Arnold Kling  

Fundamental Causes

The CBO Offers Hansonian Chart... An Interesting Editorial...

Tyler Cowen invokes Fischer Black.

in his 1991 book, "Business Cycles and Equilibrium," and his 1995 work, "Exploring General Equilibrium," he argued that major business downturns could be caused by a combination of excess risk-taking and simple bad luck.

If this view is correct, then the fact this occurred in mortgage securities is pretty much an accident of history. Wealthy people wanted to take some risk, and if they hadn't done it in mortgage lending they would have done it in something else.

It's true that all sorts of risk premiums were artificially low in recent years, not just the risk premium on mortgage lending in the United States. And perhaps a general risk premium crash was going to happen no matter what. Still, I think that there is something even more fundamentally wrong: the discrepancy between dispersed knowledge and concentrated power. The concentrated power in the mortgage industry, with its Wall Street-Washington axis, produced particularly bad distortions.

In the absence of government distortions, speculators might have channeled more funds into investments other than inflating a housing bubble. Some of the other investments might have also been unsound, but they would have been more diverse and perhaps more socially beneficial.

What we are seeing now is the Freddie/Fannie model applied to the entire financial sector. You need a government guarantee in order to be a player. Once government-guaranteed firms are on a firm footing, the equivalent of "affordable housing goals" is sure to follow. That is, government will be bossing capital around to an even larger extent than before.

The claim that this crisis was caused by "deregulation" is a claim that government needs to exercise more power. Right now, that is the conventional wisdom of the establishment. There is no mainstream newspaper or politician raising any doubts about the wisdom of increasing government power. The free market is now a fringe phenomenon, and those of us who support it are irrelevant.

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The author at Maggie's Farm in a related article titled Monday morning links writes:
    Why do I think the support of people like Powell and Warren Buffet is helpful to Obama? It's helpful because these establishment folks are saying that he's not a bomb-throwing radical. Me? I dread the effects of an Obama-Reid-Pelosi triumvirate on America [Tracked on October 20, 2008 6:16 AM]
The author at Leading Questions in a related article titled The Ethic at the Heart of the Real Financial Crisis writes:
    It has been apparent to me that at the heart of our financial crisis is the issue of trust. In an very interesting Wall Street Journal interview, Anna Schwartz, a 92 year old historian of monetary policy, states,To understand why, [Tracked on October 21, 2008 1:19 AM]
COMMENTS (28 to date)
shayne writes:

Just to point out a subtle, but [I think] critical distinction:

"That is, government will be bossing capital around to an even larger extent than before." [Emphasis mine]

It isn't capital they're bossing - it's just money. Money isn't capital until it's deployed in such a way as to expand possible future returns - Investment.

It's that artifact of the current trend in government meddling that has me most concerned. Given the first $150+ Billion economic 'stimulus' package, the $700+ Billion bailout, the additional commitment of pre-existing Fed monies to bailouts, and the $300+ Billion 'stimulus II' package now being considered in Congress, Government seems convinced that a $13 Trillion economy can only survive with an additional $2+ Trillion of borrowed monies. And with the overwhelming majority of it unleashed on the Consumer component of the economy, not the Investment component.

Steve Sailer writes:

There will always be another bubble and another crash, but the number of years between crashes matters a lot in terms of total increase in wealth over a generation.

cato writes:

say it isn't so arnold:

"The free market is now a fringe phenomenon, and those of us who support it are irrelevant."

We need you to continue to describe your best thoughts on the crisis amidst the clamour of political takeovers of the economy.

I predict that ten years from now the books written about this crisis will reference your early thoughts extensively.

Thingumbob writes:

Well since we're on the subject of what was done to quell speculative excess in the 1930s, the 800 lb gorilla in the room happens to be Bretton Woods. Why? What led to derivatives (recently rightly referred to in Congressional testimony as the latest incarnation of Bucket Shop practices) engulfing the world monetary system? It was none other than the end of the system of settling imbalance of trade among nations in gold. After the Nixon administration pulled the plug on this in 1971 the scene was set for a global casino of currency speculation. One bubble after another was created and blown out. Now we are at the point of either attempting insanely to further hypothecate our economies or to return to the Bretton Woods system of stability.

