Arnold Kling  

One-paragraph Macro

Are Government Subsidies to Hi... State GovernmentPensions...

Brad DeLong writes,

In normal times, when one investor wants more liquidity or safety, another will be willing to take on duration and risk, and they will simply swap portfolios at current market prices. But in abnormal times, they cannot: The semiconductor fabs are long-run, durable, risky assets that cannot practically be liquidated. And so when the everybodies all decide that they want liquidity and safety -- well, the economy cannot magically liquidate the fixed capital stock at a reasonable price. And to liquidate at falling prices creates mass unemployment.

Brad is constrained by space (he is writing a book review in a newspaper), but this is about as good a one-paragraph summary of macro that you will find.

I'll add this. A real business cycle is when those semiconductor fabs should not have been built in the first place. Some surprising event has made them a poor use of long-term capital. A Keynesian business cycle is when the fabs are still the best use of long-term capital, but there has been a mass increase in liquidity preference.

The drop in housing construction is part of a real business cycle (at least in housing). The financial crisis looks like a mass increase in liquidity preference. However, it also looks to me like a real business cycle taking place in the financial sector--the financial sector became bloated, and the market is sending it a signal to contract. That is what makes me think that the consensus to focus on Keynesian remedies today may be wrong. To the extent that liquidity preference is a problem, I think that we should penalize it.

Comments and Sharing

COMMENTS (15 to date)
Greg writes:

Great distinction between the two cycles! Thanks.

Gary Rogers writes:

I think we have been doing a pretty good job of penalizing liquidity preference for the last 50 years and it has resulted in the low savings and high levarage. We are now in the process of delevaraging, which cannot be helped through Keynesian stimulation. We are headed for a long adjustment period.

Grant writes:

Has there ever been a Keynesian business cycle?

Devin Finbarr writes:

Moldbug looks more right every day.

I think the best way to understand a credit crisis is to make an analogy with stock bubbles.

In a stock bubble, people price stocks based on what other people will pay for the stock. Stocks become collectibles, like baseball cards or tulips. When the bubble pops, stocks revert back to being priced based on dividend yields. This can result in a wild swing in share price, even when the underlying company maintains a predictable level of growth.

Credit market bubbles happen the same way. People price 30-year bonds based on what other people will pay for the bonds, not based on holding them to maturity. When a person expects to be able to sell a bond instantly, they may accept a very low yield, perhaps 2%. But if we expected to hold the bond to maturity, we would demand a 9% yield. When the credit bubble bursts, pricing reverts back to what people would pay based on holding to maturity.

People need to realize when they buy a bond without the intention to sell someone else, they have introduced market psychology risk. Buying an AAA 30-year bond paying 2% yield, with the sole intention of selling it before maturity, is as risky as buying Intel in 2000. The underlying cash flow is perfectly safe, but the asset is way overpriced.

The best way to understand the financial crisis is to imagine the money market funds all held Intel stock. The funds bought the stock at $50 with a dividend yield of 2%. The bubble bursts, and even though Intel is doing fine, no one will buy the stock for more than $12. Everyone is yelling "liquidity crisis!" because they can't sell the stock at the original price of $50. People are astounded that the stock is selling for pennies on the dollar, even though the underlying cash flow is fine. They decry the market "fear". They demand the lender of last resort to "provide liquidity". Of course, what they call a "liquidity crisis" is simply supply and demand. The $12 is the accurate price. The $50 was the bubble price, based on the idea that there would always be another sucker to buy the asset at an inflated price.

Preventing something like the current financial crises is actually rather simple in theory: Any fund that has a mandate to invest in safe instruments must invest with the assumption that everything they buy will be completely illiquid. They must buy based on the assumption that they will hold to maturity. Furthermore, any time long term AAA paper is funneled through a CDO CP Put provider and turned into 180 day commercial paper, the resulting commercial paper should be rated as junk bonds. The yield of the bond might be risk-free, but the market price for selling that yield short term is extremely volatile.

In other words, to quote Mises ( via Moldbug): "The date on which the bank's obligations fall due must not precede the date on which its corresponding claims can be realized. Only thus can the danger of insolvency be avoided."

Richard writes:

Perhaps that excerpt from Delong's article is a good one. But check out this, from the very end. As best I can tell, it's not even a sentence! The LA Times needs an editor!

"And the problem this time is that we did not understand the degree to which all the mortgage finance companies, investment conduits, MBS vehicles, CDO tranches, monolines and other non-bank financial players that had taken on the role of banks -- of making long-term durable risky investments yet promising those who contributed the funds that their funds were liquid and safe -- without being regulated like banks."

bgc writes:

AK continues to be almost the only economist I read who is not sounding like a carpetbagger.

But another one who has kept his integrity is Thomas Sowell - and Sowell always emphasises the questino 'Then what would happen' as necessary to evaluating policy.

In other words, what would the new set of incentives do?

And - given that politics is always about trade-offs - what would be the downside of penalizing liquidity preference in this way?

