Arnold Kling  

What I'm Reading

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The Able Slave... Immigration, Skill, Efficiency...

The Kindle sample for Robert Hetzel's The Great Recession. I will probably buy the book, but its exorbitant price strikes me as profoundly unfair. If you are interested in the book, then I recommend my Million Mutinies series (continues here and here as helpful background. Hetzel assumes that the reader has some background in macroeconomics already.

Anyway, an excerpt from the sample:


One explanation highlights market disorder resulting from swings in the psychology of financial markets from excessive risk taking to excessive risk aversion. The other explanation highlights monetary disorder based on central bank (Federal Reserve) interference with the operation of the price system.

Within this framework, Hetzel is, along with Scott Sumner, an adherent of the monetary-disorder school. I belong to the market-disorder school, although I am not as Keynesian as is the typical market-disorderist.

Consider the following thought experiment. Call what we actually did--the bailouts, the stimulus, the actual path of monetary policy--plan A. Suppose that in March of 2008, when folks were contemplating a bailout of Bear Stearns, the Fed instead had gone with Plan B, in which Ben Bernanke says, "Folks, it looks like there is going to be some heavy weather ahead on Wall Street. A lot of firms are in shaky situations. I want everyone to know that, no matter what happens, (a) we are not going to do anything to assist any individual firm; and (b) we are not going to allow nominal GDP to fall below the path in our forecast, which calls for an increase of 5 percent per year."

What would have happened? One possibility is that, ironically, market disorder would have been reduced by such an announcement. For example, it is highly unlikely that October's "break the buck" incident would have occurred. Lehman would have had to negotiate from weakness with potential purchasers. And Reserve Primary would have had to think twice about loading up on Lehman paper. (Reserve Primary was the money market fund whose shares fell below $1 in value when Lehman went bankrupt.)

But let's assume the opposite. Let's assume that there would have been at least as much market disorder under Plan B as there was with the bailouts, and that under plan B nothing like TARP would have been considered. In that scenario, perhaps some firms would have gone under, perhaps not. But let's assume that the "run on repo" and the overall contraction of the shadow banking system would have been as bad or worse with plan B as what actually took place.

Would the market response to Bernanke's promise to maintain nominal GDP have resulted in the economy remaining closer to full employment? I can think of three channels.

1. Wage rates. If anything, workers who believed the hypothetical promise to maintain nominal GDP would have been less likely to make wage concessions. Thus, this goes the in the wrong direction.

2. Domestic investment. In theory, investment projects should have looked more promising. But which ones? Not housing or commercial development in the "sand" states. Construction activity elsewhere? Factories? Computers? Maybe we can tell a story in which stock market investors do not sell stocks, Tobin's q does not fall, and so investment does not fall. Or maybe not. Perhaps the declines in the stock prices of financial stocks would have been even worse and more long-lasting.

3. International trade. If domestic demand does not respond to Bernanke, then the only way he can keep his promise is through a large devaluation, resulting in an increase in exports and a decline in imports.

If you're a market-disorder adherent, what do you think about Plan B vs. Plan A? Again, let's stipulate that there would have been more market disorder without the bailouts. Does that mean, not withstanding the huge currency devaluation, inflation and nominal GDP would have been no higher than under plan A?

That is the question that I would like to see posed to the IGM Experts Panel. Based on their previous answers, I would say that most of these folks are market-disorder adherents.

My own answer is a bit unusual for a market-disorder person. That is, I think that plan A exacerbated rather than alleviated market disorder. But I don't think plan B would have done much good, either. I would have preferred a "plan B lite" which would have made an effort to keep nominal GDP growth at 5 percent, but without an ironclad commitment. My guess is that real GDP was bound to decline in the latter part of 2008, and the only way to maintain nominal GDP growth of 5 percent over that period would have been to cause a lot of inflation. But I cannot see any harm in 3 percent nominal GDP growth (in fact, it actually declined in the last half of 2008 and the first half of 2009).



COMMENTS (5 to date)
Major_Freedom writes:

Consider the following thought experiment. Call what we actually did--the bailouts, the stimulus, the actual path of monetary policy--plan A. Suppose that in March of 2008, when folks were contemplating a bailout of Bear Stearns, the Fed instead had gone with Plan B, in which Ben Bernanke says, "Folks, it looks like there is going to be some heavy weather ahead on Wall Street. A lot of firms are in shaky situations. I want everyone to know that, no matter what happens, (a) we are not going to do anything to assist any individual firm; and (b) we are not going to allow nominal GDP to fall below the path in our forecast, which calls for an increase of 5 percent per year."

This is an impossible thought experiment, because (b) presupposes a failure of (a).

If the Fed was going to not let NGDP fall below 5% growth per year, then unless they were going to send money out via helicopters, and increase EVERYONE'S bank balances, then it is inevitable that certain individual firms will be benefited, for example, the primary dealers are typically the only firms that the Fed sends money to.

In a world of collapsing spending, where the prices of everything have nowhere to go but down, sending checks to the primary dealers is a handout, regardless if they sent the Fed treasury bills, MBSs, etc, in return. The prices the Fed pays will ipso facto be higher than what those prices would have otherwise been had the primary dealers sold these securities to other market participants who are experiencing stress because they can't print their own money.

Here's the fundamental flaw in "NGDP/AD" type thinking: It fails to include relative spending, relative prices, spending here versus spending there, and prices here versus prices there.

If the market's spending is falling, but then the Fed gives money to some bank, after which the "aggregated" spending total goes back up, there is no general increase in prosperity. Those who didn't receive the money would still be experiencing losses, and those who did receive the new money will be able to avoid losses, or at least spend more money on goods, which depreciates everyone else's purchasing power.