E. Barandiaran writes:

I suggest to read this interview to Anna Schwartz

Paludicola writes:

Jacob Weisberg has declared that Libertarianism is dead, so I suppose that that's that.

E. Barandiaran writes:

As long as you fail to criticize people like Tyler, don't be surprised that no newspaper or politician raises any doubts about the wisdom of increasing government power. In his article, Tyler starts with the idea that "Many countries — not just the United States — came to have fundamentally unsound banking systems." Then he jumps to his three forces/trends/factors: "All three were needed to bring about the scope of the current mess — so that means we’ve had some very bad luck on top of everything else." Finally, he attempts to support his argument by making reference to Fisher Black. This is Monday morning quarterbacking at its worst: totally useless for the next game. Unsound banking systems? Excessive risk taking? Systemic/systematic risk? Too many adjectives that we have been discussing for years; forget about Kindleberger, Minsky, Simons, and just look at the thousands of papers and books written in the past 10 years. Only ex post we may agree to call a particular situation unsound, excessive or systemic--ex ante they mean anything you want. You will see this sort of quarterbacking in the meetings of world leaders called by Bush and Sarkozy for next month. You can compare this nonsense with the clear reasoning of Anna Schwartz (although she is 92).

Greg Ransom writes:

Lets see.

I can believe Anna Schwartz, who changed macroeconomics forever, or I can believe Tyler Cowen, whose barely known claim to fame as a macroeconomis is an attack on a line of thought he demonstrably misunderstands, and never seriously studied.

I'll go with Schwartz.

Steve Roth writes:

E. Barandiaran: "I suggest to read this interview to Anna Schwartz"

Thanks, E., for pointing that out.

Ms Schwartz says that we should hew to the very "creative destruction" philosophy that justified the inept monetary policy that she and Friedman so effectively disparaged. Because this time it's different. Really.

The dizzying depth of these nested ironies is approaching the level of clinical schizophrenia.

Arnold: I would be extremely interested to hear your response to Professor Livingston's recent posts. They strike me as insightful, even profound, in articulating a plausible mechanism of causation for this crash and that big one, both:

El Presidente writes:

I think Tyler is observing the phenomenon accurately.

Try this on for size. If you had a choice between paying $2M and receiving no direct return, or paying $2M and receiving your principal plus interest equal to or slightly above the rate of inflation, which would you choose?

If you are in a high tax bracket you probably look for ways to minimize your tax liability. While Treasury bills aren't the best investment, they offer far better returns than taxes. That is, they allow an INDIVIDUAL to recover more value than can be appropriated for personal use from public expenditures. Please understand that I am not accepting the notion that government spending is less efficient than private investment. I am only stating that selfishly "rational" individuals prefer low-yield investments to taxes.

When we balance the budget and begin paying off the debt, we are replenishing the capital we have borrowed; increasing the liquidity of the market in a certain sense. The money will now seek another investment, another source of return. This drives up risk tolerance for want of alternative investment, and this activity is directed by those with considerable personal and institutional wealth.

I don't think this has to end catastrophically, but I believe Tyler is framing an accurate portrayal of events. Knowing this is apt to occur is a good reason to adjust tax policy and regulatory policy to balance the risk-taking behavior and prevent it from introducing unnecessary and potentially destructive volatility into the market.

There are similarities and differences between our current situation and the crash of '29. One similarity was consolidated wealth chasing large returns and accepting increasing risk on behalf of other market participants. This leads others in the market to dance while somebody fires a pistola at their zapatos (market volatility). The volatility results in "bubbles" that grow bigger and last longer than those we would otherwise be accustomed to. The bubbles themselves are not oddities. It is the size and duration that are unusual and problematic. One significant difference is a much higher rate of market participation. This means that we are all much more directly affected by the excesses. The subject of the asset bubble, housing, is also very different. It is the largest single asset purchase most people will ever make. These differences have widely distributed the risk allowing the potential magnitude of the boom and bust to grow even larger.