E. Barandiaran writes:

You're right. DeLong's paragraph is a good summary of what many economists call macro. But it's nonsense. There is nothing in the theory behind the paragraph that can explain why suddenly people will change their mind--why normal times become abnormal. As long as these changes are treated as exogenous you don't have a theory: neither living systems nor nonliving matter can survive large "exogenous" hits (have you ever been in an earthquake?). Anything that you can say about how to deal with these hits depend first on their nature (this is why we usually like to start with a diagnosis of the problem) and then on their consequences and how to reduce them. So far we have many ideas about what has happened and what we can do, but I'm sure you will agree that we don't have a diagnosis and therefore we don't have a plan (I've just read that some monitor of bailouts is complaining about the mess that they have become). Sorry, DeLong's ideas have little value added: his last paragraph could have been written by any of my children, none of which has any training in economics.
I think that for more than two months you have been confusing what to do with the "stock" problem (the legacy of the ongoing crisis) and what to do with the "flow" problem (the prevention of a new crisis). Unfortunately macro theory does not help you to understand the ongoing crisis and offers not guidance on how to prevent future crisis. I learnt this in the Chilean crisis of 1982/83, after teaching macro theory for many years. The theoretical developments of the past 25 years have contributed to understanding how the economy works in normal times, but nothing about how abnormal times occur and more importantly how to prevent them.
I couldn't understand what would be the purpose of penalizing liquidity--you don't penalize people running out of a theatre that is burning.

E. Barandiaran writes:

One more point. I think that the discussion about the last war (the Great Depression) is motivated by the frustration of not having anything useful to say about the ongoing war. By the time we understand the similarities and differences between the two wars--what would be very helpful to a diagnosis--we will be confronting a new war. This discussion is strong evidence of how useless macro theory is to understand the ongoing crisis.

Bill Woolsey writes:

Explain how this flight to safety and liquidty can generate mass umeployment without monetary disquilbrium.

The factories can still sell their products at current (or higher) nominal prices, but the desire for safety and liquidty means that they cannot get the fiancing to fund them. So there are shortages of goods and services.

I don't believe it.

IT is rather that people must want to hold a larger quantity of the medium of exchange than is supplied. (That is where this desire for liquidty is relevant. A demand for money. And, perhaps, banks holding reserves reducing the supply of money.) It is easy to obtain more money. Spend less. The result is that firms sell less. This includes computer factories.
The problem isn't that they could sell their products at current prices but no one will finance them becaue they are too risky. It
is rather that they cannot sell their products.

And, by the way. When their sales fall off, they
have trouble getting loans to carry them over the
lean period. It looks like there is this irrational rush to safety and liquidty.

As for Kling's "real business cycle," shifts between sectors of the economy happen all the time. We can imagine it being so large that structural unemployment rises so much and there is such a large loss in specific capital, that we see a "recession." But the logic of the situation involves other sectors that have been starved for resources. They are expanding as fast as possible, and the only reason for the recession is that they can't expand as fast as the shrinking sectors shrink. Well, let's do some history and show that this is what is happening. Where are these expanding sectors that just can meet demand fast enough?

I think a true "real business cycle theory" would require that people were saving more and accumulating extra capital because of illusionary capital productivity, and workers were working more because of real wages that only could be generated from these production processes that don't really turn out as well as thought.

When we find out the truth, then people will want to save less and workers will work less. So, we see temporarily less unemployment (as the labor force participation rate falls) and more consumption (as the return on postponing consumption falls.)

Further, how can the failure of the production processes to pay off as hoped be anything other than fewer goods getting produced, and so shortages?

Unless of course, we have monetary disquilibrium.

The first principle of macroeconomics should be scarcity.

The second, should be monetary equilibrium/disequilibrium.

Every explantion should start with both of those.

Anyone who wants to, can then say... and the immedately monetary disequiliberium is corrected by a general deflation of all prices and nominal incomes, creating the real amount of money poeple want to hold... So any output effects are due to....

And then, anyone with any sense can say.. no..
prices and nominal incomes will not smoothly deflate.

How plausible is this story in the context of growing nominal expenditure? What is it that is causing money supply or demand to change in a way that prevents growing nominal expenditure?

fundamentalist writes:

DeLong’s article provides more heat than light. He wrote:

“And so when the everybodies all decide that they want liquidity and safety -- well, the economy cannot magically liquidate the fixed capital stock at a reasonable price. And to liquidate at falling prices creates mass unemployment.”

Austrian economists have been trying to get mainstream econ to understand this for over a century. Capital is not homogenous. It takes various forms. Some forms are more easily liquidated than others. If all capital goods were easy to sell, there would be no depressions.

DeLong: “If the everybodies want liquidity in their portfolios but the private market cannot turn durable capital into directly useful cash, Krugman argues, the government should step in and do so: It should directly or indirectly buy the long-term bonds that underpin our social investments in exchange for cash that it prints up fresh for the occasion. A confidence trick? Yes. A potential source of inflation? Possibly. But it works. “

It doesn’t seem to bother DeLong that he doesn’t even ask why everyone suddenly desires liquidity. It just happens, like other shocks. Mainstream economists have gotten away with the “shock” nonsense far too long and it’s time readers told them they have no clothes on. Stuff happens, or shocks occur, is not an explanation; it’s a pure admission of ignorance. They would be more honest to just say they don’t know. The reason for people desiring liquidity suddenly is the main cause of liquidity crises.

