friedman

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Paying For Our Past Sins

Michael Kinsley’s argument for immediate austerity is about “paying for our past sins”:

Krugman also is on to something when he talks about paying a price for past sins. I don’t think suffering is good, but I do believe that we have to pay a price for past sins, and the longer we put it off, the higher the price will be. And future sufferers are not necessarily different people than the past and present sinners. That’s too easy. Sure let’s raise taxes on the rich. But that’s not going to solve the problem. The problem is the great, deluded middle class—subsidized by government and coddled by politicians. In other words, they are you and me. If you make less than $250,000 a year, Obama has assured us, you are officially entitled to feel put-upon and resentful. And to be immune from further imposition.

Austerians don’t get off on other people’s suffering. They, for the most part, honestly believe that theirs is the quickest way through the suffering. They may be right or they may be wrong. When Krugman says he’s only worried about “premature” fiscal discipline, it becomes largely a question of emphasis anyway. But the austerians deserve credit: They at least are talking about the spinach, while the Krugmanites are only talking about dessert.

To Kinsley, austerity is the necessary spinach. I don’t really understand this. In the United States a crisis in shadow finance spread into the banking industry leading to a default cascade throughout the financial system, which resulted in a wider crisis throughout the economy, and ever since 2008 even after the banking sector was propped-up, unemployment throughout the wider economy has been rife, economic output has fallen far below its long-term trend line, and bank deposits are soaring as the weak economy has damaged confidence and convinced possessors of money to save and not spend or invest.

So many activities in the boom — from home speculation, to NINJA loans, to subprime securitisation, and ultimately the 40-year cycle of total credit growth that led to the Minsky Moment in 2008 — proved unsustainable. But a huge cost has already been paid for those unsustainable activities in the form of the initial crash, and depressed growth, and unemployment, etc. The structure of production has been irrevocably changed by the bust. But are the people suffering the unemployment, the depressed real wage growth, etc, the people who created the total debt growth? No, of course not. Any connection is arbitrary — the people creating the credit default swaps and structured securitised products (ABS, MBS, etc) and NINJA loans that triggered the banking crises in many cases have kept their jobs and been promoted. Certainly, some bankers like Dick Fuld who were involved in creating the crisis lost their jobs, but while people who had nothing whatever to do with the banking crisis have lost their jobs or worse have never even got a job.

So who does Kinsley want to consume the spinach? The people who take the hit to their purchasing power in an austerity program aren’t the ones who caused the financial crisis. Perhaps financial regulators and central bankers were to some degree responsible, but the overwhelming majority of people dependent on government income had nothing whatever to do with financial regulation. Though certainly one side-effect of the crisis has been falling tax revenues, which has meant bigger deficits. But structural deficits are actually relatively low, and nominal deficits are rapidly falling. And the actual interest rate cost of servicing the deficits are at record lows and with current soaring savings levels, unlikely to start rising anytime soon. So any appearance of a deficit problem is a side-effect of a depressed economy. Ultimately, austerity will reduce the government’s use of resources — capital, and labour. And what is the problem with the economy at the moment? Slack resources in capital and labour to such an extent that interest rates are at record lows and unemployment is very high. Kinsley’s “spinach” has nothing whatever to do with the problem. In the long run, once the economy is at full-employment and businesses are booming, and interest rates have risen some austerity will be helpful, not least to take the edge off the boom. But why now? Immediate austerity is iatrogenic medicine — misidentifying the problem, and prescribing a cure that harms the patient.

In my view a bust after an economic boom may be to some degree be unavoidable as an artefact of human psychology. Ultimately, we should remember that a credit-driven boom isn’t a sign of overproduction of goods and services, or a society living beyond its means. After all, the demand for goods and services really existed, and the capacity for the production and use of goods and services really existed. Humans are excitable animals, prone to strange twinges  of spirit both in mania and depression. The business cycle delivers the dessert and the spinach in recurrent cycles. Actions have consequences, and the actions leading into the slump have had huge consequences. But what about our present sins? Having the government force more spinach onto a society already suffering from massive unemployment of people, resources and capital is a strange and cruel prescription. We have already had our spinach in the crash of 2008 and the following slump. Huge numbers of people are unemployed, or have dropped out of the labour force, or have not had the chance to enter the labour force. That is the spinach. If the economy was a man, spinach would be coming out of his ears. Michael Kinsley and his intellectual cousins want to offset spinach with more spinach. Yet the economy has much the same or higher pre-slump capacity for ice cream, and pizza and milkshakes and marshmallows. In the long run, society will rediscover its taste for economic growth, for income growth, and all the slack resources will be used up to produce things that people actually want and need. Yet that does not help the unemployed who have eaten plateful after plateful of spinach as a consequence of actions for which they were mostly not responsible. What could help the unemployed? Job creation and putting slack resources to use.