Beyond this, the mortgage, as an instrument, is a form of redistribution. It is a purchase contract for a fixed-term annuity representing a share of the seller's (home buyer's) income. It is private. It is consensual. It is redistribution. When redistribution occurs on a massive scale, there are consequences to the larger economy. It changes the incentives for other economic activities, the going rate of return for given risk, etc. If we were to raise the marginal tax rates for the highest brackets, that would decrease private investment and consumption while increasing government savings. There is no less a change when a boom in mortgages on overpriced assets transfers an increasing share of future income to the wealthiest. This contributes to the already extreme disparity in the distribution of income, stoking the cycle that produced the volatility which brought about the asset bubble and looser credit in the first place.

This is why I believe the Community Reinvestment Act and use of GSEs to facilitate mortgages were not the only culprits and didn't have to result in catastrophe. Large reduction in capital gains tax rates combined with a return to increasing debt financing of operating expenses by the federal government created an environment in which the expansion of credit was no longer tenable. Consolidated wealth had a renewed hedge (federal debt instruments) against risk to individuals and the damage they could cause to the larger economy, as well as the promise that they would pay a reduced share of taxes in the mean time. If we had instead increased capital gains tax rates and maintained pay-go, wouldn't investors have been very cautious about increasing federal expenditures? ? ? Can somebody say "moral hazard"? If we had held the budget in balance, there would be nowhere to run and hide. There would be no increase in the federal debt ballast that facilitates this behavior. Without the tax cuts, investors would have a larger incentive to pursue a stable economy. Short term profits would not be as easy to come by and the repayment period for investments would be extended changing both the volume of investment spending and the nature of winning investments.

Frejus writes:

"but they would have been more diverse and perhaps more socially beneficial."

Total speculation on your part. You are making an argument that speculates in support of your case. Not warranted or backed up by facts.

The stock market in 2000 crashed and burned not because of distortion but for a more basic reason: herding.

Markets are bubbly at times. The fact that they are is not an argument to do nothing. Hiding one's head in the sand is not a strategy.

That's what the free market folks are losing right now. They were wrong. Consider this blog: Said a few years ago only a 20% change of housing meltdown--wrong. Supported Bush's war in Iraq--wrong. Supported Bush and right wing ideologues (read Norquist and Delay) that have DIRECTLY lead to the failure of libertarianism--wrong.

As the saying goes: you reap what you sow.

MattYoung writes:

I agree that concentrations of power eventually cause severe recessions, and smaller concentrations of power cause minor, sector localized recessions.

That still leaves you with the task of computing how much concentration is too much. Even when the concentration of power is optimum, there will still be moments in which an external technology shock could cause a severe recession, because a severe enough technology shock requires even concentrated power to adapt to the new "means of production" to quote Marx.

If course, if the power structure of government, built in 1787 is now way off equilibrium because of geographic expansion, then we will eventually we should break things up, without another civil war.

Grant writes:


Total speculation on your part. You are making an argument that speculates in support of your case. Not warranted or backed up by facts.

That isn't speculation at all! Far too many houses were built during the boom. There were more banks wanting to give out mortgages than there were good borrowers. No one doubts that had more money been invested in things other than mortgages and home construction, we'd all be better off. That is the essence of a bubble: over-investment in some asset.

Markets are bubbly at times. The fact that they are is not an argument to do nothing. Hiding one's head in the sand is not a strategy.
Who advocates "doing nothing"? There will always been clusters of bad investments, maybe for reasons inherent in markets, maybe for reasons inherent in human beings, or both. To fix these bubbles you have to have a mechanism that out-performs markets; simply "doing something" doesn't cut it. In short, a political solution would need to:

1) More accurately identify bubbles than the market process can.
2) More efficiently work to dismantle bubbles than the market process does.
3) Do these things without imposing significant costs on the market or taxpayer.

Remember that markets can dismantle bubbles already. You need to show that government would be better at it, and I'm not sure if there is any evidence of that. Asserting "markets fail, use government to fix them" is just plain lazy. You have to show that government can in fact solve the problems you claim it can. What it ought to do presupposes what it actually can do, so can you explain to us how government can out-perform markets in this respect?

