Arnold Kling  

Brad DeLong on the Crisis

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He writes,

In normal times, our models predict, with the ability to diversify portfolios that exists today the risk discount on assets like corporate equities should be around 1% per year. It is more like 5% per year in normal times -- it is more like 10% per year today.

Read the whole thing. I give Brad a lot of credit for steering clear of IS-LM analysis and trying to re-think macro from the ground up.

In my important 9th lecture on macroeconomics, I said that the financial sector tries to hold long-term, risky assets and issue short-term, risk-free liabilities. What has been going on this year is a massive reversal of that. Financial institutions are fighting and clawing with one another to shed long-term, risky assets and instead acquire short-term, risk-free assets. The financial sector has become dysfunctional in a really major way.

The trick is to right-size the financial sector while slowing down the pace of de-leveraging. In my opinion, the bailouts and rescues are not helping with either process.

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COMMENTS (11 to date)
fundamentalist writes:

DeLong’s article is not an analysis of the crisis, but merely a description of what happened. He really offers no explanation for the causes of what he describes.

DeLong: “From my standpoint, the puzzle is multiplied by the fact that we economists have what we regard as pretty good theories about (4) and (5), and yet those theories do not seem to work at all.”

He got that right! Strange that he realized this but refuses to accept other answers.

BTW, what Delong calls “Liquidity Discount” is essentially what Austrians call time preferences. There might be some disagreement over his math for determining it.

DeLong: “And our models for why the risk discount has taken such a huge upward leap in the past year and a half are little better than simple handwaving and just-so stories. Our current financial crisis remains largely a mystery: a $2 trillion impulse in lost value of securitized mortgages has set in motion a financial accelerator that we do not understand at any deep level that has led to ten times the total losses in financial wealth of the impulse.”

I don’t think most Austrians, even Larry White, would quibble too much with what DeLong has written. We would simply agree with him that “those theories do not seem to work at all” in explaining the crisis. They are correct as far as they go, they’re simple not sufficient.
DeLong: “And this automatically rules out what I regard as the most likely and fruitful road to walk down to understand this financial crisis: the road that starts from investigating how human psychological limits lead to bad private-sector contract design that then magnifies psychological biases. I am not happy with the state of such explanations-they seem to involve, at the moment, a great deal of handwaving.”

So DeLong prefers psychology to economics. That explains a whole lot about his writings. However, like Larry’s dismissal of greed, DeLong’s favorite answer must explain why humans bump up against their “psychological limits” on a regular basis. And in spite of his unhappiness with the “state of such explanations” he won’t consider anything else.

DeLong: “In the past two years the wealth that is the global capital stock has fallen in value from $80 trillion to $60 trillion.”

Here is the crux of DeLong’s confusion. He assumes that we have an objective standard for measuring wealth. Now in the physical world we do have objective standards. Liters, kilometers, tons, inches, etc., change very little with time so that a kilometer this year is the same length as it was a decade ago. But with what do we measure wealth? We measure it with money and the value of money changes from year to year due to changes in its quantity relative to quantities of goods and services available. Over the past century the dollar has lost 99% of its value in relation to goods and services. The situation is similar to what would exist if the kilometer shrank by about 5% every year. Measuring distances would be very difficult. Economists compensate, to some degree, for the devaluation in the dollar by deflating prices with different price indexes. A problem with the indexes is that they don’t include asset prices.

So what does all this have to do with the global capital stock falling by $20 trillion which DeLong can’t account for? It has to do with fractional banking, which DeLong refuses to learn about or discuss. The money supply expands primarily by banks granting more loans. In the past five years everyone took on a huge amount of debt and thereby expanded the money supply. Since the quantity of money grew relative to goods and services, the value of money fell again. Stated another way, when the value of money falls, we see that as a rise in prices, especially in assets. So a large part of the growth in capital stock worldwide was little more than a growth in the quantity of money.

Now what happens when people take on too much debt and someone can’t pay it back? The debt starts unwinding, slowly at first, then faster and faster. Everyone starts trying to deleverage, that is, unload debt. But the increase in debt caused the money supply to grow. So if people get rid of that debt, the money supply must fall and with it the prices of capital stock.

But the money supply hasn’t fallen; it has simply stalled or grown very slowly. However that has the same effect if production continues to increase. A fixed amount of dollars with an increasing amount of production translates into a more valuable dollar, which is the same as saying that prices have fallen. There is the missing billions that so mystified DeLong. It’s all in the Austrian theory of money and business cycles, but DeLong refuses to learn it. However his honesty in admitting how little he knows is honorable and refreshing.

fundamentalist writes:

PS, I should have added that the main way that people pay off debt is to sell assets and when everyone is selling, their prices fall rapidly.