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The World Before Central Banking

In today’s world, there are many who want government to regulate and control everything. The most bizarre instance, though — more bizarre even than banning the sale of large-sized sugary drinks — is surely central banking.

Why? Well, central banking was created to replace something that was already working well. Banking panics and bank runs happen, and they have always happened as long as there has been banking.

But the old system that the Fed displaced wasn’t really malfunctioning — unlike what the defenders of central banking today would have us believe. Following the Panic of 1907, a group of private bankers led by J.P. Morgan successfully bailed out the system by acting as lender of last resort. The amount of new liquidity disbursed into the system was set not by academics like Ben Bernanke, but by experienced market participants. And because the money was directed from private purses, rather than being created out of thin air, only assets and companies with value were bought up.

The rationale of the supporters of the Federal Reserve Act was that a central banking liquidity mechanism would act as a safeguard against such events, to act as a permanent lender-of-last-resort backed by government fiat. They wanted something bigger and better than a private response.

Yet the Banking Panic of 1907 — a comparable market drop to both 1929 or 2008 — didn’t result in a residual depression.

As the WSJ noted:

The largest economic crisis of the 20th century was the Great Depression, but the second most significant economic upheaval was the panic of 1907. It was from beginning to end a banking and financial crisis. With the failure of the Knickerbocker Trust Company, the stock market collapsed, loan supply vanished and a scramble for liquidity ensued. Banks defaulted on their obligations to redeem deposits in currency or gold.

Milton Friedman and Anna Schwartz, in their classic “A Monetary History of the United States,” found “much similarity in its early phases” between the Panic of 1907 and the Great Depression. So traumatic was the crisis that it gave rise to the National Monetary Commission and the recommendations that led to the creation of the Federal Reserve. The May panic triggered a massive recession that saw real gross national product shrink in the second half of 1907 and plummet by an extraordinary 8.2% in 1908. Yet the economy came roaring back and, in two short years, was 7% bigger than when the panic started.

Ben Bernanke, widely seen as the pre-eminent scholar of the Great Depression thought things would be much, much better under his watch. After all, he has claimed that he understood the lessons of Friedman and Schwartz who criticised the 1930s Federal Reserve for continuing to contract the money supply, worsening the Great Depression; M2 in 1933 was just 72% of its 1929 peak.

So a bigger crash and liquidation in 1907 allowed the economy to roar back, and continue growing. Meanwhile, in today’s controlled, planned and dependent world of central liquidity insurance, quantitative easing and TARP, growth remains anaemic four years after the crash. Have the last four years proven conclusively that central banking — even after the lessons of the 1930s — is inferior to the free market?

Certainly, Bernanke’s response to 2008 has been superior to the 1930s Fed — M2 has not dropped by anything like what it did from 1929:


Industrial production has not fallen by as significant an amount as 1929, nor has homebuilding. And there are many other wide-scale economic differences between 1907 and 2008 in terms of the shape of the economy, and the shape of employment, the capital structure, and the wider geopolitical reality. But the bounce-back is still vastly inferior to the free-market reality of 1907. I think there are greater problems to central banking, ones of which Friedman, Schwartz and Bernanke were unaware (but of which Rothbard and von Mises were acutely aware).

Does central banking retard the economy by providing liquidity insurance and a backstop to bad companies that would not otherwise be saved under a free market “bailout” (like that of 1907)? And is it this effect — that I call zombification — that is the force that has prevented Japan from fully recovering from its housing bubble, and that is keeping the West depressed from 2008? Will we only return to growth once the bad assets and bad companies have been liquidated? That conclusion, I think, is becoming inescapable.

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The Non-Paradox of Inactivity

The Paradox of Thrift states:

If everyone tries to save more money during times of recession, then aggregate demand will fall and will in turn lower total savings in the population because of the decrease in consumption and economic growth. The paradox is, narrowly speaking, that total savings may fall even when individual savings attempt to rise, and, broadly speaking, that increase in savings may be harmful to an economy.