Brad Hutchings writes:

I think the background point Tyler is trying to make is that housing is not exceptional, and thus socializing the housing market is not warranted. I'm sympathetic to where I think he's coming from.

The $700 Billion Paulson plan is a giant wad of cash looking for something to do. It's already shown that it's not going to do what anyone thought it was going to do, in forcing the big banks to sell ownership positions to the government. The other plan for the Paulson money on the table is McCain's $300 Billion plan to prop up housing values by buying foreclosed properties. How far are we from the government setting the prices of homes by fiat?

There's a significant portion of the American public that believes that health care ought not be subject to the market economy. Are they not ripe to think the same about housing, of which new construction and sales represents 5%-6% of GDP, if they believe that the housing bubble was caused by the finance system, rather than by a variety of factors? They already believe that government could regulate the industry to avoid the problems.

We believers in free markets are in a tough spot now. The housing crisis is so big, it overshadows the Presidential election. Anyone who will do something in this emergency has the political upper hand over those who would prefer to let the market figure its way out of the problems. So we're going to get a lot of bad plans, plans that consolidate power, plans that will be like spitting into a tidal wave. And we need lots of different arguments at our disposal to try to slow down whatever madness ensues. While Tyler's argument may not quite be applicable to the mess as it's understood this week, it could be the perfect retort to what ensues next.

Bill writes:

Is Anna Schwartz one of those crazy Austrian economists? Probably not... but her analysis is the same: From the WSJ link above. Sorry for the long quote but I think it's pretty remarkable:

How did we get into this mess in the first place? As in the 1920s, the current "disturbance" started with a "mania." But manias always have a cause. "If you investigate individually the manias that the market has so dubbed over the years, in every case, it was expansive monetary policy that generated the boom in an asset.

"The particular asset varied from one boom to another. But the basic underlying propagator was too-easy monetary policy and too-low interest rates that induced ordinary people to say, well, it's so cheap to acquire whatever is the object of desire in an asset boom, and go ahead and acquire that object. And then of course if monetary policy tightens, the boom collapses."

The venerable Ms. Schwartz goes on to skewer Alan Greenspan and describe what's wrong with the government's newest panacea. As E. Barandiaran above suggested the whole article is a wonderful read:

I know Mr. Kling (via a bloggingheads interview) discounts the influence of expansive monetary policy... perhaps this statement by a giant of his field (and monetarism in particular) will prompt him to look into this a little more?

Cowcup writes:

Mr Kling, could you please analyze the effects of FED's doing since Oct 2007. I recently read a speech of Ben Bernanke from that period. I didn't notice the date first and I thought it's given in this year.

My impression of Tyler Cowen's and for example, Kenneth Arrow's analysis is that they seem to abstract away too fast based on what is widely known so far. But it seems they paid little attention to what happened in the previous year. They didn't for example analyze what's FED doing during that period. It is as if before Sep 2008, it's only Wall St and Fannie Freddie meddling with risks.

As far as I can tell, it's probably not like that. It's not that market can't deal with risks by their own. At least the evidence is not strong enough. It would be, in programmer's jargon, a premature optimization or premature abstraction to assume the root cause is that market made mistakes dealing with risks. And I notice in your writing, you are sliding towards that direction too, maybe.

I hope, in contrast to the way of thinking of Kenneth Arrow, people could pay more attention to the way of thinking of Coase. The facts should be straight out first before theorizing.

Sincere hopes.

Cowcup writes:

And by the way, Mr Kling, you really shouldn't be too pessimistic. Think about Milton Friedman, he lived through Great Depression and WWII and Great Society and Vietnam Draft. He triumphed. The only possibly bigger challenge we are facing is the new-clear issue. And the chance of it going awry in the next 4 years is not that big, I believe.

As Vernon Smith said, bubble and burst cannot really be avoided since there are always green people joining the market. One can argue that the left-right thing is about the same. You always have new voters come along.

