind to further his own self-interest, so too, arbitrary regulatory actions, prevent individuals’ rational actions from resulting in outcomes that further their interests, and so they will rationally choose not to act. Irrational action drives out rational action. This one of the reasons why laissez faire is so important (and moral).

The best plans I’ve seen are merely variations of what would happen if the free market was cleaning up the mess. Banks would be forced to write down assets. Those that were insolvent would go into bankruptcy. In bankruptcy, debt holders would become equity holders, and assets would be sold off (presumably to banks who are healthy) in order to restructure balance sheets. The Luigi Zingales plan is a variation of this motif. Private bankers could do this, but until government chooses the free market path, it will not happen.

The free market did not cause the financial crisis. Fiscal “stimulus” will not work. Free market mechanisms are the only mechanisms that will fix the banking sector.

Labels: stimulus, TARP