Also, because NGDP/AD targeting necessarily leads to certain firms receiving the new money first before all others, it generates relative price changes, since what they spend their money is not everything in the economy, but only what they buy in particular.

Relative price changes brings about real capital structure changes. It's inevitable. Yet these changes are not the consequence of consumer preference changes, but solely monetary changes.

That in turn makes the new, altered capital structure completely dependent on continued inflation to sustain it, and not only that, but it requires accelerating inflation, since the more inflation is used, the more altered the capital structure will become, which require even more inflation to be sustained. It's a vicious cycle.

So what would have been the result if Bernanke credibly announced 5% NGDP in 2008? The market would have not corrected by as much as it has, since it would have required even more inflation at the time, and thus a prolonging and intensifying of capital structure stress, but observationally, there almost certainly would have been a smaller drop in employment and output.

But is employment the goal? Is just any old output the goal? Or should the goal be sustainable employment, and sustainable output?

Avoiding corrections, i.e. maintaining employment and output, via inflation and the relative price and spending changes therein, would not have eliminated the needed corrections to a stressed capital structure.

Perhaps the only way that 5% NGDP targeting MIGHT avoid stressing the economy's capital structure, would be if the Fed sent checks to every single person who owns dollars, in the exact same proportion according to their existing cash balances, to whatever degree results in 5% NGDP growth. I am sceptical however, because when people are suddenly awash with new money, it is possible that their consumption/investment habits might change. The collective actions of people therefore might result in a stressing of the capital structure. The other problem is that individuals might "game" the system, by purposefully hoarding cash that the Fed sends, thus compelling the Fed to keep sending more and more money as people stockpile money. Sure, people who do that might end up earning a negative real return on their cash holding, but they're still making a net gain in gross terms because they're getting free cash! It would be like getting $100 which you can use to buy 2% fewer goods from the tracked basket each year you hold onto it. Even as the years pass, you're still in control of "free" purchasing power.

Indeed, if the tracked basket of goods contains a good that is "underweighted" according to your personal consumption basket, you might actually end up gaining a positive return on your cash, for example today, if your personal basket has lots of electronics, which typically fall in price.

Or you might live in a small apartment, and notice that the tracked basket of goods puts far more weight into houses than your personal basket. You will pay lower prices for the things you buy, than someone who buys a house pays for the things they buy. Of course the comparison is all wonkey because of the differences in goods, but you get the point.

Mike Rulle writes:

This is great, including Million Mutinies.

I would have preferred "B", but who knows?

I still have a hard time accepting that a drop in housing prices to levels present just 5 years earlier (2003) was sufficient to cause the subsequent havoc. It is much more simple to believe we exascerbated the problem through governmental panic, driven by persuasive "selling" by Wall Street Firms to have the US backstop them. Losses had already been taken that were close to $1 trillion----yet the top 30 banks had used only $130 billion of Tarp money 18 months later. Most large top 10 banks actually had a profitable year in 2008 which is still hard to believe.

But many were predicting the mark to market losses would still be in the multiple trillions because of derivatives (in which AIG ended up being the only concentrated uncollateraized holder of credit derivatives---for every seller of credit risk in the derivatives market there was usually a collateralized buyer of the credit risk).

Plus we cannot isolate the financial markets from the presidential politics of 2008. Never before has such a crisis occurred so close to a presidential election. 2008 should have resulted in similar outcomes as 1998 (LTCM) and the S&L crisis but it did not. There was a political interest to create a crisis---hence the term "Depression Porn"---coined by Virginia Postrel. This has also been followed by a new government philosophy. Who can say what has caused what? But I remain an anti-modernist or a believer in "regular economics".

Also, metaphorically LTCM was AIG---and Greenspan forced the banks to put up their own money---as banks were already doing with AIG----and he ironically was criticized for "bailing out LTCM". Nothing prevented the Feds dong that again this time. Except this time, out of the blue, AIG came to be perceived as the melting nuclear core of the financial world---when it was really just a big nothing.

At the end of the day it all "just happened". It is not longer possible to disassemble the pieces and come up with a coherent theory explaining it. Like "Universes", unexplained economic turmoil are just one of those things that happen from time to time.

And next time will be different.

Komori writes:
I still have a hard time accepting that a drop in housing prices to levels present just 5 years earlier (2003) was sufficient to cause the subsequent havoc

Take in isolation, no. However, once you take high leverage into account, it doesn't take much of a drop to completely wipe out the initial investment. Compound that by having everything else running on the same kind of leverage (banks in particular) and it doesn't take much of a shock to get the dominoes started.

Philo writes:

That should read: “. . . in which Ben Bernanke, *speaking for a unanimous FOMC*, says . . . .”

Ari Tai writes:

Perhaps "A" with more-or-less random (public drawing) of businesses that have been rescued by the public purse to be auctioned off in whole or in part - where shareholders and management are reminded to at least the degree of Roman Legion "decimation" that there are (business, if not life-ending) consequences.

Perhaps the draw / lottery continues until 10% of the rescue funds are recovered - i.e. the sum of pre-cash value of the firms drawn matches 10% of the rescue, perhaps in tiers by business valuation - amount of support - if not uniformly distributed.

I (still) think we have Spitzer to thank for AIG's troubles. It wasn't until after he drove the founder out that AIG put revenue above principles (and perhaps the larger crash is really a measure of the general decline of civil society - just because something isn't clearly illegal doesn't mean it's not evil).

Then again, this is what we get for not preparing our brightest students in our best schools to succeed in disciplines that build things (like STEM) given competition from foreign students - they go where intellect is rewarded but technical skills are not needed (like law & finance). And given supply creates (legal) demand, we now have (perhaps the majority of the) electorate that think law and regulation are a substitute (for civil society). (and that an economy can be managed - because our models of human behavior are so precise we need not worry about free-will).

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