The lost opportunity for you guys, I mean, academic economists, is you lost a chance to win Nobel. I think. :D If I were a young economist in the ivory tower, I would feel really, really bad these few days. :D But we know that Keynes only wrote his stuff AFTER the Great Depression, so I do think you guys should work hard, harder. :D

P. Allen writes:

It’s really discouraging to see the one-sided nature of the analysis of the liquidity GROWTH crisis (not actually liquidity itself mind you). May I present the other side of the coin. Perchance, instead of being over leveraged, was the economy not leveraged enough? And, subsequently, is it still on course to increase leverage, Fed be dam*ed?

Most of the conversation surrounding the recent malaise in the financial sector hinges on subprime borrowing, which has been chastised as a practice in undisciplined lending. However, when most of these mortgages were written (by one of the largest and most diverse industries in the global economy, the financial sector) they made a tremendous amount of economic sense. Sub-prime mortgages are typically variable rate products that start out as fixed then adjust to the Prime Rate plus some sort of market driven spread. What is important to point out here, though, is that the Prime Rate is a spread product itself, tied explicitly to changes in monetary policy through the open market operations of Fed funds (a spread of roughly +3.0 % since the early 90’s). Therefore, these specific products basically leave the borrower unhedged against any aggressive movements (and subsequent errors) by the Fed in the short run.

Now when a majority of these subprime contracts were being written in the early part of this century, Fed funds (for better or for worse) was averaging around 1.5%. During that period, the Fed was having a difficult time trying to convince the market that then-current levels of monetary policy were temporary (Perhaps because they weren’t all that “low” and actually were deemed close to correct by the economy, but I digress) therefore the risk inherent in subprime mortgages created in this environment was actually true, barring of course, any grievous error by Mr. Greenspan.

Over the next five years the Fed more than tripled its target overnight lending rate under the guise of combating not real but “expected” inflation. (I don’t know about anyone else, but I can’t feed my family with “expected” food, it has to be the real deal) Rightfully so, the market was not kind to Mr. Greenspan’s motives as yields on longer government securities (in this case the 30yr Treasury Bond) fell almost in lock step with tighter monetary policy expectations. (i.e. a significant flattening of the yield curve, the most important gauge any central banker can watch) The conundrum (see the quote below from the Fed’s testimony on Capitol Hill back in Feb ’05) that he then misplayed through either hubris or ignorance (I’ll let history decide) is the exact point at which monetary policy became disastrously deleveraging to the financial sector (Actual Fed funds was at 2.5 % in Feb ’05 with a 3.5% rate priced in 6 months out). In the end the economy is going to get what it needs, it is the financial sector that will continue to suffer by it.

Why does the economy need some much leverage right now? Simply put, the economy has an over supply of productivity that is mostly going unused. Just like a bulge of inventory sitting on the docks or shelves, the domestic economy has amassed a tremendous amount of efficiencies during the last growth phase (83-99) of the current productivity cycle. In order to unlock this potential, leverage (and its natural byproduct liquidity) is the correct tool for the job.

Too much productivity? Seems like a nice problem to have. Well as any economists or business owners (worth thier salt) will tell you, there is no such thing as a good problem or a bad problem. A problem is a problem is a problem. (The fact that it is a surplus or deficit is secondary, the fact that it is an imbalance is the real significance) The surplus nature of productivity is creating an above average wedge in the output gap (potential output versus realized GDP. Productivity, you may recall, is a key component to potential GDP) and that is at the heart of the matter. Don’t believe me? Look at the stats.

Since 1948, productivity growth has lagged that of GDP growth by an average of 1.09 percent. Since 2000, however, productivity is outgrowing GDP by 0.28 percent. Believe it or not, producers need to realize an appropriate amount of the glut of efficiencies currently inherent in the economic landscape before they can create more. Of course, some potential will be wasted (as the government’s relief package is set to do), but right now it is still economically favorable to close the output gap by realizing more growth (than wasting potential) through leverage. This process, by the way, results in pockets (not a spiral) of severe deflationary pressures much like we have seen since the growth phase of the productivity cycle gave way to the surplus phase in 2000.

