Mitt Romney – supposedly advised by Mankiw among others – is outraged:
[T]he American economy doesn’t need more artificial and ineffective measures. We should be creating wealth, not printing dollars.
That word “artificial” caught my eye, because it’s the same word liquidationists used to denounce any efforts to fight the Great Depression with monetary policy. Schumpeter declared that
Any revival which is merely due to artificial stimulus leaves part of the work of depressions undone
Hayek similarly decried any recovery led by the “creation of artificial demand”.
Milton Friedman – who thought he had liberated conservatism from this kind of nonsense –must be spinning in his grave.
The Romney/liquidationist view only makes sense if you believe that the problem with our economy lies on the supply side – that workers lack the incentive to work, or are stuck with the wrong skills, or something.
Perhaps Krugman ought to consider more seriously the reality that since both Japan and now America have gone down the path of continually bailing out a corrupt, dysfunctional and parasitic financial system that neither nation has truly recovered.
Our ancestors who correctly judged the climate, soil and rainfall and planted crops that flourished were rewarded with a bumper harvest. Those who planted the wrong crops did not get a bailout — they got a lean harvest, and were forced to either learn from their mistakes, or perish. While some surely perished from misfortune, and some surely survived from luck, this basic antifragile mechanism ensured the survival of the fittest agriculturalists and the transmission of their methods, ideas and genes to further generations. In the financial sector today the Darwinian mechanism has been turned on its head; in both Japan and the West, financiers have not been forced by failure to learn from their mistakes, because governments and regulators protected them from failure with injections of liquidity. Markets have become hypnotised and junkified, trading the possibility of the next injection of central banking liquidity instead of market fundamentals.
So it should be no surprise that financial institutions have continued making exactly the same mistakes that created the crisis in 2008. That crisis was caused by excessive financial debt. Many Wall Street banks in 2008 had forty or fifty times as much leverage as they had equity. The problem with leverage is that while successful bets can very quickly lead to massive profits, bad bets can very quickly lead to insolvency, liquidity panics and default cascades.
Following 2008, many on Wall Street promised they had learned their lesson, and that the days of excessive leverage and risk-taking with borrowed money were over. But, in October 2011, another Wall Street bank was taken down by bad bets financed by excessive leverage: MF Global. Their leverage ratio? 40:1.
So why was the banking system bailed out in the first place? Defenders of the bailouts have correctly pointed out that not bailing out certain banks would have caused the entire system to collapse. This is because the global financial system is an interconnected web. If a particularly interconnected bank disappears from the system, and cannot repay its creditors, the creditors themselves become threatened with insolvency. Without state intervention, a single massive bankruptcy can quickly snowball into systemic destruction. The system itself is fundamentally unsound, fundamentally fragile, and prone to collapse.
Government life-support has given Wall Street failures the resources to continue their dangerous and risky business practices which caused the last crisis. Effectively, Wall Street and the international financial system has become a government-funded zombie — unable to sustain itself in times of crisis through its own means, dependent on suckling the taxpayer’s teat, alive but yet failing to invest in small business and entrepreneurs.
My theory is this: our depression is not a problem of insufficient demand. It is systemic; most prominently and immediately financial fragility, financial zombification, moral hazard, and excessive private debt, alongside a huge number of other long-term systemic problems.
The new policy of unlimited quantitative easing is an experiment. If those theorists of insufficient aggregate demand are right, then the problem will soon be solved, and we will return to strong long-term organic growth, low unemployment and prosperity. I would be overjoyed at such a prospect, and would gladly admit that I was wrong in my claim that depressed aggregate demand has merely been a symptom and not a cause. On the other hand, if economies remain depressed, or quickly return to elevated unemployment and weak growth, or if the new policy has severe adverse side effects, it is a signal that those who proposed this experiment were wrong.
Certainty is something that economists in particular should be particularly guarded against, even as a public relations strategy. Isaac Newton famously noted in the aftermath of the South Sea bubble that “I can calculate the motion of heavenly bodies but not the madness of people.” In the sphere of human action, there are no clear and definitive mathematical principles as there are in astronomy or thermodynamics; there have always been oddities, exceptions and quirks. There has always been wildness, even if it is at times hidden.
So we shall see who is right. I lean toward the idea— as Schumpeter did — that the work of depressions and crises is clearing out unsustainable debt, unsustainable business models, unsustainable companies, unsustainable banks and — as much as anything else — unsustainable economic theories.