Economists should find out what causes people to change their minds. Individuals change their minds all the time, but it’s rare for a large segment of the population to go off in the same direction at the same time. People and businessmen want liquidity in uncertain times. Uncertain times are caused by large amounts of business failures. Mainstream econ needs to figure out why failures cluster on a fairly regular basis. Austrians have already figured it out.

DeLong says that the government should step in and provide liquidity because “it works.” He doesn’t know what caused the sudden desire for liquidity, but he is certain that the gov can stop it and he has the historical examples to prove it. But how does he know that? He must assume that the economy can not recover on its own, that without state intervention the economy would do nothing but get worse. That flies in the face of historical economics. DeLong credits state intervention for the recovery when the truth may be that the economy recovered in spite of state intervention. That’s what Austrian econ would predict.

DeLong quotes Krugman’s solution for bankers behaving as bad boys: “Krugman's principle is: "[A]nything that . . . plays an essential role in the financial mechanism should be regulated when there isn't a crisis so that it doesn't take excessive risks" -- that is to say, if things turn out badly, the entire financial sector won't freeze up.”

So I guess DeLong and Krugman assume that we had no bank regulation at all before the current crises? No. They’re not that stupid. How about this: past regulation failed miserably so lets add some more. But what are we to assume they think about the massive regulation of banks until the crisis hit? Regulations were stupid and regulators lazy? What makes them think future regulations will be less stupid and regulators less lazy?
The problem with the irrational faith in regulations that DeLong and Krugman have is that it must assume that regulators are smarter than bankers. They’re not. Bankers are not teenagers acting badly. They’re among the smartest businessmen in the country, far smarter than any state flunky trying to oversee the banks. However, when the Feds monkey with interest rates they distort prices across the entire economy. Businessmen need accurate prices in order to plan well. Distorted prices ruin well-reasoned plans and make the planners look stupid or irresponsible. As Kling wrote, “A real business cycle is when those semiconductor fabs should not have been built in the first place.” So why was it built? Were the planners just stupid? No. Artificially low interest rates made the plant look profitable for the long run. But once the plant was built, the owners found that they had to compete with consumer goods manufacturers for scarce resources because consumers hadn’t reduced consumption. Suddenly the prices of inputs rise to the point that making chips is unprofitable. In addition, real interest rates rise enough to make it even less profitable. So they fail.

DeLong: “Japan did it in 1998, investing the equivalent of $2 trillion when scaled to the U.S. today.”

So DeLong thinks there is no limit to how much the gov should spend to rescue us. But where does he think the gov gets his money? That insight alone is the acid test of an economist. The gov has no money of his own. He either borrows, taxes or counterfeits money. Borrowing and taxing does not create more wealth; it merely redistributes it. Counterfeiting has its own problems, the least of which is price inflation. In short, DeLong says to destroy our children’s future in order to save ours. That is so typical of narcissistic baby boomers. Our children will curse us for burdening them with huge government debt, high inflation and a stagnant economy.

DeLong: “We won't make this mistake again. At least not for a generation.”

How many times do we have to listen to that in our lifetimes? Did DeLong learn nothing from the stagflation of the 1970’s?

8 writes:

A Keynesian business cycle is when an "attractive hooker" offers free sex, but no one wants it. Economists assume there's been a massive change in "sexual preference". Government intervention is necessary, first with free porn and condoms, and eventually with free beer. Later, Joe Sixpack wakes up with a hangover and an STD, and can't find his keys or his wallet.

winterspeak writes:

Arnold: Moldbug has been the first to call out maturity transformation as being the key reason why the credit bubble in the mortgage market turned into a complete meltdown of the financial system.

You have a number of posts where you tried to make sense of this assertion.

You are now saying that "liquidity preference" (an awful phrase -- I'm guessing you mean a desire to convert any and all asset allocations to cash *now*) is the key exacerbating factor that generated the crises. You say it should be penalized. Are you willing to say it should simply be outlawed, and that monies loaned and borrowed should have matching maturities?

fundamentalist writes:

The stylized calculations of GDP give too much weight to consumer goods. As a result, GDP doesn’t decline until retail gets into trouble, which happens only at the beginning of the recession. That’s why so many economists mistakenly think that consumer spending drives the economy; they focus on GDP. In terms of employment, the capital goods and raw materials industries occupy a far larger proportion of the economy than the GDP indicates. The business cycle starts in the capital goods and raw materials industries and ends with them. Every financial adviser knows that those industries are far more volatile than retail or distribution. But know one who focuses on GDP will get it. Consumers stop spending because some of those employed in the capital goods and raw materials industries have lost their jobs due to the failures of business plans.

fundamentalist writes:

8, that's a great analogy and very appropriate!

nicholas shackel writes:

I'd be interesting in hearing your response to this from Krugman

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