Notice that despite all the mounting “inflationary pressures building” through the burden of mounting government debt, that the 30yr bond has returned almost 20% on a total return basis over the last year (not bad for a 4.5 percent coupon bearing security) while comparable TIPs (sorry Arnold) have posted negative returns! Notice also, that the 30yr is setting new interest rates lows over the last month while TIPS are crashing and the dollar is rising. That is not a flight to quality my friends, that is actual economic fundamentals at play. (C’mon libertarian economists, this should be your finest hour! The markets told the Fed not to do this, they did it any way, and they are now paying for it.) The economy is driving market rates lower to provide the leverage needed to exploit the tremendous amount of cost cutting productivity weighing on the landscape. The Fed destroyed the financial sector by pulling the rug from under their collective feet by ignoring, perhaps the strongest market signal ever sent. That is the cause of this crisis. Not excessive risk taking by mortgage lends, careless monetary policy decisions by the Fed. My friends, not only does the market work, it works phenomenally!

My prediction going forward? Expect long-term interest rates to move significantly lower over the next decade as well as the unemployment rate. Both could easily bottom out under 3.0% at some point over that timeframe. High grade corporate credit, as a result, will outperform almost all asset classes in this scenario. The reaction on the 30yr, TIPs, and the Dollar are a few of the “unexpecteds” that have cofounded experts so far. The next will be the avoidance of a recession, the appearance of a mass of supply of everything, the drop in service prices, and the resiliency of the consumer.

“In this environment, long-term interest rates have trended lower in recent months even as the Federal Reserve has raised the level of the target federal funds rate by 150 basis points. This development contrasts with most experience, which suggests that, other things being equal, increasing short-term interest rates are normally accompanied by a rise in longer-term yields……... For the moment, the broadly unanticipated behavior of world bond markets remains a conundrum.”- Alan Greenspan before Congress on Feb 16th, 2005

El Presidente writes:

P. Allen,

"My prediction going forward? Expect long-term interest rates to move significantly lower over the next decade as well as the unemployment rate. Both could easily bottom out under 3.0% at some point over that timeframe. High grade corporate credit, as a result, will outperform almost all asset classes in this scenario. The reaction on the 30yr, TIPs, and the Dollar are a few of the “unexpecteds” that have cofounded experts so far. The next will be the avoidance of a recession, the appearance of a mass of supply of everything, the drop in service prices, and the resiliency of the consumer."

Is the market in the habit of making three lefts in order to make a right? If this is the way to such imminent prosperity then why worry about feeding your family "real food"? The volatility itself is problematic because it robs the economy of directional momentum and causes individuals to pull back from the involvement they would have to pursue in order to make your predictions come true, ceteris paribus. The US economy, and perhaps the whole world, has taken a wrong turn down a dead-end street. It will need to back out of the alley in order to resume a better course. It won't be able to crash through a wall into some glorious economic nirvana. It would be nice, but it won't happen. There will have to be policy changes in order to restore confidence and create some measure of stability. If we could negotiate a grand compromise of income/wealth distribution that would make your vision of increased leverage possible via increased faith in our ability to predict and achieve certain outcomes, what would that look like? Would there be "real food" in that world?

Modern economies depend on good faith; trust. That's what brings our food and everything else to us from places we have never seen and people we have never met. It's what enables the leverage that you are asking for. It's what assures us that giving our money to strangers working for banks whose name on the front of the building might change overnight will not result in our complete and total ruin. Trust needs stability. When trust disappears, there is no economy. Where will you get your real food?

> The free market is now a fringe phenomenon, and those of us who support it are irrelevant.

I'm starting to get worried about the future and its prospects for economic growth. Please tell me that a bunch of libertarian economists are holding secret weekly meetings to devise a strategy on how to win back public opinion in ~10 years, after the failure of increased government intervention becomes clear. Please...

Steve Sailer writes:

Political correctness makes you stupid, and stupidity is expensive. California accounts for about half of all the mortgage default dollars so far, but it was never plausible that today's California population could pay off their huge mortgages. The median California is just too dumb to earn that much money. California's students rank between 44th and 49th in the country on the NAEP tests of school achievement.