It is in many ways a microcosm of Keynesian economics — mostly right, but in a few details spectacularly and outlandishly wrong

(A small detour: In many cases, these few details matter — big time. Austrian economics, of course, is the inverse of this — mostly wrong, but in a few details spectacularly and outlandishly right. I remain unsure as to which set of ideas gives more insight; although I am deeply impressed by some insights of Austrian economics, I generally think the only sensible economic outlook is to scavenge for whatever explanations fit the facts.)

If many people in the economy cease economic activity and hoard their capital, of course the economy will slow down — both in nominal (GDP) and generally also in real terms. Satisfying supply and demand requires a constant and continuous flow of productivity, and goods, and services and money.

Of course there is no paradox there: lowered economic activity is almost always deleterious (the exception being the rare cases when a type of economic activity is itself deleterious to the health of the economy.)

But here is where the paradox of thrift really falls down: saving is not necessarily the same thing as hoarding. Hoarding is saving without investment. And there’s a good chunk of evidence to suggest that more saving with investment is correlated with stronger economic health.

From Lawrence Kotlikoff:

Facts reinforce the idea that spending is no cure-all for what ails America. Most countries experiencing full employment and rapid growth do so while saving at very high rates. China is growing like crazy with a saving rate of more than 30 percent. Japan also saved at very high rates when it was booming. Since then, both rates have plummeted.

The U.S. has also done better when saving was high. In the 1950s and 1960s, saving averaged 14 percent of national income, which grew at 4.4 percent a year in real terms. In the 1990s and 2000s, saving averaged 5.1 percent and national income increased only 2.4 percent.

The connection between saving and growth runs through domestic investment. Countries that save invest not only by building inventory for tomorrow; they also invest in physical capital that makes workers more productive.

U.S. saving is highly correlated with domestic investment; when we save, we primarily invest here at home in starting businesses, buying equipment, and building factories.

In reality, Keynes (and his antecedents) identified an important economic eventuality — a slowdown resulting from hoarding. However, associating this with saving — and subsequently tilting policy toward consumption — is really a misidentification. Societies need investment to grow, and investment requires saving.

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How to Predict the Future

I’ve spent most of today reading.

The modern world appears divided into two camps (no — not those who believe the world can be divided into two camps, and those who don’t): those who believe that man has mastered nature, and those who know better.

The first camp share two chief delusions:

  1. That human beings — through the use of simulations, models, mathematics and other predictive techniques — can routinely make accurate predictions about the future.
  2. That these predictions should be deployed — usually via the power of government — to advance society.

The first supposition has been shown to be largely wrong, both empirically (predictions from models and simulations routinely miss — sometimes by wild margins, as they did during the 2008 meltdown) and rationally (economies are nonlinear systems where the output is not proportional to the input, and therefore chaos will always skew predictions). The second supposition is problematic, because it is dependent upon the first one being true.

The problem is that human beings want to predict the future — and accurately. Businesses want to be able to know what products will be selling in six months, six years or sixty years, so they can make money from it. Children want to know what field to study at college, so that they can get a paying job. Governments want to know what interest rates will be in three months, six months or 10 years, so they can decide how much to borrow. Scientists want to know what amounts of greenhouse gases will be emitted over the next half century, so they can attempt to model climate change.

And most significantly, those in power want the (often-undeserved) authority granted by a “window on the future “.

The best way to come-to-terms with this problem is to treat it as an advantage and not as a disadvantage. It is inevitable that there will be some forms of mathematical, statistical and predictive modelling, just as it is inevitable that philosophers and historians will write predictive literary works. Some will be wrong, and some will be right. The key is that it must be safe to be wrong. Societies, communities, individuals and organisations should plan for the future based not on the idea that the future is predictable, but based around the fact that the future is uncertain, and fundamentally difficult to predict. This means that everything needs leeway to break.

Some crucial examples:

  1. An international financial system which is torn down via a default-cascade through default of one bank or one nation is not robust to bad predictions.
  2. A banking system which is torn down through debt-deflation during a credit contraction is not robust to bad predictions.
  3. A lifestyle in which one bad prediction leads to serious illness or injury is not robust to bad predictions.
  4. An organisation  or family whose wealth (or health) can be destroyed by uncontrollable externalities is not robust to bad predictions.
  5. A nation dependent on the import of credit, resource and goods from hostile nations is not robust to bad predictions.
This just means that economists, writers, historians, bureaucrats and just about anyone who claims that they need to predict the future (that’s all of us, occasionally) needs to frequently and honestly ask themselves the question: what happens if I am wrong?