Nick Rowe writes:

What Brad DeLong calls "liquidity" is really time preference, as fundamentalist says. But then true liquidity also exists, as a separate influence on valuation. 30 year US government bonds, for example, are very liquid assets. 6 month commercial paper is much less liquid. Some of the changes in asset values seem to be caused by changes in the liquidity premium, not by changes in time preference.

What Brad DeLong says about money is also not quite right. Money does not disappear when it is loaned out, but is spent, and can then be loaned out again, and again. In principle, it is possible for an extra $1 in money to "hot potato" around the economy and create an extra $1 trillion in loans.

But these quibbles aside, it was a great essay.

El Presidente writes:

"The trick is to right-size the financial sector while slowing down the pace of de-leveraging. In my opinion, the bailouts and rescues are not helping with either process.

Who wants to volunteer to have a band-aid removed from their skin slowly? Who wants to be last in line to leave a burning theater?

Anyone? Bueller? Bueller? Bueller? Anyone? Bueller?

The perceived conflict is between what is best for the individual and what is best for the whole economy. The problem is that we do not think in terms of aligning these interests very well. Nor do we often achieve it. Our libertarian sensibilities often preclude it.

El Presidente writes:

I would add one more.

6. Wealth is the ability to command the resources of others. Resources are finite in an ultimate sense. So, wealth is finite, at least in the short run. Wealth is built on trust, which must depend on truth. Lies and errors erode wealth.

The Snob writes:

DeLong writes,

"We have had little or no bad news about resource constraints, technological opportunities, or political arrangements."

Not sure I buy that. The past 5 years have been full of Peak Oil, global warming, Katrina, Iraq bungling, and T. Boone Pickens buying land to drill for water instead of oil. Big government and big business both appear to be pretty incompetent at the moment.

Peak oil in particular caught my eye because of the number of otherwise serious and respectable people I knew who bought into this economic Lysenkoism. It made me feel like there was something a lot weirder than usual in the zeitgeist.

floccina writes:

I do not understand this:

In normal times, our models predict, with the ability to diversify portfolios that exists today the risk discount on assets like corporate equities should be around 1% per year. It is more like 5% per year in normal times -- it is more like 10% per year today.

The yield on the Vanguard total market fund is 3% and at the peak it was 1.5%. You may say, but earnings were higher than that but that does the investors no good in fact I would say that with thousands of stock owners none with more than 10% of a company, management owns the company and so any retained earnings belong to management. Management certainly acts as if this was the case. If anything the risk discount on assets like corporate equities has been too low.

Carl the EconGuy writes:

I think the real puzzle for macroeconomics is this: macro theories are based on the assumption that economic activities are determined by *real* wealth, i.e., resources and technology. The financial value of assets don't enter in. That's the problem we're seeing now. Without any change in real resources, a recession has hit when the market valuation of real assets changed, without any change in real assets. Where's the theory for that? Asset pricing models are built on estimates of future prices and risk, and therefore include huge subjective elements. All durable assets are therefore like art objects: they are worth what you think they will fetch in the market, now or sometime in the future. In other words, we need a theory that integrates subjective estimates of real wealth with current real economic decisions. Where's the macroeconomic theory of subjective wealth estimates as co-determinants of employment, investment, and growth? We have wreckage of macrotheories around us, that's where we are today. I guess we have just realized that they are wrecks -- meaning that macro theory has been a house of cards all along. Back to the drawing board!

fundamentalist writes:

Carl the EconGuy: "Where's the macroeconomic theory of subjective wealth estimates as co-determinants of employment, investment, and growth?"

I agree! It's in the Austrian Business Cycle Theory.

Carl the EconGuy writes:

Fundamentalist: Austrian theory has a capital theory based on Bayesian principles, but to my knowledge it does not offer a complete macro-theory that explains the dynamics after a big-shift in personal wealth estimates without changes in real assets. Like all macro-theories, it works pretty well when things are tottering along the usual road, but fails to give us clear guidance when we've run off the road in a serious way and are bumping around on the rocks. Or have I missed something?

El Presidente writes:

Carl the EconGuy,

Where's the theory for that?

Marriner Stoddard Eccles' testimony before the Senate Finance Committee in February of 1933 lays it out nicely. Now, as then, there is a decline in velocity and output without a decline in real assets. No major physical calamity, just a financial crisis stemming from bad faith and shocks to expectations.

My own sentiment is that distribution of wealth/income (using Gini coefficient and a sort of compounding effect) affects the value of currency, which affects the terms of exchange and then the volume of exchange, given a stable money supply. The fiscal solution would be increasing the progressivity of taxes (marginal rates, property taxes, and EITC) and increasing government spending to soak up excess unemployment and redistribute through wages. Combine that with sound (not careless) government investment in public goods and you have a slow and steady path back to stability. I'm not sure if there is a recognized coherent theory that formalizes these connections. I know my macro profs treated me like a heretic for bringing it up though.

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