But, who says these kinds of things? Well, there's me. But if you put them in an email to your colleagues questioning our investments in the California market, it will turn up in discovery in the next discrimination suit against your firm. You will be fired and your firm will have to promises to loan out more money to deadbeats.

E. Barandiaran writes:

A few days ago, in response to a TC's post in Marginal Revolution I posted a comment with the title "Wall Street y los monos" (Wall Street and the monkeys). It is a joke about how Wall Street is supposed to work--it displays the fraud that may underlie any transaction. I heard it first in Argentina, around 1981 or 1982, at the beginning of what would be a terrible decade of hyperinflation and heavy income losses. In Argentina, it has been repeated many times and not surprisingly in the past few weeks it has been recycled. For a majority of Argentinians and many other people around the world, the financial system is not a casino but a Ponzi game that justifies a Willie Sutton. For libertarians, it is not consolation to know that for most of these peoples, the same government that has been stealing their money for centuries should prohibit or at least regulate tightly all financial transactions.
For libertarians financial markets is not different from other markets, except for the high degree of trust that financial transactions require. Building financial systems requires a lot of trust, like building the human castles shown in these two videos:

It is not contagion but the collapse of trust that breaks down financial systems.

NOTE: The best example of contagion that I have heard of (thanks to Prof. J. Danilsson of LSE) is shown in this type of situation:

Larry writes:

One reason we had a housing bubble is that the ocean of money looking to become capital has grown much more rapidly than the world economy in recent years. See, e.g., OPEC and BRIC. With a better tax and regulatory regime we could have kept it from piling into housing, but it was going to pile in somewhere.

If the situation of savings growing faster than investment opportunities persists, we're going to have a long-term lowering of returns. Either we'll see a series of bubbles-that-pop as the sheep flock from fad to fad (next up: alternative energy) or as a generalized bubble that will inflate more slowly because its scope is much broader. That (super) bubble will pop too, one day.

The US isn't over-saving. We're over-consuming. The rest of the world is the problem. Can we get them to shift towards a better balance between savings and consumption? Perhaps not until they reach a much greater level of wealth.

El Presidente writes:


"If the situation of savings growing faster than investment opportunities persists, we're going to have a long-term lowering of returns."

Exactly! When more money is distributed at the bottom of the income spectrum, we get a wealth effect. When it is distributed at the top of the income spectrum, we get the same wealth effect, more heavily weighted in investment due to the difference in MPS & MPC for those with higher incomes. This leads to expectations of increased profits where none can be found. Profits are thus manufactured via "creative accounting" or greater risk-taking ensues until some of the cash is redistributed downward through losses on risky ventures; or until the money itself is withdrawn from the economy by government in a taxes-for-bonds swap. Monetary policy cannot achieve this transition since monetary policy didn't create it. It is a purely fiscal shift that fiscal policy must address.

P.Allen writes:

“It won't be able to crash through a wall into some glorious economic nirvana.”

El Presidente-

Who said anything about economic nirvana? Certainly not I. We are facing a very critical productivity imbalance. While that will ultimately lower the unemployment rate it will keep wages stable, meaning no wage growth! Corporate earning will also suffer as companies compete to lower prices , however, cashflows will remain positive. Concentration will swing to growing marketshare not growing the market. It is here that you will find your “directional momentum”. The economy will grow (hence the no recession) but it will grow at a subpar rate over the next decade. The output gap will widen further, creating a further drain on all things “liquidity growth”. Those that did not have the adequate time to respond (again the Fed effectively pulling the leverage rug from under their feet) to exploit the abundance of cost cutting will have trouble surviving in thier current form, if at all.

It is what it is. I argue for more leverage and that is exactly what the economy is doing through the downward pressure on long-term interest rates. Jobs are aplenty because there is a tremendous amount of work to do (No need to create ‘em when you are having trouble filling ‘em). Higher incomes are not because we can either do the work or let it go to waste, the choice is ours. Trust? Trust in the economy, not the Fed. You may question my thesis, but you have not responded to my facts. Why are longer-term interest rates falling? Why is the dollar gaining strength? Why did not $4 gasoline kill the consumer? Why did $3.50 loaves of bread not starve a nation already living on borrowed time?

Could it be that perhaps the consumer got just a bit more efficient? Could it be that producers are also getting more efficient? Could it be that we have grossly underestimated just how productive the economy can be in its current form. If so, increasing leverage makes a h#ll of a lot of sense. This is no nirvana my friend. This is life. Deleveraging the economy was a huge mistake, something the Fed may have a hard time living down when things get real ugly about a decade from now. (If I sound a tad bit angry it is because I have two sons that will be of conscripting age at that point)

Don’t paint me Pollyannaish my friend, this is an imbalance that will be corrected. The choice is to do it the economy’s way (realize more growth) or the government’s (waste more potential). Either way the output gap will compress to a more acceptable range over the next 10 years. I’ll take my cues from real market fundamentals not imaginary inflation expectation conjured up by the central banking wizards in the bowels of the Fed building. I stopped believing in the bogeyman when I turned 5, I suggest the Fed do the same and get the h#ll out of the way so we can get something done about this.

Larry writes:

"When more money is distributed at the bottom of the income spectrum, we get a wealth effect."

Not unless those receiving the money perceive it as a permanent income increase. Otherwise no wealth effect. One-time rebates don't have a wealth effect. Nor do temporary tax cuts. And of course, if it's purely redistribution, you get a negative wealth effect among the givers (taxpayers).

"When it is distributed at the top of the income spectrum, we get the same wealth effect, more heavily weighted in investment due to the difference in MPS & MPC for those with higher incomes. This leads to expectations of increased profits"

Profits can increase and continue doing so when the economy grows and productivity increases. Investment can accelerate both.

El Presidente writes:

Not unless those receiving the money perceive it as a permanent income increase. Otherwise no wealth effect.

This is absolutely right. Capital gains rate cuts amount to beefing up disposable income for those whose income comes directly from capital gains, those generally congregating at the top of the income spectrum. It's an increase in a stream of income. A matching change in an income stream to everybody else would be necessary to balance that unless there was a pressing need/opportunity to increase investment spending in a way that would actually proportionally benefit everybody else. I would agree that a "stimulus" or multiple stimuli will not result in a wealth effect. At best, it will result in higher deposits who's ownership is maintained by the depositors instead of the financial institution. But the roulette wheel keeps on spinning and the dealer continues to clear the table with each spin. There's a hole in the boat and our bucket isn't big enough.

Profits can increase and continue doing so when the economy grows and productivity increases. Investment can accelerate both.

Can, yes. But maybe introducing more capital into an economy with high capital intensity relative to the rest of the world pushes us away from a balanced-growth path and provides a lower return than either enhancing the productivity of other nations or investing in the efficiency of labor at home. Investing in (E) here would require a higher median real wage in exchange for improved individual commitment to education. Declining marginal returns to capital mean that, though we may grow, it will be slower, and other places with higher growth rates will become more attractive investments. If we bet on capital, we could lose. I wouldn't say it's certain, but I do think it's plausible.

El Presidente writes:

P. Allen,

Don’t paint me Pollyannaish my friend, this is an imbalance that will be corrected. The choice is to do it the economy’s way (realize more growth) or the government’s (waste more potential).

I would like to say that I respect your views and you personally from my experience with you on this site. I've been on somewhat of a terror for a few days I suppose. Please accept my apology if my remarks strayed from the theoretical into the personal. I'm attempting to right my course.

Simultaneous 3% interest and 3% unemployment, especially for any sustained period of time, sounds pretty good to me. I do not wish to paint you as pollyannaish, but I am concerned that your projections are too optimistic. I don't feel that they are justified by a preponderance of what I am seeing. Instead, I think that if they are correct, it will require a great deal of faith to push through this trouble to get to the place you envision. Again, I don't mean that to be derogatory in any way. Still, my faith that we will reach a new plateau is shaky, at best, because I don't see it as being compatible with the sentiments of our society or the trend in the world generally. When the news of the hour is that an increase in marginal rates is tantamount to socialism, that tells me that the public is not ready/willing to rise to that plateau and remain there for an extended period of time. It is possible, and I may be wrong. Here's to hoping you're right.

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